The Current Yield Curve on the International Bond Market in Euro

question 8

Essay

The current yield curve on the international bond market in euro is flat at 4% for top-quality borrowers. A French company of good standing can issue plain-vanilla straight and floating-rate bonds at the following conditions:
$\bullet$ Bond A: Straight Bond. Five-year straight bond with a fixed coupon of 4%.
$\bullet$ Bond B: FRN. Five-year dollar FRN with a semiannual coupon set at LIBOR.
An investment banker proposes to the French company to issue bull and/or bear FRNs at the following conditions:
$\bullet$ Bond C: Bull FRN. Five-year FRN with a semiannual coupon set at:
7.60% - LIBOR.
$\bullet$ Bond D: Bear FRN. Five-year FRN with a semiannual coupon set at:
2*LIBOR - 4.2%.
The floor on all coupons is zero. The investment bank also proposes a five-year floor option at a strike of 2.1%. This floor will pay to the French company the difference between 2.1% and LIBOR, if it is positive, or zero if LIBOR is above 2.1%. The cost of this floor is spread over the payment dates and set at an annual 0.05%. The bank also proposes a five-year cap at a strike of 7.60%. The annual premium on the cap is 0.1%. The company can also enter in a five-year interest-rate swap 4% fixed against LIBOR.
a. Assume that the French company issues Bonds C and D in equal proportions. Is it more advantageous than issuing Bonds A and B in equal proportion and why?
b. Find out the borrowing cost reduction that can be achieved by issuing the bull note compared to issuing a fixed-coupon straight bond at 4%.
c. Find out the borrowing cost reduction that can be achieved by issuing the bull note compared to issuing a plain-vanilla FRN at LIBOR.
d. Find out the borrowing cost reduction that can be achieved by issuing the bear note compared to issuing a fixed-coupon straight bond at 4%.
e. Find out the borrowing cost reduction that can be achieved by issuing the bear note compared to issuing a plain-vanilla FRN at LIBOR.

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Definitions:

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