Management of Commercial Bank

Class Three & Four

For
PGDM
Great Lake Institute of Management, Chennai
By
Praloy Majumder

(For Classroom discussion only)

Class Three
Because of these several sources, the dependence on inter bank call money market
is reduced to a great extent over the years. This is also the reason for reducing the
number of participants in the call money markets as entities can park their short
term funds in several other short term avenues as mentioned above.
The call money market , at present , would be used by banks only for meeting the
cash reserve ratio only. As mentioned in the previous chapter, CRR is an important
tools for money supply as it effects the high power money. RBI changes CRR from
time to time and CRR can be maintained by banks by keeping fund in the current
account with RBI. For maintenance of CRR, if bank finds that there is a shortfall, the
bank can borrow in the call money market till the time bank concerned arranges
deposits or other long term funds. For the lending banks point of view, banks can
lend only up to a certain amount linked to its net worth in the call money market. For
remaining surplus , it can lend in other short term avenues as mentioned above.
CRR and its maintenance : As mentioned earlier ,CRR is the cash reserve ratio.
The CRR is maintained on the Net Demand and Time Liabilities of the banking
system. Let us explain it with the help of an example :
Suppose on a particular Friday ( assuming it a reporting Friday ) , the total deposits
of a bank is say Rs 5000 crores. This consists of the following :
Demand Deposits : The deposits which is paid on demand and on which no interest is
paid.
Time Deposits: This represents deposits on which interest is paid and the original
date of maturity is after a specified period which is determined at the time of
receiving the deposits.
Let us also assume that the break up of this demand and time liabilities is as
follows :
Demand Deposit : Rs 500 crores
Time Deposit

: Rs 4500 crores.

Another break up of this deposit is carried out. Suppose the demand deposit to the
banking system is say Rs 50 crores and the remaining amount , deposit to public is
Rs 450 crores. The similar bifurcation for time deposit is Rs 500 crores and Rs 4000
crores respectively . This is represented below :

Demand and Time Liability ( DTL) (Rs 5000 cr)

DTL Bank

DTL Public

Demand

Time

Deposit
(Rs 50 cr)

Demand

Deposit

Time

Deposit

( Rs 450 cr)

(Rs 450 cr)

Deposit
(Rs 4000 cr)

Fig 3.1Break up of Demand Time Liabilities in the Banking System

From this Rs 5000 crores of deposits , the banks would invest in assets mainly in the
forms of loans and advances and investments. Out of the loans and advances and
investments , a bank can give loans and advances to other bank or can invest in the
securities of the other banks. These are called as Assets to the banking system . Let
us assume that in the above example the inter bank assets are of Rs 500 crores. So
the Net Demand and Time Liability (NDTL)= Demand and Time Liability(DTL) Asset
to the Banking System .
If we define DTL= DTL to Others (I) + DTL to Bank (II)
And Asset to the Banking System as III
NDTL= I+II-III if II-III>0
NDTL= I if II-III <0
In the above mentioned case, the NDTL of the bank as on the reporting Friday is Rs
4450 cr + Rs 550 cr Rs 500 cr = Rs 4500 crores .
If the Cash Reserve Ratio (CRR) is 5% then the CRR to be maintained is Rs 4500
crores * 5% = Rs 225 crores.

This means that the average balance on the Current account with the Reserve Bank
of India would be Rs 225 crores from Saturday to 14 days ending on next reporting
Friday. Besides this, the bank

needs to maintain 85% or any percentage as

stipulated by RBI from time to time on a daily basis and the balance amount can be
adjusted on the last day of the fortnight. The banks

do not earn interest on the

balance maintained on the Current Account of RBI up to the eligible CRR balance at
the rate of bank rate. Banks can borrow in the call money market only for
maintenance of CRR ,not for other purposes. Whenever , a bank fell short of CRR
balance, it would borrow in the call money market to meet the CRR requirement.
Similarly, if a bank has a surplus then it can lend for a day in the call money market
but there is a ceiling which is linked to the net worth of the lending bank.
Notice Money : When bank borrows fund for more than one day but less than 7
days it is called as notice money. Bank generally borrows under notice money when
it visualizes that the mismatch will continue for more than one day but less than
seven days and there is a probability that the call money interest rate would show an
upward trend in the next seven days . In such case the bank would borrow under
notice money from another bank and would try to replace this borrowing by taking
term money .
Term Money : When bank borrows for more than 7 days , it is called as term
money. When bank raises fixed deposits for more than 7 days it is called as term
money. Please keep it in mind that the term money also encompasses capital market
since the term money which is maturing over one year will come under term money.
Treasury Bills : This is short term money market instrument issued by RBI on
behalf of the government to meet the cash flow mismatch in the revenue account.
The tenure of T Bills would be from 14 days to 364 days. However , the most popular
T Bill is 91 days T Bill. T Bill is a discounted instruments and it is issued at a discount
to the face value. The yield on treasury bill helps one to build up a risk free pure
discount yield curve in the short term.
Certificate of Deposit : Certificate of deposit is also another money market
instrument and issued by banks . CD is a negotiable instrument issued by banks to
raise fund in large quantum. Banks can pay differential interest on CD.
Commercial Paper : Commercial paper is also another money market instrument
issued by corporations, primary dealers and financial institution.

