2.2.1.4. Hedging with T-Bills
Hedgers use futures contracts to protect their financial positions against fluctuating interest rates. A company may need to sell the T-bills it presently holds in order to cover an expected future cash shortfall, and the company may worry rising interest rates will lower their value. It shorts a T-bill futures contract, which allows it to lock in a futures price now to protect against falling prices. The profit it makes when it offsets the T-bill futures contract will cover the reduced value of its T-bill holdings.
A T-bill futures contract is also useful when a company expects a large cash inflow three months from now and will want to invest the money in T-bills. If it expects interest rates to fall, raising the cost of buying T-bills, it will go long T-bills futures and lock in the current low price. The profit from selling the futures contract at a higher price than it paid will hedge the risk of buying T-bills in a higher cost market.
Today, a company wishing to hedge its T-bill holdings must use other short-term financial instruments, such as Federal Funds futures. This is known as a “cross hedge,” which we will discuss shortly.
Sample Question 1
In mid-May, DISCOM expects $1 million cash to become available three months from now on August 17, which it will want to invest in T-bills until it disburses the money in November. Expecting interest rates to drop, it decides to hedge its interest rate risk by:
- A. Buying September T-bill futures
- B. Selling September to T-bill futures
- C. Buying December T-bill futures
- D. Selling December T-bill futures
Answer: A. Because DISCOM will receive the $1 million in mid-August, it will want to acquire the T-bill futures contract that matures immediately following that date. Declining interest rates means rising T-bill prices. DISCOM will want to buy September T-bill futures at today’s cheaper price, expecting to benefit from the higher pric