Study of Government Securities

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STUDY OF GOVERNMENT SECURITIES (BONDS) AND CALL MONEY MARK

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STUDY OF GOVERNMENT SECURITIES (BONDS)

AND CALL MONEY MARKET

SUMMER INTERSHIP REPORT

Roll No.:801

Batch:

In partial fulfillment of the requirements for Master Of Management Studies(MMS) Two Year Full Time Degree Course.

Rajiv Gandhi Institute of Technology , Mumbai.Dept. of Management Studies

(Affiliated to University of Mumbai)

Year 2014-15


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DECLARATION

I declare that this report entitled STUDY OF GOVERNMENT SECURITIES (BONDS) AND CALLMONEY MARKET is my original work and not copied from elsewhere nor submitted before for any degree,diploma or course to any Institute or University and due acknowledgement has been given in the bibliographyto all sources be they printed, electronic or personal.

Name of The Student : Signature:

Gaurav R. Behere

Date:


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ACKNOWLEDGEMENT

First I would like to thank the University of Mumbai for providing the Summer Internship Project as a part ofMMS curriculum. This project has been of great learning experience.

This project is the blessing of many people who have supported me through this. I would heartily thankProf.Devendra Suralkar fo r being my guide throughout the project.

I am very thankful to the management of Mumbai District Central Co -operati ve Bank for giving me a chance to do my project in this esteemed organization.

I would also like t o thank Mrs. Sopan Nalawade(Section Incharge, Fund Management ) who was there withme throughout the working of the

project.

This project required a lot of research work and surveys to be carried out which wouldnt have been possiblewithout the help of all staff members, so I would like to thank them also for providing me a helping hand.

Last but not the least I would thank the Almighty for always being with me.


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ABSTRACT

The debt market is one of the most critical components of the financial system of any economy and actsas a leverage tool in a financial system. The debt market comprises of two segments: government securities

market and corporate debt market. Indian debt market is dominated by government securities as compared tocorporate debt securities. Indian corporate bonds market is very underdeveloped and illiquid in comparison withthe Government securities market and mostly depends on highly safe AAA rated bonds for both issuance andtrading. This paper presents an overview of the corporate debt market in India. It is concluded that Indiancorporate debt market has shown growth trend in primary market and secondary market as well. There are a lotof challenges available in the market which are major obstacles in the development of the market like lack ofinformation among the investors, high stamp duty charges, lack of innovative debt instruments etc.


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CONTENTS

SR.NO. TITLE PAGENO.

1 INTRODUCTION 5

1.1 IMPORTANCE OF STUDY 9

1.2 OBJECTIVE OF STUDY 9

2 REVIEW OF LITERATURE

2.1 CONCEPTUAL BACKGROUND OF TOPIC 10

3 ABOUT THE ORGANISATION 24

4 RESEARCH METHODOLOGY 26

4.1 FORMULATION OF HYPOTHESIS 26

4.2 RESEARCH METHODOLOGY ADOPTED 284.3 LIMITATION OF STUDY 28

5 FINDING AND ANALYSISI 29

6 RECOMMENDATION 35

7 CONCLUSION 36

8 BIBLIOGRAPHY 37


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INTRODUCTION

Debt market refers to the financial market where investors buy and sell debt securities, mostly in theform of bonds. These markets are important source of funds, especially in a developing economy like India.India debt market is one of the largest in Asia. Like all other countries, debt market in India is also considered a

useful substitute to banking channels for finance.

The most distinguishing feature of the debt instruments of Indian debt market is that the return is fixed.This means, returns are almost risk-free. This fixed return on the bond is often termed as the 'coupon rate' or the'interest rate'. Therefore, the buyer (of bond) is giving the seller a loan at a fixed interest rate, which equals tothe coupon rate.

The Bond Market in India with the liberalization has been transformed completely. The opening up ofthe financial market at present has influenced several foreign investors holding up to 30% of the financial inform of fixed income to invest in the bond market in India.

The bond market in India has diversified to a large extent and that is a huge contributor to the stablegrowth of the economy. The bond market has immense potential in raising funds to support the infrastructuraldevelopment undertaken by the government and expansion plans of the companies.

Sometimes the unavailability of funds becomes one of the major problems for the large organization.The bond market in India plays an important role in fund raising for developmental ventures. Bonds are issuedand sold to the public for funds.

Bonds are interest bearing debt certificates. Bonds under the bond market in India may be issued by thelarge private organizations and Government Company. The bond market in India has huge opportunities for the

market is still quite shallow. The equity market is more popular than the bond market in India. At present the bond market has emerged into an important financial sector.

The different types of bond market in India

Corporate Bond Market

Municipal Bond Market

Government and Agency Bond Market

Funding Bond Market

Mortgage Backed and Collateral Debt Obligation Bond Market

The major reforms in the bond market in India

The system of auction introduced to sell the government securities.

The introduction of delivery versus payment (DvP) system by the Reserve Bank of India to nullify therisk of settlement in securities and assure the smooth functioning of the securities delivery and payment.


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The computerization of the SGL.

The launch of innovative products such as capital indexed bonds and zero coupon bonds to attract

more and more investors from the wider spectrum of the populace.

Sophistication of the markets for bonds such as inflation indexed bonds.

The development of the more and more primary dealers as creators of the Government of India bonds

market.

The establishment of the a powerful regulatory system called the trade for trade system by the Reserve

Bank of India which stated that all deals are to be settled with bonds and funds.

A new segment called the Wholesale Debt Market (WDM) was established at the NSE to report thetrading volume of the Government of India bonds market.

Issue of ad hoc treasury bills by the Government of India as a funding instrument was abolished with

the introduction of the Ways And Means agreement.

Classification of Indian Debt Market

Indian debt market can be classified into two categories:

Government Securities Market (G-Sec Market): It consists of central and state government securities. Itmeans that, loans are being taken by the central and state government. It is also the most dominant category

in the India debt market.

Bond Market: It consists of Financial Institutions bonds, corporate bonds and debentures and Public

Sector Units bonds. These bonds are issued to meet financial requirements at a fixed cost and hence remove

uncertainty in financial costs.

Advantages

The biggest advantage of investing in Indian debt market is its assured returns. The returns that the market offeris almost risk-free (though there is always certain amount of risks, however the trend says that return is almostassured). Safer are the government securities. On the other hand, there are certain amounts of risks in the


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corporate, FI and PSU debt instruments. However, investors can take help from the credit rating agencies whichrate those debt instruments. The interest in the instruments may vary depending upon the ratings.

Another advantage of investing in India debt market is its high liquidity. Banks offer easy loans to the investorsagainst government securities.

Disadvantages

As there are several advantages of investing in India debt market, there are certain disadvantages as well. As thereturns here are risk free, those are not as high as the equities market at the same time. So, at one hand you aregetting assured returns, but on the other hand, you are getting less return at the same time.

