Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 1: Fixed Income Instruments

Dr. Kedar nath Mukherjee

Objectives:

The objectives of this chapter are: to make the readers aware about the different types
of instruments available in the fixed income market, with special reference to Indian
debt market; nature of the instruments, their structures and features. At the end of this
chapter, the readers are expected to be familiar with:

§ What types of debt instrument are available in FI market, especially in India?

§ How domestic market issues are different from international market issue?
§ How debt instruments are classified as per their features?
§ What kind of securities are issued by the Central Govt./State
Govt./PSUs/Corporates?
§ How SLR approved securities are different from Non-SLR securities?

Structure:
1. Debt market instruments: Classification
1.1. Classification of debt instruments based on markets
1.2. Classification of debt instruments based on their features
1.2.1. Fixed Rate Bond
1.2.2. Floating Rate Bond
1.2.3. Zero Coupon Bond
1.2.4. Treasury STRIPS
1.2.5. Bonds with embedded options
1.2.6. Step-up/Step-down Bond
1.2.7. Asset Backed and Mortgage Backed Securities (ABS/MBS)
1.2.8. Tax Saving Bond

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

1.2.9. Foreign Currency Convertible Bonds

1.2.10. Perpetual Bond
1.2.11. Junk Bond
1.2.12. Covered Bond
1.2.13. Secured/Unsecured Bond
1.2.14. Inflation Indexed Bond
1.2.15. Basel III Bond
1.3. Classification of debt instruments based on issuing sectors and sub-sectors
1.3.1. Central Govt. Dated Securities
1.3.2. Special Securities
1.3.3. Treasury Bills (T bills)
1.3.4. State Development Loans (SDL)
1.3.5. Other Approved Securities (OAS)
1.3.6. Municipal Bonds
1.3.7. Public Sector Undertaking Bonds (PSU Bonds)
1.3.8. Corporate Bond / Debenture
1.3.9. Commercial Papers & Certificate of Deposits
1.4. Regulatory Classification of Debt Instruments (in India)
1.4.1. SLR securities
1.4.2. Non-SLR Securities

1.0 Debt Market Instruments: Classification

Debt instruments or securities available in the financial market can be presented under
different classifications. Such classification can be based on:
1. Markets (Domestic, International Markets)
2. Features of the debt instrument (e.g. Maturity, Type of Coupon, Optionality,
Convertibility, etc.)
3. Issuing Sectors and Sub-Sectors (Resident Sector: Central Govt., State Govt.,
Municipal Bodies, Non-Govt. Entities, Non-Resident Sector)
4. Regulatory Classification, etc.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

1.1 Classification of Debt Instruments based on Markets

Debt instruments, irrespective of their nature and properties, can be issued either in the
Issuer’s Domestic market or in the International market. This classification allows
analysing the relative attractiveness of the domestic debt market in comparison with
the international markets.
This classification is particularly important for emerging market economies, and
indicates the strength and viability of the economy to raise funds domestically through
debt issues. Resident institutions in emerging economies, in absence of reasonable
access to the international markets, generally raise funds in their domestic market. But
at the same time, financial liberalization allows financial markets to become more open
to foreign issuers and investors. Therefore many economies attract foreign investors by
way of issuing securities in the international markets. This international debt issuance
induces inflow of relatively cost-effective foreign capital, leading to facilitate the
domestic institutions with a lower borrowing cost, and accordingly may promote
economic growth.
Any debt issue can be classified as a Domestic Market issue depending upon the
Residence of Issuer, or Location of Issue. When a resident of an economy issues certain
debt products in the same economy, the market for such security, regardless of the
currency of the issue, can be classified as domestic market. At the same time, if the
location of the issue is important, all debt securities issued in a specific economy, either
by residents or non-residents, and irrespective of the currency of issue, can be classified
as domestic market issues. Once securities are issued by a resident of an economy, the
classification (Domestic vs. International) can be broadly based on:
§ The Recognized Exchange (Domestic or International) in which the security is
listed.
§ The availability of security identification number, an International Security
Identification Number (ISIN) with a country code, or a domestic security code.
§ The Currency (Domestic vs. Foreign) at which the security is issued.

1.2 Classification of Debt Instruments based on their Feature

Depending on the nature and characteristics (e.g. Coupon, Maturity, Additional Features
like options, Risk, Currency, etc.) of the instruments, debt securities can be classified as
follows:

1.2. i Fixed Rate Bonds / Straight Bond / Plain Vanilla Bond:

These are bonds the coupon rates of which are fixed for their entire life or
maturity. Most Government bonds are issued as fixed rate bonds. Most of the popular
corporate bonds are also of similar type, paying a semi-annual but fixed coupon over
their life and the principal at the end of the maturity.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

For example – 7.80% GS2020 was issued on May 3rd, 2010 for a tenor of 10
years maturing on May 3rd, 2020. Coupons on this security are paid half-yearly at
3.90% (half yearly payment being the half of the annual coupon of 7.80%) of the face
value on November 03 and May 03 of each year, till the maturity. Similarly, POWER
FINANCE CORP. LTD. 9.52 02MY17 is a corporate bond, paying a fixed coupon rate of
9.52% per annum but payable semi-annually, and matured on May 02 2017.

1.2. ii Floating Rate Bonds / Floaters:

These are the bonds, even if the coupon of which are usually paid semi-annually, the
coupon rate is not fixed throughout the life and varies over time with reference to some
benchmark / reference rate of interests. These types of bonds may have some Floor or
Cap attached on it, representing that even if the benchmark rate change by any value,
the coupon rate even if floating but will always lies within the range of Floor and Cap
rate. Some of the well-known benchmark rates used in Indian market are: Mumbai
(London) Interbank Offer Rate (MIBOR / LIBOR), Call Rate, T-bill rate, Prime Lending
Rate (PLR), etc.
Presently (as on December 2014) 6 – 7 such Floating Rate Bonds (FRBs), issued
by the Govt. of India, are outstanding in the Indian debt market. For example, FRB 2020,
issued on December 21 2009 and maturing on December 21 2020, paying a semi-annual
coupon in every six months depending on some reference rate and a certain spread, is
one of the FRB issued by the Govt. of India and presently captures an outstanding
volume of 13000 crore as on December 01 2014. In the case of most floating rate bonds
issued by the Government of India so far, the base/reference rate is the weighted
average cut-off yield of the last three 364- day Treasury bill auctions preceding the
coupon re-set date and the spread is decided through the auction. Floating Rate Bonds
were first issued in September 1995 in India. For example, the last coupon payment
date of the above Floating Rate Bond FRB 2020 was December 21 2014, when the base
rate on the bond for the coupon payments was fixed at 8.50% being the weighted
average rate of implicit yield on 364-day Treasury Bills during the preceding six
auctions. At the same time, a cut-off spread (mark up over the benchmark rate) of 34
basis points (0.34%) was decided through an auction. Hence the coupon rate applicable
on December 21 2014 would be 8.84% (8.50% plus 0.34%).
Unlike in case of a simple floating rate bond or Floaters, there are also certain
floaters the coupon rate of which moves in the opposite direction from the reference
rate. These securities are called Inverse Floaters or Reverse Floaters. Issuers (investors)
may like to use this kind of a structure in a Rising (Falling) interest rate scenario, to
reduce the cost of raising funds (generate higher return on investment). The coupon of
an inverse floater is the difference between a fixed rate and a floating benchmark rate,
say MIBOR. Most Non-Banking Finance Companies (NBFCs) in India, such as Mahindra
and Mahindra Finance, Rabo India Finance, Cholamandalam Finance and Sundaram
Finance, etc. have issued inverse floaters to raise funds. Suppose, Hindalco, one of the

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

largest Aluminium maker in India, wants to float Rs.100 crore bonds issue, with a “AAA”
rating from CRISIL, with an inverse floating interest rate structure as on February 27
2015. Suppose the bond is of 5-year maturity, with a call/put option at the end of 3
years. The floating coupon will be the difference between a fixed rate of 17.04 percent
and the NSE 3-Months MIBOR, a benchmark for the call money in India, and is payable
semi-annually. If the 3-M MIBOR as on the issue date is 8.54 percent, the semi
annualised rate applicable to the inverse floater for calculating the nearest coupon
would be 8.50 percent (17.04 – 8.54). If the 3-M MIBOR is expected to rise (fall) at 9.04
percent (at 8.04 percent), HINDALCO the bond issuer (any investor) is likely to pay less
(receive more) by 50 basis points. That’s how bond issuer or investors/traders gets
benefited from this kind of issues, depending upon their view on interest rates.

1.2. iii Zero Coupon Bonds:

Zero Coupon Bonds (ZCBs) are bonds with no coupon payments. Like Treasury Bills,
they are issued at a discount to the face value. Instead of paying any periodic coupons,
the ZCB holder gets the price discount in the beginning itself. Therefore, ZCBs are
alternatively known as Deep Discount Bonds. The Government of India issued such
securities in the nineties. It has not issued zero coupon bonds after that. All Treasury
Bills issued by the Govt. of India are the only zero coupon debt instruments, which are
essentially short-term money market instruments. Such ZCBs, if not available in the
market, can be created by government dealer firms, known as Primary Dealers (PDs) in
India, under the Treasury’s Separate Trading of Registered Interest and Principal
Securities (STRIPS) Program. These zero coupon instruments are called as Treasury
STRIPS.
In case of ZCB issued by any Non-Govt. entity, since the issuers do not pay any
interest regularly, the credit risk of such bonds gets un-recognized till the maturity, and
therefore carries a significant amount of credit risk for the investors. Because of this
high credit risk, RBI has stringent norms for Indian banks to invest in such ZCBs.
However, as per RBI norms, banks can invest in zero-coupon bonds, provided the issuer
creates a sinking fund and keeps it in liquid investments or government securities.
These types of debt instruments in India are normally offered to retirement funds such
as exempted provident funds, gratuity funds and superannuation funds. ZCBs are
generally issued at the shorter end of the maturity, say up to two years.

1.2. iv STRIPS:

Separate Trading of Registered Interest and Principal of Securities (STRIPS) are a

special form of zero coupon securities. STRIPS are instruments wherein each cash flow
of the fixed coupon security is converted into a separate tradable Zero Coupon Bond.
For example, when Rs.100 of the 7.80% GS 2020 is stripped, each cash flow of coupon
(Rs.3.90/- in each half year) will become coupon STRIP and the principal payment
(Rs.100 at maturity) will become a principal STRIP. These cash flows are traded
separately as independent securities in the secondary market. STRIPS in Government

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

securities are expected to ensure availability of sovereign zero coupon bonds, which
will facilitate the development of a market determined zero coupon yield curve (ZCYC).
STRIPS also provide institutional investors with an additional instrument for their
asset- liability management. Further, as STRIPS have zero reinvestment risk, being zero
coupon bonds, they can be attractive to retail/non-institutional investors. Unlike in case
of ZCBs issued by Non-Govt. entities, such Treasury STRIPS is free from any credit risk.

1.2. v Bonds with Embedded Options:

Bond may have an option (Call or Put) embedded in it, giving certain rights to the
issuers and / or investors. The more common types of bonds with embedded options
are: Callable bond, Puttable bond, and Convertible bond. Callable bond gives the issuer
the right to redeem or buy back them prematurely on certain terms. The call option can
be an American or a European option. The purpose of such option is to reduce the cost
of issuer in the regime of falling interest rates. On the other hand, Puttable bond gives
investor the right to prematurely sell them back to the issuer on certain predefined
terms. Puttable bond safeguard the interest of bond holders when interest rates rises in
the market. Convertible bonds, alternatively known as Hybrid Securities, give bond
holder the right to convert them into equity shares on certain terms. Such bond can be
fully or partly convertible. In case of partly convertible, investors are offered equity
shares for the part which is redeemed and the other part remains as a bond. Callable
(Putable) Bonds are generally traded at a lower (higher) price in comparison with the
similar option-free bonds. Since call/put option can be exercised after the specific lock-
in period but on some specific call/put date (1st Call Date/2 nd Call Date/…./n-th Call
Date), the prices at which the bond will be called-off or sell off in all possible call/put
dates are also specified in the bond indenture. These schedules of alternative prices are
called Call/Put Schedule.
6.72%GS2012 was issued on July 18, 2002 for a maturity of 10 years maturing
on July 18, 2012. The optionality on the bond could be exercised after completion of five
years tenure from the date of issuance on any coupon date falling thereafter. The
Government has the right to buy back the bond (call option) at par value (equal to the
face value) while the investor has the right to sell the bond (put option) to the
Government at par value at the time of any of the half-yearly coupon dates starting from
July 18, 2007. Even if presently there is no such callable/putable GOI bond outstanding
in the market, but these types of instruments are very common in Non-Govt. securities
market. Many corporates in India presently issue such bonds with a higher coupon rate
to attract investors, but may like to include a call and / or call & put option, to ensure
the exit route the moment market moving against the bond issuer.

1.2. vi Step-Up/Step-Down Bond:

Partly similar to a fixed rate bond, a Step-up bond pays a specific coupon rate for the
initial period, followed by a higher coupon rate for the subsequent periods. Therefore, a

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

step-up bond, even if offer a lower coupon during the initial period of its issuance,
always offers higher but predetermined coupons during the later periods. In other
words, the coupon income in a Step-up bond steps-up from one period to another.
Suppose, a 6 years step-up bond, offering 7 percent for the first two years, and 8.5
percent for the third and fourth years, and 9 percent for the fifth and sixth years.
Suppose, the coupon rate for the similar 6-year fixed rate bond is 8 percent per annum.
The initial coupon in this type of bond is generally lower than the coupon of similar
fixed rate bond, where the motivation for the investors is to earn more in the coming
years, but at the cost of lower earnings during the initial periods. Many step-up bonds
are callable, giving the issuers some protection against falling interest rates. On the
other hand, Step-Down bonds or notes are structured to offer a higher coupon in the
initial period, followed by a lower coupon in the subsequent periods. This type of
instrument motivates the investor to subscribe such issue to get a better immediate
return in comparison with the similar fixed rate instrument, and therefore can
strengthen the demand for such instrument in the market. Step-Down bonds may be
issued with some put option, giving the buyers a chance to exercise their put option
when the find a rise in the market rates.
The major advantages from investing in step-up bonds includes: exposure to
high-quality issuers, availing a higher coupon payments to offset inflation, benefits of
higher liquidity, lower level of interest rate risk in rising interest rate environment.
However, the promise of higher future earnings from high future coupon payments
really may not make any sense, especially when the step-up bond has a call option. The
callability nature of most step-up bonds make the higher future returns elusive, and the
promise for offering a higher future coupon may not materialize if the call option is
exercised. Since issuers of step-up bonds are often found to exercise their call option
even if interest rates remains flat, may be to avoid the higher future coupon payment,
callable step-up bonds have more call risk than traditional callable bonds. Step-up
bonds are generally more attractive to the investors when rates are expected to rise
quickly and to a level above the step-up rates, leading to demotivate the issuers to
exercise the call option.

1.2. vii Mortgage Backed / Asset Backed Securities:

Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS) are two important
debt instruments, especially in developed markets like USA. Securities created by a
third-party entity or a Special Purpose Vehicle (SPV), from a pool of mortgages, of
different quality, originated by a single or multiple originator (s), are called Mortgage
Backed Securities. Once the securities are created, the same is sold to general investors
with different risk-return profile. Whereas Asset Backed Securities, even are of similar
nature and are created through almost the same process, but are created from Non-
Mortgage related assets, such as auto loans, credit card loans, student loan, etc.
As far as the structure of MBS or ABS is concerned, there are broadly three
parties involved: Originator/Seller, Issuer and Investor. Besides originating the
mortgages or the loan assets, and thereafter selling them to the issuers, Sellers of such

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

assets may also act as a service agent, in terms of collection of regular interest payments
on the loan and its principal in due time from the borrowers. This process enables the
originators/sellers to off-load these exposures from their Balance Sheet, and allows
them to take fresh exposures. Issuers, who can be a third-party entity or a SPV, acquire
the assets from sellers, pool them together, and issue the securities to investors, and can
earn their commission. Institutional Investors, like Investment Banks, Commercial
Banks, other Non-Banking Financial Institutions, Insurance Companies, etc., may like to
invest in these securities, with an expectation of earning a relatively higher yield and
also to diversify their existing portfolio. Investors are also exposed to two major risks:
Prepayment Risk and Default Risk. Early payment of the loan-principal by the original
borrower, leading to a reduction in the future interest components which are the major
sources of earnings for the issuer to provide return to the security holders/investors,
may finally cause a fall in the yield on such securities, exposing the investors to a risk of
lower earning. Similarly non-payment of any dues (periodic interest and / or principal)
by the original borrower may also lead to a credit risk losses to the issuers, which may
be finally passed on to the security holders/investors, as experienced in the 2008 US
Sub-Prime Crisis. These securities, depending on the risk-return profile, are categorized
into three tranches: Senior Tranche (Low Risk – Low Return), Mezzanine Tranche
(Moderate Risk – Moderate Return), and Junior/Equity Tranche (High Risk – High
Return). The losses incurred by the security issuers due to any credit risk on part of the
original borrowers are primarily borne by the holder of the Junior Tranche, and
thereafter the remaining losses (if any) are passed on to the other two categories of
investors, depending upon the risk profile of their investment.

1.2. viii Tax-Savings Infrastructure Bonds:

Tax-free infrastructure bonds are proposed by Indian government to channelize

retail and institutional savings into the infra sector. To make these bonds attractive and
widen the investor base, government may allow full tax exemptions to interest income
from these bonds. To make these instruments even more attractive to retail investors,
infra companies may offer an extra margin to investors for a limited amount of
investment. A number of such tax-free bond issues are slated to hit the stands in Indian
market. According to the government, ten infrastructure or infrastructure finance
companies, including India Infrastructure Finance Co (IIFCL), National Highways
Authority of India (NHAI), Housing and Urban Development Corp (Hudco), Power
Finance Corp (PFC) and IRFC, have together been allowed to raise Rs.60,000 crore from
the public during 2012-13.

1.2. ix Foreign Currency Convertible Bonds (FCCB):

In order to raise money in foreign currency, corporates may issue certain bonds in
currencies different from the issuers’ domestic currency, retaining all features of a
convertible bond. Several Multinational corporations tap the foreign bond markets by
issuing FCCBs which are quasi-debt instruments and tradable in stock exchanges. FCCBs
are attractive to both Issuers and Investors. Investors get the safety of guaranteed

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payments on the bonds and are also able to take advantage of any price appreciation in
the company’s stock. FCCBs may also carry an option feature (Call or Put) and normally
offer an interest (if any) lower than a normal debt paper or foreign currency loans or
External Commercial Borrowings (ECBs). FCCBs have been extremely popular with
Indian corporate for raising foreign funds at competitive rates.

1.2. x Perpetual Bonds:

Perpetual bonds, having no specific maturity like equity, are classified as hybrid
instrument because they have both equity and debt features. These bonds, usually
issued by banks, are not redeemable unless the issuer desires, and therefore are treated
as equity. RBI considers such bonds as part of banks’ Tier-I capital, which traditionally
comprised equity instruments. For example, CENTRAL BANK OF INDIA 9.4%
PERPETUAL BOND is a perpetual bond paying an annual interest of Rs.9.4/- for every
face value of Rs.100/-. Other such bond issuers are Tata Steel Ltd., Tata Motors Finance
Ltd., Tata Power Co. Ltd., State Bank of India, IDBI Ltd., etc.

1.2. xi Junk Bonds:

Any bond issued by a corporate having a credit rating below investment grade is known
as Junk bond. Due to poor credit worthiness, issuer of such bond offers very high yield,
comparative to high rated bond of similar tenor, to compensate bond holder for the
additional risk.

1.2. xii Covered Bonds:

Covered bonds are debt issued by banks that are fully collateralized by residential or
commercial mortgage loans or by loans to public sector institutions, and typically have
the highest credit ratings. The notes offer an additional protection to bondholders than
asset-backed debt because in addition to looking at the collateral pool as an ultimate
source of repayment, the issuing bank is also liable for the repayment. Covered bonds
are the second largest segment of the European bond market after government bonds.

1.2. xiii Secured / Unsecured Bonds:

Corporate bonds can be either secured against assets of the corporates or can also be
unsecured. Holder of secured corporate bonds, in the event of winding up of the
company, can be repaid by selling off the assets against which the bonds were secured.
Holders of senior secured bonds are ranked higher than the holders of subordinated
secured bonds and unsecured bonds in repayment of dues in case of closure of the
company. Unsecured bond holders are paid off before any payment is made to the
holder of preference shares issued by the corporation.

1.2. xiv Inflation Indexed Bonds:

These are bonds, the principal of which is linked to an accepted index of inflation with a
view to protecting the holder from inflation. Inflation Indexed Bonds (IIBs) were issued

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in India in the name of Capital Indexed Bonds (CIBs) during 1997, providing inflation
protection only to principal and not to interest payment. But IIBs are expected to
provide inflation protection to both principal and interest payments. With inflation
indexed bond, the real rate of return is known in advance, and the nominal return varies
with the rate of inflation realized over the life of the bond. Hence, neither the purchaser
nor the issuer faces a risk that an unanticipated increase or decrease in inflation will
erode or boost the purchasing power of the bond’s payments. Investors who desire
predictable real cash flows can now include indexed bonds in their portfolios. The
certain real return will be attractive to investors who are particularly risk averse. It will
also be attractive to savers who want to protect their savings from being eroded by
inflation. Since Inflation-indexed bonds remove the investor’s inflation risk, so by
issuing indexed bonds, the Treasury can avoid paying the inflation risk premium found
in nominal interest rates on conventional bonds and can thereby lower its borrowing
costs.
Inflation component on principal will not be paid with interest but the same
would be adjusted in the principal by multiplying principal with index ratio (IR), ratio of
recent inflation index to the base index. At the time of redemption, adjusted principal or
the face, whichever is higher, would be paid. Interest rate will be provided protection
against inflation by paying fixed coupon rate on the principal adjusted against inflation.
The consumer price index (CPI) reflects the inflation at large face and therefore, globally
CPI or Retail Price Index (RPI) is used for IIBs. Since all India CPI is being released since
January 2011, and it will take some time to stabilize, it has been decided to consider
WPI for inflation protection in IIBs. For example, if the annual coupon is 8 per cent and
the principal is Rs.100/-, the investor will be paid Rs.8/- per annum. If the inflation
index rises 10 per cent, the principal will become Rs.110/-. The coupon will remain 8
per cent, resulting in an interest payment of Rs.110 x 8 per cent = Rs.8.8/-

1.2. xv Basel III Bonds:

Basel Committee on Bank Supervision (BCBS), disseminating guidance on critical issues

to ensure healthy banking systems across the world, issues international norms, called
as Basel Accord, to sets minimum capital standards for banks. BCBS has produced three
such accords, Basel III being the most recent (in Year 2010) Accord. The Basel-III
Accord is a global standard for banks, setting out minimum requirements for capital,
liquidity and leverage, designed to rectify some of the blunders and irrational market
practices that led to the 2008-09 global financial crisis.
In this regard, BCBC, followed by the Reserve Bank of India (RBI) propose an
Additional Tier I (Core Capital) and Tier II (Subordinated Debts) capital instruments or
bonds issued by banks, requiring absorption of principal losses at an objective pre-
specified trigger point through either (i) conversion into common shares or (ii) a write-
down mechanism, allocating losses to the instruments. These bonds are commonly
known as Basel III bonds. A survey estimate says that Indian banks will require an
additional Rs.5 trillion (Equity/Tier I capital of Rs.1.75 trillion and non-equity/Tier II
capital of Rs.3.25 trillion) of capital to be Basel III compliant by 2019. In case there is no
injection of fresh capital from the Govt. of India, the entire non-equity capital and
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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

significant part of the equity capital may have to be accumulated through these Basel
compliant bonds. Other than Bank of India, IDBI Bank, several other Indian banks are
also exploring the issuances of Basel III bonds.
This loss-absorption clause makes such bonds costly for the bank to issue as they
have to pay extra interest to cover the additional risk borne by investors. For example,
Bank of India in July 2014 raised Rs.1,250 crore through Basel III bonds at a coupon rate
of 11%, roughly 100 – 150 basis points higher than normal bonds without the Basel III
clause. These bonds can be issued to both institutional and retail investors. To broaden
the investor base, the minimum maturity of the bonds has also been relaxed from 10 to
5 years.

1.3 Classification of debt instruments based on issuing sectors and sub-sectors

Debt securities available in the financial market of an economy can be classified based
on different Issuing Sectors (Resident and Non-Resident Sectors), and Sub-Sectors. If
not from an investor’s perspective, but from the Monetary Policy and Financial Stability
perspective, it is important to understand and analyze the sector-wise debt markets in
the country. Presence of Non-Residents in the domestic debt market may indicate the
openness of the national capital market for international players.
Resident Sectors can again be sub-classified as: General Government, Financial
Corporations, Non-Financial Corporations, Households, and Non-Profit Institutions
Serving Households. Debt securities are predominantly issued by the first three sectors.
General Govt. sector includes Central Govt., State Govt. and Local Govt. or Municipal
Bodies. Financial Corporations refers to the Central Bank, other Money Issuing
Corporations (if any), and other Financial Corporations. Non-Financial Corporations
includes all other Public and Private Entities including Banks, NBFC, PSUs, Corporates,
etc.
Debt securities, within the Resident Sector, issued by different sub-sector are described
in the following section.

1.3. i Central Govt. Dated Securities:

Long term (more than 1-Year of Original Maturity) debt instruments, issued by the
Central Govt. (Govt. of India), are called as Dated Government securities. These
securities may 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. The nomenclature of a typical dated fixed coupon Government
security contains the following features – coupon, name of the issuer, maturity and face
value. For example, 7.49% GS 2017 would mean: a fixed income security issued by the
Govt. of India, on April 16 2007, with a Coupon of 7.49% paid on face value, payable
Half-yearly (October 16 and April 16) every year, till the maturity of the security on
April 2017, and redemption of the face/par value at maturity. Presently (as on
December 1 2014), there are a total of 88 such Govt. securities, with different coupon

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and maturity profiles, are outstanding in the market, with a total outstanding volume of
INR 38277.78 Billion (INR 3827777.61 Crore).

1.3. ii Special Securities:

In addition to its traditional issues (Dated Securities and Treasury Bills), Government of
India, under the market borrowing programme, also issues, from time to time, some
special securities to entities like Oil Marketing Companies, Fertilizer Companies, the
Food Corporation of India, etc. as a compensation to these companies in lieu of cash
subsidies. In other words, the losses incurred by these companies while offering the
concerned products to the general public at a subsidized rates, decided by the Govt., is
not compensated by the Govt. in cash, but by issuing bonds, guaranteed by the Central
Govt. These securities are usually long dated securities carrying coupon with a spread of
about 20-25 basis points over the yield of the dated securities of comparable maturity.
These securities are, however, not eligible SLR securities but are eligible as collateral for
market repo transactions. The beneficiary, like oil marketing companies may divest
these securities in the secondary market to banks, insurance companies / Primary
Dealers, etc., for raising cash.

1.3. iii Treasury Bills (T bills):

Treasury bills or T-bills are money market instruments, which are short term debt
instruments issued by the Central Government (Govt. of India). These instruments in
India are presently issued in three tenors, namely, 91 Day, 182 Day and 364 Day.
Treasury bills are zero coupon securities and do not pay any interim coupon/interest.
They are issued at discount and redeemed at face value at 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/- at
maturity. The return to the investors is the difference between the maturity value or the
face value and the issue price, i.e. the discount amount. 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 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. Treasury Bills are short term (up to one year) borrowing instruments of the
Government of India which enable investors to park their short term surplus funds
while reducing their market risk. T-bills auctions are held on the Negotiated Dealing
System (NDS) and the members electronically submit their bids on the system. Non-

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competitive bids are routed through the respective custodians or any bank or PD which
is a NDS member.

1.3. iv State Development Loans (SDL):

State Development Loans (SDLs) are market borrowings by state governments.

RBI co-ordinates the actual process of selling these securities. Each state is allowed to
issue securities up to a certain limit each year. Generally, the coupon rates on State
Development Loans are higher than those of Central Government Securities of the same
maturity. This shows that the central government is considered more creditworthy than
state governments. Interest payment frequency is half yearly and other modalities are
similar to GOI Securities. They are issued in dematerialized form. State Government
Securities can be issued in the physical form (in the form of Stock Certificate) on
separate request and are transferable. State Development Loans are traded in
secondary market but are much less liquid than GOI Securities.
The State Development Loans are normally sold through the auction process. All
the auctions are multiple price auctions, through competitive bidding, conducted by
Reserve Bank of India and allotment procedure is similar to that for GOI Securities. Non-
competitive bidding has been introduced in the auction of SDL. One day prior to the
auction, bids are submitted by Primary Dealers (PD) to RBI indicating the amount they
are willing to underwrite and the fee expected. RBI, along with State Govt.
representatives, then examine the bids on the basis of the market conditions and take a
decision on the amount to be underwritten and the fee to be paid.

1.3. v Other Approved Securities (OAS):

These securities are generally issued by a Central or State Government undertakings.

The issuers mention in the offer document that particular security is eligible for SLR
purposes and permission to that effect has been obtained from Central Government.
The repayment of interest and principal of the security is guaranteed by Central or State
Governments. The coupon rate offered is generally higher compared to G-sec. and SDL
of similar maturities. These securities are not active in secondary market. The issuers of
such securities in the past are ICICI, IDBI, NABARD, SIDBI, HUDCO, State Financial
Corporation and State Electricity Boards. However, similar types of issuance are not
observed in recent years.

1.3. vi Municipal Bonds:

Municipal bonds are debt obligations, issued by States, Cities and other Government
Bodies, to meet the financial requirement of any Public Infrastructural projects like
School building, Highways, Hospitals, Sewage systems etc. Interest of such bond is paid
through the revenue generated from the business that backs the obligation. These types
of bonds, even if very popular in developed economies like US, are hardly issued in
India. In order to meet challenges created by growing urbanization, Municipal
Corporations in India need to incur huge expenditure to support urban infrastructure in

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the coming decades. Municipal bonds have advantages in terms of the size of borrowing
and the maturity period, often 10 to 20 years. Both these features are considered ideal
for urban infrastructure financing. If appropriately structured, municipal bonds can be
issued at interest costs that are lower than the risk-return profile of individual Urban
Local Bodies (ULBs).
There are basically two types of municipal bonds: General Obligation Bonds, and
Revenue Bonds. In case of the first, the principal and interest both are secured by full
faith and credit of the issuer and usually guaranteed by either the issuer’s unlimited or
limited tax paying power. In case of revenue bonds, principal and interest are secured
by revenues of the ULBs derived from tolls, charges or rents from the facility built with
the proceeds of the bond issue. Major Public projects financed by revenue bonds include
toll roads, bridges, airports, water and sewage treatment facilities, hospitals, etc. Since
1997, 25 municipal bond issues have taken place in India, which have included taxable
and tax-free bonds and pooled financing issues, mobilizing a funds nearly Rs.14 Billion.

1.3. vii Public Sector Undertaking Bonds (PSU Bonds):

In the event of reduction in the Central Govt. funding to Public Sector Undertakings
(PSUs) through the general budget, PSU bonds issue has become an important fund
raising programme adopted by the public sector undertakings. Accordingly like other
entities, PSUs also issue bonds in the primary market to raise funds, especially to meet
their regular working capital, and / or capital expenditure requirement. The market for
PSU bonds in India has grown substantially over the past decade. All PSU bonds have a
built in redemption, may be within a maturity period of 5 to 10 years, and some of them
are embedded with put or call options. The majority of the PSU bonds, issued by state
owned undertakings, carrying interest and principal payment guaranteed by the
respective state government, are privately placed with banks or large institutional
investors. Historically, default rates of PSU bonds are negligible and PSUs are perceived
as quasi-sovereign bodies
PSUs are permitted to issue two types of bonds: Tax Free Bond and Taxable Bond.
Tax free bonds are bonds for which the amount of interest is exempted from the
investor’s income. PSUs issue tax free bonds or bonds with certain exemptions under
the Income Tax Act with prior approval from the government through the Central Board
of Direct Taxes (CBDT) for raising funds. This feature was introduced with the purpose
of lowering the interest cost for PSUs which were engaged in businesses which could
not afford to pay market determined rates of interest. Therefore there are both taxable
coupon PSU bonds and tax free coupon PSU bonds. PSUs which have raised funds
through the issue of tax free bonds are central PSUs such as MTNL and NTPC, and state
PSUs such as State Electricity Boards (SEBs) and State Financial Corporations (SFCs).
The bonds issued by the State Financial Corporations are SLR eligible for cooperative
banks and non-banking finance companies (NBFCs). PSUs are allowed to issue floating
rate bonds, deep discount bonds, and variety of other bonds. All new issues have to be
listed on a stock exchange. Investors in PSU bonds include banks, insurance companies,

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non-banking finance companies, provident funds, mutual funds, financial institutions

and individuals

1.3. viii Corporate Bond / Debenture:

A debenture is a debt security issued by a corporation that may or may not be secured
by specific assets, but rather by the general credit of the corporation. Corporate
treasury use this as a tool to raise medium / long-term funds that becomes a part of
their capital structure. But unlike a debenture, corporate bonds are a form of loans,
secured by stated assets, and are typically issued by financial institutions, government
undertakings and large companies. These two terms are used interchangeably in Indian
debt market.
A Corporate Bond / Debenture are debt security issued by a private company,
which offers to pay interest in lieu of the money borrowed for a certain period. In
essence, it represents a loan taken by the issuer who pays an agreed rate of interest
during the lifetime of the instrument and repays the principal normally, unless
otherwise agreed, on maturity.
These are debt instruments issued by private sector companies, with maturities
mostly ranging between 1 to 10 years. Long maturity bonds/debentures are rarely
issued, as investors are not comfortable with such maturities, especially in order to
avoid the credit risk involved in corporate bonds. Generally, corporate
bonds/debentures are less liquid as compared to PSU bonds and the liquidity is
inversely proportional to the residual maturity. Debenture gives the investors dual
benefit of adequate security and good returns. Debentures are transferrable
instruments and may be transferred from one party to another by using transfer form.
Debentures are not negotiable and are issued in physical and dematerialised form.

1.3. ix Commercial Papers & Certificate of Deposits:

Commercial Papers (CPs) are short term debt instruments, issued by non-bank entities
like manufacturing companies, NBFCs and primary dealers etc. It is a popular
instrument for financing working capital requirements of companies, and can be issued
either in the form of Promissory Note or in a dematerialized form through any of the
depositories approved by and registered with the SEBI. Similar to Treasury Bills, CPs
can be issued for a minimum period of 7 days and maximum period of 1 year, at a
discount to face value and redeemable at par to the holder on their maturity. CPs must
be issued by private placement only, with a minimum size of Rs. 5 lakhs and in the
multiples of Rs. 5 lakhs thereafter. All CPs in India need to have a minimum credit rating
provided by the external rating agencies.
On the other hand, Certificate of Deposits (CDs) are short-term instruments,
essentially issued by the commercial banks and Special Financial Institutions (SFIs), and
can be issued to individuals, co-operatives and companies. CDs are freely transferable

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from one party to another. Similar to T-Bills and CPs, maturity period of CDs ranges
from 91 days to one year. Banks after issuing CDs, cannot buy-back their own CDs
before the maturity date. Banks are allowed to issue CDs at floating rate, provided the
methodology of computing the floating rate is objective and transparent and market
based, where the issuing bank/FI are free to determine the discount/coupon rate.
Banks have to maintain SLR and CRR on the issue price of CDs.

1.4 Regulatory Classification of Debt Instruments (in India)

As per RBI norms, debt instruments in available in India can be categorized as (A) SLR
Approved securities, and (B) Non-SLR securities. SLR Securities comprises of: Dated
Securities issued by the Central Govt. (i.e. G-Sec.) and State Govt. (SDL), Treasury Bills
issued by the Central Govt., and Other Approved Securities (OAS). RBI fixes SLR
(statutory liquidity ratio) from time to time – currently (July 2017) it is at 20%. RBI
requires banks to maintain 20% of their Net Demand and Time Liabilities (NDTL) which
is to be maintained on daily basis by investment in cash (other than CRR) and in the
prescribed securities. These securities are approved securities for SLR purposes under
section 24 of the Banking Regulation Act, 1949, and Indian Trust Act, 1882 and are
issued under Public Debt Act, 1944.

1.4. i SLR Securities:

Statutory Liquidity Ratio refers to the amount that the commercial banks require
to maintain in the form of gold or govt. approved securities before providing credit to
the customers. SLR is determined and maintained by the Reserve Bank of India in order
to control the expansion of bank credit, to ensure the solvency of commercial banks, to
compel the commercial banks to invest in government securities like government
bonds, and is determined as percentage of Net Demand and Time Liabilities (NDTL). The
minimum limit of SLR is presently 20% of NDTL. However the average limit maintained
by the banks in India is significantly higher than the statutory requirement, may be
more than 25 percent of NDTL. If any Indian bank fails to maintain the required level of
Statutory Liquidity Ratio, then it becomes liable to pay penalty to Reserve Bank of India.
The defaulter bank pays penal interest at the rate of 3% per annum above the Bank
Rate, on the shortfall amount for that particular day. However on account of default
continuing to the next succeeding working day (s), the penalty rate may be increased to
a rate of 5 percent per annum above the Bank Rate for the concerned days of default on
the shortfall. The RBI can increase the SLR to contain inflation, suck liquidity in the
market, to tighten the measure to safeguard customers’ money, or vice versa.

1.4. ii Non-SLR Securities:

Indian banks, as an institutional investor in the financial market, targeted to earn

reasonable return within a tolerable level of risk, and to create an well diversified
portfolio, makes their Treasury investments not only in SLR approved securities, but
also in another range of securities available in the market, subjected to fulfilling some

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regulatory norms as set by the central bank (RBI). Any investments made by banks in
India, other than in SLR approved securities, are classified as Non-SLR Securities which
comprises of: Non-SLR Govt. (Central and State) securities, Debentures and Bonds of
PSUs, Corporate Bond and Debentures, Floating Rate Bonds, Equity and Preference
shares, Mutual Funds and Venture Capital Funds, Post Office Deposits schemes, etc.
Banks are free to invest in such securities, but should undertake the usual due diligence
in respect of investments in non-SLR instruments.
Banks can invest both in listed and non-listed securities, subjected to the
specified norms. Board of Directors of banks should fix a prudential limit for their total
investment in non-SLR securities and several sub-limits in different classes of Non-SLR
investments. The total investment in un-listed securities and securities issued by SPVs
for Mortgage Backed Securities (MBS) and securitized papers issued for infrastructure
projects should not exceed 20 per cent of the banks total non-SLR investment as on
March 31, of the previous year, with a sub-ceiling of 10 per cent for investments
covered under unlisted securities. Banks must not invest in unrated debt securities.
Debt securities should carry a credit rating of not less than investment grade from a
Credit Rating Agency registered with the SEBI.

Self-Learning Exercise

1. Even if Equity and Bond are two important financial market instruments, both are
significantly different from each other. Explain.
2. How special dated securities, issued by the Govt. (Central and State), without SLR
status, are different from the normal securities issued by them but with SLR
status?
3. How a corporate in the domestic market can meet his financing requirement
through foreign debt market? Explain the possible channel/instruments
highlighting their advantages and limitations.
4. Why banks or other financial institutions, like insurance companies, requires fixed
income portfolio?
5. Describe the basic features of a bond and how these features makes the bonds
different from each other.
6. Suppose that coupon reset formula for a floating-rate bond is: 1-month LIBOR +
100 basis points, payable semi-annually. (a) What is the reference rate? (b) What
is the Quoted Margin? (c) Suppose that on coupon reset date that 1-month LIBOR
is 2.8%. What will the coupon rate be for the period?
7. What could be the common options embedded in a bond issue? Explain the
importance of embedded options and identify whether the option benefits the
issuer or the bond holder.

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References:

v Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 1, 3,

13, 16); McGraw-Hill.
v A V Rajwade, 2008; Handbook on Debt Securities and Interest Rate Derivatives
(Chapter: 1, 3, 4, 5); Tata McGraw-Hill.
v Sundaresan, Suresh M, 2002, Fixed Income Markets and their Derivatives
(Chapter:1, 3, 4, 6); Thomson Asia, Singapore.
v Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 5, 14); Butterworth-Heinemann.
v Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 1, 2); NIBM In-house Publication.
v IDMD-Reserve Bank of India, 2015; Government Securities Market: A Primer; RBI
Publication.
v Roy Debjyoti, 2014; Government Securities Market: A Study of the Microstructure,
Mechanism and Constituent Products; Monthly Newsletter, CCIL.
v National Stock Exchange of India Ltd., 2015; Indian Securities Market: A Review;
NSE Publication.

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Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 2: Risk and Return Measures

Dr. Kedar nath Mukherjee

Objectives:

The objective of this chapter is to make the readers aware about different types of risk
that a fixed income portfolio manager is exposed to for investing in various fixed income
securities/instruments, and various possible measures to estimate the returns from
such investments. This chapter is expected to enable the readers to answer the
following questions:
i. What are the different types of risk involved in fixed income investment?
ii. How to capture risks in individual security and for the portfolio?
iii. What are the different measures to calculate returns from such investment?
iv. How to estimate security-wise and portfolio returns?

Structure:
1. Risk and Return in Bonds: Meaning and Linkages
2. Risks Associated with Fixed Income Securities
2.1. Interest Rate Risk
2.2. Reinvestment Risk
2.3. Yield curve risk
2.4. Liquidity Risk
2.5. Call Risk (Timing Risk)
2.6. Credit Risk
2.7. Legal Risk
2.8. Foreign Exchange Risk
2.9. Volatility Risk
2.10. Sovereign risk (country risk, political risk)
3. Return Measures for Fixed Income Securities

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3.1. Nominal Return

3.2. Current Yield (CY)
3.3. Yield to Maturity (YTM)
3.4. Return till Call (Put) Date (YTC / YTP)
3.5. Yield to Worst (Best) (YTW / YTB); Holding Period Yield;
3.6. Total Return (TR); Portfolio Yield

1. Risk and Return in Bonds: Meaning and Linkages

Bonds are an important component of most investment portfolios, especially for

institutional investors. Bonds reduce the overall risk of a portfolio by introducing
diversity. Bonds produce steady current income—income that investors receive, say in
every quarter /six months. This steady stream of income is important to some investors,
depending on their current needs. Bonds are low-risk investments than stocks; may be
at the cost of lower returns. Attractiveness of bond investment largely depends upon
the future movement of interest rates. Bonds are attractive options when the market
anticipates interest rates to fall. As interest rates fall, bond value rises, giving a positive
return to the investor. The main sources of return from a bond are: regular
(Annual/Semi-annual) coupon income, re-investment income (i.e. interest on coupon
received), and bond’s price appreciation (if any). Even if the coupon rate, the major
source of return from a bond, is fixed in a fixed-rate bond, there may be several risk
factors causing different levels of variation in the returns from a bond. Alternatively,
bonds are susceptible to a number of risks, depending on the nature of the bond issue.
Like other investment opportunity in the financial market, the Risk-Return linkage is
also applicable in bond investment. If an investor wants to earn higher return, he has to
compromise with some risk factor (s), such as credit risk, interest rate risk, liquidity
risk, etc. There can be different measures available to capture the risk and return from
individual bonds or a portfolio of bonds.

