A stock market, equity market or share market is the aggregation of buyers and sellers of stocks (also called shares), w
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Table of contents :
What is Risk Return Analysis?
What are Investment vehicles?
Pitfalls to avoid
Insurance & Annuity
What is risk management?
How stock market works?
How are shares traded?
What is Nifty and Sensex?
What are stocks?
What makes stock price to change?
How to do buying and selling of stocks?
Securities lending – Going short
3)Mutual fund concepts
What are mutual funds?
Mutual Funds: Structure In India
Advantages Of Investing In MFs?
Disadvantages of investing in mutual funds
Types of mutual funds
Growth and dividend options
Payout and reinvestment plans
Systematic Investment Plan(SIP)
Systematic Transfer Plan:
Systematic withdrawal plan(SWP)
What is the concept of NAV in mutual funds?
How is NAV calculated?
How does NAV help investors?
Returns in a mutual fund
Cost involved in MF investing
What is new fund offer?
Taxation of mutual funds
When to sell your funds?
How to select a fund?
How to read fact sheets?
Types of asset classes
Critics of Technical analysis
Importance of support and resistance
Interpreting volumes on a chart
Golden Mean Ratio
Importance of charts
Types of derivative
What are derivatives
How do derivatives work?
Applications of financial derivatives
Potential pitfalls of derivatives
7)Futures & Options
F&O Important terminologies
Synthetic short call
Bull call spread
Bull put spread
Bear put spread
Bear call spread
Future & Forward contract
Moneyness of an option
Types of margins levied in the Futures & Options(F&O) trading
Stock market is a place where shares of pubic listed companies are traded. A stock exchange facilitates stock brokers to trade company stocks and other securities. ... A stock may be bought or sold only if it is listed on an exchange.
Introducation to stock market
Copyright © 2020 Karthikeyan This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out, or otherwise circulated without the publisher's prior written consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser and without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book. All rights reserved. ISBN: 9798586020017
TABLE OF CONTENTS CHAPTER 1: CORE CONCEPTS ........................................................................ 5 ➢
What is Risk Return Analysis? .................................................................. 5
What are Investment vehicles? .................................................................. 7
Pitfalls to avoid .......................................................................................... 7
Financial planning ...................................................................................... 9
Insurance & Annuity ................................................................................ 10
Tax Implications ...................................................................................... 11
What is risk management? ....................................................................... 13
Hedging .................................................................................................... 14
Stop loss ................................................................................................... 15
Private equity ........................................................................................... 17
CHAPTER 2: EQUITY CONCEPTS .................................................................. 18 ➢
How stock market works? ........................................................................ 18
How are shares traded? ............................................................................ 19
What is Nifty and Sensex? ....................................................................... 21
What are stocks? ...................................................................................... 22
What makes stock price to change? ......................................................... 22
How to do buying and selling of stocks? ................................................. 23
Demat ....................................................................................................... 24
Dematerialization ..................................................................................... 25
Insider Trading ......................................................................................... 29
Corporate Actions .................................................................................... 29
IPO’s ........................................................................................................ 38
Securities lending – Going short .............................................................. 41
CHAPTER 3: MUTUAL FUND CONCEPTS .................................................... 42 ➢
What are mutual funds? ........................................................................... 42
Mutual Funds: Structure In India ............................................................. 42
Advantages Of Investing In MFs? ........................................................... 45
Disadvantages of investing in mutual funds ............................................ 47
Types of mutual funds.............................................................................. 50
Growth and dividend options ................................................................... 59
Payout and reinvestment plans ................................................................. 59
Systematic Investment Plan(SIP) ............................................................. 60
Systematic Transfer Plan: ........................................................................ 61
Systematic withdrawal plan(SWP) .......................................................... 62
What is the concept of NAV in mutual funds? ........................................ 62
How is NAV calculated?.......................................................................... 63
How does NAV help investors? ............................................................... 64
Returns in a mutual fund .......................................................................... 64
Cost involved in MF investing ................................................................. 65
What is new fund offer? ........................................................................... 66
Taxation of mutual funds ......................................................................... 66
When to sell your funds? ......................................................................... 68
How to select a fund? ............................................................................... 69
How to read fact sheets? .......................................................................... 78
Portfolio management .............................................................................. 81
CHAPTER 4: ASSET ALLOCATIONS ............................................................. 84 ➢
Types of asset classes............................................................................... 84
Risk profiling ........................................................................................... 85
CHAPTER 5: TECHNICAL ANALYSIS ........................................................... 87 ➢
Critics of Technical analysis .................................................................... 87
Importance of support and resistance....................................................... 89
Interpreting volumes on a chart ............................................................... 89
Golden Mean Ratio .................................................................................. 90
Importance of charts ................................................................................ 91
Fibonacci Retracements ........................................................................... 91
CHAPTER 6: DERIVATIVES CONCEPTS ...................................................... 93
Types of derivative .................................................................................. 93
What are derivatives................................................................................. 98
How do derivatives work? ....................................................................... 98
Applications of financial derivatives ....................................................... 98
Potential pitfalls of derivatives ................................................................ 99
CHAPTER 7: FUTURES & OPTIONS............................................................. 101 ➢
F&O Important terminologies ................................................................ 101
Synthetic short call ................................................................................. 105
Long put ................................................................................................. 106
Short put ................................................................................................. 107
Bull call spread ...................................................................................... 108
Bull put spread ....................................................................................... 109
Bear put spread ...................................................................................... 110
Bear call spread ...................................................................................... 110
Long straddle ......................................................................................... 111
Short straddle ......................................................................................... 112
Long Strangle ......................................................................................... 114
Short Strangle......................................................................................... 116
Future & Forward contract ..................................................................... 118
Moneyness of an option ......................................................................... 122
Types of margins levied in the Futures & Options(F&O) trading ......... 123
CHAPTER 1: CORE CONCEPTS ➢ What is Risk Return Analysis? The concept of risk-return analysis is integral to the process of investing and finance. All financial decisions involve risks of varying degrees. You may expect to earn returns at 15% per annum, from an asset class like equity, but the risk of not achieving that will always be there.
Return is simply a reward for shouldering risks related to investment - greater the risk, more the returns. Returns are measured by how much investors' money has grown over the investment period across asset classes such as equities, ETFs, mutual funds, bonds and corporate FDs. While you cannot gauge returns in advance, you can make an educated guess on the kind of returns that you expect. Most investment expectations depend on what has happened in the past. Unfortunately, history doesn’t always repeat itself! Haven't we all seen the highs of 2007, followed by the lows in 2008? Even if you are reasonable in your investment expectations for returns, there is the possibility that actual investing returns turn out different than expected. You certainly run the risk of losing some or all of your original investment. Why is that? It is because of an uncertain future (e.g., the global economic environment), and uncertainty over the quality and stability of investments. In general, greater the uncertainty, more the risk. Some familiar sources of uncertainty (or risks) that we must absorb, while making investments are:
Business and Industry Risk There might be an industry-wide slowdown or even a global economic 5|Page
recession as we are experiencing now. That presents an uncertain future for any business. A company might see its earnings drop significantly due to management ineptitude or wrong decisions. A drop in earnings may cause the company's stock prices to fall, resulting in investment losses for investors.
Inflation Risk The money you earn today is always worth more than the same amount of money at a future date. This is because goods and services usually cost more in the future due to inflation. So, your investment return must beat the inflation rate. If it merely keeps pace with inflation, then your investment return is not worth much. We have seen inflation soaring up to 11% in 2008. Now, in 2019, it’s at 1-2%. Perhaps, an average inflation rate over the next ten years may work out at 5-6%. There's enough uncertainty here too.
Market Risk Market risk is about the uncertainty faced in the stock market, which primarily invests in equities. Several macro and micro-economic details singularly or plurally - can spook the equity market. We have seen how the massive mandate in elections has re-invigorated the market. On the other hand, a fragmented hung parliament may have caused the market to nosedive. Even for a well-managed business growing profitably, its equity stock may drop in value simply because the overall stock market has fallen.
Liquidity Risk Sometimes you are not able to get out of your investment conveniently and at a reasonable price. For example, in 2008, you may have found it tough to sell your house at a price you wanted. In 2007, however, it was a breeze to have your home sold. There can be a phase when the equity market is merely inactive or volatile to keep investors away. It means you can't sell your investment or get the price you want if you needed to sell it immediately. 6|Page
What are Investment vehicles?
An investment vehicle is a product that investors use to generate positive returns.
Investment vehicles can be low-risk (fixed deposits and bonds) or carry a higher degree of risk as is the case with equity shares, equity derivatives, options, and futures. There are a wide variety of investment vehicles, and many investors choose to hold several types of investment vehicles in their portfolios. This can enable diversification while minimizing risk.
➢ Pitfalls to avoid Successful investors learn to avoid the common pitfalls and follow those insights that can put them well on their way to becoming a better investor.
Buying Low-Priced Stock What sounds better? Buying 1,000 equity shares of Rs.1 each or buying 20 equity shares at Rs.50 each? Most would probably vouch for the former, considering it looks like a bargain as the opportunity for profits increases from owning more equity shares. In reality, the money you make does not depend on how many equity shares you own. Instead, it depends on the amount of money invested. Many investors have a love affair with cheap stocks, but low-priced stocks generally miss a crucial ingredient of past stock market winners: institutional sponsorship. Stocks can't make significant gains without the buying power of mutual funds, banks, insurance companies, and other deep-pocketed investors fuelling their price moves. It's not retail trades of 100, 200, or 300 equity shares that cause a stock to surge higher in price. 7|Page
Institutional investors account for about 70% of the trading volume each day on the exchanges -- so it's a good idea to fish in the same pond as they do. Stocks priced at Rs.10, Rs.20 or Rs.30 per share are not on the radar of institutional investors. Many of these stocks are thinly-traded, so it's hard for mutual funds to buy and sell big volume equity shares. Remember: Cheap stocks are cheap for a reason. Stocks sell for what they’re worth. In many cases, investors who try to grab cheap stocks don’t realize that they're buying a company marred with no institutional sponsorship, slow earnings and sales growth, and a shrinking market share. These are negative traits for a stock to have. Institutions have research teams that seek great opportunities. Since they buy in vast quantities over time, consider piggybacking their choices if you find that these fund managers have better-than-average performance. The reality is that your prospect of doubling your money in Re.1 stock sounds good, but your chances are better of winning the lottery. Hence, focus on institutional-quality stocks.
Avoiding Stocks With High P/E Ratios "Focus on stocks with low P/E ratios. They're attractively valued, and there’s a lot of upsides." How many times have you heard this statement from investment pros? While it's true that stocks with low P/E ratios can go higher, investors often misuse this valuation metric. Leaders in an industry group often trade at a higher premium than their peers for a simple reason: they're expanding their market share faster because of outstanding earnings and sales growth prospects. Stocks on your watch list should have traits of significant stock market winners from the past: leaders in their industry group, top-notch earnings and sales growth, and rising fund ownership - to name a few. A dynamic new product or service doesn't hurt either. Stocks with ‘high’ P/E ratios share a common trait: their performance shows there's plenty of bullishness about the company's prospects.
Letting Small Losses Turn Into Big Ones Insurance policies help us minimize risk when it comes to our health, home or car. In the stock market, most people don't even think about buying insurance policies with individual stocks. However, it's a good practice.
Averaging Down Averaging down means you're buying stock as the price falls in the hope of getting a bargain in the stock market. It's also known as throwing good money after bad or trying to catch a falling knife. Either way, trying to lower your average cost in a stock is another risky proposition.
Buying Stocks In A Down Market Some investors don't pay any attention to the current state of the market when they buy stocks and equity shares, and it’s a mistake. The goal is to buy equity shares and stocks when the major indexes are showing signs of accumulation and to sell when they're showing signs of distribution. Three-fourth of all stocks follow the stock market's trend, watch it each day, and don't go against the trend. It's not hard to tell when the indexes start to show signs of duress. Distribution days will start to crop up in the stock market where the indexes close lower on heavier volume than the day before. In this case, a strong stock market opening will fizzle into weak closes. And leading stocks in the stock market's leading industry groups will start to sell off on heavy volume. When you're buying stocks, make sure you're swimming with the market tide, not against it.
➢ Financial planning Financial planning is the task of determining how a business will afford to achieve its strategic goals and objectives through prudent investments in equity shares, mutual funds and ETFs, among others. Usually, a company creates a financial plan immediately after the vision and objectives have been set. 9|Page
Tasks involved in financial planning: - Assess the business environment - Confirm the business vision and objectives - Identify the types of resources needed to achieve these objectives - Quantify the amount of resource (labor, equipment, materials) - Calculate the total cost of each type of resource - Summarize the costs to create a budget - Identify any risks and issues with the budget set Financial planning is critical to the success of any organization. It provides the business plan with rigor, by confirming that the objectives set are achievable from a financial point of view. It also helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within the budget set.
➢ Insurance & Annuity A promise of compensation for specific potential future losses in exchange for a periodic payment. Insurance is designed to protect the financial wellbeing of an individual, company or other entity in the case of unexpected loss. Some forms of insurance are required by law, while others are optional. Agreeing to the terms of an insurance policy creates a contract between the insured and the insurer. In exchange for payments from the insured (called premiums), the insurer agrees to pay the policyholder a sum of money upon the occurrence of a specific event. In most cases, the policyholder pays part of the loss (called the deductible), and the insurer pays the rest. Examples include car insurance, health insurance, disability insurance, life insurance, and business insurance.
What is an annuity? An annuity is a long-term, interest-paying contract offered through an insurance company or financial institution. An annuity can be ‘deferred’ as a means of accumulating income while deferring taxes, or be "immediate", meaning it pays you income now at fixed or variable interest rates as long as you are living. You can contact your insurance agent for details on current rates.
The Opposite of Life Insurance 10 | P a g e
Annuities are sometimes described as the opposite of life insurance. While they protect you from living too long, life insurance protects you from dying too soon. With an annuity, you are paid as long as you live, but with a life insurance policy, you are paid when you die. With an annuity, the financial risk of living too long is transferred to the insurance company.
A Lifetime Income With the average retirement period lengthening, annuities are gaining importance. Only an annuity can pay you an income you can't outlive, even after all the money you put into the annuity has been exhausted. Therefore, annuities can help you manage your cash flow and provide a safe and competitive means to accumulate funds.
➢ Tax Implications
When it’s stated that an investment may have tax implications, it means that it may affect the tax you pay. It's generally used in reference to your federal income tax return filed with the IRS (& state tax return if your state has an income tax). If receiving a prize has tax implications, it would likely mean that you need to report the income on your federal tax return.
Tax Implications of Stock Options As with any investment, it's considered income. The government levies a tax on income. How much tax you'll ultimately pay and when you'll pay them will vary depending on the type of stock options you're offered, and the rules associated with those options. There are two basic types of stock options. An incentive stock option (ISO) offers preferential tax treatment and must adhere to special conditions set forth by the Internal Revenue Service. This type of stock option allows employees to avoid paying taxes on the stock they own until the equity shares are sold.
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When the stock is ultimately sold, short or long-term capital gains taxes are paid based on the gains earned (the difference between the selling price and the purchase price). This tax rate tends to be lower than traditional income tax rates. The longterm capital gains tax is 10 percent and applies if you sell the equity share after a year of holding with gains above Rs. 1 lakh. The short-term capital gains are added to your income and taxed as per the existing income tax rates.
Nonqualified stock options NQSOs don't receive preferential tax treatment. Thus, when you purchase stock (by exercising options), you will pay the regular income tax rate on the spread between what was paid for the stock and the market price at the time of exercise. Employers, however, benefit because they are able to claim a tax deduction when employees exercise their options. For this reason, employers often extend NQSOs to employees who are not executives.
Other types of options and stock plans In addition to the options discussed above, some public companies also offer Employee Stock Purchase Plans (ESPPs) under Section 423 of the tax code. It permits the employees to purchase company’s stocks at a discounted price (up to 15 percent) and receive preferential tax treatment on the profits earned when the stock is sold later. Many companies also offer stocks as a part of 401(k) retirement plan. This plan allows the employees to set aside some money for their retirement and they’re not taxed on this income until their retirement. Some employers offer an added perk of matching the employee's contribution to the 401(k) plan with the company stocks.
