A proper trading system for junk bonds as is available for GSECS be set up and introduce RTGS. This enables a trading market and establishes a speculative element so very critical to development of any market.

Risk return must equate.

Risk Return Equation

To assess the risk a bond carries, we need to find: -

Default probabilities

Ratings transition probabilities

Assessment of the net spread over treasury security.

For measuring the default, we suggest the following model: -

The first variable proposed for the model is the firm's cash flow, which, by falling, may signal the beginning of forthcoming financial difficulties. Because a firm's overall risk hinges on the success of its projects, we expect the risk of default to vary directly with the firm's cash flow. Indeed, when a project turns sour and the cash flow is reduced, a firm would find it increasingly difficult to honor its debt obligations on time. As a result, it is expected that the probability of default to be negatively correlated with the firm's cash flow. Instead of relying on the absolute cash flow, we use the cash flow margin which is computed as the sum of quarterly net profit before extraordinary items and quarterly depreciation and amortization, divided by quarterly net sales. This is then multiplied by 100 to yield a percentage figure.

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* Contributed by -
Saurabh Joshi & R. T. Sivasubramaniyan,
PGDM - II Finance,
SCMHRD, Pune.