NISM Series V-D · Chapter 18: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets

L1 · Foundation

Foundation — Interest rates, fixed income securities and the three risks

What an interest rate is and the macro and micro factors that set it, effective, nominal and real rates, the components of a fixed income security, the five classifications of bonds, and the three risks — credit, price and reinvestment — that make a fixed-income security something other than a fixed-return security.

17 min read · Worth 4% of the paper · Written from pages 426–495 of the official NISM workbook · Updated 18 September 2026

18.1 What an interest rate is

"Debt is a concept of 'I OWE YOU' in which the receiver of the favour is willing to return the favour with agreed rate of return for using the favour for the time period." Mr A borrows X from Mr B for three months and repays X + Δ, where Δ = X × R% × 3/12.

The distinction that matters: "LOANS ARE GENERALLY NON-TRADABLE. On the other hand, Mr A can give in writing a 'NOTE'... the 'Note' given by Mr A is treated as a 'DEBT INSTRUMENT' or 'DEBT SECURITIES' which is a TRADABLE SECURITY." In that transaction "Mr A here is the ISSUER, Mr B is the INVESTOR, R is the YIELD or rate of interest."

"the interest rate is essentially a CHARGE TO THE BORROWER FOR THE USE OF AN ASSET... The interest rate is THE COST OF DEBT FOR THE BORROWER AND THE RATE OF RETURN FOR THE LENDER. Interest rates are typically quoted as the annual percentage rate which is generally termed as nominal annual interest rate."

Interest rate is subjective

"If we say, interest rate is 6%, IT DOES NOT PROVIDE ANY CLARITY": a housing loan up to Rs 50 lakh for 15 years may be 6%, a personal loan 7%, a housing loan for 20 years 6.5%, a housing loan above Rs 50 lakh 6.25%, a 5-year government security 5%, and a 5-year AAA corporate bond 5.50%. "the interest rate changes with change in TENOR, AMOUNT, CREDIT RISK etc."

The six macro factors

Demand for money — "When the economy is doing better, there will be MORE DEMAND FOR FUNDS... which will possibly RAISE THE COST OF MONEY. However, during RECESSION... interest rate would show a DEPRESSION."
Supply of money — "typically CONTROLLED BY THE CENTRAL BANK... When the inflation kicks in, the central bank would like to TIGHTEN the supply of money."
Fiscal deficit and government borrowing — "When fiscal deficit is high..., the traders would DEMAND HIGHER INTEREST RATE to support such borrowing and the funds for corporates would be CONSTRAINED."
Inflation — "the savers need COMPENSATION, as the REAL VALUE of their money would DROP, and therefore the nominal interest rate has to be HIGHER."
Global interest rates and foreign exchange rates — "Global investors would ARBITRAGE between various markets... to attract foreign investment..., the domestic interest rate also has to INCREASE."
Central bank actions — "A rise in policy REPO RATE would lead to increase in MONEY MARKET RATES which will affect the BOND MARKET YIELDS."

The six micro factors

Maturity/tenor ("interest rates are POSITIVELY CORRELATED with the tenor"); credit risk ("higher level of perceived credit risk... higher interest rate"); seniority ("the ORDER IN WHICH BONDHOLDERS ARE PAID in case the issuer defaults"); security ("Unsecured bonds not backed by any specific assets, hence pay HIGHER interest rates"); liquidity ("Investors are willing to PAY A PREMIUM for bonds that are EASY TO TRADE"); and investor sentiment ("When sentiments turn NEGATIVE, investors RUSH TO SAFER ASSETS like government securities").

18.1.1 Effective rate

"The effective interest rate can be DIFFERENT FROM ANNUAL INTEREST RATE DUE TO COMPOUNDING EFFECT." On Rs 1,000 at 6 per cent compounded semi-annually: Rs 30 after six months, then Rs 30.90 on Rs 1,030 — Rs 60.90 for the year. "while the nominal rate is 6%, the EFFECTIVE RATE IS 6.09%."

