study material class four five

8/10/2019 Study Material Class Four Five

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Management of Commercial Bank

Class Three & Four

For

PGDM

Great Lake Institute of Management, Chennai

By

Praloy Majumer

!For Classroom iscussion only"

1


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Class Three

Because of these se#eral sources, the e$enence on inter %ank call money market

is reuce to a great etent o#er the years' This is also the reason for reucing thenum%er of $artici$ants in the call money markets as entities can $ark their short

term funs in se#eral other short term a#enues as mentione a%o#e'

The call money market , at $resent , (oul %e use %y %anks only for meeting the

cash reser#e ratio only' )s mentione in the $re#ious cha$ter, C** is an im$ortant

tools for money su$$ly as it effects the high $o(er money' *BI changes C** from

time to time an C** can %e maintaine %y %anks %y kee$ing fun in the current

account (ith *BI' For maintenance of C**, if %ank fins that there is a shortfall, the

%ank can %orro( in the call money market till the time %ank concerne arranges

e$osits or other long term funs' For the lening %anks $oint of #ie(, %anks can

len only u$ to a certain amount linke to its net (orth in the call money market' For

remaining sur$lus , it can len in other short term a#enues as mentione a%o#e'

CRR and its maintenance+ )s mentione earlier ,C** is the cash reser#e ratio'

The C** is maintaine on the et Deman an Time Lia%ilities of the %anking

system' Let us e$lain it (ith the hel$ of an eam$le +

-u$$ose on a $articular Friay ! assuming it a re$orting Friay " , the total e$osits

of a %ank is say *s ./// crores' This consists of the follo(ing +

Demand Deposits+ The e$osits (hich is $ai on eman an on (hich no interest is

$ai'

Time Deposits+ This re$resents e$osits on (hich interest is $ai an the original

ate of maturity is after a s$ecifie $erio (hich is etermine at the time of

recei#ing the e$osits'

Let us also assume that the %reak u$ of this eman an time lia%ilities is as

follo(s +

Deman De$osit + *s .// crores

Time De$osit + *s 0.// crores'

)nother %reak u$ of this e$osit is carrie out' -u$$ose the eman e$osit to the

%anking system is say *s ./ crores an the remaining amount , e$osit to $u%lic is

*s 0./ crores' The similar %ifurcation for time e$osit is *s .// crores an *s 0///

crores res$ecti#ely ' This is re$resente %elo( +

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Deman an Time Lia%ility ! DTL" !*s ./// cr"

DTL Bank DTL Pu%lic

Deman Time Deman Time

De$osit De$osit De$osit De$osit

!*s ./ cr" ! *s 0./ cr" !*s 0./ cr" !*s 0/// cr"

Fig 3.1Break up of Demand Time Liabilities in the Banking Sstem

From this *s ./// crores of e$osits , the %anks (oul in#est in assets mainly in the

forms of loans an a#ances an in#estments' 1ut of the loans an a#ances anin#estments , a %ank can gi#e loans an a#ances to other %ank or can in#est in the

securities of the other %anks' These are calle as )ssets to the %anking system ' Let

us assume that in the a%o#e eam$le the inter %ank assets are of *s .// crores' -o

the et Deman an Time Lia%ility !DTL"2 Deman an Time Lia%ility!DTL" 3)sset

to the Banking -ystem '

If (e efine DTL2 DTL to 1thers !I" 4 DTL to Bank !II"

)n )sset to the Banking -ystem as III

DTL2 I4II5III if II5III6/

DTL2 I if II5III 7/

In the a%o#e mentione case, the DTL of the %ank as on the re$orting Friay is *s

00./ cr 4 *s ../ cr 3 *s .// cr 2 *s 0.// crores '

If the Cash *eser#e *atio !C**" is .8 then the C** to %e maintaine is *s 0.//

crores 9 .8 2 *s ::. crores'

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This means that the a#erage %alance on the Current account (ith the *eser#e Bank

of Inia (oul %e *s ::. crores from -aturay to ;0 ays ening on net re$orting

Friay' Besies this, the %ank nees to maintain


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Li$uidit %d&ustment Facilit 'L%F( + Ener the scheme , re$o auctions ! for

injection of li>uiity " an re#erse re$o scheme ! for a%sor$tion of li>uiity " (ill %e

conucte on a aily %asis' Ener the re#erse re$o auctions, the *BI (oul sale the

securities to the commercial %anks against (hich the %anks (oul gi#e fun' The *BI

agrees to %uy %ack the security at a $reetermine rate (hich reflects the interest

rate' Let us e$lain it (ith an eam$le +

-u$$ose that *BI conucts re#erse re$o on o#em%er ;.th://. for one ay' The

interest rate (oul %e .8 $er annum' If a %ank %ecome successful in the re#erse

re$o auction , it (oul ha#e to gi#e *s ; crores' -ince the %ank (oul %e maintaining

a current account (ith *BI, the account (oul %e e%ite %y this amount ' The %ank

(ill maintain a -u%siiary General Leger !-GL" (ith *BI' =ithin the -GL account ,

the %ank (ill maintain *e#erse *e$o Constituents -GL account' In this account the

re>uire amount of security (oul %e creite' 1n the net ay , the current account

of the %ank (ill %e creite %y an amount (hich is e>ual to the $rinci$al amount of

