11 FIMMDA-NSE Debt Market (Basic)

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( NSE)
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CONTENTS
CHAPTER 1....................................................................................................................................................6
DEBT INSTRUMENTS: FUNDAMENTAL FEATURES ................................................................6
1 . 1 INSTRUMENT FEATURES ................................................................................................................. 6
1 . 2 MODIFYING THE COUPON OF A BOND........................................................................................... 7
1 . 3 MODIFYING THE TERM TO MATURITY OF A BOND...................................................................... 9
1 . 4 MODIFYING THE PRINCIPAL REPAYMENT OF A BOND.............................................................. 11
1 . 5 ASSET BACKED SECURITIES.......................................................................................................... 11
CHAPTER 2..................................................................................................................................................13
INDIAN DEBT MARKETS: A PROFILE...........................................................................................13
2 . 1 MARKET SEGMENTS...................................................................................................................... 13
2 . 2 PARTICIPANTS IN THE DEBT MARKETS........................................................................................ 15
2. 3 SECONDARY MARKET FOR DEBT INSTRUMENTS...................................................................... 17
CHAPTER 3..................................................................................................................................................24
CENTRAL GOVERNMENT SECURITIES: BONDS.....................................................................24
3 . 1 INTRODUCTION............................................................................................................................... 24
3 . 2 G-SECS: TRENDS IN VOLUMES, TENOR AND YIELDS................................................................... 27
3 . 3 PRIMARY ISSUANCE PROCESS...................................................................................................... 28
3 . 4 PARTICIPANTS IN GOVERNMENT BOND MARKETS................................................................... 33
3 . 5 CONSTITUENT SGL ACCOUNTS..................................................................................................... 35
3 . 6 PRIMARY DEALERS........................................................................................................................ 35
3.6.1 Eligibility....................................................................................................................................36
3.6.2 Bidding Commitment ................................................................................................................36
3.6.3 Underwriting..............................................................................................................................36
3.6.4 Other Obligations......................................................................................................................38
3.6.5 Facilities for Primary Dealers................................................................................................39
3.6.6 Reporting System.......................................................................................................................40
3 . 7 SATELLITE DEALERS...................................................................................................................... 40
3 . 8 SECONDARY MARKETS FOR GOVERNMENT BONDS................................................................. 41
3 . 9 SETTLEMENT OF TRADES IN G-SECS............................................................................................. 41
CHAPTER 4..................................................................................................................................................48
CENTRAL GOVERNMENT SECURITIES: T-BILLS...................................................................48
4 . 1 ISSUANCE PROCESS........................................................................................................................ 48
4 . 2 CUT-OFF YIELDS.............................................................................................................................. 50
4 . 3 INVESTORS IN T-BILLS.................................................................................................................... 51
4 . 4 SECONDARY MARKET ACTIVITY IN T-BILLS............................................................................... 51
CHAPTER 5..................................................................................................................................................53
STATE GOVERNMENT BONDS..........................................................................................................53
5 . 1 GROSS FISCAL DEFICIT OF STATE GOVERNMENTS AND ITS FINANCING............................... 53
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5 . 2 VOLUMES AND COUPON RATES................................................................................................... 53
5 . 3 OWNERSHIP PATTERN OF STATE GOVERNMENT BONDS.......................................................... 54
CHAPTER 6..................................................................................................................................................56
CALL MONEY MARKETS.....................................................................................................................56
6 . 1 VOLUMES IN THE CALL MARKET................................................................................................. 56
6 . 2 PARTICIPANTS IN THE CALL MARKETS........................................................................................ 57
6 . 3 CALL RATES..................................................................................................................................... 60
CHAPTER 7..................................................................................................................................................62
CORPORATE DEBT: BONDS ...............................................................................................................62
7 . 1 MARKET SEGMENTS...................................................................................................................... 62
7 . 2 SEBI (ISSUE AND LISTING OF DEBT SECURITIES) REGULATIONS, 2008....................................... 64
7 . 3 LISTING CRITERIA ON NSE WDM................................................................................................ 67
7 . 4 SECONDARY MARKET FOR CORPORATE DEBT SECURITIES..................................................... 69
7 . 5 CREDIT RATING............................................................................................................................... 71
7 . 6 RATING SYMBOLS .......................................................................................................................... 72
CHAPTER 8..................................................................................................................................................79
COMMERCIAL PAPER & CERTIFICATE OF DEPOSITS .......................................................79
8 . 1 GUIDELINES FOR CP ISSUE............................................................................................................. 79
8 . 2 RATING NOTCHES FOR CPS............................................................................................................ 84
8 . 3 GROWTH IN THE CP MARKET........................................................................................................ 85
8 . 4 STAMP DUTY................................................................................................................................... 86
8 . 5 CERTIFICATES OF DEPOSIT............................................................................................................ 87
CHAPTER 9..................................................................................................................................................91
REPOS............................................................................................................................................................91
9 . 1 INTRODUCTION............................................................................................................................... 91
9 . 2 REPO RATE....................................................................................................................................... 92
9 . 3 CALCULATING SETTLEMENT AMOUNTS IN REPO TRANSACTIONS......................................... 94
9 . 4 ADVANTAGES OF REPOS............................................................................................................... 94
9 . 5 REPO MARKET IN INDIA: SOME RECENT ISSUES.......................................................................... 95
9 . 6 SECONDARY MARKET TRANSACTIONS IN REPOS...................................................................... 96
9 . 7 REPO ACCOUNTING........................................................................................................................ 97
CHAPTER 10 ............................................................................................................................................ 106
BOND MARKET INDICES AND BENCHMARKS ...................................................................... 106
10 . 1 I-BEX: SOVEREIGN BOND INDEX............................................................................................106
10.1.1 Why a Sovereign Bond Index?........................................................................................... 106
10.1.2 Features of a Bond Index.................................................................................................... 106
10.1.3 Methodology and Assumptions.......................................................................................... 107
10.1.4 Definitions............................................................................................................................. 109
10.1.5 Returns on Individual Bonds.............................................................................................. 109
10.1.6 Market Indices...................................................................................................................... 110
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10.1.7 Adjustment Factor................................................................................................................ 110
10.1.8 Index Statistics...................................................................................................................... 111
10.1.9 Calibration Issues................................................................................................................ 112
10.1.10 Principal Return Index and Total Return Index........................................................... 112
10 . 2 THE FIMMDA NSE MIBID-MIBOR............................................................................................115
10.2.1 Introduction to Polled Benchmarks.................................................................................. 115
10.2.2 Polling Methodology........................................................................................................... 116
10.2.3 Methodology to Determine Average Rates...................................................................... 116
CHAPTER 11 ............................................................................................................................................ 119
TRADING MECHANISM IN THE NSE-WDM............................................................................. 119
11 . 1 DESCRIPTION OF THE NSE - WDM..........................................................................................119
11 . 2 ORDER TYPES AND CONDITIONS...........................................................................................120
11 . 3 MARKET PHASES AND STARTING UP....................................................................................121
11 . 4 TRADING MECHANISM...........................................................................................................122
11 . 5 ORDER ENTRY.........................................................................................................................123
11.5.1 Order Entry in Continuous Market................................................................................... 124
11.5.2 Order Entry i n Negotiated Trades Market ...................................................................... 125
11 . 6 ORDER VALIDATION...............................................................................................................126
11 . 7 ORDER MATCHING..................................................................................................................128
11 . 8 TRADE MANAGEMENT..........................................................................................................131
11 . 9 REPORTS...................................................................................................................................132
11. 10 SETTLEMENT...........................................................................................................................132
11. 11 RATES OF BROKERAGE..........................................................................................................132
CHAPTER 12 ............................................................................................................................................ 135
REGULATORY AND PROCEDURAL ASPECTS ....................................................................... 135
12 . 1 GOVERNMENT SECURITIES ACT, 2006...................................................................................136
12 . 2 SEBI (GUIDELINES FOR DISCLOSURE AND INVESTOR PROTECTION), 2000.......................138
12 . 3 SEBI (ISSUE AND LISTING OF DEBT SECURITIES) REGULATIONS, 2008...............................144
12 . 4 MARKET PRACTICES AND PROCEDURES.............................................................................147
12.4.1 Dealing Principles & Procedures..................................................................................... 147
CHAPTER 13 ............................................................................................................................................ 159
VALUATION OF BONDS ..................................................................................................................... 159
13 . 1 BOND VALUATION: FIRST PRINCIPLES..................................................................................159
13 . 2 TIME PATH OF A BOND............................................................................................................160
13 . 3 VALUING A BOND AT ANY POINT ON THE TIME SCALE......................................................162
13 . 4 ACCRUED INTEREST...............................................................................................................165
13 . 5 YIELD........................................................................................................................................166
13.5.1 Current Yield........................................................................................................................ 167
13.5.2 Yield to Maturity (YTM)...................................................................................................... 167
13.5.3 Yield to Maturity of a Zero Coupon Bond....................................................................... 169
13.5.4 Using the Zero-Coupon Yield for Bond Valuation......................................................... 170
13.5.5 Bond Equivalent Yield......................................................................................................... 171
13 . 6 WEIGHTED YIELD....................................................................................................................172
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13 . 7 YTM OF A PORTFOLIO.............................................................................................................172
13 . 8 REALISED YIELD......................................................................................................................174
13 . 9 YIELDPRICE RELATIONSHIPS OF BONDS.............................................................................175
13.9.1 Price Yield Relationship: Some Principles.................................................................. 176
CHAPTER 14 ............................................................................................................................................ 180
YIELD CURVE AND TERM STRUCTURE OF INTEREST RATES .................................... 180
14 . 1 YIELD CURVE: A SIMPLE APPROACH.....................................................................................180
14.1.1 Yield Curve from a Sample of Traded Bonds.................................................................. 180
14.1.2 Limitations of the Simple Yield Curve............................................................................. 182
14 . 2 BOOTSTRAPPING.....................................................................................................................183
14 . 3 ALTERNATE METHODOLOGIES TO ESTIMATE THE YIELD CURVE...................................185
14.3.1 NSE ZCYC (Nelson Seigel Model).................................................................................. 185
14 . 4 THEORIES OF THE TERM STRUCTURE OF INTEREST RATES...............................................187
14.4.1 Pure Expectation Hypothesis............................................................................................. 187
14.4.2 Liquidity Preference Hypothesis....................................................................................... 188
14.4.3 Preferred Habitat Hypothesis............................................................................................ 188
CHAPTER 15 ............................................................................................................................................ 193
DURATION............................................................................................................................................... 193
15 . 1 INTRODUCTION AND DEFINITION.........................................................................................193
15 . 2 CALCULATING DURATION OF A COUPON PAYINGBOND.................................................195
15 . 3 COMPUTING DURATION ON DATES OTHER THAN COUPON DATES.................................196
15 . 4 MODIFIED DURATION.............................................................................................................198
15 . 5 RUPEE DURATION...................................................................................................................201
15 . 6 PORTFOLIO DURATION..........................................................................................................203
15 . 7 LIMITATIONS OF DURATION..................................................................................................205
CHAPTER 16 ............................................................................................................................................ 208
FIXED INCOME DERIVATIVES ...................................................................................................... 208
16 .1 WHAT ARE FIXED-INCOME DERIVATIVES?..........................................................................208
16.1.1 Forward Rate Agreements.................................................................................................. 208
16 . 2 MECHANICS OF FORWARD RATE AGREEMENTS...............................................................211
16 . 3 INTEREST RATE FUTURES......................................................................................................212
16 . 4 INTEREST RATE SWAPS..........................................................................................................213
16 . 5 GUIDELINES ON EXCHANGE TRADED INTEREST RATE DERIVATIVES ............................220
GLOSSARY OF DEBT MARKET TERMS ..................................................................................... 225
GUIDELINE FOR USING EXCEL:................................................................................................... 238

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Di st r i but i on of w ei ght s i n t he
FI MMDA- NSE Debt Mar k et ( Basi c) Modul e Cur r i cul u m

Chapt er
No.
Ti t l e Wei ght s
( % )
1 Debt I nst rument s: Fundament al Feat ures 3
2 I ndian Debt Market s: A Profile 4
3 Cent ral Government Securit ies: Bonds 10
4 Cent ral Government Securit ies: T-Bills 3
5 St at e Government Bonds 2
6 Call Money Mar ket s 2
7 Corporat e Debt : Bonds 8
8 Commercial Paper & Cert ificat e of Deposit s 3
9 Repos 5
10 Bond Market I ndices and Benchmarks 4
11 Trading Mechanism in t he NSE-WDM 7
12 Regulat ory and Procedural Aspect s 9
13 Valuat ion of Bonds 12
14 Yield Curve and Term St r uct ur e of I nt er est Rat es 10
15 Dur at ion 10
16 Fixed I ncome Derivat ives 8

Not e: Candidat es ar e advised t o r ef er t o NSEs websit e: www. nseindia. com,
click on NCFM link and t hen go t o Announcement s link, r egar ding
r evisions/ updat ions in NCFM modules or launch of new modules, if any.
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CHAPTER 1
DEBT I NSTRUMENTS: FUNDAMENTAL
FEATURES

Debt inst r ument s ar e cont r act s in which one par t y lends money t o anot her on
pre- det ermined t erms wit h regard t o rat e of int erest t o be paid by t he
bor r ower t o t he l ender , t he per i odi ci t y of such i nt er est payment , and t he
r epayment of t he pr incipal amount bor r owed ( eit her in inst allment s or in
bullet ) . I n t he I ndian secur it ies mar ket s, we gener ally use t he t er m bond f or
debt inst r ument s issued by t he Cent r al and St at e gover nment s and public
sect or or ganisat ions, and t he t er m debent ur es for inst r ument s issued by
pr i vat e cor por at e sect or .
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1.1 I NSTRUMENT FEATURES

The pr incipal feat ur es of a bond ar e:

a) Mat ur i t y
b) Coupon
c) Pr incipal

I n t he bond market s, t he t erms mat ur i t y and t er m - t o- mat ur i t y , are used
qui t e f r equent l y. Mat ur i t y of a bond r ef er s t o t he dat e on whi ch t he bond
mat ur es, or t he dat e on which t he bor r ower has agr eed t o r epay ( r edeem)
t he pr incipal amount t o t he lender . The bor r owing is ext inguished wit h
redempt ion, and t he bond ceases t o exist af t er t hat dat e. Ter m t o mat ur it y,
on t he ot her hand, refers t o t he number of years remaining for t he bond t o
mat ur e. Ter m t o mat ur it y of a bond changes ever yday, f r om t he dat e of issue
of t he bond unt il it s mat urit y.

Cou pon Rat e r efer s t o t he per iodic int er est payment s t hat ar e made by t he
borrower ( who is also t he issuer of t he bond) t o t he lender ( t he subscriber of
t he bond) and t he coupons ar e st at ed upf r ont eit her dir ect ly specif ying t he
number ( e. g. 8%) or indi rect ly t ying wit h a benchmark rat e ( e. g.
MI BOR+ 0. 5%) . Coupon r at e i s t he r at e at whi ch i nt er est i s pai d, and i s
usually r epr esent ed as a per cent age of t he par value of a bond.

Pr i n ci p al is t he amount t hat has been borrowed, and is also called t he par
v al ue or f ace v al ue of t he bond. The coupon is t he pr oduct of t he pr incipal
and t he coupon r at e. Typical face values in t he bond mar ket ar e Rs. 100

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I n t hi s wor kbook t he t er ms bonds, debent ur es and debt i nst r ument s have been used i nt er- changeabl y.
7
t hough t her e ar e bonds wit h f ace values of Rs. 1000 and Rs. 100000 and
above. All Gover nment bonds have t he face value of Rs. 100. I n many cases,
t he name of t he bond it self conveys t he key feat ures of a bond. For example
a GS CG2008 11. 40% bond refers t o a Cent ral Government bond mat uring in
t he year 2008, and paying a coupon of 11. 40%. Since Cent ral Government
bonds have a f ace value of Rs. 100, and nor mally pay coupon semiannual l y,
t his bond will pay Rs. 5.70 as six- mont hly coupon, unt il mat urit y, when t he
bond will be redeemed.

The t er m t o mat ur it y of a bond can be calculat ed on any dat e, as t he dist ance
bet ween such a dat e and t he dat e of mat ur it y. I t is also called t he t er m or t he
t enor of t he bond. For inst ance, on Febr uar y 17, 2004, t he t er m t o mat ur it y
of t he bond mat ur ing on May 23, 2008 will be 4. 27 year s. The gener al day
count convent ion in bond mar ket is 30/ 360Eur opean which assumes t ot al 360
days in a year and 30 days in a mont h.

Ther e is no r igid classif icat ion of bonds on t he basis of t heir t er m t o mat ur it y.
Gener al l y bonds wi t h t enor s of 1- 5 years are called short - t er m bonds; bonds
wi t h t enors r anging f r om 4 t o 10 year s ar e medium t er m bonds and above 10
year s ar e long t er m bonds. I n I ndia, t he Cent r al Gover nment has issued up t o
30 year bonds.

Box 1 . 1 : Compu t i n g t er m t o mat u r i t y i n y ear s
The dist ance bet ween a given dat e and t he dat e on whic h a bond mat ures is
t he t er m t o mat ur it y of a bond. This dist ance can be calculat ed in year s, as
follows:
Use f unct ion YEARFRAC in Excel. The input s ar e st ar t _dat e which is t he
dat e on which we want t o measur e t he t er m t o mat ur it y of t he bond;
end_dat e is t he dat e on which t he bond mat ures; basis is t he manner in
which t he number of days bet ween t he st ar t and t he end dat es ar e t o be
count ed. The number s 0- 4 represent t he various ways in which days can be
count ed. We have used 4 which is a 30/ 360 days convent ion.
Anot her opt ion is t o use t he f unct ion called DAYS360 and pr ovide t he st ar t
and end dat e as well as t he logical values. I t would provide t he days t o
mat ur it y. Divide t he same by 360 would give t he year s.
The r esult is 4. 27, which is the t er m t o mat ur it y of t he bond, in year s, on
February 17, 2004.

1.2 MODI FYI NG THE COUPON OF A BOND

I n a plain vanilla bond, coupon is paid at a pre- det ermined rat e, as a
per cent age of t he par value of t he bond. Sever al modif icat ions t o t he manner
in which coupons / int er est on a bond ar e paid ar e possible.
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Zer o Cou pon Bon d
I n such a bond, no coupons are paid. The bond is inst ead issued at a
discount t o it s f ace value, at which it will be r edeemed. Ther e ar e no
int er mit t ent payment s of int er est . When such a bond is issued for a ver y long
t enor , t he issue pr ice is at a st eep discount t o t he r edempt ion value. Such a
zero coupon bond is also called a deep discount bond. The effect ive int er est
ear ned by t he buyer is t he dif f er ence bet ween t he f ace value and t he
discount ed pr ice at which t he bond is bought . Ther e ar e also inst ances of zer o
coupon bonds being issued at par, and redeemed wit h int erest at a premium.
The essent ial feat ure of t his t ype of bonds is t he absence of int ermit t ent cash
f lows.
Tr easu r y St r i ps
I n t he Unit ed St at es, gover nment dealer f ir ms buy coupon paying t r easur y
bonds, and cr eat e out of each cash f low of such a bond, a separ at e zer o
coupon bond. For exampl e, a 7- year coupon- paying bond compr ises of 14
cash flows, represent ing half - year ly coupons and t he r epayment of pr incipal
on mat ur it y. Dealer fir ms split t his bond int o 14 zer o coupon bonds, each one
wit h a dif f er ing mat ur it y and sell t hem separ at ely, t o buyer s wit h var ying
t enor preferences. Such bonds are known as t reasury st rips. ( St rips is an
acr onym f or Separ at e Tr ading of Regist er ed I nt er est and Pr incipal Secur it ies) .
We do not have t reasury st rips yet in t he I ndian market s. RBI and
Gover nment ar e making effor t s t o develop mar ket for st r ips in gover nment
secur it ies.
Fl oat i n g Rat e Bon ds
I nst ead of a pre- det er mined r at e at which coupons ar e paid, it is possible t o
st r uct ur e bonds, wher e t he r at e of int er est is r e- set per iodically, based on a
benchmar k r at e. Such bonds whose coupon r at e is not f ixed, but r eset wit h
r ef erence t o a benchmar k r at e, ar e called float ing r at e bonds. For example,
I DBI issued a 5 year f loat ing r at e bond, in July 1997, wit h t he r at es being r e-
set semi - annually wit h r ef er ence t o t he 10 year yield on Cent r al Gover nment
securit ies and a 50 basis point mar k- up. I n t his bond, ever y six mont hs, t he
10- year benchmar k r at e on gover nment secur it ies is ascer t ained. The coupon
r at e I DBI would pay for t he next six mont hs is t his benchmar k r at e, plus 50
basis point s. The coupon on a f loat ing r at e bond t hus var i es al ong wi t h t he
benchmar k r at e, and is r eset per iodically.

The Cent r al Gover nment has also st ar t ed issuing f loat ing r at e bonds t ying t he
coupon t o t he aver age cut - off yields of last six 364- day T- bills yields.

Some float ing rat e bonds also have caps and floors, which represent t he
upper and lower limit s wit hin which t he float ing r at es can var y. For example,
t he I DBI bond described above had a floor of 13. 5%. This means, t he lender
would r eceive a minimum of 13. 5% as coupon r at e, should t he benchmar k
rat e fall below t his t hreshold. A ceiling or a cap represent s t he maximum
9
int er est t hat t he bor r ower will pay, should t he benchmar k r at e move above
such a level. Most cor por at e bonds linked t o t he call r at es, have such a
ceiling t o cap t he int er est obligat ion of t he bor r ower , in t he event of t he
benchmar k call r at es r ising ver y st eeply. Float ing r at e bonds, whose coupon
r at es ar e bound by bot h a cap and f loor , ar e called as r ange not es, because
t he coupon r at es var y wit hin a cer t ain r ange.

The ot her names, by which float ing rat e bonds are known, are variable rat e
bonds and adj ust able r at e bonds. These t er ms ar e gener ally used in t he case
of bonds whose coupon rat es are reset at longer t ime int ervals of a year and
above. These bonds ar e common in t he housing loan mar ket s.

I n t he developed mar ket s, t her e ar e float ing r at e bonds, whose coupon r at es
move in t he dir ect ion opposit e t o t he dir ect ion of t he benchmar k r at es. Such
bonds ar e called inver se float er s.
Ot her Var i at i ons
I n t he mid- ei ght i es, the US mar ket s wit nessed a var iet y of coupon st r uct ur es
in t he high yield bond market ( j unk bonds) for leveraged buy - out s. I n many
of t hese cases, st r uct ur es t hat enabl ed t he bor r ower s t o def er t he payment of
coupons were creat ed. Some of t he more popular st r uct ur es wer e: ( a)
def er r ed int er est bonds, wher e t he bor r ower could def er t he payment of
coupons in t he init ial 3 t o 7 year period; ( b) St ep- up bonds, wher e t he
coupon was st epped up by a f ew basis point s per iodically, so t hat t he int er est
bur den in t he init ial years is lower, and increases over t ime; and ( c)
ext endible r eset bond, in which invest ment banker s r eset t he r at es, not on
t he basis of a benchmark, but aft er re- negot iat ing a new rat e, which in t he
opinion of t he lender and bor r ower , r epr esent ed t he r at e for t he bond aft er
t aki ng i nt o account t he new ci r cumst ances at t he t i me of r eset .

1.3 MODI FYI NG THE TERM TO MATURI TY OF A BOND
Cal l abl e Bon ds
Bonds t hat al l ow t he i ssuer t o al t er t he t enor of a bond, by r edeemi ng i t pr i or
t o t he original mat urit y dat e, ar e called callable bonds. The inclusion of t his
feat ur e in t he bonds st r uct ur e pr ovides t he issuer t he r ight t o fully or par t ially
ret ire t he bond, and is t herefore in t he nat ure of call opt ion on t he bond.
Since t hese opt ions ar e not separ at ed fr om t he or iginal bond issue, t hey ar e
also called embedded opt ions. A call opt ion can be an European opt ion,
wher e t he issuer specifies t he dat e on which t he opt ion could be exer cised.
Alt er nat ively, t he issuer can embed an Amer ican opt ion in t he bond, pr ovi di ng
him t he r ight t o call t he bond on or anyt ime befor e a pr e- specif ied dat e.

The call opt ion pr ovides t he issuer t he opt ion t o r edeem a bond, if int er est
rat es decline, and re- issue t he bonds at a lower r at e. The invest or , however ,
10
loses t he opport unit y t o st ay invest ed in a high coupon bond, when int erest
r at es have dr opped. The call opt ion, t her ef or e, can ef f ect ively alt er t he t er m
of a bond, and car r ies an added set of r isks t o t he invest or , in t he f or m of call
risk, and reinvest ment r isk. As we shall see lat er , t he pr ices at which t hese
bonds would t r ade in t he mar ket ar e also dif f er ent , and depend on t he
probabilit y of t he call opt ion being exercised by t he issuer. I n t he home loan
market s, pre- payment of housing loans r epr esent a special case of cal l
opt ions exer cised by bor r ower s. Housing f inance companies ar e exposed t o
t he risk of borrowers exercising t he opt ion t o pre- pay, t hus ret iring a housing
loan, when int er est r at es f all. The Cent r al Gover nment has also issued an
embedded opt ion bond t hat gi ves opt i ons t o bot h i ssuer ( Gover nment ) and
t he holder s of t he bonds t o exer cise t he opt ion of call/ put aft er expir y of 5
year s. This embedded opt ion would r educe t he cost f or t he issuer in a f alling
int er est r at e scenar io and helpf ul f or t he bond holder s in a r ising int er est r at e
scenar io.
Pu t t abl e Bon ds
Bonds t hat pr ovide t he invest or wit h t he r ight t o seek r edempt ion fr om t he
issuer , pr ior t o t he mat ur it y dat e, ar e called put t able bonds. The put opt ions
embedded in t he bond pr ovides t he invest or t he r ight s t o par t ially or f ully sell
t he bonds back t o t he issuer , eit her on or bef or e pr e- specif ied dat es. The
act ual t er ms of t he put opt ion ar e st ipulat ed in t he or iginal bond indent ur e.

A put opt ion provides t he invest or t he right t o sell a low coupon- paying bond
t o t he issuer , and invest in higher coupon paying bonds, if int er est r at es move
up. The issuer will have t o re- issue t he put bonds at higher coupons.
Put t able bonds represent a re- pricing risk t o t he issuer. When int erest rat es
incr ease, t he value of bonds would decline. Ther ef or e put opt ions, which seek
r edempt ions at par , r epr esent an addit ional loss t o t he issuer .
Con v er t i bl e Bon ds
A conver t ible bond pr ovides t he invest or t he opt ion t o conver t t he value of
t he out st anding bond int o equit y of t he bor r owing f ir m, on pr e- specified
t erms. Exercising t his opt ion leads t o redempt ion of t he bond prior t o
mat ur it y, and it s r eplacement wit h equit y. At t he t ime of t he bonds issue,
t he indent ur e clear ly specif ies t he conver sion r at io and t he conver si on pr i ce.
The conver sion r at io r ef er s t o t he number of equit y shar es, which will be
issued in exchange f or t he bond t hat is being conver t ed. The conver sion pr ice
is t he r esult ing pr ice when t he conver sion r at io is applied t o t he value of t he
bond, at t he t ime of conver sion. Bonds can be f ully conver t ed, such t hat
t hey are fully redeemed on t he dat e of conversion. Bonds can also be issued
as par t i al l y conver t i bl e, when a par t of t he bond i s r edeemed and equi t y
shar es ar e issued in t he pre- specified conversion rat io, and t he non-
conver t ible por t ion cont inues t o r emain as a bond.

11
1.4 MODI FYI NG THE PRI NCI PAL REPAYMENT OF A
BOND
Amor t i si n g Bon ds
The st r uct ur e of some bonds may be such t hat t he pr incipal is not r epaid at
t he end/ mat ur i t y, but over t he life of t he bond. A bond, in which payment
made by t he bor r ower over t he lif e of t he bond, includes bot h int er est and
principal, is called an amort ising bond. Aut o loans, consumer loans and home
loans ar e examples of amor t ising bonds. The mat ur it y of t he amor t ising bond
r ef er s only t o t he last payment in t he amor t ising schedule, because t he
principal is repaid over t ime.
Bonds w i t h Si nk i ng Fund Pr ov i si ons
I n cer t ain bond indent ur es, t her e is a pr ovision t hat calls upon t he issuer t o
ret ire some amount of t he out st anding bonds every year. This is done eit her
by buying some of t he out st anding bonds in t he mar ket , or as is mor e
common, by cr eat ing a separ at e fund, which calls t he bonds on behalf of t he
issuer . Such pr ovisions t hat enable r et ir ing bonds over t heir lives are called
sinking f und pr ovisions. I n many cases, t he sinking f und is managed by
t r ust ees, who r egular ly r et ir e par t of t he out st anding bonds, usually at par .
Sinking funds also enable paying off bonds over t heir life, rat her t han at
mat urit y. One usual variant is applicabilit y of t he sinking fund provision aft er
few year s of t he issue of t he bond, so t hat t he funds ar e available t o t he
bor r ower f or a minimum per iod, bef or e r edempt ion can commence.
1.5 ASSET BACKED SECURI TI ES

Asset backed secur it ies r epr esent a class of fixed income secur it ies, cr eat ed
out of pooling t oget her asset s, and cr eat ing secur it ies t hat r epr esent
par t icipat ion in t he cash flows fr om t he asset pool. For example, select
housing loans of a loan originat or ( say, a housing finance company) can be
pool ed, and secur i t i es can be cr eat ed, whi ch r epr esent a cl ai m on t he
r epayment s made by home loan bor r ower s. Such secur it ies ar e called
mor t gagebacked secur it ies. I n t he I ndian cont ext , t hese secur it ies ar e
known as st r uct ur ed obligat ions ( SO) . Since t he secur it ies ar e cr eat ed f r om a
select pool of asset s of t he or iginat or , it is possible t o cher r y - pick and cr eat e
a pool whose asset qualit y is bet t er t han t hat of t he originat or. I t is also
common f or st r uct ur ing t hese inst r ument s, wit h clear cr edit enhancement s,
achieved eit her t hrough guarant ees, or t hrough t he creat ion of exclusive pre-
empt ive access t o cash flows t hr ough escr ow account s. Asset s wit h r egular
st r eams of cash flows ar e ideally suit ed for creat ing asset - backed securit ies.
I n t he I ndian cont ext , car loan and t r uck loan r eceivables have been
secur it ized. Secur it ized home loans r epr esent a ver y lar ge segment of t he US
bond mar ket s, next in size only t o t r easur y bor r owings. However , t he mar ket
12
for secur it izat ion has not developed appreciably because of t he lack of legal
clar it y and conducive r egulat or y envir onment .

The Secur it izat ion and Reconst r uct ion of Financial Asset s and Enfor cement of
Secur i t y I nt er est Act wer e appr oved by par l i ament in November 2002. The
Act also provides a legal framework for secur it izat ion of financial asset s and
asset r econst r uct i on. The securit izat ion companies or r econst r uct ion
companies shall be regulat ed by RBI . The securit y receipt s issued by t hese
companies will be secur it ies wit hin t he meaning of t he Secur it ies Cont r act
( Regulat ion) Act , 1956. These companies would have power s t o acquir e
asset s by issuing a debent ur e or bond or any ot her secur it y in t he nat ur e of
debent ur e in lieu t her eof. Once an asset has been acquired by t he asset
r econst r uct ion company, such company would have t he same power s f or
enfor cement of secur it ies as t he or iginal lender . This has given t he legal
sanct ion t o secur it ized debt in I ndia.

Model Quest i ons

1. On v al u e dat e Ju n e 1 0 , 2 0 0 0 , w h at i s t h e t er m t o m at u r i t y i n
y ear s, of a gov er n men t secu r i t y mat u r i n g on 2 3
r d
Mar ch 2 0 0 4 ?

Use t he year fr ac funct ion in Excel, wit h t he following specificat ions:
Set t lement dat e: June 10, 2000
Mat ur it y Dat e: Mar ch 23, 2004
Basis: 4. ( Gover nment secur it ies t rade on 30/ 360 European basis. We
t her efor e use 4 , in t he Excel funct ion, which applies t his day count
convent ion) .

An s: 3 . 7 8 6 y ear s.

2. Wh i ch of t h e f ol l ow i n g abou t a cal l abl e bon d i s t r u e?

a. Callable bonds always t r ade at a discount t o non- callable bonds.
b. Callable bonds expose issuer s t o t he r isk of r educed r e- invest ment
ret urn.
c. Callable bonds ar e act ually var iable t enor bonds.
d. Callable bonds are not as liquid as non- callable bonds.

An s: c.

3. Cou pon of a f l oat i n g r a t e bon d i s _ _ _ _ _ _ _
a. modified whenever t her e is a change in t he benchmar k r at e.
b. modified at pre- set int er vals wit h r efer ence t o a benchmar k r at e.
c. modified for changes in benchmark rat e beyond agreed levels.
d. modified wit hin a range, for changes in t he benchmar k r at e.

An s: b.
13
CHAPTER 2
I NDI AN DEBT MARKETS: A PROFI LE

I ndian debt mar ket s, in t he ear ly ninet ies, wer e char act er ised by cont r ols on
pr icing of asset s, segment at ion of mar ket s and bar r ier s t o ent r y, low levels of
liquidit y, limit ed number of player s, near lack of t r anspar ency, and high
t r ansact ions cost . Financial r ef or ms have signif icant ly changed t he I ndian
debt mar ket s f or t he bet t er . Most debt i nst r ument s ar e now pr i ced f r eel y on
t he mar ket s; t r ading mechanisms have been alt er ed t o pr ovide f or higher
levels of t r anspar ency, higher liquidit y, and lower t r ansact ions cost s; new
par t icipant s have ent er ed t he mar ket s, br oad basing t he t ypes of player s in
t he mar ket s; met hods of secur it y issuance, and innovat ion in t he st r uct ure of
inst r ument s have t aken place; and t her e has been a significant impr ovement
in t he disseminat ion of mar ket infor mat ion.
2.1 MARKET SEGMENTS

There are t hree main segment s in t he debt market s in I ndia, viz. ,
Gover nment Secur it ies, Public Sect or Unit s ( PSU) bonds, and cor por at e
secur it ies. The mar ket f or Gover nment Secur it ies compr ises t he Cent r e, St at e
and St at e- sponsored securit ies. I n t he recent past , local bodies such as
municipalit ies have also begun t o t ap t he debt mar ket s f or f unds. The PSU
bonds ar e gener al l y t r eat ed as sur r ogat es of sover ei gn paper , somet i mes due
t o explicit guar ant ee and oft en due t o t he comfor t of public owner ship. Some
of t he PSU bonds ar e t ax fr ee, while most bonds including gover nment
secur it ies ar e not t ax- f r ee. The RBI also issues t ax- free bonds, called t he
6. 5% RBI r elief bonds, which is a popular cat egor y of t ax- free bonds in t he
mar ket . Cor por at e bond mar ket s compr ise of commer cial paper and bonds.
These bonds t ypically ar e st r uct ur ed t o suit t he r equir ement s of inv est or s and
t he i ssui ng cor por at e, and i ncl ude a var i et y of t ai l or- made feat ur es wit h
r espect t o int er est payment s and r edempt ion. The less dominant f our t h
segment compr ises of shor t t er m paper issued by banks, most ly in t he f or m
of cer t if icat es of deposit .

The mar ket for gover nment secur it ies is t he oldest and most dominant in
t er ms of mar ket capit alisat ion, out st anding secur it ies, t r ading volume and
number of par t icipant s. I t not only pr ovides r esour ces t o t he gover nment f or
meet ing it s short t erm and long t er m needs, but also set s benchmar k f or
pricing corporat e paper of varying mat urit ies and is used by RBI as an
inst r ument of monet ar y policy. The inst r ument s in t his segment ar e f ixed
coupon bonds, commonly r ef er r ed t o as dat ed secur it ies, t r easur y bills,
f loat ing r at e bonds, zer o coupon bonds and inf lat ion index bonds. Bot h
14
Cent r al and St at e gover nment secur it ies compr ise t his segment of t he debt
mar ket .

The issues by gover nment sponsor ed inst it ut ions like, Development Financial
I nst it ut ions, as well as t he inf r ast r uct ur e- r elat ed bodies and t he PSUs, who
make r egular f or ays int o t he mar ket t o r aise medium- t er m f unds, const i t ut e
t he second segment of debt mar ket s. The gr adual wit hdr awal of budget ar y
suppor t t o PSUs by t he gover nment since 1991 has compelled t hem t o look at
t he bond mar ket for mobilising r esour ces. The pr efer r ed mode of issue has
been pr ivat e placement , bar r ing an occasional public issue. Banks, f inancial
inst it ut ions and ot her cor por at es have been t he maj or subscr iber s t o t hese
issues. The t ax- f r ee bonds, which const it ut e over 50% of t he out st anding PSU
bonds, ar e quit e popular wit h inst it ut ional player s.
The mar ket f or cor por at e debt secur it ies has been in vogue since ear ly 1980s.
Unt il 1992, int er est r at e on cor por at e bond issuance was regulat ed and was
unifor m acr oss cr edit cat egor ies. I n t he init ial year s, cor por at e bonds wer e
issued wit h sweet ener s in t he f or m of conver t ibilit y clause or equit y
war r ant s. Most cor por at e bonds wer e plain coupon paying bonds, t hough a
few variat ions i n t he f or m of zer o coupon secur i t i es, deep di scount bonds and
secur ed pr omissor y not es wer e issued.

Af t er t he de- regulat ion of int erest rat es on corporat e bonds in 1992, we have
seen a var iet y of st r uct ur es and inst r ument s in t he cor por at e bond mar ket s,
including secur it ized pr oduct s, cor por at e bond st r ips, and a var iet y of float ing
r at e inst r ument s wit h f loor s and caps. I n t he r ecent year s, t her e has been an
incr ease in issuance of cor por at e bonds wit h embedded put and call opt ions.
The maj or par t of t he cor por at e debt is pr ivat ely placed wit h t enor s of 1- 12
year s.

I nf or mat ion on t he size of t he var ious segment s of t he debt mar ket in I ndia is
not r eadily available. This is due t o t he fact t hat many debt inst r ument s ar e
pr ivat ely placed and t her ef or e not list ed on mar ket s. While t he RBI r egulat es
t he issuance of gover nment secur it ies, cor por at e debt secur it ies f all under t he
regulat ory purview of SEBI . The periodic report s of issuers and invest ors are
t her efor e sent t o t wo differ ent r egulat or s. Ther efor e, aggr egat ed dat a for t he
mar ket as a whole is dif f icult t o obt ain. The NSE pr ovides a t r ading plat f or m
for most debt inst r ument s issued in I ndia. Ther efor e, Table 2. 1 on mar ket
capit alizat ion can be said t o be indicat ive of t he r elat ive size of the various
segment s of t he debt mar ket .
The debt mar ket s also have a lar ge segment which is a non- securit ized,
t ransact ions based segment , where players are able t o lend and borrow
amongst t hemselves. These ar e t ypically shor t t er m segment s and compr ise
of call and not ice money mar ket s, which is t he most act ive segment in t he
debt mar ket s, int erbank mar ket for t er m money, mar ket s for int er- cor por at e
loans and mar ket s for r eady for war d deals ( r epos) .

15
Tabl e 2 . 1 : Mar k et Capi t al i sat i on - NSE- WDM Segmen t a s on Mar ch 3 1 ,
2008.
Secur i t y Ty pe Mar k et
Capi t al i sat i on
( Rs. cr . )
Sh ar e i n
Tot al ( % )
Gover nment Secur it ies 1, 392, 219 65. 57
PSU Bonds 96268. 47 4.53
St at e Loans 315660. 71 14. 87
Treasury Bills 111562. 13 5.25
Financial I nst it ut ions 32092. 92 1.51
Cor por at e Bonds 75675. 73 3.56
Ot hers 99867. 09 4.70
TOTAL 2123346. 28 100. 00
* Ot her s include secur it ized debt and bonds of local bodies.
2.2 PARTI CI PANTS I N THE DEBT MARKETS

Debt market s are predominant ly wholesale market s, wit h dominant
inst it ut ional invest or par t icipat ion. The invest or s in t he debt mar ket s
concent r at e in banks, f inancial inst it ut ions, mut ual f unds, pr ovident f unds,
i nsur ance compani es and cor por at es. Many of t hese par t i ci pant s ar e al so
issuer s of debt inst r ument s. The smaller number of lar ge player s has r esult ed
in t he debt mar ket s being f air ly concent r at ed, and evolving int o a wholesale
negot iat ed dealings mar ket . Most debt issues ar e pr ivat ely placed or
auct ioned t o t he par t icipant s. Secondar y mar ket dealings ar e most ly done on
t elephone, t hr ough negot i at i ons. I n some segment s such as t he gover nment
securit ies market , market makers in t he form of primary dealers have
emerged, who enable a broader holding of t reasury securit ies. Debt funds of
t he mut ual fund indust ry, comprising of liquid funds, bond funds and gilt
f unds, r epr esent a r ecent mode of int er mediat ion of r et ail invest ment s int o
t he debt mar ket s, apar t fr om banks, insur ance, pr ovident funds and financial
inst it ut ions, who have t radit ionally been maj or int ermediaries of ret ail f unds
int o debt mar ket pr oduct s.

The mar ket par t icipant s in t he debt mar ket ar e:

1. Cent r al Gover nment s, r aising money t hr ough bond issuances, t o f und
budget ar y deficit s and ot her shor t and long t er m funding r equir ement s.
2. Reser ve Bank of I ndi a, as i nvest ment banker t o t he gover nment , r aises
funds for t he gover nment t hr ough bond and t - bill issues, and also
par t icipat es in t he mar ket t hr ough open- mar ket oper at ions, in t he cour se
of conduct of monet ar y policy. The RBI r egulat es t he bank r at es and r epo
r at es and uses t hese r at es as t ools of it s monet ar y policy. Changes in
t hese benchmar k r at es dir ect ly impact debt mar ket s and all par t icipant s in
t he mar ket .
16
3. Primary dealers, who are market int ermediaries appoint ed by t he Reserve
Bank of I ndia who under wr it e and make market in government securit ies,
and have access t o t he call mar ket s and r epo mar ket s for funds.
4. St at e Gover nment s, municipalit ies and local bodies, which issue secur it ies
in t he debt mar ket s t o f und t heir development al pr oj ect s, as well as t o
finance t heir budget ar y def icit s.
5. Public sect or unit s are large issuers of debt securit ies, for raising funds t o
meet t he long t er m and wor king capit al needs. These cor por at ions ar e
also invest or s in bonds issued in t he debt mar ket s.
6. Cor por at e t r easur ies issue shor t and long t er m paper t o meet t he financial
r equi r ement s of t he cor por at e sect or . They ar e al so i nvest or s i n debt
secur it ies issued in t he mar ket .
7. Public sect or financial inst it ut ions r egular ly access debt mar ket s wit h
bonds f or f unding t heir f inancing r equir ement s and wor king capit al needs.
They also invest in bonds issued by ot her ent it ies in t he debt mar ket s.
8. Banks are t he largest invest ors in t he debt market s, part icularly t he
t r easur y bond and bill mar ket s. They have a st at ut or y r equir ement t o
hold a cer t ain per cent age of t heir deposit s ( cur r ent ly t he mandat or y
requirement is 25% of deposit s) in approved securit ies ( all government
bonds qualify) t o sat isfy t he st at ut or y liquidit y r equir ement s. Banks ar e
very large part icipant s in t he call money and overnight market s. They are
ar r anger s of commer cial paper issues of cor por at es. They ar e also act ive
in t he int erbank t er m mar ket s and r epo mar ket s f or t heir shor t t er m
funding requirement s. Banks also issue CDs and bonds in t he debt
mar ket s.
9. Mut ual funds have emerged as anot her import ant player in t he debt
mar ket s, owing pr imar ily t o t he gr owing number of bond f unds t hat have
mobilised significant amount s fr om t he invest or s. Most mut ual funds also
have specialised bond funds such as gilt funds and liquid f unds. Mut ual
funds are not permit t ed t o borrow funds, except for very short - t erm
liquidit y r equir ement s. Ther ef or e, t hey par t icipat e in t he debt mar ket s
predominant ly as invest or s, and t r ade on t heir por t folios quit e r egular ly.
10. For ei gn I nst i t ut ional I nvest or s ar e per mit t ed t o invest in Dat ed
Gover nment Secur it ies and Tr easur y Bills wit hin cer t ain specified limit s.
11. Pr ovident f unds ar e lar ge invest or s in t he bond mar ket s, as t he pr udent ial
r egulat ions gover ning t he deployment of t he f unds t hey mobi lise, mandat e
invest ment s predominant ly in t r easur y and PSU bonds. They ar e,
however, not very act ive t raders in t heir port folio, as t hey are not
per mit t ed t o sell t heir holdings, unless t hey have a funding r equir ement
t hat cannot be met t hr ough r egular accr uals and cont r ibut ions.
12. Charit able I nst it ut ions, Trust s and Societ ies are also large invest ors in t he
debt mar ket s. They ar e, however , gover ned by t heir r ules and byelaws
wi t h r espect t o t he ki nd of bonds t hey can buy and t he manner i n whi ch
t hey can t rade on t heir debt port folios.
The mat r ix of issuer s, invest or s, inst r ument s in t he debt mar ket and t heir
mat ur it ies ar e pr esent ed in Table 2. 2.

17
Tabl e 2 . 2 : Par t i ci pan t s an d Pr odu ct s i n Debt Mar k et s
I ssuer I nst r ument Mat ur i t y I nvest ors
Cent ral
Gover nment
Dat ed
Secur it ies
2- 30years RBI , Banks, I nsur ance
Compani es, Pr ovi dent
Funds, Mut ual Funds,
PDs, I ndividuals
Cent ral
Gover nment
T- Bills 91/ 182/ 364
days
RBI , Banks, I nsur ance
Funds, PDs, Mut ual
Funds, I ndividuals
St at e
Gover nment
Dat ed
Secur it ies
5- 13 years Banks, I nsur ance
Funds, RBI , Mut ual Funds,
I ndividuals, PDs.
PSUs Bonds,
St r uct ur ed
Obligat ions
5- 10 years Banks, I nsur ance
Compani es, Cor por at e,
Pr ovident Funds, Mut ual
Funds, I ndividuals
Cor por at es Debent ures 1- 12 years Banks, Mut ual Funds,
Corporat es, I ndividuals
Cor por at es,
PDs
Commercial
paper
7 days t o 1
year
Banks, Cor por at e,
Financial inst it ut ions,
Mut ual Funds, I ndi vi dual s,
FI I s
Scheduled
Commercial
Banks
7 days t o 1
year
Financial
I nst it ut ions
Cer t i f i cat es
of Deposit
( CDs) 1 year t o 3
years
Banks, Cor por at ions,
I ndividuals, Companies,
Tr ust s, Funds,
Associat ions, FI s, NRI s
Scheduled
Commercial
Banks
Bank Bonds 1- 10 years Cor por at ions, I ndividual
Compani es, Tr ust s,
Funds, Associat ions, FI s,
NRI s
Municipal
Cor por at i on
Municipal
Bonds
0- 7 years Banks, Cor por at ions,
I ndividuals, Companies,
Tr ust s, Funds,
Associat ions, FI s, NRI s
2.3 SECONDARY MARKET FOR DEBT I NSTRUMENTS

The NSE- WDM segment provides t he formal t rading plat form for t rading of a
wide r ange of debt secur it ies. I nit ially, gover nment secur it ies, t r easur y bills
and bonds issued by public sect or undert akings ( PSUs) were made available
for t rading. This range has been widened t o include non- t r adit ional
inst r ument s like, float ing r at e bonds, zer o coupon bonds, index bonds,
18
commer ci al paper s, cer t i f i cat es of deposi t , cor por at e debent ur es, st at e
government loans, SLR and non- SLR bonds issued by financial inst it ut ions,
unit s of mut ual funds and secur i t i zed debt . The WDM t r ading syst em, known
as NEAT ( Nat ional Exchange f or Aut omat ed Tr ading) , is a f ully aut omat ed
scr een based t r ading syst em t hat enables member s acr oss t he count r y t o
t r ade simult aneously wit h enor mous ease and ef f iciency. The t r ading syst em
is an order driven syst em, which mat ches best buy and sell orders on a
pr ice/ t ime pr ior it y.

Cent r al Gover nment secur it ies and t r easur y bills ar e held as demat er ialised
ent r ies in t he Subsidiar y Gener al Ledger ( SGL) of t he RBI . I n or der t o t r ade
t hese secur i t i es, par t i ci pant s ar e r equi r ed to have an account wit h t he SGL
and also a cur r ent account wit h t he RBI . The set t lement is on Deliver y ver sus
Payment ( DvP) basis. The Public Debt Of f ice which over sees t he set t lement of
t r ansact ions t hr ough t he SGL enables t he t r ansf er of secur it ies f r om one
part icipant t o anot her. Since 1995, set t lement s are on delivery - versus-
payment basis. However , aft er cr eat ion of Clear ing Cor por at ion of I ndia,
most of t he inst it ut ional t r ades ar e being set t led t hr ough CCI L wit h set t lement
guar ant ee. The set t lement t hrough CCI L is t aking place on DvP- I I I wher e
f unds and secur it ies ar e net t ed f or set t lement .

Gover nment debt , which const it ut es about t hr ee- four t h of t he t ot al
out st anding debt , has t he highest level of liquidit y amongst t he f ixed income
inst r ument s in t he secondar y mar ket . The shar e of dat ed secur it ies in t ot al
t ur nover of gover nment secur it ies has been incr easing over t he year s. Two-
way quot es ar e available f or act ive gilt secur it ies f r om t he pr imar y dealer s.
Though many t rades in gilt s t ake place t hrough t elephone, a lar ger chunk of
t r ades get s r out ed t hr ough NSE br oker s.

The inst rument - wise t ur nover f or secur it ies list ed on t he NSE- WDM i s shown
in Table 2. 3. I t is obser ved t hat t he mar ket is dominat ed by dat ed
gover nment secur i t i es ( i ncl udi ng st at e development loan) .

Tabl e 2. 3: Secu r i t y - w i se Di st r i bu t i on of Tu r n ov er on NSE WDM

Per cen t age Sh ar e of Tu r n ov er
Secu r i t i es 2 0 0 5- 06 2 0 0 6- 07 2 0 0 7- 08
Gover nment Secur it ies 72. 67 70 68. 84
Treasury Bills 22. 13 23. 71 23. 40
PSU/ I nst it ut ional Bonds 2.56 2.02 3.27
Ot hers 2.64 4.27 4.49

The maj or part icipant s in t he WDM are t he I ndian banks, foreign banks and
pr imar y dealer s, who t oget her account ed for over 59. 51% of t ur nover dur ing
2007- 08. The share of I ndian banks in t urnover is about 23. 78% in 2007- 08
whi le for eign banks const it ut e about 27. 09% and pr imar y dealer s account for
19
8. 64%. Financial inst it ut ions and mut ual funds cont ribut e about 2. 34% of t he
t ur nover . The par t icipant - wise dist r ibut ion of t ur nover is pr esent ed in Table
2. 4.

Tabl e 2. 4: Par t i ci pant - w i se Di st r i bu t i on of Tu r n ov er ( % )

Par t i ci pant
2 0 0 5-
06
2 0 0 6-
07
2 0 0 7-
08
Foreign Banks 14. 11 20. 57 27. 09
I ndian Banks 28. 07 26. 03 23. 78
Primary Dealers 21. 89 19. 82 8.64
FI s, MF and Cor por at es 3.92 2. 7 2.34
Trading Members 3.92 30. 88 38. 15
TOTAL 1 0 0 . 00 100. 00 100. 00

As seen in Table 2. 5, t he share of t op 10 securit ies in t urnover is 39. 65% in
2007- 08 and t op 50 secur it ies account ed for near ly 79. 64% of t ur nover in
t he same per iod.

Tabl e 2. 5 : Sh ar e of Top ' N' Secu r i t i es i n t h e Tu r n ov er of WDM
Segment

Year Per cen t age Sh ar e of Tu r n ov er

Top
5
Top
10
Top
25
Top
50
Top
100
1994- 95 42. 84 61. 05 80. 46 89. 81 97. 16
1995- 96 57. 59 69. 46 79. 60 86. 58 93. 24
1996- 97 32. 93 48. 02 65. 65 78. 32 90. 17
1997- 98 30. 65 46. 92 71. 25 85. 00 92. 15
1998- 99 26. 81 41. 89 64. 30 78. 24 86. 66
1999- 00 37. 11 55. 57 82. 12 90. 73 95. 28
2000- 01 42. 20 58. 30 80. 73 89. 97 95. 13
2001- 02 51. 61 68. 50 88. 73 94. 32 97. 19
2002- 03 43. 10 65. 15 86. 91 92. 74 96. 13
2003- 04 37. 06 54. 43 81. 58 90. 66 95. 14
2004- 05 43. 70 57. 51 71. 72 80. 59 89. 55
2005- 06 47. 42 59. 78 72. 02 81. 04 89. 36
2006- 07 40. 90 51. 29 65. 82 77. 15 86. 91
2007- 08 39. 65 53. 31 68. 35 79. 64 89. 55
Ret ai l Debt Mar k et
Wit h a view t o encour aging wider par t icipat ion of all classes of invest or s
acr oss t he count r y ( i ncl udi ng r et ai l i nvest or s) i n gover nment secur it ies, t he
Gover nment , RBI and SEBI have int r oduced t r ading in gover nment secur it ies
20
for ret ail invest ors. Trading in t his ret ail debt market segment ( RDM) on NSE
has been int r oduced w. e. f. Januar y 16, 2003.
RDM Tr adi ng:
Trading t akes place in t he exist ing Capit al Mar ket segment of t he Exchange
and in t he same manner in which t he t r ading t akes place in t he equit ies
( Capit al Mar ket ) segment . The RETDEBT Mar ket facilit y on t he NEAT syst em
of Capit al Market Segment is used for ent ering t ransact ions in RDM session.
The t r ading holidays and mar ket t imings of t he RDM segment ar e t he same as
t he Equit ies segment .

Tr ading Par amet er s:

The t r ading par amet er s for RDM segment ar e as below:

Face Value Rs. 100/ -
Per mit t ed Lot Size 10
Tick Size Rs. 0. 01
Operat ing Range +/ - 5%
Mkt . Type I ndi cat or D ( RETDEBT)
Book Type RD

Trading in Ret ail Debt Market is permit t ed under Rolling Set t lement , where in
each t r ading day is consider ed as a t r ading per iod and t r ades execut ed dur ing
t he day are set t led based on t he net obligat ions for t he day. Set t lement is on
a T+ 2 basis. Nat ional Secur it ies Clear ing Cor por at ion Limit ed ( NSCCL) is t he
clear ing and set t lement agency for all deals execut ed in Ret ail Debt Mar ket .
Negot i at ed Deal i n g Sy st em
The fir st st ep t owards elect ronic bond t rading in I ndia was t he int roduct ion of
t he RBI s Negot iat ed Dealing Syst em in February 2002.

NDS, int er alia, f acilit at es scr een based negot iat ed dealing f or secondar y
mar ket t r ansact ions in gover nment secur it ies and money mar ket i nst r ument s,
online r epor t ing of t r ansact ions in t he inst r ument s available on t he NDS and
disseminat ion of t r ade infor mat ion t o t he mar ket . Gover nment Secur it ies
( including T- bills) , call money, not ice/ t erm money, repos in eligible securit ies
ar e available for negot iat ed dealing t hr ough NDS among t he member s. NDS
member s concluding deals, in t he t elephone mar ket in inst r ument s available
on NDS, are required t o report t he deal on NDS syst em wit hin 15 minut es of
concluding t he deal. NDS int er faces wit h CCI L for set t lement of gover nment
secur it ies t r ansact ions f or bot h out r ight and r epo t r ades done/ r epor t ed by
NDS member s. Ot her inst r ument s viz, call money, not ice/ t er m money,
commer cial paper and cer t ificat e of deposit s set t le as per exist ing set t lement
pr ocedure.
21

Wit h t he obj ect ive of creat ing a broad- based and t ransparent market in
gover nment secur it ies and t her eby enhancing liquidit y in t he syst em, t he NDS
was designed t o pr ovide:

Elect r onic bidding in pr imar y mar ket auct ions ( T- Bills, dat ed secur it ies,
st at e gover nment secur it ies) by member s,
Elect r onic bidding for OMO of RBI including r epo auct ions under LAF,
Scr een based negot iat ed dealing syst em for secondar y mar ket
oper at ions,
Repor t ing of deals in gover nment secur it ies done among NDS
member s out side t he syst em ( over t elephone or using brokers of
exchanges) f or set t lement ,
Disseminat ion of t r ade infor mat ion t o NDS member s,
Count r ywide access of NDS t hr ough I NFI NET,
Elect r onic connect ivit y for set t lement of t r ades in secondar y mar ket
bot h f or out r ight and r epos eit her t hr ough CCI L or dir ect ly t hr ough
RBI , and Cr eat ion and maint enance of basic dat a of inst r ument s and
member s.

The f unct ional scope of t he NDS r elat ing t o t r ading includes:

giving/ r eceiving a Quot e,
placing a call and negot iat ion ( wit h or wit hout a r ef er ence t o t he quot e) ,
ent er ing t he deals successf ully negot iat ed,
set t ing up pr efer r ed count er par t y list and exposur e limit s t o t he
count er par t ies,
disseminat ion of online mar ket inf or mat ion such as t he last t r aded pr ices
of secur i t i es, volume of t r ansact ions, yield cur ve and inf or mat ion on live
quot es,
int er face wit h Secur it ies Set t lement Syst em for facilit at ing set t lement of
deals done in gover nment secur it ies and t r easur y bills.
facilit y for r epor t ing on t r ades execut ed t hr ough t he exchanges for
inf or mat ion disseminat ion and set t lement in addit ion t o deals done
t hr ough NDS.
The syst em is designed t o maint ain anonymit y of buyers and sellers from t he
mar ket but only t he vit al infor mat ion of a t r ansact ion viz. , I SI N of t he
securit y, nome nclat ur e, amount ( f ace value) , pr ice/ r at e and/ or indicat ive
yield, in case applicable, ar e disseminat ed t o t he mar ket , t hr ough Mar ket and
Tr ade Wat ch.

The benefit s of NDS include:

Tr anspar ency of t r ades in money and gover nment secur it ies mar ket ,
Elect r onic connect ivit y wit h secur it ies set t lement syst ems, t hus,
eliminat ing submission of physical SGL for m,
22
Set t lement t hr ough elect r onic SGL t r ansfer ,
Eliminat ion of er r or s and discr epancies and delay inher ent in manual
pr ocessing syst em, and
Elect r onic audit t rail for bet t er monit oring and cont rol.

NDS- OM
NDS was int ended t o be used pr incipally f or bidding in t he pr imar y auct ions
of G- secs conduct ed by RBI , and f or t r ading and r epor t ing of secondar y
mar ket t r ansact ions. However , because of sever al t echnic al pr oblems and
syst em inefficiencies, NDS was being used as a r epor t ing plat for m for
secondar y mar ket t r ansact ions and not as a dealing syst em. For act ual
t ransact ions, it s role was limit ed t o placing bids in primary market auct ions.
Much of secondar y market in t he bond mar ket cont inued t o be br oker
int er mediat ed.

I t was t her ef or e, decided t o int r oduce a scr een- based ( i. e elect r onic)
anonymous or der mat ching syst em, int egr at ed wit h NDS. This syst em ( NDS-
OM) has become oper at ional wit h ef f ect f r om August 1, 2005.

NDS- OM is an elect ronic, screen based, anonymous order driven t rading
syst em int r oduced by RBI as par t of t he exist ing NDS syst em t o f acilit at e
elect r onic dealing in gover nment secur it ies. I t is accessible t o member s
t hr ough RBI s I NFI NET Net wor k. The syst em facilit at es pr ice discover y,
liquidit y, incr eased oper at ional ef f iciency and t r anspar ency. The NDS- OM
Syst em suppor t s t r ading in all Cent r al Gover nment Dat ed Secur it ies and St at e
Gover nment secur it ies in T+ 1 set t lement t ype. Since August 1, 2006 t he
syst em was enhanced t o f acilit at e t r ading in Tr easur y Bills and When I ssued
t ransact ion in a securit y aut horized for issuance but not as yet act ually
issued. All WI t ransact ions are on an if basis, t o be set t led if and when t he
act ual secur i t y is issued. Fur t her , RBI has per mit t ed t he execut ion of int r a-
day shor t sale t r ansact ion and t he cover ing of t he shor t posit ion in
gover nment secur it ies can be done bot h on and out side t he NDS- OM plat f or m
i. e. t hr ough t elephone mar ket .

The order syst em is purely order driven wit h all bids/ offers being mat ched
based on pr ice/ t ime pr ior it y f or secur it ies t r aded on pr ice t er ms and
yield/ t ime pr ior it y f or secur it ies t r aded on yield, ensur ing t r anspar ency and
fairness t o all users. This ensures a level playing field for all part icipant s. The
t rader get s t he best bid/ offer in t he syst em. I t t hen t ries t o mat ch t he sale
or der s wit h t he pur chase or der s available on t he syst em. When a mat ch
occur s, t he t r ade is confir med. The count er par t ies ar e not awar e of each
ot hers ident it ies- hence t he anonymous nat ur e of t he syst em.

While init ially only banks and pr imar y dealer s could t r ade on it , NDS- OM has
been gr adually expanded t o cover ot her inst it ut ional player s like insur ance
23
companies, mut ual f unds, et c. Fur t her , NDS- OM has been ext ended t o cover
all ent it ies r equir ed by law or r egulat ion t o invest in Gover nment secur it ies
such as deposit t aking NBFCs, Pr ovident Funds, Pension Funds, Mut ual Funds,
I nsur ance Companies, Cooper at ive Banks, Regional Rur al Banks, Tr ust s, et c.

The NDS- OM has sever al advant ages over t he er st while t elephone based
mar ket . I t is f ast er , t r anspar ent , cheaper and pr ovides benef it s t o it s user s
like st r aight t hr ough pr ocessing, audit s t r ails for t r ansact ions. St r aight
t hr ough pr ocessi ng ( STP) of t ransact ions means t hat , f or par t icipant s using
CCI Ls clear ing and set t lement syst em, once a deal has been st r uck on NDS-
OM, no f ur t her human int er vent ion is necessar y r ight upt o set t lement , t hus
eliminat ing possibilit ies human er r or s. The t r ades agr eed on t hi s syst em f l ow
di r ect l y t o CCI L f or set t l ement .

Model Quest i ons

1 . Wh i ch of t h e f ol l ow i n g abou t t h e mar k et capi t al i sat i on of
cor por at e bon ds i n t h e NSE WDM i s t r u e?

a. Cor por at e bonds account for over 10% of t he t ot al mar ket capit alisat ion.
b. Cor porat e bonds r epr esent t he second lar gest segment of bonds, af t er
Government securit ies.
c. Mar ket capit alisat ion of cor por at e bonds is lower t han t hat of list ed st at e
loans.
d. None of t he above.

An s: c

2 . Th e most act i v e par t i ci pan t s i n t h e WDM seg men t of t h e NSE ar e:

a. Primary dealers
b. Scheduled banks
c. Trading members
d. Mut ual Funds

An s: b

3 . Wh i ch of t h e f ol l ow i n g st at emen t s ar e t r u e abou t NDS- OM ?

a. NDS- OM is a screen- based anonymous or der mat ching syst em
b. NDS- OM became oper at ional wit h ef f ect f r om August 1, 2005
c. NDS- OM is fast er , t r anspar ent and cheaper and pr ovides benefit s like
audit t rail.
d. All of t he above

Ans: d
24
CHAPTER 3
CENTRAL GOVERNMENT SECURI TI ES:
BONDS
3.1 I NTRODUCTI ON

The gover nment bond mar ket , made up of t he long- t er m mar ket bor r owings
of t he gover nment , is t he lar gest segment of t he debt mar ket .

The gover nment secur it ies mar ket has wit nessed significant t r ansfor mat ion in
t he 1990s in t er ms of mar ket design. The most significant development s
include int r oduct ion of auct ion- based pr ice det er minat ion f or gover nment
secur it ies, development of new inst r ument s and mechanisms f or gover nment
bor r owing as well as par t icipat ion by new mar ket par t icipant s, incr ease in
informat ion disseminat ion on market borrowings and secondar y mar ket
t r ansact ions, scr een based negot iat ions for t r ading, and t he development of
t he yield cur ve for gover nment secur it ies for mar king- t o- mar ket por t folios of
banks. Dur ing t he last one decade, RBI int r oduced t he syst em of pr imar y
dealers ( PDs) and sat ellit e dealers ( since discont inued from December 2002) ,
int r oduced deliver y ver sus payment ( DvP) in secur it ies set t lement , expanded
t he number of player s in t he mar ket wit h facilit y for non- compet it ive bidding
in auct ions, and allowed wider par t icipat ion in const it uent Subsidiar y Gener al
Ledger ( SGL) account s. The gover nment secur it ies mar ket also benefit ed
f r om emer gence of liquidit y ar r angement t hr ough t he Liquidit y Adj ust ment
Facilit y ( LAF) , expansion of t he r epo mar ket s, complet e st oppage of
aut omat ic monet isat ion of deficit s, and emer gence of self r egulat or y bodies,
such as, t he Pr imar y Dealer s Associat ion of I ndia ( PDAI ) and t he Fixed
I ncome Money Mar ket s and Der ivat ives Associat ion ( FI MMDA) . Cont inuous
r ef or ms i n t he G- Sec market are being under t aken f or impr oving mar ket
design and liquidit y.

To enhance liquidit y and ef f iciency, some impor t ant init iat ives have been
t aken such as: ( i) int r oduct ion of r epo/ r ever se r epo oper at ions in gover nment
secur it ies t o f acilit at e par t icipant s of manage shor t t er m liquidit y mismat ches
( ii) oper at ionalisat ion of Negot iat ed Dealing syst em ( NDS) , an aut omat ed
elect r onic t r ading plat f or m ( c) est ablishment of Clear ing Cor por at ion of I ndia
Lt d. ( CCI L) f or pr oviding an ef f icient and guar ant eed set t lement pl at f or m ( d)
i nt r oduct i on of G- secs in st ock exchanges ( e) int r oduct ion of Real t ime Gr oss
Set t lement Syst em ( RTGS) which addresses set t lement risk and facilit at es
liquidit y management , ( g) adopt ion of a modified Delivery - versus- Payment
mode of set t lement which pr ovides for net set t lement of bot h funds and
secur it ies legs and ( h) announcement of an indicat ive auct ion calendar for
Treasury Bills and Dat ed Securit ies.
25

Sever al init iat ives have been t aken t o widen t he invest or base for gover nment
secur i t i es. To enable small and medium sized invest ors t o part icipat e in t he
pr imar y auct ion of gover nment secur it ies, a Scheme of Non Compet it ive
Bidding was int r oduced in Januar y 2002, t his scheme is open t o any per son
including f ir ms, companies, cor por at e bodies, inst it ut ions, pr ovident f unds
and any ot her ent it y prescribed by RBI .

I n or der t o pr ovide banks and ot her inst it ut ions wit h a mor e efficient t r ading
plat form, an anonymous order mat ching t rading plat form ( NDS- OM) was
made operat ional from August 1, 2005. Access t o NDS OM was init ially
allowed t o commer cial banks and PDs but lat er ext ended t o ot her NDS
members such as insurance companies, mut ual funds and bigger provident
f unds. I n addit ion t o t he dir ect access, indir ect access t hr ough t he Const it uent
Subsidiar y Gener al Ledger ( CSGL) r out e was per mit t ed f r om May 2007 t o
select cat egor y of par t icipant s, viz, deposit t aking NBFCs, pr ovident funds,
pension f unds, mut ual f unds, insur ance companies, cooper at ive banks,
r egional r ur al banks and t r ust s. Wit h effect from November 2007, t he CSGL
f acilit y was ext ended t o t he Syst emically I mpor t ant Non- Deposit t aking
NBFCs ( NBFC- ND- SI ) . Fr om May 2008, access t o t he CSGL f acilit y on NDS- OM
was f ur t her ext ended t o ot her non- deposit t aking NBFCs, cor por at es and FI I s.
These ent it ies ar e allowed t o place or der s on NDS- OM t hrough direct NDS- OM
member s vi z, banks and PDs, usi ng t he CSGL r out e. Such t r ades woul d set t l e
t hr ough t he CSGL account and cur r ent account of t he NDS- OM member.

To pr ovide an oppor t unit y t o mar ket par t icipant s t o manage t heir int er est r at e
r isk mor e ef f ect ively and t o impr ove liquidit y in t he secondar y mar ket , shor t
sales was per mit t ed in dat ed gover nment secur it ies dur ing Febr uar y 2006.
When I ssued ( WI ) t r ading in Cent r al gover nment secur it ies was also
int r oduced in May 2006. WI t r ades ar e essent ially for war d t r ansact ions in a
secur it y which is st ill t o be issued. The shor t sale and when issued
t r ansact ions int r oduced in Febr uar y 2006 and May 2006 r espect ively wer e
init ially permit t ed t o be undert aken only t o NDS- OM. Wit h a view t o
encour aging wider mar ket par t icipat ion, t he cover t r ansact ions of shor t sales
and when issued wer e per mit t ed t o be under t aken out side NDS- OM i. e.
t hr ough t he t elephone mar ket or t hr ough pur chases in pr imar y issuance wit h
ef f ect from January 1, 2008.

The set t lement syst em f or t r ansact ions in gover nment secur it ies was
st andardized t o T+ 1 cycle wit h a view t o provide t he part icipant s wit h more
pr ocessing t ime at t heir disposal and t her ef or e, t o enable bet t er management
of bot h f unds as well as risk.

Holding a cur r ent account and SGL account wit h t he Reser ve Bank of I ndia
was mandat or y f or set t lement of Gover nment secur it y t r ansact ions by t he
NDS member s. However , t he medium t er m obj ect ive of t he Reser ve Bank is
t o allow cur r ent account facilit y only t o banks and PDs, which necessit at es
26
phasing out of cur r ent account s held by t he non- bank and non PD ent it ies. I n
t his r egar d, t o f acilit at e t he set t lement of Gover nment secur it y t r ansact ions
under t aken by t he non- bank and non- PD NDS member s, a syst em of Mult i
Modal Set t lement s ( MMS) in Government Securit ies market was put in place.
Under t his ar r angement , t he f unds leg of t he t r ansact ion is set t led t hr ough
t he f und account s mai nt ai ned by t hese ent i t i es and sel ect commer ci al banks
chosen as designat ed set t lement banks ( DSB) . All Government securit ies
relat ed t ransact ions, viz secondary market , primary market and servicing of
Gover nment secur it ies ( int er est payment s and r epayment s) f or t hese ent it ies
will be car r ied out t hr ough t he cur r ent account of t he DSB wit h whom t he
non- bank and non- PD ent it ies open t he set t lement account . The syst em
became effect ive fr om June 16, 2008.
As a result of t he gradual reform process undert aken over t he years, t he
I ndian G- Sec mar ket has now become incr easingly br oad- based,
char act er ised by an ef f icient auct ion pr ocess, an act ive secondar y mar ket and
a fairly liquid yield curve up t o 30 years. An act ive Primary Dealer ( PD)
syst em and elect r onic t r ading and set t lement t echnology t hat ensur e safe
set t lement wit h St r aight Thr ough Pr ocessing ( STP) and cent r al count er par t y
guar ant ee suppor t t he mar ket now.
The Reserve Bank init iat ed significant measures during 2007- 08 t o f ur t her
br oaden and deepen t he Gover nment Secur it ies mar ket in consult at ion wit h
market par t icipant s. The salient feat ur es of t he development al measur es
under t aken dur ing t he year included:
i. Per mit t ing shor t sales and when issued t r ansact ions t o be cover ed
out side NDS- OM plat form.
ii. Ext ension of NDS- OM plat form t o cert ain qualified gilt account
hol der s and
iii. Put t ing in place a set t lement mechanism t o per mit set t lement of
Gover nment secur it ies t r ansact ions t hr ough f und account s
maint ained wit h commer cial banks.
These r ef or ms have r esult ed in a mar ked change in t he nat ur e of inst r ument s
offer ed, a wider invest or base and a pr ogr essive movement t owar ds mar ket -
det er mined int er est r at es. The mar ket for gover nment secur it ies has,
however , r emained lar gely capt ive and wholesale in nat ur e, wit h banks and
inst it ut ions being t he maj or invest ors in t his segment . While t he pr imar y
mar ket for gover nment secur it ies wit nessed huge act ivit y due t o incr eased
bor r owing needs of t he gover nment , only a small par t of t he out st anding
st ock finds it s way int o t he secondar y mar ket .

The number of t r ansact i ons i n t he secondar y mar ket cont inues t o be small
relat ive t o t he size of out st anding debt and t he size of t he part icipant s. The
liquidit y cont inues t o be t hin despit e a shif t t o scr een- based t rading on NSE.
27
The holding of G- Secs among t he financial inst it ut ions has been more
diver sified, par t icular ly, wit h t he emer gence of insur ance and pension funds
as a durable invest or class for t he long- t er m secur it ies. This became possible
due t o t he sust ained effor t s devot ed t o elongat ion of t he mat ur it y pr ofile of
gover nment secur it ies.
3.2 G-SECS: TRENDS I N VOLUMES, TENOR AND YI ELDS

The gover nment r aises r esour ces in t he debt mar ket s, t hr ough mar ket
borrowings, predominant ly t o fund t he fiscal deficit . Mar ket bor r owings,
whi ch f unded about 18% of t he gr oss f i scal def i ci t s in 1990- 91, const it ut ed
77. 1% of t he gross fiscal deficit in 2007- 08, and have emerged as t he
dominant sour ce of f unding of t he def icit .

During 2007- 08, t he Cent r al Gover nment and st at e gover nment s bor r owed
Rs. 1, 88, 205 cr or e and Rs. 67, 779 cr or e r espect ively t hr ough pr imar y
issuance. The gr oss bor r owings of t he cent r al and st at e gover nment s t aken
t oget her incr eased by 19. 3% fr om Rs. 2, 00, 198 cr or e in 2006- 07 t o
Rs. 2, 55, 984 cr or e dur ing 2007- 08 while t heir net bor r owings incr eased by
32.00% from Rs. 1,25, 549 crore t o Rs. 1, 65, 728 crore in 2006- 07. The gross
and net mar ket bor r owings of Cent r al Gover nment ar e budget ed t o incr ease
furt her t o Rs. 1, 75, 780 crore and Rs. 99, 000 crore, respect ively during 2007-
08, while t hose of t he st at e gover nment s ar e t o increase Rs. 59, 062 cr or e and
Rs. 44, 737 crore.

Gover nment has been consciously t r ying t o lengt hen mat ur it y pr of ile in t he
absence of call/ put opt ions associat ed wit h secur it ies. A secur it y wit h call/ put
opt ions was int r oduced which would help t he gover nment r et ir e it s high cost
debt s. During 2007- 08, t her e was no pr imar y issuance of dat ed secur it ies
wit h mat ur it y of 5 year s. Ar ound 42. 9% of Cent r al Gover nment bor r owings
wer e ef f ect ed t hr ough secur it ies wit h mat ur it ies above 10 year s. The
maxi mum mat ur i t y of pr imar y issuance incr eased t o 30 year s. The wei ght ed
average mat urit y of dat ed securit ies issued during t he year increased
mar gi nal l y t o 14. 9 year s i n 2007- 08 from 14. 7 years 2006- 07. The mat ur it y
pr of ile of gover nment bor r owings has been going up st eadily si nce 1995- 96,
except in 2000- 01. The weight ed average mat urit y of out st anding st ock of
dat ed secur it ies incr eased fr om 9. 78 year s in 2006- 07 t o 9.84 years in 2007-
08.

The year 2007- 08 wit nessed an increase in t he cost of borrowings. The yields
on pr i mary issues of dat ed gover nment secur it ies eased dur ing t he year wit h
t he cut - off yield var ying bet ween 7. 55% and 8. 64% dur ing 2007- 08 as
against t he r ange of 7. 06 t o 8. 75% dur ing t he pr eceding year . Table 3. 1
provides a summary of average mat urit y and cut - of f yields in primary market
bor r owings of t he gover nment .

