DEBT & MONEY DEBT & MONEY MARKETSMARKETS

1-3-20091-3-2009

Fixed Income (FI) SecuritiesFixed Income (FI) Securities These are financial claims issued by These are financial claims issued by

governments, government agencies, state governments, government agencies, state governments, corporations, municipalities, banks, governments, corporations, municipalities, banks, and other financial intermediaries.and other financial intermediaries.

The buyers of FI securities are typically large The buyers of FI securities are typically large institutions, such as pension funds, insurance institutions, such as pension funds, insurance companies, commercial banks corporations, companies, commercial banks corporations, mutual funds, and central banks.mutual funds, and central banks.

The cash flows promised to the buyers of FI The cash flows promised to the buyers of FI securities represent contractual obligations of the securities represent contractual obligations of the respective issuers.respective issuers.

Representation of Debt MarketsRepresentation of Debt Markets

Issuer of Debt Securities

FinancialIntermediaries

Institutional andRetail Investors

Contd…Contd… Issuers of securities are incorporated entities with Issuers of securities are incorporated entities with

limited liabilitieslimited liabilities Investors in securities can be either wholesale Investors in securities can be either wholesale

investors (e.g. Mutual funds) or retail investors investors (e.g. Mutual funds) or retail investors (e.g. Households)(e.g. Households)

Intermediaries help in the mobilization of Intermediaries help in the mobilization of resources from the investorsresources from the investors

Instruments are floated in the capital market for Instruments are floated in the capital market for the purpose of raising capital in both debt and the purpose of raising capital in both debt and equityequity

Infrastructure is required for the efficient Infrastructure is required for the efficient functioning of the capital market, consisting of functioning of the capital market, consisting of stock exchanges, depositories and regulatorsstock exchanges, depositories and regulators

Issuers of Debt Securities

Governments and their agenciesGovernments and their agencies CorporationsCorporations Commercial BanksCommercial Banks States and municipalitiesStates and municipalities SPVsSPVs Foreign institutionsForeign institutions

FinancialIntermediaries

Primary dealersPrimary dealers Investment BanksInvestment Banks Credit Rating agenciesCredit Rating agencies

Institutional andRetail Investors

Governments Governments Pension fundsPension funds Insurance companiesInsurance companies Mutual fundsMutual funds Commercial BanksCommercial Banks Foreign institutionsForeign institutions HouseholdsHouseholds

Classification of Debt SecuritiesClassification of Debt Securities

Treasury (Government) securitiesTreasury (Government) securities Agency securitiesAgency securities Corporate securitiesCorporate securities Mortgage-backed securitiesMortgage-backed securities Asset-backed securitiesAsset-backed securities Municipal issuesMunicipal issues Emerging market securitiesEmerging market securities

Terms explainedTerms explained Bid price– the price at which a dealer is willing to buyBid price– the price at which a dealer is willing to buy Offer price– the price at which a dealer is willing to sellOffer price– the price at which a dealer is willing to sell Time to maturity– the remaining life of the claimTime to maturity– the remaining life of the claim Coupon Rate – The rate at which interest is computed on Coupon Rate – The rate at which interest is computed on

the amount of the debt instrumentthe amount of the debt instrument Yield - It is the effective interest paid on a bond, taking into Yield - It is the effective interest paid on a bond, taking into

account the periodicity of the cash flows arising there from account the periodicity of the cash flows arising there from either on account of interest payments or principal either on account of interest payments or principal repayments…repayments…

… … the yield of a security is its Internal Rate of Return (IRR), the yield of a security is its Internal Rate of Return (IRR), i.e the discount rate at which its present value of all its i.e the discount rate at which its present value of all its future cash flows is exactly equal to its market price. future cash flows is exactly equal to its market price.

