financial enrg

7/30/2019 financial enrg

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1. What is a Government Security?

1.1 A Government security is a tradable instrument issued by the Central Government or the StateGovernments. It acknowledges the Governments debt obligation. Such securities are short term(usually called treasury bills, with original maturities of less than one year) or long term (usually calledGovernment bonds or dated securities with original maturity of one year or more). In India, the

Central Government issues both, treasury bills and bonds or dated securities while the StateGovernments issue only bonds or dated securities, which are called the State Development Loans(SDLs). Government securities carry practically no risk of default and, hence, are called risk-free gilt-edged instruments. Government of India also issues savings instruments (Savings Bonds, NationalSaving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds,fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are, therefore, not eligibleto be SLR securities.

a. Treasury Bills (T-bills)

1.2 Treasury bills or T-bills, which are money market instruments, are short term debt instrumentsissued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day

and 364 day. Treasury bills are zero coupon securities and pay no interest. They are issued at adiscount and redeemed at the face value at maturity. For example, a 91 day Treasury bill of Rs.100/-(face value) may be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would beredeemed at the face value of Rs.100/-. The return to the investors is the difference between thematurity value or the face value (that is Rs.100) and the issue price (for calculation of yield onTreasury Bills please see answer to question no. 26). The Reserve Bank of India conducts auctionsusually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on thefollowing Friday. The 91 day T-bills are auctioned on every Wednesday. The Treasury bills of 182days and 364 days tenure are auctioned on alternate Wednesdays. T-bills of of 364 days tenure areauctioned on the Wednesday preceding the reporting Friday while 182 T-bills are auctioned on theWednesday prior to a non-reporting Fridays. The Reserve Bank releases an annual calendar of T-billissuances for a financial year in the last week of March of the previous financial year. The ReserveBank of India announces the issue details of T-bills through a press release every week.

b. Cash Management Bills (CMBs)

1.3 Government of India, in consultation with the Reserve Bank of India, has decided to issue a newshort-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatchesin the cash flow of the Government. The CMBs have the generic character of T-bills but are issued formaturities less than 91 days. Like T-bills, they are also issued at a discount and redeemed at facevalue at maturity. The tenure, notified amount and date of issue of the CMBs depends upon thetemporary cash requirement of the Government. The announcement of their auction is made byReserve Bank of India through a Press Release which will be issued one day prior to the date ofauction. The settlement of the auction is on T+1 basis. The non-competitive bidding scheme (referredto in paragraph number 4.3 and 4.4 under question No. 4) has not been extended to the CMBs.However, these instruments are tradable and qualify for ready forward facility. Investment in CMBs is

also reckoned as an eligible investment in Government securities by banks for SLR purpose underSection 24 of the Banking Regulation Act, 1949. First set of CMBs were issued on May 12, 2010.

c. Dated Government Securities

1.4 Dated Government securities are long term securities and carry a fixed or floating coupon(interest rate) which is paid on the face value, payable at fixed time periods (usually half-yearly). Thetenor of dated securities can be up to 30 years.

The Public Debt Office (PDO) of the Reserve Bank of India acts as the registry /depository of Government securities and deals with the issue, interest payment andrepayment of principal at maturity. Most of the dated securities are fixed coupon

securities.


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The nomenclature of a typical dated fixed coupon Government security contains the following features- coupon, name of the issuer, maturity and face value. For example, 7.49% GS 2017 would mean:

Coupon : 7.49% paid on face valueName of Issuer : Government of IndiaDate of Issue : April 16, 2007

Maturity : April 16, 2017Coupon Payment Dates : Half-yearly (October 16 and April 16) every yearMinimum Amount of issue/ sale : Rs.10,000

In case there are two securities with the same coupon and are maturing in the same year, then one ofthe securities will have the month attached as suffix in the nomenclature. For example, 6.05% GS2019 FEB, would mean that Government security having coupon 6.05 % that mature in February2019 along with the other security with the same coupon, namely,, 6.05% 2019 which is maturing inJune 2019.

If the coupon payment date falls on a Sunday or a holiday, the coupon payment is made on the nextworking day. However, if the maturity date falls on a Sunday or a holiday, the redemption proceeds

are paid on the previous working day itself.

1.5 The details of all the dated securities issued by the Government of India are available on the RBIwebsite athttp://www.rbi.org.in/Scripts/financialmarketswatch.aspx. Just as in the case of TreasuryBills, dated securities of both, Government of India and State Governments, are issued by ReserveBank through auctions. The Reserve Bank announces the auctions a week in advance through pressreleases. Government Security auctions are also announced through advertisements in major dailies.The investors, are thus, given adequate time to plan for the purchase of government securitiesthrough such auctions.

A specimen of a dated security in physical form is given at Annex 1.

1.6 Instruments:

i. Fixed Rate Bonds These are bonds on which the coupon rate is fixed for the entire life ofthe bond. Most Government bonds are issued as fixed rate bonds.

For example 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturingon April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearlypayment being the half of the annual coupon of 8.24%) of the face value on October 22 and

April 22 of each year.ii. Floating Rate Bonds Floating Rate Bonds are securities which do not have a fixed coupon

rate. The coupon is re-set at pre-announced intervals (say, every six months or one year) byadding a spread over a base rate. In the case of most floating rate bonds issued by theGovernment of India so far,the base rate is the weighted average cut-off yield of the last three

364- day Treasury Bill auctions preceding the coupon re-set date and the spread is decidedthrough the auction. Floating Rate Bonds were first issued in September 1995 in India.

For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thusmaturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at6.50% being the weighted average rate of implicit yield on 364-day Treasury Bills during thepreceding six auctions. In the bond auction, a cut-off spread (markup over the benchmarkrate) of 34 basis points (0.34%) was decided. Hence the coupon for the first six months wasfixed at 6.84%.

iii. Zero Coupon Bonds Zero coupon bonds are bonds with no coupon payments. LikeTreasury Bills, they are issued at a discount to the face value. The Government of Indiaissued such securities in the nineties, It has not issued zero coupon bond after that.

iv. Capital Indexed Bonds These are bonds, the principal of which is linked to an accepted

index of inflation with a view to protecting the holder from inflation. A capital indexed bond,with the principal hedged against inflation, was issued in December 1997. These bondsmatured in 2002. The government is currently working on a fresh issuance of Inflation
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Indexed Bonds wherein payment of both, the coupon and the principal on the bonds, will belinked to an Inflation Index (Wholesale Price Index).In the proposed structure, the principal

will be indexed and the coupon will be calculated on the indexed principal. In order to providethe holders protection against actual inflation, the final WPI will be used for indexation.

v. Bonds with Call/ Put Options Bonds can also be issued with features of optionality wherein

the issuer can have the option to buy-back (call option) or the investor can have the option to

sell the bond (put option) to the issuer during the currency of the bond. 6.72%GS2012 wasissued on July 18, 2002 for a maturity of 10 years maturing on July 18, 2012. The optionalityon the bond could be exercised after completion of five years tenure from the date ofissuance on any coupon date falling thereafter. The Government has the right to buyback thebond (call option) at par value (equal to the face value) while the investor has the right to sellthe bond (put option) to the Government at par value at the time of any of the half-yearlycoupon dates starting from July 18, 2007.

vi. Special Securities - In addition to Treasury Bills and dated securities issued by theGovernment of India under the market borrowing programme, the Government of India alsoissues, from time to time, special securities to entities like Oil Marketing Companies, FertilizerCompanies, the Food Corporation of India, etc. as compensation to these companies in lieuof cash subsidies. These securities are usually long dated securities carrying coupon with aspread of about 20-25 basis points over the yield of the dated securities of comparable

maturity. These securities are, however, not eligible SLR securities but are eligible ascollateral for market repo transactions. The beneficiary oil marketing companies may divestthese securities in the secondary market to banks, insurance companies / Primary Dealers,etc., for raising cash.