28
Tabl e 3 . 1 : Mar k et Bor r ow i n gs - Av er age Ten or an d Yi el d
Year No . o f
I ssu es
Tot al Amount
I ssu ed ( Rs. cr . )
Wei gh t ed
Ten or ( Yr s)
Wei gh t ed Cu t -
of f
Yi el d ( % p. a. )
1995- 96 20 38634. 24 5. 7376 13. 7496
1996- 97 12 27911. 06 5. 5112 13. 6928
1997- 98 13 43390. 39 6. 5757 12. 0100
1998- 99 32 83752. 82 7. 7064 11. 8624
1999- 00 30 86629. 85 12. 6614 11. 7661
2000- 01 19 100183. 00 10. 60 10. 95
2001- 02 34 114213. 00 14. 30 9.44
2002- 03 31 125000. 00 13. 80 7.34
2003- 04 28 121500. 00 14. 94 5.71
2004- 05 19 80350. 00 14. 13 6.11
2005- 06 30 131000. 00 16. 90 7.34
2006- 07 33 146000. 00 14. 72 7.89
2007- 08 35 156000. 00 14. 90 8.12
Sour ce: RBI Annual Repor t s
3.3 PRI MARY I SSUANCE PROCESS

The i ssuance pr ocess f or G- secs has under gone signi f i cant changes i n t he
1990s, wit h t he int r oduct ion of t he auct ion mechanism, and t he br oad basing
of par t icipat ion in t he auct ions t hr ough cr eat ion of t he syst em of pr imar y
dealer s, and t he int r oduct ion of non- compet it ive bids. RBI announces t he
auct i on of gover nment secur it ies t hr ough a pr ess not ificat ion, and invit es
bids. The sealed bids ar e opened at an appoint ed t ime, and t he allot ment is
based on t he cut - of f pr ice decided by t he RBI . Successf ul bidder s ar e t hose
t hat bid at a higher pr ice, exhaust i ng t he accept ed amount at t he cut - off
pr i ce.

The design of t r easur y auct ions is an impor t ant issue in gover nment
bor r owing. The obj ect ives of auct ion design ar e:
1. enabling higher auct ion volumes t hat sat isf y t he t ar get bor r owing
r equir ement , wit hout r ecour se t o under wr it ing and/ or devolvement ;
2. br oadening par t icipat ion t o ensur e t hat bids ar e not concent r at ed or
skewed; and
3. ensur ing efficiency t hr ough achieving t he opt imal ( lowest possible) cost of
bor r owing f or t he gover nment .

The t wo choi ces i n t r easury auct ions, which are widely known and used, are:

Discr iminat or y Pr ice Auct ions ( Fr ench Auct ion)
Unif or m Pr ice Auct ions ( Dut ch Auct ion)

29
I n bot h t hese kinds of auct ions, t he winning bids ar e t hose t hat exhaust t he
amount on of f er , beginning at t he highest quot ed pr ice ( or lowest quot ed
yield) . However, in a uniform price auct ion, all successful bidders pay a
unif or m pr ice, which is usually t he cut - off pr ice ( yield) . I n t he case of t he
discriminat ory price auct ion, all successful bidders pay t he act ual price ( yield)
t hey bid for.
I f successful bids ar e decided by filling up t he not ified amount fr om t he lowest
bid upwar ds, such an auct ion is called a yield- based auct ion. I n such an
auct ion, t he name of t he secur it y is t he cut - off yield. Such auct ion creat es a
new secur it y, ever y t ime an auct ion is complet ed. For example, t he G- sec
10. 3% 2010 der i ves i t s name f r om t he cut - of f yield at t he auct ion, which in
t his case was 10. 3%, which also becomes t he coupon payable on t he bond.
A yield- based auct i on t hus cr eat es a new secur it y, wit h a dist inct coupon r at e,
at t he end of ever y auct i on. The coupon payment and r edempt i on dat es ar e
also unique for each secur it y depending on t he deemed dat e of allot ment for
secur it ies auct ioned.

I f successf ul bi ds ar e f i lled up in t er ms of pr ices t hat ar e bid by par t icipant s
f r om t he hi ghest pr i ce downwar d, such an auct i on i s cal l ed a pr i ce- based
auct ion. A pr ice- based auct ion facilit at es t he re- issue of an exist ing securit y.
For example, in Mar ch 2001, RBI auct ioned t he 11. 43% 2015 secur i t y. Thi s
was a G- sec, which had been earlier issued and t rading in t he market . The
auct ion was for an addit ional issue of t his exist ing secur it y. The coupon r at e
and t he dat es of payment of coupons and r edempt ion ar e alr eady known.
The addit ional issue incr eases t he gr oss cash flows only on t hese dat es. The
RBI moved from yield- based auct i on t o pr i ce- based auct ion in 1998, in order
t o enable consolidat ion of G- secs t hrough re- issue of exist ing secur it ies.
Lar ge issues would also f aci l i t at e t he cr eat i on of t r easur y st r i ps, when coupon
amount s are large enough for ensuring liquidit y in t he secondary market s.
The RBI however , has t he flexibilit y t o r esor t t o yield- based auct ions, and
not ify t he same in t he auct ion not ificat ion.

For example, assume t hat t he bids as given in Table 3. 2 ar e r eceived in a
pr i ce- based auct ion for 12. 40% 2013 paper, wit h a not ified amount of Rs.
3000 cr or e. I f t he RBI decides t hat it would absor b t he ent ir e not if ied amount
from t he bids, wit hout any devolveme nt on it self or t he PDs, it would fill up
t he not ified amount from t he highest price ( lowest yield) bid in t he auct ion.
At a cut - of f pr ice of Rs. 111. 2 ( yield 10. 7402) , t he cumulat ive bids amount t o
Rs. 3700 crore. All t he bids up t o t he next highest price of Rs. 111. 2952 will
be declared as successful, while bidders at t he cut - off price will receive
allot ment s on a pro- r at a basis.

I f all t he successf ul bidder s have t o pay t he cut - off price of Rs. 111. 2, t he
auct ion is called a Dut ch auct ion, or a unif or m pr ice auct ion. I f t he successf ul
bidder s have t o pay t he pr ices t hey have act ually bid, t he auct ion fills up t he
not ified amount s, in various prices at which each of t he successful bidders
30
bi d. Thi s i s cal l ed a Fr ench auct i on, or a di scr i mi nat or y pr i ce auct ion. Each
successful bidder pays t he act ual pr ice bid by him.

Tabl e 3. 2: I l l u st r at i on of Au ct i on s
Amount bi d
( Rs. cr . )
I mpl i ed YTM at bi d pr i ce
( % per an n u m)
Pr i ce ( Rs. )
100 10. 6792 111. 6475
650 10. 6922 111. 5519
300 10. 7102 111. 4198
1400 10. 7272 111. 2952
1250 10. 7402 111. 2000
1000 10. 7552 111. 0904
750 10. 7722 110. 9663
400 10. 7882 110. 8497
300 10. 8002 110. 7624

A t r easur y auct ion is act ually a common value auct ion, because t he value of
t he auct ioned secur it y is t he secondar y mar ket pr ice t hat pr evails af t er t he
auct ion, which is unifor m for all bidder s. Ther efor e, t he loss t o a successful
bidder is less in a Dut ch r at her t han a Fr ench auct ion. I n our ear lier example,
assume t hat t he secondar y mar ket pr ice f or t he secur it y, af t er t he auct ion,
was Rs. 110. 65. I f t he auct ion was Dut ch, t he loss t o all successf ul bidder s is
uniform, at 55 paise per bond. However, if t he auct ion was French, t he
highest successf ul bidder will make a lar ge loss of near ly a r upee 99 paise per
bond. The discr iminat or y pr ice auct ion, t hus cr eat es a winner s cur se wher e
a successful bidder is one who has priced his bid higher t han t he cut - off, but
will immediat ely suffer a loss in t he market , if t he aft er- market price is closer
t o cut - off, r at her t han his bid. Ther e is a loss in t he secondar y mar ket s, even
in a Dut ch auct ion, if t he aft er- mar ket pr ice is lower t han t he cut - off.

The dif f er ence, however , is t hat t he loss is t he same f or all successf ul bidder s.
I n market s wit h discriminat ory price auct ions, players have an incent ive t o
bias t heir bids downwar d, r elat ive t o t heir own assessment of t he bonds
resale value, t o mit igat e t he impact of t he winners curse. I f players resort t o
such downwar d adj ust ment s, t he impact is on t he yields f or t he gover nment
i n t he auct ion, where t he yields would be higher t han opt imal, t o adj ust for
players winner curse effect . I n a Dut ch auct ion, t he Government is able t o
get a bet t er pr ice, as t his ef f ect is eliminat ed f r om t he bidding pr ocess.
However , Dut ch auct i ons ar e known t o suf f er f r om noisy bids, and r elat ively
lower levels of par t icipat ion, as player s ar e awar e t hat t hey would not pay
what t hey bi d, but t he cut - off price.
Discr iminat or y pr ice auct ions ar e mor e common acr oss t r easur ies of t he
wor l d, t han uni f or m price auct ions. 90% of t he 42 count r ies sur veyed by I MF,
in a st udy on auct ions, used discr iminat or y pr ice auct ions. I t is obser ved t hat
par t icipant s would like t o bid on t he basis of t heir view of valuat ion of t he
bond, r at her t han accept t he consensus valuat ion of all bids, as most believe
31
t hat t her e could be noise in t he bidding pr ocess. An out come t hat penalizes
successf ul bidder s t o t he ext ent of t he act ual dist ance bet ween t heir
valuat ion, and t he cut - off, r at her t han a unifor m penalt y for all is pr efer r ed.
Such auct ions, t her ef or e, at t r act lar ger compet it ive par t icipat ion. Resear ch
on t he ef f iciency of t he t wo alt er nat e met hods, is lar gely inconclusive.

I n t he I ndian mar ket s, discr iminat or y pr ice auct ion as well as unifor m pr ice
auct ion is used f or all bond issuances. Whet her an auct ion will be Dut ch or
Fr ench is announced in t he not ificat ion of t he auct ion.

The RBI has t he di scr et i on t o r ej ect bi ds when t he r at es at whi ch bi ds ar e
r ecei ved ar e hi gher t han t he r at es at whi ch RBI want s t o pl ace the debt .
Depending on t he pr icing obj ect ive RBI want s t o achieve and t he bidding
pat t er n of par t icipant s, bidding success and devolvement t ake place.

Non- compet it ive bids can also be submit t ed in t r easur y auct ions. Allot ment s
t o t hese bids will be first made fr om t he not ified amount , at t he weight ed
aver age pr ice of all successful bids. The cur r ent r egulat ions of RBI pr ovide for
reservat ion of 5% of t he not ified amount in all t he auct ions for non-
compet it ive bids f r om r et ail invest or s, who can apply t hr ough PDs and ot her
mar ket par t icipant s.

Gover nment of I ndia issued a r evised gener al not ificat ion on Oct ober 08,
2008 specif ying t he gener al t er ms and condit ions applicable t o all issues of
gover nment secur it ies. The r evised not if icat ion incor por at es t he f ollowing
addit ional feat ur es:
i. The auct ions f or issue of secur it ies ( on eit her yield basis or pr ice basis)
would be held eit her on Unifor m pr ice met hod or on Mult iple pr ice
met hod or any ot her met hod as may be decided. Under Uniform
price met hod, compet it ive bids of f er ed wit h r at es up t o and including
t he maximum r at e of yield or t he pr ices up t o and including t he
minimum of f er pr ice, as det er mined by RBI , would be accept ed at t he
maximum r at e of yield or minimum offer pr ice so det er mined. Bids
quot ed higher t han t he maximum r at e of yield or lower t han t he
minimum pr ice as det er mined by RBI would be r ej ect ed. Under
Mult iple pr ice met hod, t he compet it ive bids offer ed at t he maximum
rat e of yield or t he minimum offer price as det ermined by RBI would
be accept ed. Ot her bids t ender ed at lower t han t he maximum r at e of
yield or higher t han t he minimum offer price det ermined by RBI would
be accept ed at t he r at e of yield or pr ice as quot ed in t he r espect ed bid.
ii. I ndividuals and inst it ut ions can par t icipat e in t he auct ions on non-
compet i t i ve basi s, i ndi r ect l y t hr ough a schedul ed bank or a pr i mar y
dealer offering such services or any ot her agency permit t ed by RBI for
t his pur pose. Allocat ion of secur it ies t o non- compet it ive bidder s would
be at t he discr et ion of RBI and at a pr i ce not hi gher t han t he wei ght ed
aver age pr ice ar r ived at on t he basis of t he compet it ive bids accept ed
at t he auct ion or any ot her pr ice announced in t he specif ic not if icat ion.
32
The nominal amount of secur it ies allocat ed on such basis would be
r est r ict ed t o a maximum per cent age of t he aggr egat e nominal amount
of t he issue, wit hin or out side t he nominal amount , as specified by
GOI / RBI .
iii. Gover nment secur it ies can also be issued t o t he invest or s by cr edit t o
t heir Subsidiar y Gener al Ledger Account or t o t he Const it uent s
Subsidiar y Gener al Ledger Account of t he inst it ut ion as specified by
t hem, maint ained wit h RBI or by cr edit t o t heir Bond Ledger Account
maint ained wit h RBI or wit h any inst it ut ion aut horised by RBI .
iv. Of f er f or pur chase of gover nment secur i t i es can be submi t t ed i n
elect r onic for m. Payment for t he gover nment secur it ies can be made
by successf ul par t icipant s t hr ough elect r onic f und t r ansf er ( EFT) in a
secur ed envi r onment .
v. Gover nment may issue secur it ies wit h embedded der ivat ives. Such
securit ies may be repaid, at t he opt ion of Government of I ndia or at
t he opt ion of t he holder of t he secur it y, befor e t he specified
r edempt ion dat e, wher e a call opt ion / put opt ion is specif ied in t he
specif ic not if icat ion r elat ing t o t he issue of a gover nment secur it y.
Wher e neit her a call opt ion nor a put opt ion is specif ied or exer cised,
t he gover nment secur it y would be r epaid on t he dat e of r edempt ion
specified in t he specific not ificat ion.
vi. RBI would have discret ion t o accept excess subscript ions t o t he ext ent
specified in t he Specif ic Not if icat ion pert aining t o t he issue of t he
Secur it y and make allot ment of t he secur it y accor dingly.
vii. RBI can par t icipat e in auct ion as a non compet it or and will be
al l ocat ed secur i t i es at cut - off price/ yield in t he auct ions or at any ot her
pr ice/ yield decided by Gover nment .

Val u at i on of Cen t r al Gov er n men t Secu r i t i es:
Fixed I ncome Money Mar ket and Der ivat ives Associat ion of I ndia ( FI MMDA)
have i ssued gui del i nes / cl ar i f i cat i ons i n r espect of t he met hodol ogy t o be
f ollowed f or valuat ion of Gover nment Secur it ies, bonds and debent ur es et c. at
per iodical int er vals based on guidelines issued by Reser ve Bank of I ndia.

Cent r al Gover nment Secur it ies, which qualif y f or SLR
The prices as well as t he yield curve for t he Cent ral Government Securit ies is
published by FI MMDA. The curve is t ermed as t he Base Yield Curve for t he
pur pose of valuat ion. The Base Yield Cur ve st ar t s f r om six mont h t enor . The
yield for six- mont h t enor would also be applicable for mat urit ies less t han six
mont hs.

Cent r al Gover nment Secur it ies, which do not qualif y f or SLR
The Cent r al Gover nment Secur it ies, which do not qualif y f or SLR shall be
valued af t er adding 25 basis point s ( bps) above t he cor r espondi ng yi el d on
Gover nment of I ndia Secur i t i es.
33
3.4 PARTI CI PANTS I N GOVERNMENT BOND MARKETS

Tr adit ionally, debt mar ket has been an inst it ut ional mar ket all over t he wor ld.
Banks and I nst it ut ions cont r ibut e mor e in t er m of t r ading value. I n I ndia,
banks, financial inst it ut ions ( FI s) , mut ual funds ( MFs) , pr ovident f unds,
insur ance companies and cor por at es ar e t he main invest or s. Banks have been
invest ing in t his mar ket mainly due t o st at ut or y r equir ement of meet ing
St at ut or y Liquidit y Rat io ( SLR) . Many of t hese par t icipant s ar e also issuer s of
debt inst rument s. The small number of large players has result ed in t he debt
mar ket s being fair ly concent r at ed, and evolving int o a wholesale negot iat ed
dealings market . Most debt issues are privat ely placed or auct ioned t o t he
par t icipant s. Secondar y mar ket dealings ar e most ly under t aken t hr ough
t elephonic negot iat ions among market part icipant s. I n some segment s, such
as t he gover nment secur it ies mar ket , mar ket maker s in t he f or m of pr imar y
dealer s have emer ged, which enable a br oader holding of t r easur y secur it ies.
Debt funds of t he mut ual fund indust r y, compr ising of liquid funds, bond
funds and gilt funds, r epr esent a r ecent mode of int er mediat ion of r et ail
invest ment s int o t he debt mar ket s.

The mar ket par t icipant s in t he debt mar ket ar e descr ibed below:

i. Cent ral Gover nment r aises money t hr ough issuance of bonds and T- bill
t o fund budget ar y deficit s and ot her shor t and long- t er m f unding
requirement s t hrough Reserve Bank of I ndia ( RBI ) .
ii. RBI par t icipat es in t he mar ket t hr ough open- market operat ions as well
as t hr ough Liquidit y Adj ust ment f acilit y ( LAF) in t he cour se of conduct of
monet ar y policy. RBI also r egulat es t he bank r at es and r epo r at es, and
uses t hese r at es as indir ect t ools of it s monet ar y policy. Changes in
t hese benchmar k r at es dir ect ly impact debt mar ket s and all par t icipant s
in t he mar ket as ot her int er est r at es r ealign t hemselves wit h t hese
changes.
iii. Pr imar y Dealer s ( PDs) , who ar e mar ket int er mediar ies appoint ed by
RBI , under wr it e and make mar ket in gover nment secur it ies by pr oviding
t wo- way quot es, and have access t o t he call and r epo mar ket s f or f unds.
Their per f or mance is assessed by RBI on t he basis of t heir bidding
commi t ment s and t he success r at i o achi eved at pr i mar y auct i ons. They
nor mally hold most liquid secur it ies in t heir por t folio.
iv. St at e government s, municipal and local bodies issue secur it ies in t he
debt mar ket s t o fund t heir development al pr oj ect s as well as t o finance
t heir budget ar y def icit s.
v. Public Sect or Under t akings ( PSU) and t heir finance cor por at ions ar e
lar ge issuer s of debt secur it ies. They r aise f unds t o meet t he long t er m
and wor king capit al needs. These cor por at ions ar e also invest or s in
bonds issued in t he debt mar ket s.

34
vi. Cor por at es issue shor t and long- t er m paper t o meet t heir financial
r equir ement s. They ar e also invest or s in debt securit ies issued in t he
mar ket .
vii. DFI s r egular ly issue bonds f or f unding t heir f inancing r equir ement s and
wor king capit al needs. They also invest in bonds issued by ot her ent it ies
in t he debt mar ket s. Most FI s hold gover nment secur it ies in t heir
invest me nt and t r ading por t folios.
viii. Banks are t he largest invest ors in t he debt market s, part icularly in t he
gover nment secur it ies mar ket due t o SLR r equir ement s. They ar e also
t he main par t icipant s in t he call money mar ket . Banks ar r ange CP issues
of cor por at es and ar e act ive in t he int erbank t er m mar ket s and r epo
mar ket s for t heir shor t t er m funding r equir ement s. Banks also issue
CDs and bonds in t he debt mar ket s. They also issue bonds t o r aise funds
for t heir Tier- I I capi t al r equi r ement .
ix. The invest ment nor ms for insur ance companies make t hem lar ge
par t icipant s in gover nment secur it ies mar ket .
x. MFs have emer ged as impor t ant player s in t he debt mar ket , owing t o
t he gr owing number of debt funds t hat have mobilised significant
amount s f r om t he invest or s. Most mut ual f unds also have specialised
debt f unds such as gilt f unds and liquid f unds. They par t icipat e in t he
debt market s predominant ly as invest or s, and t r ade on t heir por t f olios
quit e r egular ly.
xi. For eign I nst it ut ional I nvest or s ( FI I s) ar e per mit t ed t o invest in Dat ed
Gover nment Secur it ies and Tr easur y Bills wit hin cer t ain limit s.
xii. Pr ovident and pension funds ar e lar ge invest or s in t he debt mar ket s.
The pr udent ial r egulat ions gover ning t he deployment of t he f unds
mobilised by t hem mandat e invest ment s predominant ly in t reasury and
PSU bonds. They are, however, not very act ive t raders in t heir port folio,
as t hey are not permit t ed t o sell t heir holdings, unless t hey have a
funding r equir ement t hat cannot be met t hr ough r egular accr uals and
cont r ibut ions.
xiii. Charit able inst it ut ions, t r ust s and societ ies ar e also lar ge invest or s in t he
debt mar ket s. They ar e, however , gover ned by t heir r ules and byelaws
wit h respect t o t he kind of bonds t hey can buy and t he manner in which
t hey can t r ade on t heir debt por t folios.
xiv. Si nce Januar y 2002, r et ail invest or s have been per mit t ed t o submit non-
compet it ive bids at primary auct ion t hrough any bank or PD. They
submit bids for amount s of Rs. 10, 000 and mult iples t her eof, subj ect t o
t he condi t i on t hat a si ngl e bi d does not exceed Rs. 1 cr or e. The non-
compet it ive bids upt o a maximum of 5% of t he not if ied amount ar e
accept ed at t he weight ed aver age cut off pr ice/ yield.
xv. NDS, CCI L and WDM segment of NSEI L ar e ot her impor t ant plat f or ms
for t he debt mar ket which ar e discussed in gr eat er det ail in subsequent
sect ions.
35
3.5 CONSTI TUENT SGL ACCOUNTS

Subsidiar y Gener al Ledger ( SGL) account is a f acilit y pr ovided by RBI t o lar ge
banks and financial inst it ut ions t o hold t heir invest ment s in gover nment
securit ies and t reasury bills in t he elect ronic book ent r y for m. Such
inst it ut ions can set t le t heir t r ades f or secur it ies held in SGL t hr ough a
delivery - versus- payment ( DvP) mechanism, which ensur es simult aneous
movement of funds and secur it ies. As all invest or s in gover nment secur it ies
do not have access t o t he SGL syst em, RBI has per mit t ed such invest or s t o
open a gilt wit h any ent it y aut hor ized by RBI f or t his pur pose and t hus avail
of t he DvP set t lement . RBI has per mit t ed NSCCL, NSDL, CDSL, SHCI L, banks
and PDs t o offer const it uent SGL account facilit y t o an invest or who is
int er est ed in par t icipat ing in t he gover nment secur it ies mar ket .

The f acilit ies of f er ed by t he const it uent SGL account s ar e demat er ialisat ion,
re- mat er ialisat ion, buying and selling of t r ansact ions, cor por at e act ions, and
subscript ion t o primary market issues. All ent it ies regulat ed by RBI [ including
FI s, PDs, cooper at ive banks, RRBs, local ar ea banks, NBFCs] should
necessar ily hold t heir invest ment s in gover nment secur it ies in eit her SGL
( wi t h RBI ) or CSGL account .
3.6 PRI MARY DEALERS

Pr imar y dealer s ar e impor t ant int er mediar ies in t he gover nment secur it ies
mar ket s int r oduced in 1995. I n or der t o br oad base t he Pr imar y Dealer ship
Syst em, banks were permit t ed t o undert ake Primary Dealership business
depar t ment ally in 2006- 07. Ther e ar e now 19 pr imar y dealer s in t he debt
mar ket s. They act as under wr it er s in t he pr imar y debt mar ket s, and as
mar ket maker s in t he secondar y debt mar ket s, apar t fr om enabling t he
par t icipat ion of a number of const it uent s in t he debt mar ket s.

The obj ect ives of set t ing up t he syst em of primary dealers are
2
:
i. To st r engt hen t he infr ast r uct ur e in t he gover nment secur it ies mar ket in
or der t o make it vibr ant , liquid and br oad- based;
ii. To develop under wr it ing and mar ket making capabilit ies for gover nment
securit ies out side t he Reserve Bank, so t hat t he Reserve Bank could
gr adually shed t hese funct ions;
iii. To impr ove secondar y mar ket t r ading syst em t hat would cont r ibut e t o
pr ice discover y, enhance liquidit y and t ur nover and encour age volunt ar y
holding of gover nment secur it ies among a wider invest or base; and
iv. To make pr imar y dealer s an ef f ect ive conduit f or conduct ing open mar ket
operat ions.

2
The following sect ions on primary dealers and sat ellit e dealers have been downloaded from
www.rbi.org.in.
36
3. 6. 1 El i gi bi l i t y

The f ollowing inst it ut ions ar e eligible t o apply for pr imar y dealer ship:
i. Subsidiar ies of scheduled commer cial banks and all I ndia financial
inst it ut ions dedicat ed pr edominant ly t o t he secur it ies business and in
par t icular t o t he gover nment secur it ies mar ket ;
ii. Company incor por at ed under t he Companies Act , 1956 and engaged
pr edominant ly in secur it ies business and in par t icular t he gover nment
secur it ies mar ket ;
iii. Subsidiar ies/ j oint vent ur es set up by ent it ies incor por at ed abr oad under
For eign I nvest ment Pr omot ion Boar d ( FI PB) appr oval; and
iv. Banks which do not have a par t ly or wholly owned subsidiar y
under t aking PD business and f ulf ill t he f ollowing cr it er ia:
a. Minimum net owned funds ( NOF) of Rs. 1, 000 crore
b. Mi ni mum CRAR of 9 per cent .
c. Net NPAs of less t han 3 per cent and a pr ofit making r ecor d for
t he last t hr ee year s.
3. 6. 2 Bi ddi ng Commi t ment

A pr imar y dealer has t o make an annual commit ment t o bid f or t he
Gover nment of I ndia dat ed secur it ies and auct ion t r easur y bills auct ions on
annual basis. However success r at io r equir ement of 40% of bidding
commi t ment i n r espect of T- Bills auct ion which will be monit or ed on a half
year ly basis. The aggr egat e bids should not be less t han a specif ied amount .
The agreed minimum amount of bids has t o be separat ely indicat ed for dat ed
securit ies and t reasury bills.
While bidding, t he pr imar y dealer has t o achieve a minimum success r at io of
40 per cent f or dat ed secur it ies and 40 per cent f or t r easur y bills. The
Reser ve Bank holds discussions wit h t he pr imar y dealer s in t he mont h of
Mar ch, immediat ely af t er t he announcement of t he Cent r al Gover nment ' s
budget , t o finalise t he annual business plan of each pr imar y dealer . The
business plan is inclusive of bidding commit ment and under wr it ing obligat ion.
3. 6. 3 Under w r i t i ng

Concomit ant wit h t he obj ect ives of t he PD syst em, t he PDs ar e expect ed t o
suppor t t he pr imar y issues of dat ed secur it ies of Cent r al Gover nment and
St at e Gover nment and Tr easur y Bills of Cent r al Gover nment , t hr ough
under wr it ing/ bidding commit ment s.

Dat ed Secur it ies of Cent r al Gover nment

1. The underwrit ing commit ment on dat ed secur it ies of Cent r al
Gover nment will be divided int o t wo par t s ( i) Minimum Under wr it ing
Commit ment ( MUC) and ii) Addit ional Compet it ive Under wr it ing ( ACU) .
37
2. The MUC of each PD will be comput ed t o ensur e t hat at least 50% of
t he not if ied amount of each issue is mandat or ily under wr it t en equally
by al l PDs. The shar e under MUC wi l l be uni f or m f or al l PDs,
ir r espect ive of t heir capit al or balance sheet size. The r emaining
por t ion of t he not ified amount will be under wr it t en t hr ough an
Addit ional Compet it ive Under wr it ing ( ACU) auct ion.
3. RBI will announce t he MUC of each PD and t he balance amount which
will be under wr it t en under t he ACU auct ion. I n t he ACU auct ion, each
PD would be r equir ed t o bid f or an amount at least equal t o it s shar e of
MUC. A PD cannot bid for more t han t he 30 percent of t he not ified
amount in t he ACU auct ion.
4. The auct ion could eit her be unif or m pr ice- based or mult iple pr ice-
based depending upon t he mar ket condit ions and ot her r elevant
fact or s which will be announced before t he underwrit ing auct ion of
each issue.
5. Bids will be t ender ed by PDs wit hin t he st ipulat ed t ime, indicat ing bot h
t he amount of t he under wr it ing commit ment and under wr it ing
commission r at es. A PD can submit mult iple bids for under wr it ing.
Dependi ng upon t he bids submit t ed f or under wr it ing, RBI will decide
t he cut - off rat e of commission and inform t he PDs.
6. All successful bidder s in t he ACU auct ion will be paid under wr it ing
commi ssi on on t he ACU segment as per t he auct i on r ul es. Those PDs
who succeed in t he ACU for 4 per cent and above of t he not ified
amount of t he issue, will be paid commission on t he MUC at t he
wei ght ed aver age of al l t he accept ed bi ds i n t he ACU. Ot her s wi l l get
commission on t he MUC at t he weight ed aver age r at e of t he t hr ee
lowest bids in t he ACU.
7. I n t he GOI secur it ies auct ion, a PD should bid for an amount not less
t han t he t heir t ot al under wr it ing obligat ion. I f t wo or mor e issues ar e
float ed on t he same day, t he minimum bid amount will be applied t o
each issue separat el y.
8. Under wr it ing commission will be paid on t he amount accept ed f or
under wr it ing by t he RBI ir r espect ive of t he act ual amount of
devolvement , by cr edit t o t he cur r ent account of t he r espect ive PDs at
t he RBI , For t , Mumbai, on t he dat e of issue of secur it y.
9. I n case of devolvement , PDs would be allowed t o set - off t he accept ed
bids in t he auct ion against t heir under wr it ing commit ment accept ed by
t he Reser ve Bank. Devolvement of secur it ies, if any, on PDs will t ake
place on pro- r at a basi s, depending upon t he amount of under wr it ing
obligat ion of each PD aft er set t ing off t he successful bids in t he auct ion.
10. RBI r eser ves t he r ight t o accept any amount of under wr it ing up t o 100
per cent of t he not if ied amount or even r ej ect all t he bids t ender ed by
PDs for under wr it ing, wit hout assigning any r eason.

38
Dat ed Secur it ies of St at e Gover nment s

1. On announcement of an auct ion of dat ed secur it ies of t he St at e
Government s for which auct ion is held, RBI may invit e PDs t o
collect ively bid t o under wr it e upt o 100 per cent of t he not if ied amount
of St at e Development Loans ( SDL) .
2. A PD can bi d t o under wr i t e up t o 30 per cent of t he not i f i ed amount of
t he issue. I f t wo or more issues are float ed on t he same day, t he limit
of 30% is applied by t aking t he not ified amount s separ at ely.
3. Bids will be t ender ed by PDs wit hin t he st ipulat ed t ime, indicat ing bot h
t he amount of t he under wr it ing commit ment s and under wr it ing
commission r at es. A PD can submit mult iple bids for under wr it ing.
4. Depending upon t he bids submit t ed for underwrit ing, t he RBI will
decide t he cut - off rat e of commission and t he underwrit ing amount up
t o which bids would be accept ed and infor m t he PDs.
5. RBI r eser ves t he r ight t o accept any amount of under wr it ing up t o 100
per cent of t he not ified amount or even rej ect all t he bids t endered by
PDs for under wr it ing, wit hout assigning any r eason.
6. I n case of devolvement , PDs would be allowed t o set - off t he accept ed
bids in t he auct ion against t heir under wr it ing commit ment accept ed by
t he Reser ve Bank. Devolvement of secur it ies, if any, on PDs will t ake
place on pro- r at a basis, depending upon t he amount of under wr it ing
obligat ion of each PD af t er set t ing of f t he successf ul bids in t he
auct i on.
7. Under wr it ing commission will be pai d on t he amount accept ed f or
under wr it ing by t he RBI , ir r espect ive of t he act ual amount of
devolvement , by cr edit t o t he cur r ent account of t he r espect ive PDs at
t he RBI , For t , Mumbai, on t he dat e of issue of secur it y.

3. 6. 4 Ot her Obl i gat i ons

PDs are expect ed t o play an act ive r ole in t he gover nment secur it ies mar ket ,
bot h in it s pr imar y and secondar y mar ket segment s. The maj or r oles and
obligat ions of PDs ar e as below:

1. Suppor t t o Pr imar y Mar ket : PDs ar e r equir ed t o suppor t auct ions f or
issue of Gover nment dat ed secur it ies and Tr easur y Bills as per t he
minimum nor ms f or under wr it ing commit ment , bidding commit ment
and success r at io as pr escr ibed by RBI fr om t ime t o t ime.
2. Market making in Government securit ies: PDs shoul d of f er t wo- way
pr ices in Gover nment secur it ies, t hr ough t he Negot iat ed Dealing
Syst em- Order Mat ching ( NDS- OM) , over- t he- count er mar ket and
r ecognised St ock Exchanges in I ndia and t ake pr incipal posit ions in t he
secondar y mar ket for Gover nment secur it ies.
39
3. PDs should maint ain adequat e physical infr ast r uct ur e and skilled
manpower f or ef f icient par t icipat ion in pr imar y issues, t r ading in t he
secondar y mar ket , and t o advise and educat e invest or s.
4. A Pr imar y Dealer shall have an ef f icient int er nal cont r ol syst em f or f air
conduct of business, set t lement of t r ades and maint enance of
account s.
5. A Pr imar y Dealer will pr ovide access t o RBI t o all r ecor ds, books,
inf or mat ion and document s as and when r equir ed.
6. PDs should annually achieve a minimum t ur nover r at io of 5 t imes f or
Gover nment dat ed secur it ies and 10 t imes f or Tr easur y Bills of t he
aver age mont h- end st ocks. The t urnover rat io in respect of out right
t r ansact ions should not be less t han 3 t imes in gover nment dat ed
securit ies and 6 t imes in Treasury Bills ( Turnover rat io is comput ed as
t he r at io of t ot al pur chase and sales dur ing t he year in t he secondar y
mar ket t o aver age mont h- end st ocks) .
7. A PD should submit periodic ret urns as prescribed by RBI from t ime t o
t ime.
8. PDs oper at ions ar e subj ect t o pr udent ial and r egulat or y guidelines
issued by RBI from t ime t o t ime.

3. 6.5 Faci l i t i es f or Pr i mar y Deal er s

The Reser ve Bank cur r ent ly ext ends t he following facilit ies t o PDs t o enable
t hem t o effect ively fulfill t heir obligat ions:

i. Access t o Cur r ent Account facilit y wit h RBI .
ii. Access t o Subsidiary Gener al Ledger ( SGL) Account facilit y ( for
Gover nment secur it ies) wit h RBI .
iii. Permission t o borrow and lend in t he money market including call
money mar ket and t o t r ade in all money mar ket inst r ument s.
iv. Member ships of elect r onic dealing, t r ading and set t l ement syst ems
( NDS plat f or ms/ I NFI NET/ RTGS/ CCI L) .
v. Access t o t he Liquidit y Adj ust ment Facilit y ( LAF) of RBI .
vi. Access t o liquidit y suppor t f r om RBI under a scheme separ at ely not if ied
for st andalone PDs.
vii. Favour ed access t o open mar ket oper at ions by Reser ve Bank of
I ndia. The facilit ies ar e, however , subj ect t o r eview, depending upon
t he mar ket condit ions and r equir ement .

40
3. 6.6 Repor t i ng Syst em

St at ement s / Ret ur ns r equir ed t o be submit t ed by Pr imar y Dealer s t o Reser ve
Bank of I ndia
Sr .
No.
Ret ur n/ Repor t Per i odi ci t y
1. PDR- I Fort night ly
2. PDR- I I Mont hly
3. PDR- I I I Quart erly
4. PDR- I V Quart erly
5. Ret ur ns on FRAs/ I RS( t o I DMD) Mont hl y and
Fort night ly
6. Annual Repor t & Annual Audit ed A/ c s Annual
7. Audit or ' s Cer t if icat e on Net Owned
Funds
Yearly
8. Reconciliat ion of holdings of Govt .
Secur it ies in own A/ c and const it uent
A/ c
Yearly
9. I nvest ment s i n non- Gover nment
secur it ies
Yearly
10. Det ails of dividend declar ed dur ing t he
account ing year
Yearly
11. Ret urn on FRAs / I RS Fort night ly
12. St at ement showing balances of Govt .
Secur it ies held on behalf of each Gilt A/ c
holder
Half - Yearly
13. Ret ur n on Call Money t r ansact ions wit h
Commercial Banks
Fort night ly
14. Daily Ret ur n on Call/ Not ice/ Ter m Money
Tr ansact i ons
Daily
15. Call and Not ice Money Oper at ions
during t he Fort night
Fort night ly
16. Tot al I nvest ment s and Resour ces
invest ed in short - t er m I nst r ument s
Mont hly
17. I nf or mat i on f or I ssue of Commer ci al
Paper
On each issue of
CP
3.7 SATELLI TE DEALERS

RBI int roduced a syst em of Sat ellit e Dealers ( SDs) wit h, t he obj ect ive of
widening t he scope of or ganized dealing and dist r ibut ion ar r angement s in
Government securit ies market . However, t he Sat ellit e Dealers Syst em has
been discont inued by RBI w. e. f May 31, 2002.
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3.8 SECONDARY MARKETS FOR GOVERNMENT BONDS

Gover nment bonds ar e deemed t o be list ed as soon as t hey ar e issued.
Mar ket s for gover nment secur it ies ar e pr e- dominant ly wholesale mar ket s,
wit h t r ades done on t elephonic negot iat ion. NSE WDM pr ovides a t r ading
plat form for Government bonds, and report s over 65% of all secondar y
mar ket t r ades in gover nment secur it ies. Since par t icipant s have t o r epor t
t heir t rades t o t he PDO, and effect set t lement t hrough t he SGL, RBI s report s
on SGL t r ansact i ons pr ovi de summar y dat a on secondar y mar ket t r ansact i ons
in gover nment bonds. SGL holder s ar e expect ed t o r epor t t heir t r ades wit hin
24 hour s, due t o which t he t ime sequence of t r ades is not obser ved in t he
debt mar ket s. Since most t r ades done on t he NSE ar e also in t he for m of
negot iat ed t r ades t hat ar e subsequent ly r epor t ed, t he last t r aded pr ice is
not obser ved in t he secondar y mar ket s. The t r ading syst em at t he NSE WDM
is described in Chapt er 11.

Cur r ent ly, t r ansact ions in gover nment secur it ies ar e r equir ed t o be set t led on
t he t rade dat e or next working day unless t he t ransact ion is t hrough a broker
of a permit t ed st ock exchange in which case set t lement can be on T+ 2 basis.
I n NDS, all t r ades bet ween member s of NDS have t o be r epor t ed
immediat ely. The set t lement is r out ed t hr ough CCI L for all NDS members.
3.9 SETTLEMENT OF TRADES I N G-SECS

All t r ades in gover nment secur it ies ar e r epor t ed t o RBI- SGL f or set t lement .
The t r ades ar e set t led on DvPI I I basis ( net set t lement of secur it ies and f unds
simult aneously) . Cent r al gover nment secur it ies and T- bills are held as
demat erialised ent ries in t he SGL of RBI . The PDO, which oversees t he
set t lement of t r ansact ions t hr ough t he SGL, enables t he t r ansfer of secur it ies
fr om one par t icipant t o anot her . Tr ansfer of funds is effect ed by
cr edit ing/ debit ing t he cur r ent account of t he seller / buyer , maint ained wit h t he
RBI . Secur it ies ar e t r ansfer r ed t hr ough cr edit s/ debit s in t he SGL account . I n
or der t o do t his, t he SGL For m is f illed by t he seller , count er signed by t he
buyer , and sent t o t he RBI . The buyer t r ansf er s funds t owar ds payment . The
SGL form cont ains t ransfer inst ruct ion for funds and securit ies signed by bot h
count erpar t ies and has t o be submit t ed t o RBI wit hin one wor king day aft er
t he dat e of signing t he form. The SGL form provides det ails of t he buyer and
t he seller , t he secur it y, t he clean pr ice, accr ued int er est and det ails of cr edit
i n t he cur r ent account .

Most t r ansact ions in gover nment secur it ies ar e placed t hr ough br oker s.
Buyer s and sel l er s conf i r m t r ansact i ons t hr ough phone and f ax, af t er t he deal
is made. Br oker s ar e usually paid a commission of 0. 50 paise per mar ket lot
( of Rs. 5 crore) , for deals upt o Rs. 20 crore. Larger deals at t ract fixed
commissions.
42

Gross set t lement occasionally leads t o gridlock in t he DvP syst em due t o
shor t fall of funds on a gr oss basis in t he cur r ent account s of one or mor e SGL
account holder s, t hough suf f icient balance ar e available t o set t le on net basis.
To t ake car e of such unusual occur r ences, t he scheme of special f und f acilit y
provides int ra- day f unds t o banks and pr imar y dealer s against un- dr awn
collat er alised lending facilit y and liquidit y suppor t facilit y fr om RBI .
Clear ing Cor por at ion of I ndia Limit ed
CCI L promot ed by t he banks and financial inst it ut ions, was incorporat ed in
April 2001 t o support and facilit at e clear ing and set t lement of t r ades in
gover nment secur it ies ( and also t r ades in f or ex and money mar ket s) . I t
f acilit at es set t lement of t r ansact ions in gover nment secur it ies ( bot h out r ight
and r epo) on Deliver y ver sus Payment ( DvP- I I ) basis which pr ovides f or
set t lement of securit ies on gross basis and set t lement of funds on net basis
simult aneously up t o Mar ch 31, 2004.

As per not ificat ion issued by RBI dat ed Mar ch 29, 2004 t he set t lement of
gover nment secur it ies t r ansact ion is swit ched over t o t he DVP I I I mode w. e. f .
Apr il 02, 2004. A new guideline per mit s sale of a gover nment secur it y alr eady
cont r act ed f or pur chase, pr ovided:

t he pur chase cont r act is conf ir med pr ior t o t he sale,
t he pur chase cont r act is guar ant eed by CCI L or t he secur it y is
cont r act ed for pur chase fr om t he Reser ve Bank and,
t he sale t r ansact ion will set t le eit her in t he same set t lement cycle as
t he preceding purchase cont ract , or in a subsequent set t lement cycle
so t hat t he deliver y obligat ion under t he sale cont r act is met by t he
secur it ies acquir ed under t he pur chase cont r act ( e. g. when a secur it y is
purchased on T+ 0 basis, it can be sold on eit her T+ 0 or T+ 1 basis on
t he day of t he pur chase; if however it is pur chased on T+ 1 basis, it
can be sold on T+ 1 basis on t he day of pur chase or on T+ 0 or T+ 1
basis on t he next day) ; and,
t o shift t he set t lement of gover nment secur it ies t r ansact ions car r ied
out t hr ough CCI L t o t he DVP- I I I mode so t hat each securit y is
deliver able/ r eceivable on a net basis f or a par t icular set t lement cycle.
I t is clarified t hat so far as purchase of securit ies from t he Reserve
Bank t hr ough Open Mar ket Oper at ions ( OMO) is concer ned, no sale
t r ansact ions should be cont r act ed pr ior t o r eceiving t he conf ir mat ion of
t he deal/ advice of allot ment fr om t he Reser ve Bank.
As a cor ollar y t o t he above changes, it is also advised t hat r eady
f or war d ( r epo) t r ansact ions in gover nment secur it ies, which ar e set t led
under t he guar ant eed set t lement mechanism of CCI L, may be r olled
over, provided t he securit y prices and repo int erest rat e are
r enegot iat ed on r oll over . I t is clar ified t hat t he pur chase cont r act
referred t o in paragraph 3( a) ( i) above will include t he second
( r epur chase) leg of a r epo t r ansact ion. That is, t he bor r ower of f unds
43
( i. e. , seller in t he first leg) in a repo may sell t he securit ies cont ract ed
f or r epur chase, on T+ 0 or T+ 1 basis f or a set t lement cycle coinciding
wit h t he second leg of t he r epo or f or a subsequent set t lement cycle.
However , t he lender of funds ( i. e. ; t he buyer in t he fir st leg) in a r epo,
should not sell t he secur it ies pur chased in t he r epo, dur ing t he t enor of
t he r epo cont r act .
The modificat ions in t he exist ing guidelines in accor dance wit h t he
above pr oposals ar e expect ed t o impr ove t he liquidit y in gover nment
secur it ies mar ket by enabling sale of a gover nment secur it y on t he day
of pur chase, r educing t he pr ice r isk on t he par t of t he mar ket
part icipant s. Furt her, as t he relaxat ion enables rollover of repos, it
would f acilit at e non- banks t o move away from t he call/ not ice money
mar ket and also enabl e banks t o r educe t hei r dependence on t he cal l
money mar ket .

CCI L act s as a cent r al count er par t y f or clear ing and set t lement of gover nment
secur it ies t r ansact ions done on NDS. CCI L r eceives t r ades r epor t ed by t he
member s on t he Negot iat ed Dealing Syst em of t he Reser ve Bank of I ndia and
t he NDS- OM in bat ches ( bat ch I and I I ) wit h t he st at us r eady f or set t lement .
The t r ades r eceived by CCI L in bat ches ar e subj ect ed t o init ial validat ion and
t he Risk management depar t ment checks for mar gin availabilit y in r espect ive
member s SGF account . The t r ades which pass t he exposur e check ar e
accept ed f or guar ant eed set t lement t hr ough t he pr ocess of novat ion in which
t he CCI L becomes t he Cent ral Count er Part y. All such t rades received,
accept ed and due for set t leme nt are t aken for net t ing on t he set t lement dat e
t o arrive at memberwise securit ies and fund obligat ions. The net obligat ions
for each member in respect of securit ies and funds are arrived at as per DVP
I I I met hod of net t i ng ar r angement . Member- wise obligat ions f or secur it ies
and f unds ar e t hen elect r onically t r ansmit t ed t o RBI - PDO/ DAD f or set t l ement .
PDO/ DAD under t akes set t lement of secur it ies/ f unds in t he r espect ive
member s account t hr ough CCI Ls set t lement account s and advises CCI L on
complet ion. CCI L has well def ined pr ocess f or handling any set t lement
short age eit her in funds or in securit ies. All inst ances of such short ages are
immediat ely r epor t ed t o RBI for necessar y act ion at t heir end.

The scheme of Secur it ies Lending and Bor r owing ( SLB) in gover nment
secur it ies, made oper at ional f r om Oct ober 25, 2004, t he f ir st in t he Count r y
enabled CCI L t o bor r ow gover nment secur it ies fr om a member appr oved by
RBI f or t he exclusive pur pose of meet ing shor t ages in t he set t lement of
t r ansact i ons.

I n order t o part icipat e in t he clear ing and set t lement pr ocess, t he mar ket
par t icipant s ar e r equir ed t o enr oll as member s of CCI L. All t he member s of
RBI- NDS ar e eligible f or member ship t o t he gover nment secur it ies segment of
CCI L. The member s pay a one- t ime member ship fee of Rs. 1 lakh.

44
I t pr ovides guar ant eed set t lement f or t r ansact ions in gover nment secur it ies
t hrough improved risk management pract ices viz. , daily mark t o market
mar gin and maint enance of set t lement guar ant ee f und. .
CCI L has in place a compr ehensive r isk management syst em. During t he
set t lement pr ocesses, CCI L assumes cer t ain r isks which may ar ise due t o a
def ault by a member t o honour it s obligat ions. Set t lement being on Deliver y
Versus Payment basis, t he risk from a default is t he market risk ( change in
pr i ce of t he concer ned secur i t y) . CCI L pr ocesses ar e desi gned t o cover t he
mar ket r isk t hr ough it s mar gining pr ocess.
CCI L collect s I nit ial Mar gin and Mar k t o Mar ket Mar gin fr om member s in
r espect of t heir out st anding t r ades. I nit ial Mar gin is collect ed t o cover t he
l i kel y r i sk f r om f ut ur e adver se movement of pr i ces of t he concer ned secur i t i es.
Mar k t o Mar ket Mar gi n i s col l ect ed t o cover t he not i onal l oss ( i . e. t he
di f f er ence bet ween t he cur r ent mar ket pr i ce and t he cont r act pr i ce of t he
secur it y cover ed by t he t rade) already incurred by a member. Bot h t he
mar gins ar e comput ed t r ade- wise and t hen aggr egat ed memberwise. I n
addit ion, CCI L may also collect Volat ilit y Mar gin in case of unusual volat ilit y in
t he mar ket .
Member s ar e r equir ed t o keep balances in Set t lement Guar ant ee Fund ( SGF)
i n such a manner t hat t he same i s enough t o cover t he r equi r ement s f or bot h
I nit ial Mar gin and Mar k- t o- Mar ket Mar gin for t he t r ades done by such
member s. I n case of any shor t f all, CCI L makes mar gin call and t he concer ned
member is r equir ed t o meet t he shor t f all bef or e t he specif ied per iod of t he
next wor king day. Member s cont r ibut ion t o t he SGF is in t he for m of eligible
Govt . of I ndia Securit ies/ T- Bills and cash, wit h cash being not less t han 10 %
of t he t ot al margin re quir ement at any point of t ime.
Anot her impor t ant r isk emanat ing fr om t he pr ocess is Liquidit y Risk. To
ensur e unint er r upt ed set t lement , CCI L is r equir ed t o ar r ange for liquidit y bot h
in t erms of funds and securit ies. CCI L has arranged for Lines of Credit fr om
Banks t o enable it t o meet any r easonable shor t f all of f unds ar ising out of a
default by a member eit her in it s Secur it ies Segment or For ex Segment . I n
regard t o t he Securit ies Segment , members cont ribut ions t o SGF is mainly in
t he for m of secur it ies and t hr ough t he list of specif ied secur it ies accept able
f or cont r ibut ion t o SGF, CCI L ensur es t hat t he most liquid secur it ies in which
a signif icant por t ion of t he t r ades ar e set t led ar e likely t o be available in t he
SGF. For r equir ement s of ot her secur it ies, CCI L has put in place a limit ed
pur pose secur it y bor r owing ar r angement wit h t wo maj or mar ket par t icipant s

45
The det ails of t r ades set t led by CCI L dur ing 2002- 03 t o 2007- 08 ar e gi ven
below:
Set t l emen t of Tr ades i n Gov er n men t Secu r i t i es
Amount Rs. Million
Year Out r i ght Tr ansact i ons Repo Tr ansact i ons Tot al
No. of
Tr ades
Amount
( Face
Val ue)
No. of
Tr ades
Amount
( Face
Val ue)
No. of
Tr ades
Amount
( Face
Val ue)
2002-03 191, 843 1, 076, 147 11, 672 468, 229 203, 515 1, 544, 376
2003-04 243, 585 1, 575, 133 20, 927 943, 189 264, 512 2, 518, 322
2004-05 160, 682 11, 342, 221 24, 364 15, 579, 066 185, 046 26, 921, 287
2005-06 125, 509 8, 647, 514 25, 673 16, 945, 087 151, 182 25, 592, 601
2006-07 137, 100 10, 215, 357 29, 008 25, 565, 014 166, 108 35, 780, 371
2007-08 188, 843 16, 538, 512 26, 612 39, 487, 508 215, 455 56, 026, 020
Sour ce: Rakshit r a Mont hly news let t er of CCI L
Li qu i di t y Adj u st men t Faci l i t y ( LAF)
The liquidit y Adj ust ment Facilit y int r oduced in June 2000, allows t he Reser ve
Bank of I ndia t o manage market liquidit y on a daily basis and also t ransmit
int er est r at e signals t o t he mar ket . The LAF, init ially r ecommended by
Nar simhan Commit t ee was int r oduced in st ages in consonance wit h t he level
of mar ket development and t echnological advances in payment and
set t lement syst ems. The f ir st challenge was t o combine t he var ious sour ces of
liquidit y available from t he Reserve Bank int o a single comprehensive window
wit h a common pr ice. Consequent ly, an int er im LAF was int r oduced in Apr il
1999 as a mechanism for liquidit y management t hr ough combinat ion of r epo
oper at ions, expor t cr edit r ef inance f acilit ies and collat er alised lending
facilit ies, support ed by open market operat ions of t he RBI , at set rat es of
int er est . Banks could avail of a collat er alised lending f acilit y ( CLF) suppor t ed
by open mar ket oper at ions at set r at es of int er est , was upgr aded int o a full-
f ledged LAF. Most of t he alt er nat e pr ovisions of pr imar y liquidit y have been
gr adually phased out and now t he LAF has emer ged as t he pr incipal oper at ing
inst r ument of monet ar y policy. The RBI manages it s liquidit y in t he mar ket
t hr ough t he oper at ion of LAF as par t of it s monet ar y policy and money supply
t ar get s. I t under t akes r ever se r epo t r ansact ions t o mop up liquidit y and r epos
t o supply liquidit y in t he mar ket . The t wo r at es ar e different and t he reverse
r epo r at e is lower t han t he r epo r at e. The LAF t r ansact ions ar e cur r ent ly being
conduct ed on over night basis. The pr ocedur e pr escr ibed by RBI for oper at ion
of t he LAF r equir es t he banks t o submit bids f or r epo/ r ever se r epo
t r ansact ions at specif ied t imes. The bids ar e submit t ed elect r onically t hr ough
t he NDS. These oper at ions ar e conduct ed in t he f or enoon bet ween 9. 30 a. m.
and 10. 30 a. m. All scheduled banks and pr imar y dealer s having cur r ent and
SGL account s wi t h t he RBI ar e eligible t o par t icipat e in t he t r ansact ions wit h
bids for a minimum amount of Rs. 5 cr or e ( or mult iples t her eof) . The
t r ansact ions ar e under t aken in SLR secur it ies and/ or t r easur y bills. A unif or m
46
mar gin of 5% in t er ms of t he f ace value of t he secur it y, is kept on accept ed
bids. Thus, RBI pract ice is different from market repos, t he lat t er are based
on mar ket values and not face values of t he secur it ies.

Secon dar y Li qu i di t y Adj u st men t Faci l i t y ( SLAF)
I n r esponse t o suggest ions f r om t he mar ket par t icipant s for fine- t uning t he
management of bank reserves on t he last day of t he maint enance period, it
has been decided t o int r oduce a second LAF ( SLAF) on r epor t ing Fr idays, wit h
effect from August 1, 2008. These operat ions are conduct ed bet ween 4. 00
p.m. and 4.30 p.m.
The salient f eat ur es of t he SLAF ar e same as t hose of LAF. However , t he
set t lement for LAF and SLAF will be conduct ed separ at ely and on gr oss basis.

Model Quest i ons

1 . Wh i ch of t h e f ol l ow i n g i s t r u e abou t a u n i f or m pr i ce au ct i on ?

a. An auct ion in which all successful bids ar e made for t he same pr ice.
b. An auct ion in which all bidder s have bid a unif or m pr ice.
c. An auct ion in which all successful bidder s ar e allot t ed bonds at t he
same pr ice.
d. An auct ion in which t he cut - of f pr ice is der ived as t he weight ed
aver age of all successful bids.

Answ er : c

2 . Wh i ch of t h e f ol l ow i n g i s f al se abou t t h e dev ol v emen t of t r easu r y
i ssu es on t h e pr i mar y deal er ?

a. PDs can set - of f t he accept ed bids in an auct ion against t he
devolvement on t hem.
b. Devolvement on PDs is on pro- r at a basis, depending on t he
under wr it ing obligat ion of each PD.
c. Under wr it ing f ee is payable on t he net amount , af t er account ing f or
t he devolvement on PDs.
d. Devolvement on pro- rat a basis is done aft er set t ing off successful
bids in t he auct ion.

Answ er : c

47
3 . Th e bi ds r ecei v ed i n a t r easu r y au ct i on ar e as f ol l ow s:

Nu mber of Bon ds Pr i ce qu ot ed by
bi dder s ( Rs. )
20, 000, 000 110. 25
12, 000, 000 109. 50
10, 000, 000 109. 25
14, 000, 000 109. 00
25, 000, 000 108. 95

I f t he not ified amount is Rs. 500 cr or e, what is t he cut - off pr ice, assuming
t her e ar e no devolvement s?

Answ er :
Since it is a pr ice- based auct ion, t he bids will be filled fr om t he highest pr ice
downwar ds. I f t he bids at t he cut - off price exceed t he not ified amount , pro-
r at a allot ment s will be made. On comput ing t he amount ( product of number
of bonds and quot ed pr ice, and cumulat ing t he amount s so ar r ived, we can
r each t he cut - of f pr ice) . The cut - off price is Rs. 109. 00.
The allot ment s ar e as follows:
Quant i t y Pr i ce Qu ot ed b y
bi dder s ( Rs. )
Amou n t bi d ( Rs. ) Al l ot ment ( Rs. )
20, 000, 000 110. 25 2, 205, 000, 000 2, 205, 000, 000
12, 000, 000 109. 5 1, 314, 000, 000 1, 314, 000, 000
10, 000, 000 109. 25 1, 092, 500, 000 1, 092, 500, 000
14, 000, 000 109 1, 526, 000, 000 388, 500, 000
25, 000, 000 108. 95 2, 723, 750, 000 Nil
The allot ment at t he cut - of f pr ice is ar r ived at by f inding t he dif f er ence
bet ween t he not if ied amount and t he cumulat ive allot ment s up t o t he
pr evious bid.

4 . Usi n g t h e same d at a as i n q u est i on 3 , at w h at p r i ce n on-
compet i t i v e bi ds w i l l be al l ot t ed?

An sw er : Non- compet it ive bids will get allot ment at t he weight ed average
price of successful bids. The price and quant it y for successful bids are as
follows:
Nu mber of
Bonds
Pr i ce
( Rs. )
Bi d Amou n t Wei gh t age Wei gh t ed
Pr i ce
20, 000, 000. 00 110. 25 2, 205, 000, 000 0. 441 48. 6203
12, 000, 000. 00 109. 5 1, 314, 000, 000 0. 2628 28. 7766
10, 000, 000. 00 109. 25 1, 092, 500, 000 0. 2185 23. 8711
3, 564, 220. 18 109 388, 500, 000 0. 0777 8. 4693
109. 7373
The weight ed aver age pr ice is Rs. 109. 7373
48
CHAPTER 4
CENTRAL GOVERNMENT SECURI TI ES:
T- BI LLS

Treasury bills are short - t erm debt inst rument s issued by t he Cent ral
gover nment . Ther e ar e 3 t ypes of T- bills which are issued: 91- day, 182- day
and 364- day, r epr esent ing t he 4 t ypes of t enor s f or which t hese inst r ument s
ar e issued.

Unt i l 1988, t he only kind of Treasury bill t hat was available was t he 91- day
bill, issued on t ap; at a fixed r at e of 4. 5% ( t he r at es on t hese bills r emained
unchanged at 4. 5% since 1974! ) . 182- day T- bills were int roduced in 1987,
and t he auct ion pr ocess f or T- bills was st art ed. 364 day T- bill was int roduced
in April 1992, and in July 1997, t he 14- day T- bill was also int roduced. RBI
had suspended t he issue of 182- day T- bills from April 1992, and revived t heir
issuance since May 1999. RBI did away wit h 14- day and 182- day Tr easur y
Bills from May 2001. I t was decided in consult at ion wit h t he Cent ral
Government t o re- int roduce, 182 day TBs from April 2005. All T- bills are now
sold t hr ough an auct ion pr ocess accor ding t o a fixed auct ion calendar ,
announced by t he RBI . Ad hoc t r easur y bills, which enabled t he aut omat ic
monet isat ion of cent r al gover nment budget deficit s, have been eliminat ed in
1997. Al l T- bill issuances now represent market borrowings of t he cent ral
gover nment .
4.1 I SSUANCE PROCESS

Treasury bills ( T- bills) are short - t er m debt inst r ument s issued by t he Cent r al
gover nment . Thr ee t ypes of T- bills are issued: 91- day, 182- day and 364- day,

T- bills are sold t hrough an auct ion process announced by t he RBI at a
discount t o it s f ace value. RBI issues a calendar of T- bill auct ions ( Table 4. 1) .
I t al so announces t he exact dat es of auct i on, t he amount t o be auct i oned and
payment dat es. T- bills ar e available for a minimum amount of Rs. 25, 000 and
in mult iples of Rs. 25, 000. Banks and PDs are maj or bidders in t he T- bill
mar ket . Bot h discr iminat or y and unifor m pr ice auct ion met hods ar e used in
issuance of T- bills. Current ly, t he auct ions of all T- bills are
mult iple/ discr iminat or y pr ice auct ions, wher e t he successf ul bidder s have t o
pay t he pr i ces t hey have act ually bid for. Non- compet it ive bids, wher e bidder s
need not quot e t he rat e of yield at which t hey desire t o buy t hese T- bills, are
also allowed f r om pr ovident f unds and ot her invest or s. RBI allot s bids t o t he
non- compet it ive bidder s at t he weight ed aver age yield arrived at on t he basis
49
of t he yields quot ed by accept ed compet it ive bids at t he auct ion. Allocat ions
t o non- compet it ive bidder s ar e out side t he amount not if ied f or sale. Non-
compet it ive bidder s t her efor e do not face any uncer t aint y in pur chasing t he
desir ed amount of T- bills from t he auct ions.

Pur suant t o t he enact ment of FRBM Act wit h effect fr om Apr il 1, 2006, RBI is
pr ohibit ed fr om par t icipat ing in t he pr imar y mar ket and hence devolvement
on RBI is not allowed. Auct ion of all t he Treasury Bills ar e based on mult iple
pr ice auct ion met hod at pr esent . The not if ied amount s of t he auct ion is
decided ever y year at t he beginning of financial year ( Rs. 500 cr or e each for
91- day and 182- day Treasury Bills and Rs. 1, 000 crore for 364- day Tr easur y
Bills for t he year 2008- 09) in consult at ion wit h GOI . RBI issues a Press
Rel ease det ai l i ng t he not i f i ed amount and i ndi cat i ve cal endar i n t he begi nni ng
of t he financial year . The auct ion for MSS amount var ies depending on
prevailing market condit ion. Based on t he requir ement of GOI and pr evailing
mar ket condit ion, t he RBI has discr et ion t o change t he not ified amount . Also,
it is discr et ion of t he RBI t o accept , r ej ect or par t ially accept t he not if ied
amount depending on pr evailing mar ket condit ion

Tabl e 4. 1: Tr easu r y Bi l l s - Au ct i on Cal en dar ( 2 0 0 8- 09)

Ty pe of
Tr easur y
bi l l
Per i odi ci t y Not i f i ed
Amount
( Rs. cr .)
Day of Auct i on Day of
Payment
91-day Weekly 500 Ever y Wednesday Following
Fr i day
182 Day For t night ly 500 Wednesday
preceding t he non-
Repor t ing Fr iday
Following
Fr i day
364-day For t night ly 1000 Ever y alt er nat e
Wednesday
Following
Fr i day

The calendar f or t he r egular auct ion of TBs f or 2008- 09 was announced on
Mar ch 24, 2008. The not if ied amount s wer e kept unchanged at Rs. 500 cr or e
for 91- day and 182- day TBs and Rs. 1, 000 crore for 364- day TBs. However,
t he not ified amount ( excluding MSS) of 91- day and 182 TBs and Rs. 1, 000
cr or e for 364 day TBs. However , t he not ified amount ( excluding MSS) of 91-
day TBs was incr eased by Rs. 2, 500 cr or e each on t en occasions and by
Rs. 1, 500 cr or e each on t en occasions and by Rs. 1, 500 cr or e on one occasion
and t hat of 182 day TBs was incr eased by Rs. 500 cr or e on t wo occasions
during 2008- 09 ( upt o August 14, 2008) . Thus, an addit ional amount of
Rs. 27, 500 cr or e ( Rs. 17, 500 cr or e, net ) was r aised over and above t he not ified
amount in t he calendar t o f inance t he expect ed t empor ar y cash mismat ch
ar ising fr om t he expendit ur e on far mer s debt waiver scheme.

50
The summar y of T- bill auct ions conduct ed during t he year 2007- 08 is in Table
4.2.

Tabl e 4. 2: T- b i l l Au ct i on s 2 0 0 7- 08 - A Summar y

9 1 - day 1 8 2 - day 3 6 4- day
No of issues 54 27 26
Number of bids received ( compet it ive &
non-compet it ive)
4, 844 1, 991 2, 569
Amount of compet it ive bids ( Rs. cr.) 301, 904 115, 531 170, 499
Amount of non-compet it ive bids ( Rs. cr.) 101, 024 7, 321 3, 205
Number of bids accept ed ( compet it ive &
non-compet it ive)
1935 811 849
Amount of compet it ive bids accept ed ( Rs.
cr.)
109, 341 39, 605 54, 000
Devolvement s on PDs ( Rs. cr. ) - - -
Tot al I ssue ( Rs. cr) 210, 365 46,926 57, 205
Cut -of f pr ice - minimum ( Rs.) 98. 06 96. 17 92. 78
Cut -of f pr ice - maximum ( Rs.) 98. 90 97. 18 93. 84
I mplicit yield at cut -of f pr ice minimum
( %)
4. 4612 5. 82 6. 5824
I mplicit yield at cut -of f pr ice maximum
( %)
7. 9353 7. 99 7. 8032
Out st andi ng amount ( end of t he
year ) ( Rs. cr .)
39,957.06 16,785.00 57,205.30
Source: RBI Bullet in, Various I ssues.
4.2 CUT-OFF YI ELDS

T- bills are issued at a discount and are redeemed at par. The implicit yield in
t he T- bill is t he r at e at which t he issue pr ice ( which is t he cut - off price in t he
auct ion) has t o be compounded, for t he number of days t o mat ur it y, t o equal
t he mat ur it y value.
Yield, given pr ice, is comput ed using t he for mula:
= ( ( 100- Pr ice) * 365) / ( Pr ice * No of days t o mat ur it y)

Similar ly, pr ice can be comput ed, given yield, using t he for mula:
= 100/ ( 1+ ( yield% * ( No of days t o mat ur it y/ 365) )
For example, a 182- day T- bill, auct ioned on January 18, at a price of Rs.
95. 510 would have an implicit yield of 9. 4280% comput ed as follows:
= ( ( 100- 95. 510) * 365)/ ( 95. 510* 182)
9. 428% is t he r at e at which Rs. 95. 510 will gr ow over 182 days, t o yield Rs.
100 on mat ur it y. Tr easur y bill cut - of f yields in t he auct ion r epr esent t he
default - free money market rat es in t he economy, and are import ant
benchmar k r at es.
51
4.3 I NVESTORS I N T-BI LLS

At t he end of March 2008, Treasury bills were predominant ly held by st at e
gover nment s f ollowed by banks. Table 4. 3 pr esent s holding pat t er n of
out st anding T- bills.

Tabl e 4 . 3 : Hol di n g Pat t er n of Ou t st an di n g T- bi l l s( at t h e en d of Mar c h)
( Rs. cr . )
Hol der s 2 0 0 8 2 0 0 7 2 0 0 6 2 0 0 5
Reserve Bank of I ndia
Banks 43, 800 51, 770 49, 187 61, 724
St at e Gover nment s 91, 988 88, 822 60, 184 15, 874
Ot hers 41, 195 27, 991 8, 146 11, 628
Sour ce: RBI , Weekly St at ist ical Supplement , Var ious I ssues.

4.4 SECONDARY MARKET ACTI VI TY I N T-BI LLS

Treasury bills are most ly held t o mat urit y by a maj orit y of t he buyers.
Secondar y mar ket act ivit y is quit e spar se. The aver age t ur nover in T- bills is
shown in Table 4. 4. The 364- day T- bill is comparat ively mor e act ively t r aded,
wit h an average t urnover of around Rs. 19, 340. 73 crore.

Tabl e 4. 4: Secon dar y Mar k et Tr an sact i on s i n T- Bi l l s
( Rs. Cr .)
91- day 182- day 364- day
2006
Average 7 5 7 4 . 6 9

5011. 013

1 9 , 3 4 0 . 7 3

Minimum 729. 01

1, 928. 74

3, 892. 99

Maxi mum 23,772.56

9, 379. 00

39,005.96

Sour ce: RBI , Handbook of St at ist ics on The I ndian Economy, 2006- 07.

52
Model Quest i ons

1. A t r easu r y bi l l mat u r i ng on 28- Ju n- 2 0 0 2 i s t r adi n g i n t h e mar k et
on 3 - Ju l - 2 0 0 1 at a pr i ce of Rs. 9 2 . 8 9 1 8 . Wh at i s t h e di scou n t r at e
i n h er en t i n t h i s pr i ce?

Answ er :
The yield is comput ed as:
= [ ( 100- pr i ce) * 365] / ( Pr i ce * No of days t o mat urit y)
= [ ( 100- 92. 8918) * 365] / ( 92. 8918* 360) = 7. 7584%

2 . Wh at i s t h e pr i ce at w h i ch a t r easu r y bi l l mat u r i n g on 2 3 r d Mar ch
2 0 0 2 w ou l d be v al u ed on Ju l y 1 3 , 2 0 0 1 at a y i el d of 6 . 8 2 0 4 % ?

Answ er :
The pr i ce can be comput ed as
= 100/ { 1+ [ yield% * ( No of days t o mat urit y/ 365) ] }
= 100/ { 1+ [ 6. 8204 %* ( 253/ 365) ] } = Rs. 95. 4858

3 . Wh at i s t h e day cou n t con v en t i on i n t h e t r easu r y bi l l mar k et s?

a. 30/ 360
b. Act ual / Act ual
c. Act ual / 360
d. Act ual / 365

Answ er : d
53
CHAPTER 5
STATE GOVERNMENT BONDS
5.1 GROSS FI SCAL DEFI CI T OF STATE GOVERNMENTS
AND I TS FI NANCI NG

I n t he 1990s t he gr oss fiscal deficit ( GFD) of st at e gover nment s has gr own
from Rs. 18, 787 crore t o Rs. 1, 07, 958 crore in 2007- 08. The mar ket
bor r owi ngs have emer ged as a maj or sour ce of f inancing of t he GFD. Mar ket
bor r owings ar e cur r ent ly about 58. 9% of t he GFD ( Table 5. 1) . The shar e of
loans fr om Cent r al Gover nment as a means of financing t he deficit has fallen
over t he year s, while t he ot her sour ces, which include small savings, have
incr eased.

Tabl e 5 . 1 : Fi n an ci n g of t h e GFD of St at es
( As % of GFD)
Year Loans f r om
t he Cent r al
Gover nment
Mar k et
Bor r ow i ngs
Ot her s Gr oss
Fi scal
Def i ci t
Amount of
Mar k et
Bor r ow i ngs
( Rs. cr .)
1990-91 53.1 13.6 33.3 100 2, 556
1995-96 45.6 19.1 35.3 100 5, 888
1996-97 47.1 17.5 35.4 100 6515
1997-98 53.6 16.5 30.0 100 7280
1998-99 41.8 14.1 44.1 100 10, 467
1999-00 13.6 13.8 72. 60 100 12664
2000-01 9.5 14.2 76.3 100 12, 519
2001-02 11.6 18.3 70.1
100
17, 249
2002-03 -0.4 28.6 71.8
100
28, 484
2003-04 11.6 39.2 49.2
100
47, 286
2004-05 -9.1 32.1 77.0
100
34, 559
2005-06 0.0 17.0 83.0
100
15, 305
2006-07 P -12.2 16.8 95.4
100
13, 057
2007-08 P 2.9 58.9 56.0
100
63553
P: Provisional Dat a
Source: RBI , Annual Report 2007- 08.
5.2 VOLUMES AND COUPON RATES

The annual gr oss bor r owings of st at e gover nment s, which was less t han
Rs. 2, 000 crore unt il t he 1990s, has averaged over Rs. 44, 302 crore every
54
year , in t he last t wo year s. Mar ket bor r owings out st anding wit h st at e
government s has grown from Rs. 15, 618 crore in 1991 t o Rs. 2, 41, 982 crore
by March 2007.

The St at e gover nment bond issuance is pr esent ly managed by t he RBI along
wit h t he cent r al bor r owings. St at es have t he opt ion t o r aise t heir money
t hr ough auct ion syst em or on t ap basis. During 2002- 03, t he st at es r esor t ed
t o lar ge volumes of mar ket bor r owings and ar ound 90% of t he bor r owings
was r aised t hr ough t ap issuance and r est by auct ions. Dur ing 2003- 04,
94. 3% of t he t ot al bor r owi ngs of t he st at e was t hr ough sale of secur i t i es on a
t ap basis and 5. 7 percent by way of auct ions. The t ot al bor r owings by St at es
t hr ough sal e of secur i t i es on a t ap basi s i ncr eased t o 98% and t he r est was
done t hr ough auct ions dur ing 2004- 05.

Following t he implement at ion of t he r ecommendat ions of t he Twelf t h f inance
commission no pr ovision was made in t he Union Budget in r espect of Cent r al
loans for St at e plans during 2005- 06 and St at es were encouraged t o access
t he mar ket s t o r aise t he r equir ed r esour ces. During 2005- 06, t he St at e
Gover nment s pr efer r ed t o bor r ow t hr ough t he auct ion r out e, r aising as much
as 48. 5% of t heir t ot al borrowings t hrough auct ion ( only 2. 3%) in 2004- 05.
I n f act t went y f our st at es opt ed f or auct i on r out e under t he mar ket bor r owi ng
programme during 2005- 06 as compared wit h only t hree st at es in t he
pr evious year . I n fact , for t he fir st t ime ever , a St at e ( Punj ab) r aised t he
ent ir e amount t hr ough auct ion mode. The incr eased r ecour se t o auct ions
i ndi cat ed i mpr oved mar ket per cept i on of St at es f i scal si t uat i on. The St at e
Government raised a gross amount of Rs. 20, 825 crore in 2006- 07 ent ir ely
t hr ough t he auct ion r out e. Dur ing 2007- 08, t he st at e government raised a
gr oss amount of Rs. 67, 779 cr or e t hr ough t he auct ion r out e. RBI has indicat ed
t hat PDs may play a role in st at e gover nment bond i ssuance, ei t her as
under wr it er s, or in book building of a pr ivat e placement of bonds.
5.3 OWNERSHI P PATTERN OF STATE GOVERNMENT
BONDS

SBI and it s associat es ar e t he single lar gest owner s of st at e gover nment
secur it ies. The banking syst em as a whole is a lar ge invest or in gover nment
secur it ies. One of t he r easons for banks t o invest in st at e gover nment bonds
is t he relat ively lower risk- weight ing on t hese bonds, compar ed t o t he r isk
weight ing in case of cor por at e lending. The pr udent ial i nvest ment nor ms of
LI C and provident funds have also enabled a sizeable holding of st at e
gover nment secur it ies by t hese ent it ies. Table 5. 2 pr ovides t he pat t er n of
owner ship of st at e gover nment bonds.

55
Tabl e 5 . 2 : Pat t er n of Ow n er sh i p of St at e Gov er n men t Bon ds
( I n per cent )
I nvest or s 1991

2000 2001 2002 2003 2004 2005 2006
SBI and
associat es 22. 18 18. 36 17. 47 17. 88 20. 06 21. 59 17. 38 16. 48
Nat ionalised
banks 49. 27 39. 88 39. 87 39. 38 36. 75 36. 01 29. 90 31. 37
Ot her
Schedule
Commercial
Banks 7. 11 3. 63 3. 4 3. 03 2. 17 2. 16 1. 70 1. 78
LI C 6. 91 16. 15 16. 57 17. 62 19. 47 19. 79 21. 34 25. 19
UTI 0 0. 022 0. 019 0. 009 0. 01 0. 008 0. 0004 0
Employees
Provident
Fund
Schemes 2. 58 4. 38 4. 64 6. 19 5. 87 5. 596 5. 93 7. 98
Coal Mines
Provident
Fund
Scheme 1. 03 0 0 3. 87 3. 55 1. 25 1. 10 1. 23
Ot hers 10. 92 17. 58 18. 03 11. 99 12. 11 13. 59 22. 62 15. 95
Tot al 1 0 0 .00 1 0 0 .00 1 0 0 .00 1 0 0 .00

1 0 0 .00

1 0 0 .00

1 0 0 .00

1 0 0 .00
Sour ce: RBI , Handbook of St at ist ics on t he I ndian Economy

Model Qu est i on

1. Which of t he following about st at e gover nment bor r owings is t r ue?
a. St at e gover nment bonds ar e issued by t he r espect ive Finance Depar t ment
of t he St at es.
b. St at e gover nment bonds ar e f ully guar ant eed by t he cent r al gover nment .
c. Most st at e government bonds are issued by t he RBI .
d. St at e gover nment bonds ar e issued by t he RBI , at t he same r at es, along
wit h cent r al gover nment bonds.
Answ er : c

56
CHAPTER 6
CALL MONEY MARKETS

The call/ not ice money mar ket for ms an impor t ant segment of t he I ndian
Money Mar ket . Call and not ice money mar ket r efer s t o t he mar ket for shor t -
t erm funds ranging from overnight funds t o funds for a maximum t enor of 14
days. Under Call money market , funds are t ransact ed on overnight basis and
under not ice money market , funds are t ransact ed for t he period of 2 days t o
14 days. Par t icipant s in call/ not ice money mar ket cur r ent ly include banks
( excluding RRBs) and Pr imar y dealer s bot h as bor r ower s and lender s. Non
Bank inst it ut ions ar e not per mit t ed in t he call/ not ice money mar ket wit h
effect from August 6, 2005. The regulat ors has prescribed limit s on t he
banks and pr imar y dealer s oper at ion in t he call/ not ice money mar ket .

