Question: It is March and Cavalier Financial Services Corporation is concerned about what an increase in interest rates will do to the value of its bond portfolio. The portfolio currently has a market value of $101.1 million and Cavalier's management intends to liquidate $1.1 million in bonds in June to fund additional corporate loans. If interest rates increase to 6 percent, the bond will sell for $1 million with a loss of $100,000. Cavalier's management sells 10 June Treasury bond contracts at 109-05 in March. Interest rates do increase, and in June Cavalier's management offsets its position by buying 10 June Treasury bond contracts at 100-03.
a. What is the dollar gain/loss to Cavalier from the combined cash and futures market operations described above?
b. What is the basis at the initiation of the hedge?
c. What is the basis at the termination of the hedge?
d. Illustrate how the dollar return is related to the change in the basis from initiation to termination.