This action might not be possible to undo. Are you sure you want to continue?
Who are the key players in the debt and money markets in India?
The above diagram provides a consolidated picture of the various players in the bond/money markets and the securities. ZCB: Zero Coupon Bond I/L bonds : Inflation linked bonds FRN : Floating rate notes
What are Money Markets and money market instruments?
Money markets are markets for debt instruments with a maturity up to one year. Money markets allow banks to manage their liquidity as well as provide the central bank means to conduct its monetary policy. The most active part of the money market is the call money market (i.e. market for overnight and term money between banks and institutions) and the market for repo transactions. The former is in the form of loans and the latter are sale and buy back agreements ± both are obviously not traded. The main traded instruments are commercial papers (CPs), certificates of deposit (CDs) and treasury bills (T-Bills).
A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. In India corporates, primary dealers (PD), satellite dealers (SD) and financial institutions (FIs) can issue these notes. It is generally companies with very good rating which are active in the CP market, though RBI permits a minimum credit rating of Crisil-P2. The tenure of CPs can be anything between 15 days to one year, though the most popular duration is 90 days. Companies use CPs to save interest costs
Banks are allowed to issue CDs with a maturity of less than one year while financial institutions are allowed to issue CDs with a maturity of at least one year. .Certificates of Deposit These are issued by banks/financial institutions in denominations of Rs 5 lakhs and have maturity ranging from 30 days to 3 years.
These include short-term corporate debentures. In India treasury bills are issued in three different maturities 14 days. bills of exchange and promissory notes. . certain other short-term instruments are also in vogue with investors. 182 days and 364 days.Treasury Bills Treasury Bills are instruments issued by RBI at a discount to the face value and form an integral part of the money market. Apart from the above money market instruments.
. it may trade at higher yields. The central bank may be able to capture part of the yield differential and thus reduce the government's interest costs by purchasing and retiring older debt and replacing it with lower yielding on-the-run debt. than on-the-run securities.What are ³on the run´ and ³off the run´ securities? An on-the-run security normally is the most liquid issue for that maturity and therefore generally trades at lower yields than off-the-run debt. Because an off-the-run security generally does not have the same liquidity as an on-the-run issue. and thus lower prices.
100. in three days. For example. In reverse repo`s. Repo is nothing but collateralized borrowing and lending. Rs. The difference in price. is the interest RBI would have to pay for the money lent by SBI. RBI could engage in a three-day repo transaction with SBI. securities (like Government securities and treasury bills) are sold in a temporary sale with an agreement to buy back the securities at a future date at specified price. securities are purchased in a temporary purchase with an agreement to sell it back after a specified number of days at a pre-specified price. When one is doing a repo. . it would sell a security at. i. it is reverse repo for the other party.e.What is a Repo? Repo or Repurchase Agreements or Ready Forward transactions are short-term money market instruments. 100 to the SBI agreeing to buy it back at Rs. In a repo..07. say.
.What is Repo Rate? Repo rate is nothing but the annualized interest rate for the funds transferred by the lender to the borrower in a repo transaction.
A higher repo rate means the central bank is willing to borrow shortterm money at a higher rate. This would prompt market participants to prefer lending to the RBI unless the other market rates are higher. RBI normally hikes the repo rate to spike speculative arbitrage deals that are the primary cause for sharp rupee-dollar movements. RBI has used repo rates as part of its Liquidity Adjustment Facility (LAF) to benchmark short-term interest rates and also as a monetary tool in the past whenever the rupee had come under pressure. A higher repo rate also indirectly sets a higher floor for other money market rates such as the call rates. a higher call rate makes such arbitrage transactions costly. Typically the repo rate and reverse repo rate vary by around 2%. it sets the repo rate for all instruments issued by the central bank (it will be either the lender or borrower in a repo transaction).How does RBI use the repo rate? In case of the RBI. . As banks typically borrow in the call market and deploy the proceeds in the forex market.
