2 Who are the key players in the debt and money markets in India? The above diagram provides a consolidated picture of the various players in the bond/money markets and the securities.ZCB: Zero Coupon Bond I/L bonds : Inflation linked bonds FRN : Floating rate notes
3 What are Money Markets and money market instruments? Money markets are markets for debt instruments with a maturity up to one year.Money markets allow banks to manage their liquidity as well as provide the central bank means to conduct its monetary policy.The most active part of the money market is the call money market (i.e. market for overnight and term money between banks and institutions) and the market for repo transactions. The former is in the form of loans and the latter are sale and buy back agreements – both are obviously not traded. The main traded instruments are commercial papers (CPs), certificates of deposit (CDs) and treasury bills (T-Bills).
4 Commercial PaperA Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. In India corporates, primary dealers (PD), satellite dealers (SD) and financial institutions (FIs) can issue these notes.It is generally companies with very good rating which are active in the CP market, though RBI permits a minimum credit rating of Crisil-P2. The tenure of CPs can be anything between 15 days to one year, though the most popular duration is 90 days. Companies use CPs to save interest costs
5 Certificates of Deposit These are issued by banks/financial institutions in denominations of Rs 5 lakhs and have maturity ranging from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of less than one year while financial institutions are allowed to issue CDs with a maturity of at least one year.
6 Treasury BillsTreasury Bills are instruments issued by RBI at a discount to the face value and form an integral part of the money market. In India treasury bills are issued in three different maturities 14 days, 182 days and 364 days.Apart from the above money market instruments, certain other short-term instruments are also in vogue with investors. These include short-term corporate debentures, bills of exchange and promissory notes.
7 What are “on the run” and “off the run” securities? An on-the-run security normally is the most liquid issue for that maturity and therefore generally trades at lower yields than off-the-run debt. Because an off-the-run security generally does not have the same liquidity as an on-the-run issue, it may trade at higher yields, and thus lower prices, than on-the-run securities. The central bank may be able to capture part of the yield differential and thus reduce the government's interest costs by purchasing and retiring older debt and replacing it with lower yielding on-the-run debt.
8 What is a Repo?Repo or Repurchase Agreements or Ready Forward transactions are short-term money market instruments. Repo is nothing but collateralized borrowing and lending. In a repo, securities (like Government securities and treasury bills) are sold in a temporary sale with an agreement to buy back the securities at a future date at specified price. In reverse repo`s, securities are purchased in a temporary purchase with an agreement to sell it back after a specified number of days at a pre-specified price. When one is doing a repo, it is reverse repo for the other party.For example, RBI could engage in a three-day repo transaction with SBI, i.e., it would sell a security at, say, Rs. 100 to the SBI agreeing to buy it back at Rs , in three days. The difference in price, is the interest RBI would have to pay for the money lent by SBI.
9 What is Repo Rate?Repo rate is nothing but the annualized interest rate for the funds transferred by the lender to the borrower in a repo transaction.
10 How does RBI use the repo rate? In case of the RBI, it sets the repo rate for all instruments issued by the central bank (it will be either the lender or borrower in a repo transaction). Typically the repo rate and reverse repo rate vary by around 2%. RBI has used repo rates as part of its Liquidity Adjustment Facility (LAF) to benchmark short-term interest rates and also as a monetary tool in the past whenever the rupee had come under pressure.RBI normally hikes the repo rate to spike speculative arbitrage deals that are the primary cause for sharp rupee-dollar movements. A higher repo rate means the central bank is willing to borrow short-term money at a higher rate. This would prompt market participants to prefer lending to the RBI unless the other market rates are higher. A higher repo rate also indirectly sets a higher floor for other money market rates such as the call rates. As banks typically borrow in the call market and deploy the proceeds in the forex market, a higher call rate makes such arbitrage transactions costly.
11 What is Money Supply?Money supply is the amount of money in circulation in the economy at any point of time. It includes the currency & coins in circulation and demand & time deposits of banks, post office deposits.etc. Different components of money supply are as under:M1 = Currency with the public + Net demand deposits of banks + other deposits with RBIM2 = M1 + Post Office SavingsM3 = M2 + Net Time DepositsM3 is the level of money supply in an economy at any given point of time.
