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Question 8.P.14: Hokie Savings wants to purchase a portfolio of home mortgage...

Hokie Savings wants to purchase a portfolio of home mortgage loans with an expected average return of 6.5 percent. The management is concerned that interest rates will drop and the cost of the portfolio will increase from the current price of $50 million. In six months when the funds become available to purchase the loan portfolio, market interest rates are expected to be in the 5.5 percent range. Treasury bond options are available today at a quoted price of 10,900 (i.e., $109,000 per $100,000 contract), upon payment of a $700 premium, and are forecast to drop to a market value of $99,000 per contract. Should Hokie buy puts or calls? What before-tax profits could the Hokie earn per contract on this transaction? How many options should Hokie buy?

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Profit per contract: $109,000 – $99,000 – $700 = $9,300

 

Hokie should buy enough put options to offset the decrease in the price of the loan portfolio. Thus, figure out the price decrease and divide that number by 9,300 to get the number of put options needed.

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