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Activity 4f

If the economy continues to grow strongly, Carson may need to increase its production capacity by 50% over the next few years to meet demand. This would require financing to expand. Carson is concerned that interest rate increases by the Fed to reduce inflation could slow the economy. Carson currently relies on commercial loans with floating interest rates for debt financing. It could use short positions in Treasury bond futures contracts to offset higher debt costs if rates rise. However, this hedge would not be perfect as the profit from short futures positions depends on Treasury price movements, while higher debt costs depend on commercial loan interest rates.

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Jere Mae Maranan
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151 views2 pages

Activity 4f

If the economy continues to grow strongly, Carson may need to increase its production capacity by 50% over the next few years to meet demand. This would require financing to expand. Carson is concerned that interest rate increases by the Fed to reduce inflation could slow the economy. Carson currently relies on commercial loans with floating interest rates for debt financing. It could use short positions in Treasury bond futures contracts to offset higher debt costs if rates rise. However, this hedge would not be perfect as the profit from short futures positions depends on Treasury price movements, while higher debt costs depend on commercial loan interest rates.

Uploaded by

Jere Mae Maranan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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If the economy continues to be strong, Carson may need to increase its production capacity by

about 50 percent over the next few years to satisfy demand. It would need financing to expand
and accommodate the increase in production. If the yield curve is currently upward sloping, also
Carson is concerned about a possible slowing of the economy because of potential Fed actions
to reduce inflation. Carson currently relies mostly on commercial loans with floating interest
rates for its debt financing. Will hedge can offset the increase in debt costs if interest rates
increase? Explain what drives the profit from the short hedge versus what drives the higher cost
of debt to Carson, if interest rates increase.

How could Carson use futures contracts to reduce the exposure of its cost of debt to interest rate
movements? Be specific about whether it would use a short hedge or a long hedge.

Carson could sell Treasury bond (or Treasury bill) futures contracts. If interest rates rise, the values of
Treasury bonds decrease, and the values of Treasury bond futures contracts decrease. A short position
will result in a profit for Carson if interest rates increase, which can offset the higher cost of debt
financing.

b.Will the hedge that you described in the previous question perfectly offset the increase in debt costs if
interest rates increase? Explain what drives the profit from the short hedge, versus what drives the
higher cost of debt to Carson if interest rates increase.

No. The short position is not a perfect hedge. The profit from the short hedge is influenced by the
movement in Treasury security prices, while the cost of debt is influenced by the short-term interest
rate on commercial loans (which may be influenced by the rate the banks pay on short-term CDs. There
is not a perfect offsetting effect.

WILL THE HEDGE

If interest rate in the economy goes up, company C would have to pay higher rate on its loan. The rate
on its floating rate commercial loan would adjust upward. Company C can hedge its exposure to interest
rate risk by using interest rates futures. Interest rates future allow the holder of the contract to lock into
an interest rate payable on an asset. The rate payable on asset would be determined at the time of
purchasing the contract. The contract would become effective at the future date.

EXPLAIN WHAT DRIVES

Company C would sell interest rate future in this case. If it sells interest rate futures and interest rate
increase, prices of futures contract would fall. So They would make a profit.

At the same time, interest to be paid on its liability would go up because of interest rate. Hence, profit
made from the interest rate contract would be used to offset the higher interest rate being paid on its
loan. This would help the company reduce the increase cost of funding. The hedge that company is using
is short hedge.

Note that Company C has floating rate loan. This means that rate of interest on floating rate loan would
adjust periodically. This makes the setup of a perfect hedge difficult. There are, however, a number of
ways in which a perfect hedge can be setup. This would entail buying interest rate futures at every rate
reset date. Alternatively, company C can buy advanced interest rate derivatives at the time of taking out
commercial loans. A perfect hedge can be set up by using interest rate futures.

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