vii. Steps are being taken to introduce new types of instruments like STRIPS (Separate Tradingof Registered Interest and Principal of Securities). Accordingly, guidelines for stripping andreconstitution of Government securities have been issued. STRIPS are instruments whereineach cash flow of the fixed coupon security is converted into a separate tradable ZeroCoupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is stripped, eachcash flow of coupon (Rs.4.12 each half year) will become coupon STRIP and the principalpayment (Rs.100 at maturity) will become a principal STRIP. These cash flows are tradedseparately as independent securities in the secondary market. STRIPS in Governmentsecurities will ensure availability of sovereign zero coupon bonds, which will facilitate the

development of a market determined zero coupon yield curve (ZCYC). STRIPS will alsoprovide institutional investors with an additional instrument for their asset- liabilitymanagement. Further, as STRIPS have zero reinvestment risk, being zero coupon bonds,they can be attractive to retail/non-institutional investors. The process ofstripping/reconstitution of Government securities is carried out at RBI, Public Debt Office(PDO) in the PDO-NDS (Negotiated Dealing System) at the option of the holder at any timefrom the date of issuance of a Government security till its maturity. All dated Governmentsecurities, other than floating rate bonds, having coupon payment dates on 2nd January and2nd July, irrespective of the year of maturity are eligible for Stripping/Reconstitution. EligibleGovernment securities held in the Subsidiary General Leger (SGL)/Constituent SubsidiaryGeneral Ledger (CSGL) accounts maintained at the PDO, RBI, Mumbai. Physical securitiesshall not be eligible for stripping/reconstitution. Minimum amount of securities that needs to besubmitted for stripping/reconstitution will be Rs. 1 crore (Face Value) and multiples thereof.

d. State Development Loans (SDLs)

1.7 State Governments also raise loans from the market. SDLs are dated securities issued through anauction similar to the auctions conducted for dated securities issued by the Central Government (seequestion 3 below). Interest is serviced at half-yearly intervals and the principal is repaid on thematurity date. Like dated securities issued by the Central Government, SDLs issued by the StateGovernments qualify for SLR. They are also eligible as collaterals for borrowing through market repoas well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

2. Why should one invest in Government securities?


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2.1 Holding of cash in excess of the day-to-day needs of a bank does not give any return to it.Investment in gold has attendant problems in regard to appraising its purity, valuation, safe custody,etc. Investing in Government securities has the following advantages:

Besides providing a return in the form of coupons (interest), Government securities offer themaximum safety as they carry the Sovereigns commitment for payment of interest and

repayment of principal. They can be held in book entry, i.e., dematerialized/ scripless form, thus, obviating the need

for safekeeping.

Government securities are available in a wide range of maturities from 91 days to as long as30 years to suit the duration of a bank's liabilities.

Government securities can be sold easily in the secondary market to meet cashrequirements.

Government securities can also be used as collateral to borrow funds in the repo market.

The settlement system for trading in Government securities, which is based on Deliveryversus Payment (DvP), is a very simple, safe and efficient system of settlement. The DvPmechanism ensures transfer of securities by the seller of securities simultaneously withtransfer of funds from the buyer of the securities, thereby mitigating the settlement risk.

Government security prices are readily available due to a liquid and active secondary marketand a transparent price dissemination mechanism.

Besides banks, insurance companies and other large investors, smaller investors like Co-operative banks, Regional Rural Banks, Provident Funds are also required to holdGovernment securities as indicated below:

A. Primary (Urban) Co-operative Banks

2.2 Section 24 of the Banking Regulation Act 1949, (as applicable to co-operative societies) providesthat every primary (urban) cooperative bank shall maintain liquid assets, which at the close ofbusiness on any day, should not be less than 25 percent of its demand and time liabilities in India (inaddition to the minimum cash reserve requirement). Such liquid assets shall be in the form of cash,gold or unencumbered Government and other approved securities. This is commonly referred to as

the Statutory Liquidity Ratio (SLR) requirement.

2.3 All primary (urban) co-operative banks (UCBs) are presently required to invest a certain minimumlevel of their SLR holdings in the form of Government and other approved securities as indicatedbelow:

a. Scheduled UCBs have to hold 25 per cent of their SLR requirement in Government and otherapproved securities.

b. Non-scheduled UCBs with Demand and Time Liabilities (DTL) more than Rs. 25 crore have tohold 15 per cent of their SLR requirement in Government and other approved securities.

c. Non-scheduled UCBs with DTL less than Rs. 25 crore have to hold 10 per cent of their SLRrequirements in Government and other approved securities.

B. Rural Co-operative Banks2.4 As per Section 24 of the Banking Regulation Act 1949, the State Co-operative Banks (SCBs) andthe District Central Co-operative Banks (DCCBs) are required to maintain in cash, gold orunencumbered approved securities, valued at a price not exceeding the current market price, anamount which shall not, at the close of business on any day, be less than 25 per cent of its demandand time liabilities as part of the SLR requirement. DCCBs are allowed to meet their SLR requirementby maintaining cash balances with their respective State Co-operative Bank.

C. Regional Rural Banks (RRBs)

2.5 Since April 2002, all the RRBs are required to maintain their entire Statutory Liquidity Ratio (SLR)holdings in Government and other approved securities. The current SLR requirement for the RRBs is24 percent of their Demand and Time Liabilities (DTL).


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2.6 Presently, RRBs have been exempted from the 'mark to market' norms in respect of their SLR-securities. Accordingly, RRBs have been given freedom to classify their entire investment portfolio ofSLR-securities under 'Held to Maturity' and value them at book value.

D. Provident funds and other entities

2.7 The non-Government provident funds, superannuation funds and gratuity funds are required bythe Central Government, effective from January 24, 2005, to invest 40 per cent of their incrementalaccretions in Central and State Government securities, and/or units of gilt funds regulated by theSecurities and Exchange Board of India (SEBI) and any other negotiable security fully andunconditionally guaranteed by the Central/State Governments. The exposure of a trust to anyindividual gilt fund, however, should not exceed five per cent of its total portfolio at any point of time.The investment guidelines for non-government PFs have been recently revised in terms of whichinvestments up to 55% of the investible funds are permitted in a basket of instruments consisting ofCentral Government securities, State Government securities and units of gilt funds, effective from

April 2009.

3. How are the Government Securities issued?

3.1 Government securities are issued through auctions conducted by the RBI. Auctions areconducted on the electronic platform called the NDS Auction platform. Commercial banks,scheduled urban co-operative banks, Primary Dealers (a list of Primary Dealers with their contactdetails is given in Annex 2), insurance companies and provident funds, who maintain funds account(current account) and securities accounts (SGL account) with RBI, are members of this electronicplatform. All members of PDO-NDS can place their bids in the auction through this electronic platform.

All non-NDS members including non-scheduled urban co-operative banks can participate in theprimary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urbanco-operative banks need to open a securities account with a bank / Primary Dealer such an accountis called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduledcommercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operativebank).

3.2 The RBI, in consultation with the Government of India, issues an indicative half-yearly auctioncalendar which contains information about the amount of borrowing, the tenor of security and thelikely period during which auctions will be held. A Notification and a Press Communique giving exactparticulars of the securities, viz., name, amount, type of issue and procedure of auction are issued bythe Government of India about a week prior to the actual date of auction. RBI places the notificationand a Press Release on its website (www.rbi.org.in) and also issues an advertisement in leadingEnglish and Hindi newspapers. Information about auctions is also available with the select branchesof public and private sector banks and the Primary Dealers.

4. What are the different types of auctions used for issue of securities?

Prior to introduction of auctions as the method of issuance, the interest rates were administrativelyfixed by the Government. With the introduction of auctions, the rate of interest (coupon rate) gets fixedthrough a market based price discovery process.

4.1 An auction may either be yield based or price based.

i. Yield Based Auction: A yield based auction is generally conducted when a new Governmentsecurity is issued. Investors bid in yield terms up to two decimal places (for example, 8.19 percent, 8.20 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrivedat the yield corresponding to the notified amount of the auction. The cut-off yield is taken asthe coupon rate for the security. Successful bidders are those who have bid at or below thecut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative exampleof the yield based auction is given below:


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Yield based auction of a new security

Maturity Date: September 8, 2018

Coupon: It is determined in the auction (8.22% as shown in the illustrationbelow)

Auction date: September 5, 2008

Auction settlement date: September 8, 2008*

Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 underT+1 cycle.

Details of bids received in the increasing order of bid yields

Bid No. Bid YieldAmount of bid

(Rs. crore)Cummulative

amount (Rs.Cr)

Price* withcoupon as

8.22%

1 8.19% 300 300 100.19

2 8.20% 200 500 100.14

3 8.20% 250 750 100.13

4 8.21% 150 900 100.09

5 8.22% 100 1000 100

6 8.22% 100 1100 100

7 8.23% 150 1250 99.93

8 8.24% 100 1350 99.87

The issuer would get the notified amount by accepting bids up to 5. Since the bidnumber 6 also is at the same yield, bid numbers 5 and 6 would get allotmentpro-rata so that the notified amount is not exceeded. In the above case eachwould get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the yields arehigher than the cut-off yield.