18.1.2 Nominal and real interest rate

"The NOMINAL interest rate is the STATED interest rate (coupon rate)... However, the INFLATION REDUCES THE PURCHASING POWER of money. Therefore, the nominal interest rate has to be ADJUSTED for the rate of inflation... The nominal interest rate adjusted for inflation is called REAL interest rate."

"if the nominal interest rate on a bond is 9% and the inflation rate is 6%, then the real interest rate will be around 3%... a bond with a 7% nominal interest rate will have a REAL interest rate of −2% (approximately), if the rate of inflation is 9%."

18.2 Fixed income securities

"'Fixed Income Securities' are debt instruments that pay a FIXED AMOUNT OF INTEREST - in the form of coupon payments - to investors. The interest payments are made periodically while the principal invested returns to the investor at maturity."

Why they are called "fixed":

"Their LIFE is fixed: they will be redeemed on a SPECIFIED FUTURE DATE... The only exception to this rule is a DUTCH PERPETUAL BOND ISSUED IN 1648. In recent years, some Indian banks and corporates have issued perpetual bonds, which are NOT STRICTLY PERPETUALS BECAUSE THE ISSUER HAS CALL OPTION."
"In most cases, their CASH FLOWS are fixed, too... In some securities (e.g. FLOATING-RATE BONDS), the TIMING of cash flows is known in advance BUT NOT THEIR SIZE because the amount is linked to prevailing interest rate."

18.2.1 Key components

Component	Meaning
Issue Price	"the price at which the bonds are ISSUED... mostly same as face value in case of coupon bearing bond. In case of non-coupon bearing bond (zero coupon bond), security is generally ISSUED AT DISCOUNT"
Face Value (FV)	"also known as the PAR VALUE or PRINCIPAL VALUE. COUPON IS CALCULATED ON THE FACE VALUE"
Coupon / Interest	"the cash flow... at FIXED INTERVALS / PREDEFINED DATES... expressed as a percentage of the face value"
Coupon Frequency	"monthly, quarterly, semi-annually or annually"
Maturity date	"a date in the future on which the investor's principal will be REPAID. From that date, THE SECURITY CEASES TO EXIST"
Call / Put option date	"the date on which issuer or investor can exercise their rights to REDEEM THE SECURITY BEFORE MATURITY"
Maturity / Redemption Value	"If the redemption proceeds are MORE than the face value..., the debentures are redeemed at a PREMIUM. If one gets LESS..., then they are redeemed at a DISCOUNT and if one gets THE SAME..., then they are redeemed at PAR"

18.3 The five classifications of fixed income securities

By type of issuer

Government / Sovereign / Gilt-edged bonds
Municipal bonds
Corporate bonds
Securitized debt

By maturity

Overnight debt; ultra-short-term debt (money market); short term debt; medium term debt; long term debt; staggered maturities; and perpetual bonds (Consol bonds).

By coupon

Plain vanilla bonds; zero-coupon bonds; floating rate bonds; caps and floors; inverse floaters; inflation indexed bonds; step up/down bonds; deferred coupon bonds; and deep discount bonds.

By embedded options

Straight bonds; bonds with a call option; bonds with a put option; and bonds with both call and put options.

By security and by seniority

By security: secured debt, unsecured debt, and credit enhanced bonds. By seniority: senior debt and subordinated debt — "Bond seniority refers to the ORDER IN WHICH BONDHOLDERS ARE PAID in case the issuer defaults or goes bankrupt."

18.5 The risk-free rate and the three risks

The chapter's central warning: "fixed-income security DOES NOT MEAN FIXED-RETURN SECURITY. It merely means that the TIMING of cash flows (and in certain cases, the SIZE of cash flows, too) is FIXED AND KNOWN IN ADVANCE. IT DOES NOT NECESSARILY GUARANTEE A FIXED RETURN."

Take a 7-year bond paying 9 per cent. The 9 per cent is not guaranteed, for three reasons:

1. Credit risk. "The Company may NOT BE ABLE TO PAY interest and principal as per schedule."

2. Price risk (interest rate risk). "The 9% per annum will be the guaranteed return IF the investor HOLDS THE BOND UNTIL ITS MATURITY... If the investor wants his investment back at the end of five years, he CANNOT DEMAND PREPAYMENT from the issuing company but should SELL IT IN THE SECONDARY MARKET... The sale price MAY BE HIGHER OR LOWER than the initial purchase price... This is called interest rate risk / market risk / price risk."