Liquidity Adjustment Facility (LAF) : Under the scheme , repo auctions ( for
injection of liquidity ) and reverse repo scheme ( for absorption of liquidity ) will be
conducted on a daily basis. Under the reverse repo auctions, the RBI would sale the
securities to the commercial banks against which the banks would give fund. The RBI
agrees to buy back the security at a predetermined rate which reflects the interest
rate. Let us explain it with an example :
Suppose that RBI conducts reverse repo on November 15 th 2005 for one day. The
interest rate would be 5% per annum. If a bank become successful in the reverse
repo auction , it would have to give Rs 1 crores. Since the bank would be maintaining
a current account with RBI, the account would be debited by this amount . The bank
will maintain a Subsidiary General Ledger (SGL) with RBI. Within the SGL account ,
the bank will maintain Reverse Repo Constituents SGL account. In this account the
required amount of security would be credited. On the next day , the current account
of the bank will be credited by an amount which is equal to the principal amount of
Rs 1 crores plus interest rate @ 5% per annum for a day and corresponding quantity
of securities would be debited from the Reverse Repo CSGL. With this mechanism ,
an amount of Rs 1crores would withdrawn from the banking system on November
15th 2005 .So with this mechanism the liquidity is withdrawn from the system. Now if
RBI wants to increase the interest rate in the call money market, it would increase
the repo rate under LAF .So a bank having surplus would invest in the LAF rather
than in the call money market.
Similarly in the repo transactions, the banks would deposit securities with RBI and
would receive money on the first day. On the second day , the bank would return
back the money and it would receive the securities . In the first day, the successful
bidders current account with RBI will be credited by the amount and its

Repo

Constituents SGL account will be debited by the required quantity of eligible

securities. On the next day, the current account of the bank maintained with RBI will
be debited and RR Constituents SGL will be credited. So on the first day of the repo
of LAF , fund is injected in the system. So when RBI wants to reduce the call money
rate , it would reduce the repo rate under LAF , so banks shortage of funds will avail
the LAF instead of call money as long as it can avail the fund under LAF. Please keep
it in mind that for availing LAF the banks must have eligible security for requisite
amount . So first the bank would avail the LAF and then only it would avail the call
money market. In this way the call money market interest rate can be influenced by

RBI. For operational mechanism of LAF you can visit www.rbi.org.in and can go
through related circulars under notification section of the site.
One of the important functions of the bank is the treasury functions. Treasury
function is located at the centralised locations. Treasury of a bank consists of two
divisions :
1. Domestic Treasury
2. Foreign Treasury
Domestic treasury can also be segregated into three desks . They are :
1. Deposits collections
2. CRR Maintenance
3. Trading desks
Deposits Collections : This desk is responsible for collection of deposits at a lower
rate. This desk interact with other departments of the banks and design strategies
before announcing interest rate for different periods so that borrowing cost of the
bank is lowest .
CRR Maintenance : As we have discussed in the previous class that banks have to
maintain a certain amount of its NDTL as RBI balance . This needs to be maintained
on a daily basis. The CRR maintenance desks would monitor the outflow and inflow of
fund on a daily basis and any shortfall would be borrowed at the lowest possible cost
from different borrowing options. Similarly , any surplus amount would be invested in
appropriate instruments so that there is no loss in interest due to idle funds.
Trading Desks : This desks do the SLR maintenance . While doing the SLR
maintenance , it also take into consideration the trading opportunities available to
the bank. While doing that it needs to have some ideas of the fixed income securities
markets.

Fixed Income Security Market

Since substantial portions of the debt markets in India consists of Government of
India securities market, we shall discuss in detail about the Government of India
securities market.
Before we discuss the GoI securities market , we need to know why GoI Securities
are issued at the first place. To find out the reasons for issuance of GoI securities, we
shall start with the central budget. The central budget consists of mainly two
accounts :

Receipt

Expenditure

Under Receipt we have the following bifurcations :

Revenue Receipt (I)

o

Tax Receipt (II)

Non Tax Receipt (III)

Capital Receipt (IV)

o

Recovery of Loan (V)

Other Receipt (VI)

Borrowings (VII)

Under expenditure we have the following segregations:

Non Plan Expenditure

o

Revenue Account (VIII)

Interest (IX)

Others (X)

Capital Account (XI)

Plan Expenditure
o

Revenue Account (XII)

Capital Account (XIII)

Revenue Expenditure XIV= XII+VIII

Capital Expenditure XV= XI+XIII
Revenue Deficit XVI= XIV-I
Fiscal Deficit = XVI+XV-V-VI
It is seen from the above that the fiscal deficit is met by borrowings.
Gross Primary Deficit = Fiscal Deficit IX

