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Indian Debt Market

UTI AMC Limited


Praloy Majumder
Mumbai
May 8th ,9th & 10th ,2008
Government of India Securities …
• One applicant may submit more than one bid at different rates
of yield or prices but for each different rates of yields and prices
one has to submit separate application forms.
• The yield or price is fixed depending on the type of auction
– In case of Uniform price auction competitive bids offered
with rates up to and below or the prices up to and above
are offered at the maximum rate or minimum price. Bids
quoted higher than the maximum yield or lower than the
minimum rate are not accepted.
– In case of multiple price auction competitive bids offered
with rates up to and below the maximum yield / prices up
to and above the minimum prices are allotted as per the
yield or price of the bids received.
Classification of Investment …
• The entire investment portfolio of the FIs will be classified
under three categories:
– ‘Held to Maturity’
– ‘Available for Sale’
– ‘Held for Trading’
• The securities acquired by the FIs with the intention to hold
them till maturity will be classified under Held to Maturity.
• The securities acquired by the FIs with the intention to trade by
taking advantage of the short-term price/ interest rate
movements etc. will be classified under Held for Trading
• The securities, which do not fall within the above two
categories, will be classified under Available for Sale.
Borrowing Process
New Role of PD
• As you are aware, in terms of the Fiscal
Responsibility and Budget Management (FRBM) Act,
2003, the Reserve Bank of India’s participation in the
primary issues of Government securities stands
withdrawn .
• PDs will be required to meet underwriting
commitment instead of the earlier requirements of
bidding commitment and voluntary underwriting.
The underwriting commitment will be divided into
two parts - i) Minimum Underwriting Commitment
(MUC) and ii) Additional Competitive Underwriting
(ACU).
MUC
• The MUC of each PD will be computed to ensure that
at least 50 percent of each issue is mandatorily
covered by the aggregate of all MUCs.
• The MUC will be uniform for all PDs, irrespective of
their capital or balance sheet size.
• Since the MUC would not be through a bidding
process, the same would be incorporated in the
Undertaking given by the PDs to RBI, every year to
enable compulsory minimum underwriting for each
auction.
AUC
• The remaining portion of the notified amount will be
open to competitive underwriting through
underwriting auctions.
• Each PD would be required to bid for a minimum
amount equal to the MUC.The auctions could be
either uniform price-based or multiple price-based
depending upon the market conditions and other
relevant factors, which will be announced before the
underwriting auction for each issue.
• All successful bidders in the ACU auction will get
commission as per auction rules.
Commission
• Those PDs who succeed in the ACU for 4 per cent
and above of the notified amount of the issue, will
get commission on their MUC (3 percent) at the
weighted average of all the accepted bids in the ACU.
Others will get commission on the 3 percent in MUC
at the weighted average rate of the three lowest bids
in the ACU.
Repo and Reverse Repo
• Reverse Repo means sales of security by RBI . So it is
borrowing by RBI.
• Repo means purchase of security by RBI. So it is
lending by RBI.
• So which rate would be more ?
Session Four
Bond Characteristics
• Face or par value
• Coupon rate
– Zero coupon bond
• Compounding and payments
– Accrued Interest
• Indenture
Provisions of Bonds
• Secured or unsecured
• Call provision
• Convertible provision
• Put provision (putable bonds)
• Floating rate bonds
• Sinking funds
Bond Pricing
T

PB = ∑ C t t + ParValue T

(1+ r )
T
t =1 (1+ r )

PB = Price of the bond


Ct = interest or coupon payments
T = number of periods to maturity
y = semi-annual discount rate or the semi-annual yield to
maturity
Solving for Price: 10-yr, 8% Coupon
Bond,
Face = $1,000
20
1 1000
P = 40∑ +
t =1 ( 1.03)
t 20
(1.03)
P = $1,148.77

Ct = 40 (SA)
FV = 1000
T = 20 periods
r = 3% (SA)
Prices and Coupon Rates
Price

Yield
Yield to Maturity
• Interest rate that makes the present value of the
bond’s payments equal to its price.
Solve the bond formula for r

PB = ∑ C t
+
ParValue T

(1+r )
T
t =1 (1+r )
t
Yield to Maturity Example

35 20
1000
950 = ∑ +
(1+r )
T
(1+r )
t
t=1

10 yr Maturity Coupon Rate = 7%


Price = $950
Solve for r = semiannual rate r = 3.8635%
Yield Measures
Bond Equivalent Yield
7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %
Realized Yield versus YTM
• Reinvestment Assumptions
• Holding Period Return
– Changes in rates affects returns
– Reinvestment of coupon payments
– Change in price of the bond
Holding-Period Return:
Single Period
HPR = [ I + ( P0 - P1 )] /P
0

where
I = interest payment
P1 = price in one period
P0 = purchase price
Holding-Period Example
CR = 8% YTM = 8% N=10 years
Semiannual CompoundingP0 = $1000
In six months the rate falls to 7%
P1 = $1068.55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)
Holding-Period Return:
Multiperiod
• Requires actual calculation of reinvestment income
• Solve for the Internal Rate of Return using the
following:
– Future Value: sales price + future value of
coupons
– Investment: purchase price
Default Risk and Ratings
• Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– Duff and Phelps
– Fitch
• Rating Categories
– Investment grade
– Speculative grade
Factors Used by Rating
Companies
• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt
Protection Against Default
• Sinking funds
• Subordination of future debt
• Dividend restrictions
• Collateral
Default Risk and Yield
• Risk structure of interest rates
• Default premiums
– Yields compared to ratings
– Yield spreads over business cycles
Managing Fixed Income
Securities: Basic Strategies
• Active strategy
– Trade on interest rate predictions
– Trade on market inefficiencies
• Passive strategy
– Control risk
– Balance risk and return
Bond Pricing Relationships