*Price corresponding to the yield is determined as per the relationship givenunder YTM calculation in question 24.

ii. Price Based Auction: A price based auction is conducted when Government of India re-issues securities issued earlier. Bidders quote in terms of price per Rs.100 of face value of

the security (e.g., Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-). Bids arearranged in descending order and the successful bidders are those who have bid at or abovethe cut-off price. Bids which are below the cut-off price are rejected. An illustrative example ofprice based auction is given below:

Price based auction of an existing security 8.24% GS 2018

Maturity Date: April 22, 2018

Coupon: 8.24%

Auction date: September 5, 2008

Auction settlement date: September 8, 2008*

Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.


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Details of bids received in the decreasing order of bid price

Bid no. Price of bidAmount of bid

(Rs. Cr)Implicit

yieldCumulative

amount

1 100.31 300 8.1912% 300

2 100.26 200 8.1987% 500

3 100.25 250 8.2002% 750

4 100.21 150 8.2062% 900

5 100.20 100 8.2077% 1000

6 100.20 100 8.2077% 1100

7 100.16 150 8.2136% 1250

8 100.15 100 8.2151% 1350

The issuer would get the notified amount by accepting bids up to 5. Since the bidnumber 6 also is at the same price, bid numbers 5 and 6 would get allotment inproportion so that the notified amount is not exceeded. In the above case eachwould get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the price quoted isless than the cut-off price.

4.2 Depending upon the method of allocation to successful bidders, auction could be classifiedas Uniform Price based andMultiple Price based. In a Uniform Price auction, all the successfulbidders are required to pay for the allotted quantity of securities at the same rate, i.e., at the auctioncut-off rate, irrespective of the rate quoted by them. On the other hand, in a Multiple Price auction, thesuccessful bidders are required to pay for the allotted quantity of securities at the respective price /

yield at which they have bid. In the example under (ii) above, if the auction was Uniform Price based,all bidders would get allotment at the cut-off price, i.e., Rs.100.20. On the other hand, if the auctionwas Multiple Price based, each bidder would get the allotment at the price he/ she has bid, i.e., bidder1 at Rs.100.31, bidder 2 at Rs.100.26 and so on.

4.3 An investor may bid in an auction under either of the following categories:

i. Competitive Bidding : In a competitive bidding, an investor bids at a specific price / yield and isallotted securities if the price / yield quoted is within the cut-off price / yield. Competitive bids aremade by well informed investors such as banks, financial institutions, primary dealers, mutual funds,and insurance companies. The minimum bid amount is Rs.10,000 and in multiples of Rs.10,000thereafter. Multiple bidding is also allowed, i.e., an investor may put in several bids at various price/

yield levels.

ii. Non-Competitive Bidding : With a view to providing retail investors, who may lack skill andknowledge to participate in the auction directly, an opportunity to participate in the auction process,the scheme of non-competitive bidding in dated securities was introduced in January 2002. Non-competitive bidding is open to individuals, HUFs, RRBs, co-operative banks, firms, companies,corporate bodies, institutions, provident funds, and trusts. Under the scheme, eligible investors applyfor a certain amount of securities in an auction without mentioning a specific price / yield. Suchbidders are allotted securities at the weighted average price / yield of the auction. In the illustrationgiven under 4.1 (ii) above, the notified amount being Rs.1000 crore, the amount reserved for non-competitive bidding will be Rs.50 crore (5 per cent of the notified amount as indicated below). Non-competitive bidders will be allotted at the weighted average price which is Rs.100.26 in the givenillustration. The participants in non-competitive bidding are, however, required to hold a gilt account

with a bank or PD. Regional Rural Banks and co-operative banks which hold SGL and Current


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Account with the RBI can also participate under the scheme of non-competitive bidding withoutholding a gilt account.

4.4 In every auction of dated securities, a maximum of 5 per cent of the notified amount is reservedfor such non-competitive bids. In the case of auction for Treasury Bills, the amount accepted for non-competitive bids is over and above the notified amount and there is no limit placed. However, non-

competitive bidding in Treasury Bills is available only to State Governments and other select entitiesand is not available to the co-operative banks. Only one bid is allowed to be submitted by an investoreither through a bank or Primary Dealer. For bidding under the scheme, an investor has to fill in anundertaking and send it along with the application for allotment of securities through a bank or aPrimary Dealer. The minimum amount and the maximum amount for a single bid is Rs.10,000 andRs.2 crore respectively in the case of an auction of dated securities. A bank or a Primary Dealer cancharge an investor up to maximum of 6 paise per Rs.100 of application money as commission forrendering their services. In case the total applications received for non-competitive bids exceed theceiling of 5 per cent of the notified amount of the auction for dated securities, the bidders are allottedsecurities on a pro-rata basis.

4.5 Non-competitive bidding scheme has been introduced in the State Government securities (SDLs)from August 2009. The aggregate amount reserved for the purpose in the case of SDLs is 10% of thenotified amount (Rs.100 Crore for a notified amount of Rs.1000 Crore) and the maximum amount aninvestor can bid per auction is capped at 1% of the notified amount (as against Rs.2 Crore in CentralGovernment securities). The bidding and allotment procedure is similar to that of Central Governmentsecurities.

5. What are the Open Market Operations (OMOs)?

OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase ofGovernment securities to/ from the market with an objective to adjust the rupee liquidity conditions inthe market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts tosale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions aretight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

5 (b) What is meant by buyback of Government securities?

Buyback of Government securities is a process whereby the Government of India and StateGovernments buy back their existing securities from the holders. The objectives of buyback can bereduction of cost (by buying back high coupon securities), reduction in the number of outstandingsecurities and improving liquidity in the Government securities market (by buying back illiquidsecurities) and infusion of liquidity in the system. Governments make provisions in their budget forbuying back of existing securities. Buyback can be done through an auction process or through thesecondary market route, i.e., NDS/NDS-OM.

6. What is Liquidity Adjustment Facility (LAF)?

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excludingRRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with theRBI in case of excess liquidity on an overnight basis against the collateral of Government securitiesincluding State Government securities. Basically LAF enables liquidity management on a day to daybasis. The operations of LAF are conducted by way of repurchase agreements (repos and reverserepos please refer to paragraph numbers 30.4 to 30.8 under question no. 30 for details) with RBIbeing the counter-party to all the transactions. The interest rate in LAF is fixed by the RBI from time totime. Currently the rate of interest on repo under LAF (borrowing by the participants) is 6.25% andthat of reverse repo (placing funds with RBI) is 5.25%. LAF is an important tool of monetary policy andenables RBI to transmit interest rate signals to the market.

7. How and in what form can Government Securities be held?


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7.1 The Public Debt Office (PDO) of the Reserve Bank of India, Mumbai acts as the registry andcentral depository for the Government securities. Government securities may be held by investorseither as physical stock or in dematerialized form. From May 20, 2002, it is mandatory for all the RBIregulated entities to hold and transact in Government securities only in dematerialized (SGL) form.

Accordingly, UCBs are required to hold all Government securities in demat form.

a. Physical form: Government securities may be held in the form of stock certificates. A stockcertificate is registered in the books of PDO. Ownership in stock certificates can not betransferred by way of endorsement and delivery. They are transferred by executing a transferform as the ownership and transfer details are recorded in the books of PDO. The transfer ofa stock certificate is final and valid only when the same is registered in the books of PDO.

b. Demat form: Holding government securities in the dematerialized or scripless form is the

safest and the most convenient alternative as it eliminates the problems relating to custody,viz., loss of security. Besides, transfers and servicing are electronic and hassle free. Theholders can maintain their securities in dematerialsed form in either of the two ways:

i. SGL Account: Reserve Bank of India offers Subsidiary General Ledger Account(SGL) facility to select entities who can maintain their securities in SGL accountsmaintained with the Public Debt Offices of the Reserve Bank of India.

ii. Gilt Account: As the eligibility to open and maintain an SGL account with the RBI is

restricted, an investor has the option of opening a Gilt Account with a bank or aPrimary Dealer which is eligible to open a Constituents' Subsidiary General Ledger

Account (CSGL) with the RBI. Under this arrangement, the bank or the PrimaryDealer, as a custodian of the Gilt Account holders, would maintain the holdings of itsconstituents in a CSGL account (which is also known as SGL II account) with theRBI. The servicing of securities held in the Gilt Accounts is done electronically,facilitating hassle free trading and maintenance of the securities. Receipt of maturityproceeds and periodic interest is also faster as the proceeds are credited to thecurrent account of the custodian bank / PD with the RBI and the custodian (CSGLaccount holder) immediately passes on the credit to the Gilt Account Holders (GAH).

