Presentation 2

Indian Debt Market UTI AMC Limited Praloy Majumder Mumbai May 8th ,9th & 10th ,2008

Government of India Securities … • One applicant may submit more than one bid at different rates of yield or prices but for each different rates of yields and prices one has to submit separate application forms. • The yield or price is fixed depending on the type of auction – In case of Uniform price auction competitive bids offered with rates up to and below or the prices up to and above are offered at the maximum rate or minimum price. Bids quoted higher than the maximum yield or lower than the minimum rate are not accepted. – In case of multiple price auction competitive bids offered with rates up to and below the maximum yield / prices up to and above the minimum prices are allotted as per the yield or price of the bids received.

Classification of Investment … • The entire investment portfolio of the FIs will be classified under three categories: – ‘Held to Maturity’ – ‘Available for Sale’ – ‘Held for Trading’ • The securities acquired by the FIs with the intention to hold them till maturity will be classified under Held to Maturity. • The securities acquired by the FIs with the intention to trade by taking advantage of the short-term price/ interest rate movements etc. will be classified under Held for Trading • The securities, which do not fall within the above two categories, will be classified under Available for Sale.

Borrowing Process

New Role of PD • As you are aware, in terms of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the Reserve Bank of India’s participation in the primary issues of Government securities stands withdrawn . • PDs will be required to meet underwriting commitment instead of the earlier requirements of bidding commitment and voluntary underwriting. The underwriting commitment will be divided into two parts - i) Minimum Underwriting Commitment (MUC) and ii) Additional Competitive Underwriting (ACU).

MUC • The MUC of each PD will be computed to ensure that at least 50 percent of each issue is mandatorily covered by the aggregate of all MUCs. • The MUC will be uniform for all PDs, irrespective of their capital or balance sheet size. • Since the MUC would not be through a bidding process, the same would be incorporated in the Undertaking given by the PDs to RBI, every year to enable compulsory minimum underwriting for each auction.

AUC • The remaining portion of the notified amount will be open to competitive underwriting through underwriting auctions. • Each PD would be required to bid for a minimum amount equal to the MUC.The auctions could be either uniform price-based or multiple price-based depending upon the market conditions and other relevant factors, which will be announced before the underwriting auction for each issue. • All successful bidders in the ACU auction will get commission as per auction rules.

Commission • Those PDs who succeed in the ACU for 4 per cent and above of the notified amount of the issue, will get commission on their MUC (3 percent) at the weighted average of all the accepted bids in the ACU. Others will get commission on the 3 percent in MUC at the weighted average rate of the three lowest bids in the ACU.

Repo and Reverse Repo • Reverse Repo means sales of security by RBI . So it is borrowing by RBI. • Repo means purchase of security by RBI. So it is lending by RBI. • So which rate would be more ?

Session Four

Bond Characteristics • Face or par value • Coupon rate – Zero coupon bond • Compounding and payments – Accrued Interest • Indenture

Provisions of Bonds • • • • • •

Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds

Bond Pricing T

T PB = ∑ C t t + ParValue T (1+ r ) t =1 (1+ r )

PB =

Price of the bond

Ct =

interest or coupon payments

T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity

Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 20

1

1000 P = 40∑ + t 20 (1.03) t =1 ( 1.03) P = $1,148.77 Ct FV T r

= 40 (SA) = 1000 = 20 periods = 3% (SA)

Prices and Coupon Rates Price

Yield

Yield to Maturity • Interest rate that makes the present value of the bond’s payments equal to its price. Solve the bond formula for r T

C t PB = ∑ t t =1 (1+r )

ParValue T + T (1+r )

Yield to Maturity Example

35 950 = ∑ t t= 1 (1+r ) 20

10 yr Maturity

1000 + T (1+r )

Coupon Rate = 7%

Price = $950 Solve for r = semiannual rate

r = 3.8635%

Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386)2 - 1 = 7.88% Current Yield Annual Interest / Market Price $70 / $950 = 7.37 %

Realized Yield versus YTM • Reinvestment Assumptions • Holding Period Return – Changes in rates affects returns – Reinvestment of coupon payments – Change in price of the bond

Holding-Period Return: Single Period HPR = [ I + ( P0 - P1 )]

/P

where I = interest payment P1 = price in one period P0 = purchase price

0

Holding-Period Example CR = 8% YTM = 8% N=10 years Semiannual CompoundingP0 = $1000 In six months the rate falls to 7% P1 = $1068.55 HPR = [40 + ( 1068.55 - 1000)] / 1000 HPR = 10.85% (semiannual)

Holding-Period Return: Multiperiod • Requires actual calculation of reinvestment income • Solve for the Internal Rate of Return using the following: – Future Value: sales price + future value of coupons – Investment: purchase price

Default Risk and Ratings • Rating companies – Moody’s Investor Service – Standard & Poor’s – Duff and Phelps – Fitch • Rating Categories – Investment grade – Speculative grade

