Q2 The treasurer for Tophamcomp wishes to use financial futures to hedge her int
ID: 2662451 • Letter: Q
Question
Q2 The treasurer for Tophamcomp wishes to use financial futures to hedge her interest rateexposure.She will sell five Treasury futures contracts at $100,000per contract. It is July and the contracts must be closed out inDecember of this year.
Long-term interst rates are currently5.2 percent. If they decrease to 4.0 percent, assume the value ofcontracts will go up by %10.Also if interest rates do decrease by1.2 percent, assume the firm will have reduced interest expense onits business loans and other commitments of $50,000(i.e a savingsof this amount). This reduced expense, of course, will be separatefrom the futures contarcts.
a)What will be the profit or less onthe future contract if interest rates go to 4.0 percent?
B) Explain why a profit or less tookplace on the futures contracts
c) After considering the hedgingin part a, What is the net cost or profit to the firm of thedecrased interest expense of $50,000 What percent of this decreasedcost did the treasurer effectively hedge away?
d)Indicate whether there would be aprofit or loss on the futures contracts if interest rates wentup.
Explanation / Answer
a.) In this case, the interest rates have fallen and the Trophamhas sold Treasury futures, therefore there will be a loss when thefuture is closed = (5*100,000)*.1 = 50,000 USD. b.) A borrower will sell an interest rates future when he/sheexpects the interest rates to rise; so if the rates go up and hisdebt service increases, it will be offset by a profit from thefutures contract. On the other hand, if rates fall, the cost ofservicing the debt goes down, but there is a loss while closing thefutures contract. c.) It is 0. 100% of the interest exposure was hedged. d.) If futures contracts went up there will be a profit on thefutures contract.
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