Special tax considerations for people with large gains The Alternative Minimum Tax (AMT) may apply in cases where an employee makes large gains from incentive stock options. You should 12 | P a g e
consult your personal financial advisor to know if this tax is applicable to you or not.
➢ What is risk management? Basically, risk management is the process of identification, analysis and, either acceptance or mitigation of uncertainty about the investments.
Essentially, risk management occurs anytime an investor or fund manager analyses and attempts to quantify the potential for losses in an investment. This enables the investor to take an appropriate action (or inaction) based on the investment objectives and risk tolerance.
Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession of 2008 was largely caused by loose credit risk management of financial firms. In simpler words, risk management is a two-step process - determining the risks in an investment and then handling those risks in a way best-suited to your investment objectives. Ideally, risk management is done on a prioritization basis, wherein the risks with the potential of a bigger loss (or impact) are handled first and risks with lower probability of occurrence (or that can cause a lesser damage) are handled thereafter.
Intangible risk management Intangible risk management identifies the risks that have a 100% probability of occurring but is ignored by the organization till now. Consider these few examples: 1. When deficient knowledge is applied to a situation, a knowledge risk materializes
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2. Relationship risk appears when ineffective collaboration occurs 3. Process-engagement risk may be an issue when ineffective operational procedures are applied
These risks can reduce the productivity of workers and hence decrease cost effectiveness, profitability, service, quality, reputation, and brand value. Intangible risk management allows the risk management team to create immediate value by identifying and reducing the chances of such risks that can reduce the organisation’s productivity.
Methods of risk management: Usually, methods of risk management consist of some elements which are, more or less, performed in the following order: 1. Identify, characterize, and assess threats 2. Assess the vulnerability of critical assets to specific threats 3. Determine the risk (i.e. the expected consequences of specific types of attacks on specific assets) 4. Identify ways to reduce those risks 5. Prioritize risk reduction measures based on a strategy
➢ Hedging Hedging is the process that is used to reduce the risk of incurring losses due to negative outcomes within the stock market.
It is a concept similar to home insurance, wherein you can protect your assets against negative outcomes like fire and burglary, by purchasing an insurance policy. The only difference with hedging is that you are insuring your stocks against market risks, and you are never fully compensated for your loss.
Hedging is most useful under the following circumstances:
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1. If you have commodity investment that is subject to price movements, you can use hedging as a risk management technique 2. It helps set a price level for purchase or sale of an asset prior to the transaction. 3. Hedging will also allow you to make profits from any upward price fluctuations and protect your investments from downward price movements.
➢ Stop loss Stop loss is an order of buying or selling shares, once its price rises above (or drops below) a specified stop loss price. When the specified stop loss price is reached, the stop loss order is entered as a market order (no limit) or a limit order (fixed or pre-determined price).
With a stop loss order, the trader does not have to actively monitor how a stock is performing. However, since the order is triggered automatically when the specified price is reached, the stop loss price could be activated by a short-term fluctuation in a security's price. In a volatile market, the price at which the trade is executed can be much different from the stop loss price in case of a market order. Alternatively, in the case of a limit order, the trade may or may not get executed at all. This happens when there are no buyers or sellers available at the limit price.
Types of Stop Loss order: 1) Stop Loss Limit Order A stop loss limit order is an order to buy a security at no more (or sell at no less) than a specified limit price. This gives the trader some control over the price at which the trade will be executed. However, sometimes, it may prevent the order from being executed at all.
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A stop loss buy limit order can only be executed by the exchange at the limit price or lower. For example, if an investor is short and wants to protect his short position, but doesn't want to pay more than Rs.100 for the stock, he can place a stop loss buy limit order to buy the stock at any price up to Rs.100. By entering a limit order, the investor will not be caught buying the stock at Rs.110 if the price rises sharply. 2) Stop Loss Market Order A stop loss market order is an order to buy (or sell) a security once its price climbs above (or drops below) a specified stop loss price. In other words, a stop loss market order is an order to buy or sell a security at the market price prevailing at the time the stop loss order is triggered. This type of stop loss order gives the trader no control over the price at which the trade will be executed. A sell stop loss market order is an order to sell the stock at the best available price once the price goes below the stop loss price. A sell stop loss price is always below the current market price. For example, if a trader holds a stock currently valued at Rs.100 and is worried that the value may drop, he can place a sell stop loss order at Rs.90. If the share price drops to Rs.90, the exchange will sell the order at the next available price. This can limit the trader's losses (if the stop loss price is at or below the purchase price) or lock in some of the profits. A buy stop loss market order is typically used to limit a loss (or to protect an existing profit) on a short sale. A buy stop loss price is always above the current market price.
Advantages and disadvantages of the stop loss market order: The main advantage of a stop loss market order is that the stop loss order will always get executed. The main disadvantage of the stop loss market is that the trader has no control The main advantage of a stop loss market order is that the stop loss order will always get executed, irrespective of price fluctuations. However, the disadvantage is that the trader has no control over the price at which the transaction will be executed. 16 | P a g e
Conclusion Stop loss orders act like great insurance policies that will cost you nothing, but can save you a fortune. Unless you plan to hold a stock forever, you should consider using them to protect yourself from probable market fluctuations.
➢ Private equity Ownership in a corporation that is not publicly-traded is called private equity. Private equity involves investing in privately-held companies.
Private equity investors are institutional investors and high net worth (HNI) individuals who have a large amount of capital to commit to their investments. Private equity is usually held for an extended period, and trading in it is useful when a company faces imminent bankruptcy. That is because it provides access to substantial capital very quickly. Private equity is an umbrella term for large sums of money raised directly from accredited individuals and institutions, and then pooled in a fund that invests across business ventures. The fund is generally set up as a limited partnership, with a private equity firm as the general partner and investors as limited partners. Private equity firms typically charge substantial fees for participating in the partnership and tend to specialize in a particular type of investment. For example, venture capital firms may purchase private companies, fuel growth and, either sell them to other private investors or take them public. Corporate buyout firms buy troubled public firms, take them private, restructure them and, either sell them privately or take them public again.
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CHAPTER 2: EQUITY CONCEPTS ➢ How stock market works? If you want to buy a share or stock in any publicly-traded company, you'll most likely need the services of a brokerage firm. Though it's possible to buy and sell shares on your own, there are some practical and legal issues associated with this approach. The securities industry is highly regulated. Trading of stocks happens through a stock exchange. These are special markets where buyers and sellers are brought together to buy and sell stocks. The best-known stock exchanges in India are the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). BSE is one of the largest stock exchanges in the world, listing over 4,500 companies. Sensex is a major stock index of BSE, comparable to the DOW industrials in the US. Like BSE, NSE is also based out of Mumbai, and regularly trades in volumes exceeding that of the former. The main stock index of the NSE is S&P CNX Nifty50, or just Nifty50. Apart from equities, NSE also deals with trading of futures, debt and foreign currencies.
When most think of a stock exchange, they picture a scenario of frantic activity, with traders simultaneously jostling for positions, shouting commands, making strange hand signals, and writing up orders. However, behind this frenzied spectacle, lies a methodical and organized system of trading, where the prices of stocks are set purely by the rule of supply and demand in an auction setting. From an investor’s perspective, buying and selling stocks may seem pretty simple. If you’re availing the services of a full-service broker, you can just call him and place an order for ‘X’ number of equity shares of ‘Y’ 18 | P a g e
company. Within a few minutes, you'll receive a confirmation that your order has been completed, and you'll become the proud owner of Y's stocks. However, a lot of action takes place behind the scenes from the moment you place your order and till you receive the confirmation of its execution.
➢ How are shares traded? Stock market is the platform where buyers and sellers interact and decide on a particular stock price and conduct trading. Nowadays, the processes are entirely digital and allow trading from anywhere with functional access to the internet.
Further stock markets are classified into two types: • Primary stock market • Secondary stock market. The primary stock market is where equity shares originate (using an Initial Public Offering). Companies issue an IPO for investors. In the secondary stock market, investors trade previously-issued equity shares without the involvement of any company. The secondary stock market is what people are referring to when they talk about stock market trading.
Common terms related to stock market trading Open : The first price at which the stock trades when stock market opens in the morning. High :The highest mark hit by the price of a stock in a day. Low : The lowest mark hit by the price of a stock in a day.
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Close : The final price of the stock when the stock market closes for the day. Volume : The quantum of equity shares traded. Bid : The buying price is called bid price. Offer : The selling price is called offer price. Bid quantity : The total number of equity shares available for buying is called bid quantity. Offer quantity : The total number of equity shares available for selling is called offer quantity. Buying and selling of equity shares : Buying is also called demand (or bid) while selling is also called supply (or offer). Short selling : This is where an investor borrows and immediately sells a share, only to buy it back later at a lower price and return it to the lender, pocketing the difference. This happens only in day trading or future trading. Share trading : Buying and selling of equity shares is called share trading. Transaction : One cycle of buying and selling of stocks is called a transaction. Squaring off : This refers to a trading style that investors or traders use, mostly in day trading. Here, an investor buys (or sells) a specific quantity of stocks, only to reverse the transaction later with the objective of earning a profit. Limit order : This refers to a type of order to buy (or sell) a security at a specified price, or better. With a buy limit order, the order will be executed only at the predetermined limit (or lower). Alternatively, with a sell limit order, the order will be completed only at the specified limit (or higher).
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Market order : This refers to an order where it is executed at prevailing stock market prices. If you place a buy stock market order, it will be executed at prevailing offer prices in the stock market. Conversely, if you place a sell stock market order, it will be executed at currently available bid prices. Stop loss order: This refers to an automatic order to buy (or sell) a stock at a specific price level, more commonly called the stop price. Widely used by intraday traders, this type of order serves to limit excessive investor losses. For example - You purchased XYZ equity shares at Rs.100. Unfortunately, share prices start falling. In a bid to check your loss, you can use a stop-loss order; put sell limit order of 95 with a stop-loss of 96. This way, once stock prices start falling and touch 96, your order will get executed automatically. This can protect you from incurring further losses. However, a disadvantage is that a stop-loss order may get executed owing to short-term fluctuations as well.
➢ What is Nifty and Sensex? Sensex and Nifty are indices of their respective stock markets. An index serves as an indicator of whether stock prices are going up or down.
The Sensex is the indicator of all the major publiclytraded companies that are listed on the Bombay Stock Exchange (BSE). On the other hand, Nifty is an indicator of the major companies that are listed on the National Stock Exchange (NSE). In India, most stocks are traded on the NSE and BSE. Nifty consists of the top 50 stocks while Sensex consists of 30 stocks. If the Sensex goes up, it means the prices of the stocks of most of the major companies on the BSE have gone up. Conversely, a falling Sensex indicates that most of the stock prices of the major stocks on the BSE have 21 | P a g e
gone down. Just like the Sensex represents the top stocks of the BSE, the Nifty represents the top stocks of the NSE. Besides, there are other indexes such as the Mid-Cap Index for all mid-cap stocks and Small-Cap Index for all small-cap stocks. Indices vary across sectors. By looking at these indices, you will know whether the stocks from these sectors are moving up or down.
➢ What are stocks? In simple language, a stock is a share in the ownership of a company. Being a stockholder, you have a contribution to the company's assets and earnings. If you buy more stocks of a particular company, your ownership stakes in that company become more significant.
Different types of stocks There are various ways the stocks are categorized 1. Based on size of market capitalization - Large cap, Mid cap and Small cap 2. Depending on sectors - Banking, Pharmacy, IT, Telecommunication. 3. Method of stock issue- Preferred and Common stocks.
➢ What makes stock price to change?
To start with, demand and supply are the underlying factors that influence stock prices. 1.Variations in buying quantities and selling quantities and patterns affect stock prices 2. More people willing to buy and few ready to sell indicates increased demand; something that would push up stock prices 3. More people willing to sell and few eager to buy indicates less demand; something that would cause stock prices to come down
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There could be several reasons that push investors to buy or sell stocks. Some have been listed below: 1. News related to a company that may be positive (takeovers, mergers, acquisitions) or negative (fewer profits or a waning sales figure as declared in quarterly or annual results) 2. Some people trade on technical charts and buy and sell at different prices 3. Some people make a move based on fundamental ratios/factors. These traders also buy and sell at different prices 4. Some people enter the market after only considering the buying and selling volumes 5. Some traders buy and sell equity shares based on recent news related to the economy or a particular company's financials
➢ How to do buying and selling of stocks?
Stock transaction takes place in 3 major steps. • You place an order (buy or sell) online • Your broker is intimated about the order • Your order is then directed to the stock exchange (BSE or NSE) And finally, based on your price, your order is executed
There are two methods for placing orders: • Online trading • Offline trading Online Stock Trading - Here, you will be doing all the trading. All you will need is an internet connection, a demat and trading account.
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Offline stock trading -In this method, the broker places the order on your behalf. All you will need to do is intimate the broker about the stocks you'd want to buy or sell. You will have to shell out brokerage fees in lieu of the services rendered by the broker.
More details about online trading: Opening Demat account and trading account - With online trading, you will need a demat account to hold securities and equity shares in an electronic/dematerialized format. A demat account changes your share certificates from physical to an electronic format, allowing better accessibility. Use of demat account - Demat account is used to keep your stocks in electronic format. Now days as there are no any physical shares in paper form, everything is stored electronically. Trading account - A trading account is fundamental if you want to trade in the stock market. Previously, the stock market would function on the 'open outcry' system wherein traders used hand signals and verbally communicated their buy/sell decisions. However, in online trading, you do not have to be physically present at the stock exchange to trade. You can open demat and trading account with a registered broker who will conduct all the transactions on your behalf. Every trading account has a unique ID.
➢ Demat Demat account is a safe and convenient means of holding your securities online. Today, practically 99.9% settlement (of equity shares) takes place in demat mode only. Thus, it is advisable to have a Beneficiary Owner (BO) account to trade at the stock exchanges.
Benefits Of Demat Account 1. A safe and convenient way of holding debt and equity share instruments 2. Transactions of demat securities are cheaper compared to transactions in physical forms 3. Immediate transfer of securities is possible online 24 | P a g e
4. Increased liquidity, as securities can be sold at any time during the trading hours (between 9:00 AM to 3:30 PM Monday - Friday), and payment can be received in a very short period of time 5. No stamp duty charges 6. Risks like forgery, thefts, bad delivery, delays in transfer, etc, associated with physical certificates, are eliminated 7. Pledging of securities in a short period of time 8. Reduced administrative cost 9. Odd-lot equity shares can also be traded (can be even 1 share) 10. Nomination facility is available 11. Any change in address or bank account details can be electronically intimated to all companies in which investor holds any securities, without having to inform each of them separately. 12. Securities are transferred by the DP itself, so no need to correspond with the companies 13. Equity shares arising out of bonus, split, consolidation, merger, etc. are automatically credited to the demat account of the investor 14. Equity shares allotted in public issues are directly credited to the demat account of the applicant
Maximum Number of holders in a Demat Account Up to three people are allowed to open demat account jointly in their names.
➢ Dematerialization Dematerialization is the process of converting physical share certificates into electronic form. Shares once dematerialized are held in a demat account.
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Dematerialisation Process An investor holding securities in physical form must get them dematerialized before the transaction. The process requires the investor to fill a Demat Request Form (DRF) -- which is available with every DP -and submit the same along with the physical certificates. Every security has an ISIN (International Securities Identification Number). If there is more than one security, then an equal number of DRFs has to be filled in.
Things Investors Should Know About Account Opening And Dematerialisation: It is mandatory for an investor to provide bank account details while opening a demat account. This is done to safeguard investor's own interests. There are two major reasons for this: •
Interest and dividend warrants can't be en-cashed by any unauthorized person, as the bank account number is mentioned on it It is convenient and time-saving, as dividends and interests, issued by companies, can be directly credited to the investor's bank account (through ECS facility, wherever available)
Change in bank account details An investor can make changes to the details of his bank account. The investor must inform any change in bank account details to the DP. It will help in receiving the corporate cash benefits such as dividends, interests, etc. directly into his account in time and discourages any unauthorized use by any second party.
