Assume it is May 2018. A company expects to receive a cash payment of 10

million in 7 months time from a customer. The company will not have immediate use

of the cash until March next year. During this idling period, the financial manager will

deposit this amount of cash for three months to earn interest. The price for the

December 3-month interest rate futures in May 2018 is 94. The financial manager is

concerned the interest rate will fall when she receives the cash.

a) Design a strategy using short-term interest rate futures to hedge against the

companys exposure to the risk of changing the interest rate. Suppose the size

of interest-rate futures is 500,000.

b) Suppose the interest rate falls to 3.1% in December 2018. By how much is the

amount which the company receives less than the interest from the deposit

(compared to the level of interest in May 2018). In other words, what is the

loss incurred by the company regarding interest rate income in the cash

market?

c) Calculate the gain from the futures market in December 2018 at expiry.