Module I: Financial Securities and Valuation (15 hours)

1.1 Overview of financial economics;

1.2 Importance and role of financial markets in the economy;
1.3 Types of Financial Markets and their Features;
1.4 Money Market Securities: Types of securities in the money market (e.g., Treasury bills, commercial paper, certificates of
deposit),
1.5 Features and characteristics of money market instruments;
1.6 Capital Market Securities: Common and preferred stock;
1.7 Rights and warrants;
1.8 Bonds: Types and Characteristics;
1.9 Bond terms and structure (e.g., face value, coupon rate, maturity);
1.10 Bond Valuation: Discount bond and coupon bond valuation;
1.11 Understanding yield to maturity (YTM), current yield, and bond prices;
1.12 Discount Rates and Time Value of Money;
1.13 Mechanics of NPV Calculations;
1.14 Compound Interest, Annuity, and Perpetuity calculations.
1.1 Overview of financial economics
Financial economics is the study of how people and organizations make decisions about money when the future is uncertain.
It explains how money moves through the economy and how financial markets help connect those who have money with
those who need it.
Financial economics helps answer these simple questions:
1. How should we use our money today for a better future?
People must decide whether to spend money now or save/invest it for future benefits.

2. How are things like stocks, bonds, and other financial assets valued?
Financial economics shows why some investments earn more than others and how prices are determined in markets.

3. How do financial markets work?

Markets such as stock exchanges, bond markets, and banks help transfer money from savers to borrowers.

4. How should individuals and businesses make decisions when the future is risky or uncertain?
Financial economics provides tools to measure risk and choose wisely.
People don’t always act logically. Emotions and biases affect financial decisions.
Financial economics also studies these real-life behaviors.

When many investors start An investor trades stocks An investor refuses to

buying a particular stock, frequently because they sell a losing stock
others join in because they fear think they can “beat the because accepting the
missing out (FOMO). This can market,” even though their loss feels painful, even
push the stock price far above decisions are mostly based though selling it and
its real value and create a on guesswork. This often investing in a better stock
bubble leads to losses. would be smarter.

If a stock was once A person avoids

priced at ₹1,000 but has investing in the stock
fallen to ₹600, an market because they Someone who believes gold
investor may still believe worry they might lose prices will rise ignores news
it “should” go back to money and feel regret— suggesting they may fall and
₹1,000, even though even though staying in only reads articles that support
market conditions have only fixed deposits gives their belief.
changed. very low returns.
Financial economics is about making smart money decisions in the presence of risk, time, and changing market conditions. It
blends economic thinking with financial tools to help individuals, businesses, and governments use their money in the best
possible way.

Definition
“Principles of Corporate Finance” Brealey, Myers & Allen
Financial economics is the study of how financial markets work and how financial decisions are made, focusing on the
valuation of assets, allocation of capital, and the role of risk in investment choices.

“Finance” Bodie, Kane & Marcus

Financial economics explains how individuals and institutions use financial instruments, markets, and models to manage
money over time, especially when future outcomes are uncertain.

“Financial Economics” Zvi Bodie & Robert Merton

Financial economics examines how economic resources are allocated across time and under uncertainty, emphasizing the
pricing of financial assets and the design of financial systems that support efficient decision-making.

“Foundations of Financial Markets and Institutions” Fabozzi, Modigliani & Jones

Financial economics focuses on the behavior of financial markets, the structure of financial institutions, and the way financial
instruments help in transferring funds, managing risk, and supporting economic activity.
1.2 Importance and role of financial markets in the economy
Growth of capital markets
Businesses needs two types of capital : Fixed capital : refers to the money needed to invest in infrastructure such as building,
plant and machinery.
Working capital : refers to the money needed to run business on a day-to-day basis. This may refer to purchase of raw
materials, cost of finishing goods and transport of finished goods to stores or customers.
The financial system helps in raising capital by following: Fixed capital : businesses issue shares and debentures to raise fixed
capital. Financial service providers both public and private invest in these shares to make profit with minimal risk.
Working capital : businesses issue bills, promissory notes, etc to raise short term loans. These credit instruments are valid in the
money markets that exist for this purpose.

Foreign exchange market

These markets enable banks and other financial institutions to borrow or lend sums in other currencies. • Moreover financial
institutions can invest and reap profit from these markets. • Similarly government can also meet its foreign exchange
requirements through these markets.
Government securities
Government use the financial system to raise funds both short term and long term fund requirements.
It issues bonds and bills at attractive interest rate and provides tax concessions.

Trade development
An important economic activity. Traders need finance which is provided by financial system.
Letters of credit are issued for importers thereby helping the country to earn important foreign exchange.

