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CONTENTS WEI GHTS ( % ) PAGE


NO.
DEBT I NSTRUMENTS: FUNDAMENTAL
FEATURES. . 3. . 4
1. 1 I NSTRUMENT FEATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1. 2 MODI FYI NG THE COUPON OF A BOND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1. 3 MODI FYI NG THE TERM TO MATURI TY OF A BOND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1. 4 MODI FYI NG THE PRI NCI PAL REPAYMENT OF A BOND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1. 5 ASSET BACKED SECURI TI ES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
I NDI AN DEBT MARKETS: A
PROFI LE4. . . . . 11
2. 1 MARKET SEGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2. 2 PARTI CI PANTS I N THE DEBT MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2. 3 SECONDARY MARKET FOR DEBT I NSTRUMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
CENTRAL GOVERNMENT SECURI TI ES:
BONDS1020
3. 1 I NTRODUCTI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3. 2 DEVELOPMENTS EXPECTED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3. 3 G- SECS: TRENDS I N VOLUMES, TENOR AND YI ELDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3. 4 PRI MARY I SSUANCE PROCESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3. 5 PARTI CI PANTS I N GOVERNMENT BOND MARKETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3. 6 CONSTI TUENT SGL ACCOUNTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3. 7 PRI MARY DEALERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3. 8 SATELLI TE DEALERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3. 9 SECONDARY MARKETS FOR GOVERNMENT BONDS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3. 10 SETTLEMENT OF TRADES I N G- SECS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
CENTRAL GOVERNMENT SECURI TI ES: T-
BI LLS. 3. 40
4. 1 I SSUANCE PROCESS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
4. 2 CUT- OFF YI ELDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4. 3 I NVESTORS I N T- BI LLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4. 4 SECONDARY MARKET ACTI VI TY I N T- BI LLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
STATE GOVERNMENT
BONDS2. 45
5. 1 GROSS FI SCAL DEFI CI T OF STATE GOVERNMENTS AND I TS FI NANCI NG. . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5. 2 VOLUMES AND COUPON RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5. 3 OWNERSHI P PATTERN OF STATE GOVERNMENT BONDS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
5. 4 STATE GOVERNMENT GUARANTEED BONDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
CALL MONEY
MARKETS2. 48
6. 1 VOLUMES I N THE CALL MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
6. 2 PARTI CI PANTS I N THE CALL MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
6. 3 CALL RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
6. 4 MOVEMENT OF PARTI CI PANTS FROM CALL TO REPO MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
CORPORATE DEBT:
BONDS8. 55
7. 1 MARKET SEGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
7. 2 I SSUE PROCESS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
7. 3 I SSUE MANAGEMENT AND BOOK BUI LDI NG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
7. 4 TERMS OF A DEBENTURE I SSUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

2
7. 5 CREDI T RATI NG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
COMMERCI AL PAPER & CERTI FI CATE OF
DEPOSI TS365
8. 1 GUI DELI NES FOR CP I SSUE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
8. 2 RATI NG NOTCHES FOR CPS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
8. 3 GROWTH I N THE CP MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
8. 4 STAMP DUTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
8. 5 CERTI FI CATES OF DEPOSI T. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
REPOS5
. . 69
9. 1 I NTRODUCTI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
9. 2 REPO RATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
9. 3 CALCULATI NG SETTLEMENT AMOUNTS I N REPO TRANSACTI ONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
9. 4 ADVANTAGES OF REPOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
9. 5 REPO MARKET I N I NDI A: SOME RECENT I SSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
9. 6 SECONDARY MARKET TRANSACTI ONS I N REPOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
BOND MARKET I NDI CES AND
BENCHMARKS. 4. . 80
10. 1 I - BEX: SOVEREI GN BOND I NDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
10. 2 THE NSE - MI BOR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
TRADI NG MECHANI SM I N THE NSE-
WDM7. 91
11. 1 DESCRI PTI ON OF THE NSE - WDM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
11. 2 ORDER TYPES AND CONDI TI ONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
11. 3 MARKET PHASES AND STARTI NG UP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
11. 4 TRADI NG MECHANI SM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
11. 5 ORDER ENTRY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
11. 6 ORDER VALI DATI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
11. 7 ORDER MATCHI NG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
11. 8 TRADE MANAGEMENT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
11. 9 REPORTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
11. 10 SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
11. 11 RATES OF BROKERAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
REGULATORY AND PROCEDURAL
ASPECTS. . 9106
12. 1 PUBLI C DEBT ACT, 1944 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
12. 2 SEBI ( GUI DELI NES FOR DI SCLOSURE AND I NVESTOR PROTECTI ON) , 2000 . . . . . . . . . . . . . . . . . 108
12. 3 MARKET PRACTI CES AND PROCEDURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
VALUATI ON OF
BONDS. . 12. . 125
13. 1 BOND VALUATI ON: FI RST PRI NCI PLES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
13. 2 TI ME PATH OF A BOND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
13. 3 VALUI NG A BOND AT ANY POI NT ON THE TI ME SCALE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
13. 4 ACCRUED I NTEREST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
13. 5 YI ELD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
13. 6 WEI GHTED YI ELD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
13. 7 YTM OF A PORTFOLI O. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
13. 8 REALI SED YI ELD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
13. 9 YI ELDPRI CE RELATI ONSHI PS OF BONDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
YI ELD CURVE AND TERM STRUCTURE OF I NTEREST
RATES10. 146

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14. 1 YI ELD CURVE: A SI MPLE APPROACH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
14. 2 BOOTSTRAPPI NG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
14. 3 ALTERNATE METHODOLOGI ES TO ESTI MATE THE YI ELD CURVE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
14. 4 THEORI ES OF THE TERM STRUCTURE OF I NTEREST RATES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
DURATI ON10
159
15. 1 I NTRODUCTI ON AND DEFI NI TI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
15. 2 CALCULATI NG DURATI ON OF A COUPON PAYI NG BOND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
15. 3 COMPUTI NG DURATI ON ON DATES OTHER THAN COUPON
DATES. . . 137
15. 4 MODI FI ED DURATI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
15. 5 RUPEE DURATI ON. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
15. 7 PORTFOLI O DURATI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
15. 8 LI MI TATI ONS OF DURATI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
FI XED I NCOME
DERI VATI VES. 8174
16. 1 WHAT ARE FI XED- I NCOME DERI VATI VES? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
16. 2 MECHANI CS OF FORWARD RATE AGREEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
16. 3 I NTEREST RATE FUTURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
16. 4 I NTEREST RATE SWAPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
GLOSSARY OF DEBT MARKET TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188

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Ch apt er 1

Debt I n st r u men t s: Fu n damen t al
Feat u r es

Debt inst rument s represent cont ract s whereby one part y lends money t o anot her on
pre- det ermined t erms wit h regard t o rat e of int erest t o be paid by t he borrower t o t he
lender, t he periodicit y of such int erest payment , and t he repayment of t he principal
amount borrowed. I n t he I ndian securit ies market s, we use t he t erm bond f or debt
inst rument s issued by t he Cent ral and St at e government s and public sect or
organisat ions, and t he t erm debent ures f or inst rument s issued by privat e corporat e
sect or.
1


1. 1 I n st r u men t Feat u r es

The principal f eat ures of a bond are:
a. Mat urit y
b. Coupon
c. Principal
I n t he bond market s, t he t erms mat urit y and t erm- t o- mat urit y, are used quit e
f requent ly. Mat urit y of a bond ref ers t o t he dat e on which t he bond mat ures, or t he
dat e on which t he borrower has agreed t o repay ( redeem) t he principal amount t o t he
lender. The borrowing is ext inguished wit h redempt ion, and t he bond ceases t o exist
af t er t hat dat e. Term t o mat urit y, on t he ot her hand, ref ers t o t he number of years
remaining f or t he bond t o mat ure. Term t o mat urit y of a bond changes everyday, f rom
t he dat e of issue of t he bond unt il it s mat urit y. Coupon ref ers t o t he periodic int erest
payment s t hat are made by t he borrower ( who is also t he issuer of t he bond) t o t he
lender ( t he subscriber of t he bond) . Coupon rat e is t he rat e at which int erest is paid,
and is usually represent ed as a percent age of t he par value of a bond. Principal is t he
amount t hat has been borrowed, and is also called t he par value or f ace value of t he
bond. The coupon is t he product of t he principal and t he coupon rat e. Typical f ace
values in t he bond market are Rs. 100 and Rs. 1000. I n many cases, t he name of t he
bond it self conveys t he key f eat ures of a bond. For example a CG 11. 4% 2008 bond
ref ers t o a cent ral government bond mat uring in t he year 2008, and paying a coupon of
11. 4%. Since cent ral government bonds have a f ace value of Rs. 100, and pay coupon
semi- annually, t his bond will pay Rs. 5. 70 as six- mont hly coupon, unt il mat urit y, when
t he bond will be redeemed. The t erm t o mat urit y of a bond can be calculat ed on any
dat e, as t he dist ance bet ween such a dat e and t he dat e of mat urit y. I t is also called t he
t erm or t he t enor of t he bond. For inst ance, on February 17, 2001, t he t erm t o mat urit y
of t he bond mat uring on May 23, 2008 will be 7. 27 years.

1
I n t his workbook t he t erms bonds, debent ures and debt inst rument s have been used
int er- changeably.

5
There is no rigid classif icat ion of bonds on t he basis of t heir t erm t o mat urit y. Generally
bonds wit h t enors of 1- 5 years are called short - t erm bonds; bonds wit h t enors ranging
f rom 4 t o 10 years are called long t erm bonds.

6

Box 1. 1: Compu t i n g t er m t o mat u r i t y i n year s
The dist ance bet ween a given dat e and t he dat e on which a bond mat ures is t he t erm t o
mat urit y of a bond. This dist ance can be calculat ed in years, as f ollows:
Use f unct ion YEARFRAC in Excel. The input s are st art _dat e which is t he dat e on
which we want t o measure t he t erm t o mat urit y of t he bond; end_dat e is t he dat e on
which t he bond mat ures; basis is t he manner in which t he number of days bet ween
t he st art and t he end dat es are t o be count ed. The numbers 0- 4 represent t he various
ways in which days can be count ed. We have used 4 which is a 30/ 360 days
convent ion.
The result is 7. 27, which is t he t erm t o mat urit y of t he bond, in years, on February 17,
2001.

1. 2 Modi f yi n g t h e Cou pon of a Bon d

I n a plain vanilla bond, coupon is paid at a pre- det ermined rat e, as a percent age of t he
par value of t he bond. Several modif icat ions t o t he manner in which coupons / int erest
on a bond is paid are possible.

Zer o Cou pon Bon d
I n such a bond, no coupons are paid. The bond is inst ead issued at a discount t o it s f ace
value, at which it will be redeemed. There are no int ermit t ent payment s of int erest .
When such a bond is issued f or a very long t enor, t he issue price is at a st eep discount
t o t he redempt ion value. Such a zero coupon bond is also called a deep discount bond.
The ef f ect ive int erest earned by t he buyer is t he dif f erence bet ween t he f ace value and
t he discount ed price at which t he bond is bought . There are also inst ances of zero
coupon bonds being issued at par, and redeemed wit h int erest at a premium. The
essent ial f eat ure of t his t ype of bonds is t he absence of int ermit t ent cash f lows.
Tr easu r y St r i ps
I n t he Unit ed St at es, government dealer f irms buy coupon paying t reasury bonds, and
creat e out of each cash f low of such a bond, a separat e zero coupon bond. For example,
a 7- year coupon- paying bond comprises of 14 cash f lows, represent ing half - yearly
coupons and t he repayment of principal on mat urit y. Dealer f irms split t his bond int o 14
zero coupon bonds, each one wit h a dif f ering mat urit y and sell t hem separat ely, t o
buyers wit h varying t enor pref erences. Such bonds are known as t reasury st rips. ( St rips
is an acronym f or Separat e Trading of Regist ered I nt erest and Principal Securit ies) . We
do not have t reasury st rips yet in t he I ndian market s. RBI and Government are making
ef f ort s t o develop market f or st rips in government securit ies. There have been f ew
inst ances of privat ely placed corporat e debt , which have st ripped coupons.
Fl oat i n g Rat e Bon ds
I nst ead of a pre- det ermined rat e at which coupons are paid, it is possible t o st ruct ure
bonds, where t he rat e of int erest is re- set periodically, based on a benchmark rat e.
Such bonds whose coupon rat e is not f ixed, but reset wit h ref erence t o a benchmark
rat e, are called f loat ing rat e bonds. For example, I DBI issued a 5 year f loat ing rat e
bond, in July 1997, wit h t he rat es being re- set semi- annually wit h ref erence t o t he 10
year yield on cent ral government securit ies and a 50 basis point mark- up. I n t his bond,
every six mont hs, t he 10- year benchmark rat e on government securit ies is ascert ained.

7
The coupon rat e I DBI would pay f or t he next six mont hs is t his benchmark rat e, plus 50
basis point s. The coupon on a f loat ing rat e bond t hus varies along wit h t he benchmar k
rat e, and is reset periodically.
Some f loat ing rat e bonds also have caps and f loors, which represent t he upper and
lower limit s wit hin which t he f loat ing rat es can vary. For example, t he I DBI bond
described above had a f loor of 13. 5%. This means, t he lender would receive a minimum
of 13. 5% as coupon rat e, should t he benchmark rat e f all below t his t hreshold. A ceiling,
or a cap represent s t he maximum int erest t hat t he borrower will pay, should t he
benchmark rat e move above such a level. Most corporat e bonds linked t o t he call rat es,
have such a ceiling t o cap t he int erest obligat ion of t he borrower, in t he event of t he
benchmark call rat es rising very st eeply. Float ing rat e bonds whose coupon rat es are
bound by bot h a cap and f loor, are called as range not es, because t he coupon rat es vary
wit hin a cert ain range.
The ot her names by which f loat ing rat e bonds are known, are variable rat e bonds and
adj ust able rat e bonds. These t erms are generally used in t he case of bonds whose
coupon rat es are reset at longer t ime int ervals of a year and above. These bonds are
common in t he housing loan market s.
I n t he developed market s, t here are f loat ing rat e bonds, whose coupon rat es move in
t he direct ion opposit e t o t he direct ion of t he benchmark rat es. Such bonds are called
inverse f loat ers.
Ot h er Var i at i on s
I n t he mid- eight ies, t he US market s wit nessed a variet y of coupon st ruct ures in t he high
yield bond market ( j unk bonds) f or leveraged buy- out s. I n many of t hese cases,
st ruct ures t hat enabled t he borrowers t o def er t he payment of coupons were creat ed.
Some of t he more popular st ruct ures were: ( a) def erred int erest bonds, where t he
borrower could def er t he payment of coupons in t he init ial 3 t o 7 year period; ( b) St ep-
up bonds, where t he coupon was st epped up by a f ew basis point s periodically, so t hat
t he int erest burden in t he init ial years is lower, and increases over t ime; and ( c)
ext endible reset bond, in which invest ment bankers reset t he rat es, not on t he basis of a
benchmark, but af t er re- negot iat ing a new rat e, which in t he opinion of t he lender and
borrower, represent ed t he rat e f or t he bond af t er t aking int o account t he new
circumst ances at t he t ime of reset .

1. 3 Modi f yi n g t h e Ter m t o Mat u r i t y of a Bon d

Cal l abl e Bon ds
Bonds t hat allow t he issuer t o alt er t he t enor of a bond, by redeeming it prior t o t he
original mat urit y dat e, are called callable bonds. The inclusion of t his f eat ure in t he
bonds st ruct ure provides t he issuer t he right t o f ully or part ially ret ire t he bond, and is
t heref ore in t he nat ure of call opt ion on t he bond. Since t hese opt ions are not separat ed
f rom t he original bond issue, t hey are also called embedded opt ions. A call opt ion can
be an European opt ion, where t he issuer specif ies t he dat e on which t he opt ion could be
exercised. Alt ernat ively, t he issuer can embed an American opt ion in t he bond,
providing him t he right t o call t he bond on or anyt ime bef ore a pre- specif ied dat e.
The call opt ion provides t he issuer t he opt ion t o redeem a bond, if int erest rat es decline,
and re- issue t he bonds at a lower rat e. The invest or, however, loses t he opport unit y t o
st ay invest ed in a high coupon bond, when int erest rat es have dropped. The call opt ion,

8
t heref ore, can ef f ect ively alt er t he t erm of a bond, and carries an added set of risks t o
t he invest or, in t he f orm of call risk, and re- invest ment risk. As we shall see lat er, t he
prices at which t hese bonds would t rade in t he market are also dif f erent , and depend on
t he probabilit y of t he call opt ion being exercised by t he issuer. I n t he home loan
market s, pre- payment of housing loans represent a special case of call opt ions exercised
by borrowers. Housing f inance companies are exposed t o t he risk of borrowers
exercising t he opt ion t o pre- pay, t hus ret iring a housing loan, when int erest rat es f all.
Pu t t abl e Bon ds
Bonds t hat provide t he invest or wit h t he right t o seek redempt ion f rom t he issuer, prior
t o t he mat urit y dat e, are called put t able bonds. The put opt ions embedded in t he bond
provides t he invest or t he right s t o part ially or f ully sell t he bonds back t o t he issuer,
eit her on or bef ore pre- specif ied dat es. The act ual t erms of t he put opt ion are st ipulat ed
in t he original bond indent ure.
A put opt ion provides t he invest or t he right t o sell a low coupon- paying bond t o t he
issuer, and invest in higher coupon paying bonds, if int erest rat es move up. The issuer
will have t o re- issue t he put bonds at higher coupons. Put t able bonds represent a re-
pricing risk t o t he issuer. When int erest rat es increase, t he value of bonds would
decline. Theref ore put opt ions, which seek redempt ions at par, represent an addit ional
loss t o t he issuer.
Con ver t i bl e Bon ds
A convert ible bond provides t he invest or t he opt ion t o convert t he value of t he
out st anding bond int o equit y of t he borrowing f ir m, on pre- specif ied t erms. Exercising
t his opt ion leads t o redempt ion of t he bond prior t o mat urit y, and it s replacement wit h
equit y. At t he t ime of t he bonds issue, t he indent ure clearly specif ies t he conversion
rat io and t he conversion price. The conversion rat io ref ers t o t he number of equit y
shares, which will be issued in exchange f or t he bond t hat is being convert ed. The
conversion price is t he result ing price when t he conversion rat io is applied t o t he value
of t he bond, at t he t ime of conversion. Bonds can be f ully convert ed, such t hat t hey
are f ully redeemed on t he dat e of conversion. Bonds can also be issued as part ially
convert ible, when a part of t he bond is redeemed and equit y shares are issued in t he
pre- specif ied conversion rat io, and t he non- convert ible port ion cont inues t o remain as a
bond.

1. 4 Modi f yi n g t h e Pr i n ci pal Repaymen t of a Bon d

Amor t i si n g Bon ds
The st ruct ure of some bonds may be such t hat t he principal is not repaid at t he
end/ mat urit y, but over t he lif e of t he bond. A bond, in which payment s, made by t he
borrower over t he lif e of t he bond, includes bot h int erest and principal, is called an
amort ising bond. Aut o loans, consumer loans and home loans are examples of
amort ising bonds. The mat urit y of t he amort ising bond ref ers only t o t he last payment
in t he amort ising schedule, because t he principal is repaid over t ime.
Bon ds w i t h Si n k i n g Fu n d Pr ovi si on s
I n cert ain bond indent ures, t here is a provision t hat calls upon t he issuer t o ret ire some
amount of t he out st anding bonds every year. This is done eit her by buying some of t he
out st anding bonds in t he market , or as is more common, by creat ing a separat e f und,
which calls t he bonds on behalf of t he issuer. Such provisions t hat enable ret iring bonds

9
over t heir lives are called sinking f und provisions. I n many cases, t he sinking f und is
managed by t rust ees, who regularly ret ire part of t he out st anding bonds, usually at par.
Sinking f unds also enable paying of f bonds over t heir lif e, rat her t han at mat urit y. One
usual variant is applicabilit y of t he sinking f und provision af t er f ew years of t he issue of
t he bond, so t hat t he f unds are available t o t he borrower f or a minimum period, bef ore
redempt ion can commence.

1. 5 Asset Back ed Secu r i t i es

Asset backed securit ies represent a class of f ixed income securit ies, creat ed out of
pooling t oget her asset s, and creat ing securit ies t hat represent part icipat ion in t he cash
f lows f rom t he asset pool. For example, select housing loans of a loan originat or ( say, a
housing f inance company) can be pooled, and securit ies can be creat ed, which represent
a claim on t he repayment s made by home loan borrowers. Such securit ies are called
mort gagebacked securit ies. I n t he I ndian cont ext , t hese securit ies are known as
st ruct ured obligat ions ( SO) . Since t he securit ies are creat ed f rom a select pool of asset s
of t he originat or, it is possible t o cherry- pick and creat e a pool whose asset qualit y is
bet t er t han t hat of t he originat or. I t is also common f or st ruct uring t hese inst rument s,
wit h clear credit enhancement s, achieved eit her t hrough guarant ees, or t hrough t he
creat ion of exclusive pre- empt ive access t o cash f lows t hrough escrow account s. Asset s
wit h regular st reams of cash f lows are ideally suit ed f or creat ing asset - backed securit ies.
I n t he I ndian cont ext , car loan and t ruck loan receivables have been securit ised.
Securit ised home loans represent a very large segment of t he US bond market s, next in
size only t o t reasury borrowings. However, t he market f or securit isat ion has not
developed appreciably because of t he lack of legal clarit y and conducive regulat ory
environment .

Model Quest i ons

1. On val u e dat e Ju n e 10, 2000, w h at i s t h e t er m t o mat u r i t y i n year s, of a
gover n men t secu r i t y mat u r i n g on 23
r d
Mar ch 2004?
Use t he yearf rac f unct ion in Excel, wit h t he f ollowing specif icat ions:
Set t lement dat e: June 10, 2000
Mat urit y Dat e: March 23, 2004
Basis: 4
( Government securit ies t rade on 30/ 360 European basis. We t heref ore use 4 , in t he
Excel f unct ion, which applies t his day count convent ion) .
An s: 3. 786 year s.

2. Wh i ch of t h e f ol l ow i n g abou t a cal l abl e bon d i s t r u e?
a. Callable bonds always t rade at a discount t o non- callable bonds.
b. Callable bonds expose issuers t o t he risk of reduced re- invest ment ret urn.
c. Callable bonds are act ually variable t enor bonds.
d. Callable bonds are not as liquid as non- callable bonds.
An s: c.

3. Cou pon of a f l oat i n g r at e bon d i s

10
a. modif ied whenever t here is a change in t he benchmark rat e.
b. modif ied at pre- set int ervals wit h ref erence t o a benchmark rat e.
c. modif ied f or changes in benchmark rat e beyond agreed levels.
d. modif ied wit hin a range, f or changes in t he benchmark rat e.
An s: b.




11

Ch apt er 2

I n di an Debt Mar k et s: A Pr of i l e
2


I ndian debt market s, in t he early ninet ies, were charact erised by cont rols on pricing of
asset s, segment at ion of market s and barriers t o ent ry, low levels of liquidit y, limit ed
number of players, near lack of t ransparency, and high t ransact ions cost . Financial
ref orms have signif icant ly changed t he I ndian debt market s f or t he bet t er. Most debt
inst rument s are now priced f reely on t he market s; t rading mechanisms have been
alt ered t o provide f or higher levels of t ransparency, higher liquidit y, and lower
t ransact ions cost s; new part icipant s have ent ered t he market s, broad basing t he t ypes
of players in t he market s; met hods of securit y issuance, and innovat ion in t he st ruct ure
of inst rument s have t aken place; and t here has been a signif icant improvement in t he
disseminat ion of market inf ormat ion.

2. 1 Mar k et Segmen t s

There are t hree main segment s in t he debt market s in I ndia, viz. , Government
Securit ies, Public Sect or Unit s ( PSU) bonds, and corporat e securit ies. The market f or
Government Securit ies comprises t he Cent re, St at e and St at e- sponsored securit ies. I n
t he recent past , local bodies such as municipalit ies have also begun t o t ap t he debt
market s f or f unds. The PSU bonds are generally t reat ed as surrogat es of sovereign
paper, somet imes due t o explicit guarant ee and of t en due t o t he comf ort of public
ownership. Some of t he PSU bonds are t ax f ree, while most bonds including government
securit ies, are not t ax- f ree. The RBI also issues a set of t ax- f ree bonds, called t he 8. 5%
RBI relief bonds, which is a popular cat egory of t ax- f ree bonds in t he market .
Corporat e bond market s comprise of commercial paper and bonds. These bonds
t ypically are st ruct ured t o suit t he requirement s of invest ors and t he issuing corporat e,
and include a variet y of t ailor- made f eat ures wit h respect t o int erest payment s and
redempt ion. The less dominant f ourt h segment comprises of short t erm paper issued by
banks, most ly in t he f orm of cert if icat es of deposit .
The market f or government securit ies is t he oldest and most dominant in t erms of
market capit alisat ion, out st anding securit ies, t rading volume and number of part icipant s.
I t not only provides resources t o t he government f or meet ing it s short t erm and long
t erm needs, but also set s benchmark f or pricing corporat e paper of varying mat urit ies
and is used by RBI as an inst rument of monet ary policy. The inst rument s in t his
segment are f ixed coupon bonds, commonly ref erred t o as dat ed securit ies, t reasury
bills, f loat ing rat e bonds, zero coupon bonds and inf lat ion index bonds. Bot h Cent ral and
St at e government securit ies comprise t his segment of t he debt market .

2
This chapt er draws f rom NSE publicat ions: I ndian Securit ies Market : A Review, 2000;
Debt Market Updat es; NSENEWS, Various issues.

12
The issues by government sponsored inst it ut ions like, Development Financial
I nst it ut ions, as well as t he inf rast ruct ure- relat ed bodies and t he PSUs, who make regular
f orays int o t he market t o raise medium- t erm f unds, const it ut e t he second segment of
debt market s. The gradual wit hdrawal of budget ary support t o PSUs by t he government
since 1991 has compelled t hem t o look at t he bond market f or mobilising resources. The
pref erred mode of issue has been privat e placement , barring an occasional public issue.
Banks, f inancial inst it ut ions and ot her corporat es have been t he maj or subscribers t o
t hese issues. The t ax- f ree bonds, which const it ut e over 50% of t he out st anding PSU
bonds, are quit e popular wit h inst it ut ional players.
The market f or corporat e debt securit ies has been in vogue since early 1980s. Unt il
1992, int erest rat es on corporat e bond issuance was regulat ed and was unif orm across
credit cat egories. I n t he init ial years, corporat e bonds were issued wit h sweet eners in
t he f orm of convert ibilit y clause or equit y warrant s. Most corporat e bonds were plain
coupon paying bonds, t hough a f ew variat ions in t he f orm of zero coupon securit ies,
deep discount bonds and secured promissory not es were issued. Af t er t he de- regulat ion
of int erest rat es on corporat e bonds in 1992, we have seen a variet y of st ruct ures and
inst rument s in t he corporat e bond market s, including securit ised product s, corporat e
bond st rips, and a variet y of f loat ing rat e inst rument s wit h f loors and caps. I n t he
recent years, t here has been an increase in issuance of corporat e bonds wit h embedded
put and call opt ions. The maj or part of t he corporat e debt is privat ely placed wit h t enors
of 1- 12 years.
I nf ormat ion on t he size of t he various segment s of t he debt market in I ndia is not
readily available. This is due t o t he f act t hat many debt inst rument s are privat ely placed
and t heref ore not list ed on market s. While t he RBI regulat es t he issuance of
government securit ies, corporat e debt securit ies f all under t he regulat ory purview of
SEBI . The periodic report s of issuers and invest ors are t heref ore sent t o t wo dif f erent
regulat ors. Theref ore, aggregat ed dat a f or t he market as a whole is dif f icult t o obt ain.
The NSE provides a t rading plat f orm f or most debt inst rument s issued in I ndia.
Theref ore, Table 2. 1 on market capit alizat ion can be said t o be indicat ive of t he relat ive
size of t he various segment s of t he debt market .
The debt market s also have a large segment which is a non- securit ised, t ransact ions
based segment , where players are able t o lend and borrow amongst t hemselves. These
are t ypically short t erm segment s and comprise of call and not ice money market s, which
is t he most act ive segment in t he debt market s, int er- bank market f or t erm money,
market s f or int er- corporat e loans and market s f or ready f orward deals ( repos) .

Tabl e 2. 1: Mar k et Capi t al i sat i on - NSE- WDM Segmen t at t h e en d of Sept ember
2001

Secu r i t y t ype Mar k et Capi t al i sat i on
( Rs. cr . )
Sh ar e i n Tot al ( % )
Government Securit ies 474, 779 70. 01
PSU Bonds 42, 781 6. 31
St at e Loans 50, 217 7. 40
Treasury Bills 23, 347 3. 44
Mut ual Funds 37, 843 5. 58
Financial I nst it ut ions 26, 499 3. 91
Corporat e Bonds 14, 685 2. 17

13
Ot hers 8, 010 1. 18
TOTAL 678, 161 100. 00

2. 2 Par t i ci pan t s i n t h e Debt Mar k et s

Debt market s are pre- dominant ly wholesale market s, wit h dominant inst it ut ional
invest or part icipat ion. The invest ors in t he debt market s concent rat e in banks, f inancial
inst it ut ions, mut ual f unds, provident f unds, insurance companies and corporat es. Many
of t hese part icipant s are also issuers of debt inst rument s. The smaller number of large
players has result ed in t he debt market s being f airly concent rat ed, and evolving int o a
wholesale negot iat ed dealings market . Most debt issues are privat ely placed or
auct ioned t o t he part icipant s. Secondary market dealings are most ly done on t elephone,
t hrough negot iat ions. I n some segment s such as t he government securit ies market ,
market makers in t he f orm of primary dealers have emerged, who enable a broader
holding of t reasury securit ies. Debt f unds of t he mut ual f und indust ry, comprising of
liquid f unds, bond f unds and gilt f unds, represent a recent mode of int ermediat ion of
ret ail invest ment s int o t he debt market s, apart f rom banks, insurance, provident f unds
and f inancial inst it ut ions, who have t radit ionally been maj or int ermediaries of ret ail
f unds int o debt market product s.
The market part icipant s in t he debt market are:
i. Cent ral government s, raising money t hrough bond issuances, t o f und budget ary
def icit s and ot her short and long t erm f unding requirement s.
ii. Reserve Bank of I ndia, as invest ment banker t o t he government , raises f unds f or
t he government t hrough bond and t - bill issues, and also part icipat es in t he market
t hrough open- market operat ions, in t he course of conduct of monet ary policy. The
RBI regulat es t he bank rat es and repo rat es and uses t hese rat es as t ools of it s
monet ary policy. Changes in t hese benchmark rat es direct ly impact debt market s
and all part icipant s in t he market .
iii. Primary dealers, who are market int ermediaries appoint ed by t he Reserve Bank of
I ndia who underwrit e and make market in government securit ies, and have access
t o t he call market s and repo market s f or f unds.
iv. St at e Government s, municipalit ies and local bodies, which issue securit ies in t he
debt market s t o f und t heir development al proj ect s, as well as t o f inance t heir
budget ary def icit s.
v. Public sect or unit s are large issuers of debt securit ies, f or raising f unds t o meet t he
long t erm and working capit al needs. These corporat ions are also invest ors in bonds
issued in t he debt market s.
vi. Corporat e t reasuries issue short and long t erm paper t o meet t he f inancial
requirement s of t he corporat e sect or. They are also invest ors in debt securit ies
issued in t he market .
vii. Public sect or f inancial inst it ut ions regularly access debt market s wit h bonds f or
f unding t heir f inancing requirement s and working capit al needs. They also invest in
bonds issued by ot her ent it ies in t he debt market s.
viii. Banks are t he largest invest ors in t he debt market s, part icularly t he t reasury bond
and bill market s. They have a st at ut ory requirement t o hold a cert ain percent age of
t heir deposit s ( current ly t he mandat ory requirement is 25% of deposit s) in
approved securit ies ( all government bonds qualif y) t o sat isf y t he st at ut ory liquidit y

14
requirement s. Banks are very large part icipant s in t he call money and overnight
market s. They are arrangers of commercial paper issues of corporat es. They are
also act ive in t he int er- bank t erm market s and repo market s f or t heir shor t t er m
f unding requirement s. Banks also issue CDs and bonds in t he debt market s.
ix. Mut ual f unds have emerged as anot her import ant player in t he debt market s, owing
primarily t o t he growing number of bond f unds t hat have mobilised signif icant
amount s f rom t he invest ors. Most mut ual f unds also have specialised bond f unds
such as gilt f unds and liquid f unds. Mut ual f unds are not permit t ed t o borrow f unds,
except f or very short - t erm liquidit y requirement s. Theref ore, t hey part icipat e in t he
debt market s pre- dominant ly as invest ors, and t rade on t heir port f olios quit e
regularly.
x. Foreign I nst it ut ional I nvest ors are permit t ed t o invest in t reasury and corporat e
bonds, an amount not exceeding 30% of t heir port f olio exposure t o I ndian market s.
xi. Provident f unds are large invest ors in t he bond market s, as t he prudent ial
regulat ions governing t he deployment of t he f unds t hey mobilise, mandat e
invest ment s pre- dominant ly in t reasury and PSU bonds. They are, however, not
very act ive t raders in t heir port f olio, as t hey are not permit t ed t o sell t heir holdings,
unless t hey have a f unding requirement t hat cannot be met t hrough regular
accruals and cont ribut ions.
xii. Charit able I nst it ut ions, Trust s and Societ ies are also large invest ors in t he debt
market s. They are, however, governed by t heir rules and byelaws wit h respect t o
t he kind of bonds t hey can buy and t he manner in which t hey can t rade on t heir
debt port f olios.
The mat rix of issuers, invest ors, inst rument s in t he debt market and t heir mat urit ies are
present ed in Table 2. 2.

2. 3 Secon dar y Mar k et f or Debt I n st r u men t s

The NSE- WDM segment provides t he only f ormal t rading plat f orm f or t rading of a wide
range of debt securit ies. I nit ially, government securit ies, t reasury bills and bonds issued
by public sect or undert akings ( PSUs) were made available f or t rading. This range has
been widened t o include non- t radit ional inst rument s like, f loat ing rat e bonds, zero
coupon bonds, index bonds, commercial papers, cert if icat es of deposit , corporat e
debent ures, st at e government loans, SLR and non- SLR bonds issued by f inancial
inst it ut ions, unit s of mut ual f unds and securit ised debt . The WDM t rading syst em,
known as NEAT ( Nat ional Exchange f or Aut omat ed Trading) , is a f ully aut omat ed screen
based t rading syst em t hat enables members across t he count ry t o t rade simult aneously
wit h enormous ease and ef f iciency. The t rading syst em is an order driven syst em, which
mat ches best buy and sell orders on a price/ t ime priorit y.
Since it s incept ion in 1994, t he t raded value and average daily t rade in t he WDM
segment of t he NSE have grown signif icant ly. Figure 2. 1 port rays t he t rends in t he
secondary market volumes t raded at NSE.

Tabl e 2. 2: Par t i ci pan t s an d Pr odu ct s i n Debt Mar k et s
I ssu er I n st r u men t Mat u r i t y I n vest or s
Cent ral
Government
Dat ed
Securit ies
2 - 20 years RBI , Banks, I nsurance Companies,
Provident Funds, Mut ual Funds, PDs

15
Cent ral
Government
T- Bills 91/ 364 days RBI , Banks, I nsurance Companies,
Provident Funds, PDs, Mut ual
Funds, I ndividuals
St at e
Government
Dat ed
Securit ies
5- 10 years Banks, I nsurance Companies,
Provident Funds
PSUs Bonds,
St ruct ured
Obligat ions
5- 10 years Banks, I nsurance Companies,
Corporat e, Provident Funds, Mut ual
Funds, I ndividuals
Corporat es Debent ures 1- 12 years Banks, Mut ual Funds, Corporat es,
I ndividuals
Corporat es,
PDs
Commercial
paper
3 mont hs t o 1
year
Banks, Corporat e, Financial
inst it ut ions, Mut ual Funds,
I ndividuals
Banks Cert if icat es of
Deposit
3 mont hs t o 1
year
Banks, Corporat es


16
Fi gu r e 2. 1: Gr ow t h of Tu r n over at NSE WDM

The volume of t rades has increased in t he secondary debt market s, over t he years, as
can be seen in Table 2. 3.

Tabl e 2. 3: NSE WDM: Sel ect ed I n di cat or s
I n di cat or 1996-
97
1997-
98
1998-
99
1999-
00
2000-
01
Number of Trades 7804 16821 16092 46987 64470
Turnover ( Rs. cr. ) 42278 111263 105469 304216 428582
Average Trade Size ( Rs.
cr. )
5. 42 6. 61 6. 55 6. 47 6. 65

Cent ral Government securit ies and t reasury bills are held as demat erialised ent ries in
t he Subsidiary General Ledger ( SGL) of t he RBI . I n order t o t rade t hese securit ies,
part icipant s are required t o have an account wit h t he SGL and also a current account
wit h t he RBI . The set t lement is on Delivery Vs. Payment ( DVP) basis. The Public Debt
Of f ice which oversees t he set t lement of t ransact ions t hrough t he SGL enables t he
t ransf er of securit ies f rom one part icipant t o anot her. Since 1995, set t lement s are on
delivery- versus- payment basis. The RBI is in t he process of implement ing t he set t ing up
of a clearing corporat ion f or government debt , af t er which a real t ime gross set t lement
( RTGS) in government securit ies can be int roduced.
Government debt , which const it ut es about t hree- f ourt h of t he t ot al out st anding debt ,
has t he highest level of liquidit y amongst t he f ixed income inst rument s in t he secondary
market . The share of dat ed securit ies in t ot al t urnover of government securit ies has
been increasing over t he years. I t was 76% during 1997- 98, which increased t o 89% in
0
20,000
40,000
60,000
80,000
100,000
120,000
J
u
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-
9
4
N
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Month & Year
T
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1,000
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Turnover (Rs. cr.) Average DailyTurnover (Rs. cr.)

17
2000- 01. Two- way quot es are available f or act ive gilt securit ies f rom t he primary
dealers. Though many t rades in gilt s t ake place t hrough t elephone, a larger chunk of
t rades get s rout ed t hrough NSE brokers. T- bills account f or about 10% of t ot al SGL
t urnover.
The non- government debt securit ies are t raded occasionally and account f or less t han
2% of t ot al t urnover of debt securit ies. These are t raded on t he BSE as well as on t he
WDM and CM segment s of t he NSE. NSE, wit h a t urnover of Rs. 14, 498 crore during
2000- 01, account ed f or over 99% of t rades in non- government securit ies. The share of
WDM segment of NSE in t he t urnover f or dat ed securit ies and T- bills increased f rom
41. 93% in 1998- 99 t o 54. 5% in 1999- 2000 and improved f urt her t o 59% during 2000-
01. The inst rument - wise t urnover f or securit ies list ed on t he NSE- WDM is in t able 2. 4.

Tabl e 2. 4: Secu r i t y- w i se Di st r i bu t i on of Tu r n over on NSE WDM
Per cen t age sh ar e of t u r n over Secu r i t i es
1997- 98 1998- 99 1999-
2000
2000- 01
Government Securit ies 76. 14 80. 19 92. 99 91. 22
PSU Bonds 2. 27 1. 64 0. 50 0. 84
I nst it ut ional Bonds 1. 37 3. 11 1. 10 1. 00
Treasury Bills 16. 96 10. 15 3. 62 5. 40
Bank Bonds and CDs 1. 07 0. 82 0. 26 0. 47
Corporat e Bonds and
CPs
2. 18 4. 01 1. 52 1. 05
Ot hers 0. 01 0. 09 0. 01 0. 01

The maj or part icipant s in t he WDM are t he I ndian banks, f oreign banks and primary
dealers, who t oget her account ed f or over 70% of t urnover during 2000- 01. The share of
I ndian banks in t urnover, which had been at about 42% during 1992- 2000, declined t o
33. 6% during 2000- 01. The share of f oreign banks decreased t o 16. 9% in 2000- 01 f r om
a high of 22. 83% in 1998- 99. Primary dealers, represent a f ast growing segment of debt
market part icipant s, who cont ribut ed 22. 14% of t urnover in 2000- 01. The share of
t rading members increased t o 23. 24% in 2000- 01, up f rom 18. 75% in 1999- 2000.
Financial inst it ut ions and mut ual f unds cont ribut e about 4% of t he t urnover. The
part icipant - wise dist ribut ion of t urnover is present ed in Table 2. 5.

Tabl e 2. 5: Par t i ci pan t - w i se Di st r i bu t i on of Tu r n over ( % )
Par t i ci pan t 1996- 97 1997- 98 1998- 99 1999- 2000 2000- 01
Foreign banks 37. 13 22. 65 22. 83 15. 05 16. 90
I ndian banks 30. 01 41. 24 42. 12 42. 72 33. 54
Primary dealers 16. 00 12. 06 14. 64 19. 42 22. 14
FI s, MFs and
Corporat es
3. 01 3. 84 4. 57 4. 06 4. 18
Trading members 13. 85 20. 21 15. 84 18. 75 23. 24
100. 00 100. 00 100. 00 100. 00 100. 00

The number of act ive t rading members increased f rom 18 in Sept ember 1994 t o 55 in
Sept ember 1997, but declined t o 48 in March 2001. The number of act ive part icipant s

18
has been increasing cont inuously. I t increased f rom 10 in Sept ember 1994 t o 80 in
Sept ember 2000 and 88 in March 2001.
As seen in Table 2. 6, t he share of t op N securit ies in t he t ot al t urnover wit nessed a
declining t rend f rom 1995 t o 1999. However, t he year 1999- 2000 wit nessed a reversal
of t rend. The share of t op 10 securit ies in t urnover increased t o 58% in 2000- 01 f r om
42% in 1998- 99 indicat ing t hat t rading is get t ing concent rat ed in f ewer securit ies. Top
50 securit ies account ed f or nearly 90% of t urnover in t he years 1999- 2000 and 2000-
01.

19

Tabl e 2. 6: Sh ar e of Top ' N' Secu r i t i es i n t h e Tu r n over of WDM Segmen t
Per cen t age Sh ar e of Tu r n over Year
Top 5 Top 10 Top 25 Top 50 Top 100
1994- 95 42. 84 61. 05 80. 46 89. 81 97. 16
1995- 96 57. 59 69. 46 79. 6 86. 58 93. 24
1996- 97 32. 93 48. 02 65. 65 78. 32 90. 17
1997- 98 30. 65 46. 92 71. 25 85. 00 92. 15
1998- 99 26. 81 41. 89 64. 30 78. 24 86. 66
1999- 00 37. 11 55. 57 82. 12 90. 73 95. 28
2000- 01 42. 20 58. 30 80. 73 89. 97 95. 13

Model Quest i ons

1. Wh at i s t h e l i mi t on t h e ex posu r e of For ei gn I n st i t u t i on al I n vest or s t o
I n di an debt mar k et s?
a. There is no limit on t he ext ent of invest ment s FI I s can make in t he debt market s.
b. FI I s cannot invest more t han 30% of t heir port f olio in debt inst rument s.
c. FI I s cannot invest more t han 30% of t heir port f olio in government bonds.
d. FI I s cannot invest more t han 30% of t heir port f olio in corporat e bonds.
An s: b

2. Wh i ch of t h e f ol l ow i n g abou t t h e mar k et capi t al i sat i on of cor por at e bon ds i n
t h e NSE WDM i s t r u e?
a. Corporat e bonds account f or over 10% of t he t ot al market capit alisat ion.
b. Corporat e bonds represent t he second largest segment of bonds, af t er Government
securit ies.
c. Market capit alisat ion of corporat e bonds is lower t han t hat of list ed st at e loans.
d. None of t he above.
An s: c

3. Th e most act i ve par t i ci pan t s i n t h e WDM segmen t of t h e NSE ar e:
a. Primary dealers
b. Scheduled banks
c. Trading members
d. Mut ual Funds
An s: b




20
Ch apt er 3

Cen t r al Gover n men t Secu r i t i es: Bon ds

3. 1 I n t r odu ct i on

The government bond market , made up of t he long- t erm market borrowings of t he
government , is t he largest segment of t he debt market . I n t he year 2000- 2001, nearly
65% of all borrowings in t he primary market were by t he government and over 90% of
secondary market volumes were in government securit ies. The market capit alizat ion of
out st anding government bonds is est imat ed at Rs. 5, 25, 000 crore.
The 1990s have seen signif icant policy ref orms in t he government securit ies ( G- sec)
market . The early ninet ies saw t he int roduct ion of auct ion- based price det erminat ion f or
government borrowings; development of appropriat e inst rument s and mechanisms f or
t he borrowing programme; a signif icant increase in inf ormat ion disseminat ion on market
borrowings and secondary market t ransact ions; and t he development of t he RBI s yield
curve f or marking t he G- sec port f olios of banks t o t he market . I n t he mid- ninet ies, RBI
int roduced t he syst em of primary dealers; t he NSE was creat ed as t he f irst f ormal
mechanism f or t rading on G- secs; DVP was int roduced in securit ies set t lement ; number
of players in t he G- sec market s was increased wit h t he f acilit y f or non- compet it ive
bidding in auct ions, const it uent SGL account s and t he set t ing up of gilt f unds; and repos
re- emerged as import ant inst rument s of short t erm liquidit y.
The lat e ninet ies have seen t he emergence of market based liquidit y arrangement
t hrough t he Liquidit y Adj ust ment Facilit y ( LAF) ; expansion of t he repo market s; growt h
in t he number and volume of secondary market t ransact ions in G- secs; t he creat ion of a
market yield curve; t he complet e st oppage of aut omat ic monet isat ion of def icit s; t he
creat ion of on- going review mechanisms such as t he St anding Commit t ee of government
securit ies market ; and t he emergence of self regulat ing indust ry bodies such as t he
Primary Dealers Associat ion of I ndia ( PDAI ) and t he Fixed I ncome Money Market s and
Derivat ives Associat ion ( FI MMDA) .

3. 2 Devel opmen t s Ex pect ed

The f ollowing are import ant development s t hat are expect ed in t he government
securit ies market s, in t he near f ut ure, as st at ed in t he policy pronouncement s of t he
RBI :
3

A Clearing Corporat ion wit h St at e Bank of I ndia as chief promot er wit h f ive ot her
banks and f inancial inst it ut ions is expect ed t o commence it s operat ions in 2001.
The Corporat ion is expect ed t o f acilit at e clearing and set t lement of money,
government securit ies and f orex t ransact ions. I t would be possible t o implement
Real Time Gross Set t lement ( RTGS) of G- secs when t he clearing corporat ion

3
Monet ary and Credit Policy f or t he year 2001- 2002, RBI .

21
becomes f ully operat ional. Annexure- I provides more det ails on t he proposals
relat ing t o t he Clearing Corporat ion.
I t was ment ioned in t he Mid- t erm Review of Oct ober 2000 t hat in order t o promot e
ret ail access t o government securit ies, an order driven screen- based t rading in
government securit ies on t he st ock exchanges would be int roduced in consult at ion
wit h t he Securit ies and Exchange Board of I ndia ( SEBI ) . The progress in
implement at ion is being cont inuously reviewed.
I t has been decided t o int roduce an elect ronic Negot iat ed Dealing Syst em ( NDS) in
2001 wit h a view t o f acilit at ing t ransparent elect ronic bidding in auct ions and
secondary market t ransact ions in government securit ies on a real- t ime basis.
Annexure- I I provides more det ails about t he proposed NDS.
The Public Debt Act is proposed t o be replaced by t he Government Securit ies Act .
The enact ment will provide f lexibilit y in undert aking t ransact ions in government
securit ies and f acilit at e ret ailing.

3. 3 G- secs: Tr en ds i n Vol u mes, Ten or an d Yi el ds

The government raises resources in t he debt market s, t hrough market borrowings, pre-
dominant ly t o f und t he f iscal def icit . Market borrowings, which f unded about 18% of t he
gross f iscal def icit s in 1990- 91, const it ut ed 68. 64% of t he gross f iscal def icit in 2000- 01,
and have emerged as t he dominant source of f unding of t he def icit .
The abolit ion of t he aut omat ic monet isat ion of def icit in 1997 has led t o signif icant
increases in market borrowings of t he government . I n t he year 1997- 98 market
borrowings were about Rs. 32, 500 crore. This f igure rose in t he very next year t o nearly
Rs. 69, 000 crore, and an average of Rs. 77, 000 crore in t he lat est 3 years. The
budget ed net borrowings f or t he year 2001- 2002 is Rs. 77, 353 crore.
The average mat urit y of G- secs issued in t he market has increased over t he years,
part icularly since 1998- 99, when t he RBI int roduced securit ies wit h 12, 15 and 20- year
t enors in t he market . I n 1999- 2000, 23 out of t he 30 issues were f or t enors of 10 years
or more, account ing f or over 77. 5% of t ot al issuances. This led t o a sharp increase in
t he weight ed average mat urit y of G- sec issues in t hat year.
The cost of market borrowing on t he ot her hand has been decreasing over t he years.
The weight ed average cost of borrowing f or t he year 2000- 01 was 10. 95% ( whole year) ,
regist ering an 82 basis point drop in average cut - of f yields, as compared t o t he earlier
year. The current rat es are nearly 2. 75% lower t han what t he average rat es f or G- secs
were in 1995- 96. Table 3. 1 provides a summary of average mat urit y and cut - of f yields
in primary market borrowings of t he government .

Tabl e 3. 1: Mar k et Bor r ow i n gs - Aver age Ten or an d Yi el d
Year No. of
I ssu es
Tot al Amou n t
I ssu ed ( Rs. cr . )
Wei gh t ed
Ten or ( Yr s)
Wei gh t ed Cu t - of f
Yi el d ( % p. a. )
1995-
96 20 38634. 24 5. 7376 13. 7496
1996-
97 12 27911. 06 5. 5112 13. 6928
1997-
98 13 43390. 39 6. 5757 12. 0100

22
1998-
99 32 83752. 82 7. 7064 11. 8624
1999-
00 30 86629. 85 12. 6614 11. 7661
2000-
01 19 67183. 45 9. 9438 10. 7977
Source: Compiled f rom RBI , Handbook of St at ist ics on I ndian Economy, 2000, Table
193. Dat a f or 2000- 01 are f rom various WSS, RBI .

3. 4 Pr i mar y I ssu an ce Pr ocess

The issuance process f or G- secs has undergone signif icant changes in t he 1990s, wit h
t he int roduct ion of t he auct ion mechanism, and t he broad basing of part icipat ion in t he
auct ions t hrough creat ion of t he syst em of primary dealers, and t he int roduct ion of non-
compet it ive bids. RBI announces t he auct ion of government securit ies t hrough a press
not if icat ion, and invit es bids. The sealed bids are opened at an appoint ed t ime, and t he
allot ment is based on t he cut - of f price decided by t he RBI . Successf ul bidders are t hose
t hat bid at a higher price, exhaust ing t he accept ed amount at t he cut - of f price.
The design of t reasury auct ions is an import ant issue in government borrowing. The
obj ect ives of auct ion design are:
1. enabling higher auct ion volumes t hat sat isf y t he t arget borrowing requirement ,
wit hout recourse t o underwrit ing and/ or devolvement ;
2. broadening part icipat ion t o ensure t hat bids are not concent rat ed or skewed; and
3. ensuring ef f iciency t hrough achieving t he opt imal ( lowest possible) cost of
borrowing f or t he government .
The t wo choices in t reasury auct ions, which are widely known and used, are:
Discriminat ory Price Auct ions ( French Auct ion)
Unif orm Price Auct ions ( Dut ch Auct ion)
I n bot h t hese kinds of auct ions, t he winning bids are t hose t hat exhaust t he amount on
of f er, beginning at t he highest quot ed price ( or lowest quot ed yield) . However, in a
unif orm price auct ion, all successf ul bidders pay a unif orm price, which is usually t he
cut - of f price ( yield) . I n t he case of t he discriminat ory price auct ion, all successf ul
bidders pay t he act ual price ( yield) t hey bid for.
I f successf ul bids are decided by f illing up t he not if ied amount f rom t he lowest bid
upwards, such an auct ion is called a yield- based auct ion. I n such an auct ion, t he name
of t he securit y is t he cut - of f yield. Such auct ion creat es a new securit y, every t ime an
auct ion is complet ed. For example, t he G- sec 10. 3% 2010 derives it s name f rom t he
cut - of f yield at t he auct ion, which in t his case was 10. 3%, which also becomes t he
coupon payable on t he bond. A yield- based auct ion t hus creat es a new securit y, wit h a
dist inct coupon rat e, at t he end of every auct ion. The coupon payment and redempt ion
dat es are also unique f or each securit y depending on t he deemed dat e of allot ment f or
securit ies auct ioned.
I f successf ul bids are f illed up in t erms of prices t hat are bid by part icipant s f rom t he
highest price downward, such an auct ion is called a price- based auct ion. A price- based
auct ion f acilit at es t he re- issue of an exist ing securit y. For example, in March 2001, RBI
auct ioned t he 11. 43% 2015 securit y. This was a G- sec, which had been earlier issued
and t rading in t he market . The auct ion was f or an addit ional issue of t his exist ing

23
securit y. The coupon rat e and t he dat es of payment of coupons and redempt ion are
already known. The addit ional issue increases t he gross cash f lows only on t hese dat es.
The RBI moved f rom yield- based auct ion t o price- based auct ion in 1998, in order t o
enable consolidat ion of G- secs t hrough re- issue of exist ing securit ies. Large issues
would also f acilit at e t he creat ion of t reasury st rips, when coupon amount s are large
enough f or ensuring liquidit y in t he secondary market s. The RBI however, has t he
f lexibilit y t o resort t o yield- based auct ions, and not if y t he same in t he auct ion
not if icat ion.
For example, assume t hat t he bids as given in Table 3. 2 are received in a price- based
auct ion f or 12. 40% 2013 paper, wit h a not if ied amount of Rs. 3000 crore. I f t he RBI
decides t hat it would absorb all t he not if ied amount f rom t he bids, wit hout any
devolvement on it self or t he PDs, it would f ill up t he not if ied amount f rom t he highest
price ( lowest yield) bid in t he auct ion. At a cut - of f price of Rs. 111. 2 ( yield 10. 7402) ,
t he cumulat ive bids amount t o Rs. 3700 crore. All t he bids up t o t he next highest price
of Rs. 111. 2952 will be declared as successf ul, while bidders at t he cut - of f price, will
receive allot ment s on a pro- rat a basis.
I f all t he successf ul bidders have t o pay t he cut - of f price of Rs. 111. 2, t he auct ion is
called a Dut ch auct ion, or a unif orm price auct ion. I f t he successf ul bidders have t o pay
t he prices t hey have act ually bid, t he auct ion f ills up t he not if ied amount s, in various
prices at which each of t he successf ul bidders bid. This is called a French auct ion, or a
discriminat ory price auct ion. Each successf ul bidder pays t he act ual price bid by him.

Tabl e 3. 2: I l l u st r at i on of Au ct i on s
Amou n t bi d
( Rs. cr . )
I mpl i ed YTM at bi d pr i ce
( % per an n u m)
Pr i ce ( Rs. )
100 10. 6792 111. 6475
650 10. 6922 111. 5519
300 10. 7102 111. 4198
1400 10. 7272 111. 2952
1250 10. 7402 111. 2000
1000 10. 7552 111. 0904
750 10. 7722 110. 9663
400 10. 7882 110. 8497
300 10. 8002 110. 7624

A t reasury auct ion is act ually a common value auct ion, because t he value of t he
auct ioned securit y is t he secondary market price t hat prevails af t er t he auct ion, which is
unif orm f or all bidders. Theref ore, t he loss t o a successf ul bidder is less in a Dut ch
rat her t han a French auct ion. I n our earlier example, assume t hat t he secondary market
price f or t he securit y, af t er t he auct ion, was Rs. 110. 65. I f t he auct ion was Dut ch, t he
loss t o all successf ul bidders is unif orm, at 55 paise per bond. However, if t he auct ion
was French, t he highest successf ul bidder will make a large loss of nearly a rupee 99
paise per bond. The discriminat ory price auct ion, t hus creat es a winners curse where
a successf ul bidder is one who has priced his bid higher t han t he cut - of f , but will
immediat ely suf f er a loss in t he market , if t he af t er- market price is closer t o cut - of f ,
rat her t han his bid. There is a loss in t he secondary market s, even in a Dut ch auct ion, if

24
t he af t er- market price is lower t han t he cut - of f . The dif f erence, however, is t hat t he loss
is t he same f or all successf ul bidders.
I n market s wit h discriminat ory price auct ions, players have an incent ive t o bias t heir
bids downward, relat ive t o t heir own assessment of t he bonds resale value, t o mit igat e
t he impact of t he winners curse. I f players resort t o such downward adj ust ment s, t he
impact is on t he yields f or t he government in t he auct ion, where t he yields would be
higher t han opt imal, t o adj ust f or players winner curse ef f ect . I n a Dut ch auct ion, t he
Government is able t o get a bet t er price, as t his ef f ect is eliminat ed f rom t he bidding
process. However, Dut ch auct ions are known t o suf f er f rom noisy bids, and relat ively
lower levels of part icipat ion, as players are aware t hat t hey would not pay what t hey
bid, but t he cut - of f price.
Discriminat ory price auct ions are more common across t reasuries of t he world, t han
unif orm price auct ions. 90% of t he 42 count ries surveyed by I MF, in a st udy on
auct ions, used discriminat ory price auct ions. I t is observed t hat part icipant s would like
t o bid on t he basis of t heir view of valuat ion of t he bond, rat her t han accept t he
consensus valuat ion of all bids, as most believe t hat t here could be noise in t he bidding
process. An out come t hat penalizes successf ul bidders t o t he ext ent of t he act ual
dist ance bet ween t heir valuat ion, and t he cut - of f , rat her t han a unif orm penalt y f or all is
pref erred. Such auct ions, t heref ore, at t ract larger compet it ive part icipat ion. Research
on t he ef f iciency of t he t wo alt ernat e met hods, is largely inconclusive.
I n t he I ndian market s, discriminat ory price auct ion is used f or all bond issuances. The
recent credit policy 2001- 02 has announced t hat f rom t his year onwards, t he
government would experiment wit h unif orm price auct ions in G- secs. Whet her an
auct ion will be Dut ch or French will be announced in t he not if icat ion of t he auct ion.
The RBI has t he discret ion t o rej ect bids when t he rat es at which bids are received are
higher t han t he rat es at which RBI want s t o place t he debt . Depending on t he pricing
obj ect ive RBI want s t o achieve and t he bidding pat t ern of part icipant s, bidding success
and devolvement s t ake place.
Non- compet it ive bids can also be submit t ed in t reasury auct ions. Allot ment s t o t hese
bids will be f irst made f rom t he not if ied amount , at t he weight ed average price of all
successf ul bids. The recent credit policy 2001- 02 has announced t hat 5% of t he not if ied
amount in all t he f ut ure auct ions will be reserved f or non- compet it ive bids f rom ret ail
invest ors, who can apply t hrough PDs and SDs.