Retail participation is also very less here, though increased recently. There are also some issues of liquidity and price discovery as the retail debt market is not yet quite well developed.

Debt Instruments

There are various types of debt instruments available that one can find in Indian debt market.

Government Securities

It is the Reserve Bank of India that issues Government Securities or G-Secs on behalf of theGovernment of India. These securities have a maturity period of 1 to 30 years. G-Secs offer fixed interest rate,where interests are payable semi-annually. For shorter term, there are Treasury Bills or T-Bills, which areissued by the RBI for 91 days, 182 days and 364 days.

Corporate Bonds

These bonds come from PSUs and private corporations and are offered for an extensive range of tenuresup to 15 years. There are also some perpetual bonds. Comparing to G-Secs, corporate bonds carry higher risks,which depend upon the corporation, the industry where the corporation is currently operating, the currentmarket conditions, and the rating of the corporation. However, these bonds also give higher returns than the G-Secs.

Certificate of Deposit

These are negotiable money market instruments. Certificate of Deposits (CDs), which usually offerhigher returns than Bank term deposits, are issued in DEMAT form and also as a Usance Promissory Notes.There are several institutions that can issue CDs. Banks can offer CDs which have maturity between 7 days and1 year. CDs from financial institutions have maturity between 1 and 3 years. There are some agencies like

ICRA, FITCH, CARE, CRISIL etc. that offer ratings of CDs. CDs are available in the denominations of ` 1 Lacand in multiple of that.

Commercial PapersThere are short term securities with maturity of 7 to 365 days. CPs are issued by corporate entities at a discountto face value.


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A study has been conducted in order to understand the price dynamics of the Indian securities market primary auction.

i. Importance of the Study

In this dynamic market scenario where all the global strong economies are struggling with their sovereigncrisis, Indian sovereign debt is in a much better position. This report studies the price movement of auction ofgovernment securities and relationship of duration and convexity for a bond or portfolio of bond.

ii. Objectives To understand Indian debt market, its functions and importance. To understand the working of fund management section in Co-operative bank. To understand primary market auction, CBLO, OMO etc. To understand the price dynamics of primary market auction for government securities. To understand concepts like duration, convexity, its relationship for a bond and its importance.

To understand investors position while trading in government securities market. To analyse macro economy factors and its impact on G-secs. To evaluate portfolio to maximise returns at given level of risk.


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REVIEW OF LITERATURE

Government Security

A Government security is a tradable instrument issued by the Central Government or the State

Governments. It acknowledges the Governments debt obligation. Such securities are short term (usually called

treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or

dated securities with original maturity of one year or more). In India, the Central Government issues both,

treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities,

which are called the State Development Loans (SDLs). Government securities carry practically no risk of

default and, hence, are called risk-free gilt-edged instruments. Government of India also issues savings

instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, FoodCorporation of India bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are,

therefore, not eligible to be SLR securities.

Treasury Bills (T-bills)

Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the

Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury

bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face valueat maturity. For example, a 91 day Treasury bill of Rs.100/- (face value) may be issued at say Rs. 98.20, that is,

at a discount of say, Rs.1.80 and would be redeemed at the face value of Rs.100/-. The return to the investors is

the difference between the maturity value or the face value (that is Rs.100) and the issue price (for calculation

of yield on Treasury Bills please see answer to question no. 26). The Reserve Bank of India conducts auctions

usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the following Friday.

The 91 day T-bills are auctioned on every Wednesday. The Treasury bills of 182 days and 364 days tenure are

auctioned on alternate Wednesdays. T-bills of of 364 days tenure are auctioned on the Wednesday preceding the

reporting Friday while 182 T-bills are auctioned on the Wednesday prior to a non-reporting Fridays. The

Reserve Bank releases an annual calendar of T-bill issuances for a financial year in the last week of March of

the previous financial year. The Reserve Bank of India announces the issue details of T-bills through a press

release every week.


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Cash Management Bills (CMBs)

Government of India, in consultation with the Reserve Bank of India, has decided to issue a new short-

term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in the cash flow

of the Government. The CMBs have the generic character of T-bills but are issued for maturities less than 91days. Like T-bills, they are also issued at a discount and redeemed at face value at maturity. The tenure, notified

amount and date of issue of the CMBs depends upon the temporary cash requirement of the Government. The

announcement of their auction is made by Reserve Bank of India through a Press Release which will be issued

one day prior to the date of auction. The settlement of the auction is on T+1 basis. The non-competitive bidding

scheme (referred to in paragraph number 4.3 and 4.4 under question No. 4) has not been extended to the CMBs.

However, these instruments are tradable and qualify for ready forward facility. Investment in CMBs is also

reckoned as an eligible investment in Government securities by banks for SLR purpose under Section 24 of the

Banking Regulation Act, 1949. First set of CMBs were issued on May 12, 2010.

Dated Government Securities

Dated Government securities are long term securities and carry a fixed or floating coupon (interest rate)

which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities

can be up to 30 years.

In case there are two securities with the same coupon and are maturing in the same year, then one of the

securities will have the month attached as suffix in the nomenclature. For example, 6.05% GS 2019 FEB, would

mean that Government security having coupon 6.05 % that mature in February 2019 along with the other

security with the same coupon, namely, 6.05% 2019 which is maturing in June 2019.

If the coupon payment date falls on a Sunday or a holiday, the coupon payment is made on the next working

day. However, if the maturity date falls on a Sunday or a holiday, the redemption proceeds are paid on the

previous working day itself.

State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an auction

similar to the auctions conducted for dated securities issued by the Central Government (see question 3 below).

Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities

issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also


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eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from

the RBI under the Liquidity Adjustment Facility (LAF).

The different types of auctions used for issuing securities:

Prior to introduction of auctions as the method of issuance, the interest rates were administratively fixed by

the Government. With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market

based price discovery process.

Yield Based Auction

A yield based auction is generally conducted when a new Government security is issued. Investors bid inyield terms up to two decimal places (for example, 8.19 per cent, 8.20 per cent, etc.). Bids are arranged inascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction.The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or

below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of theyield based auction is given below:

Price Based Auction

A price based auction is conducted when Government of India re-issues securities issued earlier. Biddersquote in terms of price per Rs.100 of face value of the security (e.g., Rs.102.00, Rs.101.00, Rs.100.00,Rs.99.00, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those whohave bid at or above the cut-off price. Bids which are below the cut-off price are rejected. An illustrativeexample of price based auction is given below:

Depending upon the method of allocation to successful bidders, auction could be classified as Uniform

Price based and Multiple Price based. In a Uniform Price auction, all the successful bidders are required to pay

for the allotted quantity of securities at the same rate, i.e., at the auction cut-off rate, irrespective of the rate

quoted by them. On the other hand, in a Multiple Price auction, the successful bidders are required to pay for

the allotted quantity of securities at the respective price / yield at which they have bid.