Employment growth
It plays key role in employment growth in an economy.
Businesses and industries are financed by financial system which leads to growth in employment.
This results to an increase in economic activity and domestic trade.
Increase trade further leads to increase in marketing and sales thereby increasing employment.
Balances economic growth
There are primary, secondary and tertiary sector industries and all need funds for growth.
The financial system of the country funds these sectors and provide sufficient fund for each sector.
Thus financial system plays an important role in an economy and no economy can run successfully without sound financial
system.

Households provide labor - receive income - spend

money - firms earn revenue
Firms produce goods - pay households - save and
borrow
Government collects taxes - spends on households and
firms - borrows or saves
Financial Market acts as the central hub that channels all
savings into investments
1.3 Types of Financial Markets and their Features
1.4 Money Market Securities: Types of securities in the money market (e.g., Treasury bills, commercial paper, certificates
of deposit) & 1.5 Features and characteristics of instruments
Call money: funds borrowed/lent for a very short period — effectively overnight (one day).
Notice money: funds borrowed/lent for a short period longer than overnight but up to 14 days (2–14 days).
Term money: funds borrowed/lent for a longer short-term — from a minimum of 15 days up to a maximum of 1 year.
These instruments collectively form an essential segment of the short-term (money) market.
The interest rate on call money is known as the call money rate (or call rate) — a key barometer of short-term liquidity in the
banking system.
Because of their high liquidity and short maturities, these instruments help banks and financial institutions manage day-to-day
(or short-term) mismatches in liquidity — e.g. meeting reserve requirements, dealing with sudden withdrawals, or funding
temporary positions.

Suppose:
Bank A has large inflows during the day (e.g. customers deposit money) & by evening is required to maintain a certain cash
reserve ratio (CRR).
Bank B is short of liquidity because of unexpected withdrawals or funding needs.
Bank B approaches Bank A and borrows ₹50 crore overnight (i.e. for 1 day). They agree on a call money rate of 6% p.a.
For one day, interest = 6% / 365 × ₹50 crore = ₹25,000
Next morning Bank B returns ₹50 crore + ₹25,000 interest to Bank A.
This transaction helps Bank B meet its liquidity requirement temporarily, and Bank A earns a return on its surplus funds —
both meet their short-term needs efficiently.
Determination of the rate:
Imagine that the banking system faces a sudden cash outflow — perhaps due to tax payments or large withdrawals. As a result:
Many banks need short-term funds simultaneously, increasing demand for overnight money.
Supply of lendable funds in the call market becomes scarce.
The call money rate shoots up.
Consequences:
Banks borrowing at high call rates will face higher cost of funds, which may lead them to raise lending rates to customers
(loans, credit lines).
If the high rates persist, short-term liquidity becomes expensive and tight — possibly leading to stress for small banks or
institutions with limited access to funds.
The central bank (RBI) may step in — injecting liquidity via repo operations — to bring down the call rate and ease stress,
restoring smooth functioning of the money market.
Hence a high call rate signals liquidity shortage, and a low rate suggests liquidity surplus. This is why monitoring call / notice
/ term money markets matters.
Treasury Bills
Treasury Bills are short-term money market instruments
Issued by the Government of India through the Reserve Bank of India (RBI)
Used to raise short-term funds to meet temporary budget deficits
They are promissory notes payable on a future date at face value
Example: If a Treasury Bill of ₹100 is issued at ₹96, the investor earns ₹4 as return on maturity.

Nature: Short-term borrowing instrument of the Government

Issued at discount and redeemed at face value
No periodic interest; return comes from discount
Considered risk-free due to government guarantee

Features of Treasury Bills: Treasury Bills are negotiable securities Issued by the Government of India
Issued at a discount and repaid at par value Highly liquid due to short maturity Risk-free investment
Provide assured return Low transaction cost
Classification of Treasury Bills : Based on maturity period, Treasury Bills are of four types:
1) 91-Days Treasury Bills - Introduced in 1992–93
Issued through auction system
Purchased mainly by: RBI
Banks
State governments
Financial institutions
Both competitive and non-competitive bids are allowed
Example: A bank purchases a 91-day T-bill for ₹98 and receives ₹100 after 91 days.

2) 182-Days Treasury Bills - Introduced in 1986

Sold through auctions
Purchased by: Individuals, firms, companies, banks, and institutions
Not purchased by RBI
Example: A mutual fund invests surplus funds in a 182-day T-bill for safe short-term return.
3) 364-Days Treasury Bills - Introduced in April 1992
Auctioned regularly
Similar to 182-day T-bills
Popular among investors due to longer maturity
Example: An insurance company invests idle funds for one year in 364-day T-bills.

