Money Market and Its Instruments

I n d i a n F i n a n c i a l S y s t e m P a g e | 1

ASSIGNMENT

INDIAN FINANCIAL SYSTEM

Money Market And Its Instruments

Fixed Income Securities – “In Fixed Income Securities Income varies inversely with purchase price… Why???”

Submitted to:- Submitted

by:-

Dr. KP Ramakrishnan Vidhu Jain

Section F12

Roll No 83

INDIAN FINANCIAL SYSTEM ---- VIDHU JAIN ---- F12 ---- FW 2007-09


Money Market and its Instruments

Money Market:

Money market means market where money or its equivalent can be traded.

Money is synonym of liquidity. Money market consists of financial institutions

and dealers in money or credit who wish to generate liquidity. It is better

known as a place where large institutions and government manage their

short term cash needs. For generation of liquidity, short term borrowing and

lending is done by these financial institutions and dealers. Money Market is

part of financial market where instruments with high liquidity and very short

term maturities are traded. Due to highly liquid nature of securities and their

short term maturities, money market is treated as a safe place. Hence,

money market is a market where short term obligations such as treasury

bills, commercial papers and bankers acceptances are bought and sold.

Benefits and functions of Money Market:

Money markets exist to facilitate efficient transfer of short-term funds

between holders and borrowers of cash assets.

o For the lender/investor, it provides a good return on their funds.

o For the borrower, it enables rapid and relatively inexpensive

acquisition of cash to cover short-term liabilities.

One of the primary functions of money market is to provide focal point for

RBI’s intervention for influencing liquidity and general levels of interest rates

in the economy. RBI being the main constituent in the money market aims at

ensuring that liquidity and short term interest rates are consistent with the

monetary policy objectives.

Money Market & Capital Market:



Money Market is a place for short term lending and borrowing, typically

within a year. It deals in short term debt financing and investments. On the

other hand, Capital Market refers to stock market, which refers to trading in

shares and bonds of companies on recognized stock exchanges. Individual

players cannot invest in money market as the value of investments is large,

on the other hand, in capital market, anybody can make investments

through a broker. Stock Market is associated with high risk and high return

as against money market which is more secure. Further, in case of money

market, deals are transacted on phone or through electronic systems as

against capital market where trading is through recognized stock exchanges.

Money Market Futures and Options:

Active trading in money market futures and options occurs on number of

commodity exchanges. They function in the similar manner like any other

futures and options.

Money Market Instruments:

Money market instruments are generally characterized by a high degree of

safety of principal and are most commonly issued in units of $1 million or

more. Maturities range from one day to one year; the most common are

three months or less. Active secondary markets for most of the instruments

allow them to be sold prior to maturity. Unlike organized securities or

commodities exchanges, the money market has no specific location.

Available from financial institutions, money markets give the smaller investor

the opportunity to get in on treasury securities. The institution buys a variety

of treasury securities with the money you invest. The rate of return changes

daily, and services such as check writing may be offered. The major

participants in the money market are commercial banks, governments,

corporations, government-sponsored enterprises, money market mutual

funds; futures market exchanges, brokers and dealers. Investment in money

market is done through money market instruments. Money market



instrument meets short term requirements of the borrowers and provides

liquidity to the lenders. Common Money Market Instruments are as follows:

1. Treasury Bills

2. Repurchase Agreements (Repo/Reverse Repo)

3. Commercial paper

4. Certificate of Deposits

5. Bankers Acceptance

6. Eurodollar

Treasury Bills (T--Bills): Treasury Bills, one of the safest money

market instruments, are short term borrowing instruments of the

Central Government of the Country issued through the Central Bank

(RBI in India). These are issued by the Reserve Bank usually a period of

91 days. The Reserve Bank uses these bills to take money out of the

market. This will reduce a banks ability to lend to its clients leading to

a contraction of the money supply. The bill consists of an obligation to

pay the bearer the face value of the bill upon a given date. A bank

buying such a bill will not pay face value for it but would instead buy it

at a discount. The bill is tradable so the purchaser does not have to

hold it until the due date. If interest rates decrease during the term of

the bill, the holder can sell the bill at a profit before the due date. They

are zero risk instruments, and hence the returns are not so attractive.

It is available both in primary market as well as secondary market. It is

a promise to pay a said sum after a specified period. T-bills are short-

term securities that mature in one year or less from their issue date.