Competitive Bidding

In a competitive bidding, an investor bids at a specific price / yield and is allotted securities if the price /

yield quoted is within the cut-off price / yield. Competitive bids are made by well informed investors such as

banks, financial institutions, primary dealers, mutual funds, and insurance companies. The minimum bid


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amount is Rs.10,000 and in multiples of Rs.10,000 thereafter. Multiple bidding is also allowed, i.e., an

investor may put in several bids at various price/ yield levels.

Non-Competitive Bidding

With a view to providing retail investors, who may lack skill and knowledge to participate in the auction

directly, an opportunity to participate in the auction process, the scheme of non-competitive bidding in dated

securities was introduced in January 2002. Non-competitive bidding is open to individuals, HUFs, RRBs, co-

operative banks, firms, companies, corporate bodies, institutions, provident funds, and trusts. Under the scheme,

eligible investors apply for a certain amount of securities in an auction without mentioning a specific price /

yield. Such bidders are allotted securities at the weighted average price / yield of the auction. The participants in

non-competitive bidding are, however, required to hold a gilt account with a bank or PD. Regional Rural Banks

and co-operative banks which hold SGL and Current Account with the RBI can also participate under the

scheme of non-competitive bidding without holding a gilt account.

Open Market Operations (OMOs)

OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase of

Government securities to/ from the market with an objective to adjust the rupee liquidity conditions in the

market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to sale of

securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will

buy securities from the market, thereby releasing liquidity into the market.

Buyback of Government securities

Buyback of Government securities is a process whereby the Government of India and State

Governments buy back their existing securities from the holders. The objectives of buyback can be reduction of

cost (by buying back high coupon securities), reduction in the number of outstanding securities and improving

liquidity in the Government securities market (by buying back illiquid securities) and infusion of liquidity in the

system. Governments make provisions in their budget for buying back of existing securities. Buyback can be

done through an auction process or through the secondary market route, i.e., NDS/NDS-OM


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Liquidity Adjustment Facility (LAF)

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding

RRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case

of excess liquidity on an overnight basis against the collateral of Government securities including State

Government securities. Basically LAF enables liquidity management on a day to day basis. The operations of

LAF are conducted by way of repurchase agreements (repos and reverse repos please refer to paragraph

numbers 30.4 to 30.8 under question no. 30 for details) with RBI being the counter-party to all the transactions.

The interest rate in LAF is fixed by the RBI from time to time. Currently the rate of interest on repo under LAF

(borrowing by the participants) is 6.25% and that of reverse repo (placing funds with RBI) is 5.25%. LAF is an

important tool of monetary policy and enables RBI to transmit interest rate signals to the market.

How and in what form can Government Securities be held?

The Public Debt Office (PDO) of the Reserve Bank of India, Mumbai acts as the registry and central

depository for the Government securities. Government securities may be held by investors either as physical

stock or in dematerialized form. From May 20, 2002, it is mandatory for all the RBI regulated entities to hold

and transact in Government securities only in dematerialized (SGL) form. Accordingly, UCBs are required to

hold all Government securities in DEMAT form.

Physical form

Government securities may be held in the form of stock certificates. A stock certificate is registered in

the books of PDO. Ownership in stock certificates cannot be transferred by way of endorsement and delivery.

They are transferred by executing a transfer form as the ownership and transfer details are recorded in the books

of PDO. The transfer of a stock certificate is final and valid only when the same is registered in the books of

PDO.

DEMAT form

Holding government securities in the dematerialized or scripless form is the safest and the most

convenient alternative as it eliminates the problems relating to custody, viz. loss of security. Besides, transfers

and servicing are electronic and hassle free. The holders can maintain their securities in dematerialsed form in

either of the two ways:


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SGL Account: Reserve Bank of India offers Subsidiary General Ledger Account (SGL) facility to select

entities who can maintain their securities in SGL accounts maintained with the Public Debt Offices of

the Reserve Bank of India.

Gilt Account: As the eligibility to open and maintain an SGL account with the RBI is restricted, an investorhas the option of opening a Gilt Account with a bank or a Primary Dealer which is eligible to open a

Constituents' Subsidiary General Ledger Account (CSGL) with the RBI. Under this arrangement, the bank

or the Primary Dealer, as a custodian of the Gilt Account holders, would maintain the holdings of its

constituents in a CSGL account (which is also known as SGL II account) with the RBI. The servicing of

securities held in the Gilt Accounts is done electronically, facilitating hassle free trading and maintenance

of the securities. Receipt of maturity proceeds and periodic interest is also faster as the proceeds are

credited to the current account of the custodian bank / PD with the RBI and the custodian (CSGL accountholder) immediately passes on the credit to the Gilt Account Holders (GAH).

Investors also have the option of holding Government securities in a dematerialized account with a

depository (NSDL / CDSL, etc.). This facilitates trading of Government securities on the stock exchanges.

How does the trading in Government securities take place?

There is an active secondary market in Government securities. The securities can be bought / sold in the

secondary market either (i) Over the Counter (OTC) or (ii) through the Negotiated Dealing System (NDS) or

(iii) the Negotiated Dealing System-Order Matching (NDS-OM).

Over the Counter (OTC)/ Telephone Market

In this market, a participant, who wants to buy or sell a government security, may contact a bank / Primary

Dealer / financial institution either directly or through a broker registered with SEBI and negotiate for a certain

amount of a particular security at a certain price. Such negotiations are usually done on telephone and a deal

may be struck if both counterparties agree on the amount and rate. In the case of a buyer, like an urban co-

operative bank wishing to buy a security, the bank's dealer (who is authorized by the bank to undertake

transactions in Government Securities) may get in touch with other market participants over telephone and

obtain quotes. Should a deal be struck, the bank should record the details of the trade in a deal slip and send a

trade confirmation to the counterparty. The dealer must exercise due diligence with regard to the price quoted

by verifying with available sources


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Negotiated Dealing System

The Negotiated Dealing System (NDS) for electronic dealing and reporting of transactions in government

securities was introduced in February 2002. It facilitates the members to submit electronically, bids or

applications for primary issuance of Government Securities when auctions are conducted. NDS also provides an

interface to the Securities Settlement System (SSS) of the Public Debt Office, RBI, Mumbai thereby facilitating

settlement of transactions in Government Securities (both outright and repos) conducted in the secondary

market. Membership to the NDS is restricted to members holding SGL and/or Current Account with the RBI,

Mumbai.

Stock Exchanges

Facilities are also available for trading in Government securities on stock exchanges (NSE, BSE) which

cater to the needs of retail investors.

