The Basic Premise of Financial Markets-

1. Overview of Financial Markets The Basic Premise of Financial Markets- • As we know, a market is where buyers and sellers meet to exchange goods, services, money, or anything of value. In a financial market, the buyers are investors, or lenders: the sellers are issuers, or borrowers. An investor / lender is an individual, company, government, or any entity that owns more funds than it can use. An issuer / borrower is an entity that has a need for capital. Each investor and issuer is active in a market that meets its needs. Needs are based on many factors, including a time horizon (short- or long term), a cost / return preference, and type of capital (debt or equity). • The third group of participants in the marketplace includes financial intermediaries called brokers and dealers. Brokers facilitate the buying and selling process by matching investors and issuers according to their needs. Dealers purchase securities from issuers and sell them to investors. Brokers and dealers may be referred to as investment bankers. Investment banking firms specialize in the financial markets.

3. The Structure of Indian Debt Market

4. Participants and Instruments In Debt Markets

5. Short term instruments • Call/Notice Money (1-14 days) • Term Money – FDs (upto 1 year) • Repo (1-14 days)- 1 yr • CBLO (1 day to 3 months)-(Collateral Borrowing &Lending Obligation) • Treasury Bills (91 days, 182 days and 365 days • Certificates of Deposits (upto 1 year) • Commercial Paper (upto 1 year) • Bills Rediscounting schemes (upto 6 months) Instruments • Long term instruments • Government of India dated securities (GOISECs) • Inflation linked bonds • Zero coupon bonds • State government securities (state loans) • Public Sector Undertaking Bonds (PSU Bonds) • Corporate debentures • Bonds of Public Financial Institutions (PFIs)

6. Money Market INSTRUMENT • Call / Notice Money • It is an important segment of the Indian money market. In this market, banks and primary dealers borrow and lend funds to each other on unsecured basis. • If the period is more than 1 day and up to 14 days it is called “notice money”. • Term money • Money lent for 15 days to 1 year is called “term money”. • No brokers. Settlement is done between the participants through the current accounts maintained with the RBI.

7. REPO • Repurchase agreements are contracts for the sale and future repurchase of a financial asset, most often sovereign securities. • On the termination date, the seller repurchases the asset at the price agreed at inception of the repo. • The difference between the sale and repurchase prices represents interest for the use of the funds. • A repo is essentially a short term interest bearing loan against collateral.

8. Collateralized Borrowing and Lending Obligation (CBLO) • As an alternative to the call money market, CCIL has developed CBLO, a money market instrument recognized by RBI. • An instrument issued at a discount and in electronic book entry form, for initial maturities ranging from one day to one year.

9. Treasury Bills • Promissory notes of the central government and therefore qualify as being free of credit risks. • Issued to meet short term funding requirements of the government account with Reserve Bank. • Sale is by auction. Any individual, corporate, bank, primary dealer or other entity is free to buy T-Bill. • Denominations of 91, 182 and 364 days.

10. Commercial Paper (CP)Corporate, primary dealers & All-India Financial Institutions (FIs) can issue CP • Promissory notes issued by the corporate sector for raising short term funds. • Sold at a discount to face value. • Maturity can range between a minimum of 7 days and a maximum of 1 year. • Every CP issue has an Issuing and Paying Agent (IPA), which has to be a scheduled bank. • Stamp duty is currently payable on CP issues, depending on the maturity and who the initial buyer is.

11. Certificate of Deposit (CD) • Similar to CPs except that the issuer is a bank. • Minimum amount of a CD can be Rs. 1 lakh and maturity between 7 days and 1 year. • Financial Institutions can issue CDs only for maturities between 1 and 3 years. • No premature cancellation of CD is allowed Bills Rediscounting Scheme • The RBI introduced the Bills Market Scheme (BMS) in 1952 which was later modified into the New Bills Market Scheme (NBMS). • Under this scheme commercial banks can rediscount the bills which were originally discounted by them with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealers etc.)

12. CAPITAL MARKET INSTRUMENT Government of India dated securities (GOISECs): • GOISECs are issued by the Reserve Bank of India on behalf of the Government of India. These form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). • They have maturity ranging from 1 year to 30 years. • GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year

13. Inflation linked bonds: These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time - the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Investors are often loath to invest in longer dated securities due to uncertainty of future interest rates. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital.

