In 2008, when the U.S. automobile industry was struggling, the price of Ford Mot

Question

In 2008, when the U.S. automobile industry was struggling, the price of Ford Motor Company bonds rose. In this question, you need to calculate how tlie price increase also affects the interest rate. (a) What is the interest rate on a one-year Ford bond with a fare value of $5,000 and a price of $4,750? (b) What is the new interest rate on a one-vear Ford bond with a face value of $5,000 and a price of $4,950? 2. Let's say you own a firm that produces and sells Ping-Pong tables. The name of your company is iPong because your tables have a plug-in jack for all Apple products. To finance a new facton, you deckle to sell I winds. Your bonds are rated BBB. (a) Draw supply and demand curves for your iPong I Kinds. (The quantity of bonds is measured along the x axis, and the price along the y axis.) Label the supply curve S. the demand curve D. and the equilibrium price p. (b) How will the demand for il'ong bonds In- affected if a new secondary market agrees to buy and sell ilpong bonds? Illustrate the now demand curve in the graph above, and label it Dsst. How will this affect the price and interest rate on iPong bonds? 3. This question involves the hypothetical iPong firm form the previous question. (a) How will demand affected if a ratings agency upgrades your bond rating to A A? (b) How will the ratings upgrade affect the price of your bond? (c) How will the ratings upgrade affect your cost of borrowing? 4. Use supply and demand curves to illustrate how default risk affects both the price and the interest rate of a bond.

Explanation / Answer

1.a.

Interest rate = {(Face value – Price) ÷ Face value} × 100

                    = {(5,000 – 4,750) ÷ 5,000} × 100

                    = (250 ÷ 5,000) × 100

                    = 5%

1.b.

Interest rate = {(Face value – Price) ÷ Face value} × 100

                    = {(5,000 – 4,950) ÷ 5,000} × 100

                    = (50 ÷ 5,000) × 100

                    = 1%

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