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.

d. Indicate whether there would be a profit or loss on the futures contracts if interest rates dropped.

Short answer

The decrease in interest rate will result in a loss at the time of the sale of the futures contract.

Step-by-step solution

Meaning on interest rates on bonds

The interest rate is the interest that the issuer of the bond will pay to the bondholder. This is an income for the bondholder and serves as an incentive for them to purchase the bonds.

Impact of interest rate drop on the futures contract

The decline in the interest rates will lead to a loss in the futures contract. The lower interest rates will increase the bond prices and the purchase price will be higher than the selling price and which will lead to a loss on the sale.