Treasury Bills are the safest short-term investment

Important instrument of money market and monetary policy
Suitable for risk-averse investors and institutions
Commercial Bill Market – Bills of exchange
Commercial Bill Market is a market for short-term credit instruments
It deals in bills of exchange used in trade and commerce
Commercial bills are the most important short-term papers in the bill market
Mainly used to provide short-term finance to trade and industry

Example: A wholesaler sells goods to a retailer on credit for 3 months and draws a bill of exchange. This bill is traded in
the commercial bill market.

Bills of exchange - is a written document

It contains an unconditional order
Signed by the drawer
Directs the drawee to pay a certain sum: On a fixed future date, or On demand
Parties to a Bill of Exchange
Drawer – Person who draws the bill (creditor) Mani Ratan (seller) - Drawer
Drawee – Person who accepts and pays the bill (debtor) Ram Lal (buyer) - Drawee
Payee – Person who receives payment Mani Ratan - Payee
Working of a Bill of Exchange
Seller sells goods on credit
Seller draws a bill on buyer
Buyer accepts the bill
Seller may: Hold till maturity, or
Discount it with a bank
On maturity, buyer pays the amount

Example: A trader/Seller needs money immediately, so he discounts the bill with a bank at 12% per annum.

Nature of Commercial Bills: Used for short-term finance

Maturity period usually ranges from 30 to 90 days
They are marketable instruments
Can be discounted and rediscounted

Types of Bills of Exchange: Commercial Bills

Commercial Paper
It is a short-term money market instrument
It is an unsecured promissory note
Issued by companies, banks, insurance and finance companies
Used to raise short-term funds at fixed maturity
Issued either: At a discount, or
With a fixed interest rate

Example: A reputed company issues CP worth ₹50 lakh for 90 days to meet working capital needs.

Nature: Short-term unsecured debt instrument

Negotiable by endorsement and delivery
Issued in physical or dematerialized form
Used mainly by financially strong companies
Features of Commercial Paper
Short-Term Instrument - Fixed maturity
Minimum maturity: 15 days
Maximum maturity: 1 year
Example: A company issues CP for 180 days to finance inventory.

Unsecured Instrument - No collateral security required - Issued only by companies with strong credit rating
Issued at Discount or Interest - CP may be: Issued below face value, or Carry fixed interest
Example: Face value ₹10,00,000, Issue price ₹9,70,000, Return = ₹30,000.
Investors in CP: Individuals Development of Commercial Bill Market in India
Banks RBI introduced reforms in: 1970 & 1990
Companies More institutions allowed to rediscount bills
Financial institutions Still remains underdeveloped compared to advanced economies
Non-Resident Indians (NRIs)

Commercial Papers in India: RBI introduced CP scheme in 1989

Instrument came into operation in 1990
Any company (public or private) can issue CP if it satisfies RBI conditions
Maturity now can be as low as 30 days
CPs are freely transferable
Banks cannot underwrite CP issues
Commercial bills are important tools of short-
term finance
Underwriting means a guarantee to buy unsold securities if investors do
They promote discipline, liquidity, and
not subscribe to the full issue.
efficiency
Need policy support to strengthen bill culture
in India
Certificate of Deposit (CD)
It is a negotiable money market instrument
It represents a bank deposit receipt
Issued for a fixed period and fixed interest rate
CDs are transferable from one party to another
Issued in bearer form or dematerialised form

Example: A bank issues a CD of ₹10 lakh for 1 year at a fixed interest rate to an investor.

Nature: Short-term, interest-bearing instrument

Marketable and transferable
Part of time deposits of banks
High liquidity and safety

Features of Certificates of Deposit: Issued by: Scheduled commercial banks Financial institutions
Maturity ranges from: 91 days to 1 year (banks), 1 to 3 years (term lending institutions)
Issued as promissory notes
Transferability - Freely transferable - Transfer allowed after lock-in period of 30 days
Interest Issued: At a discount, or With fixed interest rate
Example: A CD of ₹10 lakh issued at ₹9.80 lakh gives ₹20,000 return on maturity.