12 What are debt market instruments? Typically those instruments that have a maturity of more than a year and the main types are – Government Securities (G-secs or Gilts) Like T-bills, gilts are issued by RBI on the behalf of the Government. These instruments form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). Typically they have maturity ranging from 1 year to 20 years. Like T-Bills, gilts are issued through the auction route. but RBI can sell/buy securities in its Open Market Operations (OMO`s include conducting repos as well and are used by RBI to manipulate short-term liquidity and thereby the interest rates to desired levels) The other types of government securities are – Inflation linked bonds Zero coupon bonds State government securities (state loans)
13 Bonds/Debentures What is the difference between bonds and debentures? World over, a debenture is a debt security issued by a corporation that is not secured by specific assets, but rather by the general credit of the corporation. Stated assets secure a corporate bond, unlike a debenture. But in India these terms are used interchangeably. A bond is a promise in which the Issuer agrees to pay a certain rate of interest, usually as a percentage of the bond's face value to the Investor at specific periodicity over the life of the bond. Sometimes interest is also paid in the form of issuing the instrument at a discount to face value and subsequently redeeming it at par. Some bonds do not pay a fixed rate of interest but pay interest that is a mark-up on some benchmark rate. Typically PSUs, public financial institutions and corporate issue bonds. Another distinction is SLR and non-SLR bonds. SLR bonds are those bonds which are approved securities by RBI which fall under the SLR(Statutory liquidity ratio) limits of banks.
14 What affects bond prices? Largely interest rates and credit quality of the issuer are the two main factors which affect bond prices Interest Rates : The price of a debenture is inversely proportional to changes in interest rates that in turn are dependent on various factors. When interest rates fall, the existing bonds become more valuable and the prices move up until the yields become the same as the new bonds issued during the lower interest rate scenario Credit Quality : When the credit quality of the issuer deteriorates, market expects higher interest from the company and the price of the bond falls and vice-versaAnother factor that determines the sensitivity of a bond is the “Maturity Period”. A longer maturity instrument will rise or fall more than a shorter maturity instrument.
15 What affects interest rates? The factors are largely macro economic in nature –Demand/Supply of money: When economic growth is high, demand for money increases, pushing the interest rates up and vice versa. Government Borrowing and Fiscal Deficit : Since the government is the biggest borrower in the debt market, the level of borrowing also determines the interest rates. On the other hand, supply of money is done by the central bank by either printing more notes or through its Open Market Operations (OMO) RBI : RBI can change the key rates (CRR, SLR and bank rates) depending on the state of the economy or to combat inflation. The RBI fixes the bank rate which forms the basis of the structure of interest rates & the Cash Reserve Ratio (CRR) & Statuary Liquidity Ratio (SLR), which determines the availability of credit & the level of money supply in the economy. (CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash assets & SLR is the percentage of its total deposits a bank has to keep in approved securities. The purpose of CRR & SLR is to keep a bank liquid at any point of time. When banks have to keep low CRR or SLR, it increases the money available for credit in the system. This eases the pressure on interest rates & interest rates move down. Also when money is available & that too at lower interest rates, it is given on credit to the industrial sector that pushes the economic growth Bank Rate is the benchmark rate of RBI at which it refinances Banks and Primary Dealers. It is used as a reference rate to signal the interest policy of the central bank
16 Inflation RateInflation Rate : Typically a higher inflation rate means higher interest rates. The interest rates prevailing in an economy at any point of time are nominal interest rates, i.e., real interest rates plus a premium for expected inflation. Due to inflation, there is a decrease in purchasing power of every rupee earned on account of interest in the future; therefore the interest rates must include a premium for expected inflation. In the long run, other things being equal, interest rates rise one for one with rise in inflation.
17 What is fiscal deficit?The difference between total government spending on account of revenue, capital and net loans and between total government receipts on account of revenue and of capital receipts that are not borrowings. The important point to note is that accumulated interest burden from previous years is reflected in the Fiscal Deficit as well as this fiscal's revenue and capital surpluses/ deficits. The Fiscal Deficit is usually shown as a percentage of GDP. A low Fiscal Deficit is considered the best symptom of financial health. India has a Fiscal Deficit in the range of 5-6 per cent. This is much higher than considered safe and the higher fiscal deficit could result in firming up of rates.