7.2 Investors also have the option of holding Government securities in a dematerialized account witha depository (NSDL / CDSL, etc.). This facilitates trading of Government securities on the stockexchanges.

8. How does the trading in Government securities take place?

8.1 There is an active secondary market in Government securities. The securities can be bought /sold in the secondary market either (i) Over the Counter (OTC) or (ii) through the Negotiated DealingSystem (NDS) or (iii) the Negotiated Dealing System-Order Matching (NDS-OM).

i. Over the Counter (OTC)/ Telephone Market

8.2 In this market, a participant, who wants to buy or sell a government security, may contact a bank /Primary Dealer / financial institution either directly or through a broker registered with SEBI andnegotiate for a certain amount of a particular security at a certain price. Such negotiations are usuallydone on telephone and a deal may be struck if both counterparties agree on the amount and rate. Inthe case of a buyer, like an urban co-operative bank wishing to buy a security, the bank's dealer (whois authorized by the bank to undertake transactions in Government Securities) may get in touch withother market participants over telephone and obtain quotes. Should a deal be struck, the bank shouldrecord the details of the trade in a deal slip (specimen given at Annex 3) and send a tradeconfirmation to the counterparty. The dealer must exercise due diligence with regard to the pricequoted by verifying with available sources (See question number 14 for information on ascertainingthe price of Government securities). All trades undertaken in OTC market are reported on thesecondary market module of the NDS, the details of which are given under the question number 15.

ii. Negotiated Dealing System


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8.3 The Negotiated Dealing System (NDS) for electronic dealing and reporting of transactions ingovernment securities was introduced in February 2002. It facilitates the members to submitelectronically, bids or applications for primary issuance of Government Securities when auctions areconducted. NDS also provides an interface to the Securities Settlement System (SSS) of the PublicDebt Office, RBI, Mumbai thereby facilitating settlement of transactions in Government Securities(both outright and repos) conducted in the secondary market. Membership to the NDS is restricted to

members holding SGL and/or Current Account with the RBI, Mumbai.

8.4 In August, 2005, RBI introduced an anonymous screen based order matching module on NDS,called NDS-OM. This is an order driven electronic system, where the participants can tradeanonymously by placing their orders on the system or accepting the orders already placed by otherparticipants. NDS-OM is operated by the Clearing Corporation of India Ltd. (CCIL) on behalf of theRBI (Please see answer to the question no.19 about CCIL). Direct access to the NDS-OM system iscurrently available only to select financial institutions like Commercial Banks, Primary Dealers,Insurance Companies, Mutual Funds, etc. Other participants can access this system through theircustodians, i.e., with whom they maintain Gilt Accounts. The custodians place the orders on behalf oftheir customers like the urban co-operative banks. The advantages of NDS-OM are pricetransparency and better price discovery.

8.5 Gilt Account holders have been given indirect access to NDS through custodian institutions. Amember (who has the direct access) can report on the NDS the transaction of a Gilt Account holder ingovernment securities. Similarly, Gilt Account holders have also been given indirect access to NDS-OM through the custodians. However, currently two gilt account holders of the same custodian are notpermitted to undertake repo transactions between themselves.

iii. Stock Exchanges

8.6 Facilities are also available for trading in Government securities on stock exchanges (NSE, BSE)which cater to the needs of retail investors.

9. Who are the major players in the Government Securities market?

Major players in the Government securities market include commercial banks and primary dealersbesides institutional investors like insurance companies. Primary Dealers play an important role asmarket makers in Government securities market . Other participants include co-operative banks,regional rural banks, mutual funds, provident and pension funds. Foreign Institutional Investors (FIIs)are allowed to participate in the Government securities market within the quantitative limits prescribedfrom time to time. Corporates also buy/ sell the government securities to manage their overall portfoliorisk.

10. What are the Do's and Donts prescribed by RBI for the Co-operative banks dealing inGovernment securities?

While undertaking transactions in securities, urban co-operative banks should adhere to theinstructions issued by the RBI. The guidelines on transactions in government securities by the UCBshave been codified in the master circular UBD.BPD. (PCB). MC.No 12/16.20.000/2010-11 dated July1, 2010 which is updated from time to time. This circular can also be accessed from the RBI websiteunder the Notifications Master circulars section(http://rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=3686). The important guidelines to be keptin view by the UCBs relate to formulation of an investment policy duly approved by their Board ofDirectors, defining objectives of the policy, authorities and procedures to put through deals, dealingsthrough brokers, preparing panel of brokers and review thereof at annual intervals, and adherence tothe prudential ceilings fixed for transacting through each of the brokers, etc.

The important Dos & Donts are summarized in theBox Ibelow.

BOX IDos & Donts for Dealing in Government Securities
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Dos

Segregate dealing and back-up functions. Officials deciding about purchase and saletransactions should be separate from those responsible for settlement and accounting.

Monitor all transactions to see that delivery takes place on settlement day. The funds accountand investment account should be reconciled on the same day before close of business.

Keep a proper record of the SGL forms received/issued to facilitate counter-checking by theirinternal control systems/RBI inspectors/other auditors.

Seek a Scheduled Commercial Bank (SCB), a Primary Dealer (PD) or a Financial Institution(FI) as counterparty for transactions.

Give preference for direct deals with counter parties.

Use CSGL/ Gilt Accounts for holding the securities and maintain such accounts in the samebank with whom the cash account is maintained.

Insist on Delivery versus Payment for all transactions.

Take advantage of the non-competitive bidding facility for acquiring Government of Indiasecurities in the primary auctions conducted by the Reserve Bank of India.

Restrict the role of the broker to that of bringing the two parties to the deal together, if a dealis put through with the help of broker.

Have a list of approved brokers. Utilize only brokers registered with NSE or BSE or OTCEI foracting as intermediary.

Place a limit of 5% of total transactions (both purchases and sales) entered into by a bankduring a year as the aggregate upper contract limit for each of the approved brokers. Adisproportionate part of the business should not be transacted with or through one or a fewbrokers.

Maintain and transact in Government securities only in dematerialized form in SGL Account orGilt Account maintained with the CSGL Account holder.

Open and maintain only one Gilt or dematerialized account.

Open a funds account for securities transactions with the same Scheduled Commercial bankor the State Cooperative bank with whom the Gilt Account is maintained.

Ensure availability of clear funds in the designated funds accounts for purchases andsufficient securities in the Gilt Account for sales before putting through the transactions.

Observe prudential limits for investment in permitted non-SLR securities (bonds ofnationalized banks, unlisted securities, unlisted shares of all-India Financial Institutions andprivately placed debt securities).

The Board of Directors to peruse all investment transactions at least once a month

Donts

Do not undertake any purchase/sale transactions with broking firms or other intermediaries onprincipal to principal basis.

Do not use brokers in the settlement process at all, i.e., both funds settlement and delivery ofsecurities should be done with the counter-parties directly.

Do not give power of attorney or any other authorisation under any circumstances to

brokers/intermediaries to deal on your behalf in the money and securities markets. Do not undertake Government Securities transaction in the physical form with any broker.

Do not routinely make investments in non-SLR securities (e.g., corporate bonds, etc) issuedby companies or bodies other than in the co-operative sector.

11. How are the dealing transactions recorded by the dealing desk?

11.1 For every transaction entered into by the trading desk, a deal slip should be generated whichshould contain data relating to nature of the deal, name of the counter-party, whether it is a direct dealor through a broker (if it is through a broker, name of the broker), details of security, amount, price,contract date and time and settlement date. The deal slips should be serially numbered and verifiedseparately to ensure that each deal slip has been properly accounted for. Once the deal isconcluded, the deal slip should be immediately passed on to the back office (it should be separateand distinct from the front office) for recording and processing. For each deal, there must be asystem of issue of confirmation to the counter-party. The timely receipt of requisite written


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confirmation from the counter-party, which must include all essential details of the contract, should bemonitored by the back office. With The need for counterparty confirmation of deals matched on NDS-OM will not arise, as NDS-OM is an anonymous automated order matching system. However, in caseof trades finalized in the OTC market and reported on NDS, confirmations have to be submitted by thecounterparties in the system i.e., NDS. Also, please see question no. 15.

