On January 31, a firm learns that it will have additional funds available on May 31. It will use the funds to purchase $5,000,000 par value of the APCO 9 1/2 percent bonds maturing in about 21 years.
Interest is paid semiannually on March 1 and September 1. The bonds are rated A2 by Moody's and are selling for 78 7/8 per 100 and yielding 12.32 percent. The modified duration is 7.81. The firm is considering hedging the anticipated purchase with September T-bond futures. The futures price is 71 8/32. The firm believes the futures contract is tracking the Treasury bond with a coupon of 12 3/4 percent and maturing in about 25 years. It has determined that the implied yield on the futures contract is 11.40 percent and the modified duration of the contract is 8.32.
The firm believes the APCO bond yield will change 1 point for every 1-point change in the yield on the bond underlying the futures contract.
a. Determine the transaction the firm should conduct on January 31 to set up the hedge.
b. On May 31, the APCO bonds were priced at 82 3/4. The September futures price was 76 14/32. Determine the outcome of the hedge.