The Underlying Market

Chapter 1: Introduction to Interest Rate, Interest Rate Instruments and Markets

NISM Series IV — Interest Rate Derivatives | ~25% weightage | ~100 questions

What this chapter is about

The largest chapter in the entire Series IV workbook at 68 pages. This is not a derivatives chapter — it is a fixed income fundamentals chapter. Before you can understand interest rate futures, you need to understand bonds: how they are priced, what yield means, how duration measures risk, what repo is, and how the yield curve works. Roughly 25% of all exam questions come from here. Master the bond math and the yield curve concepts, and you've secured the foundation of the exam.

Fixed Income Instruments — the building blocks

Money market (maturity < 1 year): Treasury Bills, Call Money, Certificates of Deposit, Commercial Paper, Repo/Reverse Repo

Bond market (maturity ≥ 1 year): Government bonds (G-Secs), State Development Loans, Corporate bonds

Together = Debt market = Fixed Income Securities market

Standard money market tenors: Overnight (ON), 1W, 2W, 1M to 1Y Most liquid: ON, 1M, 3M

Standard bond market tenors: 2Y, 5Y, 7Y, 10Y, 15Y, 20Y, 25Y, 30Y Most liquid: 2Y and 10Y

Types of bonds — must know all four

Coupon bond: Pays periodic coupons (interest) + principal at maturity. Most common. Has reinvestment risk.

Zero coupon bond: No periodic payments. Issued at discount, redeemed at face value. No reinvestment risk. True return can be calculated in advance. Duration = Maturity.

Annuity: Equal periodic payments of coupon + part of principal. Example: EMI loans. Most consumer/housing loans are structured as annuities.

Consol (Perpetual bond): Pays coupon forever, principal never repaid. Example: UK government consols at 3%.

Treasury Bills — the short-term government instrument

• Issued by Government of India, auctioned by RBI
• Maturities: 91-day, 182-day, 364-day
• Zero coupon instruments (issued at discount, redeemed at face value)
• Minimum and multiple of issue: Rs 25,000
• Auction day: Wednesday (91-day every week; 182-day and 364-day alternate weeks)
• Quoted as: 100 minus discount yield (e.g., if yield = 5%, quote = 95)

Government Securities (G-Secs) — the long-term government instrument

Depository: Public Debt Office (PDO) of RBI

Account types:

• SGL Account (Subsidiary General Ledger): Held by Scheduled Commercial Banks (SCBs), Primary Dealers (PDs), and select financial institutions directly with PDO
• CSGL Account (Constituent SGL): Held by others (investors) through SCBs or PDs — investors hold G-Secs here in their SCB/PD
• Gilt Account: Investor account with SCB or PD (not with PDO). Maximum one Gilt Account per investor. Every debit requires Gilt Account Holder's authorization. Right of set-off cannot be applied.

RBI-regulated entities must hold G-Secs compulsorily in electronic form (SGL or Gilt Account).

Auction types: Yield-based (new securities) and Price-based (re-issuance)

Eligible to open CSGL: SCBs, PDs, NSDL, CDSL, SHIL (Stock Holding Corp), NABARD, CCIL

Yield measures — the most tested bond calculations

Coupon rate: Annual coupon / Face value. NOT a true return measure — ignores price premium/discount and capital gain/loss at redemption.

Current Yield = Annual Coupon / Current Market Price × 100

• Better than coupon but still ignores capital gain/loss at redemption
• Example: Bond at Rs 105, coupon 9%: Current yield = 9/105 × 100 = 8.57%
• Example: Bond at Rs 97, coupon 8.5%: Current yield = 8.5/97 × 100 = 8.76%

Yield to Maturity (YTM):

• The internal rate of return (IRR) if bond held to maturity and all coupons reinvested at YTM
• Also an alternative way of quoting bond price
• Assumes flat term structure (same rate for all cash flows) — this is a limitation
• Assumes reinvestment at YTM itself — also a limitation
• True return measure? Not completely — but better than coupon and current yield

True return: Only zero coupon bond gives a truly calculable return in advance (no reinvestment).

