NISM Series XXI A PMS Short Notes – Chapter 4 & 5: Fixed Income Securities and Derivatives

Welcome to Part 3 of 7 in our NISM Series XXI A – PMS exam preparation series. This blog post covers two critical chapters:

Chapter 4: Investing in Fixed Income Securities
Chapter 5: Derivatives

These chapters cover bond pricing, yield measures, duration, and derivative instruments — all of which are regularly tested in the NISM XXI A PMS Distributors Exam.

📖 Missed earlier parts? Part 1: Investments | Part 2: Securities Markets & Stocks

Table of Contents

What is a Bond (Fixed Income Security)?
Determinants of Bond Safety
Bond Pricing and Yield Measures
Measuring Price Volatility of Bonds
Duration (Macaulay Duration)
Introduction to Derivatives
Types of Derivative Products
Structure of Derivative Markets
Purpose of Derivatives
Commodity and Currency Derivatives
Key Concepts: Arbitrage, Margin, Open Interest
Practice Questions

Chapter 4: Investing in Fixed Income Securities What is a Bond / Fixed Income Security?

A bond (or fixed income instrument) creates fixed financial obligations on the issuer. When a company or government issues a bond, it agrees to:

Pay a fixed amount of interest called the coupon periodically
Repay the original principal (called the face value or par value) on the maturity date

These two fixed obligations are what define bonds — making them predictable and lower-risk compared to equity.

Coupon Payment Frequencies

Most bonds: Semi-annual interest payments
Some bonds: Annual, quarterly, or monthly payments
Zero-Coupon Bonds: No periodic interest payment — issued at a deep discount and redeemed at face value

Bonds with Embedded Options

Bond Type	Embedded Option	Who Benefits
Callable Bond	Issuer can redeem before maturity	Issuer (can refinance if rates fall)
Puttable Bond	Investor can sell back before maturity	Investor (exit if rates rise)
Convertible Bond	Investor can convert to equity shares	Investor (upside from equity)

Determinants of Bond Safety

The indenture is the most important document for bond investors — it is the legal agreement between the bond issuer and bondholders. It contains:

Par value (face value)
Coupon rate and payment frequency
Maturity period
Collateral (if any)
Seniority of payments

Credit Ratings

Rating agencies assess the issuer's creditworthiness (probability of default) and assign ratings expressed as grades from AAA to D.

Rating Category	Grades	Risk Level
Investment Grade	AAA, AA, A, BBB	Lower default risk
High Yield / Speculative (Junk)	BB, B, CCC, CC, C, D	Higher default risk

Bond Pricing and Yield Measures Bond Pricing Formula

The price of a bond equals the present value of all future cash flows (coupons + face value), discounted at the Yield to Maturity (YTM).

Bond Price = Σ [Coupon / (1 + YTM/2)^t] + [Face Value / (1 + YTM/2)^2n]

Where: t = each semi-annual period (1 to 2n) n = years to maturity YTM = Yield to Maturity (annualised) Bond Yield Measures — Quick Reference Table

Yield Measure	Formula / Definition
Coupon Yield	Annual Coupon Payment ÷ Face Value × 100
Current Yield	Annual Coupon Payment ÷ Current Market Price × 100
Yield to Maturity (YTM)	Discount rate that equates present value of all future cash flows to current market price. Most comprehensive yield measure.
Yield to Call (YTC)	Estimated return if bond is held only until the first call date (for callable bonds)

Featured Snippet Answer: What is YTM? YTM (Yield to Maturity) is the discount rate that equates the present value of all future cash flows (coupons + face value) of a bond to its current market price. It assumes the investor holds the bond until maturity and reinvests all coupons at the same rate.

Measuring Price Volatility of Bonds

Bond prices change as interest rates change. Here are the four key rules every NISM PMS candidate must memorise:

#	Rule	Explanation
1	Bond prices and interest rates move in opposite directions	When interest rates rise, bond prices fall — and vice versa
2	Bond price volatility is inversely related to coupon rate	Lower coupon bonds are more sensitive to interest rate changes
3	Bond price volatility is directly related to maturity	Longer maturity bonds are more volatile when rates change
4	Bond price movements are asymmetrical for equal yield changes	Price gains from yield decrease > price losses from equal yield increase

Interest Rate Risk is the risk arising from changes in prevailing market interest rates that affect the value of fixed income investments.

Duration (Macaulay Duration)

Duration measures the weighted average time it takes to recover the initial investment in a bond in present value terms. It is the primary tool used to assess a bond's sensitivity to interest rate changes.

Higher duration = more sensitive to interest rate changes
Zero-coupon bonds have duration equal to their maturity
Coupon bonds have duration less than their maturity

Key Formula Note: Modified Duration = Macaulay Duration ÷ (1 + YTM/m), where m = coupon payment frequency per year. Modified duration measures the % change in bond price for a 1% change in yield.

Chapter 5: Derivatives What is a Derivative?

A derivative is a financial contract whose value is derived from an underlying asset. The underlying asset can be:

Financial assets: stocks, bonds, currencies, interest rates, market indices
Commodities: metals (gold, silver, copper), energy (crude oil, natural gas)
Agricultural commodities: wheat, cotton, sugar

Types of Derivative Products 1. Forward Contract

A forward contract is a private agreement between two parties to buy or sell an asset on a specific future date at a price agreed today.