*s ; crores $lus interest rate .8 $er annum for a ay an corres$oning >uantity

of securities (oul %e e%ite from the *e#erse *e$o C-GL' =ith this mechanism ,

an amount of *s ;crores (oul (ithra(n from the %anking system on o#em%er

;.th://. '-o (ith this mechanism the li>uiity is (ithra(n from the system' o( if

*BI (ants to increase the interest rate in the call money market, it (oul increase

the re$o rate uner L)F '-o a %ank ha#ing sur$lus (oul in#est in the L)F rather

than in the call money market'

-imilarly in the re$o transactions, the %anks (oul e$osit securities (ith *BI an

(oul recei#e money on the first ay' 1n the secon ay , the %ank (oul return

%ack the money an it (oul recei#e the securities ' In the first ay, the successful

%iers current account (ith *BI (ill %e creite %y the amount an its *e$o

Constituents -GL account (ill %e e%ite %y the re>uire >uantity of eligi%le

securities' 1n the net ay, the current account of the %ank maintaine (ith *BI (ill

%e e%ite an ** Constituents -GL (ill %e creite' -o on the first ay of the re$o

of L)F , fun is injecte in the system' -o (hen *BI (ants to reuce the call money

rate , it (oul reuce the re$o rate uner L)F , so %anks shortage of funs (ill a#ailthe L)F instea of call money as long as it can a#ail the fun uner L)F' Please kee$

it in min that for a#ailing L)F the %anks must ha#e eligi%le security for re>uisite

amount ' -o first the %ank (oul a#ail the L)F an then only it (oul a#ail the call

money market' In this (ay the call money market interest rate can %e influence %y

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*BI' For o$erational mechanism of L)F you can #isit ((('r%i'org'in an can go

through relate circulars uner notification section of the site'

1ne of the im$ortant functions of the %ank is the treasury functions' Treasury

function is locate at the centralise locations' Treasury of a %ank consists of t(o

i#isions +

;' Domestic Treasury

:' Foreign Treasury

Domestic treasury can also %e segregate into three esks ' They are +

;' De$osits collections

:' C** Maintenance

A' Traing esks

De$osits Collections + This esk is res$onsi%le for collection of e$osits at a lo(er

rate' This esk interact (ith other e$artments of the %anks an esign strategies

%efore announcing interest rate for ifferent $erios so that %orro(ing cost of the

%ank is lo(est '

C** Maintenance + )s (e ha#e iscusse in the $re#ious class that %anks ha#e to

maintain a certain amount of its DTL as *BI %alance ' This nees to %e maintaine

on a aily %asis' The C** maintenance esks (oul monitor the outflo( an inflo( of

fun on a aily %asis an any shortfall (oul %e %orro(e at the lo(est $ossi%le cost

from ifferent %orro(ing o$tions' -imilarly , any sur$lus amount (oul %e in#este in

a$$ro$riate instruments so that there is no loss in interest ue to ile funs'

Traing Desks + This esks o the -L* maintenance ' =hile oing the -L*

maintenance , it also take into consieration the traing o$$ortunities a#aila%le to

the %ank' =hile oing that it nees to ha#e some ieas of the fie income securities

markets'

6
http://www.rbi.org.in/http://www.rbi.org.in/


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Fi)ed *ncome Securit "arket

-ince su%stantial $ortions of the e%t markets in Inia consists of Go#ernment of

Inia securities market, (e shall iscuss in etail a%out the Go#ernment of Inia

securities market'

Before (e iscuss the GoI securities market , (e nee to kno( (hy GoI -ecurities

are issue at the first $lace' To fin out the reasons for issuance of GoI securities, (e

shall start (ith the central %uget' The central %uget consists of mainly t(o

accounts +

*ecei$t

H$eniture

Ener *ecei$t (e ha#e the follo(ing %ifurcations +

*e#enue *ecei$t !I"

o Ta *ecei$t !II"

o on Ta *ecei$t !III"

Ca$ital *ecei$t !I"

o *eco#ery of Loan !"

