PC Bank has $100,000 in fixed rate loans paying an annual interest rate of 10 percent, payable semiannually. PC Bank also has $100,000 in certificates of deposit. Their depositors demand the market rate of interest, whatever that may be. The market rate for certificates of deposit is prime less 2 percent. Currently, January 1, 2008 prime stands at 8 percent. PC Bank is satisfied with the current spread, i.e., the difference between the rate it receives and pays out, but worries that the spread could diminish if interest rates rose.

The Cybernet Bank is similarly worried. They too currently have a comfortable spread. In particular, they also currently receive 10 percent on their $100,000 variable rate loans (paying prime + 2 percent) and pay their depositors a fixed rate of 6 percent. Their certificates of deposit with a book value of $100,000 are fixed for 10 years. In contrast to PC Bank, The Cybernet Bank is concerned that interest rates will fall, eating into their comfortable spread.

Required:

i. PC Bank and the Cybernet Bank decide that they can both be better off by swapping their loan coupon payments. Explain why this is the case.

ii. Assume PC Bank and the Cybernet Bank sign a 10-year swap agreement on January 1, 2008, with settlement occurring on June 30 and December 31 of each year. In addition, assume that Cybernet adopted the FASB's Fair Value Option standard (SFAS-159), and decided to mark its certificates of deposit to market, and to show any gains/losses on its derivatives in income. If prime falls to 6 percent on July 1, 2008, for each bank, show the journal entries corresponding only to the swap agreement (including net settlement) for the following dates.

• January 1, 2008
• June 30, 2008

Assume the fair value of the swap agreement on June 30, 2008 is $3,000, reflecting the market's expectation of the present value of difference in future cash flows arising from the swap. Make sure to indicate which bank accounts for the derivative contract as a fair value hedge and a cash flow hedge.