Reasons for change in price of Government security:

The price of a Government security, like other financial instruments, keeps fluctuating in the secondary market.

The price is determined by demand and supply of the securities. Specifically, the prices of Government

securities are influenced by the level and changes in interest rates in the economy and other macro-economic

factors, such as, expected rate of inflation, liquidity in the market, etc. Developments in other markets like

money, foreign exchange, credit and capital markets also affect the price of the Government securities. Further,

developments in international bond markets, specifically the US Treasuries affect prices of Government

securities in India. Policy actions by RBI (e.g., announcements regarding changes in policy interest rates like

Repo Rate, Cash Reserve Ratio, Open Market Operations, etc.) can also affect the prices of Government

securities.

The Government securities transactions settlement

Primary Market

Once the allotment process in the primary auction is finalized, the successful participants are advised of

the consideration amounts that they need to pay to the Government on settlement day. The settlement cycle for

dated security auction is T+1, whereas for that of Treasury bill auction is T+2. On the settlement date, the fund


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accounts of the participants are debited by their respective consideration amounts and their securities

accounts (SGL accounts) are credited with the amount of securities that they were allotted.

Secondary Market

The transactions relating to Government securities are settled through the members securities / current

accounts maintained with the RBI, with delivery of securities and payment of funds being done on a net basis.

The Clearing Corporation of India Limited (CCIL) guarantees settlement of trades on the settlement date by

becoming a central counter-party to every trade through the process of novation, i.e., it becomes seller to the

buyer and buyer to the seller.

All outright secondary market transactions in Government Securities are settled on T+1 basis. However,

in case of repo transactions in Government securities, the market participants will have the choice of settling the

first leg on either T+0 basis or T+1 basis as per their requirement.

Delivery versus Payment (DvP) Settlement

Delivery versus Payment (DvP) is the mode of settlement of securities wherein the transfer of securities

and funds happen simultaneously. This ensures that unless the funds are paid, the securities are not delivered

and vice versa. DvP settlement eliminates the settlement risk in transactions. There are three types of DvP

settlements, viz., DvP I, II and III which are explained below;

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

occur transaction by transaction without netting the payables and receivables of the participant.

DvP II In this method, the securities are settled on gross basis whereas the funds are settled on a net basis,

that is, the funds payable and receivable of all transactions of a party are netted to arrive at the final payable

or receivable position which is settled.

DvP III In this method, both the securities and the funds legs are settled on a net basis and only the final

net position of all transactions undertaken by a participant is settled.

Liquidity requirement in a gross mode is higher than that of a net mode since the payables and receivables

are set off against each other in the net mode.


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The role of the Clearing Corporation of India Limited (CCIL)

The CCIL is the clearing agency for Government securities. It acts as a Central Counter Party (CCP) for

all transactions in Government securities by interposing itself between two counterparties. In effect, during

settlement, the CCP becomes the seller to the buyer and buyer to the seller of the actual transaction. All outrighttrades undertaken in the OTC market and on the NDS-OM platform are cleared through the CCIL. Once CCIL

receives the trade information, it works out participant-wise net obligations on both the securities and the funds

leg. The payable / receivable position of the constituents (gilt account holders) is reflected against their

respective custodians. CCIL forwards the settlement file containing net position of participants to the RBI

where settlement takes place by simultaneous transfer of funds and securities under the Delivery versus

Payment system. CCIL also guarantees settlement of all trades in Government securities. That means, during

the settlement process, if any participant fails to provide funds/ securities, CCIL will make the same available

from its own means. For this purpose, CCIL collects margins from all participants and maintains Settlement

Guarantee Fund.

When issued market

'When Issued', a short term of "when, as and if issued", indicates a conditional transaction in a security

notified for issuance but not yet actually issued. All "When Issued" transactions are on an "if" basis, to be

settled if and when the security is actually issued. 'When Issued' transactions in the Central Governmentsecurities have been permitted to all NDS-OM members and have to be undertaken only on the NDS-OM

platform. When issued market helps in price discovery of the securities being auctioned as well as better

distribution of the auction stock.

The relationship between yield and price of a bond

If interest rates or market yields rise, the price of a bond falls. Conversely, if interest

rates or market yields decline, the price of the bond rises. In other words, the yieldof a bond is inversely related to its price. The relationship between yield tomaturity and coupon rate of bond may be stated as follows:

When the market price of the bond is less than the face value, i.e., the bond sells at a discount, YTM >

current yield > coupon yield.

When the market price of the bond is more than its face value, i.e., the bond sells at a premium, coupon

yield > current yield > YTM.


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

yield = coupon yield.

The risks involved in holding Government securities

Government securities are generally referred to as risk free instruments as sovereigns are not expected to

default on their payments. However, as is the case with any financial instrument, there are risks associated with

holding the Government securities. Hence, it is important to identify and understand such risks and take

appropriate measures for mitigation of the same. The following are the major risks associated with holding

Government securities.

Market risk Market risk arises out of adverse movement of prices of the securities that are held by an

investor due to changes in interest rates. This will result in booking losses on marking to market or realizing

a loss if the securities are sold at the adverse prices. Small investors, to some extent, can mitigate market risk

by holding the bonds till maturity so that they can realize the yield at which the securities were actually

bought.

Reinvestment risk Cash flows on a Government security includes fixed coupon every half year and

repayment of principal at maturity. These cash flows need to be reinvested whenever they are paid. Hence

there is a risk that the investor may not be able to reinvest these proceeds at profitable rates due to changes in

interest rate scenario.

Liquidity risk Liquidity risk refers to the inability of an investor to liquidate (sell) his holdings due to non-

availability of buyers for the security, i.e., no trading activity in that particular security. Usually, when a

liquid bond of fixed maturity is bought, its tenor gets reduced due to time decay. For example, a 10 year

security will become 8 year security after 2 years due to which it may become illiquid. Due to illiquidity, the

investor may need to sell at adverse prices in case of urgent funds requirement. However, in such cases,

eligible investors can participate in market repo and borrow the money against the collateral of the securities.

Techniques for Risk Mitigation

Holding securities till maturity could be a strategy through which one could avoid market risk.

Rebalancing the portfolio wherein the securities are sold once they become short term and new securities of

longer tenor are bought could be followed to manage the portfolio risk. However, rebalancing involves

transaction and other costs and hence needs to be used judiciously. Market risk and reinvestment risk could also


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be managed through Asset Liability Management (ALM) by matching the cash flows with liabilities.

ALM could also be undertaken by matching the duration of the cash flows.

Advanced risk management techniques involve use of derivatives like Interest Rate Swaps (IRS)

through which the nature of cash flows could be altered. However, these are complex instruments requiringadvanced level of expertise for proper understanding. Adequate caution, therefore, need to be observed for

undertaking the derivatives transactions and such transactions should be undertaken only after having complete

understanding of the associated risks and complexities.

