sapm History

8/7/2019 sapm History

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Stock market indices are the barometers of the stock market.They mirror the stock market behavior.With some companies listed on the Bombay stock exchange, it is not possibleto look at the prices of every stock to find out whether the market

movement is upward or downward. The indices give a broadoutline of the market movement and represent the market. Someof the stock market indices are BSE Sensex, BSE- 200, Dollex,NSE-50, CRISIL-500, Business Line 250 and RBIIndices of Ordinary Shares.Usefulness of Indices1. Indices help to recognise the broad trends in the market.2. Index can be used as a bench mark for evaluating the investorsportfolio.3. Indices function as a status report on the general economy.

Impacts of the various economic policies are reflect on the stockmarket.4. The investor can use the indices to allocate funds rationallyamong stocks. To earn returns on par with the market returns, hecan choose the stocks that reflect the market movement.5. Index funds and futures are formulated with the help of theindices. Usually fund managers construct portfolios to emulateany one of the major stock market index. ICICI has floated ICICIindex bonds. The return of the bond is linked with the index

movement.6. Technical analysts studying the hostorical performance of theindices predict the future movement of the stock market. Therelationship between the individual stock and index predicts theindividual share price movement.Computation of Stock IndexA stock market index may either be a price index or a wealthindex. The unweighted price index is a simple arithmeaverage of share prices with a base date. This index gives an ideaabout the general price movement of the constituents thatreflects the entire market. In a wealth index the prices areweighted by market capitalisation. In such an index, the baseperiod values are adjusted for subsequent rights and bonusoffers. This gives an idea about the real wealth created forshareholders over a period of time. The following example givesthe calculation procedure for the wealth index.


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Let us take an example of an index constructed with three scripsX, Y and Z.Equity of the company X : 100 (Par value Rs. 10)Equity of the company Y : 200 (par value Rs. 10)

Equity of the company Z: 250 (par value Rs. 10)Market price of scrip X : Rs. 20Market price of scrip Y: Rs. 30Market price of scrip Z : Rs. 40Market Capitalisation (MC) = Number of shares Prices of sharesX = 100 Rs. 20 = Rs. 2,000Y = 200 Rs. 30 = Rs. 6,000Z = 250 Rs. 40 = Rs. 10,000Aggregate Market Capitalisation = Rs. 18,000.Index at period N = 100

Market Price at N + 1X Share price = Rs. 25Y Share price = Rs. 40Z Share price = Rs. 50Market capitalisationX = 100 Rs. 25 = Rs. 2,500Y = 200 Rs. 40 = Rs. 8,000Z = 250 Rs. 50 = Rs. 12,500Aggregate Market Capitaliation = Rs. 23,000

Index at period N + 1 = Rs. 23,000 100/18,000N + 1 = 127.78The weight may be the trading volumeof the pascrip.When the index uses the trading volume as weight, on itsshows the depth of the market in terms of trading volumes andconditions. All India Equity index of Financial Express with baseyear 1979 uses the trading volume of the scrip as weight.The Business Line - (BL) - 250 (Base January 17 1994 = 100) acomprehensive index comprising of 43 industry group is a wealthindex and the weight uses is the market capitalisation. If theindex is broad based it can indicate the market movement in acomprehensive manner. The influence of individual scrip is smalerin a broad based index. In the case of the unweighted price indexselected scrips price average is calculated in relation to a baseyear. They show just the price movement. The Ordinary SharePrice Index of the Economic Times with base year 1984-


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85 is of this types.

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Mutual FundsMutual funds are investment companies that use the funds frominvestors to invest in other companies or investment alternatives.They have the advantage of professional managemdiversification, convenience and special services such as checkwriting and telephone account service. It is generally easy to sellmutual fund shares although you run the risk of needing to sell

and being forced to take the price offered. Mutual funds come invarious types, allowing you to choose those funds with objectiveswhich most closely match your own personal invesobjectives. A load mutual fund is one that has sales charge orcommission attached. The fee is a percentage of the initialinvestment. Generally, mutual funds sold through brokers areload funds while funds sold directly to the public are no-load orlow-load. As an investor, you need to decide whether you want totake the time to research prospective mutual funds yourself or

pay the commission and have a broker who will do that for you.All funds have annual management fees attached.

Mutual Fund Schemes may be Classified on the Basis of itsStructure and its Investment Objective.1. By Structure

a. Open - Ended Funds

An open-ended mutual fund is the one whose units can be freelysold and repurchased by the investors. Such funds are not listedon bourses since the Asset Management Companies (AMCs)provide the facility for buyback of units from unit holders either atthe NAV, or NAV-linked prices. Instant liquidity is the USP of open-ended funds: you can invest in or redeem your units at will in amatter of 2-3 days. In the event of volatile markets, open-endedfunds are also suitable for investment appreciation in the short-term. This is how they work: if you expect the interest rates to


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fall, you park your money in an open-ended debt fund. Then,when the prices of the underlying securities rise, leading to anappreciation in your funds NAV, you make a killing by selling itoff. On the other hand, if you expect the Bombay Stock Exchange

Sensitivity Index-the Sensex-to gain in the short term, you canpick up the right open-ended equity fund whose portfolio hasscrips likely to gain from the rally, and sell it off once its NAV goesup.

