Bond Mathematics

Day 1 Course Coverage

Day 2 Course Coverage

Session 1

Session 1

Key Terms in Bond Markets

Money Markets
Money Market Instruments

Key Excel Functions

Basic Bond Valuation

Session 2

Session 2

Government Securities
STRIPs

Valuation of Bonds
Yield concepts
Pricing of Bonds
Day count convention

Session 3

Session 3

Prudential Norms for Securities

Valuation of Securities
Corporate Bond Market

Floating Rate Bonds

Inflation Indexed Bonds
YTM and ZCYC

Session 4

Session 4

Bond Market Dynamic and Macro economic factors.

Bond Mathematics Time Value of Money

Duration, Modified Duration and Convexity

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Domestic and Forex Treasury

Role and functions of Treasury

Reserve and
Investments

Pricing of
products &
other

Liquidity
Management
Treasury
Functions

Derivatives
Trading &
Arbitrage

ALM
Risk
Management

Key Terminologies of Fixed Income Market

Fixed Income Terminologies

The face value
(also known as the par value or principal) is the amount on which the Coupon (Interest) is
calculated. This is also of money a holder will usually receive back on the maturity of the bond. It is
generally also the redemption price. A newly issued bond usually sells at the par value.
The coupon
is the amount the bondholder will receive as interest payments. Coupon payments are the cash flows
that are offered by a particular security at fixed intervals.

Yield to maturity of a bond

is the discount rate that equates the present value of a bonds cash flow to the bonds current market
price.
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Fixed Income Terminologies

Zero coupon or accrual bonds

do not pay a coupon. Instead, these types of bonds are issued at a deep discount and pay the full
face value at maturity.
The maturity date
is the future day on which the investor's principal will be repaid.

The issuer

is an extremely important factor as their stability is investors main assurance of getting paid
back. For example, the Government is far more secure than any corporation.

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Fixed Income Terminologies

Term to Maturity

This refers to the number of years remaining for the bond to mature.
Bond Price in the Market
When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield
of the older bonds and bringing them into line with the newer bonds being issued with a
lower coupon
Yield Curve
This is a graphical representation of the relationship between maturity & yield to
maturity
Current Yield
This is a measure of the return on the bond in relation to the current price.
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Financial System
Money and Capital Markets

Money & Capital market

Money Market

Financial System
Capital Market
- Debt
- Equity

10

Money Market

Call/Notice Money Markets

Market where funds are lent / borrowed for
short term (less than one year).
Funds are transacted on overnight basis in
Call Money market.
Under Notice Money market, funds are
transacted for the period between 2 to 14
days.
Term money = 15 days to 1 year

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Call/Notice Money Markets

Features of Call / Notice Money Markets
Participants

SCBs (excluding RRBs), Cooperative Banks (Other

than LDBs) and Primary Dealers

Type of transactions

Uncollateralized borrowing / lending

Maturity

Overnight for call money

2 to 14 days for notice money

Quotes / Rates

Expressed annualized (A/365 day basis in nearest

rupee terms)

Repayment of borrowing

Both interest and principal are paid at maturity

LDB = Land Development Banks

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Market Participants Call / Notice Market

Following are not permitted in call/notice money markets :
Financial Institutions,
Insurance Companies, &
Mutual Funds

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Call/Notice money markets

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NDS- Call

TTA = Total Traded Amount

above data contains trades concluded between NDS-Call
LTR = Last Traded Rate
Members and Non-Members outside NDS-Call System
LTA = Last traded amount
WAR = weighted average rate and subsequently reported on the System
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Trends in Money Market

Call Money Market is a market for overnight borrowing & lending.
Since Indian call money markets are very active, trends in call
money and other short term money markets provide important
information about liquidity in the system.
Increase in call money rates indicates tightness of liquidity in the
short term which if continues may spread to term money market as
well
Exercise call money trend

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Why did Call Rate go up?