They are issued with three-month, six-month and one-year maturity

periods. The Central Government issues T- Bills at a price less than

their face value (par value). They are issued with a promise to pay full

face value on maturity. So, when the T-Bills mature, the government

pays the holder its face value. The difference between the purchase



price and the maturity value is the interest income earned by the

purchaser of the instrument. T-Bills are issued through a bidding

process at auctions. The bid can be prepared either competitively or

non-competitively. In the second type of bidding, return required is not

specified and the one determined at the auction is received on

maturity. Whereas, in case of competitive bidding, the return required

on maturity is specified in the bid. In case the return specified is too

high then the T-Bill might not be issued to the bidder. At present, the

Government of India issues three types of treasury bills through

auctions, namely, 91-day, 182-day and 364-day. There are no treasury

bills issued by State Governments. Treasury bills are available for a

minimum amount of Rs.25K and in its multiples. While 91-day T-bills

are auctioned every week on Wednesdays, 182-day and 364-day T-bills

are auctioned every alternate week on Wednesdays. The Reserve Bank

of India issues a quarterly calendar of T-bill auctions which is available

at the Banks’ website. It also announces the exact dates of auction, the

amount to be auctioned and payment dates by issuing press releases

prior to every auction. Payment by allottees at the auction is required

to be made by debit to their/ custodian’s current account. T-bills

auctions are held on the Negotiated Dealing System (NDS) and the

members electronically submit their bids on the system. NDS is an

electronic platform for facilitating dealing in Government Securities

and Money Market Instruments. RBI issues these instruments to absorb

liquidity from the market by contracting the money supply. In banking

terms, this is called Reverse Repurchase (Reverse Repo). On the other

hand, when RBI purchases back these instruments at a specified date

mentioned at the time of transaction, liquidity is infused in the market.

This is called Repo (Repurchase) transaction.

Repurchase Agreements : Repurchase transactions, called Repo or

Reverse Repo are transactions or short term loans in which two parties



agree to sell and repurchase the same security. They are usually used

for overnight borrowing. Repo/Reverse Repo transactions can be done

only between the parties approved by RBI and in RBI approved

securities viz. GOI and State Govt. Securities, T-Bills, PSU Bonds, FI

Bonds, Corporate Bonds etc. Under repurchase agreement the seller

sells specified securities with an agreement to repurchase the same at

a mutually decided future date and price. A repo agreement is the sale

of a security with commitment to repurchase the same security as a

specified price and on specified date while a reverse repo is purchase

of security with a commitment to sell at predetermined price and date.

A repo transaction for party would mean reverse repo for the second

party. In lieu of the loan, the borrower pays a contracted rate to the

lender, which is called the repo rate. As against the call money market

where the lending is totally unsecured, the lending in the repo is

backed by a simultaneous transfer of securities. The main players in

this market are all institutional players like banks, primary dealers like

PNB Gilts Limited, financial institutions, mutual funds, insurance

companies etc. allowed to operate a SGL with the Reserve Bank of

India. Further RBI also operates daily repo/ reverse repo auctions to

provide a benchmark rates in the markets as well as managing in the

liquidity in the system. RBI sucks or injects liquidity in the banking

system by daily repo/ reverse operations.

Similarly, the buyer purchases the securities with an agreement to

resell the same to the seller on an agreed date at a predetermined

price. Such a transaction is called a Repo when viewed from the

perspective of the seller of the securities and Reverse Repo when

viewed from the perspective of the buyer of the securities. Thus,

whether a given agreement is termed as a Repo or Reverse Repo

depends on which party initiated the transaction. The lender or buyer

in a Repo is entitled to receive compensation for use of funds provided

to the counterparty. Effectively the seller of the security borrows



money for a period of time (Repo period) at a particular rate of interest

mutually agreed with the buyer of the security who has lent the funds

to the seller. The rate of interest agreed upon is called the Repo rate.

The Repo rate is negotiated by the counterparties independently of the

coupon rate or rates of the underlying securities and is influenced by

overall money market conditions.

Commercial Papers: Commercial paper is a low-cost alternative to

bank loans. It is a short term unsecured promissory note issued by

corporate and financial institutions at a discounted value on face value.

They are usually issued with fixed maturity between one to 270 days

and for financing of accounts receivables, inventories and meeting

short term liabilities. Say, for example, a company has receivables of

Rs 1 lacs with credit period 6 months. It will not be able to liquidate its

receivables before 6 months. The company is in need of funds. It can

issue commercial papers in form of unsecured promissory notes at

discount of 10% on face value of Rs 1 lacs to be matured after 6

months. The company has strong credit rating and finds buyers easily.

The company is able to liquidate its receivables immediately and the

buyer is able to earn interest of Rs 10K over a period of 6 months.