Yield to Maturity- It is the percentage rate of return paid on Yield to Maturity- It is the percentage rate of return paid on a bond if the investor buys and holds it to maturitya bond if the investor buys and holds it to maturity

Tenor – It is the maturity period of debt instrumentTenor – It is the maturity period of debt instrument Fixed and Floating RatesFixed and Floating Rates

Contd.Contd. Call option– the right of the issuer to call back the issued securities- to buy Call option– the right of the issuer to call back the issued securities- to buy

back the securities at predetermined future timesback the securities at predetermined future times

Put option– the right of the holder to sell back his securities to the issuerPut option– the right of the holder to sell back his securities to the issuer

Bullet securities- Simple non-callable debt securities with a fixed maturity Bullet securities- Simple non-callable debt securities with a fixed maturity and a fixed couponand a fixed coupon

Secured Debt- Secured Debt, such as mortgaged bonds, is backed by Secured Debt- Secured Debt, such as mortgaged bonds, is backed by tangible assets of the issuing company. In the event of financial distress, tangible assets of the issuing company. In the event of financial distress, such assets may be sold to satisfy the obligations of debt holders. such assets may be sold to satisfy the obligations of debt holders.

Unsecured Debt- is not secured by any assetsUnsecured Debt- is not secured by any assets

RisksRisks Interest rate risk –fluctuation in bond pricesInterest rate risk –fluctuation in bond prices Credit risk – promise of payments being made - default freeCredit risk – promise of payments being made - default free Timing risk –Uncertainty about the timing of the cash flows (Security being Timing risk –Uncertainty about the timing of the cash flows (Security being

called back by the issuer) called back by the issuer) Event risk –Decline in issuer’s credit ratingEvent risk –Decline in issuer’s credit rating

Treasury (Government) securitiesTreasury (Government) securities

These are debt securities with These are debt securities with maturities ranging from a few days maturities ranging from a few days to 30 yearsto 30 years

These are regarded as Risk free by These are regarded as Risk free by the investment community, since the investment community, since they are backed by the Governmentthey are backed by the GovernmentT - bills T - notes T - bonds

Maturity <=1 yrMaturity 1-10 yrs Maturity 10-30 yrs

Corporate securitiesCorporate securities

These are securities issued by corporations These are securities issued by corporations for the purpose of raising capitalfor the purpose of raising capital

These are smaller in size ($100 – 200 mn) These are smaller in size ($100 – 200 mn) as compared to treasury issues ($10 – 12 as compared to treasury issues ($10 – 12 bn). However the number of issues is much bn). However the number of issues is much larger.larger.

These entail a number of risks to investors.These entail a number of risks to investors. The presence of credit risk, the relative The presence of credit risk, the relative

lack of liquidity compared to the treasuries, lack of liquidity compared to the treasuries, and the call features cause investors to and the call features cause investors to demand a higher yield on corporate issues.demand a higher yield on corporate issues.

The corporate debt issues fall into The corporate debt issues fall into three groups as per maturity - three groups as per maturity -

Short maturities under a year are in Short maturities under a year are in the money market sector – the money market sector – Commercial PaperCommercial Paper

In the 1-5 year sector are the In the 1-5 year sector are the medium term notes – Floatersmedium term notes – Floaters

Longer maturities come under the Longer maturities come under the Corporate bonds classificationCorporate bonds classification

Mortgage-backed securities- Mortgage-backed securities- Securitized AssetsSecuritized Assets

Securitization is a process by which Securitization is a process by which illiquid assets are transformed into illiquid assets are transformed into very liquid financial instrumentsvery liquid financial instruments

Process of SecuritizationProcess of Securitization

Originator 1

Originator 2

Originator 3

Pool of mortgages

Special Purpose Vehicle (SPV)

Mortgage-backed Securities (MBS)

Financial Intermediaries

Institutional & Retail investors

Credit & liquidityEnhancements(guarantees)

Credit rating agencies(issuance of high credit)

Process ExplainedProcess Explained

Originator: Securitization begins with an Originator: Securitization begins with an institution playing the role of the originator. This institution playing the role of the originator. This institution creates individual mortgages or institution creates individual mortgages or receivables.receivables.

Pooling and standardization: The above assets Pooling and standardization: The above assets (loans) are then pooled. The pooling activity is (loans) are then pooled. The pooling activity is performed to create a large enough loan portfolio performed to create a large enough loan portfolio to interest large institutional investors. to interest large institutional investors.

The individual loans are standardized along The individual loans are standardized along

dimensions like maturity, interest rate, amount of dimensions like maturity, interest rate, amount of loan, geographical location, etc. This makes the loan, geographical location, etc. This makes the cash flows from the pool easier to predict. cash flows from the pool easier to predict.

Contd.Contd.