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Source: Moneycontrol
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Collateralized Borrowing & Lending Obligation (CBLO)

A money market instrument and a product developed by CCIL for the benefit of the
entities who :
have either been phased out from inter bank call money market, or
have been given restricted participation in terms of ceiling on call borrowing &
lending transactions and do not have access to the call market.
A discounted instrument
Issued in electronic book entry form
for the maturity period ranging from one day to one year.
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CBLO Market
CBLO

A part of money market

Open for all categories of participants such as banks, PDs, FIs, MFs, PFs,
Corporates etc.

CCIL membership available to all repo eligible entities as per RBI guidelines

Need for CBLO

Since call money market is an inter-bank market, CBLO provides an excellent

mechanism for banks as well as non-bank participants to manage short term
liquidity.
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Collateralized Borrowing & Lending Obligation (CBLO)

All Government Securities & T-bills, as & when notified by the CCIL.
CBLOs are normally done for a minimum maturity period of one day.

Interest to be calculated on an A/365 day year basis.

CBLO bid, refers to lending of funds & borrowing of securities.
CBLO offer, refers to borrowing of funds & lending of securities.

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CBLO Markets

Normal Market
Auction Market

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Category-wise Call / CBLO Activity as per CCIL Month

Dec, 2013

http://www.business-standard.com/article/finance/banks-choose-cblo-market-over-rbi-sliquidity-window-113070400032_1.html
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Category-wise Call / CBLO Activity as per CCIL Month

Dec., 2013

Source : CCIL Publication

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Source: business standard

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Source: business standard

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CBLO Trading Platform

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Treasury Bills
Treasury bills are short-term negotiable securities
issued in their domestic money markets by
Governments.
They are used for short term funding as well as to
control the money supply in the economy.
They do not pay interest but are traded at discount to
their par value or face value.

They are the most liquid part of the money markets.

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Issue of Treasury bills : Dec, 2013

Source : CCIL Publication

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Treasury Bills Basic Calculations

Discount =
[(FV IP)/FV]*365/No. of days to maturity

Price =
Par Value*[(1 - Dis. *(t/365)]

Yield =
[(FV IP)/IP]*365/No. of days to maturity

Exercise T-bill Cal

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Trading in T bills on various platforms as per CCIL

Month : Dec, 2013

Source : CCIL Publication

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Commercial paper
Commercial Papers are negotiable short-term
unsecured promissory notes with fixed maturities,
issued by well rated companies generally sold on
discount basis.

These are basically instruments evidencing the

liability of the issuer to pay the holder in due course
a fixed amount (face value of the instrument) on the
specified due date.

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Commercial paper
Features

Fresh issues in demat form only

Issued subject to minimum of Rs 5 lakhs and in the multiples of Rs. 5 Lakh
thereafter,

Issued at a discount to face value

Maturity is 7 days to 1 year
Unsecured and backed by credit of the issuing company
No underwriting or co-acceptance
Call/put options not permitted
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Commercial paper
Eligibility Criteria
Any private/public sector co. wishing to raise money through the CP market has to
meet the following requirements:
Tangible net-worth not less than Rs 4 crore - as per last audited statement.
Should have Working Capital limit sanctioned by a bank / FI.
Credit Rating not lower than A3- by Credit Rating Agency approved by
Reserve Bank of India.
Borrower account is a classified as standard asset.
CPs can be issued as stand alone product.
PD and FIs can also issue Commercial Papers
Documentation as per FIMMDA and reporting of trading to FIMMDA

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Issue of CPs in India

Savings from CP
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Certificate of Deposit
Issued by banks for specified period of time and
at a specified rate of interest.

It is a time deposit with the bank.

They offer a slightly higher yield than TBills because of higher default risk.
In short, they are transferable, negotiable, short
term, issued at discount or interest bearing,
maturity dated money market instruments.
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Certificate of Deposit
The maturity period of the CDs for banks varies between 7
days to 1 year. For FIs, the tenor is not less than 1 year and
tenor of the maturity can extend upto 3 years.
CDs can be issued at discount or on floating rate basis

The settlement of CDs is compulsorily in a DvP mechanism.