Change in the address of investor as provided to the DP Any change in your correspondence address should be informed to DP immediately. It enables DP to make necessary changes in the records and inform the concerned companies about the same.
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Opening multiple accounts An investor is allowed to open a demat account more than once, either with the existing DP or with different DPs.
Minimum balance of securities required in demat account There is no stipulated minimum balance of securities to be maintained in a demat account.
Account opening and ownership pattern of securities One must make sure to open a demat account in the same ownership pattern in which the physical securities are held. For example, you have two share certificates, one in your name (say 'X') and the other held jointly with someone else (say 'XY'). In such a case, you will have to open demat accounts separately, for respective ownership patterns (one in your name, i.e. 'X' and the other account in the name of 'XY').
Same combination of names on certificates but different sequence of names on the certificates or demat account Regulations provide that the client receives a contract note indicating details like the order number, trade number, time, price, brokerage, etc. within 24 hours of the trade. In case of any doubts about the details of the contract note, you can avail of the facility provided by NSE, wherein you can verify the trades on the NSE website. The stock exchange generates and maintains an audit trail of orders/trades for a specific period, and you can counter check details of your transaction.
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Holding a joint account on "Either or Survivor" basis like a bank account No investor can open a demat account on an ‘either or survivor’ basis like a bank account.
Allowing somebody else to operate your Demat account Account-holders (Beneficiary Owner) can authorize another person to operate the demat account on their behalf by executing a power of attorney. After submitting a power of attorney to the DP, that person can manage the account on behalf of the beneficiary owner (BO).
Addition/deletion of the names of the account holders after opening the account It is not possible to make changes in the names of the account holders of a BO account. At the time an investor opens a demat account , it has to be done in a desired holding/ownership pattern.
Closing a demat account and transfer of securities to another account with same or different DP An investor can close the demat account with one DP and transfer all the securities to another account with existing or a different DP. As per SEBI circular issued on November 09, 2005, there are no charges for account closure or transfer of securities by an investor from one DP to another.
Freezing/Locking a demat account The account holder can freeze his demat account for the desired period. A frozen account prevents securities from being transferred out of (debited) and into (credited) the account. - Demat equity shares do not have any distinctive number
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- Demat securities are fungible assets. Therefore they are interchangeable and identical
➢ Insider Trading The legitimacy of insider trading depends on when the insider makes the trade. It is illegal if the material information is yet to be published in the public domain. Trading with privileged information tips the scale of competition against those who do not have the same. Illegal insider trading, therefore, includes tipping others with confidential information. Directors are not the only ones who have the potential to be convicted of insider trading. People such as brokers and even family members can be guilty. However, once the information is available for the public, using it for stock trading is not illegal.
Insider trading is legal once the material information has been made public, at which time the insider has no direct advantage over other investors. SEBI (Securities & Exchange Board Of India), requires insiders to report all their transactions. So, as insiders have information about the internal affairs of the company, it may be wise for potential investors to look at these reports to find out whether the members of the company are trading their stocks as per the legal norms.
➢ Corporate Actions When a publicly-traded company issues a corporate action, it is initiating a process that will bring actual change to its stock. By understanding these different types of procedures and their effects, an investor can have a clearer picture of what a corporate action indicates about a company's financial affairs and how that action will influence the company's share price and performance. This knowledge, in turn, will aid the investor in determining whether to buy or sell the stock in question.
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Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders. Some examples are stock splits, dividends, mergers and acquisitions, rights issues and spin-offs.
Let's take a closer look at these different examples of corporate actions.
Stock Splits: As the name implies, a stock split (also referred to as a bonus share) divides each of the outstanding shares of a company, thereby lowering the price per share. The stock market will adjust the price on the day the action is implemented. A stock split, however, is a non-event, meaning that it does not affect a company's equity, or its market capitalization. Only the number of equity shares outstanding changes; so a stock split does not directly change the value of net assets of a company. A company announcing a 2-for-1 (2:1) stock split, for example, will distribute an additional share for every one outstanding share. So the total equity shares outstanding will double. If the company had 50 equity shares outstanding, it would have 100 after the stock split. At the same time, because the value of the company and its equity shares did not change, the price per share will drop by half. So if the pre-split price was Rs.100 per share, the new rate would be Rs.50 per share. So why would a firm issue such an action? More often than not, the board of directors will approve (and the shareholders will authorize) a stock split to increase the liquidity of the share on the stock market. The result of the 2-for-1 stock split in our example above is two-fold: first, the drop in the share price will make the stock more attractive to a broader pool of investors. Secondly, the increase in available equity shares 30 | P a g e
outstanding on the stock exchange will make the stock more accessible to interested buyers. It is essential to consider that the value of the company, or it's market capitalization (equity shares outstanding x stock market price/share), does not change. But the greater liquidity and higher demand for the stock will typically boost its price, thereby increasing the company's market capitalization and value. A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1) split can also be termed a stock split of 100%. Likewise, a 3 for 2 split (3:2) would be a 50% split, and so on. A reverse split might be implemented by a company that would like to increase the price of its equity shares. If a Re.1 stock had a reverse split of 1 for 10 (1:10), holders would have to trade in 10 of their old equity shares for a new one, but the stock would increase from Rs.1 to Rs.10 per share (retaining the same market capitalization). A company may decide to use a reverse split to shed its status of a ‘penny stock’. Also, companies may use a reverse split to drive out small investors.
Dividends: There are two types of dividends a company can issue: cash and stock dividends. Typically, only one or the other is released at a specific period (either quarterly, bi-annually or yearly), but both may co-occur. When a dividend is declared and issued, the equity shares of a company is affected because the distributable equity (retained earnings and/or paid-in capital) is reduced. A cash dividend is straightforward. For each share owned, a certain amount of money is distributed to each shareholder. Thus, if an investor owns 100 equity shares and the cash dividend is Rs.0.50 per share, the owner will receive a total of Rs.50. A stock dividend also comes from distributable equity, but in the form of stock instead of cash. A stock dividend of 10%, for example, means that for every ten equity shares owned, the shareholder receives an additional share. For example, if the company has 1,000,000 shares outstanding 31 | P a g e
(common stock), the stock dividend will increase the company's outstanding equity shares to a total of 1,100,000. The increase in equity shares outstanding, however, dilutes the earnings per share. The distribution of cash dividends signal that the company has substantial retained earnings from which the shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it can replace those funds in the future. At the same time, when a growth stock starts to issue dividends, it may indicate that the company is changing. If it is a rapidly growing company, a newly-declared dividend may indicate that the company has reached growth stability and that it would be sustainable into the future.
Rights Issues: A company implementing a rights issue is offering additional and/or new equity shares, but only to already existing shareholders. The existing shareholders get the right to purchase or receive these equity shares before the public. A rights issue regularly takes place in the form of a stock split and can indicate that existing shareholders are getting a chance to benefit out of a promising new development.
Mergers and Acquisitions: A merger occurs when two or more companies combine into one, on mutually agreed terms. The merger usually occurs when one company surrenders its stock to the other. If a company undergoes a merger, it may indicate its ability to undertake more significant responsibilities. On the other hand, it may also mean a shrinking industry in which smaller companies are being combined with larger corporations to increase chances of survival in a highly competitive scenario. For more information, see ‘What happens to the stock price of companies that are merging together?’ A reverse merger occurs when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading 32 | P a g e
status without having to go through the tedious process of initial public offering (IPO). In case of an acquisition, however, a company seeks out and buys a majority stake of the target company's equity shares. In this case, the stocks are not swapped or merged. Acquisitions can be either friendly or hostile. In the case of hostile takeovers, the acquired company is compelled to transfer majority stake to another entity.
Spin Offs: A spin off occurs when an existing publicly-traded company releases a part of its assets or distributes new equity shares to create an independent business entity. Often, the new equity shares will be offered through a rights issue to existing shareholders before they are presented to new investors (if at all). Depending on the situation, a spin-off could be indicative of a company ready to take on a new challenge or one that is restructuring or refocusing core business activities. An investor needs to understand the various types of corporate actions to get a clearer picture of how a company's decisions affect the shareholder. The type of measure used can tell the investor a lot about the company, and all actions will change the stock itself -- one way or another.
Assimilation: It refers to the absorption of a new issue of stock into the parent security where the original equity shares did not rank pari passu with the parent equity shares. Once assimilated, the equity shares then rank on an equal footing with the parent equity shares. Assimilation is also referred to as funding of equity shares.
Acquisition: Acquisition is marked by one company buying all (or most) of another company's shares to retain full ownership of that company.
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When a firm acquires 50% of the target firm's stock, the acquirer becomes eligible to decide on the newly-acquired assets without having to wait for approval from the acquired company's shareholders. To execute an acquisition strategy, the acquiring company may resort to corporate action events such as a merger or a takeover bid (usually by announcing a tender offer or an exchange offer).
Bankruptcy: A company files for bankruptcy when it fails to honour its financial commitments or pay its creditors their dues. A petition is filed in court, where the company's outstanding debts are paid off (either partially or fully) from its assets. However, bankruptcy might not always result in liquidation. An alternative is a reorganization, in which the firm’s obligations may be re-negotiated. Usually, a specialized and qualified lawyer (insolvency practitioner) will handle the proceedings. Any outstanding creditor can file a claim. In case of liquidation, the insolvency practitioner will go on to sell the company's assets. Only after all the debts have been cleared will the company's equity shares will be honored.
Bonus Issue: A bonus issue, also called scrip issue or capitalization issue, is effectively a free issue of equity shares -- paid for by the company out of its capital reserves. The shareholders are awarded additional securities (equity shares, rights or warrants) free of payment. However, the nominal value of equity shares does not change. Please note that a bonus issue should NOT be confused with dividends. A company calls for a bonus issue to increase the liquidity of its equity shares in the market. Increasing the number of equity shares in circulation reduces the share price.
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Bonus issue is generally used to describe what is technically a capitalization of reserves. The company, in effect, issues free equity shares paid for out of its accumulated profits (reserves).
Bonus Rights: It refers to the distribution of rights that give existing shareholders the privilege to subscribe to additional equity shares at a discounted rate. This corporate action is similar in features to a bonus and rights issue.
Class Action It refers to a lawsuit filed against the company, usually by a large group of shareholders, a representative person, or an organization. Class action may result in a payment to the shareholders.
Delisting It is the process of removing the security from a stock exchange. Delisting can be done mandatorily by the stock exchange or voluntarily by the company itself. After delisting, a stock can no longer be traded on the stock exchange.
De-merger Converse to an acquisition or a merger, a demerger is a type of corporate restructuring wherein a company's business operations are segregated into two (or more) smaller components -- typically as result of dissolution of an earlier merger. A demerger can take place through a spin off (a divestiture strategy wherein a parent company's undertaking is segregated into another independent company) and split up (wherein a firm splits into one or multiple independent companies). Equity shares of the new company will be booked according to a predetermined ratio.
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A general announcement is used to convey a company's shareholders of any event that takes place.
Initial Public Offering (IPO) It refers to the first corporate action event whereby a private company decides to go public by getting listed on the stock exchange and making the equity shares accessible to the general public. With an IPO, a company can raise adequate equity shares capital by issuing its equity shares to the public. After IPO, the company's equity shares can then be traded on the stock exchange.
Liquidation It refers to a process by which a debt-laden firm decides to initiate proceedings to wind up operations and use its assets to pay off liabilities and other financial obligations. A company goes into liquidation when it is inevitable that it is in no financial shape to run business operations anymore. The residual balance - after paying off the company's creditors -- is then used to pay the shareholders. The person responsible for liquidating the company and dissolving its operations is called a liquidator.
Mandatory Exchange / Mandatory Conversion It refers to the conversion of securities (generally convertible bonds or preferred equity shares) into an agreed-upon number of other types of securities (usually common equity shares).
Merger It is a type of corporate restructuring whereby two (or more) companies are consolidated into a single company. There are primarily two types of mergers: horizontal mergers and vertical mergers. Mergers aim at maximizing market share, expanding to newer territories, unifying current product lines, growing revenues and bettering profit 36 | P a g e
margins. After a merger, equity shares of the newly-formed company are distributed among existing shareholders of the merged businesses, according to a set ratio.
Par Value Change Par value refers to the amount per share of a company's stock. It is usually listed on stock certificates. However, par value is not reflective of the actual cost of the stock. Par value change happens when a company's stocks are split-up.
Scheme of Arrangement It refers to an agreement, approved by the court, between the company, and its creditors and shareholders. A scheme of arrangement might alter creditor and shareholder rights.
Scrip Dividend This is the UK version of an optional dividend. No stock dividends/coupons are issued, but shareholders can elect to receive either cash or new equity shares based on the ratio or by the net dividend divided by the reinvestment price. The default is always cash.
Scrip Issue Shareholders are awarded additional securities (equity shares, rights or warrants) free of payment. The nominal value of equity shares does not change. Corporate may raise capital in the primary stock market by way of an initial public offering, rights issue or private placement. Initial Public Offerings (IPO) involves selling of securities to the public in the primary stock market.
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➢ IPO’s IPO or Initial Public Offering is a way for a company to raise money from investors for its future projects and get listed on the Stock Exchange.
Initial Public Offering (IPO) is the selling of securities to the public in the primary stock market.
From an investor’s point of view, IPO gives a chance to buy equity shares of a company, directly from the company at the price of their choice. From a company perspective, IPO helps them to identify their real value which is decided by millions of investors once their equity shares are listed on the stock exchanges. IPOs also provide funds for their future growth or paying their previous borrowings.
There are two types of Public Issues: ISSUE OFFER PRICE DEMAND TYPE Price at which securities are Demand for the offered and securities Fixed would be offered is Price allotted is made known only Issues known in after the closure advance to the of the issue investors A 20 % price Demand for the band is offered securities by the issuer offered, and at Book within which various prices, Building investors are is available on a Issues allowed to bid real time basis and the final on the BSE price is website during determined by 38 | P a g e
PAYMENT RESERVATIONS 50 % of the shares 100 % advance offered are payment is reserved for required to be applications below made by the Rs. 1 lakh and the investors at the balance for higher time of amount application. applications. 10 % advance payment is 50 % of shares required to be offered are made by the reserved for QIBS, QIBs along 35 % for small with the investors and the application, balance for all while other other investors. categories of
the issuer only after closure of the bidding.
the bidding period.
investors have to pay 100 % advance along with the application.
Price Band: Companies with the help of lead managers (merchant bankers or syndicate members) decide on the price or price band of an IPO. SEBI does not play any role in fixing the price of a public issue. It validates the content of the IPO prospectus. Companies and lead managers conduct stock market research and roadshows before they decide the appropriate price for the IPO. It involves a high risk of IPO failure if they ask for a higher premium. Often, investors do not like the company or the issue price, and subsequently don't apply for it, resulting in an undersubscribed issue. In this case, companies either revise the issue price or suspend the IPO.
Date of the issue: Once the draft prospectus of an IPO is cleared by SEBI and approved by the stock exchanges, it’s up to the company going public to finalize the date and duration of the IPO. The company consults with the lead managers, registrar of the issue and the stock exchanges before it decides the time.
The role of the registrar of an IPO: Registrar of a public issue is an independent financial institution, registered with SEBI and the stock exchanges. The registrar is appointed by the company going public. The responsibility of a registrar for an IPO mainly involves the processing of IPO applications, allocating equity shares to applicants based on SEBI guidelines, processing refunds through ECS or cheque and transferring allocated equity shares to the investor’s demat account. 39 | P a g e
The role of Lead Managers in an IPO: Lead managers are independent financial institutions appointed by the company going public. Companies appoint more than one lead manager to manage big IPOs. They are usually called book running lead manager and co-book running lead managers. Their primary responsibilities are to initiate the IPO processing, helping the company in roadshows, creating draft offer documents, getting them approved by SEBI and stock exchanges, and assisting the company in listing equity shares on the stock market.
