The rupee fixed-income market appears to provide a huge number of just such fools. Extrapolating to the other old adage, "A fool and his money are soon parted", it would seem that most of these are on the investor side.

Exim Bank has recently announced a 10-year bond issue with a 13.5 per cent coupon, interest payable annually, with a call and put at each of five and seven years. The bond is being issued at a 0.09 per cent discount, that is, the investor has to put up 99.10 for each of these glorious instruments. The issue opened on December 3, and is scheduled to remain open till December 21.

In analysing this instrument, it is important to recognize that bonds with multiple calls and puts act strangely. This is because in calculating the probability of exercise of each option, one has to take into account the subsequent options. We analysed the bond as follows:

1 First off, sincethe seven-year call and put are not followed by any optionalities, one of the options is certain to be exercised, making the instrument effectively a seven-year bond (instead of a 10-year bond).

2 The call at five years will be exercised if the value of the remaining bond - which is a five-year bond with a call at two years (the seven-year call) - is more than 100. The probability of that multiplied by the average gain on exercise will be the value of this option.

3 The put at five years will be exercised if the value of the remaining bond - a five-year bond with a put at two years - is less than 100. Again, the probability of this occurring multiplied by the average gain on exercise will the value of this option.

4 Note that unlike in the case of the seven-year call and put, the total probability of exercise will not add up to 100 per cent.

Using our zero-coupon gilts curve model and applying a Monte Cario simulation technique (with some adjustments for the fact that the price of the bonds are notnormally distributed), we priced the options as outlined above, and found that the bond prices out to 99.10 at a credit spread of 76 basis points off of risk free. This seems remarkably low, even for a AAA issuer like Exim Bank.

In fact, on December 4, a seven-year balance tenor IDBI bond (14 per cent, 2005) was traded on the NSE at a price of 101.90, which worked out to a credit spread of 172 basis points and a YTM of 14.30 pper cent. Of course, the fact remains that the secondary market is not very liquid - the trade was for an amount of Rs 5 crore, while the primary issue of Exim Bank is for Rs 300 crore - and this difference in credit spread may be explained on liquidity considerations alone.

Working backwards, however, we find that if the "real" credit spread for a AAA borrower was indeed 76 basis points for a seven-year tenor, then the price of the 14 per cent IDBI 2005 bond (assuming liquidity considerations were not an issue) would be around 106.30 (for a YTM of 13.25 per cent). Clearly, this isimplausible.

This suggests that the coupon offered by Exim Bank is somewhat lower than what would be expected. Assuming liquidity considerations are 50 per cent controlling, and splitting the difference, that is, taking the credit spread to 125 basis points (which, in our view, is still low) - would take the required coupon on the Exim Bank issue to 14.02 per cent, and the price on the IDBI bond to 103.95 for a YTM of 13.79 per cent.

It remains to be seen whether the issue is successful, in which case either there is such a huge excess of liquidity that credit-risk considerations (at least for AAA borrowers) have become substantially easier, or, investors are the fools in the market.

(From Mecklai Financial & Commercial Services)