Investment Objectives

How Suitable Are Open-Ended Funds for An Increase In MyInvestment?Open-ended equity funds are, indeed, suitable for an increase orappreciation in your investment. Again, your choice in an equity

fund can vary, depending on your appetite for risk. Sector specificfunds like Infotech/Technology or Pharma funds invest only incompanies of that particular sector, and are more risky.At the same time, if the scrips of a particular sector are doingwell, the returns from investing in an sector-specific mutual fundmay prove to be worth the risk.Are Open-Ended Mutual Funds Suitable For RegulIncome?An open-ended debt fund is best suited for income. Debt funds

generally give you an option of receiving dividend on a monthly,quaterly, half-yearly or on annual basis.To What Extent Do Open-Ended Funds Protect Me AgainstInflation?Open-Ended Mutual Funds provide a fair amount of protectionagainst inflation. But funds with an equity portfolio-growth funds-provide better protection than debt funds because equities, overthe long term, provide the best means of beating inflation.Moreover, long term capital gains are taxed after indexing forinflation.

Can I Borrow Against Open-Ended Mutual Funds?There are some banks that offer loans against your mutual funds.Different banks have their own criteria on which they approve theloans.Risk Considerations


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How Assured Can I Be Of Getting My Full Investment Back?You cannot be completely sure of getting your full investmentback. It depends on the quality and the kind of portfolio youinvest in. In fact, in an equity fund, there are no guarantees at all

since the fund trades in the secondary markets, and a crash therecould result in a major part of your investment coming to nothing.However, in debt funds, the credit ratings of the constituents ofthe portfolio are a good indicator to how safe the fund, and, thus,your principal amount is. For instance, if the portfolio consists ofmostly government securities, it is the safest.

b. Close Ended Funds

Closed-ended mutual funds have a fixed number of units, and afixed tenure (3, 5, 10, or 15 years), after which their units are

redeemed or they are made open-ended. These funds havevarious objectives: generating steady income by investing in debtinstruments, capital appreciation by investing in equities, or bothby making an equal allocation of the corpus in debt and equityinstruments.How Suitable are Closed-Ended Funds For an Increase inMy Investment?Since units of closed-ended funds rise and fall in the market likeany other stock, they are well suited for an increase in your

investment. However, a mutual fund is more influenced by thevalue of its own portfolio than any other factor. Units of an equityfund are more frequently traded than a debt fund. Also, the NAVof an equity fund rises and falls at a much faster pace.On the other hand, an equity fund provides healthy appreciationin NAV in the long term.Are Closed-Ended Mutual Funds Suitable For ReguIncome?Closed-ended debt funds, with their conservative investmentapproach, are best suited for income. These funds dividend annually or semi-annuallyTo What Extent Do Closed-Ended Funds Protect Against Inflation?With stocks being better than bonds in providing returns on a longterm basis, an equity closed-ended fund is better equipped toguard your investment against inflation in the long run.


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Can I Borrow Against Closed-Ended Mutual Funds?Risk Considerations

How Assured Can I Be Of Getting My Full Investment Back?You cannot be completely sure of getting your full investment

back. Depending on their investment objective and underlyingportfolio, closed-ended funds can be very volatile or be fairlystable. Hence, your principal is not assured.

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Life Insurance

A life insurance policy is a contract between an individual (termedas insured) and an insurance company (insurer) to pay theinsured, or his nominated heirs, a specified sum of money on the

happening of an event. The event could be the expiry of theinsurance policy or the death of the insured before the expiry(date of maturity) of the policy as per the terms of the policy. In asimple example, a person takes an insurance policynominates his wife as the beneficiary. On the death of this person,his wife gets the amount for which the life insurance policy waspurchased. There are many variants of a life insurance policy:1. Whole Life Assurance Plans

These are low-cost insurance plans where the sum assured ispayable on the death of the insured.2. Endowment Assurance Plans

Under these plans, the sum assured is pay-able on the maturity ofthe policy or in case of death of the insured individual beforematurity of the policy.3. Term Assurance Plans

Under these plans, the sum assured is payable only on the deathof the insured individual before expiry of the policy.4. Pension Plans

These plans provide for either immediate or deferred pension for

life. The pension payments are made till the death of theannuitant (per-son who has a pension plan) unless the policy hasprovision of guaranteed period.Life Insurance Corporation (LIC) is a government company. Tillrecently, the LIC was the sole provider of life insurance policies tothe Indian public. However, the Insurance RegulatorDevelopment Authority (IRDA) has now issued licences to a


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few private companies to conduct the business of life insurance.

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Risk in a Traditional SenseRisk in holding securities is genrally associated with possibilitythat realized returns will be less than the returns that wereexpected. The source of such disappointment is the failure ofdividends (interest) and/or the securitys price to materialize asexpected.

Systematic Risk

Market Risk

Finding stock prices falling from time to time while a companysearnings are rising, and vice versa, is not uncommon. The price ofa stock may fluctuate widely within a short span of time eventhough earnings remain unchanged. The causes of phenomenon are varied, but it is mainly due to a change ininvestors attitudes toward equities in general, or toward certaintypes or groups of securites in particular. Variability in return onmost common stocks that is due to basic sweeping changes ininvestor expectations is referred to as market risk.Maket risk is caused by investor reaction to tangible as well asintangible events. Expectaitions of lower corporate profits ingeneral may cause the larger body of common to fall in price.Investors are expressing their judgement that too much is beingpaid for earnings in the light of anticipated events. The basis forthe reaction is a set of real, tangible events political, social, oreconomic. Intangible events are related to market psychology.