Guarantees and credit enhancement: For a fee, a Guarantees and credit enhancement: For a fee, a standardized portfolio is then guaranteed by a standardized portfolio is then guaranteed by a federal agency against default. The securitization federal agency against default. The securitization and the guarantee enhance the marketability of and the guarantee enhance the marketability of the securities that are then issued as claims to the securities that are then issued as claims to the guaranteed cash flows from the pool of the guaranteed cash flows from the pool of assets. assets.

Special Purpose Vehicle (SPV) : The : The SPV is created solely to construct the pool of financial assets and then issue the asset-backed securities. The primary objective of creating SPV is to place distance between the originators and the pool of nators and the pool of assets. assets.

Contd.Contd.

This process of pooling, This process of pooling, standardizing, and selling claims on standardizing, and selling claims on guaranteed loans has the effect of guaranteed loans has the effect of improving the liquidity of what might improving the liquidity of what might otherwise be illiquid assets. otherwise be illiquid assets.

Relative Risk exposure of FixedRelative Risk exposure of FixedIncome SecuritiesIncome Securities

Type of Type of RiskRisk

TreasuryTreasury CorporateCorporatess

MBSMBS

Credit Credit RiskRisk

AbsentAbsent VariesVaries Very lowVery low

Interest Interest RiskRisk

VariesVaries VariesVaries VariesVaries

Liquidity Liquidity RiskRisk

Very lowVery low VariesVaries LowLow

Timing Timing RiskRisk

NoneNone HighHigh Very highVery high

Market OrganizationMarket Organization

The organization of markets or The organization of markets or market structure refers to the market structure refers to the institutional arrangement by which institutional arrangement by which buyers of securities are matched buyers of securities are matched with sellers. with sellers.

Classification of market Classification of market organizationsorganizations

Direct SearchDirect Search

Brokered MarketBrokered Market

Dealer Market Dealer Market

Auction MarketsAuction Markets

Direct SearchDirect Search It is an arrangement in which buyers It is an arrangement in which buyers

directly search and identify sellers directly search and identify sellers without the benefit of one or more without the benefit of one or more intermediaries. intermediaries.

For this structure to come about, the For this structure to come about, the frequency of transactions must be so low frequency of transactions must be so low that no intermediary finds it economical that no intermediary finds it economical to provide any service. to provide any service.

The costs of search, location and The costs of search, location and negotiation are fully borne by the negotiation are fully borne by the individual transactor. As a result, this individual transactor. As a result, this market structure may frequently lead to market structure may frequently lead to trades away from the best possible price. trades away from the best possible price.

Contd.Contd.

This type of market structure is not This type of market structure is not of too much interest and works only of too much interest and works only in case of illiquid securities with very in case of illiquid securities with very few buyers and sellers.few buyers and sellers.

Brokered MarketBrokered Market When trading becomes more frequent, When trading becomes more frequent,

brokers may find it economical to brokers may find it economical to Intermediate (for a fee) and match buyers Intermediate (for a fee) and match buyers and sellers at mutually agreed upon terms. and sellers at mutually agreed upon terms.

Thus, the broker acts as an agent to buyers Thus, the broker acts as an agent to buyers and sellers. and sellers.

For a Brokered market to come about, the For a Brokered market to come about, the trading volume in securities must be trading volume in securities must be heavy, and there must be significant heavy, and there must be significant economies of scale in the search costs to economies of scale in the search costs to locate counterparties, so that direct search locate counterparties, so that direct search is a more costly alternative to buyers and is a more costly alternative to buyers and sellers. sellers.

Contd.Contd.

Transactions away from the best Transactions away from the best possible price must not be too costly possible price must not be too costly for buyer and seller, since the broker for buyer and seller, since the broker may not be able to execute the order may not be able to execute the order instantaneously. instantaneously.

The Brokered markets are quite The Brokered markets are quite common in the securities industrycommon in the securities industry

Dealer MarketDealer Market

The secondary market for Treasury is The secondary market for Treasury is organized as a dealer market.organized as a dealer market.

Dealers stand ready to buy and sell treasury Dealers stand ready to buy and sell treasury securities at bid and offer prices that are securities at bid and offer prices that are disseminated to investors either through disseminated to investors either through electronic screen or through telephones. electronic screen or through telephones.