3. 5 Par t i ci pan t s i n Gover n men t Bon d Mar k et s

Government bonds are approved securit ies f or t he purposes of st at ut ory liquidit y
requirement s of banks. Banks, t heref ore, have been t radit ionally t he largest holders of
government bonds. Though t he SLR has been progressively reduced t o 25% of t he net
demand and t ime liabilit ies of banks, it is est imat ed t hat banks hold about 35% of t heir
net demand and t ime liabilit ies in government bonds. This excess holding is est imat ed
t o be wort h about Rs. 1, 00, 000 crore, or an amount equivalent t o a years gross
borrowing. Banks hold about 60% of out st anding G- secs. The government is keen t o
ensure a more broad- based holding of bonds, and has init iat ed a number a st eps in t he
recent years t owards meet ing t his obj ect ive.
Apart f rom banks, provident f unds and insurance companies are large holders of
government bonds, buying t hem t o comply wit h prudent ial norms governing t heir

25
port f olios. These inst it ut ions hold about 20% of out st anding G- secs. However, t he f act
t hat provident f unds are not act ively managed port f olios, and do not mark t heir
port f olios t o market , makes t hem large dormant holders of government bonds.
Primary dealers and sat ellit e dealers hold government bonds eit her due t o devolvement
or underwrit ing commit ment s, or t o enable repo t ransact ions and market making. They
are market part icipant s who t urn over t heir port f olios very rapidly, and have enabled
liquidit y in secondary market t o a large ext ent . Ot hers invest ors in G- secs include
mut ual f unds, primary and sat ellit e dealers, and Const it uent SGL account s wit h banks
and PDs.

3. 6 Con st i t u en t SGL Accou n t s

Subsidiary General Ledger ( SGL) account is a f acilit y provided by RBI t o large banks and
f inancial inst it ut ions t o hold t heir invest ment s in government securit ies and t reasury bills
in t he elect ronic book ent ry f orm. Such inst it ut ions can set t le t heir t rades f or securit ies
held in SGL t hrough a delivery- versus- payment ( DVP) mechanism, which ensures
movement of f unds and securit ies simult aneously. As all invest ors in government
securit ies do not have access t o t he SGL syst em, RBI has permit t ed such invest ors t o
hold t heir securit ies in physical st ock cert if icat e f orm. They may also open a const it uent
SGL account wit h any ent it y aut horised by RBI f or t his purpose, and t hus avail of t he
DVP set t lement . Such client account s are ref erred t o as const it uent SGL account s or SGL
I I account s.
Through a const it uent SGL account , an ent it y can part icipat e in t he primary and
secondary market s f or government securit ies, and avail of t he demat erialised holding
and DVP set t lement f acilit ies. NSCCL, banks, and PDs of f er const it uent SGL account
f acilit y t o an invest or who is int erest ed in part icipat ing in t he government securit ies
market s. The f acilit ies of f ered by t he const it uent SGL account are as f ollows:
i. Demat erialisat ion
ii. Re- mat erialisat ion
iii. Buy/ sell t ransact ions wit h
Any ot her NSCCL const it uent account holder
Any SGL account holder wit h RBI
Any const it uent of ot her SGL account holder wit h RBI
RBI under it s open market operat ions
iv. Corporat e act ions
I nt erest payment
Redempt ion
Conversion int o any ot her securit y
v. Primary market s

3. 7 Pr i mar y Deal er s

Primary dealers are import ant int ermediaries in t he government securit ies market s
int roduced in 1995. There are now 19 primary dealers in t he debt market s. They act as
underwrit ers in t he primary debt market s, and as market makers in t he secondary debt
market s, apart f rom enabling t he part icipat ion of a number of const it uent s in t he debt
market s.

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The obj ect ives of set t ing up t he syst em of primary dealers are
4
:
( i) To st rengt hen t he inf rast ruct ure in t he government securit ies market in order t o
make it vibrant , liquid and broad- based;
( ii) To develop underwrit ing and market making capabilit ies f or government securit ies
out side t he Reserve Bank, so t hat t he Reserve Bank could gradually divest t hese
f unct ions;
( iii) To improve secondary market t rading syst em t hat would cont ribut e t o price
discovery, enhance liquidit y and t urnover and encourage volunt ary holding of
government securit ies among a wider invest or base; and
( iv) To make primary dealers an ef f ect ive conduit f or conduct ing open market
operat ions.

3. 7. 1 El i gi bi l i t y

A person who sat isf ies t he f ollowing crit eria can apply f or primary dealership:
a. Subsidiaries of scheduled commercial banks and all I ndia f inancial inst it ut ions and
engaged predominant ly in securit ies business and in part icular t he government
securit ies market ; or
b. Companies incorporat ed under t he Companies Act , 1956 and engaged
predominant ly in securit ies business and in part icular t he government securit ies
market ;
c. Subsidiaries/ j oint vent ures set up by ent it ies incorporat ed abroad under FI PB
approval; and
d. The company has net owned f unds
5
of Rs. 50 crore.


4
The f ollowing sect ions on primary dealers and sat ellit e dealers have been downloaded
f rom www. rbi. org. in.
5
Net owned f unds include: paid- up equit y capit al, free reserves, balance in share
premium account and capit al reserves represent ing surplus arising out of sale proceeds
of asset s but not reserves creat ed by revaluat ion of asset s. From t he aggregat e of t hese
it ems accumulat ed loss balance and book value of int angible asset s, if any, should be
deduct ed t o arrive at t he value of net owned f unds.

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3. 7. 2 Bi ddi n g Commi t men t

A primary dealer has t o make an annual commit ment t o bid f or t he Government of I ndia
dat ed securit ies and auct ion t reasury bills. The aggregat e bids should not be less t han a
specif ied amount . The agreed minimum amount of bids has t o be separat ely indicat ed
f or dat ed securit ies and t reasury bills.
While bidding, t he primary dealer has t o achieve a minimum success rat io of 33. 33 per
cent f or dat ed securit ies and 40 per cent f or t reasury bills. The Reserve Bank holds
discussions wit h t he primary dealers in t he mont h of March, immediat ely af t er t he
announcement of t he cent ral government ' s budget , t o f inalise t he annual business plan
of each primary dealer. The business plan is inclusive of bidding commit ment and
underwrit ing obligat ion.

3. 7. 3 Un der w r i t i n g

Primary dealers underwrit e a port ion of t he issue of government securit y t hat is f loat ed
f or a pre- det ermined amount . Normally primary dealers are collect ively of f ered t o
underwrit e up t o 100 per cent of t he not if ied amount in respect of all issues where
amount s are not if ied. The underwrit ing commit ment of each primary dealer is broadly
decided on t he basis of it s size in t erms of it s net owned f unds, it s holding st rengt h, t he
commit t ed amount of bids and t he volume of t urnover in securit ies.
A primary dealer can, however, of f er t o underwrit e an amount not exceeding f ive t imes
of it s net owned f unds or t he balance liquidit y support available f rom t he Reserve Bank
at t he t ime of making commit ment f or underwrit ing, whichever is higher. The amount
so arrived at does not exceed 30 per cent of t he not if ied amount of t he issue. I f t wo
issues are f loat ed at t he same t ime, t he limit of 30 per cent is applied by t aking t he
not if ied amount s of bot h t he issues t oget her.
The underwrit ing commit ment of each primary dealer is decided t hrough an auct ion
process. On announcement of t he not if ied amount f or dat ed securit ies of t he cent ral or
st at e government s f or which an auct ion is held, t he Reserve Bank invit es bids f rom
primary dealers f or underwrit ing. The procedure f or submission of bids by t he primary
dealers f or underwrit ing and t heir scrut iny is:
i. The bids are t endered by each primary dealer in a prescribed f orm in a
sealed cover so as t o reach t he Chief General Manager, I nt ernal Debt
Management Cell, Reserve Bank of I ndia, Cent ral Of f ice, Mumbai. Bids
have t o be submit t ed during banking hours on t he working day
immediat ely preceding t he day of t he auct ion of t he loan.
ii. A primary dealer can submit mult iple bids f or underwrit ing.
iii. A primary dealer who does not wish t o part icipat e in t he underwrit ing of a
part icular issue has t o submit a bid wit h ` nil' commit ment .
iv. Depending upon t he bids submit t ed f or underwrit ing, t he Reserve Bank
decides t he cut - of f rat e of f ee and t he underwrit ing amount up t o which
bids have been accept ed.
v. Once t he cut - of f f ee is decided, all bids quot ed above t he cut - of f f ee are
rej ect ed.
vi. The Reserve Bank reserves t he right t o accept any amount of underwrit ing
up t o 100 per cent of t he not if ied amount or even rej ect all t he bids

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t endered by primary dealers f or underwrit ing, wit hout assigning any
reason.
vii. Primary dealers have t o invariably bid at t he securit y auct ions at least t o
t he ext ent of t heir underwrit ing commit ment as accept ed by t he Reserve
Bank.
viii. Primary dealers can set - of f t he accept ed bids in t he auct ion against t he
t ot al devolvement , if any, on account of t heir underwrit ing commit ment
accept ed by t he Reserve Bank.
ix. Devolvement of securit ies, if any, on primary dealers t akes place on pro-
rat a basis, depending upon t he amount of underwrit ing obligat ion accept ed
by each primary dealer af t er set t ing of f t he successf ul bids in t he auct ion.
x. Underwrit ing f ee is paid on t he ent ire amount accept ed f or underwrit ing by
t he Reserve Bank, irrespect ive of t he act ual amount of devolvement . The
amount of f ee is credit ed t o t he current account of t he respect ive primary
dealer at t he Reserve Bank of I ndia, Fort , Mumbai, on t he dat e of t he
auct ion.
xi. The same syst em of underwrit ing is f ollowed in t he case of st at e
government f loat at ions t hrough auct ion.

3. 7. 4 Ot h er Obl i gat i on s

The primary dealers also have t o f ulf ill cert ain ot her obligat ions. These are:
i. A primary dealer has t o of f er a f irm t wo- way quot e eit her t hrough over- t he- count er
t elephone market or t hrough a recognised st ock exchange of I ndia.
ii. A primary dealer also has t o deal in t he secondary market f or government securit ies
and t ake principal posit ions.
iii. The annual t urnover of a primary dealer in a f inancial year should not be less t han
f ive in government dat ed securit ies and t en in t reasury bills. Of t he t ot al, t urnover
in respect of out right t ransact ions should not be less t han t hree in respect of
government dat ed securit ies and six in respect of t reasury bills. The t urnover is
calculat ed as t ot al purchase and sales during t he year / average of mont h- end
st ocks during t he year. Purchases are inclusive of primary market purchases and
sales are inclusive of redempt ion of mat urit ies.
iv. The primary dealers have t o maint ain physical inf rast ruct ure in t erms of of f ice,
comput ing equipment , communicat ion f acilit ies like t elex/ f ax, t elephone, et c. , and
skilled manpower f or ef f icient part icipat ion in primary issues, and t rading in t he
secondary market . Primary dealers also have t o advise and educat e invest ors.
v. Primary dealers are expect ed t o have an ef f icient int ernal cont rol syst em f or f air
conduct of business and set t lement of t rades and maint enance of account s.
vi. They are also expect ed t o provide t o t he Reserve Bank access t o all records, books
inf ormat ion and document s as may be required.
vii. The primary dealers should adhere t o all prudent ial and regulat ory guidelines
prescribed by t he Reserve Bank f rom t ime t o t ime.
viii. Aut horised primary dealers should f orm a self - regulat ory organisat ion ( SRO) , which
would evolve a code of conduct and a syst em f or securit ies t ransact ions. ( The
Primary Dealers Associat ion of I ndia, PDAI , is t he SRO f ormed in I ndia) .
ix. I n respect of t ransact ions in government securit ies, a primary dealer should have a
separat e desk and should maint ain separat e account s and have an ext ernal audit of

29
annual account s. The primary dealer should maint ain separat e account s in respect
of t heir own posit ion and cust omer t ransact ions.
x. The primary dealer should bring t o t he at t ent ion of t he Reserve Bank any maj or
complaint against him or act ion init iat ed/ t aken against him by aut horit ies, such as,
t he st ock exchanges, t he Securit ies and Exchange Board of I ndia, Cent ral Bureau of
I nvest igat ion, Enf orcement Direct orat e, I ncome Tax, et c.
xi. The primary dealers should det ermine prudent ial ceilings, wit h t he prior approval of
t heir boards of direct ors f or reliance on borrowings f rom t he money market
including repos, as a mult iple of net owned f unds, subj ect t o t he guidelines, if any,
issued by t he Reserve Bank in t his regard.

3. 7. 5 Faci l i t i es f or Pr i mar y Deal er s

The f ollowing f acilit ies have been ext ended t o primary dealers:
Liquidit y Support
Liquidit y support is available t o primary dealers t hrough t he Liquidit y Adj ust ment Facilit y
( LAF) . LAF is described in Appendix I I I t o t his Chapt er. The Reserve Bank provides
liquidit y support t o t he primary dealers against collat eral of government securit ies. The
limit s f or individual primary dealer are indicat ed in t heir aut horisat ion let t ers.
Current and SGL Account s
One current account and t wo subsidiary general ledger ( SGL) account s f or government
securit ies are provided t o t he primary dealers. A primary dealer ut ilises one SGL account
f or it s own operat ions and t he second f or operat ions on behalf of it s const it uent s. The
account s are of f ered at all of f ices of t he Reserve Bank.
Access t o Call Money Market
Primary dealers are permit t ed t o borrow and lend in t he money market including in t he
call money market and t o t rade in all money market inst rument s.
Repos and Ref inance
Liquidit y support t o primary dealer is given t hrough Repos operat ions/ ref inance wit h t he
Reserve Bank. The repos are conduct ed in cent ral government dat ed securit ies and
t reasury bills up t o a limit f ixed by t he Reserve Bank.
Funds t hrough CPs
Primary dealers can raise f unds t hrough commercial paper. They can access f inance
f rom commercial banks as any ot her corporat e borrower.
Primary dealers also have t he f acilit y of t ransf er of f unds f rom one cent er t o anot her
under t he Reserve Bank' s Remit t ance Facilit y Scheme and of clearing of cheques arising
out of government securit ies t ransact ions, t endered at t he Reserve Bank' s count ers.
Primary dealers are proposed t o be given f avoured access t o t he Reserve Bank' s open
market operat ions.

3. 7. 6 Repor t i n g Syst em

Primary dealers are required t o submit t o t he Reserve Bank:
a. a daily report on market inf ormat ion,
b. a daily report on t ransact ions in t he prescribed f ormat PDR- 1,
c. a mont hly report of t ransact ions in securit ies, risk posit ion and perf ormance
wit h regard t o part icipat ion in auct ions, in t he prescribed f ormat PDR- 2, and
d. an annual report on it s perf ormance t oget her wit h annual audit ed account s.

30

3. 8 Sat el l i t e Deal er s

Following t he int roduct ion of a syst em of primary dealers in t he government securit ies
market , a need was f elt t o develop t he support ing inf rast ruct ure. The Reserve Bank of
I ndia, t heref ore, int roduced t he concept of sat ellit e dealers. The obj ect ive behind
creat ing sat ellit e dealers was t o widen t he scope of organised dealing and dist ribut ion
arrangement s in government securit ies market . Sat ellit e dealers f orm t he second t ier in
t rading and dist ribut ion of government securit ies.

31
The obj ect ives of t he syst em of sat ellit e dealers are t o:
i. Furt her st rengt hen t he inf rast ruct ure in government securit ies market by
including int ermediaries t hat have good dist ribut ion channels and t hus add
dept h t o secondary market t rading and widen t he invest or base;
ii. Enhance liquidit y and t urnover in government securit ies;
iii. Provide a ret ail out let f or government securit ies and encourage volunt ary
holding of government securit ies among a wider invest or base.

3. 8. 1 El i gi bi l i t y

Eligibilit y condit ions f or sat ellit e dealers are t he same as t hose applicable t o primary
dealers. To become a sat ellit e dealer, however, t he minimum net owned f unds required
are Rs. 5 crore. Ot her paramet ers regarding minimum capit al st andards, int ernal cont rol
syst em, prudent ial and regulat ory guidelines and regist rat ion requirement s f or sat ellit e
dealers are similar t o t hose applicable t o primary dealers. The procedure f or select ion
of sat ellit e dealers is similar t o t he procedure applied f or select ion of primary dealers
except t hat in t he case of sat ellit e dealers, t he regist rat ion is valid f or t hree years.

3. 8. 2 Rol e an d Obl i gat i on s

Sat ellit e dealers are expect ed t o play an act ive supplement ary role along wit h primary
dealers in t he government securit ies market , bot h in it s primary and secondary
segment s. Sat ellit e dealers have t o execut e an undert aking t hat f orms t he basis f or
issue of regist rat ion let t er t o sat ellit e dealers.
The undert aking covers t he f ollowing aspect s:
i. Commit ment t o generat e out right t urnover of cent ral government
securit ies including t reasury bills of not less t han Rs. 30 crore in a year;
ii. Achieve a port f olio of not less t han 20 per cent in government
securit ies in relat ion t o t heir t ot al asset s bef ore t he end of t he f irst
year of operat ions af t er regist rat ion;
iii. Have adequat e organisat ional st ruct ure wit h good dist ribut ion channels
across t he count ry in t erms of of f ice, comput ing equipment ,
communicat ion f acilit ies like t elex/ f ax, t elephone, et c. , and
iv. Deploy skilled manpower f or ef f icient market ing and t o advise and
educat e invest ors.

3. 8. 3 Faci l i t i es

The Reserve Bank has ext ended t he f ollowing f acilit ies t o sat ellit e dealers:
i. Subsidiary general ledger ( SGL) account f acilit y f or government securit ies
f or t heir own t ransact ions ( account - I ) as also f or client s t ransact ions
( account - I I ) ;
ii. Current account f acilit y only f or put t ing t hrough government securit ies
t ransact ions;
iii. Reverse repos were allowed t o sat ellit e dealers up t o 50 per cent of t he
out st anding st ock ( f ace value) of t he cent ral government dat ed securit ies
and auct ion t reasury bills This f acilit y has been wit hdrawn in April 2001.

32
SDs have t o now access repo market s f or short - t erm liquidit y
requirement s.
iv. Sat ellit e dealers can raise f unds t hrough commercial paper;
v. Sat ellit e dealers can ent er int o ready f orward t ransact ions in eligible
securit ies and wit h eligible inst it ut ions.

3. 8. 4 Repor t i n g Syst em

A sat ellit e dealer has t o submit t o t he Reserve Bank a mont hly report on t ransact ions in
securit ies, risk posit ion and perf ormance wit h regard t o out right sales. The report has t o
be submit t ed in specif ied f ormat s. Sat ellit e dealers also have t o submit t o t he Reserve
Bank an annual report on it s perf ormance along wit h t he annual audit ed account s.

3. 9 Secon dar y Mar k et s f or Gover n men t Bon ds

Government bonds are deemed t o be list ed as soon as t hey are issued. Market s f or
government securit ies are pre- dominant ly wholesale market s, wit h t rades done on
t elephonic negot iat ion. NSE WDM provides a t rading plat f orm f or Government bonds,
and report s over 65% of all secondary market t rades in government securit ies. Since
part icipant s have t o report t heir t rades t o t he PDO, and ef f ect set t lement t hrough t he
SGL, RBI s report s on SGL t ransact ions provide summary dat a on secondary market
t ransact ions in government bonds. SGL holders are expect ed t o report t heir t rades
wit hin 24 hours, due t o which t he t ime sequence of t rades is not observed in t he debt
market s. Since most t rades done on t he NSE are also in t he f orm of negot iat ed t rades
t hat are subsequent ly report ed, t he last t raded price is not observed in t he secondary
market s. The t rading syst em at t he NSE WDM is described in Chapt er 11.
Current ly, t ransact ions in government securit ies are required t o be set t led on t he t rade
dat e or next working day unless t he t ransact ion is t hrough a broker of a permit t ed st ock
exchange in which case set t lement can be on T plus 5 basis. Wit h t he progress made in
comput erizat ion of Public Debt Of f ice ( PDO) , it is possible t o have pooled t erminal f acilit y
locat ed at Regional Of f ices across t he count ry and member- t erminals paving t he way for
a Negot iat ed Dealing Syst em ( NDS) ( Annexure- 2) . I n t he proposed NDS, all t rades
bet ween members of NDS will have t o be report ed on t he NDS, which will be direct ly
linked t o t he set t lement syst em. As t his will provide cert aint y t o market part icipant s in
respect of demand f or set t lement f unds f or securit ies t ransact ions on t he day of
set t lement , it is expect ed t o improve cash and liquidit y management among money
market part icipant s. This is also expect ed t o have a st abilising inf luence on call money
market .

3. 10 Set t l emen t of Tr ades i n G- secs

Set t lement of t ransact ions in t he Government securit ies market is pre- dominant ly on
Delivery- vs- Payment ( DVP) mode, where f unds and securit ies are t ransf erred
simult aneously, t hrough t he Public Debt Of f ice ( PDO) of t he RBI . I t is essent ial t hat
securit ies are held in demat f orm in t he SGL f or DVP t o be possible. Transf er of f unds is
ef f ect ed by credit ing t he current account of t he buyer maint ained wit h t he RBI .
Securit ies are t ransf erred t hrough ef f ect ing changes in t he SGL account . I n order t o do

33
t his, t he SGL Form ( Form I I I , Rule 7, Public Debt Act , 1944) is f illed by t he seller,
count ersigned by t he buyer, and sent t o t he RBI . The buyer t ransf ers f unds t owards
payment . The SGL f orm cont ains a t ransf er inst ruct ion f or f unds and securit ies signed by
bot h count er part ies, and has t o be submit t ed t o t he RBI wit hin one working day af t er
t he dat e of signing t he f orm. For t ransact ions which set t le on t he same dat e, t he SGL
f orm has t o reach RBI by 3. 00 p. m. The SGL f orm provides det ails of t he buyer and t he
seller, t he securit y, t he clean price, accrued int erest , det ails of credit in t he current
account ( wit hout which securit ies will not be t ransf erred) , and is signed by bot h buyer
and seller.
The PDO debit s t he current account of t he buyer and t he SGL account of t he seller. The
t oken number t hat is issued by t he RBI and t he cont ract not e of t he broker are verif ied
by t he buyer and seller. Most t ransact ions ( about 70%) are put t hrough by brokers.
Buyers and sellers conf irm t ransact ions t hrough phone and f ax af t er t he deal is made.
Brokers are usually paid a commission of 50 paise per market lot ( Rs. 5 Cr. ) , f or deals
up t o Rs. 20 crore. Larger deals at t ract f ixed commissions.
Though t he SGL is comput erised, t he back- of f ice operat ions f or a deal in G- secs is
largely manually execut ed. The deal blot t er of part icipant s is manual in many
part icipant s of f ices. Deal conf irmat ions happen t hrough paper. The SGL f orm is f illed
and manually delivered at t he RBI , where t he dat a is keyed int o t he syst em, in a
sequence t hat is not according t o t he t ime st amp of t he t rade. The creat ion of t he NDS
is expect ed t o convert most of t hese manual t ransact ions int o real- t ime mechanical
ones, driven by elect ronic connect ivit y bet ween RBI s PDO, t he Clearing Corporat ion,
and t he part icipant s dealing rooms. I t would t hen be possible t o achieve RTGS ( real
t ime gross set t lement ) .

Model Quest i ons

1. Wh i ch of t h e f ol l ow i n g i s t r u e abou t a u n i f or m pr i ce au ct i on ?
a. An auct ion in which all successf ul bids are made f or t he same price.
b. An auct ion in which all bidders have bid a unif orm price.
c. An auct ion in which all successf ul bidders are allot t ed bonds at t he same price.
d. An auct ion in which t he cut - of f price is derived as t he wei ght ed average of all
successf ul bids.
An sw er : c

2. Wh i ch of t h e f ol l ow i n g i s f al se abou t t h e devol vemen t of t r easu r y i ssu es on
t h e pr i mar y deal er ?
a. PDs can set - of f t he accept ed bids in an auct ion against t he devolvement on
t hem.
b. Devolvement on PDs is on pro- rat a basis, depending on t he underwrit ing
obligat ion of each PD.
c. Underwrit ing f ee is payable on t he net amount , af t er account ing f or t he
devolvement on PDs.
d. Devolvement on pro- rat a basis is done af t er set t ing of f successf ul bids in t he
auct ion.
An sw er : c


34
3. Th e bi ds r ecei ved i n a t r easu r y au ct i on ar e as f ol l ow s:
Nu mber of Bon ds Pr i ce qu ot ed by bi dder s ( Rs. )
20, 000, 000 110. 25
12, 000, 000 109. 50
10, 000, 000 109. 25
14, 000, 000 109. 00
25, 000, 000 108. 95
I f t h e n ot i f i ed amou n t i s Rs. 500 cr or e, w h at i s t h e cu t - of f pr i ce, assu mi n g
t h er e ar e n o devol vemen t s?
An sw er :
Since it is a price- based auct ion, t he bids will be f illed f rom t he highest price downwards.
I f t he bids at t he cut - of f price exceed t he not if ied amount , pro- rat a allot ment s will be
made. On comput ing t he amount ( product of number of bonds and quot ed price, and
cumulat ing t he amount s so arrived, we can reach t he cut - of f price) . The cut - of f price is
Rs. 109. 25.
The allot ment s are as f ollows:
Qu an t i t y Pr i ce Qu ot ed by bi dder s ( Rs. ) Amou n t bi d ( Rs. ) Al l ot men t
( Rs. )
20, 000, 000 110. 25 2, 205, 000, 000 2, 205, 000, 000
12, 000, 000 109. 50 1, 314, 000, 000 1, 314, 000, 000
10, 000, 000 109. 25 1, 092, 500, 000 1, 481, 000, 000
14, 000, 000 109. 00 1, 526, 000, 000 Nil
25, 000, 000 108. 95 2, 723, 750, 000. 00 Nil
The allot ment at t he cut - of f price is arrived at by f inding t he dif f erence bet ween t he
not if ied amount and t he cumulat ive allot ment s up t o t he previous bid.

4. Usi n g t h e same dat a as i n qu est i on 3, at w h at pr i ce n on - compet i t i ve bi ds
w i l l be al l ot t ed?
An sw er : Non- compet it ive bids will get allot ment at t he weight ed average price of
successf ul bids. The price and quant it y f or successf ul bids are as f ollows:
Nu mber of Bon ds Pr i ce ( Rs. ) Wei gh t age Wei gh t ed Pr i ce
20, 000, 000. 00 110. 25 0. 4410 48. 62025
12, 000, 000. 00 109. 50 0. 2628 28. 77660
13, 556, 064. 07 109. 25 0. 2962 32. 35985
109. 7567
Th e w ei gh t ed aver age pr i ce i s Rs. 109. 7567.

35

Appen di x I - Cl ear i n g Cor por at i on

The main f eat ures of t he proposed Clearing Corporat ion f or clearing of money,
government securit ies and f orex market s t ransact ions are:
The Clearing Corporat ion will be const it ut ed as a limit ed liabilit y Company under t he
I ndian Companies Act 1956 and will be known as The Clearing Corporat ion of I ndia
Lt d.
The Company will have an aut horised capit al of Rs. 50 crore.
The Clearing Corporat ion will be owned by t he market part icipant s and promot ed by
St at e Bank of I ndia. The ot her core promot ers of t he company will be Bank of
Baroda, HDFC Bank, I CI CI , I DBI and LI C.
The Clearing Corporat ion will be managed by a Board of Direct ors headed by a non-
execut ive Chairman.
The Clearing Corporat ion will address t he need f or ef f icient securit ies set t lement
syst em covering money, government securit ies and f orex market s.
The Clearing Corporat ion will:
- f acilit at e ext ension of repos market t o non- Government securit ies and
enlargement of market part icipant s.
- act as a t ri - part y agent f or ef f icient management of collat eral in
consonance wit h int ernat ionally accept ed best pract ices.
- act as a cent ral count er- part y t hrough novat ion t hereby minimising
count er- part y risk.
- manage a Set t lement Guarant ee Fund t hereby minimising set t lement
risk.

Appen di x I I - Negot i at ed Deal i n g Syst em

The salient f eat ures of t he Negot iat ed Dealing Syst em are:
Banks, Primary Dealers and Financial I nst it ut ions having Subsidiary General Ledger
and Current Account s wit h RBI will be eligible t o become members of t he syst em.
The syst em will f acilit at e submission of bids/ applicat ions f or auct ions/ f loat at ions of
government securit ies t hrough pooled t erminal f acilit y locat ed at regional of f ices of
PDO across t he count ry and t hrough member- t erminals.
The syst em can be used f or daily Repo and Reverse Repo auct ions under LAF.
I t will provide an elect ronic dealing plat f orm f or primary and secondary market
part icipant s in government securit ies and also f acilit at e report ing of t rades execut ed
t hrough exchanges f or inf ormat ion disseminat ion and set t lement in addit ion t o deals
done t hrough t he syst em.
Government dat ed securit ies, Treasury Bills, Repurchase Agreement s ( Repos) ,
Call/ Not ice/ Term Money, Commercial Paper, Cert if icat es of Deposit , Forward Rat e
Agreement s/ I nt erest Rat e Swaps, et c. , will be t he eligible inst rument s.
NDS will be int egrat ed wit h Securit ies Set t lement Syst em ( SSS) of PDO of RBI t o
f acilit at e set t lement of deals done in government securit ies and t reasury bills.
I t will f acilit at e disseminat ion of inf ormat ion relat ing t o primary issuance t hrough
auct ion/ sale on t ap and underwrit ing apart f rom secondary market t rade det ails t o
part icipant s.


36



37

Appen di x I I I : Li qu i di t y Adj u st men t Faci l i t y ( LAF)

I n order t o provide bet t er liquidit y f or part icipant s in t he short - t erm debt market s, t he
RBI support s such part icipant s t hrough t he LAF. The Narasimham Commit t ee ( 1998) had
recommended t his measure, and t he RBI int roduced LAF in phases. The int erim LAF,
int roduced in April 1999, provided liquidit y t o part icipant s t hrough a combinat ion of
repos, and collat eralised lending f acilit ies, support ed by open market operat ions of t he
RBI , at set rat es of int erest . Banks could avail of a collat eralised lending f acilit y ( CLF) at
0. 25% of t heir f ort night ly average out st anding deposit s, f or 2 weeks at t he bank rat e,
and an addit ional f acilit y ( ACLF) of t he same amount at bank rat e plus 2%. These
f acilit ies could be ext ended f or anot her 2 weeks, at a penal rat e of 2%, but were
f ollowed by a cooling of f period of 2 weeks. The st ipulat ion of t he cooling of f period was
removed in Oct ober 1999.
Primary dealers are provided level I liquidit y support ( equivalent t o t he collat erlised
lending f acilit y f or banks) against t he collat eral of government securit ies, based on a set
of paramet ers specif ied by t he RBI , at t he bank rat e, f or up t o 90 days. Addit ional level
I I support f or an equivalent amount was available at bank rat e plus 2% f or a period not
exceeding 2 weeks at a t ime.
The gradual implement at ion of t he f ull- f ledged LAF involves t he f ollowing st eps:
a. Replacing t he addit ional CLF f or banks and level I I liquidit y support t o PDs wit h
variable reverse repo auct ions.
b. Replacing t he f ixed rat e repos by variable rat e repo auct ions.
c. Replace t he CLF and t he level I support t o PDs wit h a variable rat e reverse repo
auct ion.
d. I n t he f inal st age, af t er t he implement at ion of t he RTGS and f ull comput erisat ion of
t he Public debt of f ice, repo operat ions t hrough elect ronic t ransf ers will be
int roduced, so t hat LAF can be operat ed at dif f erent t imings of t he day, if necessary.
The LAF is int ended t o primarily meet t he day- t o- day liquidit y mismat ches in t he
syst em, and is not int ended t o meet t he f inancing requirement s of eligible inst it ut ions.
Wit h ef f ect f rom June 2000, RBI int roduced t he LAF. I n t he f irst st age of LAF, Repo and
reverse repo auct ions are conduct ed by t he RBI on a daily basis, except on Sat urdays,
wit h a t enor of one day except on Fridays and days preceding holidays. Banks and PDs
part icipat e in t hese auct ions. RBI conduct s unif orm price auct ions, and t he int erest
rat es f or repos and reverse repos are decided t hrough t he cut - of f rat es emerging f r om
t hese auct ions. I n August 2000, RBI int roduced repo auct ions f or t enors ranging
bet ween 3 t o 7 days.
The LAF serves t hree obj ect ives:
Since RBI responds t o t he liquidit y needs of t he syst em on a daily basis, it has
great er f lexibilit y in det ermining t he quant um and rat es at which f unds are made
available t o t he syst em.
RBI can also at t empt t o ensure t hat t he f unds are primarily ut ilised t o meet day- t o-
day liquidit y needs.
The repo and reverse repo rat es would set up a corridor wit hin which t he short t erm
money market rat es may be expect ed t o move.
RBI receives t he bids f or LAF in t he morning. The Financial Market Commit t ee meet s at
12. 00 noon t o assess t he bids. The act ual amount of liquidit y t o be absorbed or inj ect ed
int o t he syst em is det ermined by t he RBI af t er t aking int o account t he liquidit y

38
condit ions in t he market , t he int erest rat e sit uat ion and t he st ance of policy. The rat e of
int erest depends on t he quot es received in t he bids. RBI has also rej ect ed all bids in t he
repo auct ions, on f ew occasions.

Ch an ges i n St an di n g Li qu i di t y Faci l i t i es Avai l abl e t o t h e Syst em an d
I n t r odu ct i on of Back - st op Faci l i t y
6

When t he LAF was reviewed, it was f elt t hat f or a smoot h t ransit ion t o f ull- f ledged
operat ion of LAF, t he syst em would need a back- st op f acilit y at a variable rat e of
int erest , as a cushion, over and above t he support available t hrough st anding liquidit y
f acilit ies at t he Bank Rat e and t hrough t he LAF operat ions in daily auct ions.
The f ollowing modif icat ions t o t he present st anding liquidit y f acilit ies have been
announced:
I t is proposed t o split t he st anding liquidit y f acilit ies available f rom RBI int o t wo
part s, viz. , ( i) normal f acilit y and ( ii) back- st op f acilit y. Accordingly, t he t ot al
quant um of support available t o banks under CLF and export credit ref inance, and
t he quant um of support available f or PDs will be spilt int o t wo component s, i. e. ,
normal f acilit y and back- st op f acilit y.
The normal f acilit y will be provided at t he Bank Rat e. The back- st op f acilit y will be
provided at a variable daily rat e. The variable rat e would be linked t o cut - of f rat es
emerging in regular LAF auct ions and in t he absence of such rat es, t o Nat ional St ock
Exchange Mumbai I nt er- bank Of f er Rat e ( NSE- MI BOR) as det ailed below:
( i) The variable rat e f or t he back- st op f acilit y, t o be f ixed on a daily
basis would be 1. 0 percent age point over t he reverse repo cut - of f
rat e at which f unds were inj ect ed earlier during t he day in t he
regular LAF repos auct ions.
( ii) Where no reverse repo bid was accept ed as part of LAF auct ion,
t he rat e will be 2. 0 t o 3. 0 percent age point s over t he repo cut - of f
rat e of t he day emerged in LAF auct ion as may be decided by RBI .
( iii) I n case no bids were accept ed earlier during t he day at eit her repo
or reverse repo auct ions, t he rat e will be 2. 0 t o 3. 0 percent age
point s over NSE- MI BOR as may be decided by RBI .
Back- st op f acilit y would be operat ed t ill close of banking hours.
Of t he t ot al limit s of liquidit y support available t o PDs and banks, t he normal f acilit y
would init ially const it ut e about t wo- t hirds and t he back- st op f acilit y about one- t hird.
PD- wise and bank- wise limit s will be announced separat ely.
Ch an ges i n LAF Oper at i n g Pr ocedu r es
The f ollowing measures relat e t o LAF operat ing procedures:
The minimum bid size f or LAF is being reduced f rom t he exist ing Rs. 10 crore t o Rs. 5
crore t o add f urt her operat ional f lexibilit y t o t he scheme and enable small level
operat ors t o part icipat e.
The LAF t iming is being advanced by 30 minut es - 10. 30 a. m. f or receipt of bids and
f or announcement of result s t o 12. 00 noon.
Wit h a view t o st abilising market expect at ions and arrest ing volat ilit y in call rat es, it
has been decided t o provide t he market wit h addit ional inf ormat ion. The market

6
I nt roduced in t he Monet ary and Credit Policy, 2001.

39
would be provided wit h inf ormat ion on t he scheduled commercial banks aggregat e
cash balances maint ained wit h RBI on a cumulat ive basis during t he f ort night wit h a
lag of t wo days.
At present , repo auct ions are conduct ed wit hout any pre- announced rat e and bids
are accept ed on t he basis of unif orm price met hod. Wit h a view t o providing quick
int erest rat e signals, when necessary, in order t o meet unexpect ed domest ic or
ext ernal development s, RBI will hencef ort h have an addit ional opt ion t o swit chover
t o f ixed rat e repos on overnight basis; but t his opt ion is expect ed t o be sparingly
used. For t he purpose of such repos, t he rat es of int erest int ended t o be of f ered
would be announced as part of auct ion announcement on t he previous evening or
bef ore 10. 00 a. m. on t he day of auct ion, if necessary.
I n addit ion t o overnight repos, RBI will also have t he discret ion t o int roduce longer-
t erm repos up t o 14- day period as and when required.








40
Ch apt er 4

Cen t r al Gover n men t Secu r i t i es: T- Bi l l s

Treasury bills are short - t erm debt inst rument s issued by t he Cent ral government . Unt il
recent ly, 4 t ypes of T- bills were issued: 14- day, 91- day, 182- day and 364- day,
represent ing t he 4 t ypes of t enors f or which t hese inst rument s are issued. The RBI
announced t he decision t o do away wit h t he 14 and 182- day bills, in t he credit policy
announcement made in April 2001.
Unt il 1988, t he only kind of t reasury bill t hat was available was t he 91- day bill, issued
on t ap, at a f ixed rat e of 4. 5% ( t he rat es on t hese bills remained unchanged at 4. 5%
since 1974! ) . 182- day T- bills were int roduced in 1987, and t he auct ion process f or T-
bills was st art ed. 364 day T- bill was int roduced in April 1992, and in July 1997, t he 14-
day T- bill was also int roduced. RBI had suspended t he issue of 182- day T- bills f r om
April 1992, and revived t heir issuance since May 1999. All T- bills are now sold t hrough
an auct ion process according t o a f ixed auct ion calendar, announced by t he RBI . Ad hoc
t reasury bills, which enabled t he aut omat ic monet isat ion of cent ral government budget
def icit s, have been eliminat ed in 1997. All T- bill issuances now represent market
borrowings of t he cent ral government .

4. 1 I ssu an ce Pr ocess

Treasury bills are sold t hrough an auct ion process, in which banks and primary dealers
are maj or bidders. Non- compet it ive bids are allowed in t he auct ions, in which provident
f unds and ot her invest ors can part icipat e. Non- compet it ive bidders need not quot e t he
rat e of yield at which t hey desire t o buy t he T- bills. The Reserve Bank allot s bids t o t he
non- compet it ive bidders at t he weight ed average yield arrived at on t he basis of t he
yields quot ed by accept ed compet it ive bids at t he auct ion. Allocat ions t o non-
compet it ive bidders are out side t he amount not if ied f or sale. Non- compet it ive bidders
t heref ore do not f ace any uncert aint y in purchasing t he desired amount of T- bills f rom
t he auct ions. The Reserve Bank of I ndia issues a calendar of T- bill auct ions ( Table 4. 1) .
I t also announces t he exact dat es of auct ion, t he amount t o be auct ioned and payment
dat es by issuing press releases prior t o every auct ion.

Tabl e 4. 1: Tr easu r y Bi l l s - Au ct i on Cal en dar
Type of
Tr easu r y
bi l l
Per i odi ci t
y
Not i f i ed
Amou n t ( Rs.
cr . )
Day of Au ct i on Day of
Paymen t
91- day Weekly 250 Every Wednesday Following
Thursday
364- day Fort night l
y
750 Wednesday
preceding t he
report ing Fridays
Following
Thursday


41
Since May 1999, devolvement s on PDs in T- bill auct ions has been done away wit h, any
devolvement being on t he RBI alone, t hus enabling t hem t o manage T- bill yields as an
int erest rat e policy t ool. The syst em f or underwrit ing t he T- bills by PDs was replaced by
a syst em of minimum bidding commit ment . Each PD is required t o make a minimum
bidding commit ment f or auct ions of T- bills so t hat t hey t oget her absorb 100% of not if ied
amount . Bot h discriminat ory and unif orm price auct ion met hods are used in issuance of
T- bills. The auct ions of 91- day T- bills are unif orm price auct ions, where all successf ul
bidders are allot t ed at t he cut - of f prices. Theref ore, t he weight ed average price and t he
cut - of f price is t he same in t he 91- day T- bill auct ion. I n case of all ot her bills,
discriminat ory price auct ion is f ollowed, where t he successf ul bidders have t o pay t he
prices t hey have act ually bid f or. T- bills are available f or a minimum amount of
Rs. 25, 000 and in mult iples of Rs. 25, 000.
The summary of T- bill auct ions conduct ed during t he year 1999- 2000 is in Table 4. 2.
Non- compet it ive bids in 182- day and 364- day T- bills were allowed since July 1999.

Tabl e 4. 2: T- bi l l Au ct i on s 1999- 2000 - A Su mmar y
14 - day 91- day 182 - day 364- day
No of issues 53 53 23 26
Number of compet it ive bids 791 835 NA 975
Amount of compet it ive bids ( Rs. cr. ) 10415. 5 10733. 5 NA 23061. 8
4
Number of non- compet it ive bids 50 26 NA NA
Amount of non- compet it ive bids ( Rs.
cr. )
11253. 35 3035 NA NA
Number of compet it ive bids accept ed 327 331 NA 454
Amount of compet it ive bids accept ed
( Rs. cr. )
4065 3645 1655 10733. 0
9
Devolvement s on PDs ( Rs. cr. ) 640. 71 57 0 0
Devolvement s on RBI ( Rs. cr. ) 1808. 71 1595 645 2266. 91
Tot al I ssue ( Rs. cr) 17767. 77 8332 2900 13000
Cut - of f price - minimum ( Rs. ) 99. 66 97. 69 95. 29 90. 64
Cut - of f price - maximum ( Rs. ) 99. 75 97. 95 95. 71 91. 48
I mplicit yield at cut - of f price
minimum ( %)
6. 5163 8. 3716 8. 9646 9. 31
I mplicit yield at cut - of f price
maximum ( %)
8. 8702 9. 4585 9. 8856 10. 33
Ou t st an di n g amou n t ( en d of t h e
year ) ( Rs. cr . )
325 1520 1300 13000
Source: RBI Bullet in, Various I ssues.

4. 2 Cu t - Of f Yi el ds


42
T- bills are issued at a discount and are redeemed at par. The implicit yield in t he T- bill
is t he rat e at which t he issue price ( which is t he cut - of f price in t he auct ion) has t o be
compounded, f or t he number of days t o mat urit y, t o equal t he mat urit y value.
Yield, given price, is comput ed using t he f ormula:
= ( ( 100- Price) * 365) / ( Price * No of days t o mat urit y)

Similarly, price can be comput ed, given yield, using t he f ormula:
= 100/ ( 1+ ( yield% * ( No of days t o mat urit y/ 365) )
For example, a 182- day T- bill, auct ioned on January 18, at a price of Rs. 95. 510 would
have an
implicit yield of 9. 4280% comput ed as f ollows:
= ( ( 100- 95. 510) * 365) / ( 95. 510* 182)

9. 428% is t he rat e at which Rs. 95. 510 will grow over 182 days, t o yield Rs. 100 on
mat urit y. Treasury bill cut - of f yields in t he auct ion represent t he def ault - f ree money
market rat es in t he economy, and are import ant benchmark rat es.

4. 3 I n vest or s i n T- Bi l l s

Treasury bills are pre- dominant ly held by banks. I n t he recent years, t here has been a
growt h in t he number of non- compet it ive bids, result ing in signif icant holding of T- bills
by provident f unds, t rust s and mut ual f unds. Table 4. 3 present s holding pat t ern of
out st anding T- bills.

Tabl e 4. 3: Hol di n g Pat t er n of Ou t st an di n g T- bi l l s
( Rs. cr. )
At t h e en d of Mar ch I n vest or s
2001 2000 1999 1998 1997
RBI 995 6798 814 626 1468
Banks 13267 6536 8610 13321 8070
St at e government s 4455 2417 6603 7884 1262
Ot hers 4262 2777 3955 4015 3140
Tot al T- bi l l s
Ou t st an di n g
22979 18528 19982 25846 13940
As % of Ou t st an di n g Amou n t
RBI 4. 33 36. 69 4. 07 2. 42 10. 53
Banks 57. 74 35. 28 43. 09 51. 54 57. 89
St at e government s 19. 39 13. 05 33. 04 30. 50 9. 05
Ot hers 18. 55 14. 99 19. 79 15. 53 22. 53
Tot al 100. 00 100. 00 100. 00 100. 00 100. 00
Source: RBI , Weekly St at ist ical Supplement , Various I ssues.


43
4. 4 Secon dar y Mar k et Act i vi t y i n T- bi l l s

Treasury bills are most ly held t o mat urit y by a maj orit y of t he buyers. T- bills account
f or about 5. 5%
of t ot al market act ivit y in all debt inst rument s. Secondary market act ivit y is quit e
sparse. The average t urnover in T- bills is in Table 4. 4 The 364- day T- bill is
comparat ively more act ively t raded, wit h an average t urnover of nearly Rs. 1000 crore,
t he recent years f igures f or t he f irst six mont hs of 2000- 01 being Rs. 1394 crore.
The increase in volume of t rading in 364 day T- bills, f ollowed t he increase in t he not if ied
amount in t he auct ions t o Rs. 750 crore. The credit policy April 2001 has increased t he
not if ied amount f or t he 91- day T- bill t o Rs. 250 crore, up f rom Rs. 100 crore. The
liquidit y of t his inst rument is expect ed t o improve wit h t his move. The limit ed liquidit y
in 14- day and 182 day T- bills has been cit ed as one of t he reasons f or t he RBI s decision
t o discont inue t heir issuance.

44
Tabl e 4. 4: Aver age Dai l y Secon dar y Mar k et Tu r n over i n T- Bi l l s
( Amount in Rs. cr. )
14- day 91- day 182- day 364- day
1997
Aver age 358 221 - 1, 091
Mi n i mu m 0 29 - 243
Max i mu m 2, 000 920 - 2, 258
1998
Aver age 293 602 - 794
Mi n i mu m 0 0 - 96
Max i mu m 1, 331 3, 122 - 2, 992
1999
Aver age 167 363 112 936
Mi n i mu m 0 74 0 44
Max i mu m 370 1, 254 345 4, 589
2000
Aver age 180 275 162 1143
Mi n i mu m 0 50 0 330
Max i mu m 552 863 560 3, 690
Source: RBI , Handbook of St at ist ics on I ndian Economy, 2000.

Model Quest i ons

1. A t r easu r y bi l l mat u r i n g on 28- Ju n - 2002 i s t r adi n g i n t h e mar k et on 3- Ju l -
2001 at a pr i ce of Rs. 92. 8918. Wh at i s t h e di scou n t r at e i n h er en t i n t h i s pr i ce?
An sw er :
The yield is comput ed as:
= ( ( 100- price) * 365) / ( Price * No of days t o mat urit y)
= ( ( 100- 92. 8918) * 365) / ( 92. 8918* 360) ) = 7. 7624%

2. Wh at i s t h e pr i ce at w h i ch a t r easu r y bi l l mat u r i n g on 23
r d
Mar ch 2002
w ou l d be val u ed on Ju l y 13, 2001 at a yi el d of 6. 8204% ?
An sw er :
The price can be comput ed as
= 100/ ( 1+ ( yield% * ( No of days t o mat urit y/ 365) )
= 100/ ( 1+ ( 6. 8204%* ( 253/ 365) ) = Rs. 95. 4858

3. Wh at i s t h e day cou n t con ven t i on i n t h e t r easu r y bi l l mar k et s?
a. 30/ 360
b. Act ual/ Act ual
c. Act ual/ 360
d. Act ual/ 365
An sw er : d

45
Ch apt er 5

St at e Gover nment Bonds

5. 1 Gr oss Fi scal Def i ci t of St at e Gover n men t s an d i t s
Fi n an ci n g

I n t he 1990s t he gross f iscal def icit ( GFD) of st at e government s has grown f rom Rs.
18, 787 crore t o Rs. 90, 092 crore. Nearly 60% of t he gross f iscal def icit of st at es is on
account of revenue def icit s, arising most ly out of expendit ure overruns. I n 1999- 2000,
revenue expendit ures exceeded budget est imat es by 4%. Non- plan revenue
expendit ures such as wages and salaries, pensions, and int erest payment s, const it ut e
about 80% of revenue expendit ures of st at es. St at e government bonds represent t he
market borrowings used in f inancing t he GFD. St at e government s also provide
guarant ees on t he bonds issued by st at e level public sect or ent erprises. Market
borrowings are current ly about 13% of t he GFD having f allen f rom a high of 17. 5% in
1996- 97 ( Table 5. 1) . The share of loans f rom Cent ral Government as a means of
f inancing t he def icit has f allen over t he years, while t he ot her sources, which include
small savings, have increased in t he 1990s.

Tabl e 5. 1: Fi n an ci n g of t h e GFD of St at es ( As per cen t age
of GFD)
Year Loan s f r om
t h e Cen t r al
Gover n men t
Mar k et
Bor r ow i n gs
Ot h er s Gr oss Fi scal
Def i ci t
Amou n t of
Mar k et
Bor r ow i n gs
( Rs. cr . )
1990- 91 53. 1 13. 6 33. 3 100 2556
1996- 97 47. 1 17. 5 35. 4 100 6515
1997- 98 53. 6 16. 5 30. 0 100 7280
1998- 99 41. 8 14. 1 44. 1 100 10467
1999- 00 36. 0 13. 9 50. 1 100 12636
2000- 01 33. 8 13. 3 53. 0 100 12567
Source: RBI , Annual Report 2000- 01.

5. 2 Vol umes and Coupon Rat es

The annual gross borrowings of st at e government s, which was less t han Rs. 2, 000 crore
unt il t he 1990s, has averaged over Rs. 12, 000 crore every year, in t he last t wo years.
Market borrowings out st anding wit h st at e government s has grown f rom Rs. 15, 618
crore in 1991 t o Rs. 83, 783 crore by March 2000.
The St at e government bond issuance is present ly managed by t he RBI along wit h t he
cent ral borrowings. A pre- det ermined percent age of st at e def icit s are f unded t hrough
market borrowings by t he RBI . St at es have t he opt ion t o manage t heir own market
borrowings t o a maximum ext ent of 35% of t ot al market borrowings. The coupon rat es
at which st at e government s borrow are current ly f ixed at 25 bps spread above t he rat es

46
f or cent ral government borrowing f or similar t enor. The weight ed average coupon is
present ed in Figure 5. 2. I t is expect ed t hat t his rest rict ion would be relaxed as bet t er
managed st at e government s have access t o market borrowings at f lexible rat es. RBI
has indicat ed t hat PDs may play a role in st at e government bond issuance, eit her as
underwrit ers, or in book building of a privat e placement of bonds.

5. 3 Ow n er sh i p Pat t er n of St at e Gover n men t Bon ds

SBI and it s associat es are t he single largest owners of st at e government securit ies. The
banking syst em as a whole is a large invest or in government securit ies. One of t he
reasons f or banks t o invest in st at e government bonds is t he relat ively lower risk-
weight ing of 20% on t hese bonds, compared t o t he 100% weight ing in case of corporat e
lending. The prudent ial invest ment norms of LI C and provident f unds have also enabled
a sizeable holding of st at e government securit ies by t hese ent it ies. Table 5. 2 provides
t he pat t ern of ownership of st at e government bonds.

Tabl e 5. 2: Pat t er n of Ow n er sh i p of St at e Gover n men t Bon ds
( I n per cen t )
I n vest or s 1991 1996 1997 1998 1999
SBI and associat es 22. 18 20. 92 20. 57 19. 91 18. 95
Nat ionalised banks 49. 27 43. 15 42. 42 41. 23 40. 15
Ot her Schedule Commercial
Banks 7. 11 3. 58 3. 31 3. 64 3. 28
LI C 6. 91 12. 17 13. 46 14. 55 16. 15
UTI 0. 0000 0. 0026 0. 0000 0. 0000 0. 0016
Employees Provident Fund
Schemes 2. 58 2. 20 2. 94 3. 42 3. 93
Coal Mines Provident Fund
Scheme 1. 03 1. 77 1. 51 1. 63 1. 63
Ot hers 10. 92 16. 21 15. 79 15. 63 15. 90
Tot al 100. 00 100. 00 100. 00 100. 00 100. 00
Source: RBI , Annual Report , various issues

5. 4 St at e Gover n men t Gu ar an t eed Bon ds

Apart f rom market borrowings t hrough issuance of bonds, St at e government s also
guarant ee bonds t hat are issued by st at e level public sect or unit s. I t is est imat ed t hat
t he f iscal posit ion of st at es could be impact ed by t hese guarant ees, which may have
been made wit hout a complet e assessment of t he underlying risk. I n many cases, t he
bonds issued by t he PSUs, are not backed by capit al invest ment s in proj ect s, but are
ut ilized f or regular expenses ( including paying salaries, in some cases) and f or f unding
development al proj ect s, wit h limit ed cash f low generat ion pot ent ial. While t he
out st anding guarant ees issued by t he Cent ral government has been brought down f rom
7. 8% of t he GDP in 1993 t o 4% in 2000, t he f igures f or st at e government guarant ees
have remained around 5% of t he GDP. ( The RBI dat a on t his aspect is not available on
all st at es. This number is f or 17 maj or st at es) .

Model Qu est i ons


47
1. Wh i ch of t h e f ol l ow i n g abou t st at e gover n men t bor r ow i n gs i s t r u e?
a. St at e government bonds are issued by t he respect ive Finance Depart ment of t he
St at es.
b. St at e government bonds are f ully guarant eed by t he cent ral government .
c. Most st at e government bonds are issued by t he RBI .
d. St at e government bonds are issued by t he RBI , at t he same rat es, along wit h
cent ral government bonds.
An sw er : c


48
Ch apt er 6

Cal l Mon ey Mar k et s

Call and not ice money market ref ers t o t he market f or short - t erm f unds ranging f rom
overnight f unds t o f unds f or a maximum t enor of 14 days. Banks and primary dealers
are allowed t o lend as well as borrow in t he call market s, while a select list of
part icipant s, namely, f inancial inst it ut ions, UTI , mut ual f unds, and a select number of
corporat es are allowed t o part icipat e as lenders in t he call market . Call money
t ransact ions are essent ially unsecured OTC t ransact ions, wit h same day set t lement , and
are pref erred by part icipant s f or t heir operat ional ease, over most ot her short - t erm
inst rument s including repos.

6. 1 Vol u mes i n t h e cal l mar k et

Call market s represent t he most act ive segment of t he debt market s, wit h volumes
averaging Rs. 40, 000 crore per day, higher t han t hat of any ot her inst rument , including
government securit ies, in t he market .
Though t he demand f or f unds in t he call market is mainly governed by t he banks' need
f or resources t o meet t heir st at ut ory reserve requirement s, it also of f ers t o some
part icipant s a regular f unding source f or building up short - t erm asset s. However, t he
demand f or f unds f or reserve requirement s dominat es any ot her demand in t he market .
The aggregat e borrowings in t he call money market as proport ion of aggregat e cash
balances maint ained by commercial banks wit h t he RBI , on average, was around 32% i n
recent period. Figure 6. 1 displays t he average daily volumes in t he call market s.

Fi gu r e 6. 1: Aver age Dai l y Vol u mes i n t h e Cal l Mar k et ( Rs. cr . )
0
10000
20000
30000
40000
50000
60000
M
a
r
-
9
8
M
a
y
-
9
8
J
u
l
-
9
8
S
e
p
-
9
8
N
o
v
-
9
8
J
a
n
-
9
9
M
a
r
-
9
9
M
a
y
-
9
9
J
u
l
-
9
9
S
e
p
-
9
9
N
o
v
-
9
9
J
a
n
-
0
0
M
a
r
-
0
0
M
a
y
-
0
0
J
u
l
-
0
0
S
e
p
-
0
0
Month-Year
A
v
g
.

D
a
i
l
y

V
o
l
u
m
e
s

(
R
s
.

c
r
.
)




49
6. 2 Par t i ci pan t s i n t h e Cal l Mar k et s

Whet her call money market s should be pure int er- bank market s, or should ot her
part icipant s be encouraged, has been a mat t er of discussion f or a number of years. The
Chakravart hy Commit t ee ( 1985) f elt t hat allowing addit ional non- bank part icipant s int o
t he call market would not dilut e t he st rengt h of monet ary regulat ion by t he RBI , as
resources f rom non- bank part icipant s do not represent any addit ional resource f or t he
syst em as a whole, and t heir part icipat ion in call money market would only imply a
redist ribut ion of exist ing resources f rom one part icipant t o anot her. I n view of t his, t he
Chakravart y Commit t ee recommended t hat addit ional non- bank part icipant s may be
allowed t o part icipat e in call money market .
The Vaghul Commit t ee ( 1990) , while recommending t he int roduct ion of a number of
money market inst rument s t o broaden and deepen t he money market , recommended
t hat t he call market s should be rest rict ed t o banks. The ot her part icipant s could choose
f rom t he new money market inst rument s, f or t heir short - t erm requirement s. One of t he
reasons t he commit t ee ascribed t o keeping t he call market s as pure int er- bank market s
was t he dist ort ions t hat would arise in an environment where deposit rat es were
regulat ed, while call rat es were market det ermined.
The Narasimham Commit t ee I I ( 1998) also recommended t hat call money market in
I ndia, like in most ot her developed market s, should be st rict ly rest rict ed t o banks and
primary dealers. Since non- bank part icipant s are not subj ect t o reserve requirement s,
t he Commit t ee f elt t hat such part icipant s should use t he ot her money market
inst rument s, and move out of t he call market s.
The RBI const it ut ed a Technical Group on Phasing Out of Non- banks f rom Call/ Not ice
Money Market in December 2000. The report of t his t echnical group was present ed in
March 2001. The recommendat ion of t his group is t hat complet e wit hdrawal of non-
bank part icipant s f rom t he call/ not ice money market should be co- t erminus wit h f ull
f ledged operat ionalisat ion of t he Clearing Corporat ion, and during t he int ermediat e
period, t heir operat ions should be phased out in such a manner t hat t heir migrat ion t o
repo/ reverse repo market becomes smoot h and t here is no disrupt ion in t he call money
market .
The part icipant s in t he call market s have increased in t he 1990s, wit h a gradual opening
up of t he call market s t o non- bank ent it ies. I nit ially DFHI was t he only PD eligible t o
part icipat e in t he call market , wit h ot her PDs having t o rout e t heir t ransact ions t hrough
DFHI , and subsequent ly STCI . I n 1996, PDs apart f rom DFHI and STCI were allowed t o
lend and borrow direct ly in t he call market s. Present ly t here are 19 primary dealers
part icipat ing in t he call market s.
Since 1991, corporat es have been allowed t o lend in t he call market s, init ially t hrough
t he DFHI , and present ly t hrough any of t he PDs. I n order t o be able t o lend, corporat es
have t o provide proof of bulk lendable resources t o t he RBI and should not have any
out st anding borrowings wit h t he banking syst em. The minimum amount corporat es have
t o lend has been reduced f rom Rs. 20 crore, in a phased manner t o Rs. 3 crore in 1998.
There were, unt il recent ly, 50 corporat es eligible t o lend in t he call market s, t hrough t he
primary dealers. Corporat es do not have access t o call money market s, af t er June 30,
2001.