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Market risk is usually touched off by a reaction to real events, buttheemotional instability of investors acting collectively leads to asnow balling over reaction. The initial decline in the market can

cause the fear of loss to grip invetors, and a kind of her instinctbuilds as all investors make for the exit. These reactions toreactions frequently culiminate in excessive sellings, pushingprices down far out of live with fundamental value. With a triggermechanism such as the assassination of a politican, the threat ofwar, or an oil shortage, virtually all stocks are adversely affected.Likewise, stcks in a particular industry group can be hard hit whenthe industry goes out of fashion.This discussion of market risk has emphasized adverse reactions.Certainly, buying paincs also occur as reactions to real events,

however, investors are not likely to think of sharp price advancesas risk.Two other factors, interest rates and inflation, are an integral partof the real forces behind market risk and are part of the largercategory of systematic or uncontrollable influences. Let us turnour attention to interest rates. This risk factor has its most directeffect on bond investments.

Interest-Rate RiskInterest-rate risk refers to the uncertainty of future market valuesand of the size of future income, caused by fluctuations in thegeneral level of interest rates. The root cause of interest-rate risklies in the fact that, as the rate of interest paid on U.S.government securities (USGs) rises or falls, the rates of returndemanded on alternative investment vehicles such as stocks andbonds issued in the private sector,rise or fall. In other words, as the cost of money changes fornearly risk-free securities (USGs), the cost of money to more risk-prone issuers (Private sector) will also change. Investors normallyregard USGs as coming closest to being risk free. The interestrates demanded on USGs are thought to approximate the purerate of interest, or the cost of hiring money at no risk. Changes inrates of interest demanded on USGs will permeate the system of


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available securities, from corporate bonds down to the riskiestcommon stocks.Interest rates on USGs shift with changes in the supply anddemand for government securities. For example, a

operating deficit experienced by the U.S. government will requirefinancing. Issuance of added amounts of USGs will increase theavailable supply. Poetntial buyers of this new supply may beinduced to buy only if interest rates are somewhat higher thanthose currently prevailing on outstanding issues. If rates on USGsadvance from, say, 9 percent to 9 percent, investors holdingoutstanding issues that yield 9 per cent will notice a decline in theprice of their securities. Because the 9 percent rate is fixed bycontract on these old USGs, a poetntial buyer would be able torealize the competitive 9 percent rate only if the current holder

market down the price. As the rate on USGs advances, theybecome relatively more attractive and other securities becomeless attractive.

Purchasing-Power Risk

Market risk and interest-rate risk can be defined in terms ofuncertainties as to the amount of current dollars to be receivedby an investor. Purchasing-power risk is the uncertainty of thepurchasing power of the amounts to be received. In more

everyday terms, purchasing-power risk refers to the impact ofinflation or deflation on an investment. If we think of investmentas the postponement of consumption, we can see that when aperson purchases a stock, he has foregone the opportunity to buysome good or service for as long as he owns the stock. If, duringthe holding period, good or services rise, the investor actuallyloses purchasing power.Rising prices on goods and services are normally associated withwhat is referred to as inflation. Falling prices on goods andservices are termed deflation. Both inflation and deflation arecovered in the all-encompassing term purchasing power risk.Generally, purchasing-power risk has come to be identified withinflation (rising prices); the incidence of declining prices in mostcountries has been slight. Rational investors should include intheir estimate of expected return an allowance for purchasing-power risk, in the form of an expected annual percentage change


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in prices. If a cost-of living index begins the year at 100 and endsat 103, we say that the rate of increase (inflation) is 3 percent[(103-100)/100]. If from the second to thethird year, the indexchanges from 103 to 109, the rate is about 5.8 percent [109-

103/103].Just as changes in interest rates have a systematic influence onthe prices of all securities, both bonds and stocks, so too doanticipated puchasing-power changes manifest themselves. Ifannual changes in the consumer price index of other measureof purchsaing power have been averaging steadily around 3.5percent and prices will apparently spurt ahead by 4.5 percentover the next year, required rates of return will adjust upward.This process will affect government and corporate bonds as wellas common stocks.

Market, purchasing-power and interest-rate risk are the principlesources of systematic risk in securites; but we should alsoconsider another important category of security risunsystematic risks.

Unsystematic RiskUnsystematic risk is the portion of total risk that is unique orpeculiar to a firm or an industry, above and beyond that affectingsecurites markets in general. Factors such as manag

capability, consumder preferences, and labor strikes can causeunsystematic variability of returns for a companys stock.Because these factors affect one industry and/or one firm, theymust be examined separately for each company. The uncertaintysurroundings the abilityof theissuer to make paymentssecurities stems from two sources: (1) the operating environmentof the business, and (2) the financing of the firm. These risks arereferred to as business risk and financial risk, respectively. Theyare strictly a function of the operating conditions of the firm a andthey way in which it chooses to finance its operations. Ourintention here will be directed to the broad aspecimplications of business and financial risk. In-depth treatment willbe the principal goal of later chapters on analysis of the economy,the industry, and the firm.