2. Risks Associated with Fixed Income Securities

Investment in any financial asset generates a return subject to some uncertainty. This
uncertainty may be favourable or unfavourable to an investor. Any uncertainty if causes
any kind of financial losses for the investor is termed as Risk in general, and Financial
Risk in particular. In other words, Risk refers to the Chance of Financial Losses due to
unforeseen or random changes in underlying Risk Factors. Since the goal of investing is
to get the best return possible from the investment, investment risk is the possibility
that the investor will get back less than his investment or his expected return, or that he
will get less than what he could have had if he had invested his money elsewhere,

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commonly known as opportunity costs. Even if investment in fixed income securities

like bond generates a fixed income for the investor, such investments are also exposed
to several risk factors and may cause different degree of financial losses for the investor.
Some of such important risk factors are discussed in the following section:

2.2. i Interest Rate Risk:

Since the value of a bond at any point of time is nothing but the present value (PV) of all
the future cash flows due on the bond, and the PVs of future cash flows are inversely
related with the existing rate of interests of different respective tenors, there is an
inverse relation between the price of a bond and the rate of interest. These lead bond
investors to be exposed to interest rate risk. Alternatively, in the event of rise in interest
rate (s), the price of a bond decreases and the investor has to face a capital loss, leading
to the Interest Rate Risk. Risk of a certain fall in the price of a fixed income security only
due to a possible rise in interest rate is specifically called as the Price Risk. Change in
interest rate also lead to another type of risk in bond investment, and is known as
reinvestment risk, as disused in the next section. There is a possible trade-off between
the price risk and reinvestment risk, arise due to change in interest rates.
Suppose an investor has bought 06.79 GS 2029, a bond issued by the
Government of India, paying a coupon of 6.79 percent per annum, maturing in 2029, at
Par value at a Coupon rate of 6.79%. Now suppose, the market Interest Rate has gone up
by 21 basis, from 6.79% to 7.00% and the investor want to sell the bond where the
coupon rate would be same 6.79%. Since the bond is selling at Par, nobody would like to
buy the bond at Par with a coupon rate of 6.79%, where the market interest rate is
7.00%. Here neither the investor can change the Coupon rate nor can he change the
actual maturity of the bond so that the same would be saleable in the market. Here what
the bond seller can do is to reduce the bond price so that the amount of coupon received
on the bond at the bond’s par value would be equal to the amount based on the new or
revised interest rate on the new or revised price, so that without changing the original
coupon rate, the current market rate can be offered to the prospect buyer of the bond.
The magnitude of interest rate risk largely depends upon the features of a bond
issue, such as: Maturity, Coupon Rate, Coupon Payment Frequency, Yield, presence of
Options, etc. In case of floating rate bond, even if the coupon rates are adjusted with the
prevailing market rates in every coupon reset dates, the value of such bond is exposed
to interest rate fluctuation during two coupon reset dates. Interest rate risk of a bond
can be captured through different measures, such as: Macaulay Duration, Modified
Duration (MD), Effective Duration, Key Rate Duration, Price Value Basis Points (PVBP or
PV01), and Convexity.

2.2. ii Reinvestment Risk:

Reinvestment Risk is based on the assumption that interim cash flows from a fixed-
income security are reinvested at every interval, so that further interest can be earned

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on interest. But if the investor fails to reinvest the periodic coupons at a predetermined
rate, the actual Yield from the bond up to its maturity will be different than whatever
expected. For example, an investor bought a Central Govt. security 6.79 GS 2027 with a
face value of INR 10 crore, having an annual coupon of 6.79%. Every year, the investor
receives INR 67.90 lacs (6.79% × INR 10 Crore). This amount can be reinvested back
into another bond. But if over time the market rate suddenly falls to 6%, then INR 67.90
Lacs received from the bond can only be reinvested at 6%, instead of the 6.79% rate of
the original bond. This risk is contrary to interest rate risk, because when interest rates
rise, interest rate risk increases, but reinvestment risk declines. Alternatively, due to
rise in interest rates, there will be a fall in the price of a security, but the investors can
be in a position to reinvest their interim cash flows at a higher rate and thereby can
earn some gain, termed as reinvestment gain. Similarly, in the event of a sudden fall in
the interest rates, future values of interim cash flows may decline, leading to a risk in
the investment, called Reinvestment Risk. Since there is no interim coupon payment in
case of zero coupon bonds, such instrument do not have any reinvestment risk. How
severe is the reinvestment risk for a fixed coupon bond largely depends upon the
maturity and the coupon rate of the bond. The longer the maturity of a bond, higher will
be the likelihood that interest rates will be lower for the remaining maturity, and
therefore severe would be the impact. On the other hand, the higher the coupon rate of a
bond, bigger will be the coupon payments to be reinvested at a lower rate, leading to a
bigger loss due to fall in interest rates.

2.2. iii Yield Curve Risk:

Maturity of a bond is one of the important factors for its Price Sensitivity due to change
in the interest rate or the Yield. Therefore the value of a Portfolio of bonds with
different maturities depends on how the value of individual bonds with different
maturity periods changes following the change in interest rates. The rate of interest or
the Yield of different bonds varies according to their respective maturities, as may be
depicted by the yield curve. The Graphical relation between the Yield and Maturity of
different bonds is known as Yield Curve. It is basically assume that in the scenario of
changing interest rate, the yield of different bond with different maturities changes by
similar basis points, commonly known as Parallel Shift in the Yield Curve. But in real
market condition, when there is any change in the rate of interest, even if all the rates
change in a similar direction, the magnitude of change is not necessarily be same for all
bonds with different maturities, which can be represented by a Nonparallel Shift in the
Yield Curve.

For example, in India, if the 10-Year risk-free rate or base yield (i.e. yield on 10-Year GOI
bond) changes by 50 basis points, yields of all other maturities are expected to
experience a positive change, but need not to be exactly 50 bps. As a result, the risk-free
yield curve will shift upward, but need not be shifted upward parallel by 50 bps. Due to
nonparallel shift, yield curve may become more Flatter or more Steeper. If the yield

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curve flattens, then the yield spread between long- and short-term interest rates
narrows. On the other hand, steepening the yield curve represents widening the spread
between long- and short-term interest rates. The price sensitivity of the whole bond
portfolio, in the event of change in the interest rates, largely depends on market
expectation towards the type of shifts in the yield curve. Accordingly, a portfolio
consisting of few short term securities and some long term securities, and in a situation
where short-term rates increases more than the rise in long-term rates, i.e. in the event
of flattening the yield curve, the fall in the value of long-term securities may be less than
the losses incurred in short-term securities, finally affecting the portfolio loss. Because
of these unequal changes in the interest rates of different tenors, a portfolio manager
may fails to capture the actual loss in his bond portfolio, assuming a parallel shift in the
yield curve, causing a risk for the institution. Interest rate sensitivity measures, e.g.
Modified Duration and PVBP/PV01, even if captures how sensitive is the bond portfolio
to a future change in interest rates, these measure are based on the assumption of
parallel shift in the yield curve. Therefore, bond investors, who invest in several bonds
throughout the maturity segment, and captures interest rate risk through the aforesaid
measures, are exposed to another risk, called Yield Curve Risk.

2.2. iv Liquidity Risk:

If an investor doesn’t want to hold a bond till its maturity and intend to sell the same in
between, he is concerned whether the market is liquid enough to offer him a right/fair
price. Market liquidity can be measured through number of dealers, size of bid-offer
spreads, market depth, etc. Alternatively, Liquidity refers to the ease with which a
reasonable size of a security can be transacted in the market within a short notice,
without adverse price reaction. Liquidity Risk is the risk that the investor may have to
sell his bond at a price which is actually lower than its true market price based on the
prevailing interest rate. The liquidity risk can be measured by capturing the size of the
Spread between the Bid Price (the Price which a buyer is willing to pay) and the Ask
Price (the Price which the seller intends to receive). The wider the Bid-Ask Spread, the
greater would be the Liquidity Risk. One measure of liquidity risk in the Govt. debt
market can also be the difference between the volume of trading of newly issued on-the-
run security and the volume of trading when the issue becomes old, called as off the run.
But such measure can be applied only when new securities of very similar maturity are
issued in the market, leading to make both on-the-run and off-the-run security of
similar maturity available in the market. Liquidity risk is an important concern for bond
investors or traders, especially if the underlying bond market does not experience
sufficient number and volume of trading on a regular basis. A player in the fixed income
securities market needs to fix the extent of liquidity premium for all illiquid securities,
in order to undertake any trading on the same, or to calculate how much worthy are
those security under such illiquid market condition. Market players, especially in
illiquid market like in India, face a very significant challenge not only to capture the
liquidity risk even in case of Govt. securities, but also to price the same. Two similar

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bonds with similar maturity, but with different degree of liquidity, are expected to be
priced differently. Future cash flows of the bond with lesser liquidity are subjected to be
discounted at a higher interest rate due to the presence of illiquidity premium, leading
the bond to be traded at a lower price.

2.2. v Call Risk (Timing Risk):

A coupon bond can be issued with a provision of Early Settlement before its scheduled
maturity. In case of a Callable bond, the issuer can call back the bond when the Interest
rate of similar bond available in the market falls below the coupon rate applicable to the
original bond. Therefore, the cash flow pattern of a callable bond is Uncertain because it
is not known to the investor when the bond will be called. If the bond is called due to a
fall in the interest rate and accordingly the coupon rate, the investor has to reinvest his
proceeding at a lower rate comparative to the original rate of interest and is therefore
exposed to Reinvestment Risk. At the same time, the potential for Price Appreciation, due
to fall in the interest rate, will also be lower comparative to a similar but option-free
bond. This will lead to insufficient capital gain for the investor because of Price
Compression occurred due to the embedded option. This Reinvestment Risk and the Risk
of Price Compression can be treated as the Call Risk which is present only in those
bonds with embedded call option.

2.2. vi Credit Risk:

Since Govt. of India cannot be expected to default on its promised payments of coupons
and the principal amount against the Central Govt. securities, these securities do not
carry any credit risk. However, there are bonds issued by various Non-Govt. entities that
carry a significant amount of counterparty/credit risk, in terms of inability to service all
or some of the promised obligations, depending upon their credit worthiness that may
change due to financial distress, reorganization, workouts, or bankruptcy.

When an investor buys some bond from a bond issuer other than the Government, he is
expected to be exposed to some credit risk based on the credit worthiness of the issuer.
The major types of credit risk are – Default Risk, Downgrade Risk, and Credit Spread
Risk. Default Risk can be defined as the risk that the issuer will fail to satisfy the terms of
the obligation with respect to the payment of interest and principal on due time. Default
risk can actually be calculated not only by considering the rate of Default but also the
rate of Recovery out of total default. Downgrade Risk refers to the migration of credit
quality, as exhibited by the different grade of Credit Ratings provided by different
external Rating Agencies in the form of Transition Matrix, from Higher or Good rating to
Lower or Bad rating. Credit rating of a bond issue or an entity indicates the potential
default risk associated with a particular bond issue or the issuer. This rating migration
may lead to a fall in the market value of a bond. It is well known that the price of a bond
issue is inversely related with the yield of the bond which actually comprises of two
components – Yield on a Similar Default-free (e.g. Government) bond, and the Risk

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Premium above such yield to compensate the concerned risk associated with that bond.
This risk premium is alternatively known as the Yield Spread and the part of this yield
spread attributable to the default risk is known as the Credit Spread. Since credit spread
is an integral part of the yield of a Non-Govt. security, any change (e.g. increase) in such
spread will lead to increase in the yield, resulting to a fall in the value of the bond. This
expected decline in the value of a bond due to rise in credit spread is known as the
Credit Spread Risk.

For example, a 10-year AAA rated bond with a 7.50% coupon currently sells at
Rs.100/-. Suppose, the risk-free yield of similar tenor is 7.00% p.a., making a credit
spread of 50 basis points for AAA rated issues. Some investors may invest in the bond
because of its AAA rating, considering the highest level of safety. Suppose the revised
rating of the same security is now migrated to A. The risk-return ratio that was once
attractive to the current bondholders, will now become unattractive as the risk has
increased without any increase in returns. Even if the spread offered in such bond is
fixed at 50 bps (7.50% minus 7.00%), the market now expect a slightly higher spread
due to the down gradation of its credit quality. Suppose, the market expects a credit
spread of 1% for ‘A’ rated bonds, taking the yield level to 8.00% p.a. (risk-free yield of
7% plus a credit spread of 1%). In such case Holders of this bond, if prefers to sell the
bond in the market, will get a lower price, due to rise in yield expectation, caused by the
downward pressure, and therefore exposed to the credit risk.

2.2. vii Legal Risk:

Legal Risk is the risk that changes in the law may adversely affect the price of the bond.
Most legal risk is associated with the tax exemption of particular bonds, especially
infrastructure bond, municipal bonds, because these bonds are exempt from income tax.
However, if tax rates decline, the advantage of the tax exemption also declines, and
therefore the price of the bond in the secondary market as well. This is specifically
known as tax risk. The second type of legal risk occurs because tax-exempted securities
have to satisfy specific legal requirements, and if it is later determined that the security
does not satisfy these requirements, its tax-exemption status may be eliminated, which
would reduce not only the effective return of the bond after taxes, but it would reduce
the price of the bond in the secondary market as well, and therefore the concerned yield
would have to be equal with the taxable yield of other comparable bonds.

2.2. viii Foreign Exchange Risk:

If an investor holds a bond the cash flows of which are not denominated in domestic
currency, he is supposed to expose to the risk of unfavorable change in the foreign
exchange rate between the two currencies, known as Exchange-rate Risk or Currency
Risk. Though the amounts of cash flows, either coupons or principal, are certain in
foreign currency, they are uncertain in domestic currency and depend on the prevailing
exchange rate at the time of the cash flows. If the foreign currency depreciates at the

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time of cash flows, though the investor gets a fixed amount of payment in terms of
foreign currency, the amount of payment in terms of domestic currency would be less
than whatever expected. This risk of receiving less (in domestic currency), while
investing in any bond issue where payment is made in foreign currency, is represented
as Exchange-rate Risk.

2.2. ix Volatility Risk:

Volatility, not of bond’s price but of the yield of the bond, significantly affects the price
of a bond issued with some embedded options (Call or Put). The larger the yield
volatility, the higher would be the price for the call and put options, supposed to be
embedded with a bond issue. Since the price of a Callable (Putable) bond is equal to the
price of a similar option-free bond Minus (Plus) the price of the Call (Put) option, an
Increase (Decrease) in the yield volatility will lead to Rise (Fall) in the price of the Call
and Put option. Rise in yield volatility therefore lead to a simultaneous Fall (Rise) in the
price of the Callable (Putable) bond. This risk of price decline of a bond with embedded
option due to change in the yield volatility is known as Volatility Risk.

2.2. x Sovereign risk (country risk, political risk):

Sovereign Risk (Country Risk, Political Risk) is the risk associated with the laws of the
country, or to events that may occur there. Particular events that can hurt a bond are
the restriction of the flow of capital, taxation, and the nationalization of the issuer. A
particular form of sovereign risk is convertibility risk, which is the prohibition of the
exchange of the foreign currency for domestic currency. The only hope for an investor
in this situation is to accept local currency or wait until the rules change. Because many
countries, especially emerging countries, have inadequate laws regarding financial
disclosures or accounting rules, it may be difficult to assess the true creditworthiness of
the bond issuer. Disclosure risk results from this lack of disclosure about an issuer or
accounting rules that don't adequately reflect the true financial status of the issuer.
Even if an investment in a fixed income security like bond may be exposed to all
the above risks, Call Risk, Credit Risk, Volatility Risk, Foreign Exchange Risk, Sovereign
Risk are almost absent in case of any domestic securities issued by the Government.

3.0 Return Measures for Fixed Income Securities

Given the three important sources of potential return from a Fixed Income security,
such as Coupon Interest, Capital Gain (Loss), and Reinvestment Income, various yield
measures, expressed as a Percentage Return, can be applied based on a single or all of
the above potential sources. Accordingly, different return measures give different
information regarding the FI securities, at different possible scenarios. These measures
may reflect the return for an individual Fixed Income security or for the Portfolio of
various FI securities. Return can be calculated for a specific period (Monthly, Semi-

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Course: Treasury Management (Module II: Security Analysis and Portfolio Management) NIBM, Pune

annually, Annually), or for the Full Maturity / Holding Period. Different such return
measures include:

3. i Nominal Return / Coupon Rate (CR):

Nominal Return is nothing but the Rate of Interest promised to be paid by the bond
issuer to the bond holder over a span of time. Nominal Return is normally expressed at
annual basis, but can be expected to be due and received Annually, Semi-annually, or
Quarterly. In other words, Nominal Yield is the stated interest rate of the bond as the
percentage of bond’s par value. Nominal Return can be Positive or Zero, based on the
type of bond. In case of Zero-Coupon bond, there is no nominal return. For example, a
bond with a par value of Rs.100/- that pays 8% interest, pays Rs.8/- per year in 2 semi-
annual payments of Rs.4/- each. Nominal Return can be fixed throughout the maturity,
or can vary based on some Benchmark Rate, depending upon the nature of the security
(Fixed or Floating Rate Bond). In case of Floating rate bonds, coupon rate gets adjusted
at every Coupon Re-set Date. Coupon rate in a floating rate bond can be with or without
any contracted premium or Spread over the benchmark or reference rate. The Nominal
Yield is therefore calculated as:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡⁄

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑌𝑖𝑒𝑙𝑑 = 𝐵𝑜𝑛𝑑 ′ 𝑠 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒

3. ii Current Yield (CY):

Bonds after their issuance in the primary market get traded in the secondary market,
not necessarily at the par value, but may be traded at a price less or more than the par
value. Therefore, the return of an investor on a bond issue purchased from a secondary
market need not necessarily to be the nominal return. Investment in secondary market
may yield an interest rate that is different from the nominal yield, called the Current
Yield, or current return. Movement of such yield measure depends on the movement in
the market price of the concerned security, such that:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡⁄

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = 𝐵𝑜𝑛𝑑′ 𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

Even if nominal yield of a fixed rate bond is fixed throughout its maturity, the current
yield may be extremely volatile, depending on the price volatility of the concerned bond
issue. If a bond is traded at its par value, then the current yield will be equal to the
nominal yield. Larger the difference between the current market price of a bond and its
par value, wider would be the difference between the nominal and current yield, such
that:

 In case a bond is traded at a Discount, => Current Yield > Nominal Yield
 In case a bond is traded at a Premium, => Current Yield < Nominal Yield

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Current yield is important and is required to be considered along with the nominal
return of a bond issue, especially in case of fixed rate bond, in order to get the current
market condition reflected in the bond price, enabling investors to take their investment
decision based on their preference.
Example:
Suppose a 10% coupon bond with a face value of Rs.100/- is currently traded at Rs.95/-.
In such case, even if the nominal yield is 10%, the current yield of the bond is 10.53%
(Rs.10 / Rs.95). Similarly, if the bond is traded at a premium, e.g. at Rs.105/-, the
current yield would be 9.52% (Rs.10 / Rs.105). If the bond is still traded at its par value,
i.e. at Rs.100/-, there won’t be any difference between the nominal and current yield.

3. iii Average Return or Yield to Maturity (YTM):

YTM of a bond is the average rate of return that an investor earns from his investment
in that bond if the same is hold till its maturity. YTM can also be treated as the Internal
Rate of Return (IRR) or the Hurdle Rate of Return required to sale the bond at its ruling
market price. Even if the nominal and current yields consider only one source of
income, i.e. the coupon income, to estimate the return from a bond, the YTM takes into
consideration all the possible sources of income from a bond issue. YTM assumes that
bonds are hold till maturity and interest receipts are reinvested at the same rate.
Technically, YTM is that single Discounting Rate that makes the sum of present values of
all future cash flows due from a security till its maturity equal with the current market
price. Accordingly, once a security is traded, its market price, along with the amount and
timing of its interim cash flows due till the maturity may be used to extract the Yield to
Maturity of that security. Alternatively, if the YTM of a security on a given date is known,
the price of that security can be estimated.
Example:
Suppose, a GOI bond (7.28 GS 2019), offering an annual coupon of 7.28 percent, payable
semi-annually, maturing on June 03 2019, is currently (on July 11 2017) traded at a
price of INR 101.6300/-. The market may like to know the YTM or the IRR of that
security, for being traded at the ruling market price (i.e. at Rs.101.6300/-).
Yield to Maturity of a bond may be estimated through different approaches or methods.
It can be solved manually (in MS Excel) through the bond pricing structure following a
discounted future cash flow methods, either by a trial-and-error process, or with the
help of some Excel optimization technique (e.g. Goal Seek or Solver), or may be by using
a pre-specified financial function available in MS Excel.
Given the Settlement and Maturity Date for the security, the Residual Maturity of the
given security is estimated as 1.8944 years or 3.7899 semi-annual periods. Therefore,
there will be four semi-annual cash flows due in that security till the maturity. First

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three will be the semi-annual coupon, followed by the last and final semi-annual coupon
plus the principal redemption due at maturity.
Considering the settlement date, maturity date, day count convention used, the actual
due dates for all the four future cash flows may be estimated, which can further be used
while discounting the future CFs, at an unknown interest rate known as YTM, as shown
below:

Semi-annual Semi-annual Yield to Discounted CF

Period Cash Flows Maturity [DCF =
(t) (CF) (YTM) CF/(1+YTM/2)^t]
0.7889 3.64 6.3478% 3.5514
1.7889 3.64 6.3478% 3.4421
2.7889 3.64 6.3478% 3.3362
3.7889 103.64 6.3478% 92.0688
Dirty Price ∑ DCF 102.3985
Clean Price = ∑ DCF - AI 101.6301

The first and second column of the above table is known and the sum of the DCF (i.e. the
dirty price) minus the Accrued Interest (i.e. the market price) is also known. Therefore,
the single unknown (i.e. YTM), to be used to discount all the cash flows may be
estimated, by using the Excel optimization with the following details:
Objective Function : Sum of DCF (i.e. Dirty Price) - Accrued Interest = Market Price (i.e.
Clean Price) = ∑ DCF - 0.7684 = 101.6300
Changing Parameter : YTM
Accordingly YTM may be estimated, with a close approximation, following a detail
process. The YTM arrived at through this process is 6.3478% per annum.
At the same time, YTM may also be extracted from the price date with the help of a
single Excel function, given below:
=YIELD (Settlement, Maturity, Rate, Price, Redemption, Frequency, [Basis])
Providing details about the above required parameters, such as Settlement Date (=July
11 2017), Maturity Date (= June 03 2019), Coupon Rate (7.28%), Market Price (=
Rs.101.63/-), Redemption Value (Rs.100/-), Coupon Payment Frequency (= 2), and Day
Count Convention, represented as “Basis” (= 4, to represent 30/36 convention), the YTM
of a security may be directly estimated through the MS Excel function “YIELD”. The YTM
of the above security, extracted by using the Excel function is 6.3479%, which is very
close to the YTM estimated above, similar till the first three decimals.
Yield to Maturity of a portfolio of securities may be estimated as the weighted average
YTM of all the securities in the portfolio. Weights to be assigned with the security-wise

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YTM are nothing but the market value of position in individual security divided by the
market value of the whole portfolio. Therefore the YTM of a portfolio, consisting of ‘i'
number of securities is defined as:
𝑀𝑉𝑆1 𝑀𝑉𝑆2 𝑀𝑉𝑆𝑖
𝑌𝑇𝑀𝑃 = (𝑌𝑇𝑀𝑆1 × ⁄𝑀𝑉 ) + (𝑌𝑇𝑀𝑆2 × ⁄𝑀𝑉 ) +. . . . . . + (𝑌𝑇𝑀𝑆𝑖 × ⁄𝑀𝑉 )
𝑃 𝑃 𝑃

When a bond is bought at a discount, yield to maturity will always be greater

than the current yield because there will be a gain when the bond matures, and the
bondholder receives par value back, thus raising the true yield; when a bond is bought
at a premium, the yield to maturity will always be less than the current yield because
there will be a loss when par value is received, which lowers the true yield. Interrelation
between Different Yield Measures and Trading Price of a bond is such that:

Price of Bond Relationship

Bond Traded at Par CR = CY = YTM

Bond Traded at Discount CR < CY < YTM
Bond Traded at Premium CR > CY > YTM

3. iv Return till the Call (Put) Date (YTC / YTP):

Yield to Call (YTC) or Yield to Put (YTP) is applicable only to Callable (Putable) bonds.
YTC (YTP) is the Rate of Interest that equate the PV of all the Interim cash flows,
expected to be received till the possible call (put) date, and its Call (Put) price received
when the bond is Buy-back (Sell-off). Alternatively, YTC (YTP) is the yield that will make
the present value of the cash flows up to concerned (First / Second / Last) call (put)
date equal to the current market price of the bond. Cash flows can be considered till the
first call (put) date if the bond is assumed to be hold only till the first call (put) date. YTC
(or YTP) and YTM differ only due to the difference in holding period. Just like YTM,
these are also measures of Internal Rate of Return (IRR), but are calculated for each of
the Possible Call (Put) Dates when the bond is expected to be Buy-back (Sell-off). Yield
to First Call (Yield to First Put) is the YTC (YTP) at the Earliest possible date when the
bond is Buy-back (Sell-off). There can be as many numbers of YTCs or YTPs as the total
number of possible dates when the Issuer (Holder) is allowed to exercise his Call (Put)
option. In short, YTC or YTP are nothing but the bond’s YTM after reducing the maturity
to the possible call or Put date, and after converting the bond’s par value to the call
(put) price of the bond, as agreed upon in the bond, and provided in the Call (Put)
Schedule.
Example:
Suppose, a 5-Year 10% annual coupon payment Treasury callable bond, with a call (at
the first call date) price of Rs.105/-, and with the first call date after a lock-in period of 2
years is traded at a market price of 103. What would be the Yield to First Call? As
discussed above, YTFC is nothing but the YTM of the bond after adjusting the bond’s

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maturity to 2 years (i.e. reducing bond’s actual maturity to the first call date) and the
redemption value to Rs.105/- (instead of the par value as in the case of an option-free
bond due at maturity). Therefore the YTFC is such that:

103 = {10 / (1+YTFC)^1} + {(10+105) / (1+YTFC)^2}; => YTFC = 10.63%

Similarly, the YTC for all possible call dates can be calculated by increasing the bond’s
maturity to that date and by altering the redemption value to the call price of the bond
at the respective call date.

3. v Yield to Worst (YTW) and Yield to Best (YTB):

Besides YTM, an investor can also calculate the Yield measures for all the possible Call
(Put) dates till the maturity. Given a specific YTM and all possible YTCs (YTPs) for
Callable (Putable) bond at the respective Call (Put) price of the bond, the investor can
find out the Worst or Best return that can be generated from such investment. Lowest
(Highest) of the YTM and all the YTCs (YTPs) is known as the Worst (Best) Return or
Yield to Worst (Yield to Best). Holder of a Callable (Putable) bond, in the event of Falling
(Rising) market interest rates of concerned tenor, can generate the YTW (YTB) if the
Call (Put) option is exercised in the first Call (Put) date. Therefore, YTW in case of
callable bond is supposed to be the Yield to First Call (YTFC), and YTB in case of a
putable bond is also supposed to be the Yield to First Put (YTFP). YTW can be treated as
the minimum possible yield that an investor will definitely earn from a callable bond at
any possible circumstances. Similarly, YTB is the maximum possible yield that an
investor is expected to earn from a putable bond, if the put option is exercised in the
right time.

3. vi Total Return (TR):

Even if there are different return measures used by different types of players
involved in the bond market, an investor in order to calculate the actual and
comprehensive return from a fixed income security, need to be concerned towards the
following:

o The Return should be generated with Certainty

o The Return measure should consider all possible cash flows (CFs) during the
Holding, not necessarily the Maturity, period of the security
o Return measure should undertake the Actual Rate (s), not some Assumed rate, at
which the interim CFs can be reinvested
o Return measure should also consider the Actual Capital Gain (Loss) expected to
be released from the sale of security at the end of the investment horizon (IH), if
falls before the maturity.

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Total Return represents the overall return actually generated from a security or
portfolio of securities. Total Return measure is linked with the actual Investment
horizon, not the Maturity of the security, and therefore alternatively known as Holding
Period Return. It is the Rate of Interest that makes the bond's current price equal to the
total projected value of the security at the end of the investment horizon. TR largely
depends on Investment Horizon, Actual Reinvestment Rate, and bond’s expected selling
price at the end of the time horizon, such that:
Semi-annual TR = [ { ( Total Projected Amount at the End of IH / Bond's Purchase Price ) ^
( 1 / Total Semi-annual Period within IH ) } – 1 ]
Total projected amount expected to be generated at the end of the IH is the sum
of coupon cum interest on coupon and projected Selling Price of the bond at the end of
the IH. Accordingly, Annual TR (Bond-equivalent basis) = Semi-annual TR × 2.
Example:
Suppose, an investor, as on July 2 2017, is holding a Govt. security (6.35 GS 2020),
maturing on 2-Jan-2020, currently traded at INR 99.7550/-. Suppose, the investor may
like to hold the security for next 1.5 years.
Compute the Total Return or Holding Period Return from the specified security,
assuming that the investor reinvests all his semi-annual coupons, received till the
holding period, at the same YTM, prevailed today.
Suppose, the FIMMDA-PDAI GOI Base Yields, till a period of 5 years, as on the given date
are:
Maturity 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
YTM 6.32 6.34 6.32 6.33 6.43 6.53 6.57 6.58 6.57 6.57

From the given data, the following details can be observed or estimated:

Settlement Date 2-Jul-2017

Maturity Date 2-Jan-2020
Coupon 6.35%
Market Price 99.7550
YTM (Estimated in MS Excel) 6.4577%
Res. Mat. 2.5000
No. of CFs 5

Holding Period (Yrs.) 1.5

Details of the Bond at the End of the Holding Period:
Settlement Date 2-Jan-2019
Maturity Date 2-Jan-2020

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Res. Mat. 1.0000

Coupon 6.35%
Estimation of 1-Year Forward Rate after 1.5 Year:
Year YTM
1.50 6.3189%
2.50 6.4290%
FR (1.5 Y, 2.5 Y) 6.5943%
Bond Price after 1.5 Year 99.7672
Cash Flows Till the Holding Period:
Coupon Income 9.5250
Future Value of All Coupon 9.8359
Bond Selling Price after 1.5
Year 99.7672

Considering all possible cash flows (Inflows and Outflows) till the holding period, the
Holding Period Return or Total Return, as shown in the previous section, can be
estimated. Accordingly, the Annual Return can be estimated as:
Annual Holding Period Return = [ { ( Total Projected Amount at the End of IH / Bond's
Purchase Price ) ^ ( 1 / Total Semi-annual Period within IH ) } – 1 ] × 2
= [ { ( 9.8359 + 99.7672) / 99.7550 } ^ { 1 / (1.5 × 2 ) } – 1 ] × 2 = 6.3761%

Total Return of a Portfolio of various Fixed Income securities can be calculated

differently depending on two possible circumstances:
 When the Investment Horizon (IH) for all securities are Equal
 When different securities are expected to hold for different periods
If the IH for all the securities are equal, then the semi-annual TR can be calculated on
Aggregate Basis, such that:
Portfolio TR = [ { ( Total Projected Amount for all securities at the End of IH / Purchase
Price of the Portfolio ) ^ ( 1 / Total Semi-annual Period within IH ) } – 1 ]
In case of different IH, Portfolio TR can be the weighted Avg. of Total Return of
individual securities. Respective weight could be the market value of total position in
individual security w.r.t. the market value of the total portfolio.

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Self-Learning Exercise:

1. How change in interest rates affect investment in any bond?

2. Explain the interest rate risk of a floating rate security and why such security’s
price differ from par value
3. How a fixed coupon bond and a zero coupon bond are different to an investor in
terms of interest rate risk (if any), even if both the bonds are expected to hold till
the maturity?
4. What is Liquidity Risk, even in a Govt. Security?
5. Why call risk is very common in Corporate Bonds?
6. How a bank, investing in Govt. securities with different maturities, may be exposed
to Yield Curve Risk?
7. How Internal Rate of Return (IRR) and Yield to Maturity (YTM) are similar, in the
context of bond market?
8. How to arrive at the Bond Portfolio YTM using the yield information of various
securities in the portfolio. Explain with an example.
9. What are Yield-to-Worst and Yield-to-Best? Are these yield measures useful to
bond investors?
10. What is Holding-period Return and how the same is different from the YTM?

References:

 Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 2, 5);
McGraw-Hill.
 Sundaresan, Suresh M, 2002, Fixed Income Markets and their Derivatives
(Chapter: 2); Thomson Asia, Singapore.
 Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 4); Butterworth-Heinemann.
 Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 2); Wiley Finance.
 Bruce Tuckman, 2002; Fixed Income Securities: Tools for Today's Markets
(Chapter: 3); John Wiley & Sons, Inc.
 Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 3, 4); NIBM In-house Publication.

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Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 3: Term Structure of Interest Rates

Dr. Kedar nath Mukherjee

Objectives:

The objective of this chapter is to make the readers aware about different concepts of
interest rates used in fixed income securities market; construction and analysis of term
structure of such interest rates; and different theories explaining the interest rate term
structures. At the end of this chapter, the readers are expected to be familiar with:
i. What are the different concepts of interest rates in the context of fixed income
securities market?
ii. What are the major factors determining the yield or interest rates on debt
securities?
iii. How Yield to Maturity (YTM), Spot Rates, Forward Rates are extracted from the
available market information?
iv. How to construct term structure of various rates: Yield Curve, Zero Coupon
Yield/ Spot Rate Curve, and Forward Rate Curve using different methods?
v. What are the important theories deriving the term structure of interest rates?

Structure:
1. Interest Rates: Meaning and Different Types
2. Some Important Interest Rates in Indian Debt Market
2.1. Benchmark Rate
2.2. G-Sec. Yield
2.3. T-Bill Rate
2.4. Swap Rate
3. Major Determinants of Rate of Interest
4. Term Structure of Interest Rates: Different Types
4.1. Yield Curve

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4.2. Spot Rate Curve

4.3. Forward Rate Curve
4.4. Credit Spread
5. Theories of Interest Rate Term Structure

5.1. Expectations Theory

5.2. Liquidity Preference Theory
5.3. Market Segmentation Theory
5.4. Preferred Habitat Theory

1.0 Interest Rates: Meaning and Different Types

Interest Rate is the rate which is charged or paid for the use of money, and is expressed
as an annual percentage of the principal. From an investor’s perspective, interest rate is
the annual return which he generates from his investment. Interest rate can be of two
types: Nominal and Real Interest Rates. Nominal Interest Rates are normally positive,
but real interest Rate can be negative, depending upon the economic situation,
especially rate of inflation. Interest Rate may change because of several factors; such as:
Inflationary Expectations, Alternative Investments, Risk of Investment, Liquidity
Preference, Tax Implication, and most importantly the tenor or period. Depending upon
the length of the period, interest rates could be short-term with less than one year term,
and long term with any tenor above one year. In some cases, there can be some rates of
medium term with a tenor between one to 5/10 years. Some important short term rates
are: Interbank Call Rates of different tenors (LIBOR / MIBOR with a tenor of 1-Day, 1-
Month, 3-Months, 6-Months, 1-Year); Repurchase or Repo Rates (with a tenor of 1-Day,
7-Day, 14-Day, 1-Month); Deposit/Lending Rates (for 3-Month, 6-Month, 12-Months),
Treasury-Bill Rates (of 91-Days, 182-Days, 364-Days); Short-term Swap Rates, etc. On
the other hand, some of the long term rates includes: Yield of long-term Govt. securities,
Corporate Bond Yields, Bank Lending Rates, Long-term Swap Rates, etc.

2.0 Some Important Interest Rates in Indian Debt Market

2. I Benchmark Rate:
Benchmark Interest Rate, alternatively known as base interest rate,
is the minimum interest rate that investors will demand for their Non-Govt. investment,
say a non-Treasury security. It is also tied to the Yield to Maturity offered on On-the-
Run (Most recently issued) treasury security of comparable-maturity. Alternatively, a
Benchmark Rate is an interest rate against which other interest rates are calculated. For

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example, benchmark rate could be the interest rate at which the Central Bank of an
economy (here RBI) gives loan (borrows money) to (from) the commercial banks under
their jurisdiction, which further can be used as a benchmark by the commercial banks to
decide the interest rate for their loan or deposit products, of different tenors. The
interest rate at which commercial banks and other selected FIs can borrow (lend)
money from (to) the Reserve Bank of India is called Repo Rate (Reverse Repo Rate),
which are presently (as on July 2017) at 6.25% (6.00%). At the same time, the other
benchmark rate, offered by the central bank, in India are: Marginal Standing Facility
(MSF) Rate, and Bank Rate, which are presently (in July 2017) stood at 6.50%. Unless in
case of borrowing under Repo from RBI through Liquidity Adjustment Facility (LAF)
against the excess SLR securities, banks without holding excess SLR securities can still
draw down on their holding of SLR securities and borrow from the Reserve Bank of
India at the MSF rate, which is Repo Rate plus 1%. MSF is a window for banks to borrow
from the RBI in an emergency situation when inter-bank liquidity dries up completely.
Similarly, benchmark rate can also be an interest rate at which commercial banks
are ready to borrow or lend each other. For example, London Inter-Bank Offer Rate
(LIBOR), or Mumbai Interbank Offer Rate (MIBOR) are another form of benchmark rate,
available internationally and in India. These are widely used benchmark rates to price
several financial products, including loans and advances, debt securities, and other
financial instruments.

2. ii G-Sec. Yield:
Govt. Security Yield, or Yield to Maturity of a Dated (original maturity of more than 1-
Year) security issued by the Central Govt. is the average rate of interest/return that an
investor is expected to earn from a risk-free (counterparty risk) investment till the
maturity of the security. This yield may vary depending upon the maturity of the debt
security. G-Sec. yields of different tenors are extracted from the market prices of various
Govt. securities, and therefore are treated as market based risk-free rate of interest, that
can be further used as benchmark rate of interest, especially in Non-Govt. securities
market. Movement in the G-Sec. yield is a very good indicator of the expected change (if
any) in the domestic economy. Below are some G-Sec. yield of different tenors, extracted
from the actual trade in GOI securities, as on July 25 2017, collected from CCIL NDS-OM:
Maturity/Tenor G-Sec. Yield Traded Security (Maturity Date)
5.40 Years 6.5173% 06.84 GS 2022 (19-Dec-2022)
9.11 Years 6.6501% 06.97 GS 2026 (6-Sep-2026)
12.42 Years 6.7233% 06.79 GS 2029 (26-Dec-2029)
18.12 Years 7.0431% 07.40 GS 2035 (9-Sep-2035)

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2. iii T-Bill Rate:

Treasury-Bill (T-Bill) Rate is the risk-free rate of interest offered by the Central Govt. on
its short-term debt obligation having a maturity of less than one year. T-Bills are
normally issued with maturities of 91-Days (i.e. 3-Months), 182-Days (i.e. 6-Months),
and 364-Days (i.e. 12-Months), which are reasonably liquid short-term financial
instruments. T-Bill rates are very good indicator of short-term risk free rate of interest
in an economy, and therefore can be used not only as a short-term benchmark rate of
interest for all Non-Govt. debt products, but to use as an important input to price any
financial product/instrument. T-Bill rates in India, prevailed as on 25-July-2017,
published by the RBI, are:
91-Day T-Bill Rate 182-Day T-Bill Rate 364-Day T-Bill Rate
6.1081% 6.3305% 6.2872%

2. iv Swap Rate:
It is the interest rate charged to swap a floating rate debt into a debt with fixed interest
rate. Alternatively, a swap rate measures the cost for a Bank or Financial Institution to
swap or switch from a floating rate agreement to a fixed rate agreement for a specific
period, say 3-Months to 10-Year. Therefore, swap rate is a fixed rate of interest
applicable to swap an asset or liability of a financial institution, linked to a floating rate
of interest, say LIBOR/MIBOR, for a specific tenor. Since swap deals happens between
two Non-Govt. entities, the rate applicable to such swap contract, i.e. the swap rate, is
not a risk-free rate of interest, and therefore is supposed to be slightly higher than the
risk-free G-Sec. yield of similar tenor, leading to a positive spread. But there may some
instances, like observed in India, where the swap rates are consistently bellow the
respective G-Sec. yield, leaving a Negative Swap Spread, almost for all tenors, as shown
below (as on July 25 2017):
Swap Tenor Wt. Avg. Swap Rate G-Sec. Yield Swap Spread
6-Month 6.1100% 6.30% - 0.1900%
1-Year 6.1790% 6.32% - 0.1410%
3-Year 6.1025% 6.45% - 0.3475%
5-Year 6.2183% 6.49% - 0.2717%

3.0 Major Determinants of Rate of Interest

In the context of debt securities market, the rate of interest which is of high
importance is the Yield on debt security, may be of different types, such as Govt.
security, Non-Govt. security with different level of credit risk, securities with different
level of liquidity, securities with call risk, etc. Yield on Govt. securities of different
maturities are considered to be the risk-free rate of interests for the concerned tenors,

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and all other yield can be subsequently derived from the risk-free yield after adjusting
for credit risk premium, illiquidity premium, or call premium. Risk-free interest rate or
yield on Govt. securities can be derived through a market based mechanism, where the
same is based on the market demand and supply of debt securities. As applicable to any
market based pricing, larger the demand, greater would be the price, and higher the
supply, lower would be the price. At the same time, as per the basic bond pricing rule,
there is an inverse relationship between the price and yield of a security. Accordingly,
higher the price, lower would be the yield, and vice versa. Therefore, if demands for
debt securities are high, it leads to higher prices, finally leading to a lower yield or
interest rates, and vice versa. Therefore, in a market based economy, interest rates can
largely depend upon the factors affecting the demand and supply of debt securities in
that economy, including any specific move by the bond market regulator or Govt. as
control mechanism. Accordingly, the determinants of yield or interest rate of debt
securities are:
 Supply or Issuance of Securities:
 OMO Purchase/OMO Sale by Govt.:
 Sovereign Credit Rating:
 Expected Future Inflation (WPI / CPI):
 Growth Rate:
 Policy Rate:
 Liquidity Ratio (CRR & SLR):
 Global Economy:
 FII Movements:
 Major Exchange Rate:
 Default & Liquidity Factor:

4.0 Term Structure of Interest Rates: Different Types

It is well known that, if identical bonds have different terms to maturity, consequently
their interest rates differ. Term structure of interest rates is the relationship among
yields on financial instruments with identical tax, risk and liquidity characteristics, but
only of different time to maturity. Therefore, the term structure of interest rates can be
referred as the relationship between yield of various bonds and other fixed income
products and their respective time to maturity. The term structure of interest rates is
very important because, there is a common belief that the shape of the term structure
reflects the market's future expectation for interest rates and the conditions for
monetary policy. Different types of term structure can be constructed depending on the
nature of interest rates, such as Yield to Maturity, Spot Rates, Forward Rates, etc.

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Depending on the relation between the rate of interest and time, a term structure may
be broadly of three different shapes: Upward Sloping, Downward Sloping and Flat. A
Term Structure can be with multiple slopes at different maturity levels, known as
Humped Curve. In a normal market condition, term structure of interest rates is
expected to be an upward slopping curve, where interest rate increases as the maturity
increase but at a decreasing rate. Such Term Structure of Interest Rates can again be
constructed with different Risk Profile: such as Risk-Free term structure, term structure
of interest rates for different category of bond issuer with different level of credit
worthiness. The basic term structure of interest rates of an economy is the term
structure constructed out of Yield to Maturity on Govt. securities of different maturities,
commonly known as Base Yield Curve. Yield curve broadly takes the following shapes:

Based on different types of interest rates, term structure can be broadly

classified as: Yield Curve, Spot Rate Curve, and Forward Rate Curve, which are discussed
in the following section.

4.1 Yield Curve:

Term structure of interest rates basically refers to the relationship between the Yield to
Maturity (YTM) of similar bonds but with different terms to maturity. When YTM of
such bonds are plotted against their tenors, it represents the yield curve. The yield
curve is also defined as the graphical presentation of yields on bonds with different
terms to maturity, but with the same risk profile, liquidity and tax considerations. Such
yield curve can be constructed for particular types of bonds, like Govt. securities,
Corporate Bonds, etc.
The yield curve can be classified as upward sloping, flat or downward sloping.
When the yield curve is upward-sloping, the short-term interest rates are below the
long-term rates. When yield curves are flat, the short-term interest rates and long-term
interest rates are the same. When the yield curves are downward-sloping, the long-term
rates are below the short-term rates. Some of the important facts about the yield curve
are:
 Interest Rates are Non-Negative; and follows the properties of Mean-Reverting,
i.e. even if interest rates changes in both the direction (positive or negative), the
same has a tendency to converge towards the mean/average rate.

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 Interest rates on bonds of different maturities move together over time, leading
to a positive correlation between interest rates of different tenors.
 Changes in Interest Rates are correlated, but not Perfectly Correlated.
Alternatively magnitude of change in interest rates of different tenors are not the
same.
 Volatility of Short and Medium Term Rates are higher than that of Long-term
rates. Generally, debt securities of short and medium term are relatively more
liquid than the long term security, mainly due to lack of investors for such long
term security and high level of uncertainty to forecast very long term rate of
interests.
 When short-term interest rates are low, yield curves are more likely to have an
upward slope; when short-term interest rates are high, yield curves are likely to
slope forward and be inverted.
 Even if yield levels of various tenors may not consistently follow a single pattern
(upward/downward/flat), the trend line, if drawn, usually slope upward.

