Financial Management Individual Work – Cheap Research Essays

Project description
Instructional Objectives for this activity:
Describe how to use derivatives in risk management
Derivatives are frequently used to reduce the risks associated with financial and commodity markets, since their values are determined by market prices or interest rates of existing securities. Critics argue that derivatives need more regulation before they can be used comfortably, but proponents maintain that derivatives are not used to speculate, but to hedge risks. The concept of derivatives bears close attention, because derivatives can play a role in risk management.

This Mini Case asks you to take a closer look at the concepts of using derivatives in risk management through researching and answering questions pertaining to this concept for a fictional board of directors presentation.

Complete the Chapter 24 Mini Case by downloading the following handout and referring to the steps in your textbook:
13-03-11

Chapter 24. Mini Case for Derivatives and Risk Management

Assume that you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that specializes in creating exotic sauces from imported fruits and vegetables. The firm’s CEO, Bill Stooksbury, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the pressing need for smaller companies to institute corporate risk management programs. Since no one at Tennessee Sunshine is familiar with the basics of derivatives and corporate risk management, Stooksbury has asked you to prepare a brief report that the firm’s executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and corporate risk management and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

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i. It is January and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion, and is concerned that interest rates will rise during the interim. Currently, TS can issue 20-year bonds at 7%, but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-Bond futures are trading at 111-25. What are the risks of not hedging and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%.

Size of bond issue 5,000,000
Current interest rate 7%
Maturity of debt issue 20 years

If interest rates increased from 7% to 8%, then the value of the bonds would decrease from $5,000,000 to:

New rate on bonds 8%
New value of bonds $4,505,181.00
Decrease in value of bonds $494,819.0

So if Tennessee Sunshine waits and interest rates increase by 1%, they could lose almost half a million dollars through higher interest costs. They can hedge this cost with T-Bond futures.

The CBOT has futures contracts on hypothetical U.S. Treasury bonds. The hypothetical bonds have a 20-year maturity and an annual coupon rate of 6% (payable semi-annually).

Size of futures contract (dollars per contract) = $100,000
Settle price on futures contract as quoted = 111 and 25 32nds
Settle price on futures contract (% of par, decimal) = 111.781%
Settle price on futures contract (dollars) = $111,781

Tennessee Sunshine will use a short hedge, which means it agrees to deliver the contract in June (actually, it will not deliver bonds, but will settle up). How many contracts must TS sell short?