Hedging with Futures
Arnold (2008) argues that there exists an inverse relationship between interest rates and the value of a bond. Consequently, this means that for example when interest rates go up the value of the bonds would decline. Kenny, South Park’s treasurer, is concerned that a rise in the interest rates within the next six months would lead to a reduction in value of the bond. Kenny’s fears are legit, and it warrants him to hedge the risk of having the bonds invested in reduce in value by entering a futures contract.
A futures contract is an agreement to buy or sell financial assets at a price to be paid later on an organized market (Bloomfield, 2006). In South Park town’s case, the assets involved are bonds. Kenny is faced with a decision of either selling or buying the futures in a bid to hedge the risk. Therefore, Kenny needs to buy the futures contracts and wait for the interest rates of the bonds to go up fast. In doing this, he will be able to realize a gain since at high-interest rates the bond will be more valuable as compared to now. It would be considered a wrong investment decision if Kenny sold the futures contracts and waited for the interest rates to rise because it would result in a loss for the town. The loss would be due to buying back the financial asset when its value has gone up due to rise in the interest rates. Therefore, it would be prudent for Kenny buy the contract futures rather than sell them.
Arnold, G. (2008). Corporate financial management. Pearson Education.
Bloomfield, R. J. (2006). Behavioral finance. Johnson School Research Paper, (38-06).