4.1. i Possible Shapes of Yield Curve:

The possible shapes of yield curve are explained below.

o Normal / Upward Slopping Yield Curve:

The upward sloping yield curves are most commonly observed type of yield curves in
developed nations. If a yield curve is upward sloped, short term interest rates are below
long term interest rates. In other words, longer term interest rates are usually higher
than shorter term interest rates. The positive slope reflects investor expectations for the
economy to grow in the future, which is again expected to be associated with a greater
risk that inflation rises, causing a higher inflation-risk premium that investors demand
for their longer term investments. This expectation for higher inflation in the future
than the present generates both an expectation that the central bank will tighten
monetary policy by raising short term interest rates in the future to slow economic
growth and dampen inflationary pressure and the need for a risk premium associated
with the uncertainty about the future rate of inflation and the risk this poses to the
future value of cash flows. Investors price these risks into the yield curve by demanding
higher yields for maturities further into the future.
In such normal market condition, with higher expectation for long term rates, the shape
of the yield curve, even if upward slopping, again depends on the fundamental relation
between change in interest rates w.r.t change in time or maturity. In other words, for a
fixed increase in time, if the interest rate increases but at a constant rate, the shape of
the yield curve looks like an upward sloping Straight Line. On the other hand, for every
positive change in time, if the yield increases but at an increasing rate, the yield curve
takes a shape of upward sloping Convex Curve. However, both these situation do not

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support the fundamental relationship between change in time and change in interest
rates. Therefore, in a normal market scenario, when yield movements are positively
interrelated with change in time, the yield curve takes a shape of upward sloping
Concave Curve, exhibiting the fact that for every positive change in time/maturity, the
change in interest rates/yields are positive, but that happens with a Decreasing Rate.

YTM

Upward Concave
Upward Straight Line
Upward Convex

Maturity

o Inverted / Downward sloping yield curve:

However, normality being associated with a positive slope has not always been the
normal. If an economy experience persistent deflation, the yield curve typically becomes
downward slopping, reflecting the fact that deflation made future cash flows more
valuable than current cash flows. Downward slopping curve is alternatively called
Inverted Yield Curve. If a yield curve is inverted, long run interest rates are below short
term interest rates. In such abnormal market environments, bonds with longer
maturities are expected to offer lower yields than bonds with shorter maturities. This
shape is often seen when the market expects interest rates to fall. Under this abnormal
and contradictory circumstance, long-term investors will settle for lower yields now if
they think the economy will slow or even decline in the future. An inverted yield curve
may indicate a worsening economic situation in the future.
Like normal upward slopping yield curve, inverted yield curve may also takes the shape
of downward slopping straight line, downward slipping concave or downward slopping
convex. If it is assumed that for every positive change in maturity, the yield changes but
at a lower rate, then an inverted yield curve may take the shape of downward slopping
convex curve.

o Flat yield curve:

If a yield curve is flat, short term interest rates are almost equal to long term interest
rates. These curves indicate that the market environment is sending mixed signals to
investors, who are interpreting interest rate movements in various ways. During such

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an environment, it is difficult for the market to determine whether interest rates will
move significantly in either direction, upward or downward, farther into the future. A
flat yield curve usually occurs when the market is making a transition that releases
different but simultaneous indications of how interest rates will move. In other words,
there may be some signals that short-term interest rates will rise, and other signals that
long-term interest rates will fall. This condition will create a yield curve that is flatter
than the normal positively slopped curve. When the yield curve is flat, investors can
optimize their risk/return tradeoff mostly by choosing fixed-income securities with the
least risk, or highest credit quality. In rare instances, wherein long-term interest rates
starts declining, a flat curve can sometimes lead to an inverted curve, which may be a
matter of concern for the market.

o Humped yield curve:

Even if there are three most usual shapes of yield curves, the relationship between an
interest rate and the term to maturity of a bond may not be consistently same, so that
yield curves can often be classified as Humped. It is often seen that the market expects
that interest rates to first rise (fall) during a period and then fall (rise) during another
period. This kind of yield curve, having two different slopes during two different
periods, is known as a Humped Yield Curve.

Actual YC of GOI Yields as on Feb. 02 2017 (Trades>=50Crore)

7.4

7.2

6.8 y = -3E-05x3 - 2E-05x2 + 0.0576x + 6.1997

R² = 0.856
6.6

6.4

6.2

6
0.00 5.00 10.00 15.00 20.00 25.00 30.00

Wtd Avg Yield (%) Poly. (Wtd Avg Yield (%))

When interest rates change by the same amount for bonds of all terms, this is called a
Parallel Shift in the yield curve. The shape of the yield curve remains unchanged,
although interest rates are higher or lower across the curve. A change in the shape of
the yield curve is called a twist and means that interest rates for bonds of some maturity
change differently than bond of other maturity. When the difference between long and
short term interest rates is large, the yield curve is said to be steep. The lower short
term interest rates reflect the easy availability of money and low or declining inflation.
Higher longer term interest rates reflect investors' fears of future inflation. Tight
monetary policy results in short term interest rates being higher than longer term rates.

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Even if Yield Curve can be theoretically constructed very easily, there may be
various issues involved to extract a valid Yield Curve. Issues required to be addressed
before the construction of a valid Yield Curve include:

 Availability of yields for all required maturity points

 If required to be Interpolated, how accurate is the Method of Interpolation
 Validity of the Assumption undertaken in the concerned method
 Acceptable level of Trade-off between the Accuracy and Smoothness

4.1. ii Methods of Constructing Yield Curve:

In absence of sufficient yield points throughout all the required maturities, a complete
yield curve is constructed through different interpolation method. Some of the
important methods are:
 Linear Interpolation Method
Under the first method, it is assumed that any unknown rate lies on a straight line
between two adjacent known rates on the yield curve. The slope of the segment joining
the known lower rate (R1) and the unknown rate (Rn) must be equal to the slope of the
segment joining the two known rates (R1 and R2). This will ensure that all three points
lie on the same line. Accordingly, the unknown rate (R n) for known tenors (tn) can be
derived, such that:
Rn = R1 + [{(R2 - R1) / (t2 - t1) } × (tn - t1)]

Example:
Suppose, the weighted average yield on few of the Govt. of India securities, say till a
residual maturity of 5 years, traded in NDS-OM platform, as on January 29 2016 are as
follows:
Res. Maturity 0.2027 0.9644 1.2137 1.4438 2.2000 2.2301
W. Avg. Yield 7.47 7.24 7.24 7.3 7.34 7.34
Res. Maturity 3.3452 3.4548 3.9288 4.2630 4.3644 4.8685
W. Avg. Yield 7.45 7.47 7.54 7.62 7.58 7.62

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From the given yields of different tenors, how yields for different intermediate tenors
are interpolated, following Linear Interpolation technique?

Solution:

Since the available market yields are different fraction of residual maturities, yields of
some required tenors, say 3 Months, 6 Months, 12 Months, 2 Year, 3 Year, and so on,
may be till 30 Years, need to be linearly interpolated, to construct a yield curve.

From the yield points of two given tenors, the yield of any intermediate tenor may be
extracted through the Linear Interpolation technique, as explained above, and further
shown below.
Tenor (Year) Yield Tenor (Year) Yield
0.2027 (t1) 7.47% (R1) 1.4438 (t1) 7.30% (R1)
0.25 (tn) ? (Rn) 1.50 (tn) ? (Rn)
0.9644 (t2) 7.24% (R2) 2.20 (t2) 7.34 (R2)
As per the equation, given above, assuming a constant change in the yield points from
one tenor to another, the yield for 0.25 years and 1.50 years can be extracted as follows:
0.25 Year Yield = R1 + [{(R2 - R1) / (t2 - t1) } × (tn - t1)] = 7.47% + [{(7.24% - 7.47%) /
(0.9644 – 0.2027) } × (0.25 – 0.2027)] = 7.4557%.
1.50 Year Yield = R1 + [{(R2 - R1) / (t2 - t1) } × (tn - t1)] = 7.30% + [{(7.34% - 7.30%) /
(2.20 – 1.4438) } × (1.50 – 1.4438)] = 7.3294%
The same process may be followed to interpolate the yield for all required tenor or
maturity.
 Cubic Interpolation Method
Cubic Interpolation method assumes that any unknown rate belongs to a cubic
polynomial which contains four known rates on the yield curve. There are four
unknown parameters in a cubic polynomial function, such that:
Rt = a + bt + ct2 + dt3
‘t’ represents the known tenor. Values of these 4 parameters (a, b, c, and d) can be
obtained simultaneously from the known rates. Each segment of the YC is a cubic
polynomial whose slope and curvature depend on the known rates and the time points
between which the unknown rate is inserted. This yield curve is not smooth, but
supposed to be more practical comparative to the one extracted by the first method.
Steps required to construct Yield Curve through Cubic Interpolation:
 Selection of any four points on the available yield curve nearest to the Required
TTM
 Form the TTM and YTM matrices

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 Multiply the YTM Matrix with the Inverse of the TTM Matrix to compute the
coefficients of the cubic polynomial
 Use the polynomial to interpolate the YTM
 Follow the same steps to calculate YTMs for all the required TTM

 Cubic Spline Method

A spline is a piecewise polynomial, consisting of individual polynomial segments joined
by Knot Points. Even if different pieces are joined together, several conditions are
imposed to ensure the smoothness so as to appear as a graph of a single polynomial.
The objective of this method is to produce a continuous curve, joining market observed
rates as smoothly as possible. Under the cubic polynomial method, several polynomials
are joined together, but what is ensured here is the smoothness at the joining points.
For continuity and smoothness, the imposed conditions while joining two polynomials
are: equal values at the knot points; equal Slopes at the knot points; equal Curvature at
knot points; and zero curvature at the End Points. The Boundary Condition (4 th) ensures
that the slopes of extrapolated segments (beyond end points) are constant and the YC is
Linear.

4.2 Spot Rate Curve:

Yield to Maturity (YTM), even if a very important interest rate or yield measure in the
context of bond market, have certain limitation. YTM as a yield measure, extracted from
coupon bearing securities, depends upon the specific maturity and also the
reinvestment rates. Therefore, YTM may not be considered to construct a robust term
structure of interest rates, free from reinvestment risk. This may lead to consider a type
of interest rates or yields which are extracted from some zero coupon instruments, and
therefore free form any reinvestment risk. Yields from zero-coupon securities are
termed as Spot Rates. The zero-coupon yield curve or spot rate curve plots zero-coupon
yields (or spot rates) against term to maturity.
In the first instance if there is a liquid zero-coupon bond market, such spot rate curve
can be easily constructed. However it is not necessary to have a set of zero-coupon
bonds available and/ or traded in a market, in order to construct this curve. There can
be many markets where zero coupon instruments are available only for few tenors (like
3 Months, 6 Months, and 12 Months, as in the case of Treasury Bills in India), or no zero-
coupon bonds are traded, where spot rates can be theoretically extracted from the
conventional yield to maturity (YTM) curve. These zero-coupon yields or spot rates are
known as theoretical spot rates and the curve constructed out of those yields is termed
as Theoretical Spot Rate Curve. Yields of Treasury strips, which are essentially zero-
coupon securities, of various maturities can be considered as zero-coupon yields or spot
rates. But in absence of a developed strip market like in India, various alternative

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methods can be applied to extract the Zero Coupon Yield or Spot Rates. One of the
important methods is known as Method of Bootstrapping. Under this method, the spot
rates are theoretically extracted from the available YTM of coupon bearing securities of
different maturities, or from the current market prices of such securities. Spot rates can
be alternatively extracted from another parametric methods, such as Nelson Siegel (NS)
Method, Nelson-Siegel-Svensson (NSS) Method, where all the concerned spot rates are
modeled in proper functional form and are applied into the market data. Since spot
rates are applicable to zero-coupon securities, having no reinvestment risk, the spot
rate curve is viewed as the true term structure of interest rates. Accordingly, spot rate
for a maturity of n year is regarded as the true n-year rate of interest and therefore
represents the average annual return till the n-th year.

4.2. i Method of Bootstrapping:

Bootstrapping is simply a procedure for extracting zero coupon bond yields from
available trades in coupon bearing bonds. Any option-free coupon bearing security can
be considered as a package of zero-coupon securities, known as Treasury Strips. Each
zero coupon security in the package has a maturity equal to its coupon payment date
and, in the case of principal, equal to maturity date. The value of the Treasury coupon
security should be equal to the value of the package of zero-coupon securities. If this
equality does not hold, it will be possible to create arbitrage profits.
The basic idea is to start with an initial short term bond – typically a 6 months or 12
months bond, which are truly zero coupon bonds, and then calculate their yield. It is
typical to observe a six month and a twelve month zero and therefore the first coupon
bearing bond matures at month 18. The first two semi-annual ZC yields, easily available
from the 6-months (182 Days) and 12-months (364 Days) Treasury Bills, denoted as Z 6
and Z12, can be used to calculate the 18 months spot rate, denoted as Z 18. Once the 18-M
spot rate is derived, it becomes possible to get Z 24. The same process can be repeated to
extract the desired number of spot rates. Typically the par-value coupon bearing bond
can be used. Given that the values of Z6 and Z12 are known, what needs to be done is to
find the value of Z18 that makes this statement true:
𝐶/2 𝐶/2 𝐶/2 + 100
100 = + 2
+
(1 + 𝑍6 /) (1 + 𝑍12 /2) (1 + 𝑍18 /2)3
For example, let us say that Z6=10%, Z12 = 12%, and that the coupon on a par-priced
coupon bond is 13%. The 18 month zero rate would be:
13 / 2 13 / 2 100  13 / 2
100   
(1.05) (1.06) (1  Z18 / 2) 3
2

1/ 3
106.5  106.5 
 88.02  ;  Z18 / 2     1;
(1  Z18 / 2) 3
 88.02 
Z18  13.1176%

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Par ZCYC curve, constructed from the actual trades in GOI securities as on January 29
2016, reported in NDS-OM platform, using the method of Bootstrapping, may be
considered, as given below.

GOI Par ZCYC / Spot Rate Curve (Bootstrapping) as on Jan 29 2016

8.80%

8.60%

8.40%

8.20%

8.00%

7.80%

7.60%

7.40%

7.20%
0 3 6 9 12 15 18 21 24 27 30

Example:
Spot rates, under the bootstrapping method, for any tenor can be solved from the prices
of various coupon bonds. If one spot rate is known, then the spot rate for the next longer
period can be calculated through this method. When two consecutive spot rates are
known, the third one can be calculated from the market price of a bond having three
future cash flows. Consider an example where the market prices of three annual
payment bonds, traded at par, with different maturities are available, such that:
Bond Maturity Coupon Yield Price (Rs.)
1 1 Year 3% 3% 100
2 2 Year 4% 4% 100
3 3 Year 5% 5% 100
The above details of three bonds with three maturities can be used to calculate the spot
rates for 1st, 2nd, and 3rd years. Since the 1-Year bond makes only one payment of
Rs.1030/- due at the end of the 1st year, the 1-year discounting rate or spot rate is
nothing but 3%. In case of the second 2-year bond, two cash flows due at the end of 1 st
and 2nd years are respectively Rs.40/- and Rs.140/-. Since the discounting factor
applicable to the first year (i.e. 3%) and the current market price of the concerned bond
(i.e. Rs.100/-) are known, the rate of interest applicable to discount the second cash
flow can be calculated and will represent the spot rate for the second year. Once the
spot rates (S.R.) for the first and second year are known, the spot rate for the third year
can also be calculated.

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The price of 2-year and 3-Year bond can be represented as:

{4/(1+3%)^1} + {104/(1+S.R.2)^2} = 100; => S.R.2 = 4.019%
{5/(1+3%)^1} + {5/(1+4.019%)^2} + {105/(1+S.R.3)^3} = 100; => S.R.3 = 5.069%

4. 3 Forward Rate Curve:

Forward Rates are the future rates of interest for a further future period in time, e.g., six
month rate six months from now. Zero Coupon Treasury yields are used to extrapolate
the theoretical spot rates which are again used to extrapolate the Forward Rates.
Forward rates normally represent short-term rates, but can be of any period and can be
applicable at any certain time in the future. Given the spot rates for two consecutive
periods, it is possible to calculate the forward rate between the two periods, such that:
F m, n = [{(1+zn) ^ n / (1+zm) ^ m} ^ (1/(n-m))]-1
Zm and Zn and are the two consecutive spot rates (say respectively for 6 months and 12
months), and Fm,n is the forward rate for a period of (n-m), say for 6 months, m period
from now. Forward Rate is the Rate of Interest applicable to an instrument between
Two Future Dates (m and n) contracted today. n-th Period Forward Rate (FR) measures
the Marginal Reward for Lengthening the Maturity of the Investment by n period. Term
structure of forward rate reflects the movement of Marginal Rate of interest over the
future periods, and therefore helps investors to take their investment decisions
depending on their views about the interest rates.

Example:
As par the above example of extracting spot rates, it may be possible to extract the
forward rates during the second and third year. The second year forward rate is nothing
but the 1-year annual rate of interest applicable at the end of the first year. Similarly, the
third year forward rate represents the 1-Year annual rate of interest applicable at the
end of the second year. These two future rates of interest can be calculated assuming an
arbitrage-free market condition, where the proceed of a straight 2-year investment at
the end of two years at S.R.2 will be equal to the proceed of same 2-year investment
initially made for one year at S.R. 1 and gradually rolled over for the second year at 1-
year Forward Rate one year from now. Similarly, the same logic may be applicable to
extract the 1-year forward rate two years from now. Alternatively, the arbitrage-free
conditions are such that:

X (1  S ..R.2 ) 2  X (1  S .R.1 )(1  F .R.1 )

X (1  S ..R.3 ) 3  X (1  S .R.2 ) 2 (1  F .R.2 )

If X represent the principal invested; S.R.1, S.R.2, and S.R.3 represent the three
consecutive spot rates for period 1, 2, and 3; and F.R. 1, and F.R.2 represents the annual

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forward rates respectively at the end of first and second year, then the forward rates
can be calculated as:
100 (1+4.019%)^2 = 100 (1+3%)^1 × (1+F.R.1); => F.R.1 = {(1+4.019%)^2} /
{(1+3%)^1} -1;
=> F.R.1 = 5.048% ; and
100 (1+5.069%)^3 = 100(1+4.019%)^2×(1+F.R.2); =>
F.R.2={(1+5.069%)^3}/{(1+4.019%)^2}-1;
=> F.R.1 = 7.201%

GOI Yield Curve, Spot & Forward Rates Curve as on Jan 29 2016
11.50%
11.00%
10.50%
10.00%
9.50%
9.00%
8.50%
8.00%
7.50%
7.00%
6.50%
0 3 6 9 12 15 18 21 24 27 30
YTM (Interpolated) Spot Rates Forward Rates

4. 4 Credit Spread

The credit spread, or quality spread, is the additional yield an investor expects for
acquiring a Non-Govt. security, issued by different types of issuers, like Banks (Public or
Private), Public Sector Undertakings (PSU), Financial Institutions (FIs), Non-Banking
Finance Companies (NBFCs), Corporate Entities, etc., on and above the risk-free yield on
securities issued by the Central Govt. The yield of Non-Govt. security is the sum of Risk-
free Yield plus the credit spread, depending upon the credit worthiness of the
concerned entity. Accordingly, the price of a non-treasury bond changes not only due to
change in Risk-free Treasury yield, but also due to any change in the concerned spread
of the non-treasury issue. The concerned spread may be Nominal Spread or Z-Spread.
Non-Treasury Yield Curve can be constructed by adding the concerned spread over the
Treasury Spot Rates of respective tenors. Nominal Spread changes for different entities
and also for different periods. Nominal Spreads for Indian Non-Govt. entities are
regularly published by FIMMDA. On the other hand, Zero-Volatility Spread or Z-Spread
of a Non-Treasury issue is the spread that an investor is expected to realize over the
entire Treasury Spot Rate curve if the non-Treasury issue is assumed to be held till

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maturity. Z-Spread is assumed to be constant over the entire life of the Non-Treasury
security, and therefore known as Static Spread.

Non-Treasury ZCYC in India as on January 29 2016

8.80%
8.60%
8.40%
8.20%
8.00%
7.80%
7.60%
7.40%
7.20%
1 3 5 7 9 11 13 15
GOI ZCYC ZCYC (PSU / Fis & Banks - AAA)
ZCYC (NBFC - AAA) ZCYC (Corporates - AAA)

When inflation rates are increasing (or the economy is contracting) the credit spread
between corporate and Treasury securities widens. This is because investors must be
offered additional compensation (in the form of a higher coupon rate) for acquiring the
higher risk associated with corporate bonds.
When interest rates are declining (or the economy is expanding), the credit spread
between Govt. and corporate fixed-income securities generally narrows. The lower
interest rates give Non-Govt. entities an opportunity to borrow money at lower rates,
which allows them to expand their operations and also their cash flows. When interest
rates are declining, the economy is expanding in the long run, so the risk associated with
investing in a long-term corporate bond is also generally lower.

5.0 Theories of Interest Rate Term Structure

Economists have developed theories to explain the empirical observations about the
shape of the interest rate term structure. Four main theories are: Expectations Theory,
Market Segmentation Theory, Liquidity Premium Theory, and Preferred Habitat Theory.
These theories are explained in the following section.

5. 1 Expectations Theory:

The expectations hypothesis of the term structure states that the interest rate on a long-
term bond will equal an average of the short-term interest rates that people expect to
occur over the life of the long-term bond. For example, if people expect that short-term
interest rates will be 7% on average over the coming five years, the prediction is that
the interest rate on bonds with five years yield to maturity will also be 7%. The key

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assumptions behind this hypothesis are that short-term and long-term securities can be
treated as perfect substitutes, investors are risk neutral and the shape of the yield curve
is determined by investors’ expectations of future interest rates and future inflation.
According to the expectations hypothesis, both strategies of straightway
investing in a longer maturity bond, and initially investing in a shorter maturity bond
and gradually rolling over should yield exactly the same result, since investors are
indifferent to bonds of different maturities, and bonds are perfect substitutes. The
interest rate on the two-year bond must equal the average of the two one-year interest
rates. For example, assume the current interest rate on the one-year bond is 7% and an
investor’s expectation is that the interest rate on the one-year bond next year will be
8%. If the investor pursues the strategy of buying the two one-year bonds, the expected
return over the two years will equal 7.5%, which is (7%+8%)/2. The investor will be
willing to hold the two-year bond only if the expected return per year of the two-year
bond is equal to or greater than 7.5%. In other words, the interest rate on the two-year
bond must equal 8.5%, the average interest on the two one-year bonds.
All these expectation theories share a common hypothesis that the short-term forward
rates are closely approximated to the short-term future rates as expected by the market
participants, but differ at the influence of other factors, beyond just the market’s
expectation, in capturing the short-term forward rates. Pure Expectation Theory ignores
the presence of any systematic factors other than the expected future short-term rates.
Pure Expectation Theory / Hypothesis simply conveys the shape (Upward rising, Flat,
Downward slopping) of the Term Structure based on the markets’ expectation about the
future short-term rate of interest. Pure Expectation theory of having a similar return on
investment irrespective of the investment horizon is meaningful not from the angle of
longer investment horizon, but from the angle of shorter investment horizon, e.g. within
a period of 6 months. This theory is actually termed as Local Expectations theory which
is nothing but a part of pure expectations.

5. 2 Liquidity Preference Theory:

This theory of the term structure states that the interest rate on a long-term bond will
equal an average of short-term interest rates expected to occur over the life of the long-
term bond, plus a premium that responds to supply and demand conditions for that
bond. The liquidity premium theory modifies the expectations theory by assuming that
investors are risk-averse and therefore demand a premium for long-term bonds
because of interest rate risk. In other words, it is assumed that investors require a
liquidity premium to induce them to lock up their funds for longer-term maturity and
compensate them for the increased risk.
The liquidity premium theory’s main assumption is that bonds of different
maturities are substitutes, but not perfect substitutes, which means that the expected
return on one bond does influence the expected return on a bond of a different maturity.
Liquidity premium theory also allows investors to prefer bond of one maturity over

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another. Investors tend to prefer shorter-term bonds because these bonds bear less
interest-rate risk. As such, if the investors were to hold bonds of longer maturities they
must be offered a liquidity premium to induce them to do so.

5. 3 Market Segmentation Theory:

In this theory, individuals have strong maturity preferences, thus bonds of different
maturities trade in separate markets. This means that markets for bonds of different
maturities are completely separated and segmented and cannot substitutable. As a
result, the demand and supply of bonds of particular maturity are little affected by the
bonds of neighboring maturities’ prices, and therefore determined independently. It is
assumed that borrowers have particular periods for which they want to borrow and
lenders have particular holding periods in their mind. In short, investors and borrowers
are concerned with specific maturities only. Interest rates are determined
independently in separate markets with different maturities, without affecting other
segments of the credit market. Investors or bond issuers only care about one segment of
the bond market.
This theory explains why yield curves are usually upward-sloping. Investors
have to decide whether they need short-term or long-term instruments. In this
situation, investors may prefer their portfolio to be liquid. Thus, they will prefer short-
term instruments to long-term instruments. This results so that short-term instruments
will receive higher demand in the market. This higher demand to the short-term
instruments will cause higher prices and lower yield. Therefore, short-term yields are
lower than long-term yields. It does not, however, explain why interest rates tend to
move together over time.

5. 4 Preferred Habitat Theory:

This theory assumes that investors have a preference for bonds of one maturity over
another, i.e., a particular bond maturity in which they prefer to invest. However, they
will be willing to buy bonds that do not have the preferred maturity only if they can
have a somewhat higher expected return. The investors are likely to prefer the habitat
of short-term bonds over that of longer-term bonds; they will only hold longer-term
bonds if they have a higher expected return. The above reasoning will lead to the same
approach as implied by the liquidity premium theory with a term premium that rises
with maturity.

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Self-Learning Exercise:

1. What is Yield Curve? Why Treasury Yield Curve is very important not only to the
players in financial market, but also for the whole economy?
2. Explain the basic theories of term structure of interest rates and describe the
implications of each theory towards the shape of a yield curve
3. A newly joined bond trader, expected to trade in Govt. securities in a bank, is trying
to understand the movement of risk-free yield in the market. What
factors/news/market announcements he should look at to forecast the future
movement in the yield, and how each of these factors affect the yield movement?
4. “A Yield curve, as on a given date, may not be simply constructed from all the yields
on dated securities of various maturities, traded on that date”. Do you agree on this
statement? If not, why?
5. On a given date, can a bond trader quickly interpolate the yield for a tenor of 8.85
years from the available yields for 8.60 years and 9.10 years using linear
interpolation technique? Can the application of the same method be justified to
interpolate the yield of a specific intermediate tenor from the yield of two far
tenors?
6. How cubic interpolation method is superior to linear interpolation to construct a
term structure of interest rates? Is there any difficulties for a bond portfolio
manager, especially in illiquid bond markets like in India, to successfully follow this
non-linear method to construct a valid and robust interest rate term structure?
7. What is Zero Coupon Yield or Spot Rate? How are they different from YTM?
8. What is method of Bootstrapping, used to construct a ZCYC? How this method uses
the market information on coupon bearing securities to construct ZCYC? Is it
possible to use this method in Indian market without any assumption?
9. What is Forward Rates? How they are extracted from the Spot Rates?
10. “Forward rates are poor predictors of the actual future rates that are realized.
Consequently, they are of little value to an investor.” Explain why you agree or
disagree with this statement.

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References:

 Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 7, 8,

41); McGraw-Hill.
 Sundaresan, Suresh M, 2002, Fixed Income Markets and their Derivatives
(Chapter: 8); Thomson Asia, Singapore.
 Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 6); Butterworth-Heinemann.
 Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 3, 4); Wiley Finance.
 Bruce Tuckman, 2002; Fixed Income Securities: Tools for Today's Markets
(Chapter: 2, 3, 4); John Wiley & Sons, Inc.
 A V Rajwade, 2008; Handbook on Debt Securities and Interest Rate Derivatives
(Chapter: 9); Tata McGraw-Hill.
 Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 5); NIBM In-house Publication.
 FIMMDA, (2013); Note on Cubic Spline Valuation Methodology; FIMMDA
Publication.

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Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 4: Pricing and Valuation of Fixed Income Securities

Dr. Kedar nath Mukherjee

Objectives:

The objective of this chapter is to make the readers familiar with the mechanism to
price and value different types of fixed income securities, depending on their specific
features. At the end of this chapter, the readers are expected to be familiar with:
i. How to value fixed income securities, generating series of future cash flows?
ii. What are the different steps involved in the valuation process?
iii. What are the important issues to be looked into while valuing a bond?
iv. How valuation of bonds with some special features, e.g. valuation of floating rate
bond, bonds with embedded options, are different from the standard bond
valuation?
v. What are the market practices towards valuation of various bonds?
vi. What are the Regulatory (RBI, FIMMDA) Guidelines for the valuation of different
debt instruments in India?
Structure:
1. Valuation of Bond: Meaning
2. Valuation of a Bond: Broader Steps
3. Valuation of Bond: Important Issues
3.1. Valuation in-between Two Coupon Payment Dates / with Accrued Interest
3.2. Selection of Day Count Conventions
3.3. Selection of Single or Multiple Discounting Rates
3.4. Presence of Some Special Feature (s)
4. Valuation of FI Securities: RBI-FIMMDA Guidelines

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1.0 Valuation of Bond: Meaning

Value of a financial asset is very important for any market player and concerned
entities, such as Investors, traders (Buyer or Seller), Dealer/Broker, Regulator, etc., to
deal with that asset. Therefore, an asset may need to be valued at any point of time
during the course of its existence. Value of any financial asset represents two values:
Market Value and Fair Value. Market value is the value or price at which the asset is
being traded in the market, which broadly depends on the demand and supply of the
concerned asset. But fair value represents how much worthy is the asset as on the
valuation date under the prevailing market condition. There is no doubt that any asset
gets traded in the market not at their fair value but at the market value. Market value
may be higher or lower than the fair value. The general rule of Demand and Supply also
works here to value a financial asset, that says: Greater the demand, higher would be
the price, and vice versa. A trader (buyer and seller) generally gets an idea of how
much price to quote for any asset only after considering the fair value. Therefore, Fair
Valuation of any financial assets, including debt securities, is very important. Besides
for trading purposes, whenever any existing positions need to be valued, especially in
absence of the market price, an investor needs to depend on the fair value of the asset.
Therefore, fair valuation of a financial asset is one of the important aspects for an
investor.
Whenever any amount is invested in some financial asset, like equity shares,
bonds, etc., investors expect some returns in the form of some future cash flows from
the asset over a certain period of time, as long as the investment holds. In case of any
investment in a debt instrument or bond, investor gets certain number and amount of
cash flows in the future. The bond investor may like to understand how much worthy
all those future cash flows are in today’s date, which can be arrived at by calculating
the present value of all future cash flows, considering the Time Value of Money.
Fundamentally, the fair value of a bond is nothing but the sum of the present values of
all future cash flows expected to be due from the bond, in single or multiple occasions,
with or without full certainty. Therefore, broadly a general Debt or Bond valuation
process involves:
· Estimation of Expected Future Cash Flows
· Calculation of Present Values of all CFs, after using respective Discounting
Factors; and
· Summing up the Present or Discounted values of all expected future cash flows.
All the three broader steps again involve several issues to be considered, depending
upon the nature of the debt issue, such as: Fixed Rate, Floating Rate, Zero-Coupon,
Callability/Putability, etc.

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2.0 Valuation of a Bond: Broader Steps

2. i Step 1: Estimating All Future Cash Flows

In case of a fixed income security the possible future cash flows would be either the
coupons or the principal, and the treatment of these two types of cash flows are similar
except the time period. Again, as far as the certainty of different cash flows is concerned,
cash flows for different Govt. securities are free from any uncertainty or default risk. In
case of Zero-coupon bond, the cash flow comes only once in its life time, i.e. at the time
of its maturity. Similarly, coupon-bearing securities provides both coupons at different
coupon payment dates (semi-annually or annually) until the maturity and the principal
payment at the time of maturity. But even if the name “Fixed Income Security” conveyed
that the cash flows expected to be generated from such security are certain and fixed,
may be in terms of amount of cash flows and number of cash flows, there may be certain
complexity in the following circumstances:
ü If the coupon payment is not fixed throughout the holding period and is revised
at every coupon reset date, referencing to some available market rate of interest
rate, and based on some coupon reset formula, i.e. for Floating Rate bonds;
ü If some Option (Call Option or Put Option) features are embedded with the bond
in regards to change the contractual due date for the payment of the principal,
i.e. in case of bonds with Embedded Options;
ü If the investor is given a choice to convert his bond to common stock, i.e. for
Convertible Bonds.

For example, in case of 8 40 GS 2024, the current benchmark GOI dated security with a
residual maturity of roughly 9.5 years, in March 2015, the future cash flows due are: 19
semi-annual coupons of Rs.4.20/- each in every six months’ time till the maturity, and
the single principal amount of Rs.100.00/- due at the maturity. Therefore, there are 20
future cash flows due from this security till the maturity, which are certain both in
terms of amount of the CFs and the timing or number of the CFs.

Similarly, GOI FLOATING RATE BOND 2020, maturing on December 21 2020, offers 12
(as on March 2015) semi-annual floating coupons, linked to the weighted average cut-
off yield of the last three 364- day GOI Treasury bill auctions preceding the coupon re-
set date, till the maturity, and one principal payment at the maturity. In such case, even
if the recent semi-annual coupon, due on June 21 2015 but reset on December 21 2014
depending on the then previous three T-Bills cut-off yields, is known to the market,
majority of the future cash flows in the form of the following 11 coupons are still not
certain but can be anticipated based on the current market condition and future interest
rates expectations. This uncertainty in terms of the amount but not the number of
future cash flows may bring some amount of subjectivity in the valuation process and
the resultant number, i.e. value of the FRB.

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In case of a callable bond, say, IDFC LIMITED SR-PP 2/2015 OPT II 9.6 NCD 29AP24
FVRS10LAC (ISIN: INE043D07GK9), a Secured Non-Convertible Debenture issued by
IDFC Limited with a fixed coupon of 9.60% p.a., payable annually, issued on April 29
2014 and maturing on April 29 2024, has an embedded Call Option where the option
can be exercised on April 29 of every years after a lock-in period of 4 years, i.e. on April
29 2019, April 29 2020, April 29 2021, April 29 2022, and April 29 2023. If the bond is
called-off by the issuer in either of these possible call dates, all the interim coupon
expected to be due after the option being exercised will be stopped and the principal
amount will be redeemed either at par or as per the call schedule. Therefore, in case of a
bond with embedded option, even if the amount of future cash flows are fixed and
certain, the total number of such cash flows, or the date till which the CFs are expected,
are not certain and depend upon the possibility for the issuer to exercise his option and
close the debt contract before the scheduled maturity. Even if all possible dates, may be
after a specific lock-in period, on which the option (call / put) can be exercised, are
clearly specified, the date when the option will be actually exercised is always uncertain
and depend upon the prevailing market condition. This uncertainty need to be captured
in the valuation mechanism to value a debt instrument with some embedded option.

2. ii Step 2: Estimating Present Value of Future Cash Flows

After estimating the expected future cash flows, both in terms of amount of CFs and
total number of CFs, the next step is to derive their present values, considering the time
value of money theory. The present values of all future cash flows can be estimated
through the respective discounting factors, applicable to different point of time
depending upon the timing of those future cash flows whenever due. Time Value of
Money and Method of calculating the Discounting Factors are discussed in the following
section.

Time Value of Money and Respective Discounting Factor

In general, money today is not the same as money in one year or at any future point of
time. This is because if a saver allows someone to utilize his savings of Rs.100/-, say for
next one year, he will be expecting some value for the time which he has given to the
person to utilize his savings for next one year. If the saver X has Rs.100 today, and gives
the same to a Borrower Y for next one year, he may expect to receive from him
Rs.109.00/- at the end of one year. This difference in value (Rs.9.00/-) between the
money in the future and the money today is the Time Value of Money, which again
depend upon the Rate of Interest, Timing of Cash Flows, and Frequency of Cash Flows.
This time value can be computed to arrive at either the Future Value of some Present
Cash Flow (s), or to arrive at the Present Value of some Future Cash Flow (s). These are
basically done through Compounding (Discounting) the Present (Future) Cash Flow (s),
for a specific period of time and with a specified frequency. The factor which can be
used to compound or discount respectively the present and future cash flows are known

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

as Compounding Factor and Discounting Factor, which are function of Rate of Interest,
Timing and Frequency of CFs. Alternatively, an n-th period discount (compounding)
factor is the present (future) value of one unit of currency that is payable at the end
(beginning) of period n. The rate of interest to be used depends upon the nature of the
cash flows: risk free or risky. Normally, risk-free, short-term and well accepted in the
market, interest rates are used. Timing and Frequency of CFs are also equally important
to arrive at the compounding or discounting factor, and therefore the time value of
money. Depending upon the frequency of CFs, the time value of money can be estimated
through: a Discrete Process or a Continuous Process, respectively with a well-defined
(Semi-annually, Quarterly, Monthly, etc.) time intervals, and a Regular but Un-Defined
time intervals. Therefore, the Compounding and Discounting Factor, under Discrete and
Continuous process, can be arrived at:
o Compounding Factor (Discrete) : 1 × [{1+(r/m)} ^ (t×m)]
o Discounting Factor (Discrete) : 1 / [{1+(r/m)} ^ (t×m)]
o Compounding Factor (Continuous) : 1 × exp + ( r × t)
o Discounting Factor (Continuous) : 1 / exp ( r × t) or 1 × exp – ( r × t)
Where: r = Annualized Interest Rate / Continuously Compounded Interest Rate, m =
Frequency of Compounding/Discounting, t = Time Period for the cash flow, exp =
Exponential Function
Accordingly, the Future (Present) value of any Present (Future) CF can be
estimated by adjusting the Compounding (Discounting) factor with the respective CFs.
Now as far as the discounting of different future cash flows due from a fixed income
security or a bond is concerned, a single interest rate can be used or different cash flows
can be discounted at different rate of interest applicable to the respective cash flows at
the respective time. Accordingly the entire future cash flows of a bond may be
traditionally discounted by using the YTM of the concerned period or maturity, or by
using different tenor-specific interest rates, as and when the future cash flows are due.
Use of these two different approaches by different market players while discounting the
future cash flows may create an arbitrage opportunity in the market.
For an example, if an investor requires to buys 8.07% G.S. 2017, maturing on
January 15 2017 and yielding 7.76% p.a. as on March 5 2014, where the semi-annual
future cash flows of Rs.4.035/- each can be discounted with their respective discounting
(Discrete) factor, extracted as follows:
Timing of CFs Single IR p.a. Semi-Annual Discounting Factor
(Semi-Annual Period) (YTM) IR
July 15 2015 (0.73) 7.76% 3.88% 1 / (1 + 3.88%) ^ 0.73 = 0.9726
Jan 15 2016 (1.73) 7.76% 3.88% 1 / (1 + 3.88%) ^ 1.73 = 0.9363
July 15 2016 (2.73) 7.76% 3.88% 1 / (1 + 3.88%) ^ 2.73 = 0.9013
Jan 15 2017 (3.73) 7.76% 3.88% 1 / (1 + 3.88%) ^ 3.73 = 0.8676

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

The first semi-annual period is just the number of days in between the settlement date
(March 05 2015) and the date of first CF (i.e. July 15 2015) out of a total number of days
in a semiannual period (i.e. 180 Days as per 30/360 Day Count Convention). This gives
the first semiannual period of 0.73 years. The subsequent semi-annual periods can be
computed just by adding one period every time. This can be discussed in more detail in
the following section.
Once the discounting factors are arrived at, considering the rate of interest (single or
multiple) and the timing of the CFs, then the present value of all CFs can be derived just
by multiplying the CFs with their respective Discounting Factors, such that:
Timing: July 15 2015 Jan 15 2016 July 15 2016 Jan 15 2017
CF : Rs.4.035/- Rs.4.035/- Rs.4.035/- Rs.4.035/- + Rs.100.00/-
DF : 0.9726 0.9363 0.9013 0.8676
DCF : 3.9244 3.7780 3.6367 90.2608

2. iii Step 3: Deriving Final Value of the Security

After discounting all the expected cash flows by using a single interest rate, the final
step to value a fixed income security is to add the discounted values of all the expected
future cash flows. In the above example, the sum of the four discounted future cash
flows or the present value of the four future CFs due at different future point of time
from the 8.07% G.S. 2017 till the maturity (Jan 15 2017) is Rs.101.5999/-. Even if the
value of each future CFs remains the same, the value of the bond will keep changing,
depending upon the change in the discounting factor, which again depend upon the
concerned Interest Rate and the timings of the CFs.
Even if every bond has a face value, say Rs.100 per security, it is not necessary to
have the same value at any valuation date. The value (market value or fair value) of a
bond can be equal to, greater than or lower than the face value. A bond can be valued
and traded at Par (i.e. Equal to Book/Face Value), at Discount (Less than Face Value), or
at Premium (More than Face Value). Now the issue is, when the fixed income security is
expected to be traded at Par, at Discount, or at Premium? The answer depends on the
similarity or dissimilarity between the Coupon Rate of the security of a specific maturity
and the Yield to Maturity (YTM) for the concerned period at the time of settlement or
valuation. Any fixed income security will be valued and accordingly traded at Par when
there is no difference between the coupon rate and the YTM. Similarly when the coupon
rate is Lower (Higher) than the Yield, the value of the security is expected to be Lowe
(Higher) than its par value and accordingly the security can be traded at Discount
(Premium). For example, 8.40% G.S. 2024, with a residual maturity of roughly 9.40
years, offering a semi-annual coupon of Rs.4.20/- till July 2024, is traded at a market
price of Rs.104.56/- as on March 05 2015. The bond is traded at premium basically
because of lower market expectation (7.70% p.a.) for a risk-free investment for the

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

similar maturity (9.40 years). Similarly, 7.35% G.S. 2024, maturing on June 22 2024,
almost with the similar maturity (9.31 years), is found to be traded at a discounted price
of Rs.97.14/- as on March 05 2015, because of the lower coupon than the market
expectation. Here, even if both the bonds are of almost similar maturity and issued by
the same issuer (GOI), but still the bonds are traded at a different price just because of
the difference in the coupon offered by those securities and the market yield for the
respective tenors or maturities. The amount of discount (premium) on any bond is
broadly the present value of the total opportunity loss (gain) applicable to the bond by
way of accepting a lower (higher) coupon on that bond till the maturity. Since market
expectation changes on a continuous basis, it is very unusual to see a bond traded at par
or very close to par, unless the same is an on-the-run issue, offered very recently in the
market.
In this context, one fact is important to note is that though the price of a bond can
deviate (Higher or Lower) from its par value, the extent of deviation tends to reduce as
the security moves towards its maturity, and the value of the security will be exactly
equal to par at the date of maturity, and therefore is expected to be redeemed only at
par. This feature of bond’s price movement from any date before maturity till the exact
maturity is commonly known as Pull-to-Par, as exhibited in the following figure.

Figure1 : Pull-to-Par Feature of a Coupon Bearing Bond

Time Path of Discount and Premium Bonds

1300

1200
Price of Bonds

1100

1000

900

800

700
Years to M aturity
Price of the Discount Bond Price of the Premium Bond

The valuation of coupon-bearing fixed income security also depends on the

frequency of coupon payments, i.e. whether the coupons are paid Annually or
Semiannually. Accordingly, the actual time when the future cash flows will be due,
amount of individual future cash flows, and yield or discount rate (s) applicable to the
respective dates need to be adjusted. Semiannual coupon payment would be half of the
annual coupon, required yield or discount rate would also be half (as par Convention) of
the annual rate, and the each semiannual period of six months may be treated as one
period. One of the important facts is that, the larger the frequency of coupon payments
in a fixed income security, the higher would be the value for the security. Therefore, the

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

value of a security with semiannual coupon payments is higher than the value of the
similar security but with annual coupon payments. The reason behind this is the higher
interest income generated by reinvesting the coupons received at shorter intervals. For
example, the price of 8.40 GS 2024, yielding 7.70% p.a. and paying Rs.4.20/- semi-
annually, as on March 05 2015, is Rs.104.56/-. The similar bond, all features remains the
same but pays an annual coupon, will be priced differently, here Rs.104.47/-, which is
almost 9 paisa less than the price of the bond with semi-annual coupon payment.
The Discounted Cash Flow approach, to price a fixed coupon (semi-annually
paid) bond, can be summarized in the following section, where the pricing equation can
be described as:

C1 C2 C3 C + MVt
P= + + + ...... + 2t
(1 + r / 2) (1 + r / 2) (1 + r / 2)
1 2 3
(1 + r / 2) 2t
CFt MVn
= åt =0.5
n
+
(1 + r / 2) (1 + r / 2)2n
2t

Where C1, C2, …., Ct are the semi-annual cash flows till the maturity ‘t’ (t = 0.5, 1, 1.5, 2, ….
,n years) MVn is the Redemption Price at the maturity (i.e. at year n) which is at Par, r is
the discounting rate, which can be traditionally the YTM of the concerned maturity.
Since the value of a fixed rate bond has two components: the present value of all
fixed semi-annual coupon payments and the present value of maturity/redemption
amount, the valuation of such bond can also be done through the present value of
annuity function, such that:

é 1 ù
ê1 - (1 + r / 2 )2t ú é 1 ù
Value = Semi - annualCoup on ´ ê ú + MaturityValue ´ ê 2t ú
ê r/2 ú ë (1 + r / 2 ) û
ê ú
ë û

Where ‘r' is the single discounting rate or YTM, and ‘t’ is the time to maturity.
Since there is no coupon payments in case of Zero-coupon fixed income security, the
value of such security is derived only by discounting the maturity value, such that:

MaturityVa lue
Value =
(1+ r / 2 )2t
Even if there is no coupon payments in a Zero-coupon fixed income security, the
valuation formula has consider a semiannual interest rate and semiannual periods, just
to exhibit an uniformity between the Valuation Process for Coupon-bearing security and
Zero-coupon security.
The Microsoft Excel Function, used to price a fixed rate option-free bond, is given as:

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

=PRICE(Settlement, Maturity, Rate, Yld, Redemption, Frequency, [Basis])

Where, the inputs required are: the settlement or the valuation date for the concerned
bond (Settlement), maturity date of the bond (Maturity), the coupon rate of the bond
(Rate), the market rate or the yield to maturity for the concerned tenor (Yld), the
redemption price which is usually the par value (Redemption), the frequency of coupon
payments (Frequency), and the choice of number of days during a specific period and
during a year, alternatively the Day-Count Convention (Basis), discussed in the
following section. Once this information regarding a bond is given, the bond price can be
easily extracted.