Minimum size of issue: ₹10 lakh - Further amounts in multiples of ₹5 lakh

Who Can Issue CDs? - All scheduled banks (except RRBs) Institutions like:IDBI, ICICI, IFCI8
To Whom Issued – Individuals – Corporations – Companies - Trust funds – Associations - NRIs (non-repatriation basis)

Basis Commercial Paper (CP) Certificate of Deposit (CD)

No Buy-Back or Loan Companies, finance
Issuers Scheduled banks & FIs
companies
Issuing bank cannot buy back CDs
Minimum Investment ₹10 lakh ₹10 lakh
Loans cannot be granted against CDs
Maturity 15 days – 1 year 91 days – 1 year
Individuals, corporates,
Purchasers Individuals, banks, NRIs
NRIs
Lock-in Period 45 days 30 days
1.6 Capital Market Securities: Common and preferred stock
Capital market is a market for long-term funds
It focuses on financing fixed investments
It is an institutional source of long-term capital
Operates in contrast to the money market, which deals with short-term funds

Example: Funds raised to build factories, power plants, highways, or large infrastructure projects

Participants in the Capital Market

Mutual Funds
Insurance Companies
Banks and Financial Institutions
Foreign Institutional Investors (FIIs)
Corporates
Individual Investors

Example: LIC investing in government bonds or shares of large companies

 Objectives / Functions of Capital Market Primary Market
Mobilise long-term savings for investment
Provide equity capital to entrepreneurs
Encourage wider ownership of productive assets
Provide liquidity to investors
Reduce cost of financial transactions

Example: A startup raises funds through shares instead of taking costly bank loans
Secondary Market
(Stock Exchange)
Segments of Capital Market - Capital market is divided into two segments:
• Provides funds directly to
Primary Market • Also called Stock Exchange Market
companies
(New Issue Market) • Deals with existing (old) securities
• Example: IPO of a company
like Zomato or Paytm or • Does not provide funds directly to companies
• Also called New Issue Market Government issuing new • Provides liquidity and marketability
• Deals with new securities issued for the first time
bonds • Example: Buying and selling shares of Reliance
• Helps in capital formation Industries on NSE or BSE
Equity securities represent ownership interest in a company - Equity holders have a residual claim on income and assets
Paid after all liabilities (bondholders, creditors) are settled
Two main types:
Preferred Stock
Common Stock
Investors are primarily interested in common stock
Example: Company earns ₹10 lakh profit - Pays interest and taxes of ₹6 lakh - Remaining ₹4 lakh belongs to equity
shareholders

Features of Preferred Stock: Fixed dividend rate - Dividend is paid before common stock dividend
Usually no voting rights
Dividend is not legally binding
Often callable (company can redeem)
Non-Cumulative Preferred Stock
Cumulative Preferred Stock Unpaid dividends do not accumulate
Unpaid dividends accumulate Missed dividend is lost forever
Must be paid before common stock dividend
Priority of Claims (Liquidation) - Order of payment:
 Bondholders
 Preferred shareholders
 Common shareholders

Example: Company assets = ₹50 lakh - Debts = ₹30 lakh → paid first
Remaining ₹20 lakh: Preferred shareholders paid next
Balance goes to common shareholders

Common Stock – Represents true ownership in the company Rights of Common Shareholders

Holders have voting rights Right to vote in company matters

Dividend is variable Right to receive dividends (if declared)

Highest risk but highest return potential Right to residual assets

Right to participate in growth

Example: Dividend this year = ₹5 per share - Next year = ₹8 per share - Depends on company performance
1.7 Rights and warrants
Rights (Rights Issue)
Meaning: Rights are short-term privileges given to existing shareholders
Allow them to buy new shares of the company
Issued at a price lower than market price
Objective: raise additional capital
Features: Offered only to existing shareholders
Issued in a fixed ratio (e.g., 1:5, 2:3)
Short validity period

Purpose: Raise funds for: Expansion

Debt repayment
Working capital
Protects shareholders from ownership dilution
Example: Market price of share = ₹100 - Rights issue price = ₹70 - Rights ratio = 1:4
A shareholder holding 4 shares can buy 1 new share at ₹70

Value of a Right - Market price = ₹100, Rights price = ₹70, Rights ratio = 1:4, Value of one right = (Market price − Rights
price) ÷ (Number of old shares + 1) = (100 − 70) ÷ 5 = ₹6

Advantages: Cheaper source of finance

No underwriting cost
Existing shareholders benefit
Maintains control structure
Why we cannot simply say: Value of right = ₹100 − ₹70 = ₹30
Because: One right does not give you one share
You need 4 rights to buy 1 new share
So ₹30 benefit must be spread across 4 rights

Total position before rights - 4 shares x ₹100 = ₹400

After exercising rights - Old shares = 4, New shares = 1
Total shares = 5
Total amount invested: Old shares = ₹400 + New share (rights price) = ₹70 - Total investment = ₹470

Theoretical Ex-Rights Price (TERP)