The dealer market structure reduces the time The dealer market structure reduces the time of search compared to brokered markets. The of search compared to brokered markets. The dealers unlike brokers also take outright dealers unlike brokers also take outright positions in securities; hence they are also positions in securities; hence they are also exposed to the market risks on their exposed to the market risks on their inventories. inventories.

Contd.Contd.

The dealer market structure reduces the The dealer market structure reduces the time of search compared to brokered time of search compared to brokered markets. markets.

The dealers unlike brokers also take The dealers unlike brokers also take outright positions in securities; hence they outright positions in securities; hence they are also exposed to the market risks on are also exposed to the market risks on their inventories. their inventories.

Auction MarketsAuction Markets

These are centralized markets in These are centralized markets in which all market participants interact which all market participants interact simultaneously. These reduce further simultaneously. These reduce further the cost of search and provide better the cost of search and provide better bid offer spreads.bid offer spreads.

Properties of market organizationsProperties of market organizations

Transparency- It is the extent to Transparency- It is the extent to which information about trades, which information about trades, quotes and other market information quotes and other market information such as volume of trading are such as volume of trading are available to all players in the market. available to all players in the market.

The cost of obtaining such The cost of obtaining such information is also critical. Hence in a information is also critical. Hence in a well functioning market organization, well functioning market organization, transparency should be present at a transparency should be present at a sufficiently low cost. sufficiently low cost.

Contd…Contd…

Adverse Selection Problem- When Adverse Selection Problem- When intermediaries attempt to match intermediaries attempt to match potential buyers with potential sellers potential buyers with potential sellers in market, they face the risk of in market, they face the risk of trading with either buyers or sellers trading with either buyers or sellers who have more information that the who have more information that the others about the security that is others about the security that is about to be transacted. about to be transacted.

Bid-offer spreadBid-offer spread

Bid price– the price at which a dealer Bid price– the price at which a dealer is willing to buyis willing to buy

Offer price– the price at which a Offer price– the price at which a dealer is willing to selldealer is willing to sell

Case for wider bid-offer spreadCase for wider bid-offer spread

In order to protect themselves against In order to protect themselves against such trades, the intermediaries will such trades, the intermediaries will then charge a wider bid-offer spread to then charge a wider bid-offer spread to all participants in the market. all participants in the market.

This can be a serious factor in the This can be a serious factor in the determination of the bid-offer spread in determination of the bid-offer spread in case relevant information is not case relevant information is not available to all participants or the cost available to all participants or the cost of obtaining information is significantof obtaining information is significant

Contd…Contd…

In addition, the intermediaries routinely take In addition, the intermediaries routinely take large inventory positions in securities and large inventory positions in securities and absorb the risk of price fluctuations before absorb the risk of price fluctuations before such inventories are sold to customers. such inventories are sold to customers.

The risk of the security in a market, the The risk of the security in a market, the ability to offload that risk in other markets, ability to offload that risk in other markets, and the uncertainty in the cost of financing and the uncertainty in the cost of financing such inventories will all contribute both to such inventories will all contribute both to the bid-offer spread and to the depth of the the bid-offer spread and to the depth of the market. market.

Players in G-Sec marketsPlayers in G-Sec markets

TreasuryTreasury Federal Reserve SystemFederal Reserve System Primary dealersPrimary dealers Other dealersOther dealers Interdealer brokersInterdealer brokers InvestorsInvestors

TreasuryTreasury

It is the fulcrum of the G-Sec market. It is It is the fulcrum of the G-Sec market. It is the issuer of short-term and long-term debt the issuer of short-term and long-term debt securities on a regular basis.securities on a regular basis.

It is responsible for borrowing money in It is responsible for borrowing money in capital markets to meet government capital markets to meet government expenditure. It also carries out the task of expenditure. It also carries out the task of tax collection. Thus, the treasury has to tax collection. Thus, the treasury has to decide the amount and type of debt that decide the amount and type of debt that must be sold. must be sold.

The US Treasury issues marketable debt The US Treasury issues marketable debt securities such as T-bills, T-notes and T-securities such as T-bills, T-notes and T-bonds. bonds.

Federal Reserve SystemFederal Reserve System- Lender of - Lender of Last Resort Last Resort

It acts as the agent of the Treasury in issuing It acts as the agent of the Treasury in issuing treasury debt. The conduct of monetary treasury debt. The conduct of monetary policy, including the open Market policy, including the open Market Operations, is also carried out by the Fed Operations, is also carried out by the Fed Reserve. Reserve.

