The Yield Curves in U These Are Yields for Zero-Coupon Bonds of One- and Two-Year

question 34

Essay

The yield curves in U.S. dollars and Swiss francs are as follows:
$$\begin{array} { l c c } & \text { U.E. Dollar\% } & \text { Swiss Franc\% } \\\hline 1 \text { Year } & 10 & 6 \\2 \text { Years } & 12 & 7 \\\hline\end{array}$$ These are yields for zero-coupon bonds of one- and two-year maturities. The spot exchange rate is SF/$ = 1.5.
a. What are the implied one-year and two-year forward exchange rates?
b. You contemplate issuing a dual-currency bond. You could issue zero-coupon bonds in both currencies at the interest rates above. Instead, you wish to issue bonds of SF 150 with a coupon C in Swiss francs, paid each year for two years, and reimbursed for $100 at the end of two years. What is the interest rate c% (c = C/150) on the bond that would be consistent with the yield curves above?
c. You contemplate issuing a two-year currency option bond. The bond is issued for $100 and gives the option to receive the coupons and principal payment in either dollars or Swiss francs at a fixed exchange rate of SF/$51.5. A bank gives you quotes on the premiums for SF calls with a strike price of 1/1.5 = 0.66666 US$. The premium for a one-year call is 4 U.S. cents (per Swiss franc) and for a two-year call is 7 U.S. cents. What coupon rate should you set on your currency option bond?