Bond Coupon Maturity Initial


YTM
A 12% 5 Years 10%

B 12% 30 Years 10%

C 3% 30 Years 10%

D 3% 30 Years 6%
Bond Pricing Relationships

Bond Bond Bond Bond


A B C D

Price at 10% YTM 1075.82 1188.54 340.12 587.06

Price at 11% YTM (ABC) 1036.96 1086.94 304.50 503.64


and 7% (D)

Price at 9% YTM(ABC) 1116.69 1308.21 383.58 692.55


and 5% (D)
Bond Pricing Relationships
Percentage change in bond

A
prices

C
Changes in Yield to Maturity D
Bond Pricing Relationships
• Inverse relationship between price and yield.
• An increase in a bond’s yield to maturity results in a
smaller price decline than the gain associated with a
decrease in yield.
• Long-term bonds tend to be more price sensitive than
short-term bonds.
Bond Pricing Relationships

Bond Bond Bond Bond


A B C D

Decrease in Price due to -38.86 -101.60 -35.62 -83.42


increase in Yield

Increase in Price due to 40.87 119.67 43.46 105.50


decrease in yield

% Change -3.61% -8.55% -10.47% -14.21%

% Change 3.80% 10.07% 12.78% 17.97%


Bond Pricing Relationships
(cont’d)
• As maturity increases, price sensitivity increases at a
decreasing rate.
• Price sensitivity is inversely related to a bond’s
coupon rate.
• Price sensitivity is inversely related to the yield to
maturity at which the bond is selling.
Duration
• A measure of the effective maturity of a bond.
• The weighted average of the times until each payment is received,
with the weights proportional to the present value of the
payment.
• Duration is shorter than maturity for all bonds except zero
coupon bonds.
• Duration is equal to maturity for zero coupon bonds.
Duration: Calculation
t
wt = CF t (1 + y ) Price
T
D = ∑t ×wt
t =1

CFt =Cash Flow for period t


Duration Calculation:
Example using Table 16.3
8% Time Payment PV of CF Weight C1 X
Bond years (10%) C4

.5 40 38.095 .0395 .0197

1 40 36.281 .0376 .0376

1.5 40 34.553 .0358 .0537

2.0 1040 855.611 .8871 1.7742

sum 964.540 1.000 1.8852


Duration/Price Relationship
Price change is proportional to duration and not to
maturity.
∆P/P = -D x [∆(1+y) / (1+y)
D* = modified duration
D* = D / (1+y)
∆P/P = - D* x ∆y
Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its
time to maturity.
Rule 2 Holding maturity constant, a bond’s duration is
higher when the coupon rate is lower.
Rule 3 Holding the coupon rate constant, a bond’s
duration generally increases with its time to
maturity.
Rule 4 Holding other factors constant, the duration of a
coupon bond is higher when the bond’s yield to
maturity is lower.
Rules for Duration (cont’d)
Rules 5 The duration of a level perpetuity is equal to:

(1 +y)
Rule 6 The duration of a level annuity is equal to:
y

1+ y T

y (1 + y ) T − 1
Rules for Duration (cont’d)
Rule 7 The duration for a corporate bond is equal to:

1 + y (1 + y ) + T (c − y )

y c[(1 + y ) T − 1] + y
Duration and Convexity
Price

Pricing Error
from convexity

Duration

Yield
Convexity
• Convexity :
– 1/ P*(1+y)2*∑[CFt/(1+y)t (t2+t)]
Yield Curve
Yield Curve and Term Structure
of Interest Rate
• Yield Curve : If we plot the yield ( observed on a
particular day ) of different securities of different
maturity in Y axis against the corresponding
maturity of the securities in the X axis, we get an
Yield curve. The Yield curve can take the shape of the
following :
– Upward slopping yield curve
– Downward slopping yield curve
– Flat Yield Curve
Yield Curve and Term Structure
of Interest Rate
• The shape of the yield curve is explained with the
help of the term structure of interest rate. The term
structure has three theories :
– Unbiased Expectation Theory
– Liquidity Preference Theory
– Market Segmentation Theory
Yield Curve and Term Structure
of Interest Rate
• Unbiased expectation theory : It holds that the forward rate represents the
average opinion of the expected future spot rate for the period in question.
• The investor could follow a maturity strategy investing the money now for the
two years at two years spot rate of say 8% p.a and at the end , he will get 1.1664.
• Or he can invest in 1 year for 7% to get 1.07 after one year and then to reinvest
after one year.
• Although the investor does not know what the one year spot rate will be one
year from now, the investor has an expectation about what it would be. This is
denoted by es1,2.
• .If the investor thinks that it will be 10% , then his.her investment has an
expected value 1.177(=1*1.07*1.10)
• In this case , the investor would chose a roll over strategy.
• Under this unbiased expectation theory, the equilibrium condition is satisfied by
the following equation :
– (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2
Yield Curve and Term Structure
of Interest Rate
– (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2
– The meaning of the above equilibrium equation is
that the expected return from a maturity strategy
must equal the expected return on a rollover
strategy.
– An upward slopping yield curve would be
explained by the fact that es1,2 is to expected to rise
in the future;
– An downward slopping yield curve would be
explained by the fact that es1,2 is to expected to
decline in the future;
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : It starts with the
notion that investors are primarily interested in
purchasing short term securities. This is due to price
risk .
• Considering this , the investor must require a
premium for investment in the longer term security.
This is called the liquidity premium.
• This is defined as the difference between the forward
rate and expected spot rate . So
f12 = es12 + L12
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : The equation of the Liquidity
Preference theory :
– (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2
– The above inequality holds as the maturity strategy is more
risky so the return should be more.
Downward slopping Yield Curve : Here s1> s2 . The above
inequality will hold if es1,2 is substantially lower than the s1
implying that the market interest rate is expected to decline
sharply.
Flat Yield Curve : Here s1= s2 The above equation will be true if
es1,2 is less than s1 .
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : The equation of the Liquidity
Preference theory :
– (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2
– The above inequality holds as the maturity strategy is more
risky so the return should be more.
Downward slopping Yield Curve : Here s1> s2 . The above
inequality will hold if es1,2 is substantially lower than the s1
implying that the market interest rate is expected to decline
sharply.
As an example, assume that the one year spot rate (s1) is 7%
and the two year spot rate (s2) is 6%.
This is a situation where the term structure is downward
slopping.
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : Now according to the
liquidity preference theory,
(1+0.07)(1+es12) <(1.06)2