It indicates the amount of fresh borrowing going to meet the interest expenses.
It can be seen from the above that fiscal deficit is met by borrowings. It is also seen
from the above that the deficit in the revenue account is not good for an economy
where as the deficit in the capital account would go for the building up of productive
assets. So when the fiscal deficit would only go for meeting the capital account deficit
, it will go for productive investment. So the aim of the central government would be
to eliminate the revenue deficit as early as possible.
Now we shall see what are the options available to the government for raising funds
under the head borrowing mentioned above. Funds can be raised under the head
borrowing through the following methods :

Small Savings,EPF and PPF

RBI Bonds

External Borrowings

Market Borrowings

We shall see the pros and cons of all these different methods and then we shall see
which methods are mostly used by the government .
Small Savings,EPF and PPF : These are the methods by which resources are
raised directly from the public. Considering the social security aspect of the country ,
political issues associated such type of borrowing the interest rate can not be
reduced beyond a certain point. The best example would be the hue and cry raised
when the EPF rate was reduced in recent times although the rate is quite higher
compared to other types of borrowings. Besides, small savings are the major source
of funds for states as state gets a certain percentage of funds they mobilize under
the small savings scheme. So the interest rate can not be reduced to a great extent
under these methods. If government plans to borrow predominantly in this route, it
would have to pay more interest on

its borrowing. So this will not be

the most

preferred route of borrowing for government. At present government borrows

approximately about 25% of its total borrowing through this route.
RBI Bonds: This is a good tool for raising funds from high net worth individual. The
interest rate can be made lower compared to that of the previous mode of
borrowing. Besides, the borrowing is directly from the public so the securities are
widely distributed resulting in the lesser adverse effect on the financial system due to
adverse movement in price. Besides the effect of high power money is also reduced if
borrowing is carried out through this route. This would increase in share of
borrowings of the government in days to come. However, the difficulties in this type

of borrowing is that it is difficult to raise such huge funds from retail base within one
year.
External Borrowing :

Another options of the government would be to borrow

from external sources. However, for borrowings from external sources, the assistance
comes with lots of strings attached . In a democratic country like ours where there
are opposition parties, this type of borrowing can raise several issues which can be
very embarrassing and politically unwise for the ruling party. So this can be used
only as last resorts.
Market Borrowing :

This is the most preferred method of borrowing for

government of India to bridge the fiscal deficit. There is a captive market for this
type of borrowing. Schedule commercial banks in our country is supposed to keep
minimum 25% of their NDTL as Statutory Liquidity Ratio ( SLR) . It means that 25%
of NDTL as on a reporting Friday would be kept in SLR approved securities. Banks
can not default on this account. So banks have to keep 25% of NDTL in SLR
securities. Government of India (GoI) securities are SLR approved securities .So
government has a captive market for GoI securities in the form of schedule
commercial banks in the country. As long as SLR stipulation is there, the government
would not have any problem in getting fund up to the SLR requirement as banks do
not have any option other than investing in the GoI Securities. Besides, Pension
Funds , Insurance Companies are also legally bound to invest a certain portion of
their portfolio in GoI securities . This also creates a captive market for the
government. Besides, treasury profits generated by GoI securities prompts many
corporate houses to invest in GoI securities. Due to these factors the market
borrowing forms the major portion of borrowings of the central government and at
present 70% of the fiscal deficit are bridged in this fashion. The market borrowing
can be performed by any or combinations of the following methods :

Issue of securities through Auctions

Issue of securities through pre announced coupon rates

Issue of securities through Tap Sale

Issue of securities by conversion of T Bills/dated securities

Issue of securities by any other modes as decided by Government from time

to time.

Issue of securities through auction: This is the most popular methods of raising
funds under market borrowing programme. Since market borrowing is the major
source of borrowing of the Government of India, this method is the mostly used

method for bridging the fiscal deficit by the central government. Once the budget is
announced in the month of February , the borrowing requirement can be determined
from the fiscal deficit figure. Then the government would seat with RBI for finalizing
the borrowing programme. The RBI will then announce a tentative borrowing
calendar so that this news are factored in the interest rate the beginning of the year.
This can be explained with the help of the Rational Expectation theory of interest
rate. Now, after the announcement , the RBI can borrow the money under two types
of auction process. In both the type of auction process the following steps are
followed:
1. The RBI will put a public announcement about the auction process. The
announcement would carry the issue size, type of auction, type of
warding to the successful bidder, the process of bidding i.e. submission
of application form and place and date of submission of application
form etc.
2. The advertisement would also state the amount reserved under non
competitive biddings. To promote the investment culture among larger
number of people, the RBI allocates a certain percentage of the issue
size under Non Competitive bidding. In this category , people have to
just quote the amount bidding for not the price or interest rate. The
bidders would be awarded at the price or interest rate at which the
competitive bidders are awarded. This would act as an incentive for an
entity to participate in the bidding process as he/she need not to
posses the specialist knowledge required for investing in fixed income
securities.
3. After the bids are submitted , the bids are opened as per the normal
procedures and name of successful bidders are published .
4. The successful bidders are required to deposit the money asked for
with the stipulated date as per the process mentioned in the
advertisement.
5. On receipt of the money, the RBI credit the securities in the Subsidiary
General Ledger (SGL) of the successful bidders who are having the
account with RBI , for others who do not maintain a SGL , the security
is credited with Constituents Subsidiary General Ledger (CSGL)
account maintained or the amount can be issued in the Physical form
if the investors asked for it.

