2. An FI has a $260 million asset portfolio that has an average duration of 3.7 years. The average duration of its $220 million in liabilities is 6.9 years. Assets and liabilities are yielding 8 percent. The FI uses put options on T-bonds to hedge against unexpected interest rate increases. The average delta () of the put options has been estimated at 0.2 and the average duration of the T-bonds is 10.2 years. The current market value of the T-bonds is $95,000. Put options on T-bonds are selling at a premium of $1.25 per face value of $100.

a. What is the interest rate risk exposure of the FI? Why?

b. What kind of options should the FI purchase to hedge this risk?

c. How many option contracts should the FI purchase to hedge its interest rate risk exposure? The face value of the T-bonds is $100,000.

d. If interest rates increase 50 basis points, what will be the change in value of the equity of the FI?

e. What must be the change in interest rates before the change in value of the balance sheet (equity) will offset the cost of placing the hedge?