This is the new average price per share, not the market price.
TERP=470/ 5 = ₹94

Calculating the Value of One Right

Each old share had a price of ₹100
After rights, each share is worth ₹94
Loss in value per old share = 100 − 94 = ₹6
This ₹6 is the value of one right
Rights dilute price but not value
Price falls after rights issue – loss - Value of right compensates for that fall - no real loss to shareholder
Rights issue is value-neutral, not price-neutral

Price fall per old share = ₹6

Value of right per old share = ₹6
The loss in share price (₹6) is exactly offset by the value of the right (₹6) attached to that share.
Warrants
Meaning: A warrant is a long-term financial instrument
Gives holder the right (not obligation) to buy shares
At a fixed price within a specified time period
Issued along with bonds or preference shares

Features: Long-term validity

Exercise price is called exercise/strike price
Not compulsory to exercise
Separate trading instrument

Purpose: Reduce borrowing cost

Encourage future equity investment

Example: Exercise price = ₹120, Market price after 3 years = ₹160

Investor exercises warrant and gains = ₹160 − ₹120 = ₹40 per share

If Market Price is Lower - Exercise price = ₹120, Market price = ₹100

Warrant is not exercised - Loss limited to warrant price paid
1.8 Bonds: Types and Characteristics;
A bond is a debt security. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount
of time.
When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the
issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face
value or par value of the bond, when it "matures," or comes due after a set period of time.

Investors buy bonds because:

They provide a predictable income stream. Typically, bonds pay interest on a regular schedule, such as every six months.
If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while
investing.
Bonds can help offset exposure to more volatile stock holdings.

Companies, governments and municipalities issue bonds to get money for various expenses, which may include:
Providing operating cash flow - Financing debt - Funding capital investments in schools, highways, hospitals, and other projects
Types of Bond:
Government Bonds - are issued by the central or state government when they need funds, for example, to build infrastructure
or manage the budget. These are among the safest investments because they are backed by the government
Backed by the government, it is very low-risk - Easy to buy and sell (high liquidity) - Some offer tax benefits - Help diversify
investment mix
Participants: Risk-averse investors, retirees, and anyone looking for steady income and safety.

Corporate Bonds - Companies issue corporate bonds when they need money for things like expansion, new projects, or
working capital. These bonds offer higher interest rates compared to government bonds to make up for the added risk.
Higher returns (usually 8–14%) - Steady income from regular interest payments - Adds variety to portfolio - Actively
traded—so easy to sell if needed
Participants: Investors who want better returns and can handle moderate risk.

Fixed-Rate Bonds - pay a set interest rate for their entire term - steady paycheck.
Stable, predictable income - Low risk and minimal price swings - Great for long-term financial planning (like retirement)
Participants: Conservative investors who prefer consistent income with low risk.
Floating-Rate Bonds - floating interest rate - they adjust at regular intervals based on market benchmarks, such as the repo rate.
Interest income rises if market rates go up - Helps protect against inflation - Can offer better returns in a rising interest rate
environment
Participants: Investors who want protection against inflation and interest rate changes.

Callable Bonds - can be “called” or redeemed early by the issuer, usually when interest rates fall. This helps the issuer
refinance, but the investor may need to reinvest sooner than expected.
Offer higher interest to make up for the call risk (up to 14%) - Can gain in value if not called early - Regular income until
maturity or early call
Participants: Seasoned investors who can manage reinvestment risk and want higher yields.

Puttable Bonds - These bonds gives the investor, the right to sell them back to the issuer before maturity. That means more
control, especially during uncertain times.
You can exit early if needed - Protects investor if the issuer’s credit weakens
Participants: Cautious investors who value flexibility and want to reduce risk.
Inflation-Linked Bonds - adjust both interest and principal based on inflation indicators, such as the Consumer Price Index
(CPI), ensuring your money retains its value over time.
Protect investor’s return from inflation - Guaranteed interest above inflation levels - Helps stabilise your portfolio in
uncertain times
Participants: Long-term investors seeking inflation protection and stability.

Convertible Bonds - start as regular debt but can be converted into company shares later, offering a mix of fixed income and
stock market potential.
Earn interest while holding the bond - Gain from share price growth if converted - Lower risk compared to directly buying
stocks
Participants: Investors who want the safety of bonds but don’t want to miss out on equity gains.