Follow-on public offering or FPO: Follow-on public offering (FPO) is the public issue of equity shares for an already listed company.
Primary & secondary market: The primary stock market is the market where equity shares are offered investors by the issuer company in a bid to raise adequate capital. The secondary stock market is where stocks are traded after they are initially offered to investors in the primary stock market. The secondary stock market comprises equity and debt markets. The secondary stock market is a platform to trade listed equities, while the primary stock market is a way for companies to enter into the secondary stock market.
Benefits of IPO’s: For businesses: Issuing stocks is a fast way to raise revenue for business expansion and growth. By becoming a publicly-traded company, a business can take advantage of new, more substantial opportunities, and can start working towards worldwide expansion.
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IPO gives a company fast access to public capital. While public offering can be costly and time-consuming, its tradeoffs are appealing to companies. IPOs are a relatively low-risk strategy for businesses and have the potential to open up a sea of opportunities in the future. For investors: The primary reason why IPOs are attractive is that they are undervalued. Initially, companies might undervalue their IPO -- sell their equity shares at a price lower than the market value -- to make it more attractive. It often helps to encourage investors into buying the IPO. That's because investors may believe that the new publicly-traded company could generate substantial profits and become the next big thing. As the price and demand for the IPO's grow, early investors stand to make quick profits. If you hope to invest in equity of companies, understanding the ins and outs of an IPO is critical to your success. Since IPOs are in some cases undervalued, they can often be sold within a short period for a good profit. When a publicly-traded company issues a corporate action, it is initiating a process that will bring actual changes to its stock. By understanding the different types of procedures and their effects, an investor can have a clearer picture of what a corporate action indicates about a company's financial affairs and how that action will influence the company's share price and performance. This knowledge, in turn, will aid the investor in determining whether to buy or sell the stock in question.
➢ Securities lending – Going short Shorting stock, also known as short selling, refers to the sale of stocks that the seller doesn't own, or equity shares that the seller has loaned from a broker. The investor anticipates buying (covering the short) the equity shares back at a lower price than what they were sold for, recognizing the difference as a profit.
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CHAPTER 3: MUTUAL FUND CONCEPTS ➢ What are mutual funds? A mutual fund is a type of professionally managed collective investment scheme that pools money from many investors and invests it across stocks, bonds, short-term money market instruments and other securities. Mutual funds have a fund manager who invests the money on behalf of the investors by buying/selling stocks, bonds, etc.
The investor invests in a mutual fund scheme which in turn takes the responsibility of investing in stocks and shares after due analysis and research. The investor need not bother with researching hundreds of stocks and can leave it to the professional fund management team. Another reason why investors prefer mutual funds is that mutual funds offer diversification. Investor money is invested by the mutual fund in a variety of shares, bonds and other securities, thereby diversifying investors' portfolio across different companies and sectors. This helps in reducing the overall risk of the portfolio. Also, it is less expensive to invest in mutual funds. Some mutual fund houses allow a minimum investible amount of only Rs.500.
➢ Mutual Funds: Structure In India Mutual funds in India follow a 3-tier structure. There is a sponsor (firsttier) who thinks of starting a mutual fund. The sponsor approaches the Securities and Exchange Board of India (SEBI), the market regulator and also the regulator for mutual funds.
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The sponsor and trustee are two separate entities. A sponsor is only the promoter of the mutual fund, which brings in the required capital, starts a mutual fund and sets up the AMC. On the other hand, the mutual fund trustee's role is not to manage the money. A trustee's role is to supervise whether the money is being managed as per the stated objectives. In other words, a trustee can be considered the internal regulator of a mutual fund.
Once SEBI is convinced, the sponsor creates a public trust (the second-tier) as per the Indian Trusts Act, 1882. Trusts have no legal identity in India and cannot enter into contracts; hence, trustees are authorized to act on behalf of the trust. Contracts are entered into in the name of the mutual fund’s trustees. Once the trust is set up, it is registered with SEBI. Following this, the trust is formally considered as the mutual fund. The AMC manages investors' money Trustees appoint the Asset Management Company (the third-tier) to manage investors' money on a day-to-day basis. The AMC -- in return of services -- charges a fee. The investors bear this fee. Fifty per cent of the AMC’s board of directors must be independent directors. Once approved by SEBI, the AMC functions under the supervision of its board of directors, trustees and SEBI. It is the AMC that floats new schemes and manages these by buying and selling securities. For this, the AMC needs to follow the rules and regulations prescribed by SEBI. Besides, the AMC also has to adhere to the terms of the agreement it signs with the trustees. The AMC cannot deal with a single broker beyond a specific limit of transactions. Appointments of intermediaries, including independent 43 | P a g e
financial advisers (IFA's), national and regional distributors and banks, is also done by the AMC. Finally, it is the AMC that is responsible for the actions of its employees and service providers. When the mutual fund intends to launch a new scheme, the AMC has to submit a draft offer document to SEBI. After the necessary approval from SEBI, this document becomes the offer document of the mutual fund scheme. An offer document is a legal document that investors rely upon for investing in the mutual fund scheme. The compliance officer has to sign the due diligence certificate in the offer document.
A Custodian A mutual fund custodian is a trust, bank or a similar financial institution responsible for holding and safeguarding securities owned by a mutual fund. A mutual fund's custodian may also act as the mutual fund's transfer agent, maintaining records of shareholder transactions and balances.
Role of a custodian Since a mutual fund is essentially a large pool of funds collected from different investors, it requires a third-party custodian to hold and safeguard the securities that are mutually owned by all the investors. This structure mitigates the risk of fraudulent activity by separating the fund managers from the physical securities and investor records. The custodian holds only the physical securities. Delivery and receipt of mutual fund units are done by the custodian or a depository participant, subject to instructions issued by the AMC. The trustees provide the overall direction and responsibility. Regulations provide that the sponsor and custodian must be separate entities.
Role of Registrar and Transfer Agents Registrar and Transfer agents (RTA) perform the vital role of maintaining investor records. All New Fund Offer (NFO) forms, redemption forms (i.e. when an investor wants to exit from a mutual fund scheme, it requests for redemption) go to the RTA’s office where the information is converted 44 | P a g e
from physical to electronic format. It acts as a single-window system for investors. The RTA takes care of aspects such as the number of mutual fund units an investor gets, the price at which the investor gets the mutual fund units, applicable NAV, the amount an investor would get in case of redemption, exit loads, folio number, etc. Registrar and Transfer agents also help investors with information and details on new fund offers, dividend distributions and maturity dates in case of fixed maturity plans. While such details are also available with the mutual fund houses, RTA is a one-stop-shop for all the information. Investors can get information about various investments in different schemes of different mutual fund houses at a single place.
➢ Advantages Of Investing In MFs? Investing in mutual funds has its share of advantages. They have been listed below:
Expert fund management Besides the necessary skill set, investing in mutual funds requires a continuous study of market dynamics and thorough research into the different industries and companies within them. But when you invest in a mutual fund, you are also choosing a professional money manager. With the money that you invest in a mutual fund, the manager buys and sells securities that he/she has thoroughly researched on. It saves you the time and effort of having to conduct a detailed study every time you decide to buy and sell stocks. Instead, a professional mutual fund manager does it for you.
Diversification of risks Diversification involves mixing investments within a portfolio as a way to mitigate risks. For example, by choosing to buy stocks in the retail sector and offsetting them with stocks in the industrial sector, you can reduce the impact of the performance of any one security on your entire portfolio. 45 | P a g e
To achieve a truly diversified portfolio, you may have to buy stocks across capitalizations from different industries, and bonds with varying maturity periods from different issuers. For an individual investor, this can be quite costly. However, a mutual fund spreads its risk by investing in several stocks or bonds. A mutual fund typically invests in companies across a wide range of industries, so the risk is diversified. You can diversify across asset classes at a very low cost. Within the various asset classes also, mutual funds hold hundreds of different securities (a diversified equity mutual fund, for example, would typically have around a hundred different shares).
Cost-Efficiency Mutual funds collect money from a large pool of investors, and that is how they achieve economies of scale. This way, mutual funds can offer you a low-cost alternative for managing and investing your funds. Mutual funds take advantage of their buying and selling sizes, and thereby reduce transaction costs for investors. When you invest in a mutual fund, you can diversify without the numerous commission charges. With an investment in mutual funds, you can make transactions on a larger scale, for less money.
Liquidity Unless you choose a close-ended mutual fund, it is undoubtedly easy to invest in and exit a particular mutual fund scheme. Mutual funds are typically very liquid investments. Unless they have a pre-specified lock-in, you can sell your units at any given point in time (when the market is high). Typically mutual funds take a couple of days for returning your money to you. Since they are well-integrated with the banking system, most mutual funds can send money directly to your banking account.
Transparency Statutory authorities require mutual fund companies to disclose their Net Asset Value (NAV). NAVs are calculated on a daily basis and published 46 | P a g e
through available media. Mutual fund companies disclose their financial statements to their investors and others. Full disclosure of investments periodically, flexibility in terms of needsbased choices, stringent SEBI regulations and strict compliance to investor-friendly norms make mutual fund relatively high on transparency.
Tax Benefits Investment in mutual funds also enjoys several tax advantages. Dividends from mutual funds are tax-free in the hands of the investor (this, however, depends upon changes in Finance Act). Also, as mentioned under Sec 80C of the IT Act, you can invest up to Rs.1.5 lakh in tax-saving mutual funds (ELSS, for instance). While a long-term capital gains (LTCG) tax of 10% is applicable on returns more than Rs.1 lakh beyond one year, mutual funds have consistently delivered better returns vis-a-vis other tax-efficient instruments.
Well-Regulated Mutual funds are highly regulated. The mutual fund manager has to submit all necessary documents to the statutory authorities for their approval, to make an investment in the required securities.
➢ Disadvantages of investing in mutual funds Fees and commissions: An administrative fee is required by all kinds of funds to meet the expenses. There are many mutual funds which even charge a commission on sales or "loads" to pay financial consultants, brokers, financial institutions or financial planners. If you buy stocks or shares from a load fund, you have to pay a commission on sales irrespective of the fact that you are consulting a financial advisor or a broker.
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Taxes: In a typical year, most efficiently-managed mutual funds can sell anywhere from 20 - 70 % of their portfolio. If your mutual fund makes a profit, you will pay taxes on the income you receive, even if you reinvest the money you made. The tax incidence depends on the type of mutual funds.
Management Risk: When you invest in a mutual fund, you depend on the fund manager to make the right decisions. If the manager does not perform as per your expectations, you might fall short on your projected returns from the mutual fund. Of course, if you invest in index funds, you forego management risk, because these funds do not employ managers.
Risks Involved In Investing: Credit Risk: Credit risk or default risk refers to the situation where the borrower fails to honor either one or both of his obligations of paying regular interest and returning the principal on maturity. It can happen in the case of the borrower turning bankrupt. Credit risk can be taken care of by investing in instruments issued by companies with very high credit rating. The probability of default by a borrower with a high credit rating is comparatively lower than the one with a low credit rating. Government paper is the ultimate safe bet when it comes to credit risk. That’s because if the government does not have cash (similar to a company going bankrupt), it can print more money to meet its obligations or change tax laws so as to earn more revenue (neither of which a corporation can do!). Default risk is the risk that an issuer of fixed income security may default (i.e. the issuer will be unable to make timely principal and interest payments on the security). Because of this risk, corporate debentures are
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issued at a higher yield above those offered on government securities, which are sovereign obligations and free of credit risk. Typically, the value of fixed-income security will fluctuate depending upon the changes in the perceived level of credit risk as well as any actual event of default. Higher the credit risk, higher the yield required in return as compensation. Interest rate risk: In the case of fixed-income investment, any change in the prevailing rates of interest is likely to affect the value of the fund's holdings, and thus value of the fund's units. Increased rates of interest, that frequently accompany inflation and a growing economy, are likely to hurt the value of the units. Generally, the value of securities held by funds will vary inversely with changes in prevailing interest rates. As with debt instruments, changes in interest rates may affect the scheme's net asset value. The prices of financial instruments are inversely proportional to interest rates. generally, the prices of long-term securities fluctuate more in response to interest rate changes as compared to shortterm securities. In India, debt and government securities markets can be volatile, leading to price fluctuations of fixed income securities, and thereby possible variations in the NAV. The best way to mitigate interest rate risk is to invest in papers with shortterm maturities. As the interest rate rises, the investor will get back the invested funds faster. He can then reinvest the money in debt papers that offer a higher interest rate. However, this should be done only when the investor believes that interest rates will continue to rise in the future. Otherwise, frequent trading in debt paper will be costly and cumbersome. Market risk:
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Systemic risks or market risks refer to risks that affect the entire market and have an impact on the whole class of assets. The value of an investment may decline over time because of economic changes or other events that affect the overall market. Systemic risks include risks related to interest rates, inflation, exchange rates, and political events. Inflation Risk: Inflation risk is the uncertainty over the inflation-adjusted future value of your investment. There is always a chance that rising inflation will undermine the performance of your investment. Inflation risk happens when increasing cost of living renders mutual fund investments yields lesser than what was expected. Liquidity risk: Liquidity risk is a type of investment risk that investors undertake while buying assets with low resale opportunities. Liquidity risk stems from the lack of marketability of an investment that cannot be traded quickly without adversely impacting its market price. Liquidity of an investment may be inherently restricted by trading volumes, transfer procedures and settlement periods. Policy risk: Policy risk refers to the uncertainty in investment due to a change in policies. Changes in government policy, political unrest or major political rejigs can change the investment environment.
➢ Types of mutual funds
Open-ended In open-ended MFs, the mutual fund house continuously buys and sells units from investors. With open-ended funds, mutual fund units can be redeemed or issued at any time during the life of the scheme. New units are created and issued if there is demand; else, old units are eliminated if there is redemption pressure.
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There is no fixed date on which the mutual fund units would be permanently redeemed or terminated. If you want to invest in open-ended funds, you need to buy those units from the mutual fund house. Similarly, when you want to redeem your units, the mutual fund house will directly pay you the value of the units. In other words, new investors can join the scheme by directly buying the mutual funds at its Net Asset Value (NAV), in case of open-ended schemes.
Close-ended The mutual fund units of a close-ended scheme are issued only at the time of NFO. These units are issued for a fixed tenure or duration. New units are not issued on a continuous basis, and existing units are not eliminated before the end of the mutual fund's term. At the time of an NFO, you can buy close-ended units from the mutual fund house, and redeem the units at the time of the closure of the scheme. However, if you want to buy or sell the mutual fund units of a close-ended scheme during its lifetime, you have to do that through a stock exchange. The units of close-ended schemes are listed on the stock exchanges, just like ordinary shares, and can be purchased or sold through a broker.
Index funds Equity schemes come in many variants, and thus, can be segregated according to their risk levels. At the lowest end of the equity funds risk spectrum lie index funds, while at the highest end lie sectoral schemes or specialty schemes. These schemes are considered the riskiest. A mutual fund scheme that faithfully buys the index, without making any judgment on which stocks to buy more (or less), is known as an index fund. The mutual fund makes no effort to beat the index (passive investing). Unlike actively-managed equity funds, index funds do not attempt to outperform the benchmark index. Measure of performance for an index fund is the tracking error (difference between the performances of index fund versus the underlying benchmark 51 | P a g e
index. Theoretically speaking, these funds ensure performance identical to that of the index which is the benchmark.