10

Now we shall discuss the different types of auction process first . There are
two types of auction process. They are :

Yield Based Auction

Price Based Auction

Yield Based Auction : Under this type of auction , the bidders are asked to
quote the biding amount along with the yield at which the amount is quoted.
This can be explained with the help of following examples :
As per the Government of India borrowing programme, the RBI is announcing
the following auction :
Govt.

of India will borrow Rs 5000 crores under uniform price yield based

auction for standard coupon bearing securities of 20 years maturity. Out of

the above issues size 10% is reserved under non competitive category.
This means that the RBI is asking bid under uniform price yield based auction
for 20 years period. The coupon would be paid at half yearly interval . The
amount reserved for non competitive bidding is Rs 500 crores. It

means

amount available for competitive bidding is Rs 4500 crores. Now let us take 4
different situations :
The following bidding is put by different banks :
Bank Name

Bid Amount

Type of Bidding

Bank A
Bank B
Bank C
Entity X
Entity Y
Entity Z

( Rs Crores)
2000
1500
2500
1
5
5

C
C
C
NC
NC
NC

Yield Quoted
(%)
5.50
5.45
5.40

C- Competitive
NC- Non Competitive
Situation I : Now if RBI decides that the cut off yield is 5.38% p.a. , then
none of the bidder under the competitive scheme would qualify and only the
non competitive bidder would get allotted at the cut of yield . The remaining
amount i.e. Rs 4989 crores would be taken by Primary Dealers ( PD) as PDs
are the underwriter to the issue. We shall talk more about this issue and role
of RBI in the Government borrowing programme separately .
Situation II : If RBI decides a cut of yield of 5.40% , those who have quoted
at the cut off yield or below would qualify. In this case only Bank C would

11

qualify. Bank C would get Rs 2500 crores at 5.40% . The Non Competitive
bidders would get Rs 11 crores at 5.40% and the remaining amount Rs 2489
crores would be taken by PD. When the auction would be over the
government of India would issue securities with coupon rate 5.40%
years. If the issue date is 25

th

for 20

November 2005, then the security would be

called as 5.40% 2025 GoI securities

and the issuer would pay coupon on

each security an amount of Rs 540/- since the face value of a single security
is Rs 10000/-. The issuer would pay coupon for this amount on every 25 th May
and 25th November till 2025 and on 25th November the face value of Rs
10000/- would also be paid by the issuer. The price of the security can be
found out from the following equation :
C1

C40

Pt =

+ +
[1+(r)]1

P0
+

[1+(r)]40

Eqn 3.1
[1+(r)]40

This is the famous bond valuation equation. Here C i is called as Coupon amount and r
is yield to maturity (YTM). Please keep it in mind C i is kept constant
during the tenure of the security as this is the amount issuer will pay
to the holder of the bond. But r will keep on changing and r will
reflect the market perception of the interest rate for the remaining
maturity of the security. Another important factor is that when r is
equal to the coupon , then the present price is equal to the face value
of the security . The bond equation can also be represented in the
following format :
Pt = Ci [PVIFA](r%, n years) + P0 [PVIF](r%, n years) Eqn .3.2
In the above mentioned case since the coupon would be 5.40% p.a. and this also
reflect the YTM then the issue price of the security would be Rs 10000/- the face
value of the security. So in case of uniform price yield based auction successful
bidders would be issued security at face value.
Situation III : The cut off yield is 5.45% p.a. Here the successful bidders are Bank
B and Bank C as both of them have quoted at or below the cut off yield. So the total
amount to be awarded

through competitive bidding is Rs 4000 crores and Rs 11

crores would be given to non competitive bidders at 5.45% p.a. and remaining Rs
989 crores would be taken by PD at 5.45% p.a. Now what would be the rate at which

