In 1990, the French Bank, BNP, Issued Exchangeable Bonds Denominated

Essay

In 1990, the French bank, BNP, issued exchangeable bonds denominated in French francs (FF). These are bonds issued for FF 100 on April 1, 1990, with an annual coupon of FF 5, plus an exchange right. The bonds can be redeemed for FF 100 on April 1, 1996. The right can be exchanged on
April 1, 1991, with payment of an additional FF 100, for another bond identical to the old bond (annual coupon of FF 5 and redeemed for FF 100 on April 1, 1996). If you exercise your right, you will have paid an additional FF 100 on April 1, 1991, but you will then hold two BNP bonds with maturity in 1996.
a. Under what scenario would you exercise the exchange right (exchange the right plus FF 100 for an additional bond) on April 1, 1991? What is the attraction of such an exchangeable bond for investors?
b. On April 1, 1990, the yield curve is flat at 6%. You can buy a call on a five-year bond with a coupon of 5%. The call has a strike price of 100% and expires on April 1, 1991. Its premium is 2%. Construct a replication portfolio to determine at what price the exchangeable bond can be issued by BNP.