And it cuts both ways for different parties: "a BORROWER who wants to borrow money in future will carry the risk of INCREASE in interest rate, on the other side a LENDER who wants to lend money in future will carry risk of DECREASE in interest rate. Participants like Banks, NBFCs have interest rate exposure on BOTH ASSET AND LIABILITY SIDE."

3. Reinvestment risk. "If your investment horizon is seven years, IDEALLY THERE SHOULD BE NO INTERIM PAYMENTS. If there are..., they are to be REINVESTED until the horizon AT UNKNOWN FUTURE INTEREST RATES... Since the reinvestment rates (and income) are not known in advance, it is called reinvestment risk."

"Additionally, there can be LIQUIDITY RISK, CALL RISK, INFLATION RISK etc."

Where each risk disappears

"MARKET RISK: It DISAPPEARS if the investor holds bond TILL MATURITY DATE when it will be redeemed directly by the issuer at face value."

"REINVESTMENT RISK: It DISAPPEARS if the instrument is a ZERO-COUPON instrument because there is nothing to reinvest in the interim."

"Thus, if a person buys a ZERO-COUPON instrument, WITHOUT ANY EMBEDDED CALL OPTION, issued by a SOVEREIGN GOVERNMENT IN ITS HOME CURRENCY and HELD IT TILL MATURITY, THERE IS NO RISK; and the fixed-income security is ALSO A FIXED-RETURN SECURITY."

The risk-free rate and credit spread

"Consider that the borrower is a sovereign government, and the borrowing is in home currency. There is NO POSSIBILITY OF DEFAULT because the sovereign CAN ALWAYS PRINT MONEY and pay off the lender... The interest rate applicable to such transactions is called 'RISK-FREE' rate, the risk here being the CREDIT RISK."

"For borrowers other than the sovereign..., the interest rate... must be HIGHER... The DIFFERENCE between them is called the 'CREDIT SPREAD'." The illustration: "if the risk-free rate is 8.25% and the credit spread is 0.10% for AAA-rated borrowers and 0.25% for AA-rated, the interest rate applicable... are 8.35% and 8.50%."

"The risk-free rate is THE BENCHMARK FOR ALL VALUATIONS because it represents the RETURN WITHOUT RISK... risk-free rate is the OPPORTUNITY COST of earning return without risk."

Think of it like this

A loan cannot be passed on; a note can

The whole distinction between a loan and a debt security sits in one line: "LOANS ARE GENERALLY NON-TRADABLE. On the other hand, Mr A can give in writing a 'Note'... which is a TRADABLE SECURITY (Mr B can assign the same to someone against appropriate payment before 3 months, if he requires liquidity and wants to exit)." A loan is a private promise between two people; a note is a promise that can change hands. That single feature creates everything in this chapter — a market price, a yield, a term structure, and a reason for interest rate risk to exist at all.

"Interest rate is 6%" tells you nothing

The workbook lists six different 6-ish rates on the same page — a 15-year housing loan at 6%, a personal loan at 7%, a 20-year housing loan at 6.5%, a larger housing loan at 6.25%, a 5-year G-Sec at 5%, a 5-year AAA corporate bond at 5.50%. Its conclusion: "INTEREST RATE IS SUBJECTIVE", because it "changes with change in TENOR, AMOUNT, CREDIT RISK." Asking "what is the interest rate?" is like asking "what is the price of cloth?" — the honest answer begins with which cloth, how much, and for whom.

Fixed income is not fixed return

The single most important sentence in the chapter: "fixed-income security DOES NOT MEAN FIXED-RETURN SECURITY. It merely means that the TIMING of cash flows... is FIXED AND KNOWN IN ADVANCE. IT DOES NOT NECESSARILY GUARANTEE A FIXED RETURN." A 9 per cent bond promises when money will arrive, not what you will finally earn — because the issuer may default, the price may move if you sell early, and the coupons must be reinvested at rates nobody yet knows. A train timetable tells you when the train leaves, not whether you will enjoy the journey.