Business Risk


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Business risk is a function of the operating conditions faced by afirm and the variability these conditions inject into operatingincome and expected to increase 10 percent per year over theforeseeable future, business riskwould behigher if operating

earnings could grow as much as 14 percent or as little as 6percent than if the range were from a high of 11 percent to a lowof 9 percent. The degree of variation from the expected trendwould measure business risk.Business risk can bedivided into two broad categories: externaland internal. Internal business risk is largely asociated with theefficiency with which a firm conducts its operations with in thebroader operating environment imposed upon it. Each firmhas its own set of internal risks, and the degree to which it issuccessful in coping with them is reflectedin operating efficienty.

To large extent, external business riskis the result of operatingconditions imposes upon the firm by circumstances beyond itscontrol. Each frim also faces its own set of external risks,depending upon the specific operating environmental factors withwhich it must deal. The external factors, from cost of money todefense-budget cuts to higher traffs to a down swing in thebusiness cycle, are far too numerous to list in detail, but the mostpervasive external risk factor is probably the business cycle. Thesales of some industries (steel, autos) tend to move in tandem

with the business cycle, while the sales of otherscountrycyclically (housing). Demographic considerations can alsoinfluence revenues through changes in the birth rate or thegeographical distribution of the population by age, group, race,and so on. Political Policies are a part of external business risk;government policies with regard to monetary and fiscal matterscan affect revenues through the effect on the cost andavailability of funds. If money is more expenseive, consumers whobuy on credit may postpone purchases, and mugovernments may not sell bonds to finance a water-treatmentplant. The impact upon retail stores, telelvision manufacturers, ofwater-purification systems is clear.

Financial Risk

Financial risk is associated with the way in which a companyfinaces its activities. We usually gauge finacial risk by looking at


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the capital structure of a firm. The presence of borrowed moneyof debt in the capital structure creates fixed payment in the formof interest that must be sustained by the firm. The presence ofthese interest commitments fixed interest payments due to debt

of fixed-dividend payments on preferred stock causes the amountof rasidual earnings available for commonstockdividends to be more variable than if no interest payments wererequired. Financial risk is avoidable risk to the extent thatmanagements have the freedom to decide to borrow or not toborrow funds. A firm with no debt financing has no financial risk.By engaging in debt financing, the firm changes the characteristicof the earnings stream avaialbel to the common-stock holders.Speciafically, the reliance on debt financing, called financialleverage, has at three important effects on common

holders. Debt financing (1) increases the variability of theirreturns, (2) affects their expectations concerning their returns,and (3) increases their risk of being ruined.

How does we Measure Risk?Understanding the nature of the risk is not adequate unless theinvestor or analyst is capable of expressing it inquantitative terms. Expressing the risk of a stock in quantitative

terms makes it comparable with other stocks. Measurementcannot beassures of percent accuracy because risk is caused by numerousfactors as discussed above. Measurement provides approximate quantification of risk. The statistical tool often usedto measure is the standard deviation.Standard Deviation: It is a measure of the values of thevariables around its mean or it is the square root of the sum ofthe squared deviations from the mean divided by the number ofobservances. The arithmetic mean of the returns may be same for

two companies but the returns may vary widely.Measuring Portfolio Risk

Like in case of individual securities, the risk of a portfolio could bemeasured in terms of its variance or standard deviation. However,the variance or standard deviation of a portfolio is not simply theweighted average of variances or standard deviation of individualsecurities. The portfolio variance or standard deviation is affected


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by the association of movement of returns of two securities.Covariance of two securitiesmeasures their co-movement.How do we Calculate Co-variance?

There are three steps involved I the calculation of covariancebetween two securities;Determine the expected returns for securities Determine thedeviation of possible returns from the expected return for eachsecurity.Determine the sum of the product of each deviation of returns oftwo securities and probability. Let us consider the data of twosecurities X and Y.State ofeconomy Probability Returns

X YA 0.1 -8 14B 0.2 10 -4C 0.4 8 6D 0.2 5 15E 0.1 -4 20The expected return for security X:E (Rx) = (0.1*-0.8)+(0.2*10)+(0.4*8)+(0.2*5)+(0.1*-0.4)= 5%

The expected return for security Y:E (Ry) = (0.1*14)+(0.2*-4)+(0.4*6)+(0.2*15)+(0.1*20)=8%Covxy is the covariance of returns of securities X & Y, Rx and Ryare the returns of securities X & Y respectively E (Rx) and E (Ry)are the expected returns of securities X & Y respectivelyPi is the probability of occurrence of the state of economy.Thus the covariance between the securities X & Y is:Covxy = 0.1(-8-5) (14-8) +0.2(10-5)(-4-8)+0.4(8-5)(6-8)+0.2(5-5)(15-8)+0.1(-4-5)(20-8).= -7.8-12-2.4+0-10.8= -33.0You can note from the calculation of covariance of returns ofsecurities X and Y that it is a measure of both the standarddeviations of the securities and their associations. covariance can also be calculated as follows:


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Covariance XY = Standard deviation X * Standard deviation Y* Correlation XYCovxy = s x *y * CorxyWhere x and y are standard deviation of returns for securities X

and Y and Corxy is the correlation coefficient of securities X andY. Correlation measures the linear relationship betweevariables (in case of two securities).Thus, from the above formula, we can obtain the followingformula for calculating the correlation coefficient of securities X &Y:Correlation XY = Covariance XYStandard deviation X * Standard deviation YCorxy = Covxy s x * s yThe variances and standard deviation of securities x and y are as

follows:s x 2 = 0.1(-8-5)2+0.2(10-5)2+0.4(8-5)2+0.2(5-5)2+0.1(-4-5)2=16.9+5+3.6+0+8.1 = 33.6x = 33.6 = 5.8%y 2 = 0.1(14-8)2 +0.2(-4-8)2+0.4(6-8)2+0.2(15-8)2+0.1(20-8)2= 3.6+28.8+1.6+9.8+14.4 = 58.2y = 58.2= 7.63%The correlation coefficient of securities X and y is as follows:Corxy = -33 = 0.7456 5.8*7.63

Securities X and Y are negatively correlated. If an investor investsin the combination of these securities, he or she can reduce therisk.The Characteristic Regression Line (CRL)

The Characteristic Regression Line (CRL) is a simple regression model estimated for a particular stock against themarket index return to measure its diversifiable undiversifiable risks.The model is: Ri = ai + b I Rm+eii =Return of the ith stockaI = Interceptbi = Slope of the ith stockRm= Return of the market indexei = the error termThe security return = Todays price Yesterdays Yesterdays price * 100


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Todays market return = Todays index Yesterdays index /Yesterdays index * 100Like daily returns, weekly returns can be calculated by using thisweeks and last weeks prices instead of todays and yesterdays

prices in the above mentioned formula. Monthly can also becalculated. Lets consider the daily prices of the Bajaj Auto stockand the NSE index for the 5th Oct 2000 to 16th October 2000.The objective of this example is only to illustrate the computationof beta. Usually beta values have to be calculated from dataof a fairly long period to minimize the sampling error.Date NSE index (X) Bajaj Auto (Y)October 5 904.95 597.8October 6 845.75 570.8October 7 874.25 582.95

October 8 847.95 559.85October 9 849.10 554.60October 12 835.80 545.10October 13 816.75 519.15October 14 843.55 560.70October 15 835.55 560.95What is Beta? What Does it Imply?

Beta is the slope of the characteristic regression line. Betadescribes the relationship between the stocks return and the

index returns. In the above example, beta indicates that 1 %change in NSE index return would cause 1.19 % change in theBajaj auto stock return. Varying beta has the foimplications: Beta = +1.0: 1% change in the market index return causesexactly 1% change in the stock return. It indicates that the stockmoves in tandem with the market. Beta = + 0.5: 1% change in the market index return causesexactly 0.5% change in the stock return. The stock is less volatile

compared to the market. Beta = +2.0: 1% change in the market index return causesexactly 2% change in the stock return. The stock is more volatileWhen there is a decline of 10% in the market return, the stockwith a beta of 2would give a negative retrurn of 20%. The stockswith more than I beta value is considered to be risky.


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Negative beta value indicates that the stock return moves in theopposite direction to the market return. A stock with a negativebeta of 1 would provide a return of 10%, if the market returndeclines by 10% and vice-versa.

Note: Stocks with negative beta resist the decline in the marketreturn. But stocks with negative returns are very rare.Alpha : The intercept of the characteristic regression line is alphai.e. distance between the intersection and the horizontal axis. Itindicates that the stick return is independent of the marketreturn. A positive value of alpha is the healthy sign. Positive alphavalues would yield profitable return.

Correlation

The correlation co-efficient measures the nature and extent of

relationship between the stick market index return and the stockreturn in the particular period. The square of the correlationcoefficient is the co-efficient of determination. It givepercentage of variation in the stocks return explained be thevariation in the markets return.r2 = (0.79)2 = 0.62What does an r of 0.62 imply?The interpretation is that 62% of variation in stocks return is dueto the variations in NSE index return.


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DEBT/BOND ValuationDebt instruments promise to pay a stipulated stream of cashflows. This generally comprises periodic interest payments overthe life of the instrument and principal payment at the time ofmaturity.A vast menu of debt instruments exists. They may be classifiedinto two groups according to maturity, where maturity is definedas the length of time between the issue date and the redemptiondate. Debt instruments which have a maturity of one year or less

are called money market instruments. Debt instruments whichhave a maturity of more than one year are called bonds (ordebentures).The debt market in India has registered an impressive growthparticularly since 1993 and, not surprisingly, has accompanied by increasing complexity in instruments, interestrates, methods of analysis, and so on. It is instructive to comparethe characteristics of pre-liberalisation scenario with those of thepost-liberalisation scenario. This comparison is given in Exhibit10.1.Since debt instruments loom large in the world of finace, a basicunderstanding of certain analytical concepts and methods used indebt valuation is essential for students of finance.Types and Features of Debt InstrumentsThe variety of debt instruments may be classified as follows : Money market instruments


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Government securities and government-guaranteed bonds Corporate debenturesMoney Market Instruments