Perpetual Bonds - don’t have a maturity date. They pay interest forever, but you never get the principal back.
Lifetime income stream - Great for long-term investors who don’t need the principal
Participants: Investors focused on continuous income and not concerned about principal return.
Zero-Coupon Bonds - don’t offer regular interest payments but provide a lump sum at maturity, making them ideal for goal-
based planning.
No reinvestment worries - Receive a lump sum at maturity - Ideal for planning future expenses (like education or a house)
Participants : Long-term, risk-averse investors have a specific financial goal in mind.
1.9 Bond terms and structure (e.g., face value, coupon rate, maturity);
A bond is a debt instrument through which the issuer (government, corporation, or institution) borrows funds from investors
and promises to repay the principal (face value) on a specified future date along with periodic interest payments. Bonds
represent a creditor–debtor relationship, not ownership.
It is a debt instrument issued by a government, company, or institution.
By purchasing a bond, an investor lends money to the issuer.
The issuer promises: Periodic interest (coupon) payments
Repayment of principal at maturity
Example: Government of India issues bonds to raise funds for public expenditure.

Structure: 1. Principal / Face Value / Par Value

Principal is the amount originally collected by the issuer at the time of issue.
It represents the amount borrowed by the issuer.
Principal is also known as: Face Value/ Par Value
Example: If a bond has a face value of ₹1,000 - Principal = ₹1,000
2. Issue Price
Issue Price is the price at which a bond is issued to investors.
It may be: Equal to face value
Less than face value
More than face value

Bonds Issued at Par When Issue Price = Face Value

Bond is said to be issued at par
Example: Face Value = ₹1,000 - Issue Price = ₹1,000
Bonds Issued at Discount When Issue Price < Face Value
Difference is called Discount
Example: Face Value = ₹1,000 - Issue Price = ₹900 - Discount = ₹100

Bonds Issued at Premium When Issue Price > Face Value

Excess amount is called Premium
Example: Face Value = ₹1,000 - Issue Price = ₹1,100 - Premium = ₹100
Zero Coupon Bonds - Issued at discount - Do not pay periodic interest - Investor receives face value at maturity
Example: Issue Price = ₹700 - Face Value = ₹1,000 - Maturity Amount = ₹1,000 - No annual interest

3. Maturity of a Bond
Maturity refers to the date on which the bond expires. Maturity date is mentioned in bond quotation.
On maturity: Issuer repays the principal amount
Example of Maturity: GOI Bond quoted as “10.70% GOI Bond 2020”
Coupon rate = 10.70%
Maturity year = 2020
Principal is repaid in the year = 2020

Classification of Bonds Based on Maturity

Short-Term Bonds - Maturity up to 3 years
Medium-Term Bonds - Maturity between 4 to 10 years
Long-Term Bonds - Maturity above 10 years
4. Coupon Rate
Coupon is the annual interest rate offered on a bond.
It is calculated on face value, not market price.
Coupon may be paid:
Annually
Example: Face Value = ₹1,000 - Coupon Rate = 10% - Annual Interest: ₹1,000 × 10% = ₹100 per year

Semi-annually
Example: Face Value = ₹1,000 - Coupon Rate = 10% - Paid semi-annually Interest every 6 months: ₹1,000 × 10% ×
6/12 = ₹50

Coupon and Market Price

Coupon remains constant - Market price may fluctuate
Example: Market Price = ₹900 or ₹1,100 - Coupon is still calculated on ₹1,000
1.10 Bond Valuation: Discount bond and coupon bond valuation;
1.11 Understanding yield to maturity (YTM), current yield, and bond prices;
Yield is useful and extremely important concept in the context of bonds. Yield is a measure of return an investor earns on a
bond. When an investor purchases a bond, he earn a fixed rate of interest or coupon on that bond. Further, he may earn by
buying a bond at low price and selling it at high price. It is also possible that the investor incurs capital losses if he buys high
and sells low. These components constitute his total returns which can be measured in the form of yield.

Current Yield
Current yield is measured by relating the coupon payment on a bond to the current market price of the bond.
Current yield = Annual Coupon Payment/ Current Market price X 100

Coupon payments are fixed and are calculated on the face value of a bond. Thus, irrespective of the price at which investor
buys a bond, he receives a fixed amount as percentage of face value. However, the current yield will increase or decrease
depending upon rise or fall in market price of the bond.
If the market price increases, the current yield on the bond will fall and if decreases, the current yield will rise.
Example 1: A bond having face value of Rs. 100 is trading in the market at Rs. 90. Calculate the current yield on this
bond if coupon is 8%.
Solution: Current yield = Annual Coupon Payment/ Current Market Price X 100
Annual coupon payment = 8/100 X 100 = 8
Current Market price = 90
Therefore, Current yield = 8/90 X 100 = 8.89%

Example 2: A bond having face value of ₹100 is trading in the market at ₹110. Calculate the current yield on this bond
if coupon is 8%.

