Qs 1.

Prepare a Price and Yield based auction system

with example.

Ans:

An auction may either be yield based or price based.

Yield Based Auction: A yield based auction is generally conducted when a new
Government security is issued. Investors bid in yield terms up to two decimal
places (for example, 8.19 per cent, 8.20 per cent, etc.). Bids are arranged in
ascending order and the cut-off yield is arrived at the yield corresponding to the
notified amount of the auction. The cut-off yield is taken as the coupon rate for
the security. Successful bidders are those who have bid at or below the cut-off
yield. Bids which are higher than the cut-off yield are rejected. An illustrative
example of the yield based auction is given below:

Yield based auction of a new security

• Maturity Date: September 8, 2018

• Coupon: It is determined in the auction (8.37% as shown in the illustration
below)
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008*
• Notifi ed Amount: Rs.3500 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008

under T+1 cycle.

Details of bids received in the increasing order of bid yields

Bid No. Bid Yield Amount of bid (Rs. crore) Cummulative amount
(Rs.Cr)
1 8.32% 600 600
2 8.33% 800 1400
3 8.34% 700 2100
4 8.35% 500 2600
5 8.36% 300 2900
6 8.37% 600 3500
7 8.38% 50 3550
8 8.39% 400 3950

The issuer would get the notified amount by accepting bids up to 6. Bid numbers
7 and 8 are rejected as the yields are higher than the cut-off yield.
*Price corresponding to the yield is determined as per the relationship given
under YTM calculation in question 24.

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

Price based auction of an existing security 8.24% GS 2018

• Maturity Date: April 22, 2018

• Coupon: 8.24%
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008*
• Notified Amount: Rs.2500 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008

under T+1 cycle.

Details of bids received in the decreasing order of bid price

Amount of bid Implicit yield Cumulative
Bid no. Price of bid
(Rs. Cr) amount
1 100.31 300 8.1912% 300
2 100.26 200 8.1987% 500
3 100.25 250 8.2002% 750
4 100.21 150 8.2062% 900
5 100.20 100 8.2077% 1000
6 100.20 100 8.2077% 1100
7 100.16 150 8.2136% 1250
8 100.15 100 8.2151% 1350

The issuer would get the notified amount by accepting bids up to 5. Since the bid
number 6 also is at the same price, bid numbers 5 and 6 would get allotment in
proportion so that the notified amount is not exceeded. In the above case each
would get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the price quoted is
less than the cut-off price.

Qs 2. Why non-competitive bidding in Treasury Bills is

available only to State Governments ?
Ans:

Non-competitive bidding means that a person would be able to participate in the

auctions of Treasury Bills without having to quote the yield or price in the bid.
When you make a non-competitive bid, you agree to accept whatever interest
rate is decided at the auction. You are guaranteed that your bid will be accepted
and that you will get the full amount of your bill paid back to you. But you won't
know exactly what interest rate you will receive until the auction closes. The
State Governments generally manage their liquidity through purchase of
treasury bills issued by the Central Government. So in order to safeguard the
interest of the states non-competitive bidding is available to them.

Qs 3. Explain Cash Flow in Repo/ Reverse Repo

Transaction with examples.
Ans:

Two parties involved in Repo Transaction are: Buyer and Seller.

There are two exchanges happen in Repo Transaction.

• At the Start of the Trade : The Seller gives bonds/Collateral to the buyer
and the buyer in return pay the equivalent(market value of the collateral)
cash amount to the seller

• At the Maturity: The Buyer returns the collateral or the bonds to the Seller.
Simultaneously the Seller pays back the original cash amount plus the
interest accrued for the period to the Buyer.

The Interest rate used is called the Repo Rate

Example:

On 28-Mar-2008, Bank X wants to borrow for a market value of Rs. 101.57 from
Bank ‘Y’ with collateral of 8.07% G-Sec 2017 (Repo.) for a period of 5 Days with
ROI of 9 %( Annualized). The Last coupon date was 15-01-08. Market value of
the G Sec is Rs. 101.57 and the face value Rs.100 (Day count =actual/360).

Solution:

Market Price of security Rs.101.57

Broken period interest for the first leg* 8.07% x 73 / 360 x 100 = 1.6364

Cash consideration for the first leg: 101.57 + 1.6364 = 103.2064

Repo interest: 101.57x5/365x9.00%= 0.1252

Price for the second leg = 103.2064 + 0.1252 = 103.3316

Qs 4. Explain the issuing of commercial paper at

discount and rate of Interest with examples.