Debt instruments which have a maturity of less than 1 year at the

time of issue are called money market instruments. The importantmoney market instruments in India area Treasury certificates of deposits, and commercial paper. Treasury BillsTreasury bills represent short-term obligations of the Governmentwhich have maturities like 91 days, 182 days, and 364 days. Theydo not carry an explicit interest rate (or coupon rate). They areinstead sold at a discount and redeemed at par value. Hence theimplicit interest rate is a function of the size of the discount andthe period of maturity.Though the yield on Treasury bills is somewhat low, they haveappeal for the following reasons : (i) They can be transactedreadily as they are issued in bearer form. (ii) There is a veryactive secondary market for Treasury bills and the Discount andFinance House of India is a major market maker. (iii) Treasury billsare virtually risk free.Certificates of Deposit

A certificate of deposit (CD) represents a negotiable receipt offunds deposited in a bank for a fixed period. It may be in aregistered form or a bearer form. The latter is more popular as it

can be transacted more readily in the secondary market. LikeTreasury bills, CDs are sold at a discount and redeemed at parvalue. Hence the implicit interest rate is a function of the size ofthe discount and the period of maturity.CDs are a popular form of short-term investment for companiesfor the following reasons : (i) Banks are normally willing to tailorthe denominations and maturities to suit the needs of theinvestors. (ii) CDs are fairly liquid. (iii) CDs are generally risk-free.(iv) CDs generally offer a higher rate of interest than Treasury

bills or term deposits.Commercial PaperCommercial paper represents short-term unsecured promissorynotes issued by firms that are generally considered financially strong. Commercial pape usually has a maturity periodof 90 days to 180 days. It is sold at a discount and redeemed atpar. Hence the implicit rate is a function of the size of discount


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and the period of maturity. Commercial paper is either directlyplaced with investor of sold through dealers.Commercial paper does not presently have a well developedsecondary market in India.

The main attraction of commercial paper is that it offers aninterest rate that is typically higher than offered by Treasury billsor certificates of deposit. However, its disadvantages is that itdoes not have an active secondary market. Hence, it makes sensefor firms that plan to hold till maturity.Government Securities and Government-Guaranteed Bonds

The largest borrowers in India are the central angovernments. The Government of India periodically sells centralgovernment securities. These are essentially medium to longterm bonds issued by the Reserve Bank of India on behalf of the

Government of India. Interest payments on these bonds aretypically semi-annual. State governments also sell bonds.These are also essentially medium to long-term bonds issued bythe Reserve Bank of India on behalf of state governments.Interest payments on these bonds are typically semi-annual.Apart from the central and state governments, a number ofgovernmental agencies issue bonds that are guaranteed by thecentral government of some state government. Interest paymentson these bonds are typically semi-annual.

Corporate Debt

Bonds (or debentures) are issued frequently by public sectorcompanies, financial institutions, and private sector companies. Awide range of innovative debt securities have been created inIndia, particularly from early 1990s. This innovation has beenstimulated by a variety of factors, the most important being theincreased volatility of interest rates and changes in the tax andregulatory framework. A brief description of various types ofcorporate bonds is given below.

Straight Bonds

The straight bond (also called plain vanilla bond) is the mostpopular type of bond. It pays a fixed periodic (usually semiannual) coupon over its life and returns the principal on thematurity date.


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Zero Coupon Bonds

A zero coupon bond (or just zero) does not carry any regularinterest payment. It is issued at a steep discount over its facevalue and redeemed at face value on maturity. For example, theIndustrial Development Bank of India (IDBI) issued deep discountbonds in 1996 which have a face value of Rs. 200,000 and amaturity period of 25 years. The bonds were issued at Rs. 5,300.These bonds carry call and put options.

Floating Rate Bonds

Straight bonds pay a fixed rate of interest. Floating rate bonds, onthe other hand, pay an interest rate that is linked to a benchmarkrate such as the Treasury bill interest rate. For example, in 1993

the State Bank of India came out with the first ever issue offloating interest rare bonds in India. It issued 5million (Rs 1000)face value) unsecured, redeemable, subordinated floating interestrate bonds carrying interest at 3 percent per annum over thebanks maximum term deposit rate.

Bonds with Embedded Options

Bonds may have options embedded in them. These options givecertain rights to investors and/or issuers. The more common

types of bonds with embedded options are :Convertible Bonds Convertible bonds give the bond holder theright (option) to convert them into equity shares on certain terms.Callable Bonds Callable bonds give the issuer the right (option) toredeedm them prematurely on certain terms.Puttable Bonds Puttable bonds give the investor the right toprematurely sell them back to the issuer on certain terms.

Commodity-Linked Bonds

The payoff from a commodity linked bond depends to a certainextent on the price of a certain commodity. For example, in June1986 Standard Oil Corporation issued zero coupon notes whichwould mature in 1992. The payoff from each note was defined as :$1,000 + 200 [Price per barrel of oil in dollars - $25]. The secondterm of the payoff, however, was subject to a floor of 0.


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Bond Features

Bonds tend to be confusing because of complex provisionsattached to them. The financial contract between the issuer andthe holder of bonds is called the bond indenture which spells out

the features of the bond in terms of collateral, sinking fund, callprovision, protective covenants, and so on.

Collaterla

Collateral represents a pledge of assets in favour of the bondholders. If serves as an insurance against any possible default bythe borrower.