Diversified large cap funds These are mutual funds that restrict their stock selection to large cap stocks – typically the top 100 or 200 stocks with the highest market capitalization and liquidity. It is generally perceived that large cap stocks have sound businesses, strong management, globally competitive products and are quick to respond to market dynamics. Hence, diversified large cap funds are considered stable and safe for investment. However, since equities as an asset class are risky, there is no guaranteed return for any type of fund. These are actively-managed mutual funds, unlike index funds that are passively managed. In an actively-managed mutual fund, the fund manager pores over all the data and information, researches about the company, analyses market trends, factors in government policies on different sectors, and then selects the stock to invest. Apart from index funds, all other mutual funds are actively managed, and therefore, entail higher expenses as compared to index funds. In this case, the fund manager has the choice to invest in stocks beyond the index. Thus, active decision-making comes in. Any mutual fund scheme that is involved in active decision-making, is incurring higher expenses and may also carry higher risks. This is mainly because, as the stock selection universe increases from index stocks to large cap stocks, followed by mid cap and finally to small cap stocks, the risks associated with each also increase. The logical conclusion that can be drawn is that while actively-managed mutual funds usually produce higher returns than the index, it is not compulsory. Studies have shown that a majority of actively managedfunds are unable to beat index returns consistently.
Mid cap funds
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Mid cap mutual funds invest in stocks belonging to the mid cap segment of the market. Many of these midcaps are said to be the ‘emerging bluechips’ or ‘tomorrow’s large caps’. Mid cap funds can be managed actively or passively.
Sectoral Funds Mutual funds that invest in stocks from a single sector or related sectors are called sectoral funds. Examples of such funds are IT funds, pharma funds, infrastructure funds, etc. Regulations do not permit such mutual funds to invest over 10% of their NAV in a single company. This is to ensure that these mutual fund schemes are adequately diversified so that the investors are not subjected to undue risks.
Arbitrage funds These mutual funds invest simultaneously in the cash and derivatives market, and take advantage of the difference in prices between a stock and a derivative by taking opposite positions in both the markets.
Multicap funds Theoretically, these mutual funds can possess the qualities of small cap funds today and large cap funds tomorrow. The mutual fund manager has total freedom to invest in stocks from any sector.
Quant funds A typical description of this type of mutual fund scheme is: ‘The system is the fund manager’. It means that there are some predefined conditions that are entered into the system and as and when the user enters ‘buy’ or ‘sell’ command, the scheme enters or exits those stocks.
P/ E Ratio fund It refers to a mutual fund that invests in stocks, based upon their P/E ratios. Therefore, when a stock is trading at a historically low P/E multiple, the mutual fund will buy the stock. Alternatively, when the P/E 53 | P a g e
ratio is at the upper end of the band, the mutual fund will seek to sell the stock.
International equities fund Such a mutual fund invests in stocks of companies based out of India (investor's country of residence). It can either be a Fund of Fund (whereby, you invest in a fund, that in turn acts as a ‘feeder’ for other funds) or a fund that directly invests in overseas equities. International equities fund may be further categorized into International Commodities Securities Fund, World Real Estate Fund, etc.
Growth schemes Growth mutual funds aim at capital appreciation over the medium to longterm. Usually, such mutual fund schemes invest a primary portion of their corpus in equities. Generally entailing a higher degree of risk, growth funds provide options - capital appreciation, dividend option, etc. -- to investors. As an investor, you will have to indicate your preference in the application form. Growth funds are appropriate for investors who have a long-term investment outlook and seek capital appreciation over time.
ELSS Equity-linked savings scheme (ELSS) is a diversified equity mutual fund that offers the investor tax benefits up to Rs.1.5 lakh annually. Of the entire mutual fund landscape, only ELSS qualifies for tax deductions. These are open-ended schemes with a lock-in period of 3 years, indicating that investors cannot, under any circumstance, redeem or reinvest before three years from the date of investment. Investment in these mutual fund schemes serve the dual purpose of wealth accumulation coupled with tax benefits.
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Fund of Funds As the name suggests, Fund of Funds is a mutual fund scheme that, instead of investing directly in bonds or equities, invests in other schemes of mutual funds. The fund might invest in a mutual fund scheme belonging to the same fund house or any other fund house, for that matter. A diversified portfolio is designed to suit investors across financial objectives and risk appetite. This mutual fund scheme can invest in equity or debt, depending on the investor's investment objectives.
Fixed maturity plans Fixed maturity plans (FMPs) -- that have become popular over time -- are close-ended debt schemes. It necessarily implies that investments are allowed only during a new fund offer. FMPs entail a fixed maturity period, investing across debt instruments such as corporate bonds and high-rated securities. While fund managers are free to sell the securities prior to the date of maturity, they typically hold onto the debt papers in most cases. Investors can assess the risk exposure of the portfolio by looking at credit ratings of securities. Indicative yield is the return that investors can expect from FMPs. However, an important point to note here is that indicative yields are pre-tax. FMPs are designed to make sure investors can earn stable, tax-efficient returns.
Capital protection funds Capital protection funds, a classification of close-ended hybrid funds, aim at capital appreciation coupled with safeguarding investor-interests during times of slowdown in the economy. Considering its nature, such a mutual fund checks chances of capital loss by investing a significant share in AAA-rated bonds that have historically exhibited minimal chances of defaulting. 55 | P a g e
The portfolio is a mix of debt and equity, with a significant portion invested in debt while a small fraction is parked in equities. It is this component that provides a potential for higher returns. The mutual fund lock-in period and maturity of the debt portfolio are aligned, thereby further guarding against volatility and interest rate fluctuations. Consider, an investor invests Rs.100 in a capital protection fund, with a tenure of 12 months. The goal of the fund is to ensure that at redemption, its assets are no less than the initial investment of Rs.100. Experienced fund managers will actively manage the equity allocation. It is this structure that offers investors a shot at investing in equities without fearing capital erosion.
Gilt funds Gilt funds invest across fixed-income securities that are issued by the State and Central Governments. Generally, the money goes towards building infrastructure and funding other government expenses. Gilt funds are ideal for investors who want to keep risks in check while earning reasonable returns. While gilt funds don't carry any credit risk, their performance depends on the fluctuation of interest rates. Therefore, the best time to invest in gilt funds is during a falling interest rate regime.
Balanced funds Balanced funds, also known as hybrid funds, invest in equity and debt instruments. Typically equity-oriented balanced funds aim at optimizing capital appreciation while keeping volatility from equity exposure in check. Leading balanced mutual funds invest anywhere between 50-70% of the portfolio in equity and the remainder in debt instruments. It is this strategic blend of debt and equity that offers diversification to the investor.
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Typically debt-oriented monthly income plans (MIPs) belong to the category of hybrid mutual funds. It essentially means that the majority of the corpus is invested across debt funds and other money-market instruments. MIPs aim at considerable liquidity while providing regular dividends at the same time. However, unlike the name suggests, MIPs don't guarantee a steady monthly income. Dividends, like with other market-linked instruments, are paid out from profits. Being a debt-oriented mutual fund, both short-term capital gains (STCG) and long-term capital gains (LTCG) taxes apply to MIPs. Investments in MIPs don't have a limit, and investors don't have to pay an entry load. An experienced fund manager will take a call on when to switch to equities (or debt) and by what margin.
Child benefit plans These are debt-oriented mutual funds, with very little component invested in equities. Child benefit plans aim at capital protection and steady appreciation. Parents can invest in child benefit plans with a 5-15-year horizon, thereby ensuring their children can access a formidable corpus to meet expenses related to higher education.
Exchange-traded funds (ETFs) Exchange-traded funds (ETFs) are necessarily index funds that are listed and traded on exchanges like stocks. Globally, ETFs have opened a whole new panorama of investment opportunities to retail as well as institutional investors. Investing in ETFs enables investors to gain exposure to the stock markets as well as specific sectors with relative ease, on a real-time basis and at a lower cost than many other forms of investing. An ETF is a basket of stocks that reflects the composition of an index, like S&P CNX Nifty, BSE Sensex, CNX Bank Index, CNX PSU Bank Index, etc. The ETF's trading value is based on the net asset value of the 57 | P a g e
underlying stocks that it represents. It can be compared to a share that can be bought or sold on a real-time basis during the market hours. Practically any asset class can be used to create ETFs. Globally, there are ETFs on silver, gold, indices etc. India has ETFs on gold and indices (Nifty, Bank Nifty, etc.) as well as those that are similar to liquid funds. Gold ETFs are a particular type of ETF that invests in gold and goldrelated securities. This product gives the investor an option to diversify investments into a different asset class, other than equity and debt.
Liquid funds Liquid funds invest in short-term money market instruments that provide a fixed-interest income. These instruments include treasury bills, commercial paper, etc. that have a maturity period of 91 days. Liquid funds aim at capital safety and providing high liquidity. With this objective in mind, experienced fund managers invest in debt instruments that enjoy a high credit rating. The allocations are in keeping with the mandate of the mutual fund. Considering average portfolio maturity is three months, investing in liquid mutual funds reduces the sensitivity of returns to fluctuations in interest rates. Besides, portfolio maturity is aligned with that of the underlying securities, thereby opening up a potential for higher returns. Liquid funds are ideal for parking investors' surplus, considering these are low-risk havens that mimic a savings bank account's liquidity. Besides, liquid mutual funds don't attach any exit load, implying investors can withdraw money according to convenience. Historically, liquid funds have generated returns in the range of 7-9%. Usually, an expense ratio is charged to manage investments in liquid funds. According to a SEBI mandate, the upper limit of expense ratio has been capped at 1.05%.
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➢ Growth and dividend options
Mutual fund houses have two types of schemes on offer: Growth and dividend In the former, profits registered by the mutual fund scheme are re-invested in it, resulting in the Net Asset Value (NAV) increasing over time. When the mutual fund scheme gains, NAV rises. Alternatively, in case of a loss, the NAV decreases. The only option to realize profits is to sell or redeem your mutual fund investments. With the dividend option, profits are not reinvested. Gains or dividends are distributed to the investor from time to time. However, the amount and frequency of dividend payouts are never guaranteed. Only when the mutual fund scheme gains, are dividends declared, paid out from the NAV of the unit.
➢ Payout and reinvestment plans
What is the payout option in mutual funds? The dividend option of mutual fund has sub-options such as dividend payout and reinvestment. Under the payout option, profits made by the mutual fund scheme are given to investors at periodic intervals and not reinvested in the mutual fund. These dividends are not guaranteed. The fund may choose to dole out dividends in one year and not offer anything the following year; it is entirely at the discretion of the mutual fund. Further, the amount of dividend paid may also vary. Contrary to popular belief, dividends paid out are a cut from the NAV. So, the NAV will fall to the extent of dividend paid and dividend distribution tax (DDT), if any. Suppose, a mutual fund with a face value per unit of Rs.10 is trading at a NAV of Rs 40. It declares a dividend of 30%, which means investors will earn Rs.3 per unit. Subsequently, if you choose to sell your holdings, you will get only Rs.37 per unit, as the NAV of the mutual fund scheme will have fallen from Rs.40 to Rs.37.
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What is the reinvestment option in mutual funds? Under the reinvestment option, any dividend paid out by the mutual fund is ploughed back into the scheme. It implies that you buy additional units in the scheme, from the dividend amount, at the prevailing NAV (exdividend) of the scheme. The mutual fund scheme's NAV will fall after payment of dividend, even if the same is reinvested. So, the NAV of both dividend payout and dividend reinvestment options is the same.
➢ Systematic Investment Plan(SIP)
What is SIP? Systematic investment plan (SIP) is an investment vehicle that allows investors to invest in a mutual fund in fixed amounts, periodically. A SIP can be weekly, monthly or quarterly. Investors can initiate a SIP after identifying the mutual fund that they want to invest in and determining the amount required to achieve financial goals. A herd mentality in the stock market is to buy stocks when prices are low, and sell them when prices go up. However, timing the market can be risky and time-consuming at the same time. A more successful investment strategy is to adopt the Rupee Cost Averaging method. Systematic investing, through SIP, can help investors access the powers of compounding.
SIP is a convenient way to "invest as you earn" and allows averaging of the acquisition cost of units.
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➢ Systematic Transfer Plan:
What is a Systematic Transfer Plan (STP)? A Systematic Transfer Plan (STP) is a smart investing strategy that helps to stagger your investments, over a particular period, to balance returns and keep risks in check. For instance, if you invest in equities ‘systematically’, you can earn low-risk (or risk-free) returns even during volatile market conditions. An AMC allows you to invest a lump sum in one fund, and then systematically transfer fixed sums from it to another mutual fund scheme. While the former is called a 'source scheme' or 'transferor scheme', the latter is called a 'target' or 'destination scheme'. To apply for an STP, you have to carry out at least six capital transfers from one mutual fund scheme to another. You can get into a weekly, monthly or quarterly systematic transfer plan, as per your needs. The mutual fund deducts the number of units, equal to the specified amount, from the scheme you plan to transfer money. At the same time, the amount transferred is utilized to buy units of the mutual fund scheme that you plan to transfer money to, at the applicable NAV. Say you have to invest Rs.1 lakh in an equity mutual fund. For this, you select a liquid fund or an ultra short-term fund. It allows earning a better return as compared to a saving bank account. After this, you determine a fixed amount that is to be transferred weekly, monthly or quarterly. While no entry load is charged, SEBI permits fund houses to subject exit load up to 2%. The exit load is calculated basis the tenure of investment and type of fund. A systematic transfer plan enables a planned fund transfer between two mutual fund schemes. More often than not, investors initiate an STP to transfer funds from debt to equity. STP is a useful tool for a step-by-step exposure to equities or to reduce equity-exposure over time.
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➢ Systematic withdrawal plan(SWP)
What is a Systematic Withdrawal Plan (SWP)? A Systematic Withdrawal Plan (SWP) enables the investors to redeem their mutual fund investments in a phased and disciplined manner. Unlike withdrawals made in lump sums, an SWP helps to withdraw money in fixed installments. In essence, an SWP is the opposite of SIP. One of the many advantages of an SWP is that it helps investors customize cash flow in keeping with their financial requirements. Investors can either withdraw a fixed amount or just the capital gains on their mutual fund investment. This way, investors can not only have money invested in the mutual fund scheme but also access steady income and returns. The amount to be withdrawn should be indicated up front. SWP is redemption from a scheme, so tax provisions apply accordingly. SWP is tax-efficient for an investor who likes to save on dividend distribution tax.
Mutual fund investments are subject to market fluctuations. These can adversely affect fund NAV. More importantly, fund returns can erode if they aren't withdrawn on time. An SWP can help time withdrawals in keeping with financial needs. ➢ What is the concept of NAV in mutual funds? Everything you buy has a price, and this is true for investing too. But what is the price of a mutual fund? How much do you need to pay to invest in a mutual fund scheme? This amount depends on the fund's net asset value or NAV. It is the price at which a mutual fund is bought and sold in the open market.
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NAV basically represents the price of one unit of the mutual fund. For example, if a fund's NAV is Rs.20 and you want to invest Rs.10,000, you will be allotted 500 units in the fund. The NAV of mutual funds are reported widely in newspapers and investment portals. Open-ended funds are mandated to disclose their NAV daily while close-ended funds usually disclose their NAV weekly.
➢ How is NAV calculated? The asset allocation mix of a mutual fund includes securities and cash. Securities comprise equities, bonds and other debt instruments. The values of these securities change at every trading interval, and so does the NAV of the mutual fund. The NAV is the total market value of all the assets held in the mutual fund portfolio less liabilities, divided by the outstanding units. The market value of the investments is calculated according to the last traded or closing price of the securities. Usually, calculating NAV of mutual fund is tedious during trading hours as the price of the underlying holdings (especially stocks) keeps changing. Therefore, NAVs are usually declared after the closing of market. The costs and expenses of the fund, including management fees and operating expenses (registrar and transfer agent fee, marketing and distribution fee, audit fee and custodian fee) are deducted while calculating the NAV. The NAV of an open-ended fund does not indicate whether a fund is overpriced or underpriced. In other words, a fund with a high NAV does not mean that it is more expensive than a fund with lower NAV. Closeended funds issue a fixed number of units that are traded on the stock exchanges or over-the-counter (OTC). Typically, such funds are not traded at their NAVs, and their prices tend to generate premium or discount relative to their NAVs due to demand and supply factors.
