Suppose that you are in charge of the structured notes desk at an investment bank. A customer calls with a request for an investment that has the following attributes:
Face value of $1,000
Five year maturity
The coupon rate will be reset in advance each six months, and coupons paid in arrears
The coupon rate will start out as 4% as an annual rate, but be reviewed each six months based on the following:
If the credit spread between investment grade US corporate bonds and speculative grade US corporate bonds is greater than 4% at the end of any six month period, then the coupon rate for the subsequent period will increase by 1%.
If the default rate on speculative grade US corporate bonds over any six month period is greater than 10% of the market, then the coupon rate for the subsequent period will increase by 1% (this adjustment would be in addition to the adjustment outlined above)
Required: Suppose you agree to proceed with offering this investment to the customer. Explain what factors you would consider in pricing the product to offer to the customer, and explain how you would manage the customer’s money so as to be able to meet all the terms of this structured note.
Note: Please feel free to use bullet points and summary statements in your answer. Please restrict your answer to no more than 1,000 words, including any examples or numbers you might use in your explanation.