3.0 Valuation of Bond: Important Issues

Even if the value of any fixed income security broadly depend upon the present values
of all the expected future cash flows till its maturity, as described in the above section,
there can be some important issues, in terms amount of: amount of expected future cash
flows, number and timing of such future cash flows, method of discounting, etc., that
may make the valuation process slightly different, and perhaps little more difficult and
exhaustive. Some of such important issues and their respective adjustment in the basic
bond pricing/valuation method are discussed in the following section.

3.1 Valuation in-between Two Coupon Payment Dates / with Accrued Interest:

If the coupon-bearing fixed income security is valued exactly at some coupon payment
date, or otherwise if there is no difference between the Settlement Date and a Coupon
Payment Date, then the traditional valuation mechanism, as discussed in the above
section is applied. But if such security is traded in the market and therefore needs to be
valued between two coupon payment dates, alternatively, if the Settlement date and
Coupon Due date are different, then the valuation process needs a separate attention. In
such case, the extra component comes in the valuation formula is the specific portion of
a single/first coupon payment which is actually due to the seller of the security but
earned by the buyer or holder of the security, commonly known as Accrued Interest. In
other words, the portion of first coupon interest due from the previous coupon payment
date till the settlement/valuation date, which is before the next coupon payment date, is
known as Accrued Interest (AI). The amount of accrued interest needs to be
compensated by the buyer to the seller of the security at the time of buying the security.
When a coupon-bearing fixed income security is valued between two coupon payment
dates, the valuation is done without considering the portion of accrued interest which is
included in the first coupon and therefore in the price, and such value or price is known
as the Full Price or Dirty Price. This is the price that the buyer needs to pay to the seller.
But this is not the true price for the security as on the valuation date. The True Price or
Clean Price of the security would be the difference between the full price and the

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

amount of accrued interest. In such case the valuation need to be done by adjusting the
discounting rate (s), the time periods, and the accrued interest, such that:
C1 C2 C3 C 2t + MVt
P= + + + ...... + - AI
(1 + r / 2) i (1 + r / 2)1+i (1 + r / 2) 2+ i (1 + r / 2) t -1+i
Where, i = (Days from Value Date to Next Coupon Date) / Days in Interest Period;
depending upon the day count convention followed.
If a bond pays semiannual coupon, the accrued interest (AI) is calculated such that:

AI = Semiannual _ Coupon ´
(SettlementDate - LastCouponPaymentDate )
The Microsoft Excel Function, used toTotalNo
calculate Accrued
.ofDays Interest alPeriod
_ inSemiannu of a coupon bond, is
given as:
=ACCRINT(Issue, First_interest, Settlement, Rate, Par, Frequency, [Basis],[Calc_method])

Where, the inputs required are: the bond issue date or previous coupon payment date
(Issue), first coupon payment date or the next coupon payment date after the
settlement/valuation date (First_interest), the settlement or valuation date (Settlement),
coupon rate of the bond (Rate), par/face value of the bond (Par), the frequency of
coupon payments (Frequency), the choice of number of days during a specific period
and during a year, alternatively the Day-Count Convention (Basis), and a logical function
(Calc_method) with an inputs of TRUE or FALSE, depending upon whether the accrued
interest is required to be calculated from the issue date or from the last coupon
payment date. The previous and next coupon payment dates, number of days in the
coupon period, containing the settlement date, No. of days from the previous coupon
payment date till the settlement date, No. of days from the settlement date till the next
coupon payment date, etc. can also be extracted through the following Excel Function,
such that:
=COUPPCD(Settlement, Maturity, Frequency, [Basis])
=COUPNCD(Settlement, Maturity, Frequency, [Basis])
=COUPDAYS(Settlement, Maturity, Frequency, [Basis])
=COUPDAYBS(Settlement, Maturity, Frequency, [Basis])
=COUPDAYSNC(Settlement, Maturity, Frequency, [Basis])

Even if the amount of accrued interest, expected to be passed on to the bond seller,
should be the discounted value of the above AI, discounted for the period between the
settlement date and the next coupon payment date, the general market
practice/convention is to ignore any discounting of the actual AI, even though the same
is paid in advance.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3.2 Selection of Day Count Conventions:

Valuation of a bond issue, especially if the valuation is done in between two coupon
payment dates, also depends on how the number of days between the Settlement Date
and the Last Coupon Payment Date are counted. In other words, while calculating the
part of a single coupon, accrued for the period between the last coupon payment date
and the settlement/valuation date, there are various conventions used to count the
number of days between these two dates, commonly termed as Day Count Conventions.
There are broadly four such market conventions, such as: Actual/Actual, Actual/365,
Actual/360, and 30/360. The numerators represent the number of days in a specific
month, while the denominators represent the number of days in a specific year or the
specific coupon period (Annual/Semi-Annual). The amount of accrued interest and
therefore the clean price of a bond depend upon the day count convention follows by
the market players for different types of fixed income securities: Govt., Non-Govt., Long-
term, Short-term, etc.
Day Count Convention normally followed for a dated Govt. security in India is
30/360, irrespective of the actual number of days, whereas the valuation of dated Non-
Govt. securities or corporate bond is based on Actual/Actual. Similarly, valuation of T-
bills, commercial paper, and other short-term or money market instruments, having less
than one year to expiration, is based on Actual/Actual or Actual/365 rule. As far as
Actual/Actual convention is concerned, it is exactly similar to the Actual/365
convention, except in case of leap year.
Example:
Suppose an investor, as on March 05 2015, may like to value 7.83% G.S. 2018, a fixed
rate bond issued by the Govt. of India, offering a fixed coupon of R.3.915/- in every six
months for every Rs.100/- investment, till the maturity of the bond, i.e. on April 11
2018. Will there be any accrued interest? How the valuation can be done considering
the accrued interest (if any)? How different day count conventions (30/360, and
Actual/Actual) affect the value of the bond?
Since the bond is getting matured on April 11 2018, and the coupons are paid
semiannually, the last date of coupon paid before the settlement/valuation (i.e. before
March 05 2015) and the next date of coupon expected to be paid after the settlement
are respectively October 11 2014 and April 11 2015. Since the valuation is done in
between these two coupon payment dates, i.e. after almost 5 months (just few days less)
from the last coupon payment date, there is a majority portion of coupon or interest,
due on April 11 2015, accrued for this 5 months to the seller of the bond. Therefore,
with the assumption of 30/360 and Actual/Actual day count convention, the amount of
accrued interest, the dirty price and the clean price are calculated below.
Considering the relevant dates (Last Coupon Payment Date: October 11 2014;
Settlement / Valuation Date: March 05 2015; Next Coupon Payment Date: April 11

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

2015) for the above bond, number of days between periods, under both Actual/Actual
and 30/360 day count conventions, can be estimated as follows:
Months No. of Days No. of Days
(Actual/Actual) (30/360)

October 2014 (12th Onwards) 20 19

November 2014 30 30
December 31 30
January 2015 31 30
February 2015 28 30
March 2015 (Till 5 )
th 5 5
March 2015 31 30
April 2015 (Till 11 )
th 11 11
Total Number of Days
(October 11 2014–March 05 2015) 145 144
Total Number of Days
(March 05 2015 – April 11 2015) 26+11=37 25+11=36
Total Number of Days
(October 11 2014 – April 11 2015) 182 180

Therefore, the Accrued Interests for 7.83% G.S. 2018 as on March 05 2015, under
different day count conventions, are:

AI (under Actual/Actual) = 1st Semiannual Coupon after Settlement × {(October 11

2014 – March 05 2015) / (October 11 2014 – April 11
2015)}
= {(7.83% × Rs.100/-) / 2} × {145 / 182}
= Rs.3.1191/-
AI (under 30/360) = 1st Semiannual Coupon after Settlement × {(October 11
2014 – March 05 2015) / (October 11 2014 – April 11
2015)}
= {(7.83% × Rs.100/-) / 2} × {144 / 180}
= Rs.3.1320/-

The period (in Semi-annual terms) from the Settlement/Valuation Date till the Next
Coupon Date also need to be calculated for the valuation of the bond, and is defined by
‘i' such that:
i = (Days from Settlement/Valuation Date to Next Coupon Date) / Days in Coupon Period

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Therefore, the value of i, required to select the period to discount the respective future
CFs, again under different day count conventions, could be:
i (as per Actual/Actual) = 37 / 182 = 0.2033
i (as per 30/360) = 36 / 180 = 0.2000
Now, the 7.83% G.S. 2018, maturing on April 11 2018 and paying a semi-annual coupon
of Rs.3.915/- each, can be valued (Dirty and Clean Price) as on March 05 2015, as per
the different day count conventions. The Risk-free YTM for the concerned maturity
(3.1041 years) as on the date of valuation is 7.7529% p.a., and therefore the semi-
annual YTM stands at 3.8765%. The total number of semi-annual coupons (@Rs.3.915/-
) due in this bond are 7, due on April 11 2015, October 11 2015, April 11 2016, October
11 2016, April 11 2017, October 11 2017, and April 11 2018, and the Principal amount
of Rs.100/- is due on April 11 2018.
Therefore, the prices of 7.83% G.S. 2018, under Actual/Actual, as on March 05 2015 are:
C1 C2 C3 C4 C5 C6 C 7 + MVt
DP = + 1+ i
+ 2+i
+ 3+ i
+ 4+ i
+ 5+ i
+
(1 + r / 2) i
(1 + r / 2) (1 + r / 2) (1 + r / 2) (1 + r / 2) (1 + r / 2) (1 + r / 2) 7 -1+ i
3.915 3.915 3.915 3.915 3.915
= + + + +
(1 + 3.8765%) 0.2033
(1 + 3.8765%) 1.2033
(1 + 3.8765%) 2.2033
(1 + 3.8765%) 3.2033
(1 + 3.8765%) 4.2033
3.915 3.915 + 100
+ +
(1 + 3.8765%) 5.2033
(1 + 3.8765%) 6.2033
= 3.8848 + 3.7399 + 3.6003 + 3.4659 + 3.3366 + 3.2121 + 82.0760

DP = Rs.103.3157 / -

CP = DP - AI = 103.3157 - 3.1191 = Rs.100.1966 / -

Alternatively, the prices of 7.83% G.S. 2018, under 30/360, as on March 05 2015 are:
C1 C2 C3 C4 C5 C6 C 7 + MV t
DP = + 1+ i
+ 2+i
+ 3+ i
+ 4+i
+ 5+ i
+
(1 + r / 2) (1 + r / 2)
i
(1 + r / 2) (1 + r / 2) (1 + r / 2) (1 + r / 2) (1 + r / 2) 7 -1+ i
3.915 3.915 3.915 3.915 3.915
= + + + +
(1 + 3.8765%) 0.2000
(1 + 3.8765%) 1.2000
(1 + 3.8765%) 2.2000
(1 + 3.8765%) 3. 2000
(1 + 3.8765%) 4.2000
3.915 3.915 + 100
+ +
(1 + 3.8765%) 5.2000
(1 + 3.8765%) 6.2000
= 3.8853 + 3.7403 + 3.6008 + 3.4664 + 3.3370 + 3.2125 + 82.0863

DP = Rs.103.3287 / -

CP = DP - AI = 103.3287 - 3.1320 = Rs.100.1967 / -

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3. 3 Selection of Single or Multiple Discounting Rates:

There are two important Approaches to value a coupon-bearing fixed income security.
These are: Traditional Approach, and Arbitrage-free Valuation Approach. Both the
approaches have their own significance and therefore are used by different market
players for different purposes.

§ Traditional Approach to Valuation:

As per the first approach, all the expected future cash flows from a coupon-
bearing security are discounted at the same rate of interest or discount rate,
irrespective of the fact that different cash flows are received at different point of time.
Here the single discounting rate is the Yield-to-Maturity (YTM) for the concerned
tenor/period. YTM is the discount rate which equates the present value of promised
payments (coupon plus redemption value at maturity) to the current market price.
Alternatively, YTM is the is the Internal Rate of Return (IRR) earned by an investor who
buys the bond today at the market price, assuming that the bond will be held until
maturity, and that all coupon and principal payments will be made as scheduled. YTM
can also be treated as the Hurdle Rate of Return required to issue the bond at its ruling
market price. Here, the interest rate used for discounting depends on whether the
security to be valued is Govt. security or Non-Govt. security. In case of valuing any Govt.
security, the YTM of a risk-free instrument with similar maturity may be used to
discount all the expected cash flows. Similarly, some yield spread or yield premium,
based on the additional risk, may be added with the concerned risk-free YTM to get the
required YTM for the purpose of discounting the expected cash flows of the Non-Govt.
security. This approach is alternatively known as YTM based valuation, as followed in
the above section to value the Govt. of India security 7.83% G.S. 2018.

§ Arbitrage-free Valuation Approach:

On the other hand, the valuation of a fixed income security would found to be
arbitrage free when the expected future cash flows, received at different point of time,
are discounted at the prevailing yields available for those respective periods. Putting
differently, the coupon-bearing bonds may be viewed as a package of several (equal to
the total number of periodic coupon payments) Zero-coupon issues whose maturity
values would be equal to the amount of all expected future cash flows and whose
maturity dates would be equal to the future dates when the cash flows are expected to
be released. This way of valuing a coupon-bearing security prevents a dealer to earn any
arbitrage profit by stripping a coupon-bearing Govt. security and selling off the stripped
securities at some higher aggregate value comparative to the cost bear by him to
purchase the fixed coupon bearing security. This is the reason why this approach is
known as Arbitrage-free Valuation Approach. In such approach, multiple interest rates
or Yields are used for discounting purposes, depending on the actual periods when all

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

the future cash flows are due. These multiple rates are nothing but the Zero-Coupon
Yields, commonly known as Spot Rates of different time periods.
The same example as discussed above, 7.83% G.S. 2018, can be considered to
understand the Arbitrage-free bond valuation, or bond valuation with multiple
discounting rates.
Example:
Suppose an investor, as on March 05 2015, may like to value 7.83% G.S. 2018, a fixed
rate bond issued by the Govt. of India, offering a fixed coupon of R.3.915/- in every six
months for every Rs.100/- investment, till the maturity of the bond, i.e. on April 11
2018. How the bond can be valued with multiple discounting rates, assuming 30/360
convention, as followed for Govt. securities in India? Is there any arbitrage opportunity
for the trader on March 05 2015?
The pricing of 7.83% G.S. 2018 as on March 05 2015 can be done in the similar pricing
framework as followed above, but just by using different discounting rates, preferably
the Zero-Coupon Rates, for the respective period, available on March 05 2015. These
rates can be extracted from the CCIL NSS ZCYC Parameters (Beta 0 =7.5777, Beta 1 =
0.3153, Beta 2 = 1.4161, Tau 1 =0.2021, Beta 3 = -0.2810, and Tau 2 = 1.0001) as on
March 05 2015, provided by the CCIL. Annualized Zero Coupon rates for all the required
tenors (0.20, 1.20, 2.20, 3.20, 4.20, 5.20, and 6.20 semi-annual periods as per 30/360
rule) are estimated from the above parameters and are used in the pricing framework
to get the arbitrage-free value of 7.83% G.S. 2018 on March 05 2015, such that:
C1 C2 C3 C4 C5 C6 C 7 + MVt
DP = + 1+ i
+ 2+i
+ 3+i
+ 4+i
+ 5+ i
+
(1 + r1 / 2) i
(1 + r2 / 2) (1 + r3 / 2) (1 + r4 / 2) (1 + r5 / 2) (1 + r6 / 2) (1 + r7 / 2) 7 -1+ i
3.915 3.915 3.915 3.915
= + + +
(1 + 8.1259% / 2) 0.2000 (1 + 7.7858% / 2) 1.2000 (1 + 7.6543% / 2) 2.2000 (1 + 7.6143% / 2) 3.2000
3.915 3.915 3.915 + 100
+ + +
(1 + 7.5993% / 2) 4 .2000
(1 + 7.5928% / 2) 5.2000
(1 + 7.5895% / 2) 6.2000

= 3.8839 + 3.7396 + 3.6045 + 3.4738 + 3.3474 + 3.2254 + 82.4881

DP = 103.7628

CP = DP - AI = 103.7628 - 3.1320 = 100.6308 / -

Arbitrage _ Pr ofit = Pr ice(Multiple - Rates) - Pr ice(Single - Rate) = 100.6308 - 100.1967 = Rs.0.4341 / -

The arbitrage-free clean price of the bond as on March 05 2015 is found to be

Rs.100.6308/- which is higher than the value of the same bond, arrived at through
single rate based valuation (i.e. Rs.100.1967/-), giving an arbitrage opportunity to
market players to make a arbitrage profit of Rs.0.4341/- per Rs.100/-, by buying the
7.83% G.S. 2018 and selling the Strips created from the same.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3.4 Presence of Some Special Feature (s):

Other than a plain vanilla bond with fixed coupon and no other added features, there
can be some security bundled with some additional features, like floating rate of
interest, embedded options (call or put). Valuations of such bonds again require some
special attention.
Floating Rate securities or Notes (FRN) or Floaters are different from other fixed
income securities only in the context of coupon payments. Such coupon payments
largely depend on level of Money Market Interest Rates, e.g. LIBOR/MIBOR, T-Bill Rate,
PLR, Call Rate, etc. Coupons are normally reset Semi-annually / Quarterly / Monthly.
Coupon re-fixation period (e.g. 6-Months) and the maturity of the reference rate (e.g. 3-
Months MIBOR) are not necessarily to be same. Periodic coupon re-pricing enables the
FRN relatively insensitive to market yield even in a volatile interest rate scenario. FRN
are generally issued at certain Spread over the benchmark rate, depending on issuer’s
credit rating, liquidity, term to maturity etc., such that: Coupon Rate = Benchmark Rate ±
Contracted/Quoted/Initial Spread. Spreads are normally set at the time of issue and
remain fixed until maturity, but may subject to necessary change at some coupon re-
fixation date, depending on the concerned factors.
Given the fact that the coupon rate is equal to the prevailing market rate,
especially in either of the coupon reset dates, such bond should be traded at a par value.
Notwithstanding this fact, the valuation of such security largely depends on the level of
spread over the benchmark rate desired by the market participants. In other words, the
value of a FRN, at any re-pricing date, does have to compensate for any discrepancy
between contractual and market rate. The larger the deviation between the contracted
spread and the desired spread, the more the bond price would diverge from its par
value. Therefore the valuation of a floating rate bond largely depends upon the date of
valuation and the nature of spread (if any) added to their reference rate. Spot Rate
curve or Zero Swap curve can be used to value a FRN.
A bond embedded with a call (put) option is termed as Callable (Putable) bond.
Call (Put) option gives the issuer (holder) the right to Buy back (Sell off) the bond issue
before they matures, depending on the movement in the rate of interests. Price of such
options need to be adjusted with the price of similar option free bond to derive the
value of a callable (putable) bond. Since in case of callable (putable) bond, the issuers
(holders) enjoy the right to exercise their options, the value of a callable (putable) bond
is expected to be lower (higher) than the value of a similar option free bond. The price
of such option again depends on the chance of exercising the option, which again
depends on the movement in future rate of interests. In case of valuing a simple bond,
the future interest rates are not expected to be volatile. But the valuation of bonds with
embedded options specifically depends upon the volatility in the rate of interests.
Therefore, unlike in case of valuation of any option-free bond, the framework or
mechanism used to value a bond with any embedded option need to capture the interest

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

rate volatility. Binomial option pricing model can be successfully used to price bonds
with embedded options.

4.0 Valuation of FI Securities: RBI-FIMMDA Guidelines

Even if there are various mechanisms to value bond of different nature, Reserve Bank of
India and Fixed Income Money Market and Derivatives Association (FIMMDA), an
association of Commercial Banks, Financial Institutions and Primary Dealers in India
concerned with the domestic market operations, publishes some guideline, which are
consistently followed by the banks and other FIs in India. Valuation of various securities
available in Indian market need to be done as per the FIMMDA guidelines only,
summarised below:
ü Investments classified under HTM will be carried at acquisition cost. In case the
bond is acquired at premium, the premium should be amortized over the period
remaining to maturity. Book value of the security should continue to be reduced to
the extent of the amount amortized during the relevant accounting period.
ü Periodical valuation of investments included in the AFS and HFT would be the
market price of the issue as available from the trades / quotes. All AFS and HFT
positions need to be market to market respectively at least on Quarterly and
Monthly basis, especially for reporting purposes. It may be noted here that the book
value of the individual securities would not undergo any change after such
periodical valuation.
ü In respect of unquoted securities, a specific procedure is followed, as suggested by
the Reserve Bank of India
ü All unquoted Central Govt. securities, qualified for SLR, can be valued from the Base
Yield Curve published by FIMMDA.
ü Unquoted Central Govt. securities, not qualified for SLR, can be valued at the yield
from the same Base YC plus 25 basis points.
ü State Govt. securities can be valued from the Base Yield Curve, but after adding 25
bps with the concerned base yield.
ü Special securities (Oil Bonds, Fertilizer Bonds, IFCI / FCI bonds), directly issued by
Government of India to the beneficiary entities but do not carry SLR status, are
valued at a spread of 25 bps above the corresponding G-Sec. or base yield.
ü Treasury Bills can be valued at Carrying Cost (for Banks) or on Marked-to-Market
basis (for Primary Dealers).
ü ZCBs should be shown in the books at carrying cost, i.e. acquisition cost plus
discount accrued.

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ü Floating Rate bonds, if traded in the market, need to be valued at the traded price.
In absence of any trading, FRB need to be valued by considering all the future CFs
(extracted from the forward benchmark rate plus the contractual spread, if any),
discounted at the Risk-free YTM/ZCYC adjusted with the respective market or
Desired Spread, if any. The desired spreads added is the illiquidity spreads, and are
determined based on the simple average of the polled, conducted once in a
fortnight, numbers, after eliminating the outliers (equals to 2 standard deviations).
ü Callable bonds are valued at the Yield-to-Worst, higher of Yield to Maturity and all
possible Yield to Call, adjusting the residual tenor pertaining to the yield to worst.
In case the yield levels started falling from the beginning, yield to first call becomes
the yield to worst (for the investor) and the residual tenor till the nearest call date
becomes the tenor used for valuation. On the other hand, if the yield levels remain
the same or start rising till the maturity, the YTM becomes the yield-to-worst and
the residual tenor till the maturity becomes the tenor used for valuation.
ü Putable bonds are valued at Yield-to-Best, lower of yield to maturity and all
possible yield to put, adjusting the residual tenor pertaining to the yield to best. In
case the market yield starts rising, yield to first put becomes the yield to best (for
the investor), and the residual tenor till the nearest put date becomes the tenor
used for valuation. On contrary, if the yield level remains the same or starts falling
till the maturity, the YTM becomes the yield to best, and the complete residual
tenor till the maturity becomes the tenor used for valuation.
ü In case any bond has simultaneous call and put options, to be exercised on the same
day and with an option of multiple times till the maturity, the nearest call/put date
may be considered for valuation.
ü Perpetual Bonds should be valued, considering the final maturity as the longest
point on the Base Yield Curve (say 40 Years, as published by FIMMDA) and the
applicable spread for the longest tenor (say 15 years as published by FIMMDA).
Accordingly, cash flows of the perpetual bond till the longest point of the base yield
curve need to be considered. In case any perpetual bond has a call option, along
with step-up coupon after the call option, valuation of such security need to be
based on the cash flows with regular coupon till the call date, followed by the step-
up coupon thereafter.
ü Any Non-Govt. security continuously traded in the last 15 calendar days, with a
minimum trading volume of INR 5 Crore in any day, can be valued based on the
actual traded price.
ü Valuation of any Rated, considering the lowest of available credit ratings, not more
than 12 months old, if given by two or more rating agencies, Non-Govt. securities
can be done from the Annualized Base Yield Curve and the required spread,
regularly published by FIMMDA, depending upon the nature of issuer (Bank-PSU-
FI, NBFC, or Corporates), credit rating (AAA to BBB-) and maturity (0.5 to 15 years).

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Base yield and credit spread for any intermediate tenors may be arrived at through
Linear Interpolation.
ü Whenever a corporate bond is traded, the traded spread may be used to value all
other non-traded bonds of similar rating and residual tenor, issued by the same
entity or issuer.
ü Unrated bonds of an issuer may be valued at a spread of equivalent rated bond of
similar tenure from the same issuer, after marking-up at least by 25%.
ü In case of securities not at all rated by any rating agency, or having a rating older
than 12 months, and no corresponding bond of similar valid rating by the same
issuer exist, the published credit spread applicable to BBB- for the residual tenor
marked up by 25% need to be used for valuation.
ü CPs and CDs, having a residual tenor less than one year, should be valued at
carrying cost.
ü UDAY bonds issued by various State Governments in India to repay the DISCOM
loans need to be presently valued by adding 50 bps to the Base Yield Curve.
ü Valuation of Basel III Compliant Perpetual Bond need to be based on the concerned
base yield and the qualifying spread published by FIMMDA for two rating grades:
AA & Above, and AA- & Below, and for two tenors: 3 to 5 years, and 7 to 10 years.

Self-Learning Exercise:

1. What are the various sources of returns from a bond and how these sources affect
the current price of the bond?
2. How the coupon rate of a bond and its YTM are interrelated and how this
interrelation affects the price difference (if any) between the current price of a
bond and its par value?
3. Define the full price, clean price of a bond and the factor causing for the difference
between these two prices (if any).
4. An investor has invested in 6.90 GS 2019 today. He is little doubtful about the
movement of its market price, and trying to understand the possible price gain in
the future. What could be the maximum price of the bond he may think of?
5. What is meant by marking a position to market?
6. Suppose, two GOI dated securities (7.80 GS 2021, maturing on 11-Apr-2021, and
5.87 GS 2022, maturing on 28-Aug-2022) are presently traded at INR 104.29 and
INR 97.16 respectively. How do you think, the prices of both the bonds change as
they approaches their maturity dates?

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7. Explain the arbitrage free valuation approach and the market process that forces
the price of a bond towards its arbitrage free value, and also explain how a dealer
can generate an arbitrage profit if a bond is mispriced.
8. Identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for these
bonds.
9. “There is no interest rate risk in case of an investment in a floating rate bond. The
yield is always at per with the market, and there is no reason for the value of the
FRB to deviate from the par value.” Explain whether you agree or disagree with this
statement.
10. Identify the relationship between price of a Callable bond, price of the similar
option-free bond, and the value of the embedded call option. Explain with the help
of Price/Yield Curve.

References:

v Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 5, 16,
37); McGraw-Hill.
v Sundaresan, Suresh M, 2002, Fixed Income Markets and their Derivatives
(Chapter: 2); Thomson Asia, Singapore.
v Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 3, 15); Butterworth-Heinemann.
v Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 2); Wiley Finance.
v Bruce Tuckman, 2002; Fixed Income Securities: Tools for Today's Markets
(Chapter: 2); John Wiley & Sons, Inc.
v A V Rajwade, 2008; Handbook on Debt Securities and Interest Rate Derivatives
(Chapter: 8); Tata McGraw-Hill.
v Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 3); NIBM In-house Publication.
v Reserve Bank of India, 2015; Prudential Norms for Classification, Valuation and
Operation of Investment Portfolio by Banks; RBI Master Circular.
v FIMMDA, (2016); Valuation of Investments; FIMMDA Circular.

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Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 5: Interest Rate Sensitivity Measures

Dr. Kedar nath Mukherjee

Objectives:

The objective of this chapter is to make the readers aware about bond price sensitivity
to change in interest rates, and different measures available to capture such interest
rate sensitivity. At the end of this chapter, the readers are expected to be familiar with:
i. How the prices of different bonds respond to a change in interest rate?
ii. What is Duration, M-Duration, PV01/PVBP, and how these are measured for a
single instrument or a portfolio of instruments
iii. What is Effective Duration, and how it is different from M-Duration?
iv. What are the usefulness and limitations of these sensitivity measures?
v. What is Convexity, and how the same is measured
vi. Whether Convexity truly supplements the Duration measure to capture bond
price sensitivity to interest rates?
Structure:
1. Bond Price Sensitivity to Interest Rates: Meaning
2. Price-Yield Relationship
3. Various Interest Rate Sensitivity Measures
3.1. Duration or Macaulay Duration
3.2. Modified Duration
3.3. Effective Duration
3.4. Price Value of a Basis Point (PVBP) or PV01
4. Portfolio Sensitivity Measures
5. Limitations of Duration/M-Duration/PV01
6. Convexity

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

1.0 Bond Price Sensitivity to Interest Rates: Meaning

Prices/values of all types of fixed income securities are sensitive to any change, large or
small, in the rate of interests. Since the value of such security at any point of time is
broadly the present value (PV) of all the future cash flows due on that security, and the
PVs of future cash flows are sensitive to the rate of interests for the respective tenors,
the value of any fixed income security is sensitive to any possible change in the rate of
interest. Alternatively, there is an inverse relation between the price of a bond or fixed
income security and the rate of interest. Any rise (fall) in the rate of interest leads to a
fall (rise) in the value of a bond, leading to make a capital loss (gain) for the investor or
security holder. Therefore, all investors investing in fixed income securities are said to
be exposed to Interest Rate Risk. Net Gain or Loss in the FI portfolio depends on two
components: Capital Gain (Loss), and Revenue Loss (Gain). Any change in interest rates
affects these two components inversely. Alternatively, any possibility of a capital gain
will be supplemented by a revenue loss, and vice versa, but may not offset each other.
Risk of incurring a capital loss due to rise in interest rates is known as Price Risk, and
the risk of earning a lower reinvestment income due to fall in interest rates is termed as
Reinvestment Risk.
The relation between bond price and interest rate can also be explained with a
simple example. Suppose an investor has bought bond X at Par value at a Coupon rate of
8%. Now suppose, the market Interest Rate has gone up from 8% to 8.5% and the
investor want to sell the bond where the coupon rate would be same 8%. Since the bond
is selling at Par, nobody would like to buy the bond at Par with a coupon rate of 8%,
where the market interest rate is 8.5%. Here neither the investor can change the
Coupon rate nor can he change the actual maturity of the bond so that the same would
be saleable in the market. However, what the bond seller can do is to reduce the bond
price so that the amount of coupon received on the bond at the bond’s par value would
be equal to the amount based on the new or revised interest rate on the new or revised
price, so that without changing the original coupon rate, the current market rate can be
offered to the prospect buyer of the bond.
The magnitude of interest rate sensitivity largely depends upon the features of a
bond issue, such as: Maturity, Coupon Rate, Coupon Payment Frequency, Yield, presence
of Options, etc. In case of floating rate bond, even if the coupon rates are adjusted with
the prevailing market rates in every coupon reset dates, the value of such bond is
exposed to interest rate fluctuation during two coupons reset dates. Prices of Longer
Maturity bonds are more sensitive to interest rate changes than a similar bond but with
shorter maturity. Prices of high coupon bonds or bond with higher coupon payment
frequency are less sensitive to change in interest rates than the prices of similar low
coupon bonds or bond with lower coupon payment frequency. Higher the Initial YTM of
a bond, lower would be its price sensitivity to change in yield. In order to understand
the sensitivity of bonds with embedded options (call / put) due to change in interest

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rates, the same can be achieved by capturing the sensitivity both in the price of similar
option free bond and the price of the option (call / put). If interest rate falls, the chances
for the call (put) option holder to exercise their option increases (reduces), and
therefore the value of call (put) option tend to rise (fall). On the other hand, if interest
rate rises, the chances for the put (call) option holder to exercise their option increases
(reduces), and therefore the value of put (call) option will rise (fall). Therefore,
considering the impact of interest rate change on the value of a simple option-free bond
and also on the value of options, the net impact can be summarized as follows:

As interest rate falls (rise), the value of callable bond will not rise (fall) by the similar
amount as in case of similar option-free bond.

As interest rate rise (fall), the value of putable bond will not fall (rise) by the similar
amount as in case of similar option-free bond

Even if all fixed income securities are individually sensitive to interest rate
fluctuations and can be easily captured, the sensitivity of the entire fixed income / bond
portfolio need to be carefully analyzed and estimated. Maturity of a bond is one of the
important factors for its Price Sensitivity due to change in the interest rate or the Yield.
Therefore the value of a Portfolio of bonds with different maturities depends on how
the value of individual bonds with different maturity periods changes following the
change in interest rates. The rate of interest or the Yield of different bonds varies
according to their respective maturities. The Graphical relation between the Yield and
Maturity of different bonds is known as Yield Curve. It is basically assume that in the
scenario of changing interest rates, the yield of different bond with different maturities
changes by similar basis points, commonly known as Parallel Shift in the Yield Curve.
But in real market condition, when there is any change in the rate of interest, even if all
the rates change in a similar direction (positive or negative), the magnitude of change is
not necessarily be same for all bonds with different maturities, which can be
represented by a Un-parallel Shift in the Yield Curve. Due to this possible un-parallel
shift, yield curve may become more Flatter or more Steeper. If the yield curve flattens,
then the yield spread between long- and short-term interest rates narrows. On the other
hand, steepening the yield curve represents widening the spread between long- and
short-term interest rates. The price sensitivity of the whole bond portfolio, in the event
of change in the interest rates, largely depends on market expectation towards the type
of shifts in the yield curve. Therefore, other than price and reinvestment risk, a bond
portfolio manager may also be exposed to the risk of any un-parallel shift in the yield
curve, commonly known as Yield Curve Risk.

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2.0 Price-Yield Relationship:

Since interest rates are the major driver of the prices of fixed income securities, it is
very important to capture the relationship between the price and yield of a security.
The graphical presentation of this relationship is known as Price-Yield Curve. The
price-yield curve of any Option Free bond exhibits a downward sloping curve which is
not linear and therefore is not a straight line. The Shape of the Price/Yield curve of any
option-free bond is downward slopping and 'Convex'. However, the shape of
Price/Yield curve, of a Callable bond, is downward slopping, but exhibits negative
(positive) convexity at Lower (Higher) level of yields. On the other hand, shape of
Price/Yield curve, of a Putable bond, is downward slopping and convex, but with more
Flatness beyond a certain level of yield (Yield > Coupon).

Some of the important Properties on the Relation between the Price Volatility of
an Option-free Bond and Changes in its Yield are:
o Even if the Yield and Price of all Bonds Moves in Opposite Direction, the
Percentage Change (Positive or Negative) in the Prices or Actual Price change of
Different Bonds are Not Similar even though for a Similar Change in the Yield
o In case of small changes (positive or negative) in yield, the percentage of price
change (in both the direction) for a given bond is almost the same, irrespective of
the direction of the change in the yield
o In case of a large change (positive or negative) in the required yield (± X%), the
percentage of price change for a given bond is not same following a positive or
negative change in the yield of similar magnitude. Positive percentage change in
the price of a bond following the large negative change in the yield is
comparatively greater than the negative percentage change in the same bond’s
price following an identically large but positive change in the yield.
o Assuming other factors remaining the same, the longer (shorter) the bond's
maturity, the greater (smaller) would be the bond's price sensitivity to interest
rates.
o Assuming other factors remaining the same, the lower (higher) the coupon rate,
greater (smaller) would be the bond's price sensitivity to interest rates.
o Zero-coupon bonds have greater price sensitivity to interest rates than the
coupon bearing bond of similar maturity.
o Price of a bond with embedded options (call or put), following a rise or fall in the
rate of interest, may not fall (increase) by the similar magnitude as is possible for
an option-free bond.
Accordingly the price-yield curve for an option-free bond looks like:

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Price /Yie ld Re lations hip of an Option-fre e Bond

140.00

130.00

120.00
Bond Price (Rs.)

110.00

100.00

90.00

80.00

70.00

60.00
0.000% 2.500% 5.000% 7.500% 10.000% 12.500% 15.000% 17.500%
Yie ld (%)

3.0 Various Interest Rate Sensitivity Measures

There are some very important measures used to quantify the level of bond price
sensitivity to change in interest rates. These are Duration, Modified Duration (M-
Duration), Price Value Basis Points (PVBP) or PV01, Convexity, etc. There can be again
variety of these measures applicable to different types of bonds.

3.1 Duration or Macaulay Duration:

Duration (also known as Macaulay Duration), of a bond, can be expressed in terms of

the Average life of the security within which the original investment is expected to be
recovered. Alternatively, Macaulay Duration is the Weighted Average Maturities of all
the assumed zero coupon bonds (equal to various Cash Flows of the coupon bond),
where the weights used at different periods are the Proportion of PV of cash flows at
each period and the Full Price of the bond. For a zero coupon bond, Macaulay’s duration
clearly equals the tenor of the bond. Macaulay’s duration can be calculated as:

 n  n
 
Macaulay _ Duration  i 1 ti   PVCFi  PVCF  1 k 
i
  i 1 

Where PVCFi represents the present value of cash flows due in period i, and t i
represents the time when various interim cash flows are due till the maturity (n); k is
the frequency of interim coupon payments, and therefore is 2 for semi-annual paid
bonds.

This Macaulay Duration can also be calculated through excel by using the following
function:

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

=DURATION(Settlement, Maturity, Coupon, Yld, Frequency, [Basis])

Where, the inputs are the Date of Settlement/measuring the duration (Settlement), Date
of Maturity (Maturity), Coupon Rate (Coupon), Yield to Maturity for the concerned tenor
(Yld), Coupon Payment Frequency (Frequency), and the Day Count Convention followed
([Basis]).

Example:
Let us take a bond having 2 years maturity, and 10% coupon, semiannually paid, and
current price of Rs.101.79, prevailing 2 year yield being 9%. The duration of the bond
can be calculated as:
Time period (half Total
1 2 3 4
years)
Cash Inflows (Rs.) 5 5 5 105
PV at an yield of 9% 4.78 4.58 4.38 88.05 101.79
PV × Time 4.78 9.16 13.14 352.20 379.28

Duration in number of semiannual periods = 379.28/101.79 = 3.73

Duration in Years = 3.73/2 = 1.86 Years.

Therefore, the average maturity of the bond is 1.86 years.

3.2 Modified Duration:

Modified duration (MD) is a modified version of Macaulay Duration. Modified duration

follows the concept that interest rates and bond prices move in opposite direction. It
refers to the change in value of the security to one per cent (100 basis points) change in
interest rates (Yield). A formula that expresses the measurable change in the value of a
security in response to a change in interest rates is expressed as under:


MDuration  MacaulayDu ration 1  YTM
k

 n  n
  
Modified _ Duration  i 1 ti   PVCFi
 
 PVCF   1 k   1 1  YTM / k 
i
i 1  

Mathematically, M-Duration is the relative price change, i.e. the first order
differentiation of the bond price function [P=f (r)], and can be derived as:

1 dP 1 Ci Ci
  i 1  i  where P  i 1
n n
Duration   ;
P dr P 1  r i 1 1  r i

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Like Macaulay Duration, Modified duration can also be calculated through excel by using
the following function:

=MDURATION(Settlement, Maturity, Coupon, Yld, Frequency, [Basis])

Where, the inputs are the Date of Settlement/measuring the duration (Settlement), Date
of Maturity (Maturity), Coupon Rate (Coupon), Yield to Maturity for the concerned tenor
(Yld), Coupon Payment Frequency (Frequency), and the Day Count Convention followed
([Basis]).

If we calculate the M-Duration from the above example, M-Duration = 1.86/

(1+0.09/2) = 1.78. Therefore, approximate % of Price Fall (Rise) due to the Possible
Rise (Fall) in Yield is such that, Price Change = (- Duration) * (± Yield Change) * Current
Price. In the present example, the percentage change in price of the concerned bond due
to 2 per cent rise in yield is such that:

Price Change = - 1.78% × (+2% × 100) × 101.79 = Rs.3.62/-

3.3 Effective Duration:

Effective Duration is the same modified duration, but not applicable to an option-free
bond. This sensitivity measure is used to capture the interest rate risk of a bond with an
embedded option. Alternatively, Effective Duration is the percentage price change of a
bond

with embedded option (i.e. callable or putable bond) due to one percent change in the
rate of interest. Effective duration is calculated as:

D  PdY  P dY  2  P0  dY 

Where, P-dY, P+dY, P0, and dY represents respectively the new price when yield is
expected to fall, new price when yield is expected to rise, original price, and the change
in yield. Pricing of a bond with embedded option cannot be done simply based on
discounted values of future cash flows, as in case of option-free bond. The pricing here
need to be based on a framework where interest rate volatility is duly taken care-off.
Modified Duration can also be calculated from the above formula, by considering
normal bond pricing method, but only for option-free bonds. Therefore, effective
duration can be used as a proxy measure for modified duration, but modified duration
cannot capture the effective duration, essentially used for bond with embedded options
(call or put).

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3.4 Price Value of a Basis Point (PVBP) or PV01:

Price Value of a Basis Point (PVBP), alternatively known as PV01, describes the actual
change in price of a bond if the yield changes by one basis point (1% / 100), such that

PVBP = M-Duration × 0.0001 × Price

PV01 tells us how much money a position or a portfolio will gain or lose for a 0.01%
parallel movement in the yield curve. It therefore quantifies interest rate risk for small
changes in interest rates, and also in value. It is often used as a price alternative to
Duration or M-Duration (a time or percentage measure). Higher the PV01, the higher
would be the volatility (sensitivity of price to change in yield). From the modified
duration (given in the above example), we know that the security value will change by
1.78% for a 100 basis point (1%) change in the yield. In value terms that is equal to
1.78*(101.79/100) = Rs.1.81. Hence the PV01 = 1.81/100 = Rs. 0.018, which is 1.8 paise.
Thus, if the yield of a bond with a Modified Duration of 1.78 moves from say 9% to
9.05% (5 basis points), the price of the bond moves from Rs.101.79 to Rs.101.70
(reduction of 9 paise, i.e., 5x1.8 paise).

4.0 Portfolio Sensitivity Measures

Price sensitivity of individual securities can be ultimately converted into portfolio

measure, known as Portfolio Modified Duration, or Portfolio PV01. Weighted Average of
the M-duration of all the securities in the portfolio can be considered to measure the
price sensitivity of the bond portfolio to change in interest rates, such that:

M  Duration P  w1MD1  w2 MD2  w3 MD3  ...........  wk MDk

Here, Durations of each security is weighted by the proportion of the portfolio in that
security in terms of their current market value. So if 75% of a portfolio is in a security
with a M-duration of 8, and 25% is in a security with a M-duration of 12, then the M-
duration of the portfolio is (8% × 0.75) + (12% × 0.25) = 9%. This figure suggest that if
there is a 1% rise (fall) in the rate of interest, the value of the portfolio is going to fall
(rise) by 9 per cent of its current market value. Accordingly, a portfolio manager may
construct a bond portfolio, less sensitive to uncertain fluctuation of interest rates, by
reducing concentration on securities with higher M-duration. Similarly security-wise
PV01 can be simply added together to get the Portfolio PV01, which represent the
change in the market value of the entire portfolio due to one basis change in the interest
rate. A portfolio manager may like to have an optimum mixture of securities in his
portfolio, depending on his concern about both Risk and Return.