11.2 Once a deal has been concluded through a broker, there should not be any substitution of thecounter-party by the broker. Similarly, the security sold / purchased in a deal should not be substitutedby another security under any circumstances. A maker-checker framework should be implemented toprevent any individual misdemeanor. It should be ensured that the same person is not carrying outthe functions of maker (one who inputs the data) and checker (one who verifies and authorizes thedata) on the system.

11.3 On the basis of vouchers passed by the back office (which should be done after verification ofactual contract notes received from the broker / counter party and confirmation of the deal by thecounter party), the books of account should be independently prepared.

12. What are the important considerations while undertaking security transactions?

The following steps should be followed in purchase of a security:

i. Which security to invest in Typically this involves deciding on the maturity and coupon.Maturity is important because this determines the extent of risk an investor like an UCB isexposed to higher the maturity, higher the interest rate risk or market risk. If the investmentis largely to meet statutory requirements, it may be advisable to avoid taking undue marketrisk and buy securities with shorter maturity. Within the shorter maturity range (say 5-10years) it would be safer to buy securities which are liquid, that is, securities which trade inrelatively larger volumes in the market. The information about such securities can be obtainedfrom the website of the CCIL (http://www.ccilindia.com/OMMWCG.aspx), which gives real-time secondary market trade data on NDS-OM. Since pricing is more transparent in liquidsecurities, prices for these securities are easily obtainable thereby reducing the chances of

being misled/misinformed on the price in these cases. The coupon rate of the security isequally important for the investor as it affects the total return from the security. In order todetermine which security to buy, the investor must look at the Yield to Maturity (YTM) of asecurity (please refer to Box III under para 24.4 for a detailed discussion on YTM). Thus, oncethe maturity and yield (YTM) is decided, the UCB may select a security by looking at theprice/yield information of securities traded on NDS-OM or by negotiating with bank or PD orbroker.

ii. Where and Whom to buy from- In terms of transparent pricing, the NDS-OM is the safestbecause it is a live and anonymous platform where the trades are disseminated as they arestruck and where counterparties to the trades are not revealed. In case the trades areconducted on the telephone market, it would be safe to trade directly with a bank or a PD. Incase one uses a broker, care must be exercised to ensure that the broker is registered onNSE or BSE or OTC Exchange of India. Normally, the active debt market brokers may not be

interested in deal sizes which are smaller than the market lot (usually Rs.5 crore). So it isbetter to deal directly with bank / PD or on NDS-OM, which also has a screen for odd-lots.Wherever a broker is used, the settlement should not happen through the broker. Tradesshould not be directly executed with any counterparties other than a bank, PD or a financialinstitution, to minimize the risk of getting adverse prices.

iii. How to ensure correct pricing Since investors like UCBs have very small requirements, theymay get a quote/price, which is worse than the price for standard market lots. To be sure ofprices, only liquid securities may be chosen for purchase. A safer alternative for investors withsmall requirements is to buy under the primary auctions conducted by RBI through the non-competitive route. Since there are bond auctions about twice every month, purchases can beconsidered to coincide with the auctions. Please see question 14 for details on ascertainingthe prices of the Government securities.

13. Why does the price of Government security change?
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The price of a Government security, like other financial instruments, keeps fluctuating in thesecondary market. The price is determined by demand and supply of the securities. Specifically, theprices of Government securities are influenced by the level and changes in interest rates in theeconomy and other macro-economic factors, such as, expected rate of inflation, liquidity in themarket, etc. Developments in other markets like money, foreign exchange, credit and capital marketsalso affect the price of the Government securities. Further, developments in international bond

markets, specifically the US Treasuries affect prices of Government securities in India. Policy actionsby RBI (e.g., announcements regarding changes in policy interest rates like Repo Rate, CashReserve Ratio, Open Market Operations, etc.) can also affect the prices of Government securities.

14. How does one get information about the price of a Government security?

14.1 The return on a security is a combination of two elements (i) coupon income that is, interestearned on the security and (ii) the gain / loss on the security due to price changes and reinvestmentgains or losses.

14.2 Price information is vital to any investor intending to either buy or sell Government securities.Information on traded prices of securities is available on the RBI website http://www.rbi.org.in under

the path Home Financial Markets Watch Government securities market NDS. This will showa table containing the details of the latest trades undertaken in the market along with the prices.Additionally, trade information can also be seen on CCIL websitehttp://www.ccilindia.com/OMHome.aspx. This page can also be accessed from the RBI websitethrough the link provided. In this page, the list of securities and the summary of trades is displayed.The total traded amount (TTA) on that day is shown against each security. Typically liquid securitiesare those with the largest amount of TTA. Pricing in these securities is efficient and hence UCBs canchoose these securities for their transactions. Since the prices are available on the screen they caninvest in these securities at the current prices through their custodians. Participants can thus get real-time information on traded prices and make informed decision while buying / selling governmentsecurities. The screenshots of the above website pages are given below:

NDS Market


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NDS-OM Market


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The website of the Fixed Income, Money Market and Derivatives Association (FIMMDA),(www.fimmda.org) is also a source of price information, especially on securities that are not tradedfrequently.

15. How are the Government securities transactions reported?

15.1 Transactions undertaken between market participants in the OTC/telephone market areexpected to be reported on the NDS platform within 15 minutes after the deal is put through overtelephone. All OTC trades are required to be mandatorily reported on the secondary market module ofthe NDS for settlement. Reporting on NDS is a four stage process wherein the seller of the securityhas to initiate the reporting followed by confirmation by the buyer. This is further followed by issue ofconfirmation by the sellers back office on the system and reporting is complete with the last stagewherein the buyers back office confirms the deal. The system archi tecture incorporates maker-checker model to preempt individual mistakes as well as misdemeanor.

15.2 Reporting on behalf of entities maintaining gilt accounts with the custodians is done by therespective custodians in the same manner as they do in case of their own trades i.e., proprietary

trades. The securities leg of these trades settle in the CSGL account of the custodian. Once thereporting is complete, the NDS system accepts the trade. Information on all such successfullyreported trades flow to the clearing house i.e., the CCIL.

15.3 In the case of NDS-OM, participants place orders (price and quantity) on the system.Participants can modify / cancel their orders. Order could be a bid for purchase or offer for sale ofsecurities. The system, in turn will match the orders based on price and time priority. That is, itmatches bids and offers of the same prices with time priority. The NDS-OM system has separatescreen for the Central Government, State Government and Treasury bill trading. In addition, there is ascreen for odd lot trading for facilitating trading by small participants in smaller lots of less than Rs. 5crore (i.e., the standard market lot). The NDS-OM platform is an anonymous platform wherein theparticipants will not know the counterparty to the trade. Once an order is matched, the deal ticket getsgenerated automatically and the trade details flow to the CCIL. Due to anonymity offered by the

system, the pricing is not influenced by the participants size and standing.


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16. How do the Government securities transactions settle?

Primary Market

16.1 Once the allotment process in the primary auction is finalized, the successful participants areadvised of the consideration amounts that they need to pay to the Government on settlement day.

The settlement cycle for dated security auction is T+1, whereas for that of Treasury bill auction is T+2.On the settlement date, the fund accounts of the participants are debited by their respectiveconsideration amounts and their securities accounts (SGL accounts) are credited with the amount ofsecurities that they were allotted.

Secondary Market

16.2 The transactions relating to Government securities are settled through the members securities /current accounts maintained with the RBI, with delivery of securities and payment of funds being doneon a net basis. The Clearing Corporation of India Limited (CCIL) guarantees settlement of trades onthe settlement date by becoming a central counter-party to every trade through the process ofnovation, i.e., it becomes seller to the buyer and buyer to the seller.

16.3 All outright secondary market transactions in Government Securities are settled on T+1 basis.However, in case of repo transactions in Government securities, the market participants will have thechoice of settling the first leg on either T+0 basis or T+1 basis as per their requirement.

17. What is shut period?

Shut period means the period for which the securities can not be delivered. During the period undershut, no settlements/ delivery of the security which is under shut will be allowed. The main purpose ofhaving a shut period is to facilitate servicing of the securities viz., finalizing the payment of couponand redemption proceeds and to avoid any change in ownership of securities during this process.Currently the shut period for the securities held in SGL accounts is one day. For example, the couponpayment dates for the security 6.49% CG 2015 are June 8 and December 8 of every year. The shutperiod will fall on June 7 and December 7 for this security and trading in this security for settlement onthese two dates is not allowed.

