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INDIAN FINANCIAL SYSTEM Money Market And Its Instruments
Fixed Income Securities – “In Fixed Income
Securities Income varies inversely with purchase price… Why???”
Submitted to:Dr. KP Ramakrishnan
Submitted by:Vidhu Jain Section F12 Roll No 83
INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 2007-
I n d i a n Fi n a n c i a l S y s t e m
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Money Market and its Instruments
Money Market: Money market means market where money or its equivalent can be traded. Money is synonym of liquidity. Money market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better known as a place where large institutions and government manage their short term cash needs. For generation of liquidity, short term borrowing and lending is done by these financial institutions and dealers. Money Market is part of financial market where instruments with high liquidity and very short term maturities are traded. Due to highly liquid nature of securities and their short term maturities, money market is treated as a safe place. Hence, money market is a market where short term obligations such as treasury bills, commercial papers and bankers acceptances are bought and sold. Benefits and functions of Money Market: Money markets exist to facilitate efficient transfer of short-term funds between holders and borrowers of cash assets. o For the lender/investor, it provides a good return on their funds. o For the borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term liabilities. One of the primary functions of money market is to provide focal point for RBI’s intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives.
INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 200709
They function in the similar manner like any other futures and options. Maturities range from one day to one year. The major INDIAN FINANCIAL SYSTEM ---. It deals in short term debt financing and investments. on the other hand. Available from financial institutions. the money market has no specific location.F12 ---. anybody can make investments through a broker. and services such as check writing may be offered. in capital market. On the other hand. Individual players cannot invest in money market as the value of investments is large. Further. the most common are three months or less. Money Market Futures and Options: Active trading in money market futures and options occurs on number of commodity exchanges. Stock Market is associated with high risk and high return as against money market which is more secure.FW 200709 . Unlike organized securities or commodities exchanges. money markets give the smaller investor the opportunity to get in on treasury securities. deals are transacted on phone or through electronic systems as against capital market where trading is through recognized stock exchanges. The institution buys a variety of treasury securities with the money you invest. Money Market Instruments: Money market instruments are generally characterized by a high degree of safety of principal and are most commonly issued in units of $1 million or more.VIDHU JAIN ---. Active secondary markets for most of the instruments allow them to be sold prior to maturity. typically within a year. Capital Market refers to stock market. in case of money market. The rate of return changes daily. which refers to trading in shares and bonds of companies on recognized stock exchanges.I n d i a n Fi n a n c i a l S y s t e m Page | 3 Money Market & Capital Market: Money Market is a place for short term lending and borrowing.
I n d i a n Fi n a n c i a l S y s t e m Page | 4 participants in the money market are commercial banks. Repurchase Agreements (Repo/Reverse Repo) 3. T-bills are • INDIAN FINANCIAL SYSTEM ---. If interest rates decrease during the term of the bill.F12 ---. corporations. These are issued by the Reserve Bank usually a period of 91 days.VIDHU JAIN ---. governments. Money market instrument meets short term requirements of the borrowers and provides liquidity to the lenders. It is available both in primary market as well as secondary market. A bank buying such a bill will not pay face value for it but would instead buy it at a discount. Certificate of Deposits 5. Bankers Acceptance 6. are short term borrowing instruments of the Central Government of the Country issued through the Central Bank (RBI in India). Treasury Bills 2. government-sponsored enterprises. This will reduce a banks ability to lend to its clients leading to a contraction of the money supply. the holder can sell the bill at a profit before the due date. money market mutual funds. Investment in money market is done through money market instruments. The Reserve Bank uses these bills to take money out of the market. Commercial paper 4. The bill is tradable so the purchaser does not have to hold it until the due date. one of the safest money market instruments. They are zero risk instruments. Common Money Market Instruments are as follows: 1. The bill consists of an obligation to pay the bearer the face value of the bill upon a given date. Eurodollar Treasury Bills (T--Bills): Treasury Bills. futures market exchanges.FW 200709 . It is a promise to pay a said sum after a specified period. and hence the returns are not so attractive. brokers and dealers.