12

Bank B and Bank C would be offered. Since the auction is uniform price auction,
every eligible bidder would get at the cut off yield irrespective of their individual bid.
In this case , although Bank C has quoted 5.40% p.a. , it will get 5.45% p.a.
Situation IV: If the cut of yield is kept at 5.50% p.a., then all the bidders have
quoted at or below the cut off yield. So all the bidders would be successful. Now ,
since the total bid amount under the competitive category is Rs 6000 crores against
the total available amount under the competitive category of Rs 4500 crores , first
the vacant amount under non competitive bidding would be allocated to the
competitive bidding amount. So the total amount for awarding would be Rs 4500
crores plus Rs 489 crores i.e. total of Rs 4989 crores. Next step would be to find out
the eligible amount under competitive bidding. Since the amount is Rs 6000 crores
which is more than the total available amount , the allotment would be under the
proportional allotment. So Bank A would get (Rs 2000/Rs 6000)*Rs 4989 crores .
Similarly Bank B and Bank C would get (Rs 1500/Rs 6000)*Rs 4989 crores and (Rs
2500/Rs 6000)*Rs 4989 crores respectively.
Now we take the same example of yield based auction

but the awarding type is

differential pricing . In this case the following methodology would be pursued :

1. First determine the eligible bidder applying the same logic. Any bidder which
is quoting at or below the cut off yield would become eligible. So if we take
the situation IV , then all the banks become eligible.
2. Then the awarding would be in the process so that the total cost of the
borrowing is the least. In such case, Bank C would get Rs 2500 crores at
5.40% , Bank B would get Rs 1500 crores at 5.45% and bank C would Rs 989
crores at 5.50% p.a. The non competitive bidder would get 5.50% p.a. .
3. But Government of India would issue securities at uniform coupon rate and
the coupon rate would be at cutoff yield. So in this case the Government of
India would issue securities at 5.50% coupon and Bank B and Bank C would
pay more than the face value so that Government of India pays 5.45% and
5.40% respectively on their investment . The price is found out by putting r at
2.725% for bank B and r at 2.750% for Bank C where as the coupon would be
Rs 550/- and P0 is equal to Rs 10000/-. So in case of differential yield based
auction, different investor would pay different price at the time of subscription
in the primary market.
It may be mentioned that the uniform price auction is also called as Dutch
Auction and the differential price auction is also called as French Auction.

13

Price Based Auction : In Price based auction, the bidder is asked to bid for the
price of a security where the coupon of the security would be mentioned at the time
of advertisement . Let us take an example ,
As per the Government of India borrowing programme, the RBI is announcing the
following auction :
Govern of India will borrow Rs 5000 crores under uniform price based mechanism
for price based auction for standard 10% standard coupon bearing securities of 20
years maturity. Out of the above issues size 10% is reserved under non competitive
category.
This means that the RBI is asking bid under uniform price based mechanism for price
based auction for 20 years period and the coupon of 10% coupon would be paid at
half yearly interval . The amount reserved for non competitive bidding is Rs 500
crores that means amount available for competitive bidding is Rs 4500 crores. Now
let us take 4 different situations :
The following bidding is put by different banks :
Bank Name

Bid Amount

Type of Bidding

Bank A
Bank B
Bank C
Entity X
Entity Y
Entity Z

( Rs Crores)
2000
1500
2500
1
5
5

C
C
C
NC
NC
NC

Price Quoted
Per Rs 100
154.1757
155.0043
155.8394

The above price has been quoted by these banks by taking into consideration that
the interest rate for 20 years as of the date of issue would be 5.40% for bank
C,5.45% for bank B and 5.50% for bank C. Now , putting these different values of r
in the equation 6.1 while keeping the C value at Rs 500/- and P 0 at Rs 10,000/-, the
above mentioned prices are obtained.
Situation I : The RBI feels that the 20 years risk free rate is 5.40% p.a. So the cut
off price would be Rs 155.8394. So any one who has quoted at or above the cut off
price would become eligible for allotment. In this case, Bank C would become
eligible. So bank C would get 16,04,216 number of 10% coupon bearing securities
maturing at 25th November 2025. The participants under Non Competitive bidding
would get Rs 11 crores at the cut off price. The remaining amount would be issued to
PD and PD would give the remaining Rs 2489 crores to the government of India.

14

Situation II : The RBI feels that the 20 years risk free rate would be 5.50% p.a.
Then all the banks would become eligible and the process of allotment would be
same as mentioned in the yield based auction process.
Situation III : In case of uniform price price based auction , if the auction type is
differential price price based auction and the cutoff price has been decided as per
situation II mentioned above. In this case, the allotment mechanism would be such
that the cost of borrowing would be lowest. So C would get the maximum amount ,
then B and then A and the transfer of non competitive to competitive would follow
the same methodology.
So from the above we can find out that , the subscription price for an investor in a
Government of India securities would be at the face value only when the auction is
yield based and uniform price type. The subscription price would be different from
the face value if the auction is yield based , differential price type, price based
uniform price type and price based differential price type.
Now we shall discuss the merits of price based auction compared to that of yield
based auction. If one looks at the bond valuation formula as mentioned in equation
2.1 , one can issue a security with identical coupon which was issued earlier by
changing the price. If the present interest rate for the period of present borrowing
is less than the coupon rate to be offered in the security, the issue price would be
more than the face value. Similarly, if the present interest rate for the period of
present borrowing is more than the coupon rate to be offered in the security, the
issue price would be less than the face value of the security. Due to this property ,
reissuance of security is possible under the price based auction process. The
reissuance means issuance of a security which was earlier issued. Let us take an
example. Suppose on 25th November 1995 Govt. of India borrowed Rs 2500 crores
for 20 years under yield based auction by issuing a coupon of 11% p.a. This means
that on 25th November 1995, the interest rate for 20 years was 11% p.a. Now on
25th November 2005, the Govt. of India wants to borrow for 10 years. Let us assume
that 10 years interest rate as on November 25th 2005 is 4.95% p.a. In such case the
Govt. of India can issue 11% 25 th November 2015 at a premium . This serves two
purposes .
1. With this mechanism the number of coupon as on a particular date increases
as newer securities are issued with the same

