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2 – Illustrative Example – Hedge Accounting: FV Hedge

FV Hedge: Hedged Item – Inventory; Hedging Instrument – Futures Contract

Assume that a Midwest hog producer has an inventory of hogs. On April 1, the producer decides to
hedge the fair value of the hog inventory by acquiring two July futures contracts to sell hogs (each
contract has a notional amount of 40,000 pounds) at $0.65 per pound. Assume the contracts are
settled on July 15. It is assumed that the terms of the futures contracts and the hedged assets match
with respect to the delivery location, quantity, and quality of hogs. On July 20, the producer sells
80,000 pounds of hogs at the current market price of $0.611 per pound and offsets the contract.
Assume that the producer’s carrying basis (book value) of the hogs is $40,000 before any adjustments
related to the hedging transaction. The producer designates the futures contract as a hedge against
changes in the fair value of hogs.

The fair value of the futures contracts will be based on changes in the futures prices over the life of
the contract. This difference represents the current marked-to-market value and no discounting is
required. [Effectiveness of the hedging relationship will be assessed by comparing changes over time
in the current spot prices for hogs and changes in the value of the futures contracts attributable to
changes in spot prices. The time value of the futures contract will be excluded from the assessment of
hedge effectiveness. The time value component of the futures contract is the difference between the
original spot rate and the original futures rate and is referred to as the spot-forward difference. The
time value will periodically be recognized over the life of the contract and is measured in one of two
ways. The change in the time value, spot-forward difference, may be calculated as either (1) the
difference between the change in fair value of the contract and the change in spot rates or (2) directly
as the change in spot-forward rates over time.] Relevant values are as follows:

April 1 May 1 June 1 July 15

No. of lbs. 80,000.000 80,000.000 80,000.000 80,000.000
Spot price/lb. 0.640 0.628 0.622 0.610
Futures price/lb. 0.650 0.635 0.624 0.610

FV Hedge: Hedged Item – Firm Commitment; Hedging Instrument – Forward Contract

Assume that on April 14, when the current spot rate is $172, a company makes a firm commitment to
sell 3,000 tons of inventories at the end of June for $172 per ton. It is estimated that the cost of
inventory sold under the contract will be $430,000. Concerned that prices may increase and that the
firm commitment will prevent the company from realizing even a higher sales value, on April 14, the
company enters into a forward contract to buy 3,000 tons of identical inventory at the current forward
rate of $173 per ton.

Relevant values are as follows:

April 14 April 30 May 31 June 30

Notional amount in tons 3,000.00 3,000.00 3,000.00 3,000.00
Spot rate per ton 172.00 174.00 174.00 176.00
Forward rate per ton for remaining time 173.00 175.00 174.00 176.00
Applicable discount rate is 6% (monthly compounding, use monthly compounding). Assume that
management has decided to measure changes in the value of the commitment based on changes in
the forward rates over time and that the suggested change in value is then discounted.

FV Hedge: Hedged Item – Fixed Interest Notes Payable; Hedging Instrument – Interest Rate Swap

Assume that on January 1, 20X1, a company has taken out an 18-month, $20,000,000 note from a
bank at a fixed rate of 7% with interest due on a semi-annual basis. On January 1, 20X1, believing that
interest rates are likely to drop, the company arranged to receive a 7% fixed rate of interest from
another financial institution in exchange for the payment of variable rates. Differences between the
fixed and variable rates are to be settled on a semi-annual basis. The variable rates are based on the
LIBOR rate + 1.25% (125 basis points) and are reset semi-annually in order to determine the interest
rate to be used for the next semi-annual payment. The notional amount of the interest rate swap is
$20,000,000, and the expiration date of the swap matches the maturity date of the original bank loan.
Relevant values are as follows:

Reset dates LIBOR + 1.25% (Rates for Next Period) Assumed Fair Value of Swap
Jan 1, 20X1 7.00%
June 30, 20X1 6.80% 38,000.00
Dec 31, 20X1 6.70% 29,000.00