Fixed Income Markets - Detailed Educational Notes | MODULE D: FINANCIAL PRODUCTS AND SERVICES
Fixed Income Markets: Debt / Bond Markets
Government Securities
Government securities (G-Secs) are debt instruments issued by the central or state governments to finance their fiscal deficit. They carry low risk and often serve as benchmarks for other debt instruments. Common examples include Treasury Bills, Dated Securities, and State Development Loans.
Bond Valuation and Theorems
Bond valuation involves determining the fair price of a bond based on the present value of its future cash flows. This depends on the coupon rate, maturity period, and prevailing market interest rates.
Mathematical Example:
Consider a bond with:
- Face Value (F) = ₹1,000
- Coupon Rate (C) = 8% annually
- Time to Maturity (T) = 5 years
- Market Interest Rate (r) = 7%
The bond price (P) is given by:
P = (C × F) × [(1 - (1 + r)^-T) / r] + F × (1 + r)^-T
Substituting values:
P = (0.08 × 1000) × [(1 - (1 + 0.07)^-5) / 0.07] + 1000 × (1 + 0.07)^-5
P ≈ ₹80 × 4.1002 + ₹712.99
P ≈ ₹1040.02
Bond Theorems:
- Theorem 1: Bond prices and yields are inversely related.
- Theorem 2: Long-term bonds are more sensitive to interest rate changes than short-term bonds.
- Theorem 3: The convexity of a bond enhances its price sensitivity to interest rates.
Auction of Government Securities
Government securities are auctioned through competitive and non-competitive bidding processes. The two types are:
- Uniform Price Auction: All successful bidders pay the same price.
- Multiple Price Auction: Each successful bidder pays the price they bid.
Example: If three participants bid for ₹100 crores at 6.8%, 7.0%, and 7.2%, and the cut-off yield is 7.0%, only bids at or below 7.0% are successful in a uniform price auction.
Primary Dealers
Primary Dealers (PDs) are institutions authorized to participate directly in the primary market auctions of government securities. Their responsibilities include underwriting and market-making activities to ensure liquidity in the secondary market.
Fixed Income Money Market and Derivatives Association of India (FIMMDA)
FIMMDA is a self-regulatory organization representing participants of the fixed income market, including banks, primary dealers, and financial institutions. It standardizes practices, publishes valuation benchmarks, and works closely with regulators like RBI and SEBI.
RBI Retail Direct Scheme (RDS)
The RBI Retail Direct Scheme enables individual investors to open Retail Direct Gilt (RDG) accounts directly with RBI and invest in government securities in both primary and secondary markets.
Key Benefits:
- Direct access to government bonds
- No intermediaries required
- Low-cost investment option
Corporate Bond Market
The corporate bond market involves debt instruments issued by corporations to raise capital. These bonds generally offer higher yields than government securities but carry higher credit risk.
Mathematical Example:
Suppose a corporate bond has:
- Face Value = ₹1,000
- Coupon Rate = 9%
- Maturity = 7 years
- Market Yield = 10%
Using the same formula as before, bond valuation becomes:
P = (0.09 × 1000) × [(1 - (1 + 0.10)^-7) / 0.10] + 1000 × (1 + 0.10)^-7
P ≈ ₹90 × 4.8684 + ₹513.16
P ≈ ₹951.32
Inter-Corporate Deposits (ICDs)
ICDs are unsecured short-term loans extended by one corporate to another. They are usually issued to manage temporary liquidity mismatches. Interest rates and maturity periods are negotiated mutually.
Example:
Company A places an ICD of ₹5 crores with Company B for 90 days at an interest rate of 8%. The interest earned will be:
Interest = Principal × Rate × Time
= 5,00,00,000 × (8/100) × (90/365)
= ₹9,86,301.37
Chapter List
- Overview of Financial Markets
- Money Markets and Capital Markets
- Fixed Income Markets - Debt / Bond Markets
- Forex Markets
- Interconnection of various markets/Market Dynamics
- Merchant Banking Services
- Derivatives Market including Credit Default Swaps
- Factoring, forfaiting & Trade Receivables Discounting System (TReDS)
- Venture capital
- Leasing and Hire Purchase
- Credit Rating agencies & their functions
- Mutual Funds
- Insurance Products
- Pension Funds (include APY, NPS)
- Guidelines on Para Banking & Financial Services provided by Banks
- Real Estate Investment Funds / Infrastructure Investment Fund (concept)
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