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.
a. To calculate the profit or loss on the futures contract if interest rates go to 8.5 percent, we need to find the difference in value between the current interest rate of 7.4 percent and the new interest rate of 8.5 percent, and then apply the 10 percent decrease.
Step 1: Calculate the difference in interest rates:
New Interest Rate - Current Interest Rate = 8.5% - 7.4% = 1.1%
Step 2: Apply the 10 percent decrease:
Difference in Interest Rates * 10% = 1.1% * 10% = 0.11%
Step 3: Calculate the dollar amount of the decrease:
Decrease in Value = $105,000 * 0.11% = $115.50
Therefore, the profit or loss on the futures contract if interest rates go to 8.5 percent would be a loss of $115.50.
b. The profit or loss on the futures contracts is determined by the change in interest rates and the impact it has on the value of the contracts. In this case, when interest rates increase to 8.5 percent, the value of the contracts will decrease by 10 percent. This decrease in value results in a loss on the futures contracts.
c. To calculate the net cost to the firm of the increased interest expense of $60,800 after considering the hedging in part a, we need to subtract the loss on the futures contract from the increased interest expense.
Net Cost = Increased Interest Expense - Loss on Futures Contract
Net Cost = $60,800 - $115.50
Net Cost = $60,684.50
The treasurer effectively hedged away $115.50 of the increased cost, which is approximately 0.19% of the increased cost ($115.50 / $60,800).
d. If interest rates were to go down, the value of the futures contracts would increase. This implies that there would be a profit on the futures contracts. However, the specific calculation of the profit cannot be determined without knowing the extent of the decrease in interest rates.