Suppose, a portfolio manager, as on December 05 2014, hold a G-Sec. portfolio of 27 GOI

securities of Rs.2506.21 crore, where portfolio M-Duration and Portfolio PV01 are

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

respectively 5.52% and Rs.1.3839 crore. Therefore, the portfolio manager is expected to
lose 138.39 crore due to 1 percent rise in the rate of interest, and the same loss will be
just Rs.1.3839 crore for every one basis rise in the interest rates. Since M-Duration is a
percentage measure, the portfolio sensitivity measure can be estimated by taking the
weighted average of the security-wise M-Duration. But PV01 is an absolute sensitivity
measure, and therefore security-wise PV01 can be simply summed-up to arrive at the
portfolio PV01, but with the same assumption of equal change in interest rates for all
securities.

5.0 Limitations of Duration/M-Duration/PV01

Duration, M-Duration, and PV01 are widely used as the important bond price sensitivity
measure to interest rate fluctuations. There is no doubt that Duration measures can
easily capture the interest rate risk of a fixed income security. But percentage change in
the bond’s price due to change in interest rates as captured by these measures and the
actual price change may or may not be the same. Such difference, if found to be large,
may lead these measures un-useful and irrelevant. Consistency between the estimates
of price change as depicted by these measures and the actual change depends upon the
degree of change in the rate of interest. Bond Price sensitivity estimated through
Modified Duration differs significantly with Actual in case of large interest rate shock.
More specifically, the limitations of these sensitivity measures are:

5.1 Linearity in the Price-Yield Relations:

Duration, M-Duration and PV01 assume a linear relation between the bond price and
yield. Alternatively, the rate of change in the price of a bond is constant for every similar
change, irrespective of the direction, in the yield or rate of interest, leading to the price-
yield curve as a downward slopping straight line. But the presence of non-linearity in
the price-yield relation makes this sensitivity measures less useful, especially at certain
circumstances. This non-linearity causes for a different change in price even if yield is
expected to change by a similar amount. Impact of this non-linear price-yield relation is
more prominent in case of large change in the yield. A market like in India may
comfortably capture interest rate risk on their bond portfolio through these measures
only because the interest rates are not sufficiently volatile and therefore change by a
smaller magnitude.

5.2 Parallel Shift in Yield Curve:

For the Portfolio Duration measures (Portfolio M-Duration, Portfolio PV01) to be

meaningful, it needs to be ensured that the interest shock should be same for all
securities, i.e. the Portfolio M-Duration measure exhibits the interest sensitivity in the
market value of the whole portfolio following a fixed 100 basis points change in the
yield of all the securities, irrespective of their maturities. Alternatively, if there is any

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

change (positive or negative) in the rate of interest for any tenor, all possible rates are
expected to change in the same direction and also by a similar magnitude. This property
of term structure of interest rates is known as Parallel Shift in the yield curve. If the
yield points changes by different magnitude depending on their respective maturities,
than this bond portfolio sensitivity measures may fail to capture the interest rate risk. In
general short-term interest rates are expected to be more volatile than the long-term
rates in normal market condition, leading to a different change in the yield points
depending on their maturities, and therefore an Un-parallel Shift in the yield curve. In
such case another sensitivity measure, known as Key Rate Duration may be useful. Key
Rate Duration captures the price effect due change in yield for a specific maturity of the
yield curve, holding other yields constant. Therefore there may be several interest rate
sensitivity estimates depending on the key yield points on the yield curve, and these
multiple risk estimates may be taken into consideration to capture the interest rate risk
of a bond portfolio consisting of various securities throughout the yield curve.

6.0 Convexity

Duration is a linear measure of how the price of a bond changes in response to interest
rate changes. As interest rates change, the price is not likely to change linearly, but
instead it would change over some curved function of interest rates. The more curved
the price function of the bond is, the more inaccurate M-Duration is as a measure of the
interest rate sensitivity. This feature of the price-yield curve is known as Convexity.
Alternatively, Convexity is a measure of the curvature of how the price of a bond varies
with interest rate. This is the change in duration of a bond per unit change in the yield of
the bond. Presence of convexity makes the modified duration measure to overestimate
the fall in price due to certain rise in yield, and underestimate the rise in price due to
similar fall in yield, especially for a significant change in the yield. Specifically, it may be
assumed that the interest rate is constant across the life of the bond and that changes in
interest rates occur evenly. Using these assumptions, duration can be formulated as the
first order differentiation of the price function of the bond with respect to the interest
rate in question. Then the convexity would be the second order differentiation of the
price function with respect to the same interest rate. Relative Convexity (RC) can be
measured as:

Where, P, r, i, and C respectively represent bond price, concerned yield, time, and cash
flows. Convexity can be both positive and negative. A bond with positive convexity will
not have any call features - i.e. the issuer must redeem the bond at maturity. On the
other hand, a bond with call features - i.e. where the issuer can redeem the bond early is
deemed to have negative convexity. Convexity can be alternatively calculated as:

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

 
Convexity  P dY  P dY  2 P0  2  P0  dY 2 
Where, P-dY, P+dY, P0, and dY represents respectively the new price when yield is
expected to fall, new price when yield is expected to rise, original price, and the change
in yield. Once security specific convexities are estimated, the portfolio convexity can be
arrived at by taking the weighted average of individual convexities. Suppose, for the
same portfolio manager, as on December 05 2014, holding a G-Sec. portfolio of 27 GOI
securities of Rs.2506.21 crore, the portfolio convexity comes to 23.16. This Relative
Convexity measure once converted into a measure called Convexity Adjustment (RC ×
Δy^2), can be further used to understand the bonds price sensitivity with more
accuracy and precision. The convexity adjustment measure for the specified portfolio of
securities may work out to be 0.2316%. This is the estimate which need to be adjusted
with the M-Duration of the concerned portfolio to get the true sensitivity measure, after
considering the non-linearity of the price-yield relationship.
M-Duration and Convexity are not substitute to each other, but rather
complementary to each other. M-duration can successfully capture the bond price
sensitivity to interest rate fluctuation, which may be observed in certain market like in
India, but only for a smaller change in the yield. If there is a significant change in the
interest rates, modified duration alone may fail to capture the interest rate risk, either
by way of over-estimation of losses or under-estimation of gains. Under such
circumstances, M-duration if adjusted with the bond’s convexity can give a satisfactory
result. This measure is known as Convexity-Adjusted Modified Duration. Therefore,
change in bond’s price due to any change in yield, after adjusting for the convexity, can
be calculated as:


P P   MD  y  RC  y 
2

Example:
Suppose, as per the above example, where the value of the G-Sec. portfolio, consisting of
27 GOI securities, as on December 05 2014 stands at Rs.2506.21 crore, with a portfolio
M-Duration and convexity of 5.52% and 23.16 respectively. The portfolio sensitivity to
any change in interest rates, depending upon only M-Duration and M-Duration and
Convexity both, can be estimated as follows:

Fall (Rise) in the Value of the Portfolio due to 1% Rise (Fall) in interest rates, as per M-
Duration = 5.52% × Rs.2506.21 crore = Rs.138.39 crore.

But after adjusted with the convexity (i.e. Convexity Adjustment which is 0.2316%), the
relative change (Fall / Rise) in the value of the portfolio, due to Rise (Fall) in interests
are:
 
P P   5.52%  (1)  23.16  1%   5.2903%
2

P P   5.52%  (1)  23.16  1%   5.7535%

2

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The above numbers clearly indicate that the actual fall in the value of securities and
therefore the whole portfolio, due to certain rise in the rate of interest, is relatively
small than the rise in their value, due to similar fall in the rate of interest. Therefore,
even if the M-Duration measure indicate a similar change (5.52%) in the value of the
portfolio, irrespective of the rise or fall in interest, the convexity adjusted M-Duration
measures shown 5.2903% fall in the value of the portfolio due to 1 percent rise in
interest rates, and 5.7535% rise in the value of the portfolio due to 1 percent fall in the
rate of interests. These clearly indicate that the convexity measure helps to reduce the
overestimation of losses under a regime of rising interest rates, and underestimation of
gains under falling interest rate regime, and thereby ensure an opportunity gains for the
portfolio manager under any circumstances.

Self-Learning Exercise:

1. How the price of a fixed rate option free bond is sensitive to change in interest rates
or yields. Is the same relationship holds for a fixed rate bond with a call or put
option?
2. Explain how the basic features of a bond (Maturity, Coupon Rate and Frequency)
affects bond’s sensitivity to any change in interest rates.
3. How do you differentiate between Modified Duration and PV01? Which measure is
commonly used in the market to measure the IR risk and why?
4. Why effective duration is the most appropriate measure to capture interest rate
risk in bonds with embedded options.
5. An investor has invested in two GOI dated securities with similar maturities, but of
types: fixed and floating rate. How the IR sensitivity of both the bonds differ from
each other? What will be the duration of the FRB?
6. What are the limitations of using duration as a measure of a bond’s price sensitivity
to interest-rate changes?
7. What is Convexity of a bond and how to estimate the same? How the same is useful
in capturing the IR sensitivity of the bond?
8. How convexity measure is adjusted with M-Duration to estimate the IR risk of a
bond?
9. “M-Duration can successfully capture the IR risk of a debt security/portfolio
without considering convexity, as presently followed in developing markets like in
India.” Is it true under any circumstances?
10. Explain why you agree or disagree with the following statement: “If two bonds have
the same duration, then the percentage change in price of both the bonds will be
the same for a given change in interest rates”.

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References:

 Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 9);
McGraw-Hill.
 Sundaresan, Suresh M, 2002, Fixed Income Markets and their Derivatives
(Chapter: 7); Thomson Asia, Singapore.
 Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 7, 8, 9, 10); Butterworth-Heinemann.
 Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 5, 6); Wiley Finance.
 Bruce Tuckman, 2002; Fixed Income Securities: Tools for Today's Markets
(Chapter: 5, 6); John Wiley & Sons, Inc.
 A V Rajwade, 2008; Handbook on Debt Securities and Interest Rate Derivatives
(Chapter: 13); Tata McGraw-Hill.
 Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 6); NIBM In-house Publication.
 Reserve Bank of India, July-2015; Prudential Guidelines on Capital Adequacy and
Market Discipline-New Capital Adequacy Framework (NCAF); RBI Master Circular.
 Reserve Bank of India, July-2015; Basel III Capital Regulations; RBI Master
Circular.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Module II: Security Analysis and Portfolio Management

Section A: Fixed Income Analytics

Chapter 6: Bond Trading and Management Strategies

Dr. Kedar nath Mukherjee

Objectives:

The objective of this chapter is to make the readers aware about various real market
circumstances and a set of strategies required to trade in various fixed income products
and to manage the bond portfolio, depending on the nature of the investor, market
movements, management ability, etc. At the end of this chapter, the readers are
expected to be familiar with:
i. What are the issues required to be looked into by different types of investors to
manage their fixed income portfolio
ii. What are the Passive Strategies, bond traders or portfolio managers may like to
follow to manage their fixed income portfolio
iii. What are the various strategies that a trader or portfolio managers may like to
consider to actively manage their fixed income portfolio
iv. What are the broader Usefulness and Limitations of both Passive and Active
Strategies
Structure:
1. Bond Portfolio Management: Meaning
2. Passive Management Strategies
2.1. Bond Indexing
2.2. Cash Flow Matching
2.3. Classical Immunization
3. Advantages and Limitations of Passive Strategy
4. Important News affecting Interest Rates and Bond Yields
5. Active Management Strategies
6. Different Types of Active Management Strategies
6.1. Riding the Yield Curve; Shortening Portfolio’s Duration; Lengthening
Portfolio’s Duration; Bullet Strategy; Barbell Strategy; Ladder Strategy

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6.2. Strengths and Weaknesses for Active Management

6.3. Un-Parallel Shift in the Yield Curve: Strategies
7. Strengths and Weaknesses for Active Management

1.0 Bond Portfolio Management: Meaning

Financial institutions, including banks, whenever invest in various instruments in the

financial market and create several portfolios, are supposed to manage the same to get
the desired results. Therefore managing the portfolio of the concerned asset class
becomes very much important, especially when the financial market is extremely
volatile and uncertain, and investors have variety of objectives to meet. In order to
successfully manage an investment portfolio, what the financial institutions need to
ensure are:
o FIs need to set the specific investment objectives;
o Proper Investment Policy in line with the broader objectives need to be
established and circulated to the concerned department/person;
o Strategies need to be well defined to manage the portfolio;
o Portfolio need to be optimized by ensuring proper assets mix; and
o Performance of the portfolio needs to be measured and evaluated.
The above process of managing a portfolio of several assets is not a static event, but is a
dynamic and continuous activity for the financial institution. Bonds, being an important
asset class, constitute the major chunk of the investment portfolio of various FIs and
therefore need to be successfully managed to meet the investment objectives. The
possibility whether the objectives will be met or not largely depends upon the strategies
that portfolio managers adopt to manage their bond portfolio.
The strategy that a bond portfolio manager can adopt to manage his portfolio can be
broadly categorized as:
v Passive Management

v Active Management

There are again various specific strategies under each of the above broad categories,
which are briefly discussed in the following section.

2.0 Passive Management Strategies

Passive Management is a financial strategy in which an investor invests in accordance

with a pre-determined strategy that doesn't entail any forecasting. The idea is to
minimize investing fees and to avoid the adverse consequences of failing to correctly

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anticipate the future. Over the years, passive management has gained increasing
prominence in asset allocations. Passive management can be attractive as it offers low
management costs and provides highly diversified investments. It is an investment
strategy that does not rely on manager’s skill. Instead it relies on delivering market
returns so is appropriate for longer term investing where maximum diversification is
required. Followers of passive management believe in the efficient market hypothesis. It
states that at all times; markets incorporate and reflect all information. It is a simple
buy-and-hold approach of investing in bonds with specific maturities, coupons, and
quality ratings with the intent of holding the bonds till maturity. Passive strategies
require the formation of a portfolio with returns that broadly mirror the returns on a
bond index.
A Passive Management Strategies broadly involves:
§ Making investments to meet the Regulatory Requirements
§ Investment of Surplus Funds in Liquid Assets
§ Holding of securities till their maturities
§ Presence of Efficient Market, ensuring Market price of FI securities are fairly set
§ Focus of a portfolio manager to earn rather than to beat the market return
A bond portfolio can be passively managed in various ways. Some of the important
passive management strategies are:
Ø Bond Indexing
Ø Cash Flow Matching
Ø Classical Immunization

2.1 Bond Indexing:

A bond index is used to measure the performance of bond markets. The index can be
used as a benchmark against which investment managers measure their performance. It
can also be used as a measure to compare the performance of different asset classes.
The sovereign bond market is the most liquid segment of the bond market. Index can be
again: Broad Index and Liquid Index. Broad (Liquid) index in India for a month would
consist of top traded 20 (5 mostly Liquid) bonds, traded during the previous month.
Some of the important bond index are: Merrill-Lynch Composite Index /CCIL Broad
(Liquid) Total Return / Principal Return Index, as General Bond Indices; Salomon Smith
Barney’s Global Government Bond Index, Dow Jones CBOT Treasury Index / Dow Jones
Corporate Bond Index / Dow Jones Long-Term Inflation Indexes / CCIL’s Tenor Specific
Bond Index (0-5 Y, 5-10 Y, 10-15 Y, 15-20 Y, 20-30 Y), as Specialized Index; and Indices
offered by some investment companies to meet certain investment objectives, as
Customized Index. Some of the other bond indices presently available in Indian market
are: The CCIL All Sovereign Bonds TR / PR Index, CCIL T-Bill Liquidity Weight / Equal
Weight Index, CCIL SDL TR / PR Index.

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Composition of the CCIL Broad & Liquid INDEX

August/2016
SN.NO ISIN NO ISINDESC Maturity
1* IN0020150093 7.59% G.S. 2026 11/Jan/26
2* IN0020150069 7.59% G.S. 2029 20/Mar/29
3* IN0020150028 7.88% G.S. 2030 19/Mar/30
4* IN0020150010 7.68% G.S. 2023 15/Dec/23
5* IN0020160019 7.61% G.S. 2030 9/May/30
6 IN0020150036 7.72% G.S. 2025 25/May/25
7 IN0020140029 8.27% G.S. 2020 9/Jun/20
8 IN0020090034 7.35% G.S. 2024 22/Jun/24
9 IN0020110022 7.80% G.S. 2021 11/Apr/21
10 IN0020130038 7.28% G.S. 2019 3/Jun/19
11 IN0020140045 8.40% G.S. 2024 28/Jul/24
12 IN0020020171 6.35% G.S 2020 2/Jan/20
13 IN0020120054 8.12% G.S. 2020 10/Dec/20
14 IN0020130012 7.16% G.S. 2023 20/May/23
15 IN0020070028 8.08% G.S. 2022 2/Aug/22
16 IN0020110014 7.83% G.S.2018 11/Apr/18
17 IN0020140011 8.60% G.S. 2028 2/Jun/28
18 IN0020150051 7.73% G.S. 2034 19/Dec/34
19 IN0020140078 8.17% G.S. 2044 1/Dec/44
20 IN0020150044 8.13% G.S. 2045 22/Jun/45
Source: CCIL; * Note: Composition of the CCIL LIQUID INDEX for the respective month

Example: Formation of CCIL Liquid Bond Index:

Suppose the CCIL Liquid Bond Index, consisting of the five most liquid GOI securities,
selected on monthly basis, as specified in the above table, is valued at Rs.1996.2080/- as
on August 16 2015. The issue sizes of all the five eligible securities, forming the index, as
on the first day of August 2015, remaining same as on August 17 2015 are given
hereunder. Even if the issues sizes of the eligible securities changes, due to reissuance of
the securities, any time during a specific month, the same will not get reflected while
calculating the index values during that specific month, but will be taken into
consideration in the next month. The value of an index, within a month, changes just due
to change in the prices of the eligible securities, not due to change in the issue sizes (if
any). Suppose, we may like to estimate the value of the index as on August 17 2015. The
values of five eligible securities both as on the Aug. 16 and 17, along with the issue sizes
are given hereunder:

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8.40% G.S. 8.27% G.S. 7.72% G.S. 8.60% G.S. 8.15% G.S.
2024 2020 2025 2028 2026
Aug. 16 103.1900 101.5600 99.8100 104.9400 101.1800
Aug. 17 103.1800 101.5598 99.8208 104.8900 101.1887
Issue Size as
on Aug. 17 84,000.00 86,489.21
2015 90,000.00 73,000.00 46,000.00
(Rs. Crore)
Issue Size as
on Aug. 17
2015 900 730 460 840 865
(INR
Billions)
Based on these value of the Index as on August 16 2015, and the individual market
prices of the five eligible securities both on August 16 and 17, considering their
respective issue sizes, assumed to be fixed during the month of August, the value of the
index as on August 17 can be estimated as:
I = 1996.2080 × (103.1800×900 + 101.5598×730 + 99.8208×460 + 104.8900×840 +
101.1887×865) ÷ (103.1900×900 + 101.5600×730 + 99.8100×460 + 104.9400×840 +
101.1800×865)
=1996.0094
Rebalancing for any change in any of the Issue Size is done only on the first index
calculation day of the next month.
Bond Indexing represents construction of a bond portfolio whose returns over time
replicate the returns of a concerned bond index. In other words, Bond Indexing is the
strategy of constructing a portfolio that mimics the index along several dimensions of
risk and return on the portfolio. Indexing is a passive strategy, often used by investment
fund managers who believe that actively managed bond strategies do not outperform
bond market indices. A portfolio manager may also construct a portfolio to resemble the
index in many ways, but through various active management strategies, hoping to
consistently outperform the index. Bond Indexing can be: Pure Bond Indexing; and
Enhanced Bond Indexing with different degree of Mismatches.
In a pure bond indexing strategy, the manager replicates every dimension of the index.
Every bond in the index is purchased and its weight in the portfolio is determined by its
weight in the index. A manager, who feels he has no reason to disagree with the market
forecasts, has no reason to assume that he can outperform an indexing strategy through
active management. This approach of managing bond portfolio is alternatively known as
“Do Nothing Approach”. This approach would result in a perfect correlation between the
bond fund and the index. However, due to huge number of different bond issues in the
typical bond index as well as the inefficiencies and costs associated with pure bond
indexing, pure bond indexing strategy is rarely implemented. Replication of an index
consists of say 500 bonds, may lead to a very high transaction costs to acquire all the

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bonds. Instead of perfectly replicating an index, an enhanced portfolio can be created,

with different degree of Mismatches from the index. Enhanced indexing may include a
small tilts in the portfolio, intending to compensate for the administrative costs. This
approach replicates the index’s primary risk factors while holding only a percentage of
the bonds in the index.

2. 2 Cash Flow Matching:

A cash flow matching strategy involves constructing a bond portfolio with cash flows
that match the outlays of the liabilities. Cash flow matching is also referred to as a
Dedicated Portfolio Strategy. One method that can be used for cash flow matching is to
start with the final liability for time T and work backwards.

Buy-and-hold and indexing strategies are about generating steady rates of return in a
portfolio. But investors who want to make sure that their portfolios are worth a specific
amount at a certain point in the future, may prefer to follow a Structured or Dedicated
Strategy, essentially to meet the exact future liabilities. Cash-flow matching is one of two
kinds of structured portfolio strategies (the other is Immunization), and it is intended
for investors who need to fund a series of future expenses.

How this Cash Flow Matching strategy works can be explained through an example.
Suppose, a financial institution wants its bond portfolio manager to construct the
portfolio in such a way to meet the future liabilities of Rs.30,000/- in Year 1, Rs.40,000/-
in Year 2 and Rs.50,000/- in Year 3. In order to meet these liabilities, the manager can
invest the required fund in such a way so as to get the exact amount to settle the
liabilities whenever due. Suppose, three different bonds with maturities of 3, 2, and 1
year, and with different coupons, are available in the market. If funds are invested in
these three bonds, different sets of coupons and principals are expected to be due at the
end of every year till the 3rd year. There will be three coupons and one principal, two
coupons and one principal, and one coupon and one principal, respectively at the end of
1st, 2nd and 3rd year. The portfolio manager can invest the required fund in all these
three securities in such a way, so that the inflows due at the end of every year are
sufficient enough to meet the concerned liabilities. In such strategy, the most important
part is the estimation of the right volume of fund to be invested in various securities
available in the market. Any wrong estimation may lead to generation of insufficient
fund to meet the liabilities. This strategy is known as Cash-flow-Matching because the
manager just tries to match the inflow of cash from the asset with the outflow of cash
for the liabilities.

Cash flow matching is a very simple and peaceful strategy for the investors. But
the main vulnerability in this strategy is the assumption of no defaults in the payment of
both coupon and principal in either of the investments. But as is almost always the case,
the lower the quality of securities the investor purchases, the higher the risk those
securities carry and the higher the possibility for a loss. Further, in case of
callable bonds, if these securities are called before they mature, this can eliminate some
of the expected coupon payments, and may cause some risk for the investor or manager.

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Example: Passive Management – Cash Flow Matching

Suppose a fixed income portfolio manager wants to follow a passive strategy to manage
its fixed income portfolio by following Cash Flow Matching. The manager attempts to
match the liabilities of $4M, $3M, and $1M respectively due in years 3, 2, and 1 with 3-
year, 2-year, and 1-year bonds each paying 5% annual coupons and selling at par. The
details of assets (bonds) and liabilities are hereunder:

Coupon Par Yield Market Liability Year

Rate Value
3-Year 9.00% 100 9.00% 100 $4M 3
2-year 8.00% 100 8.00% 100 $3M 2
1-year 7.00% 100 7.00% 100 $1M 1

Calculate the actual amount of investment in these three bonds and show how the
liabilities are settled in due time with the cash flows received from these three bonds.
Solution:
§ The $4M liability at the end of year 3 is matched by buying
$36,69,724.77 worth of three-year bonds:
[$36,69,724.77 = $4,000,000/1.09]
§ The $3M liability at the end of year 2 is matched by buying
$24,71,967.38 of 2-year bonds:
[$24,71,967.38 = {$3,000,000 – (.09)($ 36,69,724.77)}/1.08]
§ The $1M liability at the end of year 1 is matched by buying
$4,41,091.01 of 1-year bonds:
[$4,41,091.01={$1,000,000–(.09)($36,69,724.77)–(.08)($24,71,967.38)}/1.07]
The following table ensures that the liabilities due in all the three years are matched
with the cash flows due in the respective years from the three bonds:

CFs from CFs from CFs from Liability

1-Year 2-Year 3-Year Principle to be Ending
Year Bond Bond Bond Payment Total CFs Met Balance

Year 1 30876.37 197757.39 330275.23 441091.01 1000000 1000000 0

Year 2 0.00 197757.39 330275.23 2471967.38 3000000 3000000 0
Year 3 0.00 0.00 330275.23 3669724.77 4000000 4000000 0

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2.3 Classical Immunization:

Immunization is a fixed-income strategy designed to address interest rate risks,

ensuring that the portfolio maintains a yield sufficient to meet any liabilities as they
come due. The change in yield can result from a change in market interest rates, either
increasing or lowering the value of the portfolio in consequence and possibly hindering
the portfolio's ability to satisfy its obligations. Effective immunization entails matching
the portfolio's duration to the length of the investment horizon, and making the present
value of the cash flow from the fixed income instrument equal that of the future liability.
Bonds are purchased with varying maturities, both lesser and greater than the time
horizon of the investor. Rebalancing would need to occur semi-annually to annually.
Defined benefit retirement plans utilize immunization to meet the cash flow needs of
retirees. The strategy is imperfect; as the conditions for immunization assume a flat
yield curve and parallel changes in it (e.g. interest rate increases or decreases are in
equal measure in terms of basis points)
Immunization is a strategy used to minimize interest rate risk, and it can be employed
to fund either single or multiple liabilities. This strategy has the characteristics of both
active and passive strategies. By definition, pure immunization implies that a portfolio
is invested for a defined return for a specific period of time regardless of any outside
influences, such as changes in interest rates. Similar to indexing, the opportunity cost of
using the immunization strategy is potentially giving up the upside potential of an active
strategy for the assurance that the portfolio will achieve the intended desired return. As
in the buy-and-hold strategy, by design the instruments best suited for this strategy are
high-grade bonds with remote possibilities of default. In fact, the purest form of
immunization would be to invest in a zero-coupon bond and match the maturity of the
bond to the date on which the cash flow is expected to be needed to meet the liabilities.
This eliminates any variability of return, positive or negative, associated with the
reinvestment of cash flows. This strategy is commonly used in the institutional
investment environment by insurance companies, pension funds and banks to match
the time horizon of their future liabilities with structured cash flows. For example, just
like a pension fund would use an immunization to plan for cash flows upon an
individual's retirement, that same individual could build a dedicated portfolio for his or
her own retirement plan.
Classical immunization is the process of structuring a bond portfolio that balances
any change in the value of the portfolio with the return from the reinvestment of the
coupon and principal payments received throughout the investment period. The goal of
classical immunization is to form a portfolio so that:
o If interest rates increase, the gain in reinvestment income ≥ the loss in portfolio
value.
o If interest rates decrease, the gains in portfolio value ≥ the loss in reinvestment
income.

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Even if classical immunization does not require any active involvement of the portfolio
manager, it works for only one time instantaneous change in interest rates. In reality,
interest rates fluctuate frequently, changing the duration of the portfolio, and therefore
necessitating a change in the immunization strategy. Alternatively, classical
immunization requires the bond portfolio to be rebalanced after every change in the
rate of interest. To keep a portfolio immunized, it must be rebalanced periodically.
Rebalancing is necessary to maintain equality between the duration of the immunized
portfolio and the duration of the liability. Therefore, frequent rebalancing, especially
when interest rates becomes more volatile, may lead this strategy little cumbersome
and costly. Transaction costs associated with rebalancing must be weighed against the
possible extent to which the terminal value of the portfolio may fall short of its target
liability. Furthermore, the mere passage of time causes the duration of both the
portfolio and its target liabilities to change, although not usually at the same rate.
Immunization can be accomplished by equating the duration of assets and liabilities.

Example: Passive Management – Classical Immunization

A fund has a single liability of Rs.1392.21 due in 4.30 years (i.e. Duration of Liability DL
= 4.30 years). Suppose the current yield curve is flat at 8.6130%.
The fund manager, investing in bonds, wants to invest in bond market in such a way so
that its liabilities are immune irrespective of the change in the rate of interest.
Show how the fund manager will invest in a bond to ensure classical immunization,
irrespective of any change in the rate of interest.
Suppose a 5-year bond, 8% annual coupon at YTM of 8.6130%, is currently traded at
Rs.975.92/-

Solution:

The present value of the future liability of Rs.1392.21, due after 4.30 years and at a
Yield of flat 8.6130%, is
PV of Rs.1392.21 = 1392.21 / (1+8.6130%) ^ 4.3 = Rs.975.92
Duration of the proposed 5-Year 8% annual coupon bond, with a Face value of
Rs.1000/-, currently yielding 8.6130%, and presently traded at Rs.975.92/-, is 4.30
years.
Therefore, if the fund buys this specific bond, the duration of which is matched with the
duration of the liability, then any parallel shift in the yield curve in the very near future
would have price and interest rate effects that exactly offset each other, and the fund
will be immune from any interest rate risk in settling the claim towards its liability
through the cash flows from its assets.

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As a result, the cash flow or ending wealth at year 4.30, referred to as the accumulation
value or target value, would be sufficient to cover the liability of Rs.1392.21/-, such that:

Time Interest Rate = 8.6130% Interest Rate = Interest Rate = 8.50%

(Year) 9.00%
1 80(1.08613)3.3 = 105.08 80(1.09)3.3 = 80(1.085)3.3 =
2 80(1.08613)2.3 = 96.74 106.32 104.72
3 80(1.08613)1.3 = 89.07 80(1.09)2.3 = 97.54 80(1.085)2.3 = 96.51
3.52 80(1.08613)0.3 = 82.01 80(1.09)1.3 = 89.48 80(1.085)1.3 = 88.95
1080/(1.08613)0.7= 80(1.09)0.3 = 82.10 80(1.085)0.3 = 81.98
Target 1019.31 1080/(1.09)0.7= 1080/(1.085)0.7=
Value 1016.78 1020.05
1392.21
1392.22 1392.21

3.0 Advantages and Limitations of Passive Strategy:

Some of the important advantages of adopting passive strategy to manage a bond

portfolio are:
§ It is straightforward and easy to understand.
§ A passive approach is also of good use if investors are engaging in premeditated
asset allocation.
§ It also ensures portfolio diversification.
§ Portfolio managers are less bothered about significant decision making.
§ It matches the risk profile of the index, and therefore the return generated. By
reducing the number of bonds in the portfolio and selecting the liquid bonds in
each cell, transaction costs can also be reduced.
§ Specific indices, such as Tenor Index, T-bill Index, SDL Index, are helpful to match
the performance of specialized bond portfolios, if separately created by the
financial institutions.
§ Enhanced indexing is another benefit, as it allows for an additional return pickup
if an investor has some information about future returns that would allow them
to slightly outperform the benchmark.
§ The passive strategy approach also avoids problems associated with statistical
models that rely on historical correlations. After the financial crisis it is clear that
these correlations are not always stable.
Even if passive strategy is simple and easy to implement, it also has some limitations,
such that:

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§ Index funds can never outperform the market.

§ Investor has the discretion as to the number and type of risk factors to focus on.
An omitted risk factor may be a significant driver of index performance; leading
to a significant tracking error between the performance of an index with that of
the index fund.
§ Passive strategies need to be monitored and rebalanced regularly so that the
actual return does not deviate from the benchmark.
§ In portfolio immunization theory, any changes in the yield curve are assumed to
be parallel. But this parallel shifts in the yield curve rarely occur. Therefore,
equating the duration of the portfolio with the duration of the liability may not
ensure complete immunization.

5.0 Important News affecting Interest Rates and Bond Yields:

The major driving force for a bond portfolio managers to actively trade and manage
their portfolio is the expected change in future rate of interests, due to change in the
Economic / Market / Regulatory conditions, such as: Demand and Supply of Securities,
Inflationary Pressure, Economic Growth (e.g. GDP Numbers), Credit Growth, Liquidity
Conditions, Global Economy, Sovereign Status of the Country (e.g. Sovereign Rating),
FIIs Movements, Major Exchange Rates, etc. Therefore it is very important for a
trader/portfolio manager to properly analyse the change in such Economic / Market /
Regulatory conditions, as reflected through various news or information continuously
flowing into the market. Some of the important news, having a strong relationship with
the interest rates are described below:

News: Reduction in Budgetary Deficit due to Fall in International Oil Prices

· The fiscal deficit of a country fixes the issue of the securities to fill the deficit.
· The government through the budget statement makes out that how much
revenue fall is taking place for the year and decides to issue the securities.
· Thus the supply is decided with the budget or fiscal deficit. Hence any news, such
as fall in the crude oil prices, may lead to a fall in the deficit, and therefore a
lower supply of securities.
· Due to a low supply and expected high demand of the instrument, the price may
go high and the yields will fall down.

News: Hike in International Prices of Crude Oil

· Higher oil prices lead to rise in the prices of almost all commodities, and
therefore country’s inflation figures. In order to control the inflation, the
government may try to suck out the liquidity, resulting to rise in policy rates, or

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rise in supply of Govt. securities, through fresh issue or OMO sale, and therefore
rise in yields.

News: Announcement for an OMO Purchase / OMO Sales by the RBI

§ Open Market Operation (OMO) is basically a liquidity adjustment mechanism,
used by the central bank of the country, to control the market, by way of injecting
more liquidity in the system, or sucking liquidity from the system, whenever
needed.
§ Under these operations, Govt. may like to buy back (i.e. OMO Purchase) the
existing Govt. securities from the market and can inject more liquidity in the
system, or Govt. may like to reissue the existing securities (OMO Sale) from the
market to absorb excess liquidity from the system, and therefore affecting the
demand and supply of Govt. securities.
§ These regulatory interventions may affect the interest rates as gets affected by
normal demand and supply forces, or may also remain stable if the market finds
it suitable even after the OMO announcements.

News: Rising Inflationary Expectation in the Country

§ Expected future rate of inflation is the very crucial factor to determine any rate
of interest. Any lender, expecting the rate of inflation to go high in the future,
may prefer to lend at an interest rates that are higher than the rate of inflation,
and vice versa.
§ Therefore, rising (falling) inflation signals a higher (softer) interest rate regime.
Interest rate or yield on debt securities therefore largely depend upon the
prevailing and future rate of inflation in that economy, as may be indicated by
the Wholesale Price Index (WPI), or Consumer Price Index (CPI).
§ Because of its higher importance, the market players always wait for the dates
when these inflation numbers are released by the competent authority.

News: Rise in Expected Growth estimates (e.g. GDP)

§ General economic condition or general growth of an economy plays a very
crucial role to determine the level of interest rate in that economy.
§ In an economy with an increasing growth rate, chances for more spending
(institutional and retail) increases, leading to more demand of available funds to
channelize credit, followed by rising inflation, and may finally lead to rise in rate
of interest.
§ Alternatively, higher growth enhances the bank lending and reduces banks’
investment in debt market, thereby reducing the demand for debt securities,
followed by fall in price and rise in interest rates or bond yields.

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§ Higher growth may boosts the confidence of the domestic as well as the
international investor into the market of the country, causing an improvement in
the sovereign rating, followed by a rise in FIIs inflows, which may finally bring
the yields down and prices up due to more demand for the domestic securities.
§ This situation holds, when the economy tends to grow without any intervention
from the central bank. On the other hand, if the higher growth rate is a result of
intervention from the central bank, the high growth may be ensured by injecting
liquidity in the system through OMO Purchase or cutting liquidity ratio (SLR),
where the price of bond and therefore the bond yield may or may not get
affected.

News: Insufficient Credit Growth in the Economy

· Whenever there is a less demand for credit, a fall in the GDP is expected in major
sectors of the economy;
· The FII inflows will be questionable and FII outflows will be expected.
· Hence reduced demand for the government securities will fetch the price down
and the yields to move up;
· Alternatively, lack of sufficient credit growth in the country will insist the
domestic institutional investors, like commercial banks, to invest more in the
Govt. securities, leading to a rise in the demand and therefore the price, and a fall
in the yield, and vice versa.

News: Downgradation of Sovereign Rating by International Rating Agency

§ Sovereign rating of an economy is adversely related to the risk-free yield in that
economy.
§ If the economy has a poor credit worthiness (say BB credit rating), even if there
is no risk for a domestic investor to invest in the securities issued by the Central
Govt. of that economy, but any such investment will be risky for a foreign
investors.
§ Therefore, expectation of foreign investors, in terms of sufficient compensation,
depending upon the sovereign rating, may also play a significant role in deciding
the rate of interest in govt. securities.
§ Accordingly, downgradation of sovereign credit rating (say from A to BBB) by
the international rating agencies, say Standard & Poor’s or Moody’s, will lead to
rise the expectation of foreign investors to invest in the domestic market,
resulting the yield to go up.

News: Change in Policy Rates (Repo Rate / Reverse Repo Rate) by the RBI
§ Rate of interests which are part of the monetary policy issued by the central
bank of an economy are known as Policy Rates. Reserve Bank of India governs

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the monetary activities such as money supply, liquidity, and interest rates
through its key policy rates: Repo Rate and Reverse Repo Rate.
§ Repo rate is the discount rate at which banks borrow from RBI. On the other
hand, Reverse repo rate is the rate at which RBI borrows money from the banks
by depositing Govt. securities with them.
§ Liquidity can be controlled through these policy rates by the RBI within a system
called Liquidity Adjustment Facility (LAF) provided by the RBI to the banks.
Therefore, any Fall (Rise) in the repo rate allow banks to get money at a cheaper
(expensive) rate, thereby controlling the money supply and liquidity in the
system.
§ Policy rates and yield on debt securities are positively interrelated. Any
expectation in the rise (fall) in repo rate may lead to a subsequent rise (fall) in
the interest rates of debt securities as well.

News: Change in Liquidity Ratios (CRR / SLR) by the RBI

§ Liquidity Ratios, like Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR),
set by the central bank especially to control the liquidity in the system depending
upon the economic condition, also play a crucial role in determining the risk-free
rate of interest or yield on debt securities.
§ CRR (presently at 4%) is the minimum proportion of bank’s total deposits that
need to be kept or deposited with RBI in cash. Similarly, SLR (presently set at
21.5%) is the minimum percentage of bank’s deposits, called as Net Demand and
time Liabilities (NDTL), which the bank has to maintain internally in the form of
gold, cash or other approved securities defined by the RBI.
§ Change in these policy/liquidity ratios is actually a regulatory move, and may
cause a change in the market rate of interest, or the interest rate may remain
stable depending upon the reaction of the market and its impact on the demand
of debt securities.
§ Any rise in CRR may lead to a fall in the demand for debt securities, causing a fall
in the prices of such securities, which may finally take the interest rate or yield at
a higher level, and vice versa.
§ On the other hand, if the SLR increases, may be due to Economic Instability or
higher Fiscal Deficit, the demand for SLR approved securities which are
essentially the Govt. securities increases, causing the bond price to rise and yield
to fall.
§ Similarly, under a stable economic condition with a lower fiscal deficit, providing
a room to free liquidity for the private sector, the central bank may decide to cut
the SLR, which may lead to fall in the demand for such bonds and therefore the
price falls and the yield rises.

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§ But under certain market condition, even if after a change in these policy ratios,
the demand for such bond may remain stable and therefore there may not be any
change in the rate of interest.

News: Change (Rise / Fall) in FII Flows in the Country

§ Domestic rate of interest can get affected by the presence of Foreign Institutional
Investors (FIIs). There can be significant Inflow and / or Outflow of funds by the
FIIs, which can affect the domestic market.
§ Significant amount of such FIIs inflows, within the permissible limit, may
increase the demand for domestic financial assets, including debts and equities,
and therefore can push the prices up, which may finally lead the yield on debt
security to fall.
§ On the other hand, in the event of significant FIIs outflows from the domestic
debt market may cause over supply of debt securities in the market, pushing the
price to go down and the yield to go up.
§ Therefore movement of FIIs in the domestic debt market may play a short-term
but crucial role in determining the rate of interest or yield on debt securities.

News: Change in Global Economic Condition

§ Not only has the economic condition in the domestic economy, but Global
Economic condition, especially some of the economies like US, UK, Europe, Japan,
etc., also plays a very crucial role in the deciding the domestic rate of interest in
India, including the yield on GOI debt securities.
§ The higher the growth possibility for the global economies, especially the large
economies, the greater would be the possibility for the foreign as well as
domestic interest rates to rise.
§ Growth, say in US economy, may lead to a possible hike in the US Fed. Rate,
making the US financial market more interesting for the FIIs, leading to a
possible FII’s outflow from the Indian market, causing a decline in the demand
for securities and a rise in the yield.

News: Appreciation of INR against USD and Fall in USD-INR Rates

§ Domestic rate of interest, if not monotonically, but up to a significant extent,
depend upon the appreciation or depreciation of the domestic currency in
comparison with the foreign currency, or alternatively the movement of the
exchange rate.
§ If suppose Indian Rupee appreciates against the US Dollars, the USD-INR
exchange rate (presently at a level of 62.67 as on March 18 2015, meaning USD 1
is equal to INR 62.67) falls.

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§ Any appreciation of INR against at least some of the major currencies (e.g. USD,
EUR, GBP, JPY, etc.) leading to a fall in the concerned Exchange Rate (e.g. USD-
INR, EURO-INR, GBP-INR, JPY-INR), may finally lead to a fall in the domestic rate
of interest, including the yield on debt securities, and vice versa. Interest Rate
Parity theory, implying the equality of the expected return on domestic assets
with the exchange rate-adjusted expected return on foreign currency assets, may
be referred to understand the linkage between the domestic rate of interest and
foreign exchange rate, to ensure a no interest arbitrage.

5.0 Active Management Strategies

Active portfolio management is a strategy of managing assets by continuously

repositioning portfolios to take advantage of most of the favorable opportunities. Main
objective of such portfolio manager is to have their portfolios outperform the
benchmark index. Alternatively, primary objective of an active strategy is to realize
returns more than what one would get from holding the securities in a passive mode i.e.
the normal returns from holding till maturity. The goal of active management is
maximizing total return. Essential to all active strategies is specification of expectations
about the factors that influence the performance of an asset class. In the case of active
bond management, this may involve forecasts of future interest rates, future interest-
rate volatility, or future yield spreads. In all active strategies, the investor is willing to
make bets on the future rather than settle with what a passive strategy can offer. To
generate such returns, positions must be taken that differ from the market consensus.
The autonomy given to managers to take positions that deviate from the benchmark
depends on the investor’s risk tolerance. Active strategies are typically speculative.
Active Management Strategies involves:
o Taking views on future interest rate movements
o Anticipating future price movements
o Investment of Surplus Funds not to earn but to beat the Market Return
o Holding of securities just to have a good deal within the stipulated time
o Reducing the loss in absence of a profitable deal
o Managing Interest Rate Risk

Typically, there are two broad kinds of active management strategies. These are:
o Trading on Interest Rate Predictions, which are called Market Timing
o Trading on Market Imperfections, which is called Bond Picking

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6.0 Different Types of Active Management Strategies:

Mangers’ anticipation or predictions toward the future rate of interest, and / or their
capability to capture market imperfections, especially in terms of price, lead to the
selection of a specific strategy to manage a bond portfolio. A bond portfolio manager
may expect the yield curve to shift in various ways. Selection of active management
strategy essentially depends upon the possible type of shift in the yield curve. Three
broader types of yield curve shifts are:

Ø No shift in the Yield Curve

Ø Parallel Shift in the Yield Curve
Ø Un-Parallel Shift in the Yield Curve

6.1 No Shift in the Yield Curve: Strategies

o Riding the Yield Curve

The simplest strategy for fixed-income investors is to purchase securities with a

maturity equal to the investment horizon and hold till their maturity. In an effort to
outperform this simple strategy, investors may purchase securities with maturities
longer than the investment horizon and then sell at the end of the horizon. This strategy
is referred to as Riding the Yield Curve. If the term structure of interest rate is upward
sloping and remain stable without any shift (upward or downward), this strategy will
provide higher holding period returns than a simple buy-and-hold strategy. If long-term
securities offer higher return, a portfolio manager, if prefer to be on the higher segment
of the yield curve, can successfully generates higher average return, provided there is a
normal yield curve in the market and no change is expected. For example, suppose the
5-year and 10-year G-Sec. rates as on a specific date are 8%, and 8.50%. An investor
with an investment horizon of 5 years may prefer to invest in the 5 year security. But if
it is assumed that the existing yield curve will remain upward slopping and unchanged
in the future, the investor may gain more if prefer to make the initial investment in the
10 year security and then selling the same after 5 years. This is called as beating the
market by riding or preferring the higher yield point of the normal yield curve.
Investors are exposed to the reinvestment risk, if choose a fixed income security with
any maturity lower than the investment horizon. Therefore investment can be made in a
security having maturity more than the investment horizon. Riding down the YC has
been proved to be a profitable strategy for investors in different countries and at
different circumstances. The amount of benefit from this strategy depends on the slope
of the yield curve and the timing of purchases and sales. Steeper the slope of the yield
curve, higher would be the returns from such strategy. But if future short term rates are
expected to rise, as assumed by expectations theory, then this strategy may fails to
generate higher returns.

