Question

The treasurer for Pittsburgh ironworks wishes to use financial futures to hedge her interest rate exposure. She will sell five treasury futures contracts at 195,000 per contract. It is July and the contract must be closed out in December of this year. Long-term interest rates are currently 14.30%. If they increase to 15.50%, assume the value of the contracts will go down by 15%. 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 $158,000. 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 15.50% by December when the contract is closed out?

B. After considering the hedging, what is the net cost to the firm of the increased interest expense of $158,000?

Answer 1