The treasurer for Bolton Iron Works wishes to use financial futures to hedge her interest rate exposure. She will sell five Canadian bond futures contracts at $72,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 6.5 percent. If they increase to 8 percent, assume the value of the contracts will go down by 10 percent. Also , if interest rates do increase by 1.5 percentage points, assume the firm will have additional interest expense on its business loans and other commitments of $40,500. This expense, of course, is separate from the futures contract.
a. What will be the profit or loss on the futures contract if interest rates go to 8 percent?
b. Explain why a profit or loss occurred on 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 $40,500? What percent of this increased cost did the treasurer effectively hedge away?
d. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.