T.J.’S FAST TRACK INVESTMENTS: INTEREST RATE FUTURES
T.J. Patrick is a young, successful industrial designer in Perth who enjoys the excitement of commodities speculation. T.J. has been dabbling in commodities since he was a teenager—he was introduced to this market by his father, who is a grain buyer for one of the leading food processors. T.J. recognises the enormous risks involved in commodities speculating but feels that because he is still single, now is the perfect time to take chances. And he can well afford to. As a partner in a thriving industrial design company, T.J. earns more than $100 000 a year. He follows a well-disciplined investment program and annually adds $15 000 to $20 000 to his portfolio. Recently, T.J. has started playing with financial futures—interest rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investment vehicles offer. This all started several months ago, when T.J. met Vincent Banano, a stockbroker who specialises in financial futures, at a party. T.J. liked what Vincent had to say (mostly how you couldn’t go wrong with interest-rate futures) and soon set up a trading account with Vincent’s company. The other day, Vincent called T.J. and suggested he get into 90-day bank-accepted bill futures. As Vincent sees it, interest rates are going to continue to head up at a brisk pace, and T.J. should short sell some bank bill futures. In particular, he thinks that rates on bank bills should go up by another half-point (moving from about 5.5% up to 6%), and he recommends that T.J. short sells four contracts. This would be a $2000 investment, because each contract requires an initial margin deposit of $500.
1. Assume 90-day bank bill futures are now being quoted at 94.35.
a. Determine the current price (underlying value) of this bank bill futures contract.
b. What would this futures contract be quoted at if Vincent is right and the yield goes up by 0.5%?
2. How much profit will T.J. make if he short sells four contracts at 94.35 and bank bill yields do go up 0.5%— that is, if T.J. covers his short position when bank bill futures contracts are quoted at 93.85? Also, calculate the return on invested capital from this transaction.
3. What happens if rates go down? For example, how much will T.J. make if the yield on bank bill futures goes down by just 0.25%?
4. What risks do you see in the recommended short-sale transaction? What is your assessment of T.J.’s new interest in financial futures? How do you think it compares to his established commodities investment program?