Sinking Fund

A sinking fund provision requires the issuing firm to retire a

certain percentage of the bond issue at stipulated points of time.

Protective Covenants

The bond indenture often contains several covenants to protectthe interest of lenders. These convenants impose restrictions onmanagement and give bondholders greater confidence that thefirm will honour its commitments. For example, convenants mayput limits on dividend payment, managerial compensation,and total borrowings.

Bond Pricing

The value of a bond or any asset, real or financial is equal tothe present value of the cash flows expected from it. Hencedetermining the value of a bond requires: An estimate of expected cash flows. An estimate of the required return.To simplify our analysis of bond valuation we will make thefollowing assumptions:The coupon interest rate is fixed for the term of the bond.The coupon payments are made every year and the next couponpayment is receivable exactly a year from now.The bond will be redeemed at par on maturity.Given these assumptions, the cash flow for a non callable bondcomprises an annuity of a fixed coupon interest payable annually


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and the principal amount payable at maturity. Hence the value ofbond is :-Where P = value (in rupees)n = number of years

C = annual coupon payment (in rupees)r = periodic required returnM = maturity valuet = time period when the payment is receivedSince the stream of annual coupon payments is an ordinaryannuity, we can apply the formula for the present value of anordinary annuity. Hence the bond value is given by the formula :To illustrate how to compute the price of a bond, consider a 10-year, 12% coupon bond with a par value of 1,000. Let us assumethat the required yield on this bond is 13%. The cash flows for this

bond are as follows :- 10 annual coupon payments of Rs. 120 Rs. 1000 principal repayment 10 years from nowThe value of the bond is :P = 120 PVIFA 13%, 10yrs + 1,000 PVIF 13%,10 yrs= 120 5.426 + 1,000 0.295= 651.1 + 295 = Rs. 946.1

Bond Values with Semi-annual Interest

Most of the bonds pay interest semi-annually. To value suchbonds, we have to work with a unit period of six months, and notone year. This means that the bond valuation equation has to bemodified along the following lines : The annual interest payment, C, must be divided by two toobtain the semi-annual interest payment. The number of years to maturity must be multiplied by two toget the number of half-yearly periods.The discount rate has to be divided by two to get the discount

rate applicable to half-yearly periods.With the above modifications, the basic bond valuation becomes :Where p = value of bondC/2 = semi-annual interest paymentr/2 = discount rate applicable to a half year periodM = maturity value2n = maturity period expressed in terms of half-yearly periods.


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As an illustration, consider a 8-year, 12% coupon bond with a parvalue of Rs. 1,000 on which interest is payable semiannually.The required return on this bond is 12 percent.

Current YieldThe current yield relates the annual coupon interest to the marketprice.The current yield calculation reflects only the coupon interestrate. It does not consider the capital gain (or loss) that an investorwill realize if the bond is purchased at a discount (or premium)and held till maturity. It also ignores the time value of money.Hence it is an incomplete and simplistic measure of yield.

Yield to Maturity

The yield to maturity (YTM) of a bond is the interest rate thatmakes the present value of the cash flows receivable from owningthe bond equal to the price of the bond. Mathematically, it is theinterest rate which satisfies the equation :Where p = price of the bondC = annual interest (in rupees)M = maturity value (in rupees)n = number of years left to maturityThe computation of YTM requires a trial and error procedure.

To illustrate this, consider a Rs. 1,000 par value bond, carrying acoupon rate of 9 percent, maturing after 8 years. The bond iscurrently selling of Rs. 800. What is the YTM on this bond ?The YTM is the value of r in the following equation :Let us begin with a discount rate of 12 percent. Putting a value of12 percent for r we find the right-hand side of the aboveexpression isRs 90 (PVIFA 12%,8yrs) + Rs 1,000 (PVIF12%,8yrs)= Rs. 90(4.968) + Rs. 1,000(0.404) = Rs. 851.0Since the value is greater than Rs 800, we may have to try ahigher value of r. Let us try r= 14 percent. This makes the righthand side equal to :Rs. 90 (PVIFA 14%,8yrs) + Rs 1,000 (PVIF14%,8yrs)= Rs 90 (4.639) + Rs,1000 (0.351) = Rs.768.1Since this value is less than Rs 800, we try a lower value for r. Letus try r = 13percent. This makes the right-hand side equal to :


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Rs 90 (PVIFA 13%,8yrs) + Rs. 1,000 (PVIF13%,8yrs)= Rs 90 (4.800) + Rs 1,000 (0.376) = Rs 808Thus r lies between 13 percent and 14 percent. Using a linearinterpolation1 in the range 13 percent ot 14 percent, we find that

r is equal to 13.2 percent.An Approximation

If you are not inclined to follow the trial-and-error approachdescribed above, you can employ the following formula to find theapproximate YTM on a bond :Where YTM = yield to maturityC = annual interest paymentM = maturity value of the bondP = present price of the bond

n = years to maturity

Yield to Call

Some bonds carry a call feature that entitled the issuer to call(buy back) the bond prior to the stated maturity accordance with a call schedule (which specifies a call price foreach call date). For such bonds, it is a practice to calculate theyield to call (YTC) as well as the YTM.