Tabl e 6. 1: Nu mber of Par t i ci pan t s i n Cal l / Not i ce Mon ey Mar k et

50
Cat egor y Ban k PD FI MF Cor por at
e
Tot al
I . Borrower 154 19 - - - 173
I I . Lender 154 19 20 35 50 277
Source: Report of t he Technical Group on Phasing Out of Non- banks f rom Call/ Not ice
Money Market , March 2001.
UTI and LI C have been permit t ed t o lend in t he call market s since 1971. Subsequent ly
20 ot her f inancial inst it ut ions have been permit t ed t o lend. I nit ially public sect or mut ual
f unds could lend in t he call market s. Since 1997, all SEBI regist ered mut ual f unds ar e
eligible t o lend.
There are 277 part icipant s in t he call market s, wit h 105 part icipant s, namely mut ual
f unds, corporat es and f inancial inst it ut ions, operat ing only on t he lending side. Banks
and PDs t echnically can operat e on bot h sides of t he call market , t hough in realit y, only
t he PDs borrow and lend in t he call market s. The bank part icipant s are divided int o t wo
cat egories: banks which are pre- dominant ly lenders ( most ly t he public sect or banks)
and banks which are pre- dominant ly borrowers ( f oreign and privat e sect or banks) .
I n t he year 2000, 66% of all borrowings in t he call market s were by banks, wit h PDs
borrowing t he remaining 34% of t he f unds. On t he lending side, 45% of t he f unds were
lent by banks, 11% by PDs and 44% by t he ot her part icipant s in t he call market s. The
call market s are also concent rat ed in f ew players on t he lending side. The St at e Bank of
I ndia is t he largest lender in t he market , lending on an average about 15% of t he f unds.
4 public sect or banks ( Canara Bank, Cent ral Bank, PNB and SBI ) and 5 f inancial
inst it ut ions ( I CI CI , I DBI , LI C, SI DBI and UTI ) , account ed f or nearly 30% of t he lending
in t he call market , in t he year 2000. Similarly, on t he borrowing side, 10 f oreign and
privat e sect or banks account ed f or nearly 39% of borrowings in t he call market s in t he
year 2000.

6. 3 Cal l Rat es

The concent rat ion in t he borrowing and lending side of t he call market s impact s liquidit y
in t he call market s. The presence or absence of import ant players is a signif icant
inf luence on quant it y as well as price. This leads t o a lack of dept h and high levels of
volat ilit y in call rat es, when t he part icipant st ruct ure on t he lending or borrowing side
alt ers.
Short - t erm liquidit y condit ions impact t he call rat es t he most . On t he supply side t he call
rat es are inf luenced by f act ors such as: deposit mobilisat ion of banks, capit al f lows, and
banks reserve requirement s; and on t he demand side, call rat es are inf luenced by t ax
out f lows, government borrowing programme, seasonal f luct uat ions in credit of f t ake.
The ext ernal sit uat ion and t he behaviour of exchange rat es also have an inf luence on
call rat es, as most players in t his market run int egrat ed t reasuries t hat hold short t erm
posit ions in bot h rupee and f orex market s, deploying and borrowing f unds t hrough call
market s.

Tabl e 6. 2: Cal l Mon ey Rat es
Year Max i mu
m ( %
p. a. )
Mi n i mu m
( % p. a. )
Aver age
( % p. a. )
Co-
ef f i ci en t
of
Ban k r at e
( En d Mar ch )
( % p. a. )

51
var i at i on *
1996 -
97
14. 6 1. 05 7. 8 37. 3 12. 0
1997 -
98
52. 2 0. 2 8. 7 85. 7 10. 5
1998 -
99
20. 2 3. 6 7. 8 14. 9 8. 0
1999 -
00
35. 0 0. 1 9. 0 12. 7 8. 0
2000 -
01
28. 0 2. 0 7. 5 11. 2 7. 5
* Of mont hly weight ed average
Source: Handbook of St at ist ics on I ndian Economy, 2000; WSS, various issues, RBI .
During normal t imes, call rat es hover in a range bet ween t he repo rat e and t he reverse
repo rat e. The repo rat e represent s an avenue f or parking short - t erm f unds, and during
periods of easy liquidit y, call rat es are only slight ly above t he repo rat es. During periods
of t ight liquidit y, call rat es move t owards t he reverse repo rat e. Table 6. 2 provides dat a
on t he behaviour of call rat es. Figure 6. 2 displays t he t rend of average mont hly call
rat es.
Fi gu r e 6. 2: Mon t h l y Aver age Cal l Rat es ( % )
0
5
10
15
20
25
30
35
40
A
p
r
-
9
0
O
c
t
-
9
0
A
p
r
-
9
1
O
c
t
-
9
1
A
p
r
-
9
2
O
c
t
-
9
2
A
p
r
-
9
3
O
c
t
-
9
3
A
p
r
-
9
4
O
c
t
-
9
4
A
p
r
-
9
5
O
c
t
-
9
5
A
p
r
-
9
6
O
c
t
-
9
6
A
p
r
-
9
7
O
c
t
-
9
7
A
p
r
-
9
8
O
c
t
-
9
8
A
p
r
-
9
9
O
c
t
-
9
9
A
p
r
-
0
0
Month-Year
A
v
g
.

M
o
n
t
h
l
y

C
a
l
l

R
a
t
e
s

(
%
)


6. 4 Movemen t of Par t i ci pan t s f r om Cal l t o Repo
Mar k et s

The RBI has been considering t he phasing out of non- bank part icipant s f rom t he call
market s, f or a long while. I n t he "Mid- Term Review of Monet ary and Credit Policy f or

52
1998- 99" announced in Oct ober 1998, t he Reserve Bank indicat ed it s int ent ion t o
ult imat ely move t owards a pure int er - bank call/ not ice/ t erm money market including
PDs. I t was indicat ed t hat simult aneously measures would be t aken t o widen t he repo
market and improve non- bank part icipat ions in a variet y of ot her inst rument s.
Accordingly, it has been decided t hat non- bank ent it ies would not be allowed
part icipat ion in t he call market s, t hrough PDs, af t er June 2001.
The Technical Group on Phasing Out of Non- banks f rom Call/ Not ice Money Market , which
submit t ed it s report in March 2001, has made t he f ollowing recommendat ions:
Access t o call money market by such non- bank part icipant s as f inancial inst it ut ions
and mut ual f unds, may be reduced in t hree st ages by placing cap in relat ion t o t heir
average daily lendings during April 2000 - March 2001.
I n t he f irst st age, each such non- bank part icipant should be allowed t o lend only up
t o 70% of t heir average daily lendings in call money market during 2000- 2001 f or a
period of t hree mont hs which should come int o ef f ect at t he earliest af t er March 31,
2001.
I n t he second st age, access should be reduced f urt her t o 40% of t heir average daily
lendings during 2000- 01.
The f inal st age should commence wit h t he set t ing up of Clearing Corporat ion or
af t er a period of t hree mont hs f rom t he conclusion of t he second st age, whichever is
lat er. The f inal st age by which t ime t he Clearing Corporat ion is expect ed t o be
est ablished should last f or a period of t hree mont hs. During t his phase, t he Group
f eels t hat access t o call money market should be permit t ed t o t hese part icipant s t o
t he ext ent of 10% of t heir average daily lending during 2000- 01. This is considered
necessary t o enable t hese part icular classes of non- bank part icipant s t o be f amiliar
wit h t he operat ions of t he Clearing Corporat ions. Af t er t he end of t his st age, t hese
ent it ies would not be permit t ed t o lend in call money market at all.
I n t he light of t he recommendat ions of t he Group and t he f eedback received on t he
recommendat ions, f ollowing st eps were announced in t he Monet ary and Credit Policy f or
2001- 02:
Permission t o corporat es t o rout e t heir call t ransact ions t hrough PDs would be
available up t o June 30, 2001, as announced in t he Mid- t erm Review of Oct ober
2000.
Access t o ot her non- bank inst it ut ions ( including f inancial inst it ut ions, mut ual f unds
and insurance companies) t o operat e in call/ not ice money market would be
gradually reduced in f our st ages:
- I n st age I , wit h ef f ect f rom May 5, 2001 non- banks would be allowed t o lend up t o
85% of t heir average daily lendings in call market during 2000- 01.
- I n st age I I , wit h ef f ect f rom t he dat e of operat ionalisat ion of Clearing Corporat ion,
non- banks would be allowed t o lend up t o 70% of t heir average daily lendings in call
market during 2000- 01.
- I n st age I I I , wit h ef f ect f rom t hree mont hs af t er st age I I , access of non- banks t o
call/ not ice money market would be equivalent t o 40% of t heir average daily
lendings in call market during 2000- 01.
- I n st age I V, wit h ef f ect f rom t hree mont hs af t er st age I I I , access of non- banks t o
call/ not ice money market would be equivalent t o 10% of t heir average daily
lendings in call market during 2000- 01.
From a dat e t o be not if ied by RBI , af t er t he on- set of st age I V, non- banks will not
be permit t ed t o lend in call/ not ice money market .

53
The above said measures would allow suf f icient t ime f or market part icipant s on bot h
lending and borrowing side t o adj ust t heir port f olios wit hout any disrupt ion in t he market
as t he programme will be implement ed in f our st ages indicat ed, in line wit h t he
recommendat ions of t he Technical Group. Wit h t he proposed est ablishment of t he
Clearing Corporat ion, repo operat ions would not only become more ef f icient , it would
also be possible t o undert ake repo t ransact ions in non- government securit ies. I t is
envisaged t hat event ually bot h call money market and repo/ reverse repo market
combined wit h market f or ot her money market inst rument s like t erm money,
Commercial Paper ( CP) , Cert if icat es of Deposit ( CDs) and Treasury Bills would const it ut e
an int egrat ed market f or equilibrat ing short - t erm f unds f or bot h banks and non- banks.
Also such int egrat ion is expect ed t o make t he money market an ef f ect ive t ransmission
channel f or monet ary policy.

Model Quest i ons

1. Wh i ch of t h e f ol l ow i n g par t i ci pan t s i n t h e cal l mar k et s ar e al l ow ed t o l en d
as w el l as bor r ow ?
a. Mut ual Funds
b. Banks and Primary Dealers
c. Corporat es
d. Financial I nst it ut ions
An sw er : b


54
2. Th e par t i ci pat i on of n on - ban k en t i t i es i n t h e cal l mar k et i s ex pect ed t o be
r edu ced t o
a. 10% of average daily lending in 2000- 01, six mont hs af t er t he commencement of
operat ions of t he clearing corporat ion.
b. 10% of t he average weekly lending in t he last 3 yeas, 3 mont hs af t er int roduct ion of
t he NDS.
c. 10% of t he average lending and borrowings, 1 year af t er commencement of
operat ions of t he clearing corporat ion.
d. None of t he above.
An sw er : a


55
Ch apt er 7

Cor por at e Debt : Bon ds

7. 1 Mar k et Segmen t s

The market f or long t erm corporat e debt has t wo large segment s:
a. Bonds issued by public sect or unit s, including public f inancial inst it ut ions, and
b. Bonds issued by t he privat e corporat e sect or
PSU bonds can be f urt her classif ied int o t axable and t ax- free bonds.
The market s f or corporat e debt have wit nessed signif icant innovat ions since 1992, when
t he regulat ion on int erest rat es on t hese bonds was removed. Corporat e bonds wit h
embedded opt ions, f loat ing- rat e int erest , conversion opt ions, and a variet y of st ruct ured
obligat ions are issued in t he market s. However, t he market f or corporat e debt , which
was nearly f ully ret ail, is now dominat ed by inst it ut ional invest ors. Even PSU bonds and
DFI bonds, which used t o be earlier ret ailed, are now privat ely placed, and t here are
hardly any public issue of bonds.

7. 2 I ssu e Pr ocess

The process of issue of corporat e securit ies issuance involves t he f ollowing st eps:
Board meet ing and Approval f or I ssue at t he AGM
Credit rat ing of t he I ssue
Creat ion of securit y f or t he said bonds/ debent ures t hrough appoint ment of
Debent ure Trust ees
Appoint ment of Advisors and I nvest ment bankers f or I ssue management
Finalisat ion of t he init ial t erms of issue
Preparat ion of t he of f er document ( f or public issue) and I nf ormat ion Memorandum
( f or privat e placement )
SEBI approval of Of f er Document f or public issue
List ing agreement wit h st ock exchanges
Of f er t he issue t o prospect ive invest ors and/ or book building
Accept ance of applicat ion money/ advance deposit s f or t he issue
Allot ment of t he issue
I ssue of let t ers of allot ment and cert if icat es/ Deposit ory conf irmat ion
Collect f inal amount s f rom invest ors
Ref und excess applicat ion money/ int erest on applicat ion money

7. 2. 1 Au t h or i t y f or t h e I ssu e

Companies have t o pass ordinary resolut ions in t heir Annual General meet ing, where t he
company aut horises t he Board of Direct ors, t o borrow t he required f unds ( usually t he
approval is in f orm of a maximum amount of borrowing represent ed as a rat io/ absolut e
amount wit h respect t o t he share capit al and t he f ree reserves of t he company) . The
company also aut horises t he Board of Direct ors t o mort gage t he propert y of t he

56
company, as securit y f or t he borrowing ( in t he case of secured borrowings) and
empowers t he Board of Direct ors t o execut e deeds and document s t hat enable t he
creat ion of such mort gages.
7. 2. 2 Appoi n t men t of Deben t u r e Tr u st ees

According t o t he SEBI Guidelines f or Disclosure and I nvest or Prot ect ion, 2000,
( hereinaf t er GDI P, 2000) in case of issue of debent ure wit h mat urit y of more t han 18
mont hs, t he issuer shall appoint a Debent ure Trust ee ( See Chapt er X of t he GDI P in
Chapt er 12. 2) . The company ent ers int o a Trust ee Agreement and a debent ure t rust
deed, which shall, among ot her t hings, specif y t he powers, aut horit ies and obligat ions of
t he company and t he Trust ees, in respect of t he debent ures. The holders of debent ures
are deemed t o have aut horised t he Trust ees t o do all deeds and act s required f or
securing t he debent ures being issued. All remedies of t he debent ure holders f or t he
amount s due on t he debent ures will be vest ed wit h t he Trust ees, on behalf of t he
invest ors.

7. 2. 3 Of f er Docu men t

Draf t of f er document has t o be f iled wit h SEBI in t he f ormat prescribed by t he SEBI . I n
t he case of privat e placement , inf ormat ion memorandum is prepared f or privat e
circulat ion, t o prospect ive invest ors.

7. 2. 4 Cr eat i on of Deben t u r e Redempt i on Reser ve ( DRR) Accou n t

A company has t o creat e DRR in case of issue of debent ure wit h mat urit y of more t han
18 mont hs, in accordance wit h t he provisions of t he SEBI GDI P, 2000, Chapt er X, and
Sect ion 117C of t he Companies Act , 1956. A Company shall creat e DRR equivalent t o
50% of t he amount of debent ure issue bef ore debent ure redempt ion commences.
Wit hdrawal f rom DRR is permissible only af t er at least 10% of t he debent ure liabilit y has
act ually been redeemed by t he company. The requirement of creat ion of a DRR shall
not be applicable in case of issue of debt inst rument s by inf rast ruct ure companies.

7. 2. 5 Cr eat i on of Ch ar ge

The securit y shall be creat ed wit hin six mont hs f rom t he dat e of issue of debent ures. I f
t he issuing company proposes t o creat e a charge f or debent ures of mat urit y of less t han
18 mont hs, it shall f ile wit h Regist rar of Companies part iculars of such charge under t he
Companies Act . Where no charge is t o be creat ed on such debent ures, t he issuer
company shall ensure compliance wit h t he provisions of t he Companies ( Accept ance of
Deposit s) Rules, 1975, as, unsecured debent ures / bonds are t reat ed as "deposit s" f or
purposes of t hese rules ( SEBI GDI P, 2000) .

7. 2. 6 Cr edi t Rat i n g

I t is mandat ory f or all public issues of debent ures t o obt ain a credit rat ing f rom a SEBI
regist ered credit rat ing agency. I n t he case of privat e placement , most Qualif ied
I nst it ut ional I nvest ors ( QI Bs) who part icipat e in t he process, insist on credit rat ing.
Most debent ure issues are t heref ore credit rat ed. A small percent age of debt issues are

57
also placed wit h inst it ut ions, based on int ernal credit rat ing of t hese inst it ut ions. ( Ref er
sect ion on Credit Rat ing in a subsequent sect ion of t his chapt er) .

7. 2. 7 Li st i n g Cr i t er i a on NSE - WDM

I n order f or a securit y t o be eligible f or list ing on t he WDM segment of t he NSE, t he
issuing corporat e has t o adhere t o t he applicable eligibilit y condit ions f or list ing. The
securit y proposed f or list ing on t he
WDM segment of t he NSE should comply wit h t he requirement s indicat ed hereunder:
Pu bl i c Sect or Un der t ak i n g
Minimum 51% holding by Cent ral Government , and/ or St at e Government s and/ or
Government Company.
I f less t han 51% shareholding is by Cent ral Government , and/ or St at e Government s
and/ or Government Company, invest ment grade credit rat ing required
Ban k s
Should be Scheduled banks, and having net wort h of Rs. 50 crore or above.
I nvest ment grade credit rat ing required
Cor por at e Bodi es
Paid up capit al of Rs. 10 crore, or Market capit alizat ion of Rs. 25 crore.
( Net wort h in case of unlist ed companies)
I nvest ment grade credit rat ing required
I n f r ast r u ct u r e Compan i es
Tax exempt ion & recognit ion as I nf rast ruct ure Company under relat ed
st at ues/ regulat ion.
Credit rat inginvest ment Grade
Mu t u al Fu n d Un i t s
Any SEBI regist ered Mut ual Fund/ Scheme
I nvest ment obj ect ive t o invest predominant ly in debt or
Scheme is t raded in secondary market as Debt inst rument .
Secu r i t i zed Debt
Minimum t ranche: Rs. 20 crore, and
Credit rat ing I nvest ment Grade

Companies seeking list ing on t he WDM are required t o apply f or t he same, in t he
prescribed f ormat , and provide inf ormat ion regarding t he I ssuer and t he securit y,
according t o t he requirement s prescribed by t he NSE. The prescribed applicat ion calls
f or det ails in 6 part s:
Part A: Det ails of t he I ssuer
Part B: Det ails of t he securit y proposed f or list ing
Part C: I nst rument Det ails
Part D: Det ails of securit ies issued in t he past
Part E: General I nf ormat ion and
Part F: List of Document s at t ached.
On accept ance of t he NSE- WDM t o list t he debent ure, a list ing agreement is signed
bet ween t he company and t he NSE, af t er which t he securit y is admit t ed f or list ing on t he
WDM. Addit ional list ing by t he same issuer can be made by execut ing a supplement ary
list ing agreement , f or each such securit y.


58
7. 2. 8 For m of Hol di n g

Bonds can be held in paper f orm or in demat erialized f orm. RBI has announced t hat
wit h ef f ect f rom Oct ober 31, 2001, banks, FI s, PDs and SDs will be permit t ed t o make
f resh invest ment s and hold bonds and debent ures, privat ely placed or ot herwise, only in
demat erialised f orm. Out st anding invest ment s in paper f orm should also be convert ed
int o demat erialised f orm by June 30, 2002.


59
7. 3 I ssu e Man agemen t an d Book Bu i l di n g

Debent ure issues which are of f ered t o t he public have t o comply wit h t he GDI P 2000 f or
t he same, and appoint SEBI regist ered int ermediaries t o advise and mange t he issue.
The lead managers and co- managers are responsible f or placing t he issue wit h t he
invest ors. The issue is managed by a consort ium of lead managers and co- managers,
underwrit ers and brokers t o t he issue.
I n t he case of privat e placement of t he issue, t he lead arranger, who is also t he advisor
and invest ment banker f or t he issue, is responsible f or managing t he issue. There is
also a virt ual book- building port al called debt on n et . com, which is a j oint vent ure of t he
I L&FS and NSE, which act s as an int ernet based book f or placing issues. I nvest ors can
bid f or issues t hrough t he port al, which enables t he lead manager t o build and close t he
book f or t he issue.

7. 3. 1 Book Bu i l di n g Pr ocedu r e

Commencing f rom t he dat e of opening of t he of f er, pot ent ial invest ors will be invit ed by
t he lead manager t o t he issue, who will also f unct ion as t he book runner, t o place
orders, by way of let t er of commit ment , in t he prescribed f ormat . I nvest ors would
indicat e t he amount t hey would like t o invest , at dif f erent coupon rat es. Alt ernat ively,
invest ors may st at e t he amount t hey would like t o invest at t he cut - of f coupon rat e. The
orders placed by t he invest ors can be alt ered, during t he t ime t he book is open, by
anot her revised commit ment let t er. The book runner st at es t he t ime and dat e when t he
book will be closed, bef ore which all invest or orders should reach t he of f ice of t he book
runner. All commit ment s are kept conf ident ial.
The issuer will det ermine t he cut - of f coupon rat e, in consult at ion wit h t he book runners,
based on t he let t ers of commit ment received f rom t he invest ors. The cut - of f coupon
rat e is t he rat e t hat will be applicable t o all invest ors t o t he issue. I n case commit ment s
are received f or at least t he minimum amount , at t he cut - of f coupon rat e, t he issuer
may reserve t he right t o f ix t he applicable coupon rat es at t he minimum of t he range.
I n case t he issue is oversubscribed, t he f inal allocat ion will be decided by t he company
and t he book runners. Priorit y is given t o t he invest ors in t he f ollowing order:
First priorit y is given t o invest ors bidding at t he lowest coupon rat es
Second priorit y is given t o invest ors bidding at a lower coupon rat e, provided t heir
bids are lower t han t he cut - of f coupon rat e
Third priorit y is given t o invest ors bidding at t he cut of f coupon rat e.
Wit hin a set of applicat ions at t he same rat e, priorit y is given t o t he earlier bidder at
t he same rat e.
I f t here is a t ie in t erms of bot h coupon rat e and t ime, t he allocat ion is done on pro-
rat a basis.

Ex ampl e

Consider t he f ollowing Commit ment schedule sent by t he book runner t o a prospect ive
invest or, wit h column A indicat ed, and ret urned by t he invest or who f ills in his order in
column B.

60
I n t he example, t he invest or is willing t o invest Rs. 2 crore, at a rat e of 10. 25% or
higher. The book runner has capped t he of f er at 10. 5%. Theref ore, should t he cut - of f
coupon rat e be bet ween 10. 25% but below 10. 5%, t his invest or is willing t o commit Rs.
2 crore. However, by indicat ing



Rs. 3. 5 crore against 10. 5%, t he invest or has commit t ed t o invest ing Rs. 3. 5 crore,
should t he cut of f rat e be 10. 5%.

A B
At cou pon r at e ( %
payabl e semi -
an n u al l y)
Tot al Amou n t
at A or Hi gh er ( Rs. )
10 -
10. 05 -
10. 10 -
10. 15 -
10. 20 -
10. 25 2, 00, 00, 000
10. 30 -
10. 35 -
10. 40 -
10. 45 -
10. 50 3, 50, 00, 000
AND/ OR -
At cut - of f rat e -

7. 4 Ter ms of a Deben t u r e I ssu e

The t erms of t he corporat e debent ure issue is st at ed in t he of f er document / inf ormat ion
memorandum. I n order t o be able t o t rade and value t he debent ure, f amiliarit y wit h t he
t erms of t he debent ure is required.
Face val u e of t he debent ure is st at ed in Rupees as t he par value. I n t he case of public
issues, t he f ace value is generally Rs. 100. I n privat ely placed debent ures, it is now t he
pract ice t o issue debent ures wit h high f ace value, since invest ors are also large
inst it ut ions, invest ing and t rading large lot s.
Pr i ce is price per debent ure in rupees. This can also vary f rom Rs. 100 in t he case of
publicly issued debent ures, t o higher amount s in t he case of privat ely placed
debent ures.
Cr edi t Rat i n g: The rat ing obt ained f rom a SEBI regist ered credit rat ing agency is
st at ed. Rat ing symbols of t he credit rat ing agency are used f or t he purpose.
Deemed dat e of al l ot men t : Each debent ure issue has a deemed dat e of allot ment ,
which is st at ed in t he of f er document . I nt erest is due on t he debent ures f rom t he dat e
on which t he debent ure is deemed t o have been allot t ed.
Appl i cabl e i n t er est r at e: I n t he case of f ixed rat e inst rument s, t he coupon is st at ed as
a percent age of t he f ace value. I n t he case of f loat ing rat e inst rument s, t he benchmark,

61
t he periodicit y of reset , mark- up t o benchmark, and t he f loor and cap if any, are st at ed.
I nt erest f or a f loat ing rat e inst rument is det ermined at t he beginning of a rest period,
and is paid at t he end of t he reset period.
I n t er est on appl i cat i on mon ey : Companies are required t o pay invest ors, int erest on
t he applicat ion money t hat is received, f rom t he dat e of realisat ion of t his amount s, t o
t he dat e immediat ely preceding t he deemed dat e of allot ment , at t he applicable coupon
rat e of t he debent ure. I n case of applicat ions t hat have been rej ect ed or allot t ed in
part , int erest det ermined in t he af oresaid manner will be payable wit hin 3 weeks of issue
closure, on t he ref undable applicat ion money.
I n t er est paymen t : The company st at es in t he of f er document t he periodicit y of int erest
payment , and t he act ual dat es on which int erest on t he debent ure will be due. For each
of t he int erest payment s, record dat es t o det ermine eligible regist ered debent ure
holders, will be not if ied t o t he st ock exchanges where t he debent ures are list ed. The
market pract ice is t o sat e t he record dat e as 30 business days preceding t he
int erest / principal repayment dat e. I nt erest is payable only t o such regist ered debent ure
holders. I nt erest payment s are subj ect t o deduct ion of t ax at source, according t o
applicable provisions of t he I ncome Tax Act , 1961.
Redempt i on : The act ual dat e of redempt ion of t he debent ure is st at ed in t he of f er
document . The t enor of t he debent ure is t he period bet ween t he deemed dat e of
allot ment and t he dat e of redempt ion. The companys liabilit y t o t he debent ure holders
is ext inguished on redempt ion of t he debent ure. Payment s is made t o t he regist ered
debent ure holder as on t he record dat e not if ied f or t he purpose of redempt ion.
Debent ures in physical f orm will have t o be redeemed by t he debent ure holder, by
surrendering t he same, duly discharged, t o t he company. Debent ures in demat f or m
are discharged on payment of redempt ion amount s t o t he regist ered debent ure holders,
as int imat ed by t he deposit ory.
Pu t / cal l opt i on : I n case t he debent ures provide a put opt ion t o invest ors and / or a call
opt ion t o t he company, t he det ails of t hese opt ions should be provided. The dat es on
which t hese opt ions may be exercised, and t he t erms of exercise have t o be st at ed.
Let t er of Al l ot men t an d Deben t u r e Cer t i f i cat e: The Company will send t o t he
allot t ees, let t er of allot ment or debent ure cert if icat e evidencing t he t it le of t he debent ure
in f avour of t he allot t ees, wit hin a st ipulat ed period, not exceeding 3 mont hs days f rom
t he deemed dat e of allot ment . I n case t he debent ure is issued in demat f orm. The
deposit ory account of t he invest or will be credit ed wit hin t he period st ipulat ed in t he
of f er document . The company will normally issue a consolidat ed let t er of
allot ment / debent ure cert if icat e t o an invest or. The invest or can request f or allot ment at
market lot s ( 1 debent ure) in t he applicat ion. Consolidat ed debent ures can be split at
t he request of t he debent ure holder, when t he original cert if icat e is surrendered, and
replaced by t he split cert if icat es, as required by t he invest or.
Secu r i t y: The repayment of debent ures, t oget her wit h int erest t hereon are secured by a
charge on asset s of t he company, t he det ails of which are st at ed in t he t erms of t he
of f er. Whet her t he charge is a f irst or second charge, whet her it would rank pari- passu
wit h claims of exist ing lenders, and whet her any credit enhancement in t he f orm of
guarant ees/ count er- guarant ees have been provided, are all st ipulat ed by t he company.

7. 5 Cr edi t Rat i n g


62
Credit rat ing is primarily int ended t o syst emat ically measure credit risk arising f rom
t ransact ions bet ween lender and borrower. Credit risk is t he risk of a f inancial loss
arising f rom t he inabilit y ( known in credit parlance as def ault ) of t he borrower t o meet
t he f inancial obligat ions t owards it s credit or. The abilit y of a borrower t o meet it s
obligat ions f luct uat es according t o t he behaviour of risk f act ors, bot h int ernal and
ext ernal, t hat impact t he perf ormance of a business ent erprise. Theref ore, most lenders
have t o incur cost s of analysing t hese f act ors bef ore a lending decision is made, and also
creat e monit oring mechanisms t hat enable such evaluat ion when t he borrowers
obligat ions are out st anding. I f such specialist assessment of credit qualit y is done by an
independent agency, it would be possible f or t he lender t o not incur t he cost s, but rely
on t he assessment of such agency. We t hen have a syst em where, t he borrower seeks
t he opinion of t he specialized agency, pays t he cost s of t hese services, and t hen
provides t he assessment t o t he lender, f or seeking f unds.
Credit rat ing is one of t he many ways of st andardising t he credit qualit y of borrowers,
t hrough a f ormal examinat ion of risk f act ors, which enables classif icat ion of credit risk
int o def ined cat egories. Such cat egorisat ion st andardises credit risk, in ways t hat
enable measurement and management of credit risk. Credit rat ing t hus enables pricing
of debt product s, and t heir valuat ion in a balance sheet , over t he period t hey are
out st anding.
Credit rat ing is a well est ablished ent erprise in most economies, including I ndia, where
specialized agencies have evolved t o creat e ext ensive met hods of analysis of
inf ormat ion, and provide rat ings t o borrowers. The accept ance of t hese rat ings by
lenders crucially hinges on t he independence of t he rat ing agency, and t he expert ise it
brings t o bear on t he process of credit rat ing. I n t he recent years, t he emphasis on
int ernal credit risk evaluat ion syst ems has grown. While European and Japanese lending
inst it ut ions have always emphasised an int ernal rat ing syst em, over ext ernal rat ings, in
count ries out side t hese regions t oo, t here is a parallel int ernal rat ing syst em being
creat ed in t he recent years. While credit evaluat ion and monit oring have been
t radit ionally in t he banking domain, t he f ormal conversion of t hese int o rat ing syst ems is
new. The impet us has been t he supervisory risk assessment and early warning
syst ems, now required by t he BI S, which emphasises t he need f or st ruct ured risk
assessment syst ems.
I n I ndia, it is mandat ory f or credit rat ing agencies t o regist er t hemselves wit h SEBI and
abide by t he SEBI ( Credit Rat ing) Regulat ions, 1999. There are 4 SEBI regist ered credit
rat ing agencies in I ndia, namely, CRI SI L, I CRA, CARE and Duf f & Phelps, which provide
a rat ing on various cat egories of debt inst rument s.
Credit rat ing agencies assess t he credit qualit y of debt issuers, on t he basis of a number
of quant it at ive and qualit at ive f act ors, employing specialized analyst s, who f ocus on
indust ry cat egories in which t hey have specialized knowledge. Apart f rom inf ormat ion
provided by t he borrower, t hese analyst s independent ly collect and assess inf ormat ion,
about t he indust ry and company variables, and perf ormance of peer group companies,
and collat e such dat a. Most rat ing agencies f ollow a commit t ee approach, where a
rat ing commit t ee examines t he inf ormat ion on t he company, and j udges t he rat ing t hat
should be assigned t o t he inst rument on of f er. Rat ing essent ially involves t he
t ranslat ion of inf ormat ion variables int o a ranking, which places t he company in a slot
t hat describes t he abilit y and willingness of t he company t o service t he inst rument
proposed t o be issued.


63
7. 5. 1 Rat i n g Symbol s

The ranking of credit qualit y is usually done wit h t he help of rat ing symbols, which
broadly classif y inst rument s int o invest ment grade, and speculat ive grade. An
illust rat ive rat ing list is provided below ( represent ing CRI SI Ls rat ing symbols) :
CRI SI L assigns rat ings t o only rupee denominat ed debt inst rument s. I nst rument s which
have t he same rat ing are of similar but not ident ical invest ment qualit y. This is because
t he number of rat ing cat egories is limit ed and hence cannot ref lect small dif f erences in
t he degree of risks. For pref erence shares, t he let t ers pf are pref ixed t o t he debent ure
rat ing symbols. The f ixed deposit rat ing symbols commerce wit h F and t he short - t erm
inst rument s use t he let t er P f rom t he concept of ' prime' .

Hi gh I n vest men t Gr ades
AAA ( Tr i pl e A) Hi gh est Saf et y
Debent ures rat ed AAA are j udged t o of f er highest saf et y of t imely payment of int erest
and principal. Though t he circumst ances providing t his degree of safet y are likely t o
change, such changes as can be envisaged are most unlikely t o af f ect adversely t he
f undament ally st rong posit ion of such issues.


AA ( Dou bl e A) Hi gh Saf et y
Debent ures rat ed AA are j udged t o of f er high saf et y of t imely payment of int erest and
principal. They dif f er in saf et y f rom AAA issues only marginally.
I n vest men t Gr ades
A Adequ at e Saf et y
Debent ures rat ed A are j udged t o of f er adequat e saf et y of t imely payment of int erest
and principal. However, changes in circumst ances can adversely af f ect such issues more
t han t hose in t he higher rat ed cat egories.
BBB ( Tr i pl e B) Moder at e Saf et y
Debent ures rat ed BBB are j udged t o of f er moderat e saf et y of t imely payment of
int erest and principal f or t he present ; however, changing circumst ances are more likely
t o lead t o a weakened capacit y t o pay int erest and repay principal t han f or debent ures in
higher rat ed cat egories.
Specu l at i ve Gr ades
BB ( Dou bl e B) I n adequ at e Saf et y
Debent ures rat ed BB are j udged t o carry inadequat e saf et y and principal, while t hey
are less suscept ible t o def ault t han ot her speculat ive grade debent ures in t he immediat e
f ut ure; t he uncert aint ies t hat t he issuer f aces could lead t o inadequat e capacit y t o make
t imely int erest and principal payment s.
B - Hi gh Ri sk
Debent ures rat ed B are j udged t o have great er suscept ibilit y t o def ault ; while current ly
int erest and principal payment s are met , adverse business of economic condit ions would
lead t o lack of abilit y or willingness t o pay, int erest or principal.
C Su bst an t i al Ri sk
Debent ures rat ed C are j udged t o have f act ors present t hat make t hem vulnerable t o
def ault ; t imely payment of int erest and principal is possible only if f avourable
circumst ances cont inue.
D Def au l t

64
Debent ures rat ed D are in def ault and in arrears of int erest or principal payment s or
are expect ed t o def ault on mat urit y. Such debent ures are ext remely speculat ive and
ret urn f rom t hese debent ures may be realised only on reorganisat ion or liquidat ion.

Rat ing agencies may apply + ( plus) or ( minus) signs f or rat ings f rom AA t o C t o
ref lect comparat ive st anding wit hin t he cat egories.

Model Quest i ons

1. Wh i ch of t h e f ol l ow i n g st at emen t s i s t r u e abou t t h e of f er docu men t ?
a. An of f er document has t o be f iled wit h SEBI f or all debent ure issues, whet her public
or privat ely placed.
b. Of f er document has t o be f iled f or all public issues only.
c. An of f er document need not be f iled if t he debent ures are issued f or mat urit ies
below 18 mont hs.
d. I n t he case of privat e placement , an abridged of f er document is t o be f iled wit h
SEBI .
An sw er : b

2. Wh i ch of t h e f ol l ow i n g st at emen t s i s f al se r egar di n g cr edi t r at i n g of
cor por at e deben t u r es?
a. All public issues of debent ures should be compulsorily credit rat ed.
b. Rat ings have t o be sought f rom agencies regist ered wit h SEBI .
c. Debent ures wit h mat urit y less t han 18 mont hs need not be rat ed.
d. Mut ual f unds are not permit t ed t o subscribe t o unrat ed corporat e paper.
An sw er : c

3. Let t er s of al l ot men t of deben t u r es h ave t o be sen t w i t h i n
a. 40 days f rom t he deemed dat e of allot ment .
b. 1 mont h f rom t he deemed dat e of allot ment .
c. 3 mont hs f rom t he deemed dat e of allot ment .
d. 30 days f rom t he dat e of closure of t he issue.
An sw er : c













65
Ch apt er 8

Commer ci al Paper & Cer t i f i cat e of
Deposi t s

Commercial paper ( CP) is a short - t erm inst rument , int roduced in 1990, t o enable non-
banking companies t o borrow short - t erm f unds t hrough liquid money market
inst rument s. CPs were int ended t o be part of t he working capit al f inance f or corporat es,
and were t heref ore part of t he working capit al limit s as set by t he maximum permissible
bank f inance ( MPBF) . CP issues are regulat ed by RBI Guidelines issued f rom t ime t o
t ime st ipulat ing t erm, eligibilit y, limit s and amount and met hod of issuance. I t is
mandat ory f or CPs t o be credit rat ed.

8. 1 Gu i del i n es f or CP I ssu e

The summary of t he lat est guidelines announced in t he Monet ary and Credit Policy of
RBI in Oct ober 2000, is as f ollows:
El i gi bi l i t y: Corporat es, Primary Dealers ( PDs) , Sat ellit e Dealers ( SDs) , and all- I ndia
Financial I nst it ut ions ( FI s) : f or a corporat e t o be eligible, ( a) t he t angible net wort h of
Rs. 4 crore; ( b) having a sanct ioned working capit al limit f rom a bank/ FI ; and ( c) t he
borrowal account is a St andard Asset .
Rat i n g Requ i r emen t : The minimum credit rat ing shall be P- 2 of CRI SI L or such
equivalent rat ing by ot her approved agencies.
Mat u r i t y: A minimum of 15 days and a maximum upt o one- year.
Den omi n at i on : Minimum of Rs. 5 lakh and mult iples t hereof .
Li mi t s an d Amou n t : CP can be issued as a st and alone product . Banks and FI s will
have t he f lexibilit y t o f ix working capit al limit s duly t aking int o account t he resource
pat t ern of companies f inancing including CPs.
I ssu i n g an d Payi n g Agen t ( I PA) : Only a scheduled bank can act as an I PA.
I n vest men t i n CP: CP may be held by individuals, banks, corporat es, unincorporat ed
bodies, NRI s and FI I s.
Mode of I ssu an ce: CP can be issued as a promissory not e or in a demat erialised f orm.
Wit h ef f ect f rom June 30, 2001, banks, FI s, PDs and SDs will be permit t ed t o make f resh
invest ment s and hold CP only in demat erialised f orm. Out st anding invest ment s in scrip
f orm should also be convert ed int o demat erialised f orm by Oct ober 31, 2001.
Underwrit ing is not permit t ed.
St an d- by Faci l i t y: I t is not obligat ory f or banks/ FI s t o provide st and- by f acilit y. They
have t he f lexibilit y t o provide credit enhancement f acilit y wit hin t he prudent ial norms.
Rol e an d Respon si bi l i t i es: The Guidelines prescribe role and responsibilit ies f or issuer,
I PA and Credit Rat ing Agency. FI MMDA may prescribe st andardised procedure and
document at ion in consonance wit h t he int ernat ional best pract ices. Till t hen, t he
procedures/ document at ions prescribed by t he I BA should be f ollowed.

8. 2 Rat i n g Not ch es f or CPs


66
Credit rat ing agencies rat e CPs on 5- not ch scale as f ollows:
P1: I ndicat es t hat t he degree of saf et y regarding t imely payment is st rong
P2: I ndicat es t hat t he degree of saf et y regarding t imely payment is st rong, however,
t he relat ive degree of saf et y is lower t han t hat of P1.
P3: I ndicat es t hat t he degree of saf et y regarding t imely payment on t he inst rument
adequat e; however t he inst rument is more vulnerable t o adverse ef f ect s of changing
circumst ances t han an inst rument rat ed in t he t wo higher cat egories.
P4: I ndicat es t hat t he degree of saf et y regarding t imely payment on t he inst rument is
minimal and it is likely t o be adversely af f ect ed by short - t erm adversit y or less
f avourable condit ions.
P5: I ndicat es t hat t he inst rument is expect ed t o be in def ault on mat urit y or is in
def ault .
These rat ings can be f urt her t uned wit h t he addit ion of + and - symbols aft er t he
rat ing.

8. 3 Gr ow t h i n t h e CP Mar k et

The CP market s have seen signif icant increase in volumes since t he relaxat ion of
guidelines in March 1997, permit t ing companies t o issue CPs upt o 100% of Maximium
Permissible Bank Finance ( MPBF) . The f irst spurt in CP issuance was in 1994, when RBI
relaxed t he eligibilit y crit eria and quant um of CP issuable by companies. However, af t er
t he wit hdrawal of st and- by f acilit y
7
in Oct ober 1994, t he market s were dull, hit t ing a low
of Rs. 76 crore of out st anding CPs, by end March 1996. Discount rat es also were st eep,
t ouching a high of 20. 15%. Volumes have spurt ed since Oct ober 1997, f rom Rs. 1500
crore of CPs out st anding at t he end of March 1998 t o Rs. 5663 crore in March 2000. The
Oct ober 2000 Guidelines which have made t he CP a st and alone product , delinking it
f rom working capit al limit s, has led t o f urt her increases in volumes. Rs. 6982 crore
wort h CPs were out st anding as at end May 2001. The discount rat es have f allen below
10% and t he range in t he discount rat es has also narrowed down t o about 165 basis
point s. Table 8. 1 shows t he t rends in CP rat es and amount s out st anding.

8. 4 St amp Du t y

The dominant invest ors in CPs are banks, t hough CPs are also held by f inancial
inst it ut ions and corporat es. I n t he recent years, mut ual f unds have emerged as

7
A st and- by f acilit y provided by a bank enables an issuer of CPs t o have it s bank f inance
limit s rest ored when t he CP mat ures, so t hat t he CP can be redeemed. The credit qualit y
of a CP depended on t he availabilit y of such a f acilit y.







67
import ant invest ors in t he secondary market s f or CPs. The concent rat ion of invest ors in
CPs in t he banking sect or is primarily due t o t he dif f erence in st amp dut ies. The
st ruct ure of st amp dut ies f or banks and non- banks is present ed in Table 8. 2.
Secondary market t ransact ions in CPs do not at t ract st amp dut ies. Theref ore mut ual
f unds and ot her non- bank invest ors f ind it cost ef f ect ive t o buy t he CPs f rom banks in
t he secondary market s. The st amp dut y st ruct ure has also led t o a near complet e
concent rat ion of t he CP market in t he 90 days t enor. The RBI has now mandat ed t hat
all f urt her issues of CPs should be in demat f orm, and t hat banks, PDs and f inancial
inst it ut ions, should convert all t heir CP holdings int o demat f orm bef ore March 2002.
This is expect ed t o reduce t he st amp dut y cost s in CP t ransact ions.

Tabl e 8. 1: CPs - Tr en ds i n Vol u mes an d Di scou n t Rat es
As at t h e
en d of
Mar ch
Amou n t
Ou t st an di n g
( Rs. cr . )
Mi n i mu m
Di scou n t Rat e
( % p. a. )
Max i mu m
Di scou n t Rat e
( % p. a. )
1994 3, 264 11. 01 12. 00
1995 604 14. 00 15. 00
1996 76 - 20. 15
1997 646 11. 25 12. 25
1998 1, 500 14. 22 15. 50
1999 4, 770 10. 05 11. 50
2000 5, 663 10. 00 12. 00
2001 5, 846 8. 75 11. 25
Source: RBI , Handbook of St at ist ics on I ndian Economy, 2000; RBI Bullet in, Various
I ssues

Tabl e 8. 2: St amp Du t i es on CPs
Ten or Rat e ( As % of Val u e) f or
Ban k s Non ban k s
Upt o 90 days 0. 05 0. 125
91- 180 days 0. 15 0. 375
181 364 days 0. 20 0. 500
Source: RBI , Report of t he Group t o review guidelines relat ing
t o CPs, March 2000.

8. 5 Cer t i f i cat es of Deposi t

Cert if icat es of Deposit s ( CDs) are short - t erm borrowings by banks. CDs dif f er f rom t erm
deposit because t hey involve t he creat ion of paper, and hence have t he f acilit y f or
t ransf er and mult iple ownership bef ore mat urit y. CD rat es are usually higher t han t he
t erm deposit rat es, due t o t he low t ransact ions cost s. Banks use t he CDs f or borrowing
during a credit pick- up, t o t he ext ent of short age in increment al deposit s. Most CDs are
held unt il mat urit y, and t here is limit ed secondary market act ivit y. Unt il recent ly, t he
minimum holding period f or a CD was regulat ed at 90 days, bef ore which a CD was not
t ransf erable. Since most CDs were issued f or t he same t enor of 90 days, t here was no

68
secondary market act ivit y. I n Oct ober 2000, RBI has reduced t his period t o 14 days,
enabling secondary market t rading in CDs.
When CDs were int roduced in 1989, t he ext ent t o which a bank can bor r ow t hr ough CDs
was rest rict ed as a percent age t o t he deposit base of t he borrowing bank. By 1993,
t hese limit s were done way wit h. CDs can now be issued f or mat urit ies ranging f rom 14
days t o 1 year, and t he minimum amount s is Rs. 5 lakh. Volumes of out st anding CDs
were very high in 1995- 96, when t he limit s t o CD issuance was removed. Table 8. 3
shows t he t rends in rat es and volume out st anding of CDs. The subsequent years have
seen a drop in CD issuance, due t o limit s on holding period on t he inst rument . Banks
and f inancial inst it ut ions are t he largest issuers of CDs, and are also subscribers t o t he
CDs of one anot her. There are limit ed ot her invest ors such as mut ual f unds, in t he CD
market s. CDs are issued in physical f orm, and t heref ore have st amp dut ies on t ransf er.


Tabl e 8. 3: CDs - Vol u me an d Rat es
As at t h e
en d of Mar ch
Vol u me of
ou t st an di n g CDs
( Rs. cr . )
Mi n i mu m r at e
( % p. a. )
Max i mu m r at e
( % p. a. )
1994 5, 571 8. 00 17. 00
1995 8, 017 7. 00 15. 00
1996 16, 316 10. 00 22. 99
1997 12, 134 8. 00 20. 75
1998 14, 296 5. 00 26. 00
1999 3, 897 6. 00 26. 00
2000 1, 227 6. 25 14. 20
2001 771 6. 50 11. 00
Source: RBI , Weekly St at ist ical Supplement s, Various I ssues

Model Quest i ons

1. Wh i ch of t h e f ol l ow i n g i s t h e l ar gest i n vest or i n CPs?
a. Mut ual Funds
b. Corporat e Treasuries
c. Financial I nst it ut ions
d. Scheduled Banks
An s: d

2. Wh i ch of t h e f ol l ow i n g en t i t i es can n ot i ssu e CPs?
a. Banks
b. Finance Companies
c. Primary Dealers
d. None of t he above
An s: d







69









Ch apt er 9

Repos
8


9. 1 I n t r odu ct i on

Repo is a money market inst rument , which enables collat eralized short t erm borrowing
and lending t hrough sale/ purchase operat ions in debt inst rument s. Under a repo
t ransact ion, a holder of securit ies sells t hem t o an invest or wit h an agreement t o
repurchase at a predet ermined dat e and rat e. I n t he case of a repo, t he f orward clean
price of t he bonds is set in advance at a level, which is dif f erent f rom t he spot clean
price by adj ust ing t he dif f erence bet ween repo int erest and coupon earned on t he
securit y.
I n t he money market , t his t ransact ion is not hing but collat eralized lending as t he t erms
of t he t ransact ion are st ruct ured t o compensat e f or t he f unds lent and t he cost of t he
t ransact ion is t he repo rat e. I n ot her words, t he inf low of cash f rom t he t ransact ion can
be used t o meet t emporary liquidit y requirement in t he short - t erm money market at
comparable cost .
I n a t ypical repo t ransact ion, t he count er- part ies agree t o exchange securit ies and cash,
wit h a simult aneous agreement t o reverse t he t ransact ions af t er a given period. To t he
lender of cash, t he securit ies lent by t he borrower serves as t he collat eral; t o t he lender
of securit ies, t he cash borrowed by t he lender serves as t he collat eral. Repo t hus
represent s a collat eralized short t erm lending. The lender of securit ies ( who is also t he
borrower of cash) is said t o be doing t he repo; t he same t ransact ion is a reverse repo in
t he books of lender of cash ( who is also t he borrower of securit ies) .
A reverse repo is t he mirror image of a repo. For, in a reverse repo, securit ies are
acquired wit h a simult aneous commit ment t o resell. Hence whet her a t ransact ion is a
repo or a reverse repo is det ermined only in t erms of who init iat ed t he f irst leg of t he
t ransact ion. When t he reverse repurchase t ransact ion mat ures, t he count er- part y
ret urns t he securit y t o t he ent it y concerned and receives it s cash along wit h a prof it
spread. One f act or which encourages an organizat ion t o ent er int o reverse repo is t hat

8
Subst ant ial port ions of t his chapt er have been drawn f rom t he Report of t he Sub- Group
on Ready Forward ( Repo) Transact ions, Technical Advisory Commit t ee on Government
Securit ies Market , RBI , 1998. The summary of recommendat ions made by t his group is
in Appendix I t o t his chapt er.

70
it earns some ext ra income on it s ot herwise idle cash.
A repo is also somet imes called a ready f orward t ransact ion as it is a means of f unding
by selling a securit y held on a spot ( ready) basis and repurchasing t he same on a
f orward basis. Though t here is no rest rict ion on t he maximum period f or which repos
can be undert aken, generally, repos are done f or a period not exceeding 14 days.
Dif f erent inst rument s can be considered as collat eral securit y f or undert aking t he ready
f orward deals and t hey include Government dat ed securit ies, t reasury bills, and select
PSU and inst it ut ional bonds.
While banks and PDs are permit t ed t o undert ake bot h repos and reverse repos, ot her
part icipant s such as inst it ut ions and corporat es can only lend f unds in t he repo market s.
The recent policy changes announced in April 2001 have removed t his rest rict ion, and
suggest a phased expansion in t he part icipat ion in repo market s. This would, however,
require t he creat ion of enabling inf rast ruct ure such as t he clearing corporat ion and
elect ronic set t lement of t ransact ions.
Repos are set t led on DVP basis on t he same day. I t is essent ial f or part icipant s in repo
t ransact ions t o hold SGL account s and current account wit h RBI . Repo t ransact ions are
also report ed in t he WDM segment of t he NSE.

9. 2 Repo Rat e

Repo rat e is not hing but t he annualised int erest rat e f or t he f unds t ransf erred by t he
lender t o t he borrower. Generally, t he rat e at which it is possible t o borrow t hrough a
repo is lower t han t he same of f ered on unsecured ( or clean) int er- bank loan f or t he
reason t hat it is a collat eralized t ransact ion and t he credit wort hiness of t he issuer of t he
securit y is of t en higher t han t he seller. Ot her f act ors af f ect ing t he repo rat e include t he
credit wort hiness of t he borrower, liquidit y of t he collat eral and comparable rat es of
ot her money market inst rument s.
I n a repo t ransact ion, t here are t wo legs of t ransact ions viz. selling of t he securit y and
repurchasing of t he same. I n t he f irst leg of t he t ransact ion which is f or a nearer dat e,
sale price is usually based on t he prevailing market price f or out right deals. I n t he
second leg, which is f or a f ut ure dat e, t he price is st ruct ured based on t he f unds f low of
int erest and t ax element s of f unds exchanged. This is on account of t wo f act ors. First , as
t he ownership of securit ies passes on f rom seller t o buyer f or t he repo period, legally t he
coupon int erest accrued f or t he period has t o be passed on t o t he buyer. Thus, at t he
sale leg, while t he buyer of securit y is required t o pay t he accrued coupon int erest f or
t he broken period, at t he repurchase leg, t he init ial seller is required t o pay t he accrued
int erest f or t he broken period t o t he init ial buyer.
Transact ion- wise, bot h t he legs are booked as spot sale/ purchase t ransact ions. Thus,
af t er adj ust ing f or accrued coupon int erest , sale and repurchase prices are f ixed so as t o
yield t he required repo rat e. The excess of t he coupon at t he f irst leg of repo would
represent t he coupon int erest f or t he repo period. Thus, t he price adj ust ment depends
direct ly upon t he relat ionship bet ween t he net coupon and t he repo amount worked out
on t he basis of t he repo int erest agreed upon t he t ot al f unds t ransf erred. When repo
rat e is higher t han current yield repurchase price will be adj ust ed upward signif ying a
capit al loss. I f t he repo rat e is lower t han t he current yield, t hen t he repurchase price
will be adj ust ed downward signif ying a capit al gain.
I f t he repo rat e and coupon are equal, t hen t he repurchase price will be equal t o t he sale

71
price of securit y since no price adj ust ment at t he repurchase st age is required. I f t he
repo rat e is great er t han t he coupon, t hen t he repurchase price is adj ust ed upward ( wit h
ref erence t o sale price) t o t he ext ent of t he dif f erence bet ween t he t wo. And, if t he repo
rat e is lower t han t he coupon t hen, t he repurchase price is adj ust ed downward ( wit h
ref erence t o sale price) . Specif ically, in t erms of repo rat e, t here will be no price
adj ust ment when t he current yield on securit y calculat ed on t he basis of sale value
( including accrued coupon) is equivalent t o repo rat e.
Alt hough repos are collat eralized t ransact ions t hey are st ill exposed t o count er- part y risk
and t he issuer risk associat ed wit h t he collat eral. As f ar as t he count er- part y risk is
concerned, t he invest or should be able t o liquidat e t he securit ies received as collat eral,
t hus largely of f set t ing any loss. Against t his t he seller / lender of bonds will hold cash or
ot her securit ies as prot ect ion against non- ret urn of t he lent securit ies. I n bot h t he cases
it is t o be ensured t hat t he realizable value equals or exceeds t he exposure. There is
also t he concent rat ion risk result ing f rom illiquid issues which are used as collat eral in
t he t ransact ion.
Generally, norms are laid down f or account ing of repos and valuat ion of collat eral are
concerned. While t here are st andard account ing norms, generally t he securit ies used as
collat eral in repo t ransact ions are valued at current market price plus accrued int erest
( on coupon bearing securit ies) calculat ed t o t he mat urit y dat e of t he agreement less
"margin" or "hai rcut ". The haircut is t o t ake care of market risk and it prot ect s eit her t he
borrower or lender depending upon how t he t ransact ion is priced. The size of t he haircut
will depend on t he repo period, riskiness of t he securit ies involved and t he coupon rat e
of t he underlying securit ies.
Since f luct uat ions in market prices of securit ies would be a concern f or bot h t he lender
as well as t he borrower it is a common pract ice t o ref lect t he changes in market price by
resort ing t o marking t o market . Thus, if t he market value of t he repo securit ies decline
beyond a point t he borrower may be asked t o provide addit ional collat eral t o cover t he
loan. On t he ot her hand, if t he market value of collat eral rises subst ant ially, t he lender
may be required t o ret urn t he excess collat eral t o t he borrower.

9. 3 Cal cu l at i n g Set t l emen t Amou n t s i n Repo
Tr an sact i on s

Repo t ransact ions involve 2 legs: t he f irst one when t he repo amount is received by t he
borrower, and t he second, which involves repayment of t he borrowing. The set t lement
amount f or t he f irst leg consist s of :
a. Value of securit ies at t he t ransact ion price
b. Accrued int erest f rom t he previous coupon dat e t o t he dat e on which t he f irst
leg is set t led.
The set t lement amount f or t he second leg consist s of :
a. Repo int erest at t he agreed rat e, f or t he period of t he repo t ransact ion
b. Accrued int erest f rom t he previous coupon dat e t o t he dat e on which t he
second leg is set t led.
c. Ret urn of principal amount borrowed.
Ex ampl e:
Consider t he f ollowing t ransact ion det ails:
Trade dat e: 13- July 2001

72
Set t lement dat e: 13- July- 2001
Trade Price: 108. 5
Face value: Rs. 10000
Securit y: 12. 5% 2004
Repo rat e: 7. 5%
Repo Term: 2 days
Fi r st l eg:
On 13
t h
July t he seller of t he repo ( borrower) receives t he f ollowing amount :
Value of t he securit y: 108. 5/ 100 * 10000 = 1, 08, 500. 00
Accrued I nt erest : ( 12. 5 * 10000) * ( 112/ 360) = 3, 888. 89
Set t lement Amount = 1, 12, 388. 89
Secon d Leg:
On 15
t h
July ( repo t erm is 2 days) , t he seller ret urns t he f ollowing amount :
Original Borrowing: = 1, 08, 500. 00
Accrued int erest : ( 12. 5 * 10000) * ( 114/ 360) = 3, 958. 33
Repo int erest : 10000 * 0. 075 * 2. 360 = 41. 67
Set t lement Amount : = 1, 12, 500. 00

9.4 Advan t ages of Repos

Repos can provide a variet y of advant ages t o t he f inancial market in general, and debt
market , in part icular as under:
An act ive repo market would lead t o an increase in t urnover in t he money market ,
t hereby improving liquidit y and dept h of t he market ;
Repos would increase t he volumes in t he debt market , as it is a t ool f or f unding
t ransact ions. I t enables dealers t o deal in higher volumes. Thus, repos provide an
inexpensive and most ef f icient way of improving liquidit y in t he secondary market s
f or underlying inst rument s. Debt market also get s a boost as repos help t raders t o
t ake a posit ion and go short or long on securit y. For inst ance, in a bullish scenario
one can acquire securit ies and in a bearish environment dispose t hem of t hus
managing cash f lows t aking advant age of f lexibilit y of repos.
For inst it ut ions and corporat e ent it ies, repos provide a source of inexpensive f inance
and of f er invest ment opport unit ies of borrowed money at market rat es t hus earning
a good spread;
Tripart it e repos of f er opport unit ies f or suit able f inancial inst it ut ions t o int ermediat e
bet ween t he lender and t he borrower.
A large number of repo t ransact ions f or varying t enors will ef f ect ively result in a
t erm int erest rat e st ruct ure, especially in t he int er- bank market . I t is well known
t hat absence of t erm money market is one of t he maj or hindrances t o t he growt h of
debt market s and t he development of hedging inst rument s.
Cent ral banks can use repo as an int egral part of t heir open market operat ions wit h
t he obj ect ive of inj ect ing/ wit hdrawing liquidit y int o and f rom t he market and also t o
reduce volat ilit y in short t erm in part icular in call money rat es. Bank reserves and
call rat es are used in such inst ances as t he operat ing inst rument s wit h a view t o
ult imat ely easing / t ight ening t he monet ary condit ions.


