RBI acts as a banker to the government participating in open market operations, maintaining price stability and ensure adequate flow of credit to productive sectors.
Open Market operations (OMO)
RBI sells or buys government securities in open market transaction depending upon whether it wants to increase liquidity or reduce it.
Reserve Requirements (CRR and SLR)
CRR or cash reserve ratio refers to a portion of deposits which banks have to keep with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk free and secondly it enables RBI to control liquidity in the system and thereby inflation. To control inflation RBI increases CRR and on other hand if it wants growth then RBI reduces it.
SLR is Statutory Liquidity Ration refers to the amount that all banks requires maintaining in cash, gold or approved securities with RBI. This helps RBI to control liquidity in the market.
It is the interest rate which RBI charges to banks for collateralized short term loan.
Reverse Repo Rate
Reverse Repo is the rate which RBI pays to banks. When banks have surplus liquidity and there are not enough borrowings from banks by consumers banks park money with RBI and earn some interest called reverse repo rate.
It is the interest rate at which banks, FIs and other approved entities in the interbank market can get financial accommodation from RBI.
Debt Instruments are contracts in which one party lends money to another on pre determined terms with regards 1) Interest rate, 2) periodicity of interest and 3) tenure of debt after which principal is repayed.
Few common examples of Debt Instruments are Fixed Deposit, NSC, PPF, Bond, Debentures etc
'Bond' is the term used for debt instruments issued by government and 'Debentures' is the term used for instruments issued by corporates or private sector.
There are bonds which are listed on stock exchanges after issuance and are traded regularly on marked to market basis. Trading platform for government securities are NDM - 'Negotiated Dealing System' and WDM- 'Wholesale Debt Market' also called NEAT(National Exchange for Automated Trading) on BSE and NSE.
Terms used in Bonds
Principal : Principal is the actual amount lent or invested or Face value of the bond.
Maturity : Maturity is the length of time until principal amount of bond must be repaid.
Coupon : Is the amount of Interest paid per year expressed as a percentage of the face value of the bond. It is mostly paid semi annually (It is called coupon as intially each bond used to have coupons attached to the bonds and holders receive the interest by stripping off the coupons and redeming them)
Different kinds of bonds
Coupon Bond : Debt obligation of semiannual interest payments generally called bearer bond or vanilla bond
Zero Coupon Bond: This bonds do not pay interest but are issued at deep discount to the face value. this are also known as deep discount bonds
Floating Rate Bond : Bond with variable interest rate is called floating rate bond. The adjustments are tied to certain money market instruments and are set every six months.
Callable Bond : Bond that can be redeemed by the issuer prior to its maturity.
Putable Bond : Bond holder can force the issuer to repurchase the bond before maturity.
Convertible Bond : Bond which can be converted to companys equity at predetermined date at the discretion of the bond holder.
Amortizing Bond: A class of debt in which a portion of principal amount is paid along with periodic interest.
DEBT INVESTMENTS THUMB RULE : Price of Bond is inversely proportional to the interest rate.
Lets look at an example. A 10 year GOI (Government of India) bond offering 7% fixed coupon has been auctioned today with face value of Rs. 100. We assume we bought it on issue and this bond gets listed on exchanges at Rs. 100. Aftere 3 months due to monetary measures taken by RBI the interest rate in market falles by one percentage to 6%.
As the bond is marked to market and traded. it has to be valued every day. so market price post interest rate cut will go up as the bond carries a higher coupon rate then prevailing market interest rate. However if the interest rate would move upward the same bond would be traded at discount price. therefore we follow the first thumb rule of interest rate and current price of a bond move in opposite direction.
Now the question is how much % price of a bond change due to changes in interest rate. in above case 1% rate cut in interest rate will affect all future cash flows to be received from this bond to the remaining tenor. We can then say that all future coupons will be re-invested at a lower interest rate and resulting in fall in YTM on the day of valuation.