Posted by Ann on Sunday, August 7, 2011 at 7:05pm.
The treasurer for Thornton Pipe and Steel Company wishes to use financial
futures to hedge her interest rate exposure. She will sell five Treasury futures
contracts at $105,000 per contract. It is July and the contracts must be closed
out in December of this year. Long-term interest rates are currently 7.4 percent.
If they increase to 8.5 percent, assume the value of the contracts will go down
by 10 percent. Also if interest rates do increase by 1.1 percent, assume the firm
will have additional interest expense on its business loans and other commitments
of $60,800. 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 go to
8.5 percent?
b. Explain why a profit or loss took place on the futures contracts.
c. After considering the hedging in part a, what is the net cost to the firm of the
increased interest expense of $60,800? What percent of this increased cost
did the treasurer effectively hedge away?
d. Indicate whether there would be a profit or loss on the futures contracts if
interest rates went down.
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