73
9. 5 Repo Mar k et i n I n di a: Some Recen t I ssu es

Repos being short t erm money market inst rument s, are necessarily being used f or
smoot hening volat ilit y in money market rat es by cent ral banks t hrough inj ect ion of
short t erm liquidit y int o t he market as well as absorbing excess liquidit y f rom t he
syst em. Regulat ion of t he repo market t hus becomes a direct responsibilit y of RBI .
Accordingly, RBI has been concerned wit h use of repo as an inst rument by banks or
non- bank ent it ies and issues relat ing t o t ype of eligible inst rument s f or undert aking
repo, eligibilit y of part icipant s t o undert ake such t ransact ions et c. and it has been
issuing inst ruct ions in t his regard in consult at ion wit h t he Cent ral Government .
Af t er evidence of abuse in t he repo market during t he period leading t o t he securit ies
scam of 1992, RBI had banned repos f rom t he market s. I t is only in t he recent past t hat
t hese rest rict ions have been removed, and af t er t he accept ance of t he report of t he
t echnical sub- groups recommendat ions, RBI has init iat ed ef f ort s f or creat ing an act ive
market f or repos. The f ollowing are some of t he recent changes in t he repo market s are
as under:
Since repos t ransact ions were used f or as short a period as one day merely as a
change in nomenclat ure f rom call money and wit h a view t o ensuring t hat banks
resort t o ready f orward t ransact ions in accordance wit h t he spirit of t his f acilit y it
was decided t hat ef f ect ive f rom Sept ember 30, 1995 t he minimum period f or repo
t ransact ions should be t hree days.
Ef f ect ive f rom Oct ober 31, 1998 when t he int er- bank liabilit ies were exempt ed f rom
t he requirement s of maint enance of CRR except f or t he st at ut ory minimum
requirement of 3% and wit h a view t o enabling banks and ot her part icipant s in t he
repo market t o adj ust t heir liquidit y in a more f lexible manner, it was decided t o
wit hdraw t he rest rict ion of t he minimum period f or repo t ransact ions in Treasury
Bills of all mat urit ies and not if ied Government of I ndia dat ed securit ies.
Since June 2000, RBI conduct s repo operat ions on a daily basis, on all working
days, t hrough unif orm price auct ions, in which PDs and banks are permit t ed t o
part icipat e.
9

Repos were init ially permit t ed only in Government securit ies. St at e government
securit ies were subsequent ly included in t he set of eligible securit ies. I t has been
decided t o ext end repos in PSU bonds and privat e corporat e debt securit ies,
provided t hey are held in demat erialised f orm in a deposit ory and t he t ransact ions
are done in recognized st ock exchanges.
I n t he recent credit policy st at ement of April 2001, it has been decided t o phase- out
non- banks f rom t he call market s, and use t he repo market s f or t he short - t erm
operat ions of non- bank players. I n order t o f acilit at e t his, it is expect ed t hat t he
RTGS in government securit ies, and t he Securit ies Clearing Corporat ion, would be in
place, in a f ixed t ime f rame. I t is expect ed t hat volumes in t he repo market s would
grow wit h t his enabling inf rast ruct ure.
The repo market s are now available f or banks and primary dealers. Wit h t he move
t o shif t non- banks out of t he call market s, t he eligible part icipant s in t he repo
market s has been ext ended t o include mut ual f unds ( subj ect t o enabling SEBI

9
See Appendix I t o Chapt er 3 on t he Liquidit y Adj ust ment Facilit y

74
Regulat ion) , f inancial inst it ut ions, corporat es, provident f unds, f inancial inst it ut ions
and such ot her non- bank players in t he money market s, as was recommended by
t he Technical Sub Group on Repos.

9. 6 Secon dar y Mar k et Tr an sact i on s i n Repos

Secondary market repo t ransact ions are set t led t hrough t he RBI SGL account s, and
weekly dat a is available f rom t he RBI on volumes, rat es and number of days. Though
t he NSE WDM also has t he f acilit y f or report ing repo t rades, t he volumes and number of
t rades have been quit e less.
The average weekly volume in t he secondary market s f or repos ( as report ed in t he SGL)
has grown f rom Rs. 788 crore in 1998- 99 t o Rs. 1591 crore in 1999- 2000. I n t he f irst
six mont hs of t he year 2000- 01 weekly t ransact ions averaged Rs. 1782 crore. Repos in
cent ral government securit ies dominat e secondary market t ransact ions. Repos in T- bills
have grown f rom an average of Rs. 29 crore in 1998- 99 t o Rs. 134 crore in 1999- 2000
and Rs. 232 crore in t he f irst six mont hs of 2000- 2001. Volumes are markedly high in
t he end- march week.
The minimum number of days f or which repos could be done was 3 days, and has been
brought down t o 1 day. The maximum number of days f or which repos have been
ent ered int o has varied over t he period 1998- 2001. The most commonly occurring
period however, is 14 days. The minimum 1- day repo rat e represent s t he f loor rat e in
t he money market s. During March end, when volumes have been very high, repo rat es
have t ouched a low of 2%. During normal t imes t hese rat es averaged 6- 8%.
The t ransit ion of non- bank players f rom call market s t o repo market s is expect ed t o
bring about signif icant changes in volumes and rat es. The concent rat ion of liquidit y in
f ew securit ies and t he relat ively low volume of t ransact ions are expect ed t o be import ant
impediment s t o a smoot h t ransit ion, t hough.

Model Quest i ons

1. I f t h e RBI an n ou n ces t h at i t h as don e r ever se r epos of Rs. 3000 cr or e, w h at
does t h i s i mpl y ?
a. RBI has lent securit ies wort h Rs. 3000 crore t hrough t he repo market s t o t he
part icipant s.
b. RBI has reversed t he repo deals of part icipant s who ent ered int o a repo wit h RBI .
c. RBI has induct ed f unds amount ing t o Rs. 3000 crores int o t he market .
d. RBI has borrowed securit ies f rom t he banking syst em, and lent t hem onward in t he
repo market s.
An sw er : c

2. A 3- day r epo i s en t er ed i n t o on Ju l y 10, 2001, on an 11. 99% 2009 secu r i t y,
mat u r i n g on Apr i l 7, 2009. Th e f ace val u e of t h e t r an sact i on i s Rs. 3, 00, 00,
000. Th e pr i ce of t h e secu r i t y i s Rs. 116. 42. I f t h e r epo r at e i s 7% , w h at i s t h e
set t l emen t amou n t on Ju l y 10, 2001?
An sw er : Set t lement amount on July 10, 2001 is t he t ransact ion value f or t he securit ies
plus accrued int erest .


75
Transact ion Value:
3, 00, 00, 000 * 116. 42/ 100 = Rs. 3, 49, 26, 000
Accrued I nt erest :
The securit ys mat urit y dat e is April 7, 2009. Using t he Cou pbs f unct ion, we can f ind
t he number of days f rom last coupon dat e. ( Set t lement : 10- Jul- 2001; Mat urit y: 7 April
2009; Frequency: 2; Basis: 4) . The number of days is 93.
Accrued int erest = 3, 00, 00, 000 * 11. 99%* 93/ 360 = Rs. 9, 29, 225. 00
Th er ef or e, t h e set t l emen t amou n t i s: Rs. 3, 49, 26, 000 + Rs. 9, 29, 225. 00 =
Rs. 3, 58, 55, 225. 00

3. Usi n g t h e same dat a as i n Qu est i on 2, det er mi n e t h e set t l emen t amou n t f or
t h e secon d l eg of t h e r epo t r an sact i on .
The set t lement amount f or t he second leg involves t he f ollowing:
I nt erest on t he Amount borrowed:
= 3, 00, 00, 000 * . 07 * 3/ 360
= Rs. 17, 500
Accrued int erest unt il t he end of repo period:
= 3, 00, 00, 000 * 0. 1199 * 96/ 360
= Rs. 9, 59, 200
Principal Amount borrowed:
= 3, 00, 00, 000 * 116. 42/ 100 = Rs. 3, 49, 26, 000
Amou n t t o be set t l ed: 17, 500 + 9, 59, 200 + 3, 49, 26, 000
= Rs. 3, 59, 02, 700

76

Appen di x I
Su mmar y of Recommen dat i on s of t h e Tech n i cal Su b Gr ou p on Repos

( i ) Need t o Wi t h dr aw t h e Gover n men t Not i f i cat i on Dat ed Ju n e 27, 1969

As long as t he June 1969 not if icat ion is operat ive, RBI would have t o cont inue t o t ake up
wit h t he Government t o issue necessary not if icat ion exempt ing, such of t hose ent it ies as
deemed necessary by t he Bank, f rom t he prohibit ion cont ained in t he not if icat ion. I t will
not be possible f or most int ending part ies ( ot her t han t he f ew permit t ed) t o legally
part icipat e in repos unless t he Not if icat ion is wit hdrawn by t he Government . Hence, t he
f irst basic legal requirement f or developing repos is t o wit hdraw t he Government
Not if icat ion dat ed June 27, 1969. ( Since wit hdrawn)

( i i ) RBI Needs t o Acqu i r e Regu l at or y Pow er s u n der 29A of SCR Act

Repo being short - t erm money market inst rument is being used f or smoot hening
volat ilit y in money market rat es by cent ral banks t hrough inj ect ion of short - t er m
liquidit y int o t he market as well as absorbing excess liquidit y f rom t he syst em.
Regulat ion of repo market t hus becomes a direct responsibilit y of RBI . As expansion of
t he repo market wit h wider part icipat ion and variet y of inst rument s would require RBI t o
have enhanced regulat ory powers over t he debt market t here is need t o amend Sect ion
29A of SCR Act , t o enable t he Government t o delegat e regulat ory powers f or of t rading
in Government Securit ies and ot her debt inst rument s. ( Since empowered)

( i i i ) Need t o Repl ace Pu bl i c Debt Act , 1944

The Group recognises t he legal impediment s in t he way t o elect ronic t ransf er of gilt
securit ies which is not possible under t he Public Debt Act , 1944 and t he need t o ef f ect
early replacement of t he Public Debt Act by t he proposed Government Securit ies Act has
assumed great expediency. The Group urges t hat immediat e st eps should be t aken t o
resolve t he legal and procedural dif f icult ies in t he way t o achieve a modern market
inf rast ruct ure I t may be wort hwhile t o t ake due cognizance of t he changing f ace of
securit ies set t lement syst ems, t he world over wit h t he use of inf ormat ion t echnology.

( i v) " Over Th e Cou n t er " an d " Tr i par t i t e" Repos t o Ex pan d t h e Mar k et

The Group is of t he view t hat keeping t he needs of t he market part icipant s a syst em of
"over t he count er" and "exchange t raded" repos wit h adequat e checks and cont rols
could be int roduced, as under:
1. All ent it ies who have SGL Account and Current Account wit h RBI may be allowed t o
undert ake over t he count er repos and reverse repos in all Government securit ies
( including t hose issued by t he St at e Government s) .
2. For t he present , such repos may be rest rict ed t o SGL Account s at Mumbai and in
due course wit h successf ul linking of all RBI of f ices, it could be ext ended t o ot her
RBI cent res.

77
3. All ent it ies including corporat es may be allowed t o undert ake repos and reverse
repos in all Government securit ies, PSU bonds, Privat e Corporat e Debt Securit ies
and bonds issued by All I ndia Financial I nst it ut ions
Provided:
1. t he debt inst rument s are held in demat erialised f orm in a deposit ory; and
2. t he t ransact ions are undert aken t hrough approved st ock exchange wit h a well
capit alised clearing corporat ion f unct ioning as legal count er part y.
Transact ions under ( c) above, involving t ripart y could be permit t ed provided:
1. t he t ripart y agent is a well capit alised Clearing Corporat ion licensed t o f unct ion as a
legal count erpart y in all such t ransact ions; and
2. where such an agency would def ine accept able securit ies f rom wit hin t he specif ied
broad cat egories as ment ioned above, execut e required haircut s, do daily marking
t o market , ensure t hat all part icipant s maint ain adequat e collat eral at all t imes, t he
quant it y t raded is in st andardised lot s and t he set t lement is done under "novat ion",
maint aining anonymit y of count erpart ies all t he t ime.

( i v) Un i f or m Accou n t i n g Pr act i ces t o be I n t r odu ced

I n order t hat t here is unif orm account ing t reat ment and suf f icient t ransparency, t he
Group has accept ed cont inuance of t he buy- sell back repo concept while has suggest ed
it s own account ing norms f or repos so t hat t here is unif ormit y in approach t owards
account ing in general and applying haircut s/ margins, booking of capit al gains/ loss and
separat ion of t he int erest paid/ received in t he t ransact ion, in part icular.

( v) Day Li gh t Over dr af t Faci l i t y f or Cu r r en t Accou n t Hol der s Requ i r ed

As regards set t lement , t he exist ing syst em of end of t he day DVP cannot be considered
risk f ree due t o bot t lenecks in movement of securit ies and cash, as explained above. A
syst em of provision of daylight overdraf t t o t he current account holders by RBI may be
t hought of t o avoid such event ualit y.

( vi ) Gu i del i n es f or Con st i t u en t s' SGL Accou n t Oper at i on s t o be I ssu ed

I n t he cont ext of gradual deepening of t he Government securit ies market and t he policy
t o promot e t he ret ail segment of t he market , it is f elt expedient t o f rame a set of
guidelines governing t he maint enance of t he Const it uent s' SGL Account s by t hese
ent it ies. The Working Group has, accordingly suggest ed out line f or t he draf t guidelines
providing f or obligat ions and code of conduct in dealing wit h t he Const it uent s' securit ies
including t ransparency and saf et y. This could be f inalised af t er discussion wit h
represent at ive self - regulat ory organisat ions of t he market part icipant s.

( vi i ) Dat e of deal an d set t l emen t dat e t o be speci f i ed

To avoid dif f erences in pract ices f ollowed it would be desirable t o st ipulat e deal dat e and
set t lement dat e. At present deals undert aken t ake, of t en more t han st ipulat ed number
of days f or execut ion and set t lement . I n order t hat t here is no conf usion deals can eit her
be set t led on t he same day or t he next day of t he deal and t his should be clearly
indicat ed in t he cont ract / t erms of deal t o ensure t hat t here is no conf usion/ variance in

78
set t lement dat e of repos.

( vi i i ) A Mast er Re- Pu r ch ase Agr eemen t f or Repos t o be I n t r odu ced

There is need f or, as done int ernat ionally, a comprehensive mast er repurchase
agreement which allows obligat ions under all out st anding repos t o be set of f against
each ot her upon def ault or insolvency of t he count erpart y. Working Group has
at t empt ed a draf t document , which could be modif ied suit ably t o meet act ual
requirement s in repo t ransact ions. The Draf t Mast er Purchase Agreement has provisions
f or absolut e t ransf er of t it le of securit ies ( including any securit ies t ransf erred t hrough
subst it ut ion or mark t o market adj ust ment of collat eral) .

( i x ) Code of Con du ct f or Repos Tr an sact i on s t o be l ai d dow n

A code of conduct would include issues part icipant s should address bef ore undert aking
repo t ransact ions, legal agreement s in prevalence, margins, marking t o market ,
exposure limit s on count erpart ies, cust ody of collat erals, right t o declare a count erpart y
in def ault , conf irmat ion of deals, mat t ers t o be covered bef ore t rading wit h a new
count erpart y, inf ormat ion t o be exchanged at point of t rade et c. The Group has included
a draf t of a code of conduct , which has been included as a part of t his report f or t he
benef it of t he market pract it ioners.

( x ) Repo Mar k et t o be Su per vi sed an d Cl osel y Mon i t or ed by RBI

The memories of t he irregularit ies commit t ed in t he Government securit ies market is st ill
very f resh in t he minds of t he market part icipant s and t he regulat ors. As more
part icipant s and inst rument s are made eligible f or undert aking repo t ransact ions RBI
may like t o monit or t he size, growt h and orderliness of t he repo market . As money
market on line dealing syst em is inst alled and made operat ive it should become possible
f or RBI t o monit or t he market online f ocusing on part icipant s, market rat es, t rading
pat t erns et c.

( x i ) Rol l Over of Repos t o be Per mi t t ed

Repos being in t he nat ure of collat eralised borrowing should be allowed t o be rolled over
wit h revaluat ion at t he t ime of roll over at rat es of int erest / value of securit ies in
alignment wit h prevailing market rat es. Furt her, since t here is no maximum period
specif ied f or repo by RBI , t he absence of percept ion of short t erm int erest rat e f or longer
period repo horizon inhibit s t he part ies t o ent er int o repos f or period longer t han a
f ort night . The rollovers could be f or any period and should not have any relat ionship
wit h t he original cont ract period.








79






80
Ch apt er 10

Bon d Mar k et I n di ces an d Ben ch mar k s

Market benchmarks serve a purpose of providing inf ormat ion t o t he part icipant s about
t he prices prevailing in t he market s. I n t he bond market s, t he most import ant market
indicat or, which every part icipant want s t o t rack, is t he movement in int erest rat es.
Market indicat ors enable pricing, valuat ion and perf ormance evaluat ion. I n t his chapt er,
we shall discuss 2 widely t racked benchmarks: t he NSE- MI BOR which provides t he
money market benchmark, and t he I - Sec bond indices, which t rack ret urns on
government securit ies

10. 1 I - Bex : Sover ei gn Bon d I n dex
10


A bond index is a product t o accurat ely measure t he perf ormance of t he bond market s.
I t is a benchmark against which f und managers and invest ment managers can measure
t heir perf ormance. Bond indices use an addit ional liquidit y crit eria besides j ust ret urns.
This is specif ically required t o meet t he needs of act ive t raders and invest ment
managers.

10. 1. 1 Wh y a Sover ei gn Bon d I n dex ?

The sovereign bond market is t he most liquid segment in t he bond market . There is a
need t o provide a benchmark against which t he perf ormance of a government securit ies
port f olio can be measured.

10. 1. 2 Feat u r es of a Bon d I n dex

The index must be:
Repr esen t at i ve: An index should span and weight t he appropriat e market s,
inst rument s and individual securit ies t o ref lect t he opport unit ies available t o t he
domest ic and int ernat ional inst it ut ional invest or.
Mar k et s: The index should cover securit ies of a wide range of mat urit ies, say one t o t en
years.
I n st r u men t s: The I nst rument s should have f ixed coupons; t hey must be t radable and
redeemable f or cash. Thus, t he index excludes most of t he long dat ed securit ies and
low coupon securit ies ( which are not t raded) .
I ssu es: Each issue of a qualif ying inst rument must meet cert ain liquidit y crit eria t o be
included in t he index. I t should generally be t raded and at accept able bid- of f er spreads.
Cu r r en t Yi el d: The principal appreciat ion of a low coupon bond is more t han t hat of a
high coupon bond t o compensat e f or t he lower int erest accrual. To avoid a dist ort ion of

10
This sect ion draws f rom t he publicat ion I - Sec Sovereign Bond I ndex, I CI CI
Securit ies and Finance Company Lt d.

81
t he principal ret urns index on t his count , securit ies where t he current yield and YTM
dif f er by more t han 100bps are excluded f rom t he index.

B. I n vest i bl e an d Repl i cabl e: An index should include only securit ies in which an
invest or can deal at short not ice and f or which f irm prices exist . Firm prices should
ideally exist f or all const it uent securit ies.
The benchmark issues included in t he index ought t o be
widely recognised market indicat ors
issues wit h high t rading volume
recent issues wit h current coupon
A securit y is excluded f rom t he index if it does not have a market lot ( Rs. 5 crore or Rs.
10 crore) t rade f or t hree cont inuous t rading days.

C. Accu r at e an d Rel i abl e: I ndex ret urn calculat ions should accurat ely ref lect t he act ual
changes in t he value of a port f olio consist ing of t he same securit ies.

D. Tr an spar en t : I nvest ment managers should know which securit ies are included in an
index and how it is const ruct ed. The f und manager must be able t o creat e his own
benchmark index and t rack it .

10. 1. 3 Met h odol ogy an d Assu mpt i on s

Secu r i t i es pr i ces
The price used is t he weight ed average price of SGL t rades as report ed by RBI ( af t er
excluding all t rades below Rs. 1 crore f ace value) .
Wei gh t i n g ch an ges
The index measures t he changing value of an index port f olio by weight ing t he t ot al
ret urn on each const it uent bond by t he market value on t he previous day. Each weight
is equal t o t he amount out st anding at t he beginning of each mont h mult iplied by t he
securit ys gross price ( net price plus accrued int erest ) . For principal ret urn calculat ions,
t he weight s do not ref lect accrued int erest ; inst ead, t he out st anding amount is adj ust ed
by t he issues net price.
Rei n vest men t
The index assumes t hat coupons received during t he mont h are immediat ely reinvest ed
int o t he bond index in proport ion t o t he lat est market values of t he const it uent s. The
index is f ully invest ed at all t imes which is only possible wit h daily indices.
Tr an spar en t
I nvest ment mangers need t o know which securit ies are included in on index and how it
is const ruct ed. This index will be document ed wit h respect t o t he ident it ies of it s
const it uent bonds and it s calculat ion met hods.
Con ven t i on s
L : List of bonds comprising t he index
i : A bond in t he bond list
TR : Tot al Ret urn
PR : Principal Ret urn
TRi : Tot al Ret urn f or a given bond i
TRi, t : Tot al Ret urn f or a given bond i t oday
TRi, t - 1 : Tot al Ret urn f or a given bond i yest erday

82
TRi, o : Tot al Ret urn f or a given bond I on base dat e of t he index
PRi : Principal Ret urn f or a given bond i
PRi, t : Principal Ret urn f or a given bond i t oday
PRi, t - 1 : Principal Ret urn f or a given bond i yest erday
PRi, o : Principal Ret urn f or a given bond i on base dat e of t he index
I Ri : I nt erest Ret urn f or a given bond i
I Ri, t : I nt erest Ret urn f or a given bond i t oday
I Ri, t - 1 : I nt erest Ret urn f or a given bond i yest erday
I Ri, o : I nt erest Ret urn f or a given bond i on base dat e of t he index
GP : Gross Price of a bond
GPi : Gross Price of a given bond i
GPi, t : Gross Price of a given bond i t oday
GPi, t - 1 : Gross Price of a given bond i yest erday
GPi, o : Gross Price of a given bond i on base dat e of t he index
NP : Net price of a bond ( clean price less voucher)
NPi : Net price of a given bond i
NPi, t : Net price of a given bond i t oday
NPi, t - 1 : Net price of a given bond i yest erday
NPi, o : Net price of a given bond i on base dat e of t he index
C : Coupon on a bond
Ci : Coupon on a given bond i
Ci, t : Coupon on a given bond i t oday
Q : Number of bonds out st anding
Qi : Number of bonds out st anding of a given bond i
Qi, t : Number of bonds out st anding of a given bond i t oday
MC : Market capit alisat ion of a bond
MCi : Market capit alisat ion of a given bond i
MCi, t : Market capit alisat ion of a given bond i t oday
D : Durat ion of a bond
Di : Durat ion of a given bond i
Y : Yield of a bond
Yi : Yield of a given bond i

10. 1. 4 Def i n i t i on s

Bon d Li st
The select ion of bonds f or t he purpose of t he index bet ween t wo rebalancing dat es.
Mar k et - cap of a bon d
I t is t he number of bonds out st anding t imes t he market price. The market value of t he
t ot al out st anding bond issue.
Gr oss Pr i ce
Gross Price of bond = Market Price + Accrued I nt erest
Net Pr i ce
Net Price of a bond = Market Price
Mar k et Cap Wei gh t
Market - cap of a bond = Par amount out st anding x Gross Price
Market - cap of a bond
Market - cap weight =

83
Sum of all market - caps of bonds in t he bond list


Rebal an ci n g
The index aut omat ically adj ust s or rebalances f or changes in t he composit ion of t he
index port f olio so t hat t he changes do not represent a capit al gain or loss t o t he index.

10. 1. 5 Ret u r n s on I n di vi du al Bon ds

Tot al r et u r n ( TR)
I t is t he absolut e ret urn t hat a bond of f ers and it includes bot h coupons and capit al gains
/ ( losses) . The t ot al ret urn index f or an individual bond is calculat ed each market day by
increasing t he previous market days index value by t he percent age change in bonds
gross price ( GP) . The gross price of a bond is it s net price plus accrued int erest . The
gross price must be adj ust ed f or loss of accrued int erest on coupon payment day by
adding t he coupon value ( C) t o t he gross price.

TRi, t = TRi, t - 1 X { ( GPi, t + Ci, t ) / GPi,t - 1

Pr i n ci pal Ret u r n ( PR)
I t is simply t he current net price divided by t he net price on t he base dat e.

PRi, t = NPi, t / NPi, o

I n t er est Ret u r n
The t ot al ret urn divided by principal ret urn index.

I Ri, t = TRi, t / PRi, t

10. 1. 6 Mar k et I n di ces

For a port f olio of bonds t he t ot al ret urn is calculat ed by mult iplying t he previous days
index value by t he rat io of t he market capit alisat ion of t he bond list on a day t o it s
market capit alisat ion on t he previous day. Each bond has an individual weight which is
mult iplied by t he price t o calculat e it s market capit alisat ion. These weight s are called
market caps ( MC) . Thus, Tot al Ret urn ( TR) of t he index is,

TRt = TRt - 1 x f or all bonds i belonging t o bond list l{ MC i, t x TRi, t x TRi, t - 1}

where market cap is,

MCi, t = Qi, t x GPi,t

The bond index must be f ully invest ed t hat is coupons, changes in t he bond list and
changes in principal amount s must be account ed f or on a daily basis. The bond list could
change when bonds ent er or leave t he index. Principal amount s could change owing t o
redempt ion or addit ional issue of f urt her bonds.
The equivalent f ormula f or t he ent ire index would t hen reduce t o

84
f or all bonds i belonging t o bond list l{ Q i, t x GP i, t }
TRt =
f or all bonds i belonging t o bond list l on base dat e { Q i, o x GP i, o } x Adj ust ment
f act or

10. 1. 7 Adj u st men t Fact or

The adj ust ment f act or can be decomposed int o t hree cont ribut ing f act ors
1. The part ial impact of a change in t he composit ion of t he bond list bet ween t wo
dat es keeping amount out st anding ( weight s) const ant at t odays values ( Adj ust ment
Fact or1)
2. The part ial impact of a change in t he amount s out st andings bet ween t he t wo dat es
keeping t he yest erdays bond list int act ( Adj ust ment Fact or2) .
3. The impact of coupons paid leaving bot h bond list and weight s const ant at
yest erdays value ( Adj ust ment Fact or3) .
Adj ust ment Fact or 1 = ( Todays list & Todays weight s)
( Yest erdays list & Todays weight s)

Adj ust ment Fact or 2 = ( Yest erdays list & Todays weight s)
( Yest erdays List & Yest erdays weight s)

Adj ust ment Fact or 3 = ( Yest erdays List & Yest erdays weight s)
( Yest erdays List & Yest erdays weight s & Todays
coupon)
The product of t he adj ust ment f act ors f rom base t o dat e is t he adj ust ment f act or in t he
denominat or of t he equat ion. Theref ore t he disaggregat ion explains how rebalancing at
t he beginning of t he mont h and coupon reinvest ment properly chain- link an index.

10. 1. 8 I n dex St at i st i cs

The durat ion, yield, remaining mat urit y and average coupon of t he bond index are
approximat ed by using t he f ollowing relat ionships.

Du r at i on
The durat ion of t he index can be approximat ed by weight ing t he individual durat ion of
t he bonds by t heir market capit alisat ion.
Durat ion of t he bond index = f or all bonds i belonging t o bond list l { MCi x Di}

Remai n i n g mat u r i t y
The residual t ime t o mat urit y of t he index is simply t he market cap weight ed years t o
mat urit y of each bond in t he bond list .
Remaining mat urit y bond index = f or all bonds i belonging t o bond list l { MCi x Year s
t o Mat urit yI }

Yi el d
The index yield can be approximat ed by weight ing each bonds yield by it s durat ion.
Rigorously, all t he cash f lows of t he component bonds need t o be discount ed t o arrive at
t he accurat e yield t o mat urit y. The durat ion calculat ed using t he yield calculat ed t hus

85
would be t he exact durat ion of t he index. For most pract ical purposes t he f ollowing
approximat ion is adequat e.
Yield bond index = f or all bonds i belonging t o bond list l { MCi x Di / Dbond_index) x
Yi}

Aver age cou pon
The average coupon is arrived at by calculat ing t he durat ion weight ed coupon rat es of
t he bonds
f or all bonds i belonging t o bond list
Average Coupon bond index =
{ MCi x Di / Dbond_index) x Ci}
10. 1. 9 Cal i br at i on I ssu es

Ru l es f or bon d i n cl u si on
Bonds may ent er or leave an index f or a variet y of reasons, such as, capit al changes and
changes in liquidit y.
Capi t al ch an ges
mandat ory redempt ions
opt ional redempt ions: call, put , conversion, ext ension
issue price relat ed: part ly paid t o f ully paid
Re- issue of exist ing bonds
Change in out st anding amount due t o OMO by RBI
Ch an ges i n Li qu i di t y
A bond may be deemed illiquid if t here is no market lot t rade f or t hree consecut ive
t rading days.
A bond can ent er t he index when
a part ly paid bond becomes f ully paid, and
t rading volumes sat isf y t he above condit ions of liquidit y.

10. 1. 10 Pr i n ci pal Ret u r n I n dex an d Tot al Ret u r n I n dex

The PRI t racks t he price movement s of bonds and is a mirror image of t he movement of
market yields. The TRI t racks t he ret urns available in t he bond market . I n a f alling
int erest rat e scenario, t he index gains on account of int erest accrual and capit al gains,
losing on reinvest ment income, whereas during rising int erest rat e periods, t he int erest
accrual and reinvest ment income is of f set by capit al losses. Theref ore t he TRI t ypically
has a posit ive slope except during periods when t he drop in market prices is higher t han
t he int erest accrual. Figure 10. 1 t racks t he I - Bex Tot al Ret urn I ndex. Figure 10. 2 t racks
t he I - Bex Principal Ret urn I ndex.


86
Fi gu r e 10. 1: I - Bex Tot al Ret u r n I n dex
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Fi gu r e 10. 2: I - Bex - Pr i n ci pal Ret u r n I n dex
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10. 2 Th e NSE - MI BOR
11


10. 2. 1 I n t r odu ct i on t o Pol l ed Ben ch mar k s

The debt market s in I ndia do not have an organizat ional f orm t hat support s a
t ransparent f orm of t rading where, prices and rat es are observable by all part icipant s.
The debt market s are dist ribut ed dealer market s in which, t rades are st ruck bet ween

11
The met hodologies described in t his chapt er were developed by Dr. Aj ay Shah. For a
complet e discussion, ref er t o, I mproved Met hods f or Obt aining I nf ormat ion f rom
Dist ribut ed Dealer Market s, by Aj ay Shah, I GI DR, Sept ember 1998.

87
dealers over t elephones, af t er negot iat ions. Since such t rades are not cent rally
report ed, last t raded prices are also not observed in such market s.
One of t he met hodologies used t o obt ain market inf ormat ion in such dist ribut ed dealer
market s is t he conduct of a poll amongst dealers, and creat e an order book t hat
comprises t he prices at which t hese dealers are willing t o t rade as principals. The design
of t he poll can be t uned t o achieve t he obj ect ive of est imat ing t he market rat es at t he
inst ant of sampling. There are t wo variat ions t o t he obj ect ive of such polling: one kind
of poll occurs eit her at t he beginning of t he market or during market hours, when
part icipant s in t he poll provide t heir est imat e of t he market rat es at t he t ime of t he poll;
an alt ernat e met hodology is t he polling of t he last t raded prices f rom dealers soon af t er
t he close of t he market .
The polling t echnique, which uses a sample of dealers, can have t wo variat ions: dealers
can be asked t o quot e rat es at which t hey would t rade as principals; alt ernat ively
dealers could provide t heir est imat e of t he market rat e, at t he t ime of polling. The
result s of t he poll are impact ed by t he choice of t hese alt ernat e polling obj ect ives.
From t he result s of t he poll, by put t ing t oget her t he rat es of t he sample of dealers,
est imat es of liquidit y in t he market as a whole is est imat ed. The est imat ion t echniques
have t o account f or biases creat ed by ext ending t he result s obt ained f rom t he sample,
f or t he market as a whole. The manner in which t he mean of t he sample is est imat ed
has import ant implicat ions f or t he reliabilit y of t he est imat e, because t he range of poll
result s could carry element s of noise, manipulat ion and idiosyncrat ic variat ion, which
would impact t he sample mean.
The NSE MI BOR is a polled benchmark, whose polling and sample mean est imat ion
t echniques explicit ly account f or t he above issues in creat ing a market benchmark f or
debt market s.

10. 2. 2 Pol l i n g Met h odol ogy

The polling met hodology involves t he f ollowing:
a. A randomly chosen sub- set of respondent s f rom a populat ion of 31 part icipant s,
consist ing of dealers and principal invest ors ( banks, inst it ut ions and primary
dealers) in t he debt market s is chosen on every polling day.
b. At an appoint ed t ime, t hey are asked t o report t heir percept ion of t he bid and
ask rat es in t he market , f or a range of t enors, on a f ixed t rade value of Rs. 100
million. Current ly, quot es are polled and processed daily by t he NSE at 0940
hours f or overnight rat e and at 1130 hours f or t he 14 day, 1 mont h and 3
mont h rat es.
c. Part icipant s in t he poll are f ree t o provide bot h bid and ask, or eit her one of t he
rat es.
d. The sampled inf ormat ion f rom poll part icipant s is kept conf ident ial. This is t o
avoid possible cart els and manipulat ion in t he poll process.
e. Monit oring of quot es t o assess qualit y of poll part icipant rat es is also done.
This is t o ensure t hat part icipant s who provided noisy est imat es, are ident if ied,
and less f requent ly polled.

10. 2. 3 Met h odol ogy t o Det er mi n e Aver age Rat es


88
Af t er t he range of rat es are obt ained f rom t he poll, an appropriat e met hodology t hat
ident if ies t he benchmark bid and ask, is applied t o t he dat a. Many exchanges use a
simple t rimmed mean, where t he out liers are t rimmed, and t he average rat es are
obt ained f rom t he mean of t he t rimmed sample. There is a well known t rade- of f
bet ween st at ist ical ef f iciency and vulnerabilit y t o manipulat ion, in met hodologies t hat
use a simple t rimmed mean.
The NSE MI BOR uses a more sophist icat ed met hodology f or obt aining t he sample mean,
such t hat t he ext ent of t rimming is opt imized t o reduce t he vulnerabilit y of dat a t o
manipulat ion, while simult aneously obt aining unbiased est imat es of t he sample mean. A
st at ist ical boot st rapping t echnique is used t o arrive at an adapt ive t rimmed mean, which
det ermines t he mean, af t er a series of comput er int ensive it erat ions t hat successively
t rim sample dat a of noise, and locat e t he mean and t he st andard deviat ion. The
overnight rat es are disseminat ed daily t o t he market at 0955 hours and t he 14 day, 1
mont h and 3 mont h rat es at 12. 15 hours.
From t he dat a obt ained, NSE disseminat es t he average bid rat e ( MI BI D) and t he
average of f er rat es ( MI BOR) and t he st andard deviat ion of sample quot es f rom t hese
means. This dat a provides a benchmark of market rat es, t hat is used f or a variet y of
pricing, t rading and valuat ion applicat ions. Since t he dat a i s capt ured and processed by
an independent agency, which has no direct t rading int erest in t he market s, t he NSE
benchmarks are widely used by market part icipant s.
NSE developed and launched t he NSE Mumbai I nt er- bank Bid Rat e ( MI BI D) and NSE
Mumbai I nt er- bank Of f er Rat e ( MI BOR) f or t he overnight money market on June 15,
1998. The success of t he overnight MI BI D/ MI BOR encouraged t he Exchange t o develop
benchmark rat es f or t he t erm money market . NSE launched t he 14- day MI BI D/ MI BOR
on November 10, 1998 and t he 1- mont h and 3 mont h MI BI D/ MI BOR on December 1,
1998.
The NSE MI BI D/ MI BOR is used as a benchmark rat e f or maj orit y of deals st ruck f or
int erest rat e swaps, f orward rat e agreement s, f loat ing rat e debent ures and t erm
deposit s. Bankers, issuers and invest ors are using t he NSE MI BI D/ MI BOR ext ensively.
Banks have been act ive in devising t ailor- made product s t o suit t he cust omer needs and
have also linked t erm deposit rat es t o t he overnight MI BI D/ MI BOR. I ssuers use t hese t o
price inst rument s on t he basis of daily int erest rat e movement and hedge against
adversit ies. These provide a comf ort zone against any unexpect ed volat ile market
movement s having an impact on t he f inancial commit ment s of t he issuer in respect of it s
debt . The t ransparency result ing f rom disseminat ion of MI BI D/ MI BOR has helped t he
issuers t o obt ain f iner rat es by issuing bonds linked t o MI BOR. A number of
organisat ions are benchmarking int erest rat e swaps t o MI BI D/ MI BOR.
The Reut ers also conduct s a poll of sample dealers and publishes t he benchmark r at es
every day. Some f loat ing rat e product s use t he Reut ers MI BOR as benchmarks.
The procedure varies f rom t he NSE model in t wo import ant ways:
a. The polling t echniques asks f or t he dealers rat es at which t hey are willing t o
t rade as principals, rat her t han t he dealers view of t he market rat es, as is t he
case wit h t he NSE MI BOR.
b. The t echnique used f or det ermining t he average rat es is t he simple t rimmed
mean, t hat t rims a given percent age of out liers, and obt ains t he average rat es
f rom t he remaining values.


89
Figure 10. 3 t racks t he NSE- MI BI D/ MI BOR overnight rat es. And Figure 10. 4 t racks t he
t rend of NSE- MI BI D/ MI BOR 1 mont h rat es.
Fi gu r e 10. 3: NSE- MI BI D/ MI BOR - Over n i gh t Rat es
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MIBID MIBOR


Fi gu r e 10. 4: NSE MI BI D- MI BOR: 1- Mon t h Rat es

90
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MIBID MIBOR


Model Quest i ons

1. Wh at does r e- bal an ci n g of a bon d i n dex mean ?
a. Changing t he weight ages in t he index so t hat t he market capit alisat ion of bonds
is kept const ant
b. Adj ust ing t he index f or changes in t he composit ion of t he index port f olio t o
ensure t hat art if icial capit al gains or losses are not included in t he index.
c. Adj ust ing t he composit ion of t he index, whenever coupons are paid, such t hat
t he index is not impact ed by changes in accrued int erest .
d. Changing t he composit ion of t he index when yield alt ers, such t hat durat ion of
t he index is kept const ant .
An sw er : b

2. Wh at i s t h e i n f or mat i on gat h er ed f r om mar k et par t i ci pan t s i n t h e pol l t o
det er mi n e NSE MI BOR?
a. The rat e at which t hey would be able t o lend and borrow in t he market s.
b. The rat e at which t hey are willing t o lend and borrow amongst one anot her.
c. Their view of t he market rat es f or lending and borrowing.
d. Their view of t he lending and borrowing rat es of specif ic market part icipant s.
An sw er : c


91
Ch apt er 11

Tr adi n g Mech an i sm i n t he NSE- WDM
12


Secondary market act ivit y in t he NSEs Wholesale Debt Market ( WDM) segment happens
t hrough t he NEAT ( Nat ional Exchange f or Aut omat ed Trading) syst em, which is a f ully
aut omat ed screen based t rading syst em. The WDM segment is meant primarily f or
banks, inst it ut ional and corporat e part icipant s and int ermediaries t o ent er int o high
value t ransact ions in debt securit ies issued by t he cent ral and st at e government s, public
sect or unit s, f inancial inst it ut ions and corporat e bodies. Bot h short - t erm inst rument s like
t reasury bills and commercial papers, and long- t erm inst rument s such as bonds and
debent ures, are available f or t rading in t he WDM segment of t he NSE.

11. 1 Descr i pt i on of t h e NSE - WDM

The t rades on t he WDM segment can be execut ed in t he Cont inuous or Negot iat ed
market . I n t he cont inuous market , orders ent ered by t he t rading members are mat ched
by t he t rading syst em. For each order ent ering t he t rading syst em, t he syst em scans f or
a probable mat ch in t he order books. On f inding a mat ch, a t rade t akes place. I n case
t he order does not f ind a suit able count er order in t he order books, it is st ored in t he
order books as a passive order. This could lat er mat ch wit h any f ut ure order ent ering t he
order book and result int o a t rade. This f ut ure order, which result s in mat ching of an
exist ing order, is called t he act ive order. I n t he negot iat ed market , deals are negot iat ed
out side t he exchange bet ween t he t wo count er part ies and are report ed on t he t rading
syst em f or approval.
The WDM t rading syst em recognises t hree t ypes of users - Trader, Privileged and
I nquiry. Trading Members can have all t he t hree user t ypes whereas Part icipant s are
allowed privileged and inquiry users only. The user- id of a t rader gives access f or
ent ering orders or t rades on t he t rading syst em. The privileged user has t he exclusive
right t o set up count er part y exposure limit s. The I nquiry user can only view t he market
inf ormat ion and set up t he market wat ch screen but cannot ent er orders or t rade or set
up exposure limit s.
The WDM support s t wo kinds of t rades: Repo t rades ( RE) , which are reversed af t er a
specif ic t erm, allowed only in specif ied securit ies and Non- Repo ( NR) t rades, which are
f or out right sales and purchase, allowed in all securit ies. Trading in debt as out right
t rades or as repo t ransact ions can be f or varying days of set t lement and repo periods.
For every securit y it is necessary t o specif y t he number of set t lement days ( whet her f or
same day set t lement or T+ 1 et c. depending on what is permit t ed by t he Exchange) , t he
t rade t ype ( whet her Repo or Non Repo) , and in t he event of a Repo t rade, t he Repo
t erm. Order mat ching is carried out only bet ween securit ies which carry t he same
condit ions wit h respect t o set t lement days, t rade t ype and repo period, if any. +
The securit y it self is represent ed by t hree f ields -

12
This mat erial draws f rom t he NSEs operat ional manuals on t he working of t he WDM.

92
Securit y Type ( e. g. GS f or Government Securit ies) ,
Securit y ( e. g. CG2010 - Cent ral Government mat uring in 2010) and
I ssue ( e. g. 6. 25%) .

93
All order mat ching is on t he basis of descript ors. All inquiries also require t he select ion of
valid descript ors. There are 6 f ields, which t oget her f orm an ent it y, which is called
Securit y Descript or in t he syst em:

Secu r i t y
Type
Secu r i t y I ssu e Set t l emen t
days
Tr ade Type Repo
Ter m
GS CG2001 11. 55% SD Non Repo -
TB 364D 060901 3 Repo 7

All t rade mat ching is essent ially on t he basis of descript or, it s price ( f or non- repos) / rat e
( f or repos) volume and order condit ions and t ypes. All volumes, in order ent ry screens
and display screens, are in Rs. lakh unless inf or med t o t he t rading members ot herwise.
All prices are in Rupees. Repo rat es are in percent ages. A maximum of t wo decimal
places are allowed f or values and f our decimal places f or prices. The Exchange set s t he
mult iples ( increment al value) in which orders can be ent ered f or dif f erent securit ies. The
Exchange announces f rom t ime t o t ime t he minimum order size and increment s t hereof
f or various securit ies t raded on t he Exchange.

11. 2 Or der Types an d Con di t i on s

The t rading syst em provides t remendous f lexibilit y t o t he users in t erms of t he t ype of
orders t hat can be placed on t he syst em. Several t ime- relat ed, price- relat ed or volume-
relat ed condit ions can easily be placed on an order. The t rading syst em also provides
complet e on- line market inf ormat ion t hrough various inquiry f acilit ies. Det ailed
inf ormat ion on t he t ot al order dept h in a securit y, t he best buys and sells available in
t he market , t he quant it y t raded in t hat securit y, t he high, t he low and last t raded prices
are available t hrough t he various market screens at all point s of t ime.

Or der Types
The most f requent ly used order t ype is t he Day order wit h set t lement dat es varying
f rom T+ 0 t o T+ 5. The t rading syst em also provides complet e on- line mar ket
inf ormat ion t hrough various inquiry f acilit ies. Det ailed inf ormat ion on t he t ot al order
dept h in a securit y, t he best buys and sells available in t he market , t he quant it y t raded
in t hat securit y, t he high, t he low and last t raded prices are available t hrough t he
various market screens at all point s of t ime.

Or der Mat ch i n g Ru l es
Orders lying unmat ched are called passive orders. Fresh orders which ent er t he syst em
and are scanning f or a suit able mat ch are called act ive orders. Orders are mat ched as
per price- t ime priorit y. The best buy order is t he one wit h t he highest buy price and t he
best sell order is t he one wit h t he lowest sell price. Order mat ching is done aut omat ically
by t he syst em. The t rade price is based on passive order price. I n case of repo t rades,
t he best buy order is one wit h lowest buy rat e and t he best sell order is one wit h t he
highest sell rat e. The t rade rat e is based on passive order rat e. However, t rade price f or
repo t rades is t he act ive order price.


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11. 3 Mar k et Ph ases an d St ar t i n g Up

Pr e- Open Ph ase
The pre- open period commences at 9. 00 a. m. The f ollowing act ivit ies can be carried out
by t he

95
Trading member/ Part icipant at t his st age:
Set up count er part y exposure limit s
Set up Market Wat ch ( t he securit ies which user would like t o view on t he
screen. I n all a user can select 180 securit y descript ors in Market wat ch)
I nquiries

Mar k et Ti mi n g
The Market remains open f rom 10 a. m. t o 5 p. m. on Monday t o Friday and f rom 10 a. m.
t o 2 p. m. on Sat urdays. At t he st art of t he t rading session, a message is displayed
indicat ing t hat t rading would begin.
The f ollowing act ivit ies are allowed at t his st age:
Order Act ivit y
I nquiries
Trade Act ivit y
Negot iat ed Trade Act ivit y
When t he market closes, t rading in all securit ies ends and none of t he above f unct ions
except request ing t rade cancellat ions are allowed.

Post Cl osi n g Per i od
SURCON
At t his st age, t he period of SURveillance and CONt rol ( SURCON) commences. I n t his
st age, a Trading member has only inquiry access. However, a Trading member can
request a t rade cancellat ion t ill 5. 15 p. m. ( On Sat urdays upt o 2. 15 p. m. ) . He can also
modif y report request s. Af t er t his period, t he t rading syst em processes t he dat a t o
make it available f or t he next day. A Trading member/ Part icipant must remain logged on
t o t he syst em t ill 5. 45 p. m. ( t ill 2. 45 p. m. on Sat urdays) as report s are generat ed at his
workst at ion. The member loses connect ion t o t he t rading syst em at 5. 45 p. m. and does
not have access t ill 6. 30 p. m. ( Bet ween 2. 45 p. m. and 3. 30 p. m. on Sat urdays) . A
t rading member get s access t o t he inquiry screens f rom 6. 30 p. m. t o 7. 15 p. m.
( Bet ween 3. 30 p. m. t o 4. 00 p. m. on Sat urdays) .
The user can also set / modif y t he CP exposures set by him vis- a- vis ot her Trading
members or Part icipant s during 6. 30 p. m. t o 7. 15 p. m. , ( Bet ween 3. 30 p. m. t o 4. 00
p. m. on Sat urdays) t o prepare f or t rading on t he next day.

11. 4 Tr adi n g Mech an i sm

Cou n t er - par t y Li mi t s
A Trading member/ Part icipant is required t o set CP limit s on ot her Trading members/
Part icipant s only on t he f irst occasion. These limit s are st ored by t he syst em and used
f or validat ion of all t ransact ions as per t he def init ion. ( See t he CP exposure screen
given in Figure 11. 1) . The limit available is reduced by t rade considerat ion, each t ime a
valid t rade is execut ed by t he Trading member/ Part icipant against t he part icular
Part icipant / Trading member. The limit becomes available only af t er t he set t lement of
t he t rade i. e. all SD t rades reduce limit available during t he day f or t rading and become
available f or t he next t rading day. Where t rades are execut ed f or ot her day set t lement
( say, T+ 2) t he limit becomes available only f or t rading on T+ 3rd day. The limit s are

96
overwrit t en only when t he Trading member/ Part icipant modif ies t he previously set
limit s.
When a Trading member/ Part icipant is added t o t he syst em his def ault limit on ot hers
and ot hers on him is zero. Hence t he new Trading member/ Part icipant will not be able
t o t ransact unless ot hers set limit on him or he set s a limit on ot hers.
All t rades execut ed by Trading members f or t heir Part icipant s ( ent i t ies regist ered wit h
NSE as Part icipant s) are not count ed in t he part icular Trading members count erpart y
exposure and are reckoned only in t he Part icipant s count erpart y exposure. Though all
client t rades which are done by t he Trading member on his own account are set t led by
t he client direct ly, t he exposure limit available of t he Trading member is reduced. I n
case of Repo t rades t he CP limit is reduced by t rade value and becomes available only
af t er t he f orward leg is execut ed.
Part icipant s can set limit s f or buy or sell or bot h. Limit s wit h respect t o asset s and call,
and t he count er- part y code are ent ered in t he screen. Count erpart y exposure limit s
cannot be changed during t rading hours and necessarily have t o be set by all
Part icipant s bef ore market opening or af t er market closes on any day.
Exchange not if ies f rom t ime t o t ime f or which market s t he CP limit s are applicable. I f
t here is any such change, t hen Current Limit is displayed according t o new change. I f a
t rade is cancelled t hen syst em rest ores CP limit s i. e. current limit f or t hat count er part y
is decreased by t rade value and same is available f or f ut ure t rades wit h t hat count er
part y.
I f t he limit originally set by a Trading member/ Part icipant is Rs. 150 lakh against a
count erpart y on any day and t he used up limit on t he next t rading day is Rs. 120 lakh,
t he Trading member/ Part icipant can modif y his previously set limit t o any new value. I f
t he new limit is lower say Rs. 100 lakh, t he syst em will regist er t he new limit but
cont inue t o show t he current value or t he used up limit as Rs. 120 lakh t ill t he t ime
t hese t rades are set t led. The new limit is applicable f or all f ut ure t rades unt il it is
modif ied.

Fi gu r e 11. 1: NEAT Cou n t er - par t y ex posu r e scr een

97


11. 5 Or der En t r y

Order ent ry mechanism enables t he Trading Member t o place orders in t he market . The
syst em accept s orders f rom all Trading Members and provides equal access t o all users.
The order ent ry screen is shown in Figure 11. 2.

Fi gu r e 11. 2: Or der En t r y Scr een on t h e NEAT

11. 5. 1 Or der En t r y i n Con t i n u ou s Mar k et

The order ent ry screen is act ivat ed in t he f ollowing manner:
On pressing t he buy or sell key, t he syst em aut omat ically picks up inf ormat ion f rom
market inquiry screens and f ills in t he f ollowing f ields:
Securit y t ype
Securit y
I ssue
Set t lement Period
Trade t ype
Repo t erm ( in t he case of a repo)
The user is required t o f ill in t he order value and price ( and repo rat e in t he case of a
repo) . The maximum number of decimal places f or t he value is 2 and f or t he price and
repo rat e is 4. I f t he user want s t o place an out right BUY order and t here are SELL

98
orders available, t hen t he best sell price and t he value available at t hat price appear by
def ault ( Same f igures as appear in t he market wat ch f or t hat securit y descript or) .
I n case of repo t rades t he user is not required t o ent er t he price, as t he syst em provides
t he def ault price. The def ault price is based eit her on t raded price in t hat securit y on t he
t rading syst em or on t raded price in t hat securit y out side t he Exchange.
For example, in t he case of Dat ed Government Securit ies if t here is no t raded price
available on t he syst em, t he def ault price is based on t he t raded price report ed in RBI s
SGL press release. I f t here is no such def ault price, t he seller s price is considered as t he
price f or repo t rade and t he considerat ion is calculat ed accordingly.
The order value should be equal t o or great er t han minimum order size and in mult iples
of t he increment s. The Exchange not if ies t he members of t he minimum order size and
t he increment s t hereof f or various securit ies t hat are t raded on t he Exchange.

11. 5. 2 Or der En t r y i n Negot i at ed Tr ades Mar k et

I n case of order ent ry in Negot iat ed t rades market or Negot iat ed t rade ent ries as t hey
are ref erred t o, t he procedure is same as in t he case of cont inuous market , f or init iat ing
t he screen and aut o f ill- up of f ields.
Addit ionally, t he user is required t o f ill in t he Count er Part icipant I D ( t he Part icipant
responsible f or set t lement wit h whom t he t rade is negot iat ed) in t he case of a
negot iat ed t rade ent ry. The Part icipant and count er Part icipant could also be Trading
members.
I n t he case of a negot iat ed t rade ent ry, t he syst em does not allow t he user t o add
at t ribut es such as GTC, GTD, I OC, MF, AON, DV and OS.
I n case of repo t rades def ault price is displayed f or bot h buyer and seller. Bot h of t hem
are allowed t o change t his price. However t he t rade t akes place only if bot h ent er same
price.
All negot iat ed t rades require Exchange approval and one of t he opt ions t hat t he
Exchange could exercise in t his regard is t o t hrow t he securit y descript or open f or
part icipat ion period. As a result , if t he negot iat ed t rade ent ry is made when t here is not
suf f icient t ime bef ore market close f or part icipat ion period and order mat ching at t he
end of t he part icipat ion period, it is cancelled aut omat ically by t he syst em.
Part icipat ion period t ime 10 minut es
Part icipat ion period mat ch t ime 10 minut es
Market close t ime 5. 00 p. m.
A negot iat ed t rade ent ry made af t er 4. 40 p. m. could result in a negot iat ed t rade and
hence, t he t rade ent ry is cancelled as soon as it is ent ered as t here is not enough t ime
f or part icipat ion period. The count er negot iat ed t rade ent ry is aut omat ically removed
f rom t he syst em at t he end of t he day.

Or der Nu mber
When an order is ent ered by t he user, t he syst em regist ers t he order and conf irms t o
t he user by displaying an Order Conf irmat ion number. This number has t he dat e of t he
order built in as t he f irst 6 digit s. Each order number is unique. This order number is
used f or all subsequent amendment s and cancellat ions, if any.
This is t rue in case of orders ent ered in t he cont inuous as well as t he negot iat ed t rades
market .


99
Or der Con f i r mat i on Sl i p
For every order accept ed by t he t rading syst em, an order conf irmat ion slip is generat ed
wit h t he order number and all det ails of t he given order at t he users local print er.

11. 6 Or der Val i dat i on

Con t i n u ou s Mar k et
The Trading syst em checks and validat es t he det ails when an order is ent ered. The
f ollowing checks are made:
Orders can be ent ered only wit hin t he t rading hours f or t he market i. e. it should not
be during pre- open period or af t er market close.
The securit y t ype, securit y and issues are valid values and t oget her should f orm an
accept able combinat ion.
Trading in t his securit y t ype, securit y and issue should be allowed at t hat t ime.
The Trading member ent ering t he order should not be under suspension by t he
Exchange.
I n case of an order ent ered by a Trading member on behalf of a Part icipant , t he
Trading member as well as t he Part icipant should not be under suspension.
Order value should be in mult iples of t he increment and at least equal t o t he
minimum order value f or t he securit y t ype or issue.
The specif ied set t lement period should be available f or t rading f or t he securit y t ype.
The set t lement days ent ered f or t hat order is a permit t ed set t lement period. The
set t lement days is count ed as per t he working days. e. g. - I f 15t h July is holiday,
t hen all orders f or T+ 1 set t lement ent ered on 14t h July ar e accept ed. T+ 1 t rades
done on 14t h are set t led on 16t h, T+ 2 t rades done on 14t h are set t led on 17t h and
so on. I n case of Repo t ransact ions ready leg set t lement is count ed as per working
days but f orward leg set t lement is count ed as per calendar days. The maximum
number of days permit t ed f or set t ling a t rade is not if ied t o t he members by t he
Exchange f rom t ime t o t ime.
The specif ied t rade t ype should be available f or t rading f or t he securit y t ype.
The Trading member/ Part icipant should be permit t ed t o t rade in t he securit y t ype
f or t hat set t lement period ( Same/ Next / Two/ Ot hers) f or t he t rade t ype ( Repo/
Non- Repo) f or t he Cont inuous Market Type
The Trading member/ Part icipant should be allowed t o buy ( lend) / sell ( borrow) in
t hat securit y t ype.
For an order, t he order value should not exceed t he issue value.
The member is allowed t o ent er orders on behalf of only t hose Part icipant s who are
regist ered wit h t he Exchange.
Ext ra validat ion checks f or order at t ribut es or condit ions are perf ormed bef ore an
order is conf irmed by t he syst em irrespect ive of whet her t hey are buy or sell orders.
Af t er t he necessary checks and validat ion are complet ed, t he syst em generat es a unique
order number, t ime st amps it and sends an order conf irmat ion t o t he member wit h order
conf irmat ion slip t o be print ed at his end.

Negot i at ed Tr ades Mar k et
For a t rade ent ry in t he negot iat ed t rades market , similar checks as in t he case of an
order ent ered in t he cont inuous market are made wit h a f ew variat ions.

100
Following is a list of checks f or ent ries in t he negot iat ed t rades market :
Negot iat ed t rade ent ries can be ent ered only wit hin t he t rading hours f or t he market
i. e. it should not be during pre- open period or af t er market close.
The securit y t ype, securit y and issues are valid values and t oget her should f orm an
accept able combinat ion.
Trading in t his securit y t ype, securit y and issue should be allowed at t hat t ime.
The Trading member ent ering t he negot iat ed t rade ent ry should not be under
suspension by t he Exchange.
I n case of a negot iat ed t rade ent ry by a Trading member on behalf of a Part icipant ,
t he Trading member as well as t he Part icipant / count er Part icipant should not be
under suspension.
Trade value should be in mult iples of t he increment and at least equal t o t he
minimum order value f or t he securit y t ype or issue.
The specif ied set t lement period should be available f or t rading f or t he securit y t ype.
The set t lement days ent ered f or t hat order is a permit t ed set t lement period. The
set t lement days is count ed as per t he working days. I n case of Repo t ransact ions
ready leg set t lement is count ed as per working days but f orward leg set t lement is
count ed as per calendar days. The maximum number of days permit t ed f or set t ling
a t rade will be not if ied t o t he members by t he Exchange f rom t ime t o t ime.
The specif ied t rade t ype should be available f or t rading f or t he securit y t ype.
The Trading member/ Part icipant should be permit t ed t o t rade in t he securit y t ype
f or t hat set t lement period ( Same / Next / Two / Ot hers) f or t he t rade t ype ( repo /
Non- repo) f or t he Negot iat ed t rades market t ype.
The Trading member/ Part icipant should be allowed t o buy ( lend) / sell ( borrow) in
t he securit y t ype.
The t rade value should not exceed t he issue size.
The member is allowed t o ent er orders only on behalf of t hose Part icipant s/ Count er
Part icipant s who are regist ered wit h t he Exchange.
Af t er t he necessary checks and validat ion are complet ed, t he syst em generat es a unique
t rade ent ry ( negot iat ed order) number, t ime st amps it and sends a t rade ent ry
( negot iat ed order) conf irmat ion t o t he member wit h a conf irmat ion slip t o be print ed at
his end.
I t is not possible t o modif y an out st anding negot iat ed t rade ent ry. Current ly, in case a
t rading member cancels a negot iat ed order bef ore approval of t he t rade by t he
Exchange, t he count er broker does not get any message t o t his ef f ect . Now if a t rading
member cancels his side of a Negot iat ed Trade order, t he count er part y member
receives a message Negot iat ed t rade alert cancelled as t he count er broker has
cancelled it s order in t he message window at his t rader workst at ion. The det ails of t he
order such as t he securit y descript or, volume and price are also displayed af t er t he
above message.
The user can cancel his negot iat ed orders t hrough single order cancellat ion. The order
can also be cancelled by invoking t he Out st anding Order screen and double clicking on
t he relevant order.

