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Chapter 3: 28BP_d (page 253)

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

Expert verified

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

Step by step solution

01

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.

02

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.

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Most popular questions from this chapter

Fisk Corporation is trying to improve its inventory control system and has installed an online computer at its retail stores. Fisk anticipates sales of 49,000 units per year, an ordering cost of \(8 per order, and carrying costs of \)1.60 per unit.

b. How many orders will be placed during the year?

Neon Light Company of Kansas City ships lamps and lighting appliances throughout the country. Ms. Neon has determined that through the establishment of local collection centers around the country, she can speed up the collection of payments by three days. Furthermore, the cash management department of her bank has indicated to her that she can defer her payments on her accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida.

a. If Neon Light Company has \(2.25 million per day in collections and \)1.05 million per day in disbursements, how many dollars will the cash management system free up?

b. If Neon Light Company can earn 6 percent per annum on freed-up funds, how much will the income be?

c. If the total cost of the new system is $400,000, should it be implemented?

What is an asset-backed public offering?

Carmen鈥檚 Beauty Salon has estimated monthly financing requirements for the next six months as follows:

January

\(8,500

February

\)2,500

March

\(3,500

April

\)8,500

May

\(9,500

June

\)4,500

Short-term financing will be utilized for the next six months.

January

9%

February

10%

March

13%

April

16%

May

12%

June

12%

Here are the projected annual interest rates:

a. Compute total dollar interest payments for the six months. To convert an annual rate to a monthly rate, divide by 12. Then multiply this value times the monthly balance. To get your answer, add up the monthly interest payments.

b. If long-term financing at 12 percent had been utilized throughout the six months, would the total-dollar interest payments be larger or smaller? Compute the interest owed over the six months and compare your answer to that in part a.

Boatler Used Cadillac Co. requires $850,000 in financing over the next two years. The firm can borrow the funds for two years at 12 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short term financing instead, he will pay 7.75 percent interest in the first year and 13.55 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly?
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