Traded Over-the-Counter (OTC) — not on any exchange
Non-standardised — customised between parties
Carries counterparty risk (the other party may default)

2. Futures Contract

A futures contract is a standardised agreement traded on an exchange to buy or sell a specific asset at a fixed price on a future date.

Feature	Forward	Futures
Trading Venue	OTC (private)	Exchange-traded
Standardisation	Customised	Standardised
Counterparty Risk	High	Low (clearing house)
Settlement	At maturity	Daily mark-to-market
Liquidity	Low	High

3. Options

An option gives the buyer the right (but NOT the obligation) to buy or sell the underlying asset at a stated price (strike price) on or before a specified date, for which the buyer pays a premium.

Type	Right	Buyer's View
Call Option	Right to BUY the underlying	Bullish (expects price rise)
Put Option	Right to SELL the underlying	Bearish (expects price fall)

4. Swaps

A swap is a contract where two parties agree to exchange specific cash flows at one or more future dates.

Interest Rate Swap: Exchange fixed interest rate payments for floating rate payments
Currency Swap: Exchange principal and interest payments in different currencies

Structure of Derivative Markets OTC Derivatives

Traded privately between two counterparties on mutually agreed terms. Non-standardised. Counterparty risk exists as there is no central clearing. Trust-based settlement.

Exchange-Traded Derivatives

Standardised contracts defined by the exchange. Settled through a clearing house. Buyers and sellers maintain margin with the clearing corporation. Lower counterparty risk due to centralised settlement.

Purpose of Derivatives — Three Uses

Purpose	Description	Who Uses It
Hedging	Protecting an existing position from adverse future price movements	Portfolio managers, exporters, importers
Speculation	Taking a position purely based on a view on future price — not backed by an underlying position	Traders, proprietary desks
Arbitrage	Exploiting price differences for the same asset in different markets (Law of One Price)	Arbitrageurs

Law of One Price: Two identical assets cannot trade at different prices in two markets. Arbitrageurs eliminate such differences by buying cheap and selling expensive, bringing prices to parity (minus transaction costs).

Commodity and Currency Derivatives Commodity Derivatives

Allow producers, traders, and processors to hedge against price volatility in commodity markets. Key economic functions:

Risk management through risk reduction and transfer
Price discovery
Transactional efficiency

Currency Derivatives

In currency markets, you always trade in currency pairs — you buy one currency and simultaneously sell another.

Currency Future (FX Future): A standardised contract to exchange one currency for another at a specified rate on a future date
Currency Option: Gives the buyer the right (not obligation) to buy or sell a currency at a specified exchange rate during a defined period

Key Concepts in Derivatives Zero-Sum Game

In a futures contract, one party's gain equals the other party's loss. The sum of both positions' gains and losses is zero (assuming no taxes or transaction costs).

Settlement Mechanism

SEBI has mandated physical settlement (delivery of the underlying stock) for all stock derivatives — earlier, most were cash-settled.

Margining Process

Margin is the collateral (funds or securities) deposited by clearing members before executing trades. It ensures financial commitments of all open positions can be met within a specified period.

Open Interest

Open Interest (OI) = Total number of outstanding derivative contracts that have not yet been settled.

OI increases when a new buyer and new seller enter the market creating a new contract
OI decreases when a buyer and seller close their matching positions
Important: Open Interest is NOT the same as trading volume
OI is a measure of market activity and participant commitment

Practice Questions — Chapters 4 & 5

A bond's price and prevailing interest rates have a _____ relationship.

a) Direct b) Inverse c) No relationship d) Parallel

✅ Answer: b) Inverse
Yield to Maturity is defined as:

a) Annual coupon ÷ face value b) Annual coupon ÷ market price c) Discount rate equating PV of cash flows to market price d) Risk-free rate + credit spread

✅ Answer: c)
A call option gives the buyer:

a) Right to sell b) Obligation to buy c) Right to buy d) Right to exchange currencies

✅ Answer: c) Right to buy
SEBI has mandated which type of settlement for stock derivatives?

a) Cash settlement b) Physical settlement c) Net settlement d) Notional settlement

✅ Answer: b) Physical settlement
Open Interest is:

a) Total contracts traded in a day b) Number of outstanding unsettled derivative contracts c) Same as volume d) Number of buyers in the market

✅ Answer: b)

Key Takeaways — Chapters 4 & 5 at a Glance

Bonds: Fixed coupon + face value repayment at maturity
Bond price ↑ when interest rates ↓ (inverse relationship)
YTM = Most comprehensive yield measure
Higher maturity = Higher price volatility | Higher coupon = Lower price volatility
Duration = Weighted average time to recover investment in PV terms
Derivatives: Forwards, Futures, Options, Swaps
Options: Right (not obligation) | Futures: Obligation to both parties
Three uses: Hedging, Speculation, Arbitrage
Open Interest ≠ Volume
SEBI mandates physical settlement for stock derivatives

Internal Links

Tags: NISM Series XXI A, fixed income securities, bond pricing, yield to maturity, duration macaulay, derivatives futures options, nism equity derivatives, commodity derivatives, currency futures, open interest, nism study material pdf