The one combination with no risk at all

Strip the three risks away one at a time and see what survives. Credit risk vanishes if the borrower is a sovereign in its home currency, since it "can always print money and pay off the lender." Market risk "disappears if the investor HOLDS BOND TILL MATURITY." Reinvestment risk "disappears if the instrument is a ZERO-COUPON instrument." So: "if a person buys a zero-coupon instrument, WITHOUT ANY EMBEDDED CALL OPTION, issued by a SOVEREIGN GOVERNMENT IN ITS HOME CURRENCY and HELD IT TILL MATURITY, THERE IS NO RISK." Every other bond is that ideal minus one or more protections.

Nominal minus inflation, and the minus sign is real

The arithmetic is simple, the consequence is not. r = R − i, so 9 per cent nominal against 6 per cent inflation gives about 3 per cent real. But the workbook drives the point home with a case that keeps recurring in India: "a bond with a 7% nominal interest rate will have a REAL interest rate of −2% (approximately), IF THE RATE OF INFLATION IS 9%." The saver sees money growing at 7 per cent and is nevertheless getting poorer. This is why "When inflation level increases, THE SAVERS NEED COMPENSATION", and why nominal rates must rise with inflation.

Six per cent that is really 6.09

Compounding quietly changes the number on the label. Rs 1,000 at 6 per cent paid half-yearly gives Rs 30, and the next half-year pays 3 per cent on Rs 1,030 = Rs 30.90 — a total of Rs 60.90, so "while the nominal rate is 6%, the EFFECTIVE RATE IS 6.09%." The formula, [(1 + r/n)^n − 1], means that the more often interest is credited, the more the stated rate understates the truth. This is why deposit advertisements quote two rates, and why a comparison between two products must always be on the same compounding basis.

Interest rate risk sits on both sides of the balance sheet

It is tempting to think of interest rate risk as the bondholder's problem alone. The chapter corrects that: "a BORROWER who wants to borrow money in future will carry the risk of INCREASE in interest rate, on the other side a LENDER who wants to lend money in future will carry risk of DECREASE in interest rate. Participants like Banks, NBFCs have interest rate exposure on BOTH ASSET AND LIABILITY SIDE for different tenor." A bank is simultaneously a lender and a borrower, so a rate move helps one book and hurts the other — which is exactly why interest rate derivatives exist, and why the next four chapters are about them.

A perpetual that is not quite perpetual

The chapter's one piece of financial history is also a caution. Bond life is fixed, "the ONLY EXCEPTION to this rule is a DUTCH PERPETUAL BOND ISSUED IN 1648." And about the modern imitations: "some Indian banks and corporates have issued perpetual bonds, which are NOT STRICTLY PERPETUALS BECAUSE THE ISSUER HAS CALL OPTION." An instrument with no stated maturity but an issuer's call is not a promise to pay forever — it is a promise to pay until the issuer finds it convenient to stop. Chapter 7's AT-1 valuation rules exist precisely because that distinction matters.