The procedure for calculating the YTC is the same as for the YTM.Mathematically the YTC is the value of r in the following equation:where M* = call price (in rupees)n* = number of years until the assumed call date

Realised Yield to Maturity

The YTM calculation assumes that the cash flows rthrough the life of a bond are re-invest at a rate equal to the yieldto maturity. This assumption may not be valid as reinvestmentrate/s applicable to future cash flows may be different. It isnecessary to define the future reinvestment rates and figure outthe realized yield to maturity.

Risk In Debt

Like any other investment, bonds should be viewed in terms oftheir risk and return. Bonds are subject to diverse risks, such as


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interest risk, inflation risk, real interest rate risk, default risk, callrisk and liquidity risk.

Interest Rate Risk

Interest rates tend to vary over time, causing fluctuations in bondprices. A rise in interest rates will depress the market prices ofoutstanding bonds whereas a fall in interest rates will push themarket prices up.Interest rate risk, also referred to as market risk, a measured bythe percentage change in the value of a bond in response to agiven interest rate change. It is a function of the maturity periodof the bond and its coupon interest rate. You can appreciate thiseasily by looking at the general formula for the current price of abond.

Inflation Risk

Interest rates are defined in nominal terms. This means that theyexpress the rate of exchange between current and future rupees.For example, a nominal interest of 12 per cent on a one year loanmeans that Rs 112 is payable a year hence for Rs 100 borrowedtoday. However, what really maters is the real rate of interest, therate of exchange between current and future goods and services.Since financial contracts are typically stated in nominal terms, the

real interest rate shouldbe adjusted for the expected inflation.According to the Fisher effect, the following relationship holdsbetween the nominal rate r, the real rate a, and the expectedinflation rate a.(1+r) = (1 + a) (1+a) (10.8)or, r = 1 + a + aa (10.9)For example, if the required real rate is 6 percent and theexpected inflation rate is 8 percent, the nominal rate will be :(0.06) + (0.08) + (0.06) (0.08) = 0.1448 percentWhen the inflation is higher than expected, the borrower gains atthe expense of the lender and vice versa. Put differently, inflationis a zero-sum game.The impact of a change in inflation rate is similar to that of achange in interest rate. This means that inflation risk is greaterfor long-term bonds. Hence, in a period of volatile inflation rates,borrowers will be disinclined to issue long-term fixedinterest


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bonds and investors, too, will be reluctant to buy such shares.During such times, floating rate bonds and shortermaturity bondsbecome more popular.

Real Interest Rate RiskEven if there is no inflation risk, borrowers and lenders are stillexposed top the risk change in the real interest rate. Shifts insupply and/ or demand for funds will change the real rate ofinterest.To understand the implications of real interest rate risk consideran example. Suppose that the real interest rate falls from 6 to 4percent because a combination of tax law changesheightened competition drives down the real interest rate. In thiscase

a firm that has borrowed funds at 6 percent on its debt.Irrespective of whether it gains or losses from a change in the realrate of interest, a firm that has locked itself into a long-term debtat a fixed real cost can experience a dramatic impact wheneverthe real rate of interest changes. As such changes can scarily bepredicted, they represent a source of risk that borrowers andlenders have to face.

Default Risk

Default risk refers to the risk accruing from the fact that aborrower may not pay interest and/ or principal on time.Default risk, also referred to as Credit Risk, is normally gaugedby the rating assigned to the debt instrument by an independentcredit rating agency (like CRISIL, ICRA, or CARE).Other thingsbeing equal, bonds which carry a higher default risk(lower credit rating) trade at a higher yield to maturity. Putdifferently, they sell at a lower price compared to governmentsecurities which are considered free from default risk (as thegovernment has the power to print money, it is believed that itwill not default in honouring its commitments).Except in the caseof highly risky instruments, referred to as junk bonds, investorsseem to be more concerned with the perceived risk of defaultrather than the actual occurrence of default. Even though theactual default may be highly unlikely, they believe that a change


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in the perceived default risk of a bond would have an immediateimpact on its market price.Call Risk

A bond may have a call provision that gives the issuer the option

to call the bond before its scheduled maturity. The issuer wouldgenerally exercise the call option when interest rates decline.While this is attractive from the issuers point of view, itexposes the investors to call risk. Since bonds are typically calledfor repayment after interest rates have fallen, investors will notfind comparable investment vehicles. They almost invariably haveto accept a lower yield when they reinvest the amount receivedon premature redemption.

Liquidity Risk

Barring some popular Government of India securities which aretraded actively, most debt instruments do not seem to have avery liquid market. The market for debt is mainly an over-the -counter market and much of the activity seems to occur in theprimary (new issues) market. Given the poor liquidity in the debtmarket, investors face difficulty in trading debt instruments,particularly when the quantity is large. They may have to accept adiscount over the quoted price while selling and pay premiumwhile buying. This seems to be a major problem in certain

segment of debt market-far bigger than most investors realize.

Interest Rate Risk

We have seen that bond prices and yields are inversely related.As interest rate fluctuate bondholders experience capital lossesand gains. Why? The reason is that in a competitive marketsecurities are priced to offer fair expected rates of return. If abond is issued with a 10 percent coupon when the competitiveyield is 10 percent, then it will sell at par. If the market rate arisesto 11 percent, the bond price must fall so that its yield rises to 11percent; conversely if the market rate falls to 9 percent, its pricemust rise.

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