The difference between the purchase price and the maturity value is the interest income earned by the purchaser of the instrument. They are issued with a promise to pay full face value on maturity. T-Bills are issued through a bidding process at auctions. Whereas.I n d i a n Fi n a n c i a l S y s t e m Page | 5 short-term securities that mature in one year or less from their issue date. six-month and one-year maturity periods. The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks’ website. RBI issues these INDIAN FINANCIAL SYSTEM ---. Treasury bills are available for a minimum amount of Rs. At present. 91-day. The Central Government issues T. The bid can be prepared either competitively or non-competitively.Bills at a price less than their face value (par value). T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. in case of competitive bidding.FW 200709 .VIDHU JAIN ---. In case the return specified is too high then the T-Bill might not be issued to the bidder. when the T-Bills mature. return required is not specified and the one determined at the auction is received on maturity.F12 ---. the Government of India issues three types of treasury bills through auctions. NDS is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments. They are issued with three-month. the government pays the holder its face value. There are no treasury bills issued by State Governments. the amount to be auctioned and payment dates by issuing press releases prior to every auction. So. namely. 182-day and 364-day Tbills are auctioned every alternate week on Wednesdays. 182-day and 364-day.25K and in its multiples. In the second type of bidding. Payment by allottees at the auction is required to be made by debit to their/ custodian’s current account. It also announces the exact dates of auction. While 91-day T-bills are auctioned every week on Wednesdays. the return required on maturity is specified in the bid.
Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. the borrower pays a contracted rate to the lender. As against the call money market where the lending is totally unsecured. They are usually used for overnight borrowing. Securities. liquidity is infused in the market. insurance companies etc. the lending in the repo is backed by a simultaneous transfer of securities. financial institutions. mutual funds. Further RBI also operates daily repo/ reverse repo auctions to provide a benchmark rates in the markets as well as managing in the • INDIAN FINANCIAL SYSTEM ---. A repo transaction for party would mean reverse repo for the second party. The main players in this market are all institutional players like banks.FW 200709 . A repo agreement is the sale of a security with commitment to repurchase the same security as a specified price and on specified date while a reverse repo is purchase of security with a commitment to sell at predetermined price and date. primary dealers like PNB Gilts Limited. this is called Reverse Repurchase (Reverse Repo). This is called Repo (Repurchase) transaction. FI Bonds. On the other hand.F12 ---. In banking terms.I n d i a n Fi n a n c i a l S y s t e m Page | 6 instruments to absorb liquidity from the market by contracting the money supply. In lieu of the loan. T-Bills. PSU Bonds. allowed to operate a SGL with the Reserve Bank of India. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. which is called the repo rate. GOI and State Govt. called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. Corporate Bonds etc. Repurchase Agreements : Repurchase transactions. when RBI purchases back these instruments at a specified date mentioned at the time of transaction.VIDHU JAIN ---.
The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. The company is able to liquidate its receivables immediately and the INDIAN FINANCIAL SYSTEM ---. It can issue commercial papers in form of unsecured promissory notes at discount of 10% on face value of Rs 1 lacs to be matured after 6 months. Similarly. a company has receivables of Rs 1 lacs with credit period 6 months. It is a short term unsecured promissory note issued by corporate and financial institutions at a discounted value on face value. Say. The company is in need of funds. They are usually issued with fixed maturity between one to 270 days and for financing of accounts receivables. It will not be able to liquidate its receivables before 6 months. The rate of interest agreed upon is called the Repo rate.I n d i a n Fi n a n c i a l S y s t e m Page | 7 liquidity in the system. RBI sucks or injects liquidity in the banking system by daily repo/ reverse operations.FW 2007- 09 . • Commercial Papers: Commercial paper is a low-cost alternative to bank loans. The company has strong credit rating and finds buyers easily. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. inventories and meeting short term liabilities. whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction.F12 ---. for example.VIDHU JAIN ---.
with 3035 days being the average maturity. The nine-month maturity limit is not violated by INDIAN FINANCIAL SYSTEM ---. including issuing a prospectus on the offering. only firms with high quality credit ratings will find buyers easily without offering any substantial discounts.The maturity of commercial paper must be less than 270 days. Registration requires extensive public disclosure. most commercial paper has a maturity of between 5 and 45 days.I n d i a n Fi n a n c i a l S y s t e m Page | 8 buyer is able to earn interest of Rs 10K over a period of 6 months. Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely transferable in demat form. CHARACTERISTICS OF COMMERCIAL PAPER: Securities offered to the public must be registered with the Securities and Exchange Commission according to the Securities Act of 1933. Commercial paper being an instrument not backed by any collateral. exemption: . however chances of default are almost negligible but are not zero risk instruments. Many issuers continuously roll over their commercial paper. The exemption requirements have been a factor shaping the characteristics of the commercial paper market. It is a time-consuming and expensive process. Most commercial paper is issued under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities as long as they have certain characteristics. financing a more-or-less constant amount of their assets using commercial paper.F12 ---.FW 200709 The following are requirements for . They are issued by corporate to impart flexibility in raising working capital resources at market determined rates.VIDHU JAIN ---. In practice. They yield higher returns as compared to T-Bills as they are less secure in comparison to these bills.