It includes the currency & coins in circulation and demand & time deposits of banks. Different components of money supply are as under: M1 = Currency with the public + Net demand deposits of banks + other deposits with RBI M2 = M1 + Post Office Savings M3 = M2 + Net Time Deposits M3 is the level of money supply in an economy at any given point of time. post office deposits. .What is Money Supply? Money supply is the amount of money in circulation in the economy at any point of time.etc.
gilts are issued by RBI on the behalf of the Government. Like T-Bills. These instruments form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget).What are debt market instruments? Typically those instruments that have a maturity of more than a year and the main types are ± Government Securities (G-secs or Gilts) Like T-bills. Typically they have maturity ranging from 1 year to 20 years. gilts are issued through the auction route. but RBI can sell/buy securities in its Open Market Operations (OMO`s include conducting repos as well and are used by RBI to manipulate short-term liquidity and thereby the interest rates to desired levels) The other types of government securities are ± Inflation linked bonds Zero coupon bonds State government securities (state loans) .
unlike a debenture. SLR bonds are those bonds which are approved securities by RBI which fall under the SLR(Statutory liquidity ratio) limits of banks. Another distinction is SLR and non-SLR bonds. public financial institutions and corporate issue bonds. Sometimes interest is also paid in the form of issuing the instrument at a discount to face value and subsequently redeeming it at par. But in India these terms are used interchangeably. A bond is a promise in which the Issuer agrees to pay a certain rate of interest. usually as a percentage of the bond's face value to the Investor at specific periodicity over the life of the bond. Some bonds do not pay a fixed rate of interest but pay interest that is a mark-up on some benchmark rate. .Bonds/Debentures What is the difference between bonds and debentures? World over. Typically PSUs. a debenture is a debt security issued by a corporation that is not secured by specific assets. but rather by the general credit of the corporation. Stated assets secure a corporate bond.
market expects higher interest from the company and the price of the bond falls and vice-versa Another factor that determines the sensitivity of a bond is the ³Maturity Period´.What affects bond prices? Largely interest rates and credit quality of the issuer are the two main factors which affect bond prices Interest Rates : The price of a debenture is inversely proportional to changes in interest rates that in turn are dependent on various factors. When interest rates fall. . A longer maturity instrument will rise or fall more than a shorter maturity instrument. the existing bonds become more valuable and the prices move up until the yields become the same as the new bonds issued during the lower interest rate scenario Credit Quality : When the credit quality of the issuer deteriorates.
demand for money increases.What affects interest rates? The factors are largely macro economic in nature ±Demand/Supply of money: When economic growth is high. it increases the money available for credit in the system. which determines the availability of credit & the level of money supply in the economy. When banks have to keep low CRR or SLR. The purpose of CRR & SLR is to keep a bank liquid at any point of time. (CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash assets & SLR is the percentage of its total deposits a bank has to keep in approved securities. Government Borrowing and Fiscal Deficit : Since the government is the biggest borrower in the debt market. This eases the pressure on interest rates & interest rates move down. pushing the interest rates up and vice versa. Also when money is available & that too at lower interest rates. SLR and bank rates) depending on the state of the economy or to combat inflation. The RBI fixes the bank rate which forms the basis of the structure of interest rates & the Cash Reserve Ratio (CRR) & Statuary Liquidity Ratio (SLR). the level of borrowing also determines the interest rates. On the other hand. it is given on credit to the industrial sector that pushes the economic growth Bank Rate is the benchmark rate of RBI at which it refinances Banks and Primary Dealers. supply of money is done by the central bank by either printing more notes or through its Open Market Operations (OMO) RBI : RBI can change the key rates (CRR. It is used as a reference rate to signal the interest policy of the central bank .
therefore the interest rates must include a premium for expected inflation. interest rates rise one for one with rise in inflation.Inflation Rate Inflation Rate : Typically a higher inflation rate means higher interest rates. . other things being equal. Due to inflation. The interest rates prevailing in an economy at any point of time are nominal interest rates..e. In the long run. i. there is a decrease in purchasing power of every rupee earned on account of interest in the future. real interest rates plus a premium for expected inflation.
This is much higher than considered safe and the higher fiscal deficit could result in firming up of rates. capital and net loans and between total government receipts on account of revenue and of capital receipts that are not borrowings. The Fiscal Deficit is usually shown as a percentage of GDP. A low Fiscal Deficit is considered the best symptom of financial health. The important point to note is that accumulated interest burden from previous years is reflected in the Fiscal Deficit as well as this fiscal's revenue and capital surpluses/ deficits. India has a Fiscal Deficit in the range of 5-6 per cent. .What is fiscal deficit? The difference between total government spending on account of revenue.
