Question 1: Hedging Financial Risks with Financial Derivatives (10 marks)

As a pension fund manager, you consider the Canada 5s of 2035 to be currently (April 2020) a good investment, and you want to purchase $1,861,704 of these bonds to strategically balance your investment portfolio. However, your next major cash receipts are not due until July 2020. You are concerned that interest rates may fall by July 2020.

Part 1: Design a simple options contract that could hedge interest rate risk for your scheduled July bond purchase: Should you buy a call option, sell a call option, buy a put option, or sell a put option? (2 marks) sell a call optionbuy a call optionsell a put optionbuy a put optionClick for List

Part 2: Suppose the call premium for one contract on the Canada 5s of 2035 is currently $1,135 for a strike price of $103,428, and the put premium is $1,160 for a similar strike price. Suppose the price of the Canada bond happens to be $105,217 in July. Based on your answer in (a) above: (Note: Enter all your answers to three decimal places):

i) Calculate the (intrinsic) value per contract of your option at the expiry date. (3 marks)

ii) Calculate your profit or loss per contract from the option. (3 marks)

iii) Calculate the break-even expiry price of the underlying for the option. (2 marks)