Banks have to maintain appropriate CRR and SLR on CDs

Minimum amount Rs. 1 Lakhs and in multiples thereafter

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Issue of CDs in India

RBI Monthly Bulletin Jan,14

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Repo and Reverse Repo

The Reserve Bank of India (Amendment) Act, 2006

(Act No. 26 of 2006) provides a legal definition of
'repo' and 'reverse repo' (vide sub-sections (c) and
(d) of section 45 U of Chapter III D of the Act) as
an instrument for borrowing (lending) funds by
selling (purchasing) securities with an agreement
to repurchase (resell) the securities on a mutually
agreed future date at an agreed price which
includes interest for the funds borrowed (lent).

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Repo and Reverse Repo

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Repo and Reverse Repo

(Accounting Treatment)
Coupon / Discount

Repo Interest Income/Expenditure

Marking To Market

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Chain Reaction

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44

Government Securities Market

http://www.rbi.org.in/Scripts/financialmarketswatch.aspx

GOI Securities

GOI securities

Liabilities of GOI issued in the

nature of Bonds
Issued to finance budget deficits
of GOI
Available in both SGL & Physical
form

RBI acts the Investment Banker ,

Custodian, Registrar and market
Regulator
Primarily, wholesale in nature
Active trading & investment avenue
for Banks, PDs, FIs, Insurance Cos.,
PFs, MFs, etc.
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Government Securities

Central Government
Securities

State Development Loans

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How GOI securities are issued ?

Auctions
Price based auctions
Yield based auctions
Multiple price auctions
Uniform price auctions
Which is widely used method?
Uniform ? / Multiple ?
What is Competitive bidding?
What is non-competitive bidding ?
non-competitive bidders are allotted securities at the weighted
of the auction.

average price/yield
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How GOI securities are issued ?

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How GOI securities are issued ?

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How GOI securities are issued ?

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51

Issuance of Gilts CCIL data

Source : CCIL Publication

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G Sec Market: A Snapshot

Particulars

1992

2005

2012

Outstanding stock (Rs. In crore)

76908

758995

2593328

Outstanding stock as ratio of GDP (%)

11.75

23.41

28.88

Weighted average cost of securities issued

during the year (%)

11.78

6.11

8.52

Min. and max. maturities of stock issued

during the year (years)

NA

5-30

5-30

Average maturity of the securities issued

during the year (years)

NA

14.13

12.66

Secondary market volume (Rs. In crore)

NA

862820

3099107

Volume/GDP (%)

NA

26.61

34.51

Volume/outstanding stock (%)

NA

113

120
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Some varieties of G Secs issued in past

Zero coupon Bonds Four issuances between 1994 & 96
STRIPS
Floating Rate Bonds Around 10 issues so far.
Capital Indexed Bond Issued in 1997 with principal indexed to
inflation, Lackluster response. Issued in 2004 again with both principal and
interest indexed to WPI, Lackluster response again.
Callable & Puttable G Secs. Issued in 2002, only one issue so far. (6.72%GS2012 July
)
Special Securities Govt bonds issued to FCI, Oil companies etc. in lieu of Cash
subsidies
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Some varieties of G Secs issued in past

When Issued Securities
Takes place from issue announcement date till
one day prior to the issue.
Dec, 2013

Source : CCIL Publication

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Inflation Indexed Bonds

Inflation Index Bonds are the latest in the types
of bonds issued by RBI.

These bonds are meant to protect investors

from inflation.
The principal amount is adjusted by the
inflation factor and coupon is paid on the
adjusted principal.
The principal amount will never be below face
value even in the event of deflation.
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How Inflation Indexed Bonds Work

Source: RBI
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PRUDENTIAL NORMS FOR

CLASSIFICATION, VALUATION AND
OPERATION OF INVESTMENT
PORTFOLIO BY BANKS

RBI Guidelines on Classification of Investments

Held to Maturity

Available For Sale

Held for Trading

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RBI guidelines on Classification of Investments

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61

Benefits for HTM Securities

Investments classified under Held to Maturity category need not be marked

to market and will be carried at acquisition cost unless it is more than the
face value, in which case the premium should be Amortised over the period
remaining to maturity

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How to Decide HTM for Trading Security?

