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Use of financial futures to hedge interest rate exposure

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 $107,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.3 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 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $63,000. This expense, of course, will be separate from the futures contracts.

a) What will be the profit or loss on the futures contract if interest rates go to 8.5 percent?

b) Explain why a profit or loss took place on the futures contract.

c) After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of $63,000? What percent of this $63,000 cost did the treasurer effectively hedge away?

d) Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.

Solution Preview

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 $107,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.3 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 1.2 percent, assume the firm will have additional interest expense on its business loans ...

Solution Summary

The solution demonstrates the use of financial futures (treasury futures contracts ) to hedge interest rate exposure.

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