Which can be true only if the expected future spot


rate is substantially less than 7% .
• Flat Yield Curve : Here s1= s2 The above equation will
be true if es1,2 is less than s1 .
• The flat yield curve would imply that the market
place expects the interest rate to decline.
Yield Curve and Term Structure

of Interest Rate
Liquidity Preference Theory : The equation of the Liquidity
Preference theory :
– (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2
Upward slopping Yield Curve : Here s1< s2 . If it is slightly
upward slopping , this can be consistent with an expectation
that interest rate are going to decline in future. For example,
if s1 is 7% and s2 is 7.1% , then the forward rate would be
given by :
(1+f12 )= [(1+s2)2]/[(1+s1)]
and the forward rate would be 7.2%. Considering a liquidity
premium of more than 0.2%, the es12 would be less than
7%.So an upward slopping yield curve means market
expects a small decline in spot rate . If the term structure is
more steeply sloped, then it is more likely that market place
expects the interest rate will rise in the future.
Yield Curve and Term Structure
of Interest Rate
• Market Segmentation Theory: According to this
theory the interest rate is determined mainly by the
demand and supply situation of the market
concerned. This explains the phenomena like sudden
spurt in call money rate even when the long term
market is steady and upward slopping .
Long term and Short Term
Interest Rates
Bond Portfolio Management

Immunization
Suppose bank wants to fund this obligation with Rs 10000 of 8%
annual coupon bonds , selling at par value with six years to
maturity.
• As long as interest rate remains 8% , the bank funds its
obligations.
• If interest rate changes, two offsetting influences will affect the
ability of the fund to grow to the targeted value of Rs 14,693.28.
• If interest rate rises, the fund will suffer a capital loss ,
impairing its ability to satisfy its obligations. However, at a
higher investment rate, reinvested coupon will grow at a faster
rate, offsetting the capital loss.
• Fixed income investors face two offsetting types of rate risk:
– Price risk
– Reinvestment risk
Immunization
• Increase in interest rate causes capital losses but at
the same time increase the rate at which the coupon
is reinvested.
• If the portfolio duration is chosen appropriately,
these two effects will cancel out exactly.
• For a horizon equal to portfolios duration, price risk
and reinvestment risk exactly cancels out.
Immunization
Payment No Years Remaining until Accumulated Value of Invested
obligation Amount
A .Interest remains at 8%
1 4 800(1.08)4=1088.39
2 3 800(1.08)3=1007.77
3 2 800(1.08)2= 933.12
4 1 800(1.08)1=864.00
5 0 800(1.08)0=800.00
5 0 10,800/(1.08) =10000.00

Total 14693.28
B .Interest falls to 7 %
1 4 800(1.07)4=1048.64
2 3 800(1.07)3= 980.03
3 2 800(1.07)2= 915.92
4 1 800(1.07)1=856.00
5 0 800(1.07)0=800.00
5 0 10,800/(1.07) =10093.46

Total 14694..05
Immunization

Payment No Years Remaining until Accumulated Value of Invested


obligation Amount
C .Interest increases to 9 %
1 4 800(1.09)4=1129.27
2 3 800(1.09)3=1036.02
3 2 800(1.09)2= 950.48
4 1 800(1.09)1=872.00
5 0 800(1.09)0=800.00
5 0 10,800/(1.09) =9908.26