The investments classified under Held for Trading category would be those
from which the FI expects to make a gain by the movement in the interest
rates / market rates. These securities are to be sold within 90 days.
If the FI is not able to sell the security within 90 days due to exceptional
circumstances such as tight liquidity conditions, or extreme volatility, or
market becoming unidirectional, the security should be shifted to the
Available for Sale category.

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HTM Securities

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Valuation of Securities

How are Securities Valued?

Quoted

Unquoted

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Quoted Security
The 'market value' for the purpose of periodical valuation of investments
included in the Available for Sale and the Held for Trading categories would be
the market price of the scrip as available from the trades / quotes on the
stock exchanges,
price of SGL Account transactions,
price list of RBI,
prices declared by Primary Dealers Association of India (PDAI) Jointly
with the Fixed Income Money Market and Derivative Association of India
(FIMMDA) periodically.

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Unquoted Central Government Security

The FIs should value the unquoted Central Government Securities on the
basis of the prices / YTM rates put out by the PDAI / FIMMDA at periodical
intervals.
Treasury Bills should be valued at carrying cost.
For the limited purpose of valuation, all special securities issued by the
Government of India, directly to the beneficiary entities, which do not carry
SLR status, may be valued at a spread of 25 bps above the corresponding
yield on Government of India securities.
At present, such special securities comprise : Oil Bonds, Fertiliser Bonds,
bonds issued to Unit Trust of India, IFCI Ltd., Food Corporation of India,
Industrial Investment Bank of India Ltd., the erstwhile Industrial
Development Bank of India and the erstwhile Shipping Development Finance
Corporation.
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Holding Pattern of GoI Securities - 2010

0.10%

4% 0.30%

2.60%

% share
Banks and Insurance cos.

13%

RBI
PFs
80%

MFs
PDs
Others

Source: RBI working paper on G-Sec

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Trading of Government Securities

Trading mechanism for G Secs.

Negotiated dealing system (NDS) is an
electronic platform for facilitating dealing
introduced in 2002.
NDS interfaces with CCIL for settlement of
government securities transactions for both
outright and repo trades.
It remains as a reporting platform rather
than a trading one.

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Trading mechanism for G Secs.

In 2005, NDS-OM (order matching) system was

introduced.

It provides STP, is purely order driven and

follows price / time priority. CCIL is the central
counter party for all trades done through this
platform.

It facilitates better price discovery, liquidity,

increase in operational efficiency & transparency.

Settlement for G Secs. is done on T + 1 basis.

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Understanding Market Watch

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Order Storage Dynamics

Order Types

Yield/Time Priority

Bid-Ask Spread

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Key terms used in Trading

SGL and CSGL

Shut Period

Trading Price

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Steps in Trading
1)

Participants place orders on NDS-OM

2)

NDS-OM matches the orders and trade is done

3)

Flow of trade details to the CCIL settlement systems

4)

CCIL sends the net fund and security obligations to members

5)

CCIL submits net settlement files at the end of day to RBI

6)

Funds and securities settlement carried out in DvP (Delivery versus

Payment) both funds and securities legs are settled on a net basis

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Trading Mechanism

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Trading in G Secs. by participants

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Secondary market activity in GoI Dated Securities

Year

Settlement volume (Rs. In

crore)

Turnover
ratio

Share in volume traded

Top 5
securities

Avg. tenor of
top security

Top security

2003-04

1458665

2.1

39%

11%

14

2004-05

862820

1.1

50%

29%

11

2005-06

657213

0.8

64%

31%

11

2006-07

883248

0.9

75%

36%

2007-08

1467704

1.3

66%

36%

10

2008-09

1955412

1.5

61%

44%

10

2009-10

2480850

1.4

61%

36%

2010-11

2552181

1.2

72%

39%

11

2011-12

3099108

1.2

86%

51%

10
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Measures to improve liquidity

Consolidation through re-issuance of existing securities.

Intra-day short selling in G Secs. allowed for banks & PDs in 2006. Short
selling now extended to 90 trading days.

