The current dollar yield curve on the international bond market is flat at 6.5 percent for AAA-rated borrowers. A French company of AA standing can issue straight and plain-vanilla FRN dollar bonds at the following conditions:
• Bond A: Straight bond. Five-year straight-dollar bond with a semiannual coupon of 6.75 percent.
• Bond B: Plain-vanilla FRN. Five-year dollar FRN with a semiannual coupon set at LIBOR plus 0.25 percent and a cap of 13 percent. The cap means that the coupon rate is limited at 13 percent, even if the LIBOR passes 12.75 percent.
An investment banker proposes to the French company the option of issuing bull and/or bear FRNs at the following conditions:
• Bond C: Bull FRN. Five-year FRN with a semiannual coupon set at 12.75 percent- LIBOR.
• Bond D: Bear FRN. Five-year FRN with a semiannual coupon set at 2 x LIBOR - 6.5 percent.
The coupons on the bull and bear FRNs cannot be negative. The coupon on the bear FRN is set with a cap of 19 percent.
Assume that LIBOR can never be below 3.25 percent or above 12.75 percent.
a. By comparing the net coupon per bond for the following combination to that of a straight Eurobond, show that it would be more attractive to the French company to issue the bull and/or bear FRNs than the straight Eurobond,
i. Issue 2 bull FRNs + 1 bear FRN.
ii. Issue 1 plain-vanilla FRN (bond B) + 1 bull FRN.
b. By comparing the net coupon per bond for the combination of 1 straight bond (bond A) + 1 bear FRN, show that ii would be more attractive to the French company to issue the bull and/or bear FRNs than the plain-vanilla FRN.