11. 7 Or der Mat ch i n g

Con t i n u ou s Mar k et

101
Order Mat ching is t he process of mat ching t he buy and sell orders on t he basis of cert ain
mat ching algorit hms. As a result of mat ching process, a t rade is generat ed. I f an order
placed is not mat ched immediat ely, t he syst em st ores t he order in t he order book
according t o price- t ime priorit y.
The orders are mat ched on t he basis of price- t ime priorit y. The best buy order mat ches
wit h best sell order. An order may mat ch part ially wit h anot her order result ing in
mult iple t rades. The best buy order is t he one wit h t he highest price and t he best sell
order is t he one wit h t he lowest price. I n case of repo t ransact ion, t he best buy order is
t he one wit h lowest repo rat e and t he best sell order is t he one wit h highest repo rat e.
The priorit y f ollowed in mat ching orders is:
Best price
Wit hin price, t ime priorit y

Cou n t er - par t y Ex posu r e Li mi t s
The process of order mat ching considers t he CP exposure limit set by t he Trading
members/ Part icipant s on ot her Trading members or Part icipant s. These limit s apply f or
order mat ching in market t ypes as not if ied by Exchange. Whenever t here is pot ent ial
order mat ch available t he syst em checks t he count er part y exposure limit available vis-
- vis t he pot ent ial count er part y bef ore approving t he mat ch. I f t he result ing t rade is not
crossing t he count er part y exposure limit t hen t he syst em concludes t he t rade provided
ot her paramet ers are met .
When a member t ransact s wit h anot her member or Part icipant on whom he has set a
limit , t he balance limit available get s reduced by an amount equal t o t he t rade
considerat ion as shown in t he message window.
During t rading hours, if a pot ent ial t rade result s in t he current CP limit crossing t he
warning limit set by t he Exchange t hen t he syst em concludes t he t rade and a message
appears on t he workst at ion of t he part icipant on whose behalf t he order ent ered st at ing
t hat t he warning limit has been exceeded.
Af t er t he warning CP limit has been crossed, if t he member cont inues t o ent er orders
and if a pot ent ial t rade result s in crossing of CP limit set by t he member, t hen t he
syst em allows t he t rade provided it is less t han or equal t o t he cut of f limit set by t he
Exchange. A message appears on t he workst at ion of t he part icipant on whose behalf t he
order was ent ered st at ing t hat CP limit has been exceeded wit h t he respect ive Trading
member/ Part icipant who has ent ered t he count er order.
Af t er crossing t he warning limit , if t he member cont inues t o ent er orders and if result ing
t rade is exceeding t he cut of f limit set by t he Exchange, t hen t he syst em does not allow
t he t rade. I t skips t he passive order and go t o t he next best passive order. I f it does not
f ind a suit able mat ch in t he books so t hat t he current value of CP limit is wit hin t he cut
of f limit , t hen such an order remains in t he respect ive book. Such orders may f ind
mat ches wit h orders f rom anot her Trading member/ Part icipant wit h whom CP exposure
is not exhaust ed.

Fr eeze
The Exchange set s lower and upper limit s t o t he t rading price f or all t he issues in t he
market . I n case a mat ch result s in t he price f alling out side t he t rading range, t he t rade
result s in a f reeze in t he securit y descript or. For a f rozen securit y descript or, order ent ry
is rest rict ed by t he syst em t ill t he t ime t he f reeze is resolved by t he Exchange. The
Trading members involved in t he t rade get a message t hat t he mat ch has result ed in a

102
f reeze. All ot her users of t he syst em are inf ormed t hat a f reeze has t aken place in t he
securit y descript or.
I n case of f reeze t he Exchange has f ollowing opt ions:
1. Cancel t he buy order and approve t he sell order
2. Cancel t he sell order and approve t he buy order
3. Approve bot h t he orders which result in t rade depending on t he t urnover limit and
count er part y exposure limit .
4. Cancel bot h t he orders
5. St art part icipat ion period
The syst em checks f or a price f reeze only during a t rade i. e. only when t here is a
pot ent ial mat ch. I f an order is ent ered at a price out side t he set range, it is allowed t o
be writ t en t o t he book. There is no validat ion f or price f reeze at order ent ry level.

Par t i ci pat i on Per i od
Wit h respect t o a f reeze, t he Exchange can st art a part icipat ion period f or t he securit y
descript or. The syst em inf orms all t he users t hat t he f reeze has been resolved and t he
part icipat ion period is open f or order ent ry. The orders causing t he f reeze are ret ained in
t he books and are allowed t o part icipat e in t his process.
During t he part icipat ion period, t here is no cont inuous mat ching in t hat part icular
securit y descript or by t he syst em. The orders ent ered by t he members are writ t en
direct ly t o t he Board lot book. Orders ent ered are by def ault f ully disclosed and DAY
orders. Orders wit h ot her price, t ime and volume condit ions are however not accept ed
during t he part icipat ion period. The part icipat ion period cont inues f or a durat ion
specif ied by t he Exchange.
Af t er t he part icipat ion period, orders are mat ched by t he syst em as per t he normal
mat ching algorit hm i. e. best buy order wit h t he best sell order. For t his mat ching
process, all t he orders in t he Book are considered. This includes orders present in t he
book bef ore t he occurrence of t he f reeze as well as orders ent ered during t he
part icipat ion period.

Negot i at ed Tr ades Mar k et
All negot iat ed t rade ent ries are st ored in a separat e book in t he syst em. A negot iat ed
t rade ent ry can mat ch only wit h anot her count er negot iat ed t rade ent ry. All negot iat ed
t rade mat ching is one- t o- one and t here can be no part ial mat ches. When a negot iat ed
t rade ent ry is made, t he syst em checks f or t he f ollowing det ails:
For t he given securit y descript or, t he Count er Part icipant I D of t he negot iat ed t rade
ent ry should mat ch t he Part icipant I D of t he count er negot iat ed t rade ent ry. The t rade
value, price and repo rat e in case of a repo t rade should mat ch exact ly wit h t hat of t he
count er t rade ent ry.
I f no mat ch is f ound f or t he negot iat ed t rade ent ry, it is writ t en t o t he negot iat ed t rade
ent ry book.
The Exchange has t he opt ions of approving t he negot iat ed t rade, cancelling t he t rade in
which case bot h t he negot iat ed t rade ent ries would be cancelled or st art a part icipat ion
period.
Wit h respect t o a negot iat ed t rade, t he Exchange can st art a part icipat ion period. The
negot iat ed t rade ent ries involved are writ t en t o t he Board lot book as normal orders
ret aining t heir original t ime st amp. The part icipat ion period process and mat ching
remains t he same as explained in t he case of f reezes.

103

11. 8 Tr ade Man agemen t

A Trade is a t ransact ion t hat t akes place when t wo orders mat ch each ot her. Whenever
a t rade t akes place, t he syst em sends t rade conf irmat ion messages t o each of t he
Trading members involved. The syst em also broadcast s t he t rade conf irmat ion t o all
Trading members in t he market t hrough t he Ticker screen. A t rade conf irmat ion slip also
get s print ed at each of t he members workst at ion wit h t he same unique t rade number.
There are some condit ions t hat could prevent a possible mat ch f rom t aking place. These
condit ions are as f ollows:
1. Suspension is in ef f ect f or t he ST/ S/ I involved.
2. Suspension is in ef f ect f or any of t he Part icipant s involved.
3. Suspension is in ef f ect f or any of t he Trading member involved.
4. Turnover limit f or one of t he members involved in t he t rade is exceeded
due t o t he t rade.
5. CP limit set by t he t rading member / part icipant on t he count er part y is
exceeded due t o t he t rade.
The above is t rue f or t rades in bot h cont inuous and negot iat ed t rades market s.


Negot i at ed Tr ade En t r y Scr een
Current ly t he user has t o ent er order det ails in t he negot iat ed buy and negot iat ed sell
order screens. A new f acilit y Negot iat ed Trade Ent ry Screen is provided wherein a user
can ent er bot h t he buy and sell negot iat ed t rade order det ails in a single screen, in case
a t rading member represent s bot h buyer as well as seller in a negot iat ed t rade.
Alt ernat ively, t he user can f irst highlight t he desired securit y descript or wit h t he
highlight bar on market wat ch screen. On invoking t he negot iat ed t rade ent ry screen t he
securit y det ails get s def ault ed on t o t he screen. The user is required t o ent er t he desired
Sell Part icipant s code in t he Count er Part icipant code f ield ( CP Field) and t he Buy
Part icipant s code in t he f ield which by def ault displays t he t rading members code. Af t er
ent ering all t he required det ails in t he respect ive f ields t he user can commit t he t rade
and conf irm t he t rade.
On conf irming t he negot iat ed t rade det ails a message Negot iat ed t rade needs
approval: . . . . . ( order det ails of t he t rade) . . . . . . . is di splayed in t he message window
screen. The syst em generat es a buy and sell order conf irmat ion slips separat ely wit h
dist inct order numbers.
The Exchange t hen receives an alert t o t his ef f ect . I n case t he Exchange approves t he
negot iat ed t rade t hen a message Negot iat ed Trade: . . . . . ( order det ails of Buy and
Sell) . . . . Approved by Cont rol is displayed in t he message window screen and t he t rading
member receives separat e buy and sell t rade conf irmat ion slips. I n case t he Exchange
rej ect s t he negot iat ed t rade alert t hen a message Order . . . . . ( order det ails of Buy and
Sell) . . . . . Negot iat ed Trade not approved - order cancelled is displayed in t he message
window screen and t he t rading member receives separat e buy and sell order cancellat ion
slips.

11. 9 Repor t s


104
The f ollowing report s are available t o t he user at t he end of every t rade day:
1. Open Orders Today: This report det ails t he orders t hat are available f or t rading t he
next t rading day.
2. Orders Placed Today: This report det ails all t he orders placed by t he member on a
given t rading day.
3. Cancelled Orders Today: This report det ails t he orders cancelled by t he member on
a t rading day.
4. Trades Done Today: This report det ails all t rades execut ed by t he member on a
t rading day.
5. Act ivit y Log Report : This report det ails all t he act ivit ies carried out by t he member
on a t rading day.

11. 10 Set t l emen t

Trades on WDM segment are set t led gross, on a t rade f or t rade basis, i. e. , each
t ransact ion is set t led individually and no net t ing of t ransact ions is allowed. The
Exchange monit ors set t lement of t hese t rades on day t o day basis, wherein part icipant s
conf irm all t rades and set t lement t hereof and also provide complet e set t lement det ails t o
t he Exchange t hrough an on- line, int eract ive dat a communicat ion syst em and f axes.
Each t rade has a unique set t lement dat e specif ied upf ront at t he t ime of order ent ry and
is used as mat ching paramet er. I t allows set t lement periods ranging f rom same day
( T+ 0) t o a maximum of six days ( T+ 5) .
The act ual set t lement of f unds and securit ies are ef f ect ed direct ly bet ween part icipant s.
As t he government securit ies are held in book ent ry f orm wit h t he RBI , t he lat t er ef f ect s
t he t ransf er of t hese securit ies t hrough book ent ry adj ust ment s. For ot her securit ies,
f unds are set t led t hrough exchange of physical inst rument s such as, pay- orders or
cheques, f or value on t he set t lement day in exchange f or physical cert if icat es.

11. 11 Rat es of Br ok er age

NSE has specif ied t he maximum rat es of brokerage chargeable by t rading members in
relat ion t o
t rades done in securit ies available on t he WDM segment of t he Exchange, as given
below:

Or der Val u e Br ok er age
Govt . of I n di a Secu r i t i es an d T- Bi l l s
Upt o Rs. 10 million 25 ps. per Rs. 100
More t han 10 million upt o 50 million 15 ps. per Rs. 100
More t han 50 million upt o 100 million 10 ps per Rs. 100
More t han 100 million 5 ps per Rs. 100
St at e Govt . Secu r i t i es & I n st i t u t i on al Bon ds
Upt o Rs. 2. 5 million 50 ps. per Rs. 100
More t han 2. 5 million upt o 5 million 30 ps. per Rs. 100
More t han 5 million upt o 10 million 25 ps per Rs. 100
More t han 10 million upt o 50 million 15 ps per Rs. 100
More t han 50 million upt o 100 million 10 ps per Rs. 100

105
PSU & Fl oat i n g Rat e Bon ds
Upt o Rs. 10 million 50 ps. per Rs. 100
More t han 10 million upt o 50 million 25 ps. per Rs. 100
More t han 50 million upt o 100 million 15 ps per Rs. 100
More t han 100 million 10 ps per Rs. 100
Commercial Papers and
Debent ures & Securit ised Debt
1% of t he order value


Model Quest i ons

1. Wh i ch of t h e f ol l ow i n g st at emen t s abou t n egot i at ed t r ade en t r y i s f al se?
a. I f a t rading member represent s bot h t he buyer and t he seller, negot iat ed t rade
orders can be ent ered in a single screen.
b. Trading members can invoke t he securit y descript or, and f ill up t he code and
t ransact ion det ails of t he selling part icipant s, and conf irm t he t rade.
c. All negot iat ed t rades require approval of t he exchange, only af t er which t rading
members receive conf irmat ion slips.
d. Negot iat ed t rade ent ries can be made out side of set count er- part y limit s, and sent
f or approval wit hin t he end of t he t rading day.
An sw er : d

2. I f t h e syst em sh ow s t h at t h e t r adi n g member s CP l i mi t i s Rs. 75 l ak h an d
h i s u sed u p l i mi t s i s Rs. 100 l ak h , w h i ch of t h e f ol l ow i n g i s f al se?
a. The CP limit s pert ain t o t wo dif f erent t rade dat es
b. The higher value pert ains t o an earlier CP limit , on a t ransact ion t hat is yet t o be
set t led.
c. The CP limit s have been changed during t rading hours
d. None of t he above
An sw er : c

3. Repo t r ades on t h e NEAT ar e mat ch ed i n t er ms of
a. Rat es, volume and ot her order condit ions.
b. Price, volume and ot her order condit ions.
c. Price- t ime priorit y.
d. Rat es- t ime priorit y.
An sw er : a




106
Ch apt er 12

Regu l at or y an d Pr ocedu r al Aspect s

The debt market s in I ndia are regulat ed by t wo agencies: RBI and SEBI . I n a not if icat ion
issued by t he Government on March 2, 2000, t he areas of responsibilit y bet ween RBI
and SEBI have been clearly delineat ed. I n t erms of t his not if icat ion, t he cont ract s f or
sale and purchase of government securit ies, gold relat ed securit ies, money market
securit ies and securit ies derived f rom t hese securit ies and ready f orward cont ract s in
debt securit ies shall be regulat ed by t he RBI . Such cont ract s if execut ed on st ock
exchanges shall however be regulat ed by SEBI , in a manner t hat is consist ent wit h t he
guidelines issued by t he RBI . However, regulat ion of money market mut ual f unds,
which pre- dominant ly invest in money market s, is done by t he SEBI , which is t he
regulat ory aut horit y f or t he mut ual f und indust ry SEBI is t he regulat ing agency f or t he
st ock market s and t he member- brokers of t he st ock exchanges, and t heref ore regulat es
t he list ing and t rading mechanism of debt inst rument s. Regulat ion of corporat e debt
issuance is also under t he purview of SEBI .
The issuance of debt inst rument s by t he government is regulat ed by t he Public Debt Act ,
1944 ( which is t o be replaced in t he near f ut ure by t he Government Securit ies Act ) . The
issuance of corporat e securit ies is regulat ed by t he SEBI Guidelines f or Disclosure and
I nvest or prot ect ion.
The Fixed I ncome Money Market & Derivat ives Associat ion of I ndia ( FI MMDA) , f ormed in
1998, is t he Self Regulat ory Organisat ion f or debt market s. I t s obj ect ive is t o enable
market development by involving market part icipant s in t he creat ion of good market
pract ices, unif orm market convent ions and high levels of int egrit y in t he debt market s.
FI MMDA has brought out t he Handbook of Market Pract ices, aimed at creat ing high
st andards of conduct and prof essionalism amongst principals and int ermediaries in t he
market place.
This chapt er is divided int o t hree sect ions, f ocusing on regulat ion and market pract ices.
Sect ion 1 discusses t he salient provisions of t he Public Debt Act , which governs t he
issuance of government securit ies. Sect ion 2 is an ext ract f rom t he SEBI Regulat ions f or
issuance of debt inst rument s by t he corporat e sect or. Sect ion 3 is an ext ract f rom t he
FI MMDA Handbook of market pract ices.

12. 1 Pu bl i c Debt Act , 1944

The Public Debt Act , 1944 applies t o Government securit ies creat ed and issued whet her
bef ore or af t er t he commencement of t his Act by t he Cent ral Government or a St at e
Government .
Government securit y means, a securit y, creat ed and issued, by t he Government , f or
t he purpose of raising a public loan, and having one of t he f ollowing f orms, namely: -
( a) A Government promissory not e payable t o or t o t he order of a cert ain person;
( b) A bearer bond payable t o t he bearer;
( c) St ock in eit her of t he f ollowing f orms:

107
Regist ered in t he books of t he Public Debt Of f ice, f or which st ock
cert if icat es are issued; or
Held at t he credit of t he holder in t he Subsidiary General Ledger
account maint ained by t he Public Debt Of f ice;
( d) A t reasury bill payable t o or t o t he order of a cert ain person.

The government may, by not if icat ion in t he Of f icial Gazet t e, specif y t he f orm and
provision f or t ransf erabilit y of t he securit ies. A t ransf er of a Government securit y
shall be made only in t he manner prescribed f or t he making of t ransf ers of
securit ies of t he class t o which it belongs and no t ransf er of a Government securit y
shall be valid if
( a) it does not purport t o convey t he f ull t it le t o t he securit y, or
( b) it is of such a nat ure as t o af f ect t he manner in which t he securit y was
expressed by t he Government t o be held.
( c) A Government promissory not e or a t reasury bill is t ransf erable subj ect t o t he
f ollowing condit ions:
( a) I t shall be t ransf erable by endorsement and delivery like a promissory not e
payable t o order.
( b) No endorsement on t he securit y is valid unless it is made by t he signat ure of
t he holder, or his duly const it ut ed at t orney or represent at ive, on t he back of
t he securit y it self .
( c) Transf er of a part of t he amount denominat ed by t he securit y is not valid.
( d) Blank t ransf ers are not be accept ed by t he Public Debt Of f ice as valid t ransf er
of a securit y.
A st ock f or which a st ock cert if icat e is issued, or which is held in t he SGL shall be
t ransf erable wholly or in part , by execut ion of an inst rument of t ransf er in t he prescribed
f orm ( Form I , I I , or I I I , as t he case may be) . The t ransf eror shall be deemed t o be t he
holder of t he st ock, unt il t he name of t he t ransf eree is regist ered by t he PDO.
The Cent ral Government may, subj ect t o t he condit ion of previous publicat ion, by
not if icat ion in t he Of f icial Gazet t e, make rules t o carry out t he purposes of t his Act . I n
part icular and wit hout prej udice t o t he generalit y of t he f oregoing power such rules may
provide f or all or any of t he f ollowing mat t ers, namely:
( a) t he f orms in which Government securit ies may be issued;
( b) t he condit ions subj ect t o which Government securit ies may be issued.
( c) t he manner in which dif f erent f orms of Government securit ies may be
t ransf erred;
( d) t he holding of Government securit ies in t he f orm of st ock by t he holders of
of f ices ot her t han public of f ices and t he manner in which and t he condit ions
subj ect t o which Government securit ies so held may be t ransferred;
( e) t he manner in which payment of int erest in respect of Government
securit ies is t o be made and acknowledged;
( f ) t he condit ions governing t he grant of duplicat e, renewed, convert ed,
consolidat ed and sub- divided Government securit ies;
( g) t he f ees t o be paid in respect of t he issue of duplicat e Government
securit ies and of t he renewal, conversion, consolidat ion and sub- division of
Government securit ies;
( h) t he f orm in which receipt of a Government securit y delivered f or discharge,
renewal, conversion, consolidat ion or sub- division is t o be acknowledged;

108
( i) t he manner of at t est at ion of document s relat ing t o Government securit ies
in t he f orm of st ock;
( j ) t he manner in which any document relat ing t o a Government securit y or
any endorsement or a promissory not e issued by [ t he Government ] may,
on t he demand of a person who f rom any cause is unable t o writ e, be
execut ed on his behalf ;
( k) t he f orm of t he bonds
( l) t he circumst ance and t he manner in which and t he condit ions subj ect t o
which inspect ion of Government securit ies, books, regist ers and ot her
document s may be allowed or inf ormat ion t heref rom may be given under
sect ion 25;
( m) t he procedure t o be f ollowed in making vest ing orders;
( n) t he f orm in which and t he persons in whose f avour nominat ions may be
made, t he manner in which and t he condit ions and rest rict ions subj ect t o
which such nominat ions may be made, t he regist rat ion, variat ion or
cancellat ion or such nominat ions and t he f ees t hat may be levied f or such
regist rat ion, variat ion or cancellat ion.

12. 2 SEBI ( Gu i del i n es f or Di scl osu r e an d I n vest or
Pr ot ect i on ) , 2000

SEBI Guidelines f or issuance of corporat e debent ures, is st ipulat ed in Chapt er X of t he
GDI P, 2000, which is reproduced hereunder.

Ch apt er X - Gu i del i n es f or I ssu e of Debt I n st r u men t s
A company of f ering Convert ible/ Non Convert ible debt inst rument s t hrough an of f er
document shall comply wit h t he f ollowing provisions in addit ion t o t he relevant
provisions cont ained in ot her chapt er of t hese guidelines.

Requ i r emen t of cr edi t r at i n g
1. No public or right s issue of debt inst rument s ( including convert ible inst rument s) in
respect of t heir mat urit y or conversion period shall be made unless credit rat ing
f rom a credit rat ing agency has been obt ained and disclosed in t he of f er document .
2. For a public / right s issue of debt securit y of issue great er t han or equal t o Rs. 100
crore t wo rat ings f rom t wo dif f erent credit rat ing agencies shall be obt ained.
3. Where credit rat ing is obt ained f rom more t han one credit rat ing agencies, all t he
credit rat ing/ s, including t he unaccept ed credit rat ings, shall be disclosed.
4. All t he credit rat ings obt ained during t he t hree ( 3) years preceding t he public or
right s issue of debt inst rument ( including convert ible inst rument s) f or any list ed
securit y of t he issuer company shall be disclosed in t he of f er document .

Requ i r emen t i n r espect of Deben t u r e Tr u st ee
1. I n case of issue of debent ure wit h mat urit y of more t han 18 mont hs, t he issuer shall
appoint a Debent ure Trust ee.
2. The names of t he debent ure t rust ees must be st at ed in t he of f er document .
3. A t rust deed shall be execut ed by t he issuer company in f avour of t he debent ure
t rust ees wit hin six mont hs of t he closure of t he issue.

109
4. Trust ees t o t he debent ure issue shall be vest ed wit h t he requisit e powers f or
prot ect ing t he int erest of debent ure holders including a right t o appoint a nominee
direct or on t he Board of t he company in consult at ion wit h inst it ut ional debent ure
holders.
5. The merchant banker shall, along wit h draf t of f er document , f ile wit h Board,
cert if icat es f rom t heir bankers t hat t he asset s on which securit y is t o be creat ed are
f ree f rom any encumbrances and t he necessary permissions t o mort gage t he asset s
have been obt ained or a No Obj ect ion Cert if icat e f rom t he f inancial inst it ut ions or
banks f or a second or pari passu charge in cases where asset s are encumbered.
6. The debent ure t rust ee shall ensure compliance of t he f ollowing:
a. Lead f inancial inst it ut ion / invest ment inst it ut ion shall monit or t he progress in
respect of debent ures raised f or proj ect f inance / modernisat ion / expansion /
diversif icat ion / normal capit al expendit ure.
b. The lead bank f or t he Company shall monit or debent ures raised f or working
capit al f unds.
c. Trust ees shall obt ain a cert if icat e f rom t he company' s audit ors:
i. in respect of ut ilisat ion of f unds during t he implement at ion period of
proj ect s.
ii. in t he case of debent ures f or working capit al, cert if icat e shall be obt ained
at t he end of each account ing year.
d. Debent ure issues by companies belonging t o t he groups f or f inancing
replenishing f unds or acquiring share holding in ot her companies shall not be
permit t ed.
Ex pl an at i on :
The expression ` replenishing of f unds or acquiring shares in ot her companies' shall
mean replenishment of f unds or acquiring share holdings of ot her companies in t he
same group. I n ot her words, t he company shall not issue debent ures f or acquisit ion
of shares / providing loan t o any company belonging t o t he same group. However,
t he company may issue equit y shares f or purposes of repayment of loan t o or
invest ment in companies belonging t o t he same group.
e. The debent ure t rust ees shall supervise t he implement at ion of t he condit ions
regarding creat ion of securit y f or t he debent ures and debent ure redempt ion
reserve.

Cr eat i on of Deben t u r e Redempt i on Reser ves ( DRR)
1. A company has t o creat e DRR in case of issue of debent ure wit h mat urit y of more
t han 18 mont hs.
2. The issuer shall creat e DRR in accordance wit h t he provisions given below:
( a) I f debent ures are issued f or proj ect f inance f or DRR can be creat ed upt o t he
dat e of commercial product ion.
( b) The DRR in respect of debent ures issued f or proj ect f inance may be creat ed
eit her in equal inst alment s or higher amount s if prof it s so permit .
( c) I n t he case of part ly convert ible debent ures, DRR shall be creat ed in respect
of non- convert ible port ion of debent ure issue on t he same lines as applicable
f or f ully non- convert ible debent ure issue.
( d) I n respect of convert ible issues by new companies, t he creat ion of DRR shall
commence f rom t he year t he company earns prof it s f or t he remaining lif e of
debent ures.

110
( e) DRR shall be t reat ed as a part of General Reserve f or considerat ion of bonus
issue proposals and f or price f ixat ion relat ed t o post t ax ret urn.
( f ) Company shall creat e DRR equivalent t o 50% of t he amount of debent ure
issue bef ore debent ure redempt ion commences.
( g) Drawl f rom DRR is permissible only af t er 10% of t he debent ure liabilit y has
act ually been redeemed by t he company.
( h) The requirement of creat ion of a DRR shall not be applicable in case of issue
of debt inst rument s by inf rast ruct ure companies.

Di st r i bu t i on of Di vi den ds
( a) I n case of new companies, dist ribut ion of dividend shall require approval of
t he t rust ees t o t he issue and t he lead inst it ut ion, if any.
( b) I n t he case of exist ing companies prior permission of t he lead inst it ut ion f or
declaring dividend exceeding 20% or as per t he loan covenant s is
necessary if t he company does not comply wit h inst it ut ional condit ion
regarding int erest and debt service coverage rat io.
( c) ( i) Dividends may be dist ribut ed out of prof it of part icular years only af t er
t ransf er of requisit e amount in DRR.
( ii) I f residual prof it s af t er t ransf er t o DRR are inadequat e t o dist ribut e
reasonable dividends, company may dist ribut e dividend out of general
reserve.

Redempt i on
The issuer company shall redeem t he debent ures as per t he of f er document .

Cr eat i on of Ch ar ge
1. The securit y shall be creat ed wit hin six mont hs f rom t he dat e of issue of
debent ures.
Provided t hat if f or any reasons t he company f ails t o creat e securit y wit hin 12
mont hs f rom t he dat e of issue of debent ures t he company shall be liable t o pay 2%
penal int erest t o debent ure holders.
Provided f urt her t hat if securit y is not creat ed even af t er 18 mont hs, a meet ing of
t he debent ure holders shall be called wit hin 21 days t o explain t he reasons t hereof
and t he dat e by which t he securit y shall be creat ed.
2. I f t he issuing company proposes t o creat e a charge f or debent ures of mat urit y of
less t han 18 mont hs, it shall f ile wit h Regist rar of Companies part iculars of charge
under t he Companies Act .
Provided t hat , where no charge is t o be creat ed on such debent ures, t he issuer
company shall ensure compliance wit h t he provisions of t he Companies ( Accept ance
of Deposit s) Rules, 1975, as, unsecured debent ures / bonds are t reat ed as
"deposit s" f or purposes of t hese rules.
3. The proposal t o creat e a charge or ot herwise in respect of such debent ures, may be
disclosed in t he of f er document along wit h it s implicat ions.

Requ i r emen t of l et t er of opt i on
Fi l i n g of l et t er of opt i on
A let t er of opt ion cont aining disclosures wit h regard t o credit rat ing, debent ure holder
resolut ion, opt ion f or conversion, j ust if icat ion f or conversion price and such ot her t erms

111
which t he Board may prescribe f rom t ime t o t ime shall be f iled wit h t he Board t hrough
an eligible Merchant Banker, in t he f ollowing cases:
Rol l over of Non Con ver t i bl e Por t i on s of Par t l y Con ver t i bl e Deben t u r es ( PCDs) /
Non Con ver t i bl e Deben t u r es ( NCDs) .
i. I n case, t he non- convert ible port ions of PCD/ NCD issued by a list ed company,
value of which exceeds Rs. 50 lakh, can be rolled over wit hout change in t he
int erest rat e subj ect t o t he f ollowing condit ions:
a. An opt ion shall be compulsorily given t o debent ure holders t o redeem t he
debent ures as per t he t erms of t he of f er document .
b. Roll over shall be done only in cases where debent ure holders have sent t heir
posit ive consent and not on t he basis of t he non- receipt of t heir negat ive
reply.
c. Bef ore roll over of any NCDs or non- convert ible port ion of t he PCDs, a f resh
credit rat ing shall be obt ained wit hin a period of six mont hs prior t o t he due
dat e of redempt ion and communicat ed t o debent ure holders bef ore roll over.
d. Fresh t rust deed shall be execut ed at t he t ime of such roll over.
e. Fresh securit y shall be creat ed in respect of such debent ures t o be rolled
over.
f . Provided t hat if t he exist ing t rust deed or t he securit y document s provide f or
cont inuance of t he securit y t ill redempt ion of debent ures f resh securit y may
not be creat ed.
Con ver si on of I n st r u men t s ( PCDs/ FCDs, et c. ) i n t o Equ i t y Capi t al
1. I n case, t he convert ible port ion of any inst rument such as PCDs, FCDs et c.
issued by a list ed company, value of which exceeds Rs. 50 lakh and whose
conversion price was not f ixed at t he t ime of issue, holders of such
inst rument s shall be given a compulsory opt ion of not convert ing int o equit y
capit al.
2. Conversion shall be done only in cases where inst rument holders have sent
t heir posit ive consent and not on t he basis of t he non- receipt of t heir
negat ive reply.
Pr ovi ded t hat where issues are made and cap price wit h j ust if icat ion
t hereon, is f ixed bef orehand in respect of any inst rument s by t he issuer and
disclosed t o t he invest ors bef ore issue, it will not be necessary t o give opt ion
t o t he inst rument holder f or convert ing t he inst rument s int o equit y capit al
wit hin t he cap price.
3. I n cases where an opt ion is t o be given t o such inst rument holders and if any
inst rument holder does not exercise t he opt ion t o convert t he debent ures int o
equit y at a price det ermined in t he general meet ing of t he shareholders, t he
company shall redeem t hat part of debent ure at a price which shall not be
less t han it s f ace value, wit hin one mont h f rom t he last dat e by which opt ion
is t o be exercised.
4. The provision of sub- clause ( iii) above shall not apply if such redempt ion is t o
be made in accordance wit h t he t erms of t he issue originally st at ed.

Con ver si on of Deben t u r es I ssu ed u n der Con sen t of Con t r ol l er of Capi t al I ssu es
A.
( a) I n case, t he value of convert ible port ion of any inst rument such as PCDs,
FCDs, et c issued by a list ed company exceeds Rs 50 Lacs and;

112
( b) where in t erms of t he consent issued by t he Cont roller of Capit al I ssues,
t he price of conversion of PCDs / FCDs is t o be det ermined at a lat er dat e
by t he Cont roller, such price and t he t iming of conversion shall be
det ermined at a general meet ing of t he shareholders subj ect t o - t he
consent of t he holders of PCDs / FCDs f or t he conversion t erms shall be
obt ained individually and conversion will be given ef f ect t o only if t he
concerned debent ure holders send t heir posit ive consent and not on t he
basis of non- receipt of t heir negat ive reply; and such holders of
debent ures, who do not give such consent , shall be given an opt ion t o
get t he convert ible port ion of debent ures redeemed or repurchased by
t he company at a price, which shall not be less t han f ace value of t he
debent ures.
( c) where t he consent f rom t he Cont roller of Capit al I ssues st ipulat es cap
price f or conversion of FCDs / PCDs, t he board of t he Company may
det ermine t he price at which t he debent ures may be convert ed.
Pr ovi ded t hat opt ions t o debent ures / ot her inst rument holders f or
conversion int o equit y not required where t he consent f rom t he
Cont roller of Capit al I ssues st ipulat es cap price f or conversion of FCDs
and PCDs and t he cap price has been disclosed t o t he invest ors bef ore
subscript ion is made.
( d) I n case of issue of debent ures f ully or part ly convert ible made in t he
past , where t he conversion was t o be made at a price t o be det ermined
by t he CCI at a lat er dat e, t he price of conversion and t ime of conversion
shall be det ermined by t he issuer company in a meet ing of t he
debent ure holders, subj ect t o t he f ollowing:
( i) The decision in t he said meet ing of debent ure holders may be
rat if ied by t he shareholders in t heir meet ing.
( ii) Such conversions shall be opt ional f or accept ance on t he part of
individuals debent ure holders. The dissent ing debent ure holders
shall have t he right t o cont inue as debent ure holders if t he t erms of
conversions are not accept able t o t hem.
( iii) Where issue of PCDs and FCDs is made pursuant t o t he consent
given by t he Cont roller of Capit al I ssues and t he consent specif ies
t he t iming of conversion but t he price of conversion of PCDs / FCDs
is t o be det ermined at a lat er dat e, t he f ollowing shall be complied
wit h: -
( e) The consent of t he shareholders is t o be obt ained only f or t he purposes of
f ixing t he price of conversion and not f or t he pre- poning and post poning t he
t iming of t he conversion approved by CCI .
( f ) The conversion price shall be reasonable ( in comparison wit h previous
conversion price where t he t erms of t he issue provide f or more t han one
conversion) and t he conversion price shall not exceed t he f ace value of t hat
part of t he convert ible debent ure which is sought t o be convert ed.
( g) I n cases where an opt ion is t o be given t o t he debent ure holders and, if any
debent ure holder does not exercise t he opt ion t o convert t he debent ures int o
equit y at a price det ermined in t he general meet ing of t he shareholders, t he
company shall redeem t hat part of debent ure at a price which shall not be less

113
t han it s f ace value wit hin one mont h f rom t he last dat e by which opt ion is t o be
exercised.
( h) The provision in sub- clause ( c) above shall not be applicable in case such
redempt ion is t o be made in accordance wit h t he original t erms of t he of f er.
B) I n cases of issues of debent ures f ully or part ly convert ible, irrespect ive of value
made in t he past , where conversion was t o be made at a price t o be det ermined
by CCI and t he consent order does not provide f or a specif ic premium or a cap
price f or conversion, t he draf t let t er of opt ion t o t he debent ure holders f iled wit h
t he Board shall cont ain j ust if icat ion f or t he conversion price.

Ot h er r equ i r emen t s
1. No company shall issue of FCDs having a conversion period of more t han 36
mont hs, unless conversion is made opt ional wit h "put " and "call" opt ion.
2. I f t he conversion t akes place at or af t er 18 mont hs f rom t he dat e of allot ment , but
bef ore 36 mont hs, any conversion in part or whole of t he debent ure shall be
opt ional at t he hands of t he debent ure holder.
3. ( a) No issue of debent ures by an issuer company shall be made f or acquisit ion of
shares or providing loan t o any company belonging t o t he same group.
Sub- clause ( a) shall not apply t o t he issue of f ully convert ible debent ures providing
conversion wit hin a period of eight een mont hs.
4. Premium amount and t ime of conversion shall be det ermined by t he issuer company
and disclosed.
5. The int erest rat e f or debent ures can be f reely det ermined by t he issuer company.

Addi t i on al Di scl osu r es i n r espect of deben t u r es
The of f er document shall cont ain: -
a. Premium amount on conversion, t ime of conversion.
b. I n case of PCDs/ NCDs, redempt ion amount , period of mat urit y, yield on
redempt ion of t he PCDs/ NCDs.
c. Full inf ormat ion relat ing t o t he t erms of of f er or purchase including t he
name( s) of t he part y of f ering t o purchase t he khokhas ( non- convert ible
port ion of PCDs) .
d. The discount at which such of f er is made and t he ef f ect ive price f or t he
invest or as a result of such discount .
e. The exist ing and f ut ure equit y and long t erm debt rat io.
f . Servicing behaviour on exist ing debent ures, payment of due int erest on
due dat es on t erm loans and debent ures.
g. That t he cert if icat e f rom a f inancial inst it ut ion or bankers about t heir no
obj ect ion f or a second or pari passu charge being creat ed in f avour of t he
t rust ees t o t he proposed debent ure issues has been obt ained.

12. 3 Mar k et Pr act i ces an d Pr ocedu r es


114
12. 3. 1 Deal i n g Pr i n ci pl es & Pr ocedu r es
13


Pr el i mi n ar y Negot i at i on s of Ter ms
Dealers should clearly st at e at t he out set , prior t o a t ransact ion being execut ed, any
qualif ying condit ions t o which it will be subj ect .
Typical examples of qualif icat ions include where a price is quot ed subj ect t o t he
necessary credit approval, limit s available f or t he count er - part y, inabilit y t o conclude a
t ransact ion because of f ices of t he member in ot her cent ers are not open. This should be
made known t o t he broker and t he pot ent ial count erpart y at an early st age and bef ore
names are exchanged.

Fi r mn ess of Qu ot at i on
Dealers, whet her act ing as principals, agent or broker, have a dut y t o make absolut ely
clear whet her t he prices t hey are quot ing are f irm or merely indicat ive. Prices quot ed by
brokers should be t aken as indicat ive unless ot herwise qualif ied.
A dealer quot ing a f irm price or rat e eit her t hrough a broker or direct ly t o a pot ent ial
count erpart y is commit t ed t o deal at t hat price or rat e in a market able amount provided
t he count erpart y name is accept able. Generally, prices are assumed t o be f irm as long
as t he count erpart y or t he broker is on line. Members shall clearly indicat e if t he price is
wit hdrawn. Generally t he t erminology is Ask me now or check ; adherence t o t he
exact t erminology is not required.
I n volat ile market s, or when news is expect ed, dealers quot ing a f irm price or rat e
should indicat e t he lengt h of t ime f or which t heir quot e is f irm.
What const it ut es a market able amount varies f rom product t o product but will generally
f amiliar t o pract it ioners. A broker, if quot ing on t he basis of small amount s or part icular
names, should qualif y t he quot at ion accordingly.
A signif icant part of t he volume t ransact ed by brokers relies on mandat es given by
dealers act ing on behalf of principals. The risk t hat t he principal runs is t hat such an
of f er could get hit af t er an adverse market move has t aken place. Because of t his risk
most market part icipant s will not give mandat es. However, in t he int erest of f ast er price
discovery and more liquid market s, mandat es should be encouraged. The Associat ion
will hence, lay down t he guidelines so t hat mandat es can be given wit h minimal risk of
adverse f ills.
The broker is expect ed t o use t he mandat e in order t o be able t o adverse t he
principals int erest t o t he ent it ies t hat t he broker expect s will have an int erest in t he
price. Generally t he broker is f ree t o show t he price t o ent it ies he deems f it , but
members have t he right t o expect t hat if a smaller set is def ined, t he broker will adhere
t o it . Mandat es shall generally be f or a period of an hour unless ot herwise specif ied.
The broker shall reveal t he name of t he ent it y of f ering t he mandat e when a count erpart y
is f irm t o deal at t he mandat e price. The Broker will t hen call t he member who of f ered
t he mandat e and reconf irm t he mandat e wit h him. I n absence of any signif icant market
movement , t he member who has of f ered t he mandat e is expect ed t o adhere t o it . I n
case t he price is not adhered t o, it is t he responsibilit y of t he member who had of f ered

13
This sect ion has been ext ract ed f rom The Handbook of Market Pract ices, Fixed I ncome
Money Market and Derivat ives Associat ion of I ndia, 1999.

115
t he mandat e t o explain why t he mandat e is no longer valid. I t is required of t he
member t hat t he mandat e price be wit hdrawn bef ore t he Broker reveals t he
count erpart y name. The only except ion t o t his is when t he count erpart y name is not
accept able.
Brokers are expect ed t o assist t he Member by checking f rom t ime t o t ime t o ensure t hat
t he mandat e is st ill current . The Member shall call t he broker if he wishes t o wit hdraw
t he mandat e bef ore it s expiry.

Con cl u di n g a Deal
Dealers should regard t hemselves as bound t o deal once t he price, name accept abilit y,
credit approval and any ot her key commercial t erms have been agreed. Oral
agreement s are considered binding. Where quot ed prices are qualif ied as being
indicat ive or subj ect t o negot iat ion of commercial t erms, members should normally t reat
t hemselves as bound t o deal at t he point where t he t erms have been agreed wit hout
qualif icat ion. Oral agreement s are considered binding; t he subsequent conf irmat ion is
evidence of t he deal but should not override t erms agreed orally.
Making a t ransact ion subj ect t o document at ion is not good pract ice. I n order t o
minimise t he likelihood if disput es arising once document at ion is prepared, dealers
should make every ef f ort t o clarif y all mat erial point s quickly during t he oral negot iat ion
of t erms, and should include t hese on t he conf irmat ion. I n special cases, dealers may
consider it prudent t o specif y t hat t he t ransact ion is subj ect t o document at ion.
Where brokers are involved, members have t he right t o expect t hat t he broker will make
t hem aware immediat ely when t he price has been dealt upon. As a general rule a deal
should be regarded as having been done where t he brokers conf irmat ion is posit ively
acknowledged by t he dealer. I t is expect ed t hat a broker shall not assume t hat a deal is
done wit hout oral conf irmat ion f rom t he dealer.

Passi n g of n ames by br ok er s
I t is good pract ice f or dealers not t o seek t he names of t he count erpart y bef ore
t ransact ing and f or brokers should not divulge t he names premat urely. Dealers and
brokers should at all t imes t reat t he det ails of t ransact ions as absolut ely conf ident ial t o
t he part ies involved.
To save t ime and conf usion, dealers should wherever pract icable give brokers prior
indicat ion of count erpart ies wit h whom, f or what soever reason, t hey would be unwilling
t o do business. I n all t heir t ransact ions, brokers should aim t o achieve a mut ual and
immediat e exchange of names.
I n t he repo market s, it is accept ed t hat members may vary t heir price depending on t he
name. Hence it is accept able f or t he member t o require pre- disclosure of t he name. I n
t he case of inst rument s like CDs and CPs, where t he seller may not be t he same ent it y
as t he issuer, t he broker shall f irst disclose t he issuers name t o t he pot ent ial buyer.
The name of t he buyer shall be disclosed only af t er t he buyer has accept ed t he seller s
name. The seller has t he right t o ref use t he buyer, as long as it is prepared at t hat t ime
t o sell t he same amount at t he same price t o an alt ernat ive accept able name
immediat ely shown t o it by t he broker.

Or al Deal Ch eck
I t is usual pract ice t o reconf irm a deal orally. Lack of response should not be const rued
as acknowledgement .

116

Wr i t t en con f i r mat i on s
The conf irmat ion provides a necessary f inal saf eguard against dealing errors.
Conf irmat ions should be dispat ched and checked and prompt ly, ever when oral deal
checks have been undert aken. The issue and checking of conf irmat ions is a back- of f ice
responsibilit y, which should be carried out independent ly f rom t hose who init iat e deals.
A conf irmat ion of each deal must be sent out wit hout delay. This is part icularly essent ial
if dealing f or same day set t lement . As a general rule all part icipant s of t he wholesale
market s should have or be aiming t o have, in place t he capabilit y t o dispat ch
conf irmat ion so t hat t hey are received and can be checked wit hin a f ew hours of when
t he deal was st ruck. Where t he product s involved are more complex, and so require
more det ails t o be included on t he conf irmat ion, t his may not be possible; nevert heless
it is in t he int erest of all concerned t hat such deals are conf irmed as quickly as is
pract icable. I t is recommended t hat principals should inquire about conf irmat ions not
received wit hin t he expect ed t ime.
All conf irmat ions should include t he t rade dat e, t he name of t he ot her count erpart y and
all ot her det ails of t he deal, including where appropriat e t he commission charged by t he
broker. I t is accept ed pract ice f or principals t o conf irm direct ly all t he det ails of
t ransact ions arranged t hrough a broker; t he broker independent ly sends a conf irmat ion
t o bot h cout erpart ies. I t is vit al t hat principals check conf irmat ions caref ully and
immediat ely upon receipt so t hat discrepancies can be quickly revealed and correct ed.
As a general rule, conf irmat ions should not be issued by or sent t o and checked by
dealers. This is a back- of f ice f unct ion. Where dealers do get involved in t hese
procedures t hey should be closely cont rolled.

Set t l emen t of di f f er en ces
I f all t he procedures out lined above are adhered t o, t he incidence and size of dif f erences
should be reduced. Mist akes, however, do occur, and t hey should be ident if ied and
correct ed prompt ly. Failure t o observe t hese principles could leave t hose responsible
bearing t he cost , wit hout limit on size or durat ion, of any dif f erences which arise.
Where dif f erence in payment s arise because of errors in t he payment of f unds, f irms
should not at t empt undue enrichment by ret aining t he f unds. I n case f unds are ret ained
t hen compensat ion t erms should be negot iat ed bet ween t he count erpart ies. The same
principle is applicable when SGLs are not lodged in t ime. Non- st andard set t lement
inst ruct ions should be checked very caref ully and any discrepancies ident if ied prompt ly
upon receipt , and not if ied direct t o t he count erpart y, or t o t he broker.

Br ok er age
I t is usual f or f irms t o pay a f ee, commission or brokerage f or using t he services of a
broker. However, t he charges are f reely negot iable bet ween principals and brokers.
Firms should pay brokerage bills prompt ly. Members should have a writ t en policy
covering t he empanelment of brokers. I t is a good pract ice t o review t he panel of
brokers at least annually.

Mar k et Con ven t i on s
Management should ensure dealers are aware of t heir responsibilit y t o act prof essionally
at all t imes and, as part of t his, t o use clear unambiguous t erminology.


117
Mar k et Di sr u pt i on / Ban k Hol i days
Occasionally unf oreseen event s mean t hat market part icipant s will have ent ered int o
cont ract s f or a part icular mat urit y dat e only t o f ind, subsequent ly, t hat , t hat day is
declared a public holiday. There are many inst ances of out st anding disput es amongst
market part icipant s and in set t ing t hem t he principle of no undue enrichment should be
f ollowed. I t is normal market pract ice t o ext end cont ract s mat uring on a non- business
day t o t he next working day.

Pr odu ct s Cover ed by t h e Han dbook
Money Market Product s
- Call/ Not ice Money Market
- Term Money Market
- Bills Rediscount ing Scheme
- Cert if icat es of Deposit
- Commercial Paper
- Fixed I ncome Product s
- Debent ures
- Financial I nst it ut ion Bonds
- Government Securit ies
- St at e Government Securit ies
- Debt issued by Public Sect or Unit s
- MI BOR Linked Bonds issued by Corporat e or I nst it ut ions.
Derivat ives Product s
- I nt erest rat e swaps such as t he:
- Overnight I ndexed Swaps
- Forward Rat e Agreement s FRAs

Deal i n g St an dar ds & Con ven t i on s

Cal l mon ey / Not i ce mon ey & Ter m mon ey
Call Money is essent ially a money market inst rument wherein f unds are borrowed/ lent
f or a t enure ranging f rom overnight t o 14 days and are at call or not ice. The borrower
or lender must convey his int ent ion t o repay / recall wit h at least 24 hours not ice.
However, monies can also be borrowed / lent wit h a specif ied mat urit y dat e i. e. repaid /
recalled on t he mat urit y.
Money lent f or a f ixed t enor f or more t han 14 days is called Term Money
I nt erest t o be calculat ed on a daily / 365 day year basis.
I nt erest t o be payable on mat urit y and rounded- of f t o t he nearest rupee.
I n case of Mat urit y of Term Money f alling on a holiday t he repayment will be made
on t he next working day at t he cont ract ed rat e.
The receiver of f unds will collect t he cheque and give t he receipt . The same procedure
should be f ollowed on t he reversal of t he deal.

I n case of an u n sch edu l ed h ol i day
Roll over of call deals may happen if t here is a st rike, nat ural calamit y, et c. The st rike
could involve eit her or bot h t he count er- part ies. I n case of disrupt ion of work, due t o
which f unds cannot be delivered or cannot be received, t he deals are necessarily rolled

118
over. I t is recommended t hat t he rat e be f ixed as t he previous working days NSE
MI BOR.

Bi l l s r edi scou n t i n g sch eme
I nt erest t o be calculat ed on a daily / 365- day year basis
I nt erest t o be calculat ed on a Front - end basis and rounded of f t o t he nearest rupee.
Amount payable t o t he borrower should be t he principal amount less t he int erest .
On mat urit y t he borrower should repay t he Principal Amount .

Ex ampl e:
Transact ion Amount : Rs. 10, 00, 00, 000/ - ( Rupees Ten crore)
No. of days : 45 days
Rat e of I nt erest : 10. 25% p. a.

Tansact ion Amount * No. of days * Rat e of I nt erest
I nt erest =
365 * 100

10, 00, 00, 000 * 45 * 10. 25
i. e. =
365 * 100

= Rs. 12, 63, 698. 63013

= Rs. 12, 63, 699/ - ( rounded of f )

Amount payable = Transact ion Amount I nt erest

= ( 10, 00, 00, 000 12, 63, 699)

= Rs. 9, 87, 36, 301/ -

Amount t o be repaid = Rs. 10, 00, 00, 000/ -
on mat urit y


I n case of an u n sch edu l ed h ol i day
I n case t he mat urit y dat e of t he t ransact ion is a holiday, t hen t he amount should be
repaid t he previous working day.

Gover n men t Secu r i t i es
I nt erest t o be calculat ed on a 30 mont h/ 360 day year basis
30
t h
and 31
st
t o be const rued as t he same day. I f a deal is done on t he 30
t h
or
31
st
day of t he mont h t hen int erest should be calculat ed f or 29 days f or t hat
mont h. ( European 30/ 360) .
I nt erest payable in a Repo t ransact ion t o be calculat ed on a daily/ 365 day year
basis.

119
Repo reversal price t o be calculat ed up t o a maximum of eight decimal places
and t he reversal amount should be adj ust ed accordingly.
Prices in t he secondary market t o be quot ed up t o a maximum of f our decimal
places and in mult iples of Rs. 0. 0025
e. g. Rs. 100. 4350 or Rs. 101. 2125 but not Rs. 102. 3745 or Rs. 103. 5018
Deal conf irmat ion must exchanged bet ween t he buyer and t he seller. Usually,
t he seller will deliver t he SGL t o t he buyer. Delivery dat e and t he t ime of t he
deal should be ment ioned on t he deal slip.

The NSE requires t hat deals done t hrough a NSE broker be report ed by him t o t he
exchange wit hin 20 minut es of t he deal t aking place. The list of aut horised signat ories of
t he member should be made available in case t he count er- part y request s

I n case of an u n sch edu l ed h ol i day
I n case of disrupt ion of work, due t o which t he SGL cannot be delivered or received, t he
SGL should be delivered t he next day. As t he bank buying t he securit y get s t he benef it
of f unds f or t he holiday, t he buyer bank should pay at O/ N MI BOR ( BSE) f or t he f unds.

Zer o Cou pon Bon ds
Prices are t o be quot ed upt o a maximum of f our decimal places.
I n t he secondary market , quot es should be in t erms of price and not yield.
Deal conf irmat ion must be exchanged bet ween t he buyer and t he seller. Seller will
deliver t he SGL t o t he buyer. Delivery dat e and t he t ime of t he deal should be
ment ioned on t he deal slip. The NSE requires t hat deals done t hrough a NSE broker be
report ed by him t o t he exchange wit hin 20 minut es of t he deal t aking place.

I n case of an u n sch edu l ed h ol i day
I n case of disrupt ion of work, it may not be possible f or t he Buying bank t o lodge t he
SGL or f or t he selling bank t o deliver t he SGL t o t he buying bank. Since t he Rupee value
of t he SGL ( Price + no. of days f or which coupon has t o be paid t o t he selling bank, or in
t he case of a T- bill or Zero, t he price as calculat ed f rom t he yield) is calculat ed f or t he
day of t he holiday, t he buying Bank would have t he advant age of f unds f or one day ( or if
t he next working day is more t han one day away, f or t he corresponding number of
days) . Hence it is necessary t hat t he selling Bank be compensat ed f or t he day( s) f or
which t he SGL has not been lodged. The f air rat e f or compensat ion, j ust as in money
deals, would t he NSE O/ N MI BOR f or t he previous working day. The Base rupee amount
is t he SGL amount .

Ex ampl e
Purchase of Rs. 5 crore of 11. 40, 29 Sept . 2000 on @ Rs. 100. 85 f or delivery on Sept .
8
t h.
159 Days have elapsed since t he previous coupon. The t ot al considerat ion t o be
delivered by t he Buyer t o t he seller is: Rs. 5, 04, 25, 000 + Rs. 25, 17, 500 = Rs.
5, 29, 42, 500.
I f due t o disrupt ion, t he SGL cannot be lodged by t he buyer, t he buyer will lodge t he
SGL on t he 9
t h
of Sept ember. The Buyer will compensat e t he seller at t he O/ N NSE
MI BOR f or t he day, say 10. 15%. Hence a t ot al compensat ion paid by t he buyer t o t he
seller would be Rs. 14, 867. 41


120
Cer t i f i cat e of Deposi t s / Commer ci al Paper / Tr easu r y Bi l l s
I nt erest t o be calculat ed on act ual number of days / 365 day year basis.
I nt erest t o be calculat ed on a rear ended basis
Price t o be calculat ed upt o a maximum of f our decimal places.

I n case yield is given t hen:
100
Price =
1 + ( Yield ( %) * ( No. of days t o mat urit y) ) / 365


121
I n case price is given t hen:

( 100 - Price) * 365
Yield =
Price * No. of Days t o mat urit y

I n t he secondary market , quot es should be in t erms of yield t o mat urit y and not price.
The Price should be quot ed upt o 4 decimal places.

Ex ampl e:
I n case a bank wishes t o sell a CP/ CD/ T- Bills say mat uring on April 29, 1999 at a YTM of
9. 5% and let us assume t hat t he price at t hat YTM works out t o be Rs. 98. 75. Then t he
bank should quot e t hat it want s t o sell t he inst rument mat uring on April 29, 1999 at a
YTM of 9. 5 % p. a. and not t hat it want s t o sell it at Rs. 98. 75.

Del i ver y
Delivery would generally be on a DVP basis wit h t he seller sending t he document s t o t he
buyer. However, t he pract ice of delivery upon clearance of buyers check is also
prevalent , and is considered accept able.
I n t he case of Primary issuance, t he st amped cert if icat e should be delivered wit hin 10
days of receipt of monies by t he issuer.

Cor por at e Bon ds / Deben t u r es
I nt erest t o be calculat ed on act ual number of days and 365 day year basis
Prices t o be quot ed upt o a maximum of f our decimal places.
Deal conf irmat ion must be exchanged bet ween t he buyer and t he seller. Seller will
deliver t he bonds/ debent ures t o t he buyer. Delivery dat e and t he t ime of t he deal
should be ment ioned on t he deal slip.
The NSE requires t hat NSE brokers report deals done by t hem wit hin 20 minut es of t he
deal t aking place. When t he deal is done af t er NSE hours, it needs t o be report ed on t he
next working day.

Model Quest i ons

1. Un der w h i ch of t h e f ol l ow i n g con di t i on s can a compan y w i t h dr aw f u n ds
f r om t h e deben t u r e r edempt i on r eser ve accou n t ?
a. Provided t he redempt ion reserve is equal t o t he redempt ion amount
b. Provided at least 50% of t he debent ures out st anding have been redeemed
c. Provided at least 10% of t he debent ures out st anding have been redeemed.
d. Companies cannot wit hdraw f unds f rom t he debent ure redempt ion reserve account
An sw er : c

2. I n t h e even t of a r ol l over of an NCD or t h e n on - con ver t i bl e por t i on of a PCD,
w h i ch of t h e f ol l ow i n g st at emen t s i s f al se?
i. The roll over will have t o occur wit hout any change in t he rat e of int erest
ii. Debent ure holders will have t o be given t he opt ion t o redeem t he debent ure as
per t he t erms of t he of f er document

122
iii. A f resh credit rat ing will have t o be obt ained six mont hs prior t o redempt ion
iv. Debent ure holders will have t o provide t heir posit ive consent wit hin 21 days of
t he receipt of t he not ice of rollover, f ailing which t hey are deemed t o have
consent ed t o t he rollover.
An sw er : d

3. A 364- day CP, mat u r i n g on 28
t h
Ju n e 2001, i s t r adi n g on 17
t h
Ju l y 2001, at a
pr i ce of Rs. 93. 3375. Wh at i s t h e Yi el d i n h er en t i n t h i s pr i ce?
An sw er :
( 100 93. 3375) * 365
Yield =
93. 3375 * 346
= 7. 5300%
( Number of days bet ween 17/ 07/ 2001 and 28/ 06/ 2002 is 346 days)

4. Th e day cou n t con ven t i on f or cor por at e bon ds i s
a. 30/ 360 US NASD
b. Act ual/ 365
c. Act ual/ 360
d. 30/ 360 European
An sw er : b

5. A 90 day CP i s i ssu ed on Ju l y 2, 2001, w h en t h e pr i ce of a t - bi l l of same
t en or i s Rs. 97. 5675. I f t h e CP w as i ssu ed at a pr i ce of Rs. 97. 45028, w h at i s
t h e spr ead at w h i ch i t h as been i ssu ed?
An sw er :
The implicit yield f or t reasury bills and CPs can be f ound using t he f ormula
Yield = ( ( 100- price) * 365) / ( Price * no of days t o mat urit y)
The yield implicit in t he price of t he T- bill is = ( ( 100-
97. 5675) * 365) ) / ( 97. 5675* 90)
= 10. 1111%
The yield implicit in t he price of t he CP is = ( ( 100- 97. 45028) * 365) ) / ( 97. 45028* 90)
= 10. 6111%
The spread at which t he CP has been issued is = 10. 6111 10. 1111
= 50 basis point s.

