a. To calculate the profit or loss on the futures contract if interest rates go to 8.5 percent, we need to find the difference in value between the current interest rate of 7.4 percent and the new interest rate of 8.5 percent, and then apply the 10 percent decrease.
Step 1: Calculate the difference in interest rates:
New Interest Rate - Current Interest Rate = 8.5% - 7.4% = 1.1%
Step 2: Apply the 10 percent decrease:
Difference in Interest Rates * 10% = 1.1% * 10% = 0.11%
Step 3: Calculate the dollar amount of the decrease:
Decrease in Value = $105,000 * 0.11% = $115.50
Therefore, the profit or loss on the futures contract if interest rates go to 8.5 percent would be a loss of $115.50.
b. The profit or loss on the futures contracts is determined by the change in interest rates and the impact it has on the value of the contracts. In this case, when interest rates increase to 8.5 percent, the value of the contracts will decrease by 10 percent. This decrease in value results in a loss on the futures contracts.
c. To calculate the net cost to the firm of the increased interest expense of $60,800 after considering the hedging in part a, we need to subtract the loss on the futures contract from the increased interest expense.
Net Cost = Increased Interest Expense - Loss on Futures Contract
Net Cost = $60,800 - $115.50
Net Cost = $60,684.50
The treasurer effectively hedged away $115.50 of the increased cost, which is approximately 0.19% of the increased cost ($115.50 / $60,800).
d. If interest rates were to go down, the value of the futures contracts would increase. This implies that there would be a profit on the futures contracts. However, the specific calculation of the profit cannot be determined without knowing the extent of the decrease in interest rates.