The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge
ID: 2807372 • Letter: T
Question
The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge her interest rate exposure. She will sell five Treasury futures contracts at $187,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 8.30 percent. If they increase to 9.50 percent, assume the value of the contracts will go down by 10 percent. Also if interest rates do increase by 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $118,000. This expense, of course, will be separate from the futures contracts.
a. What will be the profit or loss on the futures contract if interest rates increase to 9.50 percent by December when the contract is closed out?
_____(Profit or loss)_____ on future contracts ____________
b-1. After considering the hedging, what is the net cost to the firm of the increased interest expense of $118,000?
b-2. What percent of this $118,000 cost did the treasurer effectively hedge away? (Input your answer as a percent rounded to 2 decimal places.)
Net cost _________
c. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.
Explanation / Answer
a. Sales price (sale takes place in July), December treasury bond contract: $187,000
Purchase price of contract when position is closed in december (187,000 x 0.9)= 168,300
Gain per contract= 187,000-168,300= $18,700
Total profit on sale of all five contracts= 18,700 x 5= $93,500
b1. Increased interest cost= $118,000
Gain from hedging= 93,500
Net cost to treasurer= $24,500
b2. The treasurer successfully hedged away 93,500/118,000= 79.24% of the total interest cost.
c. There would be loss on future contracts if the interest rates go down because the price of contracts will then increase to the extent where it surpasses the original sales price resulting in loss on sale of contracts for the treasurer.
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