Total 14696.02
Immunization
Accumulated value of
Invested Fund

t* D* Time
Immunization
• As the time passes on the duration of the asset profile changes .
• This brings the importance of rebalancing the portfolio.
• The manager must rebalance the portfolio continuously to keep
the duration of the portfolio equal to the maturity profile of the
liability.
• This is so because duration generally decreases less rapidly than
does maturity.
• So even if the portfolio is immunized at the beginning , the
maturity and duration fall in different rate,necessitating the
rebalancing of the portfolio.
Immunization
• There are many shortcomings in immunization technique :
• It assumes that the portfolio yield curve is flat.
• In the case of an upward sloping yield curve, the appropriate
rate need to be taken from the yield curve.
• Next is the parallel shift in yield curve. In case on non parallel
shift in yield curve immunization technique would not be able
to protect the portfolio from the interest rate risk.
• The immunization does not address the inflation issues at all.
Cash Flow Matching and
Dedication
• In case of cash flow matching, the obligations are first
found out for a particular period and then cash flows
are matched by forming a portfolio.
• Once matching is carried out, the portfolio need not
be immunized.
• When matching is done for the entire investment
horizon, it is called dedication technique.
• But getting bonds to follow the cash flow matching
and dedication technique is very difficult.
Active Bond Management
Technique
• There are two ways for active bond management technique.
– Interest rate forecasting : it tries to anticipate movements
across the entire spectrum of the fixed income markets.
– Identification of relative mis pricing within fixed income
markets
• Both the techniques would generate abnormal returns only if
the analyst’s information or insight is superior to that of the
market.
• Empirical evidences do not support that individual possesses
better knowledge than that of the market.
Bond Swap
• This belong to the active bond management
technique.
• Bond swap means replacement of one types of bonds
with that of another.
• There are fives types of bond swaps :
– The substitution swap
– The intermarket spread swap
– The rate anticipation swap
– The pure yield swap
– The tax swap
Different types of bonds
• The substitution swapSwap
is an exchange of one bond for a nearly
identical substitute. The substituted bonds should be of
essentially equal coupon,maturity, quality,call feature ,sinking
fund provisions etc. This swap would be motivated by a
discrepancy between the prices of the bonds represents a profit
opportunity.
• The Intermarket spread swap is pursued when an investor
believes that the yield spread between two sectors of the bond
markets is out of line. For example if the current spread
between the corporate and government bond market is
considered too wide and is expected to narrow, the investor will
shift from government bond to corporate bond.
Different types of bonds
Swap
• The rate anticipation swap is pegged to interest rate
forecasting.If the investor views that interest rate is
likely to decrease, it would replace shorter duration
bond with longer duration bond .
• The pure yield swap is aimed to earn the higher
yield. This strategy involves replacement of lower
yield bond with higher yield.
• The tax swap is to exploit some tax benefits by
adjusting capital loss from future gains – the facilities
available with some selected securities.
Horizon Analysis
• The analysts using this approach selects a particular
holding period and predicts the yield curve at the
end of the period.
• Then bond’s end of period price is calculated from
the yield curve.
• Then the analysts add the coupon income and the
perspective capital gain of the bond to arrive at the
total return on bond in the horizon period.

Horizon Analysis
Suppose a 20 year maturity ,10% coupon bond currently yields
9% and sells at Rs 1092.01.
• An analyst with a 5 year time horizon would be concerned
about the bond’s price and the value of reinvested coupon five
years hence.
• At that time the bond will have 15 years maturity , so the
analyst will predict the yield on 15 years maturity at the end of
5 year period to determine the bond’s expected price .
• If the yield is expected to be 8% , the bond’s end of period price
will be
– 50 * Annuity Factor ( 4% ,30)+1,000 PV Factor ( 4%,30)= Rs
1172.92
Horizon Analysis
• The capital gain on this bond will be Rs 80.91 .
• Meanwhile the coupon paid by the bond will be reinvested over
the five year period.
• The analyst must predict a reinvestment rate at which the
invested coupons can earn interest.
• Suppose the assumed rate is 4% per half year period.
• If all the coupons are reinvested at this rate,the value of the ten
semiannual coupon payments with accumulated interest rate at
the end of the five year will be Rs 600.31.
• The total return proved by the bond over the holding period is
Rs 681.82/Rs 1092.01 i.e. 62.4% .
• The analyst repeats this procedure for many securities and
select the ones promising superior holding period return.
Contingent Immunization
• It is mixed passive –active strategy .
• Suppose that the interest rate at present is 10% per annum and a
manager’s portfolio is worth Rs 10 million right now.
• At current rate the manager can lock in via conventional immunization
techniques, a future portfolio value of Rs 12.1 million after 2 years.
• Now suppose that the manager wants to pursue active management
but is willing to risk losses only to the extent that the terminal value of
the portfolio would not drop lower than Rs 11 million.
• Because only Rs 9.09 million ( Rs 11million/1.102) is required to
achieve this minimum acceptable terminal value , and the portfolio is
currently worth Rs 10 million , the manager can afford to risk some
losses at the outset and might start off with an active strategy rather
than immediately immunizing.
Contingent Immunization
• The key is to calculate the value of the fund required to lock in
via immunization a future value of Rs 11 million at current
rates.
• If T denotes the time left until the horizon date and r is the
market interest rate at any particular point of time , then the
value of the fund necessary to guarantee an ability to reach the
minimum amount of terminal value is Rs 11 million/(1+r)T,
because this size portfolio if immunized will fetch Rs 11 million.
• This value becomes the trigger point.
• When the actual portfolio value dips to the trigger point , active
management will cease.
• Contingent upon reaching the trigger , an immunization
strategy is initiated .
Contingent Immunization
Rs in Million
Portfolio
Value

