On January 1, 2021, a Company Contracts with a Financial

Essay

On January 1, 2021, a company contracts with a financial institution to roll over $1,000,000 face value of its notes payable every 91 days at the Treasury bill rate plus 1.4%. The current annual interest rate on U.S. Treasury bills is 1.2%. The yield on Treasury bills is highly correlated with the yield on the company's floating rate term loans. To hedge against a possible interest rate increase, on January 1, 2021 the company sells short $1,000,000 face value of 91-day Treasury bill (interest rate) futures at 98.8 (1.2% annual discount yield), and deposits $300 cash with the broker as margin. The futures qualify as a fair value hedge of the firm commitment to roll over the notes. At the end of the 91-day period (April 2, 2021), the futures price has risen to 99.2 (0.8% annual discount yield) and the company closes out its short position. It rolls over its notes at the agreed-upon rate of 2.2%. All income effects of the notes and the futures are reported in interest expense.
Required
a. What rate does the company pay on the notes during the period January 1 through April 1, 2021?
b. Record the entries necessary on January 1 to record the futures position, and April 2, when the short position is closed out and the loan is rolled over.
c. Prepare the journal entry to record interest expense for the three months starting April 2. What is the effective annual interest rate during this period?
d. In hindsight, should the company have invested in the futures contract? Explain.