Factors Used by Rating Companies • • • • •

Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt

Protection Against Default • • • •

Sinking funds Subordination of future debt Dividend restrictions Collateral

Default Risk and Yield • Risk structure of interest rates • Default premiums – Yields compared to ratings – Yield spreads over business cycles

Managing Fixed Income Securities: Basic Strategies • Active strategy – Trade on interest rate predictions – Trade on market inefficiencies • Passive strategy – Control risk – Balance risk and return

Bond Pricing Relationships Bond

Coupon

Maturity

Initial YTM

A

12%

5 Years

10%

B

12%

30 Years

10%

C

3%

30 Years

10%

D

3%

30 Years

6%

Bond Pricing Relationships Bond A

Bond B

Bond C

Bond D

Price at 10% YTM

1075.82

1188.54

340.12

587.06

Price at 11% YTM (ABC) and 7% (D)

1036.96

1086.94

304.50

503.64

Price at 9% YTM(ABC) and 5% (D)

1116.69

1308.21

383.58

692.55

Percentage change in bond prices

Bond Pricing Relationships

A B C Changes in Yield to Maturity

D

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

Bond Pricing Relationships Bond A Decrease in Price due to increase in Yield

-38.86

Bond B -101.60

Bond C -35.62

Bond D -83.42

Increase in Price due to decrease in yield

40.87

119.67

43.46

105.50

% Change

-3.61%

-8.55%

-10.47%

-14.21%

% Change

3.80%

10.07%

12.78%

17.97%

Bond Pricing Relationships (cont’d) • As maturity increases, price sensitivity increases at a decreasing rate. • Price sensitivity is inversely related to a bond’s coupon rate. • Price sensitivity is inversely related to the yield to maturity at which the bond is selling.

Duration • A measure of the effective maturity of a bond. • The weighted average of the times until each payment is received, with the weights proportional to the present value of the payment. • Duration is shorter than maturity for all bonds except zero coupon bonds. • Duration is equal to maturity for zero coupon bonds.

Duration: Calculation wt = CF t (1 + y )

t

Price

T

D = ∑t ×wt t =1

CFt =Cash Flow for period t

Duration Calculation: Example using Table 16.3 8% Bond

Time years

Payment

PV of CF (10%)

Weight

C1 X C4

.5

40

38.095

.0395

.0197

1

40

36.281

.0376

.0376

1.5

40

34.553

.0358

.0537

2.0

1040

855.611

.8871

1.7742

sum

964.540

1.000

1.8852

Duration/Price Relationship Price change is proportional to duration and not to maturity. ∆P/P = -D x [∆(1+y) / (1+y) D* = modified duration D* = D / (1+y) ∆P/P = - D* x ∆y

Rules for Duration Rule 1 The duration of a zero-coupon bond equals its time to maturity. Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower. Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity. Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower.

Rules for Duration (cont’d) Rules 5 The duration of a level perpetuity is equal to: (1 +y) Rule 6 The duration of a level annuity is equal to: y

1+ y T − y (1 + y ) T − 1

Rules for Duration (cont’d) Rule 7 The duration for a corporate bond is equal to:

1 + y (1 + y ) + T (c − y ) − y c[(1 + y ) T − 1] + y

Duration and Convexity Price

Pricing Error from convexity Duration Yield

Convexity • Convexity : – 1/ P*(1+y)2*∑[CFt/(1+y)t (t2+t)]

Yield Curve

Yield Curve and Term Structure of Interest Rate • Yield Curve : If we plot the yield ( observed on a particular day ) of different securities of different maturity in Y axis against the corresponding maturity of the securities in the X axis, we get an Yield curve. The Yield curve can take the shape of the following : – Upward slopping yield curve – Downward slopping yield curve – Flat Yield Curve

Yield Curve and Term Structure of Interest Rate • The shape of the yield curve is explained with the help of the term structure of interest rate. The term structure has three theories : – Unbiased Expectation Theory – Liquidity Preference Theory – Market Segmentation Theory

Yield Curve and Term Structure of Interest Rate • • • •

• • •

Unbiased expectation theory : It holds that the forward rate represents the average opinion of the expected future spot rate for the period in question. The investor could follow a maturity strategy investing the money now for the two years at two years spot rate of say 8% p.a and at the end , he will get 1.1664. Or he can invest in 1 year for 7% to get 1.07 after one year and then to reinvest after one year. Although the investor does not know what the one year spot rate will be one year from now, the investor has an expectation about what it would be. This is denoted by es1,2. .If

the investor thinks that it will be 10% , then his.her investment has an expected value 1.177(=1*1.07*1.10) In this case , the investor would chose a roll over strategy. Under this unbiased expectation theory, the equilibrium condition is satisfied by the following equation :

– (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2

Yield Curve and Term Structure of Interest Rate – (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2 – The meaning of the above equilibrium equation is that the expected return from a maturity strategy must equal the expected return on a rollover strategy. – An upward slopping yield curve would be explained by the fact that es1,2 is to expected to rise in the future; – An downward slopping yield curve would be explained by the fact that es1,2 is to expected to decline in the future;