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Qualitative Indicators of Liquidity

Particulars
Volume traded (Rs. In crore)

2006-07

2010-11

1021536

2870952

0.9

1.2

972801

2082036

15

10; 102

10; 91

Bid - ask spread (on-the-run G Sec) in bps

1-2

0.5 1

Bid ask spread (off-the-run G Sec) in bps

5-6

4-5

Turnover ratio (settlement volume + outstanding

securities)
Outstanding amount (Rs. In crore)
Impact cost % (liquid securities)

Availability of price on any day (no. of securities vs.

total number of securities)

Source: RBI working paper on G-Sec

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Corporate Bond Market

Methods of Issuance of Corporate Bonds

Public Issue
Private Placement

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Bonds based on issuer types

Bonds issued by Local Bodies
Bonds issued by Public Sector Units
Bonds issued by Financial Institutions
Bonds issued by Banks
Bonds issued by Corporates

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Bond Market Size

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Methods of Trading

Exchange
Traded

OTC
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Corporate Bond Market on NSE

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Interest Rate Dynamics in India

Macro Economic Analysis

Interest rates :
Mibor
Bank deposit rates
Bank Base rates
Government securities yields
PPF interest rate
Which one should I look at ?

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Factors affecting interest rates

Demand for
money

Supply of
money

Interest
Rates

Interest
Rates

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Factors affecting interest rates

So effectively, its the demand and supply of money in the system, which
drives interest rates.
But how do we know what will impact this demand and supply situation in the
monetary system?
Let us look at the factors that affect demand for and supply of

money

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Factors affecting interest rates

Demand for funds :
May come from government
Indicators :
Increased government
spending
High fiscal deficits
Govt. borrowing programs
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Government Borrowing Programme status Source :

CCIL

Source : CCIL Publication

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Factors affecting interest rates

Demand for funds :
May come from corporate sector

Indicators :
Increased corporate
spending (more projects,
investments)
More borrowings by Corporates
reflected in higher credit
off-take
More borrowings through debt
market by issue of corporate bonds
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Factors affecting interest rates Credit Offtake

Credit off-take is classified into two groups :
Food credit
Non-food credit

Food credit means advances for agricultural purpose.

Non-food is everything else. It mainly represents demand for funds from

the industry.

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Factors affecting interest rates Credit Offtake

How do we interpret this information?
If non-food credit growth is impressive, it means that corporates are demanding
money for variety of purposes.

This is likely to increase demand for money causing upward bias in interest
rates
From where can we get the relevant information?
RBI, NSE websites
Websites of corporates
Newspapers carrying articles about companies plans to raise finance as well as
executing projects
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Factors affecting interest rates

Factors affecting supply of money?

Most important factor of increasing money supply will be foreign

exchange inflows through FII / FDI flows

If lot of money is coming into India, it is bound to create ample money

supply and lower interest rates
Hence the numbers to be tracked are FII / FDI inflows

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Factors affecting interest rates

Impact of global factors on domestic interest rates ?
Global liquidity is crucial
Hence if major economies of the world like US, Euro area change interest
rate policy it may have an indirect impact on domestic interest rates
In simple words, if global liquidity is tightening (central banks are
increasing interest rates), upward pressure on domestic interest rates is
likely and vice-versa

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98

Relationship among interest rate, inflation and stock

market

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Fixed Income Mathematics

Time value of money

Cash inflows or cash outflows occurring at different points of time have
different time value.
Hence to compare these cash flows to arrive at a particular decision, the cash

flows have to be adjusted for time value.

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Time value of money

For comparing these cash flows, we have to adjust them for time value.
This can be done either by compounding or discounting.

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Time value of money

Compounding
(1000)

200

300

500

600

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Time value of money

Compounding
The formula is,
FV = PV (1 + r)n
Here FV = Future Value, PV = Present Value

R = rate of interest

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Time value of money

Future value of annuity

Annuity is the term used to describe a series of period flows of equal amounts.
Future value annuity is used to find future value of series of payments made.

