Your broker is offering you two bonds issued by two U.S. companies. One bond has an AA credit rating and the other has a BB rating from Standard and Poor’s. Both bonds have a par value of $1,000, a coupon rate of 10%, and a maturity of 10 years. The required rate of return by investors is 8% for AAA-rated bonds and 12% for BB-rated bonds. Please answer the following questions.
1) Explain the purpose of credit ratings.
2) Explain why the required rate of return is higher for BB-rated bonds than for AA-rated bonds.
3) Calculate the price of each bond, assuming coupons are paid annually.
4) Recalculate the price of each bond, assuming coupons are paid semi-annually.