To hedge against the expected increase in interest rates, the portfolio manager needs to reduce the duration of their bond portfolio. The duration measures the sensitivity of a bond's price to changes in interest rates, and a lower duration indicates lower sensitivity.

The current market value of the portfolio is calculated using the formula for the present value of a zero-coupon bond with continuous compounding:

$P = \text{Face Value} \times e^{-\text{Yield} \times \text{Time to Maturity}}$

For the 5-year zero-coupon bond, this calculation is:

$P = 88 \text{ million} \times e^{-0.04 \times 5} = 88 \text{ million} \times e^{-0.2} = 72.05 \text{ million USD}$

The desired duration of the new portfolio is 3 years. Let $W$ be the weight of the 1.5-year maturity bond in the new portfolio, and $(1 - W)$ be the weight of the remaining 5-year maturity bond. The weighted duration can be expressed as:

$1.5 \times W + 5 \times (1 - W) = 3$

Solving for $W$ gives:

$1.5W + 5 - 5W = 3$ $-3.5W = -2$ $W = \frac{2}{3.5} = 0.5714$

This means that approximately 57.14% of the portfolio should be invested in the 1.5-year bonds, and the remaining 42.86% in the 5-year bonds.

The value of the 1.5-year maturity bond to be purchased is then:

$\text{Value of 1.5-year bond} = W \times P = 0.5714 \times 72.05 \text{ million USD} = 41.17 \text{ million USD}$

Thus, the portfolio manager should purchase USD 41.17 million of the 1.5-year bonds to achieve the desired duration of 3 years on the combined position. The correct answer is C. USD 41.17 million.