It generally represents an impending downturn in the economy. neutral or flat. the long-term yield is lower than the short-term yield. When the curve is very steep. is flat across time. .What is Yield Curve? The relationship between time and yield on securities is called the Yield Curve.e. The relationship represents the time value of money showing that people would demand a positive rate of return on the money they are willing to part today for a payback into the future. This happens when people demand higher compensation for parting their money for a longer time into the future.e. The negative yield curve (also called an inverted yield curve) is one of which the slope is negative. A typical yield curve is when the slope of the curve is positive. it indicates that players expect an expansion in the economy and interest rates to move up quickly. A neutral yield curve is that which has a zero slope. i. the yield at the longer end is higher than that at the shorter end of the time axis. This occurs when people are willing to accept more or less the same returns across maturities. i. i. where people are anticipating lower interest rates in the future. It is not often that this happens and has important economic ramifications when it does. A yield curve can be positive.e.
the annualised return an investor would get by holding a fixed income instrument until maturity. It is the composite rate of return of all payouts and coupon.What is Yield to Maturity (YTM)? Simply put. .
What is Average Maturity Period? It is a weighted average of the maturities of all the instruments in a portfolio .
Macaulay duration and modified duration. Modified duration indicates the percentage change in the price of a bond for a given change in yield. a bond with a duration 1.50% There are two types of duration. For example. where a portfolio of bonds is constructed to fund a known liability. . The percentage change applies to the price of the bond including accrued interest.50 years means that a rise in its yield by 1% would result in a decline of its value by approximately 1. Macaulay duration is useful in immunization.What is duration and modified duration? Duration is a measure of a bonds' price risk. It is weighted average of all the cash flows associated with a bond in terms of their present value.
fund managers and investors prefer bonds with higher convexity. Convexity is an important factor when interest rates are volatile .What is convexity? Convexity is a measure of the way duration and price change when interest rates change. This is because such bonds rise higher than other bonds when interest rate falls. they fall lower than other bonds. A bond is said to have positive convexity if the instrument's value increases at least as much as duration predicts when rates drop and decreases less than duration predicts when rates rise. when interest rate rises. And what is more. Typically.
if one has to sell the security during the holding period. interest rate movements can increase/decrease the returns. The mark to market component of a portfolio on a given day includes securities with residual maturity of more than six months and does not include CPs and CDs. While fixed income instruments carry a fixed rate of return if held till maturity. Hence.What is marking to market? It means adjusting value of any security to reflect its current market value. open end income and liquid funds are required to value securities with a residual maturity of over six months based on their market value. .
in case of huge redemption pressures. This allows mutual funds to tackle illiquidity risk. The mark-up on the NCD is typically 25 to 50 basis points over MIBOR. Since they don¶t have any mark to market component. Many of these floaters offer ready liquidity by means of daily put/call option. Among the floating rate instruments. which change at present frequencies. . So companies use NCDs more like a cash management tool.What are floating rate instruments? Unlike fixed income instruments. the possibility of negative returns doesn¶t exist for these instruments. Whenever they generate surpluses. Coupon rates on shortterm Non-convertible debentures (NCDs) are pegged at a mark-up over MIBOR. MIBOR (Mumbai Inter-bank Offer Rate) linked ones have become very popular in the money market segment as they benefit both the issuer and investor. In a falling interest rate scenario. companies tend to convert the NCD into a fixed-term borrowing in order to lock into a lower interest rate. floating rate instruments have variable interest rates. Borrowing or lending through NCDs with the call/put option is akin to borrowing or lending in the inter-bank call money market. companies exercise the call option and pay off investors.
not used for speculative activities).e. These derivatives are used by the fund manager for hedging the portfolio risk on a nonleverage basis (i.. IRS are generally OIS (Overnight Indexed Swaps) products benchmarked on the MIBOR . but in the same currency. In India.What are Interest Rate Swaps Interest Rate Swap (IRS) is a transaction in which a flow of coupon of one variety is exchanged for another of a different variety.
