Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets — NISM V-D

Module 3 (20% overall) opens with the fixed-income foundation (6 marks). Before you can trade an interest-rate derivative you must understand its underlying — bonds, whose prices move inversely to interest rates. This chapter covers how a bond's price is the present value of its cash flows, the difference between coupon, current yield and yield-to-maturity, the shape of the yield curve, credit risk and spread, and duration as the core measure of rate sensitivity.

Foundation

A fixed income security (bond) pays scheduled cash flows — periodic coupons and the face value at maturity. Its price is the present value of those cash flows discounted at the market yield, so price and yield move inversely: when yields rise, existing bond prices fall, and vice versa. Coupon is the fixed contractual rate on face value; current yield is annual coupon ÷ market price; yield-to-maturity (YTM) is the single discount rate that equates the bond's price to the present value of all its cash flows — the truest "return if held to maturity." Accrued interest — coupon earned since the last coupon date — applies to coupon-bearing bonds, not to zero-coupon bonds (which pay no coupon).

Deep Dive

The term structure (yield curve) plots yield against maturity. When long-term rates exceed short-term rates the curve is normal/positive (upward sloping); when short exceeds long it is inverted/negative; when they are equal it is flat. Credit risk is the risk the issuer fails to pay; the credit spread is the extra yield a risky bond offers over a risk-free government bond of the same maturity — literally "the price of credit risk." Lower ratings mean higher credit risk and wider spreads: a BBB bond carries more credit risk than an A, which carries more than a AAA. Duration measures price sensitivity to yield: modified duration says approximately how much a bond's price moves for a 1% change in yield. Higher coupon and shorter maturity both REDUCE duration (more cash arrives sooner), so raising a bond's coupon lowers its modified duration, all else equal.

Worked example

Worked example — why price and yield move opposite ways A bond pays a fixed ₹8 coupon a year on ₹100 face, with 3 years left, currently priced near par (₹100) at an 8% market yield. Now the market yield rises to 10%. The bond still pays only ₹8 — below the ₹10 a new bond of the same risk now pays — so buyers will only take it at a discount. Its price falls (to roughly ₹95) so that its yield-to-maturity climbs to 10% and matches the market. Conversely, if the market yield falls to 6%, this bond's fixed ₹8 coupon is now attractive, so its price rises above par (to roughly ₹105) until its YTM drops to 6%. Same cash flows, opposite price moves — driven entirely by the yield. And a higher-coupon bond would move LESS for the same yield change, because more of its value arrives sooner (shorter duration).

Real-world scenario

Real-world scenario — the duration surprise A retiree, Mrs. Krishnan, is sold a "safe government bond fund" and assumes safe means stable. The fund holds long-dated (high-duration) G-Secs. Over six months the RBI raises rates and the fund's NAV falls 6% — on government bonds with zero default risk. What happened? Rates rose, so existing bond prices fell, and because the fund's duration was high the fall was large. There was no credit event — this was pure interest-rate (duration) risk. A distributor who understood Chapter 18 would have set the expectation up front: government bonds are free of default risk but NOT of rate risk, and a long-duration fund can lose value when rates rise. That single conversation is the difference between an informed investor and a betrayed one.

Advanced

Duration is the bridge to the whole of Module 3. A portfolio with high duration swings more when rates move — it is exactly this exposure that interest-rate futures and options are built to hedge. Two subtleties the exam probes: (1) coupon vs duration — because a higher coupon front-loads cash flows, it shortens duration, so among two otherwise-identical bonds the higher-coupon one is LESS rate-sensitive; (2) zero-coupon bonds have duration equal to their maturity (all cash arrives at the end) and no accrued interest. For a distributor, the practical read is: a "long-duration debt fund" is a bet on falling rates and will fall hard if rates rise; a short-duration fund is defensive. Communicating that duration-driven risk in plain language is the job.

Regulatory references

RBI framework for government securities (G-Sec) market
SEBI norms on debt scheme categorisation (duration-based)
Credit rating framework (SEBI-registered rating agencies)

Common mistakes & pitfalls

Assuming "government bond = no risk" — G-Secs are free of credit risk but still carry interest-rate (duration) risk.
Thinking a higher coupon raises duration — a higher coupon LOWERS modified duration (cash arrives sooner).
Applying accrued interest to zero-coupon bonds — they pay no coupon, so no interest accrues.
Confusing current yield with YTM — current yield ignores the pull-to-par and the timing of cash flows; YTM captures both.

Frequently asked

Why do bond prices fall when interest rates rise?

A bond's coupon is fixed. When market rates rise, newly issued bonds pay more, so the old lower-coupon bond is only attractive at a discount. Its price falls until its yield-to-maturity matches the new market rate.

What does the credit spread represent?

The extra yield a risky bond pays over a risk-free government bond of the same maturity — the market's "price" of the issuer's credit risk. Lower-rated issuers pay wider spreads.

If I raise a bond's coupon, what happens to its duration?

It falls. A higher coupon front-loads cash flows, so the bond's price is less sensitive to yield changes — modified duration decreases, all else equal.

Practice questions

Click each question to reveal the answer and explanation.

Q 1

Which of the following has higher credit risk?

(a)Bond rated AAA
(b)Bond rated A
(c)Bond rated BBB
(d)All have the same credit risk

Correct: (c) Bond rated BBB

Lower rating = higher credit risk. Among AAA, A and BBB, the BBB bond is the lowest-rated and therefore carries the most credit risk. "All the same" is the bait — ratings exist precisely because credit risk differs.

Q 2

Credit spread is the price of ____________.

(a)Credit risk
(b)Reinvestment risk
(c)Price risk
(d)All of the above

Correct: (a) Credit risk

The credit spread is the extra yield over a risk-free bond that compensates for the issuer's credit risk — literally the market price of credit risk. Reinvestment and price risk are separate concepts.

Q 3

If the long-term rate is 10% and the short-term rate is 8%, the shape of the term structure of rates is ____________.

(a)Normal / positive
(b)Inverted / negative
(c)Flat
(d)Humped

Correct: (a) Normal / positive

Long-term yield (10%) above short-term yield (8%) gives an upward-sloping curve — a normal/positive term structure. Inverted would be short above long; flat would be equal.

Q 4

The concept of "accrued interest" applies to which of the following?

(a)Zero coupon bond
(b)Coupon bond
(c)Both (a) and (b)
(d)None of the above

Correct: (b) Coupon bond

Accrued interest is coupon earned since the last coupon date — it exists only for coupon-bearing bonds. A zero-coupon bond pays no coupon, so nothing accrues. "Both" is the trap.

Q 5

If the coupon of a bond increases, its Modified Duration will ____________ (other things constant).

(a)Increase
(b)Decrease
(c)May increase or decrease
(d)Remain constant

Correct: (b) Decrease

A higher coupon front-loads cash flows, so the bond's price becomes less sensitive to yield changes — modified duration DECREASES. The intuitive-but-wrong answer is "increase."

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.