They yield higher returns as compared to T-Bills as they are less secure

in comparison to these bills; however chances of default are almost

negligible but are not zero risk instruments. Commercial paper being

an instrument not backed by any collateral, only firms with high quality

credit ratings will find buyers easily without offering any substantial

discounts. They are issued by corporate to impart flexibility in raising

working capital resources at market determined rates. Commercial

Papers are actively traded in the secondary market since they are

issued in the form of promissory notes and are freely transferable in

demat form.



CHARACTERISTICS OF COMMERCIAL PAPER:

Securities offered to the public must be registered with the Securities and

Exchange Commission according to the Securities Act of 1933. Registration

requires extensive public disclosure, including issuing a prospectus on the

offering. It is a time-consuming and expensive process. Most commercial

paper is issued under Section 3(a)(3) of the 1933 Act which exempts from

registration requirements short-term securities as long as they have certain

characteristics.

The exemption requirements have been a factor shaping the characteristics

of the commercial paper market. The following are requirements for

exemption:

- The maturity of commercial paper must be less than 270 days. In practice,

most commercial paper has a maturity of between 5 and 45 days, with 30-35

days being the average maturity. Many issuers continuously roll over their

commercial paper, financing a more-or-less constant amount of their assets

using commercial paper. The nine-month maturity limit is not violated by

the continuous rollover of notes, as long as the rollover is not automatic but

is at the discretion of the issuer and the dealer.

Notes must be of a type not ordinarily purchased by the general public. In

practice, the denomination of commercial paper is large: minimum

denominations are usually $100,000, although face amounts as low as

$10,000 are available from some issuers. Typical face amounts are in

multiples of $1 million, because most investors are institutions. Issuers will

usually sell an investor the specific amount of commercial paper needed.

That proceeds from commercial paper issues be used to finance "current

transactions," which include the funding of operating expenses and the

funding of current assets such as receivables and inventories. Proceeds

cannot be used to finance fixed assets, such as plant and equipment, on a



permanent basis. Firms are allowed to finance construction as long as the

commercial paper financing is temporary and to be paid off shortly after

completion of construction with long-term funding through a bond issue,

bank loan, or internally generated cash flow.

Commercial paper is typically a discount security (like Treasury bills): the

investor purchases notes at less than face value and receives the face value

at maturity. The difference between the purchase price and the face value,

called the discount, is the interest received on the investment. Commercial

paper is, occasionally, issued as an interest-bearing note (by request of

investors). The investor pays the face value and, at maturity, receives the

face value and accrued interest. All commercial paper interest rates are

quoted on a discount basis.

Until the 1980s, most commercial paper was issued in physical form in which

the obligation of the issuer to pay the face amount at maturity is recorded by

printed certificates that are issued to the investor in exchange for funds. A

safekeeping agent hired by the investor held the certificates, until presented

for payment at maturity. On the day of maturity, the investor presents the

notes and receives payment. Commercial banks, in their role as issuing,

paying, and clearing agents, facilitate the settling of commercial paper by

carrying out the exchanges between issuer, investor, and dealer required to

transfer commercial paper for funds.

An increasing amount of commercial paper is being issued in book-entry

form whereby entries in computerized accounts are replacing the physical

commercial paper certificates. Book-entry systems will eventually completely

replace the physical printing and delivery of notes. The Depository Trust

Company (DTC), a clearing cooperative operated by member banks, began

plans in September 1990 to convert most commercial paper transactions to

book-entry form. By May 1992, more than 40 percent of commercial paper

was issued through the DTC in book-entry form.



The advantages of a paperless system are significant. In the long run the

fees and costs associated with the book-entry system will, be significantly

less than under the physical delivery system. The expense of delivering and

verifying certificates and the risks of messengers failing to deliver

certificates on time will be eliminated. As all transactions between an

issuing agent and a paying agent will be settled with a single end-of-day wire

transaction, the problem of daylight overdrafts, which arise from non-

synchronous issuing and redeeming of commercial paper will be reduced.

Certificate of Deposit: It is a short term borrowing more like a bank

term deposit account. It is a promissory note issued by a bank in form

of a certificate entitling the bearer to receive interest. The certificate

bears the maturity date, the fixed rate of interest and the value. It can

be issued in any denomination. They are stamped and transferred by

endorsement. Its term generally ranges from three months to five

years and restricts the holders to withdraw funds on demand.

