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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

HEDGING The Zinn Company plans to issue $20,000,000 of 10-year bonds in March 2018 to help finance a new research and development laboratory. Assume that interest rate futures maturing in March 2018 are selling for 125-145. It is now early June, and the current cost of debt to the high-risk biotech company is 11%. However, the firm’s financial manager is concerned that interest rates will climb even higher in coming months.

  1. a. Create a hedge against rising interest rates.
  2. b. Assume that interest rates generally increase by 200 basis points. How well did your hedge perform?
  3. c. What is a perfect hedge? Are most real-world hedges perfect? Explain.

a.

Summary Introduction

To create: The hedge against increasing interest rates.

Introduction:

Hedge is a technique used in investment opportunity mainly to reduce the risk of adverse price movement in a firm’s assets.

Explanation

Given information:

Z Company has issued a bond of $20,000,000 for 10-years period. The interest rate futures mature on March 2018 that is sold for 125-145 and the cost of debt is 11 percent.

The hedge against increasing interest rates is as follows:

Z Company might face a risky situation when the interest rate rises by March 2018. In order to reduce this risky situation, the company can use a short hedge or sell the future contracts in the market. The Company can sell 200 contracts to cover its planned $20,000,000 bond issue because the treasury notes futures contracts are for $100,000 in 10-years period. The future contract that matures in March is sold for 12514.5/32 of par. This means 125 plus (14

b.

Summary Introduction

To determine: The performance of hedge when the interest rate increases by 200 basis points.

c.

Summary Introduction

To discuss: The meaning of perfect hedge and whether most real-world hedges are perfect.

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