The treasurer for Pittsburgh Iron Works wishes to use financial
futures to hedge her interest rate exposure. She will sell five
Treasury futures contracts at $164,000 per contract. It is July and
the contracts must be closed out in December of this year.
Long-term interest rates are currently 8.30 percent. If they
increase to 9.50 percent, assume the value of the contracts will go
down by 10 percent. Also if interest rates do increase by 1.2
percent, assume the firm will have additional interest expense on
its business loans and other commitments of $100,000. This expense,
of course, will be separate from the futures
contracts.
a. What will be the profit or loss on the futures
contract if interest rates increase to 9.50 percent by December
when the contract is closed out?
b-1. After considering the hedging, what is the
net cost to the firm of the increased interest expense of
$100,000?
b-2. What percent of this $100,000 cost did the
treasurer effectively hedge away? (Input your answer as a
percent rounded to 2 decimal places.)
c. Indicate whether there would be a profit or
loss on the futures contracts if interest rates went down.
Loss | |
Profit |
a. If the interest rate increases to 9.50% the value of the future contract decreases by 10% i.e. 10% X $ 1,64,000 = $ 16,400
Decrease in value of the 5 contracts = 5 X $16,400 = $ 82,000/-
i.e. Profits = $ 82,000/-
b-1 Net cost to the firm of increased interest cost of $ 1,00,000 = increase in interest cost - Profits made from hedging = $ 1,00,000 - $ 82,000 = $ 18,000
b-2 Hedge away part of the $ 1,00,000 interest cost = Profits from hedge / Interest cost
= 82,000/ 1,00,000
= 82.00 %
c. profits
This is primarily because on an interest rate increase of 1.20 % 5 contracts made a profit of $ 82,000/-Similarly, On an interest decrease of 1.20% 5 contracts will make a profit of $ 82,000/-
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