You are a banker considering the issuance of a guaranteed note with stock index participation for a client. The current yield curve is flat at 4 percent for all maturities.
Two-year at-the-money calls trade at 10 percent of the index value. You are hesitant about the terms to set in the structured note.
a. Your supervisor asks you to compute the “fair” participation rate that would be feasible for a maturity of two years and a coupon rate of 0 percent, assuming the par value is 100.
b. Explain the relationship between the amount of the guaranteed coupon and the participation rate that can be offered.