Bank PAPOUF Decides to Issue Two Bonds and Wonders What $\bullet$

question 29

Essay

Bank PAPOUF decides to issue two bonds and wonders what the fair interest rate on these bonds should be:
A. A one-year currency option bond. The bond is issued in dollars with a face value of $100. The bondholder can choose to have the coupon and principal paid in dollars or in SFr, at a specified exchange rate of SFr/$ = 2, that is, receive either $100 or SFr 200 as principal repayment, and receive either $C or SFr 2C as interest if C is the coupon set in dollars. The coupon rate is
c = C/100.
B. A two-year currency option bond. The bond is issued in dollars, with a face value of $100 and pays an annual coupon C'. The bondholder can choose to have the coupons and principal paid in dollars or in SFr, at a specified exchange rate of SFr/$ = 2, that is, receive either $100 or SFr 200 as principal repayment, and receive either $C' or SFr 2C' as interest, if C' is the coupon set in dollars. The coupon rate is c'= C'/100.
Current market conditions are given below:
$\bullet$ Interest Rates 1-Year 2-Year
Zero-coupon rates
US$ 8% 8%
SFr 4% 4%
$\bullet$ Spot exchange rate: SFr/$= 2
$\bullet$ Currency options:
SFr call, strike price 50 U.S. cents, expiration one year: 2 U.S. cents.
SFr call, strike price 50 U.S. cents, expiration two years: 5 U.S. cents.
a. Compute the coupon C on Bond A that would be consistent with market conditions at time of issue.
b. Compute the coupon C' on Bond B that would be consistent with market conditions at time of issue.

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Definitions:

Work in Process

Inventory items that are in the manufacturing process but have not yet completed production.

Cash Account

An account that records cash transactions, including both incoming and outgoing cash flows, essential for effective financial management.

Raw Materials

The basic materials from which products are made, usually processed in several stages in the production cycle.

Direct Labor Cost

The total cost of all labor directly involved in the production of goods or services.