Today is April 1, you know you will have to pay cash for goods worth $10 million that will be delivered on June 17. You will then sell those goods for a profit but won't receive payment until September 17. You know on June 17 you will have to borrow $10 million for three months. The current 3 month LIBOR is 6.25%.
You think the LIBOR rate will rise by June causing higher interest expense for the firm. You decide to use the Eurodollar futures contracts to hedge the interest rate risk. Eurodollar futures contract with June delivery has a settlement price of 93.28. The Eurodollar futures contracts with June delivery expires on June 17.
1. What is the forward interest rate implicit in the Eurodollar futures contracts with June delivery?
2. What position would you take in futures contracts to hedge the interest rate risk? And how many Eurodollar futures contracts should you use?
3. Assume on June 17 the Eurodollar futures contract is quoted at 91.
(i) Describe and calculate all cash flows that occur on June 17.
(ii) Show that Eurodollar futures contracts did help you hedge interest rate risk i.e. using Eurodollar futures contracts would result in a fixed rate loan for your firm. What interest rate have you locked in?
4. Instead assume on June 17 the Eurodollar futures contract is quoted at 94. Does using Eurodollar futures contracts will result in a fixed rate loan for your firm? Show all calculations to justify your conclusion.
The solution demonstrates the use of Eurodollar futures contracts to hedge the interest rate risk.