However, on payment of certain penalty the money can be withdrawn

on demand also. Money in a CD is tied up from a few months to six

years or more depending on the terms of the specific CD you buy. A

notice of withdrawal is required and a penalty imposed if you withdraw

money before the CD matures. Interest earned is higher than paid on

insured savings accounts. The longer you tie up money in a CD, the

higher the interest rate earned. Interest is paid either at time of

purchase or at maturity, depending on the policy of the financial

institution. In most cases, the more money you invest, the higher the

rate of interest earned. All earnings are subject to income tax. CD’s are

available from banks, savings and loans and credit unions. No

purchase fees are charged. The returns on certificate of deposits are

higher than T-Bills because it assumes higher level of risk. While

buying Certificate of Deposit, return method should be seen. Returns

can be based on Annual Percentage Yield (APY) or Annual Percentage



Rate (APR). In APY, interest earned is based on compounded interest

calculation. However, in APR method, simple interest calculation is

done to generate the return. Accordingly, if the interest is paid

annually, equal return is generated by both APY and APR methods.

However, if interest is paid more than once in a year, it is beneficial to

opt APY over APR.

Banker’s Acceptance: It is a short term credit investment created by

a non financial firm and guaranteed by a bank to make payment. It is

simply a bill of exchange drawn by a person and accepted by a bank. It

is a buyer’s promise to pay to the seller a certain specified amount at

certain date. A banker’s acceptance is used for international trade as

means of verifying payment. For instance, if an importer wants to

import a product from a foreign country, he will often get a letter of

credit from his bank and send it to the exporter. The letter of credit is a

document issued by a bank that guarantees the payment of the

importer’s draft for a specified amount and time. Thus, the exporter

can rely on the bank’s credit rather than the importer’s. The exporter

presents the shipping documents and the letter of credit to his

domestic bank, which pays for the letter of credit at a discount,

because the exporter’s bank won’t receive the money from the

importer’s bank until later. The domestic bank then sends a time draft

to the importer’s bank, which then stamps it “accepted” and, thus,

converting the time draft into a banker’s acceptance. This negotiable

instrument is backed by the importer’s promise to pay, the imported

goods, and the bank’s guarantee of payment.

The same is guaranteed by the banker of the buyer in exchange for a

claim on the goods as collateral. The person drawing the bill must have

a good credit rating otherwise the Banker’s Acceptance will not be

tradable. The most common term for these instruments is 90 days.



However, they can very from 30 days to180 days. For corporations, it

acts as a negotiable time draft for financing imports, exports and other

transactions in goods and is highly useful when the credit worthiness of

the foreign trade party is unknown. The seller need not hold it until

maturity and can sell off the same in secondary market at discount

from the face value to liquidate its receivables.

Euro Dollars: The Eurodollars are basically dollar- denominated

deposits that are held in banks outside the United States. Since the

Eurodollar market is free from any stringent regulations, the banks can

operate at narrower margins as compared to the banks in U.S. The

Eurodollars are traded at very high denominations and mature before

six months. The Eurodollar market is within the reach of large

institutions only and individual investors can access it only through

money market funds. Eurocurrency is a more general term that can refer

to any currency that is deposited in banks whose domestic currency is

different from the deposited currency, and it can involve any country,

including the Far East and the Cayman Islands. Eurodollars or Eurocurrency

does not necessarily involve either Europe or the Euro. Multi-national

corporations deposit their domestic currency in foreign banks because they

can often get better terms trading their currency with the locals than by

exchanging domestic currency for foreign currency at a bank. The interest

paid on these deposits is usually equal to the London Interbank Offer Rate

(LIBOR), which is slightly higher than the yield for 3-month Treasuries.

Broker’s Loans and Call Loans: Broker’s loans are loans from

commercial banks to brokers so that the broker’s customers can

finance stock purchases. The broker uses the stocks, held in street

name, for collateral for the loans.

Time notes are loans that must be paid by a specific date for a

specified interest rate, with terms of 6 months or less. A demand note



(aka call loan) is a loan that is payable on demand the next day at 1

day’s interest. If the note is not demanded, then the term is extended

by another day, and so on, up to 90 days. The interest rate for each

day varies with the prevailing interest rate.

An individual player cannot invest in majority of the Money Market

Instruments, hence for retail market, money market instruments are

repackaged into Money Market Funds. A

money market fund is an investment fund that invests in low risk and low

return bucket of securities viz money market instruments. It is like a mutual

fund, except the fact mutual funds cater to capital market and money

market funds cater to money market. Money Market funds can be

categorized as taxable funds or non taxable funds.

Having understood, two modes of investment in money market viz Direct

Investment in Money

Market Instruments & Investment in Money Market Funds, lets move forward

to understand

functioning of money market account.

Money Market Account: It can be opened at any bank in the similar

fashion as a savings account. However, it is less liquid as compared to

regular savings account. It is a low risk account where the money parked by

the investor is used by the bank for investing in money market instruments

and interest is earned by the account holder for allowing bank to make such

investment. Interest is usually compounded daily and paid monthly. There

are two types of money market accounts:

Money Market Transactional Account: By opening such type of account,

the account holder can enter into transactions also besides

investments, although the numbers of transactions are limited.



