Meaning and Concept of Coupons : –
Alike the word debt the Coupon itself suggests the meaning of coupon. In olden days there was a practice to paste stickers on Bond Papers, in our above example A will issue a bond paper with three stickers called as coupons to B. At end of first year B will return one Sticker to A and in return he (A) will pay Rs.8/- to B, similarly at end of second year A will again pay Rs. 8/- to B and will return second sticker and so on. These stickers are called as coupon and this terminology is still in practice while dealing in Bond Papers. In present days of advance technology there is no issue of bonds in physical forms but terminology of coupon is still prevailing.
Trading of Bond Papers in Security Market:
These bond papers can be traded in Security Market, named as Debt market. In accordance with the Securities Regulation Contract act of 1956 there are various instruments which come under the definition of securities, and one of them is Bond. Bond market comes under regulation of SEBI (Securities and Exchange Board of India) where as Gov-sec or Gilt comes under regulation of RBI (Reserve Bank of India).
Case Study – Present Value of Future Cash Flow : –
Further in our above example, with survey of market A agrees to issue bond paper with face value of Rs. 100/- for tenure of 3 years @ coupon of 8% and B agrees to invest in that paper by lending Rs.100 to A. At a latter date interest rates of market for lending and borrowing may fluctuate and when such fluctuation takes place it affects the transaction of A and B both. This is the most crucial part for trading in Bonds, We will further elaborate the aforesaid example to understand the effects such fluctuations.
To understand this mathematics of Bond it is essential to understand the definition of Bond in terms of the sum of the present value of future cash flows. And if we understand this definition then it will be simple for us to understand meaning of Bond Market. It is widely said that in finance many times the words explains better than actions. Here we will study an example to understand the above definition of bond from right hand side to left hand side.
From right to left
Years 0 1 2 3 -100
PV1 7.41 8 FV1
PV2 6.86 8 FV2
PV3 85.73 FV3
B invests Rs. 100/- in bond paper issued by A. In simple language B lends Rs. 100/- to A,
In aforesaid table 2
Row 1 : indicates number of years
PV1 : Present value at the end of 1st year
PV2 : Present value at the end of 2nd year
PV3 : Present value at the end of 3rd year
FV1 : Future cash flow at the end of 1st Year
FV2 : Future cash flow at the end of 2nd year
FV3 : Future cash flow at the end of 3rd year
When B lends money to A it is -100 shown in column 2, row 2. On day one, year is 0, at end of first year B will get Rs. 8/- ie is in column 3 row 3 which is the future value B will get denoted as FV1 Future cash flow after 1 year. Similarly after 2nd year B will get again Rs. 8/- FV2 Future cash flow after 2nd year and Rs. 108/- FV3 Future cash flow of after 3rd year.(0,1,2,3 are the number of years, 8, 8 and 108 are the future cash flows and 7.41,6.86 and 85.73 are the present values of respective future cash flows and 100 is the sum).
Further, if 8% is the interest in market, to get Rs.8/- at this rate for one year we need to invest Rs. 7.41. So that interest on Rs7.41 @ 8% we will get Rs. 0.59 which gives us total of Rs. 8/-. That means Rs. 7.41 is the present value of Rs.8 (after one year) @ 8%, which is 1st year cash flow. Similarly to get Rs.8 after 2 years, we need to invest Rs.6.86 @8% for two years, which shows Rs.6.86 is the present value of Rs.8 @ 8% ie 2nd year cash flow. Similarly Rs.85.73 is the present value of third future cash flow @ 8%. Adding all the present values, 7.41 + 6.86 + 85.73 = Rs.100/- this is how we calculated the current price of bond. The price of bond paper which is with B is Rs.100. It means on day zero neither borrower nor lender is in profit or loss.
Will be posting the 3rd part soon so stay tuned… 🙂
Financial Consultant Stock Analyst & Columnist
Beta Money Management Services