18 What is Yield Curve?The relationship between time and yield on securities is called the Yield Curve. The relationship represents the time value of money - showing that people would demand a positive rate of return on the money they are willing to part today for a payback into the future. A yield curve can be positive, neutral or flat. A typical yield curve is when the slope of the curve is positive, i.e. the yield at the longer end is higher than that at the shorter end of the time axis. This happens when people demand higher compensation for parting their money for a longer time into the future. When the curve is very steep, it indicates that players expect an expansion in the economy and interest rates to move up quickly. A neutral yield curve is that which has a zero slope, i.e. is flat across time. This occurs when people are willing to accept more or less the same returns across maturities. The negative yield curve (also called an inverted yield curve) is one of which the slope is negative, i.e. the long-term yield is lower than the short-term yield. It is not often that this happens and has important economic ramifications when it does. It generally represents an impending downturn in the economy, where people are anticipating lower interest rates in the future.
19 What is Yield to Maturity (YTM)? Simply put, the annualised return an investor would get by holding a fixed income instrument until maturity. It is the composite rate of return of all payouts and coupon.
20 What is Average Maturity Period? It is a weighted average of the maturities of all the instruments in a portfolio
21 What is duration and modified duration? Duration is a measure of a bonds' price risk. It is weighted average of all the cash flows associated with a bond in terms of their present value. For example, a bond with a duration 1.50 years means that a rise in its yield by 1% would result in a decline of its value by approximately 1.50% There are two types of duration, Macaulay duration and modified duration. Macaulay duration is useful in immunization, where a portfolio of bonds is constructed to fund a known liability. Modified duration indicates the percentage change in the price of a bond for a given change in yield. The percentage change applies to the price of the bond including accrued interest.
22 What is convexity?Convexity is a measure of the way duration and price change when interest rates change. A bond is said to have positive convexity if the instrument's value increases at least as much as duration predicts when rates drop and decreases less than duration predicts when rates rise. Typically, fund managers and investors prefer bonds with higher convexity. This is because such bonds rise higher than other bonds when interest rate falls. And what is more, they fall lower than other bonds, when interest rate rises. Convexity is an important factor when interest rates are volatile
23 What is marking to market? It means adjusting value of any security to reflect its current market value. While fixed income instruments carry a fixed rate of return if held till maturity, interest rate movements can increase/decrease the returns, if one has to sell the security during the holding period. Hence, open end income and liquid funds are required to value securities with a residual maturity of over six months based on their market value. The mark to market component of a portfolio on a given day includes securities with residual maturity of more than six months and does not include CPs and CDs.
24 What are floating rate instruments? Unlike fixed income instruments, floating rate instruments have variable interest rates, which change at present frequencies. Since they don’t have any mark to market component, the possibility of negative returns doesn’t exist for these instruments. Among the floating rate instruments, MIBOR (Mumbai Inter-bank Offer Rate) linked ones have become very popular in the money market segment as they benefit both the issuer and investor. Coupon rates on short-term Non-convertible debentures (NCDs) are pegged at a mark-up over MIBOR. The mark-up on the NCD is typically 25 to 50 basis points over MIBOR. Borrowing or lending through NCDs with the call/put option is akin to borrowing or lending in the inter-bank call money market. So companies use NCDs more like a cash management tool. Whenever they generate surpluses, companies exercise the call option and pay off investors. In a falling interest rate scenario, companies tend to convert the NCD into a fixed-term borrowing in order to lock into a lower interest rate. Many of these floaters offer ready liquidity by means of daily put/call option. This allows mutual funds to tackle illiquidity risk, in case of huge redemption pressures.
25 What are Interest Rate Swaps Interest Rate Swap (IRS) is a transaction in which a flow of coupon of one variety is exchanged for another of a different variety, but in the same currency. These derivatives are used by the fund manager for hedging the portfolio risk on a non-leverage basis (i.e., not used for speculative activities). In India, IRS are generally OIS (Overnight Indexed Swaps) products benchmarked on the MIBOR
26 Example : Fixed rate payment Floating –rate player Fixed rate player
27 Terms: Fixed Interest Rate : 7% p.a. Variable Interest Rate : NSE Over-Night MIBOR reset daily and compounded daily.Notional Principal Amount : Rs. 50 crorePeriod of Agreement : 1 yearPayment Frequency : Semi - AnnualNow, suppose the six-month period from the effective date of the swap to the first payment date comprises 182 days and the daily compounded NSE Over - Night MIBOR is 6 % p.a. on the first payment date, then the fixed and variable rate payment on the first payment date would be as follows:
28 Fixed Rate Payment. : Rs. 1,74,52,055 = (Rs Fixed Rate Payment : Rs. 1,74,52,055 = (Rs. 50,00,00,000) X (7%) X (182 Days / 365 Days)Variable Payment : Rs. 1,49,58,904 = (Rs. 50,00,00,000) X (6%) X(182 Days/ 365 Days)Often, a swap agreement will call for only the exchange of net amount between the counter parties. In the above examples, the fixed - rate payer will pay the variable - rate payer a net amount of Rs. 24,93,151 = Rs. 1,74,52,055 - Rs. 1,49,58,904. The second and final payment will depend on the daily NSE MIBOR compounded daily for the remaining 183 days. The fixed rate payment will also change to reflect the change in holding period from 182 days to 183 days.