I n pur suance of t he announcement made in t he Annual Policy St at ement of
April 2006, an elect r onic scr een- based negot i at ed quot e- driven syst em for all
dealings in call/ not ice and t er m money mar ket was oper at ionalised wit h effect
f r om Sept ember 18, 2006. This syst em has been developed by Clear ing
Cor por at ion of I ndia Lt d. on behalf of t he Reserve Bank of I ndia. The NDS-
CALL syst em pr ovides an elect r onic dealing plat for m wit h feat ur es like Dir ect
one t o one negot iat ion, r eal t ime quot e and t r ade inf or mat ion, pr ef er r ed
count er par t y set up, online exposur e limit monit or ing, online r egulat or y limit
monit or ing, dealing in call, not ice and t er m money, dealing f acilit at ed f or T+ 0
set t lement t ype for Call Money and dealing facilit at ed for T+ 0 and T+ 1
set t lement t ype for Not ice and Ter m Money. I nfor mat ion on pr evious dealt
rat es, ongoing bids/ offers on real t ime basis impar t s gr eat er t r anspar ency and
facilit at es bet t er r at e discover y in t he call money mar ket . The syst em has also
helped t o impr ove t he ease of t r ansact ions, incr eased oper at ional ef f iciency
and r esolve pr oblems associat ed wit h asymmet r y of inf or mat ion. However ,
part icipat ion on t his plat form is opt ional and current ly bot h t he elect ronic
pl at f or m and t he t el ephoni c mar ket ar e co- exist ing. Aft er t he int r oduct ion of
NDS- CALL, market part icipant s have increasingly st art ed using t his new
syst em more so dur ing t imes of high volat ilit y in call r at es.
6.1 VOLUMES I N THE CALL MARKET

Call market s represent t he most act ive segment of t he debt market s. Though
t he demand for funds in t he call market is mainly governed by t he banks'
need f or r esour ces t o meet t hei r st at ut or y r eser ve r equi r ement s, i t al so of f er s
t o some par t icipant s a r egular funding sour ce for building up shor t - t erm
asset s. However , t he demand f or f unds f or r eser ve r equir ement s dominat es
57
any ot her demand in t he mar ket . . Figur e 6. 1 displays t he aver age dai l y
volumes in t he call market s.

Fi gu r e 6 . 1 : Av er age Dai l y Vol u mes i n t h e Cal l Mar k et ( Rs. cr . )
0
5000
10000
15000
20000
25000
30000
35000
J
a
n
-
0
7
F
e
b
-
0
7
M
a
r
-
0
7
A
p
r
-
0
7
M
a
y
-
0
7
J
u
n
-
0
7
J
u
l
-
0
7
A
u
g
-
0
7
S
e
p
-
0
7
O
c
t
-
0
7
N
o
v
-
0
7
D
e
c
-
0
7
J
a
n
-
0
8
F
e
b
-
0
8
M
a
r
-
0
8
A
p
r
-
0
8
M
a
y
-
0
8
J
u
n
-
0
8
Mon t h - Year
A
v
e
r
a
g
e

D
a
i
l
y

T
u
r
n
o
v
e
r

(
R
s
.
c
r
o
r
e
)
Aver age Dai l y Tur nover ( Rs. cr )

6.2 PARTI CI PANTS I N THE CALL MARKETS

Whet her call money mar ket s should be pur e int erbank mar ket s, or should
ot her par t icipant s be encour aged, has been a mat t er of discussion for a
number of year s. The Ch ak r av ar t y Commi t t ee ( 1 9 8 5 ) f elt t hat allowing
addit ional non- bank part icipant s int o t he call market would not dilut e t he
st r engt h of monet ar y r egulat ion by t he RBI , as r esour ces fr om non- bank
par t icipant s do not r epr esent any addit ional r esour ce f or t he syst em as a
whole, and t heir part icipat ion in call money market would only imply a
r edist r ibut ion of exist ing r esour ces f r om one par t icipant t o anot her . I n view of
t his, t he Chakr avar t y Commit t ee r ecommended t hat addi t i onal non- bank
part icipant s may be allowed t o part icipat e in call money market .

The Vagh u l Commi t t ee ( 1 9 9 0 ) , while r ecommending t he int r oduct ion of a
number of money mar ket inst r ument s t o br oaden and deepen t he money
market , rec ommended t hat t he call mar ket s should be r est r ict ed t o banks.
The ot her par t icipant s could choose f r om t he new money mar ket inst r ument s,
for t heir short - t er m r equir ement s. One of t he r easons t he commit t ee
ascribed t o keeping t he call market s as pure int erbank market s was t he
dist or t ions t hat would ar ise in an envir onment wher e deposit r at es wer e
r egulat ed, while call r at es wer e mar ket det er mined.

58
The Nar asi mh am Commi t t ee I I ( 1 9 9 8 ) also r ecommended t hat call money
market in I ndia, like in most ot her developed market s, should be st rict ly
r est r ict ed t o banks and pr imar y dealer s. Since non- bank part icipant s are not
subj ect t o r eser ve r equir ement s, t he Commit t ee f elt t hat such par t icipant s
shoul d use t he ot her money mar ket i nst r ument s, and move out of t he call
mar ket s.

The RBI const it ut ed a Tech n i cal Gr ou p on Ph asi n g ou t of Non - ban k s
f r om Cal l / Not i ce Mon ey Mar k et i n December 2 0 0 0 . The r epor t of t hi s
t echnical gr oup was pr esent ed in Mar ch 2001. The r ecommendat ion of t his
gr oup was t hat complet e wit hdr awal of non- bank par t icipant s fr om t he
call/ not ice money mar ket should be co- t er minus wit h f ull f ledged
oper at ionalisat ion of t he Clear ing Cor por at ion, and dur ing t he int er mediat e
period, t heir operat ions should be phased out in such a manner t hat t heir
migrat ion t o r epo/ r ever se r epo mar ket becomes smoot h and t her e is no
disr upt ion in t he call money mar ket .

Following t he r ecommendat ions of t he Reser ve Banks I nt er nal Wor king Gr oup
( 1997) and t he Nar asimhan Commit t ee ( 1998) , st eps wer e t aken t o r ef or m
t he call money mar ket by t r ansf or ming it int o a pur e int er bank mar ket in a
phased manner. The non- banks exit was implement ed in f our st ages beginning
May 2001 wher eby l i mi t s on l endi ng by non- banks wer e pr ogr essively
reduced along wit h t he operat ionalisat ion of negot iat ed dealing syst em ( NDS)
and CCI L unt il t heir complet e wit hdrawal in August 2005. I n order t o creat e
avenues for deployment of funds by non- banks following t heir phased exit
from t he call money market , several new inst rument s were creat ed such as
market r epos and CBLO.

Despit e t hese r ef or ms, however t he behaviour of banks in t he call mar ket has
not been unif or m. Ther e ar e st ill some banks such as f or eign and new pr ivat e
sect or banks which ar e chr onic bor r ower s and public sect or banks, which ar e
t he lender s. Not wi t hst andi ng excessi ve dependence of some banks on t he cal l
money mar ket t he shor t t er m money mar ket s ar e char act er ized by high
degr ee of st abilit y. The RBI has inst it ut ed a ser ies of pr udent ial measur es and
placed limit s on bor r owing and lending of bank and PDs in t he call/ not ice
mar ket t o minimize development of var ious mar ket segment s. I n or der t o
impr ove t r anspar ency and st r engt hen ef f iciency in t he money mar ket , it was
made mandat or y f or all NDS member s t o r epor t all t heir call/ not ice money
mar ket t r ansact ions t hr ough NDS wit hin 15 minut es of conclusion of t he
t r ansact ion. The RBI and t he mar ket par t icipant s have access t o t his
informat ion on a fast er frequency and in a more classified manner, which has
impr oved t he t r anspar ency and t he pr ice discovery process. Furt her, a screen
based negot i at ed quot e- dr iven syst em for all dealings in t he call/ not ice and
t he t erm money market ( NDS- CALL) developed by CCI L and oper at ionalised
on Sept ember 18, 2006 f acilit at ed t r anspar ency and bet t er pr ice discovery in
t hese segment s.

59
Var ious r ef or m measur es have impar t ed st abilit y t o t he call money mar ket .
Wit h t he t r ansfor mat ion of t he call money mar ket int o a pur e int erbank
mar ket , t he t ur nover in t he call/ not ice money mar ket has declined
signif icant ly. The act ivit y has migr at ed t o ot her over night collat er alized
mar ket segment s such as mar ket r epo and CBLO.

The par t icipant s in t he call mar ket s incr eased in t he 1990s, wit h a gr adual
opening up of t he call market s t o non- bank ent it ies. I nit ially DFHI was t he
only PD eligible t o part icipat e in t he call market , wit h ot her PDs having t o
r out e t heir t r ansact ions t hr ough DFHI , and subsequent ly STCI . I n 1996, PDs
apart from DFHI and STCI were
allowed t o lend and borrow direct ly in t he call market s. Present ly t here are
18 pr imar y dealer s par t icipat ing in t he call mar ket s. Then fr om 1991 onwar ds,
cor por at es wer e allowed t o lend in t he call mar ket s, init ially t hr ough t he
DFHI , and lat er t hrough any of t he PDs. I n order t o be able t o lend,
cor por at es had t o pr ovi de proof of bulk lendable resources t o t he RBI and
were not suppose t o have any out st anding borrowings wit h t he banking
syst em. The minimum amount cor por at es had t o lend was r educed f r om Rs.
20 crore, in a phased manner t o Rs. 3 crore in 1998. There were 50
cor por at es eligible t o lend in t he call mar ket s, t hr ough t he pr imar y dealer s.
The cor por at es which wer e allowed t o r out e t heir t r ansact ions t hr ough PDs,
were phased out by end June 2001.

Tabl e 6 . 1 : Nu mber of Par t i ci pan t s i n Cal l / Not i ce Mon ey Mar k et
Cat egor y Ban k PD FI MF Cor por at e Tot al
I . Bor r ower 154 19 - - - 173
I I . Lender 154 19 20 35 50 277
Sour ce: Repor t of t he Technical Gr oup on Phasing Out of Non- banks from
Call/ Not ice Money Market , March 2001.

UTI and LI C were permit t ed t o lend in t he call market s since 1971.
Subsequent ly, 20 ot her financial inst it ut ions were permit t ed t o lend. I nit ially
public sect or mut ual funds could lend in t he call market s. Since 1997, all
SEBI r egist er ed mut ual f unds wer e eligible t o lend. Ther e wer e 277
par t icipant s in t he call mar ket s, wit h 105 par t icipant s, namely mut ual f unds,
cor por at es and financial inst it ut ions, oper at ing only on t he lending side.

Banks and PDs t echnically can oper at e on bot h sides of t he call mar ket ,
t hough in realit y, only t he PDs bor r ow and lend in t he call mar ket s. The bank
part icipant s are divided int o t wo cat egories: banks which are predominant ly
lenders ( most ly t he public sect or banks) and banks which are predominant ly
bor r ower s ( f or eign and pr ivat e sect or banks) .

Cur rent ly, t he par t icipant s in t he call/ not ice money mar ket cur r ent ly include
banks ( excluding RRBs) and Pr imar y Dealer s ( PDs) bot h as bor r ower s and
lenders.
60
6.3 CALL RATES

The concent r at ion in t he bor r owing and lending side of t he call mar ket s
impact s liquidit y in t he call mar ket s. The pr esence or absence of impor t ant
player s is a significant influence on quant it y as well as pr ice. This leads t o a
lack of dept h and high levels of volat ilit y in call r at es, when t he par t icipant
st ruct ure on t he lending or bor r owing side alt er s.

Short - t er m liquidit y condit ions impact t he call r at es t he most . On t he supply
side t he call r at es ar e influenced by fact or s such as: deposit mobilisat ion of
banks, capit al flows, and banks r eser ve r equir ement s; and on t he demand
side, call r at es ar e influenced by t ax out flows, gover nment bor r owing
pr ogr amme, seasonal f luct uat ions in cr edit of f t ake. The ext er nal sit uat ion
and t he behaviour of exchange r at es also have an inf luence on call r at es, as
most player s in t his mar ket r un int egr at ed t r easur ies t hat hold shor t t er m
posit ions in bot h r upee and for ex mar ket s, deploying and bor r owing funds
t hr ough call mar ket s.

During normal t imes, call rat es hover in a range bet ween t he repo rat e and
t he reverse repo rat e. The repo rat e represent s an avenue for parking short -
t er m f unds, and dur ing per iods of easy liquidit y, call r at es ar e only slight ly
above t he r epo r at es. Dur ing per iods of t ight liquidit y, call r at es move
t owar ds t he r ever se r epo r at e. Table 6. 2 pr ovides dat a on t he behaviour of
call r at es. Figur e 6. 2 displays t he t r end of aver age mont hly call r at es.

The behaviour of call rat es has hist orically been influenced by liquidit y
condit ions in t he mar ket . Call r at es t ouched a peak of about 35% in May
1992, r ef lect ing t ight liquidit y on account of high levels of st at ut ory pre-
empt ions and wit hdr awl of all r ef inance f acilit ies, bar r ing expor t cr edit
r efinance. Call r at es again came under pr essur e in November 1995 when t he
r at es wer e 35% par
Tabl e 6. 2: Cal l Money Rat es
Year Max i mum
( % p.a.)
Mi ni mum
( % p.a.)
Aver age
( % p.a.)
Bank r at e
( End Mar ch)
( % p.a.)
1996 - 97 14.6 1. 05 7.8 12.0
1997 - 98 52.2 0.2 8.7 10.5
1998 - 99 20.2 3.6 7.8 8.0
1999 - 00 35.0 0.1 8.9 8.0
2000 - 01 35.0 0.2 9.2 7.0
2001 - 02 22.0 3.6 7.2 6.5
2002 - 03 20.00 0. 50 5. 89 6. 25
2003 - 04 12. 00 1. 00 4. 62 6. 00
2004 - 05 10. 95 0.6 4. 65 6. 00
2005 - 06 8. 25 0.6 5.6 6. 00
2006-07 80 1.9 7. 22 6. 00
Sour ce: Handbook of St at ist ics on I ndian Economy, 2006- 07, RBI .
61
Fi gu r e 6 . 2 : Mon t h l y Av er age Cal l Rat es ( % )
0
2
4
6
8
10
12
14
16
J
a
n
-
0
7
M
a
r
-
0
7
M
a
y
-
0
7
J
u
l
-
0
7
S
e
p
-
0
7
N
o
v
-
0
7
J
a
n
-
0
8
M
a
r
-
0
8
M
a
y
-
0
8
Month & Year
A
v
e
r
a
g
e

M
o
n
t
h
l
y

C
a
l
l

R
a
t
e
s

(
%
)

Model Qu est i on s
1. Wh i ch of t h e f ol l ow i n g par t i ci pan t s i n t h e cal l mar k et s ar e al l ow ed
t o l en d as w el l as bor r ow ?

a. Mut ual Funds
b. Banks and Primary Dealers
c. Cor por at es
d. Financial I nst it ut ions
Answ er : b

2. The non- b an k en t i t i es ar e al l ow ed t o p art i ci pat e i n t h e cal l mon ey
mar k et ?I s t h e st at emen t t r u e or f al se?_ _ _ _
a. Tr ue
b. False
Answ er : b

3 . Wh at ar e t h e f eat u r es of NDS- Cal l Sy st em?

a. Elect r onic Dealing Plat f or m
b. Dir ect one t o one negot iat ion
c. Online Exposur e Monit or ing
d. All of t he Above

An sw er : d
62
CHAPTER 7
CORPORATE DEBT: BONDS
7.1 MARKET SEGMENTS

The cor por at e bond mar ket has been in exist ence in I ndia f or a long t ime.
However, despit e a long hist ory, t he size of t he public issue segment of t he
corporat e bond market in I ndia has remained quit e insignificant . The lack of
mar ket inf r ast r uct ur e and compr ehensive r egulat or y f r amewor k coupled wit h
low issuance leading t o low liquidit y in t he secondar y mar ket , nar r ow invest or
base, inadequat e cr edit assessment skills, high cost of issuance, lack of
t ranspar ency in t r ades and under development of secur it izat ion of pr oduct s
ar e some of t he maj or fact or s t hat hinder ed t he gr owt h of t he pr ivat e
cor por at e debt mar ket .

The mar ket f or long t er m cor por at e debt has t wo lar ge segment s:

i. Bonds issued by public sect or unit s, including public financial
inst it ut ions, and
ii. Bonds issued by t he pr ivat e cor por at e sect or
I n January 2007, Government discussed t he r elevant issues of mar ket design
of cor por at e bonds and decided as under :
i. The mar ket design for t he secondar y mar ket of cor por at e debt market
OTC as wel l as exchange based t r ansact i ons need t o be r epor t ed t o
r epor t ing plat for ms( s) ;
ii. All t he eligible and willing nat ional st ock exchanges need t o be allowed
t o set up and maint ain report ing plat forms if t hey appr oach SEBI for
t he same. SEBI needs t o coor dinat e among such r epor t ing plat f or ms
and assign t he j ob of coor dinat ion t o a t hir d agency;
iii. The t r ades execut ed on or r epor t ed t o an Exchange need not be
r epor t ed t o a r epor t ing plat for m;
iv. The par t i ci pant s must have a choi ce of plat form. They may t rade on
OTC or any exchange t r ading plat for m;
v. Exist ing exchanges could be used f or t r ading of cor por at e debt s. NSE
and BSE could pr ovide t r ading plat for ms for t his pur pose. Ther e is no
need t o cr eat e a separ at e inf r ast r uct ur e;
vi. Ther e would be no separ at e t r ading plat for ms for differ ent kinds of
invest ors. I nst it ut ional and ret ail invest ors would t rade on t he same
plat form;
vii. Only br oker s would have access t o t r ading plat f or m of an Exchange.
Banks would have t he opt ion of becoming a broker or t r ading t hr ough
63
a broker. RBI , may if consider ed necessar y r est r ict a bank t o t r ade
only on pr opr iet ar y account as a br oker .
I n order t o facilit at e development of a vibrant primary market for corporat e
bonds in I ndia, Securit ies and Exchange Board of I ndia ( SEBI ) has not if ied
Regulat ions for I ssue and List ing of Debt Secur it ies t o pr ovide for simplified
r egulat or y fr amewor k for issuance and list ing of non- conver t ible debt
secur it ies ( excluding bonds issued by Gover nment s) issued by any company,
public sect or under t aking or st at ut or y cor por at ions. These r egulat ions apply
t o public issue of debt secur it ies and list ing of debt secur it ies issued t hr ough
public issue or on pr ivat e placement basis on a r ecognized st ock exchange.
The Regulat ions will not apply t o issue and list ing of, secur it ized debt
inst r ument s and secur it y r eceipt s for which separ at e r egulat or y r egime is in
pl ace.
The Regulat ions pr ovide for r at ionalized disclosur e r equir ement s for public
issues and flexibilit y t o issuer s t o st r uct ur e t heir inst r ument s and decide on
t he mode of of f er ing, wit hout dilut ing t he ar eas of r egulat or y concer n. I n case
of public issues, while t he disclosur es specified under Schedule I I of t he
Companies Act , 1956 shall be made, t he Regulat ions require addit ional
disclosures about t he issuer and t he inst rument such as nat ure of
inst r ument s, r at ing r at ionale, f ace value, issue size, et c.
While t he requirement of filing of draft offer document s wit h SEBI for
obser vat ions has been done away wit h, emphasis has been placed on due
diligence, adequat e disclosur es, and cr edit r at ing as t he cor ner st ones of
t r anspar ency. Regulat ions pr escr ibe cer t if icat ions t o be f iled by mer chant
banker s in t his r egar d. The Regulat ions emphasize on t he r ole and obligat ions
of t he debent ure t r ust ees, execut ion of t r ust deed, cr eat ion of secur it y and
cr eat ion of debent ur e r edempt ion r eser ve in t er ms of t he Companies Act .
The Regulat ions enable elect r onic disclosur es. The dr af t of f er document needs
t o be f iled wit h t he designat ed st ock exchange t hr ough a SEBI r egi st er ed
mer chant banker who shall be r esponsible f or due diligence exer cise in t he
issue pr ocess and t he dr af t of f er document shall be placed on t he websit es of
t he st ock exchanges for a per iod of seven wor king days invit ing comment s.
The document s shal l be downl oadabl e i n PDF or HTML f or mat s. The
r equir ement s f or adver t isement s have also been simplif ied.
While list ing of secur it ies issued t o t he public is mandat or y, t he issuer s may
also list t heir debt secur it ies issued on pr ivat e placement basi s subj ect t o
compliance of simplif ied r egulat or y r equir ement s as pr ovided in t he
Regulat ions. The Regulat ions pr ovide an enabling fr amewor k for list ing of
debt secur it ies issued on a pr ivat e placement basis, even in cases wher e t he
equit y of t he issuer is not list ed. NBFCs and PFI s ar e exempt ed fr om
mandat or y list ing. However , t hey may list t heir pr ivat ely placed debt
64
secur it ies subj ect t o compliance wit h t he simplified r equir ement s and List ing
Agr eement . A r at ionalized list ing agr eement for debt secur it ies is under
preparat ion.
7.2 SEBI ( I SSUE AND LI STI NG OF DEBT SECURI TI ES)
REGULATI ONS, 2008

I ssue Requi r ement s f or Publ i c I ssues

Gener al Condi t i ons

1. No issuer should make any public issue of debt secur it ies if as on t he
dat e of f iling of dr af t of f er document and f inal of f er document as
pr ovided in t hese r egulat ions, t he issuer or t he per son in cont r ol of t he
issuer , or it s pr omot er , has been r est r ained or pr ohibit ed or debar r ed by
t he Board from accessing t he securit ies market or dealing in securit i es
and such dir ect ion or or der is in for ce.

2. The following condit ions have t o be sat isfied by an issuer for making any
public issue of debt securit ies as on t he dat e of filing of draft offer
document and f inal of f er document .

i. I f t he issuer has made an applicat ion t o mor e t han one r ecognized
st ock exchange, t he issuer is r equir ed t o choose one of t hem as
t he designat ed st ock exchange. Fur t her , wher e any of such st ock
exchanges have nat ionwide t r ading t er minals, t he issuer should
choose one of t hem as designat ed st ock exchange. For any
subsequent public issue, t he issuer may choose a dif f er ent st ock
exchange subj ect t o t he r equir ement s of t his r egulat ion.
ii. The issuer has t o obt ain in- pr inciple appr oval for list ing of it s debt
secur i t i es on t he r ecogni zed st ock exchanges wher e t he appl i cat i on
for list ing has been made.
iii. Cr edit r at ing has be obt ained f r om at least one cr edit r at ing agency
r egist er ed wit h SEBI and is disclosed in t he offer document . I f t he
cr edit r at ings have been obt ained f r om mor e t han one cr edit r at ing
agency, t hen all r at ings including t he unaccept ed r at ings have t o
be disclosed in t he of f er document .
iv. I t has t o ent er int o an ar r angement wit h a deposit or y r egist er ed
wit h SEBI f or demat er ializat ion of debt secur it ies t hat ar e pr oposed
t o be issued t o t he public in accordance wit h t he Deposit ories Act
1996 and regulat ions made t hereunder.

3. The issuer should appoint one or mor e mer chant banker s r egist er ed wit h
SEBI at least one of whom should be a lead mer chant banker .

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4. The i ssuer should appoint one or more debent ure t rust ees in accordance
wit h t he provisions of sect ion 117 B of t he Companies Act , 1956and SEBI
( Debent ur e Tr ust ee) Regulat ions, 1993.

5. The issuer should not issue debt secur it ies f or pr oviding loan t o or
acquisit ion of shares of any person who is part of t he same group or who
is under t he same management .

Fi l i n g of Dr af t Of f er Docu men t

No issuer should make a public issue of debt securit ies unless a draft of offer
document has been f iled wit h t he designat ed st ock exchange t hr ough t he lead
mer chant banker . The dr af t of f er document f iled wit h t he st ock exchange has
t o be made public by post ing t he same on t he websit e of designat ed st ock
exchange for seeking public comment s for a per iod of seven wor king days
from t he dat e of f iling t he dr af t of f er document wit h such exchange. The dr af t
offer document may also be displayed on t he websit e of t he issuer, merchant
banker s. The lead mer chant banker s should ensur e t hat t he dr af t of f er
document cl ear l y speci f i es t he names and cont act par t icular s of t he
compliance officer of t he lead mer chant banker and t he issuer including t he
post al and email addr ess, t elephone and f ax number s. The lead mer chant
banker should also ensur e t hat all comment s r eceived on t he dr af t of f er
document are sui t abl y addr essed pr i or t o t he f i l i ng of t he of f er document wi t h
t he Regi st r ar of Compani es. A copy of t he dr af t and f i nal of f er document
should be forwarded t o SEBI for it s records, simult aneously wit h filing of
t hese document s wit h t he designat ed st ock exchanges. The lead merchant
bankers should prior t o filing of t he offer document wit h t he Regist rar of
Companies, f ur nish t o SEBI a due diligence cer t if icat e as per t he f or mat
provided in Schedule I I of SEBI ( I ssue and List ing of Debt Securit ies)
Regulat ions, 2008.

El ect r on i c I ssu an ce

An issuer pr oposing t o issue debt secur it ies t o t he public t hr ough t he online
syst em of t he designat ed st ock exchange should comply wit h t he r elevant
applicable r equir ement s as may be specified by SEBI .

Pr i ce Di scov er y t h r ou gh Book Bu i l di n g

The issuer may det ermine t he price of debt securit ies in consult at ion wit h t he
lead mer chant banker and t he issue may be at fixed pr ice or t he pr ice may be
det er mined t hr ough t he book building pr ocess in accor dance wit h t he
pr ocedure as may be specified by SEBI .

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Mi n i mu m Su bscr i pt i on

The issuer may decide t he amount of minimum subscript ion which it seeks t o
raise by issue of debt securit ies and disclose t he same in t he offer document .
I n t he event of non- r eceipt of minimum subscr ipt ion all applicat ion moneys
r eceived in t he public issue shall be r ef unded f or t hwit h t o t he applicant s.

Li st i n g Of Debt Secu r i t i es
An issuer desirous of making an offer of debt securit ies t o t he public has t o
make an applicat ion for list ing t o one or more r ecognized st ock exchanges in
t er ms of sub- sect i on ( 1) of sect i on 73 of t he Compani es Act , 1956 ( 1 of
1956) . The issuer has t o comply wit h t he condit ions of list ing of such debt
securit ies as specified in t he List ing Agreement wit h t he St ock exchanges
wher e such debt secur it ies ar e sought t o be list ed.

Con di t i on s f or l i st i n g of debt secu r i t i es i ssu ed on pr i v at e pl acemen t
basi s:

An issuer may list it s debt secur it ies issued on pr ivat e placement basis on a
r ecognized st ock exchange subj ect t o t he f ollowing condit ions:

i. The issuer has issued such debt secur it ies in compliance wit h t he
pr ovisions of t he Companies Act , 1956 r ules pr escr ibed t her eunder and
ot her applicable laws.
ii. Credit rat ing has been obt ained in respect of such debt securit ies from
at least one credit rat ing agency regist ered wit h SEBI .
iii. The debt secur it ies pr oposed t o be list ed ar e in demat er ialised for m.
iv. The disclosur es as pr escr ibed under Regulat ion 21 of t he I ssue and
List ing of Debt Securit ies Regulat ions, 2008 have t o be made.

Fur t her , the issuer has t o comply wit h t he condit ions of list ing of such debt
secur it ies as specif ied in t he List ing Agr eement wit h t he st ock exchange

Con di t i on s of Con t i n u ou s Li st i n g an d Tr adi n g of Debt secu r i t ies:

Con t i n u ou s Li st i n g Con di t i on s

1) All t he issuer s making public issues of debt secur it ies or seeking list ing
of debt secur i t i es i ssued on pr i vat e pl acement basi s shoul d compl y
wit h t he condit ions of list ing specif ied in t he r espect ive agr eement f or
debt securit ies.

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2) Ever y r at ing obt ained by an issuer should be per iodically r eviewed by
t he r egist er ed cr edit r at ing agency and any r evision in t he r at ing shall
be prompt ly disclosed by t he issuer t o t he st ock exchange where t he
debt securit ies are list ed.
3) Any change in r at ing should be pr ompt ly disseminat ed t o invest or s and
pr ospect ive invest or in such manner as t he st ock exchange wher e such
secur it ies ar e list ed may det er mine fr om t ime t o t ime.
4) The issuer , t he r espect ive debent ur e t r ust ees and st ock exchanges
should disseminat e all inf or mat ion and r epor t s on debt secur it ies
including compliance r epor t s f iled by t he issuer s and t he debent ur e
t r ust ees r egar ding t he debt secur it ies t o t he invest or s and t he gener al
public by placing t hem on t heir websit es.
5) Debent ure t r ust ee should disclose t he infor mat ion t o t he invest or s and
t he gener al public by issuing a pr ess r elease in any of t he f ollowing
event s: ( a) default by issuer t o pay int er est on debt secur it ies or
r edempt ion amount ; ( b) f ailur e t o cr eat e a char ge on t he asset s;
r evision of r at ing assigned t o t he debt secur it ies.

Tr adi n g of debt secu r i t i es

1) The debt secur it ies issued t o t he public or on a pr ivat e placement basis,
which are list ed in recognized st ock exchanges, shall be t raded and
such t r ades shal l be clear ed and set t l ed i n r ecogni zed st ock exchanges
subj ect t o condit ions specif ied by SEBI .
2) I n case of t r ades of debt secur it ies which have been made over t he
count er , such t r ades shall be r epor t ed on a r ecognized st ock exchange
having a nat ion wide t r ading t er minal or such ot her plat f or m as may
be specified by t he Boar d.
3) SEBI may specif y condit ions f or r epor t ing of t r ades on t he r ecognized
st ock exchange or ot her plat f or m. .

Secon dar y Mar k et f or Cor por at e Debt Secu r i t i es
Companies have been issuing debt secur i t i es on pr i vat e pl acement basi s f r om
t ime t o t ime. I n or der t o pr ovide gr eat er t r anspar ency t o such issuances and
pr ot ect t he int er est of invest or s.

7.3 LI STI NG CRI TERI A ON NSE WDM

The secur it y pr oposed for list ing on t he WDM segment of NSE should comply
wit h t he r equir ement s as indicat ed her eunder :

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El i gi bi l i t y Cr i t er i a f or l i st i ng I ssuer
Publ i c I ssue / Pr i vat e Pl acement
Paid- up capit al of Rs.10 crores; or
Market capit alisat ion of Rs.25 crores
( I n case of unlist ed companies Net wort h more
t han Rs.25 crores)
Corporat es ( Public limit ed
companies and Privat e limit ed
companies)
Credit rat ing
Public Sect or Undert aking,
St at ut ory Corporat ion
est ablished/ constit ut ed under
Special Act of Parliament
/ St at e Legislat ure, Local
bodies/ aut horit ies,
Credit rat ing
Mut ual Funds:
Unit s of any SEBI regist ered
Mut ual Fund/ scheme :
I nvest ment obj ect ive t o
invest predominant ly in debt
or
Scheme is t raded in
secondary market as debt
inst rument
Qualifies for list ing under SEBI s Regulat ions
I nfrast ruct ure companies Qualifies for list ing under t he respect ive Act s,
Rules or Regulat ions under which t he securit ies
are issued.
Tax exempt ion and recognit ion
as infrast ruct ure company
under relat ed
st at ut es/ regulat ions
Credit rat ing
Public I ssue Privat e Placement Financial I nst it ut ions u/ s. 4A
of Companies Act , 1956
including I ndust rial
Development Corporat ions
Qualifies for list ing under
t he respect ive Act s, Rules
or Regulat ions under which
t he securit ies are issued.
Credit rat ing
Scheduled banks Scheduled
Banks
Net wort h of Rs.50
crores or above

Qualifies for list ing
under t he respect ive Act s,
Rules or Regulat ions under
which t he securit ies are
issued.
Net wort h of
Rs.50 crores or
above
Banks
Credit rat ing

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An I ssuer shall ensur e compliance wit h SEBI cir cular s/ guidelines and any ot her law,
guidelines/ dir ect ions of Cent r al Gover nment , ot her St at ut or y or local aut hor it y
issued on r egulat ing t he list ing of debt inst r ument s fr om t ime t o t ime.

7.4 SECONDARY MARKET FOR CORPORATE DEBT
SECURI TI ES

SEBI had issued a cir cular No. SEBI / MRD/ SE/ AT/ 36/ 2003/ 30/ 09 dat ed
Sept ember 30, 2003 st ipulat ing t he condit ions t o be complied in r espect of
pr ivat e placement of debt secur it ies. These condit ions gover ned t hr ee
aspect s, viz. , issuance, list ing and t r ading of pr ivat ely placed debt secur it ies.

I n order t o provide great er t ransparency t o such issuances and t o pr ot ect t he
int erest of invest ors in such securit ies, it has been decided t hat any list ed
company making issue of debt secur it ies on a pr ivat e placement basis and
list ed on a st ock exchange shall be r equir ed t o comply wit h t he following:
1. 1 The company shall make full disclosures ( init ial and cont inuing) in
t he manner pr escr ibed in Schedule I I of t he Companies Act , 1956,
SEBI ( Disclosur e and I nvest or Pr ot ect ion) Guidelines, 2000 and t he
List ing Agr eement wit h t he exchanges. However , if t he privat ely
placed debt secur it ies ar e in st andar d denominat ion of Rs. 10 Lakh,
such disclosur es may be made only t hr ough web sit es of t he st ock
exchange wher e t he debt secur it ies ar e sought t o be list ed.
1. 2 The debt secur it ies shall car r y a cr edit r at ing of not less t han
invest ment gr ade fr om a Cr edit Rat ing Agency r egist er ed wit h t he
Board.
1. 3 The company shall appoint a debent ur e t r ust ee r egist er ed wit h SEBI
in r espect of t he issue of t he debt secur it ies.
1. 4 The debt secur it ies shall be issued and t r aded in demat form.
1. 5 The company shall sign a separ at e list ing agr eement wit h t he
exchange in r espect of debt secur it ies and comply wit h t he
condit ions of list ing.
1. 6 All t rades wit h t he except ion of spot t ransact ions, in a list ed debt
secur it y, shall be execut ed only on t he t r ading plat f or m of a st ock
exchange.
1. 7 The t r ading in pr ivat ely placed debt s shall only t ake place bet ween
Qualified I nst it ut ional I nvest ors ( QI Bs) and High Net wort h
I ndividuals ( HNI s) , in st andar d denominat ion of Rs. 10 lakh.
1. 8 The r equi r ement of Rule 19( 2) ( b) of t he Secur it ies Cont r act
( Regulat ion) Rules, 1957 will not be applicable t o list ing of pr ivat ely
placed debt secur it ies on exchanges, pr ovided all t he above
r equir ement s ar e complied wit h.
1. 9 I f t he int er mediar ies r egist er ed wit h SEBI associat e t hemselves wit h
t he issuance of pr ivat e placement of unlist ed debt secur it ies, t hey
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will be held account able f or such issues. They will also be r equir ed t o
fur nish per iodical r epor t s t o SEBI in such for mat as may be decided
by SEBI . ( SEBI also pr ovides clar if icat ion r egar ding above cir cular
vide it s circular no SEBI / MRD/ SE/ AT/ 46/ 2003 dat ed December 22,
2003 at t ached as Appendix- I )
Fur t her SEBI vide it s cir cular no. SEBI / CFD/ DI L/ CI R- 39/ 2004/ 11/ 01 dat ed
November 01, 2004 pr ovides Model List ing Agr eement for List ing Debt
Secur it ies. As per above cir cular , list ing of all debt secur it ies ir r espect ive of
t he mode of issuance i. e. whet her issued on pr ivat e placement basis or
t hrough public/ right s issue, shall be done t hrough a separat e List ing
Agr eement .

The main feat ur es of t he Model List ing Agr eement ar e as under :

The Agreement may be used for list ing of all debt securit ies issued by
an issuer ir r espect ive of mode of issuance. The debt secur it ies have
been referred as debent ures in t he agreement and includes
debent ures as defined in Sect ion 2( 12) of t he Companies Act , 1956
and any ot her debt inst r ument s, which ar e pr oposed t o be list ed on
r ecognized St ock Exchange. I ssuer means any per son making an issue
of debent ures which are proposed t o be list ed excluding Supr a
Nat ional Or ganizat ions like Asian Development Bank, Wor ld Bank et c.
The Model Agr eement has t hr ee par t s. Par t ( I ) cont ains clauses which
shall be complied by all issuer s ir r espect ive of mode of issuance, Par t
( I I ) cont ains clauses which shall be complied wit h only if t he
debent ures are issued eit her t hrough public or right s issue and part
( I I I ) cont ains clauses which ar e r equir ed t o be complied wit h only if
t he debent ur es ar e issued on pr ivat e placement basis.
I n case of issuer s whose equit y shar es ar e list ed and which have
alr eady ent er ed int o a List ing Agr eement for it s equit y shar es, clauses
of Equit y List ing Agreement shall have an overriding effect over t he
Debent ur e List ing Agr eement , in case of inconsist ency, if any.

I n t he r ecent per iod, sever al measur es have been t aken t o develop t he debt
mar ket . The cor por at e bond r epor t ing and t r ading plat f or m have been
oper at ionalized at BSE, NSE and FI MMDA. SEBI has r at ionalized t he
pr ovisions of cont inuous disclosur es made by issuer s who have list ed their
debt securit ies. I t also implement ed measures t o st reamline t he act ivit y in
cor por at e bonds in line wit h Gover nment secur it ies, r educed t r adable lot s in
cor por at e bonds in r espect of all ent it ies including Qualified I nst it ut ional
invest or s t o Rs. 1 lakh and st andar di zed t he day count convent i on. I n or der t o
enhance t he safet y of invest or s, SEBI made it mandat or y t hat t he companies
i ssui ng debent ur es and t he r espect i ve debent ur e t r ust ees/ st ock exchanges
shall disseminat e all infor mat ion t hr ough r espect iv e websit es and pr ess
r eleases. Sever al ot her r efor ms such as simplificat ion of t he debt issuance
pr ocess and r at ionalizat ion of st amp dut y ar e also under consider at ion.
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I n July 2008, t he first meet ing of t he newly set up Corporat e Bond and
Secur it izat ion Advisor y Commit t ee ( CoBoSAC) was convened under t he
Chair manship of Dr . RH Pat il. The Commit t ee deliber at ed on st r eamlining
mechanisms f or r epor t ing, clear ing and set t lement and on development s in
t he Cor por at e Bond Mar ket t o dat e. The Commit t ee, af t er deliber at i on
r ecommended implement at ion of mandat or y DvP- I I I clear ing and set t lement
on exchanges wit h RTGS. I n t he meant ime, it was r ecommended t o set up a
sub- gr oup t hat would look int o issues r elat ed t o t r ade r epor t ing.
7.5 CREDI T RATI NG

Credit rat ing is pr imar ily int ended t o syst emat ically measur e cr edit r isk ar ising
from t ransact ions bet ween lender and borrower. Credit risk is t he risk of a
f inancial loss ar ising f r om t he inabilit y ( known in cr edit par lance as def ault ) of
t he bor r ower t o meet t he financial obligat ions t owards it s credit or. The
abilit y of a bor r ower t o meet it s obligat ions fluct uat es accor ding t o t he
behaviour of r isk fact or s, bot h int er nal and ext er nal, t hat impact t he
per for mance of a business ent er pr ise. Ther efor e, most lender s have t o incur
cost s of analysing t hese fact ors before a lending decision is made, and also
cr eat e monit or ing mechanisms t hat enable such evaluat ion when t he
bor r ower s obligat ions ar e out st anding. I f such specialist assessment of cr edit
qualit y is done by an independent agency, it would be possible for t he lender
t o not incur t he cost s, but r ely on t he assessment of such agency. We t hen
have a syst em wher e, t he bor r ower seeks t he opinion of t he specialized
agency, pays t he cost s of t hese ser vices, and t hen pr ovides t he assessment
t o t he lender , f or seeking f unds.

Cr edit r at ing is one of t he many ways of st andar dising t he cr edit qualit y of
borrowers, t hrough a formal examinat ion of risk fact ors, which enables
classificat ion of cr edit r isk int o defined cat egor ies. Such cat egor isat ion
st andar dises cr edit r isk, in ways t hat enable measur ement and management
of credit risk. Credit rat ing t hus enables pricing of debt product s, and t heir
valuat ion in a balance sheet , over t he per iod t hey ar e out st anding.

Credit rat ing is a well est ablished ent er pr ise in most economies, including
I ndia, wher e specialized agencies have evolved t o cr eat e ext ensive met hods
of analysis of infor mat ion, and pr ovide r at ings t o bor r ower s. The accept ance
of t hese rat ings by lenders crucially hinges on t he independence of t he r at ing
agency, and t he exper t ise it br ings t o bear on t he pr ocess of cr edit r at ing. I n
t he r ecent year s, t he emphasis on int er nal cr edit r isk evaluat ion syst ems has
gr own. While Eur opean and Japanese lending inst it ut ions have always
emphasised an int er nal r at ing syst em, over ext er nal r at ings, in count r ies
out side t hese r egions t oo, t her e is a par allel int er nal r at ing syst em being
cr eat ed in t he r ecent year s. While cr edit evaluat ion and monit or ing have
been t radit ionally in t he banking domain, t he f or mal conver sion of t hese int o
r at ing syst ems is new. The impet us has been t he super visor y r isk
72
assessment and ear ly war ning syst ems, now r equir ed by t he BI S, which
emphasises t he need f or st r uct ur ed r isk assessment syst ems.

I n I ndia, it is mandat or y f or cr edit r at ing agencies t o r egist er t hemselves wit h
SEBI and abide by t he SEBI ( Cr edit Rat ing) Regulat ions, 1999. Ther e ar e 5
SEBI regist ered credit rat ing agencies in I ndia, namely, CRI SI L, I CRA, CARE
et c, which provide a rat ing on var ious cat egor ies of debt inst r ument s.

Cr edit r at ing agencies assess t he cr edit qualit y of debt issuer s, on t he basis of
a number of quant it at ive and qualit at ive f act or s, employing specialized
anal yst s, who f ocus on i ndust r y cat egor i es i n whi ch they have specialized
knowledge. Apar t fr om infor mat ion pr ovided by t he bor r ower , t hese analyst s
independent ly collect and assess inf or mat ion, about t he indust r y and
company var iables, and per for mance of peer gr oup companies, and collat e
such dat a. Most rat ing agencies follow a commit t ee appr oach, wher e a r at ing
commit t ee examines t he inf or mat ion on t he company, and j udges t he r at ing
t hat should be assigned t o t he inst r ument on of f er . Rat ing essent ially
involves t he t r anslat ion of inf or mat ion var iables int o a r anki ng, whi ch pl aces
t he company in a slot t hat descr ibes t he abilit y and willingness of t he
company t o ser vice t he inst r ument pr oposed t o be issued.

7.6 RATI NG SYMBOLS

The r anking of cr edit qualit y is usually done wit h t he help of r at ing symbols,
whi ch br oadly classify inst r ument s int o invest ment gr ade, and speculat ive
grade. An illust rat ive rat ing list is provided below ( represent ing CRI SI Ls
r at ing symbols) :
CRI SI L assigns r at ings t o only r upee denominat ed debt inst r ument s. CRI SI Ls
rat ing is assigned t o t he issue or inst r ument alone and not t o t he issuer .
I nst r ument s which have t he same r at ing ar e of similar but not ident ical
invest ment qualit y. This is because t he number of r at ing cat egor ies is limit ed
and hence cannot r eflect small differ ences in t he degree of risks. CRI SI Ls
cr edit r at ings f all under t hr ee cat egor ies: long t er m, shor t t er m and f ixed
deposit r at ings. Long t er m r at ings cat egor ies r ange f r om AAA t o D; CRI SI L
may appl y + or - signs as suffixes for rat ings from AA t o C t o reflect
compar at ive st andings wit hin t he cat egor y. I n t he case of pr ef er ence shar es,
t he let t ers pf are prefixed t o t he debent ure rat ing symbols. The fixed
deposit rat ing symbols commence wit h F and t he shor t - t er m inst r ument s
cat egor ies r ange fr om P1 t o P5; CRI SI L may apply + or - sign for rat t ing
from P1 t o P3. use t he let t er P from t he concept of ' prime' .

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Hi gh I n v est men t Gr ades
AAA ( Tr i pl e A) Hi gh est Saf et y
Debent ur es r at ed AAA ar e j udged t o of f er highest saf et y of t imely payment
of i nt er est and pr incipal. Though t he cir cumst ances pr oviding t his degr ee of
safet y ar e likely t o change, such changes as can be envisaged ar e most
unlikely t o affect adver sely t he fundament ally st r ong posit ion of such issues.

AA ( Dou bl e A) Hi gh Saf et y
Debent ur es r at ed AA ar e j udged t o of f er high saf et y of t imely payment of
int er est and pr incipal. They differ in safet y fr om AAA issues only mar ginally.
I nv est ment Gr ades
A Adequ at e Saf et y
Debent ures rat ed A are j udged t o offer adequat e safet y of t ime ly payment of
int er est and pr incipal. However , changes in cir cumst ances can adver sely
affect such issues mor e t han t hose in t he higher r at ed cat egor ies.
BBB ( Tr i pl e B) Moder at e Saf et y
Debent ur es r at ed BBB ar e j udged t o of f er moder at e saf et y of t imely
payment of int er est and pr incipal f or t he pr esent ; however , changing
cir cumst ances ar e mor e likely t o lead t o a weakened capacit y t o pay int er est
and r epay pr incipal t han for debent ur es in higher r at ed cat egor ies.
Specu l at i v e Gr ades
BB ( Dou bl e B) I n adequ at e Saf et y
Debent ur es r at ed BB ar e j udged t o car r y inadequat e safet y and pr incipal,
while t hey ar e less suscept ible t o default t han ot her speculat ive gr ade
debent ur es in t he immediat e f ut ur e; t he uncer t aint ies t hat t he issuer f aces
could lead t o inadequat e capacit y t o make t imely int er est and pr incipal
payment s.
B - Hi gh Ri sk
Debent ur es r at ed B ar e j udged t o have gr eat er suscept ibilit y t o default ;
while cur r ent ly int er est and pr incipal payment s ar e met , adver se business of
economic condit ions would lead t o lack of abilit y or willingness t o pay, int er est
or principal.
C Su bst an t i al Ri sk
Debent ures rat ed C are j udged t o have fact ors present t hat make t hem
vulner able t o def ault ; t imely payment of int er est and pr incipal is possible only
if favourable circumst ances cont i nue.
D Def aul t
Debent ures rat ed D are in default and in arrears of int erest or principal
payment s or ar e expect ed t o def ault on mat ur it y. Such debent ur es ar e
ext r emely speculat ive and r et ur n f r om t hese debent ur es may be r ealised only
on r eor ganisat ion or liquidat ion.

Rat ing agencies may apply + ( plus) or ( minus) signs for rat ings from AA
t o C t o r ef lect compar at ive st anding wit hin t he cat egor ies.

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Model Quest i ons

1 . Wh i ch of t h e f ol l ow i n g st at emen t s i s t r u e abou t t h e of f er
docu men t ?

a. An offer document has t o be filed wit h SEBI for all debent ure issues,
whet her public or pr ivat ely placed.
b. Offer document has t o be filed for all public issues only.
c. An offer document need not be filed if t he debent ur es ar e issued for
mat ur it ies below 18 mont hs.
d. I n t he case of pr ivat e placement , an abr idged of f er document is t o be f iled
wit h SEBI .
An sw er : b

2 . Wh i ch of t h e f ol l ow i n g st at emen t s i s f al se r egar di n g cr edi t r at i n g
of cor por at e deben t u r es?

a. All public issues of debent ur es should be compulsor ily cr edit r at ed.
b. Rat ings have t o be sought fr om agencies r egist er ed wit h SEBI .
c. Debent ur es wit h mat ur it y less t han 18 mont hs need not be r at ed.
d. Mut ual funds ar e not per mit t ed t o subscr ibe t o unr at ed cor por at e paper .
Answ er : c

3 . Wh i ch of t h e f ol l owi n g st at emen t i s f al se r egar di n g t h e SEBI
I ssu e an d Li st i n g of Debt Secu r i t i es Regu l at i on , 2 0 0 8 ?

a. Pr ovides for issuance and list ing of non- conver t ible debt secur it ies
( excluding bonds issued by Gover nment s) issued by and company,
PSU or st at ut or y cor porat ions.
b. These regulat ions apply t o public issue of debt securit ies and list ing of
debt securit ies and list ing of debt securit ies t hrough public issue or on
pr ivat e placement basis on a r ecognized st ock exchange.
c. These regulat ions apply t o issue and list ing of secur it ized debt
inst r ument s and secur it y r eceipt s f or which separ at e r egulat or y r egime
is in place.
d. The Regulat ions pr ovide f or r at ionalized disclosur e r equir ement s.

Answ er : c

75
Appen di x I

Su b: Secon dar y Mar k et f or Cor por at e Debt Secu r i t i es - Cl ar i f i cat i ons
1. SEBI had issued a cir cular No. SEBI / MRD/ SE/ AT/ 36/ 2003/ 30/ 09 dat ed
Sept ember 30, 2003 st ipulat ing t he condit ions t o be complied in r espect of
pr ivat e placement of debt secur it ies. These condit ions gover ned t hr ee
aspect s, viz. , issuance, list ing and t rading of privat ely placed debt
secur it ies.
2. The said cir cular was issued by SEBI aft er a consult at ive paper on t he
subj ect was placed on t he web sit e of SEBI f or public comment s.
Subsequent t o t he issuance of t he cir cular , mar ket par t icipant s have made
repr esent at ions and suggest ions and sought clar if icat ions on t he var ious
pr ovisions of t he cir cular f r om SEBI . A ser ies of meet ings wer e also held
wit h t hem. Meanwhile, SEBI has vide pr ess r elease dat ed November 25,
2003 gr ant ed a t r ansit ion per iod up t o March 31, 2004 t o t hose issuer
companies who had issued privat ely placed debt securit ies but did not list
t hose secur it ies pr ior t o Sept ember 30, 2003 ( t he dat e of t he cir cular ) t o
enable t hem t o comply wit h t he pr ovisions of t he cir cular .
3. The clar if icat ions sought and r epr esent at ions cover ed t he f ollowing
aspect s:
Applicabilit y of t he cir cular t o
i. Type of issue r companies
ii. Pr ospect ive and exist ing issues
iii. Tenor of t he debt inst r ument s
Ext ent of disclosur es and applicabilit y of DI P Guidelines
3.3 Associat ion of SEBI r egist er ed int er mediar ies, including mer chant
bankers
3.4 Vet t ing of Offer document
3.5 Whet her t he r equir ement of 1% deposit wit h t he st ock exchange/ s is
mandat ory
3.6 Applicabilit y of minimum subscr ipt ion clause as per DI P guidelines
3. 7 Cr edi t r at i ng
3.8 List ing t hr ough a separ at e list ing agr eement
3.9 Denominat ion for issuance and market lot for t rading
3.10 Tr ading of secur it ies on t he st ock exchanges.

4. The clar if icat ions t o t he above ar e as f ollows:
4 . 1 Appl i cabi l i t y of t h e ci r cu l ar
i. Type of I ssuer companies
a) The SEBI cir cular dat ed Sept ember 30, 2003 would be applicable
t o all list ed companies which have any of t heir securit ies, eit her
equit y or debt , of f er ed t hr ough an of f er document , i. e. , t hr ough a
public issue and list ed on a recognized st ock exchange and also
includes Public Sect or Under t akings whose secur it ies ar e list ed on
a r ecognized st ock exchange.
b) Fur t her , unlist ed companies/ st at ut or y cor por at ions/ ot her ent it ies,
if t hey so desir e, may get t heir pr ivat ely placed debt secur it ies
76
list ed in t he st ock exchanges, by complying wit h t he relevant
provisions of t he said circular.
ii. Pr ospect ive and exist ing issues
a) The SEBI cir cular is applicable t o all debt secur it ies t hat have
been and would be
issued on a pr ivat e placement basis on or af t er t he dat e of t he
circular, i. e. , Sept ember 30, 2003.
b) The cir cular would also apply t o t hose issuer companies whose
out st anding debt secur it ies wer e issued pr ior t o Sept ember 30,
2003. However , such issuer companies ar e r equir ed t o comply
wi t h t he pr ovisions of t he cir cular befor e Mar ch 31, 2004 for
which t r ansit ion t ime was pr ovided vide pr ess r elease dat ed
November 25, 2003.
c) I f , however , t he issuer companies do not comply wit h t he
af or esaid condit ions f or list ing of such secur it ies bef or e Mar ch 31,
2004, t hen such secur it ies would r emain unlist ed and, would,
t her ef or e, not be per mit t ed f or t r ading in t he St ock Exchange
t rading plat form from April 01, 2004.
iii. Tenor of t he debt inst r ument s: The SEBI cir cular would not be
applicable for pr ivat e placement of debt secur it ies having a mat ur it y of
less t han 365 days.

4.2 Ex t en t of di scl osu r es an d appl i cabi l i t y of DI P Gu i del i n es
a) As already st ipulat ed in t he circular dat ed Sept ember 30, 2003 t he
issuer companies shall make f ull disclosur es ( init ial and cont i nui ng)
in t he manner prescribed in schedule I I of t he Companies Act ,
1956, Chapt er VI of t he SEBI ( DI P) Guidelines, 2000 and t he list ing
agr eement wit h t he st ock exchanges.
b) Such disclosures may be made t hrough t he web sit e of t he st ock
exchanges wher e t he debt secur i t i es ar e sought t o be l i st ed i f t he
pr ivat ely placed debt secur it ies ar e issued in t he st andar d
denominat ion of Rs. 10 lakh.
c) The issuer companies which make fr equent pr ivat e placement s of
debt securit ies would be permit t ed t o file an umbr ella of f er
document on t he lines of a Shelf pr ospect us as applicable for a
public issue.
d) As r egar ds financial disclosur es, issuer companies which ar e not in
a posit ion, f or genuine r easons, t o disclose audit ed account s upt o a
dat e not earlier t han six mont hs of t he dat e of t he offer document ,
in t erms of provisions of Clause 6. 18 of SEBI ( DI P) Guidelines,
2000 may disclose t he audit ed account s f or t he last f inancial year
and unaudit ed account s for t he subsequent quar t er s wit h a limit ed
r eview by a pr act ici ng Char t er ed Account ant .
e) I t is also being clar ified t hat t he pr ovisions ot her t han Chapt er VI of
SEBI ( DI P) Guidelines, 2000 will not be applicable for privat ely
placed debt secur it ies.

77
4 . 3 Associ at i on of SEBI r egi st er ed i n t er medi ar i es, i n cl u di n g
mer cha n t ban k er s
a) The appoint ment of int er mediar ies ( ot her t han debent ur e t r ust ee)
for pr ivat e placement of debt secur it ies is not mandat or y.
b) Si nce engagi ng t he ser vi ces of an i nt er medi ar y ( ot her t han
debent ur e t r ust ee) is not mandat or y, t he appoint ment of such an
int er mediar y would be left t o t he discr et ion of t he issuer company,
as it deems f it .
c) Ther e is no pr ohibit ion on SEBI r egist er ed int er mediar ies t o be
associat ed wit h t he pr ivat ely placed unlist ed debt secur it ies.
However , such int er mediar ies would be account able for t heir
act ivit ies. Fur t her , t hey would be r equir ed t o f ur nish per iodical
report s t o SEBI in such format as specified by SEBI from t ime t o
t ime.

4. 4 Vet t i n g of of f er docu men t
Ther e is no r equir ement of vet t ing of t he offer document by SEBI .

4 . 5 Wh et h er t h e r equ i r emen t of 1 % deposi t w i t h t h e st ock
ex ch an ge( s) i s man dat or y
Ther e is no r equir ement t o deposit 1% of t he issue size of t he pr ivat ely
placed debt secur it ies wit h t he st ock exchanges.

4 . 6 Appl i cabi l i t y of mi n i mu m su bscr i pt i on clau se as per DI P
gu i del i n es
This clause will not be applicable for pr ivat ely placed debt secur it ies.

4. 7 Cr edi t r at i ng
The debt secur it ies shall car r y a cr edit r at ing f r om a Cr edit Rat ing
Agency regist ered wit h SEBI .

4 . 8 Li st i n g t h r ou gh a separ a t e l i st i n g agr eemen t
The separ at e List ing Agr eement for list ing t he pr ivat ely placed debt
secur it ies is being finalised. Till such t ime, t he issuance pr ocess would
be allowed and t he securit ies may be list ed on t he basis of disclosures
subj ect t o t he i ssuer company f ur nishing an under t aking t o t he St ock
Exchanges st at ing, int eral i a, t hat t he i ssuer company shal l si gn t he
List ing Agr eement as soon as t he same comes int o f or ce.

4 . 9 Den omi n at i on f or i ssu an ce an d mar k et l ot f or t r adi n g
a) The pr ivat ely placed debt secur it ies need not necessar ily be issued
in denominat ion of Rs. 10 lakh.
b) The securit ies shall be issued in demat form.
c) However , if an invest or is allot t ed secur it ies of Rs. 1 lakh or less,
such securit ies may be issued in physical form at t he opt ion of t he
invest or. I t shall be disclosed by t he issuer companies t hat such
78
invest or s would not be able t o t r ade in such secur it ies t hr ough t he
st ock exchange mechanism.

4 . 1 0 Tr adi n g of secu r i t i es on t h e st ock ex ch an ges
a) The t r ading in t he pr ivat ely placed debt secur it ies would be
per mit t ed in st andar d denominat ion of Rs. 10 lakhs in t he
anonymous, or der dr iven syst em of t he st ock exchanges in a
separ at e t r ading segment . The mar ket able lot would be Rs. 10
lakh.
b) All class of invest or s would be per mit t ed t o t r ade subj ect t o t he
said st andar d denominat ion/ mar ket able lot .
c) The t r ades execut ed on spot basis shall be r equir ed t o be r epor t ed
t o t he st ock exchange/ s.
5. The st ock exchanges ar e di r ect ed t o:
a) make necessar y amendment s t o t he list ing agr eement , byelaws,
r ul es and r egulat ions f or t he implement at ion of t he above decision
immediat ely, as may be applicable and necessar y.
b) br i ng t he pr ovi si ons of t hi s ci r cul ar t o t he not i ce of t he l i st ed
companies/ member br oker s/ clear ing member s of t he Exchange
and also t o disseminat e t he same on t he websit e f or easy access t o
t he invest or s; and
c) communi cat e t o SEBI , t he st at us of t he i mpl ement at i on of t he
pr ovisions of t his cir cular in Sect ion I I , it em no. 13 of t he Mont hly
Development Repor t for t he mont h of Januar y, 2004.
6. This cir cular is being issued in exer cise of power s confer r ed by sect ion 11
( 1) of t he Secur it ies and Exchange Boar d of I ndia Act , 1992, t o pr ot ect
t he int er est s of invest or s in secur it ies and t o pr omot e t he development of ,
and t o r egulat e t he secur it ies mar ket .
79

CHAPTER 8
COMMERCI AL PAPER & CERTI FI CATE
OF DEPOSI TS

Commercial paper ( CP) is a short - t er m inst r ument , int r oduced in 1990, t o
enable non- banking companies t o bor r ow shor t - t erm funds t hrough liquid
money mar ket inst r ument s. CPs wer e int ended t o be par t of t he wor king
capit al f inance f or cor por at es, and wer e t her ef or e par t of t he wor king capit al
limit s as set by t he maximum per missible bank f inance ( MPBF) . CP issues ar e
r egulat ed by RBI Guidelines issued f r om t ime t o t ime st ipulat ing t er m,
eligibilit y, limit s and amount and met hod of issuance. I t is mandat or y f or CPs
t o be cr edi t r at ed.
8.1 GUI DELI NES FOR CP I SSUE

Guidelines f or I ssue of Commer cial Paper ( CP) as amended up t o June 30,
2008
I n t r odu ct i on
1. Commer cial Paper ( CP) is an unsecur ed money mar ket i nst r ument
issued in t he for m of a pr omissor y not e. CP, as a pr ivat ely placed inst r ument ,
was int r oduced in I ndia in 1990 wit h a view t o enabling highly r at ed cor por at e
bor r ower s t o diver sif y t heir sour ces of shor t - t er m bor r owings and t o pr ovide
an addit ional inst r ument t o invest or s. Subsequent ly, pr imar y dealer s, sat ellit e
dealers
3
and all- I ndia financial inst it ut ions were also permit t ed t o issue CP t o
enable t hem t o meet t heir shor t - t er m f unding r equir ement s f or t heir
oper at ions. Guidelines f or issue of CP ar e pr esent l y gover ned by var i ous
dir ect ives issued by t he Reser ve Bank of I ndia, as amended f r om t ime t o
t ime.

Wh o can I ssu e Commer ci al Paper ( CP) ?
2. Corporat es and primary dealers ( PDs) , and t he all- I ndia financial
inst it ut ions ( FI s) t hat have been per mit t ed t o r aise shor t - t er m r esour ces
under t he umbrella limit fixed by Reserve Bank of I ndia are eligible t o issue
CP.

3
The syst em of sat ellit e dealers has since been discont inued wit h effect from
June 1, 2002.
80
3. A cor por at e would be eligible t o issue CP pr ovided: ( a) t he t angible net
wor t h of t he company, as per t he lat est audit ed balance sheet , is not less
t han Rs. 4 cr or e; ( b) company has been sanct ioned wor king capit al limit by
bank/ s or all- I ndia financial inst it ut ion/ s; and ( c) t he bor r owal account of t he
company is classified as a St andar d Asset by t he financing bank/ s/
i nst i t ut ion/ s.

Rat i ng Requi r ement
4. All eligible par t icipant s shall obt ain t he cr edit r at ing for issuance of
Commer cial Paper fr om eit her t he Cr edit Rat ing I nfor mat ion Ser vices of I ndia
Lt d. ( CRI SI L) or t he I nvest ment I nformat ion and Credit Rat ing Agency of
I ndia Lt d. ( I CRA) or t he Cr edit Analysis and Resear ch Lt d. ( CARE) or t he
FI TCH Rat ings I ndia Pvt . Lt d. or such ot her cr edit r at ing agencies as may be
specif ied by t he Reser ve Bank of I ndia f r om t ime t o t ime, f or t he pur pose.
The minimum cr edit r at ing shall be P- 2 of CRI SI L or such equivalent r at ing by
ot her agencies. The issuer s shall ensur e at t he t ime of issuance of CP t hat
t he rat ing so obt ained is current and has not fallen due for review.

Mat ur i t y
5. CP can be issued for mat urit ies bet ween a minimum of 7 days and a
maximum up t o one year f r om t he dat e of issue. The mat ur it y dat e of t he CP
should not go beyond t he dat e up t o which t he cr edit r at ing of t he issuer is
valid.

Denomi nat i ons
6. CP can be issued in denominat ions of Rs. 5 lakh or mult iples t hereof .
Amount invest ed by a single invest or should not be less t han Rs. 5 lakh ( face
value) .

Li mi t s an d t h e Amou n t of I ssu e of CP
7. CP can be issued as a " st and alone" pr oduct . The aggr egat e amount
of CP from an issuer shall be wit hin t he limit as approved by it s Board of
Dir ect or s or t he quant um indicat ed by t he Cr edit Rat ing Agency for t he
specif ied r at ing, whichever is lower . Banks and FI s will, however , have t he
f lexibilit y t o f ix wor king capit al limit s duly t aking int o account t he r esour ce
pat t er n of c ompanies financing including CPs.
8. An FI can issue CP wit hin t he overall umbrella limit fixed by t he RBI
i. e. , issue of CP t oget her wit h ot her inst r ument s viz. , t er m money bor r owings,
t er m deposit s, cer t if icat es of deposit and int er- cor por at e deposit s should not
exceed 100 per cent of it s net owned funds, as per t he lat est audit ed balance
sheet .
9. The t ot al amount of CP pr oposed t o be issued should be r aised wit hin a
per iod of t wo weeks f r om t he dat e on which t he issuer opens t he issue f or
subscr i pt i on. CP may be issued on a single dat e or in par t s on differ ent dat es
pr ovided t hat in t he lat t er case, each CP shall have t he same mat ur it y dat e.
81
10. Every issue of CP, including renewal, should be t reat ed as a fresh
issue.

Wh o can Act as I ssu i n g an d Pay i n g Agen t ( I PA)
11. Only a scheduled bank can act as an I PA f or issuance of CP.
I n v est men t i n CP
12. CP may be issued t o and held by individuals, banking companies, ot her
cor por at e bodies r egist er ed or incor por at ed in I ndia and unincor por at ed
bodies, Non- Resident I ndians ( NRI s) and For eign I nst it ut ional I nvest or s
( FI I s) . However, invest ment by FI I s would be wit hin t he limit s set for t heir
invest ment s by Secur it ies and Exchange Boar d of I ndia ( SEBI ) .

Mode of I ssu an ce
13. CP can be issued eit her in t he form of a promissory not e or in a
demat er ialised for m t hr ough any of t he deposit or ies appr oved by and
r egist er ed wit h SEBI .
14. CP will be issued at a discount t o face value as may be det er mined by
t he issuer.
15. No issuer shall have t he issue of CP under wr i t t en or co- accept ed.

Pr ef er ence f or Demat er i al i sat i on
16. While opt ion is available t o bot h issuer s and subscr iber s t o issue/ hold
CP in demat er ialised or physical f or m, issuer s and subscr iber s ar e encour aged
t o prefer exclusive reliance on demat eria lised for m of issue/ holding.
However , wit h effect fr om June 30, 2001, banks, FI s and PDs ar e dir ect ed t o
make fr esh invest ment s and hold CP only in demat er ialised for m.

Pay men t of CP
17. The init ial invest or in CP shall pay t he discount ed value of t he CP by
means of a cr ossed account payee cheque t o t he account of t he issuer
t hr ough I PA. On mat ur it y of CP, when t he CP is held in physical f or m, t he
holder of t he CP shall pr esent t he inst r ument f or payment t o t he issuer
t hr ough t he I PA. However , when t he CP is held in demat form, t he holder of
t he CP will have t o get it r edeemed t hr ough t he deposit or y and r eceive
payment fr om t he I PA.

St and- by Faci l i t y
18. I n view of CP being a ' st and alone' product , it would not be obligat ory
in any manner on t he par t of t he banks and FI s t o pr ovide st and- by f acilit y t o
t he issuer s of CP. Banks and FI s have, however , t he f lexibilit y t o pr ovide f or
a CP issue, cr edit enhancement by way of st and- by assist ance/ cr edit , back-
st op f acilit y et c. based on t heir commer cial j udgement , subj ect t o pr udent i al
nor ms as applicable and wit h specific appr oval of t heir Boar ds.
19. Non- bank ent it ies including cor por at es may also pr ovide uncondit ional
and ir r evocable guar ant ee for cr edit enhancement for CP issue pr ovided:
82
(i) t he issuer fulfils t he eligibilit y cr it er ia pr escr ibed for issuance of CP;
(ii) t he guar ant or has a cr edit r at ing at least one not ch higher t han t he
issuer given by an appr oved cr edit r at ing agency; and
(iii) t he offer document for CP pr oper ly discloses t he net wor t h of t he
guar ant or company, t he names of t he compani es t o whi ch t he
guar ant or has issued similar guar ant ees, t he ext ent of t he
guar ant ees of f er ed by t he guar ant or company, and t he condit ions
under which t he guar ant ee will be invoked.

Pr ocedur e f or I ssuance
20. Ever y issuer must appoint an I PA for issuance of CP. The issuer
should disclose t o t he pot ent ial invest or s it s financial posit ion as per t he
st andar d mar ket pr act ice. Af t er t he exchange of deal conf ir mat ion bet ween
t he invest or and t he issuer, issuing company shall issue physical cert ificat es
t o t he invest or or ar r ange f or cr edit ing t he CP t o t he invest or ' s account wit h a
deposit or y. I nvest or s shall be given a copy of I PA cer t if icat e t o t he ef f ect t hat
t he issuer has a valid agreement wit h t he I PA and docume nt s ar e in or der .

Rol e an d Respon si bi l i t i es
21. The r ole and r esponsibilit ies of issuer , issuing and paying agent ( I PA)
and cr edit r at ing agency ( CRA) ar e set out below:
( a) I ssu er
Wit h t he simplificat ion in t he pr ocedur es for CP issuance, issuer s would
now have more flexibilit y. I ssuers would, however, have t o ensure
t hat t he guidelines and pr ocedur es laid down f or CP issuance ar e
st r ict ly adher ed t o.
( b) I ssu i n g an d Pay i n g Agen t ( I PA)
i. I PA would ensur e t hat issuer has t he minimum cr edit r at ing as
st ipulat ed by t he RBI and amount mobilised t hr ough issuance of CP
is wit hin t he quant um indicat ed by CRA f or t he specif ied r at ing or
as appr oved by it s Boar d of Dir ect or s, whichever is lower .
ii. I PA has t o ver if y all t he document s submit t ed by t he issuer viz. ,
copy of boar d r esolut ion, signat ur es of aut hor ised execut ant s
( when CP in physical f or m) and issue a cer t if icat e t hat document s
ar e in or der . I t should also cer t ify t hat it has a valid agr eement
wit h t he issuer .
iii. Cer t if ied copies of or iginal document s ver if i ed by t he I PA shoul d be
held in t he cust ody of I PA.
iv. Ever y CP issue should be r epor t ed t o t he Chief Gener al Manager ,
Financial Market Depart ment , Reserve Bank of I ndia, Cent ral
Office, Fort , Mumbai.
v. I PAs which ar e NDS member , should r epor t t he det ails of CP issue
on NDS plat f or m wit hin t wo days f r om t he dat e of complet ion of
t he issue.
vi. Furt her, all scheduled banks, act ing as an I PA, will cont inue t o
r epor t CP issuance det ails hit her t o wit hin t hr ee days fr om t he dat e
83
of complet ion of t he issue, incor por at ing det ails as per Schedule I I
t ill NDS report ing st abilizes t o t he sat isfact ion of RBI .
( c) Cr edi t Rat i n g Agen cy ( CRA)
i. Code of Conduct prescribed by t he SEBI for CRAs for undert aking
r at ing of capit al mar ket inst r ument s shall be applicable t o t hem
( CRAs) for r at ing CP.
ii. Fur t her , t he cr edit r at ing agency would hencefor t h have t he
discr et ion t o det er mine t he validit y per iod of t he r at ing depending
upon it s per cept ion about t he st r engt h of t he issuer . Accor dingly,
CRA shall at t he t ime of r at ing, clear ly indicat e t he dat e when t he
rat ing is due for review.
iii. While t he CRAs can decide t he validit y per iod of cr edit r at ing, t hey
would have t o closely monit or t he rat ing assigned t o issuers vis- a-
vis t heir t r ack r ecor d at r egular int er vals and would be r equir ed t o
make t heir r evision in t he r at ings public t hr ough t heir publicat ions
and websit e.

Document at i on Pr ocedur e
22. Fixed I ncome Money Mar ket and Der ivat ives Associat ion of I ndia
( FI MMDA) may pr escr ibe, in consult at ion wit h t he RBI , f or oper at ional
flexibilit y and smoot h funct ioning of CP mar ket , any st andar dised pr ocedur e
and document at ion t hat ar e t o be followed by t he par t icipant s, in consonance
wit h t he int er nat ional best pr act ices.
23. Violat ion of t hese guidelines will at t r act penalt ies and may also include
debar r ing of t he ent it y fr om t he CP mar ket .

Def au l t s i n CP mar k et
24. I n or der t o monit or def ault s in r edempt ion of CP, scheduled banks
which act as I PAs, are advised t o immediat ely report , on occurrence, full
par t icular s of default s in r epayment of CPs t o t he Monet ar y Policy
Depar t ment , Reser ve Bank of I ndia, Cent r al Of f ice, For t , Mumbai, in t he
pr escr ibed f or mat .

Non- appl i cabi l i t y of Cer t ai n Ot h er Di r ect i on s
25. Not hing cont ained in t he Non- Banking Financial Companies Accept ance
of Public Deposit s ( Reser ve Bank) Dir ect ions, 1998 shall apply t o any non-
banking financial company ( NBFC) insofar as it r elat es t o accept ance of
deposit by issuance of CP, in accor dance wit h t hese Guidelines.

DEFI NI TI ONS
I n t hese guidelines, unless t he cont ext ot her wise r equir es:
( a) " bank or banking company" means a banking company as defined in
clause ( c) of Sect ion 5 of t he Banking Regulat ion Act , 1949 ( 10 of
1949) or a " corresponding new bank" , " St at e Bank of I ndia" or
" subsidiar y bank" as defined in clause ( da) , clause ( nc) and cl ause
( nd) r espect ively t her eof and includes a " cooper at ive bank" as defined
in clause ( cci) of Sect ion 5 r ead wit h Sect ion 56 of t hat Act .
84
( b) scheduled bank means a bank included in t he Second Schedule of
t he Reserve Bank of I ndia Act , 1934.
( c) Al l- I ndia Financial I nst it ut ions ( FI s) mean t hose financial inst it ut ions
which have been per mit t ed specifically by t he Reser ve Bank of I ndia t o
r aise r esour ces by way of Ter m Money, Ter m Deposit s, Cer t if icat es of
Deposit , Commer cial Paper and I nt er- Corpor at e Deposit s, wher e
applicable, wit hin umbr ella limit .
( d) "Primary Dealer" means a non- banking f inancial company which holds
a valid let t er of aut horisat ion as a Primary Dealer issued by t he
Reserve Bank, in t erms of t he " Guidelines for Primary Dealers in
Gover nment Secur i t i es Mar ket " dat ed Mar ch 29, 1995, as amended
fr om t ime t o t ime.
( e) " cor por at e or company" means a company as def ined in Sect ion 45 I
( aa) of t he Reser ve Bank of I ndi a Act , 1934 but does not i ncl ude a
company which is being wound up under any law for t he t ime being in
f or ce.
( f ) "non- banking company" means a company ot her t han banking
company.
( g) non- banking financial company means a company as defined in
Sect ion 45 I ( f) of t he Reserve Bank of I ndia Act , 1934.
( h) wor king capit al limit means t he aggr egat e l i mi t s, i ncl udi ng t hose by
way of pur chase/ discount of bills sanct ioned by one or mor e banks/ FI s
for meet ing t he wor king capit al r equir ement s.
(i) " Tangible net wor t h" means t he paid- up capit al plus fr ee r eser ves
( including balances in t he share premium account , capit al and
debent ur es r edempt ion r eser ves and any ot her r eser ve not being
cr eat ed for r epayment of any fut ur e liabilit y or for depr eciat ion in
asset s or for bad debt s or reserve creat ed by revaluat ion of asset s) as
per t he lat est audit ed balance sheet of t he company, as r educed by
t he amount of accumulat ed balance of loss, balance of defer r ed
r evenue expendit ur e, as also ot her int angible asset s.
(j ) Words and expressions used but not defined herein and defined in t he
Reserve Bank of I ndia Act , 1934 ( 2 of 1934) shall have t he same
meaning as assigned t o t hem in t hat Act .

