You Are an Investment Banker Working in Switzerland Where Yields $\bullet$

Essay

You are an investment banker working in Switzerland where yields are very low (1% for all maturities). You are planning to offer a five-year Swiss franc/British pound bond with the following characteristics:
$\bullet$ Issuer: Brit Ltd., a top-quality British company.
$\bullet$ Issue amount: SFr 100 million.
$\bullet$ Coupon in SFr: 5% (or SFr 5 million).
$\bullet$ Reimbursed value: £40 million.
This bond qualifies as a Swiss franc bond for the portfolio of a Swiss insurance company.
The current spot exchange rate is 2.5 Swiss francs per British pound. The yield curve in British pounds is flat at 7%. The pound/franc swap rates are 7% in pounds against 1% in francs for all maturities.
a. Assume that Swiss insurance companies can account for their Swiss franc bond holdings
at historical costs. Give a reason why it would be attractive to invest in this bond.
b. Is the coupon rate set at fair pricing (i.e., consistent with current market conditions)?
c. The British company desires to borrow in pounds and does not wish to carry any currency risk on its debt. The investment banker needs to design a coupon swap that would hedge the currency risk on that dual-currency bond for Brit Ltd. The designed swap should have a zero value at time of contracting. Give one possible design for the swap and calculate its associated swap rate.
d. What is the pound yield paid by the British company, once it has hedged its currency risk on the dual-currency bond using the swap described above? What is the annual cost-saving in British pounds compared to a straight pound bond?