The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge
ID: 2732879 • 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 $163,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 12.30 percent. If they increase to 13.50 percent, assume the value of the contracts will go down by 20 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 $168,000. This expense, of course, will be separate from the futures contracts.
What will be the profit or loss on the futures contract if interest rates go to 13.50 percent by December when the contract is closed out? (Input the amount as a positive value.)
After considering the hedging, what is the net cost to the firm of the increased interest expense of $168,000?
What percent of this $168,000 cost did the treasurer effectively hedge away? (Input your answer as a percent rounded to 2 decimal places.)
Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.
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 $163,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 12.30 percent. If they increase to 13.50 percent, assume the value of the contracts will go down by 20 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 $168,000. This expense, of course, will be separate from the futures contracts.
Explanation / Answer
Answer:a
Answer:b-1 If interest expense of $168,000 is factored in, then the profit of $163000 is eaten away and a loss of $5000 occurs.
Net cost to the Firm=$5000
Answer:b-2 Percentage hedge away=[(168000-5000)/168000]*100=97.02%
Answer:c Loss
If interest rates decreased, then the futures contracts would result in a loss,however, since their interest rates decreased, the cost of borrowing decreased, resulting in a better scenario for Pittsburg Iron Works.
Sales price, December Treasury bond contract(Sale takes place in July) 163000 Purchase price, December Treasury bond contract (20% price decline) .8 × $163,000 130400 Gain per contract 32600 Number of contracts 5 Profit on futures contracts 163000Related Questions
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