Yield Curve and Term Structure of Interest Rate • Liquidity Preference Theory : It starts with the notion that investors are primarily interested in purchasing short term securities. This is due to price risk . • Considering this , the investor must require a premium for investment in the longer term security. This is called the liquidity premium. • This is defined as the difference between the forward rate and expected spot rate . So f12 = es12 + L12

Yield Curve and Term Structure of Interest Rate • Liquidity Preference Theory : The equation of the Liquidity Preference theory : – (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2 – The above inequality holds as the maturity strategy is more risky so the return should be more. Downward slopping Yield Curve : Here s1> s2 . The above inequality will hold if es1,2 is substantially lower than the s1 implying that the market interest rate is expected to decline sharply. Flat Yield Curve : Here s1= s2 The above equation will be true if es1,2 is less than s1 .

Yield Curve and Term Structure of Interest Rate • Liquidity Preference Theory : The equation of the Liquidity Preference theory : – (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2 – The above inequality holds as the maturity strategy is more risky so the return should be more. Downward slopping Yield Curve : Here s1> s2 . The above inequality will hold if es1,2 is substantially lower than the s1 implying that the market interest rate is expected to decline sharply. As an example, assume that the one year spot rate (s1) is 7% and the two year spot rate (s2) is 6%. This is a situation where the term structure is downward slopping.

Yield Curve and Term Structure of Interest Rate • Liquidity Preference Theory : Now according to the liquidity preference theory, (1+0.07)(1+es12) <(1.06)2 Which can be true only if the expected future spot rate is substantially less than 7% . • Flat Yield Curve : Here s1= s2 The above equation will be true if es1,2 is less than s1 . • The flat yield curve would imply that the market place expects the interest rate to decline.

Yield Curve and Term Structure of Interest Rate •

Liquidity Preference Theory : The equation of the Liquidity Preference theory : – (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2 Upward slopping Yield Curve : Here s1< s2 . If it is slightly upward slopping , this can be consistent with an expectation that interest rate are going to decline in future. For example, if s1 is 7% and s2 is 7.1% , then the forward rate would be given by : (1+f12 )= [(1+s2)2]/[(1+s1)] and the forward rate would be 7.2%. Considering a liquidity premium of more than 0.2%, the es12 would be less than 7%.So an upward slopping yield curve means market expects a small decline in spot rate . If the term structure is more steeply sloped, then it is more likely that market place expects the interest rate will rise in the future.

Yield Curve and Term Structure of Interest Rate • Market Segmentation Theory: According to this theory the interest rate is determined mainly by the demand and supply situation of the market concerned. This explains the phenomena like sudden spurt in call money rate even when the long term market is steady and upward slopping .

Long term and Short Term Interest Rates

Bond Portfolio Management

• • • •

•

Immunization Suppose bank wants to fund this obligation with Rs 10000 of 8%

annual coupon bonds , selling at par value with six years to maturity. As long as interest rate remains 8% , the bank funds its obligations. If interest rate changes, two offsetting influences will affect the ability of the fund to grow to the targeted value of Rs 14,693.28. If interest rate rises, the fund will suffer a capital loss , impairing its ability to satisfy its obligations. However, at a higher investment rate, reinvested coupon will grow at a faster rate, offsetting the capital loss. Fixed income investors face two offsetting types of rate risk: – Price risk – Reinvestment risk

Immunization • Increase in interest rate causes capital losses but at the same time increase the rate at which the coupon is reinvested. • If the portfolio duration is chosen appropriately, these two effects will cancel out exactly. • For a horizon equal to portfolios duration, price risk and reinvestment risk exactly cancels out.

Payment No

1 2 3 4 5 5

1 2 3 4 5 5

Immunization

Years Remaining until Accumulated Value of Invested obligation Amount A .Interest remains at 8% 4 800(1.08)4=1088.39 3 2 1 0 0 Total B .Interest falls to 7 % 4 3 2 1 0 0 Total

800(1.08)3=1007.77 800(1.08)2= 933.12 800(1.08)1=864.00 800(1.08)0=800.00 10,800/(1.08) =10000.00 14693.28 800(1.07)4=1048.64 800(1.07)3= 980.03 800(1.07)2= 915.92 800(1.07)1=856.00 800(1.07)0=800.00 10,800/(1.07) =10093.46 14694..05

Immunization Payment No

1 2 3 4 5 5

Years Remaining until Accumulated Value of Invested obligation Amount C .Interest increases to 9 % 4 800(1.09)4=1129.27 3 2 1 0 0

800(1.09)3=1036.02 800(1.09)2= 950.48 800(1.09)1=872.00 800(1.09)0=800.00 10,800/(1.09) =9908.26

Total

14696.02

Immunization Accumulated value of Invested Fund

t*

D*

Time

Immunization • As the time passes on the duration of the asset profile changes . • This brings the importance of rebalancing the portfolio. • The manager must rebalance the portfolio continuously to keep the duration of the portfolio equal to the maturity profile of the liability. • This is so because duration generally decreases less rapidly than does maturity. • So even if the portfolio is immunized at the beginning , the maturity and duration fall in different rate,necessitating the rebalancing of the portfolio.