Price risk and reinvestment risk

Price risk (Market risk): Bond price changes IMMEDIATELY when interest rates change.

• Interest rates rise → Bond prices fall (inverse relationship — always)
• Interest rates fall → Bond prices rise

Reinvestment risk: Effect is SLOW over time — it affects how coupons get reinvested.

• Interest rates fall → Coupons reinvested at lower rates → Total return less than YTM
• Zero coupon bonds have NO reinvestment risk (no coupons to reinvest)

Credit risk: Risk of default by issuer. Sovereign bonds = risk-free. Corporate bonds have credit risk.

Credit spread: Yield difference between corporate bond and equivalent sovereign bond. Measures credit risk premium.

• AAA → lowest credit spread (safest)
• BBB → higher credit spread (more risky)
• Interest rate will be highest for lowest credit rating (BB < BBB < A < AA < AAA)

Duration — the most important risk measure

Macaulay Duration:

• Weighted average time to receive all cash flows
• For zero coupon bond: Macaulay Duration = Maturity (exactly)
• For coupon bond: Macaulay Duration < Maturity
• Higher coupon → lower duration | Lower coupon → higher duration
• Higher YTM → lower duration | Lower YTM → higher duration
• Longer maturity → higher duration (generally)
• Measures PRICE RISK in a bond

Modified Duration (MD) = Macaulay Duration / (1 + YTM)

Key formula:

Change in bond price ≈ -MD × Change in YTM × Bond Price

Example: Bond price = Rs 100, MD = 5.80, YTM falls 0.01% (1 basis point)

Change = 100 × 5.80 × 0.0001 = Rs 0.58 → New price = 100.58

Price Value of Basis Point (PVBP): Absolute rupee change in bond price for 1 basis point change in YTM.

PVBP = MD × Bond Price × 0.0001

Both MD and PVBP measure price risk — same concept in different units (% vs Rs).

Term Structure of Interest Rates (Yield Curve)

Term structure = snapshot of interest rates for different maturities at ONE point in time. Shift = how the term structure changes over time.

Four shapes: 1. Normal (Positive/Upward sloping): Long-term rates > Short-term rates. Longer term → higher rate. Most common. Indicates economic growth expected. 2. Inverted (Negative/Downward sloping): Long-term rates < Short-term rates. Rate rises first then falls. High demand for short-term money (working capital), low demand for long-term capital expenditure. May indicate recession. 3. Flat: Long-term rate = Short-term rate. Same rate for all maturities. 4. Humped: Rate rises for medium term, then falls. High for medium term, falls on either side.

Three types of shifts: 1. Parallel shift: All rates move by the same amount in the same direction. No yield curve spread risk. 2. Steepening: Long-term minus short-term difference WIDENS (from positive to more positive, OR from negative to less negative). Anti-clockwise rotation. 3. Flattening: Long-term minus short-term difference NARROWS (from positive to less positive, OR from negative to more negative). Clockwise rotation.

Yield curve spread risk: Arises when shift is NON-PARALLEL (steepening or flattening). NOT when shift is parallel.

What drives rates:

• Short-term rates: Driven by liquidity (RBI policy, repo rate)
• Long-term rates: Driven by inflation outlook and capital expenditure demand

Accrued Interest

Applies to coupon bonds (not zero coupon).

When a bond is traded between coupon dates:

• Buyer pays seller the accrued interest
• Accrued interest = coupon rate × (days from last coupon date to settlement) / (days in coupon period)
• Buyer gets the full coupon on next coupon date — reimburses seller for their period

Dirty price (Full price) = Clean price + Accrued interest

Day count conventions:

• Actual/Actual: Use actual calendar days
• 30/360: Each month = 30 days, year = 360 days
• Example: Feb 28 to Mar 1 under 30/360 = 1 day (Feb 28 is treated as day 30)

Repo and Reverse Repo

Repo = Repurchase Agreement

• Repo from seller's perspective: Borrow money + lend security (pledge security for cash)
• Reverse Repo from buyer's perspective: Lend money + borrow security

Simple rule: Repo = Borrowing money against collateral (security)

Callable and Puttable bonds

Callable bond: Issuer has the right to prepay (redeem) before maturity. Used when rates fall — issuer can refinance at lower rates.

