Money Market and Its Instruments

I n d i a n Fi n a n c i a l S y s t e m Page | 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-
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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.
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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.
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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.
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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
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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
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• 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
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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
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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
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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.
09
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
09
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
09
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
09
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
09
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.
09
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.
09
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.
************
09

Money Market and Its Instruments

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Money Market and Its Instruments

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I n d i a n Fi n a n c i a l S y s t e m Page | 1

INDIAN FINANCIAL SYSTEM

Submitted to:- Submitted by:-

Money Market and its Instruments

Benefits and functions of Money Market:

Money Market & Capital Market:

Money Market Futures and Options:

Money Market Instruments:

participants in the money market are commercial banks, governments,

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

instruments to absorb liquidity from the market by contracting the

• Repurchase Agreements : Repurchase transactions, called Repo or

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

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

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

CHARACTERISTICS OF COMMERCIAL PAPER:

The exemption requirements have been a factor shaping the characteristics

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

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

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

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

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

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

endorsement. Its term generally ranges from three months to five

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

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

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

• Euro Dollars: The Eurodollars are basically dollar- denominated

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

An individual player cannot invest in majority of the Money Market

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

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

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

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

FIXED INCOME SECURITIES

Fixed-income securities can be contrasted with variable return

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

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

Types of Fixed Income Securities

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

FIXED INCOME SECURITIES INCOME VARIES INVERSELY WITH

• Government fiscal policy

Obviously, when considering the likes of corporate debt, considerations

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

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

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

Debt securities enable wide-based and efficient portfolio diversification and

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

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

is abundantly more economics than there is emotion involved with interest

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

• Higher Interest Rates are a Good Thing, and

• So, too, are Lower Interest Rates.

Fixed-income securities can be contrasted with variable return securities

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

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

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

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

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

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

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

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

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