The Zinn Company plans to issue $10,000,000 of 20-year bonds in June to help fin

Question

The Zinn Company plans to issue $10,000,000 of 20-year bonds in 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 11%. However, the firm's financial manager is concerned that interest rates will climb even higher in coming months. The following data are available: Future prices: Treasury Bonds - $100,000; Pts 32nds of 100% Delivery month Open High Low Settle Change Open interest December 94'28 95'13 94'22 95'05 +0'07 591,944 March 96'03 96'03 95'13 95'25 +0'08 120,353 June 95'03 95'17 95'03 95'17 +0'08 13,597 a. Use the given data to create a hedge against rising interest rates b. Assume that interest rates in general increase by 200 basis points. How well did your hedge perform? c. What is a perfect hedge? Are any real-world hedges perfect? Explain.

Explanation / Answer

after the explanations, here's an example. suppose you need to buy oil in future and are worried about price increase. you could use a few methods, since you mentioned futures here goes. Now: do nothing , BUY oil contracts @ contract size x price per barrel x no. of contracts needed based on your business. eg, $1mil suppose when you need to buy physical oil, the prices have gone up by 1%. now you close your futures position, cash in the profit, and use it to offset the higher costs of the oil, by Buying your oil @ $1.1mil, Selling the same no. of oil contracts, and making a $100k profit. notice that you would have made a profit from the futures position, and u can use it to offset your physical oil's buying price. in effect, your oil buying price is $1mil. notice that in real life, perfect hedging like this is almost impossible, as i) there could be a commodity basis risk for even things like oil, because of the different grading of the commodity in issue. (eg, jet oil vs palm oil, you have to hedge on the nearest match you can find as their beta is about the same and so ought to move in a similar direction in price) ii) the maturity date might differ from the date that you need your physical goods, iii) the size of the hedged futures amount might differ. eg, if the contract size is 10 barrels per contract and you have 14 barrels to hedge against, you can either choose to hedge 10 or 20 barrels. also, hedging with futures is not meant to make you any profit(maybe abritary profits, but not often). as you can see, when your futures earn, you lose in your commodity, and vice versa. its like a sort of insurance on the prices, if you want to see it that way.

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