A German company issues a five-year noncallable bond with a face value of 40 million. The bond
Question:
A German company issues a five-year noncallable bond with a face value of €40 million. The bond pays a coupon annually of 10%, of which 3% is estimated to be a credit premium.
A. The company would like to make the bond callable in exactly two years. Design a strategy using a European swaption that will achieve this goal. When the swaption expires, the fixed rate on the underlying swap will be denoted as FS(2,5). Evaluate what happens when this rate is at least the exercise rate and also when it is less than the exercise rate.
B. Reconsider the bond described above and assume it was actually issued as a callable bond with a 10% coupon. Construct a swaption strategy that will synthetically remove the call feature. As in Part A, let the swaption expire in two years and evaluate the outcomes.
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