QUESTION 26

A company is deciding whether to issue a one-year dual-currency bond or a one-year currency option bond.

The dual-currency bond would be issued in CHF (Swiss francs) with a principal of 100 CHF per bond, with interest payable in CHF and principal repaid in U.S. dollars ($50). Denote x the interest at which this bond is issued.

The currency option bond is issued in CHF (100 CHF), and the interest and principal are repaid in CHF or $ at the option of the bondholder. The principal repaid is either 100 CHF or $50 and the interest rate is either y CHF or 12 y dollars.

As you guessed, the current spot exchange rate is 2 CHF/$. The current one-year market interest rates are 6% in CHF and 10% in $. One-year currency options are quoted in Chicago. A put CHF is quoted at 1.2 U.S. cents per CHF; this option premium is for one CHF, with a strike price of 50 US cents. (8 points)

a. What is the fair interest rate x on the dual-currency bond? Show you work.

b. What is the fair interest rate y on the currency option bond? Show your work.