Team Members:Peeyush SahuMukul SaigalAnand SinghVijay Kumar

Himanshu VarshneyShaik Karam

Abhishek Anand

Overview of Financial Markets

Features of Bond

Type of Issuer:

Govt. and its Agencies, Municipal Govt., Corporates

Principal and Coupon Rate:

Principal is the amount which the issuer has to repay at maturity date.

Coupon rate is the nominal rate which issuer agrees to pay per year.

Maturity:

No. of years over which the issuer has promised to meet the conditions of obligations.

Yield:

The yield is the rate of return received from investing in the bond.

Credit Quality:

The "quality" of the issue refers to the probability that the bondholders will receive the

amounts promised at the due dates.

Market Price:

The price can be quoted as clean or dirty.

Bond Yield, Pricing and Volatility

Theorem #1: Bond prices are inversely related to bond yields.

Implication: When market rates fall, bond prices rise, and vice versa.

Theorem #2: Generally, for a given coupon rate, the longer is the term to maturity, the greater is the

percentage price change for a given shift in yields. (The maturity effect)

Implication: Long-term bonds are riskier than short-term bonds for a given shift in yields, but also have

more potential for gain if rates fall.

Theorem #3: For a given maturity, the lower is the coupon rate, the greater is the percentage price

change for a given shift in yields. (The coupon effect)

Implication: Low-coupon bonds are riskier than high-coupon bonds given the same maturity, but also

have more potential for gain if rates fall.

Bond Portfolio Strategy

The three principal strategies used to manage bond portfolios are:

Passive, or "buy and hold“:

The passive buy-and-hold is typically looking to maximize the income generating

properties of bonds. The premise of this strategy is that bonds are assumed to be safe,

predictable sources of income.

Index matching, or "quasi passive“:

The main objective of indexing a bond portfolio is to provide a return and risk

characteristic closely tied to the targeted index.

Dedicated and Active:

The goal of active management is maximizing total return.

Bond Indices

A bond index is intended to track broad

movements over time in fixed income securities.

A number of bond indices exist for the purposes

of managing portfolios and measuring

performance similar to NIFTY and SENSEX.

A bond index portfolio will have the same

risk/return characteristics as the index it is

based on.

Example: NSE G-Sec Index

Risk Involved

Primary:

Default: Will the borrower honor its promise to repay?

Interest Rate: How will changing market conditions affect the value of the bond?

Reinvestment Risk

Secondary:

Liquidity: How easily can bond be bought or sold?

Asset Allocation in Bond Portfolio

Types of Asset Classes:

Fixed income can be broken down into five asset classes:

a. Government-issued securities

b. Corporate-issued securities

c. Inflation-protected securities (IPS)

d. Mortgage-backed securities (MBS)

e. Asset-backed securities (ABS).

The key issue is that each one of these asset classes has different interest rate and credit

risks; therefore, these asset classes do not share the same correlation.

As a result, combining these different asset classes into a fixed-income portfolio will

increase its risk/return profile.

Portfolio Performance Measures

Portfolio YTM

Computed by determining the cash flows for the portfolio and determining the interest

rate that will make the present value of the cash flows equal to the market value of the

portfolio.

Portfolio Duration

The term duration has a special meaning in the context of bonds. It is a measurement of

how long, in years, it takes for the price of a bond to be repaid by its internal cash flows.

Portfolio Modified Duration

Modified duration of a bond portfolio is the asset weighted average of the modified

duration of individual bonds / securities in the portfolio.

Portfolio Convexity

For any given bond, a graph of the relationship between price and yield is convex. This

means that the graph forms a curve rather than a straight-line.

Modern Fixed Income Portfolio

Equity25%

Bonds (Govt, Corp etc)

29%

IPS15%

High Yield8%

REITS10%

Emerging Markets

8%

Cash5%

Size - At least $10 billion in market capitalization

High Dividends - All pay a yield of at least 2.8% (Piramal Industries)

Low Volatility - All stocks have a beta of less than 1

Reasonable Valuations - All stocks have a P/E to growth ratio, or PEG ratio of 1.75 or less,

which means that growth expectations are reasonably priced into the stock. This filter

removes companies whose dividends are artificially high due to deteriorating earnings

fundamentals.

Sector Diversification - A basket of stocks from different sectors can minimize certain

market risks by investing in all parts of the economy.