Question

Swipe Technologies has $10 million of floating rate bonds that mature in 3 years and is concerned about interest rates rising in the next year. It wishes to hedge this risk with an interest rate futures contract. A one year Eurodollar futures contract is priced at 95.5.

1. What is the current interest rate?
2. Should the Treasurer buy or sell a futures contract?
3. If the interest rate in one year is 5.2% what would be the gain or loss on the futures contract in percent and dollar amount (notational of $10 m)?
4. What is the net gain or loss considering both the bonds and the futures contracts?

Answer 1

Solution:

Eurodollar is a deposits outside the united states denominated in $, which is denoted as (100 - LIBOR)

a) As Eurodollar futures contract is priced at 95.5, Therefore interest rate is (100 - 95.5) = 4.5%

b) As the treasurer is having a liability to pay interest on the floating rate bonds, he should hedge against interest rate rising risk by selling a futures contract at 95.5.

c) If the interest rate in one year is 5.2% then,

Eurodollar futures contract after one year (100 - 5.2) = 94.8

gain on a futures contract in % = (95.5 - 94.8) = 0.7%

gain on a futures contract = $ 100,00,000 * 0.7% = $ 70,000

d) As the interest rate rises to 5.2% our liability towards interest will also rise.

Loss on Bonds =$100,00,000 * (5.2 - 4.5)%

= $ 70,000

Therefore Net gain or loss is NIL.