Company X plans tissue $10 million in bonds, three months from now. The bonds will have a maturity of 5 years, and have an annual coupon rat of 7%, paid semi annually. It is expected the bonds will be issued at par. However there is considerable uncertainty as to the actual required return on these bonds three months using T-Bond futures contracts. The futures contracts are on a 20-year treasury bond. The annual coupon rate is 4% paid semi annually. The treasury bond is also trading at par. Each contract is for a face amount of $100,000.
A) Assuming he required return on the treasury bond will change by .5% for every 1% change in the required return for Company X’s bonds. Calculate the Hedge ratio.
B) How will company X hedge its risk? Explain whether the company will buy futures contracts or sell futures contracts. How many contracts will it buy or sell?
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