A pension fund manager anticipates the purchase of a 20-year, 8 percent coupon Treasury 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 percent increase or a 1 percent decrease. The Treasury bond, when purchased in two years, will pay interest semiannually. Currently the Treasury bond is selling at par.

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

b. How can the pension fund manager use options to hedge this interest rate risk exposure?

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

d. Diagram the prices over the two-year period.

e. If options on $100,000, 20-year, 8 percent coupon Treasury 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?

f. Diagram the possible option values.

g. What is the option premium? (Use an 8 percent discount factor.)