o 1ther *ecei$t !I"

o Borro(ings !II"

Ener e$eniture (e ha#e the follo(ing segregations+

on Plan H$enitureo *e#enue )ccount !III"

Interest !IJ"

1thers !J"

o Ca$ital )ccount !JI"

Plan H$eniture

o *e#enue )ccount !JII"

o Ca$ital )ccount !JIII"

*e#enue H$eniture JI2 JII4III

Ca$ital H$eniture J2 JI4JIII

*e#enue Deficit JI2 JI5I

Fiscal Deficit 2 JI4J55I

It is seen from the a%o#e that the fiscal eficit is met %y %orro(ings'

Gross Primary Deficit 2 Fiscal Deficit 3IJ

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It inicates the amount of fresh %orro(ing going to meet the interest e$enses'

It can %e seen from the a%o#e that fiscal eficit is met %y %orro(ings' It is also seen

from the a%o#e that the eficit in the re#enue account is not goo for an economy

(here as the eficit in the ca$ital account (oul go for the %uiling u$ of $roucti#e

assets' -o (hen the fiscal eficit (oul only go for meeting the ca$ital account eficit

, it (ill go for $roucti#e in#estment' -o the aim of the central go#ernment (oul %e

to eliminate the re#enue eficit as early as $ossi%le'

o( (e shall see (hat are the o$tions a#aila%le to the go#ernment for raising funs

uner the hea %orro(ing mentione a%o#e' Funs can %e raise uner the hea

%orro(ing through the follo(ing methos +

-mall -a#ings,HPF an PPF

*BI Bons

Hternal Borro(ings

Market Borro(ings

=e shall see the $ros an cons of all these ifferent methos an then (e shall see

(hich methos are mostly use %y the go#ernment '

Small Sa+ings,-#F and ##F + These are the methos %y (hich resources are

raise irectly from the $u%lic' Consiering the social security as$ect of the country ,

$olitical issues associate such ty$e of %orro(ing the interest rate can not %e

reuce %eyon a certain $oint' The %est eam$le (oul %e the hue an cry raise

(hen the HPF rate (as reuce in recent times although the rate is >uite higher

com$are to other ty$es of %orro(ings' Besies, small sa#ings are the major source

of funs for states as state gets a certain $ercentage of funs they mo%ili@e uner

the small sa#ings scheme' -o the interest rate can not %e reuce to a great etent

uner these methos' If go#ernment $lans to %orro( $reominantly in this route, it

(oul ha#e to $ay more interest on its %orro(ing' -o this (ill not %e the most

$referre route of %orro(ing for go#ernment' )t $resent go#ernment %orro(s

a$$roimately a%out :.8 of its total %orro(ing through this route'

RB* Bonds+ This is a goo tool for raising funs from high net (orth ini#iual' The

interest rate can %e mae lo(er com$are to that of the $re#ious moe of

%orro(ing' Besies, the %orro(ing is irectly from the $u%lic so the securities are

(iely istri%ute resulting in the lesser a#erse effect on the financial system ue to

a#erse mo#ement in $rice' Besies the effect of high $o(er money is also reuce if

%orro(ing is carrie out through this route' This (oul increase in share of

%orro(ings of the go#ernment in ays to come' o(e#er, the ifficulties in this ty$e

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metho for %riging the fiscal eficit %y the central go#ernment' 1nce the %uget is

announce in the month of Fe%ruary , the %orro(ing re>uirement can %e etermine

from the fiscal eficit figure' Then the go#ernment (oul seat (ith *BI for finali@ing

the %orro(ing $rogramme' The *BI (ill then announce a tentati#e %orro(ing

calenar so that this ne(s are factore in the interest rate the %eginning of the year'

This can %e e$laine (ith the hel$ of the *ational H$ectation theory of interest

rate' o(, after the announcement , the *BI can %orro( the money uner t(o ty$es

of auction $rocess' In %oth the ty$e of auction $rocess the follo(ing ste$s are

follo(e+

;' The *BI (ill $ut a $u%lic announcement a%out the auction $rocess' The

announcement (oul carry the issue si@e, ty$e of auction, ty$e of

(aring to the successful %ier, the $rocess of %iing i'e' su%mission

of a$$lication form an $lace an ate of su%mission of a$$lication

form etc'

:' The a#ertisement (oul also state the amount reser#e uner non

com$etiti#e %iings' To $romote the in#estment culture among larger

num%er of $eo$le, the *BI allocates a certain $ercentage of the issue

si@e uner on Com$etiti#e %iing' In this category , $eo$le ha#e to

just >uote the amount %iing for not the $rice or interest rate' The

%iers (oul %e a(are at the $rice or interest rate at (hich the

com$etiti#e %iers are a(are' This (oul act as an incenti#e for an

entity to $artici$ate in the %iing $rocess as heKshe nee not to

$osses the s$ecialist kno(lege re>uire for in#esting in fie income

securities'

