Interest Rate Futures: Fair Value Hedge Fabric retailer Petren Corp. buys 300,000 yards of cloth each quarter at an average price of $3.00/yard. To finance these purchases, Petren sells $1,000 face value Treasury bonds from its available-for-sale investment portfolio. The bonds are presently carried at 90, their current market value.
Required
a. Petren sells Treasury bond futures at 90 on enough bonds to finance next quarter's purchases and settles the contracts at 92 in three months. Management designates the futures as a perfectly effective hedge. Considering both the futures contracts and the sale of the company's own Treasury bonds to finance the fabric purchase, compute the net effect on earnings.
b. Suppose a balance sheet date occurs in 45 days when the futures and the bonds are selling at 91.5. Prepare the related journal entries at this balance sheet date.
c. Suppose instead that Petren buys Treasury bond futures at 90 on enough bonds to finance the next quarter's purchases and closes out the contract at 93 in three months. Is this use of futures likely to be a qualifying hedge?
d. Considering both the futures contracts in part c and sale of the company's own Treasury bonds to finance the purchases, calculate the effect on earnings.