8.2 RATI NG NOTCHES FOR CPS

Cr edit r at ing agencies r at e CPs on 5- not ch scale as follows:
P1 : I ndicat es t hat t he degr ee of saf et y r egar ding t imely payment is st r ong
P2 : I ndi cat es t hat t he degr ee of safet y r egar ding t imely payment is st r ong,
however , t he r elat ive degr ee of safet y is lower t han t hat of P1.
P3 : I ndicat es t hat t he degr ee of saf et y r egar ding t imely payment on t he
inst r ument adequat e; however t he inst r ument is mor e vulner a ble t o adver se
ef f ect s of changing cir cumst ances t han an inst r ument r at ed in t he t wo higher
cat egor ies.
85
P4 : I ndicat es t hat t he degree of safet y regarding t imely payment on t he
inst rument is minimal and it is likely t o be adversely affect ed by short - t erm
adver sit y or less favour able condit ions.
P5 : I ndicat es t hat t he inst r ument is expect ed t o be in def ault on mat ur it y or
is in default . These r at ings can be fur t her t uned wit h t he addit ion of + and
- symbols aft er t he rat ing.
8.3 GROWTH I N THE CP MARKET

CP was int r oduced in I ndia in Januar y 1990, in pur suance of t he Vaghul
Commit t ees r ecommendat ions, in or der t o enable highly r at ed non- bank
cor por at e bor r ower s t o diver sif y t heir sour ces of shor t t er m bor r owings and
also pr ovide an addit ional inst r ument t o invest or s. CP could car r y on an
int erest rat e coupon but is generally sold at a discount . Since CP is freely
t r ansf er able, banks, f inancial inst it ut ions, insur ance companies and ot her s ar e
able t o invest t heir short - t erm surplus funds in a highly liquid inst r ument at
at t r act ive r at es of r et ur n.

The t erms and condit ions relat ing t o issuing CPs such as eligibilit y, mat urit y
per iods and modes of issue have been gr adually r elaxed over t he year s by t he
Reser ve Bank. The minimum t enor has been br ought down t o seven days ( by
Oct ober 2004) in st ages and t he minimum size of individual issue as well as
individual invest ment has also been r educed t o Rs. 5 lakh wit h a view t o
aligning it wit h ot her money mar ket inst r ument s. The limit of CP issuance was
f ir st car ved out of t he maximum permissible bank finance ( MPBF) and
subsequent ly only t o it s cash cr edit . A maj or r ef or m t o impar t a measur e of
independence t o t he CP mar ket t ook place when t he st and by f acilit y
4
of t he
r est or at ion of t he cash cr edit limit and guar ant eeing f unds t o t he issuer on
mat urit y of t he paper was wit hdrawn in Oct ober 1994. As t he reduct ion in
cash cr edit por t ion of t he MPBF impeded t he development of t he CP mar ket ,
t he issuance of CP was delinked f r om t he cash cr edit limit in Oct ober 1997. I t
was conver t ed int o a st and alone pr oduct fr om Oct ober 2000 so as t o enable
t he issuer s of t he ser vice sect or t o meet shor t - t er m wor king capit al
r equir ement s. Banks ar e allowed t o fix wor king capit al limit s aft er t aking int o
account t he r esour ce pat t er n of t he companies finances, including CPs.
Cor por at es, PDs and all- I ndia financial inst it ut ions ( FI s) under specified
st ipulat ions have per mit t ed t o r aise shor t - t er m r esour ces by t he Reser ve
Bank t hr ough t he issue of CPs. Ther e is no lock in per iod for CPs.
Furt her mor e, guidelines wer e issued per mit t ing invest ment s in CPs which has
enabled a r educt ion in t r ansact ion cost . I n or der t o r at ionalize t he and
st andar dize wher ever possible, var ious aspect s of pr ocessing, set t lement and

4
A st and- by facilit y provided by a bank enables an issuer of CPs t o have it s bank finance limit s
rest ored when t he CP mat ures, so t hat t he CP can be redeemed. The credit qualit y of a CP
depended on t he availabilit y of such a facilit y.

86
document at ion of CP issuance, sever al measur es wer e under t aken wit h a view
t o achieving t he set t lement on T+ 1 basis. For f ur t her deepening t he mar ket ,
t he Reser ve Bank of I ndia issued dr aft guidelines on secur it isait on of st andar d
asset s on Apr il 4, 2005. Accor dingly t he r epor t ing of CP issuance by issuing
and paying agent s ( I PAs) on NDS plat f or m commenced ef f ect ive on Apr il 16,
2005. Act ivit y in t he CP mar ket r ef lect s t he st at e of mar ket liquidit y as it s
issuances t end t o r ise amidst ample liquidit y condit ions when companies can
r ai se f unds t hr ough CPs at an ef f ect ive r at e of discount lower t han t he lending
r at e of bonds. Banks also pr efer invest ing in CPs dur ing cr edit downswing as
t he CP r at e wor ks out higher t han t he call r at e. Table 8. 1 shows t he t r ends in
CP r at es and amount s out st anding.

Tabl e 8 . 1 : CPs - Tr en ds i n Vol u mes an d Di scou n t Rat es
Year Amount
Ou t st an di n g at
t h e en d of Mar ch
( Rs. cr . )
Mi n i mu m
Di scount
Rat e
( % p. a. )
Max i mu m
Di scount
Rat e
( % p. a. )
1993- 1994 3, 264 9.01 16. 25
1994- 1995 604 10. 00 15. 50
1995- 1996 76 13. 75 20. 15
1996- 1997 646 11. 25 20. 90
1997- 1998 1, 500 7.65 15. 75
1998- 1999 4, 770 8.50 15. 25
1999- 2000 5, 663 9.00 13. 00
2000- 2001 5, 846 8.20 12. 80
2001- 2002 7, 224 7.10 13. 00
2002- 2003 5, 749 5.50 11. 10
2003- 2004 9, 131 4.60 9.88
2004- 2005 14, 235 4.47 7.69
2005- 2006 12, 718 5.25 9.25
2006- 2007 17, 838 6.25 13. 35
Sour ce: RBI , Handbook of St at ist ics on I ndian Economy, 2006- 07
8.4 STAMP DUTY

The dominant invest ors in CPs are banks, t hough CPs are also held by
f inancial inst it ut ions and cor por at es. The st ruct ure of st amp dut ies for banks
and non- banks is pr esent ed in Table 8. 2.

87
Tabl e 8 . 2 St r u ct u r e of St amp Du t y ( i n per cent )
Per i od Ban k s Non- Bank s
Past Pr esent Past Pr esent
I . Upt o 3 mont hs 0.05 0. 012 0. 125 0.06
I I . Above 3 mont hs upt o 6 mont hs 0.10 0. 024 0. 250 0.12
I I I . Above 6 mont hs upt o 9 mont hs 0.15 0. 036 0. 375 0.18
I V. Above 9 mont hs upt o 12 mont hs 0.20 0.05 0. 500 0.25
V. Above 12 mont hs 0.40 0.10 1.00 0. 5
Effect ive fr om Mar ch 1, 2004
I nt er nat ionally, no st amp dut y applicable on CP issuances in USA, UK and
Fr ance.
Sour ce : - RBI
8.5 CERTI FI CATES OF DEPOSI T

Wit h a view t o fur t her widening t he r ange of money mar ket inst r ument s and
giving invest or s gr eat er f lexibilit y in deployment of t heir shor t t er m sur plus
funds, Cer t ificat e of Deposit s ( CDs) wer e int r oduced in I ndia in 1989. They
are essent ially securit ized short t erm t ime deposit s issued by banks and all-
I ndia Financial I nst it ut ions dur ing t he per iod of t ight liquidit y at r elat ively
higher discount r at es as compar ed t o t er m deposit s.

Cer t ificat es of Deposit s ( CDs) ar e shor t - t er m bor r owings by banks. CDs differ
f r om t er m deposit because t hey involve t he cr eat ion of paper , and hence have
t he facilit y for t r ansfer and mult iple owner ships befor e mat ur it y. CD r at es are
usually higher t han t he t er m deposit r at es, due t o t he low t r ansact ions cost s.
Banks use t he CDs for bor r owing dur ing a cr edit pick- up, t o t he ext ent of
shor t age in incr ement al deposit s. Most CDs ar e held unt il mat ur it y, and t her e
is limit ed secondary mar ket act ivit y.

Cer t if icat es of Deposit ( CDs) is a negot iable money mar ket inst r ument and
issued in demat erialised form or as a Usance Promissory Not e, for funds
deposit ed at a bank or ot her eligible financial inst it ut ion for a specified t ime
88
period. Guidelines f or issue of CDs ar e pr esent ly gover ned by var ious
direct ives issued by t he Reserve Bank of I ndia.

CDs can be issued by ( i) scheduled commercial banks excluding Regional
Rur al Banks ( RRBs) and Local Ar ea Banks ( LABs) ; and ( ii) select all- I ndia
Financial I nst it ut ions t hat have been per mit t ed by RBI t o r aise shor t - t erm
resources wit hin t he umbrella limit fixed by RBI .
Banks have t he f r eedom t o issue CDs depending on t heir r equir ement s. An FI
may issue CDs wit hin t he overall umbrella limit fixed by RBI , i. e. , issue of CD
t oget her wit h ot her inst r ument s, viz. , t er m money, t er m deposit s, commer cial
paper s and int er- corporat e deposit s should not exceed 100 per cent of it s net
owned f unds, as per t he lat est audit ed balance sheet .
Minimum amount of a CD should be Rs. 1 lakh, i. e. , t he minimum deposit t hat
could be accept ed from a single subscriber should not be less t han Rs. 1 lakh
and in t he mult iples of Rs. 1 lakh t her eaft er . CDs can be issued t o individuals,
cor por at i ons, compani es, t r ust s, f unds, associat ions, et c. Non- Resident
I ndi ans ( NRI s) may al so subscr i be t o CDs, but onl y on non- r epat r iable basis
whi ch shoul d be cl ear l y st at ed on t he Cer t i f i cat e. Such CDs cannot be
endor sed t o anot her NRI in t he secondar y mar ket .
The mat ur it y per iod of CDs issued by banks should be not less t han 7 days
and not more t han one year. The FI s can issue CDs for a period not less t han
1 year and not exceeding 3 years from t he dat e of issue. CDs may be issued
at a discount on face value. Banks/ FI s ar e also allowed t o issue CDs on
float ing r at e basis pr ovided t he met hodology of compiling t he float ing r at e is
obj ect ive, t r anspar ent and mar ket - based. The issuing bank/ FI is f r ee t o
det ermine t he discount / coupon rat e. The int erest rat e on float ing rat e CDs
would have t o be r eset per iodically in accor dance wit h a pr e- det er mined
for mula t hat indicat es t he spr ead over a t r anspar ent benchmar k. Banks have
t o maint ain t he appr opr iat e r eser ve r equir ement s, i. e. , cash r eser ve r at io
( CRR) and st at ut or y liquidit y r at io ( SLR) , on t he issue pr ice of t he CDs.
Physical CDs ar e f r eely t r ansf er able by endor sement and deliver y. Demat t ed
CDs can be t ransferred as per t he procedure applicable t o ot her demat
secur it ies. Ther e is no lock- in per iod f or t he CDs. Banks/ FI s cannot gr ant
loans against CDs. Fur t her mor e, t hey cannot buy - back t heir own CDs bef or e
mat ur i t y
The guidelines concer ning CDs have been r elaxed over t ime. These include
(i) Freeing of CDs from int erest rat e regulat ion in 1992.
(ii) Lowering of minimum mat urit y period of CDs issued by banks t o 7
days ( Apr il 2005) wit h a view t o aligning t he minimum t enor f or
CPs and CDs as r ecommended by t he Nar simhan Commit t ee
( 1998) .
89
(iii) Per mit t ing select all- I ndia financial inst it ut ions t o issue CDs for a
mat ur it y per iod of 1 t o 3 year s.
( iv) Abolishing limit s t o CD issuances as a cer t ai n pr opor t i on of aver age
f or t night ly out st anding aggr egat e deposit s ef f ect ive Oct ober 16,
1993 wit h a view t o enabling it as a mar ket det er mined
i nst r ument .
( v) Reducing t he minimum issuance size from Rs. 1 crore in 1989 t o
Rs. 1 lakh in June 2002.
( vi) Wit hdr awal of r est r ict ion on minimum per iod f or t r ansf er abilit y wit h
a view t o pr oviding flexibilit y and dept h t o t he secondar y mar ket
act i vi t y.
(vii) Requiring banks and FI s t o issue CDs only in demat erialised form
effect ive June 30, 2002, in order t o impar t mor e t r anspar ency and
encour age secondar y mar ket and
( viii) Per mit t ing banks in Oct ober 2002 t o issue f loat ing r at e CDs as a
coupon bear ing inst r ument so as t o pr omot e flexible pr icing in t his
i nst r ument .

Table 8. 3 shows t he t r ends in r at es and volume out st anding of CDs. Banks
and f inancial inst it ut ions ar e t he lar gest issuer s of CDs, and ar e also
subscr iber s t o t he CDs of one anot her . Ther e ar e limit ed ot her invest or s such
as mut ual funds, in t he CD mar ket s. Scheduled commer cial banks r ely on CDs
t o supplement t heir deposit r esour ces t o f und t he cr edit demand. The
flexibilit y of t iming and r et ur n t hat can be offer ed for at t r act ing bulk deposit s
has made CDs t he preferred r out e for mobilizing r esour ces by some banks.

Tab l e 8 . 3 : CDs - Vol u me an d Rat es
Year Amou n t Ou t st an di n g
at t h e en d of Mar ch
( Rs. cr . )
Mi n i mu m
r at e ( %
p. a. )
Max i mu m
r at e ( %
p. a. )
1993- 1994 5, 571 7.00 18. 00
1994- 1995 8, 017 7.00 15. 00
1995- 1996 16, 316 9.00 23. 00
1996- 1997 12, 134 7.00 21. 00
1997- 1998 14, 296 5.00 37. 00
1998- 1999 3717 6.00 26. 00
1999- 2000 1, 227 6.25 14. 20
2000- 2001 771 5.00 14. 60
2001- 2002 1576 5.00 11. 50
2002- 2003 908 3.00 10. 88
2003- 2004 4, 461 3.57 7.40
2004- 2005 12, 078 1.09 7.00
2005= 2006 43, 568 4.10 8.94
2006- 2007 93, 272 4.35 11. 90
Sour ce: Handbook of St at ist ics on t he I ndian Economy 2002- 03, RBI
& RBI Bullet in.
90

Model Quest i ons

1 . Wh i ch of t h e f ol l ow i n g i s t h e l ar gest i n v est or i n CPs?

a. Mut ual Funds
b. Cor por at e Tr easur ies
c. Financial I nst it ut ions
d. Scheduled Banks

An s: d

2. Whi ch of t he f ol l ow i n g en t i t i es can n ot i ssu e CPs?

a. Banks
b. Finance Companies
c. Primary Dealers
d. None of t he above

An s: d

91
CHAPTER 9
REPOS
5

9.1 I NTRODUCTI ON

Repo is a money mar ket inst r ument , which enables collat er alized shor t t er m
bor r owing and lending t hr ough sale/ pur chase oper at ions in debt inst r ument s.
Under a repo t ransact ion, a holder of securit ies sells t hem t o an invest or wit h
an agr eement t o r epur chase at a pr edet er mi ned dat e and r at e. I n t he case of
a r epo, t he for war d clean pr ice of t he bonds is set in advance at a level, which
is dif f er ent f r om t he spot clean pr ice by adj ust ing t he dif f er ence bet ween r epo
int er est and coupon ear ned on t he secur it y.

I n t he money market , t his t ransact ion is not hing but collat eralized lending as
t he t er ms of the t r ansact ion ar e st r uct ur ed t o compensat e f or t he f unds lent
and t he cost of t he t r ansact ion is t he r epo r at e. I n ot her wor ds, t he inflow of
cash f r om t he t r ansact ion can be used t o meet t empor ar y liquidit y
requirement in t he short - t erm money market at c ompar able cost .

I n a t ypi cal r epo t r ansact i on, t he count erpar t ies agr ee t o exchange secur it ies
and cash, wit h a simult aneous agr eement t o r ever se t he t r ansact ions af t er a
given per iod. To t he lender of cash, t he secur it ies lent by t he bor r ower
ser ves as t he collat er al; t o t he lender of secur it ies, t he cash bor r owed by t he
lender ser ves as t he collat er al. Repo t hus r epr esent s a collat er alized shor t
t erm lending. The lender of securit ies ( who is also t he borrower of cash) is
said t o be doing t he r epo; t he same t r ansact ion is a r ever se r epo in t he books
of lender of cash ( who is also t he bor r ower of secur it ies) .

A reverse repo is t he mirror image of a repo. For, in a reverse repo, securit ies
ar e acqui r ed wi t h a si mul t aneous commi t ment t o r esel l . Hence whet her a
t r ansact ion is a r epo or a r ever se r epo is det er mined only in t er ms of who
init iat ed t he fir st leg of t he t r ansact ion. When t he r ever se r epur chase
t r ansact ion mat ur es, t he count erpart y ret urns t he securit y t o t he ent it y
concer ned and r eceives it s cash along wit h a profit spread. One fact or which
encour ages an or ganizat ion t o ent er int o r ever se r epo is t hat it ear ns some
ext r a income on it s ot her wise idle cash.

5
Subst ant ial port ions of t his chapt er have been drawn from t he Report of t he Sub-Group on
Ready Forward ( Repo) Transact ions, Technical Advisory Commit t ee on Government Securit ies
Market , RBI , 1998. The summary of recommendat ions made by t his group is in Appendix I t o
t his chapt er.
92
A r epo is also somet imes called a r eady f or war d t ransact ion as it is a means
of funding by selling a securit y held on a spot ( ready) basis and repurchasing
t he same on a for war d basis. Though t her e is no r est r ict ion on t he maximum
period for which repos can be undert aken, generally, repos are done for a
per iod not exceeding 14 days. Differ ent i nst r ument s can be consi der ed as
collat er al secur it y f or under t aking t he r eady f or war d deals and t hey include
Gover nment dat ed secur it ies, t r easur y bills.
While banks and PDs are permit t ed t o undert ake bot h repos and reverse
r epos, ot her par t icipant s such as inst it ut ions and cor por at es can only lend
funds in t he r epo mar ket s. The r ecent policy changes announced in Apr il
2001 have r emoved t his r est r ict ion, and suggest a phased expansion in t he
par t icipat ion in r epo mar ket s. This would, however , r equire t he cr eat ion of
enabling infr ast r uct ur e such as t he Clear ing Cor por at ion and elect r onic
set t lement of t r ansact ions.
Repos ar e set t led on DvP basis on t he same day. I t is essent ial f or
part icipant s in repo t ransact ions t o hold SGL account s and current account
wit h RBI . Repo t r ansact ions ar e also r epor t ed in t he WDM segment of t he
NSE.
9.2 REPO RATE

Repo r at e is not hing but t he annual i sed i nt er est r at e f or t he f unds t r ansf er r ed
by t he lender t o t he borrower. Generally, t he rat e at which it is possible t o
bor r ow t hr ough a r epo is lower t han t he same offer ed on unsecur ed ( or clean)
int erbank loan f or t he r eason t hat it is a collat er alized t r ansact ion and t he
cr edit wor t hiness of t he issuer of t he secur it y is of t en higher t han t he seller .
Ot her fact ors affect ing t he r epo r at e include t he cr edit wor t hiness of t he
bor r ower , liquidit y of t he collat er al and compar able r at es of ot her money
mar ket inst r ument s.

I n a r epo t r ansact i on, t her e ar e t wo l egs of t r ansact i ons vi z. sel l i ng of t he
securit y and repurchasing of t he same. I n t he first leg of t he t ransact ion
which is for a near er dat e, sale pr ice is usually based on t he pr evailing mar ket
pr ice f or out r ight deals. I n t he second leg, which is f or a f ut ur e dat e, t he pr ice
is st r uct ur ed based on t he f unds f low of int er est and t ax element s of funds
exchanged. This is on account of t wo f act or s. Fir st , as t he owner ship of
secur it ies passes on fr om seller t o buyer for t he r epo per iod, legally t he
coupon int er est accr ued for t he per iod has t o be passed on t o t he buyer .
Thus, at t he sale leg, while t he buyer of securit y is required t o pay t he
accr ued coupon int er est f or t he br oken per iod, at t he r epur chase leg, t he
init ial seller is required t o pay t he accrued int erest for t he broken period t o
t he init ial buyer .

Tr ansact ion- wise, bot h t he legs are booked as spot sale/ purchase
t r ansact ions. Thus, aft er adj ust ing for accr ued coupon int er est , sale and
r epur chase pr ices ar e f ixed so as t o yield t he r equir ed r epo r at e. The excess
93
of t he coupon at t he first leg of repo would repr esent t he coupon int er est f or
t he r epo per i od. Thus, t he pr i ce adj ust ment depends di r ect l y upon t he
r elat ionship bet ween t he net coupon and t he r epo amount wor ked out on t he
basis of t he r epo int er est agr eed upon t he t ot al funds t r ansfer r ed. When r epo
rat e is higher t han cur r ent yield r epur chase pr ice will be adj ust ed upwar d
signifying a capit al loss. I f t he r epo r at e is lower t han t he cur r ent yield, t hen
t he r epur chase pr ice will be adj ust ed downwar d signifying a capit al gain.

I f t he r epo r at e and coupon ar e equal, t hen t he r epur chase pr ice will be equal
t o t he sale pr ice of secur it y since no pr ice adj ust ment at t he r epur chase st age
is r equir ed. I f t he r epo r at e is gr eat er t han t he coupon, t hen t he r epur chase
pr ice is adj ust ed upwar d ( wit h r ef er ence t o sale pr ice) t o t he ext ent of t he
dif f er ence bet ween t he t wo. And, if t he r epo r at e is lower t han t he coupon
t hen, t he r epur chase pr ice is adj ust ed downwar d ( wit h r ef er ence t o sale
pr ice) . Specifically, in t er ms of r epo r at e, t her e will be no pr ice adj ust ment
when t he cur r ent yield on secur it y calculat ed on t he basis of sale value
( including accr ued coupon) is equivalent t o r epo r at e.

Alt hough r epos ar e collat er alized t r ansact ions t hey ar e st ill exposed t o
count erpart y risk and t he issuer risk associat ed wit h t he collat er al. As far as
t he count erpart y risk is concerned, t he invest or should be able t o liquidat e
t he secur it ies r eceived as collat er al, t hus lar gely offset t ing any loss. Against
t his t he seller / lender of bonds will hold cash or ot her securit ies as pr ot ect ion
against non- ret urn of t he lent securit ies. I n bot h t he cases it is t o be ensured
t hat t he r ealizable value equals or exceeds t he exposur e. Ther e is also t he
concent r at ion r isk r esult ing fr om illiquid issues which ar e used as collat er al in
t he t r ansact ion.

Gener ally, nor ms ar e laid down f or account ing of r epos and valuat ion of
collat er al ar e concer ned. While t her e ar e st andar d account ing nor ms,
gener ally t he secur it ies used as collat er al in r epo t r ansact ions ar e valued at
current market pric e plus accr ued int er est ( on coupon bear ing secur it ies)
calculat ed t o t he mat ur it y dat e of t he agr eement less " mar gin" or " hair cut " .
The hair cut is t o t ake car e of mar ket r isk and it pr ot ect s eit her t he bor r ower
or lender depending upon how t he t r ansact ion is pr iced. The size of t he
hair cut will depend on t he r epo per iod, r iskiness of t he secur it ies involved and
t he coupon r at e of t he under lying secur it ies.

Since f luct uat ions in mar ket pr ices of secur it ies would be a concer n f or bot h
t he lender as well as t he bor r ower i t i s a common pr act i ce t o r ef l ect t he
changes in market price by resort ing t o marking t o market . Thus, if t he
mar ket value of t he r epo secur it ies decline beyond a point t he bor r ower may
be asked t o pr ovide addit ional collat er al t o cover t he loan. On t he ot her hand,
if t he mar ket value of collat er al r ises subst ant ially, t he lender may be
r equir ed t o r et ur n t he excess collat er al t o t he bor r ower .

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9.3 CALCULATI NG SETTLEMENT AMOUNTS I N REPO
TRANSACTI ONS

Repo t r ansact ions involve 2 legs: t he fir st one when t he r epo amount i s
r eceived by t he bor r ower , and t he second, which involves r epayment of t he
bor r owing. The set t lement amount f or t he f ir st leg consist s of :
a. Value of secur it ies at t he t r ansact ion pr ice
b. Accrued int erest from t he previous coupon dat e t o t he dat e on which
t he f ir st leg is set t led.

The set t lement amount f or t he second leg consist s of :
a. Repo int er est at t he agr eed r at e, f or t he per iod of t he r epo t r ansact ion
b. Ret ur n of pr incipal amount bor r owed.

Securit y offered under Repo 11. 43% 2015
Coupon payment dat es 7 August and 7 Febr uar y
Mar ket Pr ice of t he secur it y
offered under Repo ( i. e. price
of t he secur it y in t he f ir st leg)
Rs. 113. 00 ( 1 )
Dat e of t he Repo 19 Januar y, 2003
Repo int erest rat e 7. 75%
Tenor of t he repo 3 days
Broken period int erest for t he
f i r st l eg*
11. 43%x162/ 360x100= 5. 1435 ( 2 )
Cash considerat ion for t he first
l eg
( 1) + ( 2) = 118. 1435 ( 3 )
Repo int er est * * 118. 1435x3/ 365x7. 75%= 0. 0753 ( 4 )
Broken period int erest for t he
second leg
11. 43% x 165/ 360x100= 5. 2388 ( 5 )
Pr ice for t he second leg ( 3) + ( 4)-( 5) = 118. 1435 + 0. 0753
- 5. 2388 = 112. 98
( 6 )
Cash consider at ion for t he
second leg
( 5) + ( 6) = 112. 98 + 5. 2388 =
118. 2188
( 7 )

9.4 ADVANTAGES OF REPOS

Repos can pr ovide a var iet y of advant ages t o t he f inancial mar ket in gener al,
and debt market , in part icular as under:
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An act ive repo market would lead t o an increase in t urnover in t he money
mar ket , t her eby impr oving liquidit y and dept h of t he mar ket ;
Repos would incr ease t he volumes in t he debt mar ket , as it is a t ool for
funding t ransact ions. I t enables dealers t o deal in higher volumes. Thus,
r epos pr ovide an inexpensive and most ef f icient way of impr oving liquidit y
in t he secondar y mar ket s for under lying inst r ument s. Debt mar ket also
get s a boost as repos help t raders t o t ake a posit ion and go short or long
on securit y. For inst ance, in a bullish scenario one can acquire securit ies
and in a bear ish envir onment dispose t hem of t hus managing cash f lows
t aking advant age of f lexibilit y of r epos.
For inst it ut ions and cor por at e ent it ies, r epos pr ovide a sour ce of
inexpensive f inance and of f er invest ment oppor t unit ies of bor r owed
money at mar ket r at es t hus ear ning a good spr ead;
Tr ipar t it e r epos of f er oppor t unit ies f or suit able f inancial inst it ut ions t o
int er mediat e bet ween t he lender and t he bor r ower .
A large number of repo t ransact ions for varying t enors will effect ively
result in a t erm int erest rat e st ruct ure, especially in t he int erbank
mar ket . I t is well known t hat absence of t er m money mar ket is one of t he
maj or hi ndr ances t o t he gr owt h of debt mar ket s and t he devel opment of
hedging inst r ument s.
Cent r al banks can use r epo as an int egr al par t of t heir open mar ket
oper at ions wit h t he obj ect ive of inj ect ing/ wit hdr awing liquidit y int o and
from t he market and also t o reduce volat ilit y in short t erm in part icular in
call money rat es. Bank reserves and call rat es are used in such inst ances
as t he oper at ing inst r ument s wit h a view t o ult imat ely easing / t ight ening
t he monet ar y condit ions.
9.5 REPO MARKET I N I NDI A: SOME RECENT I SSUES

Repos being shor t t er m money mar ket inst r ument s ar e necessar ily being used
for smoot hening volat ilit y in money market rat es by cent ral banks t hrough
inj ect ion of shor t t er m liquidit y int o t he mar ket as well as absor bing excess
liquidit y fro m t he syst em. Regulat ion of t he r epo mar ket t hus becomes a
dir ect r esponsibilit y of RBI . Accor dingly, RBI has been concer ned wit h use of
r epo as an inst r ument by banks or non- bank ent it ies and issues r elat ing t o
t ype of eligible inst r ument s f or under t aking r epo, eligibilit y of par t icipant s t o
under t ake such t r ansact ions et c. and it has been issuing inst r uct ions in t his
r egar d in consult at ion wit h t he Cent r al Gover nment .
Aft er evidence of abuse in t he repo market during t he period leading t o t he
secur it ies scam of 1992, RBI had banned r epos fr om t he mar ket s. I t is only
in t he r ecent past t hat t hese r est r ict ions have been r emoved, and aft er t he
accept ance of t he r epor t of t he t echnical sub- groups recommendat ions, RBI
has init iat ed ef f or t s f or cr eat ing an act ive mar ket f or r epos. I t was decided t o
adopt t he int er nat ional usage of t he t er m Repo and Rever se Repo under
LAF operat ions. Thus, when RBI absorbs liquidit y it is t ermed as Reverse Repo
and t he RBI inj ect ing liquidit y is t he r epo oper at ion. Since forward t rading in
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secur it ies was gener ally pr ohibit ed in I ndia, r epos wer e per mit t ed under
regulat ed condit ions in t erms of part icipant s and inst rument s. Reforms in t his
mar ket has encompassed bot h inst it ut ions and inst r ument s. Bot h banks and
non- banks wer e allowed in t he mar ket . All gover nment secur it ies and PSU
bonds wer e eligible for r epos t ill Apr il 1988. Bet ween Apr il 1988 and mid June
1992, only int erbank r epos wer e allowed in all gover nment secur it ies. Double
r eady for war d t r ansact ions wer e par t of t he r epos mar ket t hr oughout t he
per iod. Subsequent t o t he ir r egular it ies in secur it ies t r ansact ions t hat
sur faced in Apr il 1992, r epos wer e banned in all secur it ies, except Tr easur y
Bills, while double r eady f or war d t r ansact ions wer e pr ohibit ed alt oget her.
Repos wer e per mit t ed only among banks and PDs. I n or der t o r eact ivat e t he
repos market , t he Reserve Bank gradually ext ended repos facilit y t o all
Cent r al Gover nment dat ed secur it ies, Tr easur y Bills and St at e Gover nment
secur it ies. I t is mandat or y t o act ually hold t he secur it ies in t he por t f olio
befor e under t aking r epo oper at ions. I n or der t o act ivat e t he r epo mar ket and
pr omot e t r anspar ency , t he Reser ve Bank int r oduced r egulat or y saf eguar ds
such as delivery versus payment syst em during 1995- 96. The Reserve Bank
allowed all non- bank ent it ies maint aining subsidiar y gener al ledger ( SGL)
account t o par t icipat e in t his money mar ket segment . Fur t her mor e, NBFCs,
mut ual f unds, housing f inance companies and insur ance companies not
holding SGL account s wer e allowed by t he Reser ve Bank t o under t ake r epo
t r ansact ions fr om Mar ch 2003 t hr ough t heir gilt account s maint ained wit h
cust odians. Wit h t he incr easing use of r epos in t he wake of phased exit of
non- banks from t he call money market , t he Reserve Bank issued
comprehensive unif or m account ing guidelines as well as document at ion policy
in Mar ch 2003. Mor eover , t he DVP I I I mode of set t lement in gover nment
secur it ies ( which involves set t lement of secur it ies and f unds on a net basis) in
April 2004 facilit at ed t he int roduct ion of r ollover of r epo t r ansact ions in
gover nment secur it ies and pr ovided f lexibilit y t o mar ket par t icipant s in
managing t heir collat er als.

The oper at ionalisat ion of t he Negot iat ed Dealing Syst em ( NDS) and t he
Clear ing Cor por at ion of I ndia Lt d. ( CCI L) combined wit h t he pr udent ial limit s
on bor r owing and lending in t he call/ not ice mar ket for banks also helped in
t he development of mar ket r epos.

9.6 SECONDARY MARKET TRANSACTI ONS I N REPOS

Secondar y mar ket r epo t r ansact ions ar e set t led t hr ough t he RBI SGL
account s, and weekly dat a is available fr om t he RBI on volumes, r at es and
number of days. Though t he NSE WDM also has t he f acilit y f or r epor t ing r epo
t r ades, t her e wer e no r epo t r ansact ions r ecor ded dur ing 2005- 06, 2006- 07
and 2007- 08.

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9.7 REPO ACCOUNTI NG

Gu i del i n es f or u n i f or m accou n t i n g f or Repo / Rev er se r epo
t r an sact i on s

1. On a review of t he account ing pract ices followed by all RBI regulat ed
ent it ies for account ing r epo / r ever se r epo t r ansact ions, it emer ged t hat
t her e wer e diver gent pr act ices pr evailing among t hem. I n or der t o
ensur e unifor m account ing t r eat ment in t his r egar d and t o impar t an
element of t r anspar ency, RBI laid down unifor m account ing pr inciples, in
consult at ion wit h Fixed I ncome Money Mar ket s and Der ivat ives
Associat ion of I ndia ( FI MMDA) , f or r epo/ r ever se r epo t r ansact ions
under t aken by all t he r egulat ed ent it ies. These nor ms ar e not applicable
t o r epo / r ever se r epo t r ansact ions under t he Liquidit y Adj ust ment
Facilit y ( LAF) wit h RBI .
2. The unif or m account ing pr inciples wer e applicable f r om t he f inancial
year 2003- 04. Mar ket par t icipant s wer e allowed t o under t ake r epos f r om
any of t he t hr ee cat egor ies of invest ment s, viz. , Held For Tr ading,
Available For Sale and Held To Mat ur it y.
3. The legal charact er of repo under t he current law, viz. as out right
pur chase and out r ight sale t r ansact ions wer e kept int act by ensur ing
t hat t he securit ies sold under repo ( t he ent it y selling referred t o as
seller ) ar e excluded f r om t he I nvest ment Account of t he seller of
secur it ies and t he secur it ies bought under r ever se r epo ( t he ent it y
buying r efer r ed t o as buyer ) ar e included in t he I nvest ment Account of
t he buyer of secur it ies. Fur t her , t he buyer can r eckon t he appr oved
secur it ies acquir ed under r ever se r epo t r ansact ion f or t he pur pose of
St at ut or y Liquidit y Rat io ( SLR) dur ing t he per iod of t he r epo.
4. At pr esent r epo t r ansact ions ar e per mit t ed in Cent r al Gover nment
secur it ies including Tr easur y Bills and dat ed St at e Gover nment
secur it ies. Since t he buyer of t he secur it ies will not hold it t ill mat ur it y,
t he secur it ies pur chased under r ever se r epo by banks should not be
classified under Held t o Mat ur it y cat egor y. The fir st leg of t he r epo
should be cont r act ed at pr evailing mar ket r at es. Fur t her , t he accr ued
int erest received / paid in a repo / reverse re po t r ansact ion and t he
clean pr ice ( i. e. t ot al cash consider at ion less accr ued int er est ) should be
account ed f or separ at ely and dist inct ly.
5. The ot her account ing pr inciples t o be f ollowed while account ing f or r epos
/ reverse repos are as under:

( i ) Cou pon

I n case t he int er est payment dat e of t he secur it y of f er ed under r epo f alls
wit hin t he r epo per iod, t he coupons r eceived by t he buyer of t he secur it y
shoul d be passed on t o t he sel l er on t he dat e of r ecei pt as t he cash
consider at ion payable by t he seller in t he second leg does not include
98
any int ervening cash flows. While t he buyer will book t he coupon during
t he per iod of t he r epo, t he seller will not accr ue t he coupon dur ing t he
per iod of t he r epo.

I n t he case of discount ed inst r ument s like Tr easur y Bil l s, si nce t her e i s
no coupon, t he seller will cont inue t o accr ue t he discount at t he or iginal
discount rat e during t he period of t he repo. The buyer will not t herefore
accr ue t he discount dur ing t he per iod of t he r epo.

( i i ) Repo I n t er est I n come / Ex pen dit ur e

Aft er t he second leg of t he repo / reverse repo t ransact ion is over, ( a)
t he dif f er ence in t he clean pr ice of t he secur it y bet ween t he f ir st leg and
t he second leg should be appor t ioned over t he life of t he r epo and
should be reckoned as Repo I nt erest I ncome / Expendit ur e in t he books
of t he Seller buyer / Buyer seller r espect ively and should be debit ed /
cr edit ed as an income / expendit ur e accr ued but not due; ( b) t he
dif f er ence bet ween t he accr ued int er est paid bet ween t he t wo legs of t he
t r ansact ion should be shown as Repo I nt erest I ncome/ Expendit ure
account , as t he case may be; and ( c) t he balance out st anding in t he
Repo int er est I ncome / Expendit ur e account should be t r ansf er r ed t o t he
Pr ofit and Loss account as an income or an expendit ur e .
As r egar ds r epo / r ever se r epo t r ansact ions out st anding on t he balance
sheet dat e, only t he accrued income / expendit ure t ill t he balance sheet
dat e should be t aken t o t he Profit and Loss account . Any repo income /
expendit ur e for t he subsequent per iod in r espect of t he out st andi ng
t r ansact ions should be r eckoned for t he next account ing per iod.

( i i i ) Mar k i n g t o Mar k et

The buyer will mar k t o mar ket t he secur it ies acquir ed under r ever se
r epo t r ansact ions as per t he invest ment classif icat ion of t he secur it y. To
illust r at e, for banks , in case t he secur it ies acquir ed under r ever se r epo
t r ansact ions have been classif ied under Available f or Sale cat egor y, t hen
t he mark t o market valuat ion for such securit ies should be done at least
once a quar t er . For ent it ies t hat do not follow any invest ment
classif icat ion nor ms, t he valuat ion f or secur it ies acquir ed under r ever se
r epo t r ansact ions may be in accor dance wit h t he valuat ion nor ms
followed by t hem in respect of securit ies of similar nat ure.
I n r espect of t he r epo t ransact ions out st anding as on t he balance sheet
dat e:
( a) The buyer will mar k t o mar ket t he secur it ies on t he balance sheet
dat e and will account f or t he same as laid down in t he ext ant valuat ion
guidelines issued by t he r espect ive r egulat or y depart ment s of RBI .
( b) The seller will pr ovide f or t he pr ice dif f er ence in t he Pr of it & Loss
account and show t his differ ence under Ot her Asset s in t he balance
99
sheet . The net dif f er ence bet ween if in case of t he sale pr ice of t he
securit y offered under repo is lower t han t he book value.
( c) The seller will ignor e t he pr ice dif f er ence f or t he pur pose of Pr of it &
Loss account but show t he dif f er ence under Ot her Liabilit ies in t he
Balance Sheet , in case it is a pr ofit . t he balance sheet However , in case
of if t he sale pr ice of t he secur it y offer ed under r epo is higher t han t he
book value; and of t he secur it ies ( sold under r epo) and t he sale pr ice, in
respect of t he repos out st anding in t he books of t he Seller as on t he
Bal ance Sheet dat e, wi l l be t aken t o t he Pr of it and Loss Account , in case
it is a loss, but
( d) similarly, t he accrued int erest paid / received in t he repo / reverse
r epo t r ansact ions out st anding on balance sheet dat es should be shown
as " Ot her Asset s" or " Ot her Liabilit ies" in t he balance sheet .

( i v ) Book v al u e on r e - pu r ch ase

The seller shall debit t he repo account wit h t he original book value ( as
exist ing in t he books on t he dat e of t he f ir st leg) on buying back t he
secur it ies in t he second leg.

( v ) Accou n t i n g met h odol ogy

a. The f ol l owi ng account s may be opened , viz. i) Repo Account , ii)
Repo Pr ice Adj ust ment Account , iii) Repo I nt er est Adj ust ment
Account , iv) Repo I nt er est Expendit ur e Account , v) Repo I nt er est
I ncome Account , vi) Reverse Repo Account , vii) Reverse Repo
Pr i ce Adj ust ment Account , and viii) Reverse Repo I nt erest
Adj ust ment Account .
b. The secur it ies sold/ pur chased under r epo should be account ed for
as an out r ight sale / pur chase.
c. The secur it ies should ent er and exit t he books at t he same book
val ue. For oper at i onal ease t he wei ght ed aver age cost met hod
wher eby t he invest ment is car r ied in t he books at t heir weight ed
aver age cost may be adopt ed.

Repo
d. I n a r epo t r ansact ion, t he secur it ies should be sold in t he f ir st leg
at market relat ed prices and re- purchased in t he second leg at t he
der ived pr ice. The sale and r epur chase should be account ed in t he
Repo Account .
e. The balances in t he Repo Account should be net t ed f r om t he bank' s
I nvest ment Account f or balance sheet pur poses.
f . The difference bet ween t he market price and t he book value in t he
first leg of t he repo should be booked in Repo Price Adj ust ment
Account . Similar ly t he dif f er ence bet ween t he der ived pr ice and t he
book value in t he second leg of t he r epo should be booked in t he
Repo Pr ice Adj ust ment Account .
100

Rev er se r epo
g. I n a r ever se r epo t r ansact ion, t he secur it ies should be pur chased in
t he fir st leg at pr evailing mar ket pr ices and sold in t he second leg
at t he der ived pr ice. The pur chase and sale should be account ed
for in t he Rever se Repo Account .
h. The bal ances i n t he Rever se Repo Account should be par t of t he
I nvest ment Account f or balance sheet pur poses and can be
r eckoned for SLR pur poses if t he secur it ies acquir ed under r ever se
r epo t r ansact ions ar e appr oved secur it ies.
i. The secur it y pur chased in a r ever se r epo will ent er t he books at t he
mar ket pr ice ( excluding br oken per iod int er est ) . The differ ence
bet ween t he der ived pr ice and t he book value in t he second leg of
t he reverse repo should be booked in t he Reverse Repo Price
Adj ust ment Account .

Ot h er aspect s r el at i n g t o Repo / Rev er se Repo
j . I n case t he int er est payment dat e of t he secur it y of f er ed under
r epo f alls wit hin t he r epo per iod, t he coupons r eceived by t he
buyer of t he securit y should be passed on t o t he seller on t he dat e
of r eceipt as t he cash consider at io n payable by t he seller in t he
second leg does not include any int er vening cash f lows.
k. The dif f er ence bet ween t he amount s booked in t he f ir st and second
legs in t he Repo / Rever se Repo Pr ice Adj ust ment Account should
be t r ansfer r ed t o t he Repo I nt er est Expendi t ur e Account or Repo
I nt er est I ncome Account , as t he case may be.
l. The broken period int erest accrued in t he first and second legs will
be booked in Repo I nt er est Adj ust ment Account or Rever se Repo
I nt er est Adj ust ment Account , as t he case may be. Consequent l y
t he di f f er ence bet ween t he amount s booked i n t hi s account i n t he
fir st and second legs should be t r ansfer r ed t o t he Repo I nt er est
Expendit ur e Account or Repo I nt er est I ncome Account , as t he case
may be.
m. At t he end of t he account ing period t he , f or out st anding repos ,
t he balances in t he Repo / Rever se Repo Pr ice Adj ust ment
Account and Repo / Rever se r epo I nt er est Adj ust ment account
should be r eflect ed eit her under it em VI - ' Ot her s' under
Schedule 11 - ' Ot her Asset s' or under it em I V ' Ot hers ( including
Pr ovisions) ' under Schedule 5 - ' Ot her Liabilit ies and Pr ovisions' in
t he Bal ance Sheet , as t he case may be.
n. Since t he debit balances in t he Repo Price Adj ust ment Account at
t he end of t he account ing per iod r epr esent losses not pr ovided for
in r espect of secur it ies of f er ed in out st anding r epo t r ansact ions, it
will be necessar y t o make a pr ovision t her efor e in t he Pr of it & Loss
Account .
o. To r ef lect t he accr ual of int er est in r espect of t he out st anding r epo/
r ever se r epo t r ansact i ons at t he end of t he account ing per iod,
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appr opr iat e ent r ies should be passed in t he Pr of it and Loss account
t o reflect Repo I nt erest I ncome / Expendit ure in t he books of t he
buyer / seller r espect ively and t he same should be debit ed /
cr edit ed as an income / expendit ur e accr ued but not due. Such
ent ries passed should be reversed on t he first working day of t he
next account ing per iod.
p. I n r espect of r epos in int er est bear ing ( coupon) inst r ument s, t he
buyer would accr ue int er est dur ing t he per iod of r epo. I n r espect of
repos in discount inst r ument s like Tr easur y Bills, t he seller would
accr ue discount dur ing t he per iod of r epo based on t he or iginal
yield at t he t ime of acquisit ion.
q. At t he end of t he account ing per iod t he debit balances ( excluding
balances for repos which are st ill out st anding) in t he Repo I nt erest
Adj ust ment Account and Rever se Repo I nt er est Adj ust ment
Account should be t r ansfer r ed t o t he Repo I nt er est Expendit ur e
Account and t he cr edit balances ( excluding balances f or r epos
which are st ill out st anding) in t he Repo I nt erest Adj ust ment
Account and Rever se Repo I nt er est Adj ust ment Account should be
t r ansf er r ed t o t he Repo I nt er est I ncome Account .
r. Similar ly, at t he end of account ing per iod, t he debit balances
( excluding balances f or r epos which ar e st ill out st anding) i n t he
Repo / Reverse Repo Price Adj ust ment Account should be
t r ansf er r ed t o t he Repo I nt er est Expendit ur e Account and t he
cr edit balances ( excluding balances for r epos which ar e st ill
out st anding) in t he Repo / Reverse Repo Price Adj ust ment Account
should be t r ansf er r ed t o t he Repo I nt er est I ncome Account .

Model Quest i ons

1 . I f t h e RBI an n ou n ces t h at i t h as don e r epos of Rs. 3 0 0 0 cr or e,
w h at does t h i s i mpl y ?

a. RBI has lent secur it ies wor t h Rs. 3000 cr or e t hr ough t he r epo mar ket s t o
t he par t icipant s.
b. RBI has r ever sed t he r epo deals of par t icipant s who ent er ed int o a r epo
wit h RBI .
c. RBI has induct ed f unds amount ing t o Rs. 3000 cr or es int o t he mar ket .
d. RBI has bor r owed secur it ies fr om t he banking syst em, and lent t hem
onward in t he repo market s.
Answ er : c

102

2 . A 3- day r epo i s en t er ed i n t o on Ju l y 1 0 , 2 0 0 1 , on an 1 1 . 9 9 % 2 0 0 9
secu r i t y , m at u r i n g on Ap r i l 7 , 2 0 0 9 . Th e f ace v al u e of t h e t r an sact i on
i s Rs. 3, 00, 00, 000. The pr i ce of t he secur i t y i s Rs. 116. 42. I f t he
r epo r at e i s 7 % , w h at i s t h e set t l emen t amou n t on Ju l y 1 0 , 2 0 0 1 ?

Answer: Set t l emen t amou n t on Ju l y 1 0 , 2 0 0 1 i s t h e t r an sact i on v al u e
f or t h e secu r i t i es pl u s accr u ed i n t er est .

Tr an sact i on Val u e:
3, 00, 00, 000 * 116.42/ 100 = Rs. 3, 49, 26, 000
Accr ued I nt er est :
The secur it ys mat ur it y dat e is Apr il 7, 2009. Using t he Coupdaybs funct ion,
we can find t he number of days fr om last coupon dat e. ( Set t lement : 10- Jul-
2001; Mat ur it y: 7 Apr il 2009; Fr equency: 2; Basis: 4; The number of days is
93.
Accrued int erest = 3, 00, 00, 000 * 11. 99%* 93/ 360 = Rs. 9 , 2 9 , 2 2 5 . 0 0
Th er ef or e, t h e set t l emen t amou n t i s: Rs. 3 , 4 9 , 2 6 , 0 0 0 + Rs. 9 , 2 9 ,
2 2 5 . 0 0 = Rs. 3 , 5 8 , 5 5 , 2 2 5 . 0 0

3 . Usi n g t h e same dat a as i n Qu est i on 2 , det er mi n e t h e set t l emen t
amou n t f or t h e secon d l eg of t h e r epo t r an sact i on .

The set t lement amount for t he second leg involves t he following:
I nt er est on t he Amount bor r owed:
= 35855225 * . 07 * 3/ 365
= Rs. 20629.03
Amou n t t o be set t l ed: 3 5 8 5 5 2 2 5 + 2 0 6 2 9 . 0 3 = Rs. 3 5 8 7 5 8 5 4 . 0 3

Appen di x I
Su mmar y of Recommen dat i on s of t h e Tech n i cal Su b Gr ou p on Repos:

1. Need t o Wi t h dr aw t h e Gov er n men t Not i f i cat i on Dat ed Ju n e 2 7 ,
1 9 6 9
As long as t he June 1969 not ificat ion is oper at ive, RBI would have t o cont inue
t o t ake up wit h t he Gover nment t o issue necessar y not ificat ion exempt ing,
such of t hose ent it ies as deemed necessary by t he Bank, from t he prohibit ion
cont ained in t he not ificat ion. I t will not be possible for most int ending part ies
( ot her t han t he f ew per mit t ed) t o legally par t icipat e in r epos unless t he
Not ificat ion is wit hdr awn by t he Gover nment . Hence, t he fir st basic legal
r equir ement f or developing r epos is t o wit hdr aw t he Gover nment Not if icat ion
dat ed June 27, 1969. ( Since wit hdr awn)
103

2. RBI Needs t o Acqu i r e Regu l at or y Pow er s u n der 2 9 A of SCR Act
Repo being short - t erm money market inst rument is being used for
smoot hening volat ilit y in money mar ket r at es by cent r al banks t hr ough
inj ect ion of shor t - t erm liquidit y int o t he market as well as absorbing excess
liquidit y f r om t he syst em. Regulat ion of r epo mar ket t hus becomes a direct
r esponsibilit y of RBI . As expansion of t he r epo mar ket wit h wider par t icipat ion
and variet y of inst rument s would require RBI t o have enhanced regulat ory
power s over t he debt mar ket t her e i s need t o amend Sect i on 29A of SCR Act ,
t o enabl e t he Gover nment t o delegat e r egulat or y power s f or of t r ading in
Gover nment Secur it ies and ot her debt inst r ument s. ( Since empower ed)

3. Need t o Repl ace Pu bl i c Debt Act , 1 9 4 4
The Gr oup r ecognises t he legal impediment s in t he way t o elect r onic t r ansfer
of gilt securit ies which is not possible under t he Public Debt Act , 1944 and t he
need t o effect ear ly r eplacement of t he Public Debt Act by t he pr oposed
Gover nment Secur it ies Act has assumed gr eat expediency. The Gr oup ur ges
t hat i mmedi at e st eps shoul d be t aken t o r esolve t he legal and pr ocedur al
difficult ies in t he way t o achieve a moder n mar ket infr ast r uct ur e I t may be
wor t hwhile t o t ake due cognizance of t he changing f ace of secur it ies
set t lement syst ems, t he wor ld over wit h t he use of inf or mat ion t echnology.

4. " Ov er Th e Cou n t er " an d " Tr i par t i t e" Repos t o Ex pan d t h e Mar k et
The Gr oup is of t he view t hat keeping t he needs of t he mar ket par t icipant s a
syst em of " over t he count er " and " exchange t r aded" r epos wit h adequat e
checks and cont r ols could be int r oduced, as under :
( a) All ent it ies who have SGL Account and Cur r ent Account wit h RBI may be
allowed t o under t ake over t he count er r epos and r ever se r epos in all
Gover nment secur it ies ( including t hose issued by t he St at e Gover nment s) .
( b) For t he present , such repos may be rest rict ed t o SGL Account s at Mumbai
and in due course wit h successful linking of all RBI offices, it could be
ext ended t o ot her RBI cent r es.
(c) All ent it ies including cor por at es may be allowed t o under t ake r epos and
reverse repos in all Government securit ies, PSU bonds, Pr ivat e Cor por at e
Debt Securit ies and bonds issued by All I ndia Financial I nst it ut ions
Provided:
( i) t he debt inst r ument s ar e held in demat er ialised for m in a deposit or y;
and
( ii) t he t r ansact ions ar e under t aken t hr ough appr oved st ock exchange
wit h a well capit alised clear ing cor por at ion f unct ioning as legal count er
par t y.
Tr ansact ions under ( c) above, involving t r ipar t y could be per mit t ed pr ovided:
(I ) t he t r ipar t y agent is a well capit alised Clear ing Cor por at ion licensed
t o funct ion as a legal count er par t y in all such t r ansact ions; and
(I I ) wher e such an agency would def ine accept able secur it ies f r om wit hin
t he specif ied br oad cat egor ies as ment ioned above, execut e r equir ed
104
haircut s, do daily marking t o market , ensure t hat all part icipant s
maint ain adequat e collat eral at all t imes, t he quant it y t raded is in
st andar dised lot s and t he set t lement is done under " novat ion" ,
maint aining anonymit y of count er par t ies all t he t ime.

5. Un i f or m Accou n t i n g Pr act i ces t o be I n t r odu ced
I n order t hat t here is uniform account ing t r eat ment and sufficient
t r anspar ency, t he Gr oup has accept ed cont inuance of t he buy - sell back repo
concept while has suggest ed it s own account ing nor ms f or r epos so t hat
t her e is unif or mit y in appr oach t owar ds account ing in gener al and applying
hair cut s/ mar gins, booking of capit al gains/ loss and separ at ion of t he int er est
paid/ r eceived in t he t r ansact ion, in par t icular .

6. Day Li gh t Ov er dr af t Faci l i t y f or Cu r r en t Accou n t Hol der s Requ i r ed
As r egar ds set t l ement , t he exi st i ng syst em of end of t he day DVP cannot be
considered risk free due t o bot t lenecks in movement of securit ies and cash,
as expl ai ned above. A syst em of pr ovi si on of dayl i ght over dr af t t o t he cur r ent
account holder s by RBI may be t hought of t o avoid such event ualit y.

7. Gui del i nes f or Cons t i t u en t s' SGL Accou n t Oper at i on s t o be I ssu ed
I n t he cont ext of gr adual deepening of t he Gover nment secur it ies mar ket and
t he policy t o pr omot e t he r et ail segment of t he mar ket , it is felt expedient t o
fr ame a set of guidelines gover ning t he maint enance of t he Const it uent s' SGL
Account s by t hese ent it ies. The Wor king Gr oup has, accor dingly suggest ed
out line f or t he dr af t guidelines pr oviding f or obligat ions and code of conduct in
dealing wit h t he Const it uent s' secur it ies including t r anspar ency and saf et y.
This could be finalised aft er discussion wit h r epr esent at ive self - regulat ory
or ganisat ions of t he mar ket par t icipant s.

8. Dat e of deal an d set t l emen t dat e t o be speci f i ed
To avoid differences in pract ices followed it would be desirable t o st ipulat e
deal dat e and set t lement dat e. At pr esent deals under t aken t ake, oft en mor e
t han st ipulat ed number of days f or execut ion and set t lement . I n or der t hat
t here is no confusion deals can eit her be set t led on t he same day or t he next
day of t he deal and t his should be clear ly indicat ed in t he cont r act / t er ms of
deal t o ensur e t hat t her e is no conf usion/ var iance in set t lement dat e of r epos.

9. A Mast er Re - Pu r ch ase Agr eemen t f or Repos t o be I n t r odu ced
Ther e is need f or , as done int er nat ionally, a compr ehensive mast er
repurc hase agr eement which allows obligat ions under all out st anding r epos t o
be set of f against each ot her upon def ault or insolvency of t he count er par t y.
Wor king Gr oup has at t empt ed a dr af t document , which could be modif ied
suit ably t o meet act ual r equir ement s in r epo t r ansact ions. The Dr aft Mast er
Pur chase Agr eement has pr ovisions f or absolut e t r ansf er of t it le of secur it ies
( including any secur it ies t r ansfer r ed t hr ough subst it ut ion or mar k t o mar ket
adj ust ment of collat er al) .

105
10. Code of Conduct f or Repos Tr ans act i on s t o be l ai d dow n
A code of conduct would include issues par t icipant s should addr ess bef or e
under t aking r epo t r ansact ions, legal agr eement s in pr evalence, mar gins,
mar king t o mar ket , exposur e limit s on count er par t ies, cust ody of collat er als,
r i ght t o declar e a count er par t y in def ault , conf ir mat ion of deals, mat t er s t o be
cover ed bef or e t r adi ng wi t h a new count er par t y, i nf or mat i on t o be exchanged
at point of t r ade et c. The Gr oup has included a dr af t of a code of conduct ,
which has been included as a part of t his report for t he benefit of t he market
pr act it ioner s.

11. Repo Mar k et t o be Su per v i sed an d Cl osel y Mon i t or ed by RBI
The memor ies of t he ir r egular it ies commit t ed in t he Gover nment secur it ies
mar ket ar e st ill ver y fr esh in t he minds of t he mar ket part i ci pant s and t he
r egulat or s. As mor e par t icipant s and inst r ument s ar e made eligible for
undert aking repo t ransact ions RBI may like t o monit or t he size, growt h and
or der liness of t he r epo mar ket . As money mar ket on line dealing syst em is
inst alled and made oper at ive it should become possible f or RBI t o monit or t he
mar ket online f ocusing on par t icipant s, mar ket r at es, t r ading pat t er ns et c.

12. Rol l Ov er of Repos t o be Per mi t t ed
Repos being in t he nat ur e of collat er alised bor r owing should be allowed t o be
rolled over wit h r evaluat ion at t he t ime of r oll over at r at es of int er est / value
of securit ies in alignment wit h prevailing market rat es. Furt her, since t here is
no maximum period specified for repo by RBI , t he absence of percept ion of
shor t t er m int er est r at e for longer per iod r epo hor izon inhibit s t he par t ies t o
ent er int o r epos for per iod longer t han a for t night . The r ollover s could be for
any per iod and should not have any r elat ionship wit h t he or iginal cont r act
period.
106

CHAPTER 10
BOND MARKET I NDI CES AND
BENCHMARKS

Mar ket benchmar ks ser ve a pur pose of pr oviding inf or mat ion t o t he
part icipant s about t he prices prevailing in t he market s. I n t he bond market s,
t he most impor t ant mar ket indicat or , which ever y par t icipant want s t o t r ack,
is t he movement in int er est r at es. Mar ket i ndi cat or s enabl e pr i ci ng, val uat i on
and performance evaluat ion. I n t his chapt er, we shall discuss 2 widely
t r acked benchmar ks: t he NSE- MI BOR which pr ovides t he money mar ket
benchmar k, and t he I- Sec bond indices, which t rack ret urns on gover nment
secur it ies.

10.1 I -BEX: SOVEREI GN BOND I NDEX
6

A bond index is a pr oduct t o accur at ely measur e t he per f or mance of t he bond
mar ket s. I t is a benchmar k against which f und manager s and invest ment
manager s can measur e t heir per f or mance. Bond indi ces use addi t i onal
liquidit y crit eria besides j ust ret urns. This is specifically required t o meet t he
needs of act ive t r ader s and invest ment manager s.
10. 1. 1 Why a Sov er ei gn Bond I ndex ?

The sovereign bond market is t he most liquid segment in t he bond mar ket .
Ther e i s a need t o pr ovi de a benchmar k agai nst whi ch t he per f or mance of a
gover nment secur it ies por t folio can be measur ed.
10. 1. 2 Feat ur es of a Bond I ndex

Th e i n dex mu st be:
A. Repr esen t at i v e: An index should span and weight t he appr opr iat e
market s, inst r ument s and individual secur it ies t o r ef lect t he oppor t unit ies
available t o t he domest ic and int er nat ional inst it ut ional invest or .
Mar k et s: The index should cover secur it ies of a wide r ange of mat ur it ies, say
one t o t en year s.
I n st r u men t s: The I nst r ument s shoul d have f i xed coupons; t hey must be
t r adable and r edeemable f or cash. Thus, t he index excludes most of t he long
dat ed secur it ies and low coupon secur it ies ( which ar e not t r aded) .

6
This sect ion draws from t he publicat ion I -Sec Sovereign Bond I ndex, I CI CI Securit ies and
Finance Company Lt d.
107
I ssu es: Each issue of a qualifying inst rument must meet cert ain liquidit y
crit eria t o be included in t he index. I t should generally be t raded and at
accept able bid- offer spr eads. ( Which have now defined as 10 paise)
Cur r ent Yi el d: The principal appreciat ion of a low coupon bond is more t han
t hat of a high coupon bond t o compensat e f or t he lower int er est accr ual. To
avoid a dist or t ion of t he pr incipal r et ur ns index on t his count , secur it ies wher e
t he cur r ent yield and YTM dif f er by mor e t han 100bps ar e excluded f r om t he
index.

B. I n v est i bl e an d Repl i cabl e: An index should include only secur it ies in
which an invest or can deal at short not ice and for which firm prices exist .
Fir m pr ices should ideally exist for all const it uent secur it ies.
The benchmar k issues included in t he index ought t o be
widely recognised market indicat ors
issues wit h high t rading volume
r ecent issues wit h cur r ent coupon
A secur it y is excluded f r om t he index if it does not have a mar ket lot ( Rs. 5
cr or e or Rs. 10 cr or e) t r ade for t hr ee cont inuous t r ading days.

C. Accu r at e an d Rel i abl e: I ndex ret urn calculat ions should accur at ely r eflect
t he act ual changes in t he value of a por t f olio consist ing of t he same
secur it ies.

D. Tr anspar ent : I nvest ment manager s should know which secur it ies ar e
included in an index and how it is const r uct ed. The fund manager must be
able t o cr eat e his own benchmar k index and t r ack it .
10.1.3 Met hodol ogy and Assumpt i ons

Secu r i t i es pr i ces
The pr ice used is t he weight ed aver age pr ice of SGL t r ades as r epor t ed by RBI
( aft er excluding all t r ades below Rs. 1 cr or e face value) .
Wei gh t i n g ch an ges
The index measur es t he changing value of an index por t f olio by weight ing t he
t ot al r et ur n on each const it uent bond by t he mar ket value on t he pr evious
day. Each weight is equal t o t he amount out st anding at t he beginning of each
mont h mult iplied by t he secur it ys gr oss pr ice ( net pr ice plus accr ued
int er est ) . For pr incipal r et ur n calculat ions, t he weight s do not r eflect accr ued
int er est ; inst ead, t he out st anding amount is adj ust ed by t he issues net pr ice.
Rei n v est men t
The index assumes t hat coupons r eceived dur ing t he mont h ar e immediat ely
r einvest ed int o t he bond index in pr opor t ion t o t he lat est mar ket values of t he
const it uent s. The index is f ully invest ed at all t imes which is only possible
wit h daily indices.

108
Tr anspar ent
I nvest ment manger s need t o know which secur it ies ar e included in on index
and how it is const r uct ed. This index will be document ed wit h r espect t o t he
ident it ies of it s const it uent bonds and it s calculat ion met hods.
Conv ent i ons
l : List of bonds compr ising t he index
i : A bond in t he bond list
TR : Tot al Ret urn
PR : Principal Ret urn
TR
i
: Tot al Ret ur n for a given bond i
TR
i,t
: Tot al Ret ur n for a given bond i t oday
TR
i
,
t- 1
: Tot al Ret ur n for a given bond i yest er day
TR
i,o
: Tot al Ret urn for a given bond I on base dat e of t he index
PR
i
: Principal Ret urn for a given bond i
PR
i
,
t
: Principal Ret urn for a given bond i t oday
PR
i,t - 1
: Principal Ret urn for a given bond i yest erday
PRi, o : Pr incipal Ret ur n for a given bond i on base dat e of t he index
I Ri : I nt erest Ret ur n for a given bond i
I R
i,t
: I nt er est Ret ur n for a given bond i t oday
I R
i
,
t- 1
: I nt er est Ret ur n for a given bond i yest er day
I Ri, o : I nt er est Ret ur n for a given bond i on base dat e of t he index
GP : Gr oss Pr ice of a bond
GP
i
: Gross Price of a given bond i
GP
i,t
: Gr oss Pr ice of a given bond i t oday
GP
i
,
t - 1
: Gr oss Pr ice of a given bond i yest er day
GP
i,o
: Gr oss Pr ice of a given bond i on base dat e of t he index
NP : Net pr ice of a bond ( clean pr ice less voucher )
NP
i
: Net pr ice of a given bond i
NP
i,t
: Net price of a given bond i t oday
NP
i,t - 1
: Net price of a given bond i yest erday
NPi, o : Net price of a given bond i on base dat e of t he index
C : Coupon on a bond
C
i
: Coupon on a given bond i
C
i,t
: Coupon on a given bond i t oday
Q : Number of bonds out st anding
Q
i
: Number of bonds out st anding of a given bond i
Q
i,t
: Number of bonds out st anding of a given bond i t oday
MC : Mar ket capit alisat ion of a bond
MC
i
: Mar ket capit alisat ion of a given bond i
MC
i,t
: Mar ket capit alisat ion of a given bond i t oday
D : Durat ion of a bond
D
i
: Dur at ion of a given bond i
Y : Yield of a bond
Y
i
: Yield of a given bond i

109
10.1.4 Def i ni t i ons

Bond Li st :
The select ion of bonds f or t he pur pose of t he index bet ween t wo r ebalancing
dat es.

Mar k et - cap of a b on d :
I t is t he number of bonds out st anding t imes t he mar ket pr ice. The mar ket
value of t he t ot al out st anding bond issues.

Gr oss Pr i ce:
Gr oss Pr ice of bond = Market Price + Accrued I nt erest

Net Pr i ce:
Net Pr ice of a bond = Mar ket Pr ice

Mar k et Cap Wei gh t :
Market - cap of a bond = Par amount out st anding x Gr oss Pr ice

Market - cap wei ght =
list bond in the bonds of caps - market all of Sum
bond a of cap - Market

Rebal an ci n g
The index aut omat ically adj ust s or r ebalances f or changes in t he composit ion
of t he index port folio so t hat t he changes do not represent a capit al gain or
loss t o t he index.

10. 1. 5 Ret ur ns on I ndi v i dual Bonds

Tot al r et ur n ( TR)
I t is t he absolut e r et ur n t hat a bond of f er s and it includes bot h coupons and
capi t al gai ns / ( l osses) . The t ot al r et ur n i ndex f or an individual bond is
calculat ed each mar ket day by incr easing t he pr evious mar ket days index
value by t he per cent age change in bonds gr oss pr ice ( GP) . The gr oss pr ice of
a bond is it s net pr ice plus accr ued int er est . The gr oss pr ice must be adj ust ed
for loss of accr ued int er est on coupon payment day by adding t he coupon
value ( C) t o t he gr oss pr ice.

TR
i,t
= TR
i,t - 1
* { ( GP
i,t
+ C
i,t
) / GP
i,t - 1

Pr i n ci pal Ret u r n ( PR)
I t is simply t he cur r ent net pr ice divided by t he net pr ice on t he base dat e.

PR
i , t =
NP
i , t
/ NP
i,o

110

I n t er est Ret u r n
The t ot al r et ur n divided by pr incipal r et ur n index.

I R
i, t =
TR
i , t
/ PR
i,t

10. 1. 6 Mar k et I ndi ces

For a por t f olio of bonds t he t ot al r et ur n is calculat ed by mult iplying t he
pr evious days index value by t he r at io of t he mar ket capit alisat ion of t he
bond list on a day t o it s mar ket capit alisat ion on t he pr evious day. Each bond
has an individual weight which is mult iplied by t he pr ice t o calculat e it s
mar ket capi t al i sat i on. These wei ght s ar e cal l ed mar ket caps ( MC) . Thus, Tot al
Ret urn ( TR) of t he index is,

TR
t
= TR
t - 1
* for all bonds i belonging t o bond list l { MC
i,t
* TR
i,t
* TR
i,t - 1
}

wher e mar ket cap is,

MC
i,t
= Q
i,t
* GP
i,t

The bond index must be f ully invest ed t hat is coupons, changes in t he bond
list and changes in principal amount s must be account ed for on a daily basis.
The bond list could change when bonds ent er or leave t he index. Principal
amount s could change owing t o r edempt ion or addit ional issue of fur t her
bonds. The equivalent f or mula f or t he ent ir e i ndex woul d t hen r educe t o
TR
t =

factor Adjustment * } GP * {Q date base on l list bond to belonging i bonds all for
} GP * {Q l list bond to belonging i bonds all for
o i, o i,
t i, t i,

10.1.7 Adj ust ment Fact or

The adj ust ment fact or can be decomposed int o t hr ee cont r ibut ing fact or s:
1. The par t ial impact of a change in t he composit ion of t he bond list bet ween
t wo dat es keepi ng amount out st anding ( weight s) const ant at t odays
values ( Adj ust ment Fact or 1)
2. The par t ial impact of a change in t he amount s out st anding bet ween t he
t wo dat es keeping t he yest er days bond list int act ( Adj ust ment Fact or 2) .
3. The impact of coupons paid leaving bot h bond list and weight s const ant at
yest er days value ( Adj ust ment Fact or 3) .

111

Adj ust ment Fact or 1 =
weights) Todays & list s (Yesterday
weights) Todays & list (Todays

weights) Yesterdays & List s (Yesterday
weights) Todays & list s (Yesterday

coupon) Todays & weights Yesterdays & List s (Yesterday
weights) Yesterdays & List s (Yesterday

The pr oduct of t he adj ust ment f act or s f r om base t o dat e is t he adj ust ment
f act or in t he denominat or of t he equat ion. Ther ef or e t he disaggr egat ion
explains how r ebalancing at t he beginning of t he mont h and coupon
r einvest ment pr oper ly chain- link an index.
10.1.8 I ndex St at i st i cs

The dur at ion, yield, r emaining mat ur it y and aver age coupon of t he bond
index ar e appr oximat ed by using t he f ollowing r elat ionships.

Dur at i on
The dur at ion of t he index can be appr oximat ed by weight ing t he individual
durat ion of t he bonds by t heir market capit alisat ion.
Durat ion of t he bond index = for all bonds i belonging t o bond list l { MCi *
Di}

Remai n i n g mat u r i t y
The residual t ime t o mat urit y of t he index is simply t he market cap weight ed
year s t o mat ur it y of each bond in t he bond list .
Remai ni ng mat ur it y bond index = f or all bonds i belonging t o bond list l
{ MCi * Year s t o Mat ur i t y
i
}

Yi el d
The index yield can be appr oximat ed by weight ing each bonds yield by it s
dur at ion. Rigor ously, all t he cash f lows of t he component bonds need t o be
discount ed t o ar r ive at t he accur at e yield t o mat ur it y. The dur at ion calculat ed
using t he yield calculat ed t hus would be t he exact dur at ion of t he index. For
most pr act ical pur poses t he f ollowing appr oximat ion is adequat e:

Yield bond index = f or al l bonds i belonging t o bond list l { ( MC
i
* D
i
/
D
bond_index
) * Y
i
}

112
Av er age cou pon
The aver age coupon is ar r ived at by calculat ing t he dur at ion weight ed coupon
r at es of t he bonds
Aver age Coupon bond index =
} C * ) D / D * {(MC
l list bond to belonging i bonds all for
i bond_index i i

10. 1. 9 Cal i br at i on I ssues

Rul es f or b on d i n cl u si on
Bonds may ent er or leave an index f or a var iet y of r easons, such as, capit al
changes and changes in liquidit y.

Capi t al ch an ges
mandat or y r edempt ions
opt ional r edempt ions: call, put , conver sion, ext ension
issue pr ice r elat ed: par t ly paid t o fully paid
Re- issue of exist ing bonds
Change in out st anding amount due t o OMO by RBI

Ch an ges i n Li qu i di t y
A bond may be deemed illiquid if t here is no market lot t rade for t hree
consecut ive t r ading days. A bond can ent er t he index when:
a par t ly paid bond becomes f ully paid, and
t r ading volumes sat isf y t he above condit ions of liquidit y.
10.1.10 Pr i nci pal Ret ur n I ndex and Tot al Ret ur n I ndex

The PRI t racks t he price movement s of bonds and is a mirror image of t he
movement of mar ket yields. The TRI t r acks t he ret urns available in t he bond
mar ket . I n a falling int er est r at e scenar io, t he index gains on account of
int er est accr ual and capit al gains, losing on r einvest ment income, wher eas
during rising int erest rat e periods, t he int erest accrual and reinvest ment
income is of f set by capit al losses. Ther ef or e t he TRI t ypically has a posit ive
slope except dur ing per iods when t he dr op in mar ket pr ices is higher t han t he
int er est accr ual. Figur e 10. 1 t r acks t he I- Bex Tot al Ret urn I ndex. Figure 10. 2
t r acks t he I- Bex Principal Ret urn I ndex.

While t her e exist s an ar r ay of indices f or t he equit y mar ket , a well-
const r uct ed and widely accept ed bond index is conspicuous by it s absence.
Ther e ar e a f ew addit ional dif f icult ies in const r uct ion and maint enance of debt
indices. First , on account of t he fixed mat urit y of bonds vis- - vis t he
per pet uit y of equit y, t he univer se of bonds changes f r equent ly ( new issues
come in while exist ing issues ar e r edeemed) . Secondly, while mar ket pr ices
for t he const it uent s of an equit y index ar e nor mally available on all t r ading
days over a long period of t ime, market prices of const it uent bonds in a bond
113
index, ir r espect ive of t he select ion cr it er ia used, may not be available daily.
This is on account of t he f act t hat t he liquidit y of a secur it y var ies over it s
lifet ime and, in addit ion, can wit ness significant fluct uat ions over a shor t
per iod of t ime. However , mar ket par t icipant s need an index t o compar e t heir
per f or mance wit h as well as t he per f or mance of dif f er ent classes of asset s.
A wi del y t r acked benchmar k i n t hi s cont ext i s t he I CI CI Secur i t i es ( I sec)
bond index ( i- BEX) , which measures t he performance of t he bond market s by
t r acking r et ur ns on gover nment secur it ies NSEs G- Sec I ndex and NSE s T-
Bills I ndex.

Fi gu r e 1 0 . 1 : I - Bex Tot al Ret ur n I ndex
500.00
1000.00
1500.00
2000.00
2500.00
3000.00
3500.00
4000.00
4500.00
5000.00
A
p
r
-
0
5
J
u
l
-
0
5
O
c
t
-
0
5
J
a
n
-
0
6
A
p
r
-
0
6
J
u
l
-
0
6
O
c
t
-
0
6
J
a
n
-
0
7
A
p
r
-
0
7
J
u
l
-
0
7
O
c
t
-
0
7
J
a
n
-
0
8
A
p
r
-
0
8
J
u
l
-
0
8
Month & Year
T
o
t
a
l

R
e
t
u
r
n
s

Fi gu r e 1 0 . 2 : I - Bex - Pr i nci pal Ret ur n I ndex
1050.00
1100.00
1150.00
1200.00
1250.00
1300.00
1350.00
A
p
r
-
0
5
A
u
g
-
0
5
D
e
c
-
0
5
A
p
r
-
0
6
A
u
g
-
0
6
D
e
c
-
0
6
A
p
r
-
0
7
A
u
g
-
0
7
D
e
c
-
0
7
A
p
r
-
0
8
A
u
g
-
0
8
Months & Year
P
r
i
n
c
i
p
a
l

R
e
t
u
r
n
s

These have emer ged as t he benchmar k of choice acr oss all classes of mar ket
par t icipant s - banks, financial inst it ut ions, pr imar y dealer s, pr ovident funds,
114
i nsur ance compani es, mut ual f unds and for eign inst it ut ional invest or s. I t has
t wo var iant s, namely, a Pr incipal Ret ur n I ndex ( PRI ) and Tot al Ret ur n I ndex
( TRI ) . The PRI t r acks t he pr ice movement s of bonds or capit al gains/ losses
since t he base dat e. I t is t he movement of prices quot ed in t he market and
could be seen as t he mir r or image of yield movement s.

Dur i ng 2007- 08, t he PRI of i- BEX and NSE G- Sec I ndex incr eased by 2. 03%
and 0. 78% r espect ively. The TRI t r acks t he t ot al r et ur ns available in t he bond
mar ket . I t capt ur es bot h int er est accruals and capit al gains/ losses. I n a
decl i ni ng i nt er est r at e scenar i o, t he i ndex gai ns on account of i nt er est accr ual
and capit al gains, while losing on reinvest ment income. As against t his,
during rising int erest rat e periods, t he int erest accrual and reinvest ment
income is of f set by capit al losses. Ther ef or e, t he TRI t ypically has a posit ive
slope except dur ing per iods when t he dr op in mar ket pr ices is higher t han t he
int er est accr ual. Dur ing 2007- 08, t he TRI r egist er ed gains of 9. 23% and
6. 93% for i- BEX and NSE G- Sec I ndex r espect ively.