Money Market Investor Account: By opening such type of account, the

account holder can only do the investments with no transactions.

Money Market Index: To decide how much and where to invest in money

market an investor will refer to the Money Market Index. It provides

information about the prevailing market rates. There are various methods of

identifying Money Market Index like:

Smart Money Market Index- It is a composite index based on intraday

price pattern of the money market instruments.

Salomon Smith Barney’s World Money Market Index- Money market

instruments are evaluated in various world currencies and a weighted

average is calculated. This helps in determining the index.

Banker’s Acceptance Rate- As discussed above, Banker’s Acceptance is

a money market instrument. The prevailing market rate of this

instrument i.e. the rate at which the banker’s acceptance is traded in

secondary market, is also used as a money market index.

LIBOR/MIBOR- London Inter Bank Offered Rate/ Mumbai Inter Bank

Offered Rate also serves as good money market index. This is the

interest rate at which banks borrow funds from other banks.



FIXED INCOME SECURITIES

Fixed income security originally referred to instruments that pay a fixed rate

of interest, usually fixed coupon rate.

Fixed-income securities can be contrasted with variable return

securities such as stocks. To understand the difference between stocks and

bonds, you have to understand a company's motivation. A company wants to

raise money, and it doesn't want to wait until it has earned enough through

ongoing operations (selling products or providing services). In order for a

company to grow as a business, it often must raise money; to finance an

acquisition, buy equipment or land or invest in new product development.

Investors will only give money to the company if they believe that they will

be given something in return commensurate with the risk profile of the

company. The company can either pledge a part of itself, by giving equity in

the company (stock), or the company can give a promise to pay regular

interest and repay principal on the loan (bond or bank loan) or (preferred

stock).

These days the definition of fixed income securities includes many debts

instruments whose promised cash flows are far from fixed.

People who invest in fixed-income securities are typically looking for a

constant and secure return on their investment. For example, a retired

person might like to receive a regular dependable payment to live on, but

not consume principal. This person can buy a bond with their money, and



use the coupon payment (the interest) as that regular dependable payment.

When the bond matures or is refinanced, the person will have their money

returned to them.

Interest rates change over time, based on a variety of factors, particularly

rates set by the Federal Reserve. For example, if a company wants to raise

$1 million and not a lot of people in the market have free cash to lend, the

company will have to offer a high rate of interest (coupon) to get people to

buy their bond. If there are a lot of people in the market trying to get a

return on their money, the company can offer a lower coupon.

Types of Fixed Income Securities A money market account is simply a bank account which offers the

prevailing\ (and constantly changing) interest rate.

Zero coupon bonds do not pay any coupon, but only the principal at

maturity. These are a form of short term debt. E.g. Treasury bills,

commercial paper, Negotiable Certificates of Deposit (NCD’s)...

Consuls are fixed coupon bonds which mature at 1, i.e. they pay a

fixed percentage of the principal at regular intervals for all time, but

the principal is never repaid.

Annuities pay a constant amount at regular intervals. These constant

payments thus include both the interest and part of the principal. The

gradual payment of the principal is called amortization.

Floating rate notes (FRN’s) are bonds that pay a variable coupon at

regular intervals. This variable coupon is generally linked to some

market-observable reference rate

Structured notes are a class of debts instruments with more complex

pay-off patterns, possibly tailored to an investor’s requirements. For

example inverse floaters have coupon payments that vary inversely

with a reference date: The coupon might be (15%¡LIBOR)+. Inverse

floaters can be used to hedge against falling interest rates.



Callable bonds can be called back by the issuer at fixed price on

fixed dates. AB Corp. floats a 10-year 15%-fixed coupon bond. After 5

years, its cost of capital is in the region of 6%, but AB Corp. is still

paying 15%. If the bond has a call feature built in, AB Corp. can call

back the bond, and float a new issue with a 6% coupon instead.

Puttable bonds can be put back to the issuer at fixed prices on fixed

dates. Investor X buys a 20-year 10%-fixed coupon bond from AA-rated

AB Corp. After 10 years, this credit rating has migrated to B-. The bond

has devalued substantially, but if it has a put feature built in, then

investor X can sell the bond back to AB Corp. at a reasonable price.

Convertible bonds can be converted to equity at a predetermined

conversion ratio on predetermined dates. A bond with a conversion

ratio of 3 allows the bond to be converted to shares.

FIXED INCOME SECURITIES INCOME VARIES INVERSELY WITH

PURCHASE PRICE AND VICEVERSA. WHY ??