In practice. is the interest received on the investment. because most investors are institutions. bank loan. although face amounts as low as $10.I n d i a n Fi n a n c i a l S y s t e m Page | 9 the continuous rollover of notes. Notes must be of a type not ordinarily purchased by the general public. as long as the rollover is not automatic but is at the discretion of the issuer and the dealer.VIDHU JAIN ---.000. receives the face value and accrued interest. Commercial paper is. That proceeds from commercial paper issues be used to finance "current transactions. occasionally. at maturity. The difference between the purchase price and the face value.FW 200709 . Until the 1980s.000 are available from some issuers. the denomination of commercial paper is large: minimum denominations are usually $100. All commercial paper interest rates are quoted on a discount basis. such as plant and equipment. called the discount. most commercial paper was issued in physical form in which the obligation of the issuer to pay the face amount at maturity is recorded by printed certificates that are issued to the investor in exchange for funds. or internally generated cash flow." which include the funding of operating expenses and the funding of current assets such as receivables and inventories. Commercial paper is typically a discount security (like Treasury bills): the investor purchases notes at less than face value and receives the face value at maturity. issued as an interest-bearing note (by request of investors). INDIAN FINANCIAL SYSTEM ---. on a permanent basis. Proceeds cannot be used to finance fixed assets. Typical face amounts are in multiples of $1 million.F12 ---. The investor pays the face value and. Issuers will usually sell an investor the specific amount of commercial paper needed. Firms are allowed to finance construction as long as the commercial paper financing is temporary and to be paid off shortly after completion of construction with long-term funding through a bond issue.
and clearing agents. investor.F12 ---. An increasing amount of commercial paper is being issued in book-entry form whereby entries in computerized accounts are replacing the physical commercial paper certificates.VIDHU JAIN ---. and dealer required to transfer commercial paper for funds. In the long run the fees and costs associated with the book-entry system will. As all transactions between an issuing agent and a paying agent will be settled with a single end-of-day wire transaction.I n d i a n Fi n a n c i a l S y s t e m P a g e | 10 A safekeeping agent hired by the investor held the certificates. The certificate bears the maturity date. paying. Commercial banks. the problem of daylight overdrafts. The Depository Trust Company (DTC). the fixed rate of interest and the value. which arise from non-synchronous issuing and redeeming of commercial paper will be reduced. It is a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. It can be issued in any denomination. the investor presents the notes and receives payment. The advantages of a paperless system are significant. facilitate the settling of commercial paper by carrying out the exchanges between issuer. On the day of maturity. in their role as issuing. more than 40 percent of commercial paper was issued through the DTC in book-entry form. be significantly less than under the physical delivery system. • Certificate of Deposit: It is a short term borrowing more like a bank term deposit account. until presented for payment at maturity. began plans in September 1990 to convert most commercial paper transactions to book-entry form.FW 200709 . The expense of delivering and verifying certificates and the risks of messengers failing to deliver certificates on time will be eliminated. a clearing cooperative operated by member banks. Book-entry systems will eventually completely replace the physical printing and delivery of notes. They are stamped and transferred by INDIAN FINANCIAL SYSTEM ---. By May 1992.
the higher the interest rate earned.VIDHU JAIN ---. on payment of certain penalty the money can be withdrawn on demand also. The longer you tie up money in a CD. No purchase fees are charged. Its term generally ranges from three months to five years and restricts the holders to withdraw funds on demand. A banker’s acceptance is used for international trade • INDIAN FINANCIAL SYSTEM ---. Returns can be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). Interest earned is higher than paid on insured savings accounts.F12 ---. Money in a CD is tied up from a few months to six years or more depending on the terms of the specific CD you buy. In APY. depending on the policy of the financial institution. However. the higher the rate of interest earned. in APR method. All earnings are subject to income tax. if interest is paid more than once in a year.I n d i a n Fi n a n c i a l S y s t e m P a g e | 11 endorsement. savings and loans and credit unions. return method should be seen. In most cases. simple interest calculation is done to generate the return. interest earned is based on compounded interest calculation. A notice of withdrawal is required and a penalty imposed if you withdraw money before the CD matures. CD’s are available from banks. While buying Certificate of Deposit. the more money you invest. if the interest is paid annually. Accordingly. Interest is paid either at time of purchase or at maturity. it is beneficial to opt APY over APR.FW 200709 . It is simply a bill of exchange drawn by a person and accepted by a bank. Banker’s Acceptance: It is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. However. It is a buyer’s promise to pay to the seller a certain specified amount at certain date. The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. However. equal return is generated by both APY and APR methods.