The NSE- gover nment Secur it ies I ndex pr ices component s off t he NSE
benchmark ZCYC, so t hat t he movement s reflect ret urns t o an invest or on
account of change in int er est r at es. The index pr ovides a benchmar k for
por t folio management by various invest ment managers and gilt funds. The
movement s of popular fixed income indices at mont hly rat es are present ed in
Table 10.1.

Tabl e 6- 15: Debt Mar k et I ndi ces, 2007- 0 8
I Sec I - BEX
( Base Au g u st 1 ,
1 9 9 4 = 1 0 0 0 )
NSE- T- Bi l l s
I ndex
NSE- G Sec
I ndex
At t h e
en d of
t he
mont h
TRI PRI TRI PRI TRI PRI
Apr- 07 4069. 77 1239. 62 224. 19 224. 19 246. 89 108. 70
May- 07 4114. 76 1245. 33 225. 61 225. 61 247. 79 108. 46
Jun- 07 4130. 32 1241. 87 227. 15 227. 15 254. 61 110. 78
Jul- 07 4253. 34 1271. 47 229. 17 229. 17 256. 55 111. 20
Aug- 07 4231. 31 1256. 53 230. 03 230. 03 261. 09 112. 64
Sep- 07 4251. 29 1254. 59 231. 44 231. 44 256. 39 110. 02
Oct - 07 4297. 44 1260. 58 232. 50 232. 50 258. 24 110. 12
Nov- 07 4315. 46 1258. 08 234. 08 234. 08 259. 29 110. 06
Dec- 07 4383. 47 1270. 47 235. 58 235. 58 262. 58 110. 73
Jan- 08 4480. 57 1291. 24 237. 26 237. 26 268. 01 112. 30
Feb- 08 4488. 96 1285. 74 238. 51 238. 51 269. 25 112. 33
Mar- 08 4445. 35 1264. 82 239. 71 239. 71 264. 01 109. 55
Source: I CI CI Securit ies and NSE
115
10.2 THE FI MMDA NSE MI BI D-MI BOR
7

10.2.1 I nt r oduct i on t o Pol l ed Benchmar k s

The debt mar ket s in I ndia do not have an or ganizat ional f or m t hat suppor t s a
t r anspar ent f or m of t r ading wher e, pr ices and r at es ar e obser vable by all
par t icipant s. The debt mar ket s ar e dist r ibut ed dealer mar ket s in which,
t r ades ar e st r uck bet ween dealer s over t elephones, af t er negot iat ions. Since
such t r ades ar e not cent r ally r epor t ed, last t r aded pr ices ar e also not
observed in such market s.
One of t he met hodologies used t o obt ain market informat ion in such
dist r ibut ed dealer mar ket s is t he conduct of a poll amongst dealer s, and
cr eat e an or der book t hat compr ises t he pr ices at which t hese dealer s ar e
willing t o t r ade as pr incipals. The design of t he poll can be t uned t o achieve
t he obj ect ive of est imat ing t he mar ket r at es at t he inst ant of sampling. Ther e
ar e t wo var iat ions t o t he obj ect ive of such polling: one kind of poll occur s
eit her at t he beginning of t he market or during market hours, when
part icipant s in t he poll provide t heir est imat e of t he mar ket r at es at t he t ime
of t he poll; an alt ernat e met hodology is t he polling of t he last t raded prices
f r om dealer s soon af t er t he close of t he mar ket .

The polling t echnique, which uses a sample of dealer s, can have t wo
variat io ns: dealer s can be asked t o quot e r at es at which t hey would t r ade as
pr incipals; alt er nat ively dealer s could pr ovide t heir est imat e of t he mar ket
r at e, at t he t ime of polling. The r esult s of t he poll ar e impact ed by t he choice
of t hese alt er nat e polling obj ect i ves.

Fr om t he r esult s of t he poll, by put t ing t oget her t he r at es of t he sample of
dealers, est imat es of liquidit y in t he market as a whole is est imat ed. The
est imat ion t echniques have t o account for biases cr eat ed by ext ending t he
r esult s obt ained from t he sample, for t he market as a whole. The manner in
which t he mean of t he sample is est imat ed has import ant implicat ions for t he
r eliabilit y of t he est imat e, because t he r ange of poll r esult s could car r y
element s of noise, manipulat ion and idiosyncr at ic var iat ion, which would
impact t he sample mean.

The NSE MI BOR is a polled benchmar k, whose polling and sample mean
est imat ion t echniques explicit ly account f or t he above issues in cr eat ing a
mar ket benchmar k f or debt mar ket s.

7
The met hodologies described in t his chapt er were developed by Dr. Aj ay Shah. For a complet e
discussion, refer t o, I mproved Met hods for Obt aining I nformat ion from Dist ribut ed Dealer
Market s, by Aj ay Shah, I GI DR, Sept ember 1998.
116

10. 2. 2 Pol l i ng Met hodology

The polling met hodology involves t he following:
a. A r andomly chosen sub- set of r espondent s f r om a populat ion of 29
par t icipant s, consist ing of dealer s and pr incipal invest or s ( banks,
inst it ut ions and pr imar y dealer s) in t he debt mar ket s is chosen on ever y
polling day.
b. At an appoint ed t ime, t hey ar e asked t o r epor t t heir per cept ion of t he
bid and ask r at es in t he mar ket , for a r ange of t enor s, on a fixed t r ade
value of Rs. 100 million. Current ly, quot es are polled and processed
daily by t he NSE at 0940 hours for overnight rat e and at 1130 hours for
t he 14 day, 1 mont h and 3 mont h rat es.
c. Par t icipant s in t he poll ar e f r ee t o pr ovide bot h bid and ask, or eit her
one of t he r at es.
d. The sampled inf or mat ion f r om poll par t icipant s is kept conf ident ial. This
i s t o avoid possible car t els and manipulat ion in t he poll pr ocess.
e. Monit or ing of quot es t o assess qualit y of poll par t icipant r at es is also
done. This is t o ensur e t hat par t icipant s, who pr ovided noisy est imat es,
ar e ident ified, and less fr equent ly polled.
10. 2. 3 Met hodol ogy t o Det er mi ne Av er age Rat es

Af t er t he r ange of r at es is obt ained f r om t he poll, an appr opr iat e met hodology
t hat ident if ies t he benchmar k bid and asks is applied t o t he dat a. Many
exchanges use a simple t rimmed mean, where t he out liers are t r i mmed, and
t he aver age r at es ar e obt ained f r om t he mean of t he t r immed sample. Ther e
is a well known t rade- off bet ween st at ist ical efficiency and vulner abilit y t o
manipulat ion, in met hodologies t hat use a simple t r immed mean.

The NSE MI BOR uses a mor e sophist icat ed met hodology f or obt aining t he
sample mean, such t hat t he ext ent of t r imming is opt imized t o r educe t he
vulner abilit y of dat a t o manipulat ion, while simult aneously obt aining unbiased
est imat es of t he sample mean. A st at ist ical boot st r apping t echnique is used
t o ar r ive at an adapt ive t r immed mean, which det er mines t he mean, af t er a
series of comput er int ensive it erat ions t hat successively t rim sample dat a of
noise, and locat e t he mean and t he st andar d deviat ion. The over night r at es
are disseminat ed daily t o t he market at 0955 hours and t he 14 day, 1 mont h
and 3 mont h rat es at 11. 50 hours.

Fr om t he dat a obt ained, NSE disseminat es t he aver age bid r at e ( MI BI D) and
t he average offer rat es ( MI BOR) and t he st andard deviat ion of sample quot es
fro m t hese means. This dat a pr ovides a benchmar k of mar ket r at es, which is
used for a var iet y of pr icing, t r ading and valuat ion applicat ions. Since t he
dat a is capt ured and processed by an independent agency, which has no
117
dir ect t r ading int er est in t he market s, t he NSE benchmar ks ar e widely used
by mar ket par t icipant s.

NSE has been comput ing and disseminat ing t he NSE Mumbai I nt erbank Bid
Rat e ( MI BI D) and NSE Mumbai I nt erbank Offer Rat e ( MI BOR) for t he
overnight money market from June 15, 1998, t he 14- day MI BI D/ MI BOR from
November 10, 1998 and t he 1 mont h and 3 mont h MI BI D/ MI BOR from
December 1, 1998. Fur t her , t he exchange int r oduced a 3 Day FI MMDA- NSE
MI BI D- MI BOR on all Fridays wit h effect from June 6, 2008.

The NSE MI BI D/ MI BOR is used as a benchmar k r at e for maj orit y of deals
st r uck for int er est r at e swaps, for war d r at e agr eement s, float ing r at e
debent ur es and t er m deposit s. Banker s, issuer s and invest or s ar e using t he
NSE MI BI D/ MI BOR ext ensively. Banks have been act ive in devising t ailor-
made pr oduct s t o suit t he cust omer needs and have also linked t er m deposit
r at es t o t he over night MI BI D/ MI BOR. I ssuer s use t hese t o pr ice inst r ument s
on t he basis of daily int er est r at e movement and hedge against adver sit ies.
These provide a comfort zone against any unexpect ed volat ile mar ket
movement s having an impact on t he f inancial commit ment s of t he issuer in
r espect of it s debt . The t r anspar ency r esult ing f r om disseminat ion of
MI BI D/ MI BOR has helped t he issuer s t o obt ain f iner r at es by issuing bonds
linked t o MI BOR. A number of or ganisat ions ar e benchmar king int er est r at e
swaps t o MI BI D/ MI BOR.

The Reut er s also conduct s a poll of sample dealer s and publishes t he
benchmar k r at es ever y day. Some f loat ing r at e pr oduct s use t he Reut er s
MI BOR as benchmarks. The procedure varies from t he NSE model in t wo
i mpor t ant ways:

a. The polling t echniques asks for t he dealers rat es at which t hey are
willing t o t r ade as pr incipals, r at her t han t he dealer s view of t he
mar ket r at es, as is t he case wit h t he NSE MI BOR.
b. The t echnique used for det er mining t he aver age r at es is t he simple
t r immed mean, t hat t r ims a given per cent age of out lier s, and obt ains
t he aver age r at es f r om t he r emaining values.

118
Figur e 10. 3 t r acks t he NSE- MI BI D/ MI BOR over night r at es dur ing 2007- 08.

Fi gur e 10. 3: NSE- MI BI D/ MI BOR - Ov er n i gh t Rat es
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
3
-
A
p
r
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0
7
1
4
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2
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a
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2
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a
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0
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8
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1
9
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3
0
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1
1
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2
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2
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1
3
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4
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1
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2
6
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S
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7
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1
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2
9
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9
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N
o
v
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2
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N
o
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1
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D
e
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1
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D
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a
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0
8
MIBID MIBOR

Model Quest i ons
1. What does r e - bal an ci n g of a bon d i n dex mean ?

a. Changing t he weight ages in t he index so t hat t he mar ket
capit alisat ion of bonds is kept const ant
b. Adj ust ing t he index for changes in t he composit ion of t he index
port folio t o ensure t hat art ificial capit al gains or losses are not
included in t he index.
c. Adj ust i ng t he composi t i on of t he i ndex, whenever coupons ar e
pai d, such t hat t he i ndex i s not i mpact ed by changes i n accr ued
i nt er est .
d. Changing t he composit ion of t he index when yield alt ers, such t hat
dur at ion of t he index is kept const ant .

An sw er : b

3. Wh at i s t h e i n f or mat i on g at h er ed f r om mar k et p ar t i ci p an t s i n
t h e pol l t o det er mi n e NSE MI BOR?
4.
a. The r at e at whi ch t hey woul d be abl e t o l end and bor r ow i n t he
mar ket s.
b. The rat e at which t hey are willing t o lend and borrow amongst one
anot her.
c. Their view of t he mar ket r at es for lending and bor r owing.
d. Their view of t he lending and bor r owing r at es of specif ic mar ket
par t icipant s.

Answ er : c
119
CHAPTER 11
TRADI NG MECHANI SM I N THE NSE-
WDM

Secondar y mar ket act ivit y in t he NSEs Wholesale Debt Mar ket ( WDM)
segment happens t hr ough t he NEAT ( Nat ional Exchange f or Aut omat ed
Tr ading) syst em, which is a f ully aut omat ed scr een based t r ading syst em. The
WDM segment is meant primar ily for banks, inst it ut ional and cor por at e
par t icipant s and int er mediar ies t o ent er int o high value t r ansact ions in debt
secur it ies issued by t he cent r al and st at e gover nment s, public sect or unit s,
f inancial inst it ut ions and cor por at e bodies. Bot h short - t erm inst rument s like
t r easur y bills and commer cial paper s, and long- t er m inst r ument s such as
bonds and debent ures, are available for t rading in t he WDM segment of t he
NSE.
11.1 DESCRI PTI ON OF THE NSE - WDM

The t r ades on t he WDM segment can be execut ed in t he Cont inuous or
Negot iat ed market . I n t he cont inuous market , orders ent ered by t he t rading
members are mat ched by t he t rading syst em. For each order ent ering t he
t r ading syst em, t he syst em scans for a pr obable mat ch in t he or der books. On
finding a mat ch, a t r ade t akes place. I n case t he or der does not f ind a
suit able count er order in t he order books, it is st ored in t he order books as a
passive or der . This could lat er mat ch wit h any f ut ur e or der ent er ing t he or der
book and r esult int o a t r ade. This fut ure order, which result s in mat ching of
an exist ing or der , is called t he act ive or der . I n t he negot iat ed mar ket , deals
ar e negot iat ed out side t he exchange bet ween t he t wo count er par t ies and ar e
r epor t ed on t he t r ading syst em for appr oval.
The WDM t r ading syst em r ecognizes t hr ee t ypes of user s - Tr ader , Pr ivileged
and I nqui r y. Tr adi ng Member s can have al l t he t hr ee user t ypes wher eas
Par t icipant s ar e allowed pr ivileged and inquir y user s only. The user- id of a
t r ader gi ves access f or ent er i ng or der s or t rades on t he t r adi ng syst em. The
pr ivileged user has t he exclusive r ight t o set up count er par t y exposur e limit s.
The I nquir y user can only view t he mar ket inf or mat ion and set up t he mar ket
wat ch screen but cannot ent er orders or t rade or set up exposure li mit s.
The WDM suppor t s t wo kinds of t r ades: Repo t r ades ( RE) , which ar e r ever sed
af t er a specif ic t er m, allowed only in specif ied secur it ies and Non- Repo ( NR)
t rades, which are for out right sales and purchase, allowed in all securit ies.
Trading in debt as out r ight t r ades or as r epo t r ansact ions can be for var ying
days of set t lement and r epo per iods. For ever y secur it y it is necessar y t o
specify t he number of set t lement days ( whet her for same day set t lement or
T+ 1 et c. depending on what is per mit t ed by t he Exchange) , t he t r ade t ype
( whet her Repo or Non Repo) , and in t he event of a Repo t rade, t he Repo
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t erm. Order mat ching is carried out only bet ween securit ies which carry t he
same condit ions wit h r espect t o set t lement days, t r ade t ype and r epo per iod,
if any.
The secur it y it self is r epr esent ed by t hr ee fields -
Secur it y Type ( e. g. GS for Gover nment Secur it ies) ,
Secur it y ( e. g. CG2010 - Cent ral Government mat uring in 2010) and
I ssue ( e. g. 6. 25%) .

All order mat ching is on t he basis of descript ors. All inquir ies also r equir e t he
select ion of valid descr ipt or s. Ther e ar e 6 f ields, which t oget her f or m an
ent it y, which is called Secur it y Descr ipt or in t he syst em:

Secur i t y
Ty pe
Secur i t y I ssue Set t l emen t
day s
Tr ade
Ty pe
Repo
Ter m
GS CG2012 7. 40% 1 Non Re po -
TB 364D 110604 1 Repo 7

All t r ade mat ching is essent ially on t he basis of descr ipt or , it s pr ice ( for non-
r epos) / r at e ( f or r epos) volume and or der condit ions and t ypes. All volumes,
in order ent ry screens and display screens, are in Rs. lakh unless informed t o
t he t rading members ot herwise. All prices are in Rupees. Repo rat es are in
per cent ages. A maximum of t wo decimal places ar e allowed f or values and
f our decimal places f or pr ices. The Exchange set s t he mult iples ( incr ement al
value) in which orders can be ent ered for different securit ies. The Exchange
announces fr om t ime t o t ime t he minimum or der size and incr ement s t her eof
for var ious secur it ies t r aded on t he Exchange.
11.2 ORDER TYPES AND CONDI TI ONS

The t r ading syst em pr ovides t r emendous fle xibilit y t o t he user s in t er ms of
t he t ype of or der s t hat can be placed on t he syst em. Sever al t ime- r elat ed,
pr i ce- relat ed or volume - r elat ed condit ions can easily be placed on an or der .
The t r ading syst em also pr ovides complet e online market informat ion
t hr ough var ious inquir y facilit ies. Det ailed infor mat ion on t he t ot al or der
dept h in a securit y, t he best buys and sells available in t he market , t he
quant it y t r aded in t hat secur it y, t he high, t he low and last t r aded pr ices ar e
available t hr ough t he var ious mar ket scr eens at all point s of t ime.

Or der Ty pes
The most frequent ly used order t ype is t he Day order wit h set t lement dat es
var yi ng f r om T+ 0 t o T+ 2. The t r adi ng syst em al so pr ovi des compl et e online
mar ket infor mat ion t hr ough var ious inquir y facilit ies. Det ailed inf or mat ion on
t he t ot al or der dept h in a secur it y, t he best buys and sells available in t he
mar ket , t he quant it y t r aded in t hat secur it y, t he high, t he low and last t r aded
pr ices ar e available t hr ough t he var ious mar ket scr eens at all point s of t ime.
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Or der Mat ch i n g Ru l es f or con t i n u ou s mar k et
Or der s lying unmat ched ar e called passive or der s. Fr esh or der s which ent er
t he syst em and ar e scanning for a suit able mat ch ar e called act ive or der s.
Or der s ar e mat ched as per pr ice- t i me pr i or i t y. The best buy order is t he one
wit h t he highest buy pr ice and t he best sell or der is t he one wit h t he lowest
sell pr ice. Or der mat ching is done aut omat ically by t he syst em. The t r ade
pr ice is based on passive or der pr ice. I n case of r epo t r ades, t he best buy
or der is one wit h lowest buy r at e and t he best sell or der is one wit h t he
highest sell r at e. The t r ade r at e is based on passive or der r at e. However ,
t r ade pr ice for r epo t r ades is t he act ive or der pr ice.
11.3 MARKET PHASES AND STARTI NG UP
Pr e- Open Ph ase
The pre- open per iod commences at 9. 00 a. m. The f ollowing act ivit ies can be
car r ied out by t he
Tr ading member / Par t icipant at t his st age:
Set up count er par t y exposur e limit s
Set up Mar ket Wat ch ( t he secur it ies which user would like t o view on
t he scr een. I n all a user can select 180 secur it y descr ipt or s in Mar ket
wat ch)
I nquir ies
Mar k et Ti mi n g
The Market remains open from 10 a. m. t o 5. 45 p. m. on Monday t o Friday At
t he st ar t of t he t r ading session, a message is displayed indicat ing t hat t r ading
woul d begin.
The f ollowing act ivit ies ar e allowed at t his st age:
Or der Act i vi t y
I nquir ies
Tr ade Act i vi t y
Negot i at ed Tr ade Act i vi t y
When t he mar ket closes, t r ading in all secur it ies ends and none of t he above
funct ions except r equest ing t r ade cancellat ions ar e allowed.
Post Cl osi n g Per i od
SURCON
At t his st age, t he per iod of SURveillance and CONt r ol ( SURCON) commences.
I n t his st age, a Tr ading member has only inquir y access. However , a Tr ading
member can r equest a t r ade cancellat ion t ill 3. 05 pm for same day t r ades and
5. 50 p. m. f or ot her day t r ades He can also modif y r epor t r equest s. Af t er t his
per iod, t he t r ading syst em pr ocesses t he dat a t o make it available for t he
next day. A Tr ading member / Par t icipant must r emain logged on t o t he syst em
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t ill 5. 50 p. m. as report s ar e gener at ed at his wor kst at ion. The member loses
connect ion t o t he t rading syst em at 5. 50 p. m. and does not have access t ill
6. 15 p. m. A t rading member get s access t o t he inquiry screens from 6. 45
p. m. t o 7. 00 p. m.
The user can also set / modif y t he CP exposur es set by him vis- a- vis ot her
Tr ading member s or Par t icipant s dur ing 6. 15 p. m. t o 7. 00 p. m. , t o pr epar e
for t r ading on t he next day.
11.4 TRADI NG MECHANI SM
Cou n t erpar t y Li mi t s
A Tr ading member / Par t icipant ar e r equir ed t o set CP limit s on ot her Tr ading
member s/ Par t icipant s only on t he fir st occasion. These limit s ar e st or ed by
t he syst em and used f or validat ion of all t r ansact ions as per t he def init ion.
( See t he CP exposur e scr een gi ven i n Fi gur e 11. 1) . The l i mi t avai l abl e i s
r educed by t r ade consider at ion, each t ime a valid t r ade is execut ed by t he
Tr ading member / Par t icipant against t he par t icular Par t icipant / Tr ading
member . The limit becomes available only af t er t he set t lement of t he t r ade
i. e. all SD t r ades r educe limit available dur ing t he day f or t r adi ng and become
available for t he next t rading day. Where t rades are execut ed for ot her day
set t l ement ( say, T+ 2) t he l i mi t becomes avai l abl e onl y f or t r adi ng on T+ 3r d
day. The limit s ar e over wr it t en only when t he Tr ading member / Par t icipant
modifies t he pr eviously set limit s. However CP exposur e limit can not be
r educe below t he out st anding cur r ent asset limit s alr eady t aken.
When a Tr ading member / Par t icipant ar e added t o t he syst em his def ault limit
on ot her s and ot her s on him is zer o. Hence t he new Tr ading member /
Par t icipant will not be able t o t r ansact unless ot her s set limit on him or he
set s a limit on ot hers.
All t r ades execut ed by t r ading member s f or t heir Par t icipant s ( ent it ies
r egist er ed wit h NSE as Par t icipant s) ar e not count ed in the part icular Trading
member s count er par t y exposur e and ar e r eckoned only in t he Par t icipant s
count erpart y exposure. Though all client t rades which are done by t he
Tr ading member on his own account ar e set t led by t he client dir ect ly, t he
exposur e limit available of t he Tr ading member is r educed. I n case of Repo
t r ades t he CP limit is r educed by t r ade value and becomes available only af t er
t he for war d leg is execut ed.
Par t icipant s can set limit s f or buy or sell or bot h. Limit s wit h r espect t o
asset s and cal l , and t he count erpar t y code ar e ent er ed in t he scr een.
Count erpart y exposure limit s can be set by all Part icipant s before market
opening, during market hours and aft er market closes on any day. However
CP exposur e l i mi t can not be r educe bel ow t he cur r ent days exposur e alr eady
t aken.
Exchange not ifies from t ime t o t ime for which market s t he CP limit s are
applicable. I f t her e is any such change, t hen Cur r ent Limit is displayed
accor ding t o new change. I f a t r ade is cancelled t hen syst em r est or es CP
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limit s i. e. cur r ent limit for t hat count er par t y is decr eased by t r ade value and
same is available f or f ut ur e t r ades wit h t hat count er par t y.
I f t he limit or iginally set by a Tr ading member / Par t icipant is Rs. 150 lakh
against a count er par t y on any day and t he used up limit on t he next t r ading
day is Rs. 120 lakh, t he Tr ading member / Par t icipant can modify his
pr eviously set limit t o any new value. I f t he new limit is lower say Rs. 100
lakh, t he syst em will r egist er t he new limit but cont inue t o show t he cur r ent
value or t he used up limit as Rs. 120 lakh t ill t he t ime t hese t r ades ar e
set t led. The new limit is applicable for all fut ur e t r ades unt il it is modified.

Fi gu r e 1 1 . 1 : NEAT Cou n t er- p ar t y ex p osu r e scr een

11.5 ORDER ENTRY

Or der ent r y mechani sm enables t he Tr ading Member t o place or der s in t he
mar ket . The syst em accept s or der s f r om all Tr ading Member s and pr ovides
equal access t o all users. The order ent ry screen is shown in Figure 11. 2.

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Fi gu r e 1 1 . 2 : Or der En t r y Scr een on t h e NEAT

11.5.1 Or der Ent r y i n Cont i nuous Mar k et

The or der ent r y scr een is act ivat ed in t he following manner :
On pr essing t he buy or sell key, t he syst em aut omat ically picks up
infor mat ion fr om mar ket inquir y scr eens and fills in t he following fields:
Secur i t y t ype
Secur i t y
I ssue
Set t lement Per iod
Tr ade t ype
Repo t er m ( in t he case of a r epo)

The user is r equir ed t o f ill in t he or der value and pr ice ( and r epo r at e in t he
case of a r epo) . The maximum number of decimal places for t he value is 2
and f or t he pr ice and r epo rat e is 4. I f t he user want s t o place an out r ight
BUY or der and t her e ar e SELL or der s available, t hen t he best sell pr ice and
t he value available at t hat pr ice appear by def ault ( Same f igur es as appear in
t he mar ket wat ch f or t hat secur it y descr ipt or ) .
I n case of r epo t r ades t he user is not r equir ed t o ent er t he pr ice, as t he
syst em provides t he default price. The default price is based eit her on t raded
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pr ice in t hat secur it y on t he t r ading syst em or on t r aded pr ice in t hat secur it y
out side t he Exchange.
For example, in t he case of Dat ed Gover nment Secur it ies if t her e is no t r aded
price available on t he syst em, t he default price is based on t he t raded price
report ed in RBI s SGL press release. I f t here is no such default price, t he
sel l er s pr i ce i s consi dered as t he pr i ce f or r epo t r ade and t he consi der at i on i s
calculat ed accor dingly.
The or der value should be equal t o or gr eat er t han minimum or der size and in
mult iples of t he incr ement s. The Exchange not ifies t he member s of t he
minimum or der size and t he incr ement s t her eof f or var i ous secur i t i es t hat ar e
t r aded on t he Exchange.

11. 5. 2 Or der Ent r y i n Negot i at ed Tr ades Mar k et

I n case of or der ent r y in Negot iat ed t r ades mar ket or Negot iat ed t r ade ent r ies
as t hey are referred t o, t he procedure is same as in t he case of cont inuous
mar ket , for init iat ing t he scr een and aut o fill- up of fields.
Addit ionally, t he user is r equir ed t o f ill in t he Count er Par t icipant I D ( t he
Par t icipant r esponsible for set t lement wit h whom t he t r ade is negot iat ed) in
t he case of a negot iat ed t r ade ent r y. The Par t icipant and count er Par t icipant
could also be Tr ading member s.
I n t he case of a negot iat ed t r ade ent r y, t he syst em does not allow t he user t o
add at t ribut es such as GTC, GTD, I OC, MF, AON, DV and OS.
I n case of repo t rades default price is displayed for bot h buyer and seller.
Bot h of t hem ar e allowed t o change t his pr ice. However t he t r ade t akes place
only if bot h ent er same pr ice.
All negot iat ed t rades require Exchange approval and one of t he opt ions t hat
t he Exchange coul d exercise in t his r egar d is t o t hr ow t he secur it y descr ipt or
open f or par t icipat ion per iod. As a r esult , if t he negot iat ed t r ade ent r y is
made when t her e is not sufficient t ime befor e mar ket close for par t icipat ion
per iod and or der mat ching at t he end of t he par t icipat ion per iod, it is
cancelled aut omat ically by t he syst em.

Par t icipat ion per iod t ime 1 minut e
Par t icipat ion per iod mat ch t ime 1 minut e
Market close t ime 5.45 p.m.

A negot iat ed t r ade ent r y made in last t wo minut e of mar ket close could result
in a negot iat ed t r ade and hence, t he t r ade ent r y is cancelled as soon as it is
ent ered as t here is not enough t ime for part icipat ion period. The count er
negot iat ed t r ade ent r y is aut omat ically r emoved f r om t he syst em at t he end
of t he day.

126
Or der Nu m b er
When an order is ent ered by t he user, t he syst em regist ers t he order and
confir ms t o t he user by displaying an Or der Confir mat ion number . This
number has t he dat e of t he order built in as t he first 8 digit s. Each order
number is unique. This order number is used for all subsequent amendment s
and cancellat ions, if any. This is t r ue in case of or der s ent er ed in t he
cont inuous as well as t he negot iat ed t r ades mar ket .

Or der Con f i r mat i on Sl i p
For ever y or der accept ed by t he t r ading syst em, an or der confirmat ion slip is
generat ed wit h t he order number and all det ails of t he given order at t he
users local print er.
11.6 ORDER VALI DATI ON

Cont i nuous Mar k et
The Tr adi ng syst em checks and val i dat es t he det ai l s when an or der i s
ent er ed. The f ollowing checks are made:
Or der s can be ent er ed only wit hin t he t r ading hour s for t he mar ket i. e. it
should not be during pre- open per iod or aft er mar ket close.
The secur it y t ype, secur it y and issues ar e valid values and t oget her should
f or m an accept able combinat ion.
Trading in t his secur it y t ype, secur it y and issue should be allowed at t hat
t ime.
The Tr ading member ent er ing t he or der should not be under suspension
by t he Exchange.
I n case of an order ent ered by a Trading member on behalf of a
Part icipant , t he Trading me mber as well as t he Part icipant should not be
under suspension.
Or der value should be in mult iples of t he incr ement and at least equal t o
t he minimum or der value f or t he secur it y t ype or issue.
The specified set t lement period should be available for t rading for t he
secur it y t ype.
The set t lement days ent er ed f or t hat or der is a per mit t ed set t lement
per iod. The set t lement days is count ed as per t he wor king days. e. g. - I f
15t h July is holiday, t hen all or der s for T+ 1 set t lement ent er ed on 14t h
July ar e accept ed. T+ 1 t r ades done on 14t h ar e set t led on 16t h and T+ 2
t r ades done on 14t h ar e set t led on 17t h. I n case of Repo t r ansact ions
r eady leg set t lement is count ed as per wor king days but f or war d leg
set t lement is count ed as per calendar days. The maximum number of
days permit t ed for set t ling a t rade is not ified t o t he members by t he
Exchange fr om t ime t o t ime. Cur r ent ly r epo upt o 14 days ar e allowed.
The specif ied t r ade t ype should be available f or t r ading f or t he secur it y
t ype.
127
The Tr ading member / Par t icipant should be per mit t ed t o t r ade in t he
secur it y t ype f or t hat set t lement per iod ( Same/ Next / Two) f or t he t r ade
t ype ( Repo/ Non- Repo) f or t he Cont inuous Mar ket Type
The Tr ading member / Par t icipant should be allowed t o buy ( lend) / sell
( bor r ow) in t hat secur it y t ype.
For an or der , t he or der value should not exceed t he issue value.
The member is allowed t o ent er or der s on behalf of only t hose Par t icipant s
who are regist ered wit h t he Exchange for non- part icipant ; member has t o
put t heir own br oker code.
Ext ra validat ion checks for or der at t r ibut es or condit ions ar e per for med
befor e an or der is confir med by t he syst em ir r espect ive of whet her t hey
are buy or sell orders.
Af t er t he necessar y checks and validat ion ar e complet ed, t he syst em
generat es a unique order number; t ime st amps it and sends an order
conf ir mat ion t o t he member wit h or der conf ir mat ion slip t o be pr int ed at his
end.

Negot i at ed Tr ades Mar k et
For a t r ade ent r y in t he negot iat ed t r ades mar ket , similar checks as in t he
case of an order ent ered in t he cont inuous market are made wit h a few
var iat ions.
Following is a list of checks f or ent r ies in t he negot iat ed t r ades mar ket :
Negot iat ed t r ade ent r ies can be ent er ed only wit hin t he t r ading hour s f or
t he market i. e. it should not be during pre- open per iod or af t er mar ket
cl ose.
The secur it y t ype, secur it y and issues ar e valid values and t oget her should
f or m an accept able combinat ion.
Tr ading in t his secur it y t ype, secur it y and issue should be allowed at t hat
t ime.
The Tr ading member ent er ing t he negot iat ed t rade ent ry should not be
under suspension by t he Exchange.
I n case of a negot iat ed t rade ent ry by a Trading member on behalf of a
Par t icipant , t he Tr ading member as well as t he Par t icipant / count er
Par t icipant should not be under suspension.
Trade value should be in mult iples of t he incr ement and at least equal t o
t he minimum or der value f or t he secur it y t ype or issue.
The specified set t lement period should be available for t rading for t he
secur it y t ype.
The set t lement days ent er ed for t hat or der is a per mi t t ed set t l ement
per iod. The set t lement days is count ed as per t he wor king days. I n case
of Repo t r ansact ions r eady leg set t lement is count ed as per wor king days
but f or war d leg set t lement is count ed as per calendar days. The maximum
number of days per mit t ed f or set t ling a t r ade will be not if ied t o t he
member s by t he Exchange fr om t ime t o t ime.
The specif ied t r ade t ype should be available f or t r ading f or t he secur it y
t ype.
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The Tr ading member / Par t icipant should be per mit t ed t o t r ade in t he
secur i t y t ype f or t hat set t lement per iod ( Same / Next / Two) f or t he t r ade
t ype ( repo / Non- r epo) f or t he Negot iat ed t r ades mar ket t ype.
The Tr ading member / Par t icipant should be allowed t o buy ( lend) / sell
( bor r ow) in t he secur it y t ype.
The t r ade value should not exceed t he issue size.
The member is allowed t o ent er orders only on behalf of t hose
Par t icipant s/ Count er Par t icipant s who ar e r egist er ed wit h t he Exchange.
for non- par t icipant , member has t o put t heir own br oker code.
Af t er t he necessar y checks and validat ion ar e compl et ed, t he syst em
gener at es a unique t r ade ent r y ( negot iat ed or der ) number , t ime st amps it
and sends a t r ade ent r y ( negot iat ed or der ) conf ir mat ion t o t he member wit h
a confir mat ion slip t o be pr int ed at his end.
I t is not possible t o modify an out st anding negot iat ed t r ade ent r y. Cur r ent ly,
in case a t r ading member cancels a negot iat ed or der befor e neat appr oval of
t he t r ade by t he Exchange, t he count er br oker does not get any message t o
t his effect . Now if a t rading member cancels his side of a Negot i at ed Tr ade
or der , t he count er par t y member r eceives a message Negot iat ed t r ade aler t
cancelled as t he count er br oker has cancelled it s or der in t he message
window at his t r ader wor kst at ion. The det ails of t he or der such as t he secur it y
descr ipt or , volume and pr ice ar e also displayed aft er t he above message.
The user can cancel his negot iat ed or der s t hr ough single or der cancellat ion.
The or der can also be cancelled by invoking t he Out st anding Or der scr een and
double clicking on t he r elevant or der .
11.7 ORDER MATCHI NG
Cont i nuous Mar k et
Order Mat ching is t he process of mat ching t he buy and sell orders on t he
basis of cer t ain mat ching algor it hms. As a r esult of mat ching pr ocess, a t r ade
is generat ed. I f an order placed is not mat ched immediat ely, t he syst em
st or es t he or der in t he or der book accor ding t o pr ice- t ime pr ior it y.
The or der s ar e mat ched on t he basis of pr ice- t ime pr ior it y. The best buy or der
mat ches wit h best sell or der . An or der may mat ch par t ially wit h anot her or der
result ing in mult iple t rades. The best buy or der is t he one wit h t he highest
pr ice and t he best sell or der is t he one wit h t he lowest pr ice. I n case of r epo
t r ansact ion, t he best buy or der is t he one wit h lowest r epo r at e and t he best
sell or der is t he one wit h highest r epo r at e.
The priorit y followed in mat ching orders is:
Best pr i ce
Wit hin pr ice, t ime pr ior it y

Cou n t erpar t y Ex posu r e Li mi t s
The pr ocess of or der mat ching consider s t he CP exposur e limit set by t he
Tr ading member s/ Par t icipant s on ot her Tr ading member s or Par t icipant s.
129
These limit s apply f or or der mat ching in mar ket t ypes as not if ied by
Exchange. Whenever t her e is pot ent ial or der mat ch available t he syst em
checks t he count er par t y exposur e limit available vis- - vis t he pot ent ial
count er par t y bef or e appr oving t he mat ch. I f t he r esult ing t r ade is not
cr ossing t he count er par t y exposur e limit t hen t he syst em concludes t he t r ade
pr ovided ot her par amet er s ar e met .
When a member t ransact s wit h anot her member or Part icipant on whom he
has set a l i mi t , t he bal ance l i mi t avai labl e get s r educed by an amount equal
t o t he t r ade consider at ion as shown in t he message window.
Dur ing t r ading hour s, if a pot ent ial t r ade r esult s in t he cur r ent CP limit
cr ossing t he war ning limit set by t he Exchange t hen t he syst em concludes t he
t r ade and a message appears on t he workst at ion of t he part icipant on whose
behalf t he or der ent er ed st at ing t hat t he war ning limit has been exceeded.
Af t er t he war ning CP limit has been cr ossed, if t he member cont inues t o ent er
orders and if a pot ent ial t rade result s in cr ossing of CP limit set by t he
member, t hen t he syst em allows t he t rade provided it is less t han or equal t o
t he cut of f limit set by t he Exchange. A message appear s on t he wor kst at ion
of t he par t icipant on whose behalf t he or der was ent er ed st at ing t hat CP limit
has been exceeded wit h t he respect ive Trading member/ Part icipant who has
ent ered t he count er order.
Aft er cr ossing t he war ning limit , if t he member cont inues t o ent er or der s and
if r esult ing t r ade is exceeding t he cut off limit set by t he Exchange, t hen t he
syst em does not allow t he t r ade. I t skips t he passive or der and go t o t he next
best passive order. I f it does not find a suit able mat ch in t he books so t hat
t he cur r ent value of CP limit is wit hin t he cut of f limit , t hen such an or der
remains in t he r espect ive book. Such or der s may f ind mat ches wit h or der s
f r om anot her Tr ading member / Par t icipant wit h whom CP exposur e is not
exhaust ed.

Fr eeze
The Exchange set s l ower and upper l i mi t s t o t he t r adi ng pr i ce f or al l t he
issues in t he mar ket . I n case a mat ch r esult s in t he pr ice f alling out side t he
t r ading r ange, t he t r ade r esult s in a fr eeze in t he secur it y descr ipt or . For a
frozen securit y descript or, order ent ry is rest rict ed by t he syst em t ill t he t ime
t he freeze is resolved by t he Exchange. The Trading members involved in t he
t r ade get a message t hat t he mat ch has r esult ed in a f r eeze. All ot her user s
of t he syst em ar e i nf or med t hat a f r eeze has t aken pl ace i n t he secur i t y
descr ipt or .
I n case of fr eeze t he Exchange has following opt ions:
1. Cancel t he buy or der and appr ove t he sell or der
2. Cancel t he sell or der and appr ove t he buy or der
3. Approve bot h t he orders which result in t rade depending on t he t urnover
limit and count er par t y exposur e limit .
4. Cancel bot h t he orders
5. St ar t par t icipat ion period
130
The syst em checks for a price freeze only during a t rade i. e. only when t here
is a pot ent ial mat ch. I f an order is ent ered at a price out side t he set range, it
is allowed t o be writ t en t o t he book. There is no validat ion for price freeze at
order ent ry level.

Par t i ci pat i on Per i od
Wi t h r espect t o a f r eeze, t he Exchange can st ar t a par t i ci pat i on per i od f or t he
secur i t y descr i pt or . The syst em i nf or ms al l t he user s t hat t he f r eeze has been
r esolved and t he par t icipat ion per iod is open f or or der ent r y. The or der s
causing t he freeze are ret ained in t he books and are allowed t o part icipat e in
t his pr ocess.
Dur ing t he par t icipat ion per iod, t her e is no cont inuous mat ching in t hat
par t icular secur it y descr ipt or by t he syst em. The or der s ent er ed by t he
member s ar e wr it t en dir ect ly t o t he Boar d lot book. Or der s ent er ed ar e by
default fully disclosed and DAY or der s. Or der s wit h ot her pr ice, t ime and
volume condit ions ar e however not accept ed dur ing t he par t icipat ion per iod.
The par t icipat ion per iod cont inues for a dur at ion specified by t he Exchange.
Aft er t he part icipat ion period, orders are mat ched by t he syst em as per t he
nor mal mat ching algor it hm i. e. best buy or der wit h t he best sell or der . For
t his mat ching pr ocess, all t he or der s in t he Book ar e consider ed. This includes
or der s pr esent in t he book befor e t he occur r ence of t he fr eeze as well as
or der s ent er ed dur ing t he par t icipat ion per iod.

Negot i at ed Tr ades Mar k et
All negot iat ed t r ade ent r ies ar e st or ed in a separ at e book in t he syst em. A
negot iat ed t r ade ent r y can mat ch only wit h anot her count er negot iat ed t r ade
ent r y. All negot iat ed t r ade mat ching is one- t o- one and t her e can be no par t ial
mat ches. When a negot iat ed t r ade ent r y is made, t he syst em checks f or t he
following det ails:
For t he given secur i t y descr i pt or , t he Count er Par t i ci pant I D of t he negot i at ed
t r ade ent r y should mat ch t he Par t icipant I D of t he count er negot iat ed t r ade
ent ry. The t rade value, price and repo rat e in case of a repo t rade should
mat ch exact l y wi t h t hat of t he count er t rade ent r y.
I f no mat ch is found for t he negot iat ed t r ade ent r y, it is wr it t en t o t he
negot iat ed t rade ent ry book.
The Exchange has t he opt ions of appr oving t he negot iat ed t r ade, canceling
t he t r ade in which case bot h t he negot iat ed t r ade ent r ies would be cancelled
or st ar t a par t icipat ion per iod.
Wit h r espect t o a negot iat ed t r ade, t he Exchange can st ar t a par t icipat ion
per iod. The negot iat ed t r ade ent r ies involved ar e wr it t en t o t he Boar d lot
book as nor mal or der s r et aining t heir or iginal t ime st amp. The par t icipat ion
per iod pr ocess and mat ching r emains t he same as explained in t he case of
f r eezes.

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11.8 TRADE MANAGEMENT

A Tr ade is a t r ansact ion t hat t akes place when t wo or der s mat ch each ot her .
Whenever a t r ade t akes place, t he syst em sends t r ade conf ir mat ion messages
t o each of t he Tr ading member s involved. The syst em also br oadcast s t he
t rade confirmat ion t o all Trading members in t he market t hrough t he Ticker
scr een. A t r ade conf ir mat ion slip also get s pr int ed at each of t he member s
wor kst at ion wit h t he same unique t rade number.
Ther e ar e some condit ions t hat could pr event a possible mat ch f r om t aking
place. These condit ions ar e as follows:
1. Suspension is in effect for t he ST/ S/ I involved.
2. Suspension is in effect for any of t he Part icipant s involv ed.
3. Suspension is in effect for any of t he Tr ading member involved.
4. Tur nover limit for one of t he member s involved in t he t r ade is
exceeded due t o t he t r ade.
5. CP limit set by t he t r ading member / par t icipant on t he count er
par t y is exceeded due t o t he t r ade.
The above is t r ue f or t r ades in bot h cont inuous and negot iat ed t r ades
mar ket s.

Negot i at ed Tr ade En t r y Scr een
Cur r ent ly t he user has t o ent er or der det ails in t he negot iat ed buy and
negot iat ed sell or der scr eens. A new f acilit y Negot iat ed Trade Ent r y Scr een is
pr ovided wher ein a user can ent er bot h t he buy and sell negot iat ed t r ade
or der det ails in a single scr een, in case a t r ading member r epr esent s bot h
buyer as well as seller in a negot iat ed t r ade.
Alt ernat ively, t he user can first highlight t he desir ed secur it y descr ipt or wit h
t he highlight bar on market wat ch screen. On invoking t he negot iat ed t rade
ent r y scr een t he secur it y det ails get s def ault ed on t o t he scr een. The user is
r equir ed t o ent er t he desir ed Sell Par t icipant s code in t he Count er Par t icipant
code field ( CP Field) and t he Buy Part icipant s code in t he field which by
def ault displays t he t r ading member s code. Af t er ent er ing all t he r equir ed
det ails in t he r espect ive fields t he user can commit t he t r ade and confir m t he
t r ade.
On confir ming t he negot iat ed t r ade det ails a message Negot iat ed t r ade
needs appr oval: . . . . . ( or der det ails of t he t r ade) . . . . . . . is displayed in t he
message window scr een. The syst em gener at es a buy and sell or der
conf ir mat ion slips separ at ely wit h dist inct or der number s.
The Exchange t hen r ecei ves an al er t t o t hi s ef f ect . I n case t he Exchange
appr oves t he negot iat ed t r ade t hen a message Negot iat ed Tr ade: . . . . . ( or der
det ails of Buy and Sell) . . . . Approved by Cont rol is displayed in t he message
wi ndow screen and t he t r ading member r eceives separ at e buy and sell t r ade
conf ir mat ion slips. I n case t he Exchange r ej ect s t he negot iat ed t r ade aler t
t hen a message Or der . . . . . ( or der det ails of Buy and Sell) . . . . . Negot iat ed Tr ade
not approved - or der cancel l ed i s displayed in t he message window scr een
132
and t he t r ading member r eceives separ at e buy and sell or der cancellat ion
slips.
11.9 REPORTS

The following r epor t s ar e available t o t he user at t he end of ever y t r ade day:
1. Open Or der s Today: Thi s r epor t det ai l s t he or der s t hat ar e available f or
t r ading t he next t r ading day.
2. Or der s Placed Today: This r epor t det ails all t he or der s placed by t he
member on a given t r ading day.
3. Cancelled Orders Today: This report det ails t he orders cancelled by t he
member on a t r ading day.
4. Tr ades Done Today: This r epor t det ails all t r ades execut ed by t he member
on a t r ading day.
5. Act ivit y Log Report : This report det ails all t he act ivit ies carried out by t he
member on a t r ading day.
11.10 SETTLEMENT

Tr ades on WDM segment ar e set t led gr oss, on a t r ade for t r ade basis, i. e. ,
each t r ansact ion is set t led individually and no net t ing of t r ansact ions is
allowed. The Exchange monit or s set t lement of t hese t r ades on day t o day
basis, wher ein par t icipant s confir m all t r ades and set t lement t her eof and also
pr ovi de compl et e set t l ement det ai l s t o t he Exchange t hr ough an online,
int er act ive dat a communicat ion syst em and f axes. Each t r ade has a unique
set t lement dat e specif ied upf r ont at t he t ime of or der ent r y and is used as
mat ching par amet er . I t allows set t l ement per i od T+ 1 f or Gover nment
Securit ies & Treasury Bills and for Non- gover nment Secur it ies r anging f r om
same day ( T+ 0) t o a maximum of t wo days ( T+ 2) .

All Gover nment secur it ies t r ades set t led t hr ough Clear ing Cor por at ion of I ndia
Lt d. I t facilit at es set t lement on Delivery versus Payment ( DVP- I I ) basis which
pr ovides for set t lement of secur it ies on gr oss basis and set t lement of funds
on net basis simult aneously. For ot her secur it ies, f unds ar e set t led t hr ough
exchange of physi cal i nst r ument s such as, pay- orders or cheques, for value
on t he set t lement day in exchange f or Secur it ies ( Eit her physical cer t if icat es
or t hrough Demat ) .
11.11 RATES OF BROKERAGE

NSE has specif ied t he maximum r at es of br oker age char geable by t r ading
member s in r elat ion t o t r ades done in secur it ies available on t he WDM
segment of t he Exchange, as given below:

133
Or der Val ue Br ok er age
Gov t . of I n di a Secu r i t i es an d T- Bi l l s
Upt o Rs. 10 million 25 ps. per Rs. 100
More t han 10 million upt o 50 million 15 ps. per Rs. 100
Mor e t han 50 million upt o 100 million 10 ps per Rs. 100
Mor e t han 100 million 5 ps per Rs. 100
St at e Gov t . Secu r i t i es , I n st i t u t i on al Bon ds an d Su pr a I n st i t u t i on al
Bonds
Upt o Rs. 2. 5 million 50 ps. per Rs. 100
More t han 2. 5 million upt o 5 million 30 ps. per Rs. 100
More t han 5 million upt o 10 million 25 ps per Rs. 100
More t han 50 million upt o 100 million
Mor e t han 100 million
10 ps per Rs. 100
5 ps per Rs. 100
PSU & Fl oat i n g Rat e Bon ds
Upt o Rs. 10 million 50 ps. per Rs. 100
More t han 10 million upt o 50 million 25 ps. per Rs. 100
Mor e t han 100 million 10 ps per Rs. 100
Commer cial Paper s and
Debent ures
1% of t he order value

Model Qu est i ons

1. Wh i ch of t h e f ol l ow i n g st at em en t s ab ou t n eg ot i at ed t r ad e en t r y i s
f al se?

a. I f a t r ading member r epr esent s bot h t he buyer and t he seller , negot iat ed
t r ade or der s can be ent er ed in a single scr een.
b. Tr ading member s can invoke t he secur it y descr ipt or , and f ill up t he code
and t r ansact ion det ails of t he selling par t icipant s, and confir m t he t r ade.
c. All negot iat ed t r ades r equir e appr oval of t he exchange, only aft er which
t r ading member s r eceive confir mat ion slips.
d. Negot iat ed t r ade ent r ies can be made out si de of set count erpart y limit s,
and sent for appr oval wit hin t he end of t he t r ading day.

An sw er : d

134

2 . A t r ad i n g m em b er on t h e WDM seg m en t of NSE set s u p a cou n t er
par t y l i mi t of Rs. 4 0 0 l ak h agai n st a cou n t er par t y an d u t i l i se Rs. 2 8 0
l ak h on a gi v en day w h i ch i s ou t st an di n g i n cu r r en t asset l i mi t . Th e
n ex t d ay , h e m od i f i es t h e CP l i m i t t o Rs. 1 5 0 l ak h . Wh i ch of t h e
f ol l ow i n g w i l l h ol d good?

a. The CP limit s cannot be modif ied t o al level lower t han amount s in cur r ent
asset limit .
b. The count er par t y has t o be not ified about t he r educt ion in t he CP limit .
c. The new CP limit will r esult in t he count er par t y canceling or r ever sing t hat
amount of t r ansact ion t hat exceed t he new CP limit .
d. The ear lier t r ansact ion will r emain in t he syst em as ut ilized CP limit unt il
t hose t r ades ar e set t led; t he new CP limit will apply for fr esh t r ades.

An sw er : a

3 . Rep o t r ad es on t h e NEAT ar e mat ch ed i n t er ms of

a. Rat es, volume and ot her or der condit ions.
b. Pr ice, volume and ot her or der condit ions.
c. Pr i ce- t ime priorit y.
d. Rat es- t ime pr ior it y.

An sw er : a
135

CHAPTER 12
REGULATORY AND PROCEDURAL
ASPECTS

The debt market s in I ndia are regulat ed by t wo agencies: RBI and SEBI . I n a
not if icat ion issued by t he Gover nment on Mar ch 2, 2000, t he ar eas of
r esponsibilit y bet ween RBI and SEBI have been clear ly delineat ed. I n t er ms
of t his not if icat ion, t he cont r act s f or sale and pur chase of gover nment
secur it ies, gold r elat ed secur it ies, money mar ket secur it ies and secur it ies
der ived fr om t hese secur it ies and r eady for war d cont r act s in debt secur it ies
shall be r egulat ed by t he RBI . Such cont r act s if execut ed on st ock exchanges
shall however be r egulat ed by SEBI , in a manner t hat is consist ent wit h t he
guidelines issued by t he RBI . However, regulat ion of money market mut ual
funds, which predominant ly invest in money market s, is done by t he SEBI ,
which is t he r egulat or y aut hor it y for t he mut ual fund indust r y SEBI is t he
r egulat ing agency f or t he st ock mar ket s and t he member- br oker s of t he st ock
exchanges, and t her ef or e r egulat es t he list ing and t r ading mechanism of debt
inst rument s. Regulat ion of corporat e debt issuance is also under t he purview
of SEBI .

The issuance of debt inst r ument s by t he gover nment is r egulat ed by t he
Gover nment Secur it ies Act 2006. The issuance of cor porat e secur it ies is
r egulat ed by t he SEBI Guidelines for Disclosur e and I nvest or pr ot ect ion.

The Fixed I ncome Money Mar ket & Der ivat ives Associat ion of I ndia ( FI MMDA) ,
formed in 1998, is t he Self Regulat ory Organisat ion for debt market s. I t s
obj ect i ve i s t o enable mar ket development by involving mar ket par t icipant s in
t he cr eat ion of good mar ket pr act ices, unif or m mar ket convent ions and high
levels of int egr it y in t he debt mar ket s. FI MMDA has br ought out t he
Handbook of Mar ket Pr act ices, aimed at cr eat ing high st andar ds of conduct
and pr ofessionalism amongst pr incipals and int er mediar ies in t he mar ket
pl ace.

This chapt er is divided int o t hree sect ions, focusing on regulat ion and market
pr act ices. Sect ion 1 discusses t he salient pr ovisions of t he Gover nment
Secur it ies Act , which gover ns t he issuance of gover nment secur it ies. Sect ion
2 is an ext ract from t he SEBI Regulat ions for issuance of debt inst rument s by
t he cor por at e sect or . Sect ion 3 is an ext r act f r om t he FI MMDA Handbook of
mar ket pr act i ces.

136
12.1 GOVERNMENT SECURITI ES ACT, 2006

Wit h a view t o consolidat ing and amending t he law r elat ing t o t he
Gover nment Secur it ies and it s management by t he Reser ve Bank of I ndia, t he
Par liament had enact ed t he Gover nment Secur it ies Act , 2006. The Act
r ecei ved t he pr esident ial assent on August 30, 2006.

The Gover nment Secur it ies Act also pr ovides t hat RBI may make r egulat ions
t o car r y out t he pur poses of t he Act . Gover nment Secur it ies Regulat ions,
2007 have been made by t he Reser ve Bank of I ndia t o car r y out t he pur poses
of t he Gover nment Secur it ies Act , 2006.

The Gover nment Secur it ies Act , 2006 and Gover nment Secur it ies Regulat ions,
2007 have come int o force wit h effect from December 1, 2007. The
Gover nment Secur it ies Act applies t o Gover nment secur it ies cr eat ed and
issued by t he Cent r al and t he St at e Gover nment .

The new Act and Regulat ions would f acilit at e widening and deepening of t he
Gover nment Secur it ies mar ket and it s mor e effect ive r egulat ion by t he
Reser ve Bank in var ious ways such as:

(i) St r ipping or r econst it ut ion of Gover nment secur it ies
(ii) Legal r ecognit ion of beneficial owner ship of t he invest or s in
Gover nment Secur it ies t hr ough t he Const it uent s Subsidiar y
Gener al Ledger ( CSGL) .
(iii) St at ut or y backing f or t he Reser ve Bank' s power t o debar
Subsidiary General Ledger ( SGL) account holder s f r om t r ading,
eit her t empor ar ily or per manent ly, f or misuse of SGL account
f acilit y;
( iv) Facilit y of pledge or hypot hecat ion or lien of Government
securit ies for availing of loan;
( v) Ext ension of nominat ion f acilit y t o hold t he secur it ies or r eceive
t he amount t her eof in t he event of deat h of t he holder ;
( vi) Recognit ion of t it le t o Gover nment secur it y of t he deceased
holder on t he basis of document s ot her t han succession
cer t ificat e such as will execut ed by t he deceased holder ,
r egist er ed deed of f ami l y set t l ement , gi f t deed, deed of
par t it ion, et c. , as pr escr ibed by t he Reser ve Bank of I ndia.
(vii) Recognit ion of mot her as t he guardian of t he minor for t he
pur pose of holding Gover nment Secur it ies;
( viii) St at ut or y power s t o t he Reser ve Bank t o call f or inf or mat ion,
cause inspect ion and issue dir ect ions in r elat ion t o Gover nment
secur it ies.

Ever y Regulat ion made by t he Reser ve Bank of I ndia ar e t o be appr oved by
t he Par l i ament .
137

GOVERNMENT SECURI TI ES ACT 2 0 0 6

Gover nment secur it y means a secur it y cr eat ed and issued by t he
Gover nment for t he pur pose of r aising a public loan or for any ot her pur pose
as may be not ified by t he Gover nment in t he Official Gazet t e.

A Gover nment secur it y may be issued in t he for m of a-

(i) a Gover nment pr omissor y not e,
(ii) a bearer bond payable t o bearer,
(iii) a st ock or
( iv) a bond held in a bond ledger account .

A st ock means a Government securit y ( i) regist ered in t he books of t he RBI
f or which a st ock cer t if icat e is issued; or ( ii) held at t he cr edit of t he holder in
t he subsi di ar y gener al ledger account including t he const it uent s subsidiar y
gener al ledger account maint ained in t he books of t he RBI , and t r ansf er able
by r egist r at ion in t he books of t he RBI .

A t r ansf er of a gover nment secur it y shall be valid only if it pur por t s t o convey
t he f ull t it le t o t he secur it y. The t r ansf er of t he Gover nment secur it ies shall be
made in such form and in such manner as may be prescribed.

GOVERNMENT SECURI TI ES REGULATI ONS, 2 0 0 7

Gover nment Secur it ies Regulat ions, 2007 have been made by t he Reser ve
Bank of I ndia t o car r y out t he pur poses of t he Gover nment Secur it ies Act .

The Gover nment Secur it ies Regulat ions, 2007 pr ovides f or t r ansf er of
Government securit ies held in different forms. Government securit y held in
t he for m of Gover nment Pr omissor y Not es i s t r ansf er abl e by endor sement
and delivery. A bearer bond is t ransferable by delivery and t he person in
possession of t he bond shall be deemed t o be t he holder of t he bond.
Gover nment secur it ies held in t he for m of St ock Cer t i f i cat e , Subsidiary
Gener al Ledger account including a const it uent Subsidiar y Gener al Ledger
Account ) & Bond Ledger Account ar e t r ansf er able, bef or e mat ur it y, by
execut ion of forms - I I I , I V & V respect ively appended t o t he Government
Secur it ies Regulat ions. Gover nment secur it ies held in subsidiar y gener al
ledger account including a const it uent s subsidiar y gener al ledger account or
bond ledger account , shall also be t r ansf er able by execut ion of a deed in an
elect r onic for m under digit al signat ur e.

A per son unabl e t o wr it e, execut e or endor se a document , may apply t o t he
Execut ive Magist r at e t o execut e t he document or make endor sement on his
behalf aft er pr oducing sufficient document ar y evidence about his ident it y and
138
sat isf ying t he Execut ive Magist r at e t hat he has under st ood t he i mpl i cat i ons of
such execut ion or endor sement .

12.2 SEBI ( GUI DELI NES FOR DI SCLOSURE AND
I NVESTOR PROTECTI ON), 2000

SEBI Guidelines f or issuance of cor por at e debent ur es is st ipulat ed in Chapt er
X of t he DI P, 2000, which is r epr oduced her eunder.

Ch apt er X - Gu i del i n es f or I ssu e of Debt I n st r u men t s
A company of f er ing Conver t ible/ Non Conver t ible debt inst r ument s t hr ough an
of f er document shall comply wit h t he f ollowing pr ovisions in addit ion t o t he
r elevant pr ovisions cont ained in ot her chapt er of t hese guidelines.

Requ i r emen t of cr edi t r at i n g
1. No company shall make a public issue or r ight s issue of debt inst r ument s
( whet her convert ible or not ) , unless credit rat ing is obt ained from at least
one credit rat ing agency regist ered wit h t he board and disclosed in t he
of f er document .
2. Where rat ings are obt ained from more t han one credit rat ing agencies, all
t he r at ings including t he unaccept ed cr edit r at ings, shall be disclosed in
t he of f er document .
3. All t he credit rat ings obt ained during t he t hree years ( 3) preceding t he
public or r ight s issue of debt inst r ument ( including conver t ible
inst r ument s) for any list ed secur it y of t he issuer company shall be
disclosed in t he of f er document .
Requ i r emen t i n r espect of Deben t u r e Tr u st ee
1. No company shall issue a pr ospect us or a let t er of of f er t o t he public f or
subscript ion of it s debent ures, unless t he company has appoint ed one or
mor e debent ur e t r ust ees for such debent ur es in accor dance wit h t he
pr ovisions of t he Companies Act , 1956.
2. The names of t he debent ur e t r ust ees shal l be st at ed i n t he Of f er
Document s and also in all t he subsequent per iodical communicat ions sent
t o t he debent ur e holder s.
3. A t rust deed shall be execut ed by t he issuer company in favour of t he
debent ur e t r ust ees wit hin t hr ee mont hs of t he closur e of t he issue.
4. Tr ust ees t o t he debent ur e issue shall be vest ed wit h t he r equisit e power s
for pr ot ect ing t he int er est of debent ur e holder s including a r ight t o appoint
a nominee dir ect or on t he Boar d of t he company in consult at ion wit h
inst it ut ional debent ur e hol der s.
139
5. The mer chant banker shall, along wit h t he dr af t of f er document , f ile wit h
t he Boar d, cer t ificat es fr om t he banker s of t he Company t hat t he asset s
on which t he secur it y is t o be cr eat ed ar e f r ee f r om any encumbr ances
and t he necessary permissions t o mor t gage t he asset s have been
obt ained or No - obj ect ion Cer t if icat e f r om t he Financial I nst it ut ions or
Banks f or a second or par i passu char ged in cases wher e asset s ar e
encumber ed. The mer chant banker shall also ensur e t hat t he secur it y
cr eat ed is adequat e t o ensur e 100% asset cover f or t he debent ur es.
Pr ovided t hat in case of a f ast t r act issue of debt inst r ument s, t he
cert ificat e specified in t his clause shall not be filed wit h SEBI .
6. The debent ur e t r ust ee shall ensur e compliance of t he f ollowing:
a) 100( I t shall obt ain r epor t s f r om t he lead bank, r egar ding monit or ing
pr ogr ess of t he pr oj ect . )
b) 101( I t shall monit or ut ilizat ion of funds r aised in t he debent ur e issue. )
c) Tr ust ees shall obt ain a cer t ificat e fr om t he company' s audit or s:
( i ) i n r espect of ut ilisat ion of f unds dur ing t he implement at ion per iod of
pr oj ect s.
( ii) in t he case of debent ur es f or wor king capit al, cer t if icat e shall be
obt ained at t he end of each account ing year .
d) Debent ur e issues by companies belonging t o t he gr oups for financing
r eplenishing f unds or acquir ing shar e holding in ot her companies shall
not be per mit t ed.
e) The debent ur e t r ust ees shall super vise t he implement at ion of t he
condit ions r egar ding cr eat ion of secur it y f or t he debent ur es and
debent ur e r edempt ion r eser ve.

Cr eat i on o f Deben t u r e Redempt i on Reser v es ( DRR)
For t he r edempt ion of t he debent ur es issued, t he company shall cr eat e
debent ur e r edempt ion r eser ve in accor dance wit h t he pr ovisions of t he
Companies Act , 1956.

Di st r i bu t i on of Di v i den ds

a. I n case of t he compani es which have def ault ed in payment of int er est on
debent ures or redempt ion of debent ures or in creat ion of securit y as per
t he t er ms of issue of t he debent ur es, any dist r ibut ion of dividend shall
r equir e appr oval of t he Debent ur e Tr ust ees and t he Lead I nst it ut ion, if
any.

b. I n t he case of exist ing companies prior permission of t he lead inst it ut ion
for declaring dividend exceeding 20% or as per t he loan covenant s is
necessar y if t he company does not comply wit h inst it ut ional condit ion
r egar ding int er est and debt ser vice cover age r at io.

c. ( i) Dividends may be dist ribut ed out of profit of part icular years only aft er
t ransfer of requisit e amount in DRR.
140
( ii) I f residual profit s aft er t ransfer t o DRR are inadequat e t o dist ribut e
r easonable dividends, company may dist r ibut e dividend out of gener al
reserve.

Redempt i on
The issuer company shall r edeem t he debent ur es as per t he of f er document .

Di scl osu r e an d Cr eat i on of Ch ar ge
1. The offer document shall specifically st at e t he asset s on which secur it y
shall be cr eat ed and shall also st at e t he r anking of t he char ge/ s. I n case
of second or r esidual char ge or subor dinat ed obligat ion, t he of f er
document shall clear ly st at e t he r isks associat ed wit h such subsequent
char ge. The r el evant consent f or cr eat i on of secur i t y such as pari passu
let t er, consent of t he lessor of t he land in case of leasehold land et c. shall
be obt ained and submit t ed t o t he debent ur e t r ust ee bef or e opening of
issue of debent ure.
2. The of f er document shall st at e t he secur it y / asset cover t o be maint ained.
The basis for comput at ion of t he secur it y / asset cover , t he valuat ion
met hods and periodicit y of such valuat ion shall also be disclosed. The
secur it y / asset cover shall be ar r ived at aft er r educt ion of t he liabilit ies
having a fir st / pr ior char ge, in case t he debent ur es ar e secur ed by a
second or subsequent char ge.
3. The issue pr oceeds shall be kept in an escr ow account unt il t he document s
f or cr eat ion of secur it y as st at ed in t he of f er document , ar e execut ed.
4. The pr oposal t o cr eat e a char ge or ot her wise in r espect of such
debent ur es, may be disclosed in t he offer document along wit h it s
implicat ions.

Requ i r emen t of l et t er of opt i on
Fi l i n g of l et t er of opt i on
Wher e t he company desir es t o r ollover t he debent ur es issued by it , it shall f ile
wit h SEBI a copy of t he not ice of t he r esolut ion t o be sent t o t he debent ur e-
holder s f or t he pur pose, t hr ough a mer chant banker pr ior t o dispat ching t he
same t o t he debent ur e- holder s. The not ice shall cont ain disclosur es wit h
r egar d t o cr edit r at ing, necessit y f or debent ure- holder s r esolut ion and such
ot her t er ms which SEBI may specif y. Wher e t he company desir es t o conver t
t he debent ur es int o equit y shar es in accor dance wit h t he clauses ment ioned
in t he guidelines ( Clause10. 7. 2) , it shall f ile wit h SEBI a copy of t he let t er of
opt ion t o be sent t o debent ur e- holders wit h t he Board, t hrough a merchant
banker , pr ior t o dispat ching t he same t o t he debent ur e- holders. The let t er of
opt ion shall cont ain disclosures wit h regard t o opt ion for conversion,
j ust if icat ion f or conver sion pr ice and such ot her t er ms which SEBI may
speci f y.
141

Rol l ov er of Non Con v er t i bl e Por t i on s of Par t l y Con v er t i bl e
Deben t u r es ( PCDs) / Non Con v er t i bl e Deben t u r es ( NCDs) , by compan y
not bei ng i n def aul t .

The non- conver t ible por t ions of PCDs or t he NCDs issued by a l i st ed company,
t he value of which exceeds Rs. 50 lacs, can be r olled over wit hout change in
t he int er est r at e subj ect t o sect ion 121 of t he Companies Act , 1956 and
subj ect t o t he f ollowing condit ions, if t he company is not in def ault :

( a) A resolut i on t o t hi s ef f ect i s passed by post al bal l ot , havi ng t he assent
from not less t han 75% of t he debent ure- holders.

( b) The company shall redeem t he debent ures of all t he dissent ing debent ure
holder s, who have not assent ed t o t he r esolut ion.

( c) Before ro ll over of any NCDs or non- conver t ible por t ion of t he PCDs, at
least one r at ing shall be obt ained fr om a cr edit r at ing agency r egist er ed wit h
t he Boar d wit hin a per iod of six mont hs pr ior t o t he due dat e of r edempt ion
and communicat ed t o t he debent ur e holders before t he roll over.

( d) Fr esh t r ust deed shall be execut ed at t he t ime of such r oll over .

( e) Fr esh secur it y shall be cr eat ed in r espect of such debent ur es t o be r olled
over.

Pr ov i ded t hat if t he exist ing t r ust deed or t he secur it y document s pr ovide f or
cont inuance of t he secur it y t ill r edempt ion of debent ur es, f r esh t r ust deed or
f r esh secur it y need not be cr eat ed.

Rol l ov er of Non Con v er t i bl e por t i on s of Par t l y Con v er t i bl e Deben t u r es
( PCDs) / Non Con v er t i bl e Deben t u r es ( NCDs) , by t h e compan y bei ng
i n def aul t

The non- conver t ible por t ions of PCDs and t he NCDs issued by a list ed
company, t he value of which exceeds Rs. 50 lacs, can be rolled over wit hout
change in t he int er est r at e subj ect t o sect ion 121 of t he Companies Act , 1956
and subj ect t o t he f ollowing condit ions, wher e t he company is in default :

( a) A r esolut ion t o t his ef f ect is passed by post al ballot , having t he assent
from not less t han 75% of t he debent ure- holders.

( b) The company shal l send an Audi t or s cer t i f i cat e on t he cash f l ow of the
company wit h comment s on t he liquidit y posit ion of t he company t o all
debent ur e holder s, along wit h t he not ice for passing t he said r esolut ion.
142

( c) The company shall r edeem t he debent ur es of all t he dissent ing debent ur e
holder s, who have not assent ed t o t he resolut ion.

( d) The debent ur e t r ust ee shall decide on whet her t he company is r equir ed t o
cr eat e f r esh secur it y and execut e f r esh t r ust deed in r espect of such
debent ures t o be rolled over.

Pr ov i ded t hat if t he exist ing t r ust deed or t he secur it y document s pr ovide f or
cont inuance of t he secur it y t ill r edempt ion of debent ur es, fr esh secur it y and
f r esh t r ust deed need not be cr eat ed.

I n case of Con v er si on of I n st r u m en t s ( PCDs/ FCDs, et c. ) i n t o eq u i t y
capi t al .

a. I n case, t he conver t ible por t ion of any inst r ument such as PCDs, FCDs et c.
issued by a list ed company, value of which exceeds Rs. 50 Lacs and whose
conversion price was not fixed at t he t ime of issue, holders of such
inst r ument s shall be given a compulsor y opt ion of not conver t ing int o
equi t y capit al.
b. Conver sion shall be done only in cases wher e inst r ument holder s have
sent t hei r posi t i ve consent and not on t he basi s of t he non- r ecei pt of t hei r
negat ive r eply.

Pr ov i ded t h at where issues are made and cap price wit h j ust ificat ion
t her eon, is fixed bef or ehand in r espect of any inst r ument s by t he issuer and
disclosed t o t he invest or s befor e issue, it will not be necessar y t o give opt ion
t o t he inst r ument holder f or conver t ing t he inst r ument s int o equit y capit al
wit hin t he cap pr ice.
c. I n cases wher e an opt ion is t o be given t o such inst rument holders and if
any inst r ument holder does not exer cise t he opt ion t o conver t t he
debent ur es int o equit y at a pr ice det er mined in t he gener al meet ing of t he
shar eholder s, t he company shall r edeem t hat par t of debent ure at a price
which shall not be less t han it s f ace value, wit hin one mont h f r om t he last
dat e by which opt ion is t o be exer cised.
d. The pr ovision of sub- clause ( iii) above shall not apply if such r edempt ion
is t o be made in accor dance wit h t he t er ms of t he issue or iginally st at ed.

e. The debent ur e t r ust ee shall submit a cer t ificat e of compliance ( as per
clauses 10. 7. 1. 1, 10. 7. 1. 1A or 10. 7. 1. 2 of DI P guidelines as t he case may
be, t o t he mer chant banker which shall be f iled wit h t he Boar d wit hin 15
days of t he closur e of t he r ollover or conver sion) .

f . Companies may issue unsecur ed/ subor dinat ed debt
inst r ument s/ obligat ions ( which ar e not ' public deposit s' as per t he
provisions of Sect ion 58 A of t he Companies Act , 1956 or such ot her
143
not ificat ions, guidelines, Circ ular et c. issued by RBI , DCA or ot her
aut hor it ies) .

Pr ov i ded t h at such issue shall be subscr ibed by Qualif ied I nst it ut ional
Buyers or ot her invest or who has given posit ive consent for subscribing t o
such unsecur ed / sub- or dinat ed debt inst r ument s / obligat i on.

Ot h er r equ i r emen t s
a. ( i) No issue of debent ures by an issuer company shall be made for
acquisit ion of shar es or pr oviding loan t o any company belonging t o t he
same group.

( ii) Sub- clause ( a) shall not apply t o t he issue of fully conver t ible
debent ures pr oviding conver sion wit hin a per iod of eight een mont hs.

b. Pr emium amount and t ime of conver sion shall be det er mined by t he issuer
company and disclosed.

c. The int er est r at e f or debent ur es can be f r eely det er mined by t he issuer
company.

Addi t i on al Di sclosu r es i n r espect of deben t u r es

The offer document shall cont ain:

( a) Pr emium amount on conver sion, t ime of conver sion.
( b) I n case of PCDs/ NCDs, r edempt ion amount , per iod of mat ur it y, yield on
r edempt ion of t he PCDs/ NCDs.
( c) Full infor mat ion r elat ing t o t he t er ms of of f er or pur chase i ncl udi ng t he
name( s) of t he par t y of f er ing t o pur chase t he khokhas ( non- conver t ible
port ion of PCDs) .
( d) The discount at which such offer is made and t he effect ive price for t he
invest or as a r esult of such discount .
( e) The exist ing and fut ur e equit y and long t er m debt r at io.
( f ) Ser vicing behaviour on exist ing debent ur es, payment of due int er est on
due dat es on t er m loans and debent ur es.
( g) That t he cer t ificat e fr om a financial inst it ut ion or banker s about t heir no
obj ect ion for a second or pari passu charge being creat ed in favour of t he
t r ust ees t o t he pr oposed debent ur e issues has been obt ained.

144

12.3 SEBI ( I SSUE AND LI STI NG OF DEBT SECURI TI ES)
REGULATI ONS, 2008

I ssue Requi r ement s f or Publ i c I ssues

Gen er al Condi t i ons

1. No issuer should make any public issue of debt secur it ies if as on t he
dat e of f iling of dr af t of f er document and f inal of f er document as
pr ovided in t hese r egulat ions, t he issuer or t he per son in cont r ol of t he
issuer , or it s pr omot er , has been r est r ained or pr ohibit ed or debar r ed
by t he Boar d f r om accessing t he secur it ies mar ket or dealing in
secur it ies and such dir ect ion or or der is in for ce.

2. The following condit ions have t o be sat isfied by an issuer for making
any public issue of debt securit ies as on t he dat e of filing of draft offer
document and f inal of f er document .

i. I f t he issuer has made an applicat ion t o more t han one recognized
st ock exchange, t he issuer is r equir ed t o choose one of t hem as
t he designat ed st ock exchange. Fur t her , wher e any of such st ock
exchanges have nat ionwide t r ading t er minals, t he issuer should
choose one of t hem as desi gnat ed st ock exchange. For any
subsequent public issue, t he issuer may choose a dif f er ent st ock
exchange subj ect t o t he r equi r ement s of t his regulat ion.
ii. The issuer has t o obt ain in- pr inciple appr oval for list ing of it s debt
secur it ies on t he r ecognized st ock exchanges wher e t he applicat ion
for list ing has been made.
iii. Credit rat ing has been obt ained fr om at least one cr edit r at ing
agency regist er ed wit h SEBI and is disclosed in t he of f er document .
I f t he credit rat ings have been obt ained from more t han one credit
r at ing agency, t hen all r at ings including t he unaccept ed r at ings
have t o be disclosed in t he of f er document .
iv. I t has t o ent er int o an ar r angement wi t h a deposi t or y r egi st er ed
wit h SEBI f or demat er ializat ion of debt secur it ies t hat ar e pr oposed
t o be issued t o t he public in accordance wit h t he Deposit ories Act
1996 and regulat ions made t hereunder.

3. The issuer should appoint one or more mer chant bankers r egist er ed wit h
SEBI at least one of whom should be a lead merchant banker.

145
4. The issuer should appoint one or more debent ure t rust ees in accordance
wit h t he provisions of sect ion 117 B of t he Companies Act , 1956and SEBI
( Debent ur e Tr ust ee) Regulat ions, 1993.

5. The issuer should not issue debt secur it ies for pr oviding loan t o or
acquisit ion of shares of any person who is part of t he same group or who
is under t he same management .