Immunization • There are many shortcomings in immunization technique : • It assumes that the portfolio yield curve is flat. • In the case of an upward sloping yield curve, the appropriate rate need to be taken from the yield curve. • Next is the parallel shift in yield curve. In case on non parallel shift in yield curve immunization technique would not be able to protect the portfolio from the interest rate risk. • The immunization does not address the inflation issues at all.

Cash Flow Matching and Dedication

• In case of cash flow matching, the obligations are first found out for a particular period and then cash flows are matched by forming a portfolio. • Once matching is carried out, the portfolio need not be immunized. • When matching is done for the entire investment horizon, it is called dedication technique. • But getting bonds to follow the cash flow matching and dedication technique is very difficult.

Active Bond Management Technique

• There are two ways for active bond management technique. – Interest rate forecasting : it tries to anticipate movements across the entire spectrum of the fixed income markets. – Identification of relative mis pricing within fixed income markets • Both the techniques would generate abnormal returns only if the analyst’s information or insight is superior to that of the market. • Empirical evidences do not support that individual possesses better knowledge than that of the market.

Bond Swap • This belong to the active bond management technique. • Bond swap means replacement of one types of bonds with that of another. • There are fives types of bond swaps : – The substitution swap – The intermarket spread swap – The rate anticipation swap – The pure yield swap – The tax swap

•

Different types of bonds The substitution swapSwap is an exchange of one bond for a nearly

identical substitute. The substituted bonds should be of essentially equal coupon,maturity, quality,call feature ,sinking fund provisions etc. This swap would be motivated by a discrepancy between the prices of the bonds represents a profit opportunity. • The Intermarket spread swap is pursued when an investor believes that the yield spread between two sectors of the bond markets is out of line. For example if the current spread between the corporate and government bond market is considered too wide and is expected to narrow, the investor will shift from government bond to corporate bond.

Different types of bonds Swap • The rate anticipation swap is pegged to interest rate forecasting.If the investor views that interest rate is likely to decrease, it would replace shorter duration bond with longer duration bond . • The pure yield swap is aimed to earn the higher yield. This strategy involves replacement of lower yield bond with higher yield. • The tax swap is to exploit some tax benefits by adjusting capital loss from future gains – the facilities available with some selected securities.

Horizon Analysis • The analysts using this approach selects a particular holding period and predicts the yield curve at the end of the period. • Then bond’s end of period price is calculated from the yield curve. • Then the analysts add the coupon income and the perspective capital gain of the bond to arrive at the total return on bond in the horizon period.

•

Horizon Analysis Suppose a 20 year maturity ,10% coupon bond currently yields

9% and sells at Rs 1092.01. • An analyst with a 5 year time horizon would be concerned about the bond’s price and the value of reinvested coupon five years hence. • At that time the bond will have 15 years maturity , so the analyst will predict the yield on 15 years maturity at the end of 5 year period to determine the bond’s expected price . • If the yield is expected to be 8% , the bond’s end of period price will be – 50 * Annuity Factor ( 4% ,30)+1,000 PV Factor ( 4%,30)= Rs 1172.92

Horizon Analysis

• The capital gain on this bond will be Rs 80.91 . • Meanwhile the coupon paid by the bond will be reinvested over the five year period. • The analyst must predict a reinvestment rate at which the invested coupons can earn interest. • Suppose the assumed rate is 4% per half year period. • If all the coupons are reinvested at this rate,the value of the ten semiannual coupon payments with accumulated interest rate at the end of the five year will be Rs 600.31. • The total return proved by the bond over the holding period is Rs 681.82/Rs 1092.01 i.e. 62.4% . • The analyst repeats this procedure for many securities and select the ones promising superior holding period return.

Contingent Immunization • It is mixed passive –active strategy . • Suppose that the interest rate at present is 10% per annum and a manager’s portfolio is worth Rs 10 million right now. • At current rate the manager can lock in via conventional immunization techniques, a future portfolio value of Rs 12.1 million after 2 years. • Now suppose that the manager wants to pursue active management but is willing to risk losses only to the extent that the terminal value of the portfolio would not drop lower than Rs 11 million. • Because only Rs 9.09 million ( Rs 11million/1.102) is required to achieve this minimum acceptable terminal value , and the portfolio is currently worth Rs 10 million , the manager can afford to risk some losses at the outset and might start off with an active strategy rather than immediately immunizing.