6. Compu t e t h e Ru pee val u e of an SGL t r an sact i on , w i t h t h e f ol l ow i n g dat a:
Cou pon Rat e: 11. 68%
Mat u r i t y dat e: Au gu st 6, 2002
Set t l emen t Dat e: Ju l y 11, 2001
Pr i ce: Rs. 105. 4025
Tr an sact i on amou n t : Rs. 50000000
An sw er :
Value of t he t ransact ion = number of securit ies * t rade price
= ( 50000000/ 100) * 105. 4025
= Rs. 5, 27, 01, 250
Accrued I nt erest f or t he period since t he last coupon is

123
= days since t he last coupon/ 360 * coupon rat e *
f ace value
= ( 155/ 360) * 0. 1168 * 50000000
= Rs. 25, 14, 444

124
Set t lement amount = Value of t ransact ion + Accrued I nt erest
= Rs. 5, 27, 01, 250 + 25, 14, 444
= Rs. 5, 52, 15, 694
( Number of days since t he last coupon dat e can be comput ed using t he coupbs f unct ion
in Excel. Specif y Set t lement dat e; mat urit y dat e; f requency = 2; and basis = 4)

6. Th e det ai l s of a t r an sact i on i n G- Secs i s as u n der :
Cou pon Rat e: 10. 50%
Mat u r i t y Dat e: May 21, 2005
Set t l emen t Dat e: Ju l y 29, 2001
Pr i ce: Rs. 111. 9125
Tr an sact i on Amou n t : Rs. 63500000
Th e bu yer i s u n abl e t o l odge t h e SGL on t h e set t l emen t dat e. Th e t r an sact i on i s
set t l ed 1 day l at er . I f t h e NSE over n i gh t MI BOR on t h e pr evi ou s day w as
8. 25% , w h at i s t h e amou n t f or w h i ch t h i s SGL w i l l set t l e?
An sw er :
Value of t he t ransact ion is = number of securit ies * t rade price
= ( 63500000/ 100) * 111. 91025
= Rs. 7, 10, 64, 438
Accrued I nt erest f or t he period since t he last coupon
= days since t he last coupon/ 360 * coupon rat e * f ace value
= ( 68/ 360) * 0. 1050 * 63500000
= Rs. 12, 59, 417
Set t lement amount = Rs. 7, 10, 64, 438 + 12, 59, 417
= Rs. 7, 23, 23, 855
( Number of days since t he last coupon dat e can be comput ed using t he coupbs f unct ion
in Excel. Specif y Set t lement dat e; mat urit y dat e; f requency = 2; and basis = 4)
The amount of int erest t o be paid f or 1 day delay in set t lement will be t he overnight
MI BOR applied t o t he set t lement amount , on act ual/ 365 day basis.
I nt erest t o be paid = 7, 23, 23, 855 * 0. 0825* 1/ 365
= Rs. 16, 347. 17
Theref ore set t lement amount wit h int erest will be = Rs. 7, 23, 40, 201

125
Ch apt er 13

Val uat i on of Bonds
14


13. 1 Bon d Val u at i on : Fi r st pr i n ci pl es

The value of a f inancial inst rument is well underst ood as t he present value of t he
expect ed f ut ure cash f lows f rom t he inst rument . I n case of a plain vanilla bond, which
we will f irst see, bef ore underst anding t he variat ions, t he cash f lows are pre- defined.
The cash f lows expect ed f rom a bond, which is not expect ed t o def ault are primarily
made up of ( i) coupon payment s and ( ii) redempt ion of principal.
The act ual dat es on which t hese cash f lows are expect ed are also known in advance, in
t he case of a simple non- callable bond. Theref ore, valuat ion of a bond involves
discount ing t hese cash f lows t o t he present point in t ime, by an appropriat e discount
rat e. The key issue in bond valuat ion is t his rat e. We shall begin wit h a simple
assumpt ion t hat t he rat e we would use is t he required rat e on t he bond, represent ing
a rat e t hat we underst and is available on a comparable bond ( comparable in t erms of
t enor and risk) .
For example, consider a Cent ral Government bond wit h 11. 75% coupon, mat uring on
April 16, 2006 ( Table 13. 1) . The cash f lows f rom t his bond are t he semi- annual coupon
and t he redempt ion proceeds receivable on mat urit y. I n order t o value t he bond, we
need t he t enor f or which we have t o value t he bond and t he required rat e f or t his
t enor. Let us assume f or simplicit y, t hat we are valuing t he bond on it s issue dat e and
t he required rat e or t he 8- year rat e in t he market is 12%. Since government bonds
pay coupons semi- annually, t his bond would pay ( 11. 75/ 2) = Rs. 5. 875, every six
mont hs as coupon. I n order t o value t his bond, we need t o list t hese cash f lows and
discount t hem at t he required rat e of 6% ( semi- annual rat e f or t he comparable 12%
rat e)
15
.
Theref ore, t he value of t he bond can be st at ed in general t erms as:

n
n
r
c
r
c
r
c
r
c
P
) 1 (
........ ..........
) 1 ( ) 1 ( ) 1 (
3
3
2
2 1
0
+
+
+
+
+
+
+
( 13. 1)

where P0 is t he value of t he bond
c1 , c2 cn are cash f lows expect ed f rom t he bond, over n periods
r is t he required rat e at which we shall discount t he cash f lows.


14
I t is expect ed t hat all readers are f amiliar wit h t he f irst principles of t ime value of
money. Those who require a primer on t he subj ect may ref er t o any st andard t ext on
Finance.
15
I n t he bond market s, t he annual rat es are simply divided by t wo t o arrive at t he semi -
annual rat es. Ef f ect ive semi- annual rat es can vary, if we considered t he impact of re-
invest ing t he six mont hly coupon unt il t he end of t he year.

126
I t is import ant t o see t hat t he value of t he bond depends crucially on t he required rat e.
Higher t he rat e at which we discount t he cash f lows, lower t he value of t he bond. I n
ot her words, t he required rat e and t he value are inversely relat ed. This is an import ant
principle in bond analyt ics and we shall ret urn t o t his principle in some det ail lat er in t he
workbook. Since t he required rat e is t he rat e at which we are discount ing t he cash
f lows, given t he same level of cash f lows ( same coupons) , higher t he rat e at which cash
f lows are discount ed, lower t he present value of t he bond. I t is also import ant t hat we
use an appropriat e rat e in t he discount ing process. We shall examine t his issue also in
some det ail in lat er part s of t he workbook.

Tabl e 13. 1: Val u e of a 11. 75% bon d w i t h 8 year s t o r edempt i on at par
Semi - an n u al
per i od
Cash f l ow
( Rs. )
Pr esen t val u e af t er di scou n t i n g @ 6%
( Rs. )
1 5. 875 5. 542
2 5. 875 5. 229
3 5. 875 4. 933
4 5. 875 4. 654
5 5. 875 4. 390
6 5. 875 4. 142
7 5. 875 3. 907
8 5. 875 3. 686
9 5. 875 3. 477
10 5. 875 3. 281
11 5. 875 3. 095
12 5. 875 2. 920
13 5. 875 2. 754
14 5. 875 2. 599
15 5. 875 2. 451
16 105. 875 41. 677

Val u e of t h e
bon d 98. 737

13. 2 Ti me Pat h of a Bon d

Consider a 12. 5% Cent ral Government bond mat uring on March 23, 2004, selling at a
required yield of 9. 7% on February 5, 2001 f or Rs. 106. 89. I f t he required yield does
not change, t here would st ill be a change in it s value and as t his bond moves t owards
mat urit y, t he value will converge t o t he redempt ion value of Rs. 100.
Let us put f ort h t he generalisat ions t hat we know f rom t he bond value equat ion, all of
which arise f rom t he inverse relat ionship bet ween required yield and t he value of t he
bond:
a. I f t he required yield on a bond is equal t o it s coupon, t he bond will sell at par.
b. The price of a bond will be higher t han t he redempt ion value, if t he required yield is
lower t han t he coupon rat e. This is because coupons earned at a higher rat e are
being discount ed at a lower rat e. We may also underst and t he premium in t he price
of t he bond, as arising f rom higher demand f or a bond wit h coupons t hat are higher

127
t han t he prevalent market rat es. Such a bond which sells at a price higher t han t he
redempt ion value is called a premium bond.
c. The price of a bond will be lower t han t he redempt ion value, if t he required yield is
higher t han t he coupon rat e. This is because coupons earned at a lower rat e are
being discount ed at a higher rat e. These bonds sell at a discount because buyers
have t he opt ion of seeking higher rat e bonds when required rat es go up, rat her t han
buy int o a lower coupon bond. Such a bond is called a discount bond.
We illust rat e t he t ime pat h of t his bond at t his required rat e and f ew ot hers assumed
required rat es in Table 13. 2.


Tabl e 13. 2: Ti me pat h of 12. 5% 2004 Bon d
Requ i r ed r at e ( % ) Dat e
9. 7 10. 5 13 13. 5
05- Feb- 01 107. 384 105. 194 98. 707 97. 472
06- May- 01 106. 866 104. 834 98. 794 97. 640
04- Aug- 01 106. 349 104. 472 98. 874 97. 801
02- Nov- 01 105. 827 104. 108 98. 966 97. 978
31- Jan- 02 105. 276 103. 720 99. 049 98. 148
01- May- 02 104. 717 103. 330 99. 151 98. 342
30- Jul- 02 104. 139 102. 922 99. 238 98. 523
28- Oct - 02 103. 569 102. 522 99. 346 98. 728
26- Jan- 03 102. 967 102. 095 99. 435 98. 915
26- Apr- 03 102. 358 101. 667 99. 555 99. 141
25- Jul- 03 101. 720 101. 211 99. 650 99. 342
23- Oct - 03 101. 081 100. 755 99. 749 99. 550
21- Jan- 04 100. 407 100. 266 99. 826 99. 739
23- Mar - 04 100 100 100 100

We have illust rat ed in Table 13. 2, t hat t he value of a bond whet her premium or
discount , would t end t o redempt ion value as it nears mat urit y. The dat es have been
chosen at int ervals of 90 days and t he required yields have been chosen t o illust rat e t he
t ime pat h of bot h discount and premium bonds.
Theref ore, value of a bond will change over t ime, even if required rat es do not change.
This is an import ant propert y of bond values.

13. 3 Val u i n g a Bon d at An y Poi n t on t h e Ti me Scal e

I n t he simple example where we applied t he principles of discount ing, we discount ed t he
cash f lows of t he bond, on t he dat e of issue of t he bond. I f we valued t he bond, say on
t he f irst coupon dat e, we would consider all t he cash f lows f rom t hat t ime point unt il
mat urit y of t he bond. Such valuat ion is a simple exercise because, we need t o discount
cash f lows f or a t ime period t hat culminat es int o a cash f low dat e. The valuat ion
exercise can consider rounded semi annual periods ( t he n in t he equat ion) .
I n realit y, we need t o be able t o value a bond on any dat e f rom t he dat e of it s issue
( t his dat e is called t he valuat ion dat e, or set t lement dat e f or t he bond) . We should be
able t o discount t he expect ed cash f lows t o t he valuat ion dat e, exact ly measuring t he
f ract ional period of t ime on t he t ime scale. Theref ore t he n in t he bond equat ion should

128
be equal t o t he act ual dist ance, which is seldom a round number. Comput ing t his
dist ance f or t he purpose of valuing a bond depends on t he day count convent ion in t he
bond market s.
I n order t o value a bond accurat ely we need t o know t he act ual dat es on which coupons
will be paid, t he number of days bet ween t wo coupon periods and t he dist ance of t he
act ual valuat ion dat e f rom t he previous and t he next coupon. All of t his depends on t he
market convent ion used, f or count ing t he days on t he t ime line, which is also called t he
day count convent ion. There are 5 popular day count convent ions:
a. 30/ 360: This convent ion considers each mont h, including February, as
having 30 days and t he year as consist ing of 360 days. There are 2
variat ions t o t his convent ion: US NASD convent ion and t he European
30/ 360 convent ion. The 30/ 360 convent ion is used in t he t reasury bond
market s in many count ries. I ndian t reasury market s use t he European
30/ 360 day count convent ion.
b. Act ual/ 360: This convent ion count s t he act ual number of days in a mont h,
but uses 360 as t he number of days in t he year.
c. Act ual/ act ual: This convent ion uses t he act ual number of days in t he
mont h and t he act ual number of days in t he year, 366, f or a leap year.
d. Act ual/ 365: This convent ion uses t he act ual number of days in a mont h
and365 days as t he days in t he year.

For example consider t he period January 2, 2001 t o June 30, 2001. The number of
days in t his period and t he period in t erms of years can vary depending on t he day count
convent ion, as can be seen in Table 13. 3.

Tabl e 13. 3: Days i n t h e per i od Jan 2 Ju n e 30, 2001
Day cou n t
con ven t i on
Nu mber of days
i n t h e per i od
Nu mber of days
i n t h e year
Nu mber of days
as a year f r act i on
30/ 360 178 360 0. 494444
Act ual/ act ual 179 365 0. 490411
Act ual/ 360 179 360 0. 497222
Act ual/ 365 179 365 0. 490411

I f we have t o value a bond on any dat e ot her t han t he coupon dat e, we have t o use t he
appropriat e day count convent ion t o measure t he n in t he bond valuat ion equat ion. I n
t he general f orm, we did not care about t he act ual dat e of mat urit y of t he bond, since
we measured t ime periods as rounded half - years. For real-lif e bond valuat ion, we have
t o know t he set t lement dat e, as well as t he act ual dat e of mat urit y, so t hat , using t he
appropriat e day count convent ion, we can discount t he cash f lows f or t he act ual t ime
dist ance t hat is involved.
Table 13. 4 provides t he dat a using t he coupon f unct ions of Excel, f or an illust rat ive
sample of 4 t reasury bonds, using t he 30/ 360 day count convent ion.

Box 13. 1: Cou pon s an d Cou pon days
I n order t o f ind t he expect ed f ut ure cash f lows f rom a bond, t he dat es on which t hese
cash f lows are expect ed and t he dist ances f rom t he set t lement dat es, we can use t he

129
coupon f unct ions in Excel. The f ollowing are t he coupon f unct ions t hat are commonly
used:
a. Coupnum: number of coupons payable bet ween t he set t lement dat e and t he
mat urit y dat e.
b. Coupdays: number of days in t he coupon period, cont aining t he set t lement dat e
c. Coupdaybs: number of days f rom beginning of t he coupon period t o t he set t lement
dat e
d. Coupdaysnc: number of days f rom t he set t lement dat e t o t he next coupon dat e
I n all t hese cases, we need t o specif y t he set t lement dat e, mat urit y dat e, f requency of
coupon payment s per annum and t he day count convent ion ( also called basis) . We can
use t he yearf rac f unct ion t o convert t he number of days int o f ract ional years. ( See Box
1. 1)






Tabl e 13. 4: Cou pon days f or set t l emen t dat e Febr u ar y 5, 2001
Name of t h e
Secu r i t y
Mat u r i t y
Dat e
Nu mber of
cou pon s
u n t i l
mat u r i t y
Nu mber of
days i n t h e
cou pon
per i od
Nu mber of
days f r om
pr evi ou s
cou pon
t o
set t l emen t
Nu mber of
days f r om
set t l emen t
t o n ex t
cou pon
CG 12. 5%
2004
23- Mar- 04 7 180 132 48
CG 11. 68%
2006
10- Apr- 06 11 180 115 65
CG 11. 5%
2008
23- May- 08 15 180 72 108
CG 11. 3 %
2010
28- Jul- 10 19 180 7 173

I n order t o value a bond, on a set t lement dat e t hat is not a coupon dat e, we have t o re-
cast t he bond valuat ion equat ion 13. 1, as f ollows:

)] / ( ) 1 [( )] / ( 1 [
2
) / (
1
0
) 1 (
.........
) 1 ( ) 1 (
dicp dnc n
n
dicp dnc dicp dnc
r
c
r
c
r
c
P
+ +
+ +
+
+
( 13. 2)

Where c1, c2 . . cn are expect ed cash f lows f rom t he bond. Given t he redempt ion value,
coupon rat e and f requency of coupons, we can comput e t hese cash f lows.
dnc is t he number of days t o t he next coupon
dicp is t he days in t he coupon period


130
Since t he f irst cash f low c1, is only dnc/ dicp periods away f rom t he set t lement dat e, we
discount it only f or t hat period. For t he subsequent cashf lows, we can generalise t he
period f or which discount ing is t o be done, as [ ( n- 1) + dnc/ dicp] . We can use t he
price f unct ion in Excel, in order t o use equat ion 13. 2 in act ual valuat ion of a bond.
Alt ernat ively, we can use t he coupon f unct ions t o f ind out t he values in equat ion 13. 2
and value t he bond using t he PV f unct ion.

The value of t he same bond, by merely varying t he day count convent ion ( change t he
basis in Excel t o 1, 2 and 3) can vary t o Rs. 99. 0136, Rs. 99. 0143 ands. 99. 0134
respect ively.
Using Excel, readers can check t he impact of changes in t he day count convent ion and
t he f requency of coupon payment s on t he value of t he bond. Are t here any
generalisat ions here?

131

Box 13. 2: Pr i ce f u n ct i on
The price f unct ion in Excel will comput e t he price of a bond, given t he f ollowing:
Set t lement : t he dat e on which t he bond is sought t o be valued
Mat urit y: t he dat e on which t he bond mat ures
Rat e: t he rat e at which coupon is paid
Yld: t he required rat e f or valuat ion
Redempt ion: t he redempt ion value of t he bond
Frequency: number of coupons per year
Basis: day count convent ion t o be used.
On providing t hese input s, Excel comput es t he cash f lows f rom t he coupon rat e and
redempt ion values, t he t ime as t he dist ance bet ween set t lement dat e and each of t he
cash f lows, given t he day count convent ion specif ied in t he basis and discount s t he cash
f lows t o t he set t lement dat e, using t he specif ied required rat e. Bot h set t lement and
mat urit y will have t o be f ormat t ed as dat e f ields. Yield and coupon have t o be provided
as rat es. The numbers 0 4 are used f or t he various day count convent ions. Use t he
f unct ion as = price( set t lement , mat urit y, rat e, yld, redempt ion, f requency, basis)
For example, in order t o value t he 11. 75% 2006 bond, mat uring on April 16, 2006, on
February 5, 2001, using t he day count convent ion of 30/ 360 and t he required yield of
12%, we shall st at e
= price ( 16/ 04/ 2006, 02/ 02/ 2001, 0. 1175, 0. 12, 100, 2, 4)
= Rs. 99. 0125

13. 4 Accr u ed I n t er est

The discount ing of expect ed f ut ure cash f lows t o t he present provides a valuat ion f or t he
bond, which denot es t he price at which a bond can be bought or sold, provided buyer
and seller agree on t he price based on such value ( whet her t hey will do so depends on
t heir view of t he required rat e among ot her t hings) . We will proceed on t he assumpt ion
t hat t he required yield represent s t he market and t hat t here would be buyers and
sellers at t his f air value. I f a t ransact ion t akes place at t he value det ermined by t he
bond equat ion, t he buyer pays f or all t he f ut ure cash f lows occurring af t er t he dat e of
set t lement , discount ed unt il t he set t lement dat e, in ret urn f or receiving all t hose cash
f lows.
However, if t he set t lement occurs at a dat e, which is not a coupon dat e, as can most ly
be t he case, t he t ransact ion t akes place on a dat e t hat f alls bet ween t wo coupon dat es.
This would mean t hat t he seller has held t he bond f or a period beginning f rom t he
previous coupon, t o t he set t lement dat e and is eligible t o receive a part of t he next
coupon, in proport ion t o his holding period. The seller on t he ot her hand, holds t he
bond only f or t he period beginning t he set t lement dat e, but receives t he next coupon
ent irely, having bought t he bond.
Theref ore in t he bond market s, int erest on a bond is not account ed on t he coupon dat e,
but is accrued on an everyday basis. On every t ransact ion in t he market s, t he buyer
has t o pay t he seller, a part of t he coupon he would receive lat er, t o compensat e t he
seller f or holding t he bond f or t he f ract ion of t he coupon period. This cash f low t hat is
paid t o t he seller is called accrued int erest ands comput ed as f ollows:


132
1
]
1

dicp
dflc
c AI . . . ( 13. 3)

Where df lc represent s days f rom t he last coupon and dicp represent s t he days in t he
coupon period and is t he coupon payment . We know t hat bot h t hese values depend on
t he day count convent ion and can be f ound wit h t he help of t he coupon f unct ions in
Excel.
Let us consider t he bonds in Table 13. 5. We can comput e t he accrued int erest f or t hese
bonds using t he dat a f or coupons ( provided in column 1) , given t he set t lement dat e of
February 5, 2001. The accrued int erest is t he amount of coupons t hat are due t o t he
seller, having held t he bond f rom t he previous coupon dat e unt il t he set t lement dat e.
I f t he price of t he bond includes accrued int erest , it is called as t he dirt y price or full
price of t he bond. Price t hat excludes accrued int erest is called clean price. I n most
market s t he convent ion is t o quot e t he clean price, t hough t he buyers always pay t he
seller t he clean price and t he accrued int erest , t hat is t he dirt y price. I t is import ant t o
remember t hat t he price f unct ion in Excel provides t he clean price of t he bond.

Tabl e 13. 5: Accr u ed I n t er est on Set t l emen t Dat e Febr u ar y 5, 2001
Secu r i t y Semi - an n u al
Cou pon ( Rs. )
Mat u r i t y Days si n ce l ast
cou pon / Days
i n t h e cou pon
per i od
Accr u ed
I n t er est
( Rs. )
CG 12. 5 %2004 6. 25 23- Mar- 04 0. 7333 4. 5833
CG 11. 68%
2006
5. 84 10- Apr- 06 0. 6389 3. 7311
CG 11. 5% 2008 5. 75 23- May- 08 0. 4000 2. 3000
CG 11. 3% 2010 5. 65 28- Jul- 10 0. 0389 0. 2197
CG 11. 03 %
2012
5. 515 18- Jul- 12 0. 0944 0. 5209

13. 5 Yi el d

The ret urns t o an invest or in bond is made up of t hree component s: coupon, int erest
f rom re- invest ment of coupons and capit al gains/ loss f rom selling or redeeming t he
bond. When we are able t o compare t he cash inf lows f rom t hese sources wit h t he
invest ment ( cash out f lows) of t he invest or, we can comput e yield t o t he invest or.
Depending on t he manner in which we t reat t he t ime value of cash f lows and re-
invest ment of coupons, we are able t o get various int erpret at ions of t he yield on an
invest ment in bonds.

13. 5. 1 Cu r r en t Yi el d

One of t he earlier measures on yield on a bond, current yield was a very popular
measure of bond ret urns in t he I ndian market s, unt il t he early 1990s. Current yield is
measured as
= Annual coupon receipt s/ Market price of t he bond

133
This measure of yield does not consider t he t ime value of money, or t he complet e series
of expect ed f ut ure cash f lows. I t inst ead compares t he coupon, as pre- specif ied, wit h
t he market price at a point in t ime, t o arrive at a measure of yield. Since it compares a
pre- specif ied coupon wit h t he current market price, it is called as current yield.
For example, if a 12. 5% bond sells in t he market f or Rs. 104. 50, current yield will be
comput ed as
= ( 12. 5/ 104. 5) * 100
= 11. 96%
Current yield is no longer used as a st andard yield measure, because it f ails t o capt ure
t he f ut ure cash f lows, re- invest ment income and capit al gains/ losses on invest ment
ret urn. Current yield is considered a very simplist ic and erroneous measure of yield.

13. 5. 2 Yi el d t o Mat u r i t y ( YTM)

I n t he previous sect ion on bond valuat ion, we used equat ion 13. 1 t o show t hat t he value
of a bond is t he discount ed present value of t he expect ed f ut ure cash f lows of t he bond.
We solved t he equat ion t o det ermine a value, given an assumed required rat e. I f we
inst ead solve t he equat ion f or t he required rat e, given t he price of t he bond, we would
get an yield measure, which is knows as t he YTM or yield t o mat urit y of a bond. That is,
given a pre- specif ied set of cash f lows and a price, t he YTM of a bond is t hat rat e which
equat es t he discount ed value of t he f ut ure cash f lows t o t he present price of t he bond.
I t is t he int ernal rat e of ret urn of t he valuat ion equat ion.
For example, if we f ind t hat a 11. 99% 2009 bond is being issued at a price of Rs. 108,
( f or t he sake of simplicit y we will begin wit h t he valuat ion on a cash f low dat e) , we can
st at e t hat ,

18 2
) 1 (
995 . 105
.. ..........
) 1 (
995 . 5
) 1 (
995 . 5
108
r r r +
+
+
+
+


This equat ion only st at es t he well known bond valuat ion principle t hat t he value of a
bond will have t o be equal t o t he discount ed value of t he expect ed f ut ure cash f lows,
which are t he 18 semi- annual coupons of Rs. 5. 995 each and t he redempt ion of t he
principal of Rs. 100, at t he end of t he 9
t h
year. That value of r which solves t his
equat ion is t he YTM of t he bond. We can f ind t he value of r in t he above equat ion using
t he I RR f unct ion in Excel
16
. The value of r t hat solves t he above equat ion can be f ound
t o be 5. 29%, which is t he semi - annual rat e. The YTM of t he bond is 10. 58%.
However, as we have already not ed in t he sect ion on valuat ion, we should be able t o
comput e price and yield f or a bond, at any given point of t ime. We t heref ore have t o be
able t o comput e t he yield by plot t ing t he cash f lows accurat ely on t he t ime line ( using
t he appropriat e day count convent ion) and calculat e YTM, given t he price at any point on

16
I RR can be comput ed by list ing t he cashf lows in a single column, wit h init ial out f low
st at ed as a negat ive number, say b2: b20 and using f ormula = I RR ( b2: b20) .

134
t he t ime line. We have t o adopt a procedure very similar t o t he one we used f or bond
valuat ion
17
and we can use t he yield f unct ion in Excel t o comput e t he YTM f or a bond.
Yield t o mat urit y represent s t he yield on t he bond, provided t he bond is held t o mat urit y
and t he int ermit t ent coupons are re- invest ed at t he same YTM rat e. I n ot her words,
when we comput e YTM as t he rat e t hat discount s all t he cash f lows f rom t he bond, at
t he same YTM rat e, what we are assuming in ef f ect is t hat each of t hese cash f lows can
be re- invest ed at t he YTM rat e f or t he period unt il mat urit y.
Let us illust rat e t his limit at ion of YTM wit h an example. Suppose an invest or buys t he
11. 75% 2006 bond at Rs. 106. 84. The YTM of t he bond on t his dat e is 10. 013%.
Consider t he inf ormat ion about t he cash f lows of t he 11. 75% 2006 bond in Table 13. 6.
I t is seen t hat cash f lows f rom coupon and redempt ion are Rs. 164. 625, if t he bond is
held t o mat urit y. However, t he act ual yield on t he bond depends on t he rat es at which
t he coupons can be re- invest ed. The YTM of 10. 02 is also t he act ual ret urn on t he bond,
at mat urit y, only if all coupons can be re- invest ed at 10. 02%. I f t he act ual rat es of re-
invest ment of t he bond are dif f erent , as in columns 5 and 7 in Table 13. 6, as is most ly
t he case, t he act ual yield on t he bond could be dif f erent .

Box 13. 3: Usi n g t h e Yi el d Fu n ct i on
The yield f unct ion in Excel will comput e t he yield of a bond, given t he f ollowing:
Set t lement : t he dat e on which t he yield is sought t o be comput ed
Mat urit y: t he dat e on which t he bond mat ures
Rat e: t he rat e at which coupon is paid
Price: t he market price of t he bond
Redempt ion: t he redempt ion value of t he bond
Frequency: number of coupons per year
Basis: Day count convent ion t o be used ( represent ed by numbers 0- 4)
On providing t hese input s, Excel comput es t he cash f lows f rom t he coupon rat e and
redempt ion values, t he t ime as t he dist ance bet ween set t lement dat e and each of t he
cash f lows, given t he day count convent ion specif ied in t he basis and f ind by t rial and
error, t he rat e t hat equat es t he f ut ure t he cash f lows t o t he price on t he set t lement
dat e.
Use t he f unct ion as = yield( set t lement , mat urit y, rat e, price, redempt ion, f requency,
basis)
For example, in order t o value t he 11. 75% 2006 bond, mat uring on April 16, 2006, on
February 2, 2001, using t he day count convent ion of 30/ 360, at price of Rs. 106. 84, we
shall st at e t he f ollowing:
= yield( 16/ 04/ 2006, 02/ 02/ 2001, 0. 1175, 106. 84, 100, 2, 0)
Excel will ret urn a yield of 10. 002%, which is t he YTM of t he bond.

13. 5. 3 Yi el d t o Mat u r i t y of a Zer o Cou pon Bon d

I n t he case of a zero coupon bond, since t here are no int ermit t ent cash f lows in t he f orm
of coupon payment s, t he YTM is t he rat e t hat equat es t he present value of t he mat urit y

17
Readers who have skipped t he earlier discussion are ref erred t o sect ion 13. 3 on
valuat ion of bonds.

135
or redempt ion value of t he bond t o t he current market price, over t he dist ance in t ime
equal t o t he set t lement and mat urit y dat es. For example, if a zero coupon bond sells at
Rs. 93. 76 on February 5, 2001 and mat ures on January 1, 2002, it s YTM is comput ed as

) 365 / 330 (
) 1 (
100
76 . 93
ytm +

= 7. 39%
I n t he case of zero coupon bond, int erest is accrued on an everyday basis unt il mat urit y,
at t his discount ing rat e.

136

Tabl e 13. 6: Wh y YTM i s n ot ear n ed even i f a Bon d i s h el d t o Mat u r i t y
Case- I Case- I I Days t o
mat u r i t y
Cash
f l ow
dat e
Cash
f l ow
Fu t u r e
val u e i f
r e-
i n vest e
d at
YTM of
10. 02%
Assu me
d
r e-
i n vest
men t
r at es
Re-
i n vest
men t
r et u r n s

Assu me
d r e-
i n vest
men t
r at es
Re-
i n vest
men t
r et u r n
s
1800 16- Apr- 01 5. 875 7. 5022 10. 25 9. 5698 9. 25 9. 1436
1620 16- Oct - 01 5. 875 7. 3210 10. 00 9. 0214 9. 00 8. 6582
1440 16- Apr- 02 5. 875 7. 1442 9. 75 8. 5237 8. 75 8. 2172
1260 16- Oct - 02 5. 875 6. 9717 9. 50 8. 0716 8. 50 7. 8165
1080 16- Apr- 03 5. 875 6. 8033 9. 25 7. 6608 8. 25 7. 4523
900 16- Oct - 03 5. 875 6. 6389 9. 00 7. 2874 8. 00 7. 1214
720 16- Apr- 04 5. 875 6. 4786 8. 75 6. 9481 7. 75 6. 8209
540 16- Oct - 04 5. 875 6. 3221 8. 50 6. 6398 7. 50 6. 5482
360 16- Apr- 05 5. 875 6. 1694 8. 25 6. 3597 7. 25 6. 3009
180 16- Oct - 05 5. 875 6. 0204 8. 00 6. 1055 7. 00 6. 0771
0 16- Apr- 06 105. 875 105. 8750 7. 75 105. 8750 6. 75 105. 8750
Al t er n at e
Val u es 164. 625 173. 2469 182. 0626
180. 031
4

13. 5. 4 Usi n g t h e Zer o- Cou pon Yi el d f or Bon d Val u at i on

I f int erest rat es are a f unct ion of t ime t o mat urit y, t hen valuat ion of a bond, using t he
same YTM rat e, can lead t o erroneous result s, as we saw in t he pervious sect ion. I n
ot her words, t he YTM of a zero coupon bond is a pure int erest rat e f or t he t enor of t he
bond. I n all t he ot her cases, if we used a YTM rat e f or valuat ion, we have assumed t hat
a single rat e, equivalent t o t he YTM, exist s f or all t he t ime periods f or which coupons
have t o be invest ed. Theref ore, t he appropriat e rat es f or various t enors will have t o be
used t o value cash f lows f or t hat t enor. We call such a valuat ion as t he zero coupon
yield based valuat ion. I n t he next chapt er, we shall discuss t he met hodology used f or
est imat ing t he zero coupon yield curve ( ZCYC) . I n t his sect ion, we shall see how t he
valuat ion of a bond changes if we use t he ZCYC f or valuat ion. The equat ion we use will
be


Consider t he 12. 5% 2004 bond, whose cash f lows are in Table 13. 7.
The valuat ion in Table 13. 7 uses a dif f erent rat e f or each of t he cash f lows. I n t he next
chapt er on yield, we shall see how t he appropriat e ZCYC rat e is est imat ed. The NSE
est imat es t he ZCYC f rom market prices and enables t he comput at ion of appropriat e
discount rat es, used in t he t able.
) 4 . 13 .....( .......... ..........
) 1 (
......
) 1 ( ) 1 (
2
2 1
m
m
r
R C
r
C
r
C
PV
+
+
+ +
+
+
+


137
Tabl e 13. 7: Usi n g t h e ZCYC f or val u at i on of bon ds
Cou pon
dat es
Cash
f l ow s
( Rs. )
Di st an ce i n
year s f r om
set t l emen t dat e
Appr opr i at e
ZCYC r at e
Pr esen t val u e
of t h e
cash f l ow ( Rs. )
23- Mar- 01 6. 25 0. 13611 9. 6148 6. 168741
23- Sep- 01 6. 25 0. 64722 9. 5108 5. 876878
23- Mar- 02 6. 25 1. 15000 9. 4519 5. 606264
23- Sep- 02 6. 25 1. 66111 9. 4272 5. 344058
23- Mar- 03 6. 25 2. 16389 9. 4302 5. 096338
23- Sep- 03 6. 25 2. 67500 9. 4548 4. 853332
23- Mar- 04 106. 25 3. 18056 9. 4956 78. 55363
Val u e of t h e bon d 111. 4992

13. 5. 5 Bon d Equ i val en t Yi el d

I n all t he examples which we have seen so f ar, we have det ermined t he semi- annual
coupon f rom t he annual coupon, by simply dividing t he annual coupon by 2. We have
comput ed t he semi- annual yield f or t he purpose of det ermining t he price, by similarly
dividing t he annual yield by 2. I f cash f lows are compounded mult iple t imes during a
year, t he ef f ect ive rat es are not t he annual rat e divided by t he number of compounding
periods. This is because, int ermit t ent cash f lows can be re- deployed, at prevailing rat es,
t o arrive at an ef f ect ive annual rat e.
For example, if annual yield is 11. 75%, t he semi- annual yield is simply t aken as
11. 75/ 2, which is 5. 875%. However, if t he six mont hly coupon is re- invest ed at
5. 875%, t he ef f ect ive annual yield will be higher t han 11. 75%, at 12. 095%. I n ot her
words, semi- annual yields should be annualised, by incorporat ing t he ef f ect of t he re-
invest ment , as f ollows:

Ef f ect ive Annual yield = ( 1+ Periodic int erest rat e)
k
1

where k is t he number of payment s in a year. This f ormula can be used t o comput e
ef f ect ive yields f or any number of compounding periods in a year.
I n t he above example,

Ef f ect ive annual yield = { ( 1+ 0. 05875)
2
} - 1

= 12. 095%

Though it is well known t hat semi- annual yields are t heref ore not half t he annual yields,
in most bond market s, t he convent ion is t o simply divide t he annual yield by 2, t o get
t he semi- annual yield. The semi- annual yield t hus simplist ically comput ed is called t he
Bond Equivalent Yield ( BEY) . Given t he f ormula above, bond equivalent yield is

= ( 1+ ef f ect ive yield)
1/ k
- 1

Using t he numbers f rom t he same example,
BEY = ( 1+ . 12095)
1/ 2
1

138
= 5. 875%

I n t he yield calculat ions f or most f ixed income securit ies, unless ot herwise st at ed, it is
t he bond- equivalent - yield t hat is used.

13. 6 Wei gh t ed Yi el d

When bonds are t raded at dif f erent prices during a day, t he yield f or t he day is usually
report ed as t he weight ed yields, t he weight s being t he market value of t he t rades ( price
t imes quant it ies t raded) . For example, assume t hat t he t rades in CG11. 3% 2010 are as
in Table 13. 8. The weight ed yield is comput ed using market values f or each t rade as
t he weight age.

Tabl e 13. 8: Wei gh t ed Yi el d
Qu an t i t y Pr i ce
( Rs. )
Mar k et Val u e
( Rs. )
YTM ( % ) YTM as Pr opor t i on of
mar k et val u e
10000 105. 23 1052300 10. 4177 1. 4925
2500 105. 45 263625 10. 3820 0. 3726
4000 105. 47 421880 10. 3787 0. 5961
6500 105. 50 685750 10. 3739 0. 9685
9000 105. 63 950670 10. 3528 1. 3399
8500 105. 71 898535 10. 3399 1. 2649
12000 105. 8 1269600 10. 3253 1. 7847
6000 105. 95 635700 10. 3011 0. 8915
5500 106. 00 583000 10. 2931 0. 8170
3500 106. 20 371700 10. 2609 0. 5192
2000 106. 25 212500 10. 2528 0. 2966

Tot al
Val u e 7345260 Wei gh t ed Yi el d 10. 3435

13. 7 YTM of a Por t f ol i o

YTM of a port f olio is not comput ed as t he average or weight ed average of t he YTMs of
t he bonds in t he port f olio. We are able t o comput e weight ed yields only when t he cash
f lows of t he bonds under quest ion are t he same, as was t he case in weight ed yields. I n
a port f olio of bonds, each bond would have a dif f erent cash f low composit ion and
t heref ore, using a weight ed yield would provide erroneous result s. We t heref ore f ind
t he YTM of t he port f olio as t hat rat e which equat es t he expect ed cash f lows of t he bonds
in t he port f olio, wit h t he market value of t he port f olio. Consider f or example, a
port f olio of bonds as in Table 13. 9.

139
Tabl e 13. 9: YTM of a por t f ol i o: Sampl e Bon ds
Bon d Mat u r i t y
Dat e
Nu mber of
Bon ds
Pr i ce as
on Feb 5,
2001 ( Rs. )
Mar k et Val u e
( Rs. )
CG 11. 75 2001 25/ 08/ 01 20000 101. 1 2022000
CG 11. 68 2002 6/ 08/ 02 25000 102. 915 2572875
CG 12. 5 2004 23/ 03/ 04 32000 107. 48 3439360
Tot al 8034235

Box 13. 4: XI RR Fu n ct i on
The XI RR f unct ion comput es t he I RR ( equivalent t o YTM in our case) f or a series of cash
f lows, occurring at dif f erent point s in t ime, when we provide t he dat es and t he cash
f lows. The f unct ion requires { values, dat es, guess} . The values have t o be in a column,
wit h t he init ial cash out f low shown as a negat ive number. I n t he above example, t he
market value on February 05, Rs. 80, 34, 235 is t o be shown as a negat ive value. The
dat es on which t he cash inf lows occur are shown in a corresponding column.
When we use t he f unct ion as, f or inst ance,
= XI RR ( b2: b14, c2: c14) we get t he result 0. 13145, which is 13. 145%. We have t o
remember however, t hat t he XI RR f unct ion support s only t he act ual/ 365 day count
convent ion. We use t his f unct ion as an approximat ion, because f inding t he YTM is an
it erat ive t rial and error process, which can be complex ot herwise.

The cash f lows f rom t hese bonds accrue on dif f erent dat es, as t hese bonds have
dif f erent dat es t o mat urit y. Table 13. 10 shows t he dat es and t he cash f lows f or t hese
bonds and given t he quant it y of bonds held, t he t ot al cash f lows f rom t his port f olio, on
t he given dat es. The yield t o mat urit y of t his port f olio is t hat rat e which equat es t his
series of cash f lows in column 3 of t able 13. 9, t o t he market value on t able 13. 8, as on
February 5, 2001. We can f ind t he YTM by using t he XI RR f unct ion in Excel.

Tabl e 13. 10: Por t f ol i o Cash Fl ow s
Dat e
Cash f l ow
per bon d
Tot al
cash f l ow s
25- Feb- 01 5. 875 117500
25- Aug- 01 105. 875 2117500
6- Feb- 01 5. 84 146000
6- Aug- 01 5. 84 146000
6- Feb- 02 5. 84 146000
6- Aug- 02 105. 84 2646000
23- Mar- 01 6. 25 200000
23- Sep- 01 6. 25 200000
23- Mar- 02 6. 25 200000
23- Sep- 02 6. 25 200000
23- Mar- 03 6. 25 200000
23- Sep- 03 6. 25 200000
23- Mar- 04 106. 25 3400000
YTM 13. 145%


140
13. 8 Real i sed Yi el d

The act ual yield realised by t he invest or in a bond, over a given holding period, is called
realised yield. Realised yield represent s t he horizon ret urn t o t he invest or, f rom all t he
t hree component s of bond ret urn, namely, coupon, ret urn f rom re- invest ment of coupon
and capit al gain/ loss f rom selling t he bond at t he end of t he holding period. The realised
yield t o t he invest or is t he rat e which equat es cash f lows f rom all t hese t hree sources, t o
t he init ial cash out f low. Realised yield is also called t ot al ret urn f rom a bond.
Depending upon t he reinvest ment rat es available t o t he invest or and t he yields which
prevail at t he end of t he holding period, t he invest ors realized yield f rom holding a
bond can vary. For example, consider t he 12. 5% 2004 bond. The realized yield on a 1-
year horizon based on a set of assumpt ions about re- invest ment rat es and YTM at t he
end of t he holding period, are as f ollows:

Purchase price of t he bond on 23 March 2001 Rs. 107. 42 ( YTM 9. 6%)
Coupons received: 2 Semi- annual Rs. 12. 50
Reinvest ment of 1
st
coupon f or 1 year @ 7. 5% Rs. 6. 7185
Reinvest ment of 2
nd
coupon f or 6 mont hs @ 7% Rs. 6. 4651
Sale of bond at t he end of 1 year @ 7. 8% yield Rs. 108. 5
Coupon income f rom t he bond f or 1 year Rs. 12. 5
I ncome f rom coupon re- invest ment Re. 0. 6838
Capit al gain on sale Rs. 1. 08
Tot al cash f lows f rom t he bond Rs. 14. 26
Tot al r et u r n f or 1 year h ol di n g per i od 14. 26/ 107. 42
= 13. 2785%

The t ot al ret urn t o t he invest or is at t ribut able t o all t he t hree sources of income and
depends on t he re- invest ment rat e and t he sale price. An increase in int erest rat es will
enhance t he reinvest ment income of t he invest or, while reducing t he capit al gains; a
decrease in int erest rat es will generat e capit al gains, while reducing t he re- invest ment
income of t he invest or. The invest ment horizon will also impact t he percent age
composit ion of each of t hese component s t o t he t ot al ret urn of t he invest or. Holding
t he bond over a longer t ime will enhance coupon component of t he ret urn and
reinvest ment , if rat es are increasing. However, t he capit al gains will drop, due t o a f all
in yield, as well as due t o t he t ime pat h ef f ect , leading t o t he bond t ending t o
redempt ion value, as it nears mat urit y.
Realised yield, or t ot al ret urn t heref ore provides t he invest or t he t ool t o analyse impact
of int erest rat es and holding period, on t he act ual ret urns earned f rom a bond.

13. 9 Yi el dPr i ce Rel at i on sh i ps of Bon ds

The basic bond valuat ion equat ion shows t hat t he yield and price are inversely relat ed.
This relat ionship is however, not unif orm f or all bonds, nor is it symmet rical f or
increases and decreases in yield, by t he same quant um.

141
Consider Figure 13. 1 which plot s t he price- yield relat ionship f or a set of bonds:

Fi gu r e 13. 1 Pr i ce Yi el d Rel at i on sh i p of Bon ds
0
20
40
60
80
100
120
140
160
180
200
0 0.05 0.1 0.15 0.2 0.25
YTM (%)
P
r
i
c
e

(

R
s
.
)


CG2001 CG2002 CG2005 CG2009 CG2013


13. 9. 1 Pr i ce Yi el d Rel at i on sh i p: Some Pr i n ci pl es

a. Price- yield relat ionship bet ween bonds is not a st raight line, but is convex. This
means t hat price changes f or yield changes are not symmet rical, f or increase
and decrease in yield.
b. The sensit ivit y of price t o changes in yield in not unif orm across bonds.
Theref ore f or a same change in yield, depending on t he kind of bond one holds,
t he changes in price will be dif f erent .
c. Higher t he t erm t o mat urit y of t he bond, great er t he price sensit ivit y. We
not ice in Figure 13. 1, t hat CG2013 has t he st eepest slope, while 2001 and 2002
are virt ually f lat . Price sensit ivit ies are higher f or longer t enor bonds, while in
t he short - t erm bond, one can expect relat ive price st abilit y f or a wide range of
changes in yield.
d. Lower t he coupon, higher t he price sensit ivit y. Ot her t hings remaining t he
same, bonds wit h higher coupon exhibit lower price sensit ivit y t han bonds wit h
higher coupons.
I n t he bond market s t heref ore, we are int erest ed in t wo key quest ions: What is t he yield
at which reinvest ment and valuat ion happens and how t he change in t his yield impact s
t he value of t he bonds held. These are t he quest ions we address in t he next t wo
chapt ers.


142
Model Quest i ons

1. A GOI secu r i t y w i t h cou pon of 11. 68% , mat u r i n g on 6- Au g- 2002, i s t o be
set t l ed on

143
1- Feb- 01. Wh at ar e t h e n u mber of days f r om t h e pr evi ou s cou pon dat e?
a. 179
b. 176
c. 178
d. 175
An sw er : d.
We use t he cou pdaybs f unct ion in Excel and specif y t he f ollowing:
Set t lement dat e: February 1, 2001
Mat urit y Dat e: August 6, 2002
Frequency: 2
Basis: 4
The answer is: 175 days

2. Wh at i s t h e accr u ed i n t er est on a 11. 68% GOI secu r i t y, mat u r i n g on 6- Au g-
2002, t r adi n g on 1- Ju n - 200 1 at a YTM of 7. 7395% ?
a. Rs. 3. 6901
b. Rs. 3. 7311
c. Rs. 3. 7105
d. Rs. 3. 7520
An sw er : b
Accrued int erest is comput ed as
Coupon payment * ( number of days f rom previous coupon/ days in t he coupon period)
We use t he cou pbs and cou pdays f unct ions t o ascert ain days f rom previous coupon
and days in t he coupon period.
The amount of coupon is Rs. 11. 68/ 2.
Theref ore, t he accrued int erest is
= 5. 84 * ( 115/ 180)
= Rs. 3. 7311

3. A 11. 68% GOI secu r i t y mat u r i n g on 6- Au g- 2002, i s bei n g pr i ced i n t h e
mar k et on 11- Ju l - 01 at Rs. 104. 34. Th e YTM of t h e bon d i s
a. 7. 3728%
b. 7. 3814%
c. 7. 3940%
d. 7. 3628%
We use t he Yi el d f unct ion in Excel, specif ying set t lement ( 11 July 2001) and mat urit y
dat es ( 6 Aug 2002) , coupon ( 0. 1168) , price of t he securit y ( 104. 34) , redempt ion ( 100)
f requency ( 2) , basis ( 4) .
The answer obt ained is 7. 3728%
An sw er : a

144
4. Th e f ol l ow i n g i s t h e descr i pt i on of bon ds h el d i n a por t f ol i o. Wh at i s t h e
por t f ol i o yi el d, u si n g t h e w ei gh t ed yi el d met h od?
Cou pon
( % p. a. )
Mat u r i t y dat e Mar k et pr i ce on Ju l y 11,
2001 ( Rs. )
Nu mber of
bon ds
11. 68 6- Aug- 2002 104. 34 5400
11. 15 1- Sep- 2002 104. 03 5560
13. 82 30- May- 2002 105. 5 5720
12. 69 10- May- 2002 104. 9 5880
11. 00 23- May- 2003 105. 74 6040

An sw er :
The yield of each of t he bonds can be comput ed using t he yield f unct ion ( see solved
example 3 above) . The market value of each bond can be comput ed as t he product of
number of bonds and market price as on July 11, 2001.
Cou pon
( % p. a. )
Mat u r i t y dat e Pr i ce ( Rs. ) Yi el d ( % ) Nu mber of
bon ds
Mar k et Val u e
( Rs. )
11. 68 6- Aug- 2002 104. 34 7. 3728% 5400 563436
11. 15 1- Sep- 2002 104. 03 7. 3770% 5560 578406. 8
13. 82 30- May- 2002 105. 5 7. 2731% 5720 603460
12. 69 10- May- 2002 104. 9 6. 5056% 5880 616812
11. 00 23- May- 2003 105. 74 7. 6309% 6040 638669. 6

The yield of t he port f olio can be f ound by weight ing each bonds yield by t he market
value of t he bond in t he port f olio. This is done as:

{ ( 7. 3728* 563436) + ( 7. 3770* 578406. 8) + ( 7. 2731* 603460) + ( 6. 5056* 616812) + ( 7. 6309
* 638669. 6) } / ( 563436+ 578406. 8+ 603460+ 616812+ 638669. 6)

We can do t he same in Excel, using t he f ormula

= sumproduct ( yield array, market value array) / sum( market value array)
The answer in bot h cases is 7. 2302%, which is t he port f olio yield.

5. On Apr i l 12, 2001, a deal er pu r ch ases a 11. 68% GOI bon d mat u r i n g on 6-
Au g- 2002 f or Rs. 104. 34. He h ol ds t h e bon d f or 1 year , an d sel l s i t on Apr i l 11,
2001, f or Rs. 100. 90. I f t h e cou pon s r ecei ved du r i n g t h e h ol di n g per i od ar e r e-
i n vest ed at 8. 2405% ( 1st cou pon ) an d 6. 7525% ( 2n d cou pon ) , w h at i s t h e
r eal i sed yi el d on t h e i n vest men t ?
An sw er :
The component s of realized yield are:
Coupon income, re- invest ment of coupons and capit al gains/ losses.

Cou pon i n come:
The number of coupons bet ween t he acquisit ion dat e and dat e of sale of t he bond can be
f ound wit h t he coupnum f unct ion. I n t his case t here are t wo coupons. Theref ore t he
coupon received is:

145
Rs. 11. 68

Re- i n vest men t I n come:
We can f ind t he f irst coupon dat e, by using t he coupncd f unct ion in Excel. We t hen
use t he Days360 f unct ion t o know t he number of days f or which t he f irst coupon will be
invest ed.
The f irst coupon is due on August 6, 2001. Since t he bond will be sold on April 11,
2002, t he number of days f or which t he coupon will be re- invest ed will be 245 days.
The int erest rat e applicable t o t his coupon, as given in t he quest ion, is 8. 2405%.
Tehref ore t he re- invest ment income can be comput ed as:

= ( 11. 68/ 2) * ( 245/ 360) * 0. 082405

= 0. 327514

Similarly, t he second coupon is due on 6
t h
Feb 2002. I t will be reinvest ed f or 65 days, at
6. 7525%. The reinvest ment income will be

= ( 11. 68/ 2) * ( 65/ 360) * 0. 067525

= 0. 071201

Capit al gain/ loss:

Rs. 100. 90 104. 34

= - 3. 44

The t ot al rupee ret urn f rom holding t he bond f or a year is

= 11. 68 + 0. 327514+ 0. 071201 3. 44

= 8. 6347

The released yield t heref ore is

= ( 8. 6347/ 104. 34) * 100

= 8. 2756%










146



Ch apt er 14

Yi el d Cu r ve an d Ter m St r u ct u r e of
I nt er est Rat es

I nt erest rat es are pure prices of t ime, and are t he discount ing f act ors used in t he
valuat ion equat ion f or bonds. I t is crucial t hat we are able t o derive t hese discount
f act ors f rom t he market such t hat t he valuat ions we do are current and accurat e. The
process of det ermining t he discount f act ors, ( which we know as t he yields or int erest
rat es) will have t o t heref ore draw f rom t he current market prices of bonds. The broad
pict ure of t he debt market can be discerned in t erms of a f unct ional relat ionship bet ween
t wo variables: t ime and int erest rat es. The f ocus of t his chapt er is t he underst anding of
t his relat ionship bet ween t ime and int erest rat es. This relat ionship not only provides
t ools f or valuat ion of bonds, but also enables ident if icat ion of arbit rage opport unit ies in
t he market and assessment market expect at ions of f ut ure int erest rat es.

14. 1 Yi el d Cu r ve: A Si mpl e Appr oach

The simplest approach t o observing t he int erest rat es in t he market , is t o draw t he yield
curve f rom t he YTM of t raded bonds. The YTMs of t raded bonds is used as an
approximat ion of t he int erest rat e f or t he given t erm t o mat urit y of t he bond. When we
obt ain a plot of t hese relat ionships bet ween YTMs and t erm t o mat urit y of a set of
t raded bonds, we can ident if y t he f unct ional relat ionship bet ween t ime and yield, by
f it t ing a curve t hrough t he plot of point s. Alt ernat ively, we can use t hese YTMs t o
est imat e yields f or any t enor, by met hods of int erpolat ion.

14. 1. 1 Yi el d Cu r ve f r om a Sampl e of Tr aded Bon ds

Consider f or example, bonds t raded on March 29, 2001 ( Table 14. 1) . From t he
observed market prices in column 5, we can comput e t he YTM of t hese bonds, using t he
yield f unct ion in Excel. The t erm t o mat urit y of t he bonds is t he dist ance in t ime
bet ween t he mat urit y dat e of t he bonds ( column 3) and t he set t lement dat e ( March 29,
2001) . The t erm t o mat urit y is shown in column 4. We can see t hat bonds wit h varying
t erms t o mat urit y have t raded at dif f erent yields, and t he general t endency is f or yields
t o increase as t he t erm increases.
I n order t o be able t o model t his relat ionship int o a f unct ion, t hat can be used f or
valuing bonds, we need t o est imat e t he relat ionship as an equat ion, so t hat given values
of t enor ( x) , we can est imat e values of yield ( y) .
This can be done by plot t ing t he t erm t o mat urit y and t he yield t o mat urit y, and f it t ing a
3
rd
degree polynomial t o describe t he f unct ional relat ionship. A t hird degree polynomial
is specif ied as f ollows:


147

it it it it it it
e x b x b x b a y + + + +
3
3
2
2 1
. . ( 14. 1)


where b1, b2 and b3 are est imat ed co- ef f icient s, given values of t erm t o mat urit y ( x) and
yield t o mat urit y ( y) .

Tabl e 14. 1: Sampl e Bon ds f or Yi el d Cu r ve
Name Cou pon
( % )
Mat u r i t y
Dat e
Ter m t o Mat u r i t y
( year s)
Pr i ce
( Rs. )
YTM
( % )
CG2001 11. 75 25- Aug- 01 0. 41 101 0. 090924
CG2002 11. 15 9- Jan- 02 0. 79 102. 75 0. 074125
CG2003 11. 1 7- Apr- 03 2. 05 103. 515 0. 091537
CG2004 12. 5 23- Mar- 04 3. 03 108. 31 0. 092473
CG2005 11. 19 12- Aug- 05 4. 44 106. 19 0. 094220
CG2006 11. 68 10- Apr- 06 5. 11 107. 58 0. 097364
CG2007 11. 9 28- May- 07 6. 25 109. 31 0. 098426
CG2008 11. 4 31- Aug- 08 7. 53 107. 6 0. 099240
CG2009 11. 99 7- Apr- 09 8. 14 109. 18 0. 102808
CG2010 11. 3 28- Jul- 10 9. 47 106. 6 0. 101823
CG 2011 12. 32 29- Jan- 11 9. 98 110. 97 0. 104987
CG2013 12. 4 20- Aug- 13 12. 58 111. 2 0. 107401

Fi g 14. 1: Yi el d Cu r ve as on Mar ch 29, 2001
y = 8E-06x
3
- 0.0003x
2
+ 0.004x + 0.0817
0
0.02
0.04
0.06
0.08
0.1
0.12
0 2 4 6 8 10 12 14
Term To Maturity ( in Years)
Y
i
e
l
d

t
o

M
a
t
u
r
i
t
y

(
%
)



148
The equat ion in Fig 14. 1 provides t he generalised relat ionship bet ween t erm t o mat urit y
and yield t o mat urit y. By f it t ing int o t he equat ion, t he t erm t o mat urit y of any given
bond, ( by subst it ut ing t he value of x) , t he corresponding YTM can be est imat ed. The
given bond can be valued by f it t ing int o it s cash f low f eat ures, t he YTM t hus derived, so
t hat value of t he bond can be comput ed.



Box 14. 1: Usi n g Ex cel t o dr aw t h e Yi el d Cu r ve
The f ollowing are t he st eps t o drawing t he yield curve using Excel:
1. Comput e yield and t erm t o mat urit y f or a set of bonds, using t he yield f unct ion,
and f inding t he dif f erence in years, bet ween set t lement dat e and mat urit y dat e
of t he bond. ( ( mat urit y dat e set t lement dat e) / 360) ) .
2. Draw an XY graph ( XY scat t er) of t hese point s, using t erm f or x values and
Yield f or Y values.
3. Choose Chart / Add t rend line/ t ype: Choose polynomial, and order 3.
4. Choose Chart / Add t rend line/ opt ions: display equat ion on t he chart .
5. Excel plot s t he graph and est imat es t he 3
rd
degree polynomial, displaying t he
equat ion of t he yield curve.

For example, we can use t he equat ion in t he yield curve above t o value t he 12. 5% 2004
bond on March 29, 2001. The bond has 3. 03 years t o mat urit y on t hat dat e, t heref ore
we plug int o t he yield curve equat ion, t his value in t he place of x, as f ollows:

Y = ( ( - 0. 000008* ( 3. 03) ^ 3) - ( 0. 0003* ( 3. 03) ^ 2) + ( 0. 004* 3. 03) + 0. 0817)

We obt ain t he value 0. 09843 as t he Y value. Since we know t he cash f lows of t his bond,
we can use t he Price f unct ion t o est imat e t he value of t his bond, plugging in 0. 09843
as t he value f or yield. The result ing price of t he bond is Rs. 108. 7497. ( The last t raded
price of t his bond on t hat dat e was Rs. 108. 31) . We can t hus use t he yield curve t o
mark a port f olio t o market , or value a given bond, which may not be t raded.

