Hedging: The Zinn Company plans to issue $15,000,000 of 20-year bonds I June to

Question

Hedging: The Zinn Company plans to issue $15,000,000 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        7.0% 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 90'16

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

Assume that interest rates in general increase by 100 basis points. How well did your hedge perform?

Explanation / Answer

The future contracts are trading at 90'16 which is 90 + 16/32 = 90.50

The total cost of investing in the future contracts worth 15,000,000 at the end of 6 months in June = [100 - 9.50*6/12]/100 = 0.9525 * 15,000,000 = 14,287,500

Yield-to-Maturity of the future contract = [(15,000,000 / 14,287,500)^6/12] - 1 = [(15,000,000 / 14,287,500) ^ 0.5] - 1 = 1.024631 - 1 = 0.024631%

Increase in interest rate = 100 basis points = 0.01%

The hedge has been useful and yielded a return of 0.024631% as against the increase in interest rate 0f 0.01%

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.