A' )fter the %is are su%mitte , the %is are o$ene as $er the normal

$roceures an name of successful %iers are $u%lishe '

0' The successful %iers are re>uire to e$osit the money aske for

(ith the sti$ulate ate as $er the $rocess mentione in the

a#ertisement'

.' 1n recei$t of the money, the *BI creit the securities in the -u%siiaryGeneral Leger !-GL" of the successful %iers (ho are ha#ing the

account (ith *BI , for others (ho o not maintain a -GL , the security

is creite (ith Constituents -u%siiary General Leger !C-GL"

account maintaine or the amount can %e issue in the Physical form

if the in#estors aske for it'

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o( (e shall iscuss the ifferent ty$es of auction $rocess first ' There are

t(o ty$es of auction $rocess' They are +

iel Base )uction

Price Base )uction

0ield Based %uction / Ener this ty$e of auction , the %iers are aske to

>uote the %iing amount along (ith the yiel at (hich the amount is >uote'

This can %e e$laine (ith the hel$ of follo(ing eam$les +

)s $er the Go#ernment of Inia %orro(ing $rogramme, the *BI is announcing

the follo(ing auction +

Go#t' of Inia (ill %orro( *s ./// crores uner uniform $rice yiel %ase

auction for stanar cou$on %earing securities of :/ years maturity' 1ut of

the a%o#e issues si@e ;/8 is reser#e uner non com$etiti#e category'

This means that the *BI is asking %i uner uniform $rice yiel %ase auction

for :/ years $erio' The cou$on (oul %e $ai at half yearly inter#al ' The

amount reser#e for non com$etiti#e %iing is *s .// crores' It means

amount a#aila%le for com$etiti#e %iing is *s 0.// crores' o( let us take 0

ifferent situations +

The follo(ing %iing is $ut %y ifferent %anks +

Bank ame Bi )mount

! *s Crores"

Ty$e of Biing iel uote

!8"

Bank ) :/// C .'./

Bank B ;.// C .'0.

Bank C :.// C .'0/

Hntity J ; C

Hntity . C

Hntity N . C

C5 Com$etiti#e

C5 on Com$etiti#e

Situation *+ o( if *BI ecies that the cut off yiel is .'Aualify an only the

non com$etiti#e %ier (oul get allotte at the cut of yiel ' The remainingamount i'e' *s 0


12/24

>ualify' Bank C (oul get *s :.// crores at .'0/8 ' The on Com$etiti#e

%iers (oul get *s ;; crores at .'0/8 an the remaining amount *s :0uation +

C; C0/ P/

Pt2 4 OOOOOOO4 4 H>n OA';

;4!r"Q; ;4!r"Q0/ ;4!r"Q0/

This is the famous %on #aluation e>uation' ere C iis calle as Cou$on amount an r

is yiel to maturity !TM"' Please kee$ it in min Ciis ke$t constant

uring the tenure of the security as this is the amount issuer (ill $ay

to the holer of the %on' But r (ill kee$ on changing an r (ill

reflect the market $erce$tion of the interest rate for the remaining

maturity of the security' )nother im$ortant factor is that (hen r is

e>ual to the cou$on , then the $resent $rice is e>ual to the face #alue

of the security ' The %on e>uation can also %e re$resente in the

follo(ing format +

Pt2 CiPIF)Q!r8, n years" +P/PIFQ!r8, n years" H>n OOOO'A':

In the a%o#e mentione case since the cou$on (oul %e .'0/8 $'a' an this also

reflect the TM then the issue $rice of the security (oul %e *s ;////K5 the face

#alue of the security' -o in case of uniform $rice yiel %ase auction successful

%iers (oul %e issue security at face #alue'

Situation *** / The cut off yiel is .'0.8 $'a' ere the successful %iers are Bank

B an Bank C as %oth of them ha#e >uote at or %elo( the cut off yiel' -o the total

amount to %e a(are through com$etiti#e %iing is *s 0/// crores an *s ;;

crores (oul %e gi#en to non com$etiti#e %iers at .'0.8 $'a' an remaining *s


13/24

Bank B an Bank C (oul %e offere' -ince the auction is uniform $rice auction,

e#ery eligi%le %ier (oul get at the cut off yiel irres$ecti#e of their ini#iual %i'

In this case , although Bank C has >uote .'0/8 $'a' , it (ill get .'0.8 $'a'