14. 1. 2 Li mi t at i on s of t h e Si mpl e Yi el d Cu r ve

The yield curve which we have drawn f rom t he market prices above, is a summary of
t he YTMs f or various t raded bonds, on a given dat e. They, however, may not t ruly
represent t he yields or int erest rat es f or various t enors. The YTM of a bond represent s a
single rat e, at which all t he cash f lows of a bond are discount ed. This act ually t ranslat es
int o a valuat ion proposit ion where, cash f lows accruing at varying point s in t ime are all
discount ed at t he same rat e, i. e t he YTM of t he bond. I n realit y, such a discount ing
process represent s a scenario where cash f lows accruing at any point in t he lif e of t he
bond, can be deployed at a single rat e. This would t hen t ranslat e int o a sit uat ion where
int erest rat es f or all t enors f or a given bond are equal, and hence a f lat yield curve.
What we see when we plot t he YTMs of t raded bonds, is a t endency f or YTMs of bonds
wit h varying t enors t o be dif f erent . This means t hat rat es f or varying t enors are not
unif orm, but dif f erent . I f t his were t rue, we can not use t he same YTM f or valuing all
t he cash f lows of a bond. The t rue int erest rat es, which are implicit in t he prices of

149
t raded bonds, are t heref ore not observed. The YTM is a simplif icat ion, wit h an
erroneous assumpt ion on t he re- invest ment of int ermit t ent coupons. I f we know t hat
dif f erent rat es exist across t enors, t he valuat ion equat ion will have t o be recast as
f ollows:

n
n
n
r
c
r
c
r
c
P
) 1 (
. ..........
) 1 ( 1
2
2
2
1
1
0
+
+
+
+
+
. . ( 14. 2)

Where r1, r2 . r n represent t he rat es f or t he respect ive t enors. These rat es are pure
spot rat es, in t hat t here are no assumpt ions on reinvest ment of coupons. I n ot her
words t hey are rat es t hat would be implicit in a bond t hat has a single cash f low at t he
end of t he t erm, i. e a zero coupon bond. These rat es are also called as t he zero coupon
rat es, and t he yield curve t hat is drawn f rom t hese rat es is called t he zero coupon yield
curve ( ZCYC) .
We can t hus look upon every coupon paying bond, as a bundle of zero coupon bonds,
wit h each cash f low accruing at t he end of a t erm r1, r2, r3 rn, being valued as if t hey
were zero coupon bonds of t hat t enor. The est imat ion problem t heref ore is one of
ident if ying t hese unique rat es, and modeling t heir relat ionship wit h one anot her, which
in t urn is t he basis f or t he valuat ion of t he bond.
The act ual modeling of t he t rue rat es across t enor, and t heir relat ionship across t erm is
called t he modeling of t he t erm st ruct ure of int erest rat es, which at t empt s t he
est imat ion of t he t heoret ical spot rat es, f rom a set of market prices of bonds, based on a
t heoret ical f ramework t hat explains t he relat ionship bet ween t he rat es across various
t enors. There are a number of met hods t o do t his, and we shall discuss one of t hem in
a subsequent sect ion in t his chapt er.

14. 2 Boot st r appi n g

The error caused by t he reinvest ment assumpt ion in t he yield curve derived f rom t he
YTMs of t raded bonds can be eliminat ed, if we are able t o observe t he rat es of bonds
wit hout int ermit t ent coupons, i. e zero coupon bonds. However, in most market s, zero
coupon bonds across varying t enors do not exist , and even if t hey do, are not as act ively
t raded as t he coupon paying bonds. However, in most market s, t reasury bills which are
discount ed securit ies, wit h no int ermit t ent coupons, exist at t he short end of t he market .
Theref ore, we could boot st rap f rom t he zero coupon t reasuries, and derive t he r1, r2 r n
of t he coupon paying bonds.
For example, if a t reasury bill wit h 6 mont hs t o mat urit y, is t raded in t he market at
Rs. 96. 5 and mat ures t o t he par value of Rs. 100, t he 6 mont h zero coupon rat e can be
comput ed by solving t he equat ion:

5 . 0
5 . 0
) 1 (
100
5 . 96
r +


The 6 mont h rat e t hat solves t his equat ion is 7. 492%. We can now look f or a coupon
paying bond wit h 1 year t o mat urit y, whose valuat ion equat ion, in zero coupon t erms
can be st at ed as

150

1
1
2
5 . 0
5 . 0
1
0
) 1 ( ) 1 ( r
c
r
c
P
+
+
+
. ( 14. 3)

I n t his equat ion, we know t he periodic coupons as well as t he market price. From t he
earlier equat ion, we can subst it ut e t he value of r0.5. Then t he only unknown in t his
equat ion would be r1, f or which we can solve. The process of t hus discovering t he zer o
rat es f rom prices of coupon bonds, by subst it ut ing zero rat es est imat ed f or short er
durat ions is called boot st rapping. The yield curve is t hen drawn f rom t he plot of t hese
derived zero rat es, in t he similar manner as we drew t he par yield curve.
Boot st rapping is a very popular met hod wit h bond market dealers, f or est imat ing t he
t erm st ruct ure f rom market prices. Some of t he pract ical considerat ions in est imat ing
t he zero curve in t his manner are t he f ollowing:
1. The choice of bonds f or varying mat urit ies has t o ref lect market act ivit y.
Depending on t he bonds chosen f or est imat ing t he rat es, t he derived zero rat es
can vary. I t is, however, possible t o obt ain a plot of all implied zero rat es f or
all t raded bonds, and adopt t he curve f it t ing procedure, t o overcome t his
problem.
2. I t may not be possible t o obt ain zero rat es f or t he f irst cash f low of a bond, if a
zero coupon t reasury bill wit h mat ching mat urit y is not f ound. For example,
t here could be a bond, wit h t he f irst coupon 42 days away. We, t heref ore,
need t he r1 f or 42 days, in order t o value t his bond. A t reasury bill wit h exact ly
42 days t o mat urit y may not be t raded in t he market . Dealers most ly use a
linear int erpolat ion t o sort t his problem. Traded t reasury bills f or available
mat urit ies are picked up. Assume f or inst ance we have t he rat es f or 2 bills, one
wit h 40 days t o mat urit y, and anot her wit h 52 days t o mat urit y. The zero rat e
f or t he 42- day bond is comput ed by linearly int erpolat ing bet ween t hese t wo
rat es.

Example of linear int erpolat ion:
I f t he rat e f or t he 40- day bond is 6. 542%, and t he rat e f or t he 52- day bond is
6. 675%, t he rat e f or t he 42- day bond can be f ound as

= 6. 542 + [ ( 6. 675- 6. 542) ] x [ ( 42- 40) / ( 52- 40) ]

= 6. 56416%

3. The boot st rapping t echnique is sensit ive t o t he liquidit y and dept h in t he
market . I n a market wit h f ew t rades, and limit ed liquidit y, boot st rapping is
only an approximat ion of t he t rue t erm st ruct ure, due t o simple assumpt ions
( like linear int erpolat ion) made f or linking up rat es f or one t enor and t he rat es
f or anot her. I t is not uncommon f or some t o use more sophist icat ed non- linear
int erpolat ions.


151
14. 3 Al t er n at e Met h odol ogi es t o Est i mat e t h e Yi el d
Cu r ve

I n t he est imat ion of t he yield curve f rom a set of observed market prices, t he f ollowing
are import ant considerat ions:
a. The spot rat es and t he yield curve t hat is est imat ed should have a close f it wit h
market prices. That is, t he prices est imat ed by t he model and t he prices
act ually prevalent in t he market should have a close f it .
b. The model must apply equally well t o bonds which are not part of t he sample
used f or est imat ion. That is, if a very close f it is sought t o be achieved, it may
come at t he cost of t he model not being able t o value out - of - sample bonds.
The model would have incorporat ed noise in t he est imat ion.
c. The est imat ed yield curve should be smoot h, such t hat t he spot and f orward
rat es derived f rom t hem do not show excessive volat ilit y.
A number of mat hemat ical t echniques are used t o generat e a f it t ed yield curve f rom a
set of observed int erest rat e point s. They involve an opt imalit y crit eria consist ent wit h
t he assumpt ions regarding t he t erm st ruct ure of int erest rat es.

14. 3. 1 NSE ZCYC ( Nel son Sei gel Model )

I n t he I ndian market s, t erm st ruct ure est imat ion has been done, and is disseminat ed
every day by t he Nat ional St ock Exchange. The Zero Coupon Yield Curve ( ZCYC)
published by t he NSE, uses t he Nelson- Seigel met hodology.
18
The Nelson- Siegel
f ormulat ion specif ies a parsimonious represent at ion of t he f orward rat e f unct ion given by

)] / exp( ) / [( ) / exp( ) , (
2 1 0
m m m b m f + + . . ( 14. 4)
where m denot es mat urit y and b= [ 0, 1, 2 and ] are paramet ers t o be est imat ed.
Since t he model is based on t he expect at ions hypot hesis, it develops t he t erm st ruct ure
f rom t he no- arbit rage relat ionship bet ween spot and f orward rat es. The f orward rat e
f unct ion can be mat hemat ically manipulat ed ( int egrat ed) t o obt ain t he relevant spot rat e
f unct ion, t he t erm st ruct ure:
) / exp( ) / /( )] / exp( 1 [ ) ( ) , (
2 2 1 0
m m m b m r + +
( 14. 5)
I n t he spot rat e f unct ion, t he limit ing value of r( m, b) as mat ur it y get s large is 0 which
t heref ore depict s t he long t erm component ( which is a non- zero const ant ) . The limit ing
value as mat urit y t ends t o zero is 0 + 1, which t heref ore gives t he implied short - t erm
rat e of int erest .
Wit h t he above specif icat ion of t he spot rat e f unct ion, t he PV relat ion can now be
specif ied using t he discount f unct ion given by

18
The paper ( Gangadhar Darbha, et al, 2000) t hat describes t he met hodology can be
downloaded f rom www. nse. co. in \ ` product s\ ` zcyc. The f ollowing sect ion is ext ract ed
f rom t his paper.

152

,
_



100
) , (
exp ) , (
m b m r
b m d . . ( 14. 6)
The present value arrived at is t he est imat ed/ model price ( p_est ) f or each
bond. I t is common t o observe secondary market prices ( pmk t ) t hat deviat e
f rom t his value. For t he purpose of empirical est imat ion of t he unknown
paramet ers in t erm st ruct ure equat ion above, we post ulat e t hat t he observed
market price of a bond deviat es f rom it s underlying valuat ion by an error t erm
ei, which gives us t he est imable relat ion:
i i i
e est p pmkt + _ ( 14. 7)
This equat ion is est imat ed by minimising t he sum of squared price errors. The
st eps f ollowed in t he est imat ion procedure are as f ollows:

i. A vect or of st art ing paramet ers ( 0, 1, 2 and ) is select ed,
ii. The discount f act or f unct ion is det ermined using t hese st art ing paramet ers,
iii. This is used t o det ermine t he present value of t he bond cash f lows and t hereby t o
det ermine a vect or of st art ing model bond prices,
iv. Numerical opt imisat ion procedures are used t o est imat e a set of paramet ers
( under a given set of const raint s viz. non- negat ivit y of long run and short run
int erest rat es) t hat minimise t he sum of squared price errors,
v. The est imat ed set of paramet ers are used t o det ermine t he spot rat e f unct ion and
t heref rom t he model prices ( t his is t he f irst set of result s we comput e f or each
day) ,
vi. These model prices are used t o comput e associat ed model YTMs f or each bond
( t his is t he second set of result s) .

Plot s of t he est imat ed t erm st ruct ure f or any part icular day can be obt ained by f ollowing
t he

153
procedure below:
i. Creat e a series of mat urit y values; f or inst ance 1 t o 25 years, wit h st ep lengt hs of
( say) 0. 5 years
ii. For each mat urit y, use t he est imat ed paramet ers f or t he required day t o derive
corresponding spot rat es
iii. Wit h mat urit y values on t he X- axis, plot t he spot rat es against t he mat urit y
values,
iv. Spot rat e associat ed wit h any desired mat urit y ( eg. 8. 2 years) can be similarly
derived by subst it ut ing t he est imat ed paramet ers and m= 8. 2 in t he t erm st ruct ure
equat ion.

14.4 Th eor i es of t h e Ter m St r u ct u r e of I n t er est
Rat es

The t erm st ruct ure represent s t he dif f erent rat es of market int erest rat es f or dif f erent
periods of t ime. The shape of t he curve t heref ore cont ains crucial inf ormat ion on t he
f unct ional relat ionship bet ween price and t ime. The normally observed shapes of t he
yield curve are t he f ollowing:
a. upward sloping
b. downward sloping
c. humped
d. invert ed
The most commonly known t heories t hat at t empt an int erpret at ion of t he shape of t he
yield curve are:
The pure expect at ion hypot hesis
The liquidit y pref erence hypot hesis
The pref erred habit at hypot hesis

14. 4. 1 Pu r e Ex pect at i on Hypot h esi s

This int erpret at ion explains t he yield curve as a f unct ion of a series of expect ed f orward
rat es. Pioneered by I rving Fisher in 1896, t his is t he oldest t heory of t he t erm st ruct ure,
and is t he easiest t o quant if y and apply. The t radit ional f orm of t he pure expect at ions
t heory implies t hat t he expect ed average annual ret urn on a long t erm bond is t he
geomet ric mean of t he expect ed short t erm rat es. For example, t he one year spot rat e
can be t hought of as t he product of t he six- mont h spot and t he six mont h rat e six
mont hs f rom now ( six mont h f orward) . A risk neut ral invest or would t heref ore be
indif f erent bet ween t he one year spot rat e, and a one year posit ion f ormed by a
combinat ion of a six mont h spot and a six mont h f orward. Theref ore shape of t he yield
curve is driven by t he expect at ions about t he int erest rat es. Based on t he expect at ions
hypot hesis, we can calculat e a series of short t erm rat es, which over any given period
will, in aggregat e, reproduce t he market rat es expressed in t he yield curve.

14. 4. 2 Li qu i di t y Pr ef er en ce Hypot h esi s

This hypot hesis is a modif icat ion of t he expect at ion hypot hesis, incorporat ing risk.
Ot her t hings remaining t he same, invest ors would pref er short t erm bonds t o long t erm

154
bonds, because pricing of short t erm bonds is made easier by t he lower price risk of
t hese bonds and t he short er t erm t o mat urit y. Theref ore short t erm inst rument s will
enj oy a higher liquidit y t han long t erm inst rument s. I f invest ors pref er short t erm rat es
t o long t erm rat es, int erest rat es at t he lower end of t he yield curve would be lower, and
t he yield curve would slope upwards. The liquidit y pref erence hypot hesis posit s t hat
t he long t erm rat es are not only composed of expect ed short t erm rat es, but also
cont ain a liquidit y premium. The liquidit y premium is t he addit ional yield demanded by
invest ors t o ext end t he mat urit y of inst rument s, over longer periods of t ime. Theref ore
liquidit y premium can be expect ed t o increase wit h t ime t o mat urit y.

14. 4. 3 Pr ef er r ed Habi t at Hypot h esi s

Pref erred habit at hypot hesis recognizes t hat t he market is segment ed and t hat
expect at ions of invest ors is not unif orm across various t enors. This hypot hesis posit s
t hat dist inct cat egories of invest ors exist , and t hat each of t hese cat egories pref ers t o
invest at cert ain segment s of t he yield curve. For example, corporat es wit h short t erm
surplus f unds, would pref er t o deploy t he same in short t erm inst rument s, and may be
unwilling t o t ake price risks associat ed wit h invest ing in long t erm inst rument s. On t he
ot her hand, pension and insurance companies would pref er t o invest in long t erm bonds,
t o mat ch t he liabilit y prof ile of t heir port f olios. Since t he port f olios and t he asset
requirement s of invest ors vary, t hey would pref er some t enors over t he ot her, and
t heref ore f ocus on segment s of t he yield curve. The pref erred habit at t heory t heref ore
posit s t hat depending on demand and supply at varying t enors of t he yield curve,
invest ors will have t o be receive( pay) premiums( discount s) t o shif t away f rom a
pref erred habit at . The shape of t he yield curve t heref ore is a f unct ion of demand and
supply, and does not have any f ormal relat ionship t o int erest rat e expect at ions.
We can summarise t he int erpret at ion of t he alt ernat e shapes of t he yield curve under
t hese t hree hypot heses, as f ollows:

Sh ape of t h e yi el d cu r ve Ter m
st r u ct u r e
h ypot h eses
Fl at Upw ar d
sl opi n g
Dow n w ar d
sl opi n g
Hu mped
Ex pect at i on
s
Hypot h esi s
Short t erm
int erest rat es are
not expect ed t o
change.
Short t erm
int erest rat es
are expect ed
t o increase.
Short t erm
rat es are
expect ed t o
decrease.
Short t erm
rat es are
expect ed t o
init ially
increase, and
t hen decrease.
Li qu i di t y
Pr emi u m
Hypot h esi s
There is no
liquidit y premia
on long t erm
rat es, over short
t erm rat es.
Liquidit y
premia are
posit ive wit h
increases in
t erm.
Liquidit y
premia are
negat ive wit h
increases in
t erm.
Liquidit y premia
are posit ive
upt o a cert ain
t erm, af t er
which t hey t urn
negat ive.
Pr ef er r ed
Habi t at
Hypot h esi s
Demand and
supply are
mat ched at all
Excess of
supply over
demand in
Excess of
supply over
demand in
Excess of
supply over
demand in t he

155
mat urit ies. short er
mat urit ies.
longer
mat urit ies.
int ermediat e
t erm.

The t erm st ruct ure of int erest rat es becomes very import ant in a market in which
f orwards and derivat ives t rade, as t he valuat ion and t rading of t hese inst rument s is not
possible wit hout a dependable model of t erm st ruct ure. The NSE- ZCYC is an import ant
development in t his cont ext . I n t he I ndian market s, pending t he development of t he
f orward and derivat ive market s in int erest rat e product s, and limit ed liquidit y in t he spot
market s, yield curve est imat ions are yet t o gain import ance. However, t he increasing
f ocus on valuat ion and marking t o market of port f olios, has creat ed t he need f or t he
market yield curve, f or banks, PDs, inst it ut ions and mut ual f unds. The RBI used t o
publish t he yield curves f or valuat ion of bank port f olios. Af t er t he RBI discont inued t his
pract ice nearly 2 years ago, t he FI MMDA has creat ed a st andard yield curve, based on
polled yields at t he end of every t rading day, t o enable valuat ion of port f olios on t he
basis of a st andard yield curve. This has enabled st andard indust ry pract ice on
valuat ion. SEBI has mandat ed a st andard valuat ion model f or bonds in mut ual f und
port f olios, f rom December 1, 2000, based on a durat ion- based valuat ion model
developed by CRI SI L.

Model Quest i ons

1. Th e NSE ZCYC est i mat es f or Ju l y 11, 2001 ar e as f ol l ow s:
Bet a 0 = 11. 4652
Bet a 1 = - 2. 2510
Bet a 2 = - 10. 7202
Tau = 1. 4197
Wh at i s t h e spot r at e f or a t er m t o mat u r i t y of 3. 5 year s?
An sw er :
We use t he ZCYC valuat ion equat ion ( 14. 5)
) / exp( ) / /( )] / exp( 1 [ ) ( ) , (
2 2 1 0
m m m b m r + +

We can t ake t he values provided by NSE t o an Excel Spreadsheet , and key in t he
f ormula above, subst it ut ing 3. 5 f or m in t he equat ion, and subst it ut ing t he NSE
est imat es f or B0, B1 and B2 and Tau.
We t hen get
= 11. 4652 + ( ( - 2. 2510- 10. 7202) * ( 1- exp( - 3. 5/ 1. 4197) ) / ( 3. 5/ 1. 4197) - ( - 10. 7202* exp( -
3. 5/ 1. 4197) )
= 7. 56185%

2. I f t h er e ar e 2 bon ds t r adi n g i n t h e mar k et as f ol l ow s, on Ju l y 11, 2001 as
det ai l ed bel ow :
i . 11. 98% 2004 ( Mat u r i t y 8- Sep- 2004) : Rs. 111. 8
i i . 11. 19% 2005 ( Mat u r i t y 12 Au g 2005) : Rs. 111. 83
Wh at i s t h e l i n ear l y i n t er pol at ed r at e f or 3. 5 year s, u si n g t h e above dat a?
An sw er :

156
Using t he Yi el d f unct ion, we can f ind out t he YTM of t he above bonds as 7. 6917% and
7. 7524% respect ively. Using t he year f r ac f unct ion, we can f ind t he t erm t o mat urit y of
t hese bonds as 3. 1583 years and 4. 0861 years respect ively.

To f ind t he YTM f or a 3. 5 year bond, we can do a linear int erpolat ion, as f ollows:
= 7. 6917 + ( 7. 7524- 7. 6917) * ( ( 3. 5- 3. 1583) / ( 4. 0861- 3. 1583) )
= 7. 7141%

3. I f t h e yi el d cu r ve i s u p w ar d sl opi n g, w h i ch of t h e f ol l ow i n g i s f al se?
a. The market expect s short t erm int erest rat es t o increase.
b. The liquidit y premium is increasing wit h increase in t enor.
c. There is an excess of demand over supply in short er mat urit ies.
d. The int erest rat es are posit ively relat ed t o t erm, along t he yield curve.
An sw er : c


157
4. Th e f ol l ow i n g t er m st r u ct u r e of i n t er est r at es i s gi ven t o you :

Ten or
( i n
year s)
Yi el d
( % p. a. )
0. 30 7. 0257
0. 35 7. 0487
0. 40 7. 0847
0. 45 7. 1589
0. 50 7. 1905
0. 55 7. 2025
0. 60 7. 2368
0. 65 7. 2604
0. 70 7. 2928
0. 75 7. 3138
0. 80 7. 3388
0. 85 7. 3704
0. 90 7. 3939
0. 95 7. 4181
1. 00 7. 4379

On 15t h June 2001, you are required t o value a bond wit h a coupon of 11. 04%,
mat uring on 10- Apr- 2002. The f ace value of t he bond is Rs. 100. Given t he yield curve
inf ormat ion in t he t able above, what is t he value of t he bond? ( Use linear int erpolat ion
t o f ind discount ing rat es f or each of t he component cash f lows) .
An sw er :
We have t o f irst f ind t he cash f lows of t he bond upt o t he dat e of mat urit y, and t he
dist ance in years of each of t he cash f lows t o t he set t lement dat e.

We use t he coupncd f unct ion and f ind t hat t here are 115 days t o t he f irst coupon and
295 days t o t he next coupon, which t ranslat e int o 0. 319444 years and 0. 819444 years
respect ively.

The discount rat e f or t hese t wo t enors can be f ound wit h by int erpolat ion f rom t he t erm
st ruct ure inf ormat ion t hat is given in t he t able above.

The rat e f or t he t enor of 0. 319444 years can be f ound by linear int erpolat ion bet ween
t he t enors 0. 3 and 0. 35 years, as f ollows:

= 7. 0257+ ( 7. 0487- 7. 0257) * ( 0. 31944 0. 3) / ( 0. 35- 0. 3)

= 7. 0346%

Similarly t he rat e f or t he t enor of 0. 819444 can be f ound by int erpolat ion bet ween t he
t enors 0. 8 and 0. 85 years, as f ollows:

= 7. 3388 + ( 7. 7304 - 7. 7304) * ( 0. 81944 0. 8) / ( 0. 85- 0. 8)


= 7. 3511%

We can now value t he bond by discount ing t he cash f lows using t hese rat es, as f ollows:

81944 . 0 31944 . 0
) 073511 . 1 (
525 . 105
) 070346 . 1 (
525 . 5
+

= Rs. 104. 9627

158

This is t he value of t he bond, comput ed by discount ing each cash f low by t he
int erpolat ed yield f rom t he t erm st ruct ure of int erest rat es.

5. Th e NSE- ZCYC est i mat e of t h e spot r at e f or t h e t er m 7. 2876 year s i s
9. 1648% . Wh at i s t h e di scou n t ed val u e of a cash f l ow of Rs. 100, r ecei vabl e at
t h e en d of t h at t er m?
An sw er :
We can use t he ZCYC est imat es t o arrive at t he discount ed value of any cash f low, by
using t he f ormula:

}
100
* ) , (
exp{ ) , (
m b m r
b m d

Theref ore t he discount f act or t o be applied t o t he cash f low of Rs. 100, receivable at t he
end of 7. 2876 years is ( Excel recognises t he t erm exp in t he f ormula)

= exp ( ( - 9. 1684 * 7. 2876) / 100)

= 0. 5128

Theref ore, t he discount ed value of Rs. 100 will be

= 100* 0. 5128

= Rs. 51. 28












159
Ch apt er 15

Du r at i on

Durat ion, as t he name suggest s is, in a simple f ramework, a measure of t ime, t hough it s
applicat ions in underst anding t he price- yield relat ionship are more int ense. We shall
begin wit h t he simple def init ion, and lat er illust rat e t he alt ernat e applicat ions, including
modif ied durat ion and PV01.

15. 1 I n t r odu ct i on an d Def i n i t i on

I n t he case of bonds wit h a f ixed t erm t o mat urit y, t he t enor of t he bond is a simple
measure of t he t ime unt il t he bond' s mat urit y. However, if t he bond is coupon paying,
t he invest or receives some cash f lows prior t o t he mat urit y of t he bond. Theref ore it
may be usef ul t o underst and what t he average mat urit y of a bond, wit h int ermit t ent
cash f lows is. I n t his case we would f ind out what t he cont ribut ion of each of t hese cash
f lows is, t o t he t enor of t he bond. I f we can comput e t he weight ed average mat urit y of
t he bond, using t he cash f lows as weight s, we would have a bet t er est imat e of t he t enor
of t he bond. Since t he coupons accrue at various point s in t ime, it would be appropriat e
t o use t he present value of t he cash f lows as weight s, so t hat t hey are comparable.
Theref ore we can arrive at an alt ernat e measure of t he t enor of a bond, account ing f or
all t he int ermit t ent cash f lows, by f inding out t he weight ed average mat urit y of t he
bond, t he present value of cash f lows being t he weight age used. This t echnical measure
of t he t enor of a bond is called durat ion of t he bond.
Let s us at t empt an int uit ive underst anding of durat ion, wit h t he help of an example.
Suppose one had t wo opt ions:
Buy bond A selling at Rs. 100. 25 wit h 1 year t o mat urit y. The redempt ion value of
t he bond is Rs. 110. 275.
Buy bond B, also selling at Rs. 100. 25, and 1 year t o mat urit y. However, t he bond
pays Rs. 50. 5 at t he end of 6 mont hs, and Rs. 57. 5 at t he end of 1 year, on
mat urit y.
Bot h t hese bonds have t he same t enor of 1 year, and are priced at t he same yield 10%.
Would one t heref ore be indif f erent bet ween t he t wo opt ions? Why not ?
I nt uit ively, we seem t o pref er opt ion ( b) t o opt ion ( a) , because we receive some cash
f lows earlier, in t he second case. I n ot her words, t hough t he t wo opt ions are f or 1
years t enor, we int uit ively underst and t hat t he second opt ion places some f unds earlier
t han a year wit h us, and t heref ore must have an average mat urit y of less t han 1 year.
I f we are able t o comput e what percent age of f unds, in present value t erms is available
t o us, in t he case of bond B, we can underst and what t he average mat urit y of bond B is.
We at t empt doing t hat in Table 15. 1.
The 2 cash f lows accruing at t he end of 6 mont hs and 1 year have dif f erent present
values. At a discount ing rat e of 5% ( bond equivalent yield of 10% f or half year) , t he
cash f lows present values are Rs. 48. 1 and Rs. 52. 15 respect ively.
This present value cash f low st ream act ually means t hat 48% of t he bonds cash f lows
accrue at t he end of 6 mont hs, and 52% of cash f lows accrue at t he end of 1 year.

160
( Not e t hat t he sum of t he cash f lows is t he current value of t he bond, i. e. Rs. 100. 25;
and t he sum of t he weight s of t he cash f lows adds up t o 1) . I f we apply t hese weight s
t o t he period associat ed wit h t he cash f low, we know t hat t he weight ed mat urit y of t he
bond is 1. 52 half years, or 0. 76 years.
This is why we seem t o pref er bond B, whose average mat urit y is act ually less t han a
year. The durat ion of t his bond is 0. 76 years. I n t he case of bond A, all t he cash f lows
accrue at t he end of t he year. Theref ore, t he durat ion of t he bond is also 1 year.
I n any bond wit h int ermit t ent cash f lows accruing prior t o mat urit y, t he average
mat urit y will be lesser, and durat ion is a measure of t his average mat urit y of a bond.

Tabl e 15. 1: Wei gh t ed Pr esen t Val u es an d Du r at i on
Per i od Cash
f l ow
( Rs. )
Pr esen t val u e
of cash f l ow
( Rs. )
Wei gh t of
t h e pr esen t
val u e
Wei gh t ed
t en or of t h e
bon d ( Year )
1 50. 5 48. 10 0. 48 0. 48
2 57. 5 52. 15 0. 52 1. 04
Tot al 100. 25 1. 000 1. 52
Du r at i on 1. 52/ 2 = 0. 76
yr s

15. 2 Cal cu l at i n g Du r at i on of a Cou pon Payi n g Bon d

Fredrick Macaulay, in 1938, f irst propounded t he idea of durat ion, and we call his
measure as Macaulays durat ion.
Macaulay durat ion in years

n
i
t
pvtcf k
pvcf t
1
. ( 15. 1)

Where k = number of payment s per year ( in t he case of semiannual coupon paying
bonds, k = 2)

n = number of periods unt il mat urit y ( years t o mat urit y x k)

t = period in which cash f low is expect ed t o be received ( t = 1, 2, n)

pvcf t = present value of t he cash f low in period t discount ed at t he yield t o mat urit y

pvt cf = Tot al present value of t he cash f lows of t he bond, discount ed at t he bonds yield
t o mat urit y ( t his would act ually be t he price of t he bond) .

The above equat ion can also be st at ed as

( 1xPVCF1 + 2xPVCF2 + 3xPVCF3 . + nxPVCFn) / ( k x PVTCF) ( 15. 2)


161
Let us consider an example. See Table 15. 2. Column 1 list s t he period in which t he
cash f lows accrue. Column 2 is t he list of cash f lows, which in t his case are t he coupons
f or all t he periods, except t he last one, when t he coupon and redempt ion amount are
due. Column 3 is t he present value of each of t he cash f lows, discount ed f or t he
appropriat e period, at t he YTM rat e of 9%. ( 4. 5% on a semi - annual basis) . For example,
Rs. 5. 26 is t he discount ed value of Rs. 5. 5 receivable in six mont hs, discount ed at t he
rat e of 4. 5%.

The sum of t he present values is Rs. 107. 91 which is t he value of t he bond at a YTM of
9%. Column 4 provides t he weight ed value of t he present values, by comput ing t he
product of t he present values and t he period in column 1. Durat ion of t he bond is t he
sum of t hese weight ed values divided by t he sum of t he present value of t he cash f lows.
8. 039 is t he durat ion in half - years. Theref ore durat ion in years is 8. 039/ 2, which is 4. 02
years.

Tabl e 15. 2: Du r at i on of a 5 year 11% bon d, at a YTM of 9%
Per i od Cash f l ow s
( Rs. )
Pr esen t
Val u e of
Cash Fl ow s ( Rs. )
Wei gh t ed
Pr esen t
Val u es
( a)
Wei gh t ed
Cash
Fl ow s
( b)
Du r at i on
( c)
1 5. 5 5. 26 5. 263 0. 049 0. 049
2 5. 5 5. 04 10. 073 0. 047 0. 093
3 5. 5 4. 82 14. 459 0. 045 0. 134
4 5. 5 4. 61 18. 448 0. 043 0. 171
5 5. 5 4. 41 22. 067 0. 041 0. 204
6 5. 5 4. 22 25. 341 0. 039 0. 235
7 5. 5 4. 04 28. 291 0. 037 0. 262
8 5. 5 3. 87 30. 940 0. 036 0. 287
9 5. 5 3. 70 33. 309 0. 034 0. 309
10 105. 5 67. 93 679. 344 0. 630 6. 295
Tot al 107. 91 867. 535 1. 00 8. 04
( a)
Present Value in column ( 3) t imes period in column ( 1) .
( b)
Present Value in column ( 3) as f ract ion of Tot al present value.
( c)
Weight ed Cash f lows in column ( 5) t imes period in column ( 1) .

We can arrive at t he same result by f inding out t he weight of each of t he discount ed
cash f lows t o t he t ot al, and applying t his weight t o t he periods in which cash f lows
accrue. I n column 5 we f ind t he proport ion of cash f lows accruing in each of t he
periods, t o t he t ot al cash f lows. Durat ion is t he sum product of t hese weight s, mult iplied
by t he period in column 1, and summed up. We arrive at t he same value of 4. 02 years.
We also not ice what proport ion of t he cash f lows of t he bond accrue in each of t he
periods, in column 5. Only 63% of t he bonds cash f lows accrue in 5 years.

15. 3 Compu t i n g Du r at i on on Dat es ot h er t h an
Cou pon Dat es


162
I n t he example above, we had comput ed durat ion, discount ing t he cash f lows f or whole
periods, as we had assumed t hat t he calculat ions are made at t he beginning of t he cash
f low st ream. I n realit y, we should be able t o comput e durat ion on any day when a bond
is out st anding. I n order t o do t his, t he f ract ional periods represent ing t he dist ance of
each of t he cash f low f rom t he dat e of mat urit y will have t o be calculat ed, and t he
discount ing of cash f lows done f or t hese f ract ional periods. As in t he case of yield and
price calculat ions, t he day count convent ion in t he market should be known, apart f rom
t he set t lement and t he mat urit y dat es. We could t hen use t he Excel f unct ion Durat ion.

163
Box 15. 1: Fu n ct i on Du r at i on
I n order t o use Excel t o comput e t he durat ion of a bond on any given set t lement dat e,
we provide t he f ollowing values:
Set t lement dat e: t he dat e on which we want t o comput e t he durat ion, in dat e f ormat
Mat urit y dat e: t he dat e on which t he bond would redeem, in dat e f ormat
Coupon: Coupon of t he bond, as a rat e
Yield: YTM of t he bond, as a rat e
Frequency: Frequency of payment of coupons per year, 2 f or semi annual bonds
Basis: Day count convent ion in t he market . 4 f or European 30/ 360 convent ion.
Excel will ret urn t he durat ion of t he bond in years.

Tabl e 15. 3 Du r at i on of Sel ect G- Secs on Mar ch 29, 2001
Name Cou pon
( % )
Mat u r i t y
Dat e
Ter m t o
Mat u r i t y ( yr s)
Pr i ce
( Rs. )
Yi el d t o
Mat u r i t y
Du r at i on
( yr s)
CG2001 11. 75
25- Aug-
01 0. 41 101. 00 0. 09092 0. 406
CG2002 11. 15 9- Jan- 02 0. 79 102. 75 0. 07413 0. 752
CG2003 11. 10 7- Apr- 03 2. 05 103. 52 0. 09154 1. 779
CG2004 12. 50
23- Mar-
04 3. 03 108. 31 0. 09247 2. 593
CG2005 11. 19
12- Aug-
05 4. 44 106. 19 0. 09422 3. 554
CG2006 11. 68 10- Apr- 06 5. 11 107. 58 0. 09736 3. 794
CG2007 11. 90
28- May-
07 6. 25 109. 31 0. 09843 4. 457
CG2008 11. 40
31- Aug-
08 7. 53 107. 60 0. 09924 5. 239
CG2009 11. 99 7- Apr- 09 8. 14 109. 18 0. 10281 5. 217
CG2010 11. 30 28- Jul- 10 9. 47 106. 60 0. 10182 6. 006
CG2011 12. 32 29- Jan- 11 9. 98 110. 97 0. 10499 6. 054
CG2013 12. 40
20- Aug-
13 12. 58 111. 00 0. 10740 6. 849
Not i ce t h at t h e du r at i on of t h e 2013 12. 4 secu r i t y i s on l y 6. 85 year s, w h i l e i t s
t er m t o mat u r i t y i s 12. 58 year s.

The basic relat i onship bet ween coupon, t erm t o mat urit y and t he yield and durat ion can
be int uit ively underst ood, by viewing durat ion as t he f ulcrum t hat balances t he present
value of cash f lows of a bond. I f we view t he present values of t he cash f lows f rom a
bond, as weight s placed on a scale, durat ion represent s t he f ulcrum which would balance
t hese weight s on t he t ime scale. We have diagrammat ically represent ed t his in Figure
15. 3. which present s t he cash f lows of a 11%, 5- year bond, semi annual coupons,
selling at YTM of 11%. The durat ion of t his bond is 4. 02 years. I f we can imagine t hat
t here is a f ulcrum at 4. 02 on t he graph, we could begin t o see how t he f ulcrum would
behave f or changes in t he f act ors inf luencing durat ion. An increase in t he t erm would
mean more number of bars on t he chart . The f ulcrum would move t o t he right . Higher
t he t erm, great er t he durat ion. I f t he coupon rat es were higher, t he size of each of t he
bars would be higher. The f ulcrum would t hen move lef t . Durat ion and coupon are
inversely relat ed. Higher t he coupon, lower t he durat ion. I f t he yield at which we
discount t he cash f low increases, t he size of t he bars would decrease. The f ulcrum
would move t o t he lef t . Yield and durat ion are inversely relat ed.

164
Fi gu r e 15. 3: Pr esen t val u e of Cash Fl ow s on t h e Ti me Scal e
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
1 2 3 4 5 6 7 8 9 10
Years
P
r
e
s
e
n
t

V
a
l
u
e

o
f

C
a
s
h

F
l
o
w
s




Apart f rom t hese f act ors, durat ion is also impact ed by t he st ruct ure of t he bond. A bond
wit h sinking f und provisions would have a lower durat ion, as a higher percent age of t he
cash f lows of t he bond would accrue bef ore mat urit y. Similarly, callable bonds have
short er durat ion t han ot herwise comparable non- callable bonds. Call opt ions reduce t he
out st anding mat urit y period of a bond. Est imat ing t he durat ion of a callable bond is,
however, complicat ed by t he need t o est imat e t he probabilit y t hat t he opt ion will be
exercised.

15. 4 Modi f i ed Du r at i on

Though int uit ively we have known durat ion as t he weight ed average t erm t o mat urit y of
a bond, an alt ernat e explanat ion which looks at durat ion as t he approximat ion of t he
slope of t he price- yield relat ionship, is signif icant , and has import ant applicat ions. We
have known t hat a bonds realized yield is impact ed by coupon, t erm t o mat urit y and
yield. Durat ion is a single measure approximat ion of t he impact of all of t hese t hree
f act ors, on t he price of a bond, f or a given change in yield. Theref ore, durat ion is an
import ant measure of sensit ivit y of a bond t o changes in underlying yield, and hence t he
int erest rat e risk of a bond.

The price of a bond is t he present value of t he cash f lows associat ed wit h t he bond, and
can be represent ed as


n
n
n
t
t
t
r
C
r
C
r
C
r
C
P
) 1 (
.........
) 1 ( ) 1 ( ) 1 (
2
2 1
1
+ +
+
+

. . ( 15. 3)



165
I n order t o underst and how price changes f or a small change in yield, we can t ake t he
f irst derivat ive

166
of t he above equat ion wit h respect t o r, t o get t he f ollowing equat ion:


1
]
1

+
+
+
+
+ +

n
n
r
nC
r
C
r
C
r dr
dP
) 1 (
.......
) 1 (
2
) 1 ( ) 1 (
1
2
2
1
1
. ( 15. 4)


This equat ion comput es t he absolut e change in t he price of a bond f or a given change in
yield. I n order t o convert t he same int o a percent age change in price f or a percent age
change in yield, we divide bot h sides of equat ion by t he bond price, as f ollows:


P r
nC
r
C
r
C
r P dr
dP
n
n
1
.
) 1 (
.......
) 1 (
2
) 1 ( ) 1 (
1 1
.
2
2
1
1
1
]
1

+
+
+
+
+ +

. . ( 15. 5)
Th e t er m on t h e r i gh t h an d si de of t h e above equ at i on can be r ew r i t t en as
=
r
Duration
+

1
( 15. 6)

This f ormula represent s t he percent age change in price of a bond, f or small changes in
yield. This measure is known as t he modif ied durat ion of a bond. We can st at e t his
relat ionship in a generalized f orm as
% change in price of a bond = Modif ied durat ion * % change in yield

For example, f or a bond wit h a modif ied durat ion of 7. 5, a 50 basis point change in yield
will result in a 7. 5 * 50/ 100 = 3. 75% change in price, in t he opposit e direct ion ( not ice
t he minus sign in t he equat ion, signif ying t hat t he change in price is in t he opposit e
direct ion of t he change in yield - yield and price are inversely relat ed) . I f t he yield is
semi- annual, we use half t he yield in t he equat ion.
Modif ied durat ion is t he slope of t he line in t he priceyield f unct ion, and f or small
changes in t he yield of a bond, modif ied durat ion indicat es t he percent age change in
price t hat can be expect ed. Modif ied durat ion is, t heref ore, a direct measure of t he
int erest rat e sensit ivit y of a bond. Higher t he modif ied durat ion of a bond, great er t he
percent age change in price f or a given change in yield.

Box 15. 2: Modi f i ed Du r at i on Fu n ct i on
I n order t o use Excel t o comput e t he modif ied durat ion of a bond on any given
set t lement dat e, we use t he f unct ion Mdurat ion, and provide t he f ollowing values:
Set t lement dat e: t he dat e on which we want t o comput e t he modif ied durat ion, in dat e
f ormat
Mat urit y dat e: t he dat e on which t he bond would redeem, in dat e f ormat
Coupon: Coupon of t he bond, as a rat e
Yield: YTM of t he bond, as a rat e

167
Frequency: Frequency of payment of coupons per year, 2 f or semi annual bonds
Basis: Day count convent ion in t he market . 4 f or European 30/ 360 convent ion.
Excel will ret urn t he modif ied durat ion of t he bond in years.
I t has t o be remembered t hat modif ied durat ion will provide close approximat ion of t he
act ual change in prices, f or small changes in yield. For large changes in yield, however,
t he f irst order derivat ive, which is what modif ied durat ion is, is inadequat e.

Tabl e 15. 4: Modi f i ed Du r at i on of a Set of Bon ds
Name Cou pon
( % )
Mat u r i t y
Dat e
Ter m t o
mat u r i t y
( yr s)
Pr i ce on
Mar ch 29,
2001 ( Rs. )
YTM ( % ) Modi f i ed
Du r at i on
( Yr s)
CG2001 11. 75 25- Aug- 01 0. 41 101 0. 09092 0. 388
CG2002 11. 15 9- Jan- 02 0. 79 102. 75 0. 07413 0. 725
CG2003 11. 1 7- Apr- 03 2. 05 103. 515 0. 09154 1. 701
CG2004 12. 5 23- Mar- 04 3. 03 108. 31 0. 09247 2. 479
CG2005 11. 19 12- Aug- 05 4. 44 106. 19 0. 09422 3. 394
CG2006 11. 68 10- Apr- 06 5. 11 107. 58 0. 09736 3. 618
CG2007 11. 9 28- May- 07 6. 25 109. 31 0. 09843 4. 248
CG2008 11. 4 31- Aug- 08 7. 53 107. 6 0. 09924 4. 991
CG2009 11. 99 7- Apr- 09 8. 14 109. 18 0. 10281 4. 962
CG2010 11. 3 28- Jul- 10 9. 47 106. 6 0. 10182 5. 715
CG 2011 12. 32 29- Jan- 11 9. 98 110. 97 0. 10499 5. 752
CG2013 12. 4 20- Aug- 13 12. 58 111. 2 0. 10740 6. 500

Not ice t hat modif ied durat ion is lower t han durat ion of t he same set of bonds, comput ed
in t he beginning of t his chapt er. Tables 15. 4 and 15. 5 illust rat e t he applicat ion of
modif ied durat ion t o measuring t he int erest rat e sensit ivit y of bonds.
The modif ied durat ion of t hese bonds will provide input s f or underst anding t he int erest
rat e sensit ivit y of t he bonds. We change t he yield of t hese bonds by 50bps, and re-
comput e t he value of t he bonds, in Table 15. 5.
We can use t he same set of bonds t o illust rat e how modif ied durat ion helps est imat e
changes in t he price of bonds f or a given change in yield. We have used t he same set of
bonds in t he Table 15. 3, but changed t he yield by 50 basis point s ( column 3 in t he t able
15. 4) . The new price f or t he now changed yield is comput ed and post ed in column 4.
The act ual percent age change in price, f or a 50 bp change in yield is in column 5. The
percent age change in price, comput ed wit h modif ied durat ion ( Mdurat ion * basis point
change in yield/ 100) is in t he last column. Not ice t hat t he numbers in t he last 2
columns are f airly comparable.

Tabl e 15. 5: I n t er est Rat e Sen si t i vi t y of a Set of Bon ds - Usi n g Modi f i ed
Du r at i on
Ol d pr i ce
of t h e
bon d ( Rs. )
Modi f i ed
Du r at i on
( Yr s)
New yi el d
( + 50 bp)
( % )
New Pr i ce
( Rs. )
Act u al %
ch an ge i n
pr i ce
% Ch an ge i n
pr i ce
compu t ed w i t h
mdu r at i on
101 0. 388 0. 09592 100. 80 0. 1973 0. 1940
102. 75 0. 725 0. 07913 102. 37 0. 3701 0. 3625
103. 515 1. 701 0. 09654 102. 60 0. 8887 0. 8504
108. 31 2. 479 0. 09747 106. 98 1. 2320 1. 2394
106. 19 3. 394 0. 09922 104. 38 1. 7019 1. 6971
107. 58 3. 618 0. 10236 105. 56 1. 8785 1. 8091
109. 31 4. 248 0. 10343 106. 94 2. 1708 2. 1241

168
107. 6 4. 991 0. 10424 104. 93 2. 4773 2. 4957
109. 18 4. 962 0. 10781 106. 38 2. 5660 2. 4809
106. 6 5. 715 0. 10682 103. 56 2. 8521 2. 8575
110. 97 5. 752 0. 10999 107. 78 2. 8707 2. 8761
111. 2 6. 500 0. 11240 107. 63 3. 2116 3. 2498

15. 5 Ru pee Du r at i on

Modif ied durat ion provides a measure of percent age change in price, f or a percent age
change in yield. However t wo bonds wit h t he same measure of modif ied durat ion will
change in value, in rupee t erms, in much dif f erent manner, depending on t he price at
which t hey are t rading. Consider Table 15. 5. The rupee change in value of t he bond is
dif f erent across t he bonds, and is a f unct ion of bot h modif ied durat ion and t he price.

Theref ore rupee price change can be calculat ed as:
Modif ied durat ion * yield change ( in basis point s) * rupee price of t he bond.
We can st andardize t he expect ed price change in rupee t erms, f or a 100 basis point
change in yield as

Modif ied durat ion * 0. 01( 100 basis point s) * rupee price of t he bond.

This value is called t he dollar ( rupee) durat ion of a bond, and is comparable across
bonds selling at various prices. Table 15. 6 shows t he rupee durat ion of a set of bonds.
Rupee durat ion represent s t he change in price f or a 100 basis point change in yield.
( From t he dat a on t he bonds t hat is available, calculat e act ual change in price f or a
100bp change in yield, and compare t he same wit h value in t he last column in t he
t able15. 6) .

Tabl e 15. 6: Ru pee Du r at i on of Bon ds
Name Cou pon ( % ) Pr i ce ( Rs. ) Mdu r at i on
( Yr s)
Ru pee
Du r at i on
CG2001 11. 75 101 0. 388 0. 391799
CG2002 11. 15 102. 75 0. 725 0. 744885
CG2003 11. 1 103. 515 1. 701 1. 760554
CG2004 12. 5 108. 31 2. 479 2. 684794
CG2005 11. 19 106. 19 3. 394 3. 604203
CG2006 11. 68 107. 58 3. 618 3. 892417
CG2007 11. 9 109. 31 4. 248 4. 643677
CG2008 11. 4 107. 6 4. 991 5. 370745
CG2009 11. 99 109. 18 4. 962 5. 417223
CG2010 11. 3 106. 6 5. 715 6. 09217
CG 2011 12. 32 110. 97 5. 752 6. 383322
CG2013 12. 4 111. 2 6. 500 7. 227553

Pr i ce Val u e of a Basi s Poi n t ( PV01)

Anot her import ant variat ion t o t he rupee durat ion, which is used ext ensively in pract ice,
is t he price value of a basis point ( known commonly as PVBP or PV01) . The PV01 of a
bond is t he rupee value of change in price of a bond, f or a 1 basis point change in yield.
PV01 is calculat ed as

169

Modif ied durat ion * Price of t he bond* 0. 01/ 100.

PV01 is also = Rupee Durat ion of a bond/ 100.

PV01 of a bond is a number t hat can be applied f or any ant icipat ed change in yield, t o
ascert ain t he change in price value. I n t able 15. 6, t he last column has t o be divided by
100, t o obt ain t he PV01 of each of t he bonds. I n pract ice, PV01 is ext ensively used in
ascert aining t he price sensit ivit y of a port f olio. PV01 of a port f olio is t he port f olios
modif ied durat ion t imes t he market value of t he port f olio, mult iplied by t he value
0. 0001.
PV01 is a usef ul number in buying hedge product s f or a port f olio. The payof f f rom a
hedge has t o mat ch t he PV01 of t he port f olio, t o enable ef f ect ive hedging.

15. 7 Por t f ol i o Du r at i on

The durat ion of a port f olio of bonds can be comput ed in t wo ways:
( a) Map t he cash f lows of t he bond int o various t erm bucket s, when t hey are due, and
using yield of t he port f olio, discount t he t ot al cash f lows of t he port f olio. Comput e
durat ion wit h t he usual f ormula, t reat ing t he aggregat e cash f lows as if t hey were a
single bond.
( b) Comput e t he weight ed durat ion of a port f olio, using t he market value of t he bond as
t he weight age.

Though ( a) is concept ually sound, it is a comput at ionally int ensive procedure. Theref ore
in pract ice ( b) is a more commonly used approach t o det ermine t he durat ion of a
port f olio.

Consider t he set of bonds we have been using in t his chapt er. Table 15. 7 shows t he
durat ion of a port f olio t hat holds one each of all t he bonds. ( The weight ages can be
changed f or any quant it y holding in each of t he bond. What we require f or comput at ion
is t he market value of t he port f olios exposure t o a given bond, as a proport ion of t he
t ot al market value of t he port f olio) .

) (
1
i
N
i
i P
W D Dur

. . ( 15. 7)

Durat ion of a port f olio is t he sum product of durat ion of each securit y in t he port f olio
( Di) t imes t he proport ion of t he securit y t o t ot al port f olio value ( as a decimal) ( Wi) .

I n t he t able 15. 7, t he proport ional weight of each bond is comput ed as t he price of t he
bond divided by t he value of t he port f olio ( in t his case t he sum of t he prices of all t he
bonds, as we assume t hat we hold one bond each) .
For example, t he value 0. 079 = 101/ 1284. 205. The last column applies t hese
proport ions t o t he durat ion of each bond. The durat ion of t he port f olio is t he sum of t he
last column, which is t he weight ed durat ion of all t he bonds in t he port f olio.

170

Tabl e 15. 7: Du r at i on of a Por t f ol i o of Bon ds
Name Cou pon ( % ) Pr i ce ( Rs. ) Du r at i on
( Yr s)
Wei gh t s Wei gh t ed
Du r at i on
CG2001 11. 75 101. 00 0. 4056 0. 079 0. 032
CG2002 11. 15 102. 75 0. 7518 0. 080 0. 060
CG2003 11. 10 103. 52 1. 7786 0. 081 0. 143
CG2004 12. 50 108. 31 2. 5934 0. 084 0. 219
CG2005 11. 19 106. 19 3. 5540 0. 083 0. 294
CG2006 11. 68 107. 58 3. 7943 0. 084 0. 318
CG2007 11. 90 109. 31 4. 4572 0. 085 0. 379
CG2008 11. 40 107. 60 5. 2391 0. 084 0. 439
CG2009 11. 99 109. 18 5. 2168 0. 085 0. 444
CG2010 11. 30 106. 60 6. 0059 0. 083 0. 499
CG 2011 12. 32 110. 97 6. 0543 0. 086 0. 523
CG2013 12. 40 111. 20 6. 8486 0. 087 0. 593
Por t f ol i o val u e 1284. 205 Por t f ol i o Du r at i on 3. 942

We can comput e modif ied durat ion also in a similar manner, using market values of t he
bonds as weight s. We can t hen est imat e t he int erest rat e sensit ivit y of t he port f olio.
The modif ied durat ion of t his port f olio of bonds can be comput ed, using t he mdurat ion
f unct ion, and using t he value weight s as in t he case of port f olio durat ion.

Table 15. 8 shows t he modif ied durat ion of t his port f olio, which is 3. 754. We have also
t aken f rom our earlier illust rat ion of price sensit ivit y, t he new prices of bonds, when
int erest rat es increase by 50 basis point s.
We see t hat t he value of t he port f olio has f allen t o Rs. 1259. 906 due t o t his change in
rat es. I n percent age t erms, t his change is 1. 89%. Given t he port f olios modif ied
durat ion of 3. 754, we can expect f or a 50 basis point change in yield, a price change of

3. 754 * 0. 5 = 1. 877%


171
Modif ied durat ion of t he port f olio t hus provides a close approximat ion of t his change in
price.

Tabl e 15. 8: Modi f i ed Du r at i on of a Por t f ol i o
Name Cou pon
( % )
Pr i ce
( Rs. )
Modi f i ed
Du r at i on
Wei gh t
Wei gh t ed
Mdu r at i on
New Pr i ce
( a)
CG200
1 11. 75 101. 00 0. 388 0. 079 0. 031 100. 801
CG200
2 11. 15 102. 75 0. 725 0. 080 0. 058 102. 370
CG200
3 11. 10 103. 52 1. 701 0. 081 0. 137 102. 595
CG200
4 12. 50 108. 31 2. 479 0. 084 0. 209 106. 976
CG200
5 11. 19 106. 19 3. 394 0. 083 0. 281 104. 383
CG200
6 11. 68 107. 58 3. 618 0. 084 0. 303 105. 559
CG200
7 11. 90 109. 31 4. 248 0. 085 0. 362 106. 937
CG200
8 11. 40 107. 60 4. 991 0. 084 0. 418 104. 934
CG200
9 11. 99 109. 18 4. 962 0. 085 0. 422 106. 378
CG201
0 11. 30 106. 60 5. 715 0. 083 0. 474 103. 560
CG
2011 12. 32 110. 97 5. 752 0. 086 0. 497 107. 784
CG201
3 12. 40 111. 20 6. 500 0. 087 0. 563 107. 629
Tot al 1284. 205
Por t f ol i o Modi f i ed
Du r at i on 3. 754 1259. 906

( a)
Price assuming 50 basis point increase in yield.

15. 8 Li mi t at i on s of Du r at i on

Durat ion is not a st at ic propert y of a bond. Durat ion of a bond changes over t ime, and
wit h changes in market yields. Any st rat egy based on durat ion values of a bonds will,
t heref ore, require dynamic t uning.
Comput ing durat ion involves t he discount ing of cash f lows of a bond. I t is common t o
use t he YTM of t he bond, as t he rat e at which cash f lows are discount ed. Theref ore, t he
limit at ions of YTM ext end t o t he comput at ion of durat ion.
We use durat ion based on t he view t hat equal changes in int erest rat es occur across
various t erms. I n ot her words, when we measure change in yield and use durat ion t o
est imat e change in price , we assume t hat t he given change in yield occurs across t he
t enor spect rum. This act ually t ranslat es int o an assumpt ion of parallel shif t s in t he yield
curve, which is not a very realist ic assumpt ion t o make.
Durat ion is t he f irst derivat ive of t he price- yield f unct ion. The result s obt ained by using
durat ion t o measure price change is only an approximat ion of t he act ual price yield
relat ionship, which is not linear, but convex.

Model Quest i ons

172

1. Th e du r at i on of a cou pon payi n g bon d i s al w ays l ow er t h an i t s t er m t o
mat u r i t y, becau se:
a. Since durat ion is t he measure of average mat urit y, it has t o be lower t han t he
t enor.
b. Durat ion measures t he weight ed mat urit y, and t heref ore cannot be compared t o
t enor of a bond.
c. As long as some cash f lows are received prior t o mat urit y, t he weight age of t he
t erminal cash f low cannot be 1.
An sw er : c

2. On Ju l y 11, 2001, t h e f ol l ow i n g i s t h e mar k et val u e of t h e bon ds i n you r
por t f ol i o. ( Assu me equ al h ol di n gs i n al l t h e bon ds) . Wh at i s t h e du r at i on of
t h e por t f ol i o?
Cou pon
( % )
Mat u r i t y
dat e
Pr i ce on
11- Ju l - 2001 ( Rs. )
11. 68 6- Aug- 2002 104. 34
11. 00 23- May- 2003 105. 74
12. 50 23- Mar- 2004 111. 63
11. 98 8- Sep- 2004 111. 8
11. 19 12- Aug- 2005 111. 83
11. 68 10- Apr- 2006 114. 4
11. 90 28- May- 2007 116. 6
An sw er :
We can use t he Yield f unct ion t o f ind t he YTM and t he Durat ion Funct ion t o comput e
durat ion, as f ollows:
Cou po
n ( % )
Mat u r i t y
dat e
Mar k et Pr i ce
on 11- Ju l - 2001 ( Rs. )
YTM
( % )
Du r at i on
( Yr s)
11. 68 6- Aug- 2002 104. 34 7. 3728% 0. 990695
11. 00 23- May- 2003 105. 74 7. 6309% 1. 720562
12. 50 23- Mar- 2004 111. 63 7. 6399% 2. 318881
11. 98 8- Sep- 2004 111. 8 7. 6917% 2. 653983
11. 19 12- Aug- 2005 111. 83 7. 7524% 3. 297774
11. 68 10- Apr- 2006 114. 4 7. 9700% 3. 753991
11. 90 28- May- 2007 116. 6 8. 2733% 4. 463083
Por t f ol i o
Val u e 776. 34
Por t f ol i o Du r at i on 2. 781662
The port f olio durat ion is t he weight ed durat ion of t he bonds, using t he market values as
weight s. I t is comput ed as
Sumproduct ( market price, durat ion) / sum ( market price)
= 2. 7816

3. Usi n g t h e same dat a as i n Qu est i on 2, i f t h e ex pect at i on i s t h at yi el d w ou l d
i n cr ease by 50 basi s poi n t s, w h at w ou l d be t h e ex pect ed ch an ge i n t h e val u e of
t h e por t f ol i o?
An sw er : We can use t he mdu r at i on f unct ion in Excel, and comput e t he modif ied
durat ion of all t he bonds, and f ind t he port f olio modif ied durat ion, using a similar
met hod as in Answer 2. We would arrive at a number 2. 6763 as t he port f olio s
modif ied durat ion.
A 50bp increase in yield will reduce t he value of t he port f olio by

173
2. 6763* . 05 = 1. 3381%
I n rupee t erms t hat would be Rs. 776. 34 * 1. 3381%
= Rs. 10. 3888

174
Ch apt er 16

Fi x ed I n come Der i vat i ves

16. 1 Wh at ar e Fi x ed- I n come Der i vat i ves?

Fixed income derivat ives are securit ies t hat derive t heir value f rom some bond price,
int erest rat e or an underlying bond market variable. I n t erms of volumes globally, t hey
account f or a maj or proport ion of derivat ives market s. They are import ant because t hey
enable banks t o separat e f unding/ liquidit y decisions f rom int erest - rat e sensit ivit y
decisions.

