Hedging: The Zinn Company plans to issue $12,000,000 of 20-year bonds I June to

Question

Hedging: The Zinn Company plans to issue $12,000,000 of 20-year bonds I June to help finance a new research and development laboratory.       The bonds will pay interest semiannually. It is now November, and the current cost of debt to the high-risk biotech company is           6.0% However, the firm's finance manager is concerned that interest rates will climb even higher in coming months. A futures contract with June deliver is available at a price quoted as 98'16.

a. Use this information to create a hedge against rising interest rates.

b. Assume that interest rates in general increase by 150 basis points. How well did your hedge perform?

Explanation / Answer

Hedging of rising interest rates using futures contracts Futures are derivatives that derive the value based on the underlying asset. In case of rising interest rates, the company can sell future contracts. This will result in a fall in the value of the future due to a fall in the value of underlying asset, i.e., bond. On closing the futures transaction, i.e., by buying the future on the maturity date, a profit can be earned and the loss on account of increase in interest rates can be mitigated.

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