Situation */If the cut of yiel is ke$t at .'./8 $'a', then all the %iers ha#e

>uote at or %elo( the cut off yiel' -o all the %iers (oul %e successful' o( ,

since the total %i amount uner the com$etiti#e category is *s /// crores against

the total a#aila%le amount uner the com$etiti#e category of *s 0.// crores , first

the #acant amount uner non com$etiti#e %iing (oul %e allocate to the

com$etiti#e %iing amount' -o the total amount for a(aring (oul %e *s 0.//

crores $lus *s 0uoting at or %elo( the cut off yiel (oul %ecome eligi%le' -o if (e take

the situation I , then all the %anks %ecome eligi%le'

:' Then the a(aring (oul %e in the $rocess so that the total cost of the

%orro(ing is the least' In such case, Bank C (oul get *s :.// crores at

.'0/8 , Bank B (oul get *s ;.// crores at .'0.8 an %ank C (oul *s


14/24

#rice Based %uction /In Price %ase auction, the %ier is aske to %i for the

$rice of a security (here the cou$on of the security (oul %e mentione at the time

of a#ertisement ' Let us take an eam$le ,

)s $er the Go#ernment of Inia %orro(ing $rogramme, the *BI is announcing the

follo(ing auction +

Go#ern of Inia (ill %orro( *s ./// crores uner uniform $rice %ase mechanism

for $rice %ase auction for stanar ;/8 stanar cou$on %earing securities of :/

years maturity' 1ut of the a%o#e issues si@e ;/8 is reser#e uner non com$etiti#e

category'

This means that the *BI is asking %i uner uniform $rice %ase mechanism for $rice

%ase auction for :/ years $erio an the cou$on of ;/8 cou$on (oul %e $ai at

half yearly inter#al ' The amount reser#e for non com$etiti#e %iing is *s .//

crores that means amount a#aila%le for com$etiti#e %iing is *s 0.// crores' o(

let us take 0 ifferent situations +

The follo(ing %iing is $ut %y ifferent %anks +

Bank ame Bi )mount

! *s Crores"

Ty$e of Biing Price uote

Per *s ;//

Bank ) :/// C ;.0';?.?

Bank B ;.// C ;..'//0A

Bank C :.// C ;..'uote %y these %anks %y taking into consieration that

the interest rate for :/ years as of the ate of issue (oul %e .'0/8 for %ank

C,.'0.8 for %ank B an .'./8 for %ank C' o( , $utting these ifferent #alues of r

in the e>uation '; (hile kee$ing the C #alue at *s .//K5 an P /at *s ;/,///K5, the

a%o#e mentione $rices are o%taine'

Situation * / The *BI feels that the :/ years risk free rate is .'0/8 $'a' -o the cut

off $rice (oul %e *s ;..'


15/24

Situation ** / The *BI feels that the :/ years risk free rate (oul %e .'./8 $'a'

Then all the %anks (oul %ecome eligi%le an the $rocess of allotment (oul %e

same as mentione in the yiel %ase auction $rocess'

Situation *** / In case of uniform $rice $rice %ase auction , if the auction ty$e is

ifferential $rice $rice %ase auction an the cutoff $rice has %een ecie as $er

situation II mentione a%o#e' In this case, the allotment mechanism (oul %e such

that the cost of %orro(ing (oul %e lo(est' -o C (oul get the maimum amount ,

then B an then ) an the transfer of non com$etiti#e to com$etiti#e (oul follo(

the same methoology'

-o from the a%o#e (e can fin out that , the su%scri$tion $rice for an in#estor in a

Go#ernment of Inia securities (oul %e at the face #alue only (hen the auction is

yiel %ase an uniform $rice ty$e' The su%scri$tion $rice (oul %e ifferent from

the face #alue if the auction is yiel %ase , ifferential $rice ty$e, $rice %ase

uniform $rice ty$e an $rice %ase ifferential $rice ty$e'

o( (e shall iscuss the merits of $rice %ase auction com$are to that of yiel

%ase auction' If one looks at the %on #aluation formula as mentione in e>uation

:'; , one can issue a security (ith ientical cou$on (hich (as issue earlier %y

changing the $rice' If the $resent interest rate for the $erio of $resent %orro(ing

is less than the cou$on rate to %e offere in the security, the issue $rice (oul %e

more than the face #alue' -imilarly, if the $resent interest rate for the $erio of