Example : Fixed rate payment Fixed rate player Floating ± rate player Fixed rate payment .
Night MIBOR is 6 % p. on the first payment date. 50 crore Period of Agreement : 1 year Payment Frequency : Semi .Annual Now. Variable Interest Rate : NSE Over-Night MIBOR reset daily and compounded daily.Terms: Fixed Interest Rate : 7% p. Notional Principal Amount : Rs. suppose the six-month period from the effective date of the swap to the first payment date comprises 182 days and the daily compounded NSE Over .a.a. then the fixed and variable rate payment on the first payment date would be as follows: .
Fixed Rate Payment : Rs.93.Rs. the fixed .055 . In the above examples. 1.74.rate payer a net amount of Rs. The second and final payment will depend on the daily NSE MIBOR compounded daily for the remaining 183 days.00.49. .000) X (7%) X (182 Days / 365 Days) 2.00.904.055 = (Rs.52.rate payer will pay the variable . Variable Payment : Rs.58. a swap agreement will call for only the exchange of net amount between the counter parties. 1. 50. The fixed rate payment will also change to reflect the change in holding period from 182 days to 183 days.151 = Rs. 24. 1.000) X (6%) X (182 Days/ 365 Days) Often. 1. 50.00.904 = (Rs.00. 126.96.36.199.58.
Euro. GB Pound. Currently there are two calculating agents for the benchmark . calculates the average of the remaining eight and the value is published as LIBOR. This is a very popular benchmark and is issued for US Dollar.What are LIBOR & MIBOR? 1. MIBOR : Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the LIBOR.Reuters and the National Stock Exchange (NSE). The BBA weeds out the best four and the worst four. . The NSE MIBOR benchmark is the more popular of the two and is based on rates polled by NSE from a representative panel of 31 banks/institutions/primary dealers 2. Swiss Franc. LIBOR : Stands for London Inter Bank Offered rate. The British Bankers Association (BBA) asks 16 banks to contribute the LIBOR for each maturity and for each currency. Canadian Dollar and the Japanese Yen.
For short term instruments of less than a year maturity. 4. and AAA and within the same grade AA+. 3. Typically the highest credit rating is that of AAA and the lowest being D (for default). CRISIL ICRA CARE Fitch (Duff and Phelps is now part of Fitch) . India.What is a credit rating ? Credit Rating is an exercise conducted by a rating organisation to evaluate the credit worthiness of the issuer with respect to the instrument being issued or a general ability to pay back debt over the specified period of time. the rating symbol would be typically ³P´ (varies depending on the rating agency). 2. The rating is given as an alphanumeric code that represents a graded structure or creditworthiness. the rating agency might have different grades like A. AA. AA. Within the same alphabet class.where the ³+´ denotes better than AA and ³-³ indicate the opposite. currently we have four rating agencies ± 1.
etc.What is the ³SO´ in a rating ? [AAA(SO)] Pass Through Certificate/PTC Structured Obligation (SO) or Structured Finance is a term that is applied to a wide variety of debt instruments wherein the repayment of principal and interest is backed by: Cash flows from a pool of financial assets and/or Credit enhancement from a third party The process of converting financial assets (loans.) into tradable securities is generally referred as µsecuritization¶ and the securities thus created are referred as µasset backed securities¶ (ABS). The Pass Through Certificates (PTCs) in our portfolios also fall under this category . receivables.
VALUATION OF THINLY/NON-TRADED SECURITIES .
As a result the demand will translate into appreciation of the currency and vice versa. Interest rates : The funds will flow to that economy where the interest rates are higher resulting in more demand for that currency. So. investors flock towards perceived safe heaven currencies like US dollar resulting in a demand for that currency. In the event of global turmoil. its currency falls down. whenever. it would have a positive trade balance with USA. Often called interest rate differential Speculation : Another important factor is the speculative and arbitrage activities of big players in the forex market which determines the direction of a currency.Forex Markets How is a currency valued? The floating exchange rate system is a confluence of various demand and supply factors prevalent in an economy like ± Current account balance : The trade balance is the difference between the value of exports and imports. Inflation rate : Theoretically. leading to a higher demand for the home currency. the rate of change in exchange rate is equal to the difference in inflation rates prevailing in the 2 countries. . inflation in one country increases relative to other country. If India is exporting more than it importing.
