A company has a firm commitment to roll over a variable rate loan every 90 days. It hedges its interest rate risk by selling 90-day Treasury bills at a fixed price, for delivery in 90 days. The hedge is determined to be effective. Which statement is true?

Question

Quizplus · Accepted Answer

CA) When the Treasury bill rate increases, the value of the short position in Treasury bills (i.e., the commitment to sell Treasury bills at a fixed price) increases because the company can sell the Treasury bills at a higher rate than the fixed price it locked in. This gain on the hedge offsets the increase in interest expense on the variable rate loan, making it a beneficial hedge.C) In accounting for hedges, changes in the fair value of an effective hedge are recognized in other comprehensive income (OCI) until the forecasted transaction affects earnings. In this case, the changes in the value of the short position in Treasury bills are accumulated in OCI until the company recognizes interest expense on the loan, at which point the accumulated gains or losses are reclassified from OCI to affect earnings, thereby offsetting the variability in interest expense due to changes in interest rates.

A Company Has a Firm Commitment to Roll Over a Variable