The Fed is vested with the responsibility of The Fed is vested with the responsibility of conducting monetary policies. These policies conducting monetary policies. These policies control the money in the economy and the control the money in the economy and the level and direction of the interest rates. level and direction of the interest rates.

Contd…Contd…

The Fed also acts as the agent of the The Fed also acts as the agent of the Treasury in conducting auctions and Treasury in conducting auctions and handling payments and collections. handling payments and collections.

It also plays the role of regulator in It also plays the role of regulator in matters related to commercial banks. matters related to commercial banks.

Implementation of monetary Implementation of monetary policiespolicies

Increase/decrease in interest ratesIncrease/decrease in interest rates

Change in reserve requirementsChange in reserve requirements

Open market transactions in treasury Open market transactions in treasury securitiessecurities

Increase/decrease in interest ratesIncrease/decrease in interest rates

This is through the discount window This is through the discount window of the Fed where it lends to banks. of the Fed where it lends to banks.

This discount rate is a strong This discount rate is a strong indicator of monetary policy. indicator of monetary policy. Increase in the discount rate reflects Increase in the discount rate reflects the concern over inflationary the concern over inflationary pressures. On the other hand, pressures. On the other hand, decrease in the rate reflects concern decrease in the rate reflects concern about economic weakness. about economic weakness.

Change in reserve requirementsChange in reserve requirements

Reserve requirements refer to the Reserve requirements refer to the percentage of deposits that banks percentage of deposits that banks have to maintain either as cash or on have to maintain either as cash or on deposit with the Fed. This reserve deposit with the Fed. This reserve requirement represents a cost to the requirement represents a cost to the banks. banks.

Open market transactions in Open market transactions in treasury securitiestreasury securities

Reduce/infuse liquidity in the systemReduce/infuse liquidity in the system

Primary dealersPrimary dealers

They are banks, bank subsidiaries They are banks, bank subsidiaries and, diversified investment banks and, diversified investment banks approved to transact directly with approved to transact directly with the Fed in its market operations. the Fed in its market operations.

Other dealersOther dealers

They are not primary dealers; They are not primary dealers; however, they also routinely trade in however, they also routinely trade in G-Sec. E.g: Securities firmsG-Sec. E.g: Securities firms

Interdealer brokersInterdealer brokers

They are important players in the G-They are important players in the G-Sec market. They conceal the Sec market. They conceal the identities of the ultimate sellers and identities of the ultimate sellers and buyers, and act as principals to both buyers, and act as principals to both sides of the trade.sides of the trade.

InvestorsInvestors

Investors throughout the world hold Investors throughout the world hold US Government Securities since they US Government Securities since they are the most liquid and riskless are the most liquid and riskless (perceived to be) securities.(perceived to be) securities.

They include Central Banks, pension They include Central Banks, pension funds, insurance companies, funds, insurance companies, commercial banks, corporations, and commercial banks, corporations, and state governments. state governments.

Proprietary tradingProprietary trading

Dealers take positions in treasury and Dealers take positions in treasury and other securities not only to make a market other securities not only to make a market in these securities, but also to take in these securities, but also to take principal positions. The latter (taking of principal positions. The latter (taking of principal positions) is referred to as principal positions) is referred to as Proprietary trading.Proprietary trading.

Proprietary trading has been increasingly Proprietary trading has been increasingly responsible for a large percentage of responsible for a large percentage of dealers’ profits and risks. dealers’ profits and risks.

Dealers tend to leverage their positions Dealers tend to leverage their positions significantly in their proprietary trading significantly in their proprietary trading activities, i.e. their positions are activities, i.e. their positions are supported by borrowed funds. supported by borrowed funds.

Position ManagementPosition Management

The composition and management of The composition and management of inventory is structured in such a way as to inventory is structured in such a way as to enable the dealer to sell at a price which is enable the dealer to sell at a price which is higher than the cost of acquiring the higher than the cost of acquiring the securities.securities.

Hence, the bid-offer spread is the profit if Hence, the bid-offer spread is the profit if the price risk of inventory is eliminated.the price risk of inventory is eliminated.

