Question

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 \(138,000 per contract. It is July, and the contracts must be closed out in December of this year. Long-term interest rates are currently 13.3 percent. If they increase to 14.5 percent, assume the value of the contracts will go down by 5 percent. Also if interest rates do increase by 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of \)53,000. 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 increase to 14.5 percent by December when the contract is closed out?

Short answer

The profit on the sale of all five futures contracts is $34,500.

Step-by-step solution

Information provided in the question

Selling price = $138,000

Decline in value of contracts = 5%

Calculation of profit/loss in the sale of contract

The contract is sold at a profit of 6,900.

$\begin{array}{rcl}\mathrm{Purchase}\mathrm{price}& =& \mathrm{Selling}\mathrm{price}\times \left(1-\mathrm{Percentage}\mathrm{decline}\mathrm{in}\mathrm{contract}\mathrm{value}\right)\\ & =& \$138,000\times \left(1-0.05\right)\\ & =& \$131,100\\ \mathrm{Profit}/\mathrm{loss}\mathrm{on}\mathrm{sale}& =& \mathrm{Selling}\mathrm{price}-\mathrm{Purchase}\mathrm{price}\\ & =& \$138,000-\$131,100\\ & =& \$6,900\end{array}$

Calculation of total profit/loss in the sale of five contracts

The profit on sale of all five contracts is $34,500.

$\begin{array}{rcl}\mathrm{Total}\mathrm{profit}\mathrm{on}\mathrm{sale}& =& \mathrm{Profit}\mathrm{on}\mathrm{sale}\mathrm{of}\mathrm{one}\mathrm{contract}\times 5\\ & =& \$6,900\times 5\\ & =& \$34,500\end{array}$