On the other hand. On the one hand. it decreases the value of a currency relative to other currencies.What are the implications of such fluctuations? Depreciation of a currency affects an economy in two ways. which are in a way counter to each other. it makes the exports of a country more competitive. thereby leading to an increase in exports. . and hence imports like oil become dearer resulting in an increase of deficit.
" 2. It is Rupee's value on a trade-weighted basis. Taking this into account. prices are adjusted for the nominal effective exchange rate and this rate is called the "real effective exchange rate. 3. When RBI says that the rupee is overvalued. Yen and Pound Sterling. they mean that it has been appreciating against other major currencies due to their weakening against dollar which might impact the competitiveness of India's exports. It takes into account the Rupee's value not only in terms of dollar but also Euro. REER is the change in the external value of the currency in relation to its main trading partners. . But the relative competitiveness of Indian goods increases even when the nominal effective exchange rate remains unchanged when the rate of price increases of the trading partner surpasses that of India's.What does one mean by a currency being over-valued? What is Real Effective Exchange Rate (REER)? 1. The exchange rates versus other major currencies are average weighted by the value of India's trade with the respective countries and are then converted into a single index using a base period which is called the nominal effective exchange rate.
5 crores in the previous calendar month is considered a thinly traded security. . 2. What are thinly traded debt securities ? A debt security that has a trading volume of less than Rs. it is treated a µnon traded¶ security.What are non traded securities ? When a security is not traded on any stock exchange for a period of 30 days prior to the valuation.1.
This methodology is applicable only to investment grade securities. the final yield is used to price the security by using the NPV method. The various steps involved in the process are ± . And these securities are classified into investment grade and non-investment grade securities based on their credit ratings. the valuation methodology starts with the construction of a benchmark yield using G-secs and then building a matrix which gives benchmark yields for a certain credit quality and a duration. To put it briefly. The noninvestment grade securities are valued at a discount of 25% to the face value. The non-investment grade securities are further be classified as performing and non-performing assets and the latter are valued on separate norms. (Instruments with less than 182 days of maturity are valued on the basis of amortization as is the case with money market instruments).The Valuation Procedure The methodology is applicable to debt securities that have a maturity period of over 182 days. After adjusting the yield of a particular security for various risks.
are free of credit risk and are traded across different maturity spectrums every week. 0. 3-4 years.5-1 years. (Please note that duration is different from maturity period. there will be a benchmark YTM for each duration bucket. 5-6 years and 6 years and the volume weighted yield is computed for each bucket.) .. As mentioned above. 2-3 years. 1-2 years. The G-secs are grouped into the following duration buckets viz. duration is a measure of a bonds' price risk. 4-5 years.Construction of risk-free benchmark : A risk-free benchmark yield is built using the government securities (G-secs) as the base. G-secs are used as the benchmarks as they are traded regularly. Accordingly. It is weighted average of all the cash flows associated with a bond in terms of their present value.
Given below is a sample matrix as of November 11. This matrix is sent to us every week by CRISIL. All traded paper (with minimum traded value of Rs.Building a matrix of spreads for marking-up the benchmark yield A matrix of spreads (based on the credit rating) is built for marking up the benchmark yields. average volume weighted yields are obtained both from trades on the respective stock exchange and from the primary market issuances. Where there are neither secondary trades in a particular rating category nor primary market issuances during the fortnight under consideration. For each rating category.2002 . The matrix is built based on traded corporate paper on the stock exchanges or primary market securities. 1 crore) is classified by their ratings and grouped into 7 duration buckets. then trades during the 30 day period prior to the benchmark date are considered for computing the average YTM for such rating category.