A major issue with current yield is that it considers only coupon payments. However, coupon payments are just one of the
components of total returns from a bond. The other component of capital appreciation (or loss) is not taken into consideration
to measure the yield.
YIELD TO MATURITY
Yield to Maturity or YTM is the most popular measure of yield in the bond market. This measure of yield factors both coupon
payments as well as capital gain or loss on bond. YTM calculates returns on a bond based on the following assumptions:
i) The investor holds the bond till maturity.
ii) The coupon payments received on bonds are reinvested at an interest rate equal to YTM.

The most important aspect of YTM is that it considers time value of money. In other words, it recognizes the fact that money
received in the distant future is less valuable as compared to money received in the near future.

YTM is a measure of returns that calculates an interest rate which makes the current market price of a bond equal the present
value of future cash flows from that bond. Future cash flows from a bond are yearly (or semi-annual) coupon payments and
principal amount which is received upon maturity.
YTM is the rate at which the present value of the sum of these two payments equals the current market price of the bond.
Symbolically,
Present value of bond:
=C1 / (1+y)1 + C2 / (1+y)2 + … + Cn / (1+y)n + FV / (1+y)n
= n∑i=1 Ci / (1+y)i + FV / (1+y)n

Where:
C = Coupon amount
y = Yield to maturity
n = Number of years to maturity
FV = Face value of bond

Alternatively, YTM can be calculated using the approximate YTM formula as given below:

Where: C = Coupon amount

F–P
Approx. YTM = C + n F = Face value of bond
F+P P = Current market price of bond
2
n = Number of years to maturity
Example 1: A bond having maturity of 5 years, face value of ₹1000, coupon of 8% is currently trading at ₹900.
Calculate the approximate YTM of this bond.

Solution:
n = 5 years
F = ₹ 1,000
C = 8 / 100 × 1,000 = ₹80
P = ₹ 900
Approx. YTM =

= 10.53%
 Pvifa Table

The PVIFA table shows the present value of an annuity of Re.1 (or ₹1) received every period for a given number of periods,
discounted at a specific interest rate. - “What is the present value today of receiving Re.1 every year for n years at r% interest?”
Bond Pricing
A bond’s price is equal to the present value of its expected future cash flows. Thus, it is the present value of the sum of all the
coupon payments received on a bond and the par value of the bond which is returned to the investor after maturity or at the
time of redemption. In order to determine the bond price, the future cash flows on bond (coupon payments plus principal) are
discounted at its yield to maturity.

Example 1: Ms. Prajakta owns a bond with face value of ₹1,000 having 5 years to maturity. The bond has annual
coupon of 7%. The current market price of this bond is ₹980. If Ms. Prajakta expects to earn YTM of 10% on this
bond, should she hold this bond or sell it in the market?
Example 2: Mr. Amin is considering purchase of a bond which is currently selling at ₹ 860 in the market. This bond has
face value of ₹ 1,000 and coupon rate of 8.5%. The bond has 6 years to maturity. What should be the ideal market price
of this bond if Mr. Amin is expecting to earn 10% returns?
1.12 Discount Rates and Time Value of Money
The time value of money states that: ₹1 today is worth more than ₹1 received in the future. This is because money today can be:
Invested
Earn interest
Compensate for risk and inflation

How TVM applies to bonds - A bond promises future cash flows, namely: Periodic coupon payments - Face value at maturity
Since these are received in the future, their values must be discounted to the present.
Thus, TVM is the foundation of bond pricing.
The discount rate represents: Required rate of return
Market interest rate
Yield to maturity (YTM)

It reflects: Time preference

Risk
Opportunity cost

Role of Discount Rate in Bond Valuation

Each coupon payment is discounted using the discount rate
Face value is discounted using the same discount rate

Bond valuation formula using discount rate

n
P= Σ C + F Find today’s value of the amount you will
t = 1 (1 + r)t (1 + r)n
receive at maturity.
Where: P = Bond price
C = Coupon payment
F = Face value
r = Discount rate every coupon the bond will pay and find what it is
n = Maturity worth today
Example
Given:
Face value F = ₹1,000
Coupon rate = 10% per year
C = 10% × 1000 = ₹100
Maturity n = 3 years
Discount rate / required return r = 8% = 0.08
We want to find bond price.

