Hedging with Futures Contracts Recall that if the economy continues to be strong

Question

Hedging with Futures Contracts

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. Carson currently relies mostly on commercial loans with floating interest rates for its debt financing.

a. How could Carson use futures contracts to reduce the exposure of its cost of debt to interest rate movements? Be specific about whether it would use a shorthedge or a long hedge.

b. Will the hedge that you described in the previous question perfectly offset the increase in debt costs if
interest rates increase? Explain what drives the profit from the short hedge, versus what drives the higher
cost of debt to Carson, if interest rates increase.

Explanation / Answer

Answer:a Carson could sell Treasury bond (or Treasury bill) futures contracts. If interest rates rise, the values of Treasury bonds decrease, and the values of Treasury bond futures contracts decrease. A short position will result in a profit for Carson if interest rates increase, which can offset the higher cost of debt financing.

Answer:b No. The short position is not a perfect hedge. The profit from the short hedge is influenced by the movement in Treasury security prices, while the cost of debt is influenced by the short-term interest rate on commercial loans (which may be influenced by the rate the banks pay on short- term CDs. There is not a perfect offsetting effect.

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