On July 1, 2020, a Company Borrows $1,000,000 at a Variable

Essay

On July 1, 2020, a company borrows $1,000,000 at a variable rate of prime plus 2.5%, to be renewed every three months. Interest is payable upon renewal. Prime is 0.8% on July 1. The company hedges against increases in interest rates by selling short $1,000,000 face value of three-month Treasury bill (interest rate) futures at 99.2. The margin deposit is $500. The futures qualify as a fair value hedge of the firm commitment to roll over the loan. On October 1, prime is 1.3% and the futures price is 98.7. The company closes out its futures position and rolls over the loan as agreed. The company has a June 30 fiscal year-end and reports all income effects of the loan and the futures in interest expense.
Required
a. What rate does the company pay on the notes during the 3-month period beginning July 1?
b. Prepare the entries necessary on July 1 to record the futures position, and October 1, 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 October 1. What is the effective annual interest rate during this period?
d. In hindsight, should the company have invested in the futures contract? Explain.