denominated deposits that are held in banks outside the United States. The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. Euro Dollars: The Eurodollars are basically dollar. which then stamps it “accepted” and. they can very from 30 days to180 days. The letter of credit is a document issued by a bank that guarantees the payment of the importer’s draft for a specified amount and time. the imported goods. However.VIDHU JAIN ---. Thus. The person drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will not be tradable. The most common term for these instruments is 90 days. the exporter can rely on the bank’s credit rather than the importer’s. he will often get a letter of credit from his bank and send it to the exporter. the banks can • INDIAN FINANCIAL SYSTEM ---.I n d i a n Fi n a n c i a l S y s t e m P a g e | 12 as means of verifying payment. The domestic bank then sends a time draft to the importer’s bank. if an importer wants to import a product from a foreign country. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables. and the bank’s guarantee of payment. converting the time draft into a banker’s acceptance. This negotiable instrument is backed by the importer’s promise to pay. which pays for the letter of credit at a discount. exports and other transactions in goods and is highly useful when the credit worthiness of the foreign trade party is unknown. For instance. because the exporter’s bank won’t receive the money from the importer’s bank until later. For corporations. thus. The exporter presents the shipping documents and the letter of credit to his domestic bank. it acts as a negotiable time draft for financing imports.FW 200709 .F12 ---. Since the Eurodollar market is free from any stringent regulations.
A demand note (aka call loan) is a loan that is payable on demand the next day at 1 day’s interest. The interest paid on these deposits is usually equal to the London Interbank Offer Rate (LIBOR). The broker uses the stocks. for collateral for the loans. The Eurodollar market is within the reach of large institutions only and individual investors can access it only through money market funds. then the term is extended by another day. and so on. If the note is not demanded. with terms of 6 months or less. Multi-national corporations deposit their domestic currency in foreign banks because they can often get better terms trading their currency with the locals than by exchanging domestic currency for foreign currency at a bank. Time notes are loans that must be paid by a specific date for a specified interest rate. The Eurodollars are traded at very high denominations and mature before six months.F12 ---. hence for retail market. • Broker’s Loans and Call Loans: Broker’s loans are loans from commercial banks to brokers so that the broker’s customers can finance stock purchases. Eurocurrency is a more general term that can refer to any currency that is deposited in banks whose domestic currency is different from the deposited currency. and it can involve any country.S. which is slightly higher than the yield for 3-month Treasuries. including the Far East and the Cayman Islands.VIDHU JAIN ---. The interest rate for each day varies with the prevailing interest rate.I n d i a n Fi n a n c i a l S y s t e m P a g e | 13 operate at narrower margins as compared to the banks in U.FW 200709 . An individual player cannot invest in majority of the Money Market Instruments. held in street name. Eurodollars or Eurocurrency does not necessarily involve either Europe or the Euro. A INDIAN FINANCIAL SYSTEM ---. money market instruments are repackaged into Money Market Funds. up to 90 days.
Money Market funds can be categorized as taxable funds or non taxable funds. the account holder can only do the investments with no transactions. • Money Market Index: To decide how much and where to invest in money market an investor will refer to the Money Market Index. lets move forward to understand functioning of money market account.FW 200709 .F12 ---. the account holder can enter into transactions also besides investments. except the fact mutual funds cater to capital market and money market funds cater to money market. it is less liquid as compared to regular savings account.I n d i a n Fi n a n c i a l S y s t e m P a g e | 14 money market fund is an investment fund that invests in low risk and low return bucket of securities viz money market instruments. It is a low risk account where the money parked by the investor is used by the bank for investing in money market instruments and interest is earned by the account holder for allowing bank to make such investment. although the numbers of transactions are limited. Interest is usually compounded daily and paid monthly.VIDHU JAIN ---. However. Having understood. Money Market Account: It can be opened at any bank in the similar fashion as a savings account. It provides INDIAN FINANCIAL SYSTEM ---. Money Market Investor Account: By opening such type of account. two modes of investment in money market viz Direct Investment in Money Market Instruments & Investment in Money Market Funds. There are two types of money market accounts: • Money Market Transactional Account: By opening such type of account. It is like a mutual fund.
