Assume you plan to issue $1,000,000 in long-term bonds in October 2017. You are worried that interest rates will be 1% higher by then. The current yield-to-maturity on 30-year T-Bonds is 6.74%. There are October 2107 expiration T-Bond options available with pricing information shown below. The specifications for the options contracts are: one option contract is for $100,000 of 8% coupon, 30-year T-Bonds.

                          Call Premium                  Strike                    Put Premium

                              3.25                             114                             1.00

                              2.30                             115                            1.70

                              1.75                             116                            2.50

                              1.00                             117                            3.00

                                .50                             118                            3.60

Using T-Bond options, develop a strategy to hedge this risk.   This should include number of option contracts, buy or sell, put or call and a strike price.

Determine the outcome of the hedge if, in fact, interest rates increase by 1% by October 2017.

Did the hedge succeed in locking in today’s lower interest rate?

Hints: 1. A strike of 114 correlates to a bond priced at $1,140. 2. You need to use the current YTM of 6.74% on T-Bonds and figure out a bond price given the T-Bond option specifications. This would be your spot price.