Contingent Immunization

• The key is to calculate the value of the fund required to lock in via immunization a future value of Rs 11 million at current rates. • If T denotes the time left until the horizon date and r is the market interest rate at any particular point of time , then the value of the fund necessary to guarantee an ability to reach the minimum amount of terminal value is Rs 11 million/(1+r)T, because this size portfolio if immunized will fetch Rs 11 million. • This value becomes the trigger point. • When the actual portfolio value dips to the trigger point , active management will cease. • Contingent upon reaching the trigger , an immunization strategy is initiated .

Contingent Immunization Rs in Million

Portfolio Value

Trigger Point

t*

Horizon

t

Contingent Immunization Rs in Million

Portfolio Value

t*

Horizon

t

Interest Rate Derivatives

Interest Rate Swap

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

Interest Rate SWAP 5.0% Company B

Company A LIBOR

Cash Flows to Company B Date

LIBOR rate ( %)

Floating Cash Flow Received

Fixed Cash Flow Paid

Net Cash Flow

1.3.1999

4.20

1.9.1999

4.80

+2.10

-2.50

-0.40

1.3.2000

5.30

+2.40

-2.50

-0.10

1.9.2000

5.50

+2.65

-2.50

+0.15

1.3.2001

5.60

+2.75

-2.50

+0.25

1.9.2001

5.90

+2.80

-2.50

+0.30

1.3.2002

6.40

+2.95

-2.50

+0.45

Cash Flows to Company B Date

LIBOR rate ( %)

Floating Cash Flow Received

Fixed Cash Flow Paid

Net Cash Flow

1.3.1999

4.20

1.9.1999

4.80

+2.10

-2.50

-0.40

1.3.2000

5.30

+2.40

-2.50

-0.10

1.9.2000

5.50

+2.65

-2.50

+0.15

1.3.2001

5.60

+2.75

-2.50

+0.25

1.9.2001

5.90

+2.80

-2.50

+0.30

1.3.2002

6.40

+102.95

-102.50

+0.45

Interest Rate SWAP • If we see the previous slide we find out the following interesting phenomena : – Position of B is : • Long on a Floating Rate Bond ; • Short on Fixed Rate Bond; – Position of A is : • Long on a Fixed Rate Bond; • Short on Floating Rate Bond;

Use of Interest Rate SWAP • For Company B the swap could be used to transform a floating rate loan into a fixed rate loan. • Suppose Company B has arranged to borrow $

Forward Rate Agreement

FRA • A forward rate agreement (FRA) is a forward contractin which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate(the underlyingrate). The payments are calculated over a notional amountover a certain period, and netted, i.e. only the differential is paid. It is paid on the effective date. The reference rate is fixed zero, one or two days before the termination date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs. • The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.

FRA • The netted payment made at the termination date is: Payment = Notional Amount * ( Reference Rate – Fixed rate ) *α)/( Reference Rate * α+1) • The Fixed Rate is the rate at which the contract is agreed. • The Reference Rate is typically MIBOR, GOI rate etc. • α is the day count fraction, i.e. the portion of a year over which the rates are calculated, using the day count conventionused in the money markets in the underlying currency. • The Fixed Rate and Reference Rate are rates that should accrue over a period starting on the termination date, and then paid at the end of the period. However, as the payment is already known at the beginning of the period, it is also paid at the beginning. This is why the discount factor is used in the denominator.

Interest Rate Futures

Interest Rate Futures Contracts • Interest Rate Futures Contracts are contracts based on the list of underlying as may be specified by the Exchange and approved by SEBI from time to time. To begin with, interest rate futures contracts on the following underlyings shall be available for trading on the F&O Segment of the Exchange : – Notional T Bills – Notional 10 year bonds (coupon bearing and noncoupon bearing)

Interest Rate Futures Settlement Price • Daily settlement price for an Interest Rate Futures Contract shall be the closing price of such Interest Rate Futures Contract on the trading day. • Theoretical daily settlement price for unexpired futures contracts, shall be the futures prices computed using the (price of the notional bond) spot prices arrived at from the applicable ZCYC Curve.

Interest Rate Futures Settlement Price • In respect of zero coupon notional bond, the price of the bond shall be the present value of the principal payment discounted using discrete discounting for the specified period at the respective zero coupon yield. • In respect of the notional T-bill, the settlement price shall be 100 minus the annualized yield for the specified period computed using the zero coupon yield curve.

Interest Rate Futures Settlement Price • In respect of coupon bearing notional bond, the present value shall be obtained as the sum of present value of the principal payment discounted at the relevant zero coupon yield and the present values of the coupons obtained by discounting each notional coupon payment at the relevant zero coupon yield for that maturity.

