A French bank offers an investment product ("guaranteed bond with stock market participation") that has been extremely successful with European retail investors. This is a two-year bond with a zero coupon. However, there is an attractive clause at maturity. The bondholder will get lull principal payment plus the percentage capital appreciation on the French CAC stock index between the date of issuance and maturity, if this capital appreciation is positive. So, a bondholder investing 100 will get. at maturity, either 100 (if the CAC index went down over the two years) or 100 plus the percentage gain of the index (if the CAC index went up over the two years).
a. Assume that the stock market is expected to go up by 20 percent over the two years. What is the expected annual yield on the bond?
b. At time of issue, the euro yield curve was flat at 6 percent. A two-year at-the-money call on the CAC index was quoted at 11 percent of the index value. What was the fair value of the bond at issuance?