Question

A company wishes to use financial futures to hedge its interest rate exposure. The company will sell 10 Treasury futures contracts at $137k per contract. It is Jul and the contracts must be closed out in Dec of this year. Long-term interest rates are currently 13.2%. If they increase to 14.52%, assume the value of the contracts will go down by 5%. Also if interest rates do increase by 1.25%, assume the firm will have additional interest expense on its business loans and other commitments of $53k. This expense will be separate from the futures contracts.

Note: The term “k” is used to represent thousands (× $1,000).

Required: In percentage terms, what is the net gain (or cost) to the firm once the increased interest expense is accounted for?

Answer 1

a. The profit or loss is calculated as follows:

Particulars	Amount ($)
Contract price (A)	1,37,000
Add: decrease in price by 5%	6,850
Revised contract price (B)	1,43,850
Profit per contract (B-A)	6,850
Total profit ($6,850 X 10)	68,500

b. 1. Calculation of net cost:

Particulars	Amount ($)
Profit	68,500
Less: interest	53,000
Profit	15,500

2. Calculation of percentage of perfect hedge:

$ of hedge=(Profit on hedge/Interest)×100

=($68,500/$53,000)×100

=129.25%