Reading T Bill Futures Quotes T Bill Interest rate futures- Rs 2 lacs ; pts of 100%

July

Open

High

Low

Settle

Chg

Yield Settle Change

Open Interest

94.69

94.69

94.68

94.68

-.01

5.32

47,417

+.01

Eurodollar futures prices are stated as an index number of threemonth LIBOR calculated as F = 100 – T Bill Rate. The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 – 98.68

Interest Rate Caps or collars • An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. • In mathematical terms, a caplet payoff on a rate L struck at K is where N is the notional value exchanged and α is the day count fraction corresponding to the period to which L applies. For example suppose you own a caplet on the six month USD LIBOR rate with an expiry of 1 February 2007 struck at 2.5% with a notional of 1 million dollars. Then if the USD LIBOR rate sets at 3% on 1st February you receive 1m*0.5*max(0.03-0.025,0) = $2500.

Interest Rate Floors • An interest rate floor is a series of European put options or floorlets on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate fixed is below the agreed strike price of the floor.

New Instruments for Managing Interest Rate Risk

• Interest rate derivatives are the instruments which are used to manage Interest Rate Risk. • One such instrument is the Inverse Floater. • This is bond which pays lower coupon when interest rate rises. – For example an Inverse Floater would pay coupon rate income equal to 10%minus the rate on one year T Bill Rate .If the T Bill rate is 4% then the bond would pay coupon of 6% . • If the T Bill rate increases to 7% then the bond would pay 3% of par value : in addition , as other interest rates rise along with T Bill rate , the bond price falls as well for the usual reason that future cash flows are discounted at higher rates. • Therefore there is a dual impact and this securities fair poorly specially when interest rate rises.

New Instruments for Managing Interest Rate Risk

• Conversely it works very well when interest rate falls.

Interest Rate Risk Management • With the help of interest rate swap one can manage the interest rate movement. • Collateralized Mortgage Obligation (CMO) is another tool with which interest rate risk can be managed. • In the case of CMO, Interest Only (IO) strips and Principle Only (PO) strips would trade separately. • PO securities exhibit very long effective duration – that is their value is very sensitive to interest rate fluctuations. It performs very well if the interest rate fall. • IO securities fall when interest rate fall. It has negative effective duration. This is good for an investor who is betting an increase in interest rate.

Strategy on High Interest Situation

Interest Rate and Bond Price

• As we have said that interest rate and bond price is reciprocally related. • If interest rate goes up the price of the bond goes down. • A fund would incur losses if the fund has to sell these bonds before maturity. • So in a rising interest rate situation if a fund has invested in large maturity debt security, the bond price would come down with increase in interest rate and the NAV would be lower. • So in a rising interest rate this should not be right investment option.

Interest Rate and Bond Price

• In a rising interest rate situation, definitely one can make more money providing he/she can not incur capital loss. • Capital loss occurs when you have invested in security having maturity more than your investment horizon. • So in high interest rate situation, you have to invest in debt securities which is maturing along with your investment horizon. • There can be two such investment options.

Liquid Funds • When an investor is uncertain about the interest rate and about the timing of money requirement , he /she can invest in Liquid fund. • Since in the case of liquid fund , the securities are of shorter duration, the investor would get the benefit of higher interest rate.

Short Term Debt Funds

• Short-term debt funds do insulate losses from high interest rate and also can even give a slightly higher return. • The difference between a liquid fund and a short-term debt fund is the investment tenure. Liquid funds are ideal for investors with an investment tenure ranging from 1 day to 30 days. • While investors can remain invested in liquid funds for longer than that, the return may begin to look a little unattractive compared to the next product on the maturity parameter i.e. short-term debt funds

Corporate Bond

Corporate Bonds • Corporate bonds are the fixed income instrument issued by Corporations other than the Government. • There are broadly two types of institutions which issue corporate bonds namely Private Sector Companies and Public Sector Companies.

Corporate Bonds • Under the case of Public Sector Undertaking ( PSU) two types of bonds can be issued , namely Tax Free Bond and Taxable Bond. • In the case of tax free bonds the interest is tax free and in the case of taxable bond , the interest is taxable at the issue of the receiver of interest. The bonds issued by PSU companies are also popularly known as PSU Bonds. • In the case of other companies namely Private Sector Companies ( which consist of both Private and Public Limited companies ) some times these bonds are also called as Debentures .

Corporate Bonds • Besides these companies one of the other major players in the bond market is the bank and financial institutions . • Banks continuously issue bonds to shore up its Tier II capital which is required for meeting its capital adequacy ratio. Similar principle is applicable for Financial Institutions. • Though a mature bond market is must for overall development of the economy as company uses leverages to raise more capital , yet in India bond market has not developed to that extent. • However, there are enough opportunities to invest in the bond in the retail segment.

