Continuing growth of the company has required that we issue the company''s corporate debt soon. As you know, in 6 months we plan to issue $10 million worth of 20-year corporate bonds with a coupon of 8%, paid semiannually. Since this is our first large issue of longer term debt, I am concerned that the interest rates may drift higher over these months prior to the actual bond issuance. Could you come up with any suggestions as to how to protect us against a possible change in interest rates?
If you decide to use Treasury bond futures contracts, I think you could use the December futures settlement price of 96-19. Please consider calculating the outcomes of two possible scenarios:
1. When interest rates increase by 150 basis points.
2. When interest rates increase by 250 basis points.
What''s needed from you:
Describe the main characteristics of the futures contracts Bob suggested in his reply (such as price of a standard contract, term to maturity, and semiannual coupon rate of a standard contract) and whether you have enough information for the assessment of the hedge.
Determine the implied semiannual yield on the futures contracts, given the price of 96-19. As a reminder, T-bond futures are $100,000 per contract, 20-year to maturity, 6% coupon, semiannual compounding.
For the purpose of this case, you may assume that there are no transaction costs to buy or sell any futures contracts. You would want to use either the Excel function called RATE or a financial calculator.
Determine how many contracts you would need to hedge the entire amount of the issuance of the bonds and what you should do -- buy or sell?
Number of contracts needed for the hedge
Value of the contracts in hedge
Hint: First convert the settlement value from 32s into decimals, then multiply by the value in Step 3 (a) above.
Determine implied annual yield using the data calculated in Step 2 and Excel function RATE.
Test your first scenario when interest rates increase by 150 basis points, as follows:
Calculate the new interest rate on debt as the agreed-upon rate on actual bonds + 150 basis points;
Calculate the value of issuing the actual bonds at the new higher interest rate, using the new rate as your yield to maturity on the bonds and the agreed-upon rate as your coupon rate.
Determine the dollar value loss or savings from issuing debt at the new rate.
Calculate the new yield on the futures contract as the implied annual yield from Step 5(c) + 150 basis points.
Calculate the value of futures contracts at the new yield, using the Excel function PV, where your YTM=new yield from Step 4 (d) and the coupon rate is the coupon on a standard futures contract.
Once you have determined the new value of the futures contracts in hedge in Step 4 (e), you can calculate the dollar change in value of the futures position as the difference between the value in Step 5(f).
The last element: the total dollar value change of the position will be the sum of the dollar values in Steps 4 (c) and 4 (f).
Please follow Step 4, but using the second scenario where interest rates are expected to change by 250 basis points.
Deliverables
The end result should be the dollar value change of the position (4g) for 150 basis points and 250 basis points for 5g. Support your answer by showing all the calculations, preferably in a worksheet. Submit your analysis to my drop box.