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.

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

Short answer

The decline in the purchase price in relation to the sales price resulted in a profit.

Step-by-step solution

Meaning of futures contract

The futures contract is a contract used for selling the asset at a future date at a specified price. In this contract, the seller is obligated to provide the relevant asset to the buyer at the determined time and price.

Reason for profit or loss on the futures contract

There was a profit/loss on the futures contract as the value of the bond decreased with an increase in the costs. This resulted in a decline in the purchase price and it was less than the predetermined sales price.