Since the fixed income market is driven by interest rates (prices are

inversely related to yields), those things which impact on rates directly

influence prices. The biggest driver of these rates, from a macro

perspective, is monetary policy, the decisions central banks make in regards

to the level of domestic interest rates. Since the central banks directly

control interest rates (at least short-term rates), they have a heavy influence

over their level and direction. Other, less direct, influencers include:

Government fiscal policy

General economic growth

Employment

Inflation

Currency exchange rates and trade



Obviously, when considering the likes of corporate debt, considerations

related to that particular issuer come in to play. This includes things like

earnings, total debt outstanding, interest cover ratios, and others. All of this,

though, is also account for in the credit rating.

Fixed income securities offer a predictable stream of payments by way of

interest and repayment of principal at the maturity of the instrument. The

debt securities are issued by the eligible entities against the moneys

borrowed by them from the investors in these instruments. Therefore, most

debt securities carry a fixed charge on the assets of the entity and generally

enjoy a reasonable degree of safety by way of the security of the fixed

and/or movable assets of the company.

The investors benefit by investing in fixed income securities as they preserve

and increase their invested capital and also ensure the receipt of regular

interest income. The investors can even neutralise the default risk on their

investments by investing in govt. securities, which are normally referred to

as risk-free investments due to the sovereign guarantee on these

instruments.

The prices of debt securities display a lower average volatility as compared

to the prices of other financial securities and ensure the greater safety of

accompanying investments.

Debt securities enable wide-based and efficient portfolio diversification and

thus assist in portfolio risk-mitigation.

Yield Curve

The yield curve is the graphic portrayal of yields over the array of maturities,

from shortest to longest. An example is shown on the following chart.



Notice that the plot above depicts two lines. The blue line is the more

standard, upwardly sloping yield curve in which the longer-maturities feature

higher yields. The spread between the long maturity issues over the short

maturity ones is positive. The pink line, shows an inverted, or negatively

sloped curve. A negatively sloped curve is often considered an indication of

a pending downturn in the economy as the higher return on short term

money will tend to prevent longer-term investment.

Most fixed income securities have a par value that pays a specific rate of

interest on that value, or otherwise has a knowable rate of return; hence the

term fixed income security.

In the most general sense, risk is the possibility of something undesirable.

Since the goal of investing is to get the greatest return possible for 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

he could have had if he had invested his money elsewhere—what economists

call opportunity costs. These risks associated with fixed income securities,

however, are usually small compared to stocks, options, and other



derivatives, which is why many people invest in them. It is not possible to

lose more than your investment in fixed income securities, as you can buying

stocks on margin, for instance, because it makes no sense to borrow money

to pay for fixed income securities, since the interest rate that you would be

paying would almost certainly be more than you could earn. And it is not

likely that you will lose your initial investment because bondholders have

priority over owners if the company goes bankrupt and usually receive

periodic payments of interest, and many issuers of bonds are governments

or their agencies, which have taxing power. And because the United States

government not only has taxing power, but can print money, investments

such as U.S. Treasuries, are virtually risk-free, at least in regards to principal

and interest payments.

Many of the risks in fixed income securities apply to other investments as

well. Inflation risk, for instance, affects every investment. Not all risks apply

to every fixed income security. In fact, many risks have an inverse

relationship—when one goes up, the other goes down, which is best

represented pictographically by a seesaw.

Generally, the most important risk for fixed income securities is market risk

or interest rate risk, because interest rates change continually, and this risk

affects virtually every security.

Fixed Income Yields and security prices generally change much more slowly

than Stock Market prices and it can actually takes years for interest rates to

move in either direction by a few points. At the same time, a trend in interest

movements is likely to last longer than a trend in stock prices. There is

abundantly more economics than there is emotion involved with interest

rates movements, creating a more stable playing field for the individual

investor.



Income Investing should be much easier than it is, and should rarely produce

an anxious moment. If you are thinking long term, as you should be in this

area, the rules become simple and few:

RULE ONE is to always seek out the longest duration, Investment

Grade Only, securities with the highest (reasonable) yields.

So long as you follow RULE ONE, RULE TWO is to focus on the Cost

Basis of your Fixed Income Securities and ignore their Market Value

fluctuations.

RULE THREE is to stay focused on the income generated by these

securities, and to make decisions that grow that income annually.

All Interest Rate Sensitive Securities are Created Equal. This means that if

your bonds are up or down in price, so are everyone else's. If your fund is

down, Johnny's fund couldn't do better unless there are significant Quality or

Duration differences involved. Therefore, don't ever switch from one Fixed

Income Security to another for emotional (fear or greed) or other similarly

superficial reasons.

