Financial markets and instruments for RBI Grade B

The RBI does not just regulate financial markets; it works through them. Every policy rate decision reaches the economy by moving the call rate, then T-bill and bond yields, then bank lending rates and the rupee. That is why F&M objective questions test instrument features (tenors, issuers, discount or coupon) and descriptive questions ask how markets transmit policy or why a market is shallow. This guide covers each market with its Indian institutions, and works through the three calculations that most often appear: a T-bill yield, a bond price change and an option payoff.

The map of markets

Chapter IIID of the RBI Act (Section 45W) gives the RBI power to regulate interest rate products, money market instruments and derivatives, including those based on foreign exchange.

The money market

The money market handles short-term borrowing and lending, mostly to manage liquidity.

The weighted average call rate (WACR) is the operating target of monetary policy, kept within the corridor of the SDF (floor) and MSF (ceiling). Volumes have shifted towards secured markets (TREPS and market repo), so these rates matter as much as call money for gauging liquidity.

Worked example: T-bill yield

A 91-day T-bill with face value ₹100 is bought at ₹98.50.

1. Discount earned = 100 − 98.50 = ₹1.50.
2. Return for 91 days = 1.50 ÷ 98.50 = 0.015228.
3. Annualise: 0.015228 × 365 ÷ 91 = 0.015228 × 4.011 = 0.0611.
4. Yield ≈ 6.11%.

Note the denominator is the price paid (98.50), not the face value. A higher price means a lower yield; this inverse link runs through all fixed-income markets.

Government securities

• Dated securities: fixed or floating coupons, with maturities stretching to several decades.
• T-bills and cash management bills: short-term, discount instruments.
• State development loans (SDLs): market borrowing by state governments.
• The RBI's role: it manages the borrowing programme of the Centre and states, conducts auctions, and appoints primary dealers who underwrite and make markets.
• Trading: secondary trading happens largely on the RBI's electronic platform (NDS-OM), with settlement through CCIL.
• Retail access: the RBI Retail Direct scheme (2021) lets individuals hold government securities directly.
• Foreign access: the Fully Accessible Route (2020) removed investment limits for non-residents in specified government securities.

G-sec yields are the risk-free benchmark: corporate bonds, loans and deposits are priced at a spread over them.

Worked example: bond price and yield

A bond has face value ₹100, a 7% annual coupon and one year to maturity. It pays ₹107 at the end of the year.

1. If the market yield is 7%, price = 107 ÷ 1.07 = ₹100 (at par).
2. If the market yield rises to 8%, price = 107 ÷ 1.08 = ₹99.07.
3. The price fell by about 0.93% for a one-point rise in yield.

For longer bonds the fall is larger. Modified duration gives the approximation: percentage price change ≈ − modified duration × change in yield. A bond with modified duration 6 loses about 6 × 0.5 = 3% of its value if yields rise by 0.5 percentage points. This is why banks holding long G-secs report losses when yields rise, and why interest rate risk is a supervisory concern.

Corporate bonds and equity

The corporate bond market is smaller than the G-sec market and concentrated in highly rated issuers and financial firms. Private placements dominate, through SEBI's electronic book provider platforms. The reasons it is shallow, and why that matters for a bank-based system, are covered in the financial system guide.

The equity market has a primary segment (IPOs, follow-on offers, rights issues and qualified institutional placements) and a secondary segment on exchanges such as NSE and BSE. Shares are held in dematerialised form with the depositories NSDL and CDSL. Indian equities moved to T+1 settlement in phases, completed in January 2023. SEBI regulates issuers, exchanges and intermediaries.

The foreign exchange market

• Governed by the Foreign Exchange Management Act, 1999; the RBI regulates the market and licenses authorised dealers.
• The rupee is market-determined with RBI intervention to curb excessive volatility, not to defend a level.
• The current account is convertible (since 1994); the capital account is partially convertible, with limits by type of flow.
• Instruments: spot, forwards, currency swaps, options and exchange-traded currency futures.
• An offshore non-deliverable forward (NDF) market in the rupee also exists; the RBI has allowed banks to participate through IFSC units, which links onshore and offshore prices.

Derivatives

Worked example: option payoff

An investor buys a call option on a share with a strike of ₹100, paying a premium of ₹5.

1. At expiry the share is ₹112. Payoff = 112 − 100 = ₹12. Profit = 12 − 5 = ₹7.
2. At expiry the share is ₹103. Payoff = ₹3. Profit = 3 − 5 = −₹2 (a loss, but smaller than the premium).
3. At expiry the share is ₹95. The option is not exercised. Loss = ₹5, the premium.
4. Break-even price = strike + premium = ₹105.

The buyer's loss is capped at the premium; the seller's loss is not. Derivatives let firms hedge, but leverage can magnify losses, which is why margins, position limits and central clearing exist.

How markets transmit monetary policy

1. The MPC changes the repo rate; the RBI adjusts liquidity so the WACR moves with it.
2. Other money market rates (TREPS, CP, CD, T-bill yields) follow within days.
3. Bond yields adjust, more at the short end; the yield curve shifts or changes shape.
4. Bank lending rates move: quickly on loans linked to external benchmarks, slowly on those linked to the bank's own cost of funds (MCLR).
5. The exchange rate and asset prices react through capital flows and expectations.

Transmission is faster when markets are deep, liquid and connected. Shallow corporate bond markets and administered small savings rates slow it.

Model answer outline (15 marks)

Question: Explain how a change in the policy repo rate is transmitted through financial markets. What slows transmission in India?

1. Introduction: the operating target (WACR) and the corridor.
2. Money market: WACR, TREPS, CP and CD rates.
3. Bond market: short-end yields first; the yield curve; bank treasury income.
4. Credit market: external benchmarks versus MCLR; deposit rates.
5. Exchange rate and asset prices.
6. Frictions: fixed-rate deposits repricing slowly; small savings rates; competition for deposits; liquidity conditions; shallow bond market.
7. Conclusion: deeper, more integrated markets make monetary policy more effective.

Practice questions

1. What are the tenors of T-bills issued by the Centre?
   • 91, 182 and 364 days.
2. A 182-day T-bill of face value ₹100 is bought at ₹97. What is its approximate annualised yield?
   • About 6.2%. 3 ÷ 97 = 0.03093; × 365 ÷ 182 = 0.0620.
3. Who runs TREPS?
   • The Clearing Corporation of India (CCIL).
4. A bond has modified duration 8. Yields fall by 0.25 percentage points. What happens to its price?
   • It rises by about 2%. 8 × 0.25 = 2.
5. A put option has strike ₹200 and premium ₹8. What is the buyer's profit if the price at expiry is ₹180?
   • ₹12. Payoff 20, minus premium 8.
6. What is the tenor range of notice money?
   • 2 to 14 days.

What to do next

• Rewrite the money market table from memory, with tenors and issuers.
• Redo the T-bill and bond examples with your own numbers.
• Read the money market guide and the liquidity management guide for the RBI's operations in these markets.