$resent %orro(ing is more than the cou$on rate to %e offere in the security, the

issue $rice (oul %e less than the face #alue of the security' Due to this $ro$erty ,

reissuance of security is $ossi%le uner the $rice %ase auction $rocess' The

reissuance means issuance of a security (hich (as earlier issue' Let us take an

eam$le' -u$$ose on :.tho#em%er ;. Go#t' of Inia %orro(e *s :.// crores

for :/ years uner yiel %ase auction %y issuing a cou$on of ;;8 $'a' This means

that on :.tho#em%er ;., the interest rate for :/ years (as ;;8 $'a' o( on

:.tho#em%er ://., the Go#t' of Inia (ants to %orro( for ;/ years' Let us assume

that ;/ years interest rate as on o#em%er :.th://. is 0'.8 $'a' In such case the

Go#t' of Inia can issue ;;8 :.

th

o#em%er :/;. at a $remium ' This ser#es t(o$ur$oses '

;' =ith this mechanism the num%er of cou$on as on a $articular ate increases

as ne(er securities are issue (ith the same ientical cou$on' If the

num%ers of cou$ons are increase, all these cou$ons can %e clu%%e

together an sol as a se$arate instrument %ecause the total #alue of such

15


16/24

instrument is increase' The $rinci$al can %e trae se$arately' This im$ro#es

the li>uiity of the security' -uch traing is calle -e$arate Traing for

*egistere Interest an Princi$al -ecurities ! -T*IP-"'

:' It can %e foun out that the $rice sensiti#ity of a fie income security is

lo(er in case of high cou$on %on than a lo( cou$on %on' -o in such case,

e#en though the interest rate is lo(, %y issuing high cou$on security at a

$remium, the issuer can $ro#ie a lo( $rice sensiti#ity to the in#estor'

Consiering the mark to market #aluation, this is an im$ortant factor (hen

the interest rate rises'

*ssue of Securities through pre announced coupon rate / Go#ernment of Inia

can issue securities %y announcing the cou$on rate at the time of issuance it self'

This makes the in#estors task easy as the in#estor nee not to >uote the rate' The

securities are issue at $ar'

*ssue of securities through tap sale / This is a metho %y (hich the securities

are sol through a selling (ino( %y *BI' The sale can %e etene %eyon one ay

an the sale can %e close at any time uring the ay' This metho can %e use %y

*BI to reuce the cost of %orro(ing for the go#ernment' Let us assume that on ; st

o#em%er ://< , *BI announces a %orro(ing $rogramme of *s :.// crores uner

yiel %ase auctions for :/ years' The *BI fies the cut off yiel at 0'.8 $'a' The

yiel >uote %y all the %iers are more than the cut off yiel' In such case the *BI

(oul take the entire issue in its %ooks' *BI is also #isuali@ing that there (oul %e

some li>uiity in the system %ecause *BI is $lanning to carry out some sterili@ation

mechanism uner (hich it (oul %uy ollars against ru$ees' This inflo( of ru$ees

(oul increase the money flo( in the system an the interest rate (oul go o(n'

Besies this *BI also #isuali@ing that there (oul %e e$osit gro(th in the net one

month (hich (ill also increase the money su$$ly' )long (ith the e$osit gro(th , the

%anks (oul %e re>uire to in#est incremental amount in GoI -ecurities %ecause of

-L* re>uirement' )t that time *BI can sale the securities on ta$ at the cut of yiel at

(hich the issue (as e#ol#e on *BI'

*ssue of securities b con+ersion of T Bills2dated securities / Though this isone of the methos for issuing of GoI securities %ut this metho is not an efficient

metho' This is %ecause treasury %ills are su$$ose to the self li>uiating in nature '

If the treasury %ills are con#erte in to the GoI securities , it sho(s inefficiency in the

system ' -o this form is not encourage '

16


17/24

*ssue of securities b an other modes as decided b o+ernment from time

to time / The Go#ernment can issue securities %y any other moes as ecie from

time to time' This clause is ke$t so that the Go#ernment can use any ne(er methos

e#elo$e in the future '

#rice of a Fi)ed *ncome Securities /

In the a%o#e mentione eam$les sho(ing the $rice of the fie income securities

(e ha#e assume the follo(ing +

The cou$on $ayment ate an the issue ate is same'

In the case of seconary market transaction, the a%o#e formulas (oul a%le

to gi#e the $rice only at the cou$on $ayment ate' But the cou$on $ayment

ate (oul come only in once in the si month' -o the a%o#e mentione

formula (oul gi#e the $rice of a fie income securities accurately once in

si months'