Investors should almost never switch from one fixed income fund to

another, OR even worse, take losses on fixed income to move into

something else entirely, typically a peaking Equity Market.

Another basic rule is to avoid yields that are a great deal higher than

normal. Caveat Emptor! In one sense, Fixed Income Investing and

Equity Investing are identical...Junk is Junk.

To be a successful Fixed Income Investor you must get to the point where

you understand that:

Higher Interest Rates are a Good Thing, and

So, too, are Lower Interest Rates.



Fixed income refers to any type of investment that yields a regular (or fixed)

return.

For example, if you lend money to a borrower and the borrower has to pay

interest once a month, you have been issued a fixed-income security. When

a company does this, it is often called a bond or corporate bank debt

(although “preferred stock” is also sometimes considered to be fixed

income). Sometimes people misspeak when they talk about fixed income.

Bonds actually have higher risk, while notes and bills have less risk because

these are issued by government agencies.

The term fixed income is also applied to a person's income that does not

vary with each period. This can include income derived from fixed-income

investments such as bonds and preferred stock or pension that guarantee a

fixed income. When pensioners or retirees are dependent on their pension as

their dominant source of income, the term "fixed income" can also carry the

implication that they have relatively limited discretionary income or have

little financial freedom to make large expenditures.

Fixed-income securities can be contrasted with variable return securities

such as stocks. To understand the difference between stocks and bonds, you

have to understand a company's motivation. A company wants to raise

money, and it doesn't want to wait until it has earned enough through

ongoing operations (selling products or providing services). In order for a

company to grow as a business, it often must raise money; to finance an

acquisition, buy equipment or land or invest in new product development.

Investors will only give money to the company if they believe that they will

be given something in return commensurate with the risk profile of the

company. The company can either pledge a part of itself, by giving equity in

the company (stock), or the company can give a promise to pay regular

interest and repay principal on the loan (bond or bank loan) or (preferred

stock).



While a bond is simply a promise to pay interest on borrowed money, there

is some important terminology used by the fixed-income industry:

The issuer is the entity (company or govt.) who borrows an amount of

money (issuing the bond) and pays the interest.

The principal (of a bond) is the amount that the issuer borrows.

The coupon (of a bond) is the interest that the issuer must pay.

The maturity is the end of the bond, the date that the issuer must

return the principal.

The issue is another term for the bond itself.

The indenture is the contract that states all of the terms of the bond.

People who invest in fixed-income securities are typically looking for a

constant and secure return on their investment. For example, a retired

person might like to receive a regular dependable payment to live on, but

not consume principal. This person can buy a bond with their money, and

use the coupon payment (the interest) as that regular dependable payment.

When the bond matures or is refinanced, the person will have their money

returned to them.

Interest rates change over time, based on a variety of factors, particularly

rates set by the Federal Reserve. For example, if a company wants to raise

$1 million and not a lot of people in the market have free cash to lend, the

company will have to offer a high rate of interest (coupon) to get people to

buy their bond. If there are a lot of people in the market trying to get a

return on their money, the company can offer a lower coupon.

To complicate matters further, fixed income securities are actually traded on

the open market, just like stocks. To understand this, first realize that bonds

are usually created in round face values, for example $100,000. If the



current yield (interest rate) of newly issued similar bonds is 6% per year, and

you are buying a bond with a coupon rate below 6%, then you can get the

bond at a discount (below face value of $100,000), which brings your rate of

return on that bond to 6%. Similarly, if the coupon rate of the bond you are

buying is greater than 6% you will have to pay a premium for the bond to

bring the rate of return down to 6%.

There are also index-linked, fixed-income securities. The most common and

an example of the highest rated variety of this kind could include Treasury

Inflation Protected Securities (TIPS). This type of fixed income is adjusted to

the Consumer Price Index for all urban consumers (CPI-U), and then a real

yield is applied to the adjusted principal. This means that the US Treasury

issues fixed income that is backed by the full faith and credit of the US

government to outperform the CPI (e.g. to outperform the inflation rate). This

allows investors of all sizes to not lose the purchasing power of their money

due to inflation, which can be very uncertain at times. For example,

assuming 3.88% inflation over the course of 1 year (just about the 56 year

average inflation rate, through most of 2006), and a real yield of 2.61% (the

fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the

adjusted principal of the fixed income would rise from 100 to 103.88 and

then the real yield would be applied to the adjusted principal, meaning

103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%.

TIPS moderately outperform conventional US Treasuries, which yield just

5.05% for a 1 yr bill on October 19, 2006. By investing in such fixed income,

index linked fixed income securities; consumers can exceed the pace of

inflation, and gain value in real terms.