FVA = A [(1 + k)n -1] / k

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Time value of money

Discounting
(1000)

200

300

500

600

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Time value of money

Discounting
The formula is

PV = FV / (1 + r)n
Present value of annuity
Annuity is the term used to describe a series of period flows of equal amounts.
PVA = A [(1 + k)n -1] / k (1 + k)n

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Time value of money

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Understanding Yield To Maturity (YTM)

Basic Bond terminologies
Par Value or Face Value of bond
Coupon Rate
Maturity Date
Yield Concepts
Current Yield = Annual Coupon /
Current market price
Yield To Maturity = Discount rate that
makes sum of present values of all cash
flows from the bond equal to its market
price.
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Key Excel Functions for Bond Valuation

FV

Future Value

PV

Present Value

PMT

Annuity

IPMT

Interest Component in Annuity

PPMT

Principal Component in Annuity

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Key Excel Functions for Bond Valuation

COUPNCD

Next Coupon Date

COUPPCD

Previous Coupon Date

COUPNUM

How many coupons will be paid from the settlement date

YEARFRAC

Fraction of year

DISC

Discount of a Zero coupon Security

PRICE

Clean Price of the Bond

ACCRINT

Accrued Interest

PRICEDISC

Price of a zero coupon security

YIELDDISC

Yield of a zero coupon security

YIELD

Yield of a coupon security

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Bond Valuation

Bond Valuation

Valuation of bond involves

discounting the future cash
flows at an appropriate rate
to arrive at the present value
of bonds.

This principle is applicable to

all types of bonds, whether
zero coupon or coupon
bearing bonds.

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Coupon rate, Discount Rate & Price

Discount rate used by the market is nothing but expected yield from the bond

Relationship between coupon rate, yield and bonds price

When Coupon rate < yield required by the market, bond trades at a

discount

When Coupon rate > yield required by the market, bond trades at a

premium

For Par bonds, Coupon rate

yield required

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Coupon rate, Discount Rate & Price

As maturity approaches, price of discount bond

As maturity approaches, price of premium bond

This effect of bonds price returning to par as maturity approaches is called pull to

par effect

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Valuing bonds with Semi-annual cash flows

Adjustments required
1.

No. of semi annual periods = Annual Periods * 2

2.

Yield per period = Annual Yield/2

3.

Coupon per period = Annual Coupon/2

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Valuing bonds between coupon payments

The bond price, between any two interest payment dates, will have an element of
accrued interest till the date.
Dirty prices (or full price) are bond prices including the interest accrued.
Clean prices are bond prices excluding the accrued interest.
Market always quotes a clean price. But the seller of the bond receives dirty price

Accrued
Interest

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Valuing bonds
Long Term Vs. Short Term bonds
Which bonds are more volatile?

High Coupon Vs. Low Coupon Bonds

Which bonds are preferred in volatile times?

Capital Gains Vs. Capital Losses

Capital Gains and Losses arising from equal basis point change in interest
rates are same or not?

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Day Count Conventions

Various markets use different day count conventions to calculate
the interest rate:

Actual / Actual
Actual no. of days between two payment dates are divided by
actual no. of days in a year.
For a normal year, no. of days are 365, leap year they are 366.
30 / 360
Each month is considered to have only 30 days.
Hence the entire year is of 360 days.

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Day count and quoting conventions for Government

securities
Actual / 360
Actual no. of days between two payment dates are divided by 360
days.
Actual / 365
Actual no. of days between two payment dates are divided by 365
days.
In Indian markets, Government Securities use 30/360 convention
while all other products use Act / 365.

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Revisiting YTM and ZCYC

Shortcomings of YTM

YTM is based on following assumptions,

The intermediate cash flows to the investor
can be reinvested at a rate equal to the
yield-to-maturity and
The investor holds the bond till maturity

The first assumption can rarely hold true due to

the dynamic nature of interest rates. Similarly
the investor may not hold the bond till
maturity.

Hence the realized yield may be quite different

from YTM, giving rise to risk.

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Zero Coupon Yield Curve

The relationship between yield and maturity is

called yield curve

Yield curve is developed for Zero Coupon

Treasury Securities

The yield curve is developed from On The Run

Treasury securities. These are the securities which
are recently auctioned and hence may be in good
demand.

