Problem
The treasurer for Thornton Pipe and Steel Company wishes to use financial futures to hedge her interest rate exposure. She will sell five Canadian bond futures contracts at $105,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.4 percent. If they increase to 8.5 percent, assume the value of the contracts will go down by 10 percent. Also, if interest rates do increase by 1.1 percentage points, assume the firm will have additional interest expense on its business loans and other commitments of $60,800. This expense, of course, is separate from the futures contract.
1. What will be the profit or loss on the futures contract if interest rates go to 8.5 percent?
2. Explain why a profit or loss occurred on the futures contracts.
3. After considering the hedging in part 1, what is the net cost to the firm of the increased interest expense of $60,800? What percent of this increased cost did the treasurer effectively hedge away?
4. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.