The treasurer for Pittsburg Iron Works wishes to use financial futures to hedge her interest rate exposure.
She will sell five Treasury futures contracts at $138,000 per contract. It is July, and the contracts must be closed out in December of this year.
Long-term interest rates are currently 13.3 percent. If they increase to 14.5 percent, assume the value if the contract will go down by 5 percent.
Also id interest rates do increase by 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $53,000. This expense, of course, will be seperate from the futures contracts.
A. What will be the profit of loss on the futures contract if interest rates increase to 14.5 percent by December when the contract is closed out?
B. Explain why a profit of loss took place on the futures contracts.
C. After considering the hedging in part A, what is the net cost to the firm of the increased interest expense of $53,000? What percent of this $53,000 cost did the treasurer effectively hedge away?
D. Indicate whether there would be a profit or loss on the futures contracts if interest rates dropped.