29 What are LIBOR & MIBOR?LIBOR : Stands for London Inter Bank Offered rate. This is a very popular benchmark and is issued for US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese Yen. The British Bankers Association (BBA) asks 16 banks to contribute the LIBOR for each maturity and for each currency. The BBA weeds out the best four and the worst four, calculates the average of the remaining eight and the value is published as LIBOR.MIBOR : Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the LIBOR. Currently there are two calculating agents for the benchmark - Reuters and the National Stock Exchange (NSE). The NSE MIBOR benchmark is the more popular of the two and is based on rates polled by NSE from a representative panel of 31 banks/institutions/primary dealers
30 What is a credit rating ?Credit Rating is an exercise conducted by a rating organisation to evaluate the credit worthiness of the issuer with respect to the instrument being issued or a general ability to pay back debt over the specified period of time. The rating is given as an alphanumeric code that represents a graded structure or creditworthiness. Typically the highest credit rating is that of AAA and the lowest being D (for default). Within the same alphabet class, the rating agency might have different grades like A, AA, and AAA and within the same grade AA+, AA- where the “+” denotes better than AA and “-“ indicate the opposite. For short term instruments of less than a year maturity, the rating symbol would be typically “P” (varies depending on the rating agency). India, currently we have four rating agencies –CRISILICRACAREFitch (Duff and Phelps is now part of Fitch)
31 What is the “SO” in a rating ? [AAA(SO)] Pass Through Certificate/PTC Structured Obligation (SO) or Structured Finance is a term that is applied to a wide variety of debt instruments wherein the repayment of principal and interest is backed by: Cash flows from a pool of financial assets and/or Credit enhancement from a third party The process of converting financial assets (loans, receivables, etc.) into tradable securities is generally referred as ‘securitization’ and the securities thus created are referred as ‘asset backed securities’ (ABS). The Pass Through Certificates (PTCs) in our portfolios also fall under this category
33 Forex Markets How is a currency valued? The floating exchange rate system is a confluence of various demand and supply factors prevalent in an economy like – Current account balance : The trade balance is the difference between the value of exports and imports. If India is exporting more than it importing, it would have a positive trade balance with USA, leading to a higher demand for the home currency. As a result the demand will translate into appreciation of the currency and vice versa.Inflation rate : Theoretically, the rate of change in exchange rate is equal to the difference in inflation rates prevailing in the 2 countries. So, whenever, inflation in one country increases relative to other country, its currency falls down. Interest rates : The funds will flow to that economy where the interest rates are higher resulting in more demand for that currency. Often called interest rate differential Speculation : Another important factor is the speculative and arbitrage activities of big players in the forex market which determines the direction of a currency. In the event of global turmoil, investors flock towards perceived safe heaven currencies like US dollar resulting in a demand for that currency.
34 What are the implications of such fluctuations? Depreciation of a currency affects an economy in two ways, which are in a way counter to each other. On the one hand, it makes the exports of a country more competitive, thereby leading to an increase in exports. On the other hand, it decreases the value of a currency relative to other currencies, and hence imports like oil become dearer resulting in an increase of deficit.
35 What does one mean by a currency being over-valued What does one mean by a currency being over-valued? What is Real Effective Exchange Rate (REER)?When RBI says that the rupee is overvalued, they mean that it has been appreciating against other major currencies due to their weakening against dollar which might impact the competitiveness of India's exports.REER is the change in the external value of the currency in relation to its main trading partners. It is Rupee's value on a trade-weighted basis. It takes into account the Rupee's value not only in terms of dollar but also Euro, Yen and Pound Sterling.The exchange rates versus other major currencies are average weighted by the value of India's trade with the respective countries and are then converted into a single index using a base period which is called the nominal effective exchange rate. But the relative competitiveness of Indian goods increases even when the nominal effective exchange rate remains unchanged when the rate of price increases of the trading partner surpasses that of India's. Taking this into account, prices are adjusted for the nominal effective exchange rate and this rate is called the "real effective exchange rate."
