Miss B is a fixed income portfolio manager for Union Investment Trust Company. She forecasts a cash inflow of $5 million in June and plans to invest the funds in her baseline bond portfolio, which currently has an A quality rating, a duration of 7 years, and an annual coupon rate of 10.25%, and YTM of 10.25%. Afraid that the long-term interest rates could decline, Miss B decides to hedge her June investment by taking a position in June T-bond futures contracts when the June T-bond contract is trading at 80 16/32 and the T-bond most likely to be delivered on the contract has a YTM of 9.5% and a duration of 9 years.

1. Using the price sensitivity model, show how Miss B could hedge her June bond portfolio purchase against interest rate risk.

2. Suppose the long-term interest rates decrease over the period such that at the June expiration bonds matching Miss Bs baseline portfolio are trading at 104 of par and the price of the expiring June T-bond contract is 85. Determine Miss Bs cost of purchasing her baseline bond portfolio, her profit on the futures contract, and her hedged portfolio costs.