Issue Process

• Passing of necessary resolution in the General Meeting and Board Meeting. • Obtaining the necessary credit rating. • Creation of security for the said bonds/debentures through appointment of debenture trustees. • Appointment of advisors and investment bankers for issue management ; • Finalisation of the initial terms of the issue; • Preparation of the offer document ( in the case of Public Issue ) and Investment Memorandum ( in the case of Private Issue ) ; • SEBI approval of offer document for Public Issue;

Issue Process

• Listing agreement with Stock Exchanges. • Offer the issue to prospective investors /and or Book Builders. • Acceptance of application money /advance deposits for the issue; • Allotment of the issue ; • Issue of letter of allotment and certificates/depository confirmation ; • Collect final amounts from the investors; • Refund excess money /interest on application money;

Debenture Trustee • No Company can issue Prospectus or Letter of Offer to Public unless it has appointed one or more debenture trustees for such debentures in accordance with the provisions of the Companies Act 1956. • The names of the Debenture Trustees would be mentioned in the offer document and also in all subsequent periodical communications sent to the debenture holders. • A trust deed shall be executed by the issuer Company in favour of the debenture trustees within three months of the closure of the issue.

Offer Document • Draft offer document would be filed to the SEBI, in the prescribed format. In the case of Private Placement , Investment memorandum would be submitted to the prospective investors;

Creation of Debenture Redemption Reserves ( DRR)

• A company has to create Debenture Redemption Reserves ( DRR) in case of issue of debenture in the maturity as prescribed in the SEBI DIP guidelines and Indian Companies Act, 1956. • A company shall create DRR to the tune of 50% of the redemption amount before the debenture redemption commences. • Withdrawal from DRR is permitted only after at least 10% of the debenture liability has accurately been redeemed by the company . The creation of DRR would not be applicable for debenture to be issued by Infrastructure Companies .

Creation of Debenture Redemption Reserves ( DRR)

• A company has to create Debenture Redemption Reserves ( DRR) in case of issue of debenture in the maturity as prescribed in the SEBI DIP guidelines and Indian Companies Act, 1956. • A company shall create DRR to the tune of 50% of the redemption amount before the debenture redemption commences. • Withdrawal from DRR is permitted only after at least 10% of the debenture liability has accurately been redeemed by the company . The creation of DRR would not be applicable for debenture to be issued by Infrastructure Companies .

Credit Rating • No Company can make Public Issue or Rights Issue of the debenture unless it has obtained credit rating from at least two rating agencies and the rating must be investment grade and the same is disclosed in the offer document. • In the case of Private Placement, QIB insists on the ratings.

Term of Debenture • The terms of the debenture is mentioned in the offer document. In the case of Public Issue the face value is 100. • In the case of issuance the debentures may be clubbed for a single investors , however the investors can ask for split of the debentures and the same can be issued to the investors separately with minimum number of 1. • In the case of private placement no such minimum paid up value is there and generally it is Rs 10 lacs.

Term of Debenture • In the case of fixed interest instrument , the interest is paid as a certain percentage of the face value of the instrument. • The interest is due from the deemed date of allotment and deemed date of allotment is mentioned in the offer document. • In case of floating rate instruments , the interest rate would start from the beginning of the period and it would be applicable till the end of the period.

Term of Debenture • Companies are required to pay investors , interest on application money that is received from the date of realizations of this amount, to the date immediately preceding the deemed allotment at the applicable coupon rate of the debenture. • In case of applications that have been rejected or allotted in part, for the unallotted interest as mentioned above would be paid within 3 weeks of the issue closure , on the refundable application money.

Redemption • Debenture can be hold either in the Physical form or in the demat form . • In the case of the physical form, the physical debenture would have to be surrendered to the company and the Company’s liability will be extinguished once the debenture has been redeemed . • Debentures in the demat form are discharged on payment of redemption amounts to the registered debenture holders as intimated by the depository.

Structured Finance

What is a structured finance • A structured finance is a financial procedure to suit the need of the borrower as per its specific requirement. • In many cases, a borrower may not get funding on a plain vanilla method .However, by properly structuring the process the borrower can be funded. • Similarly by securitising the loans funding can be arranged to meet the specific requirement of the issuer of loan. • Structured finance serves several purpose starting from increase in fund flows in the system to risk mitigation of the system.

Funding of a week company • In the case of plain vanilla lending, a lending institution can lend to a borrower only if it can meet the following criteria : – Profitability : 10% of net sales . – Current Ratio : 1.33 – Leverage Ratio : 1.75 • The lender from its internal model finds that these are the parameters required at a particular point of time to avoid delinquency. • The main concern of the lender is to avoid delinquency.

Funding of a week company • A Company has the following criteria : – Profitability : 3% of net sales . – Current Ratio : 1.03 – Leverage Ratio : 2.75 • The lender wants to finance this Company . • The major concern for the lender is that if a company can not meet the above criteria , there is a probability that the Company would default. • The lender can address this concern by entering into a structured finance agreement with the company.

Funding of a week company • The lender sits with the company and analyses the customer profile of the company . • The lender rates these customers and segregate the best rated customers from the rests. • Now lender enters into agreement with the borrower in such a way that these customers would pay directly to the lender. • The lender overcollateralise the installment by 2 to 3 times . • This is an example of structured finance through escrowing of receivable.

