Question

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 $187,000 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 $118,000. 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? 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? 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?

  
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 $118,000?

  
b-2. What percent of this $118,000 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 dow

Answer 1

a	What will be the profit or loss on the futures contract if interest rates increases to 9.50% by December when the contract is closed out?
	Sales Price in December per contract				$187,000
	Less : Purchase price in December per contract
	($187000*0.90)				$168,300
	Gain per contract				$18,700
	Number of contracts				5
	Total Gain on 5 contracts				$93,500
b-1	After considering the hedging, what is the net cost to the firm of the increased interest expense of $118000
	Interest Expense		$118,000
	Gain on contracts		$93,500
	Net Cost		$24,500
b-2	What percent of this $82000 cost did the treasurer effectively hedge away
	% of net cost = Net Cost/Increase Interest Expense
		$24500/$118000
		0.207627
	Net Cost is 20.76% which means 79.24% of the interest cost was effectively hedge away by the treasurer
c	Indicate whether there would be profit or loss on the futures contract if interest rates when down
	When interest rates go down, it will lead to higher bond prices and the purchase price would exceed the sale price
	Hence there would be loss if interest rates when down