Fi l i n g of Dr af t Of f er Docu men t

No issuer should make a public issue of debt securit ies unless a draft of offer
document has been f iled wit h t he designat ed st ock exchange t hr ough t he lead
mer chant banker . The dr af t of f er document f iled wit h t he st ock exchange has
t o be made public by post ing t he same on t he websit e of designat ed st ock
exchange for seeking public comment s for a per iod of seven wor king days
f r om t he dat e of f iling t he dr af t of f er document wit h such exchange. The dr af t
offer document may also be displayed on t he websit e of t he issuer, merchant
banker s. The lead mer chant banker s should ensur e t hat t he dr af t of f er
document clear ly specif ies t he names and cont act par t icular s of t he
compliance officer of t he lead mer chant banker and t he issuer including t he
post al and email addr ess, t elephone and f ax number s. The lead mer chant
banker should also ensur e t hat all comment s r eceived on t he dr af t of f er
document ar e suit ably addr essed pr ior t o t he f iling of t he of f er document wit h
t he Regi st r ar of Compani es. A copy of t he dr af t and f i nal of f er document
should be forwarded t o SEBI for it s records, simult aneously wit h filing of
t hese document s wit h t he designat ed st ock exchanges. The lead merchant
bankers should prior t o filing of t he offer document wit h t he Regist rar of
Companies, f ur nish t o SEBI a due diligence cer t ificat e as per t he for mat
provided in Schedule I I of SEBI ( I ssue and List ing of Debt Securit ies)
Regulat ions, 2008.

El ect r on i c I ssu an ce

An issuer pr oposing t o issue debt secur it ies t o t he public t hr ough t he online
syst em of t he designat ed st ock exchange should comply wit h t he r elevant
applicable r equir ement s as may be specified by SEBI .

Pr i ce Di scov er y t h r ou gh Book Bu i l di n g

The issuer may det ermine t he price of debt securit ies in consult at ion wit h t he
lead mer chant banker and t he issue may be at fixed pr ice or t he pr ice may be
det er mined t hr ough t he book building pr ocess in accor dance wit h t he
procedure as may be specified by SEBI .

Mi n i mu m Su bscr i pt i on

146
The issuer may decide t he amount of minimum subscript ion which it seeks t o
r aise by issue of debt securit ies and disclose t he same in t he offer document .
I n t he event of non- r eceipt of minimum subscr ipt ion all applicat ion moneys
r eceived in t he public issue shall be r ef unded f or t hwit h t o t he applicant s.

LI STI NG OF DEBT SECURI TI ES
An issuer desir ous of making an offer of debt securit ies t o t he public has t o
make an applicat ion for list ing t o one or more recognized st ock exchanges in
t er ms of sub- sect i on ( 1) of sect i on 73 of t he Compani es Act , 1956 ( 1 of
1956) . The issuer has t o comply wit h t he condit ions of list ing of such debt
securit ies as specified in t he List ing Agreement wit h t he St ock exchanges

Con di t i on s f or l i st i n g of debt secu r i t i es i ssu ed on pr i v at e pl acemen t
basi s:

An issuer may list it s debt secur i t i es i ssued on pr i vat e pl acement basi s on a
r ecognized st ock exchange subj ect t o t he f ollowing condit ions:

i. The issuer has issued such debt secur it ies in compliance wit h t he
pr ovisions of t he Companies Act , 1956 r ules pr escr ibed t her eunder
and ot her applicable laws.
ii. Credit rat ing has been obt ained in respect of such debt securit ies
fr om at least one cr edit r at ing agency r egist er ed wit h SEBI .
iii. The debt secur it ies pr oposed t o be list ed ar e in demat er ialised
form.
iv. The disclosur es as pr escr ibed under Regulat ion 21 of t he I ssue and
List ing of Debt Securit ies Regulat ions, 2008 have t o be made.

Fur t her , t he issuer has t o comply wit h t he condit ions of list ing of such debt
secur it ies as specif ied in t he List ing Agr eement wit h t he st ock exchange
where such debt secur it ies ar e sought t o be list ed.

Condit ions of Cont inuous List ing and Tr ading of Debt secur it ies:

Con t i n u ou s Li st i n g Con di t i on s

i. All t he issuer s making public issues of debt secur it ies or seeking
list ing of debt securit ies issued on privat e placement basis should
comply wit h t he condit ions of list ing specified in t he r espect ive
agr eement f or debt secur it ies.
ii. Ever y r at ing obt ained by an issuer should be per iodically r eviewed
by t he r egist er ed cr edit r at ing agency and any r evision in t he
r at i ng shall be pr ompt ly disclosed by t he issuer t o t he st ock
exchange wher e t he debt secur it ies ar e list ed.
147
iii. Any change in r at ing should be pr ompt ly disseminat ed t o invest or s
and pr ospect ive invest or in such manner as t he st ock exchange
wher e such secur it ies ar e list ed may det er mine fr om t ime t o t ime.
iv. The issuer , t he r espect ive debent ur e t r ust ees and st ock exchanges
should disseminat e all inf or mat ion and r epor t s on debt secur it ies
i ncl udi ng compl i ance r epor t s f i l ed by t he i ssuer s and t he debent ur e
t r ust ees r egar ding t he debt secur it ies t o t he invest or s and t he
gener al public by placing t hem on t heir websit es.
v. Debent ur e t r ust ee should disclose t he inf or mat ion t o t he invest or s
and t he gener al public by issuing a pr ess r elease in any of t he
f ollowing event s: ( a) def ault by issuer t o pay int er est on debt
secur it ies or r edempt ion amount ; ( b) f ailur e t o cr eat e a char ge on
t he asset s; r evision of r at ing assigned t o t he debt secur it ies.

Tr adi n g of debt secu r i t i es

i. The debt secur i t i es i ssued t o t he publ i c or on a pr i vat e pl acement
basis, which ar e list ed in r ecognized st ock exchanges, shall be
t r aded and such t r ades shall be clear ed and set t led in r ecognized
st ock exchanges subj ect t o condit ions specif ied by SEBI .
ii. I n case of t r ades of debt secur it ies which have been made over t he
count er , such t r ades shall be r epor t ed on a r ecognized st ock
exchange having a nat ion wide t rading t erminal or such ot her
plat form as may be specified by t he Board.

SEBI may specify condit ions for r epor t ing of t r ades on t he r ecognized st ock
exchange or ot her plat form.
12.4 MARKET PRACTI CES AND PROCEDURES
12. 4. 1 Deal i ng Pr i nci pl es & Pr ocedur es
8

Scope

Deals done in t he I ndian mar ket should be conduct ed on t he basis of t hese
pr ovisions of FI MMDA handbook.

I n r espect of deals done wit h over seas count erpar t ies, t he count er par t y
should be made awar e of t he convent ions, followed in I ndia, in advance, t o
avoid any possible confusion.

8
This sect ion has been ext ract ed from The Handbook of Market Pract ices, Fixed I ncome Money
Market and Derivat ives Associat ion of I ndia, 2003.
148
Pr el i mi n ar y Negot i at i on of t er ms

Deal er s shoul d cl ear l y st at e at t he out set , pr i or t o a t r ansact i on bei ng
execut ed, any qualif ying condit ions t o which t he deal will be subj ect t o.
Wher e a f i r m quot e has been i ndi cat ed on t he NDS, qual i f yi ng condi t i ons
cannot be specified aft er t he conclusion of t he deal.

Typical examples of qualificat ions include where a price is quot ed subj ect t o
t he necessar y cr edit appr oval, limit s available f or t he count er par t y, inabilit y t o
conclude a t r ansact ion because of f ices of t he member in ot her cent r es ar e not
open. This should be made known t o t he br oker and t he pot ent ial
count er par t y at an ear ly st age and bef or e names ar e exchanged by t he
broker.

Fi r mn ess of Qu ot at i on

Deal er s, whet her act i ng as pr i nci pal s, agent or br oker , have a dut y t o make
absolut ely clear whet her t he prices t hey are quot ing are firm or merely
indicat ive. Pr ices quot ed by br oker s should be t aken as indicat ive unless
ot her wise qualified.

I n r espect of deals on t he NDS, t he dealer would put t he quot e as a fir m
quot e or indicat ive quot e on t he NDS. I n case t he dealer is willing t o do t he
deal only wit h a cer t ain set of count er par t ies, he should put t he quot e as
f ir m only f or pr ef er r ed count er par t ies.

I n respect of ot her deals, a dealer quot ing a firm price or rat e eit her t hrough
a broker or direct ly t o a pot ent ial count erpart y is commit t ed t o deal at t hat
pr ice or r at e i n a mar ket abl e amount pr ovi ded, t he count er par t y name i s
accept able. Generally, prices are assumed t o be firm as long as t he
count er par t y or t he br oker is on line. Member s should clear ly and immediat ely
indicat e when t he pr ices ar e wit hdr awn.

I n volat ile market s, or when some news is expect ed, dealers quot ing a firm
pr ice or r at e should indicat e t he lengt h of t ime f or which t heir quot e is f ir m.
The pr ice or t he r at e is usually f or t he mar ket able amount . I f t he quot e is not
f or a mar ket able quant it y, t he dealer / br oker should qualif y t he same while
submit t ing t he quot e.
A significant par t of t he volume t r ansact ed by br oker s r elies on mandat es
given by dealer s act ing on behalf of pr incipals. The r isk t hat t he pr incipal r uns
is t hat such an offer could get hit aft er an adverse market move has t aken
pl ace.

The br oker is expect ed t o use t he mandat e in or der t o adver t ise t he
pr incipals int er est t o t he ent it ies t hat t he br oker expect s will have an int er est
149
in t he pr ice. Gener ally, t he br oker is fr ee t o show t he price t o ent it ies he
deems fit , but members have t he right t o expect t hat if a smaller set is
def ined, t he br oker will adher e t o such a smaller set .

Mandat es shall not be for a period of more t han 15 minut es unless ot herwise
specified. Br oker s ar e expect ed t o check wit h t he pr incipal f r om t ime t o t ime
t o ensur e t hat t he mandat e is st ill cur r ent .

The br oker shall r eveal t he name of t he ent it y of f er ing t he mandat e when t he
count er par t y is f ir m t o deal at t he mandat e pr ice. The br oker will t hen call t he
member who of f er ed t he mandat e and conf ir m t he deal. I n t he absence of
any significant mar ket movement , t he member who has offer ed t he mandat e
is expect ed t o adher e t o it . I n case t he pr ice is not adher ed t o, it is t he
r esponsibilit y of t he member who had of f er ed t he mandat e t o explain why t he
mandat e is no longer valid. I t is r equir ed of t he member t hat t he mandat e
pr ice be wit hdr awn bef or e t he br oker r eveals t he count er par t y name. The
only except ion t o t his is when t he count er par t y name is not accept able.
The pr incipal should call t he br oker if he wishes t o wit hdr aw t he mandat e
bef or e it s expir y. The quot e cannot be wit hdr awn af t er t he br oker has
concluded t he deal.

Del i v er y of t h e secu r i t i es/ f u n ds

The dealer s should agr ee upon t he deliver y condit ions bef or e concluding t he
deal.

Deliver y of t he secur it ies/ funds is on a Deliver y - versus- Payment ( DVP) basis
in r espect of Gover nment Secur it ies and T- Bills. I n r espect of ot her secur it ies,
which are in demat form, since t here is no DVP mechanism, t he dealers
should agr ee upon t he pr ior it y of set t lement of t he secur it ies and funds.

Banks and pr imar y dealer s ar e cur r ent ly not allowed t o invest in secur it ies,
which ar e not in demat f or m. However , wher e physical secur it ies ar e t o be
deliver ed, t he dealer s should agr ee bef or e conclusion of t he deal as t o
whet her t he set t lement will be DvP or ot herwise ( in which case t he priorit y of
set t lement needs t o be agr eed upon) .

Con cl u di n g a Deal
Dealer s should r egar d t hemselves as bound t o honour a deal once t he pr ice,
name accept abi l i t y, cr edi t appr oval and any ot her key commer ci al t er ms have
been agr eed. Or al agr eement s/ cont r act s ar e consi der ed bi ndi ng on al l t he
par t i es concer ned. I n r espect of deals done on t he NDS, t he deal would be
consider ed as final as soon as any count er par t y r esponds t o a f ir m quot e.

150
Wher e quot ed pr ices ar e qualif ied as being indicat ive or subj ect t o negot iat ion
of commer ci al t er ms, member s shoul d nor mal l y t r eat t hemsel ves as bound t o
honour t he deal at t he point when t he t er ms have been agr eed wi t hout
qualificat ion.

Or al agr eement s ar e consider ed binding; t he subsequent conf ir mat ion is
evidence of t he deal but should not over r ide t er ms agr eed or ally.

Making a t r ansact ion subj ect t o document at ion is not a good pr act ice. I n
order t o minimise t he likelihood of disput es ar ising once document at ion is
pr epar ed, dealer s should make ever y effor t t o clar ify all mat er ial point s
quickly dur ing t he or al negot iat ion of t er ms, and should include t hese in t he
confir mat ion.
Wher e br oker s ar e involved, member s have t he r i ght t o expect t hat t he
br oker will make t hem awar e immediat ely on conclusion of t he deal. As a
general rule a deal should be regarded as having been done where t he
dealer posit ively acknowledges t he br oker s conf ir mat ion. I t is expect ed t hat a
br oker shall not assume t hat a deal is done wit hout or al conf ir mat ion f r om t he
dealer .

Passi n g of n ames by br ok er s
I t is a good pr act ice f or dealer s not t o seek t he names of t he count er par t y
bef or e t r ansact ing and f or br oker s not t o divulge t he names bef or e concluding
t he deal. Dealer s and br oker s should at all t imes t r eat t he det ails of
t r ansact ions as absolut ely conf ident ial bet ween t he par t ies involved.

To save t ime and avoid confusion, dealer s should, wher ever pr act ical, give
br oker s pr ior indicat ion of count er par t ies wit h whom, f or what soever r eason,
t hey would be unwilling t o do business. I n all t heir t r ansact ions, br oker s
should aim t o achieve a mut ual and immediat e exchange of names.
I n t he repo market s, it is accept ed t hat members may vary the price ( second
leg) depending on t he count er par t y. Hence it is accept able f or t he member t o
know t he name of t he count er par t y in advance.
I n t he case of inst r ument s like Cer t if icat e of Deposit s and Commer cial Paper s,
where t he seller may not be t he same ent it y as t he issuer, t he broker shall
first disclose t he issuers name t o t he pot ent ial buyer. The name of t he buyer
shall be disclosed only af t er t he buyer has accept ed t he seller s name. The
seller has t he r ight t o r efuse t o t r ansact wit h t he buyer .
Re por t i n g of deal s on t h e NDS
The dealer s should ent er t he deals, concluded on t he NDS or t o be r epor t ed
on t he NDS, wit hin a per iod of 15 minut es of t he conclusion of t he deal.
Deals in Gover nment Secur it ies and T- Bills may be conduct ed eit her on t he
NDS or ot her wise. However , all t he deals in Gover nment Secur it ies and
Tr easur y Bills have t o be r epor t ed on t he NDS. Since t he set t lement of t he
151
deals amongst members will be t hrough CCI L, it would have t o be ent ered in
t he NDS. The dealer of t he selling count erpar t y of t he secur it ies has t o ent er
t he deal int o NDS and t he dealer of t he buying count er par t y have t o appr ove
t he deal. The back office of bot h t he count er par t ies have t o t hen appr ove t he
deal.

I t woul d be a good pr act i ce t o concl ude t he appr oval of t he deal s wi t hi n a
period of 30 minut es from t he t ime of conclusion of t he deal. I n any case t he
pr ocess should be complet ed befor e t he t ime of closur e of t he NDS.

Or al Conf i r mat i ons
No oral confirmat ion is essent ial in respect of deals, ent ered in t he NDS. I n
r espect of ot her deal s an or al conf i r mat i on of t he deal s by t he back of f i ce i s a
good pr act i ce.

Lack of r esponse should not be const r ued as confir mat ion.

Wr i t t en Con f i r mat i on s
A wr i t t en conf i r mat i on of each deal must be sent out at t he ear l i est and a
conf i r mat i on shoul d be r ecei ved f r om t he count er par t y
The conf ir mat ion pr ovides a necessar y f inal saf eguar d against dealing er r or s.
Conf ir mat ions should be despat ched and checked pr ompt ly, even when or al
deal conf ir mat ions have been under t aken.

A conf irmat ion of each deal must be sent out at t he earliest . This is
par t icular ly essent ial if dealing f or same day set t lement . All par t icipant s of t he
wholesale mar ket s should have in place t he capabilit y t o despat ch
conf i r mat i ons so t hat t hey ar e r ecei ved and can be checked wi t hi n a f ew
hour s fr om t he t ime of st r iking t he deal. Wher e t he pr oduct s involved ar e
mor e complex, and so r equir e mor e det ails t o be included on t he
confirmat ion, t his may not be possible; nevert heless it is in t he int erest of all
concer ned t hat such deals are confirmed as quickly as possible and in no
case l at er t han t he next wor ki ng day of t he dat e of t he deal . I t i s
r ecommended t hat pr incipals should inquir e about conf ir mat ions not r eceived
wit hin t he expect ed t ime.

All confir mat ions should include t he t rade dat e, value dat e, t he name of t he
count erpart y and all ot her det ails of t he deal, including, wherever
appr opr iat e, t he commission char ged by t he br oker .
All confirmat ions should st at e The set t lement of t he deals in Fixed I ncome,
Money Mar ket and Rupee Der ivat ives ar e subj ect t o FI MMDAs mar ket
convent ions ir r espect ive of t he count er par t y being a member of FI MMDA .
152
I t is an accept ed pract ice for principals t o confirm direct ly all t he det ails of
t ransact ions arranged t hrough a broke r ; who independent ly sends a
cont r act / t r ansact ion conf ir mat ion t o bot h count er par t ies.
I t is vit al t hat pr incipals upon r eceipt of confir mat ions immediat ely check t he
confirmat ions carefully so t hat discrepancies are quickly revealed and
cor r ect ed. As a general rule, confirmat ions should not be issued by or sent t o
and checked by dealer s. Conf ir mat ion is a back- office funct ion.

Set t l emen t of Di f f er en ces
I f all t he procedures out lined above are adhered t o, t he incidence and size of
differ ences should be r educed. Er r or s may occur , and t hey should be
ident ified and cor r ect ed pr ompt ly. Failur e t o obser ve t hese pr inciples could
leave t hose r esponsible bear ing t he cost of any dif f er ences, which ar ise.
Wher e dif f er ence in payment ar ises because of er r or s in t he payment of
f unds, f ir ms should not at t empt undue enr ichment by r et aining t he f unds. I n
case f unds ar e r et ai ned t hen compensat i on t er ms shoul d be negot i at ed
bet ween t he count er par t ies. The same pr inciple is applicable in case of
deliver y of secur it ies.

Rou n di n g of f
All int er est r eceivable/ payable should be r ounded of f t o t he higher r upee if
t he paise component is equal t o or higher t han 50 paise and should be
ignored if t he paise component is less t han 50 paise.

The r ounding of f of paise should also be done in respect of broken period
int er est r eceivable/ payable.

Ban k Hol i day s / Mar k et Di sr u pt i on
The list of holidays will be displayed by FI MMDA on it s websit e.
I f due t o unfor eseen event s, a par t icular dat e for which t r ansact ions have
been ent ered int o is subsequent ly declar ed as a holiday, and t hen while
set t ling such claims, t he pr inciple of no undue enr ichment should be followed.

Deal i n g St an dar ds & Con v en t i on s
Cal l mon ey / Not i ce mon ey & Ter m mon ey
Call Money is essent ially a money market inst rument wher ein funds ar e
bor r owed/ lent f or a t enur e r anging f r om over night t o 14 days and ar e at call
or not ice. The borrower or lender must convey his int ent ion t o repay / recall
wit h at least 24 hour s not ice. However , monies can also be bor r owed / lent
wit h a specified mat ur it y dat e i. e. r epaid / r ecalled on t he mat ur it y.
Money lent for a fixed t enor for more t han 14 days is called Term Money
I nt er est t o be calculat ed on a daily / 365 day year basis.
I nt erest t o be payable on mat urit y and rounded- of f t o t he near est r upee.
I n case of Mat ur it y of Ter m Money falling on a holiday t he r epayment will
be made on t he next wor king day at t he cont r act ed r at e.
153
The r eceiver of funds will collect t he cheque and give t he r eceipt . The same
pr ocedur e should be followed on t he r ever sal of t he deal.

I n case of an u n sch edu l ed h ol i day
Roll over of call deals may happen if t here is a st rike, nat ural calamit y, et c.
The st r ike could involve eit her or bot h t he count erpart ies. I n case of
disrupt ion of work, due t o which funds cannot be delivered or cannot be
r eceived, t he deals ar e necessar ily r olled over . I t is r ecommended t hat t he
r at e be fixed as t he pr evious wor king days FI MMDA NSE Over night MI BOR.

Bi l l s r edi scou n t i n g sch eme
I nt er est t o be calculat ed on a daily / 365- day year basis
I nt er est t o be calculat ed on a Fr ont - end basis and r ounded of f t o t he
nearest rupee.
Amount payabl e t o t he bor r ower shoul d be t he pr i nci pal amount l ess t he
int er est .
On mat ur it y t he bor r ower should r epay t he Pr incipal Amount .
Example:
Transact ion Amount : Rs. 10, 00, 00, 000/ - ( Rupees Ten cr or e)
No. of days : 45 days
Rat e of I nt er est : 10. 25% p. a.

Tr ansact ion Amount * No. of days* Rat e of I nt er est
I nt er est =
365 * 100

10, 00, 00, 000 * 45 * 10. 25
i.e. =
365 * 100

= Rs. 12, 63,698. 63013

= Rs. 12, 63, 699/ - ( r ounded of f )

Amount payable = Transact ion Amount I nt erest

= ( 10, 00, 00, 000 12, 63, 699)

= Rs. 9, 87, 36, 301/ -

Amount t o be r epaid = Rs. 10, 00, 00, 000/ -
on mat urit y

I n case t he mat ur it y dat e of t he t r ansact ion is a holiday, t hen t he amount
should be r epaid t he pr evious wor king day.
154

Gov er n men t Secu r i t i es

I nt er est t o be calculat ed on a 30 mont h/ 360 day year basis
30
t h
and 31
st
t o be const r ued as t he same day. If a deal is done on
t he 30
t h
or 31
s t
day of t he mont h t hen int er est should be calculat ed for
29 days for t hat mont h. ( Eur opean 30/ 360) .
I nt er est payable in a Repo t r ansact ion t o be calculat ed on a daily/ 365
day year basis.
Repo r ever sal pr ice t o be calculat ed up t o a maximum of eight decimal
places and t he r ever sal amount should be adj ust ed accor dingly.
Prices in t he secondary market t o be quot ed up t o a maximum of four
decimal places and in mult iples of Rs. 0. 0025
e. g. Rs. 100. 4350 or Rs. 101. 2125 but not Rs. 102. 3745 or Rs.
103. 5018
Deal confirmat ion must exchange bet ween t he buyer and t he seller.
Usually, t he seller will deliver t he SGL t o t he buyer . Deliver y dat e and
t he t ime of t he deal should be ment ioned on t he deal slip.

The NSE r equir es t hat deals done t hr ough a NSE br oker be r epor t ed by him t o
t he exchange wit hin 20 minut es of t he deal t aking place. The list of
aut hor ised signat or ies of t he member should be made available in case t he
count erpar t y r equest s

I n case of disr upt ion of wor k, due t o which t he SGL cannot be deliver ed or
r eceived, t he SGL should be deliver ed t he next day. As t he bank buying t he
secur it y get s t he benef it of f unds f or t he holiday, t he buyer bank should pay
at FI MMDA NSE Overnight MI BOR f or t he f unds.

Zer o Cou pon Bon ds
Pr ices ar e t o be quot ed up t o a maximum of four decimal places.
I n t he secondar y mar ket , quot es should be in t er ms of pr ice and not yield.
Deal conf ir mat ion must be exchanged bet ween t he buyer and t he seller .
Seller will deliver t he SGL t o t he buyer . Deliver y dat e and t he t ime of t he
deal should be ment ioned on t he deal slip. The NSE requires t hat deals done
t hrough a NSE broker be report ed by him t o t he exchange wit hin 20 minut es
of t he deal t aking place.

I n case of a n u n sch edu l ed h ol i day
I n case of disr upt ion of wor k, it may not be possible f or t he Buying bank t o
lodge t he SGL or f or t he selling bank t o deliver t he SGL t o t he buying bank.
Since t he Rupee value of t he SGL ( Pr ice + no. of days f or which coupon has
t o be paid t o t he selling bank, or in t he case of a T- bill or Zero, t he price as
calculat ed f r om t he yield) is calculat ed f or t he day of t he holiday, t he buying
Bank would have t he advant age of f unds f or one day ( or if t he next wor king
day is more t han one day away, for t he cor r esponding number of days) .
155
Hence it is necessar y t hat t he selling Bank be compensat ed for t he day( s) for
which t he SGL has not been lodged. The fair r at e for compensat ion, j ust as in
money deal s, woul d t he FI MMDA NSE Over ni ght MI BOR f or t he pr evi ous
wor king day. The Base r upee amount is t he SGL amount .

Ex ampl e
Purchase of Rs. 5 crore of 11. 40, 29 Sept . 2000 on @ Rs. 100. 85 for delivery
on Sept . 8
t h.
159 Days have elapsed since t he pr evious coupon. The t ot al
considerat ion t o be deliv ered by t he Buyer t o t he seller is: Rs. 5, 04, 25, 000 +
Rs. 25, 17, 500 = Rs. 5, 29, 42, 500.
I f due t o disrupt ion, t he SGL cannot be lodged by t he buyer, t he buyer will
lodge t he SGL on t he 9
th
of Sept ember. The Buyer will compensat e t he seller
at t he O/ N NSE MI BOR for t he day, say 10. 15%. Hence a t ot al compensat ion
paid by t he buyer t o t he seller would be Rs. 14, 867. 41

Cer t i f i cat e of Deposi t s / Commer ci al Paper / Tr easu r y Bi l l s
I nt er est t o be calculat ed on act ual number of days / 365 day year basis.
I nt er est t o be calculat ed on a rear ended basis
Pr ice t o be calculat ed up t o a maximum of f our decimal places.

I n case yield is given t hen:
100
Pr ice =
1 + ( Yield ( %) * ( No. of days t o mat urit y) ) / 365

I n case price is given t hen:

( 100 - Pr ice) * 365
Yield =
Pr ice * No. of Days t o mat ur it y

I n t he secondar y mar ket , quot es should be in t er ms of yield t o mat ur it y and
not pr ice. The Pr ice should be quot ed up t o 4 decimal places.

Ex ampl e:

I n case a bank wishes t o sell a CP/ CD/ T- Bills say mat uring on April 29, 1999
at a YTM of 9. 5% and let us assume t hat t he pr ice at t hat YTM wor ks out t o
be Rs. 98. 75. Then t he bank should quot e t hat it want s t o sell t he inst r ument
mat uring on April 29, 1999 at a YTM of 9. 5 % p. a. and not t hat it want s t o
sell it at Rs. 98.75.

Del i ver y
Delivery would generally be on a DvP basis wit h t he seller sending t he
document s t o t he buyer . However , t he pr act ice of deliver y upon clear ance of
buyer s check is also pr evalent , and is consider ed accept able.
156
I n t he case of Primary issuance, t he st amped cert ificat e should be delivered
wit hin 10 days of receipt of monies by t he issuer.

Cor por at e Bon ds / Deben t u r es
I nt er est t o be calculat ed on act ual number of days and 365 day year basis
Pr ices t o be quot ed upt o a maximum of f our decimal places.
Deal conf ir mat ion must be exchanged bet ween t he buyer and t he seller .
Seller will deliver t he bonds/ debent ur es t o t he buyer . Deliver y dat e and t he
t ime of t he deal should be ment ioned on t he deal slip.
The NSE requires t hat NSE brokers report deals done by t hem wit hin 20
minut es of t he deal t aking place. When t he deal is done af t er NSE hour s, it
needs t o be r epor t ed on t he next wor king day.

Model Quest i ons

1. Th e day cou n t con v en t i on f or cor por at e bon ds i s

a. 30/ 360 US NASD b. Act ual / 365

c. Act ual / 360 d. 30/ 360 Eur opean

An sw er : b

2. A 3 6 4 - d ay CP, mat u r i n g on 2 8
t h
Ju n e 2 0 0 2 , i s t r ad i n g on 1 7
t h
Ju l y
2 0 0 1 , at a pr i ce of Rs. 9 3 . 3 3 7 5 . Wh at i s t h e Yi el d i n h er en t i n t h i s
pr i ce?

An sw er :
Yield =
346 * 93.3375
365 * 93.3375) (100

= 7. 5300% ( Number of days bet ween 17/ 07/ 2001 and 28/ 06/ 2002 is
346 days)

3. A 9 0 day CP i s i ssu ed on Ju l y 2 , 2 0 0 1 , w h en t h e pr i ce of a t - bi l l of
same t en or i s Rs. 9 7 . 5 6 7 5 . I f t h e CP w as i ssu ed at a pr i ce of Rs.
9 7 . 4 5 0 2 8 , w h at i s t h e spr ead at w h i ch i t h as been i ssu ed?
An sw er :
The implicit yield for t r easur y bills and CPs can be found using t he for mula
Yield = ( ( 100- pr ice) * 365) / ( Pr ice * no of days t o mat ur it y)
The yield implicit in t he pr ice of t he T- bill is = ( ( 100-
97. 5675) * 365) ) / ( 97. 5675* 90)
157
= 10. 1111%
The yield implicit in t he pr ice of t he CP is = ( ( 100-
97. 45028) * 365) ) / ( 97. 45028* 90)
= 10. 6111%
The spread at which t he CP has been issued is = 10. 6111 10. 1111
= 50 basis point s.

4. Com p u t e t h e Ru p ee v al u e of an SGL t r an sact i on , w i t h t h e f ol l ow i n g
dat a:
Coupon Rat e: 11. 68%
Mat u r i t y dat e: Au gu st 6 , 2 0 0 2
Set t l emen t Dat e: Ju l y 1 1 , 2 0 0 1
Pr i ce: Rs. 1 0 5 . 4 0 2 5
Tr an sact i on amou n t : Rs. 5 0 0 0 0 0 0 0

An sw er :
Value of t he t r ansact ion = number of secur it ies * t r ade pr ice
= ( 50000000/ 100) * 105. 4025
= Rs. 5, 27, 01, 250
Accr ued I nt er est f or t he per iod since t he last coupon is
= days since t he last coupon/ 360 * coupon r at e *
face value
= ( 155/ 360) * 0. 1168 * 50000000
= Rs. 25,14,444

Set t lement amount = Value of t r ansact ion + Accr ued I nt er est
= Rs. 5, 27, 01, 250 + 25, 14, 444
= Rs. 5, 52, 15, 694
( Number of days since t he last coupon dat e can be comput ed using t he
coupdaybs funct ion in Excel. Specify Set t lement dat e; mat ur it y dat e;
frequency = 2; and basis = 4)

5. Th e det ai l s of a t r an sact i on i n G- Secs i s as u n der :
Coupon Rat e: 10. 50%
Mat u r i t y Dat e: May 2 1 , 2 0 0 5
Set t l emen t Dat e: Ju l y 2 9 , 2 0 0 1
Pr i ce: Rs. 1 1 1 . 9 1 2 5
Tr an sact i on Amou n t : Rs. 6 3 5 0 0 0 0 0
Th e bu y er i s u n abl e t o l odge t h e SGL on t h e set t l emen t dat e. Th e
t r an sact i on i s set t l ed 1 day l at er . I f t h e NSE ov er n i gh t MI BOR on t h e
pr ev i ou s day w as 8 . 2 5 % , w h at i s t h e amou n t f or w h i ch t h i s SGL w i l l
set t l e?

158
An sw er :
Value of t he t ransact ion is = number of securit ies * t rade price
= ( 63500000/ 100) * 111. 9125
= Rs. 7, 10, 64, 438
Accr ued I nt er est for t he per iod since t he last coupon
= days since t he last coupon/ 360* coupon rat e * face value
= ( 68/ 360) * 0. 1050 * 63500000
= Rs. 12, 59, 417
Set t lement amount = Rs. 7, 10, 64, 438 + 12, 59, 417
= Rs. 7, 23, 23, 855
( Number of days since t he last coupon dat e can be comput ed using t he
coupbs f unct ion in Excel. Specif y Set t lement dat e; mat ur it y dat e; f r equency =
2; and basis = 4)
The amount of int er est t o be paid for 1 day delay in set t lement will be t he
over night MI BOR applied t o t he set t lement amount , on act ual/ 365 day basis.
I nt er est t o be paid = 7, 23, 23, 855 * 0. 0825* 1/ 365
= Rs. 16, 347.17
Ther efor e set t lement amount wit h int er est will be = Rs. 7, 23, 40, 201
159

CHAPTER 13
VALUATI ON OF BONDS
13.1 BOND VALUATI ON: FI RST PRI NCI PLES

The value of a financial inst rument is well under st ood as t he pr esent value of
t he expect ed f ut ur e cash f lows f r om t he inst r ument . I n case of a plain vanilla
bond, which we will f ir st see, bef or e under st anding t he var iat ions, t he cash
flows are pre- def i ned. The cash f l ows expect ed f r om a bond, whi ch is not
expect ed t o def aul t ar e pr i mar i l y made up of ( i ) coupon payment s and ( i i )
r edempt ion of pr incipal.
The act ual dat es on which t hese cash flows ar e expect ed ar e also known in
advance, in t he case of a simple non- callable bond. Ther efor e, valuat ion of a
bond involves discount ing t hese cash f lows t o t he pr esent point in t ime, by an
appr opr iat e discount r at e. The key issue in bond valuat ion is t his r at e. We
shall begin wit h a simple assumpt ion t hat t he r at e we would use is t he
r equir ed r at e on t he bond, r epr esent ing a r at e t hat we under st and is
available on a compar able bond ( compar able in t er ms of t enor and r isk) .
For exampl e, consi der a Cent r al Gover nment bond wi t h 11. 75% coupon,
mat ur ing on Apr il 16, 2006 ( Table 13. 1) . The cash f lows f r om t his bond ar e
t he semi - annual coupon and t he r edempt ion pr oceeds r eceivable on mat ur it y.
I n or der t o val ue t he bond, we need t he t enor f or whi ch we have t o val ue t he
bond and t he r equir ed r at e f or t his t enor . Let us assume f or simplicit y, t hat
we are valuing t he bond on it s issue dat e and t he r equir ed r at e or t he 8-
year r at e in t he mar ket is 12%. Since gover nment bonds pay coupons semi-
annually, t his bond would pay ( 11. 75/ 2) = Rs. 5. 875, every six mont hs as
coupon. I n or der t o val ue t hi s bond, we need t o list t hese cash f lows and
discount t hem at t he required rat e of 6% ( semiannual rat e for t he
compar able 12% r at e)
9
.
Ther efor e, t he value of t he bond can be st at ed in gener al t er ms as:

n
n
r
c
r
c
r
c
r
c
P
) 1 (
........ ..........
) 1 ( ) 1 ( ) 1 (
3
3
2
2 1
0
+
+
+
+
+
+
+
( 13. 1)

where P
0
is t he value of t he bond
c
1
, c
2
c
n
ar e cash f lows expect ed f r om t he bond, over n periods

9
I n t he bond market s, t he annual rat es are simply divided by t wo t o arrive at t he semi-annual
rat es. Effect ive semiannual rat es can vary, if we considered t he impact of reinvest ing t he six
mont hly coupon unt il t he end of t he year.
160
r is t he r equir ed r at e at which we shall discount t he cash f lows.

I t is import ant t o see t hat t he value of t he bond depends crucially on t he
r equir ed r at e. Higher t he r at e at which we di scount t he cash f l ows, l ower t he
value of t he bond. I n ot her words, t he required rat e and t he value are
inver sely r elat ed. This is an impor t ant pr inciple in bond analyt ics and we shall
r et ur n t o t his pr inciple in some det ail lat er in t he wor kbook. Si nce t he
r equir ed r at e is t he r at e at which we ar e discount ing t he cash f lows, given t he
same level of cash flows ( same coupons) , higher t he rat e at which cash flows
ar e discount ed, lower t he pr esent value of t he bond. I t is also impor t ant t hat
we use an appr opr iat e r at e in t he discount ing pr ocess. We shall examine t his
issue also in some det ail in lat er part s of t he workbook.

Tabl e 1 3 . 1 : Val u e of a 1 1 . 7 5 % bon d w i t h 8 y ear s t o r edempt i on at par
Semi- an n u al
per i od
Cash f l ow
( Rs. )
Pr esen t v al u e af t er
di scou n t i n g @ 6 %
( Rs. )
1 5. 875 5. 542
2 5. 875 5. 229
3 5. 875 4. 933
4 5. 875 4. 654
5 5. 875 4. 390
6 5. 875 4. 142
7 5. 875 3. 907
8 5. 875 3. 686
9 5. 875 3. 477
10 5. 875 3. 281
11 5. 875 3. 095
12 5. 875 2. 920
13 5. 875 2. 754
14 5. 875 2. 599
15 5. 875 2. 451
16 105. 875 41. 677
Val u e of t h e bon d 98. 737

13.2 TI ME PATH OF A BOND

Consider a 12. 5% Cent ral Government bond mat uring on March 23, 2004,
selling at a r equir ed yield of 9. 7% on Febr uar y 5, 2001 f or Rs. 106. 89. I f t he
r equir ed yield does not change, t her e would st ill be a change in it s value and
as t his bond moves t owar ds mat ur it y, t he value will conver ge t o t he
redempt ion value of Rs. 100.
161
Let us put fort h t he generalisat ions t hat we know from t he bond value
equat ion, all of which ar ise fr om t he inver se relat ionship bet ween r equir ed
yield and t he value of t he bond:

a) I f t he r equir ed yield on a bond is equal t o it s coupon, t he bond will sell
at par .
b) The pr ice of a bond will be higher t han t he r edempt ion value, if t he
r equir ed yield is lower t han t he coupon r at e. This is because coupons
earned at a higher rat e are being discount ed at a lower rat e. We may
also underst and t he premium in t he price of t he bond, as arising from
higher demand f or a bond wit h coupons t hat ar e higher t han t he
pr evalent mar ket r at es. Such a bond which sells at a price higher t han
t he redempt ion value is called a premium bond.
c) The price of a bond will be lower t han t he redempt ion value, if t he
r equir ed yield is higher t han t he coupon r at e. This is because coupons
earned at a lower rat e ar e being discount ed at a higher r at e. These
bonds sell at a discount because buyers have t he opt ion of seeking
higher rat e bonds when required rat es go up, rat her t han buy int o a
lower coupon bond. Such a bond is called a discount bond.
We i l l ust r at e t he t ime pat h of t his bond at t his r equir ed r at e and f ew ot her s
assumed required rat es in Table 13. 2. We have illust rat ed in Table 13. 2, t hat
t he value of a bond whet her pr emium or discount , would t end t o r edempt ion
value as it near s mat ur it y. The dat es have been chosen r andomly and t he
r equir ed yields have been chosen t o illust r at e t he t ime pat h of bot h discount
and pr emium bonds.
Ther efor e, value of a bond will change over t ime, even if r equir ed r at es do not
change. This is an impor t ant pr oper t y of bond values.

Tabl e 1 3 . 2 : Ti me pat h of 7 . 4 0 % 2 0 1 2 Bon d
Req u i r ed r at e ( % ) Dat e
5 5 . 5 6 7
29- Jan- 04 116. 0689 112. 4667 109. 0019 102. 4616
14- Sep- 04 115. 0706 111. 7081 108. 4657 102. 3226
21- Nov- 04 114. 7716 111. 4819 108. 3073 102. 286
6- Jun- 05 113. 8681 110. 7912 107. 8153 102. 1523
21- Nov- 05 113. 0896 110. 1962 107. 3925 102. 0423
6- Jun- 06 112. 1406 109. 4671 106. 8707 101. 8992
29- Jan- 07 110. 9715 108. 566 106. 2235 101. 7196
21- Nov- 07 109. 4659 107. 4058 105. 3924 101. 5014
29- Jan- 08 109. 0975 107. 1182 105. 1823 101. 4362
21- Nov- 08 107. 5153 105. 8928 104. 3001 101. 2017
21- Nov- 09 105. 466 104. 2955 103. 1413 100. 8807
14- Sep- 10 103. 7168 102. 9245 102. 1403 100. 5957
21- Nov- 10 103. 3129 102. 6091 101. 9119 100. 5369
03- May - 12 100 100 100 100

162
13.3 VALUI NG A BOND AT ANY POI NT ON THE TI ME
SCALE

I n t he simple example wher e we applied t he pr inciples of discount ing, we
discount ed t he cash f lows of t he bond, on t he dat e of issue of t he bond. I f we
valued t he bond, say on t he f ir st coupon dat e, we would consider all t he cash
f l ows f r om t hat t i me point unt il mat ur it y of t he bond. Such valuat ion is a
simple exer cise because; we need t o discount cash f lows f or a t ime per iod
t hat culminat es int o a cash f low dat e. The valuat ion exer cise can consider
r ounded semi annual per iods ( t he n in t he equat ion) .
I n r ealit y, we need t o be able t o value a bond on any dat e fr om t he dat e of it s
issue ( t his dat e is called t he valuat ion dat e, or set t lement dat e for t he bond) .
We should be able t o discount t he expect ed cash f lows t o t he valuat ion dat e,
exact ly measuring t he fract ional period of t ime on t he t ime scale. Therefore
t he n i n t he bond equat i on shoul d be equal t o t he act ual di st ance, whi ch i s
seldom a r ound number . Comput ing t his dist ance for t he pur pose of valuing
a bond depends on t he day count convent ion in t he bond market s.
I n order t o value a bond accurat ely we need t o know t he act ual dat es on
which coupons will be paid, t he number of days bet ween t wo coupon per iods
and t he dist ance of t he act ual valuat ion dat e f r om t he pr evious and t he next
coupon. All of t his depends on t he mar ket convent ion used, for count ing t he
days on t he t ime line, which is also called t he day count convent ion. Ther e
ar e 5 popular day count convent ions:
a. 30/ 360: This convent ion consider s each mont h, including Febr uar y,
as having 30 days and t he year as consist ing of 360 days. Ther e
ar e 2 var iat ions t o t his convent ion: US NASD convent ion and t he
Eur opean 30/ 360 convent ion. The 30/ 360 convent ion is used in
t he t r easur y bond mar ket s in many count r ies. I ndian t r easur y
market s use t he Eur opean 30/ 360 day count convent ion.
b. Act ual / 360: This convent ion count s t he act ual number of days in a
mont h, but uses 360 as t he number of days in t he year.
c. Act ual/ act ual: This convent ion uses t he act ual number of days in
t he mont h and t he act ual number of days in t he year, 366, for a
leap year.
d. Act ual/ 365: This convent ion uses t he act ual number of days in a
mont h and365 days as t he days in t he year .

For example consider t he per iod Januar y 2, 2001 t o June 30, 2001. The
number of days in t his per iod and t he per iod in t er ms of year s can var y
depending on t he day count convent ion, as can be seen in Table 13. 3.

163
Tabl e 1 3 . 3 : Day s i n t h e per i od Jan 2 Ju n e 3 0 , 2 0 0 1
Day cou n t
con v en t i on
Nu mber of
day s
i n t h e per i od
Nu mber of day s
i n t h e y ear
Nu mber of
day s as a y ear
f r act i on
30/ 360 178 360 0. 494444
Act ual / act ual 179 365 0. 490411
Act ual / 360 179 360 0. 497222
Act ual / 365 179 365 0. 490411

I f we have t o value a bond on any dat e ot her t han t he coupon dat e, we have
t o use t he appropriat e day count convent i on t o measur e t he n in t he bond
valuat ion equat ion. I n t he gener al f or m, we did not car e about t he act ual
dat e of mat urit y of t he bond, since we measured t ime periods as rounded
half - year s. For r eal- lif e bond valuat ion, we have t o know t he set t lement
dat e, as well as t he act ual dat e of mat ur it y, so t hat , using t he appr opr iat e
day count convent i on, we can di scount t he cash f l ows f or t he act ual t i me
dist ance t hat is involved.

Box 1 3 . 1 : Cou pon s an d Cou pon day s
I n or der t o f i nd t he expect ed f ut ur e cash f l ows f r om a bond, t he dat es on
which t hese cash f lows ar e expect ed and t he dist ances f r om t he set t lement
dat es, we can use t he coupon f unct ions in Excel. The f ollowing ar e t he
coupon funct ions t hat ar e commonly used:

a) Coupnum : number of coupons payable bet ween t he set t lement dat e
and t he mat ur it y dat e.
b) Cou pday s: number of days i n t he coupon per i od, cont ai ni ng t he
set t l ement dat e
c) Cou pday bs: number of days f r om beginning of t he coupon per iod t o t he
set t l ement dat e
d) Cou pday sn c: number of days from t he set t lement dat e t o t he next
coupon dat e

I n all t hese cases, we need t o specif y t he set t lement dat e, mat ur it y dat e,
f r equency of coupon payment s per annum and t he day count convent ion ( also
called basis) . We can use t he yearfrac f unct i on t o conver t t he number of
days int o fr act ional year s. ( See Box 1. 1)

Table 13. 4 provides t he dat a using t he coupon funct ions of Excel, for an
illust r at ive sample of 4 t r easur y bonds, using t he 30/ 360 day count
convent ion.

164
Tabl e 1 3 . 4 : Cou pon day s f or set t lemen t dat e Febr u ar y 5 , 2 0 0 1

Name of t he
Secur i t y
Mat ur i t y
Dat e
Number
of
coupons
unt i l
mat ur i t y
Number of
days i n t he
coupon
per i od
Number of
days f r om
pr evi ous
coupon
t o set t l ement
Number of
days f r om
set t l ement t o
nex t coupon
CG 12. 5% 2004 23-Mar-04 7 180 132 48
CG 11. 68% 2006 10-Apr-06 11 180 115 65
CG 11. 5% 2008 23-May-08 15 180 72 108
CG 11. 3 % 2010 28-Jul-10 19 180 7 173

I n or der t o value a bond, on a set t lement dat e t hat is not a coupon dat e, we
have t o re- cast t he bond valuat ion equat ion 13. 1, as follows:

)] / ( ) 1 [( )] / ( 1 [
2
) / (
1
0
) 1 (
.........
) 1 ( ) 1 (
dicp dnc n
n
dicp dnc dicp dnc
r
c
r
c
r
c
P
+ +
+ +
+
+
( 13. 2)

Where c
1
, c
2
. . c
n
ar e expect ed cash f lows f r om t he bond. Given t he
r edempt i on val ue, coupon r at e and f r equency of coupons, we can comput e
t hese cash f l ows.
dnc is t he number of days t o t he next coupon
di cp is t he days in t he coupon per iod

Since t he f ir st cash f low c
1
, is only dnc/ di cp per i ods away f r om t he set t l ement
dat e, we discount it only f or t hat per iod. For t he subsequent cashf lows, we
can generalise t he period for which discount ing is t o be done, as [ ( n- 1) +
dnc/ di cp] . We can use t he price funct ion in Excel, in order t o use equat ion
13. 2 in act ual valuat ion of a bond. Alt er nat ively, we can use t he coupon
f unct ions t o f ind out t he values in equat ion 13. 2 and value t he bond using t he
PV f unct ion.

The value of t he same bond, by mer ely var ying t he day count convent ion
( change t he basis in Excel t o 1, 2 and 3) can vary t o Rs. 99. 0136, Rs.
99. 0143 ands. 99. 0134 r espect ively.
Using Excel, r eader s can check t he impact of changes in t he day count
convent ion and t he f r equency of coupon payment s on t he value of t he bond.
Ar e t her e any gener alisat ions her e?

165
Box 1 3 . 2 : Pr i ce f u n ct i on
The pr i ce f unct i on i n Excel wi l l comput e t he pr i ce of a bond, gi ven t he
following:
Set t lement : t he dat e on which t he bond is sought t o be valued
Mat ur it y: t he dat e on which t he bond mat ur es
Rat e: t he r at e at which coupon is paid
Yld: t he required rat e for valuat ion
Redempt ion: t he r edempt ion value of t he bond
Fr equency: number of coupons per year
Basi s: day count convent ion t o be used.
On pr oviding t hese input s, Excel comput es t he cash f lows f r om t he coupon
r at e and r edempt ion values, t he t ime as t he dist ance bet ween set t lement
dat e and each of t he cash f lows, given t he day count convent ion specif ied in
t he basis and discount s t he cash flows t o t he set t lement dat e, using t he
specified required rat e. Bot h set t lement and mat urit y will have t o be
f or mat t ed as dat e f ields. Yield and coupon have t o be pr ovided as r at es. The
numbers 0 4 are used for t he various day count convent ions. Use t he
f unct ion as = pr ice( set t lement , mat ur it y, r at e, yld, r edempt ion, f r equency,
basis)
For example, in order t o value t he 11. 75% 2006 bond, mat uring on April 16,
2006, on Febr uar y 5, 2001, using t he day count convent ion of 30/ 360 and t he
r equir ed yield of 12%, we shall st at e
= pr ice ( 16/ 04/ 2006, 02/ 02/ 2001, 0. 1175, 0. 12, 100, 2, 4)
= Rs. 99.0125

13.4 ACCRUED I NTEREST

The discount ing of expect ed f ut ur e cash f lows t o t he pr esent pr ovides a
valuat ion f or t he bond, which denot es t he pr ice at whic h a bond can be
bought or sold, pr ovided buyer and seller agr ee on t he pr ice based on such
value ( whet her t hey will do so depends on t heir view of t he required rat e
among ot her t hings) . We will pr oceed on t he assumpt ion t hat t he r equir ed
yi el d r epr esent s t he market and t hat t here would be buyers and sellers at
t his fair value. I f a t r ansact ion t akes place at t he value det er mined by t he
bond equat ion, t he buyer pays f or all t he f ut ur e cash f lows occur r ing af t er t he
dat e of set t lement , discount ed unt il t he set t lement dat e, in r et ur n f or
r eceiving all t hose cash f lows.
However, if t he set t lement occurs at a dat e, which is not a coupon dat e, as
can most ly be t he case, t he t r ansact ion t akes place on a dat e t hat f alls
bet ween t wo coupon dat es. This would mean t hat t he seller has held t he
bond f or a per iod beginning f r om t he pr evious coupon, t o t he set t lement dat e
and is eligible t o receive a part of t he next coupon, in proport ion t o his
holding per iod. The seller on t he ot her hand, holds t he bond only for t he
per i od begi nni ng t he set t l ement dat e, but r ecei ves t he next coupon ent i r el y,
having bought t he bond.
166
Ther efor e in t he bond mar ket s, int er est on a bond is not account ed on t he
coupon dat e, but is accrued on an everyday basis. On every t ransact ion in
t he mar ket s, t he buyer has t o pay t he seller , a par t of t he coupon he would
r ecei ve l at er , t o compensat e t he sel l er f or hol di ng t he bond f or t he f r act i on of
t he coupon per iod. This cash f low t hat is paid t o t he seller is called accr ued
i nt er est ands comput ed as follows:

1
]
1
dicp
dflc
c AI
. ( 13. 3)

Where dflc r epr esent s days fr om t he last coupon and di cp r epr esent s t he days
in t he coupon per iod and is t he coupon payment . We know t hat bot h t hese
values depend on t he day count convent ion and can be f ound wit h t he help of
t he coupon f unct ions in Excel.
Let us consi der t he bonds i n Tabl e 13. 5. We can comput e t he accr ued
int er est for t hese bonds using t he dat a for coupons ( pr ovided in column 1) ,
gi ven t he set t l ement dat e of Febr uar y 5, 2001. The accr ued i nt er est i s t he
amount of coupons t hat ar e due t o t he seller , having held t he bond fr om t he
pr evious coupon dat e unt il t he set t lement dat e.
I f t he pr ice of t he bond includes accr ued int er est , it is called as t he di r t y pr i ce
or f ul l pr i ce of t he bond. Pr ice t hat excludes accr ued int er est is called cl ean
pr i ce. I n most mar ket s t he convent ion is t o quot e t he clean pr ice, t hough t he
buyer s al ways pay t he sel l er t he cl ean pr i ce and t he accr ued i nt er est t hat is
t he dir t y pr ice. I t is impor t ant t o r emember t hat t he pr ice f unct ion in Excel
pr ovides t he clean pr ice of t he bond.

Tabl e 1 3 . 5 : Accr u ed I n t er est on Set t l emen t Dat e Febr u ar y 5 , 2 0 0 1
Secur i t y Semi-
annual
Cou pon
( Rs. )
Mat ur i t y Day s si n ce
l ast
cou pon / Day s
i n t h e
cou pon
per i od
Accr u ed
I n t er est
( Rs. )
CG 12. 5 %2004 6.25 23- Mar- 04 0. 7333 4. 5833
CG 11. 68% 2006 5.84 10- Apr- 06 0. 6389 3. 7311
CG 11. 5% 2008 5.75 23- May- 08 0. 4000 2. 3000
CG 11. 3% 2010 5.65 28- Jul- 10 0. 0389 0. 2197
CG 11. 03 % 2012 5. 515 18- Jul- 12 0. 0944 0. 5209
13.5 YI ELD

The r et ur ns t o an invest or in bond ar e made up of t hr ee component s: coupon,
int erest from reinvest ment of coupons and capit al gains/ loss f r om selling or
r edeeming t he bond. When we ar e able t o compar e t he cash inf lows f r om
167
t hese sour ces wit h t he invest ment ( cash out flows) of t he invest or , we can
comput e yield t o t he invest or . Depending on t he manner in which we t r eat
t he t ime value of cash flows and reinvest ment of coupons, we ar e able t o get
var ious int er pr et at ions of t he yield on an invest ment in bonds.
13. 5. 1 Cur r ent Yi el d

One of t he earlier measures on yield on a bond, current yield was a very
popular measur e of bond r et ur ns in t he I ndian mar ket s, unt il t he ear ly 1990s.
Current yield is measured as:
Current Yield = Annual coupon r eceipt s/ Mar ket pr ice of t he bond
This measur e of yield does not consider t he t ime value of money, or t he
complet e ser ies of expect ed f ut ur e cash f lows. I t inst ead compar es t he
coupon, as pre- specif ied, wit h t he mar ket pr ice at a point in t ime, t o ar r ive at
a measure of yield. Since it compares a pre- specif ied coupon wit h t he cur r ent
mar ket pr ice, it is called as cur r ent yield.
For example, if a 12. 5% bond sells in t he mar ket for Rs. 104. 50, cur r ent yield
will be comput ed as
= ( 12.5/ 104. 5) * 100
= 11. 96%
Cur r ent yield is no longer used as a st andar d yield measur e, because it f ails
t o capt ur e t he fut ur e cash flows, r e- invest ment income and capit al
gains/ losses on invest ment r et ur n. Cur r ent yield is consider ed a ver y
simplist ic and er r oneous measure of yield.

13. 5. 2 Yi el d t o Mat ur i t y ( YTM)

I n t he pr evi ous sect i on on bond val uat i on, we used equat i on 13. 1 t o show
t hat t he value of a bond is t he discount ed pr esent value of t he expect ed
f ut ur e cash f lows of t he bond. We solved t he equat ion t o det er mi ne a val ue,
given an assumed required rat e. I f we inst ead solve t he equat ion for t he
required rat e, given t he price of t he bond, we would get a yield measure,
which is knows as t he YTM or yield t o mat urit y of a bond. That is, given a
pre- specif i ed set of cash f l ows and a pr i ce, t he YTM of a bond i s t hat r at e
which equat es t he discount ed value of t he f ut ur e cash f lows t o t he pr esent
pr ice of t he bond. I t is t he int er nal r at e of r et ur n of t he valuat ion equat ion.
For example, if we find t hat an 11. 99% 2009 bond is being issued at a pr ice
of Rs. 108, ( for t he sake of simplicit y we will begin wit h t he valuat ion on a
cash f l ow dat e) , we can st at e t hat ,

18 2
) 1 (
995 . 105
.. ..........
) 1 (
995 . 5
) 1 (
995 . 5
108
r r r +
+
+
+
+

168

This equat ion only st at es t he well known bond valuat ion pr inciple t hat t he
value of a bond will have t o be equal t o t he discount ed value of t he expect ed
fut ur e cash flows, which ar e t he 18 semiannual coupons of Rs. 5. 995 each
and t he r edempt ion of t he pr incipal of Rs. 100, at t he end of t he 9
th
year .

That value of r whic h solves t his equat ion is t he YTM of t he bond. We can
f ind t he value of r in t he above equat ion using t he I RR funct ion in Excel
1 0
.
The value of r t hat solves t he above equat ion can be found t o be 5. 29%,
which is t he semi - annual r at e. The YTM of t he bond is 10.58%.

However, as we have already not ed in t he sect ion on valuat ion, we should be
able t o comput e price and yield for a bond, at any given point of t ime. We
t her efor e have t o be able t o comput e t he yield by plot t ing t he cash flows
accur at ely on t he t ime line ( using t he appr opr iat e day count convent ion) and
calculat e YTM, given t he pr ice at any point on t he t ime line. We have t o
adopt a pr ocedur e ver y similar t o t he one we used for bond valuat ion
1 1
and
we can use t he yield f unct ion in Excel t o comput e t he YTM f or a bond.

Yield t o mat ur it y r epr esent s t he yield on t he bond, pr ovided t he bond is held
t o mat urit y and t he int ermit t ent coupons are reinvest ed at t he same YTM
r at e. I n ot her wor ds, when we comput e YTM as t he r at e t hat di scount s all t he
cash flows fr om t he bond, at t he same YTM r at e, what we ar e assuming in
ef f ect is t hat each of t hese cash f lows can be r e- invest ed at t he YTM r at e f or
t he per iod unt il mat ur it y.

Let us illust r at e t his limit at ion of YTM wit h an example.
Suppose an invest or buys t he 11. 75% 2006 bond at Rs. 106. 84. The YTM of
t he bond on t his dat e is 10. 013%. Consider t he infor mat ion about t he cash
f lows of t he 11. 75% 2006 bond in Table 13. 6. I t is seen t hat cash f lows f r om
coupon and r edempt ion ar e Rs. 164. 625, if t he bond is held t o mat ur it y.
However , t he act ual yield on t he bond depends on t he r at es at which t he
coupons can be reinvest ed. The YTM of 10. 02 is also t he act ual r et ur n on
t he bond, at mat urit y, only if all coupons can be reinvest ed at 10. 02%. I f
t he act ual rat es of reinvest ment of t he bond are different , as in columns 5
and 7 in Table 13. 6, as is most ly t he case, t he act ual yield on t he bond could
be dif f er ent .

10
I RR can be comput ed by list ing t he cashflows in a single column, wit h init ial out flow st at ed as
a negat ive number, say b2: b20 and using formula = I RR ( b2: b20) .
11
Readers who have skipped t he earlier discussion are referred t o sect ion 13.3 on valuat ion of
bonds.
169

Box 1 3 . 3 : Usi n g t h e Yi el d Fu n ct i on
The yield funct ion in Excel will comput e t he yield of a bond, given t he
following:
Set t lement : t he dat e on which t he yield is sought t o be comput ed
Mat ur it y: t he dat e on which t he bond mat ur es
Rat e: t he r at e at which coupon is paid
Pr ice: t he mar ket pr ice of t he bond
Redempt ion: t he r edempt ion value of t he bond
Fr equency: number of coupons per year
Basis: Day count convent ion t o be used ( r epr esent ed by number s 0- 4)
On pr oviding t hese input s, Excel comput es t he cash f lows f r om t he coupon
r at e and r edempt ion values, t he t ime as t he dist ance bet ween set t lement
dat e and each of t he cash f lows, given t he day count convent ion specif ied in
t he basis and f ind by t r ial and er r or , t he r at e t hat equat es t he f ut ur e t he cash
f lows t o t he pr ice on t he set t lement dat e.
Use t he funct ion as = yield( set t lement , mat urit y, rat e, pr ice, r edempt ion,
fr equency, basis)
For example, in order t o value t he 11. 75% 2006 bond, mat uring on April 16,
2006, on Febr uar y 2, 2001, using t he day count convent ion of 30/ 360, at
pr ice of Rs. 106. 84, we shall st at e t he following:
= yield( 02/ 02/ 2001, 16/ 04/ 2006, 0. 1175, 106. 84, 100, 2, 4)
Excel will r et ur n a yield of 10. 0229%, which is t he YTM of t he bond.

13. 5. 3 Yi el d t o Mat ur i t y of a Zer o Coupon Bond

I n t he case of a zer o coupon bond, since t her e ar e no int er mit t ent cash flows
i n t he f or m of coupon payment s, t he YTM i s t he r at e t hat equat es t he pr esent
value of t he mat ur it y or r edempt ion value of t he bond t o t he cur r ent mar ket
price, over t he dist ance in t ime equal t o t he set t lement and mat urit y dat es.
For example, if a zer o coupon bond sells at Rs. 93. 76 on Febr uar y 5, 2001
and mat ur es on Januar y 1, 2002, it s YTM is comput ed as:

) 365 / 330 (
) 1 (
100
76 . 93
ytm +

= 7. 39%
I n t he case of zer o coupon bond, int er est is accr ued on an ever yday basis
unt il mat ur it y, at t his discount ing r at e.

170
Tabl e 1 3 . 6 : Wh y YTM i s n ot ear n ed ev en i f a Bon d i s h el d t o Mat u r i t y
Case- I Case- I I Day s t o
mat ur i t y
Cash f l ow
dat e
Cash
f l ow
Fut ur e
v al ue i f
r e-
i nvest ed
at YTM
of
1 0 . 0 2 %
Assum
ed
r e-
i nvest
ment
r at es

Re-
i nvest
ment
r et ur ns

Assumed
r e- i nvest
ment
r at es

Re-
i nvest
ment
r et ur ns

1800 16-Apr-01 5. 875 9. 5789 10. 25 9. 6843 9. 25 9. 2334
1620 16-Oct -01 5. 875 9. 1219 10. 00 9. 1141 9. 00 8. 7308
1440 16-Apr-02 5. 875 8. 6867 9. 75 8. 5977 8. 75 8. 2752
1260 16-Oct -02 5. 875 8. 2722 9. 50 8. 1299 8. 50 7. 8621
1080 16-Apr-03 5. 875 7. 8776 9. 25 7. 7059 8. 25 7. 4875
900 16-Oct -03 5. 875 7. 5017 9. 00 7. 3213 8. 00 7. 1478
720 16-Apr-04 5. 875 7. 1438 8. 75 6. 9726 7. 75 6. 8399
540 16-Oct -04 5. 875 6. 8030 8. 50 6. 6563 7. 50 6. 5610
360 16-Apr-05 5. 875 6. 4784 8. 25 6. 3697 7. 25 6. 3087
180 16-Oct -05 5.875 6. 1693 8. 00 6. 1100 7. 00 6. 0806
0 16-Apr-06 105. 875 105. 8750 7. 75 105. 8750 6. 75 105. 8750
Al t er nat e Val ues 1 6 4 . 6 2 5 183.5085 182.5368 180.4022
Assumes compounding will be done semi- annually.
13. 5. 4 Usi ng t he Zer o- Coupon Yi el d f or Bond Val uat i on

I f int er est r at es ar e a funct ion of t ime t o mat ur it y, t hen valuat ion of a bond,
usi ng t he same YTM r at e, can l ead t o er r oneous r esul t s, as we saw i n t he
per vious sect ion. I n ot her wor ds, t he YTM of a zer o coupon bond is a pur e
int erest rat e for t he t enor of t he bond. I n all t he ot her cases, if we used a
YTM rat e for valuat ion, we have assumed t hat a single rat e, equivalent t o t he
YTM, exist s for all t he t ime per iods for which coupons have t o be invest ed.
Ther ef or e, t he appr opr iat e r at es f or various t enors will have t o be used t o
value cash flows for t hat t enor . We call such a valuat ion as t he zer o coupon
yield based valuat ion. I n t he next chapt er , we shall discuss t he met hodology
used f or est imat ing t he zer o coupon yield cur ve ( ZCYC) . I n t hi s sect i on, we
shal l see how t he val uat i on of a bond changes i f we use t he ZCYC f or
valuat ion. The equat ion we use will be

Consider t he 12. 5% 2004 bond, whose cash flows ar e in Table 13. 7.
The valuat ion in Table 13. 7 uses a different rat e for eac h of t he cash flows.
I n t he next chapt er on yield, we shall see how t he appropriat e ZCYC rat e is
est imat ed. The NSE est imat es t he ZCYC fr om mar ket pr ices and enables t he
comput at ion of appr opr iat e discount r at es, used in t he t able.
) 4 . 13 .....( .......... ..........
) 1 (
......
) 1 ( ) 1 (
2
2 1
m
m
r
R C
r
C
r
C
PV
+
+
+ +
+
+
+
171

Tabl e 1 3 . 7 : Usi n g t h e ZCYC f or v al u at i on of bon ds
Cou pon
dat es
Cash
f l ow s
( Rs. )
Di st ance i n
y ear s f r om
set t l ement
dat e
Appr opr i at e
ZCYC r at e
Pr esen t v al u e
of t he
cash f l ow ( Rs. )
Semi- An n u al
Compoundi ng
23- Mar- 01 6.25 0. 13611 9. 6148 6. 17062
23- Sep- 01 6.25 0. 64722 9. 5108 5. 88522
23- Mar- 02 6.25 1. 15000 9. 4519 5. 62024
23- Sep- 02 6.25 1. 66111 9. 4272 5. 36322
23- Mar- 03 6.25 2. 16389 9. 4302 5. 12017
23- Sep- 03 6.25 2. 67500 9. 4548 4. 88154
23- Mar- 04 106. 25 3. 18056 9. 4956 79. 10151
Val u e of t h e bon d 1 1 2 . 1 4 2 5 2

13. 5. 5 Bond Equi v al ent Yi el d

I n all t he examples which we have seen so f ar , we have det er mined t he semi-
annual coupon f r om t he annual coupon, by si mpl y di vi di ng t he annual coupon
by 2. We have comput ed t he semiannual yield for t he purpose of
det er mining t he price, by similarly dividing t he annual yield by 2. I f cash
f lows ar e compounded mult iple t imes dur ing a year , t he ef f ect ive r at es ar e
not t he annual rat e divided by t he number of compounding periods. This is
because; int er mit t ent cash f lows can be r e- deployed, at pr evailing r at es, t o
ar r ive at an effect ive annual r at e.
For example, if annual yield is 11. 75%, t he semiannual yield is simply t aken
as 11. 75/ 2, which is 5. 875%. However, if t he six mont hly coupon is re-
invest ed at 5. 875%, t he effect ive annual yield will be higher t han 11. 75%, at
12. 095%. I n ot her words, semiannual yields should be annualised, by
incor por at ing t he effect of t he r e- invest ment , as follows:

Effect ive Annual yield = ( 1+ Per iodic int er est r at e)
k
1

where k i s t he number of payment s in a year . This f or mula can be used t o
comput e effect ive yields for any number of compounding per iods in a year .
I n t he above example,

Effect ive annual yield = { ( 1+ 0. 05875)
2
} - 1

= 12. 095%
Though it is well known t hat semiannual yields are t herefore not half t he
annual yields, in most bond market s, t he convent ion is t o simply divide t he
annual yield by 2, t o get t he semiannual yield. The semiannual yi el d t hus
simplist ically comput ed is called t he Bond Equivalent Yield ( BEY) .
172
Given t he for mula above, bond equivalent yield is = ( 1+ effect ive yield)
1/ k
- 1

Using t he number s fr om t he same example,
BEY = ( 1+ . 12095)
1/ 2
1
= 5. 875%

I n t he yield calculat ions for most fixed income secur it ies, unless ot her wise
st at ed, it is t he bond- equivalent - yield t hat is used.
13.6 WEI GHTED YI ELD

When bonds ar e t r aded at differ ent pr ices dur ing a day, t he yield for t he day
is usually r epor t ed as t he weight ed yields, t he weight s being t he mar ket value
of t he t r ades ( pr ice t imes quant it ies t r aded) . For exampl e, assume t hat t he
t r ades in CG11. 3% 2010 ar e as in Table 13. 8. The weight ed yield is
comput ed using mar ket values f or each t r ade as t he weight age.

Tabl e 13. 8: Wei ght ed Yi el d
Quant i t y Pr i ce
( Rs. )
Mar k et
Val u e
( Rs. )
YTM ( % ) YTM as
Pr opor t i on of
mar k et v al ue
10000 105. 23 1052300 10. 4177 1. 4925
2500 105. 45 263625 10. 3820 0. 3726
4000 105. 47 421880 10. 3787 0. 5961
6500 105. 50 685750 10. 3739 0. 9685
9000 105. 63 950670 10. 3528 1. 3399
8500 105. 71 898535 10. 3399 1. 2649
12000 105. 8 1269600 10. 3253 1. 7847
6000 105. 95 635700 10. 3011 0. 8915
5500 106. 00 583000 10. 2931 0. 8170
3500 106. 20 371700 10. 2609 0. 5192
2000 106. 25 212500 10. 2528 0. 2966

Tot al
Val ue 7345260
Wei gh t ed
Yi el d 1 0 . 3 4 3 5

13.7 YTM OF A PORTFOLI O

YTM of a por t folio is not comput ed as t he aver age or wei ght ed aver age of t he
YTMs of t he bonds in t he por t f olio. We ar e able t o comput e weight ed yields
only when t he cash f lows of t he bonds under quest ion ar e t he same, as was
t he case in weight ed yields. I n a port folio of bonds, each bond would have a
dif f er ent cash f low composit ion and t her ef or e, using a weight ed yield would
pr ovide er r oneous r esult s. We t her efor e find t he YTM of t he por t folio as t hat
r at e whi ch equat es t he expect ed cash f l ows of t he bonds i n t he por t f ol i o, wit h
173
t he mar ket value of t he por t folio. Consider for example, a por t folio of bonds
as in Table 13. 9.

Tabl e 1 3 . 9 : YTM of a por t f ol i o: Sampl e Bon ds
Bond Mat u r i t y
Dat e
Number
of Bonds
Pr i ce as
on Feb 5,
2 0 0 1
( Rs. )
Mar k et
Val u e
( Rs. )
CG 11. 75 2001 25/ 08/ 01 20000 101. 1 2022000
CG 11. 68 2002 6/ 08/ 02 25000 102. 915 2572875
CG 12. 5 2004 23/ 03/ 04 32000 107. 48 3439360
Tot al 8034235

Box 1 3 . 4 : XI RR Fu n ct i on
The XI RR f unct i on comput es t he I RR ( equi val ent t o YTM i n our case) f or a
ser ies of cash f lows, occur r ing at differ ent point s in t ime, when we pr ovide t he
dat es and t he cash flows. The funct ion r equir es { values, dat es, guess} . The
values have t o be in a column, wit h t he init ial cash out flow shown as a
negat ive number . I n t he above example, t he mar ket value on Febr uar y 05,
Rs. 80, 34, 235 is t o be shown as a negat ive value. The dat es on which t he
cash inflows occur ar e shown in a cor r esponding column.
When we use t he f unct ion as, f or inst ance,
= XI RR ( b2: b14, c2: c14) we get t he result 0. 13145, which is 13. 145%. We
have t o r emember however , t hat t he XI RR f unct ion suppor t s only t he
act ual/ 365 day count convent ion. We use t his f unct ion as an appr oximat ion,
because f inding t he YTM is an it er at ive t r ial and er r or pr ocess, which can be
complex ot her wise.

The cash f lows f r om t hese bonds accr ue on dif f er ent dat es, as t hese bonds
have dif f er ent dat es t o mat ur it y. Table 13. 10 shows t he dat es and t he cash
f lows f or t hese bonds and given t he quant it y of bonds held, t he t ot al cash
f lows f r om t his por t f olio, on t he given dat es. The yield t o mat ur it y of t his
por t f olio is t hat r at e which equat es t his ser ies of cash f lows in column 3 of
t able 13. 9, t o t he mar ket value on t able 13. 8, as on Febr uar y 5, 2001. We
can f ind t he YTM by using t he XI RR f unct ion in Excel.

174
Tabl e 13. 10: Por t f ol i o Cash Fl ow s
Dat e
Cash f l ow
per bon d
Tot al
cash f l ow s
25- Feb- 01 5. 875 117500
25- Aug- 01 105. 875 2117500
6- Feb- 01 5.84 146000
6- Aug- 01 5.84 146000
6- Feb- 02 5.84 146000
6- Aug- 02 105. 84 2646000
23- Mar- 01 6.25 200000
23- Sep- 01 6.25 200000
23- Mar- 02 6.25 200000
23- Sep- 02 6.25 200000
23- Mar- 03 6.25 200000
23- Sep- 03 6.25 200000
23- Mar- 04 106. 25 3400000
YTM 13. 1586%
13.8 REALI SED YI ELD

The act ual yield realised by t he invest or in a bond, over a given holding
per iod, is called r ealised yield. Realised yield r epr esent s t he hor izon r et ur n t o
t he invest or , f r om all t he t hr ee component s of bond r et ur n, namely, coupon,
ret urn from reinvest ment of coupon and capit al gain/ loss fr om selling t he
bond at t he end of t he holding per iod. The r ealised yield t o t he invest or is t he
r at e which equat es cash flows fr om all t hese t hr ee sour ces, t o t he init ial cash
out flow. Realised yield is also called t ot al ret urn from a bond.
Depending upon t he r einvest ment rat es available t o t he invest or and t he
yields which pr evail at t he end of t he holding per iod, t he invest or s r ealized
yield f r om holding a bond can var y. For example, consider t he 12. 5% 2004
bond. The r eal i zed yi el d on a 1- year hor izon based on a set of assumpt ions
about reinvest ment rat es and YTM at t he end of t he holding period, are as
follows:

Pur chase pr ice of t he bond on 23 Mar ch 2001 Rs. 107. 42 ( YTM 9. 6%)
Coupons received: 2 Semi-annual Rs. 12. 50
Reinvest ment of 1
st
coupon for 1 year @ 7. 5% Rs. 6. 7188
Reinvest ment of 2
nd
coupon for 6 mont hs @ 7% Rs. 6. 4688
Sal e of bond at t he end of 1 year @ 7. 8% yi el d Rs. 108. 55
Coupon income f r om t he bond f or 1 year Rs. 12.5
I ncome from coupon re-invest ment Re. 0. 6876
Capit al gain on sale Rs. 1. 13
Tot al cash flows fr om t he bond Rs. 14. 3176
Tot al r et ur n f or 1 year hol di ng per i od 14. 3176/ 107. 42
= 1 3 . 3 2 8 6 %
175

The t ot al r et ur n t o t he invest or is at t r ibut able t o all t he t hr ee sour ces of
income and depends on t he reinvest ment rat e and t he sale price. An
incr ease in int er est r at es will enhance t he r einvest ment income of t he
invest or , while r educing t he capit al gains; a decr ease in int er est r at es will
generat e capit al gains, while reducing t he reinvest ment income of t he
invest or . The invest ment hor izon will also impact t he per cent age composit ion
of each of t hese component s t o t he t ot al r et ur n of t he invest or . Holding t he
bond over a longer t ime will enhance coupon component of t he r et ur n and
r einvest ment , if r at es ar e incr easing. However , t he capit al gains wi l l dr op,
due t o a fall in yield, as well as due t o t he t ime pat h effect , leading t o t he
bond t ending t o r edempt ion value, as it near s mat ur it y.
Realised yield or t ot al ret urn t herefore provides t he invest or t he t ool t o
analyse impact of int er est r at es and holding per iod, on t he act ual r et ur ns
ear ned fr om a bond.
13.9 YI ELDPRI CE RELATI ONSHI PS OF BONDS

The basic bond valuat ion equat ion shows t hat t he yield and pr ice ar e inver sely
r elat ed. This r elat ionship is however , not unifor m for all bonds, nor is it
symmet r ical for incr eases and decr eases in yield, by t he same quant um.
Consi der Fi gur e 13. 1 whi ch pl ot s t he pr i ce- yield r elat ionship for a set of
bonds:

Fi gur e 13. 1 Pr i ce Yi el d Rel at i on sh i p of Bon ds
0
20
40
60
80
100
120
140
160
180
200
0 0.05 0.1 0.15 0.2 0.25
YTM ( %)
P
r
i
c
e

(

R
s
.
)

CG2001 CG2002 CG2005 CG2009 CG2013

176
13. 9. 1 Pr i ce Yi eld Rel at i onshi p: Some Pr i nci pl es

a. Pr i ce- yield relat ionship bet ween bonds is not a st raight line, but is
convex. This means t hat pr ice changes for yield changes ar e not
symmet r ical, for incr ease and decr ease in yield.
b. The sensit ivit y of pr ice t o changes in yield in not unif or m acr oss bonds.
Therefore for a same change in yield, depending on t he kind of bond
one holds, t he changes in pr ice will be dif f er ent .
c. Higher t he t er m t o mat ur it y of t he bond, gr eat er t he pr ice sensit ivit y.
We not ice in Figure 13. 1, t hat CG2013 has t he st eepest slope, while
2001 and 2002 are virt ually flat . Price sensit ivit ies are higher for
longer t enor bonds, while in t he short - t er m bond, one can expect
r elat ive pr ice st abilit y for a wide r ange of changes in yield.
d. Lower t he coupon, higher t he pr ice sensit ivit y. Ot her t hings r emaining
t he same, bonds wit h higher coupon exhibit lower pr ice sensit ivit y
t han bonds wit h lower coupons.
I n t he bond market s t herefore, we are int erest ed in t wo key quest ions: What
is t he yield at which r einvest ment and val uat i on happens and how t he change
in t his yield impact s t he value of t he bonds held. These ar e t he quest ions we
addr ess in t he next t wo chapt er s.