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6. 2 Parallel Shift in the Yield Curve: Strategies

A Parallel Shift in the Yield Curve is a phenomenon that occurs when the interest rate on
all maturities increases or decreases by the same number of basis points. For example :
If the 10-year Treasury bond yield increases (falls) by 100 basis points, then the 3
month, 6 month, 1 year, 5 year, 20 year, and 30 year all rate are expected to increase
(fall)+ by the same 100 basis points. In such case, a portfolio manager may outperform
the market by swapping the existing bonds with others set of bonds of required
maturity, depending upon the anticipation of rising or falling rate of interests. This
strategy is known as Rate Anticipation Swaps.
o Rate Anticipation Swaps

If yield curve is expected to experience parallel shift, a portfolio manager may follow
this strategy in which bonds are exchanged according to their current duration and
predicted interest rate movements. Alternatively, Rate Anticipation Swaps involves
simultaneously selling and buying bonds with different durations. A rate anticipation
swap is often made in order to take advantage of more profitable bond opportunities.
Rate anticipation swaps are speculative in nature, since they depend on the outcome of
the expected interest rate change. The nature of swaps depends on the upward or
downward parallel shift in the yield curve.
A parallel upward shift in the yield curve

o Strategy: Shortening Portfolio’s Duration

When the yield curve is expected to shift upward parallel, manager of a bond portfolio
with longer duration may be expected to suffer severe losses. In such circumstances,
managers can attempt to reduce the duration of their bond portfolio by swapping some
of the higher duration bonds with some lower duration bonds. This strategy will ensure
reduction of losses expected to be suffered by the portfolio manager due to rise in
interest rates. The objective of this strategy is to preserve the value of a bond.

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Downward parallel shift in the yield curve:

o Strategy: Lengthening Portfolio’s Duration.

When the yield curve is expected to shift downward parallel, a portfolio manager is
expected to enjoy the price gain in all the bonds irrespective of their duration. But
higher the duration, greater would be the price gain due to fall in interest rates.
Therefore, in the event of falling interest rates, a portfolio manager could swap some of
his lower duration bonds with some higher duration bonds, and thereby can increase
the duration of the bond portfolio. This strategy is extremely sensitive to interest rate
changes and as a result would subject the manager to a higher return-risk position,
providing greater upside gains in value if rates decrease but also greater losses in value
if rates increase.

6.3 Un-Parallel Shift in the Yield Curve: Strategies

When yield curve is expected to change, the change in the yield for various bonds with
different maturities do not occur evenly. For example, given a yield curve for bonds with
one-year, five-year, and 10-year maturities, the yield for the one-year bond may
increase by 50 basis points, the five-year may stay the same, and the 10-year may
increase or decrease by 20 basis points. This kind of shift in the yield curve is known as
un-parallel yield curve shift. Historically, two types of un-parallel yield curve shifts have
been observed:
a) Yield Curve Shifts with Twists; and
b) Yield Curve Shifts with Humpedness

Yield Curve Shifts with Twists:

Yield Curve Flattening
Yield curve flattening means that the yield spread between the yield on a long-term and
a short-term bond has decreased.

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Yield Curve Steepening

Yield curve steepening means that the yield spread between a long-term and a short-
term bond has increased

Yield Curve Shifts with Humpedness:

A shift with humpedness is a non-parallel shift in the YC in which short-term and long-
term rates change by greater magnitudes than intermediate rates, known as Butterfly
Shifts. It is the combination of a barbell (called the wings of the butterfly) and a bullet
(called the body of the butterfly). Depending on the nature of the shifts, this can be
categorized as positive butterfly and negative butterfly.
Positive Butterfly:
A Positive Butterfly refers to an increase in both short and long-term rates relative to
the intermediate rates. For example, if short-term and long-term rates move upward by
100 basis points (1%) while medium-term rates remain the same, the convexity of the
yield curve will increase. This yield curve shift is called a positive butterfly shift because
it causes the curve to hump.

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Negative Butterfly:
In case of Negative Butterfly, both short and long-term rates decrease more relative to
the intermediate rates. Alternatively, negative butterfly is a kind of non-parallel yield
curve shift in which long- and short-term yields decrease by a greater degree than
intermediate rates. This yield curve shift effectively humps the curve, adding to the
curvature of the yield curve. For example, a negative butterfly shift can happen when
short- and long term-rates decrease by 75 basis points (0.75%), while intermediate
rates only decrease by 50 basis points (0.50%). This is the reverse of a positive
butterfly, in which short- and long-term rates increase more than intermediate rates.

o Bullet Strategy:

Bullet Strategy is a fixed-income strategy in which a portfolio is designed to have

securities with maturities and /or durations that are highly concentrated at one point
on the yield curve, preferably the intermediate points. Alternatively, bullet strategy is
based on the acquisition of a number of different types of securities over an extended
period of time, but with all the securities maturing around the same target date. One of
the main benefits of the bullet strategy is that it allows the investor to minimize the
impact of fluctuations in the interest rate, while still realizing excellent returns on the
investments. A bullet strategy can be useful if prevailing interest rates for medium-term
bonds are higher than either short-term or long-term. On the other hand, if severity of
rise in interest rates are expected to be more both in the short and long end of the yield
curve, it may be a good proposition to remain in the intermediate segment of the yield
curve, where neither the gain due to fall in interest, nor the loss due to rise in interest
are severe. Therefore such strategy can ensure a moderate portfolio return at any
circumstances, i.e. for any change in the future rate of interests. The main benefit of
bullet strategy is that its sets off the possibility of higher opportunity loss (if interest
rates increases) with the higher opportunity gain (if interest rates fall), especially when
it is difficult to predict the nature of shifts in the yield curve.

If the yield curve flattens, a portfolio manager may adopt a strategy of constructing a
bullet portfolio by including more long date securities where impact of rising rates are
comparatively less, and therefore the potential loss may decline. Similarly, if the yield
curve steepens, an investor may prefer short duration bonds compared to the long
duration bonds, and therefore may adopt the Bullet Strategy, concentrating on the
lower segment of the yield curve. If any humpedness is found in the yield curve, i.e. shift
in the yield curve with a twist where both short and long end of the yield curve shifts
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upward, keeping the intermediate segment unchanged or shifting downward, (i.e.

positive butterfly), the portfolio manager may prefer bullet strategy with bonds of
intermediate maturity or duration.

o Barbell Strategy:

A strategy of concentrating in both sides (long end and short end) of the yield curve is
known as Barbell Strategy. With this strategy, a portfolio manager will prefer to buy
only short term issues and long term issues, without purchasing anything in between.
Securities with short-term maturities provide Liquidity and help to reduce the Market
Risk of the portfolio, while Securities with longer maturities gives higher yields and help
to Increase Portfolio return. It is a strategy focusing both on the risk and return, not
only achieving one at the cost of other. Higher amount of loss in long dated securities
due to rise in rate of interest may partially get neutralized by the smaller loss amount
incurred in short dated securities. Similarly, smaller price gain in short dated securities
due to fall in interest may expected to be widened due to higher gain in long dated
securities for the similar movement in the rate of interest. Therefore, this strategy duly
deals with the uncertain movement in the rate of interest, and gives focus both on
leveraging return and curtailing risk.
Barbell strategy is profitable when yield curve is expected to shift but with a twist,
where both the short and long end of the curve are expected to move downward, and
intermediate portion is expected to remain same or moves upward (i.e. Negative
Butterfly). In such case, a barbell portfolio, a combination of short and long dated
securities, can experience a higher capital gain due to fall in the interest rates, or can
experience a lower potential loss due to rise in interest rates throughout the segment
but with different degree.

o Ladder Strategy:

A strategy in which a bond portfolio is constructed to have approximately equal

amounts invested in each maturity within a given range, to reduce interest rate risk.
Alternatively, in a Ladder Strategy, after deciding the maximum acceptable maturity
within the bond portfolio, the portfolio manager tries to evenly spread his investment
across all the maturities. The Face Value of bonds maturing every year may be roughly
equal. In a Ladder Strategy, the portfolio manager may be in a position to capitalize on
higher interest rates on long-term investments by setting up bonds that mature at
different times and reinvesting the proceeds of those bonds at varying intervals.
Suppose a manager has purchased bonds that will mature in two, four and six years.
These are short-term bonds and typically will not provide with large returns. However,
buying these bonds allows the manager to reinvest into longer-term, higher interest
rate bonds at different intervals. When the two-year bond matures, the proceeds can be
invested into a 10-year bond, and the same process can be repeated with the other
bonds as well. This will allow the manager to leverage the portfolio yield. On the other

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hand, ladder strategy can also enable the portfolio manager to reduce the overall
portfolio duration and thereby the overall interest rate risk. Since the total investable
fund is parked in all possible securities throughout the maturity ladder, the
concentration risk gets diluted, and the portfolio manager can soften the portfolio loss
in the event of rising interest rates. It is a kind of safe strategy to trade in an uncertain
market, without taking any extreme positions. Some of the important advantages of a
ladder portfolio are: Higher Average Yield, More Consistent Return, Lower Expenses,
Less Reinvestment Risk, Portfolio Diversification, Ongoing Liquidity, etc. In a normal
market, it is more common to see that a bond portfolio manager follows a ladder
strategy, may be with slight variation in the volume of investments made throughout
the maturity ladder.

7.0 Strengths and Weaknesses for Active Management:

Essential to all active strategies is specification of expectations about the factors that
influence the performance of an asset class. In the case of active bond management, this
may involve forecasts of future interest rates, future interest-rate volatility, or future
yield spreads. Some of the important strengths and weaknesses of active bond portfolio
management are briefed hereunder:

Strengths:
· Takes advantage of bond market inefficiencies
· Portfolio is adjusted when opportunities arise and when market conditions
change
· Tax sensitive management can be applied
· Active decisions are made to properly weight the portfolio by sectors and credit
diversification
· Application of sector rotation
· Specific security selection adds value
· If interest rates declines are anticipated, managers can increase portfolio
duration and vice versa

Weaknesses:
· Passive portfolio management costs much less than active management. This
give passive investors an increase net returns as the management costs are
lower.
· Passive portfolios are also more tax efficient with their ‘buy and hold forever’
approach result in low income tax costs.
· Active portfolio often attracts capital gains tax on the gains made on the trading
of securities.

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· Passive portfolios have predictable styles. A passive investor knows exactly what
types of securities he or she is invested in. Active managers, on the other hand,
can vary the composition of their portfolios significantly over time.

Self-Learning Exercise:

1. What could be the investment objective of a Bank and a Pension Fund to invest in
fixed income securities?
2. Suppose, a portfolio manager of a mutual fund is following a benchmark index, say
CCIL Broad Index, an index consisting of 20 most liquid Central Govt. securities in
India, as far as its investment in Treasury bond is concerned. Suppose, the portfolio
manager is outperforming the index, but still worried for not meeting the
investment objective. Explain how such situation arises?
3. Liability structure is very important for an institution to decide the nature of its
assets, more specifically investments. What are the two major dimensions of
liabilities of an institution, which are of grave concern for the manager of
investment portfolio of an institution? Is it always easy for institutions like banks
and insurance companies to estimate their liability?
4. How two bond portfolio managers, one is following bond indexing and the other is
actively managing the portfolio, are different in their approaches to manage their
respective portfolios?
5. In order to neutralize two opposite positions against a small parallel shift in the
yield curve, the interest rate sensitivities of both the positions need to be matched.
Is it sufficient enough just to match the M-Durations of both the positions? Explain.
6. What is the objective of a bond immunization strategy? What is the basic
underlying principle in an immunization strategy?
7. In situation of steepening of the yield curve, what kind of bond portfolio, Bullet or
Barbell, having almost the same PV01, perform better?
8. Why ladder portfolio is preferable than the bullet or barbell portfolio under any
circumstances?
9. Is it practically feasible to follow a Bond Swap strategy by a portfolio manager to
rebalance the portfolio M-Duration when the market expect a parallel shift (upward
or downward) in the yield curve?
10. How an active bond portfolio manager may like to construct his/her portfolio
expecting Butterfly Shifts in the Yield Curve? Explain.

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References:

v Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 43,
47); McGraw-Hill.
v Moorad Choudhry; The Bond and Money Markets: Strategy, Trading, Analysis
(Chapter: 57, 58, 61); Butterworth-Heinemann.
v Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 7, 8); Wiley Finance.
v A V Rajwade, 2008; Handbook on Debt Securities and Interest Rate Derivatives
(Chapter: 15); Tata McGraw-Hill.
v Mukherjee K N, 2014; Fixed Income Securities: Valuation, Risk & Risk Management
(Chapter: 10); NIBM In-house Publication.

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Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 1: Introduction to Equity Markets

Dr M. M Manickaraj

Objective
The objective of this chapter is to give an introduction to equity stocks and equity
markets.

Structure
The chapter has been organised as follows:
1. Characteristics of equity stocks
1.1. Separation of ownership and management
1.2. Limited liability
1.3. Residual claim
1.4. Infinite life
2. Types of equity stocks
3. Equity markets
3.1. Primary markets
3.2. Secondary markets
3.3. Equity markets in India
4. Trading in equities
4.1. Types of trading
4.1.1. Cash trade
4.1.2. Margin trade
4.1.2.1. Margin requirements
4.1.2.2. Securities eligible for margin trading
4.1.3. Short selling
4.1.3.1. Rollover SLB facility
4.1.4. Intraday trade
4.2. Stamping of trades
4.3. Types of orders
4.4. Cost of trading
4.5. Market making
4.6. Containing price volatility
4.6.1. Pre-Open session
4.6.2. Circuit filters
4.6.3. Scrip wise price band
4.7. Summary

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1. Characteristics of Equity Shares

Business firms raise capital by issuing different types of securities like equity shares,
preference shares, bonds and short-term instruments like commercial papers. Capital
raised through equity shares1 is ownership capital that will remain in business as long as
the business firm exists. Equity stocks offer high returns to the investors and are
considered to be one of the most attractive avenues for investment. However, making
high returns depends on one’s ability to value the stocks correctly and making investment
at the right time. The basic characteristics of equity stocks are discussed hereunder.

1.1 Separation of ownership and management

Large business firms raise capital through the issue of equity shares to the public because
the entire capital required for large businesses cannot be brought by few promoters
alone. As such, the number of shareholders, generally, is large and scattered all over the
country/world. All of them cannot participate in running the business. Besides, majority
of the shareholders may not have the knowledge, skill and time to run a business.
Shareholders (owners) therefore, appoint a management who in turn run the business in
the interests of the shareholders. Shareholders control the management by exercising
their powers to appoint and change the management by using their voting rights.

1.2 Limited liability

The shareholders’ liability towards a business firm is limited to the capital invested by
them in the firm. This is in contrast to proprietorship firms and partnership firms where
the liability of owners extends beyond their capital to include their personal properties
and income.

1.3 Residual claim

Equity shareholders are the last in the line of those who have a claim over the assets and
income of a company. In case of a going concern, the equity shareholders are entitled to
the profits remaining after paying the claims of all other stakeholders including
government, employees, suppliers and creditors. Similarly, on liquidation of the
business, they can claim the residuals remaining after settling the claims of all other
stakeholders.

1.4 Infinite life

Unlike most other financial securities equity shares have an infinite life. Business firms,
especially listed companies are perpetual entities and the equity shares issued by these
business firms also have an infinite life. Therefore, equity shareholders cannot get
repayment of their investment from the company, excepting in case of share buyback. If
they want to withdraw their investment they can do so by selling the shares in the
secondary market only.

1
The terms ‘equity shares’ and ‘equity stocks’ mean the same and are used interchangeably in this booklet.

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2. Types of Equity Stocks

Equity stocks can be classified into various categories and the major categories are as
follows:
• Value stocks: Those stocks which are fundamentally strong but trading at a price
much lower than their intrinsic value are called value stocks. These stocks would
offer very high returns if held for a longer period of time. However, identifying
stocks demands a detailed fundamental analysis.
• Growth stocks: Equity stocks of those companies whose earnings are growing very
fast are called growth stocks.
• Cyclical stocks: Stocks of companies in cyclical sectors which are highly sensitive
to the changes in overall economic condition are called cyclical stocks. For
instance, stocks of cement companies, steel companies, capital goods companies
may be called cyclical stocks.
• Defensive stocks: Stocks of companies which are least affected by macroeconomic
conditions may be called defensive stocks. Examples of defensive stocks include
pharma stocks, FMCG stocks and the like.
• Sector stocks: Stocks of companies belonging to specific sectors like IT sector,
banking sector, metal sector, real estate sector, and son on.
• Large cap stocks: These are the stocks of very big companies in the market. The
size is decided based on market capitalisation of the companies.
• Mid cap stocks: Companies which are neither very big nor small in terms of market
capitalisation may be called mid cap companies and their equity shares as mid cap
stocks.
• Small cap stocks: Shares of small cap companies are called small cap stocks.
• Others: There are several other categories of stocks like green stocks, sharia
stocks, etc. Green stocks are the stocks of companies which are environmentally
friendly activities and the companies which are running their business in an
environmentally friendly manner. Sharia stocks are those which comply with the
tenets of Islam.

3. Equity markets
Equity markets are broadly of two types – primary market and secondary market. A
brief description of the two markets is as follows:

3.1 Primary market

Business firms raise capital to start businesses. They may also raise additional capital for
financing expansion and new ventures. They raise capital through issue of different types
of securities including equity shares. The market for such new securities is called the
primary market. Equity capital can be raised using any of the following methods:

- Rights issue – issuing shares to existing shareholders

- Initial Public Offering (IPO)/Follow-on Public Offering (FPO): Shares being
issued by a new company is called IPO and new shares issued by an existing

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company are called FPO. IPO/FPO may include any one or combination of
the following:
 Private placement
 Qualified institutional placement (QIP)
 Public offer
 Rights issue

IPOs/FPOs can be made with either a fixed price or a range of price. If it is fixed price
the buyers have to necessarily buy the shares at that price and have no freedom to quote
a price. The second method is called book building method wherein the issuing
company will fix a price band and the buyers will have the freedom to quote a price within
that band. This method has become very popular and now-a-days almost all the
companies in India raise equity capital via IPOs/FPOs following this method.

3.2 Secondary markets

As equity shares cannot be sold back to the company that has issued the shares the only
exit route for the equity shareholders is selling in the secondary market. The secondary
market for equity shares is the stock exchanges. They provide a platform for the buyers
and sellers to meet and thereby facilitate trading in stocks.

3.3 Equity markets in India

Stock market transactions in India dates back to late 18 th century and the loan securities
of the East India Company were the first to be traded. Corporate securities came to the
Indian market during 1830’s and gained importance with the enactment of the
Companies Act 1850. Organised trading in securities started with the formation of the
Native Share and Stock Brokers Association in 1887 (now it is known as the Bombay
Stock Exchange). Subsequently, many regional stock exchanges were set up. First
regional exchange was the Ahmedabad Share and Stock Brokers Association formed in
1894. Over time 19 other regional stock exchanges were established. One major
development in the stock market history of India is the setting up of the National Stock
Exchange (NSE) in 1992 which started its operations in 1994. Another major
development is the enactment of the Securities and Exchange Board of India Act 1992.
These two incidents coincided with the liberalisation of the Indian economy. Since then
many things have happened in India that have transformed the Indian securities markets
and made them one of the most modern markets in the world. Significant developments
are the following:
 Introduction of National Exchange for Automated Trading (NEAT). It is a fully
automatic screen based trading system. This system matches buy and sell orders
through an automated process and anonymously. This enables reducing the time
and cost substantially.
 Dematerialisation of stocks – all the stocks were dematerialised that enabled
electronic settlement of trades. This led to substantial reduction in transaction
costs.

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 Creation of depositories: A depository is an organisation which holds securities

(like shares, debentures, bonds, government securities, mutual fund units etc.) of
investors in electronic form at the request of the investors through a registered
depository participant. It also provides services related to transactions in
securities. There are two depositories in India – National Securities Depository Ltd
(NSDL) and Central Depository Service (India) Ltd (CSDL). The services offered by
the depositories are:
o Dematerialisation (usually known as demat) of securities.
Dematerialisation is the process by which physical certificates of an
investor are converted to an equivalent number of securities in electronic
form.
o Rematerialisation (known as remat). Rematerialization is the process of
converting securities held in electronic form in a demat account back in
physical certificate form.
o Transfer of securities and change of beneficial ownership
o Settlement of trades done on stock exchanges connected to the
Depository
o Pledging and unpledging of securities for loan against shares
o Transfer of corporate action benefits like dividends directly to the Demat
and Bank account of customers

Investors can avail the services of depositories through a Depository Participant (DP)
only. A DP is an agent of the depository through which it interfaces with the investor
and provides depository services.

 Creation of clearing corporations which act as the central counter party for the
trades. When a buy order in an exchange matches with a sell order, a trade is
generated. The central counterparty steps in between the buyer and the seller
and acts as a buyer to every seller and a seller to every buyer guaranteeing
settlement of trades. This process is called novation. Clearing corporations
maintain funds for guaranteeing trades, settlement and in case a buyer or a seller
defaults. The following five clearing corporations operate in India.
o National Securities Clearing Corporation Ltd.
o Indian Clearing Corporation Ltd.
o Metropolitan Clearing Corporation of India Ltd.
o India International Clearing Corporation (IFSC) Limited
o NSE IFSC Clearing Corporation Limited
 Introduction of derivatives. Since June 2000 variety of derivative instruments
have been allowed in the Indian stock exchanges which include index futures,
index options, stock futures, stock options, currency futures, interest futures,
futures on global indices like Dow Jones Industrial Average (DJIA), S&P 500 index.
 Introduction of debt instruments for trading
 Listing and trading of Exchange Traded Funds (ETFs)

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 Listing and trading of mutual funds

3.3.1 Players in the Market

The various players in equity market are listed below.

• Investors
• Domestic institutional investors (DIIs)
• Mutual funds
• Commercial Banks
• Venture capital funds
• Private equity funds
• Insurance companies
• Pension funds
• Provident funds
• Foreign institutional investors (FIIs)
• Retail investors
• Intermediaries
• Merchant bankers
• Broking companies
• Depositories
• National Securities Depository Ltd (NSDL)
• Central Depository Services India Ltd (CDSL)
• Banks

3.3.2 Share price indices

According to the Financial Dictionary (https://financial-
dictionary.thefreedictionary.com/share+price+index) a share price index is a a group of
stocks put together in a standardized way to provide a useful window into a sector or
market's performance at a glance. That is, a stock index groups together a certain list of
stocks and usually takes an average of their prices so as to provide an idea of how the
industry or market represented in the stock index is doing. Very often, stock indices are
weighted to prevent a few data points from overwhelming it. For example, the S&P 500
is weighted according to market capitalization, while the DJIA is weighted for price. In
India, both the BSE and NSE have introduced many indices which measure the movement
in the prices of stocks. For instance, the indices offered by the NSE are as under. Thee BSE
also offers variety of indices. Among the various indices BSE Sensex and NSE’s Nifty 50
are the most popular.

Broad Market Indices

o NIFTY 50
o NIFTY NEXT 50
o NIFTY 100

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o NIFTY 200
o NIFTY 500
o NIFTY MIDCAP 50
o NIFTY MID100 FREE
o NIFTY SML100 FREE
o INDIA VIX

Sectoral Indices
o NIFTY BANK
o NIFTY AUTO
o NIFTY FIN SERVICE
o NIFTY FMCG
o NIFTY IT
o NIFTY MEDIA
o NIFTY METAL
o NIFTY PHARMA
o NIFTY PSU BANK
o NIFTY PVT BANK
o NIFTY REALTY

Strategy Indices
o NIFTY DIV OPPS 50
o NIFTY GROWSECT 15
o NIFTY QUALITY 30
o NIFTY50 VALUE 20
o NIFTY50 TR 2X LEV
o NIFTY50 PR 2X LEV
o NIFTY50 TR 1X INV
o NIFTY50 PR 1X INV
o NIFTY50 DIV POINT

Thematic Indices
o NIFTY COMMODITIES
o NIFTY CONSUMPTION
o NIFTY CPSE
o NIFTY ENERGY
o NIFTY INFRA
o NIFTY100 LIQ 15
o NIFTY MID LIQ 15

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o NIFTY MNC
o NIFTY PSE
o NIFTY SERV SECTOR

Fixed Income Indices

o NIFTY GS 8 13YR
o NIFTY GS 10YR
o NIFTY GS 10YR CLN
o NIFTY GS 4 8YR
o NIFTY GS 11 15YR
o NIFTY GS 15YRPLUS
o NIFTY GS COMPSITE

The chart below shows the movement in the value of Nifty 50 index during the two years
2016 and 2017. The index values on January 1, 2016 was 7963.2 and on December 27,
2017 it was 10490.75 indicating that the index return during these two years period was
32%. If you have a closer look at the chart it will be clear that during 2016 the change in
the value of the index was negligible and the rise in the value during 2017 was significant.
In fact, the percentage change in the value of Nifty 50 during 2016 was around 1% and
the change during 2017 was around 31%.

Chart 1: Movement in Nifty 50 Index

Nifty 50
11000
10500
10000
9500
9000
8500
8000
7500
7000
6500
6000
42401
42430

42491

42552

42826

42887

42948
42370

42461

42522

42583
42614
42644
42675
42705
42736
42767
42795

42856

42917

42979
43009
43040
43070

4. Trading in equities
In India, there are two leading national level stock exchanges, namely, the Bombay Stock
Exchange (BSE) and the National Stock Exchange (NSE). There are twenty other regional
exchanges. Presently, trading in the regional exchanges is almost nil and practically BSE,

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NSE and MCX SX are the only three exchanges which are operational. Around 5800
companies have been listed on the BSE and around 1800 companies have been listed on
the NSE. However, NSE is the largest stock exchange in the country accounting for more
than 75% of trading volume.

One can trade in these stock exchanges only through a member of an exchange concerned.
The members are called the stock brokers. To buy or sell equities in the stock exchanges
an investor must have opened the following three accounts:
• Trading account with a broker
• Demat account with a depository
• Bank account

In addition, Permanent Account Number (PAN) provided by the Income Tax Department
is mandatory for trading in stock exchanges.

All buy and sell transactions of an investor are recorded in his trading account. Now a
days, all the equity shares are in electronic form (dematerialized form) and all the
transactions are settled electronically. The demat services (electronic record keeping
and settlement) are offered by two depositories – (1) Central Depository Services India
Limited (CDSL) and (2) National Securities Depository Limited (NSDL). To avail these
services investors have to open an account with either of the two depositories. An
investor cannot, however, open a demat account directly with a depository. They can
open an account with a depository participant only. Depository participant is one who
has an account with CDSL or NSDL. All the buy transactions are credited in the demat
account and all the sell transactions are debited.

To settle money involved in the transactions one needs to have a bank account. Many
banks particularly the new generation banks like ICICI Bank, HDFC Bank, IDBI Bank and
Axis Bank have tied up with most of the broking firms and provide electronic clearing
services (ECS) through which funds are transferred electronically. ECS facilitates instant
transfer of funds to and from the trading account. If an investor has an account with a
bank which does not provide ECS, his transactions will be settled through cheques.

4.1 Types of trading

There are four different types of trades that can be made in the stock exchanges in India,
namely, cash trade, margin trade, short selling, and intraday trade.

4.1.1 Cash trade

Buying or selling stocks for delivery is called cash trade. Buyers pay cash and take
delivery of the stocks bought. Sellers, on the other hand, deliver stocks and receive
payment of cash.

4.1.2 Margin trade

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Those who want to buy for a very short period of time can do so with a limited amount of
money called margin money. The balance will be provided by the broker as loan.
Investors can, therefore, buy stocks worth several times their own money. The settlement
cycle in India is T+2. That is, any transaction should be settled within the next two trading
days. In case of margin trades the broker will pay cash and settle the transaction.
However, as per the regulations in India, margin trades should be settled by the actual
buyers within a period of one week and the loan taken from the brokers should be settled
on or before T+8. If the buyer does not bring in money to pay the lender, the
lender/broker will sell the stocks and will take his principal and interest. Balance, if any,
will be paid to the investor.

4.1.2.1 Margin requirements

Two types of margin, namely, initial margin and maintenance margin need to be
maintained for margin trading. “Initial margin” means the minimum amount, calculated
as a percentage (50%) of the transaction value, to be placed by the client, with the broker,
before the actual purchase. “Maintenance margin” means the minimum amount,
calculated as a percentage (40%) of the market value of the securities, calculated with
respect to the last trading day’s closing price, to be maintained by the client with the
broker.

One may raise the question, what if the margin money of an investor is not sufficient to
settle the transactions. This question is highly relevant particularly during periods of
high volatility in stock prices. During market crashes when prices of stocks fall drastically,
the margin will be revised upward and the investors will be asked to bring in additional
money. This is called margin call. In fact, the stock exchanges and brokers have the
discretion to increase the margins and in such a case, the margin call shall be made, as
and when required. If an investor fails to bring the additional money immediately, his
holdings will be disposed off by the broker without any further notice. Such actions will
lead to increase in the supply of shares substantially and would lead to fall in prices
further down. Fixed deposits with banks and Bank Guarantees shall be treated as cash
equivalents and shall be considered as acceptable form of initial and maintenance
margins for the purpose of availing the Margin Trading Facility

4.1.2.2 Securities eligible for margin trading

The securities in Group 1 would be eligible for margin trading facility. In addition to the
Group 1 securities, all the securities which are offered in the Initial Public Offerings
(IPOs) and which meet the conditions for inclusion in the derivatives segment of the
Stock Exchanges would be eligible for Margin Trading Facility.

Only corporate brokers with a “net worth” of at least Rs.3.00 crore would be eligible to
offer margin trading facility to their clients.

4.1.3 Short selling

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

SEBI issued a notification, on December 20, 2007, permitting short selling in select stocks
and a broad framework for short selling by institutional investors and a full-fledged
securities lending and borrowing (SLB) scheme for all market participants were
operationalised with effect from April 21, 2008. Short selling is selling a stock which the
seller does not own at the time of sale. It is a speculative action and he does it because of
his expectation that the stock price will fall within the next few days and hence he can
close his position by placing a counter order to buy the same stock and of the same
quantity. To facilitate short selling, stock lending is required. Unlike margin trades where
stocks can be bought with borrowed money in case of short selling there is a need for
borrowing stocks which is very difficult. The difficulty is because pooling the stocks in
desired quantity and lending from out of the pool has many constraints. The biggest
constraint is pooling stocks because the stocks are held by the investors and the stocks
available for lending would be very limited.

All classes of investors, viz., retail and institutional investors, are permitted to short sell.
The securities traded in Futures and Options (F&O) segment are eligible for short selling.

All categories of investors are permitted to borrow and lend securities. The borrowers
and lenders shall access the Securities Lending and Borrowing (SLB) platform set up by
the authorised intermediaries (AIs) through the clearing members (CMs) (including
banks and custodians) who are authorized by the AIs in this regard. The settlement cycle
for SLB transactions shall be on T+1 basis.

4.1.3.1 Roll-over SLB facility

Any lender or borrower who wishes to extend an existing lent or borrow position can
roll-over such positions i.e. a lender who is due to receive securities in the pay out of an
SLB session, may extend the period of lending. Similarly, a borrower who has to return
borrowed securities in the pay-in of an SLB session, may, through the same SLB session,
extend the period of borrowing. The roll-over shall be conducted as part of the SLB
session. Roll-over is available for a period of 3 months i.e. the original contract plus 2
rollover contracts.

4.1.4 Intraday trade

After introducing demat trade, buying and selling stocks within the same day has become
possible. Buying is similar to margin trade and selling is similar to short selling. However,
as the positions will be closed within the same day, the need for lending and borrowing
of money or shares does not arise.

4.2 Time Stamping of Orders

Broker member(s) have to maintain record of time when the client places the order and
reflect the same in contract note along with the time of execution of the order.

4.3 Types of orders

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Market order and limit order are the two types of orders an investor can place in a stock
exchange. Placing an order to buy or sell a stock at prevailing market price is called
market order. Limit order, on the other hand, is placing an order by quoting a price limit.
If it is for buying a stock, the price limit indicates that the broker shall execute the buy if
the price is equal to or less than the limit. If it is for selling a stock, the order shall be
executed if the price is equal to or above the limit. If the price does not reach the limit
during the day the order will not be executed.

Stock exchanges in India also offer Bulk Deals and Block Deals in stocks. A Bulk Deal
constitutes all transactions in a scrip (on an exchange) where the total quantity of shares
bought/sold is more than 0.5% of the number of equity shares of the company listed on
the exchange. The quantitative limit of 0.5% can be reached through one or more
transactions executed during the day in the normal market segment. Stock exchanges
shall disclose trade details of ”bulk deals” to the general public on the same day after the
market hours.

Block deal is execution of large trades through a single transaction without putting
either the buyer or seller in a disadvantageous position. For this purpose, stock exchanges
are permitted to provide a separate trading window. Block deal will be subject to the
following conditions:
 The said trading window may be kept open for a limited period of 35 minutes
from the beginning of trading hours i.e. the trading window shall remain open
from 9.15 am to 9.50 am.
 The orders may be placed in this window at a price not exceeding +1% from the
ruling market price/previous day closing price, as applicable.
 An order may be placed for a minimum quantity of 5,00,000 shares or minimum
value of Rs.5 crore.
 Every trade executed in this window must result in delivery and shall not be
squared off or reversed.
 The stock exchanges shall disseminate the information on block deals such as the
name of the scrip, name of the client, quantity of shares bought/sold, traded
price, etc. to the general public on the same day, after the market hours.

4.4 Costs of Trading

Costs for an investor include commission (brokerage) payable to broker, securities
transaction tax and charges payable to depository.

SEBI allows the brokers to charge not more than 2.5 percent of the transaction value from
their clients. However, due to competition among the brokers, they charge as low as 0.1
percent on trades for delivery and 0.05 percent on intraday trades. However, the
brokerage depends on the volume of business a client gives to his broker and is
negotiable.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Since 2004 Government of India is levying a tax on securities transactions called

Securities Transaction Tax (STT). The STT rates for the assessment year 2017-18 were
0.10 percent on trades for delivery and 0.025 percent on intraday trades. STT on trades
for delivery is payable by both buyers and sellers. Whereas, STT on intraday trades is
payable by sellers only.

Apart from the brokerage and STT, the investors have to pay fees to the depository for
its services. See the Annexure 1.1 for the details of charges levied by ICICI Securities Ltd,
one of the largest brokerage firms in India, for various charges to be paid by investors for
trading in the Indian stock exchanges.

4.5 Market Making

There are many scrips in which trading activity is very limited and are called illiquid
stocks. In order to create liquidity there is a need for motivating brokers to create market
for these stocks. The stock exchanges shall formulate its own benchmarks for selecting
the scrips for market making, however, the shares satisfying any of the following criteria
would not be eligible for market making:
 Shares included in the BSE Sensex and the Nifty 50;
 Shares where the average number of trades is more than 50;
 Shares where the value of trades on a daily basis is more than Rs.10,00,000;
 Shares where the company is not in operation and the Net worth erosion is
beyond 50%

The market making is allowed on a voluntary basis. Therefore, if Market Maker is not
available for such shares, the share will continue to be traded under the existing system.

4.6 Containing Price Volatility

One major source of risk to investors in equity stocks is the price volatility. Though
volatility in stock prices is quite inherent in nature very high volatility may ruin investors.
In order to contain the risk of price volatility SEBI has introduced the following two
mechanisms:
 Pre-open session
 Circuit filters

4.6.1 Pre-Open Session

India’s two premier exchanges — NSE and BSE — introduced the 15 minute special pre-
open trading session, a mechanism under which investors can bid for stocks before the
market opens. The mechanism came into operation on October 18, 2010. The mechanism
is known as ‘pre-open session call auction’ and the duration of the session is 15 minutes
(from 9:00—9:15 a.m.) out of which eight minutes shall be allowed for order entry, order
modification and order cancellation, four minutes for order matching and trade

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

confirmation and the remaining three minutes shall be the buffer period to facilitate the
transition from pre-open session to the normal market. Initially, only those stocks which
were part of BSE Sensex and NSE Nifty 50 were allowed to be traded during the pre-open
session. However, since April 1, 2013 the session was made applicable to all scrips that
are not classified as illiquid.

The major objective of the pre-open session is to determine the equilibrium price. The
equilibrium price is the price at which the maximum volume is executable. That is the
maximum volume that finds a match between buy orders and sell orders and hence can
be executed.

4.6.2 Circuit Filters

Another major initiative for containing stock price volatility is circuit filters. Stock
exchanges in India have introduced both index based market wide circuit filters and scrip
wise circuit filters.

4.6.2.1 Index based Market wide circuit filter

These circuit breakers are used to stop adverse movements either way. The circuit
breakers are applied at three stages of the index movement either way at 10%, 15% and
20%. The market wide circuit breakers would be triggered by movement of either BSE
Sensex or the NSE Nifty 50 whichever is breached earlier.
 In case of a 10% movement of either of these indices, there would be a 1 hour
market halt if the movement takes place before 1 pm. In case the movement
takes place at or after 1 pm but before 2:30 pm there will be a trading halt for ½
hour. In case the movement takes place at or after 2:30 pm there will be no
trading halt at the 10% level and the market will continue trading.
 In case of a 15% movement of either index, there will be a 2 hour halt if the
movement takes place before 1 pm. If the 15% trigger is reached on or after 1 pm
but before 2 pm, there will be a 1 hour halt. If the 15% trigger is reached on or
after 2 pm the trading will halt for the remainder of the day.
 In case of a 20% movement of the index, the trading will be halted for the
remainder of the day.

The stock exchange on a daily basis shall translate the 10%, 15% and 20% circuit breaker
limits of market-wide index variation based on the previous day's closing level of the
index.

4.6.2.2 Scrip wise price bands

 In addition to the market wide index based circuit filters, there are individual
scrip wise price bands of 20% either way, for all scrips in the compulsory rolling
settlement except for the scrips on which derivatives products are available or
scrips included in indices on which derivative products are available.

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 Appropriate individual scrip wise price bands upto 20% shall be applicable on
those scrips on which no derivatives products are available but which are part of
Index Derivatives.

4.7 Summary
Equity shares are one of the most attractive and popular avenues for investment. Equity
stocks offer very high return and the risk too is high. Valuation of equity stocks is very
complex mainly due to the fact that the equity shareholders are entitled to residual
earnings only and the life of equity stocks is infinite.

The primary as well as secondary markets for equity are very active in India. To invest in
equity stocks one has to open three different accounts, namely, (1) trading account with
a stock broking firm, (2) demat account with a depository participant, and (3) bank
account. Four different types of trades in the market investors can participate. They are,
cash trade, margin trade, short selling and intraday trade. The types of orders one can
place in the market are market orders and limit orders. There are certain costs investors
have to incur while investing in equity stocks. The costs are brokerage payable to brokers,
demat charges payable to depository participants, and securities transaction tax payable
to the government.

The Indian equity markets are well developed and there are millions of investors
including retail investors, corporates, foreign institutional investors, and domestic
institutions like mutual funds, banks, insurance companies, pension funds, provident
funds and the like participating in the market.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Annexure 1.1

ICICI Direct Stock Trading, Demat, Brokerage 2017

ICICI Direct Brokerage Charges 2017

 Trading Account Opening Charges (One Time): Rs 975

 Trading Annual maintenance charges (AMC): Rs 0
 Demat Account Opening Charges (One Time): Rs 100 (for Agreement Stamp
Paper)
 Demat Account Annual Maintenance Charges (AMC): Rs 500 (Rs 0 for 1st year
with 3 in 1 Account)

ICICI offers 2 types of brokerage plans to its customer:

1. I-Secure Plan (Flat brokerage Plan)

This plan offers Flat Brokerage (in %) irrespective of turnover value. This plan is
suitable for traders / investors looking at secured and fixed brokerage.

2. I-Saver Plan (Variable brokerage plan)

This plan offers brokerage based on the trading volume i.e. high brokerage for
low volume and low brokerage for high volume trades. This plan suitable for
traders / investors who trade in high volumes and can benefit from low
brokerage.

ICICIDirect Cash Brokerage

I - Saver Plan
Total Eligible Turnover (Per Brokerage Effective Brokerage on
calendar Quarter) (%) Intraday Squareoff
Above Rs 5 Crores 0.25 0.125%
Rs 2 Crores to 5 Crores 0.30 0.150%
Rs 1 Crores to 2 Crores 0.35 0.175%
Rs 50 Lakhs to 1 Crores 0.45 0.225%
Rs 25 Lakhs to 50 Lakhs 0.55 0.275%
Rs 10 Lakhs to 25 Lakhs 0.70 0.350%
Less than Rs 10 Lakhs 0.75 0.375%

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I - Secure Plan
Total Eligible Turnover (Per Brokerage (Equity Effective Brokerage on
calendar Quarter) Delivery %) Intraday Squareoff
Irrespective of turnover 0.55% 0.275%

ICICI Margin & Margin Plus Trading Brokerage

I - Saver Plan / I - Secure Plan

Total Eligible Turnover per month Brokerage (%)
Above Rs 20 Crores 0.030
Rs 10 Crores to 20 Crores 0.035
Rs 5 Crores to 10 Crores 0.040
Less than Rs 5 Crores 0.050

ICICI Other Brokergae Charges

1. Minimum Brokerage ICICIDirect: ICICI charges minimum brokerage of Rs 35 per

trade or 2.5% of the trade value whichever is lower.
2. ICICI charges flat 5 paisa per share (Rs 0.05) brokerage on stocks priced less
then Rs 10 per share.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

ICICI Depository Service Charges

For Resident Retail Customers and Corporates

Particulars Charges
Account Opening Nil
First Year AMC Nil
Rs 600 (Rs 500 for customers
Annual Maintenance Charges
receiving e-mail statements)
Buy - Market and Off-Market Nil
Max. Rs 500 for debt
Sell - Market and Off-Market and Redemption of MF instruments
units (% of transaction value of each ISIN) Nil for Trades done on
www.icicidirect.com
Instruction submitted through Internet (E-inst / 0.04% (Min. Rs 25 and Max. Rs
IVR) 25,000)
0.04% (Min. Rs 30 and Max. Rs
Instruction submitted through Call Centre
25,000)
0.04% (Min. Rs 35 and Max. Rs
Instruction submitted at Branches
25,000)
Rejection / fails Rs 30
Extra charges for processing of TIFDs submitted late
(% of transaction value)
Nil
Instruction submitted through Internet (E-inst /
IVR)
Instruction submitted through Call Centre Nil
Instruction submitted at Branches (accepted at
Rs 10 per ISIN
Client's risk)
Dematerialisation for each request form Rs 50
Dematerialisation for each extra certificate Rs 3
Rs 25 for every hundred
securities or part
thereof, subject to maximum fee
Rematerialisation
of Rs 3,00,000 or
a flat fee of Rs 25 per certificate,
whichever is higher.
Reconversion of MF units Rs 25 per instruction
Closure of Account Nil

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For Resident Retail Customers and Corporates

Particulars Charges
Pledge Creation/Closure/Confirmation/ Invocation
0.02% (Min. Rs 25 and Max. Rs
(% of value for each ISIN in each request)
25,000)
If, ICICI Bank is counter party
0.04% (Min. Rs 35 and Max. Rs
If, ICICI Bank is not counter party
25,000)
Additional Account Statements Rs 20

NSDL Charges (Depository Charges)

Particulars Charges
Annual Maintenance Fee for
Rs 500 p.a. (w.e.f October 1, 2013)
Corporate Account
Rs 4.50 per debit instruction (Nil for commercial paper
Sell - Market and Off-Market
and short-term debt instruments)
Reconversion of MF units
Rs 10 per instruction (w.e.f April 1, 2014)
into SoA
Redemption of MF units
Rs 4.50 per instruction (w.e.f April 1, 2014)
through Participants
A fee of Rs 10 for every hundred securities or part
Remat thereof, subject to maximum fee of Rs 5,00,000 or a flat
fee of Rs 10 per certificate, whichever is higher.
Pledge Creation Rs 25 per instruction

Source: http://www.chittorgarh.com/stockbroker/icicidirect/1/# Accessed on June

23, 2017.