Trigger Point

t* t
Horizon
Contingent Immunization
Rs in Million
Portfolio
Value

t* t
Horizon
Interest Rate Derivatives
Interest Rate Swap
Interest Rate SWAP
• Consider a three-year swap initiated on March 1,1999 ,in which
company B agrees to pay to company A an interest rate of 5%
per annum on a notional principle of $ 100 million .
• In return company A agrees to pay to Company B the six-
month LIBOR rate on the same notional principal.
• We assume the agreement specifies that payments are to be
exchanged every six months and the 5% interest rate is quoted
with semi annual compounding.
• This is represented diagrammatically in the next slide :
Interest Rate SWAP

5.0%

Company A Company B

LIBOR
Cash Flows to Company B
Date LIBOR rate ( %) Floating Cash Fixed Cash Flow Net Cash Flow
Flow Received Paid

1.3.1999 4.20

1.9.1999 4.80 +2.10 -2.50 -0.40

1.3.2000 5.30 +2.40 -2.50 -0.10

1.9.2000 5.50 +2.65 -2.50 +0.15

1.3.2001 5.60 +2.75 -2.50 +0.25

1.9.2001 5.90 +2.80 -2.50 +0.30

1.3.2002 6.40 +2.95 -2.50 +0.45


Cash Flows to Company B
Date LIBOR rate ( %) Floating Cash Fixed Cash Flow Net Cash Flow
Flow Received Paid

1.3.1999 4.20

1.9.1999 4.80 +2.10 -2.50 -0.40

1.3.2000 5.30 +2.40 -2.50 -0.10

1.9.2000 5.50 +2.65 -2.50 +0.15

1.3.2001 5.60 +2.75 -2.50 +0.25

1.9.2001 5.90 +2.80 -2.50 +0.30

1.3.2002 6.40 +102.95 -102.50 +0.45


Interest Rate SWAP
• If we see the previous slide we find out the following
interesting phenomena :
– Position of B is :
• Long on a Floating Rate Bond ;
• Short on Fixed Rate Bond;
– Position of A is :
• Long on a Fixed Rate Bond;
• Short on Floating Rate Bond;
Use of Interest Rate SWAP
• For Company B the swap could be used to transform a floating
rate loan into a fixed rate loan.
• Suppose Company B has arranged to borrow $
Forward Rate Agreement
FRA
• A forward rate agreement (FRA) is a forward contractin which
one party pays a fixed interest rate, and receives a floating
interest rate equal to a reference rate(the underlyingrate). The
payments are calculated over a notional amountover a certain
period, and netted, i.e. only the differential is paid. It is paid on
the effective date. The reference rate is fixed zero, one or two
days before the termination date, dependent on the market
convention for the particular currency. FRAs are over-the
counter derivatives. A swap is a combination of FRAs.
• The payer of the fixed interest rate is also known as the
borrower or the buyer, whilst the receiver of the fixed interest
rate is the lender or the seller.
FRA
• The netted payment made at the termination date is:
Payment = Notional Amount * ( Reference Rate – Fixed
rate ) *α)/( Reference Rate * α+1)
• The Fixed Rate is the rate at which the contract is agreed.
• The Reference Rate is typically MIBOR, GOI rate etc.
• α is the day count fraction, i.e. the portion of a year over
which the rates are calculated, using the day count
conventionused in the money markets in the underlying
currency.
• The Fixed Rate and Reference Rate are rates that should
accrue over a period starting on the termination date, and
then paid at the end of the period. However, as the payment
is already known at the beginning of the period, it is also
paid at the beginning. This is why the discount factor is
used in the denominator.
Interest Rate Futures
Interest Rate
Futures Contracts
• Interest Rate Futures Contracts are contracts based
on the list of underlying as may be specified by the
Exchange and approved by SEBI from time to time.
To begin with, interest rate futures contracts on the
following underlyings shall be available for trading
on the F&O Segment of the Exchange :
– Notional T Bills

– Notional 10 year bonds (coupon bearing and non-


coupon bearing)
Interest Rate Futures
Settlement Price
• Daily settlement price for an Interest Rate
Futures Contract shall be the closing price of
such Interest Rate Futures Contract on the
trading day.
• Theoretical daily settlement price for
unexpired futures contracts, shall be the
futures prices computed using the (price of
the notional bond) spot prices arrived at from
the applicable ZCYC Curve.
Interest Rate Futures
Settlement Price
• In respect of zero coupon notional bond, the
price of the bond shall be the present value of
the principal payment discounted using
discrete discounting for the specified period
at the respective zero coupon yield.
• In respect of the notional T-bill, the settlement
price shall be 100 minus the annualized yield
for the specified period computed using the
zero coupon yield curve.
Interest Rate Futures
Settlement Price
• In respect of coupon bearing notional bond,
the present value shall be obtained as the sum
of present value of the principal payment
discounted at the relevant zero coupon yield
and the present values of the coupons
obtained by discounting each notional
coupon payment at the relevant zero coupon
yield for that maturity.
Reading T Bill Futures Quotes
T Bill Interest rate futures- Rs 2 lacs ; pts of 100%