Ans:

Commercial paper is an unsecured promissory note with a fixed maturity of 1 to

270 days. It is a money-market security issued (sold) by
large banks and corporations to get money to meet short term debt obligations
(for example, payroll), and is only backed by an issuing bank or corporation's
promise to pay the face amount on the maturity date specified on the note.
Since it is not backed by collateral, only firms with excellent credit ratings from a
recognized rating agency will be able to sell their commercial paper at a
reasonable price. Commercial paper is usually sold at a discount from face value,
and carries higher interest repayment dates than bonds.
Example:

Essar limited has issued a CP for funding their operating expenses. The following
are the details:

Face Value: 5000000 rs

Yield: 7.5%

Maturity: 90 days

Issue Price of CP?

P = F/ (1+(r*M/100*365))

= 5000000/(1+(7.5*90)/100*365))

=4909213.181 rs

Qs 5. Explain Cash Flow in CP (Commercial Paper) and

CD (Certificate of Deposits) with examples.
Ans:

Qs A: If you wish to achieve an yield of 6.25% on Rs.10,000,000 30 day CP, what

would be the discount rate and the amount of discount?

Qs B: If the discount rate in the previous problem was in fact 6.25%, what would
be the yield and the amount be?

Solution A:

r= 6.25%

F = Rs. 10,000,000

M = 30 days

P = F/ (1+ r M/100x365)

P = 10000000 / [1+ (6.25 x 30) / (100 x 365) ]

= 9948892.67

Discount = 10000000-9948892.67 = 51107.33

Discount amount = 51107.325

Discount Amt= F x [(DR x M) / (100 x 365)]

Hence, DR=D x 100 x 365 / (F x M)

Discount Rate: 365 x 100 x 51107.33 / (10000000 x 30)

= 6.21 %

Solution B:

Discount Rate=6.25%

Yield=?

F=10,000,000

M=30 Days

Discount Amt= F x [(DR x M) / (100 x 365)]

= 10000000 x (6.25 x 30 / 100 x 365)

= 51369.86

Issue price= F-Discount Amount

=10000000- 51369.86

=9948630.14

Yield= [(10000000 / 9948630.14) - 1] x (365 x 100 / 30)

=6.28%

B) CD (Certificate of Deposits) example:

i) A 6 month CD is issued on 16-03-2009 and matures on 16-09-2009 (Maturity=

181 days). The deposit is Rs.30,000,000 and interest rate is 7.0%
( to be paid at maturity) .
 ii) What should be the secondary market proceeds for the CD on 11-04-2009 if
the yield for short 30 -day paper is 4.50%? (Day count = actual/365)

Ans)

i) r= 7%

F = Rs. 30,000,000

M = 181 days

Maturity value = 30000000 x (1 + 0.07 x(181/365)) = 31041369.86

ii)

No of days from 16-03-2009 to 11-04-2010=26.

Therefore remaining days = 155 days

P on 11-04-2010 =31041369.86/ (1+0.045 x (155/365)) = 30459305.06

Qs 6. Explain Cash Flow in Bond Pricing with examples.

Ans:

For a Bond principal is the amount the issuer agrees to pay the bondholder on
maturity date. This is also referred as maturity value/par value /face value. For
US it is $1000 and India it is Rs.1000.

Coupon is the periodic interest .Coupon rate is payment as coupon payment as

%age of face value.

Bond can be priced at premium, discount or at par.

Premium: Bond price is higher than its par value as bond’s interest rate is higher
than the current interest rate.

Discount: Bond Price is lower than its par value as it’s interest rate is lower than
the current interest rate.
 The principles in pricing a bond are exactly the same as those in other financial
securities:

The price of any financial instrument is equal to the present value of all the
future cash flows expected from the instrument.

If the coupon period is n i.e. Interest payments are made after x time-period.

N= number of years to mature

C = the Coupon Payment

r = interest rate

M = value at Maturity or par value

 
c 1  M
Bond Price = 1 − +
r  r  (1 + r ) xN
(1 + ) xN

 x 
 x

Present value of Coupon amounts Present value of

redemption amount

Total Cash Flow for a bond = Present value of Coupon amounts

Present value of redemption

amount

Example :Suppose residual maturity of the bond $1000 is now 10 yrs. If the
coupon paid for year is 100. If the interest rate for other similar instruments in
the market has risen to 12%, what will the bond ‘s worth?

Present value of the $1000 redemption value will be = $1000/1.1210 =$

321.9732

Present value of the coupon stream of $ 100 per year for 10 year

s = $100 x (1-1/1.1210)/0.12 = $ 565.0223

Total bond value now comes out to be = $ 565.0223+$ 321.9732

=$886.9955