14. Zero coupon bonds: These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T - Bills or as bonds with cumulative interest payment. • State government securities (state loans) : These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. State Government issue such securities to fund their developmental projects and finance their budgetary defictis

15. Public Sector Undertaking Bonds (PSU Bonds) : These are long term debt instruments issued by Public Sector Undertakings (PSUs). The term usually denotes bonds issued by the central PSUs (ie PSUs funded by and under the administrative control of the Government of India). The issuance of these bonds began in a big way in the late eighties when the central government stopped/reduced funding to PSUs through the general budget. Typically, they have maturities ranging between 5-10 years and they are issued in denominations (face value) of Rs.1,000 each. Most of these issues are made on a private placement basis to a targeted investor base at market determined interest rates. These PSU bonds are transferable by endorsement and delivery and no tax is deductible at source on the interest coupons payable to the investor (TDS exempt).

16. Bonds of Public Financial Institutions (PFIs) : Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways - through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately have this facility.

17. Corporate debentures: These are long term debt instruments issued by private sector companies. These are issued in denominations as low as Rs.1,000 and have maturities ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity. A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture stamp duty is a state subject and the quantum of incidence varies from state to state. There are two kinds of stamp duties levied on debentures viz issuance and transfer. Issuance stamp duty is paid in the state where the principal mortgage deed is registered. Over the years, issuance stamp duties have been coming down and are reasonably uniform. Stamp duty on transfer is paid to the state in which the registered office of the company is located. Transfer stamp duty remains high in many states and is probably the biggest deterrent for trading in debentures resulting in lack of liquidity.

18. Bond Basics & Valuation of Bonds

19. Bonds represent loans by investors to a company. In a bond contract, the investor purchases a certificate from the issuer in exchange of fixed interest payments and the return of a principal amount at the end of the contract. In this section we will discuss the terminology of the bond market and the methodology for calculating the price (present value) of a bond. • Bond Terminology There are several terms that are commonly used by investors and issuers when dealing with bonds. Coupon The periodic interest payment made by the issuer. When bonds were first developed, the bond certificate had detachable coupons that the investor would send to the issuer to receive each interest payment. The term still applies to payments, even though coupons are no longer used to redeem them. Coupon rate The interest rate used to calculate the coupon amount the bond will pay. This rate is multiplied by the face value of the bond to arrive at the coupon amount.

20. Face (par) value The amount printed on the certificate. The face value represents the principal in the loan agreement, which is the amount the issuer pays at maturity of the bond. Maturity date The date the loan contract ends. At this time, the issuer pays the face value to the investor who owns the bond. YieldYield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield. Bonds are often referred to as fixed income securities because they have a fixed payout to the investor. Since the coupon rate is set before the sale of the bond, the investor knows the amount of the interest payments.

21. Factors Affecting Bond Price Factors affecting bond prices can be market-wide or issuer-specific. Market-wide factors affect all bonds in a particular category or group more or less to the same degree. Issuer-specific factors affect a particular bond or all bonds of a particular issuer. Interest Rates: When interest rates rise, bond prices fall, and vice versa, because interest, once expressed as a percentage of principal, is set in rupees. For example, if you buy a 5 percent coupon bond, it will pay Rs.50 for every Rs.1,000 in principal until maturity. If interest rates rise to, say, 6 percent and you want to sell, your bond's price will have to be adjusted to Rs. 833 to yield 6 percent (Rs. 50 ÷ Rs. 833 X 100 = 6 percent). The opposite is true when interest rates fall. Credit Ratings: At issuance, every bond gets a credit rating from a credit rating agency based on the issuer's ability to repay. Higher rated bonds command higher prices (have lower yields). But an issuer's ability to repay may change over time. If the credit rating is lowered, the price of the bond will fall. Just a rumor or fear of a downgrade can send a bond's price lower.