18. What is Delivery versus Payment (DvP) Settlement?

Delivery versus Payment (DvP) is the mode of settlement of securities wherein the transfer ofsecurities and funds happen simultaneously. This ensures that unless the funds are paid, thesecurities are not delivered and vice versa. DvP settlement eliminates the settlement risk intransactions. There are three types of DvP settlements, viz., DvP I, II and III which are explainedbelow;

i. DvP I The securities and funds legs of the transactions are settled on a gross basis, that is, the

settlements occur transaction by transaction without netting the payables and receivables of theparticipant.

ii. DvP II In this method, the securities are settled on gross basis whereas the funds are settled on anet basis, that is, the funds payable and receivable of all transactions of a party are netted to arrive atthe final payable or receivable position which is settled.

iii. DvP III In this method, both the securities and the funds legs are settled on a net basis and onlythe final net position of all transactions undertaken by a participant is settled.

Liquidity requirement in a gross mode is higher than that of a net mode since the payables andreceivables are set off against each other in the net mode.

19. What is the role of the Clearing Corporation of India Limited (CCIL)?


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The CCIL is the clearing agency for Government securities. It acts as a Central Counter Party (CCP)for all transactions in Government securities by interposing itself between two counterparties. Ineffect, during settlement, the CCP becomes the seller to the buyer and buyer to the seller of theactual transaction. All outright trades undertaken in the OTC market and on the NDS-OM platform arecleared through the CCIL. Once CCIL receives the trade information, it works out participant-wise netobligations on both the securities and the funds leg. The payable / receivable position of the

constituents (gilt account holders) is reflected against their respective custodians. CCIL forwards thesettlement file containing net position of participants to the RBI where settlement takes place bysimultaneous transfer of funds and securities under the Delivery versus Payment system. CCIL alsoguarantees settlement of all trades in Government securities. That means, during the settlementprocess, if any participant fails to provide funds/ securities, CCIL will make the same available from itsown means. For this purpose, CCIL collects margins from all participants and maintains SettlementGuarantee Fund.

20. What is the When Issued market?

'When Issued', a short term of "when, as and if issued", indicates a conditional transaction in asecurity notified for issuance but not yet actually issued. All "When Issued" transactions are on an "if"basis, to be settled if and when the security is actually issued. 'When Issued' transactions in theCentral Government securities have been permitted to all NDS-OM members and have to beundertaken only on the NDS-OM platform. When Issued market helps in price discovery of thesecurities being auctioned as well as better distribution of the auction stock. For urban cooperativebanks, detailed guidelines have been issued in the RBI master circular UBD.BPD. (PCB). MC.No/16.20.000/2009-10 dated July 01, 2009.

21. What are the basic mathematical concepts one should know for calculations involved inbond prices and yields?

The time value of money functions related to calculation of Present Value (PV), Future Value (FV),etc. are important mathematical concepts related to bond market. An outline of the same withillustrations is provided in theBox IIbelow.

Box II

Time Value of Money

Money has time value as a Rupee today is more valuable and useful than a Rupee a year later.

The concept oftime value of money is based on the premise that an investor prefers to receive a

payment of a fixed amount of money today, rather than an equal amount in the future, all else beingequal. In particular, if one receives the payment today, one can then earn interest on the money untilthat specified future date. Further, in an inflationary environment, a Rupee today will have greaterpurchasing power than after a year.

Present value of a future sum

The present value formula is the core formula for the time value of money.The present value (PV) formula has four variables, each of which can be solved for:Present Value (PV) is the value at time=0Future Value (FV) is the value at time=ni is the rate at which the amount will be compounded each periodn is the number of periods
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An illustration

Taking the cash flows as;

Period (in Yrs) 1 2 3

Amount 100 100 100

Assuming that the interest rate is at 10% per annum;

The discount factor for each year can be calculated as 1/(1+interest rate)^no. of years

The present value can then be worked out as Amount x discount factor

The PV of Rs.100 accruing after;

Year Amount discount factor P.V.

1 100 0.9091 90.91

2 100 0.8264 82.64

3 100 0.7513 75.13

The cumulative present value = 90.91+82.64+75.13 = Rs.248.69

Net Present Value (NPV)

Net present value (NPV) ornet present worth (NPW) is defined as the present value of net cashflows. It is a standard method for using the time value of money to appraise long-term projects. Used

for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cashflows, in present value (PV) terms, once financing charges are met. Use Advanced FinancialCalculators.

Formula

Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed.Therefore


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In the illustration given above under the Present value, if the three cash flows accrues on a deposit ofRs. 240, the NPV of the investment is equal to 248.69-240 = Rs.8.69

22. How is the Price of a bond calculated? What is the total consideration amount of a tradeand what is accrued interest?

The price of a bond is nothing but the sum of present value all future cash flows of the bond. Theinterest rate used for discounting the cash flows is the Yield to Maturity (YTM) (explained in detail inquestion no. 24) of the bond. Price can be calculated using the excel function Price (please refer to

Annex 4, serial no 5.).

Accrued interest is the interest calculated for the broken period from the last coupon day till a dayprior to the settlement date of the trade. Since the seller of the security is holding the security for theperiod up to the day prior to the settlement date of the trade, he is entitled to receive the coupon forthe period held. During settlement of the trade, the buyer of security will pay the accrued interest inaddition to the agreed price and pays the consideration amount.

An illustration is given below;

For a trade of Rs.5 crore (face value) of security 6.49%2015 for settlement date August 26, 2009 at aprice of Rs.96.95, the consideration amount payable to the seller of the security is worked out below;

Here the price quoted is called clean price as the accrued interest component is not added to it.

Accrued interest:

The last coupon date being June 8, 2009, the number of days in broken period till August 25, 2009(one day prior to settlement date) are 78.

The accrued interest on Rs.100 face value for 78 days = 6.49x(78/360)= Rs.1.4062

When we add the accrued interest component to the clean price, the resultant price is called thedirty price. In the instant case, it is 96.95+1.4062 = Rs.98.3562

The total consideration amount = Face value of trade x dirty price= 5,00,00,000 x (98.3562/100)= Rs.4,91,78,083.33

23. What is the relationship between yield and price of a bond? If interest rates or market yields rise, the price of a bond falls. Conversely, if interest rates or marketyields decline, the price of the bond rises. In other words, the yield of a bond is inversely related to itsprice. The relationship between yield to maturity and coupon rate of bond may be stated as follows:


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When the market price of the bond is less than the face value, i.e., the bond sells at adiscount, YTM > current yield > coupon yield.

When the market price of the bond is more than its face value, i.e., the bond sells at apremium, coupon yield > current yield > YTM.

When the market price of the bond is equal to its face value, i.e., the bond sells at par, YTM =current yield = coupon yield.

24. How is the yield of a bond calculated?

24.1 An investor who purchases a bond can expect to receive a return from one or more of thefollowing sources:

The coupon interest payments made by the issuer;

Any capital gain (or capital loss) when the bond is sold; and

Income from reinvestment of the interest payments that is interest-on-interest.

The three yield measures commonly used by investors to measure the potential return from investingin a bond are briefly described below:

i) Coupon Yield24.2 The coupon yield is simply the coupon payment as a percentage of the face value. Coupon yieldrefers to nominal interest payable on a fixed income security like Government security. This is thefixed return the Government (i.e., the issuer) commits to pay to the investor. Coupon yield thus doesnot reflect the impact of interest rate movement and inflation on the nominal interest that theGovernment pays.

Coupon yield = Coupon Payment / Face Value

Illustration:

Coupon: 8.24Face Value: Rs.100Market Value: Rs.103.00Coupon yield = 8.24/100 = 8.24%

ii) Current Yield

24.3 The current yield is simply the coupon payment as a percentage of the bonds purchase price; inother words, it is the return a holder of the bond gets against its purchase price which may be more orless than the face value or the par value. The current yield does not take into account thereinvestment of the interest income received periodically.