Money Market

While the Government securities market generally caters to the investors with a long term investment

horizon, the money market provides investment avenues of short term tenor. Money market transactions are

generally used for funding the transactions in other markets including Government securities market and

meeting short term liquidity mismatches. By definition, money market is for a maximum tenor of up to one

year. Within the one year, depending upon the tenors, money market is classified into:

i. Overnight market - The tenor of transactions is one working day.

Notice money market The tenor of the transactions is from 2 days to 14 days.

Term money market The tenor of the transactions is from 15 days to one year.

The different money market instruments

Money market instruments include call money, repos, Treasury bills, Commercial Paper, Certificate of

Deposit and Collateralized Borrowing and Lending Obligations (CBLO).

Call money market

Call money market is a market for uncollateralized lending and borrowing of funds. This market is

predominantly overnight and is open for participation only to scheduled commercial banks and the primary

dealers.


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Repo market

Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement

to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest

for the funds borrowed.

The reverse of the repo transaction is called reverse repo which is lending of funds against buying of

securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price

which includes interest for the funds lent.

It can be seen from the definition above that there are two legs to the same transaction in a repo/ reverse

repo. The duration between the two legs is called the repo period. Predominantly, repos are undertaken on

overnight basis, i.e., for one day period. Settlement of repo transactions happens along with the outright

trades in government securities.

The consideration amount in the first leg of the repo transactions is the amount borrowed by the seller of

the security. On this, interest at the agreed repo rate is calculated and paid along with the consideration

amount of the second leg of the transaction when the borrower buys back the security. The overall effect of

the repo transaction would be borrowing of funds backed by the collateral of Government securities.

The money market is regulated by the Reserve Bank of India. All the above mentioned money market

transactions should be reported on the electronic platform called the Negotiated Dealing System (NDS).

As part of the measures to develop the corporate debt market, RBI has permitted select entities (scheduled

commercial banks excluding RRBs and LABs, PDs, all-India FIs, NBFCs, mutual funds, housing finance

companies, insurance companies) to undertake repo in corporate debt securities. This is similar to repo in

Government securities except that corporate debt securities are used as collateral for borrowing funds. Only

listed corporate debt securities that are rated AA or above by the rating agencies are eligible to be used for

repo. Commercial papers, certificate of deposit, non-convertible debentures of original maturity less than

one year are not eligible for the purpose. These transactions take place in the OTC market and are required

to be reported on FIMMDA platform within 15 minutes of the trade for dissemination of information. They

are also to be reported on the clearing house of any of the exchanges for the purpose of clearing andsettlement.

Collateralised Borrowing and Lending Obligation (CBLO)

CBLO is another money market instrument operated by the Clearing Corporation of India Ltd. (CCIL), for

the benefit of the entities that have either no access to the inter-bank call money market or have restricted

access in terms of ceiling on call borrowing and lending transactions. CBLO is a discounted instrument


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available in electronic book entry form for the maturity period ranging from one day to ninety days (up to

one year as per RBI guidelines). In order to enable the market participants to borrow and lend funds, CCIL

provides the Dealing System through Indian Financial Network (INFINET), a closed user group to the

Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI and through

Internet for other entities who do not maintain Current account with RBI.

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

Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions, Insurance Companies,

Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO segment is extended to entities who

are not members of RBI- NDS, viz., Co-operative Banks, Mutual Funds, Insurance companies, NBFCs,

Corporates, Provident/ Pension Funds, etc.

By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of

eligible securities. Eligible securities are Central Government securities including Treasury Bills, and such

other securities as specified by CCIL from time to time. Borrowers in CBLO have to deposit the required

amount of eligible securities with the CCIL based on which CCIL fixes the borrowing limits. CCIL

matches the borrowing and lending orders submitted by the members and notifies them. While the

securities held as collateral are in custody of the CCIL, the beneficial interest of the lender on the securities

is recognized through proper documentation.

Commercial Paper (CP)

30.13 Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory

note. Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) that have been permitted to

raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP.

CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of

issue.

Certificate of Deposit (CD)

30.14 Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form or

as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified

time period. Banks can issue CDs for maturities from 7 days to one a year whereas eligible FIs can issue for

maturities 1 year to 3 years.


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The role and functions of FIMMDA

The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an association of

Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance Companies

was incorporated as a Company under section 25 of the Companies Act, 1956 on June 3rd, 1998.

FIMMDA is a voluntary market body for the bond, money and derivatives markets.

FIMMDA has members representing all major institutional segments of the market. The membership

includes Nationalized Banks such as State Bank of India, its associate banks and other nationalized banks;

Private sector banks such as ICICI Bank, HDFC Bank, IDBI Bank; Foreign Banks such as Bank of

America, ABN Amro, Citibank, Financial institutions such as IDFC, EXIM Bank, NABARD, Insurance

Companies like Life Insurance Corporation of India (LIC), ICICI Prudential Life Insurance Company,

Birla Sun Life Insurance Company and all Primary Dealers.

The FIMMDA represents market participants and aids the development of the bond, money and

derivatives markets.

It acts as an interface with the regulators on various issues that impact the functioning of these markets. It also undertakes developmental activities, such as, introduction of benchmark rates and new derivatives

instruments, etc.

FIMMDA releases rates of various Government securities that are used by market participants for

valuation purposes.

FIMMDA also plays a constructive role in the evolution of best market practices by its members so that

the market as a whole operates transparently as well as efficiently.


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ABOUT THE ORGANISATION

Organisation History

The Mumbai District Central Co-operative Bank Ltd. is a central financing agency of all affiliated co-

operative societies in Mumbai district, which is popularly known as "MUMBAI BANK" and is registered underMCS Act in the year 1974 and started its functioning on 12th Feb.1975. Since there is no agriculture productionin this District, MUMBAI BANK is catering to the financial needs of non-agricultural co-operative societiessuch as urban co-op. banks, urban co-op. credit societies, Employees co-op. credit societies, Housing co-op.societies, Co-op. consumers stores, Industrial, fisheries and labour co-op. societies etc.

In India, an integral part of the policies formed by the Co-operative movement is focused on thedevelopment of the country, upliftment of poor and propagation of principle which represents the very socio-cultural ethos of the country. Co-operative movement has enabled us to develop the economy and to bringsocial change at large. The success of the co-operative depends largely on their ability to face the challenges by

converting these challenges into opportunities of growth and development in the fast changing liberalizedeconomic era. The Indian co-operative movement is so far the largest movement in the world. In India co-operatives operate in almost all important sectors i.e. agricultural, agro-processing, fertilizer, marketing, credit,dairies, spinning, handloom and handicrafts, sugar, fisheries, banking, etc.