This leads to the management of the This leads to the management of the Interest rate riskInterest rate risk

Management of the Interest rate Management of the Interest rate riskrisk

Interest rate risk is a primary source of price Interest rate risk is a primary source of price fluctuations in the G-Sec market. fluctuations in the G-Sec market.

To manage their positions, or to profit from To manage their positions, or to profit from interest rate fluctuations, dealers position interest rate fluctuations, dealers position securities to reflect their assessment of future securities to reflect their assessment of future interest rates. interest rates.

Hence, in case the dealer anticipates fall in Hence, in case the dealer anticipates fall in interest rates, he would take “a long position” interest rates, he would take “a long position” in the security. in the security.

Similarly, in case he expects interest rates to Similarly, in case he expects interest rates to go up, he would take “go short” on the go up, he would take “go short” on the security. security.

Leveraging positions: positions Leveraging positions: positions supported by borrowed fundssupported by borrowed funds

Government securities are liquid and Government securities are liquid and default free, hence they are excellent default free, hence they are excellent collateral.collateral.

So dealers borrow money on a So dealers borrow money on a collateralized basis to buy such collateralized basis to buy such securities. securities.

This enables dealers with limited This enables dealers with limited capital to take much bigger positions capital to take much bigger positions in securities. in securities.

Repo and Reverse RepoRepo and Reverse Repo

Repo- the Rate at which RBI lends to Repo- the Rate at which RBI lends to Banks. 5%Banks. 5%

Reverse Repo- the Rate at which RBI Reverse Repo- the Rate at which RBI borrows from Banks. 3.5%borrows from Banks. 3.5%

Sale-repurchase/purchase-resale Sale-repurchase/purchase-resale agreementsagreements

Since G-Secs serve as excellent Since G-Secs serve as excellent collateral, hence they can be used to collateral, hence they can be used to borrow money (viewed as secured). borrow money (viewed as secured).

Contd…Contd… Hence, a party (Party A) may buy G-Secs from Hence, a party (Party A) may buy G-Secs from

another party (Party B), with an agreement to resell another party (Party B), with an agreement to resell those G-Secs to Party B at a later date. This is those G-Secs to Party B at a later date. This is known as Repo. known as Repo.

Similarly, Reverse Repo would be when a party Similarly, Reverse Repo would be when a party (Party A) in need of funds may sell G-Secs to (Party A) in need of funds may sell G-Secs to another party (Party B), thereby getting cash from another party (Party B), thereby getting cash from Party B, with an agreement to repurchase those G-Party B, with an agreement to repurchase those G-Secs back from Party B at a later date.Secs back from Party B at a later date.

The buyer of the collateral does not deliver funds The buyer of the collateral does not deliver funds equal to the market value of the collateral; a Hair equal to the market value of the collateral; a Hair Cut (or Margin) will be deducted from the total Cut (or Margin) will be deducted from the total amount to be paid and only the remainder is amount to be paid and only the remainder is delivered to the seller. delivered to the seller.

Repo TransactionRepo Transaction

Deliver T-BondDeliver T-Bond Sell T-BondSell T-Bond

Receive Cash equal to Pay Cash plusReceive Cash equal to Pay Cash plus

invoice price minus hair cut repo interestinvoice price minus hair cut repo interest

Repo Dealer

Auctions are used by Governments to Auctions are used by Governments to sell sell debt securitiesdebt securities

Two types of auctions to sell Two types of auctions to sell government debtgovernment debt

Multiple price or multiple-yield Multiple price or multiple-yield auctionauction

Uniform price or Uniform -yield Uniform price or Uniform -yield auctionauction

Multiple price or multiple-yield Multiple price or multiple-yield auctionauction

Here, bidders submit multiple bids i.e. prices at Here, bidders submit multiple bids i.e. prices at which they ant to buy and the amount that they which they ant to buy and the amount that they want to buy at each price. In the multiple-yield want to buy at each price. In the multiple-yield auction, bidders submit yields instead of prices. auction, bidders submit yields instead of prices.

The Treasury will determine the aggregate The Treasury will determine the aggregate demand consisting of the prices and the amounts demand consisting of the prices and the amounts demanded by all bidders at each price. demanded by all bidders at each price.

Then the treasury will choose the bids that are Then the treasury will choose the bids that are highest and allocate the securities at the highest highest and allocate the securities at the highest bid. Whatever supply is left will be sold to the bid. Whatever supply is left will be sold to the next highest bid at that price, and son on until next highest bid at that price, and son on until the supply is exhausted.the supply is exhausted.