Current yield = (Annual coupon rate / Purchase price)X100

Illustration:The current yield for a 10 year 8.24% coupon bond selling for Rs.103.00 per Rs.100 par value iscalculated below:

Annual coupon interest = 8.24% x Rs.100 = Rs.8.24Current yield = (8.24/Rs.103)X100 = 8.00%

The current yield considers only the coupon interest and ignores other sources of return that will affectan investors return.

iii) Yield to Maturity

24.4 Yield to Maturity (YTM) is the expected rate of return on a bond if it is held until its maturity. Theprice of a bond is simply the sum of the present values of all its remaining cash flows. Present value is


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calculated by discounting each cash flow at a rate; this rate is the YTM. Thus YTM is the discount ratewhich equates the present value of the future cash flows from a bond to its current market price. Inother words, it is the internal rate of return on the bond. The calculation of YTM involves a trial-and-error procedure. A calculator or software can be used to obtain a bonds yield-to-maturity easily(please see theBox III).

Box III

YTM Calculation

YTM could be calculated manually as well as using functions in any standard spread sheet like MSExcel.

Manual (Trial and Error) Method

Manual or trial and error method is complicated because Government securities have many cashflows running into future. This is explained by taking an example below.

Take a two year security bearing a coupon of 8% and a price of say Rs. 102 per face value of Rs.100; the YTM could be calculated by solving for r below. Typically it involves trial and error by takinga value for r and solving the equation and if the right hand side is more than 102, take a higher valueof r and solve again. Linear interpolation technique may also be used to find out exact r once wehave two r values so that the price value is more than 102 for one and less than 102 for the othervalue.

102 = 4/(1+r/2)1+ 4/(1+r/2)

2+ 4/(1+r/2)

3+ 104/(1+r/2)

4

Spread Sheet Method using MS Excel

In the MS Excel programme, the following function could be used for calculating the yield of

periodically coupon paying securities, given the price.

YIELD (settlement,maturity,rate,price,redemption,frequency,basis)

Wherein;

Settlement is the security's settlement date. The security settlement date is the date on which thesecurity and funds are exchanged.Maturity is the security's maturity date. The maturity date is thedate when the security expires.

Rate is the security's annual coupon rate.Price is the security's price per Rs.100 face value.

Redemption is the security's redemption value per Rs.100 face value.Frequency is the number of coupon payments per year. (2 for Government bonds in India)Basis is the type of day count basis to use. (4 for Government bonds in India which uses 30/360basis)

25. What are the day count conventions used in calculating bond yields?

Day count convention refers to the method used for arriving at the holding period (number of days) ofa bond to calculate the accrued interest. As the use of different day count conventions can result indifferent accrued interest amounts, it is appropriate that all the participants in the market follow auniform day count convention.

For example, the conventions followed in Indian market are given below.


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Bond market: The day count convention followed is 30/360, which means that irrespective of theactual number of days in a month, the number of days in a month is taken as 30 and the number ofdays in a year is taken as 360.

Money market: The day count convention followed is actual/365, which means that the actual numberof days in a month is taken for number of days(numerator) whereas the number of days in a year is

taken as 365 days. Hence, in the case of Treasury bills, which are essentially money marketinstruments, money market convention is followed.

26. How is the yield of a Treasury Bill calculated?

It is calculated as per the following formula

Wherein;

P Purchase priceD Days to maturityDay Count: For Treasury Bills, D = [actual number of days to maturity/365]

IllustrationAssuming that the price of a 91 day Treasury bill at issue is Rs.98.20, the yield on the same would be

After say, 41 days, if the same Treasury bill is trading at a price of Rs. 99, the yield would then be

Note that the remaining maturity of the treasury bill is 50 days (91-41).

27. What is Duration?

27.1 Duration (also known as Macaulay Duration) of a bond is a measure of the time taken to recoverthe initial investment in present value terms. In simplest form, duration refers to the payback period ofa bond to break even, i.e., the time taken for a bond to repay its own purchase price. Duration isexpressed in number of years. A step by step approach for working out duration is given in theBoxIVbelow.

Box: IV

Calculation for Duration
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First, each of the future cash flows is discounted to its respective present value for each period. Sincethe coupons are paid out every six months, a single period is equal to six months and a bond with twoyears maturity will have four time periods.

Second, the present values of future cash flows are multiplied with their respective time periods

(these are the weights). That is the PV of the first coupon is multiplied by 1, PV of second coupon by

2 and so on.

Third, the above weighted PVs of all cash flows is added and the sum is divided by the current price(total of the PVs in step 1) of the bond. The resultant value is the duration in no. of periods. Since oneperiod equals to six months, to get the duration in no. of year, divide it by two. This is the time periodwithin which the bond is expected to pay back its own value if held till maturity.

Illustration:

Taking a bond having 2 years maturity, and 10% coupon, and current price of Rs.102, the cash flowswill be (prevailing 2 year yield being 9%):

Time period (years) 1 2 3 4 Total

Inflows (Rs.Cr) 5 5 5 105

PV at an yield of 9% 4.78 4.58 4.38 88.05 101.79

PV*time 4.78 9.16 13.14 352.20 379.28

Duration in number of periods = 379.28/101.79 = 3.73Duration in years = 3.73/2 = 1.86 years

More formally, duration refers to:

a. the weighted average term (time from now to payment) of a bond's cash flows or of any seriesof linked cash flows.

b. The higher the coupon rate of a bond, the shorter the duration (if the term of the bond is keptconstant).

c. Duration is always less than or equal to the overall life (to maturity) of the bond.d. Only a zero coupon bond (a bond with no coupons) will have duration equal to its maturity.e. the sensitivity of a bond's price to interest rate (i.e., yield) movements.

Duration is useful primarily as a measure of the sensitivity of a bond's market price to interest rate(i.e., yield) movements. It is approximately equal to the percentage change in price for a given changein yield. For example, for small interest rate changes, the duration is the approximate percentage by

which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 15-yearbond with a duration of 7 years would fall approximately 7% in value if the interest rate increased by1% per annum. In other words, duration is the elasticity of the bond's price with respect to interestrates.

What is Modified Duration?

27.2 Modified duration (MD) is a modified version of Macaulay Duration. It refers to the change invalue of the security to one per cent change in interest rates (Yield). The formula is


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Illustration

In the above example given in Box IV, MD = 1.86/(1+0.09/2) = 1.78

What is PV 01?

27.3PV01 describes the actual change in price of a bond if the yield changes by one basis point(equal to one hundredth of a percentage point). It is the present value impact of 1 basis point (0.01%)movement in interest rate. It is often used as a price alternative to duration (a time measure). Higher

the PV01, the higher would be the volatility (sensitivity of price to change in yield).

Illustration

From the modified duration (given in the illustration under 27.2), we know that the security value willchange by 1.78% for a change of 100 basis point (1%) change in the yield. In value terms that isequal to 1.78*(102/100) = Rs.1.81.

Hence the PV01 = 1.81/100 = Rs. 0.018, which is 1.8 paise. Thus, if the yield of a bond with aModified Duration of 1.78 years moves from say 9% to 9.05% (5 basis points), the price of the bondmoves from Rs.102 to Rs.101.91 (reduction of 9 paise, i.e., 5x1.8 paise).

What is Convexity?

27.4 Calculation of change in price for change in yields based on duration works only for smallchanges in prices. This is because the relationship between bond price and yield is not strictly lineari.e., the unit change in price of the bond is not proportionate to unit change in yield. Over largevariations in prices, the relationship is curvilinear i.e., the change in bond price is either less than ormore than proportionate to the change in yields. This is measured by a concept called convexity,which is the change in duration of a bond per unit change in the yield of the bond.

28. What are the important guidelines for valuation of securities?

28.1 For the Cooperative banks, investments classified under 'Held to Maturity' (HTM) category need

not be marked to market and will be carried at acquisition cost unless it is more than the face value, inwhich case the premium should be amortized over the period remaining to maturity. The individualscrip in the Available for Sale (AFS) category in the books of the cooperative banks will be marked tomarket at the year-end or at more frequent intervals. The individual scrip in the Held for Trading(HFT) category will be marked to market at monthly or at more frequent intervals. The book value ofindividual securities in AFS and HFT categories would not undergo any change after marking tomarket.

28.2 Central Government securities should be valued by taking the prices/ yields put out by the FixedIncome Money Market and Derivatives Association of India (FIMMDA) and the Primary Dealers

Association of India (PDAI) jointly on the website of the FIMMDA. Prices of all Central Governmentsecurities are given out everyday while prices and yield curve for valuation are given at the end ofevery month. For example, the FIMMDA valuation of a Central Government security, 7.46%2017 as

on March 31, 2009 was Rs.101.69. If a cooperative bank was holding the same security in AFS orHFT categories at a book value of Rs.102, the bank would be required to book a depreciation of


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Rs.0.31 per Rs.100 face value of holding. If the total holding was Rs. 1 crore, the total depreciation tobe booked would be Rs.31,000/-.