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➢ How does NAV help investors? NAV helps in assessing the performance of mutual fund. Various analysis tools like point-to-point return, CAGR and ROI are derived using the fund's NAV. Moreover, the advanced analysis of risk-adjusted returns is not possible without the NAV of a fund. A fund's NAV helps investors assess the worth of their investments and determine how the value of such investments has moved over time. For instance, in 2010, you purchased 1,000 units of a mutual fund at Rs.15. According to this figure, your investment was worth Rs.15,000. After two years, the NAV rises to Rs. 20. It means that the value of your investment has grown to Rs.20,000, and if you redeem the units now, you make a profit of Rs.5,000.
➢ Returns in a mutual fund
Dividends The dividend option does not reinvest the profits made by the mutual fund. Profits or dividends are distributed to the investor from time to time. However, the amount and frequency of dividends are never guaranteed. These are declared only when the scheme makes a profit, and are at the discretion of the fund manager. The dividend is paid from the NAV of a mutual fund unit.
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These are profits that result when a security, price of which increases over its purchase price, is sold. If the security is not sold, gains remain unrealized. A capital loss would occur when the opposite takes place. Capital gains can be long-term or short-term, depending on the time when the units are sold. If the units are held for more than a year, they generate long-term capital gains (LTCG) while if redeemed within a year, generate short-term capital gains (STCG). LTCG and STCG are accordingly taxed.
➢ Cost involved in MF investing
Loads Investors have to bear expenses for availing professionally-managed services of the mutual fund. One of these is entry load, a fee that is charged to meet the selling and distribution expenses of the scheme. A significant portion of the entry load goes towards paying commissions to the fund distributor (can be an independent financial advisor, bank or a large national/regional distributor). They are the intermediaries who help investors choose the right scheme and invest in them from time to time, in keeping with their financial requirements. The second type of expense is exit load - a fee that reduces the in-hand investor returns. However, not all schemes have exit loads. Some schemes have a Contingent Deferred Sales Charge (CDSC). It is a modified exit load, wherein investors have to pay different charges depending on the investment period. Usually, exit loads increase if investors redeem investments early (before the lock-in period). Therefore, longer the investment horizon, lesser will be the exit load. After some time, the exit load reduces to nil, i.e. if the investor exits after a specified period, he/she will not have to bear any exit load.
Expense Ratio Among other things, which an investor must look into before investing in a mutual fund, is the Expense Ratio of the scheme. Expense Ratio is defined as the ratio of expenses incurred by a scheme to its Average 65 | P a g e
Weekly Net Assets. It represents the ratio of the amount of investors' money that is going for expenses to the amount that is getting invested. Expense ratio of a mutual fund should be as low as possible.
➢ What is new fund offer? The launch of a new mutual fund scheme is known as a New Fund Offer (NFO). It is like an invitation to the investors to put their money into a particular mutual fund scheme by subscribing to its units. When a scheme is launched, the distributors talk to potential investors and collect money from them by way of cheques or demand drafts. Mutual funds cannot accept cash. (Mutual funds units can also be purchased online through a number of intermediaries who offer online purchase/redemption facilities). However, before investing, you must read the Offer Document (OD) carefully to understand the risks associated with the scheme.
➢ Taxation of mutual funds Income from mutual funds can be divided into 2 parts: Capital gains (increase in value of your investment) and Dividends (amount that investors receive on regular intervals from dividend plans). So taxation of mutual funds in India can also be divided into 2 parts: Capital gains and Dividends. Capital gain is appreciation in the value of asset. If you buy something for Rs. 1 lakh and sell it for Rs. 1.5 lakh, you have made a capital gain of Rs. 50,000. Capital gains are further divided into short term and long term capital gains, depending on their investment horizon. •
Short term capital gain arises if the investments are held for less than one year or, in simple words, sold before completion of 1 year. Here, 1 year means 365 Days. Long term capital gain arises if investment is sold after 1 year.
Mutual fund capital gain tax further depends on the type of fund it is – Equity or Debt.
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Equity mutual funds are those funds in which equity holding is more than 65% of the total portfolio. So, even balanced funds can be categorized as equity funds. Fund of Funds (mutual funds which invest in other funds) and International Funds (mutual funds which have more than 35% exposure to international equities) are kept under debt category for tax purposes. Long term capital gain tax on equity mutual funds: If you buy and hold an equity mutual fund for more than 1 year, the tax will be NIL. For example, if you invest Rs. 1 lakh in XYZ Fund and after 1 year, its value is Rs. 1.3 Lakh, there will be zero tax on capital appreciation of Rs. 30,000. This is a very big advantage of equity mutual funds. Short term capital gain tax on equity mutual funds: If you sell an equity mutual fund before the completion of one year, you will need to pay a tax of 15% on capital gains. In the above example where the gain was Rs. 30,000, if this was a short-term capital gain, the investor would have to pay Rs. 4,500 as short term capital gain tax.
Capital Gain Tax on Debt Mutual Funds All other funds that do not qualify as equity funds, including Fund of Funds and International Funds, are classified as debt mutual funds. Short term capital gain tax on debt mutual funds: Any short term capital gain that arises due to selling of debt mutual funds before 1 year will be added to the investor’s income. Once it is added, it will be taxed according to the tax slab of that individual. Long term capital gain on debt mutual funds: Here, taxation depends on whether investor would like to use indexation or not. • •
Without Indexation – 10% tax on capital gains With Indexation – 20% tax on capital gains
Mutual Fund Dividend Taxation Again, this taxation will depend on which type of mutual fund you are investing in – equity or debt. There is no dividend distribution tax on
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equity mutual funds and also, the dividend received by investors is tax free. So, again it’s a bonus for equity mutual fund investors. Even in the case of debt mutual funds, dividends received by investors are tax free in their hands and they don’t need to show it as taxable income. However, a dividend distribution tax is paid by mutual fund companies to income tax departments.
➢ When to sell your funds?
Constant Underperformance You can think of selling your mutual fund if it has consistently underperformed as compared to its benchmark. Investors should study the performance of a fund for four consecutive quarters before arriving at a decision. If there is no substantial improvement in its performance relative to its benchmark or peers, you may want to get out. Benchmarking is an important factor in gauging a mutual fund’s performance and determining whether it has kept up to its overall investment objective. Benchmarks can provide investors a perspective on the expected riskadjusted performance of fund portfolios and help them take investmentrelated decisions. So, if your portfolio warrants investing in an index fund as a passive strategy, compare its performance with the index and not with its diversified equity counterparts. Even if the index has underperformed, you should remain invested since it serves a particular purpose in your portfolio. You may also consider exiting a mutual fund if the management changes. The entry or exit of fund managers could have a bearing on its performance.
Repositioning It may be worthwhile to evaluate your investment strategy periodically to ensure that it meets your objectives at every stage of life. It could be buying a house, marriage, birth of a child, education or retirement. If your financial objective has been met, it may be time to modify your portfolio, say, move to debt funds as you get closer to retirement.
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Change In Your Goals Mutual fund investments are based on financial goals; you follow a certain investment philosophy and allocate your assets in a way that they fulfill your objectives. For instance, if you are single, in your early 20s and your first goal is to buy a car, you might invest a higher percentage in equities. Once you have reached your goal, even if it is earlier than you thought, it makes sense to sell your funds and actualise it.
➢ How to select a fund?
Return Measurements Point To Point Returns These are calculated by considering NAVs at two points in time - entry date and exit date. To know how your investment has grown on an annual basis, you will need to check the Compounded Annual Growth Rate (CAGR). While CAGR can be calculated for any period, a simple point-to-point return is preferred when the holding period is less than one year. CAGR is ideal for more extended holding periods. While calculating point-to-point return is more comfortable, and the method is used extensively to analyze fund’s performance, it is not foolproof. It fails to determine the consistency of historical returns. Rolling Returns In case of rolling returns, returns are calculated continuously for each defined interval -- which can be days, weeks, months, quarters, or even years. The resultant amount can be compared to Category Average Rolling Return. So, if a particular mutual fund has delivered a 12%-yearly rolling return, while its category average one-year rolling return is 14%, it implies that the fund has fared worse than its category average.
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An analysis of rolling returns also throws light on other relevant statistics, the most important ones being the maximum (the highest of yearly returns) and minimum returns (the lowest figure). It not only helps to determine performance consistency but also assesses the fund's best and worst periods, in terms of returns.
Risk Measures Standard Deviation Standard deviation measures the total risk associated with a mutual fund (market and company-specific). It measures the extent to which fund returns vary across the average. Fund returns constitute the percentage change in its NAV, and it can be calculated on a daily, weekly, monthly or yearly basis. A high standard deviation implies that the periodic returns are fluctuating significantly from the average return, thereby indicating a higher degree of volatility. On the other hand, a low standard deviation implies that the periodic returns are fluctuating close to the average return, thereby suggesting a lesser degree of risk. Downside Probability It calculates the probability of negative returns from the portfolio. Downside probability is equal to the total number of negative returns in a period/Total number of returns in a period. Since the figure hints at the probability of negative returns, a higher number is considered bad, whereas a lower value is deemed favorable. A statistical tool -- Frequency Distribution Method -- is generally used for computing the probability. Maximum Drawdown (MDD) Maximum drawdown (MDD) is the most significant drop of your portfolio from the peak to the bottom in a specific period. A drawdown, the amount by which your portfolio declines from a peak reading to its lowest value before attaining a new peak, is one of the real measures of the risks you are taking in your investment program. Maximum drawdown is always smaller than or equal to the difference between maximum loss and maximum gain. It depends on the chosen time interval (be it annually, monthly or daily) and observation period. 70 | P a g e
Maximum drawdown is an excellent way to compare the inherent volatility of different strategies. Tracking Error It is the difference between the price behavior of a portfolio or position and that of the benchmark. It can be easily calculated on a standard MS Office spreadsheet. In other words, tracking error refers to the standard deviation percentage difference between the returns that an investor receives and that of the benchmark or index it was intended to mimic/beat. The fund manager may buy/sell securities anytime during the day, whereas the underlying index will be calculated based on the closing prices of the Nifty 50 stocks. Therefore, there will be a difference between the returns of the scheme and the index. Also, there may be a divergence in returns because of cash position held by the fund manager. It will lead to investors' money not being allocated precisely as per the index, but only very close to it. If the index’s portfolio composition changes, it will take some time for the fund manager to exit the earlier stock and replace it with the new entrant in the index. These and other reasons, like dividend accrued but not distributed, and accrued expenses result in returns of the scheme being different from those delivered by the underlying index. This difference should be as low as possible. Investors prefer the fund with the least tracking error, considering it is tracking the index closely. Tracking error is also a function of the scheme expenses. Therefore, lower the costs, lower the tracking error of a mutual fund.
Performance Evaluation Sharpe Ratio Risk premium refers to returns exceeding the risk-free rate of return that an asset class is expected to yield. Therefore, a risk premium is a type of compensation that investors enjoy for tolerating that additional risk, as opposed to a risk-free asset class. Sharpe ratio uses Standard Deviation as a measure of risk. It is calculated as: 71 | P a g e
(Rs minus Rf) ÷ Standard Deviation, where Rs is the return from an investment and Rf is the risk-free rate of return. Thus, if the risk-free return is 5% and a scheme with a standard deviation of 0.5 earned a return of 7%, its Sharpe Ratio would be: (7% - 5%) ÷ 0.5 = 4%. Sharpe ratio is effectively the risk premium per unit of risk. Higher the Sharpe ratio, better the scheme. However, exercise caution while carrying out Sharpe ratio comparisons between schemes. For instance, don't equate the Sharpe ratio of an equity scheme to that of a debt scheme. Treynor Ratio Also known as the reward-to-volatility ratio, Treynor ratio is a metric deployed to calculate excess returns generated for every additional unit of risk that a portfolio assumes. Similar to Sharpe ratio, excess returns here indicate additional returns earned over and above the gains from a riskfree investment. However, unlike Sharpe ratio that uses standard deviation as a measure of risk, Treynor ratio uses beta. Treynor Ratio is calculated as: (Rs minus Rf) ÷ Beta For example, risk-free return (Rf) is 5%, and a scheme with a beta of 1.2 earned a return of 8%. Here, Treynor Ratio would be: (8% - 5%) ÷ 1.2 = 2.5%. Higher the Treynor ratio, better the scheme. However, the ratio should ideally be restricted to diversified equity schemes. Information Ratio Also known as appraisal ratio, Information ratio seeks to measure the performance of an investment relative to its benchmark index, after accounting for additional risks. In other words, Information ratio (IR) measures a portfolio manager's ability to generate excess returns relative to a benchmark and assess investor consistency.
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Higher the ratio, more consistent is the portfolio manager. Rp = Return of the portfolio Ri = Return of the index or benchmark Sp-i = Tracking error (standard deviation of the difference between Rp and Ri) Therefore, IR = (Rp - Ri)/Sp-i A high IR can be achieved by high portfolio returns, low index returns and little tracking error. For example: 1. Manager A might have returns of 13% and a tracking error of 8% 2. Manager B has returns of 8% and tracking error of 4.5% 3. The index has returns of -1.5% In this case, Manager A's IR = [13-(-1.5)]/8 = 1.81, and Manager B's IR = [8-(-1.5)]/4.5 = 2.11 Here, Manager B has lower active returns but a better IR. A higher ratio signifies the ability of the manager to generate higher returns by taking on additional risks.
Equity Portfolio Attributes -
Market Cap Concentration
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Professional portfolio managers, who work for an investment management company, do not have a choice about the general investment philosophy that is used to govern the portfolios they manage. An investment firm may have strictly-defined parameters for stock selection and investment management. An example would be a firm defining a value investment selection style using specific trading guidelines. Furthermore, portfolio managers are also usually constrained by market capitalization guidelines. For example, small-cap managers may only select stocks in the Rs.200-500 crore market-cap range. Therefore, the first step in portfolio management is to understand the universe from which investments are selected. Some portfolios use a bottom-up approach, wherein investment decisions are made primarily by selecting stocks without considering the sector economic forecasts. Other styles may be top-down oriented, wherein portfolio managers consider analyzing entire sectors or macroeconomic trends as a starting point for analysis and stock selection. Other methods use a combination of these approaches.
Debt Portfolio Attributes Issuer Concentration The debt market comprises broadly two segments, viz., Government securities market or G-Sec market and corporate debt market. The latter is further classified as a market for PSU bonds and private sector bonds. Maturity Profile A bond fund maintains a weighted average maturity, which is the average of all the current maturities of the bonds held in the fund. The longer the average maturity, the more sensitive the fund tends to be to changes in interest rates. Also defines the weighted average maturity, maximum and maturity for certain asset types like a corporate bond, Gilts etc. Credit quality The overall credit quality of a bond fund will depend on the credit quality of the securities in the portfolio. Bondi credit ratings can range from speculative—often referred to as high-yield—to very high, generally referred to as investment-grade bonds. Funds that invest in lower-quality securities can potentially deliver higher yields and returns, but will also 74 | P a g e
likely experience greater volatility, due to the fact that their interest payments and principal are at greater risk. The relative credit risk of a bond is reflected in ratings assigned by independent rating companies such as CRISIL, ICRA, CARE, Fitch etc. These rating companies use a letter scale to indicate their opinion of the relative credit risk of a bond, with the highest credit rating being AAA.