Open High Low Settle Chg Yield Open


Settle Change Interest

July 94.69 94.69 94.68 94.68 -.01 5.32 +.01 47,417

Eurodollar futures prices are stated as an index number of three-


month LIBOR calculated as F = 100 – T Bill Rate.
The closing price for the July contract is 94.68 thus the implied yield
is 5.32 percent = 100 – 98.68
Interest Rate Caps or collars
• An interest rate cap is a derivative in which the buyer receives
payments at the end of each period in which the interest rate
exceeds the agreed strike price. An example of a cap would be
an agreement to receive a payment for each month the LIBOR
rate exceeds 2.5%.
• In mathematical terms, a caplet payoff on a rate L struck at K is
where N is the notional value exchanged and α is the day count
fraction corresponding to the period to which L applies. For
example suppose you own a caplet on the six month USD
LIBOR rate with an expiry of 1 February 2007 struck at 2.5%
with a notional of 1 million dollars. Then if the USD LIBOR rate
sets at 3% on 1st February you receive 1m*0.5*max(0.03-0.025,0)
= $2500.
Interest Rate Floors
• An interest rate floor is a series of European put
options or floorlets on a specified reference rate,
usually LIBOR. The buyer of the floor receives money
if on the maturity of any of the floorlets, the reference
rate fixed is below the agreed strike price of the floor.
New Instruments for
Managing Interest Rate Risk
• Interest rate derivatives are the instruments which are used to manage
Interest Rate Risk.
• One such instrument is the Inverse Floater.
• This is bond which pays lower coupon when interest rate rises.
– For example an Inverse Floater would pay coupon rate income
equal to 10%minus the rate on one year T Bill Rate .If the T Bill rate
is 4% then the bond would pay coupon of 6% .
• If the T Bill rate increases to 7% then the bond would pay 3% of par
value : in addition , as other interest rates rise along with T Bill rate ,
the bond price falls as well for the usual reason that future cash flows
are discounted at higher rates.
• Therefore there is a dual impact and this securities fair poorly specially
when interest rate rises.
New Instruments for
Managing Interest Rate Risk
• Conversely it works very well when interest rate falls.
Interest Rate Risk
Management
• With the help of interest rate swap one can manage the interest
rate movement.
• Collateralized Mortgage Obligation (CMO) is another tool with
which interest rate risk can be managed.
• In the case of CMO, Interest Only (IO) strips and Principle Only
(PO) strips would trade separately.
• PO securities exhibit very long effective duration – that is their
value is very sensitive to interest rate fluctuations. It performs
very well if the interest rate fall.
• IO securities fall when interest rate fall. It has negative effective
duration. This is good for an investor who is betting an increase
in interest rate.
Strategy on High Interest
Situation
Interest Rate and Bond Price
• As we have said that interest rate and bond
price is reciprocally related.
• If interest rate goes up the price of the bond
goes down.
• A fund would incur losses if the fund has to
sell these bonds before maturity.
• So in a rising interest rate situation if a fund
has invested in large maturity debt security,
the bond price would come down with
increase in interest rate and the NAV would
be lower.
• So in a rising interest rate this should not be
right investment option.
Interest Rate and Bond Price
• In a rising interest rate situation, definitely
one can make more money providing he/she
can not incur capital loss.
• Capital loss occurs when you have invested
in security having maturity more than your
investment horizon.
• So in high interest rate situation, you have to
invest in debt securities which is maturing
along with your investment horizon.
• There can be two such investment options.
Liquid Funds