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Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 2: Valuation of Equity Stocks

Dr M. Manickaraj

Objective
The objective of this section is to demonstrate the valuation of equity stocks using
various methods and models.

Structure
1. Introduction
2. Balance sheet based approaches
2.1. Liquidation value approach
2.2. Replacement value approach
3. Dividend discount models
3.1. Zero dividend growth model
3.2. Constant dividend growth model
3.2.1. Value of growth opportunities
3.2.2. Increasing the value of stocks
3.3. Variable dividend growth model
3.3.1. Two stage growth model
3.3.2. Three stage growth model
4. Estimation of key inputs for dividend discount models
4.1. Estimation of earnings
4.1.1. Estimation of growth in earnings
4.2. Estimation of cost of equity
5. Free cash flow models
5.1. Reasons for using free cash flow models
5.2. Valuation of equity
6. Relative valuation models
6.1. Steps for using relative valuation model
6.1.1. Definition of the multiple
6.1.2. Other multiples
7. Summary

1. Introduction
The fundamental principle of sound investing is that an investor does not pay more for
an asset than its value. Hence, the critical element of investment management is to know

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the value of an asset before buying or selling. There are many techniques to value stocks.
The following three approaches are commonly used for valuation of equity stocks:

 Balance sheet based approaches

 Discounted cash flow (DCF) models
 Dividend discount models
 Free cash flow models
 Relative valuation models

Amongst these DCF and relative valuation models are the most widely used models. This
section is devoted for explaining balance sheet approaches and dividend discount
models.

2. BALANCE SHEET BASED APPROACHES

Every business firm maintains its books of accounts wherein all its financial transactions
are recorded. At the end of every period, normally one year, they prepare the two
statements – profit and loss account and balance sheet. While the profit and loss account
shows the incomes, expenses and finally profits made during the period, the balance
sheet shows the assets and liabilities of the business on the account closing date.
Liabilities of a firm would include owners’ funds (equity capital) and outsiders funds
(outside liabilities). Owners (shareholders in case of listed companies), are eligible for
the assets that would remain after meeting the firm’s obligations to the outsiders. Value
of equity, therefore, is the value of all the assets minus outside liabilities (it is also referred
to as net worth). In order to arrive at the value per share, one has to simply divide the net
worth by the number of shares outstanding. The value so determined is often referred to
as the book value. The approach is illustrated with an illustration below.

Illustration 2.1: The Balance Sheet of Softech Ltd for the year ended March 31,.2005 is
as follows:
Rs. Crore
Liabilities Assets
 Share capital (70 crore shares  Net fixed assets 1500
of Rs. 2 each) 140  Current assets 2500
 Reserves and surplus 2690  Deferred revenue
 Long-term borrowings --- expenses not written 30
 Current liabilities 1200 off
Total Liabilities 4030 Total Assets 4030

Book Value (BV) Per Share = Net worth / No. of shares …………………. (1)

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Net worth of Softech Ltd1 = Net fixed assets + Current Assets – Liabilities
= 1500 + 2500 – 1200
= Rs.2800 Crore
BV per share = 2800 / 70
= Rs.40

In the investment world, the book value is rarely accepted as the intrinsic value of equity
stocks. The main reason for not accepting the book value is that the values shown in the
balance sheet are based on historical cost. Moreover, the accounting standards stipulate
that the values of different assets shall be estimated conservatively. Book value, hence,
may not reflect the true value of shares.

The following two approaches are suggested as alternatives for balance sheet based book
values:
- Liquidation value
- Replacement value

2.1 Liquidation Value

If a business is to be liquidated, what may be the value that can be realised by disposing
of all the assets of the firm? This value minus liabilities, divided by the number of shares
will give the value of a share.
Liquidatio n Value of All Assets  Liabilitie s
Liquidatio n Value 
Number of Shares

2.2 Replacement cost

Another way of finding out the value of shares is to consider the replacement value of all
the assets. The replacement value is the cost that may be required to build a business
firm with the same capacity and features of the existing firm. The replacement value of
assets minus liabilities, divided by number of shares, will be the value of a share.
Replacemen t Value of All Assets  Liabilitie s
Replacemen t Value 
Number of Shares
These two models too are not generally used for valuation of equity, because finding out
the market price for each and every asset of a business firm is next to impossible.

3. DIVIDEND DISCOUNT MODELS

Value of any asset can be thought of as the present value of cash flows expected from the
asset. The discounted cash flow (DCF) models are available since long back and are in

1
Deferred revenue expenses are not assets and hence are not taken into account. Similarly, items like cumulative
losses may appear on the asset side. Therefore, one should always start from the asset side and exclude such items
for finding out the net worth/book value.

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vogue for valuation of most of the assets. The same are also used for valuation of equity
stocks.

The cash flows for investors in equity stocks of a company are dividends paid by the
company. In addition, they will get the terminal price when they sell the stocks. The
intrinsic value of a stock, hence, can be defined as the present value of all cash payments
to the investor in the stock, including dividends as well as the proceeds from sale of the
stock, discounted at an appropriate risk-adjusted rate of return, k. This definition means
that the value of a share is the present value of dividend incomes and the sale price of the
stock. Mathematically,

n
Dt Pn
V0    ………………………………. (2.1)
t 1 (1  k ) t
(1  k ) n
Where,
Vo = Present value of stock
Dt = Dividend income for period t

Pn = Selling price of the stock

’k’ is the minimum rate of return expected by the investors from the stock. This
rate should include risk-free rate and the risk premium. Capital Asset Pricing
Model (CAPM) given below is the most widely used method for estimating the
discount rate.

k  R f   ( Rm  R f ) ............................. (2.2)

Where, Rf is the risk-free rate of return;  (called beta) of the stock; and
Rm is the return on a market portfolio.

Illustration 2.2: The risk free rate of return is 5% p.a, the beta of Ozone Ltd is 0.8 and
the market offers a return of 18% p.a. What is the expected rate of return for the investors
of Ozone Ltd?

k  R f   ( Rm  R f )
= 5% + 0.8 (18% - 5%)
= 15.4%

Given the expected rate of return what is the intrinsic value of the stock? Assume that
Ozone Ltd will pay a dividend of Rs.10 next year and the stock can be sold for a price of
Rs.250 at the end of the year.

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D1 P1
V0  
(1  k ) (1  k )
10 250
V0  
1.154 1.154

= Rs.225.30

One may raise the question what is Pn in equation 2.1 and how to determine that?
Assuming a holding period of one year each, the value of the stock at the beginning of the
first year is the present value of the dividend for the year and the selling price at the end
of the year. The price at the end of the year will be present value of the dividend for the
second year and the price at the end of the second year, and so on. Hence, what ultimately
matters is only dividend income. Based on this, the following four dividend discount
models have been developed:

 Zero dividend growth model

 Constant dividend growth model
 Two-stage dividend growth model, and
 Three-stage dividend growth model

3.1 Zero Dividend Growth Model

Generally, business firms retain a part of its earnings for reinvestment in the business.
However, if a company has no potential for growth, it may disburse all its earnings as
dividends. Therefore, the earnings per share and dividend per share will be equal. Since
no additional investment is being made and the business has no potential for growth the
earnings of the company too will not grow, rather it will remain constant forever. The
stream of dividends therefore will be a perpetual uniform cash flow. In this case, equation
2.1 will shrink to equation 2.3.

D1
V0  ………………………………… (2.3)
k

Where, V0 = Value of stock

D1 = Dividend for the next period.
k = Minimum required rate of return

Illustration 2.3: A stock pays a total dividend of Rs.5 in a year. The risk free rate is 6%
and the risk premium for this stock is 4%. The company is expected to maintain the
dividend at Rs.5 forever. What is the intrinsic value for the stock?

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First, let us find out k.

k  R f  Risk Premium
 6  4 10%
The value of the stock is
V0  D1 / k

 5 / .10
 Rs .50
3.2 Constant Dividend Growth Model
A firm, which does not grow, hardly exists. Supposing a firm has reached a steady state
of growth and its growth rate over time is expected to be constant. In this case, equation
2.3 shall be modified as follows:

D1
V0  ………………………………… (2.4)
kg

Where, g = the dividend growth rate. Growth rate can be calculated as follows:
g = ROE x b
Where, ROE = Return on equity, and
b = retention rate (i.e. 1 – dividend payout ratio).

Illustration 2.4: M Limited’s ROE is expected to be 25% and it follows a policy to retain
75% of its earnings. If the EPS for the forthcoming year is expected to be Rs.18, what
price will you pay for the stock? Expected return on the stock is 20%.

D1 = EPS1 x Payout Ratio

= 18 x .25
= Rs.4.5
g = ROE x b
= 25 x .75
= 18.75%
V0 = 4.5 / (0.20 - 0.1875)
= Rs.360.

Illustration 2.5: An all equity firm has Rs.100 million invested in its business. Its ROE is
15%. It follows a payout ratio of 40%. Number of shares outstanding is 3 million. Find
out the growth rate of the firm’s earnings? If the investors’ expected rate of return is
12.5% what is its intrinsic value? What is the present value of its growth opportunities?

Total earnings = Capital x ROE

= 100 mn x .15
= Rs.15 mn.

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Earnings Per Share = Total earnings / No. of shares

= 15 mn /3 mn
= Rs.5
Dividend per share = EPS x Payout Ratio
= 5 x .40
= Rs.2
Growth rate (g) = ROE x b
= 15 x .60
= 9%
V0 = 2 / (.125 - .09)
= Rs.57.14

3.2.1 Value of Growth Opportunities

Equation 5 shows that discount factor ‘k’ is adjusted for the growth rate ‘g’ and hence the
growth in the earnings of a company will contribute significantly to its stock value. One
can raise the question, how much of a stock’s value is due to the growth in its earnings?
To answer the question we should be able to decompose the value of the stock into the
value of a non-growing stock (NGV0) and the value of growth opportunities (PVGO), as
follows:

Vo  NGVo  PVGO .................................... (2.5)

Value of a non-growing stock is simply the value of the stock if the firm does not retain its
earnings. (i.e., if the firm disburses all its earnings as dividends). The value of NGVo and
PVGO of the stock in illustration 2.5 are:

E1
NGV0  ................................. (2.6)
k
5

0.125
 Rs .40

PVGO  V0  NGV0 ................................. (2.7)

 57.14  40
 Rs.17.14

If this company’s ROE in the future will be 12.5% (i.e. equal to its expected rate of return,
k), what will be its intrinsic value?

In this case, the growth rate will be 12.5 x .60 = 7.5%. Therefore, the value of the firm will
be

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

2
V0 
.125  .075

 Rs .40
This is just equal to the value of a non-growing stock. The result shows that growth as
such will not increase the value of the stock. Rather, ROE being greater than the
required rate of return is a necessary condition for value creation.

3.2.3 Increasing the Value of Stocks:

The objective of the management of any business firm is to maximise the value of its
equity stocks. Given the constant dividend growth model, one can understand what
determines the value of a stock and hence what the management of a company shall do
to maximise the value of its stock. Value of stocks can be maximised by increasing the
numerator and/or by decreasing the denominator in equation 5. As such, the value of a
stock can be increased by any or a combination of the following:

 Increasing the expected dividend per share. To pay more dividends the earnings
of the firm should increase.
 Decreasing the required rate of return. The minimum required rate of return is
made up of risk-free rate, market return and beta. Risk-free rate of return and
market return are determined by the market and the management has no control
over them. The risk of the firm as measured by beta alone can be controlled by
the management. Therefore, the management shall try to minimise the beta of the
firm by taking up projects that are less risky and by making the firm’s earnings
more stable.
 Increasing the rate of growth in earnings. Growth in earnings can be increased
either by taking up projects that are more profitable than the existing businesses
and/or by maximising the profits from the existing businesses.

3.3 Variable Dividend Growth Models

The constant dividend growth model discussed above assumes that the dividends of a
company will grow at the same rate over an indefinite period. This could be true for
matured firms and firms in industries which have reached the maturity stage of its life
cycle. But in reality there are many companies whose earnings grow faster and such high
growth cannot be sustained for long. For such companies, models that would consider
multiple growth rates need to be applied. Two different models – two-stage growth model
and three-stage growth model – which are extension of the constant dividend growth
model are discussed hereunder. All the three models are widely for valuation across the
entire world.

3.3.1 Two-Stage Growth Model:

There are many companies growing at a higher rate which could be because it is a new
business or because the industry it operates in is growing at a faster rate. This high
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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

growth rate will reach a steady state because the business firm and / or the industry will
reach a stage where the growth rate will be around the growth rate of the economy. In
such cases, it may be expected that the extraordinary growth in earnings of a company
will continue for a certain number of years and thereafter it will reach a stable growth
rate that is sustainable for a very long period of time into the future. For such kind of
business firms, two-stage growth model can be applied for valuation of equity. The model
is

n
D0 (1  g a ) t Dn (1  g n ) 1
V0     ……………………………. (2.8)
t 1 (1  k ea ) t
(k en  g n ) (1  k ea ) n

Where, D0= Dividend for the most recent period

ga = Abnormal growth rate
gn = Normal growth rate
kea = Cost of equity during abnormal growth phase
ken = Cost of equity during normal growth phase

3.3.2 Three-Stage Growth Model:

The two-stage model assumes that after few years the growth in earnings of a company
will suddenly fall to a stable growth rate. This may be true for the companies whose
earnings are growing at a slightly higher rate than a sustainable stable growth rate.
However, if the earnings of a company are growing at a rate much higher than its stable
growth rate, the above model is not appropriate. In such cases, generally, the growth rate
will decline to the steady state over a number of years. Thus, there may be three different
stages of growth in the earnings of a company. The three stages are:

- Initial abnormal growth phase

- Transition phase
- Normal growth phase
Accordingly, the three-stage growth model is,

n1
EPS 0 (1  g a ) t pt n2
EPS n1 (1  g t ) pt EPS n 2 (1  g n ) p n 1
V0       n2
t 1 (1  k e,a ) t
t  n11 (1  k e , a ) (1  k e ,t )
n1 t
(k e,n  g n )  (1  k e,t )
t 1

……………. (2.9)

Where, Do, ga, gn, kea, ken are the same as in equation 2.8.
n1 = Number of years in the abnormal growth phase
n2 = Number of years in the abnormal growth phase plus number of years
in the transition phase.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

k e ,t = Cost of equity applicable to year t. It is to be noted that unlike the

abnormal growth period where a constant rate of cost of equity is used
across all the years the cost of equity for each year during the transition
period will be different. This is because the beta will gradually change
during the transition period towards the stable period beta
p = pay out ratio

Illustration 6 explains valuation of equities applying the two-stage dividend growth

model and the three-stage dividend growth model.

Illustration 2.6: Infotech Ltd is a leading player in the I.T sector in the country. Its ROE
is expected to be 20%. Its beta is likely to be 1.35. The average return offered by the
Sensex was 14%. Risk-free rate is 6.5%. The company’s EPS for the just concluded year
was Rs.25. Its dividend pay out ratio was 0.2 and paid a dividend of Rs.5 last year.
a) Find out the value of the stock applying two-stage dividend growth model
assuming that the extraordinary growth in its earnings will continue for the next
five years and thereafter it will reach a stable growth of 10%.

b) Also find out the value of the stock applying the three-stage growth model
assuming that the extraordinary growth will continue for five years and will
decline gradually over the next five years and reach a stable growth rate of 10%.

Solution:
a) Valuation Using Two-Stage Growth Model

Cost of equity for abnormal growth period = 6.5 + 1.35 (14 – 6.5)
= 16.625%

Growth rate for the abnormal growth period = ROE x (1- Payout Ratio)
= 20 x 0.8 = 16%

Assuming that the beta of the stock during the stable growth period will be 1, cost of
equity for the stable growth period works out to 14% as shown below.

Cost of Equity for Stable Growth Period = 6.5% + 1 (14% – 6.5%)

= 14%

Retention rate during the stable growth period, assuming that the ROE will reach 15%, is
calculated as

Growth rate = ROE x Stable Period Retention Rate

So, Retention Rate = Growth Rate / ROE

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

= 10 / 15
= 0.67
Payout Ratio = 1- 0.67
= 0.33

EPS for the next year is simply the EPS for the most recent year multiplied by the expected
growth rate. That is

EPS1 = EPS0 x (1+Growth Rate)

= 25 x 1.16
= 29

In the same way the EPS and DPS for the subsequent years and the present value of
dividends during the abnormal growth phase are worked out in table 2.1.
Table 2.1
Abnormal Growth Phase
Year Growth Payout EPS DPS Cost of Discount PV of
Rate Ratio Equity (kea) Factor DPS
[(1+kea)t]
1 16% 0.2 29.00 5.80 16.625% 1.16625 4.97
2 16% 0.2 33.64 6.73 16.625% 1.3601 4.95
3 16% 0.2 39.02 7.80 16.625% 1.5863 4.91
4 16% 0.2 45.27 9.05 16.625% 1.85 4.89
5 16% 0.2 52.51 10.50 16.625% 2.1575 4.87
Total 24.59

The value of the dividend cash flow during the stable growth phase may be calculated as
follows:

EPS for sixth year (EPS6 ) = EPS5 x (1+Stable Growth Rate)

= 52.51 x 1.1
= 57.76
DPS6 = EPS6 x Stable Period Payout Ratio

= 57.76 x .33
= 19.06
Value of dividends stream during stable growth phase = 19.06 / (0.14 - 0.10)

= 476.50

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

This value of 476.50 is at the end of abnormal growth phase (i.e. at the end of fifth year).
The present value of the amount is

= 476.50 / (1.16625)5
= 220.86

So, Value of the Stock = 24.59 + 220.86

= Rs. 245.45

b) Valuation Using Three Stage Growth Model

The value of dividends during the abnormal growth stage is the same as in the two-stage
growth model. The present value of dividends during the transition phase is worked out
in Table 2.2.
Table 2.2
Transition Phase
Year ROE Growth Payout EPS DPS Beta Cost of (1+ k e PV of
Ratio Equity( k e )t DPS
)
6 23% 14.8% .36 60.28 21.70 1.28 16.1% 2.5049 8.66
7 21% 13.6% .35 68.48 23.97 1.21 15.575% 2.895 8.28
8 19% 12.4% .35 76.97 26.94 1.14 15.05% 3.307 8.15
9 17% 11.2% .34 85.59 29.10 1.07 14.525% 3.8145 7.63
10 15% 10% 0.33 94.15 31.07 1 14% 4.3486 7.14
39.86

Cost of equity during the transition period is declining year after year because we have
assumed that the beta of the stock will decrease gradually to 1. It may also be noted that
ROE has been assumed to decline over the transition period to reach a normal level by
the end of the abnormal period (15% in this illustration). The assumption/s is very
important because it is the basis for arriving at payout ratio and DPS. This is the only way
by which the fundamentals of the company can be taken into account in estimating the
dividends. Contrarily, if one would go strictly by equation 2.9 ROE and payout ratio will
be ignored.
The value of stable growth phase may be calculated as follows:

EPS11 = EPS10 x (1+Stable Growth Rate)

= 94.15 x 1.1
= 103.57

DPS11 = EPS10 x Stable Period Payout Ratio

= 103.57 x .33
= 34.18

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34.18 1
Value of stable growth phase   5
(.14 - .10) (1.16625 x 1.161 x 1.15575 x 1.1505 x 1.14525 x 1.14)

= 196.50

Value of the Stock = Value of Abnormal Growth Phase + Value of Transition Phase
+ Value of Stable Growth Phase

= 24.59 + 39.86 + 196.50

= Rs.260.95

Exercise: Students may find out the value of Infotech Ltd’s equity stocks by assuming
different values for beta, growth rates, ROE and payout ratios in illustration 2.6.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

4. ESTIMATION OF KEY INPUTS FOR DIVIDEND DISCOUNT MODELS

The discussion in the previous section shows that the dividend discount models are of
simple equations in nature and finding the value of stocks is very easy. Contrarily, in the
investment world, valuation of equities is considered to be one of the most complex one.
What makes the valuation of equity complex? There are two main reasons. One is that the
equity shareholders are entitled to the residual earnings only. There is no upper limit
and lower limit for the residual earnings and hence the earnings available to the equity
investors need to be estimated as precisely as possible and it is very difficult. The second
reason is that the models take into account cash flows for an infinite number of periods
into the future. Predicting cash flows for infinite number of periods will be difficult.
Similarly, factors influencing the discount rate are also difficult to be identified.
Estimating the value of an equity stock, hence, does not depend much on the models but
on the reliability of assumptions and accuracy of inputs fed into the models. The critical
inputs required for applying dividend discount models for valuation of equity broadly
are: rate of growth in dividends for different time periods and cost of equity. The key
inputs necessary for using dividend discount models and how these inputs can be
estimated are discussed in this section. The section is organised into the following
sections:
 Estimation of earnings
 Estimation of cost of equity
o Risk free rate
o Market return
o Beta

4.1 Estimation of Earnings

The numerator in the dividend discount models is the dividends. Dividends are estimated
by applying the applicable growth rates over the base year dividend. If three stage growth
model is used for valuation of a stock growth rate for the abnormal growth period and
for the stable growth period are required. During the transition period the abnormal
growth rate is normally assumed to decline linearly to reach the stable growth rate.
Growth rates for the transition years hence can be calculated if the abnormal growth rate
and stable growth rate are available. The following equation is commonly used for
estimating the growth in earnings:

Growth = Return on equity x Retention Rate

Return on equity for the future years can be estimated using the following equation:

PAT PBT PBIT Sales Avg.Total Assets

ROE      - - - - - - - - - (3.1)
PBT PBIT Sales Avg.Total Assets Equity

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Where, PAT = Profit after tax

PBT = Profit before tax
PBIT = Profit before interest and tax

Thus, equation 3.1 is referred to as the DuPont Equation which takes into account the
following five factors which are the major factors influencing the ROE of any firm:
- Tax burden (the difference between PBT and PAT is income tax)
- Interest burden (the difference between PBT and PBIT is interest on
borrowings)
- Operating profit margin (PBIT/Sales)
- Total assets turnover (Sales/Avg. Total Assets)
- Financial leverage (Avg. Total Assets/Equity)

The objective of using equation 3.1 take ROE as the basis and move backward to capture
the fundamentals influencing the profitability of companies.

The ROE of the two major two wheeler manufacturing companies for the year 2015-16
has been analysed using the DuPont Equation and the results are presented in Table 3.1.

Table 3.1
DuPont Analysis of Bajaj Auto Ltd and TVS Motor Company Ltd
Bajaj Auto TVS Motor
PAT/PBT 0.61 0.74
PBT/PBIT 1.00 0.91
PBIT/Net Sales 19.7% 5.0%
Net Sales / Average Total Assets 1.45 2.35
Average Total Assets / Average Net Worth 1.36 2.67
ROE (Net of non-operating items)@ 23.7% 21.1%
Source of financial data: Ace Equity
@: Estimated using equation 3.1. For instance, the ROE of Bajaj Auto was derived as
follows:
23.7% = 0.61 x 1.00 x 19.7% x1.45 x 1.36
Table 3.1 shows that the ROE of both the companies is more or less same. However, the
operating profit margin of TVS Motor was substantially lower at 5% compared to Bajaj
Auto’s 19.7%. Despite lower operating margin TVS motor could achieve an ROE of 21.2%
due to higher assets turnover (2.35) and higher financial leverage (2.67). Table also
shows that TVS Motor has paid tax at a lower rate 26% (1 – PAT/PBT) and has incurred
interest expense equal to 9% of its PBIT (1 – PBT/PBIT). Bajaj Auto has paid tax at 39%
and has not incurred any interest expense.

Based on realistic assumptions regarding the various factors like interest rate, leverage,
profit margin, etc, one can estimate the future maintainable ROE of any company.
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4.1.1 Estimation of Growth in Earnings

Growth in earnings can then be estimated by multiplying the ROE with the retention ratio
of the company. The retention ratio can be ascertained from the dividend policy of a
company, if it is available. Or else, the average payout ratio may be worked out from its
historical earnings and dividends. Alternatively, the average for the industry may be
taken.

An alternative for estimating the growth rates is to use the historical growth in the
earnings of a company. The historical growth is generally compared with the growth in
sales to confirm the reliability of the earnings growth.

4.2 Estimation of Cost of Equity

We have already seen that the most widely used model for estimation of cost of equity is
the CAPM. The CAPM requires the following estimates:

o Risk-free rate
o Market return
o Beta

Risk-free rate: Yield from the government securities is normally taken as the proxy for
risk-free rate. There are many types of government securities with different maturity
periods. G-Sec with what maturity shall be considered for estimating the risk-free rate?
Many practitioners take the yield from 10-year G-Sec. However, all the securities
including the G-Sec are subject to inflation risk. Therefore, the right kind of G-Sec for
determining the risk-free rate is the one with the shortest term to maturity. In India, the
government security issued with the shortest term to maturity is the 91-Day Treasury
Bills and it is the most appropriate instrument for estimating the risk-free rate. There is
another issue in estimating the risk-free rate. Whether to consider the yield for the most
recent period or the yield forecasted for the future or historical average yield? It is
suggested that the long-term average of the historical yield can be considered. The
average of the last ten years yield from 91-day T-Bills is roughly 7 percent. Whereas, the
average yield over the last 15 years ending March 2014 from the 10-Year G-Sec was
around 8.60 percent.

Market Return: Return offered by the market is inferred from a stock price index. There
are many indices in the market. Some are broader in nature comprising stocks from
various sectors and large number of stocks. Examples are Sensex, Nifty, BSE100 index
and BSE500 index. Some are sector specific like bank index, IT sector index, metal index,
etc. For the purpose of estimating the risk premium it is better to take a broader index.
Sensex and Nifty are the most commonly used indices for the purpose. The markets are
highly volatile and have offered different rates of return in the past. For instance, returns

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

from the Indian equity markets as measured from Nifty50 Index values have been as in
the following table:
Table 3.1
Return on Nifty 5o Index
Year Returns Year Returns
1997-98 15.35% 2007-08 23.89%
1998-99 -3.48% 2008-09 -36.19%
1999-
41.78% 2009-10 73.76%
2000
2000-01 -24.88% 2010-11 11.14%
2001-02 -1.62% 2011-12 -9.2%
2002-03 -13.40% 2012-13 7.3%
2003-04 81.14% 2013-14 18.0%
2004-05 14.89% 2014-15 26.7%
2005-06 67.15% 2015-16 -8.9%
2006-07 12.31% 2016-17 18.5%

Nifty return has been in the range of -36.19 percent (during the year 2008-09) to 81.14
percent (during the year 2003-4) during the last twenty years. It is advisable to take the
long term average return from any such broader index. The average return of the Nifty
has been 11.90 percent. This rate does not include dividend return. Assuming dividend
yield of around three percent for the Nifty50 stocks market return can be taken as 15
percent.

Beta: Capital market theorists contend that investors will be paid a premium only for
bearing the risk that cannot be eliminated through diversification. Accordingly, the CAPM
considers beta as the measure of risk. To date, beta is considered to be the only measure
available for measuring non-diversifiable risk (also referred to as systematic risk). Beta
of any stock can be measured simply by regressing the stock returns on the index returns.
This gives the historical beta. Investors, on the other hand, are concerned about
estimating the future risk involved in their equity investment. How to forecast beta? One
way out is to calculate the historical beta and use the same as a measure of future beta.
However, it has been proved by researchers that the betas do not remain constant. It has
been found that betas have a tendency to move towards 1 (the market beta). The betas
lower than 1 increase towards 1 and higher betas decrease towards 1. Taking this into
account, Bloomberg has suggested the following approximation to arrive at the future
beta:

Future Beta = 0.67 * Historical Beta + 0.33 * 1

For example, if the historical beta of a stock has been 1.4, the estimated beta would be
1.29 (0.67 * 1.44 + 0.33).

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

5. FREE CASH FLOW MODELS

Sections 2 and 3 have explained the use of dividend discount models (DDMs) for valuation
of equity. The free cash flow models are extensions of DDMs. The objective of this section
is to explain the use of free cash flow models for valuation of equity.

5.1 Reasons for using Free Cash Flow Models:

The accounting earnings used in the dividend discount models are subject to
manipulation by changing the methods of accounting and by playing with some
discretionary items like depreciation. Besides, there are companies paying dividends in
excess of profits available for disbursement and there are companies paying less than
what is available. Therefore, many analysts argue that using dividends for valuation of
stocks is not appropriate. They suggest the use of free cash flows.

5.2 Valuation of equity using free cash flow models

There are two different free cash flow based methods which are:

1. Free cash flow to equity (FCFE)

2. Free cash flow to firm (FCFF)

FCFE is calculated as follows:

FCFE = Profit after tax + Depreciation – Capital Expenditures – Change in

Non-cash Working Capital + Net Debt Raised. ……………………… (4.1)

The value of a stock may be calculated by discounting the future FCFE in the same way as
discounting the dividends. The discount rate to be used is cost of equity. Add the cash
balance to the value arrived and divide it by the number of shares outstanding to arrive
the value per share. Another important thing to be noted is that the Profit After Tax (PAT)
being taken into account for the purpose should be net of non-recurring transactions. If
strategic investments are considered for estimating the amount of capital expenses then
the income/loss from these investments should be taken into account for estimating the
value of PAT.

FCFF is the cash flow available for disbursement to all the contributors of capital
including equity shareholders and creditors. FCFF is calculated as

FCFF = EBIT (1- Tax Rate) + Depreciation – Capital Expenditures

– Change in Non-Cash Working Capital ……………………… (4.2)

FCFF model too is similar to the DDM. But the numerator is free cash flow to firm and
denominator is weighted average cost of capital (WACC).

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Equity Debt
WACC  Cost of Equity   Cost of Debt (1  t ) 
( Debt  Equity) ( Debt  Equity)
…………… (4.3)

Value of debt should be deducted from the value of firm and the cash balance and the
value of investments not considered for estimating capital expenses should be added to
arrive at the value of equity. This value should be divided by the number shares
outstanding to arrive at the value per share.

Illustration 4.1: Free Cash Flow Models for Valuation of Equity :

The following data pertains to Softech Ltd, an IT company. Find out the value of the stock
using free cash flow to equity (FCFE) and free cash flow to firm (FCFF) methods.

Table 4.1: Financials of Softech Ltd.

2011 2012 2013 2014 2015 2016
EBIT 951.86 1200.07 1510.59 2265 2801 4205
Depreciation 160.65 188.95 230.9 268 409 469
PBT 951.15 1170.02 1470.96 2231 2766 4157
Tax provision 143.19 212.09 227.49 327 345 375
PAT 807.96 957.93 1243.47 1904 2421 3782
Non-recurring income 7.76 18.84 0.53 47 48.58 29.17
Non-recurring expenses 0 25.27 9.97 1 0.45 3.05
Gross fixed assets 1111.27 1307.74 1731.57 2459 3408 4846
Investments 66.79 66.23 1027.38 1343 876 839
In group / associate cos. 7.06 15.4 95.74 159 190 839
In mutual funds 0 0 929.6 1168 684 0
Other investments 59.73 50.83 2.04 16 2 0
Inventories 0 0 0 0 0 0
Receivables 985.87 1392.48 1325.73 2249 2715 3359
Cash & bank balance 766.95 1328.67 1638.01 1481 3334 5602
Net worth 2080.31 2860.65 3253.43 5242 6897 11162
Borrowings 0 0 0 0 0 0
Current liabilities &
provisions 481.76 736.26 1743.62 1360 2217 1824
(All figures are in Rupees crore)

Face value of a share is Rs.5 and number of shares outstanding was 571209862. The
historical beta of the company was 0.68.

WORKINGS AND SOLUTION:

FCFE Method:

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The basic procedures for applying the FCFE method are the same as that for the dividend
discount models. The main difference is that the dividends in the numerator will be
replaced by FCFE. FCFE can be calculated using equation 4.1. Before applying the
equation, profit after Tax (PAT) shall be adjusted for non-recurring items. Non-recurring
expenses should be added to PAT and non-recurring incomes should be deducted. Hence,
PAT net of non-recurring transactions of the company for the year 2016 would be
Rs.3755.88 (3782+3.05-29.17). PAT (NNRT) for the different years is as follows:

Table 4.2 : PAT adjusted for non-recurring transactions

2012 2013 2014 2015 2016
PAT (NNRT) 964.36 1252.91 1858 2372.87 3755.88

Capital expenses (Capex) incurred during the year can be ascertained from finding the
increase in gross fixed assets (GFA) in a year over the previous year. Investments,
generally is the amount invested outside the business, mainly in financial assets and are
marketable. However, investment in subsidiary/group companies is of strategic in
nature and cannot be withdrawn in the normal course. Therefore, investment in
group/subsidiary companies may also be treated as capital expenses. While doing so
income from such investments should be taken into account for estimating PAT. In this
case let us assume that it has already been done so. Capex for the year 2016 thus were Rs.
2087 [(4846-3408) + (839-190)].

Non-cash working capital is inventories plus receivables minus current liabilities. For our
purpose, we have to calculate the change in the non-cash working capital over the
previous year. For the year 2016, it is Rs.1037 [(0+3359-1824) - (0+2715-2217)].

New debt raised minus debt repayments can be calculated simply by taking the debt
outstanding at the end of the year minus the debt outstanding at the end of the previous
year. This is the net debt raised by the company during the year. This company is a debt
free company and it is zero in all the years.
Capex, change in non-cash working capital and net debt raised for the years 2012 through
2016 are as below.

Table 4.3 : Capex, change in non-cash working capital and net debt raised
2012 2013 2014 2015 2016
Capex 204.81 504.17 790.69 980 2087
-
Change in non-cash working capital 152.11 1074.11 1306.89 -391 1037
Net debt raised 0 0 0 0 0

FCFE for the years from 2012 to 2016 are as follows:

Table 4.4 : FCFE and growth in FCFE

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

2012 2013 2014 2015 2016

FCFE 796.39 2053.75 28.42 2192.87 1100.88
Growth (year–on- - -
year) 157.88% 98.62% 7615.94% 49.80%

For estimating the value of equity, the FCFE for the most recent year, i.e., 2016 will be the
base and applying appropriate growth rate we can estimate the cash flows expected in
the future. The compounded annual growth rate (CAGR) in FCFF of the company during
2012 – 2016 is
= (1100.88/796.39)1/4 – 1
=8.43%

The year-on-year growth of FCFE has been highly volatile and it makes it difficult to
estimate the future cash flows. Rather, the suitability of the FCFE method for valuation
of stocks based on historical values is questionable. However, for the sake of
demonstrating the model, let us use the historical growth and find out the value of the
stock. The average growth of the company’s FCFE has been 8.43 percent and which is not
abnormal. Hence, we can apply constant growth model as below.
FCFE2008
V0 
Ke  g
We have to add outstanding cash and bank balance to the value and the resulting figure
should be divided by the number of shares to arrive at the value per share.

Bloomberg procedure is applied for estimating the beta of Softech Ltd as follows:
Beta = 0.67 x .68 + .33
= .79
Assuming a risk free rate of 7 percent and market return of 15 percent, cost of equity (Ke)
for the company is

Ke = 7 + .79 x (15 – 7)
= 13.32%
FCFE2008
V0   Cash Balance  Non  Strategic Investments
Ke  g
1100.88  1.0843
Value of Softech' s Equity   5602  0
.1332  .0843

= Rs.30012.72 crore
Hence, value per share = 30012,72,00,000 / 571209862
= Rs.525.42

FCFF Method
Firstly, EBIT should be adjusted for non-recurring transactions. EBIT (NNRT) for the year
2007 would be Rs.4178.88 crore (4205 - 29.17+3.05). Tax rate is simply provision for

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taxes divided by profit before tax (PBT). Tax rate for the year 2016 was 9.02 percent
(375/4157). Capex and change in non-cash working capital may be taken from Table 4.3.
EBIT (NNRT), tax rate and FCFF for the years 2012 to 2016 are as follows:

Table 4.5: FCFF, EBIT adjusted for non-recurring transactions and tax rate
2012 2013 2014 2015 2016
FCFF 819.83 2085.79 64.18 2229.51 1146.91
Growth (y-on-
y) 154.42% -96.92% 3373.90% -48.56%
EBIT(NNRT) 1206.5 1520.03 2219 2752.87 4178.88
Tax Rate 18.13% 15.47% 14.66% 12.47% 9.02%
Like in FCFE method, we may use the historical growth rate for estimating the future
FCFF. The historical CAGR in FCFF is

= (1146.91/819.83)1/4 – 1
= 8.76%

As the growth rate seems to be normal, constant growth model shall be used. As the cash
flow is the cash flow available to the contributors of capital including the equity
shareholders and creditors, weighted average cost of capital (WACC) should be used as
the discounting factor. Hence,

FCFF2008
Value of the firm   Cash
WACC  g
Softech Ltd is a debt free company and hence the weighted average cost of capital (WACC)
is equal to the cost of equity for the company.
1146.91  1.0876
Value of Softech Ltd   5602
.1332  .0876

= Rs. 32956.72 crore

The value of debt outstanding should be deducted from the value of the firm. However,
as no debt is used by the company, the above value may be divided by the number of
shares to arrive the value per share.

Value per share = 32956,72,00,000 / 571209862

= Rs. 576.96

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Important Note

Historical free cash flows (both FCFE and FCFF) will normally be highly volatile
because of non-recurring items such as capex and capital raised are being
considered for their calculation. Moreover, in case the value of cash flow in the
base year or in the latest year happens to be zero or negative the growth rate
cannot be estimated. Therefore, it is always advisable that financial statements
(profit and loss account and balance sheet) be projected and based on the
projected financial statements free cash flows may be estimated for valuation of
equity.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

6. RELATIVE VALUATION MODELS

The dividend discounted models and free cash flow models discussed in the previous
sections help find out the intrinsic value of a stock. The methods give the value based on
the fundamentals of a company like earnings, growth in the earnings, dividend payout,
riskiness and the factors like leverage, interest rate and tax rate. Often the market price
of a stock diverges from its intrinsic value. This gives rise to suspecting the relevance of
the value of a stock determined based on these models. Therefore, another set of models
called relative valuation models, is widely used in the investment world. There are many
models like earnings multiples, book value multiples, revenue multiples and sector
specific multiples.

The multiples are used to determine the value of a stock in comparison to the multiple of
comparable firms. They therefore are called as relative valuation models. These models
are very popular because it is easy to compare the multiple of a firm with that of its peers
to find out whether a stock is underpriced or overpriced in the market. One can
understand the multiples easily and above all the value arrived at would reflect the
current mood of the market.

6.1 Steps for using relative valuation models

Relative valuation models, though are easy to use, would give totally misleading results if
handled without care. The following steps may be followed diligently while applying the
models.

6.1.1 Definition of the multiple: Price-to-Earnings Ratio (PER) is the most widely used
multiple for equity valuation. Price of a stock is the numerator and earnings per share
(EPS) is the denominator in the equation. However, the price and EPS are defined
differently by different analysts. For instance, current market price may be taken as the
numerator. Alternatively, the average price of the stock over some period in the past, say,
last six months can be taken. EPS which is the denominator in the equation also defined
differently. The following three different PERs are commonly used:

 Current PE Ratio = P0 / EPS0 ……………………………. (5.1)

 Trailing PE Ratio = P0 / EPST …………………………….. (5.2)
 Forward PE Ratio = P0 / EPS1 ……………………………..(5.3)
In all the above equations, the numerator is the price of the stock which can be current
market price or average price. EPS0 is the current EPS, EPST is the trailing EPS and EPS1
is the forward EPS. EPS for the most recent accounting year is called the current EPS.
Trailing EPS is the EPS calculated from the financial statements for the most recent four
quarters or the most recent twelve months. Forward EPS is the forecasted EPS for the
current accounting year. One has to define the multiple and use it consistently across time
and stocks.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

To use the multiples, one should also know the cross sectional distribution of the multiple
across the market and across the sectors. That is, knowledge of average multiple for
different industrial sectors and the multiple of different stocks within a sector is essential
to use a multiple judiciously.

It is also suggested that an analyst knows the fundamentals determining the multiple so
that he can understand the impact of the changes in the fundamentals of a company on
its multiples.

The value of a stock is determined by comparing the multiple of one company with that
of the multiple for other companies. The companies chosen for the purpose should be
comparable in terms of cash flows, growth, risk and other characteristics. An IT company
cannot be compared with a steel company. Therefore, comparable firms should be chosen
carefully. The use of PE ratio for valuation of stocks is illustrated as follows:

Illustration 9: Supposing, you are interested in finding the value of Company X’s stock
which manufactures electronics goods. There are 8 different companies in electronics
goods sector and are comparable in terms of cash flows, growth and risk. The current
market price, EPS and PE multiple for the companies are as follows:
Current
Current Market PE
Company EPS Price Ratio
A 5 75 15
B 15 270 18
C 24 288 12
D 8 136 17
E 20 400 20
F 16 240 15
G 28 448 16
H 6 96 16
Average PE Ratio 16.125

Company X’s EPS for the last financial year was Rs.12. X’s stock value can be found by
multiplying the average PE Ratio for the industry with its EPS as follows:

Value of stock X = 16.125 x 12

= Rs. 193.50

PEG Ratio
Though there are many business firms belonging to the same industry, they differ
significantly in terms of growth. PE ratio does not consider variation in growth amongst

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firms. PEG ratio given below adjusts the PE ratio for growth and is considered to be
superior to PE multiple method.

PE
PEG  ....................... (5.4)
Expected Growth Rate

PEG however, does not consider risk, the other major differentiator of stocks.

The expected growth rate and PEG ratio of the companies in illustration 5.1 were as
follows:

Growth
Company (%) PEG
A 12 1.25
B 18 1.00
C 9 1.33
D 20 0.85
E 22 0.91
F 17 0.88
G 10 1.60
H 15 1.07
Average 1.11

Assuming that the expected growth in the earnings of company X is 14 percent, PE ratio
for the company will be found as average PEG for the industry multiplied by 14. So, the
applicable PE ratio for the company is 15.56 (1.11 x 14) and hence the value of stock X is
Rs.186.72 (15.56 x 12).

6.1.2 Other Multiples

Price-to-Book Value (P/B), Price-to-Sales(P/S), Enterprise Value-to-Earnings before

Interest, Taxes, Depreciation and Amortization (EV/EBIDTA) are some of the multiples
which are in vogue. A host of other multiples like Price to business per employee, price
to number of visitors to the website, etc which are generally sector specific are also used
by the analysts.

7. Summary
There are several methods for valuation of equity stocks. Balance sheet based models do
not provide realistic estimation of value of stocks and hence are rarely used. DDMs
consider dividends as the cash flow and value of equity stocks is estimated by discounting
forecasted dividends by cost of equity. There are four different DDMs – zero growth DDM,
constant growth DDM, two-stage growth DDM and three-stage growth DDM. Zero growth

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DDM is not relevant for valuation of equity and hence is not used. The various estimates
necessary for valuation of a stock using DDMs are rate of growth in earnings, return on
equity, risk free rate, market return and beta of the stock. Valuation will be as realistic as
the estimation of these variables and hence these variables have to be estimated
considering all relevant information.

The DDMs are quite simple and easy to use. The complexity in valuation of equity lies in
estimation of the inputs needed for using the models. The key inputs/estimates needed
for using the DDMs are rate of growth in earnings, and cost of equity. Growth in earnings
of a company depends on its ROE and its dividend policy. The ROE is influenced by
multitude of factors both internal as well as external to the company. Much of the
fundamental analysis has to do with the estimation of ROE. Dividend policy of a company
would depend mainly on its growth prospects. Greater the growth potential more capital
will be required to tap the potential and higher amount of profit will be retained and if
growth prospects are less large portion of profits will be paid as dividends.

Cost of equity is the minimum expected return by the investors and the same will be used
to discount the dividend cash flows. Cost of equity of a company can be estimated using
the CAPM. The CAPM requires risk-free rate, market return and beta of the stock. While
risk-free rate and market return are common for all stocks in a market the beta will be
different for different stocks. Beta is the only factor that will differentiate cost of equity
from stock to stock.

DDMs suffer from few deficiencies and hence free cash flow models are being used for
valuation of equity. The two most commonly used free cash flow models are FCFE and
FCFF. Under FCFE model free cash flow to equity shareholders are estimated and the
same is discounted by cost of equity. FCFF model, on the other hand, uses free cash flow
to the firm and cost of capital (WACC). Under the FCFE method the present value of cash
flows is subtracted by outstanding debt and added by cash balance on hand. The value so
derived is divided by the number of equity shares to get the value per share. Under the
FCFF method outstanding amount of debt is subtracted and the cash balance on hand is
added to the present value of free cash flows. Then the resulting value is divided by the
number of equity shares to get the value per share. Though the free cash flow models are
extensions to the DDMs the free cash flows must necessarily be estimated based on
projected financial statements.