identical coupon. If the

numbers of coupons are increased, all these coupons can

be clubbed

together and sold as a separate instrument because the total value of such

15

instrument is increased. The principal can be traded separately. This improves

the liquidity of the security. Such trading is called Separate Trading for
Registered Interest and Principal Securities ( STRIPS).
2. It can be found out that the price sensitivity of a fixed income security is
lower in case of high coupon bond than a low coupon bond. So in such case,
even though the interest rate is low, by issuing high coupon security at a
premium, the issuer can provide a low price sensitivity to the investor.
Considering the mark to market valuation, this is an important factor when
the interest rate rises.
Issue of Securities through pre announced coupon rate : Government of India
can issue securities by announcing the coupon rate at the time of issuance it self.
This makes the investors task easy as the investor need not to quote the rate. The
securities are issued at par.
Issue of securities through tap sale : This is a method by which the securities
are sold through a selling window by RBI. The sale can be extended beyond one day
and the sale can be closed at any time during the day. This method can be used by
RBI to reduce the cost of borrowing for the government. Let us assume that on 1 st
November 2008 , RBI announces a borrowing programme of Rs 2500 crores under
yield based auctions for 20 years. The RBI fixes the cut off yield at 4.95% p.a. The
yield quoted by all the bidders are more than the cut off yield. In such case the RBI
would take the entire issue in its books. RBI is also visualizing that there would be
some liquidity in the system because RBI is planning to carry out some sterilization
mechanism under which it would buy dollars against rupees. This inflow of rupees
would increase the money flow in the system and the interest rate would go down.
Besides this RBI also visualizing that there would be deposit growth in the next one
month which will also increase the money supply. Along with the deposit growth , the
banks would be required to invest incremental amount in GoI Securities because of
SLR requirement. At that time RBI can sale the securities on tap at the cut of yield at
which the issue was devolved on RBI.
Issue of securities by conversion of T Bills/dated securities : Though this is
one of the methods for issuing of GoI securities but this method is not an efficient
method. This is because treasury bills are supposed to the self liquidating in nature .
If the treasury bills are converted in to the GoI securities , it shows inefficiency in the
system . So this form is not encouraged .

16

Issue of securities by any other modes as decided by Government from time

to time : The Government can issue securities by any other modes as decided from
time to time. This clause is kept so that the Government can use any newer methods
developed in the future .
Price of a Fixed Income Securities :
In the above mentioned examples showing the price of the fixed income securities
we have assumed the following :

The coupon payment date and the issue date is same.

In the case of secondary market transaction, the above formulas would able
to give the price only at the coupon payment date. But the coupon payment
date would come only in once in the six month. So the above mentioned
formula would give the price of a fixed income securities accurately once in
six months.

Then how this problem is addressed. To understand the problem , we have to

understand the complete procedure of coupon payment. The coupon is paid to the
holder of the securities at the coupon payment date by the issuer of the security. Let
us take an example, Suppose A purchase a security from the issuer X on 3 rd of
January 2009. The security is for five years and the coupon rate is 5% p.a. and the
coupon is paid on half yearly basis. The next coupon is to be paid on 3 rd June 2009.
Now suppose A sells the security to B on 4th of March 2009 and B holds the security
to the next coupon payment date. It means that the issuer would pay Rs 250/( assuming the face value of the security is

Rs 10000/-) to B on 3 rd June 2009.

There are two implications of this transaction:

A would not get the coupon from the issuer for the period it hold i.e. between
3rd January to 3rd March 2009. So it should get the payment for this period
from B.

B would get interest for the period from 4 th March 2009 till it holds and this
would be accounted for the price formula by applying the proper time scale in
the bond pricing formula.

Next step would be the calculation procedure for the time period passed after the
last coupon date. For this period the seller would get accrued interest.

17

Next step would be the calculation procedure for the time period left from the
purchase date to the next coupon payment date. This would be put in the bond price
formula to get the proper price for the trade.
There are many types of convention for calculating the days as mentioned above .
These are :

30/360 :Each month will have 30 days inclusive of February and total days in
a year is 360

Actual /360 : Each month will have actual days and the total days in a year is
360.