• When an investor is uncertain about the


interest rate and about the timing of
money requirement , he /she can invest
in Liquid fund.
• Since in the case of liquid fund , the
securities are of shorter duration, the
investor would get the benefit of higher
interest rate.
Short Term Debt Funds
• Short-term debt funds do insulate losses from
high interest rate and also can even give a
slightly higher return.
• The difference between a liquid fund and a
short-term debt fund is the investment tenure.
Liquid funds are ideal for investors with an
investment tenure ranging from 1 day to 30
days.
• While investors can remain invested in liquid
funds for longer than that, the return may
begin to look a little unattractive compared to
the next product on the maturity parameter
i.e. short-term debt funds
Corporate Bond
Corporate Bonds
• Corporate bonds are the fixed income instrument
issued by Corporations other than the Government.
• There are broadly two types of institutions which
issue corporate bonds namely Private Sector
Companies and Public Sector Companies.
Corporate Bonds
• Under the case of Public Sector Undertaking ( PSU) two types of
bonds can be issued , namely Tax Free Bond and Taxable Bond.
• In the case of tax free bonds the interest is tax free and in the
case of taxable bond , the interest is taxable at the issue of the
receiver of interest. The bonds issued by PSU companies are
also popularly known as PSU Bonds.
• In the case of other companies namely Private Sector
Companies ( which consist of both Private and Public Limited
companies ) some times these bonds are also called as
Debentures .
Corporate Bonds
• Besides these companies one of the other major players in the
bond market is the bank and financial institutions .
• Banks continuously issue bonds to shore up its Tier II capital
which is required for meeting its capital adequacy ratio. Similar
principle is applicable for Financial Institutions.
• Though a mature bond market is must for overall development
of the economy as company uses leverages to raise more capital
, yet in India bond market has not developed to that extent.
• However, there are enough opportunities to invest in the bond
in the retail segment.
Issue Process
• Passing of necessary resolution in the General Meeting and
Board Meeting.
• Obtaining the necessary credit rating.
• Creation of security for the said bonds/debentures through
appointment of debenture trustees.
• Appointment of advisors and investment bankers for issue
management ;
• Finalisation of the initial terms of the issue;
• Preparation of the offer document ( in the case of Public Issue )
and Investment Memorandum ( in the case of Private Issue ) ;
• SEBI approval of offer document for Public Issue;
Issue Process
• Listing agreement with Stock Exchanges.
• Offer the issue to prospective investors /and or Book Builders.
• Acceptance of application money /advance deposits for the
issue;
• Allotment of the issue ;
• Issue of letter of allotment and certificates/depository
confirmation ;
• Collect final amounts from the investors;
• Refund excess money /interest on application money;
Debenture Trustee
• No Company can issue Prospectus or Letter of Offer
to Public unless it has appointed one or more
debenture trustees for such debentures in accordance
with the provisions of the Companies Act 1956.
• The names of the Debenture Trustees would be
mentioned in the offer document and also in all
subsequent periodical communications sent to the
debenture holders.
• A trust deed shall be executed by the issuer
Company in favour of the debenture trustees within
three months of the closure of the issue.
Offer Document
• Draft offer document would be filed to the SEBI, in
the prescribed format. In the case of Private
Placement , Investment memorandum would be
submitted to the prospective investors;
Creation of Debenture
Redemption Reserves ( DRR)
• A company has to create Debenture Redemption Reserves
( DRR) in case of issue of debenture in the maturity as
prescribed in the SEBI DIP guidelines and Indian Companies
Act, 1956.
• A company shall create DRR to the tune of 50% of the
redemption amount before the debenture redemption
commences.
• Withdrawal from DRR is permitted only after at least 10% of
the debenture liability has accurately been redeemed by the
company . The creation of DRR would not be applicable for
debenture to be issued by Infrastructure Companies .
Creation of Debenture
Redemption Reserves ( DRR)
• A company has to create Debenture Redemption Reserves
( DRR) in case of issue of debenture in the maturity as
prescribed in the SEBI DIP guidelines and Indian Companies
Act, 1956.
• A company shall create DRR to the tune of 50% of the
redemption amount before the debenture redemption
commences.
• Withdrawal from DRR is permitted only after at least 10% of
the debenture liability has accurately been redeemed by the
company . The creation of DRR would not be applicable for
debenture to be issued by Infrastructure Companies .
Credit Rating
• No Company can make Public Issue or Rights Issue
of the debenture unless it has obtained credit rating
from at least two rating agencies and the rating must
be investment grade and the same is disclosed in the
offer document.
• In the case of Private Placement, QIB insists on the
ratings.
Term of Debenture
• The terms of the debenture is mentioned in the offer
document. In the case of Public Issue the face value is
100.
• In the case of issuance the debentures may be
clubbed for a single investors , however the investors
can ask for split of the debentures and the same can
be issued to the investors separately with minimum
number of 1.
• In the case of private placement no such minimum
paid up value is there and generally it is Rs 10 lacs.
Term of Debenture
• In the case of fixed interest instrument , the interest is
paid as a certain percentage of the face value of the
instrument.
• The interest is due from the deemed date of allotment
and deemed date of allotment is mentioned in the
offer document.
• In case of floating rate instruments , the interest rate
would start from the beginning of the period and it
would be applicable till the end of the period.
Term of Debenture
• Companies are required to pay investors , interest on
application money that is received from the date of
realizations of this amount, to the date immediately
preceding the deemed allotment at the applicable
coupon rate of the debenture.
• In case of applications that have been rejected or
allotted in part, for the unallotted interest as
mentioned above would be paid within 3 weeks of
the issue closure , on the refundable application
money.
Redemption
• Debenture can be hold either in the Physical form or
in the demat form .
• In the case of the physical form, the physical
debenture would have to be surrendered to the
company and the Company’s liability will be
extinguished once the debenture has been redeemed .
• Debentures in the demat form are discharged on
payment of redemption amounts to the registered
debenture holders as intimated by the depository.
Structured Finance
What is a structured finance
• A structured finance is a financial procedure to suit the need of
the borrower as per its specific requirement.
• In many cases, a borrower may not get funding on a plain
vanilla method .However, by properly structuring the process
the borrower can be funded.
• Similarly by securitising the loans funding can be arranged to
meet the specific requirement of the issuer of loan.
• Structured finance serves several purpose starting from increase
in fund flows in the system to risk mitigation of the system.
Funding of a week company
• In the case of plain vanilla lending, a lending institution can
lend to a borrower only if it can meet the following criteria :
– Profitability : 10% of net sales .
– Current Ratio : 1.33
– Leverage Ratio : 1.75
• The lender from its internal model finds that these are the
parameters required at a particular point of time to avoid
delinquency.
• The main concern of the lender is to avoid delinquency.
Funding of a week company
• A Company has the following criteria :
– Profitability : 3% of net sales .
– Current Ratio : 1.03
– Leverage Ratio : 2.75
• The lender wants to finance this Company .
• The major concern for the lender is that if a company can not
meet the above criteria , there is a probability that the Company
would default.
• The lender can address this concern by entering into a
structured finance agreement with the company.
Funding of a week company
• The lender sits with the company and analyses the customer
profile of the company .
• The lender rates these customers and segregate the best rated
customers from the rests.
• Now lender enters into agreement with the borrower in such a
way that these customers would pay directly to the lender.
• The lender overcollateralise the installment by 2 to 3 times .
• This is an example of structured finance through escrowing of
receivable.
Securitisation
• It is used to mean a device of structured financing where an
entity seeks
– to pool together its interest in identifiable cash
flows over time;
– transfer the same to investors either with or
without the support of further collaterals;
– and thereby achieve the purpose of financing.
Requirement of Securitisation
• Securitisation is used for fulfilling the following purpose :
– It reduces the capital requirement imposed by the regulator.
– It gives an opportunity of investors to suit their requirement
as per their subjective risk preferences.
– It also reduces the risk of the system .
Terminology in Securitisation
• The entity that securitises its assets is called the originator: the name signifies the
fact that the entity was responsible for originating the claims that are to be
ultimately securitised.
• There is no distinctive name for the investors who invest their money in the
instrument: therefore, they might simply be called investors.
• The claims that the originator securitises could either be
– existing claims, or existing assets (in form of claims), or
– expected claims over time. In other words, the securitised assets could be
either existing receivables, or receivables to arise in future. The latter, for the
sake of distinction, is sometimes called future flows securitisation, in which
case the former is a case of asset-backed securitisation.
• In US markets, another distinction is mostly common: between mortgage-
backed securities and asset-backed securities. This only is to indicate the
distinct application: the former relates to the market for securities based on
mortgage receivables, which in the USA forms a substantial part of total
securitisation markets, and securitisation of other receivables.
Terminology in Securitisation
• Since it is important for the entire exercise to be a case of transfer of
receivables by the originator, not a borrowing on the security of the
receivables, there is a legal transfer of the receivables to a separate
entity. In legal parlance, transfer of receivables is called assignment of
receivables.
• An entity is created solely for the purpose of the transaction: therefore,
it is called a special purpose vehicle (SPV) or a special purpose entity
(SPE) or, if such entity is a company, special purpose company (SPC).
• The originator transfers the assets to the SPV, which holds the assets
on behalf of the investors, and issues to the investors its own securities.
Therefore, the SPV is also called the issuer.
Terminology in Securitisation
• These securities could either represent a direct claim of the investors on
all that the SPV collects from the receivables transferred to it: in this
case, the securities are called pass through certificates or beneficial
interest certificates as they imply certificates of proportional beneficial
interest in the assets held by the SPV.
• Alternatively, the SPV might be re-configuring the cash flows by
reinvesting it, so as to pay to the investors on fixed dates, not matching
with the dates on which the transferred receivables are collected by the
SPV. In this case, the securities held by the investors are called pay
through certificates.
• The securities issued by the SPV could also be named based on their
risk or other features, such as senior notes or junior notes, floating
rate notes, etc.
Asset Backed Securities ( ABS)

