Question

You are a corporate treasurer who will purchase $1 million of bonds for the sinking fund in 3 months. You believe rates will soon fall, and you would like to repurchase the company’s sinking fund bonds (which currently are selling below par) in advance of requirements. Unfortunately, you must obtain approval from the board of directors for such a purchase, and this can take up to 2 months. What action can you take in the futures market to hedge any adverse movements in bond yields and prices until you can actually buy the bonds? Will you be long or short? Why? A qualitative answer is fine.

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Answer:

A corporate treasurer will purchase $1 million of bonds for the sinking fund. The rates will fall and want to repurchase the company's sinking fund bonds selling below par in advance of requirement. For this decision approval is required form the board of directors which can take two months.

Recommended strategy for corporate treasurer: Since a treasurer would like to purchase bonds worth $1 million now but cannot do so because of some management constraints. Therefore, he can enter into a long position. This means he can purchase treasury-bonds future contract worth of similar amount. So, in case if rates fall the treasurer needs to buy back the bond at higher prices than the prices at which these bonds could be purchased now. But the gains from future contract resulting from rising prices and lower yield of bonds would compensate this higher cost of bonds.

Why futures and Why long? The treasurer wants to purchase bonds today, but cannot. As an alternative, he can purchase or go long on the Treasury bonds futures. If the rate falls as expected in the long run, the treasurer will buy back the bonds for the sinking fund. The purchase price of that time will be higher than the prices at which they could be purchased today. It is so for the reason that, there is an inverse relationship between the bond price and their interest rates. However, the gains on the futures contract will offset this higher cost.