Key terms in this chapter

Accrued interest: Interest accruing at the coupon rate from the previous coupon date to the settlement date, paid by the buyer to the seller because the issuer pays the whole coupon to whoever holds the bond on the coupon date. It applies only to coupon bonds.
Bond Equivalent Yield (BEY): The annualised but uncompounded yield used for money market instruments, computed as (face value less price) over price, times 365 over days to maturity, on the Actual/365 convention.
Capital market and money market: A capital market trades long-term debt of over a year and equity-backed securities; a money market trades short-term fixed income securities. Money and bond markets together form the fixed income securities market.
Clean price and dirty price: The clean price is the negotiated price; the dirty or invoice price is the settlement price, always higher by the accrued interest. Markets quote clean and settle dirty, because embedding accrual would make quoted prices saw-tooth between coupon dates.
Convexity: The correction to duration for the curvature of the price-yield relationship, since duration estimates a convex relationship with a straight tangent line. It is added whichever way the yield moves, so prices rise more on a fall than they drop on an equal rise.
Credit rating scale: AAA to BBB− is investment grade, BB+ to CCC− is non-investment or junk grade, and D is default; the short-term scale runs A1+ to D. Plus and minus signs mark comparative standing within a category.
Credit risk: The risk that the issuer fails to pay interest or principal as scheduled. It is absent where the borrower is a sovereign government borrowing in its home currency, since it can always print money.
Credit spread: The difference between the rate charged to a non-sovereign borrower and the risk-free rate for the same term — the price of credit risk, quoted as an add-on by credit rating band.
Current yield: Coupon divided by clean price, expressed as a percentage — the simplest and oldest yield measure, assuming a single-period investment.
Day count convention: The rule converting a payment period into a year fraction. Actual/Actual for Indian corporate bonds, 30/360 European for Indian government securities, Actual/365 for the Indian money market and Actual/360 for swap valuation — always including the first day and excluding the last.
Debt security: A tradable written promise to repay borrowed principal with interest — unlike a loan, which is generally non-tradable. The writer is the issuer, the holder is the investor, and the rate is the yield.
Discount yield: The expected return on a discounted instrument held to maturity, using a 30-day month and 360-day year. It matters for trading 91-day T-Bill futures.
Effective interest rate: The rate actually earned once compounding is taken into account, computed as [(1 + annual rate ÷ n)^n − 1] where n is the number of compounding periods.
Face value: The par or principal value on which the coupon is calculated, and the amount the issuer agrees to repay at maturity, excluding interest.
Fixed income security: A debt instrument paying a fixed amount of interest periodically with principal returned at maturity. "Fixed" refers to the timing — and often the size — of cash flows, not to the return.
Holding period return (HPR): The true return on a coupon bond, computable only at the end of the investment period once every reinvestment rate is known — ex post, never ex ante.
Macaulay duration: The time-weighted average of the present value of a bond's future cash flows, measured in years — the weighted average maturity or payback period.
Modified duration: Macaulay duration divided by one plus the periodic yield — the percentage change in the dirty price for a 100 basis point change in yield, in the opposite direction. It is a linear approximation, accurate only for small parallel shifts.
Price risk (interest rate risk): The uncertainty that an investor selling before maturity will realise a price different from what he paid. It disappears if the bond is held to maturity, and it affects borrowers and lenders in opposite directions.
Price Value of a Basis Point (PV01): The change in the price of a bond in currency terms for a one basis point change in yield, computed as dirty price times modified duration divided by 10,000.
Real interest rate: The nominal rate adjusted for inflation, since inflation reduces the purchasing power of money. Approximately nominal rate minus inflation, and it can be negative.
Redemption at par, premium or discount: If redemption proceeds exceed face value the bond is redeemed at a premium; if they fall short, at a discount; if they equal it, at par.
Reinvestment risk: The risk that interim coupons must be reinvested at unknown future rates. It disappears in a zero-coupon instrument, where there is nothing to reinvest.
Risk-free rate: The rate applicable to a sovereign borrowing in its home currency, carrying no credit risk. It is the benchmark for all valuations and the opportunity cost of earning a return without risk.
Spot rate (zero rate): The true realised return, computable in advance only for zero-coupon instruments since there are no interim cash flows to reinvest. A 5-year zero rate of 7.5 per cent means each year's return is automatically reinvested at the same 7.5 per cent.
Term structure of interest rates: Interest rate plotted against term, also called the yield curve. There is a risk-free curve and a separate curve for each credit rating, and the risk-free curve is the most important tool in any valuation.
Term structure shifts: Steepening widens the gap between long and short rates and moves the curve anti-clockwise; flattening narrows it and moves it clockwise; a parallel shift moves all rates equally. A twist has rates moving in opposite directions; a convexity change has them moving the same way by different amounts.
Yield curve shapes: Normal, where long rates exceed short rates; inverted, where short rates exceed long; flat, where yields are constant across maturities; and humped, where medium-term yields exceed both ends.
Yield to maturity (YTM): The discount rate equating the present value of all future cash flows to the current price — the internal rate of return. It assumes the bond is held to maturity and every coupon is reinvested at the same yield, which is its main weakness.

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Original explanatory writing based on the official NISM workbook for Series V-D, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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