Asset Backed Securities in a general sense

CDO
Mortgage ABS in a
Backed Narrower
Securities Sense
( MBS) •Credit Card
Residential •Equipment
Mortgage •Student Loan
CLO CBO
Commercial •Music Royalties Loan owned Bonds
Mortgage By Traded in the
Bank Market
Process of securitisation

Credit Originator /
Enhancer Servicer
Provides Credit Receives Loan sale Receives inflow
Enhancement Fund From reference
Transfer
Of Assets Issuer of
Trustee S.P.V. Underwriter
Principal Debt
And Interest Securities
Minus
Servicing Revenues from
Fees Debt Distribution
Securities Of
Disburses
Revenues to Debt Securities
Investors Investors
CDO
• In a Collateralised Debt Obligation ( CDO) structure, the issuer
repackages ( corporate or sovereign ) debt securities or bank
loans in to a reference portfolio ( the collateral) , whose proceeds
are subsequently sold to investors in the form of debt securities
with various levels of senior claim on this collateral.
• The issued securities are structured in so called senioritised credit
tranches, which denote a particular class of debt securities
investor may acquire when they invest in a CDO transaction.
• The tranching can be done by means of various structural
provisioning governing the participations of investors in the
proceeds and losses stemming from the collateral.
CDO
• Subparticipation is one of the most convenient vehicles for
attaching different levels of seniority to categories of issued
securities, so that losses are allocated to the lowest subordinate
tranches before the mezzanine and senior tranches are
considered.
• This process of filling up the tranches with periodic losses bottom
up results in a cascading effect .
• Both interest and losses are allotted according to investor
seniority.
• This prioritisation of claims and losses from the reference
portfolio guarantee that senior tranches carry a high investment
grading ( AAA) , provided sufficient junior tranches have been
issued to shield more senior tranches from credit losses.
Types of CDO
• The classification of CDOs depends on possible variability in the
valuation of the collateral ex post the issuance of the securities.
• In Market value CDO , the allocation of payments to various
tranches depends on the mark to market returns on the reference
portfolio underlying the transactions.
• The market value form of CDO s is generally applied in cases of
distressed reference portfolio of bonds or loans such that the
credit and trading expertise of the originator of these assets might
provide grounds for arbitrage gains from the differences in prices
between the distressed assets on the bank books and their
aggregate valuation when bundled in a reference portfolio
underlying securities.
Various form of structure
enhancement – Waterfall
CDO Tranches
AAA Senior Tranches

Portfolio
Payment A Mezzanine Tranches
X 1000 Made

BB Subordinated Tranches
Y 2000
Equity Tranches
Z 4000
Various form of structure
enhancement
• Over collateralisation : Volume of assets is more than volume of
issued notes.
• Excess Spread: Difference between interest payment from assets
and CDO coupons are collected in an account.
• Guarantee by the originator.
• Insurance by the third party.

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