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.

c. After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of \(53,000? What percent of this \)53,000 cost did the treasurer effectively hedge away?

Short answer

The net cost to the firm is $18,500 and the increased cost covered is 65.1%.

Step-by-step solution

Calculation of net cost

The net cost to the firm is $18,500.

$\begin{array}{rcl}\mathrm{Net}\mathrm{cost}& =& \mathrm{Increased}\mathrm{interest}\mathrm{expense}-\mathrm{Gain}\mathrm{on}\mathrm{sale}\mathrm{of}\mathrm{futures}\mathrm{contract}\\ & =& \$53,000-\$34,500\\ & =& \$18,500\end{array}$

Calculation of the percentage of increased interest expense covered by the treasurer

The increased expense covered by the treasurer is 65.1%.

$\begin{array}{rcl}\mathrm{Percentage}\mathrm{of}\mathrm{cost}\mathrm{covered}& =& \frac{\mathrm{Profit}\mathrm{on}\mathrm{sale}\mathrm{of}\mathrm{futures}\mathrm{contract}}{\mathrm{Increased}\mathrm{interest}\mathrm{expense}}\times 100\\ & =& \frac{\$34,500}{\$53,000}\times 100\\ & =& 65.1\%\end{array}$