Use of Futures Contracts to Hedge
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1.a. A corporation is interesting in issuing bonds to the public six month from today. How can we use the futures market to hedge such a transaction? What type of future contract would you recommend?
b. A corporation is interested in repurchasing some of its outstanding common stock on the open market, how can we use futures on the S&P 500 to hedge such a transaction. What type of risk would be hedged in this transaction? Can we achieve a perfect hedge?
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The solution discusses the use of Futures Contracts to hedge the issue of bonds, and the repurchase of outstanding common stock on the open market.
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1.a. A corporation is interesting in issuing bonds to the public six month from today. How can we use the futures market to hedge such a transaction? What type of future contract would you recommend?
The risk that the corporation faces is that of rising interest rates. A rise in interest rates causes the price of bonds to fall. If that happens the corporation will have to sell bonds at a lower price and therefore, the amount of money that the corporation would be able to raise would be less.
To hedge the risk, the corporation can sell short Treasury bond futures.
If the interest rate increases the ...
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