22. Economic/Market Risk: Issuer’s ability to repay changes with changing economic conditions. In a strong economy, when companies are generating a healthy cash flow, bond investors have little to worry about. In a downturn, some weaker issuers may have difficulty generating enough cash to cover interest payments. As a result, investors seek riskier higher yielding bonds in a strong economy, bidding up their prices, and shun them in downturns, depressing the prices. Conversely, in a downturn, demand grows for safe havens such as U.S. Treasuries, pushing their prices up. When the economy picks up, investors sell Treasuries to buy stocks.The boundary between economic and market risk is often blurred. Economic risk implies a known state of affairs---i.e., a downturn has been confirmed. But markets always look forward 3-6 months, acting in anticipation. Bonds may decline long before the official numbers are released and start rising ahead of any official recovery. Market Psychology: Investor attitude toward risk changes constantly. Even if the underlying conditions do not change, prices of bonds may fluctuate based on investor perceptions and outlooks. Risk perception may affect specific issuers or sectors or countries.

23. PRICING OF BOND Investors generally use two types of pricing strategies for bond investment. Some bond investors buy quality bonds and keep them until they mature (buy and hold method). These investors don't concern themselves with bond price relative to market yield. Other investors trade in the open market, buying and selling bonds at the best possible price. Interest rates are a key factor affecting the price of bonds, so this type of investor understands that a bond price must be adjusted accordingly to actively trade in and out of the market. Pricing a bond involves finding the present value of the cash flows from the bond throughout its life. The formula for calculating the present value of a bond is: • V = C[1 / (1+R)]1+ C[1 / (1+R)]2+ ... + C[1 / (1+R)]T+ F[1 / (1+R)]T Or V = C* PVIFA (r ,t) +F* PVIF (r , t) • Where: V = Present value of the bond C = Coupon payment (coupon rate multiplied by face value) R = Discount rate (current prevailing rate) F = Face value of the bond T = Number of compounding periods until maturity

24. Example: • What is the present value of a bond with a two-year maturity date, with face value of Rs.1,000, and a coupon rate of 6%? The current prevailing market interest rate for similar issues is 5%.. Soln: C = Rs.60 (Rs.1,000 x 0.06), R = 0.05, T = 2, and F = Rs.1,000. V = C[1 / (1+R)]1 + C[1 / (1+R)]2 + F[1 / (1+R)]2 V = Rs.60[1 / (1+0.05)] + Rs.60[1 / (1+0.05)]2 + Rs.1,000[1 / (1+0.05)]2 V = Rs.60[0.95238] + Rs.60[0.90703] + Rs.1,000[0.90703] V = Rs.57.14 + Rs.54.42 + Rs.907.03 V = Rs.1,018.59

25. The present value of Rs.1,018.59 is the price that the bond will trade for in the secondary bond market. You will notice that the price is higher than the face value of Rs.1,000. In the time since these bonds were issued, interest rates have fallen from 6% to 5%. Investors are willing to pay more for the Rs.60 interest payments when compared with new bond issues that are only paying Rs.50 in interest per Rs.1,000 face value. This inverse relationship is important. As market interest rates fall, bond prices rise; As market interest rates rise, bond prices fall. A bond with a coupon rate that is higher than the prevailing interest rate sells at a premium to par value; a bond with a lower rate sells at a discount.

26. Current Yield, YTM & Duration of a Bond

27. Bond structure Serial Number BOND Name of bond e.g. GOI 2020 Nominal/Par Value e.g. Rs.100.00 Coupon rate 12 ¼ % pa. Redemption date e.g. Dec 2020 Interest Rs.12.25

28. Current Yield • In contrast to the Coupon Yield or Nominal Yield, is a Bond Yield that is determined by dividing the fixed coupon amount (that is paid as a percentage on the face or original value of the specific bond) by the current price value of the particular bond. • In other words, • Current Bond Yield = Coupon amount / current price of a bond. • Example: • IF the market price for a 8.24% G-Sec 2018 is Rs.118.85. • The current yield on the security will be: • = 0.0824 x 100 / 118.85 = 6.93 percent. • Advantage: • simple to calculate. • Disadvantage: • Reflect only current coupon income, not consider capital gain/loss that investor will realize if bond is purchased at discount/premium and held till maturity. • Ignores time value of money. • Incomplete.