Then ho( this $ro%lem is aresse' To unerstan the $ro%lem , (e ha#e to

unerstan the com$lete $roceure of cou$on $ayment' The cou$on is $ai to the

holer of the securities at the cou$on $ayment ate %y the issuer of the security' Let

us take an eam$le, -u$$ose ) $urchase a security from the issuer J on A r of

Ranuary ://' The security is for fi#e years an the cou$on rate is .8 $'a' an the

cou$on is $ai on half yearly %asis' The net cou$on is to %e $ai on A rRune ://'

o( su$$ose ) sells the security to B on 0thof March :// an B hols the security

to the net cou$on $ayment ate' It means that the issuer (oul $ay *s :./K5

! assuming the face #alue of the security is *s ;////K5" to B on Ar Rune ://'

There are t(o im$lications of this transaction+

) (oul not get the cou$on from the issuer for the $erio it hol i'e' %et(een

ArRanuary to ArMarch ://' -o it shoul get the $ayment for this $erio

from B'

B (oul get interest for the $erio from 0thMarch :// till it hols an this

(oul %e accounte for the $rice formula %y a$$lying the $ro$er time scale in

the %on $ricing formula'

et ste$ (oul %e the calculation $roceure for the time $erio $asse after the

last cou$on ate' For this $erio the seller (oul get accrue interest'

17


18/24

et ste$ (oul %e the calculation $roceure for the time $erio left from the

$urchase ate to the net cou$on $ayment ate' This (oul %e $ut in the %on $rice

formula to get the $ro$er $rice for the trae'

There are many ty$es of con#ention for calculating the ays as mentione a%o#e '

These are +

A/KA/ +Hach month (ill ha#e A/ ays inclusi#e of Fe%ruary an total ays in

a year is A/

)ctual KA/ + Hach month (ill ha#e actual ays an the total ays in a year is

A/'

)ctualK)ctual + Hach month (ill ha#e actual ays an the total actual ays

%et(een t(o cou$on $erio

)ctualKA. + Hach month (ill ha#e actual ays an the total ays in a year

are A. ays'

Let us assume that (e a$$ly the )ctual KA/ formula ' -o the seller hols the

security from Ar Ranuary to Ar March i'e' !:4:uation +

P/ 2 C;K!;4r"!ncKic$"Q 4 C;K!;4r"

S;4!ncKic$"Q4OOO''4 Cn!;4r"S!n5;"4!ncKic$"Q

H>n OOOOOOO''A'A

ere nc2 ays %et(een the traing ate an the net cou$on $ayment ate 2

ays %et(een t(o cou$on $ayment ate5 no of ays alreay $asse 2;


19/24

)fter fining out the (ays for arri#ing at the $rice, (hile in#esting the money in the

fie income securities , one nees to look into the time hori@on at (hich heKshe is

in#esting' If one is in#esting for the entire life of the securities , then he shoul look

for a $articular ty$e of criteria ' -imilarly , if one is in#esting in a time hori@on (here

heKshe (oul sale %efore the maturity $erio , he (ill look after certain other criteria'

For fining out such criteria for secon category of in#estors , one nee to

unerstan the $rice an yiel relationshi$ of a fie income securities' These are

gi#en %elo( +

Before (e $rocee (ith the rules let us take the eam$le of the follo(ing 0 fie

income %ons +

Bon Cou$on Maturity Initial TM

) ;:8 . ears ;/8

B ;:8 A/ ears ;/8

C A8 A/ ears ;/8

D A8 A/ ears 8

Face alue of the %on is *s ;///K5 '

Cou$on is $ai annually'

If the TM increases to ;:8 , then the %on ) an B (oul %e trae at $ar' -o

(hen cou$on is e>ual to the TM of the %on the $rice of the %on (ill %e the face

#alue'

-imilarly, if the TM is more than the cou$on, the $rice of the %on (oul %e lo(er

than the face #alue' In the a%o#e eam$le, in Bon C the cou$on is A8 an TM is

;/8' The $rice is *s A0/';: less than the face #alue of the %on (hich is *s ;///K5 '

In such case, the %on is su$$ose to %e trae at iscount' -imilarly, (hen the TM

of the %on is less than the cou$on, the %ons $rice is more than the face #alue an

the %on is su$$ose to %e trae at $remium'

o( let us assume that TM of all the %on %ecomes ;;8 $'a' ' Then the $rice

(oul %e +

Bon ) Bon B Bon C Bon D

Price at TM ;/A' ;/


20/24

;;8

-imilarly if the TM %ecomes ;/8 then $rices of these %ons (oul %e as follo(s +

Bon ) Bon B Bon C Bon D

Price at TM

;/8

;/?.'