In India co-operatives have gained popularity because they have proven capabilities to reach at the grassroot level and have strengthen the faith in co-operatives. The area of operation of some of the co-operatives islimited to village, taluka, district, state or all India basis. Computerization is a new need of business in co-operatives. Operational efficiency, customer service, communication & management information system are thefour important parameters to ensure success of business organization. These parameters are improved to a great

extent with the help of computers and information technology (IT) by The Mumbai District Central Co-operative Bank Limited. Co-operatives are based on the values of self-help, self-responsibility, democracy,equality, equity and solidarity. The co-operative principles are the guidelines by which co-operatives put theirvalues into practice. The International Co-operative Alliance (ICA) in its centennial conference held inManchester in September 1995 approved and adopted seven basic principles of Co-operation.

1. Voluntary and Open Membership

2. Democratic Member Control

3. Member Economic participation & Control

4. Autonomy & Independence

5. Education, Training & Information

6. Co-operation among Co-operation

7. Concern for Community


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A co-operative society is an autonomous association of persons united voluntarily to meet their commoneconomic, social and cultural needs through a jointly owned and democratically controlled enterprise. There arethree tier co-operative credit structures in the state of Maharashtra. The Maharashtra State Co-operative Bank isthe Apex institution working at the state level whereas the district central co-operative banks are working atdistrict level. These district central co-operative banks are catering to the financial needs of primary co-

operatives in the concerned district. These banks are playing vital role particularly in providing financialassistance for agriculture as well as non-agricultural cooperative sector through member co-operatives. DistrictCentral Co-operatives are also acting as a balancing centre of surplus funds of all primary co-operatives in thedistrict.

This leading District Central Co-op Bank has invested their funds in Govt.Securities, approved Bond &other securities like NABARD, HUDCO, SBI BOND etc. The total investment of the Bank as on 31st March2013 stands at Rs.1778.11 crores in various co-operative and Corporations.

We appeal to all co-operatives and corporations to come forward and avail financial assistance from our bank for the socio- economic Development of the people in greater Mumbai and Maharashtra.


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RESEARCH METHODOLOGY

Hypothesis:

H 0 = the yield, duration, issue size, outstanding stocks of the security under auction does not have significantimpact on the price changes of auctioned securities.

H 1 = the yield, duration, issue size, outstanding stocks of the security under auction have significant impact onthe price changes of auctioned securities .

The Indian gilts market is in the domain of the central bank of the country as it is not only involved inthe primary auctions but also takes part in the secondary market at the time of need. The Reserve Bank of India(RBI) conducts open market operations as well as Repo and Reverse Repo under daily liquidity adjustmentfacility that involves treasury securities. The RBI has been managing public debt with success and able to raiseresources for the Government which has been borrowing ever increasing amounts to fund the growing fiscaldeficit. Management of public debt by the RBI embraces many policy considerations that include minimizationof cost of borrowing, ensuring wider distribution of ownership of government securities so as to increase themarket depth and helping to develop a robust secondary market for gilts.

The primary auction mechanism has been successful due to participation of a fairly large number ofmarket participants in the auctions and underwriting of issues by primary dealers. The new underwriting formatintroduced by the RBI effective from April 06 (after FRMB Act came into action) will further add impetus toefficiency of the primary auction market. The announcement of introduction of a When Issued Market in dated

securities in the Annual credit Policy of RBI is a welcome step in the that direction. In India, primary auctionsare conducted by the RBI for both Treasury bills and long dated Treasury securities. The RBI comes outissuance calendar for both T-bills and dated securities well in advance (once in six month) in order to help themarket participants to plan their market strategies. Depending on market conditions, the RBI conducts multipleor uniform price auctions of the dated treasury securities. In India, the RBI has been following a passiveconsolidation of debt by re-issuing the existing papers since last couple of years. The most of the auctions are

price-based as coupons have been already fixed in those securities.

Driving down the price of the auction security relative to its secondary market is a common finding ofthe growing body of empirical studies on government debt auctions. The persistence of such phenomenon may

partly be due at least to some extent to the markets vulnerability to manipulation; it is therefore constantlymonitored by regulatory authorities throughout the world. Their concern is that market manipulability mayundermine the price-discovery process and reduce public confidence in the efficiency and integrity of themarket. Such concerns have translated into significant innovation in government market securities, which tendto benefit all by increasing liquidity and thereby lowering governments borrowing costs.

Price Dynamics Normally, auction results are declared in the evening. The market trading is almost over by that time

though at times we observe spurt in activity before the market closes on the auction day. At times, on auction


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days, market timing is extended to accommodate the trades of the market participants. Normally theauction notice is issued by the RBI about a week before the auction date. Auction process entails submission ofclosed bids by market participants in the morning (normally by 12.30PM). While submitting the bids, the

bidding entities are guided by market prices at the relevant time (through reported information at RBI Negotiated Dealing System (NDS) or NDS-Order matching system). If the market price is not available (the

concerned security is not traded before submission of a bid), the bidding entity has to price the bid using its ownestimation. Generally, auctioned securities (re-issues) have higher volume of trade in secondary market on thedate of auctions. The government auctioned Rs 15,000 crores of bonds in the month of September and the cutoff yields on the bonds auctioned were at the highest levels seen during the week. The bonds auctioned were the8.07% 2017 bond for Rs 3000 crores, the 8.08% 2022 bond for Rs 6000 crores, the 8.28% 2027 bond for Rs3000 crores and the 8.30% 2040 bond for Rs 3000 crores. The cut offs came in at 8.64%, 8.70%, 8.87% and8.92% respectively. Bond yields closed at higher than cut off levels post the auction results leading to week onweek rise in bond yields between 20bps to 33bps across the yield curve. The auction was fully subscribed, withRs 898 crores or 6% of the total auction size, devolving on Primary Dealers (PDs). PDs had fully underwrittenthe bond auction and the RBI received Rs 27,410 crores of competitive bids for the full auction, a bid to cover

ratio of 1.87 times.

The difference between cut-off price and weighted average traded price in the secondary market variedfrom Rs.0.18 to Rs.1.78. The average price difference was Rs.0.69. However, during the year, the weightedaverage price realized by the Government from the auction process was lower than the weighted average traded

price in the secondary market. There were 3 cases in which the price realization by the Govt. was higher thanthe secondary market traded prices (the difference varied from Rs.0.05 to Rs.0.31) while there were 7 cases inwhich the price realization was lower than the secondary market traded price (the difference varied from

Rs.0.06 to Rs.0.88).