This is also known as a Discriminatory auction, This is also known as a Discriminatory auction, since the treasury is choosing the bidders on the since the treasury is choosing the bidders on the basis of their bids. basis of their bids.

Uniform price or Uniform -yield Uniform price or Uniform -yield auctionauction

Here also bidders submit multiple bids. Here also bidders submit multiple bids. The treasury will determine the aggregate The treasury will determine the aggregate

demand of the market by aggregating the demand of the market by aggregating the quantity demanded at each bid. quantity demanded at each bid.

Then the treasury will choose the price (or Then the treasury will choose the price (or yield) at which the supply = aggregate yield) at which the supply = aggregate demand. demand.

At that bid (stop-out price or stop-out At that bid (stop-out price or stop-out yield), all winning bidders get their yield), all winning bidders get their demand. demand.

Bidding StrategyBidding Strategy

Dealers need to position themselves Dealers need to position themselves to bid in auctions. to bid in auctions.

Given the large size of the auctions, Given the large size of the auctions, it is essential that dealers be in a it is essential that dealers be in a position to ascertain the demand for position to ascertain the demand for the forthcoming auction and be able the forthcoming auction and be able to hedge any exposure that may to hedge any exposure that may result from shortfalls. result from shortfalls.

Such shortfalls may arise in a Such shortfalls may arise in a number of number of waysways

ShortfallsShortfalls

Demand led uncertainty Demand led uncertainty

Supply led uncertaintySupply led uncertainty

Demand led uncertaintyDemand led uncertainty

Dealers may be unable to determine with Dealers may be unable to determine with great precision the demand for the auction- great precision the demand for the auction- they know only the demands that go they know only the demands that go through their sales desk and what they see through their sales desk and what they see on broker screens. on broker screens.

It is possible that many investors will It is possible that many investors will directly bid in the auction without directly bid in the auction without participating in any pre-auction activities.participating in any pre-auction activities.

Hence, a few big customer-driven trades Hence, a few big customer-driven trades passing through the sales desk of a single passing through the sales desk of a single bidder could be very valuable private bidder could be very valuable private information to the dealer. information to the dealer.

Supply led uncertaintySupply led uncertainty

Dealers may face significant Dealers may face significant uncertainty in the primary auction uncertainty in the primary auction processes as to the amount that they processes as to the amount that they are likely to be awardedare likely to be awarded

Winner’s CurseWinner’s Curse

It refers to the possibility that the It refers to the possibility that the aggressive bidder in a discriminatory aggressive bidder in a discriminatory auction will end up paying too much auction will end up paying too much relative to the market consensus.relative to the market consensus.

Contd…Contd…

Anticipating this possibility, bidders will Anticipating this possibility, bidders will tend to shade down their bids relative tend to shade down their bids relative to the true value of the security, to to the true value of the security, to minimize the winner’s curse and invest minimize the winner’s curse and invest considerable resources in pre auction considerable resources in pre auction information gathering to learn more information gathering to learn more about the market consensus, so that about the market consensus, so that the bids are not out of line with the the bids are not out of line with the market consensus. market consensus.

Uniform price auction- Uniform price auction- Lesser Lesser relevance of winner’s curserelevance of winner’s curse

However on the other hand, in the case However on the other hand, in the case of the uniform price auction, the of the uniform price auction, the treasury allocates the security at a treasury allocates the security at a common price. common price.

Hence it gives up the power to Hence it gives up the power to discrimate. Bidders can be more discrimate. Bidders can be more aggressive since they pay the same price aggressive since they pay the same price irrespective of their bids. irrespective of their bids.

The incentive to gather pre-auction The incentive to gather pre-auction information is possibly less in this information is possibly less in this auction. auction.

Short squeezeShort squeeze

The term squeeze is used by market The term squeeze is used by market participants to refer to a shortage of participants to refer to a shortage of supply relative to the demand for a supply relative to the demand for a particular securityparticular security

and is seen in the movement of its and is seen in the movement of its price to a level which is out of line with price to a level which is out of line with the prices of comparable securities. the prices of comparable securities.

Squeeze results in higher premiums Squeeze results in higher premiums being paid by traders to borrow being paid by traders to borrow securitiessecurities