Actual/Actual : Each month will have actual days and the total actual days
between two coupon period

Actual/365 : Each month will have actual days and the total days in a year
are 365 days.

Let us assume that we apply the Actual /360 formula . So the seller holds the
security from 3rd January to 3rd March i.e. (29+28+3)=60 days and total days
between two coupon period is 180 days as two coupon would be paid in a year.
So the seller would get the accrued interest for 60 days or he should get an amount
(60/180)* Rs 250/- at the time of selling the security in addition to the price of
selling. This is called the Dirty Price.
The sale price of the security would be found out by the following equation :
P0

C1/(1+r)(dnc/dicp)]

[C1/(1+r){1+(dnc/dicp)}]+..+

[Cn(1+r){(n-1)+(dnc/dicp)}]

Eqn ..3.3
Here dnc= days between the trading date and the next coupon payment date =
days between two coupon payment date- no of days already passed =180-60=120
days
dicp= days between two coupon payment date =180 days
So dnc/dicp= 120/180=2/3
If the YTM for 4years 10 months is 5.10% , then the price would be Rs 10040.2722.
The buyer would pay to the seller on March 4th 2009, Rs 10400.2722 plus accrued
interest of (60/180)* Rs 250/- .

18

After finding out the ways for arriving at the price, while investing the money in the
fixed income securities , one needs to look into the time horizon at which he/she is
investing. If one is investing for the entire life of the securities , then he should look
for a particular type of criteria . Similarly , if one is investing in a time horizon where
he/she would sale before the maturity period , he will look after certain other criteria.
For finding out such criteria for second category of investors , one need to
understand the price and yield relationship of a fixed income securities. These are
given below :
Before we proceed with the rules let us take the example of the following 4 fixed
income bonds :

Bond
A
B
C
D

Coupon
12%
12%
3%
3%

Maturity
5 Years
30 Years
30 Years
30 Years

Initial YTM
10%
10%
10%
6%

Face Value of the bond is Rs 1000/- .

Coupon is paid annually.
If the YTM increases to 12% , then the bond A and B would be traded at par. So
when coupon is equal to the YTM of the bond the price of the bond will be the face
value.
Similarly, if the YTM is more than the coupon, the price of the bond would be lower
than the face value. In the above example, in Bond C the coupon is 3% and YTM is
10%. The price is Rs 340.12 less than the face value of the bond which is Rs 1000/- .
In such case, the bond is supposed to be traded at discount. Similarly, when the YTM
of the bond is less than the coupon, the bonds price is more than the face value and
the bond is supposed to be traded at premium.
Now let us assume that YTM of all the bond becomes 11% p.a. . Then the price
would be :

Price

at

YTM

Bond A
1036.96

Bond B
1086.94

19

Bond C
304.50

Bond D
503.64

11%
Similarly if the YTM becomes 10% then prices of these bonds would be as follows :
Price

at

YTM

Bond A
1075.82

Bond B
1188.54

Bond C
340.12

Bond D
587.06

10%
Now if the YTM becomes 9% then prices of these bonds would be as follows :
Price

at

YTM

Bond A
1116.69

Bond B
1308.21

Bond C
383.58

Bond D
692.55

9%
The above table would give you the following rules of between bond price and yield :
1. There is an inverse relationship between price and yield of a fixed income
securities. If the YTM goes up price would fall and in case of downward
movement of YTM the price would go up.
2. An increase in a bonds yield would result in smaller price decline than the
increase in price with the equal amount of fall in yield .This is explained with
the following table :

Increase

in

Price

Bond A
40.87

Bond B
119.67

Bond C
43.46

due to decrease in
YTM from 10% to
9%
Decrease in Price

38.86

101.60

35.62

due to increase in
yield from 10% to
11%
3.Long term bonds tend to be more price sensitive than the short term bonds.
This will be seen from the following table :
in

Bond A
-3.61%

Bond B
-8.55%

Bond C
-10.47%

Bond D
-14.21%

decline price
% change in

3.80%

10.07%

12.78%

17.97%

change

increase

in

price
3. As maturity increases the price sensitivity increases at a decreasing rate.

20

4. Price sensitivity is inversely related to the coupon rate ( see Bond B and Bond
C) .
5. Price sensitivity is inversely related to the YTM at which the bond is selling.
Since the price would change during the holding period ( if the holding period is less
than the maturity period of the bond) depending on the holding period horizon one
tends to select bond by taking into account the above mentioned factors.
Duration of Bond : Another measure of the effective maturity of the bond is the
duration of the bond. This would be explained as below :
If we define as the maturity of a debt instrument is the time required to get all the
payment from the instrument then you see a unique feature of fixed income
securities :
In case of coupon bearing securities you get coupon before the maturity date of the
security and you get the principal on the maturity date of the security. So the
effective maturity is less than the maturity period of the fixed income instrument as
some payments are received before the maturity period. So the concept of weighted
average payment period is coming into picture . This weighted average payment
period is called the duration of a fixed income securities. This is explained with the
help of the following example :
There is a 8% coupon bearing bond with a remaining maturity of 2 years. The YTM of
the bond is 10% . The duration of the bond is calculated as below :
Time of