Style Growth Style Growth investing entails looking for companies that have a potential to grow faster than others. The optimism is reflected in the premium valuation commanded by the market price of such companies. Typically, growth stocks have low dividend yields and above-average valuations as measured by price-to-earnings (P/E), market capitalisation-to-sales and price-to-book value ratios (P/B), reflecting the market's high expectations of superior growth. Growth investors are more apt to subscribe to the efficient market hypothesis which maintains that the current market price of a stock reflects all the currently knowable information about a company and, so, is the most reasonable price for that stock at that given point in time. They seek to enjoy their rewards by participating in what the growth of the underlying company imparts to the growth of the price of its stock. Only aggressive investors, or those with enough time to make up for short-term market losses, should buy these funds. Value Style A value investor, on the other hand, buys undervalued stocks that have a potential for appreciation but are usually ignored by the investing community. Value investors put more weight on their judgments about the extent to which they think a stock is mispriced in the marketplace. If a stock is underpriced, it is a good buy; if it is overpriced, it is a good sell. They seek to enjoy their rewards by buying stocks that are depressed because their companies are going through periods of difficulty; riding their prices upward, if, when, and as such companies recover from those difficulties; and selling them when their price objectives are reached. Value stocks usually have above-average dividend yields and low P/Es. Value funds are most suitable for more conservative, tax-averse investors. 75 | P a g e
Debt portfolio attributes Issuer concentration The aptitude and proficiency of a fund manager are what differentiates the top performing funds from the worst ones. Investors must consider the past performance of the fund manager before investing in a mutual fund. If a fund manager has recently joined an AMC, his previous fund management experience should be evaluated. In the same category of funds, say equity diversified, you should pick funds whose alpha values are greater than zero. This is because the higher the value of alpha, the better is the performance of the fund manager. Maturity profile A bond fund maintains a weighted average maturity, which is the average of all the current maturities of the bonds held in the fund. Longer the average maturity, more sensitive is the fund to changes in interest rates. Credit quality The overall credit quality of a bond fund will depend on the credit quality of the securities in the portfolio. Bond credit ratings can range from speculative (often termed high-yield) to very high (referred to as investment-grade bonds). Funds that invest in lower-quality securities can potentially yield higher returns, but also experience greater volatility, considering interest payments and principal face an increased risk. The relative credit risk of a bond reflects in ratings assigned by independent rating companies such as CRISIL, ICRA, CARE, Fitch, etc. These rating companies indicate their opinions on the relative credit risk of a bond, with the highest credit rating being AAA. Growth Style Growth investing entails looking for companies that have the potential to grow faster than others. The optimism reflects in the premium valuation commanded by the market price of such companies. Typically, growth stocks have low dividend yields and an above-average valuation, as measured by their price-to-earnings (P/E), market capitalization-to-sales, and price-to-book value ratios (P/B).
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Growth investors subscribe to the efficient market hypothesis which maintains that the current market price of a stock reflects all the currently knowable information about a company and, so, is the most reasonable price for that stock at that given point in time. Growth investors participate in the value that the growth of the particular company imparts to the price of the stock. Aggressive investors, or those with enough time to make up for short-term market losses, should buy these mutual funds. Value Style A value investor, on the other hand, buys undervalued stocks that have a potential for appreciation but are usually ignored by the investing community. Value investors put more weight to their judgment about the extent to which a stock is under-priced in the marketplace. If a stock is underpriced, it is a good buy; if it is overpriced, it is a good sell. Value investors buy depressed stocks, steer their prices upward, and sell them when they meet their price objectives. Value stocks usually have above-average dividend yields and low P/E ratios. Value funds are suitable for a more conservative, risk-averse investor.
Know Your Fund Manager Years of Experience While experience is not a fool-proof predictor of future performance, fund managers who have been managing the same mutual fund (or the same style) for at least ten years, tend to do win out — longer the tenure, better the performance and consistency. Performance of funds managed A fund manager's proficiency is what differentiates the top-performing mutual funds from the worst ones. Investors must consider the past performance of the fund manager before investing in a mutual fund. If a fund manager has recently joined an AMC, his previous fund management experience should be evaluated.
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In the same category of funds - say equity diversified - you should pick funds whose alpha values are greater than zero. That's because, higher the value of alpha, better is the performance of the fund manager.
➢ How to read fact sheets? Fact Sheet is a monthly document which all mutual funds have to publish. This document gives all details as regards the AUMs of all its schemes, top holdings in all the portfolios of all the schemes, loads, minimum investment, performance over 1, 3, 5 years and also since launch, comparison of scheme’s performance with the benchmark index (most mutual fund schemes compare their performance with a benchmark index such as the Nifty 50) over the same time periods, fund managers outlook, portfolio composition, expense ratio, portfolio turnover, risk-adjusted returns, equity/ debt split for schemes, YTM for debt portfolios and other information which the mutual fund considers important from the investor’s decision-making point of view.
The Fact Sheet would consist of the following sections by which investors can evaluate the schemes. Investment Objective: The investment objective establishes whether the fund meets the intended investment objective, i.e. for investing for growth, income or capital preservation. Fund Index: The Index, also known as the Fund Benchmark, is an indicator of how the Fund is performing relative to its peers. A benchmark is usually a predetermined set of securities based on published indexes (Eg: S&P 500) or a customized set to suit the Fund's investment strategy. Dividend Information: Dividend is a share of a company's net profits distributed by the company to a class of its stockholders. The dividend is paid in a fixed amount for each share of stock held. Net Asset Value: The net asset value per share usually represents the fund's market price, 78 | P a g e
subject to a possible sales or redemption charge. The term is used to describe the value of an entity's assets less the value of its liabilities. Total Expense Ratio: Total Expense Ratio (TER) is measuring the total costs of a fund investment. Total costs may include various fees (trading, auditing) and other expenses. The TER is calculated by dividing the total cost by the fund's total assets and is denoted as a percentage. It may vary from year to year. Graph: The graph depicts the performance of the fund relative to the fund benchmark since inception. Performance Table: This table depicts the performance of the Fund relative to the Fund benchmark since inception and over a set of standard time periods. Portfolio Composition: It provides the high-level breakdown of the Fund's holdings into Equity, Fixed Income & Cash. The Cash component shown may include Financial Instruments with duration of less than 1 year. Fund Characteristics: It is given in a tabular form summarizing characteristics of the portfolio of investments held by the Fund. The table includes information on the Fund size, the number of securities held by the Fund and statistics applicable to those securities. For Equity Funds, the statistics shown include Price/ Earning Ratio and Price/Cash Flow Ratio, wherever applicable. Fixed Income Funds show statistics relevant to the portfolio of fixed income securities held by the Fund, including their Weighted Average Credit Quality. All portfolio statistics are weighted averages relative to the size of the Fund's investment in the security, where appropriate. Not all statistics are available for all securities or Funds because of restrictions on data sourcing. Top Holdings: The top 10 or all the holdings according to underlying fund exposure are captured. This gives an indication of the broadness of the fund exposure. Industry breakdown shows the investments made in various Industries.
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What is a fact sheet? A fact sheet is a monthly document that all mutual funds have to publish. This document gives out details such as: • • • • • • • • • • • • • •
AUMs of schemes Top holdings in all the portfolios of schemes Loads Minimum investment Performance details over 1, 3 and 5 years Comparison of scheme’s performance with the benchmark index (most mutual fund schemes compare their performance with a benchmark index such as the Nifty 50) over the same periods Fund manager's outlook Portfolio composition Expense ratio Portfolio turnover Risk-adjusted returns Equity/debt split for schemes YTM for debt portfolios Other information that the mutual fund house considers vital from the investor’s decision-making point of view
The fact sheet consists of the following sections by which investors can evaluate the schemes: • •
• • •
Investment Objective: The investment objective establishes whether the mutual fund meets the intended investment objective, i.e. investing for growth, income or capital preservation. Fund Index: Also known as the fund benchmark, it is an indicator of how the fund is performing relative to its peers. A benchmark is usually a predetermined set of securities based on published indexes (Eg: S&P 500) or a customized set to suit the fund's investment strategy. Dividend Information: Dividend is a share of a company's net profits distributed by the company to a class of its stockholders. The dividend is a fixed amount paid for each share of stock held. Net Asset Value: Net asset value (value of assets minus liabilities) per share usually represents the fund's market price, subject to a possible sales or redemption charge. Total Expense Ratio: Total Expense Ratio (TER) measures the total costs of a fund investment. These costs include various fees (trading, auditing) and other expenses. TER is calculated by dividing the total cost by the fund's total assets and denoted as a percentage. TER usually varies across years.
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• • • •
Graph: The graph depicts the performance of a mutual fund relative to the benchmark since inception. Performance Table: This table charts the performance of a mutual fund relative to its benchmark, since inception and over a set of standard periods. Portfolio Composition: It provides a detailed breakdown of the fund's holdings into equity, fixed income and cash. The cash component may include financial instruments with a maturity period of less than one year. Fund Characteristics: Presented in a tabular format, it summarizes the characteristics of the portfolio of investments held by the fund. The table includes information about the size of a mutual fund, number of securities held by it, and statistics applicable to those securities.
For equity funds, the statistics may include price-to-earnings ratio and price-to-cash flow ratio, wherever applicable. Fixed-income funds exhibit statistics relevant to the portfolio of fixed income securities that are held by the mutual fund (including their Weighted Average Credit Quality.) All portfolio statistics are weighted averages relative to the size of the fund's investment in the security, wherever appropriate. Not all statistics are available for every security or fund, because of restrictions on data sourcing. • •
Top Holdings: The top 10 holdings (or all the holdings) according to underlying fund exposure are captured. It indicates broadness of fund exposure. Industry breakdown: It shows the investments made across industries.
➢ Portfolio management
Model Portfolio There is no ideal or model mutual fund portfolio that can suit every individual investor's needs and risk appetite. While there is no dearth of mutual funds in the market today, building a portfolio depends on the preferences and objectives of each individual. The factors that come into play include the age of the investor, risk appetite, investment horizon, immediacy, and, more importantly, the objective of the investment. The model portfolio, as explained below, can be constructed for four types of investors based on their risk-return appetite.
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Mutual Fund Model Portfolio
1) Aggressive: Aggressive investors tend to be risk-takers. They are willing to embrace risky investments, considering their objective is to maximize returns in the long run. These investors seek above-average returns by focusing their investments in stocks and certain types of mutual funds. Aggressive investors should invest in small and mid-cap funds as these have the potential to yield above-average returns, and are risky at the same time. Small and mid-cap funds can spruce up one's portfolio, considering these are future large-cap stocks. These funds tend to grow faster than large-cap funds; however, they entail a higher degree of volatility. 2) Moderately Aggressive: Moderately aggressive investors usually have similar investment objectives as their aggressive counterparts. However, they are characterized by a lower risk tolerance than aggressive investors. As such, their preference may be for equities (or mutual funds) or a mix of both. 82 | P a g e
Moderately aggressive investors should ideally have their investments focused on large/blue chip funds and mid-cap funds. 3) Moderately Conservative: Moderately conservative investors are willing to take on limited risks, but usually seek to balance this with investments that preserve the principal investment. It means that these investors may invest in stocks but also seek a constant income stream. In keeping with their objectives, moderately conservative investors should invest in balanced funds. Also, they can park their funds in large-cap funds or MIP for a regular income stream. Monthly income plans and balanced funds limit equity exposure and allocate a significant portion to debt instruments. This provides stability to the portfolio, while the equity portion enables capital appreciation and wealth accumulation. 4) Conservative: Conservative investors tend to be risk-averse, and their primary objective is to preserve the capital invested. In keeping with their goals, conservative investors should ideally invest in debt mutual funds and MIP that can generate a constant income stream.
Fund Recommendation You purchase a mobile phone (or any consumer durable) only after considering your needs and budget. Likewise, you should choose a mutual fund that meets your risk tolerance and investment objectives. You can read expert articles to understand how to zero in on a mutual fund that fulfills your investment-related goals as well as meets your risk appetite. Moreover, you can also follow the gamut of factors to consider while evaluating a mutual fund investment. An investor should work towards building a stable portfolio, one that includes large-cap funds to provide his portfolio the desired stability, funds with a proven track record, and some aggressive funds to enable capital appreciation.
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CHAPTER 4: ASSET ALLOCATIONS ➢ Types of asset classes Below is the list of different asset classes one can consider for investing in Indian markets for building a balanced portfolio. One has to understand different asset classes and build the portfolio as per risk appetite. In this image, you find the different asset classes and their subcategories with risk potential.
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Note: The above chart is not an exhaustive list of products and asset classes.
➢ Risk profiling In financial markets, an individual's risk profile indicates his ability to stomach risks while investing. It is one of the critical variables that a financial planner will focus on before recommending a product to an investor. An individual's risk profile will indicate whether he is a conservative, moderate or aggressive investor. 85 | P a g e
How is risk profiling carried out? Wealth management service providers use psychometric questionnaires -comprising queries on day-to-day situations -- to assess investor risk profile. Generally, the individual taking the test is asked to choose one option that best describes his response to a particular situation. These responses help financial planners and wealth managers judge how the individual will react when subject to a specific scenario. That forms the basis of the individual's ability to take risks. These questionnaires, therefore, minimize the probability of any bias that may be introduced by wealth managers in the financial planning process. While taking the test, an individual should be honest and select an option that best describes the probable response.
Challenges of risk profiling There are instances when the individual might get carried away by ambient factors while responding to the questionnaires. Peer pressure and market sentiment are some factors that can influence the process. For example, an individual may appear to be a risk-taker when the stock market exhibits an upward trend. However, the same person may appear risk-averse in times of falling stock markets. The changing moods of individuals thus make risk profiling problematic for wealth managers and financial planners. If other factors remain the same, an individual's ability to take risk will usually go down with increasing age. But some instances do not adhere to the observation. For example, a wealthy middle-aged investor, with no family liabilities, may be comfortable investing in equity. To understand the changes in an individual's risk profile that happen with increasing age and a changing asset-liability structure, wealth managers prefer to conduct investor risk profiling every three years.
In conclusion Once an individual's risk profile is established, the financial planner will suggest a financial plan, in keeping with the investor’s investment horizon and financial goals. But such a plan is likely to change with the changing risk profile of the individual.
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CHAPTER 5: TECHNICAL ANALYSIS ➢ Critics of Technical analysis In spite of extensive use across investment research and trading advisory business, technical analysis has its share of critics and detractors. A wide range of technical indicators and diverse prognosis of chart patterns make technical analysis more of an art than a science. Exact and accurate prognosis of a particular chart formation is challenging, considering the judgement of such formation is subjective. Even if the chartist is wellversed with the intricate dynamics of chart formation, the inferences drawn might still be far from the truth. However, due to increased volatility in the financial markets following the boom in information technology, charts are becoming increasingly popular for analysing pricing action in the markets. So despite the criticism, charting analysis has been only gaining in relevance with every passing day.
Significance of support and resistance Support and resistance are two of the most critical aspects of a trade setup. The importance of these two corresponding dynamics can be understood by the fact that any primary technical study or a combination of indicators eventually intends to arrive at supports and resistances for the underlying security. In simple terms, support is the level at which the security is expected to witness buying, thereby cushioning its fall; while resistance is the level at which the security is expected to witness selling, ensuring that the price does not rise above the levels of resistance.
Technical analysis indicators The basic tops and bottoms formation is the simplest way to arrive at the supports or resistances on any price chart. The other studies for arriving at the supports and resistances are pivot points, Fibonacci Retracement, moving averages and long-term trendlines. 87 | P a g e
Interpreting volumes on a chart Volumes could have a sizable bearing on a chart. At times, analysing price fluctuations in conjunction with movement in volumes of the security can accurately identify key reversal points. For instance, if the security is witnessing a massive surge in volumes at a particular price point, there is a chance that a sizeable portion of market participants consider that particular price point to be a critical support level. Often, volumes can surge after prices successfully breach a critical level and then trade above it. It magnifies the importance of volumes as an indicator of crowd psychology.
Golden Ratio There exists a special ratio, one that can be used to describe the proportions of anything and everything; from nature's smallest building blocks to the most intricate patterns out there in the universe - celestial bodies, for instance. While nature relies on this proportion to maintain the fine balance in its scheme of things, financial markets also conform to this ratio, called the Golden ratio.
The mathematics behind the ratio Scientists and mathematicians have known the golden ratio since centuries. The ratio is derived from something called the Fibonacci Sequence, named after the Italian founder, Leonardo Fibonacci. In this sequence, each number is simply the sum of its two preceding numbers/terms. For example, the sequence (1,1,2,3,5,8,13) adheres to the Fibonacci Sequence. However, the sequence is not all that important. Instead, it is the quotient of the adjacent terms that has a definitive proportion, an estimated 1.618 or 0.618 (inverse).
