In late January 2011, Starlight Corporation is considering the sale of $50 million in 10-year bonds rated AAA. The issue will most likely be registered and sold some time in April. Therefore, Starlight Corporation desires to hedge the pending issue using Treasury bond futures contracts, which each represent $100,000. Explain how you would go about hedging the bond issue?
A) sell 500 contracts
B) buy 500 contracts
C) sell 50 contracts
D) buy 50 contracts
E) buy 5000 contracts

Question

Quizplus · Accepted Answer

CTo hedge against the risk of rising interest rates (which would decrease the value of the bond issue), Starlight Corporation would sell Treasury bond futures contracts. The number of contracts needed depends on the hedge ratio, which is not provided, but selling contracts is the correct approach to hedge a future bond issuance. The exact number (500 or 50) cannot be determined without additional information such as the hedge ratio or the size of each contract relative to the bond issue. However, since each contract represents $100,000, selling 500 contracts would be more aligned with hedging a $50 million issue, assuming a direct correlation. Selling 50 contracts seems too low for a $50 million issue, but without the hedge ratio, both selling options are technically approaches to hedging.

In Late January 2011, Starlight Corporation Is Considering the Sale