The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge

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 $164,000 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 $100,000. 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?
  
b-1. After considering the hedging, what is the net cost to the firm of the increased interest expense of $100,000?
  
b-2. What percent of this $100,000 cost did the treasurer effectively hedge away? (Input your answer as a percent rounded to 2 decimal places.)

c. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.

Explanation / Answer

a. If the interest rate increases to 9.50% the value of the future contract decreases by 10% i.e. 10% X $ 1,64,000 = $ 16,400

Decrease in value of the 5 contracts = 5 X $16,400 = $ 82,000/-

i.e. Profits = $ 82,000/-

b-1 Net cost to the firm of increased interest cost of $ 1,00,000 = increase in interest cost - Profits made from hedging = $ 1,00,000 - $ 82,000 = $ 18,000

b-2 Hedge away part of the $ 1,00,000 interest cost = Profits from hedge / Interest cost

= 82,000/ 1,00,000

= 82.00 %

c. profits

This is primarily because on an interest rate increase of 1.20 % 5 contracts made a profit of $ 82,000/-Similarly, On an interest decrease of 1.20% 5 contracts will make a profit of $ 82,000/-

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