16. 1. 1 For w ar d Rat e Agr eemen t s

Spot Rat es an d For w ar d Rat es
We already have discussed Spot or Zero- Coupon int erest rat es. A spot int erest rat e
is t he int erest rat e on an invest ment st art ing t oday and ending af t er some ( say n)
years. This is a pure int erest rat e i. e. it is assumed t hat t here are no coupon payment s
bet ween t oday and n years. This is also t he yield on a zero coupon bond of t he
corresponding mat urit y. I n t he absence of zero coupon bonds, t he spot rat es can be
est imat ed f rom t he yields on coupon bearing bonds by a process called boot st rapping
A f orward rat e is t he int erest rat e cont ract ed t oday on an invest ment t hat will be
init iat ed af t er some t ime ( n years) . I n ot her words, t hey are rat es implied by current
spot rat es f or periods in t he f ut ure.
Consider t he f ollowing example:

Ti me Spot Rat e ( an n u al i zed)
1 year 6%
2 year 7%
3 year 8%

This means t hat Rs. 100 invest ed t oday will give Rs. 106 at t he end of one year.
Rs 100 invest ed t oday will give Rs, ( 100* ( 1+ 7/ 100)
2
) t hat is Rs. 114. 49 at t he end of
t wo years and Rs ( 100* ( 1+ 8/ 100)
3
) t hat is Rs. 125. 97 at t he end of t hree years.
The quest ion we must ask is as f ollows:
What would be t he amount I would receive on Rs. 100 invest ed af t er one year at t he
end of t wo years?
Not ice t hat t he payof f f rom t he above invest ment would come at t he end of t wo years
f rom t oday.
We can re- creat e t he above invest ment s using present int erest rat es. For t he sake of
simplicit y, we assume t hat bid- ask spreads are negligible.
1. Borrow t oday in an amount t hat will give Rs. 100 af t er one year. This amount is
Rs. 100/ ( 1. 06) t hat is Rs. 94. 34.
2. I nvest t he same amount f or a period of t wo years. At t he end of t wo years, t he
payof f will be Rs. 94. 34* ( 1. 07)
2
t hat is Rs. 108.

175
At t he end of one year, Rs. 100 will have t o be paid out f or t he f irst borrowing. At t he
end of t wo

176
years Rs. 108 will f low in. I n t erms of cash f lows, t his is what it looks like:

















Not ice t hat at Year 0, t here is an out f low and inf low of Rs. 94. 34 and hence t he net f low
is zero. I n ot her words, t he above series of f lows is t he same as:















I n ef f ect we have creat ed an invest ment where we will lend Rs. 100 af t er one year and
will get back Rs. 108 af t er t wo years. This means t hat t he int erest rat e f rom one year t o
t wo years f orward is 8%.
I n t he above example, t he 8% int erest rat e is called t he f orward rat e of int erest . I n
most circumst ances, t he f orward rat e of int erest is t he expect ed spot rat e f or t he
corresponding period.

Why is t he f orward rat e also t he expect ed spot rat e?
I f t he market had expect ed t he spot rat e ( f rom 1 t o 2 years) t o be less t han t he f orward
rat e indicat ed t oday, t hey would have heavily st art ed doing t he above t ransact ions t o
lock in t he great er f orward rat e. This would have meant addit ional demand f or borrowing
one- year money and lending t wo- year money. This would have pushed t he one- year
0
Year
1
Year
2
Years
Rs.
108
Rs.
100
Rs.
94.34
Rs.
94.34
0
Year
1
Year
2
Years
Rs.
108
Rs.
100

177
spot rat e up and t he t wo- year spot rat e down t ill t he implied f orward rat e was in line
wit h market expect at ions.


178
We can similarly const ruct t he 2- 3 year f orward rat e and t he 1- 3 year f orward rat e.
The rat es would be as f ollows:

Year Spot rat es
0- 1 6%
0- 2 7%
0- 3 8%

Year Forward Rat es
1- 2 8%
2- 3 10%

A point t o be not ed about f orward rat es is t hat t hey can never be negat ive. This applies
some rest rict ions on t he t erm st ruct ure of t he spot rat es. For inst ance, t he f ollowing
t erm st ruct ure cannot be possible

Year Spot rat es
0- 1 6%
0- 2 7%
0- 3 4%

This is because comput at ion shows t hat t he 2- 3 year f orward rat e is 1. 7%. I f t he
f orward rat e were negat ive, one can borrow t hree- year money and invest it f or t wo
years and sit on cash f rom year 2 t o year 3 t o make a risk f ree prof it .
Formula f or comput at ion of t he Forward Rat e:
I f we have t he n- year spot rat e as Rn and t he m- year spot rat e as Rm where m> n
And we want t o comput e t he f orward rat e Fmn f rom year n t o year m, t hen:
( 1+ Rn)
n
* ( 1+ Fmn )
m- n
= ( 1+ Rm)
m

Using t he above f ormula, Fmn can be comput ed.

16. 2 Mech an i cs of For w ar d Rat e Agr eemen t s

Forward Rat e Agreement s ( FRAs) are over t he count er derivat ive cont ract s t hat allow
count er- part ies t o lock int o a specif ied int erest rat e f or a f ut ure dat e. The buyer of an
FRA locks in a borrowing rat e while t he seller locks int o a lending rat e.
Typically t hese cont ract s are st ruct ured in such a way t hat t he dif f erence bet ween t he
market rat e and t he locked- in rat e is set t led.

Consider t he f ollowing example:
A and B ent er int o a forward rat e agreement of one year, st art ing one year f rom t oday,
f or a not ional amount of Rs. 100. Part y A is t he buyer i. e. it has locked int o a borrowing
rat e. The spot int erest rat es in t he market are t he same as t he ones ment ioned in t he
earlier example.

Pr i ci n g
The f irst quest ion t o ask is: What is t he most likely rat e at which t he Forward Rat e
Agreement will be cont ract ed?

179
The answer is obvious: I t should be t he f orward rat e implied by t odays int erest rat es
f rom year 1 t o year 2. We have earlier calculat ed t his at 8%. I f t he cont ract ed FRA rat e
is dif f erent , t hen one of t he part ies will carry out t he t wo t ransact ions ment ioned in t he
earlier example and benef it f rom it . This part y will have earned a risk- f ree prof it . I t is
unlikely t hat t he ot her part y will allow t hat t o happen.
I n pract ice, it is slight ly dif f erent because of bid- ask spreads bet ween lending and
borrowing rat es.

Suppose one year has passed by. Now t he one year spot int erest rat e is 7%. The
quest ion now is: Who has benef it ed f rom t he FRA and by how much?
The scenario now is as f ollows:
1. Part y A had locked int o a borrowing st art ing t oday and ending one year f rom
now at 8%.
2. Todays rat e is act ually 7%.
This means t hat part y A will lose out 1% at t he end of next year.
I n a t ypical FRA wit h net t ed out cash int erest payment s, t he amount t hat A would lose
will be discount ed at t he prevailing rat e ( 7%) and set t led. The FRA is t hen closed out . I t
is easy t o work out t hat t he part y t hat is long a FRA ( Borrower) receives a payment
when t he rat es go up and t he part y t hat has sold an FRA ( Lender) receives payment
when t he rat es go down.
The advant age of net t ing is t hat t he not ional amount s and int erest rat es need not be
act ually exchanged. This causes signif icant reduct ion is credit risk. However, one will
also f ind FRAs t hat are in t he nat ure of act ual lending. I n I ndia, t here is some amount of
f orward lending act ivit y bet ween banks and corporat es.

16. 3 I n t er est Rat e Fu t u r es

Fut ures are st andardized Forward cont ract s t hat are t raded on exchanges. The
count erpart in t his case will be t he exchange it self . These are cont ract s on eit her t he
level of int erest rat e of specif ied t enors, or on t he price of bonds of part icular mat urit y.
An example of t he f ormer are t he Euro- Dollar f ut ures cont ract s t raded on LI FFE. An
example of t he lat t er are t he T- Bond f ut ures t raded on CBOT. I n I ndia, int erest rat e
f ut ures have not been int roduced as yet .
There are several import ant dif f erences bet ween Fut ures and Forward cont ract s:
1. Fut ures are st andardized and available only f or cert ain t enors and dat es and
only on cert ain int erest rat e benchmarks. I n t hat sense, t heir usage is
rest rict ive.
2. Fut ures are t radable on t he exchange. Hence t hey are highly liquid inst rument s.
3. Fut ures are marked t o market daily and t he Prof it and Loss on t he cont ract is
paid out , bet ween t he part icipant and t he exchange.

Uses of FRAs an d Fu t u r es
As wit h any derivat ives cont ract s, FRAs and f ut ures have t hree main uses.
1. Hedging
2. Speculat ion
3. Arbit rage

180
Hedging: FRAs and Fut ures can be used t o remove uncert aint y about f ut ure int erest
rat es and hence reduce t he uncert aint y of f ut ure earnings.
For inst ance, suppose t he Financial Manager of a company knows t hat t here is going t o
be a large inf low of cash one year down t he line, which will have t o be invest ed. He is
also uncert ain about int erest rat es one year down t he line and want s t o remove t his
uncert aint y. A very good way t o do t his is t o sell a f orward rat e agreement st art ing one
year hence. This way, he can lock int o a f orward rat e t oday it self and remove t he
uncert aint y.
Speculat ion:
Suppose a speculat or f eels t hat int erest rat es are going t o f all drast ically in t he f ut ure,
t o a great er ext ent t han t hat implied by t he f orward rat es. He can ent er int o a f orward
rat e agreement and receive a locked in rat e. He st ands t o benef it if t he rat es indeed f all.
However, if t he rat es rise, he st ands t o lose. I n t his case, t he speculat or has t aken a
view t hat t he rat es will f all. I t is in t his sense t hat Forwards and Fut ures are j ust like
wagers on t he f ut ure levels of int erest rat es.
Sal i en t Poi n t s
1. A f orward rat e is t he int erest rat e on an invest ment t o be made at some point
in t he f ut ure.
2. A Forward Rat e Agreement is an over t he count er Forward cont ract bet ween
t wo part ies f or a specif ied int erest rat e at some point in t he f ut ure.
3. I nt erest Rat e Fut ures are st andardized f orward cont ract s on int erest rat es t hat
are t raded on an exchange.
4. Forward Rat e Agreement s and I nt erest Rat e Fut ures cont ract s can be used f or
hedging and speculat ion.

16. 4 I n t er est Rat e Sw aps

Wh at ar e i n t er est r at e sw aps ( I RS) ?
An I RS can be def ined as an exchange bet ween t wo part ies of int erest rat e obligat ions
( payment s of int erest ) or receipt s ( invest ment income) in t he same currency on an
agreed amount of not ional principal f or an agreed period of t ime.
The most common t ype of int erest rat e swaps are t he plain vanilla I RS. Current ly,
t hese are t he only kind of swaps t hat are allowed by t he RBI in I ndia. Dealing in Exot ics
or advanced int erest rat e swaps have not been permit t ed by t he RBI .
I n a plain vanilla swap, one part y agrees t o pay t o t he ot her part y cash f lows equal t o
t he int erest at a predet ermined f ixed rat e on a not ional principal f or a number of years.
I n exchange, t he part y receiving t he f ixed rat e agrees t o pay t he ot her part y cash f lows
equal t o int erest at a f loat ing rat e on t he same not ional principal f or t he same period of
t ime. Moreover, only t he dif f erence in t he int erest payment s is paid/ received; t he
principal is used only t o calculat e t he int erest amount s and is never exchanged.

An example will help underst and t his bet t er:
Consider a swap agreement bet ween t wo part ies, A and B. The swap was init iat ed on
July 1, 2001. Here, A agrees t o pay t he 3- mont h NSE- MI BOR rat e on a not ional principal
of Rs. 100 million, while B pays a f ixed 12. 15% rat e on t he same principal, f or a t enure
of 1 year.

181
We assume t hat payment s are t o be exchanged every t hree mont hs and t he 12. 15%
int erest rat e is t o be compounded quart erly. This swap can be depict ed diagrammat ically
as shown below:

MI BOR ( 3m)


12. 15%



An int erest rat e swap is ent ered t o t ransf orm t he nat ure of an exist ing liabilit y or an
asset . A swap can be used t o t ransf orm a f loat ing rat e loan int o a f ixed rat e loan, or vice
versa. To underst and t his, consider t hat in t he above example;

A had borrowed a 3 yr, 1 crore loan at 12%. This means t hat f ollowing t he swap, it will:

( a) Pay 12% t o t he lender,
( b) Receive 12. 15% f rom B
( c) Pay 3 mont h MI BOR

Thus, A s 12% f ixed loan is t ransf ormed int o a f loat ing rat e loan of MI BOR 0. 15%.
Similarly, if B had borrowed at MI BOR + 1. 50%, it can t ransf orm t his loan t o a f ixed rat e
loan @ 13. 65% ( 12. 15 + 1. 50) . Following f igure summarizes t his t ransact ion.


12% MI BOR ( 3m)
MI BOR ( 3m)

+ 1. 50% 12. 5%

An I RS can al so be u sed t o t r an sf or m asset s.

Ex ampl e

A f ixed- rat e earning bond can be t ransf ormed int o variable rat e earning asset and vice
versa. I n t he above example, it could be t hat A had a bond earning MI BOR+ 0. 5% and B
a bond earning 12. 5% int erest compounded quart erly. The swap would t hen result in A
receiving a f ixed income of 12. 65% and B receiving a variable income of MI BOR+ 0. 35%.
This can be shown diagrammat ically as f ollows:

MI BOR MI BOR ( 3m)
12. 50%
+ 0. 50%
12. 15%

Somet imes, a bank or f inancial int ermediary is involved in t he swap. I t charges a
commission f or t his. The t wo part ies of t en do not even know who t he ot her part y is. For
Par t y A Par t y B
Par t y A Par t y B
Par t y A Par t y B

182
t hem, t he int ermediary is t he count er- part y. For example, if a f inancial inst it ut ion
charging 20 basis point s were act ing as int ermediary, t he swap would look as f ollows:


12. 17% 12. 37%

MI BOR ( 3m) MI BOR ( 3m)




A Sw ap as a Combi n at i on of Bon ds
A swap can be int erpret ed as a combinat ion of bonds in such a way t hat t he receive
f ixed leg is short on a f loat ing rat e bond and long on a f ixed rat e bond and vice versa f or
t he receive f loat ing leg.
This has signif icant implicat ion on t he pricing and valuat ion of plain vanilla int erest rat e
swaps because a swap can be valued as a combinat ion of t he t wo:
An example will make t his very clear. Consider t he swap f or a not ional of Rs 100.
Part y A pays 3 mont h MI BOR and receives 12. 15% f or a period of t wo years. This is
equivalent t o A having a short posit ion in a 3 mont h MI BOR linked bond and a long
posit ion in a 2 year 12. 15% bond wit h quart erly payment s. 12. 15% is also t he going
swap rat e at t he t ime of incept ion of t he swap.
Assume t hat 1- mont h has passed since t he incept ion of t he bond. Hence t here are t wo
mont hs lef t f or t he int erest payment s t o be exchanged. Let us also assume t hat t he
swap has a look ahead conf igurat ion i. e. t he MI BOR t o be paid af t er t wo mont hs has
already been set .
1. The 12. 15% f ixed rat e bond can be valued according t o convent ional met hods
i. e. by discount ing each cash f low f rom t he bond by t he discount ing rat e f or t he
relevant period.
2. The MI BOR linked bond will reset t o par. This is because on t he next reset dat e,
t he coupon t hat will be f ixed ( MI BOR) will also be equal t o t he discount ing rat e
f or t he relevant period. Hence we have t he par value + MI BOR t o be discount ed
f or a period of t wo mont hs ( t ime t o reset ) .
The value of t he swap is simply t he dif f erence bet ween t he above t wo.

A sw ap as a st r i n g of FRAs or f u t u r es

A swap can also be int erpret ed as a st rip of FRAs or f ut ures cont ract s. Consider t hat
every t ime t he f loat ing index is reset an int erest rat e payment goes f rom one
count erpart y t o t he ot her in j ust t he same way t hat compensat ion is payable/ received
under an FRA. I n a similar way, as int erest rat e changes so t he value of a f ut ures
posit ion changes.
Consider a long f ut ures long posit ion and a short FRA posit ion remember t hese denot e
t he same obligat ion. Each posit ion gains if int erest rat es f all and loses if int erest rat es
rise. The risk/ ret urn prof ile is t hat of a swap- f loat ing rat e payer.
Similarly, f or a swap f ixed rat e payer t he posit ion is t he same as t hat f or a short f ut ures
posit ion and a long FRA posit ion. Each will lose if int erest rat es f all and gain if int erest
rat es rise.
Par t y A
Par t y
B
BANK

183

Pr i ci n g an I RS

I n order t o det ermine t he f ixed rat e or t he swap rat e t o be paid or received f or t he
desired int erest rat e swap, t he present value of t he f loat ing rat e payment s must equat e
t he present value of f ixed rat es. The t rut h of t his st at ement will become clear if we
ref lect on t he f act t hat t he net present value of any f ixed rat e or f loat ing rat e loan must
be zero when t hat loan is grant ed, provided, of course, t hat t he loan has been priced
according t o prevailing market t erms. However, we have already seen t hat a f ixed t o
f loat ing int erest rat e swap is not hing more t han t he combinat ion of a f ixed rat e loan and
a f loat ing rat e loan wit hout t he init ial borrowing and subsequent repayment of a
principal amount . Hence, in order t o arrive at an init ial f ixed rat e, we f ind t hat rat e f or
t he f loat ing leg t hat gives a zero present value f or t he ent ire swap. The market maker
t hen adds some spread so t hat t he present value t o t he market maker is slight ly
posit ive.


184
Wh y do f i r ms en t er i n t o i n t er est r at e sw aps?

Sw aps f or a com par at i ve advan t age

Comparat ive advant ages bet ween t wo f irms arise out of dif f erences in credit rat ing,
market pref erences and exposure.

Ex ampl e: Say, Firm A wit h high credit rat ing can borrow at a f ixed rat e of 12% and at
a f loat ing rat e of MI BOR + 20 bps. Anot her f irm B wit h a lower credit rat ing can borrow
at a f ixed rat e of 14 % and a f loat ing rat e of MI BOR + 150 bps.

Bef or e t h e Sw ap
Part y Fixed rat e loan Float ing rat e loan
A 12 % MI BOR + 0. 20%
B 14 % MI BOR + 1. 50%

Firm A has an absolut e advant age over f irm B in bot h f ixed and f loat ing rat es. Firm B
pays 200 bps more t han f irm A in t he f ixed rat e borrowing and only 120 bps more t han
A in t he f loat ing rat e borrowing. So, f irm B has a comparat ive advant age in borrowing
f loat ing rat e f unds.
Now, Firm A wishes t o borrow at f loat ing rat es and becomes t he f loat ing rat e payer in
t he swap arrangement . However, A act ually borrows f ixed rat e f unds in t he cash market .
I t is t he int erest rat e obligat ions on t his f ixed rat e f unds, which are swapped. At t he
same t ime, B wishes t o borrow at a f ixed rat e, and t hus will act ually borrow f rom t he
market at t he f loat ing rat e.

Then, bot h t he part ies will exchange t heir underlying int erest rat e exposures wit h each
ot her t o gain f rom t he swap. The calculat ion of t he gain f rom t he swap is shown below:
The gain t o f irm A, because it borrows in t he f ixed rat e segment is:
14% - 12% = 200 bps.
And, t he loss because f irm B borrows in t he f loat ing rat e segment is:
( MI BOR + 20 bps) ( MI BOR + 120 bps) = 130 bps.

Thus, t he net gain in t he swap = 200 120 = 70 bps. The f irms can divide t his gain
equally. Firm B can pay f ixed at 12. 15% t o f irm A and receive a f loat ing rat e of MI BOR
as illust rat ed below:

Af t er t h e Sw ap
MI BOR


12 . 15 %





12 % MI BOR + 150 bps
Par t y A Par t y B

185



Ef f ect ive cost f or f irm A = 12% + ( MI BOR 12)
= MI BOR - 15 bps

This result s int o a net gain of ( ( MI BOR + 20) - ( MI BOR - 15) ) i. e. , a gain of 35 bps.

Ef f ect ive cost f or f irm B = ( MI BOR + 150) + ( 12. 15% - MI BOR)
= 13. 65%

This result s int o a gain of ( 14% - 13. 65%) i. e. , a gain of 35 bps.
Thus, bot h t he part ies gain f rom ent ering int o a swap agreement .

As w e h ave seen , f i r ms can u se I RS t o t r an sf or m asset s an d l i abi l i t i es. Bu t
t h en , w h y don t f i r ms t ak e t h e desi r ed f or m of l oan or asset ( f i x ed or f l oat i n g)
i n t h e f i r st pl ace?
Ricardos comparat ive advant age t heory explains t his behavior t o some ext ent .
Cont inuing wit h t he same example, let us assume t hat As credit rat ing is bet t er t han
Bs, and A and B can raise loans f or f ixed and f loat ing rat es as given below:

Bef or e t h e Sw ap
Firm Fixed rat e loan rat e Float ing rat e loan rat e
A 12% MI BOR + 0. 20%
B 14% MI BOR + 1. 50%

Here, we see t hat t hough f irm A can borrow cheaply compared t o f irm B in bot h t he
market s, t he dif f erence in rat es available is not t he same. Firm B has a comparat ive
advant age in t he f loat ing rat e market because it pays only 1. 30% higher here,
compared t o t he 2% dif f erence in t he f ixed rat e market . So, f irm B will borrow at a
f loat ing rat e, and f irm A at f ixed rat e.
Af t er t he swap deal, t he cost of t he f loat ing rat e loan t o f irm A will be MI BOR- 0. 15%, a
clean gain of 35 basis point s. Similarly, f irm B also gains 35 basis point s, because t he
cost of it s loan will be 13. 35% only, af t er t he swap. Thus, bot h part ies gain f rom t he
swap, as shown below:

Af t er t h e Sw ap
Fi r m Fi x ed r at e l oan r at e Fl oat i n g r at e l oan r at e Gai n
A - Mibor - 0. 15 % 35 bps
B 13. 65% - 35 bps

I n a perf ect market , however, t he spread bet ween f ixed and f loat ing rat es of f ered
should vanish due t o I RS. This is not seen in realit y, and spreads cont inue t o persist . So,
t he credit rat ings of t he f irms are not t he only crit eria by which lenders j udge f irms, and
t he comparat ive advant age t heory cont inues t o hold.


186
Sw aps f or Redu ci n g t h e Cost of Bor r ow i n g
Wit h t he int roduct ion of rupee derivat ives, t he I ndian corporat es can at t empt t o reduce
t heir cost of borrowing and t hereby add value. A t ypical I ndian case would be a
corporat e wit h a high f ixed rat e obligat ion.
MI PL, an AAA rat ed corporat e, 3 years back had raised 4-year funds at a fixed rat e of
18. 5%. Today a 364- day T- bill is yielding 10. 25%, as t he int erest rat es have come
down. The 3- mont h MI BOR is quot ing at 10%.
Fixed t o f loat ing 1 year swaps are t rading at 50 bps over t he 364- day T- bill vs. 6- mont h
MI BOR.
The t reasurer is of t he view t hat t he average MI BOR shall remain below 18. 5% f or t he
next one year. The f irm can t hus benef it by ent ering int o an int erest rat e f ixed f or
f loat ing swap, whereby it makes f loat ing payment s at MI BOR and receives f ixed
payment s at 50 bps over a 364- day t reasury yield i. e. 10. 25 + 0. 50 = 10. 75 %.

18 . 5 % 10. 75% MI BOR


MI BOR ( 3m)

The ef f ect ive cost f or MI PL = 18. 50 + MI BOR - 10. 75
= 7. 75 + MI BOR

At t he present 3m MI BOR is 10%, t he ef f ect ive cost is = 10 + 7. 75 = 17. 75%

The gain f or t he f irm is ( 18. 5 - 17. 75) = 0. 75 %

The risks involved f or t he f irm are:
Def ault / credit risk of part y B: Since t he count erpart y is a bank, t his
risk is much lower t han would arise in t he normal case of lending t o
corporat es. This risk involves losses t o t he ext ent of t he int erest rat e
dif f erent ial bet ween f ixed and f loat ing rat e payment s.
The f irm is f aced wit h t he risk t hat t he MI BOR goes beyond 10. 75%.
Any rise beyond 10. 75% will raise t he cost of f unds f or t he f irm.
Theref ore it is very essent ial t hat t he f irm hold a well- suggest ed view
t hat MI BOR shall remain below 10. 75%. This will require cont inuous
monit oring.

How does t he bank benef it out of t his t ransact ion?
The bank eit her goes f or anot her swap t o of f set t his obligat ion and in t he process earn a
spread. The bank may also use t his swap as an opport uni t y t o hedge it s own f loat ing
liabilit y. The bank may also leave t his posit ion uncovered if it is of t he view t hat MI BOR
shall rise beyond 10. 75%.

Tak i n g advan t age of f u t u r e vi ew s / specu l at i on
I f a bank holds a view t hat int erest rat e is likely t o increase and in such a case t he
ret urn on f ixed rat e asset s will not increase, it will pref er t o swap it wit h a f loat ing rat e
int erest . I t may also swap f loat ing rat e liabilit ies wit h a f ixed rat e.
MI PL Par t y B

187
Ot her reasons f or using I RS are speculat ion on f ut ure int erest rat e movement s,
management of asset - liabilit y mismat ch, alt ering debt st ruct ure, of f - balance sheet gains,
and int erest risk management . I t has been observed t hat FRAs are more popular f or
hedging against int erest risks, while I RS are more popular f or speculat ion and
t ransf orming nat ure of asset s and liabilit ies.

Model Qu est i on s

1. An i n t er est r at e sw ap t r an sf or ms t h e n at u r e of ___________.
a) an exist ing liabilit y only
b) an exist ing asset only
c) an not ional liabilit y or an asset
d) an exist ing liabilit y or an asset
An sw er : d

2. A sw ap can be i n t er pr et ed as a st r i p of ___________.
a) f ixed rat e agreement s only
b) f ut ure cont ract s only
c) f ixed rat e agreement s or f ut ure cont ract s
d) None of t he above
An sw er : c

3. For w ar d r at es can n ot be ___________.
a) posit ive
b) negat ive
c) zero
d) higher t han spot rat e
An sw er : b





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Ch apt er 17

Gl ossar y of Debt Mar k et Ter ms
19


Accr u ed I n t er est
I f a coupon bearing securit y is t raded bet ween t wo coupon dat es, t he buyer has t o
compensat e t he seller by paying him t hat part of t he int erest which is due t o him f or t he
period f or which he has held t he securit y af t er t he immediat ely preceding coupon dat e.
The calculat ion of accrued int erest is done according t o t he day- count convent ion of t he
securit y or market ( See Day Count ) .

Ask Pr i ce
I n Financial Market s, market makers quot e bot h bid ( buy) price and ask ( of f er) price.
This indicat es t hat t he market maker, not knowing t he int ent ion of t he price t aker is
quot ing him rat es f or bot h buying as well as f or selling. The bid price is generally lower
t han t he sell price, as dict at ed by normal prof it mot ive ( Somet imes a dealer would quot e
t he same bid and ask, in which case t he price is called a "choice- price") . The dif f erence
bet ween t he bid and t he ask price is normally called t he "bid- ask spread". The spread
depends on many f act ors like liquidit y in t he inst rument quot ed, t he bias of t he dealer,
his eagerness or ot herwise t o t rade, market volat ilit y et c. A small dif f erence is
considered t o be a very f ine price as t he dealer is keeping very lit t le by way of his
prof it s. As example: A dealer quot ing 12. 50% 2004 might quot e 105. 15/ 20. This implies
t hat t he dealer is willing t o buy t he paper at 105. 15 while he is willing t o sell it at
105. 20. I n act ual pract ice t he price may be given as 15/ 20. I t is underst ood t hat market
part icipant s are aware of t he big f igure. I t should be kept in mind t hat while quot ing
int erest rat e rat es, t he bid is in f act higher t han t he of f er. For example a USD 3x6 FRA
can be quot ed as 5. 75/ 70, implying t hat t he dealer is willing t o buy t he FRA at a yield of
5. 70% while he will sell t he same FRA at an yield of 5. 75%.

Asset Back ed Secu r i t y
Any securit y t hat of f ers t o t he invest or an asset as t he collat eral is called Asset Backed
Securit y. The rat e of ret urn required by t he invest or f or such t ypes of bonds is generally
less compared t o bonds t hat of f er no collat eral.

Au ct i on
The process of issuing a securit y t hrough a price- discovery mechanism t hrough asking
f or bids. This is t he process f ollowed by t he RBI f or all t ypes of issues of debt market
paper by it .

Bal an ce Ten or
The un- expired lif e of t he securit y


19
This glossary has been downloaded and modif ied f rom www. debt onnet . com, t he f irst
int ernet based debt market port al in I ndia.

189
Ban k Rat e
Bank Rat e is a direct inst rument of credit cont rol . I t is t hat int erest rat e or discount rat e
at which banks , f inancial inst it ut ions and ot her approved ent it ies in t he int erbank
market can get f inancial accommodat ion f rom t he cent ral bank of t he count ry . By hiking
t he bank rat e t he cent ral bank makes credit expensive and by lowering t he same t hey
make credit cheaper

Basi s Poi n t
One hundredt h of a percent age ( i. e. 0. 01) . As int erest rat es are generally sensit ive in
t he second place af t er t he decimal point , t he measure has large import ance f or t he debt
market .

Ben ch mar k Rat e
Benchmark rat es are rat es or t he prices of inst rument s t hat are t raded in t he market on
which are used f or pricing of ot her inst rument s. These rat es or prices are used as
benchmark f or f loat ing rat e inst rument s. Typically a benchmark rat e should sat isf y t he
f ollowing crit eria
1. The rat e should be available readily and should eit her be direct ly observable in
t he market or made available by a credible agency
2. The benchmark should be liquid so t hat count er- hedging st rat egies are readily
available
3. The rat e should be unique and leave no scope f or ambiguit y

The benchmark should be represent at ive of t he market . I nt ernat ionally t he most popular
benchmarks are t he LI BOR and t he US Treasury. I n I ndia, given t he paucit y of rat es t hat
sat isf y t he above crit erion, not many benchmarks exist , save t he MI BOR announced by
eit her t he NSE or Reut ers.

Bi d Pr i ce
See Ask Price

Bon d
A bond a promise in which t he I ssuer agrees t o pay a cert ain rat e of int erest , usually as
a percent age of t he bond' s f ace value t o t he I nvest or at specif ic periodicit y over t he lif e
of t he bond. Somet imes int erest is also paid in t he f orm of issuing t he inst rument at a
discount t o f ace value and subsequent ly redeeming it at par. Some bonds do not pay a
f ixed rat e of int erest but pay int erest t hat is a mark- up on some benchmark rat e.

Boot st r appi n g
Boot st rapping is an it erat ive process of generat ing a Zero Coupon Yield Curve f rom t he
observed prices/ yields of coupon bearing securit ies. The process st art s f rom observing
t he yield f or t he short est - t erm money market discount inst rument ( i. e. one t hat carries
no coupon) . This yield is used t o discount t he coupon payment f alling on t he same
mat urit y f or a coupon- bearing bond of t he next higher mat urit y. The result ing equat ion
is solved t o give t he zero yield ( also called spot yield) f or t he higher mat urit y period.
This process is cont inued f or all securit ies across t he t ime series. I f represent ed
algebraically, t he process would lead t o an n t h degree polynomial t hat is generally

190
solved using numerical met hods. The most popular one being t he Newt on- Raphson
t echnique.

Cal l Mon ey
Borrowing or lending f or one day upt o 14 days, in t he int erbank market is known as call
money. Ent ry int o t his segment of t he market is rest rict ed t o not if ied part icipant s which
include scheduled commercial banks, primary dealers and sat ellit e dealers, development
f inancial inst it ut ions and mut ual f unds

Cal l Opt i on
See Opt ion

Cal l abl e Bon d
A Bond which has a Call covenant in it s t erms of issue, i. e. one in which t he I ssuer
reserves t he right t o buy- back t he issue is called a Callable Bond.

Cl ean Pr i ce
A Clean Price of a bond or securit y is t he discount ed value of all it s f ut ure cash f lows
( using a suit able discount rat e, which can be t he YTM or t he relevant spot rat e) .
However, if t he bond is t raded bet ween t wo coupon dat es, t he buyer of t he bond will
have t o compensat e t he seller f or t hat part of t he period bet ween coupons f or which t he
seller was owning t he bond ( See Accrued I nt erest ) . The price arrived at af t er adj ust ing
t he Clean Price f or t his f act or is called t he Dirt y Price.

Col l at er al i sed Bon d
Any f ixed income inst rument which has collat eral as a back up t o t he issue is called a
Collat eralised Bond. I n I ndia, relat ed t erminology is secured bonds or unsecured bonds.

Commer ci al Paper ( CP)
A Commercial Paper is a short t erm unsecured promissory not e issued by t he raiser of
debt t o t he invest or. I n I ndia Corporat es, Primary Dealers ( PD) , Sat ellit e Dealers ( SD)
and All I ndia Financial I nst it ut ions ( FI ) can issue t hese not es. For a corporat e t o be
eligible it must have a t angible net wort h of Rs 4 crore or more and have a sanct ioned
working capit al limit sanct ioned by a bank/ FI . I t is generally companies wit h very good
rat ing which are act ive in t he CP market , t hough RBI permit s a minimum credit rat ing of
Crisil- P2. The t enure of CPs can be anyt hing bet ween 15 days t o one year, t hough t he
most popular durat ion is 90 days. These inst rument s are of f ered at a discount t o t he
f ace value and t he rat e of int erest depends on t he quant um raised, t he t enure and t he
general level of rat es besides t he credit rat ing of t he proposed issue. While most of t he
issuing ent it ies have est ablished working capit al limit s wit h banks, t hey st ill pref er t o use
t he CP rout e f or f lexibilit y in int erest rat es. The credit rat ings f or CP are issued by
leading rat ing agencies. Recent ly t he quant um raised by t he issuer t hrough t he CP has
been excluded f rom t he ambit of bank f inance, but banks cont inue t o pref er earmarking
eit her t heir own limit s f or t he corporat e or t he consort ium limit s while subscribing t o t he
commercial paper.


191
Con st i t u en t SGL A/ c
SGL account holders can have t wo SGL account s wit h RBI - SGL account no. 1 and SGL
account no. 2 . SGL account no. 1 is t he account f or t he own holdings of t he bank or t he
PD or SD who has t he direct account . SGL account no. 2 is f or t heir const it uent s . Those
who are not eligible f or direct SGL account wit h RBI , say , f or example , a Provident
Fund Trust , who is not eligible f or an SGL account can hold securit ies in demat f orm by
opening a const it uent SGL account wit h a Bank, PD or SD . Thr ough t he SGL account
no. 2 of t he part y who has direct account wit h RBI t he f acilit y will be made available t o
t he PF

Con ver t i bl e Bon d
A bond t hat is part ially or f ully convert ible int o equit y wit hin a specif ied period of t ime
f rom t he dat e of issue is known as a convert ible bond. I n such cases, t he bond does not
pay t he holder t hat part of t he mat urit y value t hat is earmarked f or conversion t o
equit y.

Con vex i t y
See in conj unct ion wit h Durat ion, PVBP and I mmunizat ion. Convexit y is anot her
measure of bond risk. The measure of Durat ion assumes a linear relat ionship bet ween
changes in price and durat ion. However, t he relat ionship bet ween change in price and
change in yield is not linear and hence t he est imat ed price change obt ained by durat ion
will give only an approximat e value. The error is insignif icant when t he change in yield is
small but does not hold t rue f or larger changes in yield, as t he act ual price- yield
relat ionship is convex. Convexit y is t he measure of t he curvat ure of t he price- yield
relat ionship. I t is also t he rat e of change of durat ion wit h a change in yield. A high
convexit y is of t en a desired charact erist ic as f or a given change in yield, posit ive or
negat ive, a bond' s percent age rise in price is great er t han t he percent age price loss.

While modif ied durat ion is used t o predict t he bond' s % change in price small change in
yields, modif ied durat ion and convexit y t oget her are used t o calculat e a bond' s %
change in price f or a large change in yield, as per t his relat ionship.

Cou pon
The rat e of int erest paid on a securit y, generally a f ixed percent age of t he f ace value, is
called t he coupon. The origin of t he t erm dat es back t o t he t ime when bonds had
coupons at t ached t o t hem, which t he invest or had t o det ach and present t o t he issuer t o
receive t he money.

Cr edi t Rat i n g
Credit Rat ing is an exercise conduct ed by a rat ing organisat ion t o explore t he credit
wort hiness of t he issuer wit h respect t o t he inst rument being issued or a general abilit y
t o pay back debt over specif ied periods of t ime. The rat ing is given as an alphanumeric
code t hat represent s a graded st ruct ure or credit wort hiness. Typically t he highest credit
rat ing is t hat of AAA and t he lowest being D ( f or def ault ) . Wit hin t he same alphabet
class, t he rat ing agency might


192
CRR
This is t he acronym f or Cash Reserve Rat io. That part of t heir asset s which banks in
I ndia are required t o hold as Cash in balances wit h t he Reserve Bank of I ndia is called
t he Cash Reserve Rat io.

Cu r r en t Yi el d
Current Yield on a bond is def ined as t he coupon rat e divided by t he price of t he bond.
This is a very inadequat e measure of yield, as it does not t ake int o account t he ef f ect of
f ut ure cash f lows and t he applicat ion of discount ing f act ors on t hem.

Day Cou n t
The market uses quit e a f ew convent ions f or calculat ion of t he number of days t hat has
elapsed bet ween t wo dat es. I t is int erest ing t o not e t hat t hese convent ions were
designed prior t o t he emergence of sophist icat ed calculat ing devices and t he main
obj ect ive was t o reduce t he mat h in complicat ed f ormulae. The convent ions are st ill in
place even t hough calculat ing f unct ions are readily available even in hand- held devices.
The ult imat e aim of any convent ion is t o calculat e ( days in a mont h) / ( days in a year) .

The convent ions used are as below:
We t ak e t h e ex ampl e of a bon d w i t h Face Val u e 100, cou pon 12. 50% , l ast
cou pon pai d on 15t h Ju n e, 2000 an d t r aded f or val u e 5t h Oct ober , 2000.
A/ 360
I n t his met hod, t he act ual number of days elapsed bet ween t he t wo dat es is divided by
360, i. e. t he year is assumed t o have 360 days. Using t his met hod, accrued int erest is
3. 8888
A/ 365
I n t his met hod, t he act ual number of days elapsed bet ween t he t wo dat es is divided by
365, i. e. t he year is assumed t o have 365 days. Using t his met hod, accrued int erest is
3. 8356
A/ A
I n t his met hod, t he act ual number of days elapsed bet ween t he t wo dat es is divided by
t he act ual days in t he year. I f t he year is a leap year AND t he 29t h of February is
included bet ween t he t wo dat es, t hen 366 is used in t he denominat or, else 365 is used.
Using t his met hod, accrued int erest is 3. 8356
30/ 360
This is how t his convent ion is used in t he US. Break up t he earlier dat e as
D( 1) / M( 1) / Y( 1) and t he lat er dat e as D( 2) / M( 2) / Y( 2) . I f D( 1) is 31, change D( 1) t o 30.
I f D( 2) is 31 AND D( 1) is 30, change D( 2) t o 30. The days elapsed is calculat ed as Y( 2) -
Y( 1) * 360+ M( 2) - M( 1) * 30+ D( 2) - D( 1)
30/ 360 Eu r opean
This is t he variat ion of t he above convent ion out side of t he Unit ed St at es. Break up t he
earlier dat e as D( 1) / M( 1) / Y( 1) and t he lat er dat e as D( 2) / M( 2) / Y( 2) . I f D( 1) is 31,
change D( 1) t o 30. I f D( 2) is 31, change D( 2) t o 30. The days elapsed is calculat ed as
Y( 2) - Y( 1) * 360+ M( 2) - M( 1) * 30+ D( 2) - D( 1)
I n I ndian bond market s t he last convent ion is used. RBI while calculat ing yield in t he
SGL Transact ions f or T- Bills uses 364 as basis. This is probably because 364 is t he
longest t enure bill issued by it .


193
Der i vat i ves
A Derivat ive is any inst rument t hat derives it s value f rom t he price movement of an
underlying asset . The most popular derivat ives include Opt ions, Fut ures and Swaps.
Given t he st eep progress made by comput ing devices and t he increased import ance of
quant it at ive t echniques t o t he f inancial market s, t he st ruct ure of derivat ives have
become severely complicat ed. I t is not uncommon t o f ind a combinat ion of several
opt ions on a swap which pay- out depending on t he occurrence of some event . The main
input f or pricing is volat ilit y in t he price of t he underlying asset , which has given rise t o
t he curious sit uat ion where t he asset volat ilit y is more heavily t raded t han t he derivat ive
it self . The applicat ion of derivat ive pricing has f ound it s way in valuat ion of any
cont ingent claim, f loat ing rat e not es, corporat e valuat ion and proj ect f inance.

Di r t y Pr i ce
Dirt y Price of a securit y is it s Clean Price plus Accrued I nt erest . Also see Clean Price,
Accrued I nt erest .

Di scou n t
The quant um by which a securit y is issued or is t raded below it s par value is called
Discount . Also see Discount Basis.

Di scou n t Basi s
Securit ies t hat do not carry a coupon are generally issued at a discount t o t heir f ace
value. Examples of such securit ies are T- Bills and Commercial Papers ( CP) .

Di scr i mi n at or y Pr i ce Au ct i on
See French Auct ion

Du r at i on
Durat ion is a measure of a bonds' price risk. I t is weight ed average of all t he cash- f lows
associat ed wit h a bond, weighed by t he proport ion of value due t o t he j t h payment in
t he cash- f low st ream, wit h sum of all j ' s equalling one. Durat ion measures t he
sensit ivit y of a bonds price t o a change in yield.

Du t ch Au ct i on
This is t he process of auct ion in which af t er receiving all t he bids a part icular yield is
det ermined as t he cut - of f rat e. All bids received at yields higher t han t he cut - of f rat e
( i. e. at higher prices) are rej ect ed. All bids received at yields below t he cut - of f rat e are
given allot ment at t he cut - of f rat e. The process is ident ical t o t hat of t he French Auct ion,
except f or t he f act t hat t here is no concept of allot ment at a premium. The Liquidit y
adj ust ment Facilit y ( LAF) of RBI is an example of such auct ion. Also see French Auct ion,
Winner' s Curse.

Fl oat i n g Rat e Not e
A Float ing Rat e Not e is an inst rument t hat does not pay a f ixed rat e of int erest on it s
f ace value. The int erest paid on such inst rument s is dependent upon t he value of a
benchmark rat e. The benchmark rat e is mut ually agreed upon by t he issuer and t he
invest or and has t o sat isf y some crit eria ( See Benchmark Rat es) . The int erest paid is
t ypically a mark- up on t he benchmark so agreed. An example would be a AAA rat ed

194
corporat e issuer who issues a Not e t hat pays 30 bps above t he U. S. Treasury. I n I ndia a
very common inst rument of lat e has been an issue t hat pays a specif ied markup above
t he MI BOR.

Fr en ch Au ct i on
This is a process of auct ion in which af t er all t he bids are received, a part icular yield is
decided as t he cut - of f rat e. All bids t hat have been received at yields higher t han t he
cut - of f rat e ( i. e. at lower prices) are rej ect ed. All bids t hat have been received at below
t he cut - of f rat e ( i. e. at higher prices) are given f ull allot ment but at a premium f rom t he
price at t he cut - of f yield

Gi l t s
Anot her name f or government securit ies. The t erm ref lect s t he superior qualit y of t he
papers issued by t he government . The papers issued by t he Bank of England used t o
have gilt - edged borders and t he t erm gilt s originat ed f rom t here

Gr oss Pr i ce
See Dirt y Price

Ju n k Bon d
Any bond which has a credit rat ing below Baa/ BBB. These are bonds t hat are below
invest ment grade and carry very at t ract ive rat es of ret urn, commensurat e wit h t he high
credit risk.

LAF
This is a f acilit y by which t he RBI adj ust s t he daily liquidit y in t he domest ic market s
( I ndia) eit her by inj ect ing f unds or by wit hdrawing t hem out . This met hod was made
ef f ect ive on t he 5t h June 2000 and is open f or Banks and Primary Dealers. This met hod
has replaced t he t radit ional met hod of ref inance based on f ixed rat es.

LI BOR
St ands f or London I nt erbank Of f ered rat e. This is a very popular bench mark and is
issued f or US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and t he Japanese
Yen. The mat urit y covers overnight t o 12 mont hs. The met hodology, very brief ly - t he
Brit ish Bankers Associat ion ( BBA) at 1100 hrs GMT asks 16 banks t o cont ribut e t he
LI BOR f or each mat urit y and f or each currency. The BBA weeds out t he best f our and
t he worst f our, calculat es t he average of t he remaining eight and t he value is published
as LI BOR. The f igures are put up in Reut ers on page LI BO and SWAP. The same is
available on TeleRat e page 3170.

Macau l ay Du r at i on
See Durat ion

Mar k To Mar k et
Mark t o Market or MTM is a very popular report ing and perf ormance measurement t ools
f or any invest ment . I n t his t echnique t he price at which t he invest ment was made is
compared wit h t he price which t he asset can realised if liquidat ed in t he market at t hat
moment . The dif f erence is eit her t he MTM gain or MTM loss depending upon t he current

195
wort h vis- - vis t he original price. Liabilit ies can also be made subj ect t o t he same
analysis as asset s. Periodicit y of MTM depends on t he liquidit y of t he market in which t he
asset is a class. For example currency and bond invest ment s are MTM- ed online while
ot her invest ment s like real est at e may be MTM- ed at higher int ervals.

MI BOR
St ands f or Mumbai I nt erBank Of f ered Rat e, it is closely modeled on t he LI BOR. Current ly
t here are t wo calculat ing agent s f or t he benchmark - Reut ers and t he Nat ional St ock
Exchange ( NSE) . The NSE MI BOR benchmark is t he more popular of t he t wo, ref lect ed
by t he larger number of deals t hat are t ransact ed using t his benchmark.

Modi f i ed Du r at i on
This is a slight variat ion t o t he concept of Durat ion. Modif ied Durat ion can be def ined as
t he approximat e percent age change in price f or a 1% change in yield. Mat hemat ically it
is represent ed as Mod. Durat ion = Durat ion / ( 1+ y/ n) , where n= number of coupon
payment s in t he year

Mu l t i pl e Pr i ce Au ct i on
See French Auct ion

Net Pr i ce
See Clean Price

Non Con ver t i bl e Deben t u r e ( NCD)
A Non Convert ible debent ure, as against a convert ible debent ure, is not convert ible,
eit her in part or t he whole, int o equit y on it s mat urit y.

Not i ce Mon ey
Money borrowed or lent in t he int erbank market f or a period beyond one day and upt o
14 days.

Open Mar k et Oper at i on s
One of t he maj or inst rument s of monet ary policy by which t he cent ral bank of a count ry
manipulat es short - t erm liquidit y and t hereby t he int erest rat es t o desired levels.
Generally open market operat ions involve purchase and sale of t reasury bills in t he open
market or conduct ing repos.

PLR
This is t he acronym f or Prime Lending Rat e. This is t he rat e at which a bank in I ndia
lends t o it s prime cust omer. The bank usually f ollows an int ernal credit rat ing syst em
and charges a spread over t he PLR f or non- prime cust omers.

Pr i ce Val u e of a Basi s Poi n t
See PVBP

Pr i mar y Deal er ( PD)
A Primary Dealer in t he securit ies market is an ent it y licensed by t he RBI t o carry on t he
business of securit ies and act as market maker in securit ies. I n t urn t he Primary Dealer

196
will enj oy cert ain privileges f rom t he RBI like ref inance f rom RBI at concessional rat es,
access t o t he int erbank call money market et c. The PD has t o give an annual
undert aking t o t he RBI on his level of part icipat ion in t he primary issues of government
securit ies. To qualif y f or Primary Dealership t he applicant company should have a
net wort h of Rs. 50. 00 crore and a f ew years of experience in t he securit ies market .

PVBP
Also called t he Price Value of a Basis Point or Dollar Value of 01. This is one way of
quant if ying t he sensit ivit y of a bond t o changes in t he int erest rat es. I f t he current price
of t he bond is P( 0) and t he price af t er a one basis point rise in rat es is P( 1) t hen PVBP is
- [ P( 1) - P( 0) ] . This can be est imat ed wit h t he help of t he modif ied durat ion of a bond, as
( Price of t he bond * modif ied durat ion* . 0001)

Repo
Repo or Repurchase Agreement s are short - t erm money market inst rument s. Repo is
not hing but collat eralized borrowing and lending. I n a repurchase agreement securit ies
are sold in a t emporary sale wit h a promise t o buy back t he securit ies at a f ut ure dat e at
specif ied price. I n reverse repos securit ies are purchased in a t emporary purchase wit h a
promise t o sell it back af t er a specif ied number of days at a pre- specif ied price. When
one is doing a repo , it is reverse repo f or t he ot her part y

Rever se Repo
See Repo

Ri sk Fr ee Rat e
An int erest rat e given out by an invest ment t hat has a zero probabilit y of def ault .
Theoret ically t his rat e can never exist in pract ice but sovereign debt is used as t he
nearest proxy.

Sat el l i t e Deal er
Second level t o t he Primary Dealers , Sat ellit e Dealers are licensed by RBI t o carry on
t he business of ret ailing in government securit ies . They are basically ent it ies who have
very good dist ribut ion net work f or ret ailing. The minimum net wort h t o qualif y f or
Sat ellit e Dealership is Rs. 5. 00 crore and a f ew years of experience in t he securit ies
market .

SGL
Subsidiary General Ledger Account is t he demat f acilit y f or government securit ies
of f ered by t he Reserve Bank of I ndia . I n t he case of SGL f acilit y t he securit ies remain in
t he comput ers of RBI by credit t o t he SGL account of t he owner. RBI of f ers SGL f acilit y
only t o banks, primary dealers and sat ellit e dealers

SLR
This is t he acronym f or St at ut ory Liquidit y Rat io. That part of t heir Net Demand and
Time liabilit ies ( NDTL) t hat a bank is required by law t o be kept invest ed in approved
securit ies is known as SLR. The approved securit ies are t ypically sovereign issues. The
maint enance of SLR ensures a minimum liquidit y in t he bank' s asset s.


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Spr ead
Spread is t he dif f erence bet ween t wo rat es of int erest s. I t is of t en generalised t o imply
t he dif f erence bet ween eit her price or yield. Spreads can be bet ween t wo risk classes or
can be bet ween t enors in t he same risk class. For example 130 bps bet ween AAA and
GOI means a 1. 30% spread bet ween a AAA issue and t hat made by t he Government of
I ndia. 5 paisa spread bet ween bid and ask means t hat in t he t wo way price quot ed t he
dif f erence bet ween t he buy and sell price is 5 paisa 60 bps spread bet ween 3 mont h T
Bill over 10 Year means t hat t he dif f erence bet ween t he yield in t he 3 mont h Treasury
Bill and t hat on a 10 Year paper of t he same risk class in 60 basis point s.

STRI PS
STRI PS is t he acronym f or Separat e Trading of Regist ered I nt erest and Principal of
Securit ies. The STRI PS program let s invest ors hold and t rade t he individual int erest and
principal component s of eligible Treasury not es and bonds as separat e securit ies. When
a Treasury f ixed- principal or inf lat ion- indexed not e or bond is st ripped, each int erest
payment and t he principal payment becomes a separat e zero- coupon securit y. Each
component has it s own ident if ying number and can be held or t raded separat ely. For
example, a Treasury not e wit h 10 years remaining t o mat urit y consist s of a single
principal payment at mat urit y and 20 int erest payment s, one every six mont hs f or 10
years. When t his not e is convert ed t o STRI PS f orm, each of t he 20 int erest payment s
and t he principal payment becomes a separat e securit y. STRI PS are also called zero-
coupon securit ies because t he only t ime an invest or receives a payment during t he lif e
of a STRI P is when it mat ures.

A f inancial inst it ut ion, government securit ies broker, or government securit ies dealer can
convert an eligible Treasury securit y int o int erest and principal component s t hrough t he
commercial book- ent ry syst em. Generally, an eligible securit y can be st ripped at any
t ime f rom it s issue dat e unt il it s call or mat urit y dat e. Securit ies are assigned a st andard
ident if icat ion code known as a CUSI P number. CUSI P is t he acronym f or Commit t ee on
Unif orm Securit y I dent if icat ion Procedures. Just as a f ully const it ut ed securit y has it a
unique CUSI P number, each STRI PS component has a unique CUSI P number. All int erest
STRI PS t hat are payable on t he same day, even when st ripped f rom dif f erent securit ies,
have t he same generic CUSI P numbers. However, t he principal STRI PS f rom each not e
or bond have a unique CUSI P number. STRI PS component s can be reassembled or
"reconst it ut ed" int o a f ully const it ut ed securit y in t he commercial book- ent ry syst em. To
reconst it ut e a securit y, a f inancial inst it ut ion or government securit ies broker or dealer
must obt ain t he appropriat e principal component and all unmat ured int erest component s
f or t he securit y being reconst it ut ed. The principal and int erest component s must be in
t he appropriat e minimum or mult iple amount s f or a securit y t o be reconst it ut ed. The
f lexibilit y t o st rip and reconst it ut e securit ies allows invest ors t o t ake advant age of
various holding and t rading st rat egies under changing f inancial market condit ions t hat
may t end t o f avour t rading and holding STRI PS or f ully const it ut ed Treasury securit ies.

Ter m Mon ey
Money borrowed and lent f or a period beyond 14 days is known as t erm money


198
Tr easu r y Bi l l s
Treasury Bills are short - t erm obligat ions of t he Treasury/ Government . They are
inst rument s issued at a discount t o t he f ace value and f orm an int egral part of t he
money market . I n I ndia t reasury bills are issued t wo mat urit ies 91 days and 364 days.

Un i f or m Pr i ce Au ct i on
See Dut ch Auct ion

WDM Segmen t
The Nat ional St ock Exchange of I ndia has t wo t rading segment s , one is t he Capit al
Market s Segment and t he ot her is t he Wholesale Debt Market Segment . The Capit al
Market s Segment is meant f or equit ies t rading whereas all t he t rades in debt
inst rument s are put t hrough t he WDM Segment . t he WDM represent s t he only f ormal
screen- based t rading and report ing mechanism f or secondary market t rades in debt
inst rument s.

Wi n n er s Cu r se
I n a French auct ion, every successf ul bidder is one whose bid is equal or higher t han t he
cut - of f price. Theref ore, successf ul bidders have t o pay a premium on t he cut - of f price,
on being successf ul in t he auct ion. This is called t he winners curse in t reasury auct ions.

Yi el d Cu r ve
The relat ionship bet ween t ime and yield on a homogenous risk class of securit ies is
called t he Yield Curve. The relat ionship represent s t he t ime value of money - showing
t hat people would demand a posit ive rat e of ret urn on t he money t hey are willing t o part
t oday f or a payback int o t he f ut ure. I t also shows t hat a Rupee payable in t he f ut ure is
wort h less t oday because of t he relat ionship bet ween t ime and money. A yield curve can
be posit ive, neut ral or f lat . A posit ive yield curve, which is most nat ural, is when t he
slope of t he curve is posit ive, i. e. t he yield at t he longer end is higher t han t hat at t he
short er end of t he t ime axis. This result s as people demand higher compensat ion f or
part ing t heir money f or a longer t ime int o t he f ut ure. A neut ral yield curve is t hat which
has a zero slope, i. e. is f lat across t ime. This occurs when people are willing t o accept
more or less t he same ret urns across mat urit ies. The negat ive yield curve ( also called an
invert ed yield curve) is one of which t he slope is negat ive, i. e. t he long t erm yield is
lower t han t he short t erm yield. I t is not of t en t hat t his happens and has import ant
economic ramif icat ions when it does. I t generally represent s an impending downt urn in
t he economy, where people are ant icipat ing lower int erest rat es in t he f ut ure.

Yi el d Pi ck - Up
Yield pick up or yield give up ref ers t o t he yield gained or lost at t he t ime of init iat ion of
a t rade primarily in bonds and debent ures. Suppose one sold 12. 50 % GOI 2004 at a
yield of 10. 00 per cent and moved int o 11. 83 % GOI 2014 at a yield of 11. 25 per cent
t he yield pick up is t o t he t une of 125 basis point s. I f one did exact ly t he reverse of t his
t he yield give up is t o t he ext ent of 125 bps. These concept s are ordinarily used in bond
swap evaluat ion.


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Yi el d To Mat u r i t y
Yield t o Mat urit y ( YTM) is t hat rat e of discount t hat equat es t he discount ed value of all
f ut ure cash f lows of a securit y wit h it s current price. I n a way, it is anot her way of
st at ing t he price of a securit y as ot her t hings remaining const ant , t he price is a direct
f unct ion of t he YTM. The def iciency of YTM is t hat it assumes t hat all int ermediat e and
f inal cash f low of t he securit y is re- invest ed at t he YTM, which ignores t he shape of t he
yield curve. This makes YTM applicable as a measure f or an individual securit y and t o
dif f erent bonds in t he same risk class. The YTM, given it s inst rument - specif ic nat ure
does not provide unique mapping f rom mat urit y t o int erest rat e space. I t is used
primarily f or it s simplicit y of nat ure and ease of calculat ion. More sophist icat ed t raders
would use t he Zero Coupon Yield Curve ( ZCYC) f or valuat ion. See Zero Coupon Yield
Curve.

Zer o Cou pon Bon d
A Zero Coupon Bond ( ZCB) is one t hat pays no periodic int erest ( does not carry a
coupon) . These bonds are t ypically issued at a discount and redeemed at f ace value. The
discount rat e, appropriat ed over t he lif e of t he bond is t he ef f ect ive int erest paid by t he
issuer t o t he invest or. I n I ndia, t he spect rum of ZCB is virt ually non- exist ent beyond one
year. Upt o one year, t he Treasury Bills issued are proxied f or ZCB. Also see Zero Coupon
Yield Curve.

Zer o Cou pon Yi el d Cu r ve
The Zero Coupon Yield Curve ( also called t he Spot Curve) is a relat ionship bet ween
mat urit y and int erest rat es. I t dif f ers f rom a normal yield curve by t he f act t hat it is not
t he YTM of coupon bearing securit ies, which get s plot t ed. Represent ed against t ime are
t he yields on zero coupon inst rument s across mat urit ies. The benef it of having zero
coupon yields ( or spot yields) is t hat t he def iciencies of t he YTM approach ( See Yield t o
Mat urit y) is removed. However, zero coupon bonds are generally not available across
t he ent ire spect rum of t ime and hence st at ist ical est imat ion processes are used. The
NSE comput es t he ZCYC f or t reasury bonds using t he Nelson- Seigel procedure, and
disseminat es t his inf ormat ion on an everyday basis. The zero coupon yield curve is
usef ul in valuat ion of even coupon bearing securit ies and can be ext ended t o ot her risk
classes as well af t er adj ust ing f or t he spreads. I t is also an import ant input f or robust
measures of Value at Risk ( VaR) .