Suppose that a pension fund manager anticipates the purchase of a 20-year, 8 percent coupon T-bond at the end of two years. Interest rates are assumed to change only once every year at year end. At that time, it is equally probable that interest rates will increase or decrease 1 percent. When purchased in two years, the T-bond will pay interest semiannually.

Currently, it is selling at par. (LG 24-4)

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

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

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