The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge
ID: 2767835 • 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 $144,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 16.30 percent. If they increase to 18.50 percent, assume the value of the contracts will go down by 20 percent. Also if interest rates do increase by 2.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $157,000. 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 18.50 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 $157,000? What percent of this $157,000 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. Loss ProfitExplanation / Answer
a. Sales price, December Treasury bond contract
(Sale takes place in July) 5 x $144,000 = $720,000
Purchase price, December Treasury bond contract
(20% price decline)
.8 x $144,000 = $ 115,200 New Price of T-Bond
5 x $115,200 = $576,000 Value of 5 T-Bond Contracts
Sold 5 T-Bond Contracts in July at $720,000
Purchased 5 T-Bond Contracts in December at $576,000
Profit on futures contracts $ 144,000
b-1.
Increased interest cost $157,000
Profit from hedging 144,000
Net cost $ 13,000
b-2 Percentage hedged away = Net cost/Increased interest cost Percentage hedged away = $13,000/$157,000
Percentage hedged away = 0.0828
Percentage hedged away = 8.28%
c. If interest rates went down, there would be a loss on the futures contracts.
a. Sales price, December Treasury bond contract
(Sale takes place in July) 5 x $144,000 = $720,000
Purchase price, December Treasury bond contract
(20% price decline)
.8 x $144,000 = $ 115,200 New Price of T-Bond
5 x $115,200 = $576,000 Value of 5 T-Bond Contracts
Sold 5 T-Bond Contracts in July at $720,000
Purchased 5 T-Bond Contracts in December at $576,000
Profit on futures contracts $ 144,000
b-1.
Increased interest cost $157,000
Profit from hedging 144,000
Net cost $ 13,000
b-2 Percentage hedged away = Net cost/Increased interest cost Percentage hedged away = $13,000/$157,000
Percentage hedged away = 0.0828
Percentage hedged away = 8.28%
c. If interest rates went down, there would be a loss on the futures contracts.
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