Here's a pic of the dilemma with window in shower/tub area.

Is your question regarding window covering? In my experience best way to handle a window at a tub is to frost the glass. Sunlight will still come in and you will have your privacy.

Absolutely.

My questions is - if the glass is frosted, can shadows be seen from the outside?

I'm interested in re-tiling and re-doing this bath but hate the window and the wood frame. I don't really care about a window covering b/c it's high enough up. Just wondering how to re-do a window and how to deal with needing it waterproof. Right now, we try not to use the shower feature much.

it's curently not frosted. My main concern is window frame, waterproof, how to deal with a window in a shower area and avoid wood rot

There are a few options you could install a picture window made out of cellular PVC. You can use a Jeld-Wen window with their Auralast technology or a vinyl/aluminum window.