Company X plans to issue $20 million in bands, three months from now. The bonds

Question

Company X plans to issue $20 million in bands, three months from now. The bonds will have a maturity of l5 years, and an annual coupon rate of 7%, paid semi-annually. It is expected the bonds will be issued at par. However, there is considerable uncertainty as to the actual required return on these bonds three months from now. For this reason, Company X has decided to hedge the risk over the next three months using T-bond futures contracts. The futures contracts are on a 20-year Treasury bond. The annual coupon rate is 6% paid semiannual. The Treasury bond is also trading at per. Each contract is for a face amount of $100,000. Assuming the required return on the Treasury bond will changes by 0.5% for every 1% change in the required return for Company X's bonds, calculate the hedge ratio. How will Company X hedge its risk? Explain whether the company will buy futures contracts or sell futures contracts. How many contacts will it buy or sell?

Explanation / Answer

1) Hedge Ratio = Value of the bonds/face amount of future per contract * beta

20*10/1*0.5 = 100 contracts

2)The company should buy the futures because it is uncertinity for the actual required return on the bonds hence irrespective of the market return it definently receives 6%.

No. of contracts to buy = 100

Value = 100*1 = 100 Lacs

Example- If the required return increases to 8 % then

Amount payable on bonds = (20*10*8%) = 16

Amount receviable on future = 100(8-6)% = 2

Net amoutn =14

Amount payable if required return is stable = 20*10*7% =14 only

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