Multiples like Price to Earnings, Price to Book Value, Price to Sales and the like are widely
used for valuation of equity stocks. Value of equity stocks is estimated by comparing a
multiple of a company with that of comparable companies. This is the reason the models
are called relative valuation models.

The first step to be followed while using relative valuation models is to define the multiple
clearly and use the definition consistently. The next step is to know the cross sectional

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distribution of the multiple across sectors and across companies in various sectors. The
third step is to know the fundamental factors influencing the multiple. The fourth step is
to choose the companies that are comparable.

Among the various multiples PE multiple is the most popular one. The PE multiple
however, does not take key factors like growth in earnings and risk into account. PEG
multiple considers growth and hence is superior to PE multiple.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 3: Portfolio Analysis, Selection and Management

Dr M. Manickaraj

Objective
The objective of this chapter is to discuss the fundamentals of portfolio analysis, portfolio
selection and portfolio management.

Structure
1. Introduction
1.1. What is a portfolio?
1.2. Traditional portfolio management
1.3. Asset allocation
2. Modern portfolio theory
2.1. The effect of diversification
2.2. Efficient frontier
3. Sharpe’s single index model
3.1. Portfolio returns and portfolio risks
4. Portfolio selection
4.1. Markowitz’s approach to portfolio optimization
4.2. Optimal portfolio
5. Summary

1. Introduction
The preceding chapters discussed how to analyse the fundamentals of a stock and how to
value the stocks based on the fundamentals. Determining the value of a stock based on
the value of comparable firms also was discussed. All these will help an investor to choose
a stock for investment and to ascertain the right price to be paid for the stock. It will also
help them identify stocks which are undervalued by the market. Hence, it will help them
make good returns. While return is one side of investment the other side is risk.
Investors wish to maximise returns but want to minimise risk. Selecting a right stock and
paying right price will not ensure minimising the risk. Spreading the investment across
various stocks and sectors will help minimise the risk. The process is called portfolio
management. The fundamentals of portfolio analysis, construction and management are
discussed in this chapter.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

1.1 What is a portfolio?

Portfolio is a combination of securities and portfolio analysis considers the determination
of future risk and return in holding various blends of individual securities. Though
portfolios may consist of all sorts of assets including real and financial assets, this chapter
will confine to portfolios of equity stocks only. However, the principles are applicable to
portfolio of any securities and any assets.

1.2 Traditional Portfolio Management

Instead of putting all eggs into one basket, it is better to spread the eggs across many
baskets so that the risk will be less. To put it in investment language, instead of parking
one’s money into a single stock, it is better to spread the investment across many stocks
belonging to different industrial sectors. Though this traditional approach emphasizes
the basic principle of managing risk through forming a portfolio, it does not say how to
measure the risk of a portfolio and what an optimal portfolio is. It, therefore, does not
help in knowing whether a particular portfolio is well diversified or not. These questions
are answered by the Modern Portfolio Theory (MPT) propounded by Harry M Markowitz
and developed further by William F Sharpe and others1.

2. Asset Allocation
To minimise the risk, investment should be diversified into many assets. It involves
selection of markets and securities and allocation of funds among the selected markets
and then into securities. Allocation can be strategic or tactical in nature. Strategic asset
allocation is allocating the funds in to different asset classes. It may be said that allocation
into different markets. For example, a fund’s investment policy is to allocate 10 percent
of funds into money market, 20 percent into dated government securities, 60 percent into
equity stocks and 10 percent cash and cash equivalents. This is a long-term strategy for
the fund and is called strategic asset allocation. There are several sectors within each
market. T-Bill market, call money market, commercial paper market and money market
mutual funds are some segments within the money market. Similarly, growth stocks,
value stocks, stocks belonging to different industrial sectors are the different types within
the equity market. Allocating the funds within these sub segments of the market and
shifting the funds from one sub segment to another or from one stock to another is
normally done more often. It is called tactical asset allocation.

Strategic asset allocation is decided largely based on the objectives of a fund. For
instance, a growth fund is supposed to park a major proportion of its funds into equities
particularly into growth sectors. Regular income funds which are expected to give
regular income to its investors have to invest more into bonds. Tactical allocation on the
other hand is done to make gains out of market fluctuations and to minimise losses when
markets behave against the expectations.

1
Markowitz and Sharpe were awarded Nobel Price in Economics for their contribution to capital
market theories.

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2. Modern Portfolio Theory

Managing a portfolio requires measuring its risk and return. According to Harry
Markowitz returns of a security or a portfolio can be measured by its mean and the risk
can be measured by standard deviation or variance. The model given by him is called the
mean-variance model.

According to him portfolio returns can be calculated as follows:

N
E ( R p )   Wi E ( Ri ) ………………………… (6.1)
i 1

Where, E(Rp) = Expected return on portfolio p.

Wi = Proportion of investment in security i.
E(Ri) = Expected return on security i.

Variance of returns is calculated as

N N
 p2   W W Cov i j i, j
i 1 j 1

This equation can be expressed as follows:

N N
 W W  i j  i j
i, j ............................................... (6.2) 2
i 1 j 1

Where,  p2 = Variance of returns of portfolio p.

Covi,j = Covariance between returns of securities i and j.
 i and  j are standard deviation of securities i and j respectively.
 i, j  Correlation coefficient between securities i and j.
The double summation sign denotes all possible covariances among the securities in the
portfolio.

Equation 6.2 can be modified for a two-security portfolio and three-security portfolio as
follows:

Variance of a portfolio of two securities A and B:

 2p  wa2 a2  wb2 b2  2wa wb  a,b a b ………………………….. (6.3)

Variance of a portfolio of three securities A, B and C:

2
Square root of variance is the standard deviation.

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 2p  wa2 a2  wb2 b2  wc2 c2  2wa wb  a,b a b  2wa wc  a,c a c  2wb wc  b,c b c

………………….….(6.4)
The above two equations show that as the number of securities in the portfolio increases,
the calculation becomes tedious. In fact, the number of covariance terms required for
calculating the portfolio risk is n(n-1)/2. If there are ten securities in a portfolio, the
number of covariances required is 45, and if the number of securities in a portfolio is 100,
then it is 4950.

2.1 The Effect of Diversification

The MPT given by Markowitz facilitates measuring the effect of diversification and hence
one can choose the stocks that will help minimise the risk more efficiently. The theory
also helps to know the right mix of chosen securities that will have lower risk. MPT thus
helps investors to choose the right stocks to be included in a portfolio and to determine
the right proportion of funds to be invested in the chosen stocks. This is demonstrated
with an illustration below.

Illustration 6.1: Suppose there are two stocks A and B and the expected return from
these stocks are as follows:
Table 6.1
Stock A Stock B
Expected return under scenario 8% 14%
1 12% 6%
Expected return under scenario .5 .5
2
Probability of each scenario

Expected return for stock A = .5 x 8 + .5 x 12

= 10%
Expected return for stock B = .5 x 14 + .5 x 6
= 10%

Variance of returns can be calculated as

 
n
 i2   Ps Ri ,s  E ( Ri ) 2

t 1

Where, Ps = probability of scenario s

Rs = return on security i under scenario s
E(Ri,s) = expected return on security i

Variance of returns of stock A = .5(8-10)2 + .5(12-10)2

= 4%

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Standard deviation of stock A = 4 = 2%

Variance of returns of stock B = .5(14 -10)2 + .5(6 -10)2

= 16%
Standard deviation of stock B = 16
= 4%
N

 (R
i 1
i  Ri )( R j  R j )
Covariance between the two stocks = ………………. (6.5)
N
Where, Ri , R j are average returns of security i and j respectively.
N is the number of observations

(8  10)(14  10)  (12  10)(6  10)


2
= - 8.
Covi , j
Correlation coefficient = ………………………. (6.6)
 i j
8
=
2 4
= -1

The covariance and correlation coefficient calculated above clearly indicate that the two
stocks A and B move in the opposite direction3.

Using equation (6.3), variance of a portfolio comprising 50 percent of stock A and 50

percent of stock B is calculated as below.

 2p  .5 2  4%  .5 2  16%  2  .5  .5  (1)  2%  4%
= 1%

If the proportion of investment is changed as 2/3 in stock A and 1/3 in stock B, the
variance will be
 2p  (2 / 3) 2  4%  (1 / 3) 2  16%  2  (2 / 3)  (1 / 3)  (1)  2%  4%
= 0.
The above illustration demonstrates that the effect of diversification depends on the
following three factors:

- The risk of individual securities

3
In the real world there may not be stocks which are negatively correlated.

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- The correlation between the securities

- The proportion invested in the securities

Illustration 6.2: Calculate the total risk (standard deviation) of a three security portfolio
from the following information:
Stock A Stock B Stock C
Returns 18% 12% 15%
Standard deviation of 25% 10% 18%
returns 1.0 .20 .85
Correlation with Stock A 1.0 .40
Correlation with Stock B 1.0
Correlation with Stock C .50 .30 .20
Weight in the portfolio

The values are substituted into Equation 6.4, as follows:

 .5 2  25 2  .3 2  10 2  .2 2  18 2  2  .5  .3  .2  25  10  2  .5  .2  .85  25  18
 2  .3  .2  .4  10  18
=156.25 + 9 + 12.96 + 15 + 38.25 + 4.32
= 235.78%
Standard deviation = 235.78
= 15.35%
2.2 Efficient Frontier
Modern portfolio theory assumes that the investors are rational and risk averse.
Therefore, given two assets offering the same rate of return, investors will prefer the less
risky one. An investor will take on increased risk only if he is compensated by higher
expected returns. The implication is that a rational investor will not invest in a portfolio
if for the same level of risk an alternative portfolio exists which offers higher expected
returns.

Return and risk for every possible combination of securities can be calculated and the
same can be plotted on a diagram. The return and risk of different combinations of Stock
X and Stock Y given in Table 6.2 are calculated and the results are presented in Table 6.3.
The same have been plotted in Figure 6.1. The upper part of the curve in the figure is
known as the efficient frontier (also called as "the Markowitz Frontier”). Portfolios along
this line represent portfolios offering lowest risk at a given level of return. Conversely, at
a given level of risk, the portfolios lying on the efficient frontier offer the best possible
return. The region above the upper line is not achievable because no portfolio is available
in the region. Portfolios below the upper line are suboptimal. A rational investor,
therefore, will hold a portfolio falling on the upper line only.

Table 6.2

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Stock X Stock Y
Return 19 16
S.D 22 18
Correlation 0.172

Table 6.3
Proportion Variance S.D Return Reward - to
-
Variability*
Stock X Stock Y
1 0 484.00 22.00 19.00 0.545
0.9 0.1 407.52 20.19 18.70 0.580
0.8 0.2 344.49 18.56 18.40 0.614
0.7 0.3 294.89 17.17 18.10 0.646
0.6 0.4 258.73 16.09 17.80 0.671
0.5 0.5 236.01 15.36 17.50 0.683
0.475 0.525 232.43 15.25 17.43 0.684
0.4 0.6 226.73 15.06 17.20 0.677
0.3 0.7 230.89 15.20 16.90 0.652
0.2 0.8 248.49 15.76 16.60 0.609
0.1 0.9 279.52 16.72 16.30 0.556
0 1 324.00 18.00 16.00 0.500
*Reward-to-Variability ratio = ( R p  R f ) /  p . This ratio helps in
measuring the risk adjusted performance of stocks and portfolios. In the
above example, the portfolio with a proportion of .475 invested in Stock X
and .525 in Stock Y is the best giving the highest reward-to-variability.

Figure 6.1 : Efficient Frontier

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3. SHARPE’S SINGLE INDEX MODEL

Sharpe model is an extension of Markowitz’s model. According to Sharpe, instead of
finding the covariance of each security with every other security in the portfolio, it is
sufficient to find the covariance of every security with only a market portfolio. Most often
a share price index is taken as a proxy for market portfolio. The model is often referred
to as single index model or market model. According to this model, the relationship
between the returns of a security with the index returns can be expressed as follows:

Ri  i  i Rm  ei .............................. (6.7)

Where, Ri = Return on security i.

 = The intercept coefficient.
 = The slope coefficient. It is called as beta.
Rm = Return on market portfolio.
ei = the random error term.

Beta can also be expressed as follows:

Covi ,m
 ................................................ (6.8)
2
m
 i ,m   i   m

 m2
 i ,m   i

m
Where, Covi,m = Covariance between the returns on security i and the market returns.

If returns can be measured by equation 6.7, risk (standard deviation of returns) of a

security can be measured as below.

 i     i  m   e
Where,  i and  m = Standard deviation of returns of security i and the market portfolio
respectively. Standard deviation is a measure of total risk.
  = Standard deviation of alpha. As alpha is a constant its variance is
always zero.
 i m = Systematic Risk.
 e i = Unsystematic risk which can be calculated as total risk minus
systematic risk.( i.e. unsystematic risk =  i   i m )

Illustration 6.3 : A security’s standard deviation of returns is 15 percent, and the

standard deviation of market returns is 10 percent and the beta of the security is 0.70.
Systematic risk and unsystematic risks of the security can be found as follows:

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Total risk = standard deviation

= 15%
Systematic risk = Beta x Standard deviation of market returns
= 0.70 x 10
= 7%
Unsystematic risk = Total risk – Systematic risk
= 15 – 7
= 8%

3.1 Portfolio Returns and Portfolio Risks

According to Sharpe returns of a portfolio can be calculated by equation 6.1 as given by
Markowitz. Whereas, risk of a portfolio may be measured as,

 p   Wi  i  m   Wi  e …………………………….. (6.9)

Where,  p = Standard deviation of the portfolio returns

 m = Standard deviation of market returns.
 e = Standard deviation of the error term (Unsystematic risk).

Illustration 6.4: The data pertaining to Stock X and Stock Y are given below. Assuming
50 percent investment in each of the two stocks, calculate the portfolio return and
portfolio risk.

Stock X Stock Y
Return 19% 16%
S.D 22% 18%
Beta 0.69 0.74
S.D. of Sensex 15%
Correlation between X and Y 0.172

Rp = .5 x 19 + .5 x 16
= 17.5%
Variance (Total Risk)  .5 2  22 2  .5 2  18 2  2  .5  .5  .172  22  18
= 235.93%
So, Standard Deviation = 235.93
= 15.36%

= Systematic Risk + Unsystematic Risk

Systematic Risk   Wi  i  m

= (.5 x .69 x 15 + .5 x .74 x 15)

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= 10.73%

Unsystematic Risk = Total risk – Systematic Risk

= 15.36 – 10.73
= 4.63%

4.0 PORTFOLIO SELECTION

4.1 Markowitz’s Approach to Portfolio Optimization:

Reward-to-Variability Ratio
Reward-to-variability ratio (equation 6.10) helps to identify the best portfolio based on
risk adjusted returns.
(R p  R f )
Reward-to-Variability ratio = ………………………. (6.10)
p
Where, Rp = Return on the portfolio
Rf = Risk free rate of return
 p  Risk of the portfolio
For example, there are ten different portfolios offering return and risk as in Table 6.5.

Table 6.5
Portfolio Return Risk (%)
(%) (Standard
Deviation)
A 12 4
B 14 6
C 15 8
D 16 10
E 17 8
F 20 12
G 15 14
H 18 5
I 26 20
J 10 4

Assuming a risk-free rate of 5 percent, the reward-to-variability ratio for the different
portfolios will be as follows (Table 6.5):

Table 6.5
Portfolio Reward-to-
Variability Ratio

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

A 1.75
B 1.50
C 1.25
D 1.10
E 1.50
F 1.25
G 0.71
H 2.60
I 1.05
J 1.25

Amongst the ten portfolios, Portfolio H offers the highest reward-to-variability ratio and
it is the best one. Portfolio G offers the lowest reward to risk.

4.2 Optimal Portfolio

The Reward-to-Variability Ratio does not help identify the portfolios that will be most
suitable to an investor given his risk appetite. According to Markowitz, portfolio selection
may be done based on the utility of the portfolios. Utility of a portfolio depends on the
risk tolerance of an investor. Utility of a portfolio can be calculated as

Utility = Return on the portfolio – Risk Penalty ……………………. (6.11)

Risk Squared
Risk Penalty = …………………………….. (6.12)
Risk Tolerance

Where, risk squared is the variance of returns (  2p ), and

Risk tolerance is a value in the range of 0 to 100. Lower the value, less is the
investor’s tolerance towards risk, meaning that his risk appetite is less. Higher
value indicates higher risk tolerance. The value to be chosen depends on the risk
preference of an investor.

Based on the above equation, utility may be calculated for all the portfolios. Obviously,
one would select the portfolio with the highest utility.

There are two investors X and Y. X’s risk tolerance is 70 and investor Y’s tolerance is 25.
If these two investors want to choose one of the ten portfolios given in table 6.4, the utility
for them will be as given in table 6.6. Portfolio I gives the maximum utility to investor X
and hence it is his optimal portfolio. Whereas, Portfolio H is the optimal portfolio for
investor Y.

Table 6.6 : Utility from Different Portfolios

Portfolio Risk Penalty Utility

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Return Risk
(%) (Standard Risk Investor Investor Investor Investor
Deviation) Squared X Y X Y
A 12 4 16 0.23 0.64 11.77 11.36
B 14 6 36 0.51 1.44 13.49 12.56
C 15 8 64 0.91 2.56 14.09 12.44
D 16 10 100 1.43 4.00 14.57 12.00
E 17 8 64 0.91 2.56 16.09 14.44
F 20 12 144 2.06 5.76 17.94 14.24
G 15 14 196 2.80 7.84 12.20 7.16
H 18 5 25 0.36 1.00 17.64 17.00
I 26 20 400 5.71 16.00 20.29 10.00
J 10 4 16 0.23 0.64 9.77 9.36

4. Summary
A portfolio is a combination of securities and portfolios help diversify risk. The factors
determining the effect of diversification are: (1) the risk of individual securities; (2)
correlation among individual securities; and (3) proportion of investment in individual
securities. Portfolio analysis involves estimation of risk and return of portfolios. The
principles of portfolio analysis, portfolio selection and portfolio management are relevant
for management of all asset classes.
Traditional portfolio management does not help measure portfolio risk and does
not enable construction of optimal portfolios. Harry Markowitz, William Sharpe and
others have developed the modern portfolio theory which provides the measures for risk
and return of portfolios and it also enables construction of optimal portfolios. According
to Markowitz portfolio return is the weighted average return of all the securities in the
portfolio and portfolio risk can be measured by standard deviation of the returns. Sharpe,
however, made the estimation of portfolio risk easier by introducing the market factor.
According to Sharpe, risk of individual securities as well as of portfolios can be measured
by beta. His model also enables the breaking the total risk into systematic risk (non-
diversifiable risk) and unsystematic risk (diversifiable risk).
An efficient portfolio is the one offering the highest rate of return at a given level
of risk. Similarly, a portfolio offering the lowest risk at a given level of return can also be
called an efficient portfolio. Thus, at every level of risk one efficient portfolio can be found.
The curve connecting all the efficient portfolios can be called the efficient frontier.
Investors can choose an efficient portfolio from among the efficient portfolios based on
their risk appetite. One can also find out one’s optimal portfolio by finding out the utility
of portfolios. Utility of a portfolio is the difference between return of the portfolio minus
risk penalty of the portfolio. The portfolio that offers the highest utility given an investor’s
risk tolerance is the optimal portfolio for that investor.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 4: Capital Market Theories

Dr M. Manickaraj

Objectives
The objective of the chapter is to demonstrate how the two capital market theories –
CAPM and APT – evolved and their relevance.

Structure
1. Introduction
2. Capital Asset Pricing Model (CAPM)
2.1. Capital Market Line
2.2. Security Market Line
2.3. Zero-Beta CAPM
2.4. CAPM adjusted for taxes
3. Arbitrage Pricing Theory
3.1. The arbitrage process
4. Summary

1. Introduction
The modern portfolio theory explains how the risk and return of securities and portfolios
should be measured. Capital market theories explain how the assets will be priced in the
market. Capital Asset Pricing Model (CAPM) propounded by William Sharpe and
Arbitrage Pricing Theory (APT) given by Stephen Ross are discussed in this chapter.

2. Capital Asset Pricing Model (CAPM)

CAPM is a model that explains how the assets are priced. This model is made up of Capital
Market Line (CML) and Security Market Line (SML). Like most other economic theories
CAPM is also based on certain assumptions. They are:

1. Investors are rational and wish to maximise their expected returns. On the other
hand, they wish to minimise risk.
2. Investors choose portfolios on the basis of their expected mean and variance of
return. Mean is the measure of expected returns and variance is the measure of
risk.
3. All the investors will be holding the investments for the same length of period.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

4. There is an asset which is risk-free. Investors can do unrestricted borrowing and

lending at the risk-free rate.
5. All the information are available to investors instantaneously and at free of cost
and hence they form homogeneous expectations regarding the means, variances,
and covariances of security returns.
6. There are no taxes to be paid by investors on the income earned from the
investments.
7. There are no transaction costs to be borne by the investors.

2.1 Capital Market Line

Under the modern portfolio theory, we discussed the identification of efficient portfolios
using mean return and standard deviation of returns. Supposing there is an asset that
has no risk (having standard deviation of zero) and offers a return of 7%. An investor
wishes to allocate his funds in to this risk-free asset and a risky portfolio on the efficient
frontier. He chooses the portfolio giving a return of 17.43 percent and standard deviation
of 15.25 percent from among the various portfolios given in Table 6.3. This portfolio
offers the maximum reward to risk. Let us call this portfolio as M. The returns and risk of
different combinations of the risk-free asset and portfolio M are as follows:

Table 7.1
Proportion
Risk-
free Portfolio Portfolio Portfolio Reward-to-
Asset M Return Risk Variability Ratio
1 0 7.00% 0.00% ---
0.75 0.25 9.61% 3.81% 0.68
0.5 0.5 12.22% 7.63% 0.68
0.25 0.75 14.82% 11.44% 0.68
0 1 17.43% 15.25% 0.68

The results in the above table show that as the proportion of investment in the risky
portfolio is increased the return increases. As the return increases the risk also increases.
The last column in the table shows the reward (premium) per unit of risk as measured by
Reward-to-Variability Ratio and it is the same for all the portfolios. This relationship
establishes that the risk premium is proportional to the level of risk and hence there is
equilibrium.

CAPM assumes that unlimited borrowing and lending at the risk-free rate is possible.
Investors therefore can borrow at the risk-free rate and invest the same in risky portfolio
M. This is a leveraged portfolio and the return of the portfolio will exceed the return of
portfolio M. This relationship is shown in Table 7.2 and in Figure 7.1. The figure shows
that the portfolios falling on the straight line offer higher return at a given level of risk

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

than those portfolios falling on the curved line. Thus the introduction of the risk-free asset
changes the efficient frontier from a curved line to a straight line. This line is called the
capital market line.

The return of a portfolio given in Tables 7.1 and 7.2 can be calculated applying equation
7.1.
p
Rp  R f  ( Rm  R f ) ………………………………. (7.1)
m
Equation 7.1 is referred to as capital market line (CML). The equation clearly explains
the risk-return relationship and that there is a trade off between return and risk.

Table 7.2
Proportion
Risk- Reward-to-
free Portfolio Portfolio Portfolio Variability
Asset M Return Risk Ratio
1 0 7.00% 0.00% ---
0.75 0.25 9.61% 3.81% 0.68
0.5 0.5 12.22% 7.63% 0.68
0.25 0.75 14.82% 11.44% 0.68
0 1 17.43% 15.25% 0.68
-0.5 1.5 22.65% 22.88% 0.68
-1 2 27.86% 30.50% 0.68

The risk of a portfolio as per the capital market line is the weighted average of the risks
of risk-free asset and the risky portfolio M. As the risk of the risk-free asset is zero it is
simply the proportion invested in portfolio M multiplied by the risk of portfolio M.
Mathematically, risk of a portfolio as per the capital market line is

 p  Wm m ...................................................... (7.2)

As per the results given in Table 7.2, risk of portfolio M is 15.25 percent and hence if 50
percent of funds are invested in Portfolio M and the remaining 50 percent is invested in
the risk-free asset, the risk of the portfolio will be 7.63 percent (i.e., .5 x 15.25). If 100
percent of funds available is invested in portfolio M and no funds are invested in risk-free
asset, the risk of the portfolio will be equal to the risk of the portfolio M. i.e., 15.25 percent.
If the investor borrows at the risk-free rate and invests the available funds and borrowed
funds in the risky portfolio M, then risk will be more than that of portfolio M. The results
for different combinations of risk-free asset and risky portfolio M have been calculated
and shown in Table 7.2 above.

The combination of risk-free asset and portfolio M offer the maximum return at any given
level of risk. As the investors are rational wealth maximisers they would like to invest

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

only in portfolio M and the risk-free asset. Therefore, the price of all other risky portfolios
are expected to adjust such that they will move towards portfolio M on the capital market
line. As a result, there will be only one risky portfolio i.e., portfolio M. Portfolio M thus
will become a portfolio of all the risky assets being traded in the market and hence it can
be called the Market Portfolio.

FIGURE 7.1: CAPITAL MARKET LINE

Capital market line

20
M
18

16
Efficient Frontier
14
Portfolio
Return

12

10

8
Rf=7%
6

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Portfolio S.D

2.2 Security Market Line / CAPM

CML explains the risk-return relationship of only efficient portfolios. It does not explain
the relationship of return and risk for inefficient portfolios and individual securities. The
risk-return relationship of portfolios falling below the efficient frontier is not explained
by the CML. Beta is a measure of systematic risk and can be used for measuring the risk
of both portfolios and individual securities. Sharpe also argues that in an efficient market
where there is equilibrium, investors will be rewarded for bearing systematic risk only 1.
Systematic risk of a stock depends on its covariance with the market portfolio and hence
the risk-return relationship can be written as follows:

Ri  R f  Rm  R f  Cov i ,m

m

1
In case of a well diversified portfolio the risk that will remain is only the systematic risk which cannot be
eliminated through diversification. Accordingly, the investors holding a well diversified portfolio will expect
reward/premium for bearing the systematic risk only. Therefore, in a competitive market the prices will adjust in
such a way that the value of securities will be discounted by the market for the systematic risk only.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Covi ,m
The expression in the above equation is nothing but beta (the slope coefficient in
m
a simple linear regression equation). Beta therefore, replaces standard deviation in
equation 7.1 as the measure of risk. The above equation hence can be replaced by
equation 7.3.

Ri  R f   i Rm  R f  ………………………………. (7.3)

Equation 7.3 is the CAPM and also called as the security market line (SML). The
relationship explained by SML is shown in figure 7.2. To draw the line in the figure, return
on the market portfolio M has been assumed to be 15 percent and risk-free rate as 7
percent. Beta of the market portfolio is always 1. SML explains the risk-return
relationship of all the portfolios (efficient as well as inefficient) and also of individual
securities. However, the measure of risk as per SML is beta which is a measure of
systematic risk.

Figure 7.2: Security Market Line

25%
20%
Returns

M
15%
10%
5%
0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta

In the real world, markets are not perfect and therefore, we cannot find the relationship
between risk and return as shown in Figure 7.2. Rather, the prices may behave within a
band and the actual relationship between the risk and return may be as shown in Figure
7.3. However, the width of the band may differ from market to market. Narrower band
implies more efficiency and wider band implies lesser efficiency. As a market becomes
more mature and efficient, the band will narrow down. This is an indication that the
degree of mispricing of securities in the market is declining.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Figure 7.3 : SML in real world

30.00%

25.00%

20.00%

Return
15.00%

10.00%

5.00%

0.00%
0 0.5 1 1.5 2 2.5
Beta

2.3 Zero-Beta CAPM

CAPM is based on a set of assumptions listed at the beginning of this chapter. One of the
assumptions is, one can borrow and lend at the risk-free rate without any limit. In the real
world, however, the borrowing rate is normally greater than the lending rate. This
assumption hence makes CAPM highly unrealistic. Fisher Black has relaxed this
assumption and has given a new model called Zero-Beta CAPM.

According to Black, a portfolio which will have no relationship with the market can be
created. Since this portfolio is not having any relationship with the market portfolio, its
beta will be zero. As this portfolio consists of risky assets one can borrow as well as invest
at the rate of return offered by the portfolio. Hence, the risk-free rate in SML can be
replaced by return on the zero beta portfolio. Accordingly, the SML is rewritten as in
equation 7.4.

Ri  R z   i Rm  R z  ........................................... (7.4)

Where, Rz = the return on a zero beta asset.

As the return on the zero beta portfolio will be greater than the risk-free rate the slope of
the SML will be less than that of Sharpe’s SML as shown in Figure 7.4. Black’s model thus
proves the relevance of CAPM.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Figure 7.4
SML and Zero Beta SML

25.00%
SML

20.00%

M
15.00%
Return

Zero Beta SML

10.00%
Rz
Rf
5.00%

0.00%
0 0.5 1 1.5 2 2.5
Beta

2.4 CAPM Adjusted for Taxes

The original CAPM also assumes that there are no taxes to be paid by the investors.
Whereas, in the real world investors have to pay taxes on their income. Nevertheless, the
tax rates are different for dividend income and for capital gains. Normally, dividends
earned by investors will be taxed at normal income tax rates and capital gains are taxed
at a lower rate. Therefore, different investors falling under different tax brackets will
prefer dividend income or capital gains and accordingly they will price the securities.
Michael Brennan has considered the impact of differential taxes and has given the
following tax-adjusted CAPM:

Ri  R f (1  T )   i Rm  R f  T ( Dm  R f )  TDi ……………………… (7.5)

Where,
Td  Tg
T
1  Tg
Td = Economywide average tax rate on dividend income
Tg = Economywide average tax rate on capital gains
Dm = Dividend yield on market portfolio
Di = Dividend yield on security i.

If the rates of tax on dividend income and capital gains are equal the term T in equation
7.5 will become zero and therefore the equation will shrink to the original CAPM. Also
there are arguments by academics that evidence for the effect of taxes on the security
prices is not found and hence improvement in the original CAPM to incorporate the tax
effects is of no use.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

3. Arbitrage Pricing Theory (APT)

CAPM discussed above is based on the premise that there is only one factor that
determines the risk of a security or a portfolio and the returns. Contrarily, in the real
world there are many factors including the macroeconomic factors, industry factors,
financial factors and the like that determine the risk and return of securities. Stephen A
Ross has developed a model which takes into account the underlying factors that
generate returns for a security. The model given by him is

E ( Ri )  Rz  bi1 E ( R1 )  Rz   bi 2 E ( R2 )  Rz   .... ---------------- (7.6)

Where,
E(Ri) = Expected return on security i
Rz = Return on zero-beta portfolio
[E(Ri) – Rz ] = Risk premium associated with factor i
bi = Responsiveness of the stock to the changes in factor i

The term [E(Ri) – Rz ] in equation 7.6 may be replaced by the symbol  and can be
expressed in a short form as

E ( Ri )  Rz  bi  ------------------------------- (7.7)

Equation 7.7 is the arbitrage pricing model given by Ross. As can be seen, it is a
multifactor model unlike CAPM which is a single factor model. However, Ross does not
say what are the factors that are priced in the market and he also does not suggest the
number of factors that should be taken into the model. Thus it becomes a matter of
empirical research to be carried out to find out the factors that need to be considered to
apply the model in practice. This is a major impediment in using the model and to date
no one has come out with the factors that can be used in the model. Because of this, the
model has not become popular.

If we assume that there is only one single factor determining security returns, the APT
model will become similar to CAPM and if we assume the single factor is nothing but the
market factor it will reduce to CAPM.

3.1 The arbitrage process

An arbitrage argument is used by Ross to develop APT and to prove how equilibrium in
the market is possible. Supposing market factor is the only factor that determines returns
on securities and there are four portfolios, the returns and risk of which are as in Table
7.3. The same have been shown graphically in figure 7.5.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Table 7.3
Portfolio Returns Risk (b)
A 10.50 0.5
M 15.00 1.0
C 19.50 1.5
F 20.00 1.0

Portfolios A, M and C are falling on the straight line and hence their return is proportional
to their risk. Portfolio F is lying above the straight line and offers higher return than
equilibrium return. Higher return is available because the portfolio has been
undervalued. Investors can buy this portfolio that will give them higher return. Investors
also can earn profit through riskless arbitrage. The arbitrage process is explained as
follows. Portfolios M and F have the same level of risk but F offers higher return than M.
Supposing one sells portfolio M worth Rs.10000 short and uses the proceeds to buy
portfolio F. The results of this deal will be as shown in Table 7.4. The results show that
the net investment for the investor is zero and hence the risk involved is also zero.
However, he could make a gain of Rs.500. Thus the riskless arbitrage has got him a profit
of Rs 500.

Figure 7.5
Arbitrage Process

Table 7.4
Riskless Arbitrage
Investment Returns Risk
M -10,000 -1500 -1.0
F +10000 +2000 +1.0
Net (Arbitrage 0 +500 0
Portfolio)

The arbitrage process explained above involves selling portfolio M short and buying
portfolio F. As more and more investors will indulge in this arbitrage process supply of
portfolio M and demand for portfolio F will increase. Increase in supply will drive down

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the price of portfolio M and hence its return will increase. Increase in demand on the
other hand will lead to increase in price of portfolio F and therefore its return will
decrease. This process will continue until the return from the two portfolios will be equal.
The arbitrage process thus leads to equilibrium in the markets.

One may raise the question, portfolio M is the market portfolio and one may not be able
to construct a portfolio similar to M. In fact, portfolio similar to M can be created by
combining portfolio A and C. If one invests 50 percent of one’s funds in A and 50 percent
in C the return of the new portfolio will be 15 percent (.5 x 10.5 + .5 x 19.5). Its beta will
become 1 (.5 x .5 + .5 x 1.5). Thus, one can easily create a portfolio that will resemble
portfolio M.

4. Summary
CAPM is a model that explains how assets are priced in the market. The model is made up
CML and SML. According to the CML the measure of risk is the standard deviation and
according to the SML the measure of risk is beta. CML helps in explaining the risk-return
relationship of efficient portfolios and it does not explain the relationship of individual
securities and inefficient portfolios. SML explains the risk return relationship of all
portfolios as well as individual securities. As such SML is found to be relevant and is used
in the market. For the same reason beta has been accepted as the measure of risk. Beta
can be measured as the ratio of covariance between security returns and market returns
to variance of market returns. SML is popularly known as the CAPM.

The original CAPM was developed based on many assumptions and few of them were
highly restrictive in nature and these assumptions made the model not feasible to use.
However, researchers like Fisher Black have found the model relevant even after relaxing
these assumptions.

One of the major limitations of the CAPM is that it considers only one factor – the market
factor. APT is a multifactor model. However, the APT does not specify the factors to be
taken into account and number of factors. Therefore, the model is found to be practically
not feasible to use. Therefore, the CAPM is being used across all the markets in the world.

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Course: Treasury Management (Module II: Security Analysis & Portfolio Management) NIBM, Pune

Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 5: Performance Evaluation of Portfolios

Dr M. Manickaraj

Objective
This chapter discusses the measurement of portfolio returns and evaluation of their
risk adjusted performance.

Structure
1. Introduction
2. Measuring returns
3. Risk adjusted performance evaluation of portfolios
4. Breakdown of performance evaluation
5. Summary

1. Introduction
Institutional Investors like mutual funds, pension funds, employees’ provident fund,
insurance companies, banks and the like manage huge investment portfolios. These
portfolios are managed by professional fund managers. The institutional investors
actually invest other individual’s money. Individuals including high net worth individuals
hold investment portfolios. The investors employ various strategies, tools, and
techniques to earn superior returns. Nevertheless, ultimately the performance matters
and the same needs to be evaluated. Performance of investment portfolios can be
evaluated in terms of returns or in terms of risk. Higher the returns better the
performance and conversely higher the risk poorer the performance. Returns and risk
are said to be the two sides of the same coin. Evaluation of performance of portfolios
either based on return or based on risk will give one sided picture. Appropriate measure
of performance, however, is risk-adjusted returns. Various methods risk-adjusted
performance measures are explained hereunder.

2. Measuring Returns
Investment portfolios will normally offer regular income and capital gains. The regular
income would be in the form interest or dividends and will be offered to the investors
during the holding period. Capital gains is the difference between the selling price and

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purchase price and will be realized at the time of selling the portfolio. Returns of a
portfolio can be measured as follows:

( NAVt  NAVt 1 )  Dt
Rp   100 ...................................................... (5.1)
NAVt 1
• Where, Rp = Return on a portfolio.

NAVt = Net asset value of the portfolio at the end of period t.

NAVt-1 = Net asset value of the portfolio at the beginning of the period t.
Dt = Dividend income of the portfolio for the period t.

Net Asset Value (NAV) of a portfolio is the value of assets of the portfolio minus the value
of all its liabilities including fees payable to the fund managers and other administrative
expenses. Value of portfolios will be measured by considering the value of each security
in the portfolio. Value of equity funds, for instance, will be measured by multiplying the
closing prices of equity stocks by the number of shares held. To arrive at the NAV per unit
NAV of the fund should be divided by the number of units. Supposing an equity fund has
a corpus of Rs100 crore and the entire fund has been invested in equity shares. The
number of units issued is 10 crore and hence the value per unit of the fund will be Rs.10
each. If the value of the fund increases to Rs.110 crore by the end of the period and the
expenses/liabilities for the period is Rs.2 crore. The NAV of the fund therefore is Rs.108
crore (i.e., 110 – 2) and the return generated by the fund during the period is 8%. NAV
per unit will be Rs.10.8.

Illustration 5.1

Consider the data of Equity Fund and the values of share price index given in the table
below. The table provides the monthly NAV of the Equity Fund and the monthly closing
values of the Index. Given the data one can work out the month return of both the fund
and the index using equation 5.1.

For example, the returns of the Equity fund for the second month can be calculated as
follows:

Equity Fund’s return for the second month = (105 – 99) / 99 x 100
= 6.06%

Index return for the second month = (5195 – 4995) / 4995 x 100
= 4.00%
The returns for all the months are presented in Table 8.2.

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 Table 5.1
NAV of
Month Equity Fund Index
1 99 4995
2 105 5195
3 98 5250
4 99 5100
5 108 5206
6 110 5300
7 112 5456
8 105 5470
9 101 5300
10 107 5425
11 115 5560
12 114 5660

Table 5.2
Monthly Returns
Month Equity Fund Index
1
2 6.06% 4.00%
3 -6.67% 1.06%
4 1.02% -2.86%
5 9.09% 2.08%
6 1.85% 1.81%
7 1.82% 2.94%
8 -6.25% 0.26%
9 -3.81% -3.11%
10 5.94% 2.36%
11 7.48% 2.49%
12 -0.87% 1.80%

Using the returns available in Table 5.2 standard deviation of returns and beta can be
calculated. Annual returns of a fund can be calculated using equation 5.1. However, for
this purpose one has to consider the value of the fund at the end of the year and the value
at the beginning of the year. The results are given in Table 5.3.

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 Table 5.3
Equity Fund Index
Annual Returns 15.15% 13.31%
Std. Deviation of
Returns 5.43% 2.27%
Beta 1.26 1.00

3. Risk-Adjusted Performance Evaluation of Portfolios

Table 5.3 shows that the Equity Fund has earned higher returns than the Index. However,
the risk of the fund is higher than the Index. Therefore, there is a need for looking at the
risk-adjusted performance of the fund. The following three methods are useful to
evaluate risk-adjusted performance of portfolios.
R  Rf
Sharpe Ratio: SR  p …………………………. (5.2)
p

Rp  R f
Treynor Ratio: TR  ………………………………. (5.3)
p
Jensen’s Alpha: R p  R f     Rm  R f  ……………………….. (5.4)
Where,
Rp = Return on the portfolio
Rm = Return on the market index
βp = Beta of the portfolio
Rf = Risk free rate of return
σp = Standard deviation of returns of the portfolio
α = Excess returns earned by the portfolio (referred to as Jensen’s alpha)
Rp – Rf = Risk premium offered by the portfolio p

Equation 8.2 is the Sharpe Ratio which gives the risk premium per unit of total risk.
Treynor Ratio (Equation 5.3) gives the risk premium per unit of systematic risk. Jensen’s
alpha (equation 5.4) gives the return offered by the portfolio in excess of the normal
return. Normal return is nothing but the return as per the CAPM. Treynor Ratio and
Jensen’s alpha consider systematic risk (beta) only. Whereas, Sharpe Ratio takes total
risk (standard deviation of returns) into account.
Performance evaluation can be done by comparing a portfolio with another or else with
a benchmark. The benchmark normally used in the investment world for performance
evaluation is a market index. Using the data available in Table 5.3 and assuming a risk-
free return of 7% performance of the Equity Fund and the Index can be measured by the
three methods as follows:

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 Sharpe Ratio of Equity Fund = (15.15 – 7) / 5.43
= 1.50
Sharpe Ratio of the Index = (13.31 – 7) / 2.27
= 2.78
Treynor Ratio of Equity Fund = (15.15 – 7) /1.26
= 6.47
Treynor Ratio of the Index = (13.31 – 7) / 1.00
= 6.31
Jensen’s Alpha of Equity Fund = (15.15 – 7) = α + 1.26 x (13.31 – 7)
= 0.20
Jensen’s Alpha of the Index = (13.31 – 7) = α + 1.26 x (13.31 – 7)
=0

The above results are presented in Table 5.4. According to the Sharpe Ratio and Treynor
Ratio higher the ratio better the performance. Similarly, higher the Jensen’s Alpha better
the performance. The Equity Fund’s performance in terms of Sharpe Ratio (1.50) was
significantly poorer than the Index (2.78). Contrarily, the performance of the fund in
terms of Treynor Ratio was better than the Index. Jensen’s Alpha too shows that the
Equity Fund has performed better than the Index. Thus, the Treynor Ratio and Jensen’s
Alpha show that the Equity Fund has offered better results than the Index. Sharpe Ratio,
on the other hand, is indicating poor performance of the Equity Fund. The difference in
the results of the three methods lie in the measure of risk taken into account. The Equity
Fund’s performance was found to be good if systematic risk alone is taken into account.
If total risk is taken into account the performance of the fund is found to be not good.

Table 5.4
Equity Fund Index
Sharpe Ratio 1.50 2.78
Treynor Ratio 6.47 6.31
Jensen's Alpha 0.20% 0.00%

4. Breakdown of Performance
Eugene Fama a renowned economist has developed Equation 8.5 that helps in breaking
down the performance of portfolios.

R p  R f    Rm  R f  p
................................. (5.5)
m
Where, v = Net selectivity
Break-up of return
• Excess return earned (Selectivity)

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 = Rp – Normal return
= Rp – {Rf + Beta (Rm-Rf)}
• Penalty for diversifiable risk is the premium for total risk minus premium for
systematic risk as can be measured as follows:

 p 
Penalty for diversifiable risk  Rm  R f    Rm  R f 
 m 
• Net selectivity = Selectivity - Penalty for Diversifiable Risk

Table 5.5
Equity Fund Index
Return as per CML 22.13% 13.31%
Return as per SML (Normal
Return) 14.99% 13.31%
Excess Return (Rp - Rf) 8.15% 6.31%
Risk premium for total risk 15.09% 6.31%
Risk premium for systematic risk 7.95% 6.31%
Penalty for diversifiable risk 7.14% 0.00%
Selectivity 0.20% 0.00%
Net Selectivity -6.94% 0.00%

According to Fama if net selectivity is positive the performance of the portfolio is better
than the market and if it is negative the performance is poorer than the market. Fama’s
model and Sharpe Ratio give the same results regarding the performance of portfolios.
This is because both the models take total risk into account.

5. Summary
Performance of investment portfolios need to be evaluated at periodical intervals. While
return or risk can be used to evaluate performance they offer one sided picture.
Therefore, the right way to measure performance of investment portfolios is to use risk-
adjusted performance indicators. Sharpe Ratio, Treynor Ratio and Jensen’s Alpha are
widely used for evaluation of performance. Sharpe Ratio considers total risk and Treynor
Ratio and Jensen’s Alpha consider systematic risk only. Eugene Fama has developed a
model for evaluation of performance of portfolios with more details. According to Fama
the performance of a portfolio can be broken down into selectivity (return earned by a
portfolio in excess of normal return), premium for systematic risk, penalty for
diversifiable risk and net selectivity. Fama’s method thus helps understand the
performance of portfolios better.

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