Let us say, the recently auctioned issues are for 3month, 6 month, 1 Y, 2Y, 3Y, 5Y, 10 Y and 30Y.

How will the yields be calculated for say 4 Y or 12

Y period?

These are calculated by interpolation.

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Zero Curve Generation

Various methods are used to generate zero coupon yield curve
These are

Bootstrapping

Cubic Spline Followed by FIMMDA

Parametric approach, based on Nelson-Siegel-Svensson equation Followed by CCIL

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Valuation of Floating Rate Bonds

Indian Scenario for FRBs

Both Government as well as corporates issue FRBs.

G FRBs have been issued in the past with varying spreads over 364 day T
Bill rates

Corporates have to provide spreads depending upon the credit quality

Trading in FRBs is extremely limited. Hence market prices may not be

available.

For valuation purposes, FIMMDA gives prices of these bonds.

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Indian Scenario for FRBs

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Indian Scenario for FRBs

Source: CCIL publication

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Valuation of floating rate bonds

Floating rate bonds pay coupon which is benchmarked against a particular interest
rate.

The coupon will be decided at each reset date and may have a spread over the
benchmark rate.

Following terms are crucial to the concept :

Benchmark rate : a market determined interest rate used for the calculation of
coupon rate from time to time.

Reset frequency : the frequency at which a coupon rate is reset

Coupon payment frequency : the frequency at which coupon payment takes

place.
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Methodology

The standard method of valuing a bond is to discount all the cash flows of the
bond at a rate based on the yield available on a comparable instrument in the
market.

In simple terms, the cash flows to be discounted in case of floating rate bond is

Next coupon to be received which is known with certainty

Value of the bond at the next coupon date

A view can be taken that the bond will reset at par. In this case the valuation of
bond on any given day will be simple.

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Issues
FRBs having Zero Spread over reference rate
Value this by taking only one cashflow (i.e. next coupon & principle)
Value by taking multiple cash flows (all coupons and principle)
FRBs having a spread over reference rate
Assuming the spread has not changed since issue of this bond

Value this by taking only one cashflow (i.e. next coupon & principle)
Value by taking multiple cash flows (all coupons and principle)
Assuming that the spread has changed since the issue of this bond (for
corporate bonds)
Value this by taking only one cashflow (i.e. next coupon & principle)
Value by taking multiple cash flows (all coupons and principle)
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Valuation of bonds with embedded options

Bonds with embedded options

Callable or redeemable bonds are bonds that can be redeemed or paid off at the
option of the issuer prior to the bonds maturity date. (embedded call option)

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Bonds with embedded options

Puttable bonds are bonds that can be redeemed or paid off at the option of the
investor prior to the bonds maturity date. (embedded put option)
Investors normally calculate the yield to call (or yield to put) in addition to yield
to maturity and the lower of the two (called yield to worst) is used by conservative
investors to take their decision.

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Valuation of Bonds with Embedded Options

The potential investor in a callable bond must be compensated for the risk

that the issuer will call the bond prior to the stated maturity date.
Two disadvantages faced by an investor in callable bonds are reinvestment

risk and truncated price appreciation when yields decline.

The traditional approach to valuing callable bonds has been in terms of the
yield to worst.
Yield to worst is calculated by calculating the YTM and the yield to call for
every call date and then selecting the lowest of all the calculated yields.
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Contd
At present the valuation of callable bonds in India happens on Yield to Worst
basis and Valuation of puttable options is done on yield to best basis.

Thus the optionality element is not considered.

Let us see if this element is considered how the bond pricing can be done.

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Contd
To value a bond with an embedded option it is necessary to understand that the

bond can be decomposed into an option-free component and an option

component.
Value of a callable bond = Value of non-callable bond - Call option premium
Value of a putable bond = Value of non-putable bond + Long a put option

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Understanding Types of Risks

Interest Rate and Reinvestment Risk

As a result of the above shortfalls, the investor is exposed to
the following risks

Interest Rate Risk : If the investor does not hold bond till
maturity, an increase in future interest rates could lead to a
capital loss when the bond is sold in the secondary market.