During FY 2013-14, there were only 2 auctions in which cut-off prices in auctions were higher than thesecondary market weighted average traded price (by Rs.0.02 and Rs.0.03) while in 22 cases, the cut-off price inauctions were lower than the secondary market weighted average traded price (the difference varied betweenRs.1.05 and Rs.0.03). There were 4 cases in which the auctioned securities were not traded in the secondarymarket on auction dates. However, out of 23 comparable cases (in case secondary market trade happened onauction days), in 11 cases, weighted average price realization in auctions were lower than the secondary marketweighted average traded price (average= Rs.0.29, maximum=Rs.1.05 and minimum=Rs.0.01) while in 12 cases the weighted price realization in auctions were higher than

the secondary market weighted average traded price (average= Rs.0.13, maximum =Rs.0.46 andminimum=Rs.0.03).


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Research approach:

Secondary data have been collected by going through various websites, articles on internet regarding the primary market auction between FY 2009-2011 and statistics available on RBI & CCIL websites regardingthe same. Sampling:

For sampling purpose government securities which have been auctioned in primary market between thefinancial year 2009 and 2011 have been considered since much of the reform in the Indian debt market havetaken place during this period. FY 2013 14 was also a significant year for auctions and OMOs alongwithCRR cut and Inflation statistics but the data availability for FY 2009 to 2011 was much easier, better andaccurate.Data source:

In this study Primary data and secondary data have been used. Secondary data have been collected fromInternet. Primary data has been collected from bank database, CCIL reports, Newspaper etc. Banksinvestment, risk management & fund allocation policy have also has been an important source of data forthis research.

Limitations of the Study:Debt market is a vast ocean of securities. It being a fixed income investment and majorly affected by

macro economy factors it is difficult to come to a consensus of opinion. It fluctuates heavily as when macroeconomy indicators figure is declared. Also RBI, Government, CCIL intervention acts like a boon as well as

bane. The recent CRR cut was a significant step which made the benchmark security fall drastically. Bank portfolio is an issue of confidentiality.

A lot securities bought during the inverted interest cycle led to huge NPA and these funds generate

interest of 7-8%. Due to legal complications and other intermediary norms these funds cannot be releasedand invested in high return securities.Being a co-operative bank itself has limited scope for expanding. Due to its limited accessibility client basecannot be increased, which would had added to the deposit amount in the bank and eventually benefitted the

banks portfolio

Executive summaryDebt markets are pre-dominantly wholesale markets, with dominant institutional investor

participation. The investors in the debt markets concentrate in banks, financial institutions, mutual funds, provident funds, insurance companies and corporates. Many of these participants are also issuers of debtinstruments. The smaller number of large players has resulted in the debt markets being fairly concentrated,and evolving into a wholesale negotiated dealings market. Most debt issues are privately placed or auctioned

to the participants. Secondary market dealings are mostly done on telephone, through negotiations. Insome segments such as the government securities market, market makers in the form of primary dealers haveemerged, who enable a broader holding of treasury securities. Debt funds of the mutual fund industry,


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comprising of liquid funds, bond funds and gilt funds, represent a recent mode of intermediation ofretail investments into the debt markets, apart from banks, insurance, provident funds and financialinstitutions, who have traditionally been major intermediaries of retail funds into debt market products.

The government securities market, one of the most important components of the financial sector in amodern economy performs many important roles. From the viewpoint of the government, it is an importantsource of funds and from the viewpoint of investor it is an investment that is free from default risk. In so faras the domestic financial markets are concerned invariability the G-sec market is the most liquid segment ofthe market.

Also the major transactions in the banking sector are also of call money transactions in order tomaintain the necessary CRR. They lend or borrow money from market. The introduction of CBLO hasdefinitely hastened these procedures.

This report deals mainly with the procedure of the transactions of government securities and different parameters involved in this process.

Debt Market Overview

The bond market believes that the current bonds in auction will become illiquid soon with new bondscoming up for auction and is bidding defensively for the bonds. This defensive bidding will continue until theRBI starts issuer new bonds that will be perceived as more liquid than the older bonds. Once new bonds areissued, markets will bid more aggressively for the auctions leading to a fall in bond yields from higher levels.

The government bond yield curve steepened in the auction with the five over thirty spread moving upfrom levels of 20bps pre auction to 30bps post auctions. The steepening of the curve suggest that investorinterest is low for longer dated bonds and until investors come back into the market lured by higher yields,

traders will steepen the yield curve by bidding at higher levels of yields in long dated bonds.

Corporate bond yields did not rise as much as government bond yields as improving liquidity kept yieldsfrom rising up too sharply. Five and ten year benchmark AAA corporate bond yields rose by seven and ten basis

points respectively week on week. Five and ten year credit spreads fell by 12bps each to close at 84bps levelsrespectively. Credit spreads are more likely to move on government bond yield movements than movements incorporate bond yields.

Interest rate swaps saw a flattening of the yield curve with the five over one OIS (Overnight IndexSwaps) spread coming off from levels of negative 80bps to negative 65bps levels. The swap curve is likely to

continue on its flattening trend as the market pays five year OIS yields on worries of government bond yieldsmoving up while the one year OIS yield is likely to remain stable as it starts factoring in a status quo on policyrates by the RBI

Liquidity improved in the system on the back of government spending and half year end money held by banks coming back into the system. Bids for reverse repo at 6.75% averaged Rs 16000 crores on a daily basiswhile bids for repo at 7.75% averaged Rs 11,000 crores last week. Liquidity in the system should move with anegative bias as busy season and festive demand for cash picks up.


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FINDING AND ANALYSIS

During the period of study, it was found that out of 29 auctions understudy, only 7 instances showed that

price change in a liquid security is lower than the price change in the auctioned security. In most of the cases,

the price change in the auctioned security is higher than most liquid security at that period.

The study has attempted to empirically examine the efficiency of Govt. securities auction in Indian market.

It is observed that prices of the securities under auction generally move downward between the date of

announcement of auction and the date of auction. The yield, duration, issue size, outstanding stocks of the

security under auction have significant impact on the price changes of auctioned securities.

DURATION AND CONVEXITY THEIR RELEVANCE IN MANAGING BOND PORTFOLIOS

Duration (is also called Macaulay duration) is a measure of interest rate risk exposure of a financial assetand it measures the sensitivity of a securitys price to its interest rates. Dura tion has been defined as theapproximate percentage change in the value of a fixed income security that will result from a 1% change ininterest rate. For example, 5 year duration means the bond will decrease in value by 5 % if the interest rates rise

by 1% and increase in value by 5% if interest rate fall by 1%. Duration is a weighted measure of the length oftime the bond will pay out. Unlike maturity, duration takes into account interest payments that occur throughoutthe course of holding the bond. Basically, duration is a weighted average of the maturity of all income streamsfrom a bond or portfolio of bonds. So for a two-year bond with four coupon payments every six months of 50and a 1000 face value duration (in years) is 0.5 (50/1200) + 1(50/1200) + 1.5 (50/1200) + 2(50/1200) +2(1000/1200) = 1.875 years. Notice that the duration on any bond that will be less than the maturity because

there is some amount of the payments that are going to come before the maturity date. In this example, thematurity was 2 years Investors use duration to measure the volatility of the bond. Generally, the higher theduration (the longer an investor needs to wait for the bulk of payments); the more its price will drop as interestrates go up. Of course, with the added risk comes the greater expected return. If an investor expects the interestrates to fall during the course of time the bond is held, a bond with long duration would be more appealing

because the bonds price would increase more than comparable bonds with sho rter duration.Loosely defined, duration is how long it would take for you to get your money back if interest rate

causes your bond portfolio to drop in value. Duration is measure of mean length of time that would pass beforethe stream of known and fixed payments would return their present value. The longer the payback period, themore sensitive the value of the asset or liability is to interest rate changes. For an asset with a single payment (azero coupon bond), duration equals maturity. When there are interim payments, duration will be less thanmaturity.