is also used as a money market index. There are various methods of identifying Money Market Index like: Smart Money Market Index.Money market instruments are evaluated in various world currencies and a weighted average is calculated.VIDHU JAIN ---. LIBOR/MIBOR.As discussed above.London Inter Bank Offered Rate/ Mumbai Inter Bank Offered Rate also serves as good money market index. the rate at which the banker’s acceptance is traded in secondary market. The prevailing market rate of this instrument i.I n d i a n Fi n a n c i a l S y s t e m P a g e | 15 information about the prevailing market rates.e.FW 200709 . • • Salomon Smith Barney’s World Money Market Index.F12 ---. • • INDIAN FINANCIAL SYSTEM ---. This is the interest rate at which banks borrow funds from other banks. Banker’s Acceptance is a money market instrument. Banker’s Acceptance Rate. This helps in determining the index.It is a composite index based on intraday price pattern of the money market instruments.
and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). Fixed-income securities can be contrasted with variable return securities such as stocks. and use the coupon payment (the interest) as that regular dependable payment. to finance an acquisition. by giving equity in the company (stock). you have to understand a company's motivation. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. buy equipment or land or invest in new product development.I n d i a n Fi n a n c i a l S y s t e m P a g e | 16 FIXED INCOME SECURITIES Fixed income security originally referred to instruments that pay a fixed rate of interest. This person can buy a bond with their money.FW 200709 . INDIAN FINANCIAL SYSTEM ---. In order for a company to grow as a business. but not consume principal. For example. A company wants to raise money.F12 ---. The company can either pledge a part of itself. or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). These days the definition of fixed income securities includes many debts instruments whose promised cash flows are far from fixed. usually fixed coupon rate.VIDHU JAIN ---. To understand the difference between stocks and bonds. People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. it often must raise money. a retired person might like to receive a regular dependable payment to live on.
the company can offer a lower coupon. commercial paper. For example. These are a form of short term debt. based on a variety of factors.. particularly rates set by the Federal Reserve. they pay a fixed percentage of the principal at regular intervals for all time. Interest rates change over time.g. If there are a lot of people in the market trying to get a return on their money.FW 200709 . Annuities pay a constant amount at regular intervals. Negotiable Certificates of Deposit (NCD’s).F12 ---. the company will have to offer a high rate of interest (coupon) to get people to buy their bond.e. Consuls are fixed coupon bonds which mature at 1. Types of Fixed Income Securities • A money market account is simply a bank account which offers the prevailing\ (and constantly changing) interest rate. These constant payments thus include both the interest and part of the principal.I n d i a n Fi n a n c i a l S y s t e m P a g e | 17 When the bond matures or is refinanced. but only the principal at maturity. the person will have their money returned to them. The gradual payment of the principal is called amortization. if a company wants to raise $1 million and not a lot of people in the market have free cash to lend.VIDHU JAIN ---. Treasury bills. but the principal is never repaid. E. i. Floating rate notes (FRN’s) are bonds that pay a variable coupon at regular intervals. Zero coupon bonds do not pay any coupon.. For example inverse floaters have coupon payments that vary inversely • • • • • INDIAN FINANCIAL SYSTEM ---. This variable coupon is generally linked to some market-observable reference rate Structured notes are a class of debts instruments with more complex pay-off patterns. possibly tailored to an investor’s requirements.
The biggest driver of these rates.VIDHU JAIN ---. Other. its cost of capital is in the region of 6%. • • FIXED INCOME SECURITIES INCOME VARIES INVERSELY WITH PURCHASE PRICE AND VICEVERSA. After 5 years. AB Corp. then investor X can sell the bond back to AB Corp.I n d i a n Fi n a n c i a l S y s t e m P a g e | 18 with a reference date: The coupon might be (15%¡LIBOR)+. A bond with a conversion ratio of 3 allows the bond to be converted to shares. but if it has a put feature built in. If the bond has a call feature built in.F12 ---. is still paying 15%. Puttable bonds can be put back to the issuer at fixed prices on fixed dates. control interest rates (at least short-term rates). the decisions central banks make in regards to the level of domestic interest rates. this credit rating has migrated to B-. at a reasonable price. Investor X buys a 20-year 10%-fixed coupon bond from AArated AB Corp. those things which impact on rates directly influence prices. less direct. AB Corp. they have a heavy influence over their level and direction. Convertible bonds can be converted to equity at a predetermined conversion ratio on predetermined dates. The bond has devalued substantially. but AB Corp. • Callable bonds can be called back by the issuer at fixed price on fixed dates. floats a 10-year 15%-fixed coupon bond. from a macro Since the central banks directly perspective. and float a new issue with a 6% coupon instead. can call back the bond. After 10 years. WHY ?? Since the fixed income market is driven by interest rates (prices are inversely related to yields).FW 2007- 09 . Inverse floaters can be used to hedge against falling interest rates. is monetary policy. influencers include: • • Government fiscal policy General economic growth INDIAN FINANCIAL SYSTEM ---.
