Question

The Aleander Company plans to issue $10,000,000 of 10-year bonds at par next June, with semiannual interest payments. The company's current cost of debt is 10 percent. However, the firm's financial manager is concerned that interest rates will increase in coming months, and has decided to take a short position in U. S. government t-bond futures. See the settlement data below for t-bond futures. (Note: One standard futures contract is $100,000

Delivery Month	Open	High	Low	Settle	Change	Open Interest
(1)	(2)	(3)	(4)	(5)	(6)	(7)
Dec	103'14	103'14	102'11	102'17	-6	678,000
Mar	102'11	102'23	100'28	101'01	-5	135,855
June	101'14	101'26	100'02	100'12	-5	17,255

a.(1) Calculate the implied yield on the futures contract?

(2) How many futures contracts will be needed to hedge potential losses in bond proceeds (based on current market conditions) due to waiting (round up to the nearest integer)?

(3) Calculate the total value of the hedge position.

b. Interest rates in general increase by 200 basis points The bond's terms don't change and that the coupon rate is still 10%.

(1) Calculate the amount of proceeds be given the new market rates?

(2) Calculate the loss in proceeds based on the original target for proceeds??

c. Assume that the company had entered the hedge found in part a.

(1) Calculate the new price of the hedge position?

(2) Calculate the gain on the hedge?

(3) Calculate the net effect of the loss of proceeds and the gain on the hedge?

d. Is this problem an example of a perfect hedge or a cross hedge? Is it an example of speculation or hedging? Why?

PLEASE SHOW ALL WORK

Answer 1

Delivery
Month	Settle
(1)	(5)
Dec	102-17
Mar	101-01
June	100-12

(since the bonds are to be issued in December, December futures are entered into)

A.

(1) Calculate the implied yield on the futures contract?

The implied yield is based on the quoted price and the hypothetical bond's coupon of 6% and maturity of 20 years.

Number of contracts needed for hedge =10,000,000/100,000=100

Settle price on futures contract as quoted = 102 and 17 32nds

Note that the price is quoted as a percent of par, and it is quoted in percentage points and 32nd of percentage points.

Settle price on futures contract (% of par, decimal) = [ 102+(17/32)]/100

=102.53125%

Maturity of bond underlying futures contract =10

Coupon rate on bond underlying futures contract =6%

N=                                             20(10*2)

PV=                      $-1,025.3125(102.53125%*1000)

PMT=                                    $30(6%*1000/2)

FV=                                  $1,000

I=2.8325

Implied annual yield =2.8325*2=5.665

(2) How many futures contracts will be needed

Calculated above-100

(3) Calculate the total value of the hedge position.

Calculated above-$10253125

B.

Calculate the present value of the corporate bonds if rates increase by 2 percentage points.

Anticipated rate on debt offering =10%

Maturity of planned debt offering =10(it is a 10 year bond)

Actual rate on debt offering =12%(10+2)

Cost of bonds (Value of bonds at old coupon and new interest rate)

N=	20	=10x2
I=	6.0%	=12.%/2
PMT=	$5,00,000	=(10.%/2) x$1,00,00,000
FV=	$1,00,00,000
PV=	$88,53,008

LOSS=8853008-10000000=-1146992

Interest rates increase as expected, by 2 percentage points. Calculate the present value of the futures position based on the rate calculated above plus the 2 points.

Increase in interest rates (basis points) =2%

New yield on futures contract =7.665%(5.665+2)

Value of futures position:

N=	20	=10x2
I=	3.8325%	=7.665%/2
PMT=	$3,00,000	=(6.%/2) x$1,00,00,000
FV=	$1,00,00,000
PV=	$88,51,638

Loss=8851638-10253125=1401487

D.This is cross hedging because they are using two different securities for hedging.

Only 4 sub- parts are solved as per guidelines.