There are many formulae and definitions for duration, some of them are very sophisticated. This formulais one of the more commonly applied and gives the duration of a typical cash flow producing asset like a bond:


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Where,D = duration of the bond

CF = interest or principal payment at time t,t = time period in which principal or coupon interest is paid,n = no. of periods to maturity,i = the yield to maturity (the market interest rate)

The denominator is the price of the bond and is just another form of present value formula which can be

explained with the following example. A 5 year bond paying a coupon of 5% suddenly takes dive when pricesfall in response to a rise in interest rate from 6% to 10%. Using the present value formula we see that this resultsin a fall in price from Rs. 95.79 (present value of a 5 year bond a 5% yield to maturity when interest rates are6%) to only Rs. 81.05 (present value of a 5 year bond paying 5% coupons when interest rates are 10%.We calculate how long it is to be before we get our money back, reinvesting the coupons in either new 10%

bond trading at par or heavily discounted 5% bonds selling at Rs. 81.05 of par.We work out the numerator first,

5% *1/(1+10%)^1 + 5%*2/(1+10%)^2 + 5%*3/(1+10%)^3 + 5%*4/(1+10%)^4 + 10%*5(1+10%)^5 = 3.637The denominator is,5%/(1+10%)^1 + 5%/(1+10%)^2 + 5%/(1+10%)^3 + 5%/(1+10%)^4 + 10%/(1+10%)^5 = 0.8105So the duration is 3.637/0.8105 = 4.49 years

If we redo the exercise with a 30 year bond, 5% coupon, market interest rates at 10%, we find theduration is 11.43 years.As stated above duration is a measure of the approximate sensitivity of A bonds value to interest rate changes A bonds lifetime that accounts for the entire pattern of cash flows over the life of the bond (i.e. the

weighted average time to recovery of all interest payments plus principal.)

The number of years needed to fully recover the purchase price of a bond given the present value of its cash

flows. The price volatility of a zero coupon bond with that number years to maturity The number for each bond that summarizes 3 key factors that affect the sensitivity of a bonds price to a

change in interest rates: maturity, coupon, and YTM (i.e. a composite measure of the bonds cash flow

characteristics taking into consideration its coupon and term to maturity).


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Measures of Price Volatility

Price Value of Basis Point: It gives us the change in price for a 1 basis point change in rates. Tounderstand the same, we will take a bonds current price and YTM and increase the YTM by 0.1% (i.e. 8% to

8.01%) and re-price bond.A zero coupon bond 10 year with 10% YTM has a price today of Rs. 37.689 while the same bond with YTM of10.01% has a price of Rs. 37.653. The difference is the PVBP: Rs. 0.36 while the percentage change is PVBP/Initial Price. % DP = 0.36/ 37.6890 = 0.095%.

The lower YTM bonds have more volatility.

Duration short cut equation:

Modified Duration: It is a measure of Macaulay duration adjusted to help in the estimation of bonds pricevolatility (i.e. the sensitivity of market value to changes in interest rates) and is defined as follows:

Uses of Duration:

Duration is used as a way to ensure that a goal to be met in the future will not be affected by interest ratechanges. The Duration Gap is a well -respected subject among banks.The formula for Duration Gap is as follows:Where, D g is the duration gap (which you want to be zero if you are duration matching.

Da is the duration of assets

MV l is the market value of liabilities

MV a is the market value of assets

D l is the duration of liabilities

Duration Relationships:

Coupon is inversely related to duration: Higher coupon leads to qui cker recovery of bonds value,

resulting in shorter duration.

Yield to Maturity is inversely related to bond: Higher yield produce lower present values of cash receipt

received far out in time, thereby diminishing their relative value. Duration increases with maturity: Duration expands with time to maturity but at a decreasing rate. The duration of a portfolio is equal to the weighted average of the duration of bonds in the portfolio.


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Duration Relationships with price changes:

Percentage price change: The percentage change in a bonds price is approximately equal to negative

modified duration times the change in yield.

Price change: the change in a bonds price is approximately equal to percentage change in price times

the original price.

Estimated pric e: the estimated bonds price is approximately equal to percentage change in prices

times original price plus the original price.


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Recommendations (minimum) price volatility from a bond, bank In order to obtain maximum should choose bonds with the

longest (shortest) duration.

Bank should adopt Immunization strategy. Immunization is the strategy of protecting a portfolio againstinterest rate risk (i.e. both price and reinvestment risk). The strategy would be: purchase a bond withduration equal to the investment horizon.

Bank should have Integrated Treasury Management system to optimise their profit. ITM already existing in

the bank is functioning well but a skilled research team will only add to its profit.

Bank should get rid of securities giving low coupon which bank has invested in 2-3 years back. It should

sell these securities and invest the same amount in securities at current market interest rates.

Yields in the Government securities market have hardened, which could limit the profits earned by banks

from their investments, in turn halting the trend of booming bank profits it could be offset with an increase

in lending rates. The impact can be softened by the rise in credit demand.

Bank should target each and every individual traded security and estimate their liquidity premium and

include the same in the computation of the price of the security.


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CONCLUSION

Indian debt market is right now at a very beginning stage. There are lot of investment opportunities in it

which are yet to be discovered. With IDBI starting retail investors trading in debt market similar like stock

market there are hopes individuals will be optimise their returns by investing more and more in debt securities.

Awareness regarding the earning opportunities has to be explored.

For all bonds paying coupons, duration is always less than maturity. For a zero coupon bond, duration

is equal to time to maturity. For a deep discount bond, a point is reached at which duration actually decreases as

maturity increases.


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BIBLIOGRAPHY

www.ccilindia.comwww.rbi.org.in

www.investopedia.com

www.mumbaidistrictbank.com

www.economictimes.indiatimes.com

Wealth Times & Economic Times newspaper

CCIL reports

Research Methodology by Paner Salvum

Documents

Study of Government Securities