* Please just answer b & e all other questions have been answered** Question 4.

ID: 2807113 • Letter: #

Question

*Please just answer b & e all other questions have been answered**

Question 4. (20 points) A Treasury bond futures contract settles at 103'16.

a. Calculate the present value of one futures contract in dollars?

Current bond Percentage

103.50

103.5%

Present value of future contract

$ 103,500

b. Are current market interest rates higher or lower than the standardized rate on a futures contract? Explain.

c. Calculate the implied annual interest rate on the futures contract.

Treasury bonds

$ 100,000

Settle Price of 103'16

103.50

Settle Price of bond

$ 103,500

Cupon per annum

$ 6,000

Implied interest rate treasury bond

3.500%

d. Calculate the new value of the futures contract if interest rates increase by 1 percentage point annually.

Treasury bonds

$ 100,000

Settle Price of 103'16

103.5

Settle Price of bond

$ 103,500

Coupon per annum

$ 6,000

Implied interest rate treasury bond

3.500%

Implied annual interest increase + 1%

4.500%

Value of the futures contract

$99,043.06

e. Describe differences between forward and futures contracts? Illustrate, using a specific example, of how companies could use either a futures or forward contract to hedge a position.

Current bond Percentage

103.50

103.5%

Present value of future contract

$ 103,500

Explanation / Answer

b) The current market rates are lower as the contract prize of 103.50 is selling at a premium i.e the contract sells at more than its maturity value of $ 100.

Forward Contract

Futures Contract

Customized contract where two parties agree upon a price, quantity, and time to trade a particular asset. They are traded privately over the counter.

Standardized version of forward contract that is traded in an exchange.

Customization Possible as per the traders needs

No customization possible and is standardized

Negotiated directly by the buyer and the seller

Quoted and traded on the exchange.

High counterparty risk

Low counterparty risk

Contract settles by delivering the product

Contract settles either through delivery or cash settlement

The biggest cost for Airline companies is the cost of their fuel (Jet Fuel). It accounts for approximately 70 % of their total expenses. So airline companies are always prone to the risk of Jet Fuel prices rising, and hence they use futures/ forward contract to hedge this risk.

Jet Fuel contracts are not traded, so a close proxy of Jet Fuel, Crude Oil is used. If the company expects to Jet Fuel prices will be rising in the near future they will enter into a contract to buy a specific quantity of Crude Oil at a specific price and Specific time. This is called a Long Hedge where you are buying the forward/futures contract. By entering into the contract the Airlines Company has locked in a price for Jet Fuel, and thus removed price risk.