On January 1, 2011, Cougar Company received a two-year $500,000 loan. The loan calls for payments to made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2011, was 10 percent. Aggie company also has a two-year $500,000 loan, but Aggie's loan carries a fixed interest rate of 10 percent.
Cougar Company does not want to bear the risk that interest rates may increase in year two of the loan. Aggie Company believes that rates may decrease and they would prefer to have variable debt. So the two companies enter into an interest rate swap agreement whereby Aggie agrees to make Cougar's interest payment in 2012 and Cougar likewise agrees to make Aggie's interest payment in 2012. The two companies agree to make settlement payments, for the difference only, on December 31, 2012. If the interest rate on December 31, 2011 is 12 percent, what amount will Cougar report as the fair value of the interest rate swap at December 31, 2011 (answers rounded to the nearest dollar)?

Question

Quizplus · Accepted Answer

To determine the fair value of the interest rate swap at December 31, 2011, we need to calculate the difference between the fixed rate paid by Cougar (10%) and the prevailing market rate at December 31, 2011 (12%).

Aggie will pay Cougar the difference between the fixed rate (10%) and the prevailing market rate at December 31, 2012. Assuming the market rate remains at 12%, Aggie will pay Cougar 2% (12% - 10%) on the $500,000 loan, or $10,000.

Similarly, Cougar will pay Aggie the difference between the fixed rate (10%) and the prevailing market rate at December 31, 2012. Since Aggie has a fixed rate loan, this payment will be zero.

Therefore, at December 31, 2011, Cougar has a liability to Aggie of $10,000, which is the fair value of the interest rate swap. The answer is B ($8,929 is the correct amount after rounding to the nearest dollar).

On January 1, 2011, Cougar Company Received a Two-Year $500,000