Yield Curve INDIAN FINANCIAL SYSTEM ---. is also account for in the credit rating. The investors can even neutralise the default risk on their investments by investing in govt. total debt outstanding. considerations related to that particular issuer come in to play. though.VIDHU JAIN ---. when considering the likes of corporate debt. The prices of debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments. interest cover ratios. Fixed income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. which are normally referred to as risk-free investments due to the sovereign guarantee on these instruments. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income. most debt securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. securities. Therefore. Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation. and others. All of this. This includes things like earnings.FW 200709 .I n d i a n Fi n a n c i a l S y s t e m • • • P a g e | 19 Employment Inflation Currency exchange rates and trade Obviously.F12 ---.
Notice that the plot above depicts two lines. from shortest to longest. In the most general sense. risk is the possibility of something undesirable. The pink line. shows an inverted.I n d i a n Fi n a n c i a l S y s t e m P a g e | 20 The yield curve is the graphic portrayal of yields over the array of maturities. Most fixed income securities have a par value that pays a specific rate of interest on that value. or otherwise has a knowable rate of return. A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment. investment risk is the possibility that the investor will get back INDIAN FINANCIAL SYSTEM ---.FW 200709 . The blue line is the more standard. upwardly sloping yield curve in which the longer-maturities feature higher yields. The spread between the long maturity issues over the short maturity ones is positive. hence the term fixed income security. Since the goal of investing is to get the greatest return possible for the investment.VIDHU JAIN ---. or negatively sloped curve. An example is shown on the following chart.F12 ---.
Many of the risks in fixed income securities apply to other investments as well. options. and many issuers of bonds are governments or their agencies. as you can buying stocks on margin. are usually small compared to stocks.FW 200709 . for instance. And because the United States government not only has taxing power. which have taxing power. or that he will get less than he could have had if he had invested his money elsewhere—what economists call opportunity costs. for instance.F12 ---. There INDIAN FINANCIAL SYSTEM ---. but can print money. Fixed Income Yields and security prices generally change much more slowly than Stock Market prices and it can actually takes years for interest rates to move in either direction by a few points. which is why many people invest in them. Not all risks apply to every fixed income security. At the same time. investments such as U.VIDHU JAIN ---.S. and this risk affects virtually every security. a trend in interest movements is likely to last longer than a trend in stock prices. since the interest rate that you would be paying would almost certainly be more than you could earn. and other derivatives. the other goes down. are virtually risk-free. Generally. affects every investment. because it makes no sense to borrow money to pay for fixed income securities. the most important risk for fixed income securities is market risk or interest rate risk. It is not possible to lose more than your investment in fixed income securities. Treasuries. And it is not likely that you will lose your initial investment because bondholders have priority over owners if the company goes bankrupt and usually receive periodic payments of interest. at least in regards to principal and interest payments. Inflation risk. In fact.I n d i a n Fi n a n c i a l S y s t e m P a g e | 21 less than his investment or his expected return. because interest rates change continually. which is best represented pictographically by a seesaw. many risks have an inverse relationship—when one goes up. These risks associated with fixed income securities. however.
Johnny's fund couldn't do better unless there are significant Quality or Duration differences involved. OR even worse. as you should be in this area. If your fund is down. the rules become simple and few: • RULE ONE is to always seek out the longest duration. Fixed Income Investing and Equity Investing are identical. don't ever switch from one Fixed Income Security to another for emotional (fear or greed) or other similarly superficial reasons.I n d i a n Fi n a n c i a l S y s t e m P a g e | 22 is abundantly more economics than there is emotion involved with interest rates movements. and should rarely produce an anxious moment. • INDIAN FINANCIAL SYSTEM ---. So long as you follow RULE ONE. This means that if your bonds are up or down in price. so are everyone else's. Therefore.Junk is Junk. If you are thinking long term. Investment Grade Only. RULE TWO is to focus on the Cost Basis of your Fixed Income Securities and ignore their Market Value fluctuations. RULE THREE is to stay focused on the income generated by these securities. and to make decisions that grow that income annually. • • All Interest Rate Sensitive Securities are Created Equal. Income Investing should be much easier than it is.FW 200709 . securities with the highest (reasonable) yields..F12 ---. Caveat Emptor! In one sense. take losses on fixed income to move into something else entirely. creating a more stable playing field for the individual investor. Another basic rule is to avoid yields that are a great deal higher than normal..VIDHU JAIN ---. • Investors should almost never switch from one fixed income fund to another. typically a peaking Equity Market.