Reinvestment Risk : The assumption of the intermediate

cashflows being reinvested at the yield-to-maturity, exposes the
investor to the risk that the future reinvestment rates would be
less than the yield-to-maturity.

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Interest Rate and Reinvestment Risk

Interest Rate Risk

Reinvestment Risk

If interest rate
goes up
If interest rate
goes down

Hence the valuation of bonds can be done by using

Zero Coupon Yield Curve

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Other risks from bond investing

Call & prepayment risk

The bond may have a call option for

the issuer. Creates uncertainty of cash
flows. Yield to Call instead of Yield to
Maturity may be relevant yield.

Yield curve risk

What is a yield curve?

It is a relationship between yield and

term to maturity.

Types of yield curve :

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Other risks from bond investing

Yield curve risk
Yield curve risk arises for a portfolio of bonds. In a portfolio, many
bonds with different maturities exit. Yield curve shift may not be
parallel and hence each bonds price will change differently. This
is yield curve risk.
Credit risk
Default risk
Credit spread risk
Downgrade risk
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Other risks from bond investing

Liquidity risk

Risk of having to sell the bond below its indicated value.

Bid ask spread indicate the level of liquidity risk.

Exchange-rate risk
Arises from investing in foreign currency denominated bonds.
Volatility risk
Inflation risk
Sovereign risk

Risk arising out of investing in bonds issued by foreign governments.

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Interest Rate Risk Measurement

Measuring Interest Rate Risk

Full Valuation Approach

For a change in interest rates, the changed values of bonds can be calculated to
arrive at changed value of the portfolio.

Duration / Convexity approach

In this case, the duration and or convexity of bonds / portfolios is calculated to

arrive at approximate estimate of change in the portfolio value due to change in
interest rates.

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Macaulay & Modified Duration

Macaulay & Modified duration are two measures of duration

Modified Duration is the weighted average time to the present value of cash flows

Modified Duration directly gives the percentage change in price with a unit change in yield.
This is shown in the following slides.

DMod = [DMac / 1+(ytm/f)]

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Modified Duration as Interest Rate Sensitivity

Modified Duration is used as a measure of interest rate sensitivity.

Using the formula for duration

dP/dy = -(MD)*P

This can be written as

MD = -(dP/P)/dy

It can be seen from the above that MD is equal to minus of percentage change in price
for a unit change in the yield.

Hence, MD can directly be used as an interest rate risk measure for bonds.

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Price Value of a Basis Point

The Price Value of a Basis Point (PVBP) is the price change of a security for a
one basis point change in yield.

It is equal to Dollar Duration divided by 100.

PVBP = $D/100

For example, the 5 year bond, has

Dollar duration of 3.31

PVBP of 3.31 / 100 = 0.0331

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Drawbacks of Using Duration for Hedging

Actual Price

Price
Price Predicted
by Duration

Y0 Y1

Y2

Yield
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Convexity
Convexity measures the change in
duration when the interest rate
changes.
The relationship between market value
and interest rate is not linear.
While duration measures the market
value weighted average maturity of
future flows, convexity is a function of
dispersion of flows around that
average.
Zero Coupon bonds will have lowest
convexity, other things being equal.
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Convexity
Duration is an accurate measure only for small yield changes.
Convexity combined with duration allows us to do better approximation of price
than using duration alone.
Convexity = {(t*(t+1)*CF)/(1+r)^(t+2)}/P

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Change in Price Due to Convexity

Consider a bond with price P and convexity C. If the yield on the bond
changes by dy, the change in the price of the bond will be given by

= * C * (y)2
It can be seen that the change in price due to the property of convexity is
always positive.
Because of convexity the bond price rises at a faster rate and falls at lower
rate with changes in the yield.

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Total Change in Price of a Bond with Yield

The total change in the price of a bond due to a change in yield is the
sum of two components
Change in price due to duration
Change in price due to convexity

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Summary
Overview of Indian Fixed Income Market
Government Securities Market
Corporate Bond Market
Understanding time value of money & bond mathematics
Valuation of Fixed Income Products
Overview of Regulations

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Thank You