Model Quest i ons

1 . A GOI secu r i t y w i t h cou pon of 1 1 . 6 8 % , mat u r i n g on 6- Aug- 2 0 0 2 ,
i s t o b e set t l ed o n 1- Feb- 0 1 . Wh at ar e t h e n u m b er of d ay s f r om t h e
pr ev i ou s cou pon dat e?

a) 179
b) 176
c) 178
d) 175

Answ er : d.
We use t he coupday bs f unct ion in Excel and specif y t he f ollowing:
Set t lement dat e: Febr uar y 1, 2001
Mat ur it y Dat e: August 6, 2002
Fr equency: 2
Basis: 4
The answer is: 175 days

177

2 . Wh at i s t h e accr u ed i n t er est on a 1 1 . 6 8 % GOI secu r i t y , mat u r i n g
on 6- Aug- 2 0 0 2 , t r ad i n g on 1- Jun- 2 0 0 1 at a YTM of 7 . 7 3 9 5 % ?

a) Rs. 3. 6901
b) Rs. 3. 7311
c) Rs. 3. 7105
d) Rs. 3. 7520

Answ er : b
Accr ued int er est is comput ed as
Coupon payment * ( number of days f r om pr evious coupon/ days in t he coupon
period)
We use t he coupbs and cou pday s funct ions t o ascer t ain days fr om pr evious
coupon and days in t he coupon per iod.
The amount of coupon is Rs. 11. 68/ 2.
Ther ef or e, t he accr ued int er est is
= 5. 84 * ( 115/ 180)
= Rs. 3. 7311

3. A 1 1 . 6 8 % GOI secu r i t y mat u r i n g on 6- Au g- 2 0 0 2 , i s bei n g pr i ced
i n t h e m ar k et on 1 1- Ju l - 0 1 at Rs. 1 0 4 . 3 4 . Th e YTM of t h e bon d i s

7. 3728%
7. 3814%
7. 3940%
7. 3628%
We use t he Yi el d f unct ion in Excel, specifying set t lement ( 11 July 2001) and
mat ur it y dat es ( 6 Aug 2002) , coupon ( 0. 1168) , pr ice of t he secur it y ( 104. 34) ,
r edempt ion ( 100) fr equency ( 2) , basis ( 4) .
The answer obt ained is 7 . 3 7 2 8 %

Answ er : a

4. Th e f ol l ow i n g i s t h e descr i pt i on of bon ds h el d i n a por t f ol i o. Wh at
i s t h e por t f ol i o y i el d, u si n g t h e w ei gh t ed y i el d met h od?

Cou pon
( %
p. a. )
Mat u r i t y dat e Mar k et p r i ce on Ju l y
1 1 , 2 0 0 1 ( Rs. )
Nu mber of
bonds
11. 68 6- Aug- 2002 104. 34 5400
11. 15 1- Sep- 2002 104. 03 5560
13. 82 30- May- 2002 105. 5 5720
12. 69 10- May- 2002 104. 9 5880
11. 00 23- May- 2003 105. 74 6040

178

An sw er :
The yi el d of each of t he bonds can be comput ed usi ng t he yi el d f unct i on
( see solved example 3 above) . The mar ket value of each bond can be
comput ed as t he pr oduct of number of bonds and mar ket pr ice as on July 11,
2001.

Coupon
( %
p. a. )
Mat u r i t y
dat e
Pr i ce
( Rs. )
Yi el d ( % ) Number
of bonds
Mar k et
Val u e
( Rs. )

11. 68 6- Aug- 2002 104. 34 7. 3728% 5400 563436
11. 15 1- Sep- 2002 104. 03 7. 3770% 5560 578406. 8
13. 82 30- May- 2002 105. 5 7. 2731% 5720 603460
12. 69 10- May- 2002 104. 9 6. 5056% 5880 616812
11. 00 23- May- 2003 105. 74 7. 6309% 6040 638669. 6

The yield of t he por t folio can be found by weight ing each bonds yield by t he
mar ket value of t he bond in t he por t folio. This is done as:

{ ( 7. 3728* 563436) + ( 7. 3770* 578406. 8) + ( 7. 2731* 603460) +
( 6. 5056* 616812) + ( 7. 6309* 638669. 6) } /
( 563436+ 578406. 8+ 603460+ 616812+ 638669. 6)

We can do t he same in Excel, using t he formula
= sumpr oduct ( yield ar r ay, mar ket value ar r ay) / sum( mar ket value ar r ay)
The answer in bot h cases is 7. 2302%, which is t he por t folio yield.

5 . On Apr i l 1 2 , 2 0 0 1 , a deal er pu r ch ases a 1 1 . 6 8 % GOI bon d
m at u r i n g o n 6- Aug- 2 0 0 2 f or Rs. 1 0 4 . 3 4 . He h ol ds t h e bon d f or 1
y ear , an d sel l s i t on Apr i l 1 1 , 2 0 0 2 , f or Rs. 1 0 0 . 9 0 . I f t h e cou pon s
r ecei v ed d u r i n g t h e h ol d i n g p er i od ar e r e - i n v est ed at 8 . 2 4 0 5 % ( 1 st
cou pon ) an d 6 . 7 5 2 5 % ( 2 n d cou pon ) , w h at i s t h e r eal i sed y i el d on t h e
i nv est ment ?

An sw er :
The component s of r ealized yield ar e:
Coupon income, reinvest ment of coupons and capit al gains/ losses.
Cou pon i n come:
The number of coupons bet ween t he acquisit ion dat e and dat e of sale of t he
bond can be f ound wit h t he coupnum f unct i on. I n t hi s case t her e ar e t wo
coupons. Ther efor e t he coupon r eceived is: Rs. 11. 68
Re- i n v est men t I n come:
We can f ind t he fir st coupon dat e, by using t he coupncd funct ion in Excel.
The fir st coupon is due on August 6, 2001. Since t he bond will be sold on
Apr il 11, 2002, t he number of days for which t he coupon will be r e- invest ed
179
will be 248 days. The int erest rat e applicable t o t his coupon, as given in t he
quest ion, is 8. 2405%. Therefore t he reinvest ment income can be comput ed
as:
= ( 11. 68/ 2) * ( 248/ 365) * 0. 082405
= 0. 3270
Similar ly, t he second coupon is due on 6
t h
Feb 2002. I t will be reinvest ed for
65 days, at 6. 7525%. The r einvest ment income will be
= ( 11. 68/ 2) * ( 64/ 365) * 0. 067525
= 0. 0691
Capi t al gai n / l oss:
Rs. 100. 90 104. 34
= - 3.44
The t ot al r upee r et ur n fr om holding t he bond for a year is
= 11. 68 + 0. 3270+ 0. 0691 3. 44
= 8. 6361
Th e r el eased y i el d t h er efor e i s:
= ( 8. 6361/ 104. 34) * 100
= 8. 2769%
180
CHAPTER 14
YI ELD CURVE AND TERM STRUCTURE
OF I NTEREST RATES

I nt erest rat es are pure prices of t ime, and are t he discount ing fact ors used in
t he valuat ion equat ion for bonds. I t is cr ucial t hat we ar e able t o derive
t hese discount f act or s f r om t he mar ket such t hat t he valuat ions we do ar e
cur r ent and accur at e. The pr ocess of det er mi ni ng t he di scount f act or s, ( whi ch
we know as t he yields or int er est r at es) will have t o t her efor e dr aw fr om t he
current market prices of bonds. The br oad pict ur e of t he debt mar ket can be
discer ned in t er ms of a f unct ional r elat ionship bet ween t wo var iables: t ime
and int er est r at es. The focus of t his chapt er is t he under st anding of t his
r elat ionship bet ween t ime and int er est r at es. This relat ionship not only
provides t ools for valuat ion of bonds, but also enables ident ificat ion of
ar bit r age oppor t unit ies in t he mar ket and assessment mar ket expect at ions of
f ut ur e int er est r at es.
14.1 YI ELD CURVE: A SI MPLE APPROACH

The simplest appr oach t o obser ving t he int er est r at es in t he mar ket is t o dr aw
t he yi el d cur ve f r om t he YTM of t r aded bonds. The YTMs of t r aded bonds i s
used as an appr oximat ion of t he int er est r at e f or t he given t er m t o mat ur it y
of t he bond. When we obt ain a plot of t hese relat ionships bet ween YTMs and
t er m t o mat ur it y of a set of t r aded bonds, we can ident if y t he f unct ional
r elat ionship bet ween t ime and yield, by fit t ing a cur ve t hr ough t he plot of
point s. Alt er nat ively, we can use t hese YTMs t o est imat e yields f or any t enor ,
by met hods of int er polat ion.
14. 1. 1 Yi el d Cur v e f r om a Sampl e of Tr aded Bonds

Consider for example, bonds t raded on March 29, 2001 ( Table 14. 1) . From
t he obser ved mar ket pr ices in column 5, we can comput e t he YTM of t hese
bonds, using t he yield funct ion in Excel. The t er m t o mat ur it y of t he bonds
is t he dist ance in t ime bet ween t he mat ur it y dat e of t he bonds ( column 3)
and t he set t lement dat e ( March 29, 2001) . The t erm t o mat urit y is shown in
column 4. We can see t hat bonds wit h var ying t er ms t o mat ur it y have t r aded
at differ ent yields, and t he gener al t endency is for yields t o incr ease as t he
t er m incr eases.
I n or der t o be able t o model t his r elat ionship int o a funct ion, t hat can be used
f or val ui ng bonds, we need t o est i mat e t he r el at i onshi p as an equat i on, so
t hat given values of t enor ( x) , we can est imat e values of yield ( y) .
181
This can be done by plot t ing t he t er m t o mat ur it y and t he yield t o mat ur it y,
and f it t ing a 3r d degr ee polynomial t o descr ibe t he f unct ional r elat ionship. A
t hird degree polynomial is specif ied as f ollows:

it it it it it it
e x b x b x b a y + + + +
3
3
2
2 1
. . ( 14. 1)

where b
1
, b
2
and b
3
ar e est imat ed co- efficient s, given values of t er m t o
mat ur it y ( x) and yield t o mat ur it y ( y) .

Tabl e 1 4 . 1 : Sampl e Bon ds f or Yi el d Cu r v e
Name Coupon
( % )
Mat ur i t y
Dat e
Ter m t o
Mat u r i t y
( y ear s)
Pr i ce
( Rs. )
YTM
( % )
CG2001 11. 75 25- Aug- 01 0.41 101 0. 090924
CG2002 11. 15 9- Jan- 02 0.78 102. 75 0. 074125
CG2003 11. 1 7- Apr- 03 2.02 103. 515 0. 091537
CG2004 12. 5 23- Mar- 04 2.98 108. 31 0. 092473
CG2005 11. 19 12- Aug- 05 4.37 106. 19 0. 094220
CG2006 11. 68 10- Apr- 06 5.03 107. 58 0. 097364
CG2007 11. 9 28- May- 07 6.16 109. 31 0. 098426
CG2008 11. 4 31- Aug- 08 7.42 107. 6 0. 099240
CG2009 11. 99 7- Apr- 09 8.02 109. 18 0. 102808
CG2010 11. 3 28- Jul- 10 9.33 106. 6 0. 101823
CG 2011 12. 32 29- Jan- 11 9.83 110. 97 0. 104987
CG2013 12. 4 20- Aug- 13 12. 39 111. 2 0. 107401

Fi g 1 4 . 1 : Yi el d Cu r v e as on Mar ch 2 9 , 2 0 0 1
y = 9E-06x
3
- 0.0003x
2
+ 0.0041x + 0.0817
0
0.02
0.04
0.06
0.08
0.1
0.12
0 2 4 6 8 10 12 14
Ter m To Mat u r i t y ( i n Year s)
Y
i
e
l
d

t
o

M
a
t
u
r
i
t
y

(
%
)

182

The equat ion in Fig 14. 1 pr ovides t he gener alised r elat ionship bet ween t er m
t o mat ur it y and yield t o mat ur it y. By fit t ing int o t he equat ion, t he t er m t o
mat urit y of any given bond, ( by subst it ut ing t he value of x) , t he
cor r esponding YTM can be est imat ed. The given bond can be valued by f it t ing
int o it s cash f low f eat ur es, t he YTM t hus der ived, so that value of t he bond
can be comput ed. For example, we can use t he equat ion in t he yield cur ve
above t o value t he 12. 5% 2004 bond on Mar ch 29, 2001. The bond has 3. 03
year s t o mat ur it y on t hat dat e, t her ef or e we plug int o t he yield cur ve
equat ion, t his value in t he place of x, as follows:

Y = ( ( - 0. 000009* ( 3. 03) ^ 3) - ( 0. 0003* ( 3. 03) ^ 2) + ( 0. 0041* 3. 03) + 0. 0817)

We obt ain t he value 0. 09112 as t he Y value. Since we know t he cash f lows of
t his bond, we can use t he Pr ice funct ion t o est imat e t he value of t his bond,
plugging in 0. 09112 as t he value for yield. The result ing price of t he bond is
Rs. 108. 6754. ( The last t r aded pr ice of t his bond on t hat dat e was Rs.
108. 31) . We can t hus use t he yield cur ve t o mar k a por t f olio t o mar ket , or
value a given bond, which may not be t raded.

Box 1 4 . 1 : Usi n g Ex cel t o dr aw t h e Yi el d Cu r v e
The following ar e t he st eps t o dr awing t he yield cur ve using Excel:
1. Comput e yield and t erm t o mat urit y for a set of bonds, using t he yield
funct ion, and finding t he differ ence in year s, bet ween set t lement dat e
and mat ur it y dat e of t he bond. ( ( mat ur it y dat e set t l ement
dat e) / 360) ) .
2. Dr aw an XY gr aph ( XY scat t er ) of t hese point s, using t er m f or x values
and Yield for Y values.
3. Choose Char t / Add t r end line/ t ype: Choose polynomial, and or der 3.
4. Choose Char t / Add t r end line/ opt ions: display equat ion on t he char t .
5. Excel pl ot s t he gr aph and est i mat es t he 3
r d
degr ee polynomial,
displaying t he equat ion of t he yield cur ve.

14.1.2 Li mi t at i ons of t he Si mpl e Yi el d Cur ve

The yield curve which we have drawn fr om t he mar ket pr ices above, is a
summary of t he YTMs for various t raded bonds, on a given dat e. They,
however , may not t r uly r epr esent t he yields or int er est r at es for var ious
t enor s. The YTM of a bond r epr esent s a single r at e, at which all t he cash
flows of a bond are discount ed. This act ually t ranslat es int o a valuat ion
proposit ion where, cash flows accruing at varying point s in t ime are all
discount ed at t he same rat e, i. e. t he YTM of t he bond. I n realit y, such a
183
di scount i ng pr ocess r epr esent s a scenar io wher e cash flows accr uing at any
point in t he life of t he bond, can be deployed at a single r at e. This would
t hen t ranslat e int o a sit uat ion where int erest rat es for all t enors for a given
bond ar e equal, and hence a flat yield cur ve.
What we see when we plot t he YTMs of t r aded bonds is a t endency f or YTMs
of bonds wit h var ying t enor s t o be differ ent . This means t hat r at es for
varying t enors are not uniform, but different . I f t his were t rue, we can not
use t he same YTM f or val ui ng al l t he cash flows of a bond. The t r ue int er est
r at es, which ar e implicit in t he pr ices of t r aded bonds, ar e t her efor e not
obser ved. The YTM is a simplif icat ion, wit h an er r oneous assumpt ion on t he
reinvest ment of int er mit t ent coupons. I f we know t hat dif f er ent r at es exi st
acr oss t enor s, t he valuat ion equat ion will have t o be r ecast as f ollows:

n
n
n
r
c
r
c
r
c
P
) 1 (
. ..........
) 1 ( 1
2
2
2
1
1
0
+
+
+
+
+
. . ( 14. 2)

Wher e r
1
, r
2
. r
n
r epr esent t he r at es f or t he r espect ive t enor s. These r at es
ar e pur e spot r at es, in t hat t her e ar e no assumpt ions on r einvest ment of
coupons. I n ot her words t hey are rat es t hat would be implicit in a bond t hat
has a single cash f low at t he end of t he t er m, i. e. a zer o coupon bond. These
r at es ar e also called as t he zer o coupon r at es, and t he yield cur ve t hat is
dr awn f r om t hese r at es is called t he zer o coupon yield cur ve ( ZCYC) .
We can t hus look upon ever y coupon paying bond, as a bundle of zer o coupon
bonds, wit h each cash f low accr uing at t he end of a t er m r
1 ,
r
2 ,
r
3
r
n,
being
valued as if t hey wer e zero coupon bonds of t hat t enor . The est imat ion
pr oblem t her ef or e is one of ident if ying t hese unique r at es, and modeling t heir
relat ionship wit h one anot her, which in t urn is t he basis for t he valuat ion of
t he bond.
The act ual modeling of t he t r ue r at es acr oss t enor , and t heir r elat ionship
acr oss t er m is called t he modeling of t he t er m st r uct ur e of int er est r at es,
whi ch at t empt s t he est i mat i on of t he t heor et i cal spot r at es, f r om a set of
mar ket pr ices of bonds, based on a t heor et ical fr amewor k t hat expla ins t he
r elat ionship bet ween t he r at es acr oss var ious t enor s. Ther e ar e a number of
met hods t o do t hi s, and we shal l di scuss one of t hem i n a subsequent sect i on
in t his chapt er .
14.2 BOOTSTRAPPI NG

The error caused by t he reinvest ment assumpt ion in t he yield curve derived
from t he YTMs of t raded bonds can be eliminat ed, if we are able t o observe
t he r at es of bonds wit hout int er mit t ent coupons, i. e. zer o coupon bonds.
However, in most market s, zero coupon bonds across varying t enors do not
exist , and even if t hey do, ar e not as act ively t r aded as t he coupon paying
bonds. However , in most mar ket s, t r easur y bills which ar e discount ed
securit ies, wit h no int ermit t ent coupons, exist at t he short end of t he market .
184
Therefore, we could boot st rap from t he zero coupon t r easur ies, and der ive
t he r
1
, r
2
r
n
of t he coupon paying bonds.
For example, if a Tr easur y bill wit h 6 mont hs t o mat ur it y, is t r aded in t he
market at Rs. 96. 5 and mat ures t o t he par value of Rs. 100, t he 6 mont h zero
coupon r at e can be comput ed by solving t he equat ion:
5 . 0
5 . 0
) 1 (
100
5 . 96
r +

The 6 mont h rat e t hat solves t his equat ion is 7. 492%. We can now look for
a coupon paying bond wit h 1 year t o mat ur it y, whose valuat ion equat ion, in
zer o coupon t er ms can be st at ed as

1
1
2
5 . 0
5 . 0
1
0
) 1 ( ) 1 ( r
c
r
c
P
+
+
+
. ( 14. 3)

I n t his equat ion, we know t he per iodic coupons as well as t he mar ket pr ice.
Fr om t he ear lier equat ion, we can subst it ut e t he value of r
0.5
. Then t he only
unknown in t his equat ion would be r
1
, f or which we can solve. The pr ocess of
t hus di scover i ng t he zer o r at es f r om pr i ces of coupon bonds, by subst i t ut i ng
zer o r at es est imat ed f or shor t er dur at ions is called boot st r apping. The yield
cur ve is t hen dr awn fr om t he plot of t hese der ived zer o r at es, in t he similar
manner as we dr ew t he par yield curve.
Boot st rapping is a very popular met hod wit h bond market dealers, for
est imat ing t he t er m st r uct ur e f r om mar ket pr ices. Some of t he pr act ical
consider at ions in est imat ing t he zer o cur ve in t his manner ar e t he following:
1. The choi ce of bonds f or var ying mat ur it ies has t o r eflect mar ket
act ivit y. Depending on t he bonds chosen for est imat ing t he r at es, t he
der ived zer o r at es can var y. I t is, however , possible t o obt ain a plot of
all implied zer o r at es f or all t r aded bonds, and adopt t he cur ve f it t ing
pr ocedur e, t o over come t his pr oblem.
2. I t may not be possible t o obt ain zer o r at es for t he fir st cash flow of a
bond; if a zer o coupon Tr easur y bill wit h mat ching mat ur it y is not
f ound. For example, t her e could be a bond, wit h t he f ir st coupon 42
days away. We, t her ef or e, need t he r
1
for 42 days, in or der t o value
t his bond. A t r easur y bill wit h exact ly 42 days t o mat ur it y may not be
t raded in t he market . Dealers most ly use a linear int erpolat ion t o sort
t his pr oblem. Tr aded t r easur y bills for available mat urit ies are picked
up. Assume f or inst ance we have t he r at es f or 2 bills, one wit h 40
days t o mat ur it y, and anot her wit h 52 days t o mat ur it y. The zer o r at e
for t he 42- day bond is comput ed by linear ly int er polat ing bet ween
t hese t wo r at es.

Examp le of linear int er polat ion:
I f t he r at e f or t he 40- day bond is 6. 542%, and t he r at e f or t he 52- day
bond is 6. 675%, t he rat e for t he 42- day bond can be found as

185
= 6.542 + [ ( 6.675- 6. 542) ] x [ ( 42- 40) / ( 52- 40) ]

= 6. 56416%

3. The boot st r apping t echnique is sensit ive t o t he liquidit y and dept h in
t he mar ket . I n a mar ket wit h f ew t r ades, and limit ed liquidit y,
boot st rapping is only an approximat ion of t he t rue t erm st ruct ure, due
t o simple assumpt ions ( like linear int erpolat ion) made for linking up
r at es for one t enor and t he rat es for anot her. I t is not uncommon for
some t o use mor e sophist icat ed non- linear int erpolat ions.
14.3 ALTERNATE METHODOLOGI ES TO ESTI MATE THE
YI ELD CURVE

I n t he est imat ion of t he yield cur ve f r om a set of obser ved mar ket pr ices, t he
following ar e impor t ant consider at ions:
a. The spot r at es and t he yield cur ve t hat is est imat ed should have a
close fit wit h mar ket pr ices. That is, t he pr ices est imat ed by t he
model and t he pr ices act ually pr evalent in t he mar ket should have a
cl ose f i t .
b. The mo del must apply equally well t o bonds which ar e not par t of t he
sample used for est imat ion. That is, if a ver y close fit is sought t o be
achieved, it may come at t he cost of t he model not being able t o value
out - of- sample bonds. The model would have incorpor at ed noise in
t he est imat ion.
c. The est imat ed yield cur ve should be smoot h, such t hat t he spot and
for war d r at es der ived fr om t hem do not show excessive volat ilit y.
A number of mat hemat ical t echniques are used t o generat e a fit t ed yield
curve from a set of obser ved int er est r at e point s. They involve opt imalit y
cr it er ia consist ent wit h t he assumpt ions r egar ding t he t er m st r uct ur e of
int er est r at es.
14. 3. 1 NSE ZCYC ( Nel son Sei gel Model )

I n t he I ndian mar ket s, t er m st r uct ur e est imat ion has been done, and i s
disseminat ed ever y day by t he Nat ional St ock Exchange. The Zer o Coupon
Yield Cur ve ( ZCYC) published by t he NSE, uses t he Nelson- Seigel
met hodology. 12 The Nelson- Siegel f or mulat ion specif ies a par simonious
r epr esent at ion of t he for war d r at e funct ion given by

)] / exp( ) / [( ) / exp( ) , (
2 1 0
m m m b m f + +
. . ( 14. 4)

12
The paper ( Gangadhar Darbha, et al, 2000) t hat describes t he met hodology can be downloaded
from www.nse.co.in \ ` product s\ ` zcyc. The following sect ion is ext ract ed from t his paper.
186
where m denot es mat urit y and b= [ 0, 1, 2 and ] ar e par amet er s t o be
est imat ed.
Since t he model is based on t he expect at ions hypot hesis, it develops t he t er m
st r uct ur e fr om t he no- ar bit r age r elat ionship bet ween spot and f or war d r at es.
The f or war d r at e f unct ion can be mat hemat ically manipulat ed ( int egr at ed) t o
obt ain t he r elevant spot r at e f unct ion, t he t er m st r uct ur e:
) / exp( ) / /( )] / exp( 1 [ ) ( ) , (
2 2 1 0
m m m b m r + + (
14.5)
I n t he spot r at e f unct ion, t he limit ing value of r ( m, b) as mat ur it y get s large is
0 which t her efor e depict s t he long t er m component ( which is a non- zer o
const ant ) . The limit ing value as mat ur it y t ends t o zer o is 0 + 1, whi ch
t her efor e gives t he implied shor t - t er m r at e of int er est .
Wit h t he above specif icat ion of t he spot r at e f unct ion, t he PV r elat ion can now
be specified using t he discount funct ion given by
,
_

100
) , (
exp ) , (
m b m r
b m d . . ( 14. 6)
The present value arrived at is t he est imat ed/ model price ( p_est ) for each
bond. I t i s common t o obser ve secondar y mar ket pr i ces ( pmkt ) t hat deviat e
f r om t his value. For t he pur pose of empir ical est imat ion of t he unknown
par amet er s in t er m st r uct ur e equat ion above, we post ulat e t hat t he obser ved
mar ket pr ice of a bond deviat es fr om it s under lying valuat ion by an er r or
t erm ei, which gives us t he est imable r elat ion:
i i i
e est p pmkt + _ ( 14. 7)
This equat ion is est imat ed by minimising t he sum of squar ed pr ice er r or s. The
st eps followed in t he est imat ion pr ocedur e ar e as follows:

i. A vect or of st ar t ing par amet er s ( 0, 1, 2 and ) i s sel ect ed,
ii. The discount fact or funct ion is det er mined using t hese st ar t ing
par amet er s,
iii. This is used t o det er mine t he pr esent value of t he bond cash f lows and
t her eby t o det er mine a vect or of st ar t ing model bond pr ices,
iv. Numer ical opt imizat i on pr ocedures ar e used t o est imat e a set of
par amet er s ( under a given set of const r aint s viz. non- negat ivit y of long
run and short run int erest rat es) t hat minimise t he sum of squared price
errors,
v. The est imat ed set of paramet ers are used t o det ermine t he spot rat e
f unct ion and t her ef r om t he model pr ices ( t his is t he f ir st set of r esult s
we comput e f or each day) ,
vi. These model pr i ces ar e used t o comput e associ at ed model YTMs f or
each bond ( t his is t he second set of r esult s) .

Plot s of t he est imat ed t erm st ruct ure for any part icular day can be obt ained
by f ollowing t he pr ocedur e below:
187
(I ) Creat e a series of mat urit y values; for inst ance 1 t o 25 years, wit h
st ep lengt hs of ( say) 0. 5 year s
(I I ) For each mat ur it y, use t he est imat ed par amet er s f or t he r equir ed day
t o der i ve cor r esponding spot r at es
( I I I ) Wit h mat ur it y values on t he X- axis, plot t he spot r at es against t he
mat ur it y values,
( I V) Spot r at e associat ed wit h any desir ed mat ur it y ( eg. 8. 2 year s) can be
similar ly der ived by subst it ut ing t he est imat ed par amet er s and m= 8. 2
in t he t erm st ruct ure equat ion.

14.4 THEORI ES OF THE TERM STRUCTURE OF I NTEREST
RATES

The t er m st r uct ur e r epr esent s t he dif f er ent r at es of mar ket int er est r at es f or
dif f er ent per iods of t ime. The shape of t he cur ve t her ef or e cont ains cr ucial
infor mat ion on t he funct ional r elat ionship bet ween pr ice and t ime. The
nor mally obser ved shapes of t he yield cur ve ar e t he following:
a. upwar d sloping
b. downwar d sloping
c. humped
d. inver t ed
The most commonly known t heor ies t hat at t empt an int er pr et at ion of t he
shape of t he yield curve are:
The pur e expect at ion hypot hesis
The liquidit y pr efer ence hypot hesis
The pr efer r ed habit at hypot hesis

14.4.1 Pur e Ex pect at i on Hy pot hesi s

This int er pr et at ion explains t he yield cur ve as a funct ion of a ser ies of
expect ed f or war d r at es. Pioneer ed by I rving Fisher in 1896, t his is t he oldest
t heor y of t he t er m st r uct ur e, and is t he easiest t o quant if y and apply. The
t r adit ional f or m of t he pur e expect at ions t heor y implies t hat t he expect ed
aver age annual r et ur n on a long t er m bond is t he geomet r ic mean of t he
expect ed shor t t er m r at es. For example, t he one year spot r at e can be
t hought of as t he pr oduct of t he six- mont h spot and t he six mont h rat e six
mont hs fr om now ( six mont h for war d) . A r isk neut r al invest or would t her efor e
be i ndi f f er ent bet ween t he one year spot r at e, and a one year posit ion f or med
by a combinat ion of a six mont h spot and a six mont h forward. Therefore
shape of t he yield cur ve is dr iven by t he expect at ions about t he int er est r at es.
Based on t he expect at ions hypot hesis, we can calculat e a ser ies of shor t t er m
rat es, which over any given period will, in aggregat e, reproduce t he market
r at es expr essed in t he yield cur ve.
188

14.4.2 Li qui di t y Pr ef er ence Hy pot hesi s

This hypot hesis is a modificat ion of t he expect at ion hypot hesis, incorpor at i ng
r isk. Ot her t hings r emaining t he same, invest or s would pr ef er shor t t er m
bonds t o long t er m bonds, because pr icing of shor t t er m bonds is made easier
by t he l ower pr i ce r i sk of t hese bonds and t he shor t er t er m t o mat ur i t y.
Ther ef or e shor t t er m inst r ument s will enj oy a higher liquidit y t han long t er m
inst r ument s. I f invest or s pr efer shor t t er m r at es t o long t er m r at es, int er est
r at es at t he lower end of t he yield cur ve would be lower , and t he yield cur ve
would slope upwar ds. The liquidit y pr efer ence hypot hesis posit s t hat t he
long t erm rat es are not only composed of expect ed short t erm rat es, but also
cont ain a liquidit y pr emium. The liquidit y pr emium is t he addit ional yield
demanded by invest ors t o ext end t he mat urit y of inst rument s, over longer
per iods of t ime. Ther ef or e liquidit y pr emium can be expect ed t o incr ease wit h
t ime t o mat ur it y.

14. 4. 3 Pr ef er r ed Habi t at Hy pot hesi s

Pr ef er r ed habit at hypot hesis r ecognizes t hat t he mar ket is segment ed and
t hat expect at ions of invest or s ar e not unifor m acr oss var ious t enor s. This
hypot hesi s posi t s t hat di st i nct cat egor i es of i nvest or s exi st , and t hat each of
t hese cat egor ies pr efer s t o invest at cer t ain segment s of t he yield cur ve. For
example, cor por at es wit h shor t t er m sur plus f unds, would pr ef er t o deploy t he
same in shor t t er m inst r ument s, and may be unwilling t o t ake pr ice r isks
associat ed wit h invest ing in long t er m inst r ument s. On t he ot her hand,
pension and insur ance companies would pr ef er t o invest in long t er m bonds,
t o mat ch t he liabilit y profile of t heir port folios. Since t he port folios and t he
asset r equi r ement s of i nvest or s var y, t hey woul d pr ef er some t enor s over t he
ot her , and t her ef or e f ocus on segment s of t he yield cur ve. The pr ef er r ed
habit at t heor y t her ef or e posit s t hat depending on demand and supply at
varying t enors of t he yield curve, invest ors will have t o be receive ( pay)
pr emiums ( discount s) t o shif t away f r om a pr ef er r ed habit at . The shape of t he
yield cur ve t her ef or e is a f unct ion of demand and supply, and does not have
any for mal r elat ionship t o int er est r at e expect at ions.

189

We can summar i se t he i nt er pr et at i on of t he al t er nat e shapes of t he yi el d
cur ve under t hese t hr ee hypot heses, as follows:

Shape of t he yi el d cur ve Ter m
st r uct ur e
hypot heses
Fl at Upw ar d
sl opi ng
Dow nw ar d
sl opi ng
Humped
Ex pect at i ons
Hypot hesi s
Short t erm
int erest rat es
ar e not
expect ed t o
change.
Short t erm
int erest rat es
ar e expect ed
t o incr ease.
Short t erm
r at es ar e
expect ed t o
decr ease.
Short t erm rat es
ar e expect ed t o
init ially increase,
and t hen
decr ease.
Li qui di t y
Pr emi um
Hypot hesi s
Ther e is no
liquidit y
pr emia on
long t er m
rat es, over
short t erm
r at es.
Liquidit y
pr emi a ar e
posit ive wit h
incr eases in
t erm.
Liquidit y
pr emi a ar e
negat ive wit h
incr eases in
t erm.
Liquidit y pr emia
ar e posit ive upt o
a cer t ain t er m,
aft er which t hey
t ur n negat ive.
Pr ef er r ed
Habi t at
Hypot hesi s
Demand and
supply ar e
mat ched at
all
mat ur it ies.
Excess of
supply over
demand in
shor t er
mat ur it ies.
Excess of
supply over
demand in
l onger
mat ur it ies.
Excess of supply
over demand in
t he int ermediat e
t erm.

The t er m st r uct ur e of int er est r at es becomes ver y impor t ant in a mar ket in
which for war ds and der ivat ives t r ade, as t he valuat ion and t r ading of t hese
inst rument s is not possible wit hout a dependable model of t erm st r uct ur e.
The NSE- ZCYC is an impor t ant development in t his cont ext . I n t he I ndian
mar ket s, pending t he development of t he for war d and der ivat ive mar ket s in
int er est r at e pr oduct s, and limit ed liquidit y in t he spot mar ket s, yield cur ve
est imat ions ar e yet t o gain impor t ance. However , t he incr easing f ocus on
valuat ion and mar king t o mar ket of por t f olios has cr eat ed t he need f or t he
mar ket yield cur ve, f or banks, PDs, inst it ut ions and mut ual f unds. The RBI
used t o publish t he yield cur ves for valuat ion of bank por t f olios. Af t er t he RBI
discont inued t his pract ice nearly 2 years ago, t he FI MMDA has creat ed a
st andar d yield cur ve, based on polled yields at t he end of ever y t r ading day,
t o enable valuat ion of por t f olios on t he basis of a st andar d yield cur ve. This
has enabled st andar d indust r y pr act ice on valuat ion. SEBI has mandat ed a
st andard valuat ion model for bonds in mut ual fund port folios, from December
1, 2000, based on a dur at ion- based valuat ion model developed by CRI SI L.
190

Model Quest i ons

1. Th e NSE ZCYC est i mat es f or Ju l y 1 1 , 2 0 0 1 ar e as f ol l ow s:
Bet a 0 = 1 1 . 4 6 5 2
Bet a 1 = - 2. 2510
Bet a 2 = - 1 0 . 7 2 0 2
Tau = 1 . 4 1 9 7
Wh at i s t h e spot r at e f or a t er m t o mat u r i t y of 3 . 5 y ear s?

An sw er :
We use t he ZCYC valuat ion equat ion ( 14. 5)
) / exp( ) / /( )] / exp( 1 [ ) ( ) , (
2 2 1 0
m m m b m r + +
We can t ake t he values pr ovided by NSE t o an Excel Spr eadsheet , and key in
t he f or mula above, subst it ut ing 3. 5 f or m i n t he equat i on, and subst i t ut i ng
t he NSE est imat es f or B
0
, B
1
and B
2
and Tau. We t hen get
= 11.4652 + ( ( - 2. 2510- 10. 7202) * ( 1- exp( - 3. 5/ 1. 4197) ) / ( 3. 5/ 1. 4197) - ( -
10. 7202* exp( - 3. 5/ 1. 4197) )
= 7.56185%

2 . I f t h er e ar e 2 b on d s t r ad i n g i n t h e mar k et as f ol l ow s, on Ju l y 1 1 ,
2 0 0 1 as det ai l ed bel ow :
i . 1 1 . 9 8 % 2 0 0 4 ( Mat u r i t y 8 - Sep- 2 0 0 4 ) : Rs. 1 1 1 . 8
i i . 1 1 . 1 9 % 2 0 0 5 ( Mat u r i t y 1 2 Au g 2 0 0 5 ) : Rs. 1 1 1 . 8 3
Wh at i s t h e l i n ear l y i n t er pol at ed r at e f or 3 . 5 y ear s, u si n g t h e abov e
dat a?

An sw er :
Using t he Yi el d f unct ion, we can f ind out t he YTM of t he above bonds as
7. 6917% and 7. 7524% respect ively. Using t he y ear f r ac f unct ion, we can
f i nd t he t er m t o mat ur it y of t hese bonds as 3. 1583 year s and 4. 0861 year s
respect ively. To find t he YTM for a 3. 5 year bond, we can do a linear
int er polat ion, as follows:
= 7. 6917 + ( 7. 7524- 7. 6917) * ( ( 3. 5- 3. 1583) / ( 4. 0861- 3. 1583) )
= 7.7141%

3 . I f t h e y i el d cu r v e i s u pw ar d sl opi n g, w h i ch of t h e f ol l ow i n g i s
f al se?
a. The mar ket expect s shor t t er m int er est r at es t o incr ease.
b. The liquidit y pr emium is incr easing wit h incr ease in t enor .
c. Ther e is an excess of demand over supply in shor t er mat ur it ies.
d. The int er est r at es ar e posit ively r elat ed t o t er m, along t he yield
cur ve.

Answ er : c
191

4. The NSE- ZCYC est i mat e of t h e spot r at e f or t h e t er m 7 . 2 8 7 6 y ear s
i s 9 . 1 6 4 8 % . Wh at i s t h e di scou n t ed v al u e of a cash f l ow of Rs. 1 0 0 ,
r ecei v abl e at t h e en d of t h at t er m?

An sw er :
We can use t he ZCYC est imat es t o arrive at t he discount ed value of any cash
flow, by using t he formula:
}
100
* ) , (
exp{ ) , (
m b m r
b m d

Ther ef or e t he discount f act or t o be applied t o t he cash f low of Rs. 100,
r eceivable at t he end of 7. 2876 year s is ( Excel r ecognises t he t er m exp i n t he
for mula)
= exp ( ( - 9. 1684 * 7. 2876) / 100)
= 0. 512787

Ther efor e, t he discount ed value of Rs. 100 will be
= 100* 0. 5128
= Rs. 51.2787

5 . Th e f ol l ow i n g t er m st r u ct u r e of i n t er est r at es i s gi v en t o y ou :

Ten or
( i n
y ear s)
Yi el d
( % p. a. )
0.30 7. 0257
0.35 7. 0487
0.40 7. 0847
0.45 7. 1589
0.50 7. 1905
0.55 7. 2025
0.60 7. 2368
0.65 7. 2604
0.70 7. 2928
0.75 7. 3138
0.80 7. 3388
0.85 7. 3704
0.90 7. 3939
0.95 7. 4181
1.00 7. 4379

192
On 1 5 t h Ju n e 2 0 0 1 , y ou ar e r eq u i r ed t o v al u e a b on d w i t h a cou p on of
1 1 . 0 4% , m at u r i n g on 1 0- Ap r - 2 0 0 2 . Th e f ace v al u e of t h e bon d i s Rs.
1 0 0 . Gi v en t h e y i el d cu r v e i n f or mat i on i n t h e t abl e abov e, w h at i s t h e
v al u e of t h e bon d? ( Use l i n ear i n t er pol at i on t o f i n d di scou n t i n g r at es
f or each of t h e compon en t cash f l ow s) .

An sw er :
We have t o first find t he cash flows of t he bond up t o t he dat e of mat urit y,
and t he dist ance in year s of each of t he cash f lows t o t he set t lement dat e.
We use t he coupncd funct ion and find t hat t here are 115 days t o t he first
coupon and 295 days t o t he next coupon, which t r anslat e int o 0. 319444 year s
and 0. 819444 year s r espect ively.
The discount r at e f or t hese t wo t enor s can be f ound wit h by int er polat ion
fr om t he t er m st r uct ur e infor mat ion t hat is given in t he t able above.
The r at e for t he t enor of 0. 319444 year s can be found by linear int er polat ion
bet ween t he t enor s 0. 3 and 0. 35 year s, as f ollows:
= 7. 0257+ ( 7. 0487- 7. 0257) * ( 0. 31944 0. 3) / ( 0. 35- 0.3)
= 7. 0346%

Similar ly t he r at e for t he t enor of 0. 819444 can be found by int er polat ion
bet ween t he t enor s 0. 8 and 0. 85 year s, as follows:
= 7. 3388 + ( 7. 3704 - 7. 3388) * ( 0. 81944 0. 8) / ( 0. 85- 0.8)
= 7. 3511%

We can now value t he bond by discount ing t he cash f lows using t hese r at es,
as follows:
81944 . 0 31944 . 0
) 073511 . 1 (
52 . 105
) 070346 . 1 (
52 . 5
+
= Rs. 104. 9627

This is t he value of t he bond, comput ed by discount ing each cash flow by t he
int er polat ed yield f r om t he t er m st r uct ur e of int er est r at es.
193
CHAPTER 15
DURATI ON

Dur at ion, as t he name suggest s is, in a simple f r amewor k, a measur e of t ime,
t hough it s applicat ions in under st andi ng t he pr i ce- yield relat ionship are more
int ense. We shall begin wit h t he simple definit ion, and lat er illust r at e t he
alt er nat e applicat ions, including modified dur at ion and PV01.

15.1 I NTRODUCTI ON AND DEFI NI TI ON

I n t he case of bonds wit h a fixed t er m t o mat ur it y, t he t enor of t he bond is a
simple measur e of t he t ime unt il t he bond' s mat ur it y. However , if t he bond is
coupon paying, t he invest or receives some cash flows prior t o t he mat urit y of
t he bond. Ther efor e it may be useful t o under st and what t he average
mat ur it y of a bond, wit h int er mit t ent cash f lows is. I n t his case we would f ind
out what t he cont r ibut ion of each of t hese cash flows is, t o t he t enor of t he
bond. I f we can comput e t he weight ed aver age mat ur it y of t he bond, using
t he cash flows as weight s, we would have a bet t er est imat e of t he t enor of
t he bond. Since t he coupons accr ue at var ious point s in t ime, it would be
appropriat e t o use t he present value of t he cash flows as weight s, so t hat
t hey ar e compar abl e. Ther ef or e we can ar r ive at an alt er nat e measur e of t he
t enor of a bond, account ing for all t he int er mit t ent cash flows, by finding out
t he weight ed aver age mat ur it y of t he bond, t he pr esent value of cash flows
being t he weight age used. This t echnical measur e of t he t enor of a bond i s
called dur at ion of t he bond.

Let s us at t empt an int uit ive under st anding of dur at ion, wit h t he help of an
example. Suppose one had t wo opt ions:

Buy bond A selling at Rs. 100. 25 wit h 1 year t o mat ur it y. The r edempt ion
value of t he bond is Rs. 110. 275.
Buy bond B, also selling at Rs. 100. 25, and 1 year t o mat urit y. However,
t he bond pays Rs. 50. 5 at t he end of 6 mont hs, and Rs. 57. 5 at t he end of
1 year , on mat ur it y.

Bot h t hese bonds have t he same t enor of 1 year, and are priced at t he same
yield 10%. Would one t her ef or e be indif f er ent bet ween t he t wo opt ions? Why
not ?

194
I nt uit ively, we seem t o pr ef er opt ion ( b) t o opt ion ( a) , because we r eceive
some cash flows ear lier , in t he second case. I n ot her wor ds, t hough t he t wo
opt ions are for 1 year s t enor , we int uit ively under st and t hat t he second
opt ion places some funds ear lier t han a year wit h us, and t her efor e must
have an aver age mat ur it y of less t han 1 year . I f we ar e able t o comput e
what per cent age of f unds, in pr esent value t er ms is available t o us, in t he
case of bond B, we can under st and what t he aver age mat ur it y of bond B is.
We at t empt doing t hat in Table 15. 1.

The 2 cash f lows accr uing at t he end of 6 mont hs and 1 year have dif f er ent
present values. At a discount ing rat e of 5% ( bond equivalent yield of 10% f or
half year ) , t he cash f lows pr esent values ar e Rs. 48. 1 and Rs. 52. 15
r espect ively.

This present value cash flow st ream act ually means t hat 48% of t he bonds
cash flows accrue at t he end of 6 mont hs, and 52% of cash flows accrue at
t he end of 1 year . ( Not e t hat t he sum of t he cash f lows is t he cur r ent value
of t he bond, i. e. Rs. 100. 25; and t he sum of t he weight s of t he cash flows
adds up t o 1) . I f we apply t hese weight s t o t he per iod associat ed wit h t he
cash f low, we know t hat t he weight ed mat ur it y of t he bond is 1. 52 half year s,
or 0. 76 years.

This is why we seem t o pr efer bond B, whose aver age mat ur it y is act ually less
t han a year. The durat ion of t his bond is 0. 76 years. I n t he case of bond A,
all t he cash flows accrue at t he end of t he year. Therefore, t he durat ion of
t he bond is also 1 year.

I n any bond wit h int er mit t ent cash f lows accr uing pr ior t o mat ur it y, t he
average mat urit y will be lesser, and durat ion is a measure of t his average
mat ur it y of a bond.

Tabl e 1 5 . 1 : Wei gh t ed Pr esen t Val u es an d Du r at i on
Per i od Cash
f l ow
( Rs. )
Pr esent
val ue
of cash
f l ow ( Rs. )
Wei g h t of
t h e
pr esen t
val ue
Wei gh t ed
t en or of t h e
b on d ( Year )
1 50. 5 48. 10 0.48 0.48
2 57. 5 52. 15 0.52 1.04
Tot al 100. 25 1 . 0 0 0 1.52
Du r at ion 1. 52/ 2= 0. 76 y r s

195
15.2 CALCULATI NG DURATI ON OF A COUPON PAYI NG
BOND

Fr edr ick Macaulay, in 1938, f ir st pr opounded t he idea of dur at ion, and we call
his measur e as Macaulays dur at ion. Macaulay dur at ion in year s

n
i
t
pvtcf k
pvcf t
1
. ( 15.1)

Wher e k = number of payment s per year ( in t he case of semiannual coupon
paying bonds, k = 2)

n = number of periods unt il mat urit y ( years t o mat urit y x k)

t = per iod in which cash flow is expect ed t o be r eceived ( t = 1, 2, n)

pvcf
t
= present value of t he cash flow in period t discount ed at t he yield t o
mat ur i t y

pvt cf = Tot al pr esent val ue of t he cash f l ows of t he bond, di scount ed at t he
bonds yield t o mat ur it y ( t his would act ually be t he pr ice of t he bond) .

The above equat ion can also be st at ed as

( 1xPVCF
1
+ 2xPVCF
2
+ 3xPVCF
3
. + nxPVCF
n
) / ( k x PVTCF) ( 15. 2)

Let us consider an example. See Table 15. 2. Column 1 list s t he per iod in
which t he cash flows accrue. Column 2 is t he list of cash flows, which in t his
case ar e t he coupons f or al l t he per iods, except t he last one, when t he
coupon and r edempt ion amount ar e due. Column 3 is t he pr esent value of
each of t he cash f l ows, di scount ed f or t he appr opr i at e per i od, at t he YTM r at e
of 9%. ( 4. 5% on a semiannual basis) . For example, Rs. 5. 26 is t he
discount ed value of Rs. 5. 5 r eceivable in six mont hs, discount ed at t he r at e of
4. 5%.

The sum of t he pr esent values is Rs. 107. 91 which is t he value of t he bond at
a YTM of 9%. Column 4 pr ovides t he weight ed value of t he pr esent values,
by comput ing t he pr oduct of t he pr esent values and t he per iod in column 1.
Durat ion of t he bond is t he sum of t hese weight ed values divided by t he sum
of t he pr esent value of t he cash flows. 8. 039 is t he dur at ion in half - year s.
Therefore durat ion in years is 8. 039/ 2, which is 4. 02 year s.

196
Tabl e 1 5 . 2 : Du r at i on of a 5 y ear 1 1 % bon d, at a YTM of 9 %
Per i od Cash
f l ow s
( Rs. )
Pr esent
Val u e of
Cash Fl ow s
( Rs. )
Wei gh t ed
Pr esent
Val ues
( a)

Wei gh t ed
Cash
Fl ow s
( b)

Dur at i on
( c)

1 5. 5 5.26 5. 263 0. 049 0. 049
2 5. 5 5.04 10. 073 0. 047 0. 093
3 5. 5 4.82 14. 459 0. 045 0. 134
4 5. 5 4.61 18. 448 0. 043 0. 171
5 5. 5 4.41 22. 067 0. 041 0. 204
6 5. 5 4.22 25. 341 0. 039 0. 235
7 5. 5 4.04 28. 291 0. 037 0. 262
8 5. 5 3.87 30. 940 0. 036 0. 287
9 5. 5 3.70 33. 309 0. 034 0. 309
10 105. 5 67. 93 679. 344 0. 630 6. 295
Tot al 107. 91 8 6 7 . 5 3 5 1.00 8.04
Dur at i on = 8 . 0 4 / 2 =
4. 02 y r s
( a)
Present Value in column ( 3) t imes period in column ( 1) .
( b)
Pr esent Value in column ( 3) as fr act ion of Tot al pr esent value.
( c)
Weight ed Cash flows in column ( 5) t imes per iod in column ( 1) .

We can ar r i ve at t he same r esul t by f i ndi ng out t he wei ght of each of t he
discount ed cash f lows t o t he t ot al, and applying t his weight t o t he per iods in
which cash flows accr ue. I n column 5 we find t he pr opor t ion of cash flows
accruing in each of t he periods, t o t he t ot al cash flows. Durat ion is t he sum
pr oduct of t hese weight s, mult iplied by t he per iod in column 1, and summed
up. We ar r ive at t he same value of 4. 02 year s. We also not ice what
pr opor t ion of t he cash flows of t he bond accr ue in each of t he per iods, in
column 5. Only 63% of t he bonds cash flows accr ue in 5 years.
15.3 COMPUTI NG DURATI ON ON DATES OTHER THAN
COUPON DATES

I n t he example above, we had comput ed dur at ion, discount ing t he cash flows
f or whole per iods, as we had assumed t hat t he calculat ions ar e made at t he
beginning of t he cash f low st r eam. I n realit y, we should be able t o comput e
dur at ion on any day when a bond is out st anding. I n or der t o do t his, t he
197
f r act ional per iods r epr esent ing t he dist ance of each of t he cash f low f r om t he
dat e of mat ur it y will have t o be calculat ed, and t he discount ing of cash flows
done f or t hese f r act ional per iods. As in t he case of yield and pr ice
calculat ions, t he day count convent ion in t he mar ket should be known, apar t
f r om t he set t lement and t he mat ur it y dat es. We could t hen use t he Excel
f unct ion Dur at ion.

Box 1 5 . 1 : Fu n ct i on Du r at i on
I n or der t o use Excel t o comput e t he dur at i on of a bond on any gi ven
set t lement dat e, we pr ovide t he following values:
Set t lement dat e: t he dat e on which we want t o comput e t he dur at ion, in dat e
format
Mat ur i t y dat e: t he dat e on which t he bond would redeem, in dat e format
Coupon: Coupon of t he bond, as a r at e
Yield: YTM of t he bond, as a r at e
Fr equency: Fr equency of payment of coupons per year , 2 f or semi annual
bonds
Basis: Day count convent ion in t he market . 4 for Eur opean 30/ 360
convent ion.
Excel will ret urn t he durat ion of t he bond in years.

Tabl e 1 5 . 3 Du r at i on of Sel ect G- Secs on Mar ch 2 9 , 2 0 0 1
Name Coupon
( % )
Mat ur i t y
Dat e
Ter m t o
Mat ur i t y
( y r s)
Pr i ce
( Rs.)
Yi el d t o
Mat ur i t y
Dur at i on
( y r s)
CG2001 11. 75 25-Aug-01 0. 41 101. 00 0. 09092 0. 406
CG2002 11. 15 9-Jan-02 0. 78 102. 75 0. 07413 0. 752
CG2003 11. 10 7-Apr-03 2. 02 103. 52 0. 09154 1. 779
CG2004 12. 50 23-Mar-04 2. 98 108. 31 0. 09247 2. 593
CG2005 11. 19 12-Aug-05 4. 37 106. 19 0. 09422 3. 554
CG2006 11. 68 10-Apr-06 5. 03 107. 58 0. 09736 3. 794
CG2007 11. 90 28-May-07 6. 16 109. 31 0. 09843 4. 457
CG2008 11. 40 31-Aug-08 7. 42 107. 60 0. 09924 5. 239
CG2009 11. 99 7-Apr-09 8. 02 109. 18 0. 10281 5. 217
CG2010 11. 30 28-Jul-10 9. 33 106. 60 0. 10182 6. 006
CG2011 12. 32 29-Jan-11 9. 83 110. 97 0.10499 6. 054
CG2013 12. 40 20-Aug-13 12. 39 111. 00 0. 10740 6. 849

Not ice t hat t he dur at ion of t he 2013 12. 40 secur it y is only 6. 85 year s, while
it s t erm t o mat urit y is 12. 58 years.

The basic r elat ionship bet ween coupon, t er m t o mat ur it y and t he yield and
dur at ion can be int uit ively under st ood, by viewing dur at ion as t he fulcr um
t hat balances t he pr esent value of cash flows of a bond. I f we view t he
pr esent val ues of t he cash f l ows f r om a bond, as wei ght s pl aced on a scal e,
dur at ion r epr esent s t he fulcr um which would balance t hese weight s on t he
t ime scale. We have diagr ammat ically r epr esent ed t his in Figur e 15. 3. which
198
pr esent s t he cash f lows of a 11%, 5- year bond, semi annual coupons, selling
at YTM of 11%. The durat ion of t his bond is 4. 02 years. I f we can imagine
t hat t her e is a f ulcr um at 4. 02 on t he gr aph, we could begin t o see how t he
f ulcr um would behave f or changes in t he f act or s inf luencing dur at ion. An
incr ease in t he t er m would mean mor e number of bar s on t he char t . The
f ulcr um would move t o t he right . Higher t he t erm, great er is t he durat ion. I f
t he coupon rat es were higher, t he size of each of t he bars would be higher.
The fulcr um would t hen move left . Dur at ion and coupon ar e inver sely
r elat ed. Higher t he coupon, lower t he dur at ion. I f t he yield at which we
discount t he cash f low incr eases, t he size of t he bar s would decr ease. The
fulcr um would move t o t he left . Yield and dur at ion ar e inver sely r elat ed.

Fi gu r e 1 5 . 3 : Pr esen t v al u e of Cash Fl ow s on t h e Ti me Scal e
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
1 2 3 4 5 6 7 8 9 10
Year s
P
r
e
s
e
n
t

V
a
l
u
e

o
f

C
a
s
h

F
l
o
w
s

Apar t f r om t hese f act or s, dur at ion is also impact ed by t he st r uct ur e of t he
bond. A bond wit h sinking fund provisions would have a lower durat ion, as a
higher per cent age of t he cash f lows of t he bond would accr ue bef or e
mat ur it y. Similar ly, callable bonds have shor t er dur at ion t han ot her wise
compar abl e non- callable bonds. Call opt ions r educe t he out st anding mat ur it y
per iod of a bond. Est imat ing t he dur at ion of a callable bond is, however ,
compl i cat ed by t he need t o est i mat e t he pr obabi l i t y t hat t he opt ion will be
exercised.
15.4 MODI FI ED DURATI ON

Though int uit ively we have known dur at ion as t he weight ed aver age t er m t o
mat ur it y of a bond, an alt er nat e explanat ion which looks at dur at ion as t he
appr oximat ion of t he slope of t he pr ice- yield relat ionship, is signif icant , and
has impor t ant applicat ions. We have known t hat a bonds r ealized yield is
impact ed by coupon, t er m t o mat ur it y and yield. Dur at ion is a single
measur e appr oximat ion of t he impact of all of t hese t hr ee f act or s, on t he
199
price of a bond, for a given change in yield. Therefore, durat ion is an
impor t ant measur e of sensit ivit y of a bond t o changes in under lying yield, and
hence t he int erest rat e risk of a bond.

The price of a bond is t he present value of t he cash flows associat ed wit h t he
bond, and can be r epr esent ed as

n
n
n
t
t
t
r
C
r
C
r
C
r
C
P
) 1 (
.........
) 1 ( ) 1 ( ) 1 (
2
2 1
1
+ +
+
+
. . ( 15. 3)

I n order t o underst and how price changes for a small change in yield, we can
t ake t he f ir st der ivat ive of t he above equat ion wit h r espect t o r , t o get t he
following equat ion:

1
]
1
+
+
+
+
+ +
n
n
r
nC
r
C
r
C
r dr
dP
) 1 (
.......
) 1 (
2
) 1 ( ) 1 (
1
2
2
1
1
. ( 15. 4)

This equat ion comput es t he absolut e change in t he pr ice of a bond f or a given
change in yield. I n or der t o conver t t he same int o a per cent age change in
pr ice f or a per cent age change in yield, we divide bot h sides of equat ion by t he
bond pr ice, as f ollows:

P r
nC
r
C
r
C
r P dr
dP
n
n
1
.
) 1 (
.......
) 1 (
2
) 1 ( ) 1 (
1 1
.
2
2
1
1
1
]
1
+
+
+
+
+ +
. . ( 15. 5)

The t er m on t he r ight hand side of t he above equat ion can be r ewr it t en as
=
r
Duration
+
1
( 15.6)

This f or mula r epr esent s t he per cent age change in pr ice of a bond, for small
changes in yield. This measur e is known as t he modif ied dur at ion of a bond.
We can st at e t his r elat ionship in a gener alized for m as
% change in price of a bond = Modified durat ion * % change in yield

For example, for a bond wit h a modified durat ion of 7. 5, a 50 basis point
change in yield will result in a 7. 5 * 50/ 100 = 3. 75% change in price, in t he
opposit e direct ion ( not ice t he minus sign in t he equat ion, signifying t hat t he
change in pr ice is in t he opposit e dir ect ion of t he change in yield - yield and
pr ice ar e inver sely r elat ed) . I f t he yield is semiannual, we use half t he yield
in t he equat ion.
200
Modified durat ion is t he slope of t he line in t he priceyield funct ion, and for
small changes in t he yield of a bond, modif ied dur at ion indicat es t he
percent age change in price t hat can be expect ed. Modified durat ion is,
t her ef or e, a dir ect measur e of t he int er est r at e sensit ivit y of a bond. Higher
t he modified durat ion of a bond, great er t he percent age change in price for a
given change in yield.

Box 1 5 . 4: Modi f i ed Du r at i on Fu n ct i on
I n or der t o use Excel t o comput e t he modified dur at ion of a bond on any
given set t lement dat e, we use t he f unct ion Mdurat ion, and pr ovi de t he
following values:
Set t lement dat e: t he dat e on which we want t o comput e t he modified
durat ion, in dat e format
Mat ur it y dat e: t he dat e on which t he bond would r edeem, in dat e for mat
Coupon: Coupon of t he bond, as a r at e
Yield: YTM of t he bond, as a r at e
Fr equency: Fr equency of payment of coupons per year , 2 f or semi annual
bonds
Basis: Day count convent ion in t he mar ket . 4 for Eur opean 30/ 360
convent ion.
Excel will ret urn t he modified durat ion of t he bond in years.

I t has t o be remembered t hat modified durat ion will provide close
appr oximat ion of t he act ual change in pr ices, f or small changes in yield. For
lar ge changes in yield, however , t he f ir st or der der ivat ive, which is modif ied
dur at ion, is inadequat e.

Tabl e 1 5 . 4 : Modi f i ed Du r at i on of a Set of Bon ds
Name Coupon
( % )
Mat ur i t y
Dat e
Ter m t o
mat ur i t y
( y r s)
Pr i ce on
Mar ch 29,
2001 ( Rs.)
YTM ( % ) Modi f i ed
Dur at i on
( Yr s)
CG2001 11. 75 25-Aug-01 0. 41 101 0. 09092 0. 388
CG2002 11. 15 9-Jan-02 0. 79 102. 75 0. 07413 0. 725
CG2003 11.1 7-Apr-03 2. 05 103. 52 0. 09154 1. 701
CG2004 12.5 23-Mar-04 3. 03 108. 31 0. 09247 2. 479
CG2005 11. 19 12-Aug-05 4. 44 106. 19 0. 09422 3. 394
CG2006 11. 68 10-Apr-06 5. 11 107. 58 0. 09736 3. 618
CG2007 11.9 28-May-07 6. 25 109. 31 0. 09843 4. 248
CG2008 11.4 31-Aug-08 7. 53 107. 6 0. 09924 4. 991
CG2009 11. 99 7-Apr-09 8. 14 109. 18 0. 10281 4. 962
CG2010 11.3 28-Jul-10 9. 47 106.6 0. 10182 5. 715
CG 2011 12. 32 29-Jan-11 9. 98 110. 97 0. 10499 5. 752
CG2013 12.4 20-Aug-13 12. 58 111. 2 0. 10740 6. 500

Not ice t hat modified dur at ion is lower t han dur at ion of t he same set of bonds,
comput ed in t he beginning of t his chapt er . Tables 15. 4 and 15. 5 illust r at e t he
applicat ion of modified dur at ion t o measur ing t he int er est r at e sensit ivit y of
bonds.
201
The modified dur at ion of t hese bonds will pr ovide input s for under st anding
t he int er est r at e sensit ivit y of t he bonds. We change t he yield of t hese bonds
by 10bps ( as for lar ge change in yield modified dur at ion is inadequat e, we
have consi der ed 10 bps change i nst ead of 50 bps, so t hat answer wi l l come
correct ) , and re- comput e t he value of t he bonds, in Table 15. 5.
Tabl e 1 5 . 5 : I n t er est Rat e Sen si t iv i t y of a Set of Bon ds- Usi ng Modi f i ed
Dur at i on
Ol d pr i ce
of t he
bon d
( Rs. )
Modi f i ed
Du r at i on
( Yr s)
New y i el d
( + 10 bp)
( % )
New
Pr i ce
( Rs. )
Act u al %
ch an ge i n
pr i ce
% Ch an ge i n
pr i ce
compu t ed w i t h
mdu r at i on
101 0. 388 0. 09192 100. 960 0. 0395 0. 0388
102. 75 0. 725 0. 07513 102. 674 0. 0742 0. 0725
103. 515 1. 701 0. 09251 103. 335 0. 1786 0. 1701
108. 31 2. 479 0. 09347 108. 041 0. 2480 0. 2479
106. 19 3. 394 0. 09522 105. 825 0. 3433 0. 3394
107. 58 3. 618 0. 09836 107. 172 0. 3793 0. 3618
109. 31 4. 248 0. 09943 108. 830 0. 4391 0. 4248
107. 6 4. 991 0. 10024 107. 060 0. 5020 0. 4991
109. 18 4. 962 0. 10381 108. 612 0. 5204 0. 4962
106. 6 5. 715 0. 10282 105. 982 0. 5795 0. 5715
110. 97 5. 752 0. 10599 110. 322 0. 5835 0. 5752
111. 2 6. 500 0. 10840 110. 472 0. 6547 0. 6494

We can use t he same set of bonds t o illust r at e how modified dur at ion helps
est imat e changes in t he price of bonds for a given change in yield. We have
used t he same set of bonds in t he Table 15. 3, but changed t he yield by 10
basis point s ( column 3 in t he t able 15. 4) . The new pr ice f or t he now changed
yield is comput ed and post ed in column 4. The act ual per cent age change in
pr ice, f or a 10 bp change in yield is in column 5. The per cent age change in
pr ice, comput ed wit h modified dur at ion ( Mdur at ion * basis point change in
yield/ 100) is in t he last column. Not ice t hat t he number s in t he last 2
columns ar e fair ly compar able.
15.5 RUPEE DURATI ON

Modified dur at ion pr ovides a measur e of per cent age change in pr ice, for a
per cent age change in yield. However t wo bonds wit h t he same measur e of
modified durat ion will change in value, in rupee t erms, in much different
manner , depending on t he pr ice at which t hey ar e t r ading. Consider Table
15. 5. The rupee change in value of t he bond is different across t he bonds,
and is a funct ion of bot h modified dur at i on and t he pr i ce.

202
Ther ef or e r upee pr i ce change can be cal cul at ed as:
Modif ied dur at ion * yield change ( in basis point s) * r upee pr ice of t he bond.
We can st andar dize t he expect ed pr ice change in r upee t er ms, f or a 100 basis
point change in yield as

Modif ied dur at ion * 0. 01( 100 basis point s) * r upee pr ice of t he bond.

This value is called t he dollar ( r upee) dur at ion of a bond, and is compar able
acr oss bonds selling at var ious pr ices. Table 15. 6 shows t he r upee dur at ion of
a set of bonds. Rupee dur at ion r epr esent s t he change in pr ice for a 100 basis
poi nt change i n yi el d. ( Fr om t he dat a on t he bonds t hat i s avai l abl e, cal cul at e
act ual change in pr ice f or a 100bp change in yield, and compar e t he same
wit h value in t he last column in t he t able15. 6) .

Tabl e 1 5 . 6 : Ru pee Du r at i on of Bon ds
Name Cou pon
( % )
Pr i ce ( Rs. ) Mdu r at i on
( Yr s)
Rupee
Dur at i on
CG2001 11. 75 101 0. 388 0. 391799
CG2002 11. 15 102. 75 0. 725 0. 744885
CG2003 11. 1 103. 515 1. 701 1. 760554
CG2004 12. 5 108. 31 2. 479 2. 684794
CG2005 11. 19 106. 19 3. 394 3. 604203
CG2006 11. 68 107. 58 3. 618 3. 892417
CG2007 11. 9 109. 31 4. 248 4. 643677
CG2008 11. 4 107. 6 4. 991 5. 370745
CG2009 11. 99 109. 18 4. 962 5. 417223
CG2010 11. 3 106. 6 5. 715 6. 09217
CG 2011 12. 32 110. 97 5. 752 6. 383322
CG2013 12. 4 111. 2 6. 500 7. 227553

Pr i ce Val u e of a Basi s Poi n t ( PV0 1 )

Anot her impor t ant var iat ion t o t he r upee dur at ion, which is used ext ensively
in pract ice, is t he price value of a basis point ( known commonly as PVBP or
PV01) . The PV01 of a bond is t he r upee value of change in pr ice of a bond,
for a 1 basis point change in yield.
PV01 is calculat ed as

Modif ied dur at ion * Pr ice of t he bond* 0. 01/ 100.

PV01 is also = Rupee Durat ion of a bond/ 100.

PV01 of a bond is a number t hat can be applied for any ant icipat ed change in
yield, t o ascer t ain t he change in pr ice value. I n t able 15. 6, t he last column
has t o be divided by 100, t o obt ain t he PV01 of each of t he bonds. I n
203
pr act ice, PV01 is ext ensively used in ascer t aining t he pr ice sensit ivit y of a
por t folio. PV01 of a por t f olio is t he por t f olios modif ied dur at ion t imes t he
market value of t he port folio, mult iplied by t he value 0. 0001.
PV01 is a useful number in buying hedge product s for a port folio. The payoff
f r om a hedge has t o mat ch t he PV01 of t he por t f olio, t o enable ef f ect ive
hedging.

15.6 PORTFOLI O DURATI ON

The dur at ion of a por t f olio of bonds can be comput ed in t wo ways:

( a) Map t he cash flows of t he bond int o var ious t er m bucket s, when t hey ar e
due, and using yield of t he por t f olio, discount t he t ot al cash f lows of t he
por t f olio. Comput e dur at ion wit h t he usual f or mula, t r eat ing t he aggr egat e
cash flows as if t hey wer e a single bond.

( b) Comput e t he weight ed dur at ion of a por t folio, using t he mar ket value of
t he bond as t he weight age.

Though ( a) i s concept ually sound, it is a comput at ionally int ensive pr ocedur e.
Ther ef or e in pr act ice ( b) is a mor e commonly used appr oach t o det er mine t he
durat ion of a port folio.

Consider t he set of bonds we have been using in t his chapt er . Table 15. 7
shows t he durat ion of a port folio t hat holds one each of all t he bonds. ( The
weight ages can be changed f or any quant it y holding in each of t he bond.
What we r equir e f or comput at ion is t he mar ket value of t he por t f olios
exposur e t o a given bond, as a pr opor t ion of t he tot al market value of t he
por t folio) .

) (
1
i
N
i
i P
W D Dur

. . ( 15. 7)

Dur at ion of a por t f olio is t he sum pr oduct of dur at ion of each secur it y in t he
por t folio ( D
i
) t imes t he proport ion of t he securit y t o t ot al port folio value ( as a
decimal) ( W
i
) .

204

Tabl e 1 5 . 7 : Du r at i on of a Por t f ol i o of Bon ds
Name Cou pon
( % )
Pr i ce ( Rs. ) Du r at i on
( Yr s)
Wei ght s Wei gh t ed
Dur at i on
CG2001 11. 75 101. 00 0. 4056 0. 079 0. 032
CG2002 11. 15 102. 75 0. 7518 0. 080 0. 060
CG2003 11. 10 103. 52 1. 7786 0. 081 0. 143
CG2004 12. 50 108. 31 2. 5934 0. 084 0. 219
CG2005 11. 19 106. 19 3. 5540 0. 083 0. 294
CG2006 11. 68 107. 58 3. 7943 0. 084 0. 318
CG2007 11. 90 109. 31 4. 4572 0. 085 0. 379
CG2008 11. 40 107. 60 5. 2391 0. 084 0. 439
CG2009 11. 99 109. 18 5. 2168 0. 085 0. 444
CG2010 11. 30 106. 60 6. 0059 0. 083 0. 499
CG 2011 12. 32 110. 97 6. 0543 0. 086 0. 523
CG2013 12. 40 111. 20 6. 8486 0. 087 0. 593
Port folio value 1284. 205 Port folio Durat ion 3.942

I n t he t able 15. 7, t he pr opor t ional weight of each bond is comput ed as t he
pr ice of t he bond divided by t he val ue of t he por t f ol i o ( i n t hi s case t he sum of
t he pr i ces of al l t he bonds, as we assume t hat we hol d one bond each) . For
example, t he value 0. 079 = 101/ 1284. 205. The last column applies t hese
pr opor t ions t o t he dur at ion of each bond. The dur at ion of t he por t f olio is t he
sum of t he l ast col umn, whi ch i s t he wei ght ed dur at i on of al l t he bonds i n t he
por t folio.
We can comput e modified durat ion also in a similar manner, using market
values of t he bonds as weight s. We can t hen est imat e t he int er est rat e
sensit ivit y of t he por t f olio. The modif ied dur at ion of t his por t f olio of bonds can
be comput ed, using t he mdur at ion f unct ion, and using t he value weight s as in
t he case of por t f olio dur at ion.

Table 15. 8 shows t he modified dur at ion of t his por t folio, which is 3. 754. We
have also t aken fr om our ear lier illust r at ion of pr ice sensit ivit y, t he new pr ices
of bonds, when int er est r at es incr ease by 10 basis point s.
We see t hat t he value of t he por t f olio has f allen t o Rs. 1259. 906 due t o t his
change i n rat es. I n per cent age t er ms, t his change is 0. 383%. Given t he
por t f olios modif ied dur at ion of 3. 754, we can expect f or a 10 basis point
change in yield, a pr ice change of 3. 754 * 0. 1 = 0. 375%

Modif ied dur at ion of t he por t f olio t hus pr ovides a close appr o ximat ion of t his
change in pr ice.

205

Tabl e 1 5 . 8 : Modi f i ed Du r at i on of a Por t f ol i o
Name Coupon
( % )
Pr i ce
( Rs.)
Modi f i ed
Dur at i on Wei gh t
Wei ght ed
Mdur at i on
New Pr i ce
( a)

CG2001 11. 75 101. 00 0. 388 0. 079 0. 031 100. 9601
CG2002 11. 15 102. 75 0. 725 0. 080 0.058 102. 6738
CG2003 11. 10 103. 52 1. 701 0. 081 0. 137 103. 3351
CG2004 12. 50 108. 31 2. 479 0. 084 0. 209 108. 0414
CG2005 11. 19 106. 19 3. 394 0. 083 0. 281 105. 8254
CG2006 11. 68 107. 58 3. 618 0. 084 0. 303 107. 1719
CG2007 11. 90 109. 31 4. 248 0. 085 0. 362 108. 8300
CG2008 11. 40 107. 60 4. 991 0. 084 0. 418 107. 0598
CG2009 11. 99 109. 18 4. 962 0. 085 0. 422 108. 6118
CG2010 11. 30 106. 60 5. 715 0. 083 0. 474 105. 9823
CG 2011 12. 32 110. 97 5. 752 0. 086 0. 497 110. 3225
CG2013 12. 40 111. 20 6. 500 0. 087 0. 563 110. 4720
Tot al 1284.205
Por t f ol i o Modi f i ed
Dur at i on 3.754 1 2 7 9 . 2 8 6 1
( a)
Pr ice assuming 10 basis point incr ease in yield.

15.7 LI MI TATI ONS OF DURATI ON

Durat ion is not a st at ic propert y of a bond. Durat ion of a bond changes over
t ime, and wit h changes in market yields. Any st rat egy based on durat ion
values of a bond will, t her efor e, r equir e dynamic t uning.
Comput ing dur at ion involves t he discount ing of cash f lows of a bond. I t is
common t o use t he YTM of t he bond, as t he rat e at which cash flows are
discount ed. Ther ef or e, t he limit at ions of YTM ext end t o t he comput at ion of
dur at ion.
We use durat ion based on t he view t hat equal changes in int erest rat es occur
acr oss var ious t er ms. I n ot her wor ds, when we measur e change in yield
and use durat ion t o est imat e c hange in price , we assume t hat t he given
change in yield occur s acr oss t he t enor spect r um. This act ually t r anslat es int o
an assumpt ion of par allel shif t s in t he yield cur ve, which is not a ver y r ealist ic
assumpt ion t o make.
Dur at ion is t he fir st der ivat iv e of t he pr i ce- yield funct ion. The r esult s
obt ained by using dur at ion t o measur e pr ice change ar e only an
appr oximat ion of t he act ual pr ice yield r elat ionship, which is not linear , but
convex.

206
Model Quest i ons

1. Th e d u r at i on of a cou p on p ay i n g b on d is al w ay s l ow er t h an i t s
t er m t o m at u r i t y , b ecau se:

a) Since dur at ion is t he measur e of aver age mat ur it y, it has t o be lower
t han t he t enor .
b) Dur at ion measur es t he weight ed mat ur it y, and t her efor e cannot be
compar ed t o t enor of a bond.
c) As long as some cash flows ar e r eceived pr ior t o mat ur it y, t he weight age
of t he t er minal cash f low cannot be 1.

Answ er : c

2. On Ju l y 1 1 , 2 0 0 1 , t h e f ol l ow i n g i s t h e m ar k et v al u e of t h e b on d s
i n y ou r por t f ol i o. ( Assu me equ al h ol di n gs i n al l t h e bon ds) . Wh at i s
t h e du r at i on of t h e por t f ol i o?