are Lower Interest Rates. the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. This can include income derived from fixed-income investments such as bonds and preferred stock or pension that guarantee a fixed income. while notes and bills have less risk because these are issued by government agencies. you have been issued a fixed-income security. A company wants to raise money. Fixed income refers to any type of investment that yields a regular (or fixed) return. if you lend money to a borrower and the borrower has to pay interest once a month. you have to understand a company's motivation. When pensioners or retirees are dependent on their pension as their dominant source of income. and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services).F12 ---.FW 200709 . to finance an INDIAN FINANCIAL SYSTEM ---. Fixed-income securities can be contrasted with variable return securities such as stocks. it often must raise money. Bonds actually have higher risk. and So. it is often called a bond or corporate bank debt (although “preferred stock” is also sometimes considered to be fixed income). too. When a company does this. The term fixed income is also applied to a person's income that does not vary with each period.VIDHU JAIN ---. To understand the difference between stocks and bonds. For example. In order for a company to grow as a business.I n d i a n Fi n a n c i a l S y s t e m P a g e | 23 To be a successful Fixed Income Investor you must get to the point where you understand that: • • Higher Interest Rates are a Good Thing. Sometimes people misspeak when they talk about fixed income.
For example. or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). The principal (of a bond) is the amount that the issuer borrows. The issue is another term for the bond itself. The company can either pledge a part of itself. based on a variety of factors. When the bond matures or is refinanced. particularly rates set by the Federal Reserve. For example.I n d i a n Fi n a n c i a l S y s t e m P a g e | 24 acquisition.F12 ---. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The maturity is the end of the bond. the date that the issuer must return the principal. The indenture is the contract that states all of the terms of the bond. but not consume principal. by giving equity in the company (stock). buy equipment or land or invest in new product development.) who borrows an amount of money (issuing the bond) and pays the interest. While a bond is simply a promise to pay interest on borrowed money. a retired person might like to receive a regular dependable payment to live on. and use the coupon payment (the interest) as that regular dependable payment. This person can buy a bond with their money. the INDIAN FINANCIAL SYSTEM ---. • • • • • People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. if a company wants to raise $1 million and not a lot of people in the market have free cash to lend. the person will have their money returned to them. The coupon (of a bond) is the interest that the issuer must pay.FW 200709 .VIDHU JAIN ---. there is some important terminology used by the fixed-income industry: • The issuer is the entity (company or govt. Interest rates change over time.
giving a total return of 6.000). fixed income securities are actually traded on the open market. To complicate matters further. fixed-income securities. and you are buying a bond with a coupon rate below 6%. then you can get the bond at a discount (below face value of $100.88 and then the real yield would be applied to the adjusted principal.FW 200709 .0261. for a 5 yr TIPS). Similarly.VIDHU JAIN ---. first realize that bonds are usually created in round face values. To understand this. meaning 103.5913%.88 x 1. the company can offer a lower coupon. which equals 106. This type of fixed income is adjusted to the Consumer Price Index for all urban consumers (CPI-U). and then a real yield is applied to the adjusted principal.61% (the fixed US Treasury real yield on October 19. through most of 2006). This means that the US Treasury issues fixed income that is backed by the full faith and credit of the US government to outperform the CPI (e.F12 ---. which can be very uncertain at times.I n d i a n Fi n a n c i a l S y s t e m P a g e | 25 company will have to offer a high rate of interest (coupon) to get people to buy their bond. the adjusted principal of the fixed income would rise from 100 to 103. which yield just INDIAN FINANCIAL SYSTEM ---. There are also index-linked. For example. If there are a lot of people in the market trying to get a return on their money. and a real yield of 2. assuming 3. This allows investors of all sizes to not lose the purchasing power of their money due to inflation.g. The most common and an example of the highest rated variety of this kind could include Treasury Inflation Protected Securities (TIPS). 2006. TIPS moderately outperform conventional US Treasuries. If the current yield (interest rate) of newly issued similar bonds is 6% per year. for example $100.000. which brings your rate of return on that bond to 6%.5913. to outperform the inflation rate). just like stocks. if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%.88% inflation over the course of 1 year (just about the 56 year average inflation rate.