Puttable bond: Investor has the right to sell back (redeem) to issuer before maturity. Used when rates rise — investor can exit and reinvest at higher rates.

Trap Alert

Trap 1: "Current yield is same as YTM" — FALSE Current yield ignores capital gain/loss at redemption. YTM accounts for it (approximately).

Trap 2: "Zero coupon bond has no price risk" — FALSE Zero coupon bonds have NO reinvestment risk but DO have price risk (price still changes with interest rates). In fact, duration = maturity, so they have MORE price risk than equivalent coupon bonds.

Trap 3: "Inverted yield curve means long-term rate > short-term rate" — FALSE Inverted = long-term LOWER than short-term. Normal = long-term HIGHER.

Trap 4: "Parallel shift creates yield curve spread risk" — FALSE Only non-parallel shifts (steepening/flattening) create yield curve spread risk.

Trap 5: "High credit rating = high interest rate" — FALSE High credit rating (AAA) = LOW interest rate (low risk premium). BBB = HIGH interest rate.

Trap 6: "SGL account is for all investors" — FALSE SGL = only SCBs, PDs, select FIs. Regular investors use CSGL (through SCB/PD) or Gilt Account.

Trap 7: "An investor can have multiple Gilt Accounts" — FALSE Maximum ONE Gilt Account per investor.

Must-remember rules

• Money market < 1 year | Bond market ≥ 1 year
• Most liquid: Bond market = 2Y, 10Y | Money market = ON, 1M, 3M
• T-bills: 91/182/364 day, zero coupon, Rs 25,000 minimum, auction Wednesday
• Quoted: T-bills = 100 minus discount yield | G-Sec bonds = price per Rs 100 face value
• Depository for G-Secs = PDO of RBI
• SGL = SCBs, PDs | CSGL = investors through SCBs/PDs | Gilt = investor account with SCB/PD
• One Gilt Account max per investor
• Current yield = Coupon / Price × 100
• True return calculable only for zero coupon bonds
• Price risk: IMMEDIATE | Reinvestment risk: SLOW over time
• Zero coupon: NO reinvestment risk, YES price risk, duration = maturity
• MD formula: Change in price = -MD × ΔYield × Price
• Normal curve: long rates > short rates | Inverted: long < short | Flat: all equal
• Steepening = spread widens (anti-clockwise) | Flattening = spread narrows (clockwise)
• Parallel shift = NO yield curve spread risk
• Repo = borrow money, lend security
• Callable = issuer redeems | Puttable = investor redeems

Weightage note

~25% of all questions. Term structure questions (normal/inverted/flat/humped, parallel/steepening/flattening) appear in almost every exam — 3-5 per exam. Modified duration calculations appear 2-3 times. Current yield calculations 1-2 times. SGL/CSGL/Gilt account rules 2-3 times. T-bill auction details 1-2 times. This is the chapter to invest the most study time in.

Quick revision — 60 second scan

• Debt market = money market (< 1yr) + bond market (≥ 1yr)
• T-bills: 91/182/364 day, zero coupon, Wednesday auction, Rs 25,000 minimum
• T-bill quote: 100 minus discount | G-Sec quote: price per Rs 100
• PDO = G-Sec depository | SGL for SCBs/PDs | CSGL for investors | Gilt = investor with SCB/PD
• Current yield = Coupon / Price | True return = zero coupon only
• Price risk: immediate | Reinvestment risk: slow | Zero coupon: no reinvestment risk
• MD: change in price = -MD × change in yield × price
• Normal: long > short | Inverted: long < short | Flat: equal | Humped: medium peak
• Steepening: spread widens | Flattening: spread narrows | Parallel: no spread risk