TRADING STRATEGIES FOR DEBT MARKET T Ramji [email protected].

TRADING STRATEGIESFOR DEBT MARKET

T Ramji [email protected]

Coverage of the Presentation

Fixed Income Market

Concept of Yield

Yield Curve Analysis

FIXED INCOME MARKET

FINANCIAL MARKETFINANCIAL MARKET

MONEY MARKETMONEY MARKET

FOREX MARKETFOREX MARKET

CAPITAL MARKETCAPITAL MARKET

CALLCALL REPOREPO TERMTERM CPs,CDs,BillsCPs,CDs,Bills

DEBT MARKETDEBT MARKET

G-SECSG-SECS BONDSBONDS

Trading in Fixed Income Market

Telephone Based MarketTypes of Deals

Direct DealsBrokered Deals

Asking for a quoteShowing the sideAsking for two way

Quote ConventionsGeneration of a quote depends upon

buying/selling pressureSettlement standardized on T + 1 basisChecking of QuotesClosing the Deal

Calculation of Settlement Amount

Principal Amount is calculated as follows:

Face Value x Price

100

e.g. Rs 1 crore face value is purchased at Rs 100.50. The principal amount will be

Rs 1,00,00,000 x 100.50 = Rs 1,00,50,000

100Accrued Interest: The interest accrued since

last interest payment date has to be paid by buyer to seller

Calculation of Settlement Amount No of days for accrued interest: 30/360 day

count convention is used :• Every month is assumed to have 30 days and the year

is assumed to have 360 daysE.g 7.40% GOI 2012

• Interest payment dates 03/05 and 03/11

• Settlement date is 1st July • No of days will be calculated as:

May : ( 30 – 2) = 28 days * May is assumed to have 30 daysJune : 30 days

Calculation of Settlement Amount

No of days for accrued interest : 58 daysAccrued interest = 58 x 7.40 x 1,00,00,000 = 1,19,222.22

360 x 100 Total consideration amount = Principal

amount + Accrued Interest= 1,00,50,000 +

1,19,222.22= 1,01,69,222.22

Concept of Yield

Current YieldCurrent Yield is the annual return on the bond

based on the purchase price. = Coupon Rate x 100

Purchase PriceE.g. 11.50% GOI 2011 at a price of Rs 128

11.50 = 8.98%

128Discount Bonds - Current Yield > CouponPremium Bonds - Current Yield < Coupon.Par Bonds – Current Yield = Coupon

Yield To MaturityA Bond is seen as a series of Cash flowsAll the Cash flows on a bond are discounted to

the present value using Present Value Discount Factors

The rate at which the Present Value of the Future Cash Flows are equated to the Market Price of the Bond is the called as the Yield to Maturity (YTM).

YTM is nothing but the IRR on the bond

Sources of Cash FlowsThe return from a bond consists of 3 components:The regular interest receipts in the form of couponsThe interest from the reinvestment of such receipts The capital gain / loss upon maturity or upon selling

the bond

Yield To Maturity

The return that is earned if held till maturity The YTM on an instrument is dependent upon

a number of factors like:* Coupon Rate;* Premium/Discount on the bond;* Frequency of the compounding;* Balance maturity of the bond;* Redemption Value of the Instrument;

There is an inverse relationship between price

of the security and its Yield to Maturity.

E.g. 10.20% GOI 2007 with a face value of Rs 100 is issued at Rs 110 On 1st Jan 2005, the YTM is calculated as:

62 )1(

10.105............

)1(

10.5

)1(

10.5110

ytmytmytm

Yield To Maturity

Calculation of YTMTrial Value of YTM = 6.45

Time period

IP Date

Coupon

Discount factor

Discounted cash flow

1 12 Jan 05

5.10 0.9688 4.9407

2 12 Jul 05

5.10 0.9385 4.7863

3 12 Jan 06

5.10 0.9092 4.6368

4 12 Jul 06

5.10 0.8808 4.4919

5 12 Jan 07

5.10 0.8532 4.3516

6 12 Jul 07

105.10 0.8266 86.8747

110.0819

Calculation of YTM

Time period

IP Date

Coupon

Discount factor

Discounted cash flow

1 12 Jan 05

5.10 0.9685 4.9395

2 12 Jul 05

5.10 0.9380 4.7840

3 12 Jan 06

5.10 0.9085 4.6334

4 12 Jul 06

5.10 0.8799 4.4876

5 12 Jan 07

5.10 0.8522 4.3463

6 12 Jul 07

105.10 0.8254 86.7486

109.9393

Trial Value of YTM = 6.50

Calculation of YTM

Time period

IP Date

Coupon

Discount factor

Discounted cash flow

1 12 Jan 05

5.10 0.9686 4.9400

2 12 Jul 05

5.10 0.9382 4.7850

3 12 Jan 06

5.10 0.9088 4.6348

4 12 Jul 06

5.10 0.8803 4.4894

5 12 Jan 07

5.10 0.8527 4.3485

6 12 Jul 07

105.10 0.8259 86.8023

110.00

Trial Value of YTM = 6.48

Bonds & YieldsBond & Yields have inverse relationshipBond Prices fall on rise in yieldsBond Prices rise on fall in yieldsYou should have a long position in a

falling yield scenario and short position in a rising yield scenario

In India, shorting in the cash market is prohibited by RBI

Yield Curve Analysis

Yield CurveYield Curve is plot of YTM versus the no of years to

maturity

5.00

5.50

6.00

6.50

7.00

7.50

8.00

1 3 5 7 9 10 13 15 20 25 30Years to Maturity

YT

M

Yield CurveSteepness of the Curve

Steep CurveFlat CurveInverted Curve

Slope of the CurveShifts in the Yield Curve

Parallel ShiftNon-Parallel Shift

Trading StrategiesStrategy 1: Kinks in

yield curve Buy 10.47% 2015 Buy 10.47% 2015 and

sell 10.71% 2016

7.17.27.37.47.57.67.77.87.9

88.1

Maturity & Rate SensitivityLonger Maturity Bonds are more sensitive to

interest rate changes than shorter maturity bondsA 1% Decline in yield results in

Price Rise of Rs 0.95 in a 1 year bond (2006 maturity)

Price Rise of Rs 15 in a 30 year bond (2034 maturity)

You should have a longer maturity bonds in your books in a falling yield scenario and shift to short maturity bonds in a rising yield scenario

Coupon & Rate SensitivityLow Coupon Bonds are more

sensitive to interest rate changes than high coupon bonds

Zero Coupon Bonds have the highest price sensitivity

You should run a portfolio of low coupon stocks in a falling yield scenario and high coupon stocks in a rising yield scenario

Embedded OptionsEmbedded options affect the pricingBonds with Put Option command a

premium to other bondsBonds with Call Option trade at a discount

to other bondsBonds with both Call & Put Option are

priced as shorter term instrumentsIf a 10 Year Bond has a Call & Put Option at

the end of 5 Years, the bond is traded at prevailing 5 Year Yields

Debt ResearchTracking of Liquidity Parameters

Daily Call & Repo RatesCall VolumesLAF VolumesCBLO VolumesRefinance AvailmentInflows from Coupon Payments & RedemptionsOutflows from Auctions, OMOs etcFII investmentsRBI intervention in FX market

Debt ResearchTracking Macro-Economic Parameters

Deposit Growth & Credit OfftakeInterest Rate StanceInflationGovernment Fiscal Conditions

Tax Collection Expenditure Levels WMA levels

Money SupplyBalance of PaymentsCondition of Equity Market

Political Situation