You Are a Young Investment Banker Considering the Issuance of a Guaranteed

Essay

You are a young investment banker considering the issuance of a guaranteed note with stock index participation for a client. The current yield curve is flat at 8% for all maturities. Long-term at-the-money options on the stock market index are traded by banks. Two-year at-the-money calls trade
at 17.84% of the index value; three-year at-the-money calls trade at 20% of the index value. You
are hesitant about the terms to set in the structured note. You know that if you guarantee a higher
coupon rate, the level of participation in the stock appreciation will be less. Your boss asks you to compute the "fair" participation rate that would be feasible for various guaranteed coupon rates and maturities. In other words, based on the current market conditions (as described above), estimate the participation rates that are feasible with a maturity of two or three years, and a coupon rate of: 0%, 1%, 2%, 3%, 5%, and 7%.