28.3 State Government and other securities are to be valued by adding a spread on the CentralGovernment security yield of the corresponding residual maturity. Currently, a spread of 25 basispoints (0.25%) is added while valuing State Government securities, special securities (oil bonds,

fertilizer bonds, SBI bonds, etc.) whereas for corporate bonds the spreads given by the FIMMDA needto be added. An illustration of valuation taking a State Government bond is given in theBox Vbelow.

Box: V

Valuation of securities

Illustration for valuation of State Government BondsSecurity 7.32% A.P.SDL 2014Issue date December 10, 2004Maturity date December 10, 2014Coupon 7.32%

Date of valuation March 31, 2008

Procedure

Valuation of the above bond involves the following steps

i. Find the residual maturity of the bond to be valued.ii. Find the Central Government security yield for the above residual maturity.iii. Add appropriate spread to the above yield to get the yield for the securityiv. Calculate the price of the security using the derived yield above.

Step i.

Since valuation is being done on March 31, 2008, we need to find out the number of years from thisdate to the maturity date of the security, December 10, 2014 to get the residual maturity of thesecurity. This could be done manually by counting the number of years and months and days.However, an easier method is to use MS. Excel function Yearfrac wherein we specify the two datesand basis (please refer to Annex 4 on Excel functions for details). This gives us the residual maturityof 6.69 years for the security.

Step ii.

To find the Central Government yield for 6.69 years, we derive it by interpolating the yields between 6years and 7 years, which are given out by FIMMDA. As on March 31, 2008, FIMMDA yields for 6 and7 years are 7.73% and 7.77% respectively. The yield for the 6.69 years is derived by using thefollowing formula.

Here we are finding the yield difference for 0.69 year and adding the same to the yield for 6 years toget the yield for 6.69 years. Also notice that the yield has to be used in decimal form (e.g., 7.73% isequal to 7.73/100 which is 0.0773)

Step iii.


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Having found the Central Government yield for the particular residual maturity, we have to now loadthe appropriate spread to get the yield of the security to be valued. Since the security is StateGovernment security, the applicable spread is 25 basis points (0.25%). Hence the yield would be7.76%+0.25% = 8.01%.

Step iv.

The price of the security will be calculated using the MS Excel function Price (Please see the detailsin Annex 4). Here, we specify the valuation date as March 31, 2008, maturity date as December 10,2014, rate as 7.32% which is the coupon, yield as 8.01%, redemption as 100 which is the face value,frequency of coupon payment as 2 and basis as 4 (Pl. see example 3 in Annex 4). The price we getin the formula is Rs.96.47 which is the value of the security.

If the bank is holding Rs.10 crore of this security in its portfolio, the total value would be10*(96.47/100) = 9.647 crore.

28.4 In the case of corporate bonds, the procedure of valuation is similar to the illustration given inBox V above. The only difference is the spread that need to be added to the corresponding yield on

central government security will be higher (instead of the fixed 25 bps for State Governmentsecurities), as published by the FIMMDA from time to time. FIMMDA gives out the information oncorporate bonds spreads for various rated bonds. While valuing a bond, the appropriate spread has tobe added to the corresponding CG yield and the bond has to be valued using the standard Priceformula.

For example, assuming that a AAA rated corporate bond is having same maturity as that of the StateGovernment bond in Box V, the applicable yield for valuation will be 7.73%+ 2.09% (being the spreadgiven by FIMMDA) which is 9.82%. With the same parameters as in the Box V, the value of the bondworks out to Rs.87.92.

29. What are the risks involved in holding Government securities? What are the techniques formitigating such risks?

Government securities are generally referred to as risk free instrumentsas sovereigns are notexpected to default on their payments. However, as is the case with any financial instrument, thereare risks associated with holding the Government securities. Hence, it is important to identify andunderstand such risks and take appropriate measures for mitigation of the same. The following arethe major risks associated with holding Government securities.

29.1 Market risk Market risk arises out of adverse movement of prices of the securities that areheld by an investor due to changes in interest rates. This will result in booking losses on marking tomarket or realizing a loss if the securities are sold at the adverse prices. Small investors, to someextent, can mitigate market risk by holding the bonds till maturity so that they can realize the yield atwhich the securities were actually bought.

29.2 Reinvestment risk Cash flows on a Government security includes fixed coupon every halfyear and repayment of principal at maturity. These cash flows need to be reinvested whenever theyare paid. Hence there is a risk that the investor may not be able to reinvest these proceeds atprofitable rates due to changes in interest rate scenario.

29.3 Liquidity risk Liquidity risk refers to the inability of an investor to liquidate (sell) his holdingsdue to non availability of buyers for the security, i.e., no trading activity in that particular security.Usually, when a liquid bond of fixed maturity is bought, its tenor gets reduced due to time decay. Forexample, a 10 year security will become 8 year security after 2 years due to which it may becomeilliquid. Due to illiquidity, the investor may need to sell at adverse prices in case of urgent fundsrequirement. However, in such cases, eligible investors can participate in market repo and borrow themoney against the collateral of the securities.

Risk Mitigation


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The overall effect of the repo transaction would be borrowing of funds backed by the collateral ofGovernment securities.

30.8 The money market is regulated by the Reserve Bank of India. All the above mentioned moneymarket transactions should be reported on the electronic platform called the Negotiated DealingSystem (NDS).

30.9 As part of the measures to develop the corporate debt market, RBI has permitted select entities(scheduled commercial banks excluding RRBs and LABs, PDs, all-India FIs, NBFCs, mutual funds,housing finance companies, insurance companies) to undertake repo in corporate debt securities.This is similar to repo in Government securities except that corporate debt securities are used ascollateral for borrowing funds. Only listed corporate debt securities that are rated AA or above by therating agencies are eligible to be used for repo. Commercial paper, certificate of deposit, non-convertible debentures of original maturity less than one year are not eligible for the purpose. Thesetransactions take place in the OTC market and are required to be reported on FIMMDA platformwithin 15 minutes of the trade for dissemination of information. They are also to be reported on theclearing house of any of the exchanges for the purpose of clearing and settlement.

Collateralised Borrowing and Lending Obligation (CBLO)

30.10 CBLO is another money market instrument operated by the Clearing Corporation of India Ltd.(CCIL), for the benefit of the entities who have either no access to the inter bank call money market orhave restricted access in terms of ceiling on call borrowing and lending transactions. CBLO is adiscounted instrument available in electronic book entry form for the maturity period ranging from oneday to ninety days (up to one year as per RBI guidelines). In order to enable the market participants toborrow and lend funds, CCIL provides the Dealing System through Indian Financial Network(INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) whomaintain Current account with RBI and through Internet for other entities who do not maintain Currentaccount with RBI.

30.11 Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz.,

Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions,Insurance Companies, Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO segmentis extended to entities who are not members of RBI- NDS, viz., Co-operative Banks, Mutual Funds,Insurance companies, NBFCs, Corporates, Provident/ Pension Funds, etc.

30.12 By participating in the CBLO market, CCIL members can borrow or lend funds against thecollateral of eligible securities. Eligible securities are Central Government securities includingTreasury Bills, and such other securities as specified by CCIL from time to time. Borrowers in CBLOhave to deposit the required amount of eligible securities with the CCIL based on which CCIL fixes theborrowing limits. CCIL matches the borrowing and lending orders submitted by the members andnotifies them. While the securities held as collateral are in custody of the CCIL, the beneficial interestof the lender on the securities is recognized through proper documentation.

Commercial Paper (CP)

30.13 Commercial Paper (CP) is an unsecured money market instrument issued in the form of apromissory note. Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) thathave been permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bankof India are eligible to issue CP. CP can be issued for maturities between a minimum of 7 days and amaximum up to one year from the date of issue.

Certificate of Deposit (CD)

30.14 Certificate of Deposit (CD) is a negotiable money market instrument and issued indematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligiblefinancial institution for a specified time period. Banks can issue CDs for maturities from 7 days to onea year whereas eligible FIs can issue for maturities 1 year to 3 years.


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31. What are the role and functions of FIMMDA?

31.1 The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an associationof Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and InsuranceCompanies was incorporated as a Company under section 25 of the Companies Act,1956 on June3rd, 1998. FIMMDA is a voluntary market body for the bond, money and der

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