All fixed income securities from any entity have risks including but not

limited to:

inflationary risk

interest rate risk



currency risk

default risk

repayment of principal risk

reinvestment risk

liquidity risk

maturity risk

streaming income payment risk

duration risk

convexity risk

credit quality risk

political risk

tax adjustment risk

market risk

climate risk

Fixed income securities offer a predictable stream of payments by way of

interest and repayment of principal at the maturity of the instrument. The

debt securities are issued by the eligible entities against the moneys

borrowed by them from the investors in these instruments. Therefore, most

debt securities carry a fixed charge on the assets of the entity and generally

enjoy a reasonable degree of safety by way of the security of the fixed

and/or movable assets of the company.



The investors benefit by investing in fixed income securities as they

preserve and increase their invested capital and also ensure the

receipt of regular interest income.

The investors can even neutralize the default risk on their investments

by investing in govt. securities, which are normally referred to as risk-

free investments due to the sovereign guarantee on these instruments.

The prices of debt securities display a lower average volatility as

compared to the prices of other financial securities and ensure the

greater safety of accompanying investments.

Debt securities enable wide-based and efficient portfolio diversification

and thus assist in portfolio risk-mitigation.

Fixed-income securities can be an excellent way to diversify your portfolio.

They are also crucial for your tax planning.

Fixed-income securities represent the debt of domestic financial institutions,

companies, banks, and government issues. In essence, when you buy a

fixed-income security, you are lending money to the issuer for a specified

period of time. In return, you expect the issuer to make regular interest

payments (annually, semi-annually, quarterly, or monthly) and to pay back

the face amount on the maturity date (the end of the specified period for the

loan).

Fixed-income instruments in India typically include company bonds, fixed

deposits and government schemes. One of the key benefits of fixed-income

instruments is low risk i.e. the relative safety of principal and a predictable

rate of return (yield). If your risk tolerance level is low, fixed-income

investments might suit your investment needs better.

Most fixed-income securities offer a relatively stable and predictable income

flow. The amount of interest the issuer has agreed to pay, the coupon rate, is

set at issuance and remains the same until maturity: hence, the term "fixed



income." The different fixed-income vehicles in the market allow you to

choose from a range of credit ratings and maturities. Fixed-income securities

provide the flexibility to structure a portfolio tailored to your specific

investment objectives and tolerance for risk.

Most fixed-income securities offer a relatively safe and predictable

income flow.

The coupon (the amount of interest the issuer has agreed to pay) is set

at issuance and remains the same until maturity; thus, the term "fixed-

income."

The different fixed-income vehicles in the market allow you to choose

from a range of credit ratings and maturities (generally one day to 30

years, with some as long as 100 years). This diversity helps improve

your management of risk.

Fixed-income securities provide the flexibility and liquidity needed to

structure a portfolio tailored to your specific investment objective.

Securities are financial instruments that represent some value. A Debt or

Fixed Income Security represents a creditor relationship with a corporation,

government, bank, etc. Generally debt instruments represent agreements to

receive certain cash flows depending on the terms contained within the

agreement. Fixed-income securities are investments where the cash flows

are according to a predetermined amount of interest, paid on a fixed

schedule. The different types of fixed income securities include government

securities, corporate bonds, debentures, etc. A brief detail about some of

these investment options are given below.

Government Securities- Government Securities are issued by the Reserve

Bank of India on behalf of the Government of India. Normally the dated

Government Securities have a period of 1 year to 30 years. These are



sovereign instruments generally bearing a fixed interest rate with interests

payable semi-annually and principal as per schedule. Government Securities

provide risk free return to investors.

Corporate Bonds- Corporate Bonds are issued by public sector

undertakings and private corporations for a wide range of tenors normally up

to 15 years although some corporate have also issued perpetual bonds.

Compared to government bonds, corporate bonds generally have a higher

risk of default. This risk depends, of course, upon the particular corporation

issuing the bond, the current market conditions, the industry in which it is

operating and the rating of the company. Corporate bond holders are

compensated for this risk by receiving a higher yield than government

bonds.

Debentures – Debentures are instruments for raising loan by a Company.

They evidence an acknowledgement of debt with an obligation to repay the

sum specified along with interest as specified. They are subject to provisions

of the Companies Act, 1956 and sections 117 to 123 relating to issue,

appointment of debenture trustees, creation of Debenture Redemption

Reserve Account, etc., specifically apply to them. As per section 125(4) of

the Companies Act, registration of charge for purpose of issue of debentures

is mandatory. Debentures form a part of the Company’s capital structure but

not a part of the share capital.

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Documents

Money Market and Its Instruments