Question

A company wishes to use financial futures to hedge its interest rate exposure. The company will sell five Treasury futures contracts at $126,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 14.30%. If they increase to 15.50%, assume the value of the contracts will go down by 15%. Also, if interest rates do increase by 1.20%, assume the firm will have additional interest expense on its business loans and other commitments of $99,000. This expense will be separate from the futures contracts.

1. What will be the profit or loss on the futures contract if interest rates increase to 15.50% by December when the contract is closed out?
2. (i) After considering the hedging, what is the net cost to the firm of the increased interest expense of $99,000?

(ii) What percent of this $99,000 cost did the company effectively hedge away?

3. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.

Answer 1

a) The value of contracts sold = $126000 * 5 = $630000

Value of contracts later when they are purchased = $630000 * (1-0.15) = $535500

So, profit on Futures = $630000 - $535500 = $94500

b) i) Net cost to the firm = $99000 - $94500 = $4500

ii) % of cost the company hedged = $94500/$99000 = 95.45%

c) If the interest rates went down, the Treasury futures price will increase (inverse relationship of bond prices and interest rates) and hence the company , having sold the treasury futures will lose on the Futures contract.