Amount of

Present Value

Payment (Yrs)

Payment

of Cash Flow at

A
0.5
1
1.5
2.0

( Rs )
B
40
40
40
1040

10%
C
38.095
36.281
34.553
855.611
Duration of the bond

Wt

Effective Period

D
0.0395
0.0376
0.0358
0.8871

E
0.0197
0.0376
0.0537
1.7742
1.8852

It is evident from the above that the duration of a fixed income coupon bearing
security is less than the maturity period of the securities while for a zero coupon bind
it is equal to the maturity period of the securities as no intermediate payments are
made.
Duration is very important due to the following equation :

21

P/P=-D[(1+y)/(1+y)]

. Eqn 3.4

If we define D*= D/(1+y) then the above equation becomes

P/P =- D*y

. Eqn 3.5

There are several rules for duration of a fixed income securities. These are :
Rule 1: The duration of a zero coupon bond is equal to its maturity.
Rule 2: Holding maturity constant, a bonds duration is higher when the coupon rate
is lower . The higher the weight in earlier payment due to higher coupon lower would
be the weighted average maturity of the payment.
Rule 3: Holding the coupon rate constant, a bonds duration generally increases with
its time to maturity.
Rule 4: Holding other factors constant, the duration of a coupon bearing bond is
higher when the bonds YTM is lower.
Rule 5 : The duration of a level perpetuity is as follows :
(1+y)/y .. Eqn 3.6
Rule 6 : The duration of a level annuity is equal to the :
[(1+y)/y]- [T/{(1+y)T-1}] Eqn 3.7
Rule 7 : The duration of corporate bond is equal to :
[(1+y)/y] ([ { (1+y)+T(C-y)}]/[C{(1+y)T-1}+y]) Eqn 3.8

Rule 8 : For coupon bonds selling at par value , the duration can be calculated as
follows :
{(1+y)/y}[1 {1/(1+y)T}] ..Eqn 3.9
For example , a 10% coupon bond with 20 years to maturity , paying coupon
semiannually , would have a 5% semiannual coupon and 40 payment period. If YTM
is 4% per half year period , we get
[1.04/0.04]-[{1.04+40(0.05-0.04)}/{0.05(1.04 10-1)+0.04}=19.74 half year =
9.87 years
Duration and Convexity :

22

If one observes the equation 5.4 , he/she can find out that duration is nothing but
the slope of the curve obtained by plotting the change in yield in X axis and
percentage change in price in the Y axis. This is shown in the following figure :
Percentage change in bond price

Pricing error
Price

Due to convexity

Duration

Change in YTM (%)

Fig : 3.1 Relationship between change in price of a bond and change in YTM
The duration measures assume the linear relation ship between the change in
price and change in yield where as actually the relationship is not linear. The
relationship is convex. Due to this if the change in yield is more there would
be error in the change in price value. If duration is used then it
underestimates the increase in bond price and over estimates the decrease in
bond price with decrease and increase in YTM respectively. So the effect of
convexity needs to be brought it to get the total effect when the change in
yield is significant.
We can quantify convexity as the rate of change of the slope of the price yield
curve , expressed as a fraction of the bond price . As a practical rule , one can
view bonds with higher convexity as exhibiting higher curvature in the price
yield relationship.

23

Convexity implies that the duration approximation for bond price changes can
be improved. Accordingly the equation 5.4 can be modified as follows :
P/P =- D*y +1/2*Convexity*(y)2

. Eqn 3.10

Please note that to use the convexity rule one must express interest rates as
decimals rather than percentages.
The first term of Eqn 3.10 is the same as the duration rule . The second term
is the modification for convexity. For a bond with positive convexity , the
second term is positive , regardless of whether the yield rises or falls.
Let us use a numerical example to examine the impact of convexity . Suppose
a bank has 30 years of maturity , an 8 % coupon and sells at an initial YTM of
8%.Because the coupon rate equals to YTM , the bond sales at par. The
modified duration of the bond at an initial yield is 11.26 years and its
convexity is 212.4. If the bonds yield increases from 8% to 10% , the bond
price will fall to Rs 811.46 , a decline of 18.85%.The duration rule , would
predict a price decline of
P/P =- D*y =-11.26*0.02=-0.2252 or 22.52%
which is considerably more than the bond price actually falls. The duration
with convexity rule is more accurate :
P/P =- D*y +1/2*Convexity*(y)2 =-0.1827 or 18.27%
The convexity of a bond is calculated with the help of the following formula :
Convexity=[1/{(P)*(1+y)2}]* [(CFt/(1+y)t)*(t2+t)] Eqn 3.11
Where CFt is the cash flow paid to the bondholder at date t. CF t represents
either a coupon payment before maturity or final coupon plus par value at
maturity date.

24