Securitisation • It is used to mean a device of structured financing where an entity seeks

– to pool together its interest in identifiable cash flows over time; – transfer the same to investors either with or without the support of further collaterals; – and thereby achieve the purpose of financing.

Requirement of Securitisation • Securitisation is used for fulfilling the following purpose : – It reduces the capital requirement imposed by the regulator. – It gives an opportunity of investors to suit their requirement as per their subjective risk preferences. – It also reduces the risk of the system .

Terminology in Securitisation •

• •

•

The entity that securitises its assets is called the originator: the name signifies the fact that the entity was responsible for originating the claims that are to be

ultimately securitised. There is no distinctive name for the investors who invest their money in the instrument: therefore, they might simply be called investors. The claims that the originator securitises could either be – existing claims, or existing assets (in form of claims), or – expected claims over time. In other words, the securitised assets could be either existing receivables, or receivables to arise in future. The latter, for the sake of distinction, is sometimes called future flows securitisation, in which case the former is a case of asset-backed securitisation. In US markets, another distinction is mostly common: between mortgagebacked securities and asset-backed securities. This only is to indicate the distinct application: the former relates to the market for securities based on mortgage receivables, which in the USA forms a substantial part of total securitisation markets, and securitisation of other receivables.

Terminology in Securitisation • Since it is important for the entire exercise to be a case of transfer of receivables by the originator, not a borrowing on the security of the receivables, there is a legal transfer of the receivables to a separate entity. In legal parlance, transfer of receivables is called assignment of receivables. • An entity is created solely for the purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or a special purpose entity (SPE) or, if such entity is a company, special purpose company (SPC). • The originator transfers the assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its own securities. Therefore, the SPV is also called the issuer.

Terminology in Securitisation • These securities could either represent a direct claim of the investors on all that the SPV collects from the receivables transferred to it: in this case, the securities are called pass through certificates or beneficial interest certificates as they imply certificates of proportional beneficial interest in the assets held by the SPV. • Alternatively, the SPV might be re-configuring the cash flows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on which the transferred receivables are collected by the SPV. In this case, the securities held by the investors are called pay through certificates. • The securities issued by the SPV could also be named based on their risk or other features, such as senior notes or junior notes, floating rate notes, etc.

Asset Backed Securities ( ABS) Asset Backed Securities in a general sense

CDO Mortgage Backed Securities ( MBS) Residential Mortgage Commercial Mortgage

ABS in a Narrower Sense •Credit Card •Equipment •Student Loan •Music Royalties

CLO Loan owned By Bank

CBO Bonds Traded in the Market

Process of securitisation Credit Enhancer Provides Credit Enhancement

Trustee

Originator / Servicer Receives Fund

Transfer Of Assets

Loan sale

S.P.V.

Principal And Interest Minus Revenues Servicing Debt Fees

Disburses Revenues to Investors

Receives inflow From reference Issuer of Debt Securities

Underwriter

from

Securities

Investors

Distribution Of Debt Securities

CDO • In a Collateralised Debt Obligation ( CDO) structure, the issuer repackages ( corporate or sovereign ) debt securities or bank loans in to a reference portfolio ( the collateral) , whose proceeds are subsequently sold to investors in the form of debt securities with various levels of senior claim on this collateral. • The issued securities are structured in so called senioritised credit tranches, which denote a particular class of debt securities investor may acquire when they invest in a CDO transaction. • The tranching can be done by means of various structural provisioning governing the participations of investors in the proceeds and losses stemming from the collateral.

CDO • Subparticipation is one of the most convenient vehicles for attaching different levels of seniority to categories of issued securities, so that losses are allocated to the lowest subordinate tranches before the mezzanine and senior tranches are considered. • This process of filling up the tranches with periodic losses bottom up results in a cascading effect . • Both interest and losses are allotted according to investor seniority. • This prioritisation of claims and losses from the reference portfolio guarantee that senior tranches carry a high investment grading ( AAA) , provided sufficient junior tranches have been issued to shield more senior tranches from credit losses.

Types of CDO • The classification of CDOs depends on possible variability in the valuation of the collateral ex post the issuance of the securities. • In Market value CDO , the allocation of payments to various tranches depends on the mark to market returns on the reference portfolio underlying the transactions. • The market value form of CDO s is generally applied in cases of distressed reference portfolio of bonds or loans such that the credit and trading expertise of the originator of these assets might provide grounds for arbitrage gains from the differences in prices between the distressed assets on the bank books and their aggregate valuation when bundled in a reference portfolio underlying securities.

Various form of structure enhancement – Waterfall CDO Tranches

AAA Senior Tranches Portfolio

X Y

1000 2000

Payment Made

A Mezzanine Tranches BB Subordinated Tranches Equity Tranches

Z

4000

Various form of structure enhancement •

Over collateralisation : Volume of assets is more than volume of issued notes. • Excess Spread: Difference between interest payment from assets and CDO coupons are collected in an account. • Guarantee by the originator. • Insurance by the third party.