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.