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4. A treasurer of an American company in March realizes that it needs to raise $25 million zero-coupon bond in August for a period of 6 months. Zero-coupon bond of similar quality is currently yielding 4%, a cost, which the treasurer finds acceptabl(e) The treasurer is of the view that interest rate will rise before the company will issue the debt, hence will increase the cost of debt. So to hedge the interest rate risk the treasurer decided to hedge the risk using September Eurodollar futures contract. September 90-day Eurodollar futures contracts are currently trading at 96.25.
You are required to
a. Explain how treasurer can hedge the risk through Eurodollar futures contract? How many futures contracts are required to hedge?
b. If the September futures contract in August closes either at 95.75 or 96.80, calculate the cost of the bond to the company in each case.
4 a. The treasurer can hedge the risk by selling Eurodollar futures contract. The short futures position will lead to profit it interest rate rises, which will reduce the interest outflow on debt.
The contract price of September futures
= $ 1,000,000 [1– 0.0375 (0.25]
= $ 990,625
If the company issue debt now, it can realize
= 25,000,000/(1+0.5X.04) = $ 24,509,804
The duration of the bond is twice that of Eurodollar deposit underlying the futures contract, hence number of futures contract to be sold
= 24,509,804/990625 ( 2 = 49.48 = 50 contracts.
b. In August, Eurodollar futures contract is at 95.75, it means yield has risen to 4.25%, so it can issue bond at 4.50%.
Company will realize = 25,000,000/(1+0.5X0.045) = $ 24,449,878
Gain in futures market = (96.25 – 95.75) ( 100 ( 25 ( 50 = $ 62,500
Total amount realized = 24,449,878 + 62,500 = $ 24,512,378
Cost of zero-coupon bond =
If Eurodollar futures contract closes at 96.80, it means that...