The Current Dollar Yield Curve on the Dollar International Bond $\bullet$

question 20

Essay

The current dollar yield curve on the dollar international bond market is flat at 7% for top-quality borrowers. A company of good standing can issue plain-vanilla straight and floating-rate dollar bonds under the following conditions:
$\bullet$ Bond A: Straight bond. Five-year straight dollar bond with a coupon of 7.25%.
$\bullet$ Bond B: FRN. Five-year dollar FRN with a semiannual coupon set at LIBOR plus 0.25% and
a cap of 14%. The cap means that the coupon rate is limited to 14% even if the LIBOR passes 13.75%.
An investment banker proposes to a French company to issue bull and/or bear FRNs under the following conditions:
$\bullet$ Bond C: Bull FRN. Five-year FRN with a semiannual coupon set at: 13.75% - LIBOR.
$\bullet$ Bond D: Bear FRN. Five-year FRN with a semiannual coupon set at: 2 * LIBOR - 7% and a cap of 20.5%.
Coupons on all bonds cannot be negative. The investment bank also proposes a five-year floor option at 3.5%. This floor will pay to the French company the difference between 3.5% and LIBOR, if it is positive, or zero if LIBOR is above 3.5%. The cost of this floor is spread over the payment dates and
set at an annual 0.1%. The investment bank also proposes a five-year cap option at a strike of 13.75%. The cost of this cap is spread over the payment dates and set at an annual 0.05%. The company can also enter into a five-year interest rate swap at 7% fixed against LIBOR.
a. Explain why it would be attractive to the French company to issue these FRNs compared to current market conditions for plain-vanilla straight bonds and FRNs.
b. Find out the borrowing cost reduction that can be achieved by issuing bull notes compared to a fixed-coupon rate of 7.25%.
c. Find out the borrowing cost reduction that can be achieved by issuing bear notes compared to an FRN at LIBOR plus 0.25%.

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