You are a financial manager and you have bonds worth $3,000,000 in your portfolio which have a 7 percent coupon rate and will be maturing in 10 years from now. The market rate is also 7 percent. Suppose a futures contract on these bonds is available with a standard contract size of $300,000 per contract.

a) What type of risk are you exposed to and how will you hedge your exposure?

b) If the market interest rates change to 9 percent, show through relevant calculations, how your hedge will protect you from loss. What if the interest rate in the market went down to 5%?

c) Do you think you would have hedged better if you had used an options contract on these bonds with an exercise price of $3,140,000? The options contracts are available in the size of 100 options per contract at a price of $5 per contract. Show detailed workings.