Tradeable Instruments - II

By Zenub Husain

Table Of Contents
Debt Market and subdivisions
Fixed Income Capital Market Instruments

Bonds and their classifications

Bond Yield
Bond Valuation
Mortgage Backed Securities
CDO and their role in financial crisis

Money Market Instruments

TreasuryBills
Bankers Acceptance
Certificate of Deposit
Commercial Paper
Repos
Fed Funds
Call Loans

Debt Markets

Bigger source of borrowed funds than the banking system.

Divided into money market (short-term debt, maturity of one year or less) and
capital market (long-term debt).
Money Market is the part of financial market where instruments with high liquidity
and very short-term maturities are traded.
Also called cash equivalents
Issued by governments, financial institutions and large corporations.
Trade in very high denominations
Low risk, low return
Fixed Income Capital Market deal with long term securities. Also popularly knows
as Bond market.

Money Market Trading

Trading through OTC

Core of the money market consists of interbank lending.
Helps Industries in securing short-term loans to meet their working capital
requirements .
Helps finance trading
Government meets its funding needs
Retail Investors can gain access through money market mutual funds and money
market accounts

Money Market Instruments

Treasury Bills
Bankers Acceptance
Certificate of Deposit (CD)
Commercial Paper
Federal Funds
Call/Notice & Term Money
Repos

Treasury Bills
Issued by the Central Governments
Issued at discount through competitive bidding process at auctions
Low risk and Low return
Most marketable: High liquidity
Short term securities with maturity of less than 1 year
Retail investors can buy T-bills directly

Bankers Acceptance
Commercial bank draft requiring the bank to pay the holder of the instrument
a specified amount on a specified date
Maturities between 30-180 days typically 90 days
Issued by Banks usually merchant banks to finance international trade
Issued at discount and paid in full when it becomes due

Certificate of Deposit

Tradable Unsecured Time deposit with banks

Issued by commercial banks but can be bought at brokerage houses
Similar to bonds with specified maturity dates and interest rates
Slightly higher return due to presence of default risk
Maturity Period between 3 months to 5 years
Lock in period with substantial penalties
Eurodollar CDs are dollar-denominated CDs issued by banks abroad

Commercial Paper

Unsecured short term loan

Issued by Corporation to avoid dealing with banks
Issued at discount and at maturity it gets the return plus invested amount
Maturity periods ranging from 1-270 days with typical maturity 30-35 days.
High denomination amounts typically in multiples of $1 million

Call/Notice & Term Money

Call Rate

Federal Funds
Risk Free Rate
Fed Fund Rate

Repos
Repurchase agreement
Used as a form of short term borrowing
Term Repo: Maturity period > 30days
Reverse Repo: Dealer buys government securities and
then sells them back on a later date at a higher price

Repos Legal Framework

Collateral is not pledged but sold to buyer.

Legal Ownership transferred to buyer
Economic ownership retained with seller
Manufactured Dividend payment

Role of Reserve Bank of India:

The Reserve Bank of India (RBI) plays a key
role of regulator and controller of money
market. The intervention of RBI is varied
curbing crisis situations by reducing key policy
rates or curbing inflationary situations by
rising key policy rates such as Repo, Reverse
Repo, CRR etc.
Tool of domestic market intervention
Control future interest rates

Fixed Capital Market Instruments

Bonds
Mortgage Backed Securities

 Current Yield
The current yield on a bond refers to the ratio of
the annual interest payment to the current market
price .
Yield to Maturity
This is the rate of return that investors earn if they
buy the bond at a specific price and hold it until
maturity.

Current Yield vs YTM

Bonds : Current Yield Vs Yield to
Maturity

Current Yield

The current yield on a bond refers to the ratio of the annual interest payment to the current market price .

Yield to Maturity

This is the rate of return that investors earn if they buy the bond at a specific price and hold it until
maturity.

Bond Pricing and Valuation

Price vs Yield

Corporate Bonds
Corporations can raise capital for long-term projects
. A company with a good credit rating can issue long-term bonds at
low interest and deduct interest payments as a business expense
AAA, AA, A, BBB -- investment grade
BB, B, CCC, CC -- speculative grade
C, DDD, DD, D -- questionable to default grade
Callable Bonds
Retractable Bonds
Convertible Bonds
Insurance companies are the predominant holders of corporate
bonds

 Floating Rate Notes

T Notes (2,5, 10 years increment) T Bonds
(Terms of 30 years)

MunicipalBonds
Issued by states, counties, cities and other local governments
in the United States
Bond insurance raises bond rating and lowers bond yield
As a result of the downgrades of the major bond insurance
firms, only about 6% of all municipal bonds now come to
market with insurance, compared with about 55% up to 2007.
steep declines in muni bond prices after 2008

MORTGAGE-BACKED SECURITIES
MBS are actually pools of mortgages packaged into securities for
sale in the secondary market.
Most MBSs are issued by the government agencies Fannie Mae,
Freddie Mac and Ginnie Mae
MBSs are classified as pass-through securities or Collateralized
Mortgage Obligations
A pass-through security represents a pro-rata ownership of the
principal and interest of a pool of mortgage loans.
A CDO divides holders of the MBS into classes based on priority to
receive prepayments. These securities essentially take the interest
and principal payments from several MBS and create additional
securities with varying maturities and coupons.

CDOs and Financial Crisis

Will add

Summary View