Question

You are a corporate treasurer who will purchase $1 million of bonds for the sinking fund in three months. You believe rates soon will fall and would like to repurchase the company’s sinking fund bonds, which currently are selling below par, in advance of requirements.

Unfortunately, you must obtain approval from the board of directors for such a purchase, and this can take up to two months. What action can you take in the futures market to hedge any adverse movements in bond yields and prices until you actually can buy the bonds? Will you be long or short? Why?

Short answer

Purchase the T-bond futures contract as a proxy. Buy back the bonds for the sinking funds at higher prices than these could be repurchased today.

Step-by-step solution

Explanation on action in futures

Despite treasurer’s attempt to buy the bonds, he wouldn’t be able to do it. In this case, he can purchase the T-bond futures contract as a proxy, therefore he should enter into long position. This means treasure he should purchase treasury bonds future contracts worth of similar amount.

Explanation of benefit taking long position:

In case of fall in rates, the treasurer will have to buy back the bonds for the sinking funds at higher prices than these could be repurchased today. However this higher cost will be offset by gains on future contracts.