a) Yield to Call (YTC)
Yield to Call is the return an investor expects to earn if a bond is called (redeemed) by the issuer before its maturity date. Many corporate and municipal bonds are callable, meaning the issuer can repay the bond before it matures, usually after a lock-in period.
Formula:
YTC = [C + (Call Price – Current Price) / Years until Call] / [(Call Price + Current Price) / 2]
Key Points:
- Used when the bond includes a call feature.
- Calculated like Yield to Maturity (YTM) but uses the call date and call price.
- If interest rates fall, companies may call existing high-interest bonds and issue new lower-interest bonds.
b) Instruments of Monetary Policy
Monetary policy instruments are tools used by central banks (like RBI in India) to control money supply, inflation, and economic growth.
1. Quantitative Instruments (General Tools):
- Repo Rate: Rate at which RBI lends to banks. Affects borrowing cost and liquidity.
- Reverse Repo Rate: Rate at which RBI borrows from banks. Helps in absorbing excess liquidity.
- Cash Reserve Ratio (CRR): Percentage of deposits that banks must keep with RBI. Controls money supply.
- Statutory Liquidity Ratio (SLR): Portion of deposits to be held in gold, government bonds, etc.
- Open Market Operations (OMO): Buying and selling of government securities to manage liquidity.
2. Qualitative Instruments (Selective Tools):
- Margin Requirements: RBI changes margin on loans to control credit in specific sectors.
- Moral Suasion: Persuading banks to follow policies in public interest.
- Credit Rationing: Limits imposed on bank lending to control credit expansion.
c) Nominal and Real Interest Rate
Interest rate is the cost of borrowing money. There are two types:
1. Nominal Interest Rate
This is the stated or advertised interest rate, not adjusted for inflation. For example, if a loan has an interest rate of 10%, that’s the nominal rate.
2. Real Interest Rate
This rate is adjusted for inflation and shows the actual purchasing power of the money earned or paid.
Formula: Real Interest Rate = Nominal Rate – Inflation Rate
Example:
If Nominal Rate = 10% and Inflation = 6%, Real Rate = 4%
Importance:
- Helps in evaluating the real return on investments or cost of borrowing.
- Used by economists and policymakers for decision-making.
d) Efficient Portfolio Frontier
The Efficient Frontier is a concept from Modern Portfolio Theory (MPT) developed by Harry Markowitz. It represents a set of optimal investment portfolios that offer the highest expected return for a given level of risk.
Key Points:
- Drawn as a curve on a graph with risk (standard deviation) on X-axis and return on Y-axis.
- Portfolios below the curve are sub-optimal; those above are not feasible.
- Investors aim to choose a portfolio on the Efficient Frontier based on their risk tolerance.
Application:
- Helps in diversification and maximizing return for a given risk.
- Used by portfolio managers and financial advisors.
Conclusion
These financial concepts help in making informed decisions about investment, risk management, and monetary policy. Understanding the yield to call is crucial for bond investors, while monetary policy tools are essential for economic stability. Differentiating between nominal and real interest rates aids in real return assessment, and the efficient portfolio frontier guides optimal investment strategies.