T. J. Patrick is a young, successful industrial designer in Portland, Oregon, wh
ID: 2790733 • Letter: T
Question
T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teenager—he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he’s young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.
Recently, T. J. has started playing with financial futures—interest rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn’t go wrong with interest rate futures) and soon set up a trading account with Vinnie’s firm, Banano’s of Portland.
The other day, Vinnie called T. J. and suggested he get into five-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most—with the biggest jump in yields. Accordingly, Vinnie recommended that T. J. short sell some five-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short four contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.
Questions
Assume T-note futures ($100,000/contract; 32’s of 1%) are now being quoted at 103’16.
Determine the current underlying value of this T-note futures contract.
What would this futures contract be quoted at if Vinnie is right and the yield does go up by one percentage point, to 6.5%, on the date of expiration? (Hint: It’ll be quoted at the same price as its underlying security, which in this case is assumed to be a five-year, 6% semiannual-pay U.S. Treasury note.)
How much profit will T. J. make if he shorts four contracts at 103’16 and then covers when five-year T-note contracts are quoted at 98’00? Also, calculate the return on invested capital from this transaction.
What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105’8?
What risks do you see in the recommended short-sale transaction? What is your assessment of T. J.’s new interest in financial futures? How do you think it compares to his established commodities investment program?
Explanation / Answer
Solution:
1. The current underlying value is 103% & 16/32% or 103.5% of the face value. With a face value of $100,000, the T-notes are being priced at $103,500.
2. Time to maturity = 5 years or 10 payments
Interest rate r = 6.5/2 = 3.25%
PMT = $3000
Face value = $100000
Compute PV using financial calculator PV will be = $91889
Hence, quoted price will be 91-28
3.
(1.035 – 0.98) $100,000 x 4 = $5,500 x 4 = $22,000 gain
The initial margin is $1350 per contract, which results in a return on invested capital to
407.40% ($22,000/ ($1350 x 4))
4.
(1.035 – 1.0525) $100,000 x 4 = –$1,750 x 4 = –$7,000 loss–$7,000/ (4*1350) = –129.629%
It is possible to lose more than 100%, if T.J. Patrick continues to make maintenance margin deposits, as the rising value of the T-note exhausts his deposit.
5. The risk in short selling is that if price of T-note does not fall or interest rate will not rise, then we will lose all the investment. Also, the margin trading are decreasing the return on the investment. He will earn very good return if the price falls but at the same time he will have huge loss if interest rates fall. Therefore, if investment is risky but the good returns are expected at the very same time.
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