1.A pension fund manager anticipates the purchase of a 20-year, 8 per cent coupon T-bond at the end of two years. Interest rates are assumed to change only once every year at year-end with an equal probability of a 1 per cent increase or a 1 per cent decrease. The T-bond, when purchased in two years, will pay interest semi-annually. Currently, the T-bond is selling at par.

What is the pension fund manager’s interest rate risk exposure?

How can the pension fund manager use options to hedge that interest rate risk exposure?

What prices are possible on the 20-year T-bonds at the end of year 1 and year 2?

Show by way of diagram the prices over the two-year period.

If options on $100 000, 20-year, 8 per cent coupon T-bonds (both puts and calls) have a strike price of 101, what are the possible (intrinsic) values of the option position at the end of year 1 and year 2?

Show by way of a diagram the possible option values.

Using an 8 per cent discount factor calculate the option premium. LO 7.6