It is January, and Tennessee Sunshine is considering issuing $5 million in bonds

Question

It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20 year T-bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise as much as 1% before June. You looked online and found that June T-bond future psi are trading at 111'25. What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20 year T-bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise as much as 1% before June. You looked online and found that June T-bond future psi are trading at 111'25. What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%.

Explanation / Answer

If TS waits until June to issue its bonds, and if interest rates rise, then TS will have to pay a higher interest rate on its debt. How much does that cost TS? One way to calculate the cost is to see how much the 20-year 7 percent semi-annual bonds that it intended to issue would be worth at the new discount rate of 8%. Input N = 40, I/YR = 8/2, PMT = -5,000,000(7%/2) = 175,000, FV = -5,000,000 and solve for PV = $4,505,181.

                        Since they were going to be worth $5 million if they were issued immediately, then this represents a loss of $5,000,000 - $4,505,181 = $494,819. TS can hedge this risk by selling T-bond futures contracts.

                        The T-bond futures contracts are trading at 111 + 25/32 percent of par, or $111,781 for a $100,000 contract value. This means TS will need to sell 5,000,000/111,781 = 44.7. Because you must trade in whole contracts, TS will use 45 T-bond futures contracts to hedge the bond position.

                        T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon, semiannual payment bond, and the 111

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