Coupon
( % )
Mat ur i t y
dat e
Pr i ce on
11- Ju l - 2 0 0 1
( Rs. )
11. 68 6- Aug- 2002 104. 34
11. 00 23- May- 2003 105. 74
12. 50 23- Mar- 2004 111. 63
11. 98 8- Sep- 2004 111. 8
11. 19 12- Aug- 2005 111. 83
11. 68 10- Apr- 2006 114. 4
11. 90 28- May- 2007 116. 6

Answ er :
We can use t he Yield funct ion t o find t he YTM and t he Durat ion Funct ion t o
comput e dur at ion, as follows:

Coupon
( % )
Mat ur i t y
dat e
Mar k et Pr i ce
on 11- Jul - 2 0 0 1
( Rs.)
YTM
( % )
Dur at i on
( Yr s)
11. 68 6-Aug-2002 104. 34 7.3728% 0. 990695
11. 00 23-May-2003 105. 74 7.6309% 1. 720562
12. 50 23-Mar-2004 111. 63 7.6399% 2. 318881
11. 98 8-Sep-2004 111. 8 7.6917% 2. 653983
11. 19 12-Aug-2005 111. 83 7.7524% 3. 297774
11. 68 10-Apr-2006 114. 4 7.9700% 3. 753991
11. 90 28-May-2007 116. 6 8.2733% 4. 463083
Por t f ol i o Val ue: 776. 34
Por t f ol i o Dur at i on: 2. 781662

207
The port folio durat ion is t he weight ed durat ion of t he bonds, using t he
mar ket values as weight s. I t is comput ed as
Sum pr oduct ( mar ket pr ice, dur at ion) / sum ( mar ket pr ice)
= 2.7816

3 . Usi n g t h e sam e d at a as i n Qu est i on 2 , i f t h e ex p ect at i on i s t h at
y i el d w ou l d i n cr ease by 5 0 basi s poi n t s, w h at w ou l d be t h e ex pect ed
ch an ge i n t h e v al u e of t h e por t f ol i o?

An sw er : We can use t he mdur at i on f unct i on i n Excel , and comput e t he
modified dur at ion of all t he bonds, and find t he por t folio modif ied dur at ion,
using a similar met hod as in Answer 2. We would ar r ive at a number 2. 6763
as t he port folios modified durat ion.
A 50bp increase in yield will reduce t he value of t he port folio by
2. 6763* . 50 = 1. 3381%
I n r upee t er ms t hat would be Rs. 776. 34 * 1. 3381%
= Rs. 10.3888
The por t folio pr ice will r educed by Rs. 10. 3888/ -

208
CHAPTER 16
FI XED I NCOME DERI VATI VES
16.1 WHAT ARE FI XED-I NCOME DERI VATI VES?

Fixed income derivat ives are securit ies t hat derive t heir value from some
bond pr ice, int er est r at e or an under lying bond mar ket var iable. I n t er ms of
volumes globally, t hey account for a maj or proport ion of derivat ives market s.
They ar e impor t ant because t hey enable banks t o separ at e f unding/ liquidit y
decisions fr om int er est - r at e sensi t i vi t y decisions.
16. 1. 1 For w ar d Rat e Agr eement s

Spot Rat es an d For w ar d Rat es
We already have discussed Spot or Zero- Coupon int er est r at es. A spot
int er est r at e is t he int er est r at e on an invest ment st ar t ing t oday and ending
af t er some ( say n) year s. This is a pur e int er est r at e i. e. it is assumed t hat
t her e ar e no coupon payment s bet ween t oday and n year s. This is also t he
yield on a zero coupon bond of t he corresponding mat urit y. I n t he absence of
zer o coupon bonds, t he spot r at es can be est imat ed f r om t he yields on
coupon bear ing bonds by a pr ocess called boot st r apping
A f or war d r at e is t he int er est r at e cont r act ed t oday on an invest ment t hat will
be init iat ed aft er some t ime ( n years) . I n ot her words, t hey are rat es implied
by cur r ent spot r at es for per iods in t he f ut ur e.
Consider t he following example:

Ti me Spot Rat e
( annual i zed)
1 year 6%
2 year 7%
3 year 8%

This means t hat Rs. 100 invest ed t oday will give Rs. 106 at t he end of one
year.

Rs. 100 invest ed t oday will give Rs. ( 100* ( 1+ 7/ 100) 2) t hat is Rs. 114. 49 at
t he end of t wo years and Rs ( 100* ( 1+ 8/ 100) 3) t hat is Rs. 125. 97 at t he end
of t hr ee year s.

209
The quest ion we must ask is as follows:
What would be t he amount I would r eceive on Rs. 100 invest ed aft er one year
at t he end of t wo year s?
Not ice t hat t he payof f f r om t he above i nvest ment woul d come at t he end of
t wo year s f r om t oday.
We can re- cr eat e t he above invest ment s using pr esent int er est r at es. For t he
sake of simplicit y, we assume t hat bid- ask spr eads ar e negligible.
1. Bor r ow t oday in an amount t hat will give Rs. 100 aft er one year. This
amount is Rs. 100/ ( 1. 06) t hat is Rs. 94. 34.
2. I nvest t he same amount f or a per i od of t wo year s. At t he end of t wo
years, t he payoff will be Rs. 94. 34* ( 1. 07) 2 t hat is Rs. 108.
At t he end of one year, Rs. 100 will have t o be paid out for t he first
borrowing. At t he end of t wo years Rs. 108 will flow in. I n t erms of cash
flows, t his is what it looks like:

Not ice t hat at Year 0, t her e is an out f low and inf low of Rs. 94. 34 and hence
t he net f low is zer o. I n ot her wor ds, t he above ser ies of flows is t he same as:

0
Year
1
Year
2
Years
Rs.
108
Rs.
100
Rs.
94.34
Rs.
94.34
0
Year
1
Year
2
Years
Rs.
108
Rs.
100
210
I n ef f ect we have cr eat ed an i nvest ment wher e we wi l l l end Rs. 100 af t er one
year and will get back Rs. 108 af t er t wo year s. This means t hat t he int er est
r at e f r om one year t o t wo years forward is 8%.
I n t he above example, t he 8% int er est r at e is called t he f or war d r at e of
int er est . I n most cir cumst ances, t he for war d r at e of int er est is t he expect ed
spot r at e f or t he cor r esponding per iod.

Wh y i s t h e f or w ar d r at e al so t h e ex p ect ed sp ot r at e?
I f t he mar ket had expect ed t he spot r at e ( fr om 1 t o 2 year s) t o be less t han
t he for war d r at e indicat ed t oday, t hey would have heavily st ar t ed doing t he
above t r ansact ions t o lock in t he gr eat er f or war d r at e. This would have meant
addit ional demand for bor r owing one- year money and lending t wo- year
money. This would have pushed t he one- year spot r at e up and t he t wo- year
spot rat e down t ill t he implied forward rat e was in line wit h market
expect at i ons.

We can si mi l ar l y const r uct t he 2- 3 year forward r at e and t he 1- 3 year forward
r at e.

The r at es would be as follows:

Year Spot r at es
0- 1 6%
0- 2 7%
0- 3 8%

Year For w ar d Rat es
1- 2 8%
2- 3 10%

A point t o be not ed about forward rat es is t hat t hey can never be negat ive.
This applies some r est r ict ions on t he t er m st r uct ur e of t he spot r at es. For
inst ance, t he following t er m st r uct ur e cannot be possible

Year Spot r at es
0- 1 6%
0- 2 7%
0- 3 4%

Thi s i s because comput at i on shows t hat t he 2- 3 year forward rat e is 1. 7%. I f
t he for war d r at e wer e negat ive, one can borrow t hree- year money and invest
it for t wo year s and sit on cash fr om year 2 t o year 3 t o make a r isk fr ee
pr of i t .
211
For mu l a f or compu t at i on of t h e For w ar d Rat e:
I f we have t he n- year spot r at e as R
n
and t he m- year spot r at e as R
m
where
m> n
And we want t o comput e t he f or war d r at e F
mn
from year n t o year m, t hen:
( 1+ R
n
)
n
* ( 1+ F
mn
)
m- n
= ( 1+ R
m
)
m

Using t he above f or mula, F
mn
can be comput ed.
16.2 MECHANI CS OF FORWARD RATE AGREEMENTS

For war d Rat e Agr eement s ( FRAs) ar e over t he count er der ivat ive cont r act s
t hat allow count erpart ies t o lock int o a specified int erest rat e for a fut ure
dat e. The buyer of an FRA locks in a bor r owing r at e while t he seller locks int o
a lending rat e.
Typi cal l y t hese cont r act s ar e st r uct ur ed i n such a way t hat t he di f f erence
bet ween t he mar ket r at e and t he locked- in r at e is set t led.

Consider t he following example:
A and B ent er int o a forward rat e agreement of one year, st art ing one year
fr om t oday, for a not ional amount of Rs. 100. Par t y A is t he buyer i. e. it has
locked int o a bor r owing r at e. The spot int er est r at es in t he mar ket ar e t he
same as t he ones ment ioned in t he ear lier example.

Pr i ci ng
The f ir st quest ion t o ask is: What i s t he most l i kel y r at e at whi ch t he For war d
Rat e Agr eement will be cont r act ed?
The answer is obvious: I t should be t he for war d r at e implied by t odays
int erest rat es from year 1 t o year 2. We have earlier calculat ed t his at 8%. I f
t he cont r act ed FRA r at e is differ ent , t hen one of t he par t ies will car r y out t he
t wo t r ansact ions ment ioned in t he ear lier example and benefit fr om it . This
par t y will have ear ned a r isk- free profit . I t is unlikely t hat t he ot her part y
will allow t hat t o happen.
I n pr act ice, it is slight ly dif f er ent because of bid- ask spr eads bet ween lending
and bor r owing r at es.

Suppose one year has passed by. Now t he one year spot int erest rat e is 7%.
The quest ion now is: Who has benefit ed fr om t he FRA and by how much?
The scenario now is as follows:
1. Par t y A had locked int o a bor r owing st ar t ing t oday and ending one
year f r om now at 8%.
2. Todays rat e is act ually 7%.
This means t hat part y A will lose out 1% at t he end of next year.
I n a t ypical FRA wit h net t ed out cash int erest payment s, t he amount t hat A
would lose will be discount ed at t he pr evailing r at e ( 7%) and set t led. The FRA
is t hen closed out . I t is easy t o wor k out t hat t he par t y t hat is long a FRA
( Bor r ower ) r eceives a payment when t he r at es go up and t he par t y t hat has
sold an FRA ( Lender ) r eceives payment when t he r at es go down.
212
The advant age of net t ing is t hat t he not ional amount s and int er est r at es need
not be act ually exchanged. This causes signif icant r educt ion is cr edit r isk.
However , one will also f ind FRAs t hat ar e in t he nat ur e of act ual lending. I n
I ndia, t her e is some amount of f or war d lending act ivit y bet ween banks and
cor por at es.
16.3 I NTEREST RATE FUTURES

Fut ur es ar e st andar dized For war d cont r act s t hat ar e t r aded on exchanges.
The count er par t in t his case will be t he exchange it self . These ar e cont r act s
on eit her t he level of int er est r at e of specif ied t enor s, or on t he pr ice of bonds
of part icular mat urit y. An example of t he former are t he Euro- Dollar fut ur es
cont r act s t r aded on LI FFE. An example of t he lat t er ar e t he T- Bond fut ures
t r aded on CBOT. I n I ndia, int er est r at e fut ur es have been int r oduced r ecent ly
( June 24, 2003) on NSEI L.

Ther e ar e sever al impor t ant dif f er ences bet ween Fut ur es and For war d
cont r act s:

1. Fut ur es ar e st andar dized and available only f or cer t ain t enor s and
dat es and only on cer t ain int er est r at e benchmar ks. I n t hat sense,
t heir usage i s r est r i ct i ve.
2. Fut ur es ar e t r adable on t he exchange. Hence t hey ar e highly liquid
i nst r ument s.
3. Fut ures are marked t o market daily and t he Profit and Loss on t he
cont r act is paid out , bet ween t he par t icipant and t he exchange.

Uses of FRAs an d Fu t u r es
As wit h any der ivat ives cont r act s, FRAs and fut ur es have t hr ee main uses.
1. Hedging
2. Speculat ion
3. Arbit rage

Hedging:
FRAs and Fut ur es can be used t o r emove uncer t aint y about f ut ur e int er est
r at es and hence r educe t he uncer t aint y of f ut ur e ear nings.
For i nst ance, suppose t he Financial Manager of a company knows t hat t her e is
going t o be a lar ge inflow of cash one year down t he line, which will have t o
be invest ed. He is also uncer t ain about int er est r at es one year down t he line
and want s t o r emove t his uncer t aint y. A ver y good way t o do t his is t o sell a
forward rat e agreement st art ing one year hence. This way, he can lock int o a
for war d r at e t oday it self and r emove t he uncer t aint y.
Speculat ion:
Suppose a speculat or feels t hat int er est r at es ar e going t o fall drast ically in
t he fut ure, t o a great er ext ent t han t hat implied by t he forward rat es. He can
ent er int o a for war d r at e agr eement and r eceive a locked in r at e. He st ands t o
213
benefit if t he r at es indeed fall. However , if t he r at es r ise, he st ands t o lose. I n
t his case, t he speculat or has t aken a view t hat t he r at es will fall. I t is in t his
sense t hat For war ds and Fut ur es ar e j ust like wager s on t he f ut ur e levels of
int er est r at es.

Sal i ent Poi nt s
1. A forward rat e is t he int erest rat e on an invest ment t o be made at
some point in t he fut ur e.
2. A For war d Rat e Agr eement is an over t he count er For war d cont r act
bet ween t wo par t ies f or a specif ied int er est r at e at some point in t he
fut ur e.
3. I nt erest Rat e Fut ures are st andardized forward cont ract s on int erest
r at es t hat are t r aded on an exchange.
4. For war d Rat e Agr eement s and I nt er est Rat e Fut ur es cont r act s can be
used for hedging and speculat ion.
16.4 I NTEREST RATE SWAPS

Wh at ar e i n t er est r at e sw aps ( I RS) ?
An I RS can be defined as an exchange bet ween t wo par t ies of int er est rat e
obligat ions ( payment s of int er est ) or r eceipt s ( invest ment income) in t he
same cur r ency on an agr eed amount of not ional pr incipal f or an agr eed per iod
of t ime.

The most common t ype of int er est r at e swaps ar e t he plain vanilla I RS.
Cur r ent ly, t hese ar e t he only kind of swaps t hat ar e allowed by t he RBI in
I ndia. Dealing in Exot ics or advanced int er est r at e swaps have not been
permit t ed by t he RBI .

I n a plain vanilla swap, one part y agrees t o pay t o t he ot her part y cash flows
equal t o t he int erest at a pr edet er mined fixed r at e on a not ional pr incipal for
a number of year s. I n exchange, t he par t y r eceiving t he f ixed r at e agr ees t o
pay t he ot her par t y cash f lows equal t o int er est at a f loat ing r at e on t he same
not ional pr incipal for t he same per iod of t ime. Mor eover , only t he dif f er ence in
t he int er est payment s is paid/ r eceived; t he pr incipal is used only t o calculat e
t he int er est amount s and is never exchanged.

An example will help under st and t his bet t er :

Consider a swap agr eement bet ween t wo part ies, A and B. The swap was
init iat ed on July 1, 2001. Her e, A agr ees t o pay t he 3- mont h FI MMDA NSE-
MI BOR r at e on a not ional pr incipal of Rs. 100 million, while B pays a fixed
12. 15% r at e on t he same pr incipal, for t enur e of 1 year .

214
We assume t hat pay ment s ar e t o be exchanged ever y t hr ee mont hs and t he
12. 15% int er est r at e is t o be compounded quar t er ly. This swap can be
depict ed diagr ammat ically as shown below:

MI BOR ( 3m)

12. 15%

An int er est r at e swap is ent er ed t o t r ansf or m t he nat ur e of an exist ing liabilit y
or an asset . A swap can be used t o t ransform a float ing rat e loan int o a fixed
r at e loan, or vice ver sa. To under st and t his, consider t hat in t he above
example;

A had borrowed a 3 yr, 1 crore loan at 12%. This means t hat following t he
swap, it will:

( a) Pay 12% t o t he lender,
( b) Receive 12. 15% fr om B
( c) Pay 3 mont h MI BOR

Thus, As 12% fixed loan is t r ansfor med int o a float ing r at e loan of MI BOR
0. 15%. Similarly, if B had borrowed at MI BOR + 1. 50%, it can t ransform this
loan t o a fixed rat e loan @ 13. 65% ( 12. 15 + 1. 50) . Following figure
summar izes t his t r ansact ion.

12% MI BOR ( 3m)
MI BOR ( 3m)
+ 1. 50% 12. 15%

An I RS can al so be u sed t o t r an sf or m asset s.

Ex ampl e
A fixed- r at e earning bond can be t ransformed int o variable rat e earning asset
and vice ver sa. I n t he above example, it could be t hat A had a bond ear ning
MI BOR+ 0. 5% and B a bond ear ning 12. 5% int er est compounded quar t er ly.
The swap would t hen result in A receiving a fixed income of 12. 65% and B
r eceiving a var iable income of MI BOR+ 0. 35%.
This can be shown diagr ammat ically as follows:

MI BOR MI BOR ( 3m) 12.
50%
+ 0. 50%
12. 15%

Part y A Part y B
Par t y A Par t y B
Party A Party B
215
Somet imes, a bank or financial int ermediary is involved in t he swap. I t
char ges a commission f or t his. The t wo par t ies of t en do not even know who
t he ot her par t y is. For t hem, t he int er mediar y is t he count erpart y. For
example, if a financial inst it ut ion charging 20 basis point s were act ing as
int ermediary, t he swap would look as f ollows:

12. 17% 12. 37%

MI BOR ( 3m) MI BOR ( 3m)

Sw ap as a Comb i n at i on of Bon d s
A swap can be int er pr et ed as a combinat ion of bonds in such a way t hat t he
r eceive fixed leg is shor t on a float ing r at e bond and long on a fixed r at e bond
and vice ver sa for t he r eceive float ing leg.
This has significant implicat ion on t he pricing and valuat ion of plain vanilla
int er est r at e swaps because a swap can be valued as a combinat ion of t he
t wo:
An example will make t his ver y clear . Consider t he swap f or a not ional of Rs
100.
Part y A pays 3 mont h MI BOR and receives 12. 15% for a period of t wo years.
This is equivalent t o A having a short posit ion in a 3 mont h MI BOR linked
bond and a long posit ion in a 2 year 12. 15% bond wit h quar t er ly payment s.
12. 15% is also t he going swap r at e at t he t ime of incept ion of t he swap.
Assume t hat 1- mont h has passed since t he incept ion of t he bond. Hence
t her e ar e t wo mont hs lef t f or t he int er est payment s t o be exchanged. Let us
also assume t hat t he swap has a look ahead conf igur at ion i. e. t he MI BOR t o
be paid af t er t wo mont hs has alr eady been set .
1. The 12. 15% fixed r at e bond can be valued accor ding t o convent ional
met hods i. e. by discount ing each cash flow fr om t he bond by t he
discount ing r at e for t he r elevant per iod.
2. The MI BOR linked bond will reset t o par. This is because on t he next
r eset dat e, t he coupon t hat will be fixed ( MI BOR) will also be equal t o
t he discount ing r at e f or t he r elevant per iod. Hence we have t he par
value + MI BOR to be discount ed for a period of t wo mont hs ( t ime t o
r eset ) .
The value of t he swap is simply t he dif f er ence bet ween t he above t wo.

A sw ap as a st r i n g of FRAs or f u t u r es

A swap can also be int er pr et ed as a st r ip of FRAs or f ut ur es cont r act s.
Consider t hat ever y t ime t he float ing index is r eset an int er est r at e payment
goes from one count erpart y t o t he ot her in j ust t he same way t hat
compensat ion is payable/ received under an FRA. I n a similar way, as int erest
r at e changes so t he value of a fut ur es posit ion changes.
Par t y A
Par t y B
BANK
216
Consider a long fut ur es long posit ion and a shor t FRA posit ion r emember
t hese denot e t he same obligat ion. Each posit ion gains if int er est r at es f all and
loses if int er est r at es r ise. The r isk/ r et ur n pr of ile is t hat of a swap- float ing
rat e payer.
Similarly, for a swap fixed rat e payer t he posit ion is t he same as t hat for a
shor t f ut ur es posit ion and a long FRA posit ion. Each will lose if int er est r at es
fall and gain if int erest rat es rise.

Pr i ci n g an I RS

I n or der t o det er mine t he f ixed r at e or t he swap r at e t o be paid or r eceived
for t he desir ed int er est r at e swap, t he pr esent value of t he float ing r at e
payment s must equat e t he pr esent value of f ixed r at es. The t r ut h of t his
st at ement will become clear if we r ef lect on t he f act t hat t he net pr esent
value of any fixed rat e or float ing rat e loan must be zero when t hat loan is
gr ant ed, pr ovided, of cour se, t hat t he loan has been pr iced accor ding t o
pr evailing mar ket t er ms. However , we have alr eady seen t hat a fixed t o
float ing int er est r at e swap is not hing mor e t han t he combinat ion of a f ixed
r at e loan and a f loat ing r at e loan wit hout t he init ial bor r owing and subsequent
r epayment of a pr incipal amount . Hence, in or der t o ar r ive at an init ial f ixed
r at e, we find t hat r at e for t he float ing leg t hat gives a zer o pr esent value for
t he ent ir e swap. The mar ket maker t hen adds some spr ead so t hat t he
present value t o t he market maker is slight ly posit ive.

Wh y do f i r ms en t er i n t o i n t er est r at e sw aps?

Sw aps f or a compar at i v e adv an t age

Compar at ive advant ages bet ween t wo f i r ms ar i se out of di f f er ences i n cr edi t
r at ing, mar ket pr efer ences and exposur e.

Example: Say , Fi r m A w i t h h i gh cr edi t r at i n g can bor r ow at a f i x ed
r at e of 12% an d at a f l oat i n g r at e of MI BOR + 20 bps. An ot h er f i r m B
w i t h a l ow er cr edi t rat i n g can bor r ow at a f i x ed r at e of 1 4 % an d a
f l oat i n g r at e of MI BOR + 1 5 0 bps.

Bef or e t h e Sw ap
Par t y Fi x ed r at e l oan Fl oat i ng r at e l oan
A 12 % MI BOR + 0. 20%
B 14 % MI BOR + 1. 50%

Fir m A has an absolut e advant age over fir m B in bot h fixed and float ing r at es.
Firm B pays 200 bps more t han firm A in t he fixed rat e borrowing and only
120 bps more t han A in t he float ing rat e borrowing. So, firm B has a
compar at ive advant age in bor r owing float ing r at e funds.
217
Now, Fir m A wishes t o bor r ow at float ing r at es and becomes t he float ing rat e
payer in t he swap ar r angement . However , A act ually bor r ows f ixed r at e f unds
in t he cash market . I t is t he int erest rat e obligat ions on t his fixed rat e funds,
which ar e swapped. At t he same t ime, B wishes t o bor r ow at a fixed r at e, and
t hus will act ually bor r ow fr om t he mar ket at t he float ing r at e.

Then, bot h t he par t ies will exchange t heir under lying int er est r at e exposur es
wit h each ot her t o gain from t he swap. The calculat ion of t he gain from t he
swap is shown below:
The gain t o fir m A, because it bor r ows in t he fixed r at e segment is:
14% - 12% = 200 bps.
And, t he loss because fir m B bor r ows in t he float ing r at e segment is:
( MI BOR + 20 bps) ( MI BOR + 150 bps) = 130 bps.

Thus, t he net gain in t he swap = 200 130 = 70 bps. The f i r ms can di vi de
t his gain equally. Fir m B can pay f ixed at 12. 15% t o f ir m A and r eceive a
float ing rat e of MI BOR as illust rat ed below:

Af t er t h e Sw ap
MI BOR

12 . 15 %

12 % MI BOR + 150 bps

Ef f ect i ve cost for firm A = 12% + ( MI BOR 12. 15%)
= MI BOR - 15 bps

This r esult s int o a net gain of ( ( MI BOR + 20) - ( MI BOR - 15) ) i. e. , a gain of
35 bps.

Effect ive cost for firm B = ( MI BOR + 150) + ( 12.15% - MI BOR)
= 13. 65%

This result s int o a gain of ( 14% - 13. 65%) i. e. , a gain of 35 bps.
Thus, bot h t he par t ies gain f r om ent er ing int o a swap agr eement .

As w e h av e seen , f i r ms can u se I RS t o t r an sf or m asset s an d l i abi l i t i es.
Bu t t h en , w h y d on t f i r ms t ak e t h e d esi r ed f or m of l oan or asset ( f i x ed
or f l oat i n g) i n t h e f i r st pl ace?
Party A Party B
218
Ricar dos compar at ive advant age t heor y explains t his behavior t o some
ext ent . Cont inuing wit h t he same example, let us assume t hat As cr edit
r at ing is bet t er t han Bs, and A and B can raise loans for fixed and float ing
rat es as given below:

Bef or e t h e Sw ap
Fi r m Fi x ed r at e l oan r at e Fl oat i ng r at e l oan r at e
A 12% MI BOR + 0. 20%
B 14% MI BOR + 1. 50%

Her e, we see t hat t hough f ir m A can bor r ow cheaply compar ed t o f ir m B in
bot h t he mar ket s, t he differ ence in r at es available is not t he same. Fir m B has
a compar at ive advant age in t he f loat ing r at e mar ket because it pays only
1. 30% higher her e, compar ed t o t he 2% differ ence in t he fixed r at e mar ket .
So, firm B will borrow at a float ing rat e, and firm A at fixed rat e.
Af t er t he swap deal, t he cost of t he f loat ing r at e loan t o f ir m A will be MI BOR-
0. 15%, a clean gain of 35 basis point s. Similar ly, fir m B also gains 35 basis
point s, because t he cost of it s loan will be 13. 35 % only, af t er t he swap. Thus,
bot h par t ies gain fr om t he swap, as shown below:

Af t er t h e Sw ap
Fi r m Fi x ed r at e l oan r at e Fl oat i ng r at e l oan r at e Gai n
A - Mibor - 0. 15 % 35 bps
B 13. 65% - 35 bps

I n a perfect market , however, t he spread bet ween fixed and float ing rat es
offered should vanish due t o I RS. This is not seen in r ealit y, and spr eads
cont inue t o per sist . So, t he cr edit r at ings of t he f ir ms ar e not t he only cr it er ia
by which lender s j udge f ir ms, and t he compar at ive advant age t heor y
cont i nues t o hold.

Sw aps f or Redu ci n g t h e Cost of Bor r ow i n g
Wit h t he int r oduct ion of r upee der ivat ives, t he I ndian cor por at es can at t empt
t o r educe t heir cost of bor r owing and t her eby add value. A t ypical I ndian case
would be a corporat e wit h a high fixed rat e obli gat ion.
MI PL, an AAA r at ed cor por at e, 3 year s back had r aised 4- year funds at a fixed
r at e of 18. 5%. Assume a 364- day T- bill is yielding 10. 25%, as t he int erest
r at es have come down. The 3- mont h MI BOR is quot ing at 10%.
Fixed t o float ing 1 year swaps ar e tr ading at 50 bps over t he 364- day T- bill
vs. 6- mont h MI BOR.
The t r easur er is of t he view t hat t he aver age MI BOR shall r emain below
18. 5% for t he next one year . The f i r m can t hus benef i t by ent er i ng i nt o an
int er est r at e f ixed f or f loat ing swap, wher eby it makes float ing payment s at
MI BOR and r eceives f ixed payment s at 50 bps over a 364- day t r easur y yield
i.e. 10.25 + 0.50 = 10.75 %.

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18 . 5 % 10. 75% MI BOR

MI BOR ( 3m)

The ef f ect ive cost f or MI PL = 18.50 + MI BOR - 10. 75
= 7.75 + MI BOR

At t he present 3m MI BOR is 10%, t he effect ive cost is = 10 + 7. 75 = 17. 75%

The gain for t he firm is ( 18. 5 - 17. 75) = 0. 75 %

The risks involved for t he firm are:

Default / credit risk of part y B: Since t he count erpart y is a bank,
t his risk is much lower t han would arise in t he normal case of
lending t o cor por at es. This r isk involves losses t o t he ext ent of
t he int er est r at e differ ent ial bet ween fixed and float ing r at e
payment s.
The f ir m is f aced wit h t he r isk t hat t he MI BOR goes beyond
10. 75%. Any r ise beyond 10. 75% will r aise t he cost of f unds
for t he firm. Therefore it is very essent ial t hat t he firm hold a
well- suggest ed view t hat MI BOR shall r emain below 10. 75%.
This will r equir e cont inuous monit or ing.

How does t he bank benefit out of t his t r ansact ion?
The bank eit her goes for anot her swap t o offset t his obligat ion and in t he
pr ocess ear n a spr ead. The bank may also use t his swap as an oppor t unit y t o
hedge it s own float ing liabilit y. The bank may also leave t his posit ion
uncovered if it is of t he view t hat MI BOR shall rise beyond 10. 75%.

Tak i n g adv an t age of f u t u r e v i ew s / specu l at i on
I f a bank holds a view t hat int er est r at e is likely t o incr ease and in such a
case t he r et ur n on f ixed r at e asset s will not incr ease, it will pr ef er t o swap it
wit h a float ing r at e int er est . I t may also swap float ing r at e liabilit ies wit h a
f ixed r at e.
Ot her r easons for using I RS ar e speculat ion on fut ur e int er est r at e
movement s, management of asset - liabilit y mismat ch, alt er ing debt st r uct ur e,
of f - balance sheet gains, and int erest risk management . I t has been observed
t hat FRAs ar e mor e popular f or hedging against int er est r isks, while I RS ar e
mor e popular for speculat ion and t r ansfor ming nat ur e of asset s and liabilit ies.

MIPL Party B
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16.5 GUI DELI NES ON EXCHANGE TRADED I NTEREST
RATE DERI VATI VES

RBI issued det ailed guidelines f or Banks and I nst it ut ions allowing t hem t o
par t icipat e in t he exchange t r aded int er est r at e der ivat ives ( I RD) mar ket in
I ndia t o enable bet t er risk management . Scheduled Commercial Banks
excluding RRBs & LABs, Pr imar y Dealer s and specified Financial I nst it ut ions
are allowed t o deal in I RDs. To st art wit h Banks and FI s are allowed t o
t r ansact f or t he limit ed pur pose of hedging t he r isk in t heir under lying
invest ment por t folio while Pr imar y Dealer s ar e al l owed t o t ake t r adi ng
posit ions as well as hedging t he r isk in t he under lying invest ment por t folio.

The nor ms t hat wi l l be appl i cabl e f or t r ansact i ng I RDs on t he F&O segment of
t he st ock exchanges ar e as follows:

i) St ock ex ch an ge r egu l at i on : SCBs and AI FI s can seek
member ship of t he F & O segment of t he st ock exchanges f or t he
limit ed pur pose of under t aking pr opr iet ar y t r ansact ions f or hedging
int er est r at e r isk. SCBs and AI FI s desir ous of t aking t r ading
member shi p on t he F & O segment of t he st ock exchanges should
sat isf y t he member ship cr it er ia and also comply wit h t he r egulat or y
nor ms laid down by SEBI and t he r espect ive st ock exchanges
( BSE/ NSE) . Those not seeking member ship of St ock Exchanges,
can t r ansact I RDs t hr ough appr oved F & O member s of t he
exchanges.

ii) Set t l ement :
a) As t r ading member s of t he F&O segment , SCBs and AI FI s
should set t le t heir der ivat ive t r ades dir ect ly wit h t he clear ing
cor por at ion/ clear ing house.
b) Regulat ed ent it ies par t icipat ing t hr ough appr oved F & O
member s shal l set t l e pr opr iet ar y t r ades as a par t icipant clear ing
member or t hr ough appr oved pr of essional / cust odial clear ing
member s.
c) Br oker / t r ading member s of st ock exchanges cannot be used
for set t lement of I RD t r ansact ions.

iii) El i gi bl e u n der l y i n g secu r i t i es: For t he present , only t he int er est
r at e r isk inher ent in t he gover nment secur it ies classified under t he
Available for Sale and Held for Tr ading cat egor ies will be allowed t o
be hedged. For t his purpose, t he port ion of t he Available for Sale
and Held f or Tr ading por t f olio int ended t o be hedged must be
ident ified and car ved out for monit or ing pur poses.

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iv) Hedge cr i t er i a: I nt er est Rat e Der ivat ive t r ansact ions under t aken
on t he exchanges shall be deemed as hedge t r ansact ions, if and
only if,

a) The hedge is clearly ident ifie d wit h t he underlying
gover nment secur it ies in t he Available f or Sale and Held f or
Tr ading cat egor ies.
b) The ef f ect iveness of t he hedge can be r eliably measur ed
c) The hedge is assessed on an ongoing basis and is highly
effect ive t hr oughout t he per iod.

v) Hedge Ef f ect i v en ess: The hedge will be deemed t o be highly
ef f ect ive if at incept ion and t hr oughout t he lif e of t he hedge,
changes in t he mar ked t o mar ket value of t he hedged it ems wit h
r ef er ence t o t he mar ked t o mar ket value at t he t ime of t he hedging
ar e almost f ully of f set by t he changes in t he mar ked t o mar ket
value of t he hedging inst rument and t he act ual result s are wit hin a
r ange of 80% t o 125%. I f changes in t he mar ked t o mar ket values
are out side t he 80% - 125% r ange, t hen t he hedge woul d not be
deemed t o be highly ef f ect ive.
At pr esent , t he invest ment s held in t he ( a) AFS cat egor y ar e t o be
mar ked t o mar ket at quar t er ly or mor e f r equent int er vals ( b) HFT
cat egor y ar e t o be mar ked t o mar ket at mont hly or mor e fr equent
int ervals. The hedged port ion of t he AFS/ HFT port folio should be
not ionally mar ked t o mar ket , at least at mont hly int er vals, for
evaluat ing t he ef f icacy of t he hedge t r ansact ion.

vi) Accou n t i n g: The Account i ng St andar ds Boar d of t he I nst i t ut e of
Chart ered Account ant s of I ndia ( I CAI ) is in t he process of
developing a compr ehensive Account ing St andar d cover ing var ious
t ypes of f inancial inst r ument s including account ing f or t r ading and
hedging. However , as t he f or mulat ion of t he St andar d is likely t o
t ake some t ime, t he I nst it ut e has br ought out a Guidance Not e on
Account ing f or Equit y I ndex Fut ur es as an int er im measur e. Till
I CAI comes out wit h a compr ehensive Account ing St andar d, SCBs
and AI FI s may f ollow t he above guidance not e mut at is mut andis
for account ing of int er est r at e fut ur es also. However, since SCBs
and AI FI s ar e being per mit t ed t o hedge t heir under lying por t folio
which is subj ect t o per iodical mar k t o mar ket , t he following nor ms
will apply

a) I f t he hedge is highly effect ive , t he gain or loss on t he
hedging inst r ument s and hedged por t f olio may be set of f and
net loss, if any, should be provided for and net gains if any,
ignor ed f or t he pur pose of Pr of it & Loss Account .

222
b) I f t he hedge is not found t o be " highly effect ive" no set off will
be al l owed and t he under l yi ng secur i t ies will be mar ked t o
mar ket as per t he nor ms applicable t o t heir r espect ive
i nvest ment cat egor y.

c) Tr ading posit ion in f ut ur es is not allowed. However , a hedge
may be t emporarily rendered as not highly effect ive . Under
such ci r cumst ances, t he r el evant f ut ures posit ion will be
deemed as a t rading posit ion. All deemed t rading posit ions
should be marked t o market as a port folio on a daily basis and
losses should be provided for and gains, if any, should be
ignored for t he purpose of Profit & Loss Account . SCBs and
AI FI s should st r ive t o r est or e t heir hedge ef f ect iveness at t he
ear liest .

d) Any gains r ealized f r om closing out / set t lement of f ut ur es
cont r act s can not be t aken t o Pr of it & Loss account but car r ied
forward as " Ot her Liabilit y" and ut ilized for meet i ng
depr eciat ion pr ovisions on t he invest ment por t f olio.
vii) Capi t al adequacy : The net not ional pr incipal amount in r espect of
fut ur es posit ion wit h same under lying and set t lement dat es should
be mult iplied by t he conver sion f act or given below t o ar r ive at t he
cr edi t equi val ent :

Or i gi nal Mat ur i t y Con v er si on Fact or
Less t han one year 0. 5 per cent
One year and less t han t wo year s 1. 0 per cent
For each addit ional year 1. 0 per cent
The cr edit equivalent t hus obt ained shall be mult iplied by t he
appl i cabl e r i sk weight of 100%.

viii) ALM cl assi f i cat i on: I nt er est r at e f ut ur es ar e t r eat ed as a
combinat ion of a long and shor t posit ion in a not ional gover nment
secur it y. The mat ur it y of a f ut ur e will be t he per iod unt il deliver y or
exer cise of t he cont r act , as also t he lif e of t he under lying
inst r ument . For example, a shor t posit ion in int er est r at e f ut ur e f or
Rs. 50 crore [ delivery dat e aft er 6 mont hs, life of t he not ional
under lying gover nment secur it y 3 year s] is t o be r epor t ed as a
r isk sensit ive asset under t he 3 t o 6 mont h bucket and a risk
sensit ive liabilit y in four year s i. e. under t he 3 t o 5 year bucket .

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ix) Use of br ok er s : The exist ing nor m of 5% of t ot al t r ansact ions
dur ing a year as t he aggr egat e upper cont r act limit for each of t he
appr oved br oker s should be observed by SCBs and AI FI s who
par t icipat e t hr ough appr oved F & O member s of t he exchanges.

x) Di scl osu r es: The r egulat ed ent it ies under t aking int er est r at e
der ivat ives on exchanges may disclose as a par t of t he not es on
account s t o balance sheet s t he f ollowing det ails:
( Rs. Crores)
Sr .
No.
Par t i cul ar s Amount
1 Not ional pr incipal amount of exchange t r aded int er est
rat e derivat ives undert aken during t he year
( inst r ument -wi se)
a)
b)
c)

rat e deriva t ives out st anding as on 31
st
March ____
a)
b)
c)

r at e der ivat ives out st anding and not highly effect ive
a)
b)
c)

4 Mar k-t o-mar ket value of exchange t r aded int erest rat e
der ivat ives out st anding and not highly effect ive
a)
b)
c)

xi) Repor t i ng: Banks and Specif ied AI FI s should submit a mont hly
st at ement t o DBS or DBS ( FI D) respect ively as per t he prescribed
for mat .

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Model Quest i ons

1 . An i n t er est r at e sw ap t r an sf or ms t h e n at u r e of _ _ _ _ _ _ _ _ _ _ _ .

a) an exist ing liabilit y only
b) an exist ing asset only
c) an not ional liabilit y or an asset
d) an exist ing liabilit y or an asset

An sw er : d

2 . A sw ap can b e i n t er p r et ed as a st r i p of _ _ _ ________.

a) fixed rat e agreement s only
b) fut ur e cont r act s only
c) f ixed r at e agr eement s or f ut ur e cont r act s
d) None of t he above

Answ er : c

3 . For w ar d r at es can n ot be _ _ _ _ _ _ _ _ _ _ _ .

a) posit ive
b) negat ive
c) zero
d) hi gher t han spot r at e

An sw er : b

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Gl ossar y of Debt Mar k et Ter ms
13

Accr ued I nt er est
I f a coupon bear i ng secur i t y i s t r aded bet ween t wo coupon dat es, t he buyer
has t o compensat e t he seller by paying him t hat par t of t he int er est which is
due t o him for t he period for which he has held t he sec urit y aft er t he
immediat ely pr eceding coupon dat e. The calculat ion of accr ued int er est is
done accor ding t o t he day- count convent ion of t he secur it y or mar ket ( See
Day Count ) .

Ask Pr i ce
I n Financial Mar ket s, mar ket maker s quot e bot h bid ( buy) pr ice and ask
( offer ) pr ice. This indicat es t hat t he mar ket maker , not knowing t he int ent ion
of t he pr ice t aker is quot ing him r at es f or bot h buying as well as f or selling.
The bid pr ice is gener ally lower t han t he sell pr ice, as dict at ed by nor mal
pr of i t mot i ve ( Somet imes a dealer would quot e t he same bid and ask, in
which case t he pr ice is called a " choice- pr ice" ) . The differ ence bet ween t he
bid and t he ask pr ice is nor mally called t he " bid- ask spr ead" . The spr ead
depends on many fact ors like liquidit y in t he inst rument quot ed, t he bias of
t he dealer , his eager ness or ot her wise t o t r ade, mar ket volat ilit y et c. A small
dif f er ence is consider ed t o be a ver y f ine pr ice as t he dealer is keeping ver y
lit t le by way of his profit s. As example: A dealer quot ing 12. 50% 2004 mi ght
quot e 105. 15/ 20. This implies t hat t he dealer is willing t o buy t he paper at
105. 15 while he is willing t o sell it at 105. 20. I n act ual pr act ice t he pr ice may
be given as 15/ 20. I t is underst ood t hat market part icipant s are aware of t he
big figure. I t should be kept in mind t hat while quot ing int er est r at e r at es, t he
bid is in fact higher t han t he offer . For example a USD 3x6 FRA can be quot ed
as 5. 75/ 70, implying t hat t he dealer is willing t o buy t he FRA at a yield of
5. 75% while he will sell t he same FRA at an yield of 5. 70%.

Asset Back ed Secu r i t y
Any secur it y t hat offer s t o t he invest or an asset as t he collat er al is called
Asset Backed Secur it y. The r at e of r et ur n r equir ed by t he invest or f or such
t ypes of bonds is generally less compared t o bonds t hat of f er no collat er al.

Auct i on
The pr ocess of issuing a secur it y t hr ough a pr ice- discover y mechanism
t hr ough asking for bids. This is t he pr ocess followed by t he RBI for all t ypes of
issues of debt mar ket paper by it .

Bal an ce Ten or
The un- expired lif e of t he secur i t y

13
This glossary has been downloaded and modified from www.debt onnet .com, t he first int ernet
based debt market port al in I ndia.
226
Bank Rat e
Bank Rat e is a dir ect inst r ument of cr edit cont r ol. I t is t hat int er est r at e or
discount r at e at which banks, f inancial inst it ut ions and ot her appr oved ent it ies
in t he int er bank mar ket can get f inancial accommodat ion f r om t he cent r al
bank of t he count r y. By hiking t he bank r at e t he cent r al bank makes cr edit
expensive and by lower ing t he same cent r al bank make cr edit cheaper

Basi s Poi nt
One hundr edt h of a per cent age ( i. e. 0. 01) . As int er est r at es ar e gener ally
sensit ive in t he second pl ace af t er t he deci mal poi nt , t he measur e has l ar ge
i mpor t ance f or t he debt mar ket .

Benchmar k Rat e
Benchmark rat es are rat es or t he prices of inst rument s t hat are t raded in t he
market on which are used for pricing of ot her inst rument s. These rat es or
pr ices ar e used as benchmar k f or f loat ing r at e inst r ument s. Typically a
benchmar k r at e should sat isfy t he following cr it er ia
1. The r at e should be available r eadily and should eit her be dir ect ly
observable in t he market or made available by a credible agency
2. The benchmar k should be liquid so t hat count er- hedging st r at egies ar e
r eadily available
3. The r at e should be unique and leave no scope f or ambiguit y

The benchmar k should be r epr esent at ive of t he mar ket . I nt er nat ionally t he
most popular benchmar ks ar e t he LI BOR and t he US Tr easur y. I n I ndia, given
t he pauci t y of r at es t hat sat i sf y t he above cr i t er i on, not many benchmar ks
exist , save t he MI BOR announced by eit her t he NSE or Reut er s.

Bi d Pr i ce
See Ask Pr i ce

Bond
A bond is a promise in which t he I ssuer agrees t o pay a cert ain rat e of
int erest , usually as a percent age of t he bond' s face value t o t he I nvest or at
specific per iodicit y over t he life of t he bond. Somet imes int er est is also paid in
t he f or m of i ssui ng t he i nst r ument at a di scount t o f ace value and
subsequent ly redeeming it at par. Some bonds do not pay a fixed rat e of
int er est but pay int er est t hat is a mar k- up on some benchmar k r at e.

Boot st r appi ng
Boot st r apping is an it er at ive pr ocess of gener at ing a Zer o Coupon Yield Cur ve
from t he observ ed pr ices/ yields of coupon bear ing secur it ies. The pr ocess
st ar t s f r om obser ving t he yield f or t he shor t est - t erm money market discount
inst r ument ( i. e. one t hat car r ies no coupon) . This yield is used t o discount t he
coupon payment falling on t he same mat ur it y f or a coupon- bear ing bond of
t he next higher mat urit y. The result ing equat ion is solved t o give t he zero
yield ( also called spot yield) f or t he higher mat ur it y per iod. This pr ocess is
227
cont inued f or all secur it ies acr oss t he t ime ser ies. I f r epr esent ed algebr aically,
t he process would lead t o an nt h degree polynomial t hat is generally solved
using numer ical met hods. The most popular one being t he Newt on- Raphson
t echnique.

Cal l Mon ey
Bor r owing or lending for one day upt o 14 days, in t he int er bank mar ket i s
known as call money. Ent r y int o t his segment of t he mar ket is r est r ict ed t o
not ified par t icipant s which include scheduled commer cial banks, pr imar y
dealer s, development financial inst it ut ions and mut ual funds

Cal l Opt i on
See Opt ion

Cal l abl e Bon d
A Bond which has a Call covenant in it s t er ms of issue, i. e. one in which t he
I ssuer r eser ves t he r ight t o buy - back t he issue is called a Callable Bond.

Cl ean Pr i ce
A Clean Pr ice of a bond or secur it y is t he discount ed value of all it s f ut ur e
cash f lows ( using a suit able discount r at e, which can be t he YTM or t he
r elevant spot r at e) . However , if t he bond is t r aded bet ween t wo coupon
dat es, t he buyer of t he bond will have t o compensat e t he seller f or t hat par t
of t he per i od bet ween coupons f or whi ch t he sel ler was owni ng t he bond ( See
Accr ued I nt er est ) . The pr ice ar r ived at aft er adj ust ing t he Clean Pr ice for t his
fact or is called t he Dir t y Pr ice.

Col l at er al i sed Bon d
Any fixed income inst r ument which has collat er al as a back up t o t he issue is
called a Collat eralised Bond. I n I ndia, relat ed t erminology is secured bonds or
unsecur ed bonds.

Commer ci al Paper ( CP)
A Commercial Paper is a short t erm unsecured promissory not e issued by t he
r aiser of debt t o t he invest or . I n I ndia Cor por at es, Pr imar y Dealer s ( PD) and
All I ndia Financial I nst it ut ions ( FI ) can issue t hese not es. For a cor por at e t o
be eligible it must have a t angible net wort h of Rs 4 crore or more and have a
sanct ioned working capit al limit sanct ioned by a bank/ FI . I t is generally
companies wit h very good rat ing which are act ive in t he CP market , t hough
RBI per mit s a minimum cr edit r at ing of Cr isil- P2. The t enur e of CPs can be
anyt hi ng bet ween 15 days t o one year , t hough t he most popul ar dur at i on i s
90 days. These inst r ument s ar e offer ed at a discount t o t he face value and
t he r at e of int er est depends on t he quant um r aised, t he t enur e and t he
gener al level of r at es besides t he cr edit r at ing of t he pr oposed issue. While
most of t he issuing ent it ies have est ablished wor king capit al limit s wit h
banks, t hey st ill prefer t o use t he CP rout e for flexibilit y in int erest rat es. The
228
cr edit r at ings for CP ar e issued by leading r at ing agencies. Recent ly t he
quant um raised by t he issuer t hrough t he CP has been excluded from t he
ambit of bank f inance, but banks cont inue t o pr efer ear mar king eit her t heir
own limit s f or t he cor por at e or t he consor t ium limit s while subscr ibing t o t he
commercial paper.

Con st i t u en t SGL A/ c
SGL account hol der s can have t wo SGL account s wi t h RBI - SGL account no. 1
and SGL account no. 2 . SGL account no. 1 is t he account f or t he own holdings
of t he bank or t he PD who has t he dir ect account . SGL account no. 2 is f or
t heir const it uent s . Those who ar e not eligible for dir ect SGL account wit h RBI
, say , f or exampl e , a Pr ovi dent Fund Tr ust , who is not eligible f or an SGL
account can hold secur it ies in demat f or m by opening a const it uent SGL
account wi t h a Bank, PD . Thr ough t he SGL account no. 2 of t he par t y who has
dir ect account wit h RBI t he f acilit y will be made available t o t he PF

Con v er t i ble Bon d
A bond t hat is par t ially or fully conver t ible int o equit y wit hin a specified per iod
of t ime from t he dat e of issue is known as a convert ible bond. I n such cases,
t he bond does not pay t he holder t hat par t of t he mat ur it y value t hat is
ear mar ked for conver sion t o equit y.

Con v ex i t y
See in conj unct ion wit h Dur at ion, PVBP and I mmunizat ion. Convexit y is
anot her measur e of bond r isk. The measur e of Dur at ion assumes a linear
r elat ionship bet ween changes in pr ice and dur at ion. However , t he r elat ionship
bet ween change in pr ice and change in yield is not linear and hence t he
est imat ed pr ice change obt ained by dur at ion will give only an appr oximat e
value. The er r or is insignificant when t he change in yield is small but does not
hold t r ue for lar ger changes in yield, as t he act ual pr ice- yield relat ionship is
convex. Convexit y is t he measur e of t he cur vat ur e of t he pr ice- yield
r elat ionship. I t is also t he r at e of change of dur at ion wit h a change in yield. A
high convexit y is oft en a desir ed charact erist ic as for a given change in yield,
posit ive or negat ive, a bond' s per cent age r ise in pr ice is gr eat er t han t he
per cent age pr ice loss.

While modified durat ion is used t o predict t he bond' s % change in price small
change in yields, modified dur at ion and convexit y t oget her ar e used t o
calculat e a bond' s % change in pr ice f or a lar ge change in yield, as per t his
r elat ionship.

Coupon
The r at e of int er est paid on a secur it y, gener ally a f ixed per cent age of t he
f ace value, is called t he coupon. The or igin of t he t er m dat es back t o t he t ime
when bonds had coupons at t ached t o t hem, which t he invest or had t o det ach
and pr esent t o t he issuer t o r eceive t he money.

229
Cr edi t Rat i ng
Credit Rat ing is an exercise conduct ed by a rat ing organisat ion t o explore t he
cr edit wor t hiness of t he issuer wit h r espect t o t he inst r ument being issued or
a gener al abilit y t o pay back debt over specif ied per iods of t ime. The r at ing is
gi ven as an al phanumer i c code t hat r epr esent s a gr aded st r uct ur e or
cr edit wor t hiness. Typically t he highest cr edit r at ing is t hat of AAA and t he
lowest being D ( f or def ault ) . Wit hin t he same alphabet class, t he r at ing
agency may apply + ( plus) or - ( minus) signs as suffixes t o reflect
compar at ive st anding wit hin t he r at ing cat egor y.

CRR
This is t he acr onym for Cash Reser ve Rat io. That par t of t heir asset s which
banks in I ndia ar e r equir ed t o hold as Cash in balances wit h t he Reser ve Bank
of I ndia is called t he Cash Reserve Rat io.

Cu r r en t Yi el d
Cur r ent Yield on a bond is defined as t he coupon r at e divided by t he pr ice of
t he bond. This is a very inadequat e measure of yield, as it does not t ake int o
account t he effect of fut ur e cash flows and t he applicat ion of discount ing
fact ors on t hem.

Day Cou n t
The mar ket uses quit e a f ew convent ions f or calculat ion of t he number of
days t hat has elapsed bet ween t wo dat es. I t is int er est ing t o not e t hat t hese
convent ions wer e designed pr ior t o t he emer gence of sophist icat ed calculat ing
devices and t he main obj ect ive was t o r educe t he mat h in complicat ed
f or mulae. The convent ions ar e st ill in place even t hough calculat ing funct ions
are readily available even in hand- held devices. The ult imat e aim of any
convent ion is t o calculat e ( days in a mont h) / ( days in a year ) .

Th e con v en t i on s u sed ar e as bel ow :
We t ake t he example of a bond wit h Face Value 100, coupon 12. 50%, last
coupon paid on 15t h June, 2000 and t r aded for value 5t h Oct ober , 2000.

A/ 360
I n t his met hod, t he act ual number of days elapsed bet ween t he t wo dat es is
divided by 360, i. e. t he year is assumed t o have 360 days. Using t his met hod,
accrued int erest is 3. 8888
A/ 365
divided by 365, i. e. t he year is assumed t o have 365 days. Using t his met hod,
accrued int erest is 3. 8356
A/ A
divided by t he act ual days in t he year . I f t he year is a leap year AND t he 29t h
of Febr uar y is included bet ween t he t wo dat es, t hen 366 is used in t he
denominat or, else 365 is used. Using t his met hod, accr ued int er est is 3. 8356
230
3 0 / 3 6 0
U. S. ( NASD) met hod. I f t he st ar t ing dat e is t he 31st of a mont h, it becomes
equal t o t he 30t h of t he same mont h. I f t he ending dat e is t he 31st of a
mont h and t he st ar t i ng dat e i s ear l i er t han t he 30t h of a mont h, t he ending
dat e becomes equal t o t he 1st of t he next mont h; ot her wise t he ending dat e
becomes equal t o t he 30t h of t he same mont h.
3 0 / 3 6 0 Eu r opean
Eur opean met hod. St ar t ing dat es and ending dat es t hat occur on t he 31st of a
mont h become equal t o t he 30t h of t he same mont h.
I n I ndian bond market s t he 30/ 360 European convent ion is used. RBI while
calculat ing yield in t he SGL Tr ansact ions for T- Bills uses 364 as basis. This is
pr obably because 364 is t he longest t enur e bill issued by it .

Der i v at i v es
A Der ivat ive is any inst r ument t hat der ives it s value f r om t he pr ice movement
of an under lying asset . The most popular der ivat ives include Opt ions, Fut ur es
and Swaps. Given t he st eep progress made by comput ing devices and t he
incr eased impor t ance of quant it at ive t echniques t o t he f inancial mar ket s, t he
st r uct ur e of der ivat ives have become sever ely complicat ed. I t is not
uncommon t o find a combinat ion of sever al opt ions on a swap which pay- out
depending on t he occur r ence of some event . The main input for pr icing is
volat ilit y in t he pr ice of t he under lying asset , which has given r ise t o t he
curious sit uat ion where t he asset volat ilit y is more heavily t raded t han t he
der ivat ive it self . The applicat ion of der ivat ive pr icing has f ound it s way in
valuat ion of any cont ingent claim, f loat ing r at e not es, cor por at e valuat ion and
pr oj ect f i nance.

Di r t y Pr i ce
Dir t y Pr ice of a secur it y is it s Clean Pr ice plus Accr ued I nt er est . Also see Clean
Pr i ce, Accr ued I nt er est .

Di scount
The quant um by which a securit y is issued or is t raded below it s par value is
called Discount . Also see Discount Basis.

Di scount Basi s
Secur it ies t hat do not car r y a coupon ar e gener ally issued at a discount t o
t hei r f ace val ue. Exampl es of such secur i t i es ar e T- Bills and Commer cial
Papers ( CP) .

Di scr i mi n at or y Pr i ce Au ct i on
See Fr ench Auct ion

Dur at i on
Durat ion is a measure of a bonds' price risk. I t is weight ed average of all t he
cashflows associat ed wit h a bond, weighed by t he proport ion of value due t o
231
t he j t h payment i n t he cash- f low st r eam, wit h sum of all j ' s equalling one.
Dur at ion measur es t he sensit ivit y of a bonds pr ice t o a change in yield.

Du t ch Au ct i on
This is t he process of auct ion in which aft er receiving all t he bids a part icular
yield is det er mined as t he cut - off rat e. All bids received at yields higher t han
t he cut - off rat e ( i. e. at higher prices) are rej ect ed. All bids received at yields
below t he cut - of f r at e ar e gi ven al l ot ment at t he cut - of f r at e. The pr ocess is
i dent i cal t o t hat of t he Fr ench Auct i on, except f or t he f act t hat t her e i s no
concept of allot ment at a pr emium. The Liquidit y adj ust ment Facilit y ( LAF) of
RBI is an example of such auct ion. Also see Fr ench Auct ion, Winner ' s Cur se.

Fl oat i ng Rat e Not e
A Float ing Rat e Not e is an inst rument t hat does not pay a fixed rat e of
int erest on it s face value. The int erest paid on such inst rument s is dependent
upon t he value of a benchmar k r at e. The benchmar k r at e is mut ually agr eed
upon by t he issuer and t he invest or and has t o sat isfy some crit eria ( See
Benchmar k Rat es) . The int er est paid is t ypically a mar k- up on t he benchmar k
so agreed. An example would be a AAA rat ed corporat e issuer who issues a
Not e t hat pays 30 bps above t he U. S. Tr easur y. I n I ndia a ver y common
inst r ument of lat e has been an issue t hat pays a specified markup above t he
MI BOR.

Fr en ch Au ct i on
This is a process of auct ion in which aft er all t he bids are received, a
par t icular yield is decided as t he cut - of f r at e. All bids t hat have been r eceived
at yields higher t han t he cut - off r at e ( i. e. at lower pr ices) ar e r ej ect ed. All
bids t hat have been r eceived at below t he cut - off r at e ( i. e. at higher pr ices)
ar e given f ull allot ment but at a pr emium f r om t he pr ice at t he cut - off yield

Gi l t s
Anot her name f or gover nment secur it ies. The t erm reflect s t he superior
qualit y of t he paper s issued by t he gover nment . The paper s issued by t he
Bank of England used t o have gilt - edged bor der s and t he t er m gilt s or iginat ed
from t here

Gr oss Pr i ce
See Di r t y Pr i ce

Ju n k Bon d
Any bond which has a cr edit rat ing below Baa/ BBB. These are bonds t hat are
below invest ment gr ade and car r y ver y at t r act ive r at es of r et ur n,
commensur at e wit h t he high cr edit r isk.

LAF
This is a facilit y by which t he RBI adj ust s t he daily liquidit y in t he domest ic
mar ket s ( I ndi a) eit her by inj ect ing f unds or by wit hdr awing t hem out . This
232
met hod was made effect ive on t he 5t h June 2000 and is open for Banks and
Pr imar y Dealer s. This met hod has r eplaced t he t r adit ional met hod of r efinance
based on fixed r at es.

LI BOR
St ands f or London I nt er bank Offer ed r at e. This is a ver y popular bench mar k
and is issued for US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and
t he Japanese Yen. The mat ur it y cover s over night t o 12 mont hs. The
met hodology, ver y br iefly - t he Brit ish Bankers Associat ion ( BBA) at 1100 hrs
GMT asks 16 banks t o cont r ibut e t he LI BOR for each mat ur it y and for each
cur r ency. The BBA weeds out t he best four and t he wor st four , calculat es t he
aver age of t he r emaining eight and t he value is published as LI BOR. The
f i gur es are put up in Reut ers on page LI BO and SWAP. The same is available
on TeleRat e page 3170.

Macau l ay Du r at i on
See Dur at i on

Mar k To Mar k et
Mar k t o Mar ket or MTM is a ver y popular r epor t ing and per f or mance
measur ement t ools for any invest ment . I n t his t echnique t he pr ice at which
t he invest ment was made is compar ed wit h t he pr ice which t he asset can
r ealised if liquidat ed in t he mar ket at t hat moment . The differ ence is eit her
t he MTM gain or MTM loss depending upon t he current wort h vis- - vis t he
or iginal pr ice. Liabilit ies can also be made subj ect t o t he same analysis as
asset s. Per iodicit y of MTM depends on t he liquidit y of t he mar ket in which t he
asset is a class. For example cur r ency and bond invest ment s ar e MTM- ed
online while ot her invest ment s like real est at e may be MTM- ed at higher
int er vals.

MI BOR
St ands f or Mumbai I nt er Bank Of f er ed Rat e, it is closely modeled on t he
LI BOR. Cur r ent ly t her e ar e t wo calculat ing agent s f or t he benchmar k -
Reut er s and t he Nat ional St ock Exchange ( NSE) . The FI MMDA NSE MI BOR
benchmar k is t he mor e popular of t he t wo, r eflect ed by t he lar ger number of
deals t hat ar e t r ansact ed using t his benchmar k.

Modi f i ed Dur at i on
This is a slight var iat ion t o t he concept of Dur at ion. Modified Dur at ion can be
def ined as t he appr oximat e per cent age change in pr ice f or a 1% change in
yield. Mat hemat ically it is r epr esent ed as Mod. Dur at ion = Dur at ion / ( 1+ y/ n) ,
wher e n= number of coupon payment s in t he year and y= yield t o mat ur it y.

Mu l t i pl e Pr i ce Au ct i on
See Fr ench Auct ion

233
Net Pr i ce
See Clean Pr i ce

Non Con v er t i bl e Deben t u r e ( NCD)
A Non Convert ible debent ure, as against a convert ible debent ure, is not
conver t ible, eit her in par t or t he whole, int o equit y on it s mat ur it y.

Not i ce Mon ey
Money borrowed or lent in t he int erbank market for a period beyond one day
and upt o 14 days.

Open Mar k et Oper at i on s
One of t he maj or inst r ument s of monet ar y policy by which t he cent r al bank of
a count r y manipulat es shor t - t er m liquidit y and t her eby t he int er est r at es t o
desir ed levels. Gener ally open mar ket operat ions involve pur chase and sale of
t r easur y bills in t he open mar ket or conduct ing r epos.

Opt i ons
Opt ions ar e of t wo t ypes: Call Opt ion and Put Opt ion.

Call Opt ion gives t he buyer t he right but not obligat ion t o buy a given
quant it y of t he under lying asset , at a given pr ice on or befor e a given fut ur e
dat e.

Put Opt ion gives t he buyer t he right but not t he obligat ion t o sell a given
quant it y of t he under lying asset , at a given pr ice on or befor e a given fut ur e
dat e.

PLR
This is t he acr onym for Pr ime Lending Rat e. This is t he r at e at which a bank in
I ndia lends t o it s pr ime cust omer . The bank usually follows an int er nal cr edit
r at ing syst em and char ges a spr ead over t he PLR for non- pr ime cust omer s.

Pr i ce Val u e of a Basi s Poi n t
See PVBP

Pr i mar y Deal er ( PD)
A Pr imar y Dealer in t he secur it ies mar ket is an ent it y licensed by t he RBI t o
car r y on t he business of secur it ies and act as mar ket maker in secur it ies. I n
t urn t he Primary Dealer will enj oy cert ain privileges from t he RBI like
r ef i nance f r om RBI at concessional r at es, access t o t he int er bank call money
market et c. The PD has t o give an annual undert aking t o t he RBI on his level
of par t icipat ion in t he pr imar y issues of gover nment secur it ies. To qualify for
Pr imar y Dealer ship t he applicant company should have a net wor t h of
Rs. 50. 00 cr or e and a few year s of exper ience in t he secur it ies mar ket .

234
PVBP
Also called t he Pr ice Value of a Basis Point or Dollar Value of 01. This is one
way of quant if ying t he sensit ivit y of a bond t o changes in t he int er est r at es. I f
t he current price of t he bond is P( 0) and t he price aft er a one basis point rise
in r at es is P( 1) t hen PVBP is - [ P( 1) - P( 0) ] . This can be est imat ed wit h t he help
of t he modif ied dur at ion of a bond, as ( Pr ice of t he bond * modif ied dur at ion*
. 0001)

Rep o
Repo or Repurchase Agreement s are short - t erm money market inst rument s.
Repo is not hing but collat er alized bor r owing and lending. I n a r epur chase
agreement securit ies are sold in a t emporary sale wit h a promise t o buy back
t he securit ies at a fut ure dat e at specified price. I n reverse repos securit ies
ar e pur chased in a t empor ar y pur chase wit h a pr omise t o sell it back af t er a
specified number of days at a pr e- specified pr ice. When one is doing a r epo, it
is r ever se r epo for t he ot her par t y

Rev er se Repo
See Repo

Ri sk Fr ee Rat e
An int erest rat e given out by an invest ment t hat has a zero probabilit y of
def ault . Theor et ically t his r at e can never exist in pr act ice but sover eign debt
is used as t he near est pr oxy.

SGL
Subsi di ar y Gener al Ledger Account i s t he demat f acilit y f or gover nment
secur it ies of f er ed by t he Reser ve Bank of I ndia. I n t he case of SGL f acilit y t he
secur it ies r emain in t he comput er s of RBI by cr edit t o t he SGL account of t he
owner. RBI offers SGL facilit y only t o banks and primary dealers.

SLR
This is t he acr onym f or St at ut or y Liquidit y Rat io. That par t of t heir Net
Demand and Time liabilit ies ( NDTL) t hat a bank is required by law t o be kept
invest ed in appr oved secur it ies is known as SLR. The appr oved secur it ies ar e
t ypically sover eign issues. The maint enance of SLR ensur es a minimum
liquidit y in t he bank' s asset s.

Spr ead
Spr ead is t he dif f er ence bet ween t wo r at es of int er est s. I t is of t en gener alised
t o i mpl y t he di f f er ence bet ween ei t her pr i ce or yi el d. Spr eads can be bet ween
t wo risk classes or can be bet ween t enor s in t he same r isk class. For example
130 bps bet ween AAA and GOI means a 1. 30% spr ead bet ween a AAA issue
and t hat made by t he Gover nment of I ndia. 5 paisa spr ead bet ween bid and
ask means t hat in t he t wo way pr ice quot ed t he di f f er ence bet ween t he buy
and sell pr ice is 5 paisa 60 bps spr ead bet ween 3 mont h T Bill over 10 Year
235
means t hat t he differ ence bet ween t he yield in t he 3 mont h Tr easur y Bill and
t hat on a 10 Year paper of t he same r isk class is 60 basis point s.

STRI PS
STRI PS is t he acr onym for Separ at e Tr ading of Regist er ed I nt er est and
Pr incipal of Secur it ies. The STRI PS pr ogr am let s invest or s hold and t r ade t he
individual int er est and pr incipal component s of eligible Tr easur y not es and
bonds as separ at e secur it ies. When a Tr easur y f i xed- principal or inflat ion-
indexed not e or bond is st r ipped, each int er est payment and t he pr incipal
payment becomes a separ at e zer o- coupon secur it y. Each component has it s
own ident ifying number and can be held or t raded separat ely. For example, a
Tr easur y not e wit h 10 year s r emaining t o mat ur it y consist s of a single
pr incipal payment at mat ur it y and 20 int er est payment s, one ever y six
mont hs f or 10 year s. When t his not e is conver t ed t o STRI PS f or m, each of t he
20 int er est payment s and t he pr incipal payment becomes a separ at e secur it y.
STRI PS are also called zero- coupon secur it ies because t he only t ime an
invest or receives a payment during t he life of a STRI P is when it mat ures.

A f i nanci al i nst i t ut i on, gover nment secur i t i es br oker , or gover nment secur i t i es
dealer can conver t an eligible Tr easur y secur it y int o int er est and pr incipal
component s t hr ough t he commer ci al book- ent r y syst em. Gener ally, an
eligible secur it y can be st r ipped at any t ime f r om it s issue dat e unt il it s call or
mat ur it y dat e. Secur it ies ar e assigned a st andar d ident if icat ion code known as
a CUSI P number . CUSI P is t he acr onym for Commit t ee on Unifor m Secur it y
I dent ificat ion Pr ocedur es. Just as a fully const it ut ed secur it y has it a unique
CUSI P number, each STRI PS component has a unique CUSI P number. All
int er est STRI PS t hat ar e payable on t he same day, even when st r ipped f r om
differ ent secur it ies, have t he same gener ic CUSI P number s. However , t he
pr incipal STRI PS f r om each not e or bond have a unique CUSI P number .
STRI PS component s can be r eassembled or " r econst it ut ed" int o a f ully
const it ut ed secur it y in t he commer cial book- ent r y syst em. To r econst it ut e a
secur it y, a f inancial inst it ut ion or gover nment secur it ies br oker or dealer must
obt ain t he appr opr iat e pr incipal component and all unmat ur ed int er est
component s for t he secur it y being r econst it ut ed. The pr incipal and int er est
component s must be in t he appropriat e minimum or mult iple amount s for a
secur it y t o be r econst it ut ed. The f lexibilit y t o st r ip and r econst it ut e secur it ies
allows invest or s t o t ake advant age of var ious holding and t r ading st r at egies
under changing f inancial mar ket condit ions t hat may t end t o f avour t r ading
and holding STRI PS or f ully const it ut ed Tr easur y secur it ies.

Ter m Mon ey
Money bor r owed and l ent f or a per iod beyond 14 days is known as t er m
money

Tr easur y Bi l l s
Treasury Bills are short - t er m obligat ions of t he Tr easur y/ Gover nment . They
ar e inst r ument s issued at a discount t o t he face value and for m an int egr al
236
par t of t he money mar ket . I n I ndia t r easur y bills ar e issued f or t wo mat ur it ies
91 days and 364 days.

Uni f or m Pr i ce Auct i on
See Dut ch Auct ion

WDM Segmen t
The Nat ional St ock Exchange of I ndia has t hr ee t r ading segment s, one is t he
Capit al Market s Segment , Fut ure & Opt ion Segment and t he ot her is t he
Wholesale Debt Market Segment . The Capit al Market s Segment is meant for
equit ies t r ading wher eas all t he t r ades in debt inst r ument s ar e put t hr ough
t he WDM Segment . The WDM r epr esent s a f or mal scr een- based t r ading and
r epor t ing mechanism for secondar y mar ket t r ades in debt inst r ument s. The
F&O segment is meant for t r ading in equit y and int er est r at e der ivat ives.

Wi n n er s Cu r se
I n a Fr ench auct ion, ever y successful bidder is one whose bid is equal or
higher t han t he cut - off price. Therefore, successful bidders have t o pay a
pr emium on t he cut - off pr ice, on being successful in t he auct ion. This is
called t he winner s cur se in t r easur y auct ions.

Yi el d Cu r v e
The relat ionship bet ween t ime and yield on a homogenous risk class of
secur it ies is called t he Yield Cur ve. The r elat ionship r epr esent s t he t ime value
of money - showing t hat people would demand a posit ive r at e of r et ur n on
t he money t hey ar e wi l l i ng t o par t t oday f or a payback i nt o t he f ut ur e. I t al so
shows t hat a Rupee payable in t he fut ure is wor t h l ess t oday because of t he
r elat ionship bet ween t ime and money. A yield cur ve can be posit ive, neut r al
or flat . A posit ive yield curve, which is most nat ural, is when t he slope of t he
cur ve is posit ive, i. e. t he yield at t he longer end is higher t han t hat at t he
shor t er end of t he t ime axis. This r esult s as people demand higher
compensat ion for par t ing t heir money for a longer t ime int o t he fut ur e. A
neut ral yield curve is t hat which has a zero slope, i. e. is flat across t ime. This
occur s when people ar e willing t o accept mor e or less t he same r et ur ns acr oss
mat ur it ies. The negat ive yield cur ve ( also called an inver t ed yield cur ve) is
one of which t he slope is negat ive, i. e. t he long t er m yield is lower t han t he
shor t t er m yield. I t is not of t en t hat t his happens and has impor t ant economic
r amificat ions when it does. I t gener ally r epr esent s an impending downt ur n in
t he economy, wher e people ar e ant icipat ing lower int er est r at es in t he fut ur e.

Yi el d Pi ck- Up
Yield pick up or yield give up r efer s t o t he yield gained or lost at t he t ime of
init iat ion of a t r ade pr imar ily in bonds and debent ur es. Suppose one sold
12.50 % GOI 2004 at a yield of 10.00 per cent and moved int o 11.83 % GOI
2014 at a yield of 11. 25 per cent t he yield pick up is t o t he t une of 125 basis
point s. I f one did exact ly t he reverse of t his t he yield give up is t o t he ext ent
of 125 bps. These concept s ar e or dinar ily used in bond swap evaluat ion.
237

Yi el d To Mat u r i t y
Yield t o Mat ur it y ( YTM) is t hat r at e of discount t hat equat es t he discount ed
value of all f ut ur e cash f lows of a secur it y wit h it s cur r ent pr ice. I n a way, it is
anot her way of st at ing t he pr ice of a secur it y as ot her t hings r emaining
const ant t he pr i ce i s a di r ect f unct i on of t he YTM. The def i ci ency of YTM i s
t hat it assumes t hat all int ermediat e and final cash flow of t he securit y is re-
invest ed at t he YTM, which ignor es t he shape of t he yield cur ve. This makes
YTM applicable as a measure for an individual securit y and t o different bonds
in t he same r isk class. The YTM, given it s inst rument - specific nat ure does not
pr ovide unique mapping f r om mat ur it y t o int er est r at e space. I t is used
pr imar ily f or it s simplicit y of nat ur e and ease of calculat ion. Mor e
sophist icat ed t r ader s would use t he Zer o Coupon Yield Cur ve ( ZCYC) f or
valuat ion. See Zer o Coupon Yield Cur ve.

Zer o Cou pon Bon d
A Zer o Coupon Bond ( ZCB) is one t hat pays no per iodic int er est ( does not
car r y a coupon) . These bonds ar e t ypically issued at a discount and r edeemed
at f ace value. The discount r at e, appr opr iat ed over t he life of t he bond is t he
effect ive int erest paid by t he issuer t o t he invest or. I n I ndia, t he spect rum of
ZCB is virt ually non- exist ent beyond one year . Upt o one year , t he Tr easur y
Bills issued ar e pr oxies for ZCB. Also see Zer o Coupon Yield Cur ve.

Zer o Cou p on Yi el d Cu r v e
The Zer o Coupon Yield Cur ve ( also called t he Spot Cur ve) is a r elat ionship
bet ween mat urit y and int erest rat es. I t differs from a normal yield curve by
t he f act t hat it is not t he YTM of coupon bear ing secur it ies, which get s plot t ed.
Represent ed against t ime ar e t he yields on zer o coupon inst r ument s acr oss
mat ur it ies. The benefit of having zer o coupon yields ( or spot yields) is t hat
t he def iciencies of t he YTM appr oach ( See Yield t o Mat ur it y) ar e r emoved.
However , zer o coupon bonds ar e gener al l y not avai l abl e acr oss t he ent i r e
spect r um of t ime and hence st at ist ical est imat ion pr ocesses ar e used. The
NSE comput es t he ZCYC f or t r easur y bonds using t he Nelson- Seigel
pr ocedur e, and disseminat es t his infor mat ion on an ever yday basis. The zer o
coupon yield curve is useful in valuat ion of even coupon bearing securit ies
and can be ext ended t o ot her risk classes as well aft er adj ust ing for t he
spr eads. I t is also an impor t ant input for r obust measur es of Value at Risk
( VaR) .

238
Gui del i ne f or usi ng Ex cel :

To calculat e yield t o mat urit y ( YTM) or t erm t o mat urit y of bonds, durat ion,
modif ied dur at ion et c. inser t f unct ion ( f x) of Micr osof t Excel can be used
effect ively.

1. Enable Mi cr osof t Ex cel applicat ion in t he PC as follows:
Log int o Excel and go t o Tools
Select Add- ins
Choose ( put t ick mar ks on) Analysis ToolPak and Analysis
ToolPakVBA
Click on OK.
Re- login int o Excel.

2. I nser t t he par amet er s r elevant t o a funct ion in Excel sheet cells:
For example, t o calculat e YTM, YI ELD f unct ion of Excel may be used.
I nser t r elevant par amet er s like Set t lement dat e, Mat ur it y dat e,
Coupon, Pr ice, Redempt ion, Fr equency and Basis in separ at e cells in
an Excel sheet as shown in a sample scr een- 1 below:

Sampl e scr een- 1

239
3. Choose a new cel l f or out put and eit her click on fx key or go t o I nser t
and select Funct ion. A pop up window of I nser t Funct ion would
appear.

4. Select desired funct ion YI ELD from t he list by eit her t yping it out in
t he window sear ch f or a f unct ion or by choosing All f r om t he pull out
menu of Or select a cat egory window of I nsert Funct ion and click on
OK. A Funct ion Argument s window for YI ELD would be displayed as
shown in sample scr een- 2.

Sampl e Scr een- 2

I n t he Funct ion Argument s window, bring t he cursor in t he first field
Set t lement pick up t he input paramet er from relevant cell in t he Excel sheet
alr eady cr eat ed ( in t he above sample scr een cell C3) . Same pr ocedur e may
be followed for t he ot her par amet er s and click on OK. Calculat ed out put ,
here yield, would appear as For mula result .

11 FIMMDA-NSE Debt Market (Basic)

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