F12 ---.FW 200709 . All fixed income securities from any entity have risks including but not limited to: • • • • • • • • • • • • • • • • inflationary risk interest rate risk currency risk default risk repayment of principal risk reinvestment risk liquidity risk maturity risk streaming income payment risk duration risk convexity risk credit quality risk political risk tax adjustment risk market risk climate risk Fixed income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument.VIDHU JAIN ---. index linked fixed income securities. consumers can exceed the pace of inflation. By investing in such fixed income. most debt securities carry a fixed charge on the assets of the entity and generally INDIAN FINANCIAL SYSTEM ---. and gain value in real terms. 2006. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments.I n d i a n Fi n a n c i a l S y s t e m P a g e | 26 5. Therefore.05% for a 1 yr bill on October 19.
F12 ---. • The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income.VIDHU JAIN ---. In essence. companies. semi-annually. One of the key benefits of fixed-income instruments is low risk i. In return. securities. which are normally referred to as riskfree investments due to the sovereign guarantee on these instruments. quarterly.FW 200709 . you are lending money to the issuer for a specified period of time. when you buy a fixed-income security. you expect the issuer to make regular interest payments (annually. and government issues. or monthly) and to pay back the face amount on the maturity date (the end of the specified period for the loan). fixed-income investments might suit your investment needs better.e. fixed deposits and government schemes. They are also crucial for your tax planning. Fixed-income securities can be an excellent way to diversify your portfolio. • Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation. Fixed-income securities represent the debt of domestic financial institutions. • The prices of debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments. the relative safety of principal and a predictable rate of return (yield). • The investors can even neutralize the default risk on their investments by investing in govt. If your risk tolerance level is low. banks.I n d i a n Fi n a n c i a l S y s t e m P a g e | 27 enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. INDIAN FINANCIAL SYSTEM ---. Fixed-income instruments in India typically include company bonds.
the term "fixed income. etc. • Most fixed-income securities offer a relatively safe and predictable income flow.I n d i a n Fi n a n c i a l S y s t e m P a g e | 28 Most fixed-income securities offer a relatively stable and predictable income flow. is set at issuance and remains the same until maturity: hence. A brief detail about some of these investment options are given below. Fixed-income securities provide the flexibility to structure a portfolio tailored to your specific investment objectives and tolerance for risk. government." The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities (generally one day to 30 years. Fixed-income securities provide the flexibility and liquidity needed to structure a portfolio tailored to your specific investment objective. thus. Fixed-income securities are investments where the cash flows are according to a predetermined amount of interest. The coupon (the amount of interest the issuer has agreed to pay) is set at issuance and remains the same until maturity. paid on a fixed schedule. INDIAN FINANCIAL SYSTEM ---. The amount of interest the issuer has agreed to pay. the coupon rate. bank. with some as long as 100 years). A Debt or Fixed Income Security represents a creditor relationship with a corporation. the term "fixed-income. etc. debentures. The different types of fixed income securities include government securities. Generally debt instruments represent agreements to receive certain cash flows depending on the terms contained within the agreement.F12 ---." The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities. corporate bonds.FW 200709 . • • • Securities are financial instruments that represent some value. This diversity helps improve your management of risk.VIDHU JAIN ---.
F12 ---. As per section 125(4) of the Companies Act. of course.. They are subject to provisions of the Companies Act.I n d i a n Fi n a n c i a l S y s t e m P a g e | 29 Government Securities.Government Securities are issued by the Reserve Bank of India on behalf of the Government of India. Compared to government bonds. upon the particular corporation issuing the bond. Normally the dated Government Securities have a period of 1 year to 30 years. Debentures – Debentures are instruments for raising loan by a Company. the current market conditions. creation of Debenture Redemption Reserve Account. corporate bonds generally have a higher risk of default. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. They evidence an acknowledgement of debt with an obligation to repay the sum specified along with interest as specified. This risk depends. registration of charge for purpose of issue of debentures is mandatory. 1956 and sections 117 to 123 relating to issue. Corporate BondsCorporate Bonds are issued by public sector undertakings and private corporations for a wide range of tenors normally up to 15 years although some corporate have also issued perpetual bonds. etc. specifically apply to them.FW 200709 . ************ INDIAN FINANCIAL SYSTEM ---. Debentures form a part of the Company’s capital structure but not a part of the share capital. These are sovereign instruments generally bearing a fixed interest rate with interests payable semi-annually and principal as per schedule. appointment of debenture trustees. the industry in which it is operating and the rating of the company.VIDHU JAIN ---. Government Securities provide risk free return to investors.
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