00% 0.14% 6.74% 2.00% 0.00% 0.74% 2.52% 0.00% 0.28% 1.0-5.87% 0.00% > 6.00% 0.00% 0.17% 0.51% 1.15% 6.24% 1.00% 0.99% 1.00% 0.00% 0.00% 0.00% 0.00% 0.19% 7.00% 0.10% 6.00% 0.14% 4.00% 0.72% 1.00% .49% 3.0 yrs 6.00% 2.71% 0.00% 0.00% 0.70% 0.85% 2.00% 0.00% 0.59% 0.92% 1.95% 7.60% 4.44% 2.12% 5.09% 6.03% 4.00% 0.00% 0.01% 1.69% 0.00% 0.19% 7.00% 0.01% 1.00% 0.61% 0.60% 3.00% 0.38% 11.66% 0.00% 0.18% 5.18% 0.00% 3.00% 0.00% 0.02% 7.00% 0.43% 0.00% 0.00% 0.73% 2.0-2.0-4.00% 0.66% 8.00% 0.32% 6.15% 4.18% 8.10% 5.00% 0.98% 1.00% 0.08% 2.00% 1.68% 0.46% 6.0 yrs 6.0 yrs 6.52% 0.67% 0.00% 0.45% 10.87% 0.18% 7.16% 7.5-1.0 yrs 5.Average Gilt AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BC D 6.00% 0.19% 5.00% 0.96% 0.02% 0.00% 0.0 yrs 5.41% 1.00% 0.60% 3.0 yrs 6.47% 3.50% 3.00% 0.00% 0.17% 7.38% 13.00% 0.00% 0.28% 1.97% 2.88% 6.30% 12.33% 1.00% 0.00% 0.90% 0.0 yrs 7.00% 0.00% 0.00% 0.90% 3.91% 2.71% 0.00% 0.00% 0.10% 6.39% 1.00% 0.28% 4.00% 0.00% 0.29% 7.00% 4.86% 9.60% 3.00% 0.01% 4.50% 2.00% 0.96% 1.37% 5.00% 0.0-3.0-6.63% 0.92% 1.17% 5.10% 4.00% 5.26% 4.
25% for securities having duration of higher than two years to account for the illiquidity risk .5% for securities having a duration of upto two years and 0.5% and for securities of more than 2 year duration marking is allowed upto +/.Mark-up/Mark-down yield All debt securities are prone to certain risk and hence the marking up or down of yield is essential to get a true picture about that particular security.25% to be provide for the above mentioned types of risks Non-rated securities : Since non-rated securities tend to be more illiquid than rated securities. the yields are marked up by adding 0. The marking differs for rated and non-rated securities and is as follows : Rated securities: Securities of less than 2 year duration could be marked up or down upto 0. promoter background. The yields calculated above are marked up/marked down to account for the liquidity risk. finance company risk and the issuer class risk.0.
. The price of a debt security is the discounted value of all its future cash flows (using a suitable discount rate. which in this case is the YTM calculated).Pricing the portfolio The yields that have been calculated for the various categories in the matrix are used to price the portfolio by using the Net Present Value (NPV) method.
(click on the cells to view the formulas -Lets take the example of a AAA rated thinly traded debenture of HDFC which has a duration of 3.89%. By looking at the matrix above.45%. 2002. By looking at the matrix above.25 years and a coupon rate of 11.45%.Illustration Lets take the example of a AAA rated thinly traded debenture of HDFC which has a duration of 3. The enclosed excel sheet provides the calculation of NPV.89%. (click on the cells to view the formulas - . Say. we arrive at a yield of 6. The enclosed excel sheet provides the calculation of NPV. we arrive at a yield of 6. we purchased the debenture on July 21. Say.25 years and a coupon rate of 11. 2002. we purchased the debenture on July 21.
45 11.45 11.Par value = Rs.22 9. 2001 HDFC Cash Flows 21-Jul-01 2-Apr-02 2-Apr-03 2-Apr-04 2-Apr-05 3-Jan-06 11.56 8.93 10.45 11.74 120.95 80.40 .100 Discount rate = 9.66 NPV 10.65% (ie. yield from the matrix) Purchase date = July 21.45 108.
Income Funds Short-term Plan Gilt Funds Short Term Plan FRIF Liquid Funds Risk .Gilt Funds Long Term Plan .
Maturity Typical tenor of Investments Typical Yields 3-6 mos.18 mos. M + 40 bps 12 .A Comparison with Liquid Funds Liquid Fund Floating Rate Fund Avg. M + 75 bps 90 days 182-365 days .