Step 1: Write the cash flows year-wise

Year (t) Cash flow

1 ₹100
2 ₹100
3 ₹100 + ₹1,000 = ₹1,100
Step 2: Discount each cash flow to present value
Year 1 coupon PV
PV1 = 100/ (1.08)1 = 100/ 1.08 = ₹92.59

Year 2 coupon PV
PV2 = 100/ (1.08)2 = 100/ 1.1664 = ₹85.73

Year 3 total PV (coupon + face value)

PV3 = 1100/ (1.08)3 = 1100/ 1.2597 = ₹873.58

Step 3: Add all present values

𝑃 = 𝑃𝑉1 + 𝑃𝑉2 + 𝑃𝑉3
𝑃 = 92.59 + 85.73 + 873.58 = ₹1,051.90
Bond Price 𝑃 = ₹1,051.90
A bond has:
Face value (F) = ₹1,000
Coupon rate = 8% per year
Maturity (n) = 4 years
Market required return (r) = 10%
Find the bond price.
1.13 Mechanics of NPV Calculations
It's like a financial crystal ball that predicts whether an investment will pay off in the long run. By calculating the difference
between the present value of cash inflows and outflows, NPV helps gauge the profitability of an investment.

In simple terms, NPV compares the value of money you expect to earn from an investment (cash inflows) with the money you
spend (cash outflows), after adjusting both to today’s value using a discount rate.
If NPV is positive, the investment is expected to generate returns above its cost, making it potentially profitable. If NPV is
negative, it indicates a likely loss.

Mechanics:
Identify all relevant cash flows
Classify timing of cash flows (t₀, t₁, t₂, …)
Select appropriate discount rate
Discount each cash flow individually
Sum present values
Subtract initial investment
Interpret result
To calculate the NPV of a bond, treat the bond exactly like any investment project:
NPV (for a bond investor) = Present Value of expected bond cash flows − Price you pay today
Where the discount rate is the required return / market yield (often YTM).

NPV of a Coupon Bond

Face value (FV) = ₹1,000
Coupon rate = 8% annually
Maturity = 3 years
Required return / market yield r = 10% per year
Current market price (today) = ₹920
Step 1
Time Cash flow
(t_0) –₹920 (price paid today)
(t_1) ₹80
(t_2) ₹80
(t_3) ₹80 + ₹1,000 = ₹1,080
Step 2: Discount each cash flow to present value

Step 3: Sum present values

Step 4: Calculate NPV (compare value vs market price)

NPV = PV total − Price paid/ Investment

Bond price = PV of coupons + PV of face value (discounted at market yield/required return)

NPV tells whether the bond is under/overvalued at the current market price
1.14 Compound Interest, Annuity, and Perpetuity calculations.
Compound interest recognises that: Money earns interest
Interest itself earns interest
Value grows exponentially over time

It explains how present money grows into future money, and inversely, how future money is reduced to present value.

We calculate compound interest to: Measure growth of a single sum over time
Determine present value of a single future cash flow
Price zero-coupon bonds

Compound interest shows the cost of waiting.

Zero-coupon bond valuation is pure compound interest
One future payment → discounted back to today
Compound Interest with a Bond
Example: Zero-coupon bond
Given
Face value FV = ₹1,000
Time n = 3 years
Yield/discount rate r = 10% per year

Step 1: Understand the cash flow

A zero-coupon bond pays only one cash flow at maturity: ₹1,000 after 3 years.

Step 2: Use the compound interest discounting

Present value is the inverse of compounding: PV = FV/ (1+r)n
An annuity represents: Equal cash flows
At regular intervals
For a finite period
Instead of discounting each payment separately, annuity formulas simplify repeated discounting.

We calculate annuity to: Value regular income streams

Price coupon bonds
Evaluate projects with uniform annual returns
Compare alternatives with equal periodic payments

An annuity converts a series of future payments into a single present value.

Coupon bond (equal coupons each year)
Given
Face value FV = ₹1,000
Coupon rate = 8% annually
Maturity n = 5 years
Yield/discount rate r = 10% per year

A coupon bond has:

Coupons = equal payments each year - annuity
Face value at maturity - single lump sum
Step 1: PV of coupons using annuity formula
PV coupons = C × [1− (1+r)−n / r]

Step 2: PV of face value

PV face = FV/ (1+r)n

Step 3: Bond value today (sum of PVs)

Bond Price = PV coupons + PV face value
A perpetuity represents: Equal payments
Continuing forever
With no maturity date

It is a special case of annuity with infinite life.

We calculate perpetuity to: Value infinite income streams

Price perpetual bonds (consols)

Perpetuity measures the value today of income that never ends.

Perpetual bonds pay coupons forever
Value depends entirely on required return
Perpetuity with a Bond
Example: Perpetual bond (coupon forever)
Given
Annual coupon C = ₹80
Required return r = 10%

A perpetuity means:
Coupon payments continue forever
No maturity repayment

Step 1: Use perpetuity formula

PV = C / r

If investors demand 10%, they will pay ______for a bond that pays _____every year forever.