21/24

0' Price sensiti#ity is in#ersely relate to the cou$on rate ! see Bon B an Bon

C" '

.' Price sensiti#ity is in#ersely relate to the TM at (hich the %on is selling'

-ince the $rice (oul change uring the holing $erio ! if the holing $erio is less

than the maturity $erio of the %on" e$ening on the holing $erio hori@on one

tens to select %on %y taking into account the a%o#e mentione factors'

Duration of Bond /)nother measure of the effecti#e maturity of the %on is the

uration of the %on' This (oul %e e$laine as %elo( +

If (e efine as the maturity of a e%t instrument is the time re>uire to get all the

$ayment from the instrument then you see a uni>ue feature of fie income

securities +

In case of cou$on %earing securities you get cou$on %efore the maturity ate of the

security an you get the $rinci$al on the maturity ate of the security' -o the

effecti#e maturity is less than the maturity $erio of the fie income instrument as

some $ayments are recei#e %efore the maturity $erio' -o the conce$t of (eighte

a#erage $ayment $erio is coming into $icture ' This (eighte a#erage $ayment

$erio is calle the uration of a fie income securities' This is e$laine (ith the

hel$ of the follo(ing eam$le +

There is a


22/24

PKP25D!;4y"K!;4y"Q OOOOOOOOOO' H>n A'0

If (e efine D92 DK!;4y" then the a%o#e e>uation %ecomes

PKP 25 D9y OOOOOOOOOO' H>n A'.

There are se#eral rules for uration of a fie income securities' These are +

*ule ;+ The uration of a @ero cou$on %on is e>ual to its maturity'

*ule :+ oling maturity constant, a %ons uration is higher (hen the cou$on rate

is lo(er ' The higher the (eight in earlier $ayment ue to higher cou$on lo(er (oul

%e the (eighte a#erage maturity of the $ayment'

*ule A+ oling the cou$on rate constant, a %ons uration generally increases (ith

its time to maturity'

*ule 0+ oling other factors constant, the uration of a cou$on %earing %on is

higher (hen the %ons TM is lo(er'

*ule . + The uration of a le#el $er$etuity is as follo(s +

!;4y"Ky OOOOOOOOOOOOOOOOO'' H>n A'

*ule + The uration of a le#el annuity is e>ual to the +

!;4y"KyQ5 TKS!;4y"T5;QOOOOOO H>n A'?

*ule ? + The uration of cor$orate %on is e>ual to +

!;4y"KyQ 3! S !;4y"4T!C5y"QKCS!;4y"T5;4yQ"O H>n A'n A'

For eam$le , a ;/8 cou$on %on (ith :/ years to maturity , $aying cou$on

semiannually , (oul ha#e a .8 semiannual cou$on an 0/ $ayment $erio' If TM

is 08 $er half year $erio , (e get;'/0K/'/0Q5S;'/040/!/'/.5/'/0"KS/'/.!;'/0;/5;"4/'/02;'?0 half year 2

'


23/24

If one o%ser#es the e>uation .'0 , heKshe can fin out that uration is nothing %ut

the slo$e of the cur#e o%taine %y $lotting the change in yiel in J ais an

$ercentage change in $rice in the ais' This is sho(n in the follo(ing figure +

Percentage change in %on $rice

Pricing error

Price Due to con#eity

Duration

Change in TM !8"

Fig + A'; *elationshi$ %et(een change in $rice of a %on an change in TM

The uration measures assume the linear relation shi$ %et(een the change in

$rice an change in yiel (here as actually the relationshi$ is not linear' The

relationshi$ is con#e' Due to this if the change in yiel is more there (oul

%e error in the change in $rice #alue' If uration is use then it

unerestimates the increase in %on $rice an o#er estimates the ecrease in

%on $rice (ith ecrease an increase in TM res$ecti#ely' -o the effect of

con#eity nees to %e %rought it to get the total effect (hen the change in

yiel is significant'

=e can >uantify con#eity as the rate of change of the slo$e of the $rice yiel

cur#e , e$resse as a fraction of the %on $rice ' )s a $ractical rule , one can

#ie( %ons (ith higher con#eity as ehi%iting higher cur#ature in the $rice

yiel relationshi$'

23


24/24

Con#eity im$lies that the uration a$$roimation for %on $rice changes can

%e im$ro#e' )ccoringly the e>uation .'0 can %e moifie as follo(s +

PKP 25 D9y 4;K:9Con#eity9!y": OOOOO' H>n A';/

Please note that to use the con#eity rule one must e$ress interest rates as

ecimals rather than $ercentages'

The first term of H>n A';/ is the same as the uration rule ' The secon term

is the moification for con#eity' For a %on (ith $ositi#e con#eity , the

secon term is $ositi#e , regarless of (hether the yiel rises or falls'

Let us use a numerical eam$le to eamine the im$act of con#eity ' -u$$ose

a %ank has A/ years of maturity , an < 8 cou$on an sells at an initial TM of

study material class four five

Documents