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2. A financial firm plans to purchase $50 million in Treasury bonds in a few days and hopes to earn an interest return of 8
2. A financial firm plans to purchase $50 million in Treasury bonds in a few days and hopes to earn an interest return of 8 percent. The firm's investment officer fears a drop in market interest rates before she is ready to buy, so she asks a security dealer to write a call option on Treasury bonds at a strike price of $96,000 for each $100,000 bond. The investment officer had to pay the dealer a premium of $400 to write this call option. If market interest rates fall as predicted, the T-bonds' market price may climb up to $97,400 per $100,000 bond, permitting the investment officer to demand delivery of the bonds at the cheaper price of $96,000. 1) What does it mean by saying that the options are in the money or out of money? In this case, is the call option would be in the money or out of money? What should the financial firm do? (4 Points) 2) What profit could be earned from this call option transaction? (2 Points) Profit on call option = Security market price Strike price - Option premium 3) The projected (profit or loss) (1 Point) per bond will at least partially offset any (profit or loss) (1 Point) in interest return experienced on the bonds traded in the cash market if interest rates fall. (Choose profit or loss in the parentheses) 4) If interest rates rise instead of fall, would the option likely have dropped in the money or out of money? What should the financial firm do? (2 Points)
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