29. Yield to Maturity • It is the most popular measure of yield in the Debt Markets. • YTM refers to the percentage rate of return paid on a bond, note or other fixed income security if the investor buys and holds the security till its maturity date. • The calculation for YTM is based on the coupon rate, the length of time to maturity, face value and the market price of the bond. It can be calculated by using trial and error method. • YTM is basically the Internal Rate of Return on the bond, because it is the rate at which p.v of cash inflows from owing the bond equal to the price of bond.. • Example: IF the market price for a 9% G-Sec is Rs.800 with maturity period of 8 years and face value of 1000 rs. YTM is value of r in equation : 90 x PVIFA (r,8) + 1000 x PVIF (r,8) lets begin with taking r as of 13% we find after putting r as 13% in equation : = 808, since 808 > 800 so, we have to try higher value of r At 14%=768.10, which is less than 800 (768.10 < 800). Since r lies between 13 percent and 14 percent, we have to use trial and error method by which we find that r = 13.2%

30. YTM ( cont….) • Assumptions: • The coupon interest paid over the life of the bond is assumed to be reinvested at the same rate. • Advantage: • It considers the current coupon income + capital gain/loss investor will realize by holding the bond to maturity. • It consider time value of money. • Disadvantage: • complex to calculate.

31. Relationship between prices & yield Bond Prices Bond Prices Yields Yields YTM = 10% Coupon = 10% Bond price = Rs100 Flat yield = 10% --------------------------------- YTM  = 12% Bond price = Rs83 Flat yield = 12 % YTM = 12% Coupon = 10% Bond price = Rs 83 Flat yield = 12% --------------------------------- YTM  = 10% Bond price = Rs100 Flat yield = 10 % Example

32. Relationship between Price, coupon rate & required yield : • The price of a government security is inversely related to the market interest rate. As the interest rate increases price decreases and therefore, the yield increases. However, if the interest rates fall the G-Sec become expensive and therefore, the yield falls. • Therefore, if the market price is equal to face value of the government security, then the current yield, coupon yield and Yield to maturity will all be equal to the coupon rate or interest payable on government security. • Coupon rate = Yield to maturity if, Market price = Face value • If Market Price is less than the face value of the government security the current yield and yield to maturity will be higher than the coupon rate. • Coupon rate < Yield to maturity if, Market price < Face value • In cases where the market price of the government security/bond is more than its face value the current yield and Yield to maturity will be lower than the coupon rate. • Coupon rate > Yield to maturity if, Market price > Face value

33. Process for Issuing Bonds A simple example will illustrate the process for issuing bonds. Example : ABC Company needs capital to purchase a new piece of equipment for its operations. The company meets with financial advisors and investment bankers to discuss the possibilities of raising the necessary capital. They decide that a bond issue is the least expensive method for the company. The process is as follows: 1. ABC Company sets the maturity date and face value of the bonds. The bonds will have a maturity date of ten years from the date of issue and a face value of Rs.1,000. The company will issue as many bonds as it needs for the equipment purchase – if the equipment costs Rs.10,000,000 fully installed, then the company will issue 10,000 bonds.

34. 2. Investment bankers set the coupon rate for the bonds. The investment bankers attempt to gauge the interest rate environment and set the coupon rate commensurate with other bonds with similar risk and maturity. The coupon rate dictates whether the bonds will be sold in the secondary market at face value or at a discount or premium. • If the coupon rate is higher than the prevailing interest rate, the bonds will sell at a premium; • if the coupon rate is lower than the prevailing interest rate, the bonds will sell at a discount. 3. Investment bankers find investors for the bonds and issue them in the primary market. The investment bankers use their system of brokers and dealers to find investors to buy the bonds. When investment bankers complete the sale of the bonds to investors, they turn over the proceeds of the sale (less the fees for performing their services) to the company to use for the purchase of equipment. The total face value of the bonds appears as a liability on the company's balance sheet.

35. 4. The bonds become available in the secondary market. Once the bonds are sold in the primary market to investors, they become available for purchase or sale in the secondary market. hese transactions usually take place between two investors – one investor who owns bonds that are no longer needed for his/her investment portfolio and another investor who needs those same bonds.