You are the chief financial officer of a large multinational company; and six mo

Question

You are the chief financial officer of a large multinational company; and six months from now you will be receiving a settlement payment of $50 million, which you plan to invest in 10-year U.S. Treasury bonds. Your interest rate forecast indicates that the yield curve will drop dramatically in the next two quarters. You are considering ways that you can guard against the possible decline in interest rates before you have the funds available to invest.

            a. Briefly describe the hedging strategy using the 10-year Treasury note futures contract that would provide the best protection against this possible decline in yields.

b. Suppose that six months after you have entered into a futures contract as suggested in Part a, interest rates increases in the market actually increase substantially due to an unexpected change in monetary policy. Discuss how this increase in interest rates will affect the futures position you entered into.

c. Discuss whether you would have been better off (1) with the hedge position or (2) without the hedge position in this situation

Explanation / Answer

Answer:

(a) Company should enter into future contracts(non- delivery) to sell the treasury note at a agreed rate, yielding higher return and compensating the decline in interest rate.This would assure a minimum return to the company.

(b) If interest rate of treasury note increases, it will adversely impact the position enter into in part (a). In this case, market rate of security may go up and company needs to pay the difference between the market price and agreed rate. For example if company enters into a contract to sell(non-delivery) the treasury note at $90 after a year expecting the market price will be lessor than $ 90. After a year, due to increase in interest rate, market price of treasury bill go up to $ 92. In this case company needs to pay $ 2 (92-90) to the purchaser of option.Had the price been lessor than $90, say $89, company would have earned $ 1 (90-85) resulting higher yield from treasury note.Nevertheless company got the average return by getting the higher interest amount.

(c) In this situation, company neither has loss nor profit by increasing or decreasing interest rate. Company will be earning average return in both the situations.

Situation 1. If interest rate declines, market price of treasury bill will go down. Company will earn by its hedge position. Earning from hedge position will set-off lower interest amount.

Situation 2: If interest rate surges, market price of treasury bill will go up. Company will incur loss in its hedge position. Loss from hedge position will set-off higher interest amount.

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