36 What are thinly traded debt securities ? A debt security that has a trading volume of less than Rs. 5 crores in the previous calendar month is considered a thinly traded security.2.What are non traded securities ?When a security is not traded on any stock exchange for a period of 30 days prior to the valuation, it is treated a ‘non traded’ security.
37 The Valuation Procedure The methodology is applicable to debt securities that have a maturity period of over 182 days. (Instruments with less than 182 days of maturity are valued on the basis of amortization as is the case with money market instruments). And these securities are classified into investment grade and non-investment grade securities based on their credit ratings. This methodology is applicable only to investment grade securities. The non-investment grade securities are valued at a discount of 25% to the face value. The non-investment grade securities are further be classified as performing and non-performing assets and the latter are valued on separate norms. To put it briefly, the valuation methodology starts with the construction of a benchmark yield using G-secs and then building a matrix which gives benchmark yields for a certain credit quality and a duration. After adjusting the yield of a particular security for various risks, the final yield is used to price the security by using the NPV method. The various steps involved in the process are –
38 Construction of risk-free benchmark : A risk-free benchmark yield is built using the government securities (G-secs) as the base. G-secs are used as the benchmarks as they are traded regularly; are free of credit risk and are traded across different maturity spectrums every week. The G-secs are grouped into the following duration buckets viz., years, 1-2 years, 2-3 years, 3-4 years, 4-5 years, 5-6 years and 6 years and the volume weighted yield is computed for each bucket. Accordingly, there will be a benchmark YTM for each duration bucket. (Please note that duration is different from maturity period. As mentioned above, duration is a measure of a bonds' price risk. It is weighted average of all the cash flows associated with a bond in terms of their present value.)
39 Building a matrix of spreads for marking-up the benchmark yield A matrix of spreads (based on the credit rating) is built for marking up the benchmark yields. The matrix is built based on traded corporate paper on the stock exchanges or primary market securities. All traded paper (with minimum traded value of Rs. 1 crore) is classified by their ratings and grouped into 7 duration buckets. For each rating category, average volume weighted yields are obtained both from trades on the respective stock exchange and from the primary market issuances. Where there are neither secondary trades in a particular rating category nor primary market issuances during the fortnight under consideration, then trades during the 30 day period prior to the benchmark date are considered for computing the average YTM for such rating category. This matrix is sent to us every week by CRISIL. Given below is a sample matrix as of November 11,2002
41 Mark-up/Mark-down yield All debt securities are prone to certain risk and hence the marking up or down of yield is essential to get a true picture about that particular security. The yields calculated above are marked up/marked down to account for the liquidity risk, promoter background, finance company risk and the issuer class risk. The marking differs for rated and non-rated securities and is as follows : Rated securities: Securities of less than 2 year duration could be marked up or down upto 0.5% and for securities of more than 2 year duration marking is allowed upto +/- 0.25% to be provide for the above mentioned types of risks Non-rated securities : Since non-rated securities tend to be more illiquid than rated securities, the yields are marked up by adding 0.5% for securities having a duration of upto two years and 0.25% for securities having duration of higher than two years to account for the illiquidity risk
42 Pricing the portfolioThe yields that have been calculated for the various categories in the matrix are used to price the portfolio by using the Net Present Value (NPV) method. The price of a debt security is the discounted value of all its future cash flows (using a suitable discount rate, which in this case is the YTM calculated).
43 IllustrationLets take the example of a AAA rated thinly traded debenture of HDFC which has a duration of 3.25 years and a coupon rate of 11.45%. Say, we purchased the debenture on July 21, By looking at the matrix above, we arrive at a yield of 6.89%.The enclosed excel sheet provides the calculation of NPV. (click on the cells to view the formulas -Lets take the example of a AAA rated thinly traded debenture of HDFC which has a duration of 3.25 years and a coupon rate of 11.45%. Say, we purchased the debenture on July 21, By looking at the matrix above, we arrive at a yield of 6.89%.The enclosed excel sheet provides the calculation of NPV. (click on the cells to view the formulas -