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This proportion has come to be known by many names; some call it the golden mean, some call it PHI, while others have named it the divine proportion.
Why is the ratio so significant? That is because everything around us has dimensional properties that arrange in this ratio of 1.618. Therefore, the golden ratio appears to play a fundamental role across nature's building blocks.
➢ Importance of support and resistance Supports and resistance are two of the most critical aspects in a trade set up. The importance of these two corresponding dynamics could be underlined by the fact that any primary technical study or a combination of indicators eventually intends to arrive at supports and resistances for the underlying security.
In simple terms, support is the level at which the security is expected to witness buying, thereby cushioning its fall while resistance is the level at which the security is expected to witness selling, ensuring that the price does not rise above the levels of resistance. The basic tops and bottoms formation is the simplest way to arrive at the supports or resistances on any price chart. The other studies for arriving at the supports and resistances are Pivot Points, Fibbonaci Ratio, moving averages and long-term trendlines.
➢ Interpreting volumes on a chart Volumes could have a sizable bearing on chart. At times, analyzing price moves in conjunction with the movement in volumes on the security could give an exact and accurate idea in terms of identifying key reversal points. 89 | P a g e
If the security is witnessing a massive surge in volumes at a particular point of price, there may be chances that a substantial chunk of the market participants believe that point in price to be a critical support level. At times the volumes tend to surge after prices successfully breach a critical level and tend trade above it. This magnifies the importance of volumes as an indicator of the crowd psychology.
➢ Golden Mean Ratio The Golden mean, represented by the Greek letter phi, is one of those mysterious natural numbers, like e or pi, that seem to arise out of the basic structure of our cosmos. Unlike those abstract numbers, however, phi appears clearly and regularly in the realm of things that grow and unfold in steps, and that includes living things.
There is a special ration that can be used to describe the proportions of everything from nature's smallest building blocks, such as atoms, to the most advanced patterns in the universe, such as unimaginably large celestial bodies. Nature relies on this innate proportion to maintain balance, but the financial markets also seem to conform to this 'golden ratio.' It's derived from something known as the Fibonacci sequence, named after its Italian founder, Leonardo Fibonacci (whose birth is assumed to be around 1175 AD and death around 1250 AD). Each term in this sequence is simply the sum of the two preceding terms (1, 1, 2, 3, 5, 8, 13, etc.). But this sequence is not all that important; rather, it is the quotient of the adjacent terms that possesses an amazing proportion, roughly 1.618, or its inverse 0.618. This proportion is known by many names: the golden mean, PHI and the divine proportion, among others. So, why is this number so important? Well, almost everything has dimensional properties that adhere 90 | P a g e
to the ratio of 1.618, so it seems to have a fundamental function for the building blocks of nature.
➢ Importance of charts There are several reasons why charts have assumed significance in financial market research and analysis over the last couple of decades. •
One of the primary reasons for this was the widespread boom in the information technology during the 1990s that facilitated the use of charting software and while contributing to increased awareness about the use of charts as an efficient indicator to track financial markets. Also, considering the giant strides that financial reporting has taken in recent times coupled with the penetration of financial media in emerging economies, market movements across the world have become more 'responsive' to micro trends.
Importantly, this has been witnessed in seemingly unrelated sectors and segments in the global economy. Therefore, as news flow increased multifold, the most reliant indicator as to where the prices could be moving turned out to be the price itself. Also, the rapid boom in global news networks and the rise of social media have blurred the lines between nations, and financial markets around the world started reflecting generalized sentiments in world asset markets.
➢ Fibonacci Retracements Fibonacci sequences are generally meant to find out reversals in charts. The main area to look for in a chart with Fibonacci retracements is corrections or pullbacks. In simple words, the basic purpose of these retracements is to find supports and resistances. The retracements are 100%, 61.8%, 50% and 38.2%. Now let’s look at the daily chart of Copper. Fibonacci levels built from the bottom of Rs 397.1, i.e. 100% of the value to Rs 433.7 per kg.
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This is also the immediate bullish wave after the downtrend. If one has to look at the supports and resistances for copper from the top, i.e. Rs 433.7, he will have to consider the levels of Rs 419.9, that is also the 38.2% corrective level. Although 23.6% is one retracement level in between, it is not considered very important in the Fibonacci series. The two levels that are considered are 38.2% and 61.8%. If copper falls further below the Rs.419.9 level, it is expected that it will try to find support at Rs.411 or somewhere near that, considering it is the 61.8% correction point. Similarly, a bounce from Rs.411 will find hurdles at Rs.415 and Rs.419.9 per kg, that are the 50% and 31.8% pullback points for Copper. Note: Though 61.8% and 38.2% have been given much weight in the Fibonacci series, it depends on individual analysts to also consider 50% and 23.6% retracements, if other technical indicators indicate the same levels.
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CHAPTER 6: DERIVATIVES CONCEPTS ➢ Types of derivative
Forward Contracts These are the simplest form of derivative contracts. A forward contract is an agreement between parties to buy/sell a specified quantity of an asset at a certain future date for a certain price. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract assumes a short position and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract. No margins are generally payable by any of the parties to the other.
Futures contracts A futures contract is one by which one party agrees to buy from / sell to the other party at a specified future time, a specified asset at a price agreed at the time of the contract and payable on the maturity date. The agreed price is known as the strike price. The underlying asset can be a commodity, currency, debt or equity security etc. Unlike forward contracts, futures are usually performed by the payment of difference between the strike price and the market price on the fixed future date, and not by the physical delivery and the payment in full on that date.
Forward Contract Each contract is custom designed, and hence is unique in terms of contract size, maturity date and the asset type and quality,
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Future Contract •
Standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc.,
On the expiration date, the contract is normally settled by the delivery of the asset,
Traded through an organized exchange and thus have greater liquidity. The existence of a regulatory authority & the clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honoring of the contract and ensuring a very low level of default. Margin requirements and daily settlement to act as further safeguard.
Forward contracts being bilateral contracts are exposed to counter party risk, and If the party wishes to cancel the contract or change any of its terms, it has necessarily to go to the same counter party.
Types of Future Contracts Common types of ‘futures contracts’ are stock index futures, currency futures, and interest futures depending on their underlying assets. Index Futures Index Futures are future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are expected to rise and say the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future. Currency futures
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Currency futures are contracts to buy or sell a specific underlying currency at a specific time in the future, for a specific price. Currency futures are exchange-traded contracts and they are standardized in terms of delivery date, amount and contract terms. Currency Futures have a minimum contract size of 1000 foreign underlying currency (i.e. INR 1000). Currency future contracts allow investors to hedge against foreign exchange risk. Since these contracts are marked-to-market daily, investors can--by closing out their position--exit from their obligation to buy or sell the currency prior to the contract's delivery date. Interest Futures Interest rate futures (IRF) is a standardized derivative contract traded on a stock exchange to buy or sell an interest bearing instrument at a specified future date, at a price determined at the time of the contract. The interest rate future allows the buyer and seller to lock in the price of the interestbearing asset for a future date. IRFs can be on underlying as may be specified by the Exchange and approved by SEBI from time to time and it can be based on 1) Treasury Bills in the case of Treasury Bill Futures traded; 2) Treasury Bonds in the case of Treasury Bond Futures traded; 3) other products such as CDs, Treasury Notes are also available to trade as underlying assets in an interest rate future. Because interest rate futures contracts are large in size (i.e. INR 1 million for Treasury Bills), they are not a product for the less sophisticated trader. Determination of Future Prices The price of the futures refers to the rate at which the futures contract will be entered into. The basic determinants of futures price are spot rate and other carrying costs. In order to find out the futures prices, the costs of carrying are added/deducted to the spot rate. The costs of carrying depend upon the time involved and rate of interest and other factors. On the settlement date, the futures price would be the spot rate itself. However, before the settlement day, the futures price may be more or less than the prevailing spot rate. In case, the demand for future is high, the buyer of futures will be required to pay a price higher than the spot rate and the additional charge paid is known as the contango charge. However, if the sellers are more, the futures price may be lower than the spot rate and the difference is known as backwardation. For example, with reference to the Stock Index Futures, the pricing would be such that the investors are indifferent between owning the share and owning a futures contract. The 95 | P a g e
price of stock index futures should equate the price of buying and carrying such shares from the share settlement date to the contract maturity date. The financing cost of buying the shares would generally be more than the dividend yield. This means that there is a cost of carrying the shares purchased. So, the price of a futures contract will be higher than the price of the shares. The carrying cost of Stock Index Futures may be written as: Index value X (Financing Cost – Dividend yield) X Where t is the time period from share settlement date to the maturity date of the futures contract. For example, if the Index level is 4500, the rate of interest (financing cost is 12%), the dividend yield is 4% and the futures contract is for a period of 4 months, the carrying cost in terms of basic points is: Carrying cost = 4500 (12% – 4%) X 4/12 = 120 basis points. The value of the futures contract is 4500 + 120 = 4620 points for a period of 4 months. Swaps A swap can be defined as a barter or exchange. A swap is a contract whereby parties agree to exchange obligations that each of them has under their respective underlying contracts or we can say a swap is an agreement between two or more parties to exchange sequences of cash flows over a period in the future. The parties that agree to the swap are known as counter parties. There are two basic kinds of swaps - 1) Interest rate swaps and 2) Currency swaps. An interest rate swap contract involves an exchange of cash flows related to interest payments, or receipts, on a notional amount of principal, that is never exchanged, in one currency over a period of time. Settlements are often made through net cash payments by one counterparty to the other. Currency swap/Foreign exchange swap contracts involve a spot sale/purchase of currencies and a simultaneous commitment to a forward purchase/sale of the same currencies. Option Contracts 96 | P a g e
The literal meaning of the word ‘option’ is ‘choice’ or we can say ‘an alternative for choice’. In derivatives market also, the idea remains the same. An option contract gives the buyer of the option a right (but not the obligation) to buy/sell the underlying asset at a specified price on or before a specified future date. As compared to forwards and futures, the option holder is not under an obligation to exercise the right. Another distinguishing feature is that, while it does not cost anything to enter into a forward contract or a futures contract, an investor must pay to the option writer to purchase an options contract. The amount paid by the buyer of the option to the seller of the option is referred to as the premium. For this reward i.e. the option premium, the option seller is under an obligation to sell/buy the underlying asset at the specified price whenever the buyer of the option chooses to exercise the right. Option contracts having simple standard features are usually called plain vanilla contracts. Contracts having non-standard features are also available that have been created by financial engineers. These are called exotic derivative contracts. These are generally not traded on exchanges and are structured between parties on their own. The final difference between exotic options and regular options has to do with how they trade. Regular options consist of calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter, which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers/dealers and are not normally standardized as they are with regular options. Moneyness of an Option: Options can also be characterized in terms of their moneyness. 1. An in-the-money option is one that would lead to a positive cash flow to the buyer of the option if the buyer of the option exercises the option at the current market price. 2. An at-the-money option is one that would lead to a zero cash flow to the buyer of the option if the buyer of the option exercises the option at the current market price. 3. An out-of-the-money option is one that would lead to a negative cash flow to the buyer of the option if the buyer of the option exercises the option at the current market price.
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In-the-money At-the-money Out-of-the-money
Call Option M>E M=E M, < signs will reverse.
➢ What are derivatives A derivative is a financial instrument that derives its value from an underlying entity. The underlying entity, in this case, can be an asset or a group of assets, interest rate or an index. In investing, derivatives are used to speculate and transfer risks as well. The underlying asset value generally changes in keeping with the market conditions. The primary objective of entering into a derivatives contract is to make a profit by speculating on the underlying asset value at a future date.
➢ How do derivatives work? Say you invest in a stock, the price of which will fluctuate. In this case, you might incur a loss if the stock price nosedives. That is precisely why you enter into a derivative contract to make a profit by placing a straight bet, or hedge against losses in the spot market. When one enters into a derivatives contract, the medium and rate of repayment are specified in detail. For instance, repayment may be in currency, securities or a physical commodity such as gold or silver. Similarly, the amount of repayment may be tied to the movement in interest rates, stock indexes or foreign currency.
➢ Applications of financial derivatives
Risk management Risk management is not about the elimination of risk. Instead, it is the efficient management of risks. Financial derivatives are a powerful risk-
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limiting vehicle that individuals and organizations face in the ordinary conduct of their businesses. Successful risk management with derivatives requires a thorough understanding of the principles that govern the pricing of financial derivatives. If used correctly, derivatives can save costs and increase returns.
Trading efficiency Derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. That is because financial derivatives offer a higher degree of liquidity and entail lower transaction costs as compared to an underlying instrument.
Speculation Financial derivatives enable investors to speculate on the price of the underlying asset at a future date and make a profit. Financial derivatives act a powerful instrument for knowledgeable traders, helping them expose themselves to calculated and well-understood risks in pursuit of a reward (profit).
➢ Potential pitfalls of derivatives
Volatile investments Most derivatives trade in the open market. It is problematic for investors because of the security fluctuating in value. It is constantly changing hands, and therefore, the party who created the derivative has no control over who owns it. In a private contract, each party can negotiate the terms, depending on the other party’s position. When a derivative is sold in the open market, large 99 | P a g e
positions may be purchased by investors who have a high likelihood to default on their investment. The other party can’t change the terms to respond to the additional risk because they will then be transferred to the owner of the new derivative. Due to this volatility, investors can lose their entire value overnight.
Overpriced options Derivatives are also complicated to value because they derive their value from an underlying security. Since valuing a share of stock (or any other underlying asset) is challenging, it becomes more challenging to assess the value of a derivative accurately. Moreover, since the derivatives market is not as liquid as the stock market, and there aren’t as many 'players' in the market to close them, there are larger bid-ask spreads.
Time restrictions Possibly the biggest reason derivatives are risky for investors is that they have a shelf contract life. After they expire, they become worthless. If your investment bet doesn’t work out within the specified time frame, you can incurr a total loss.
Potential scams Investors have a hard time understanding derivatives. Scam artists often use derivatives to build complex schemes to take advantage of both amateur and professional investors.
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CHAPTER 7: FUTURES & OPTIONS ➢ F&O Important terminologies Call Option: A call option gives the buyer of the option the right (but not the obligation) to buy the underlying asset on or before a certain future date for a specified price. Put Option: A put option gives the buyer of the option the right (but not the obligation) to sell the underlying asset on or before a certain future date for a specified price. American Option: An American option can be exercised at any time up to the expiration date. Most of the option contracts traded on exchanges are of the type of American option. European Option: A European option can be exercised only on the expiration date itself. Strike Price or Exercise Price : The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Option Premium : Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. Expiration date : The date on which the option expires is known as Expiration Date. On the Expiration date, either the option is exercised or it expires worthless. Exercise Date : The date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract & its expiration date (see European/ American Option).
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Open Interest : The total number of options contracts outstanding in the market at any given point of time. Option Holder : One who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer : is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Option Class : All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options Option Series : An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May. Underlying : The specific security/asset on which an options contract is based. Contract multiplier : The contract multiplier for Sensex Futures is 50 and for Sensex Options is 100. This means that the Rupee value of a Sensex futures contract would be 50 times the contracted value and in case of Sensex Options, the rupee value would be 100 times the contracted value. The following table gives a few examples of this notional value. Ticket Size : The tick size is "0.1" for Sensex Futures. This means that the minimum price fluctuation in the value of a future can be only 0.1. In Rupee terms, this translates to minimum price fluctuation of Rs. 5 (Tick size X Contract Multiplier = 0.1 X Rs. 50). Likewise, the tick size is “0.05” for Nifty Futures.
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Within the futures industry, financial guarantees of both buyers as well as sellers of futures and options contracts are required to ensure fulfillment of contract obligations. Margins are determined on the basis of market risks and contract value. It is also referred to as ‘Performance Bond Margin’. For example let’s say there are three parties X (Buyer), Y (Seller) and Z (Broker). X is interested in buying a futures contract for Rs. 100 as he thinks its price would go up by the settlement date. Y, on the other hand, wants to sell the futures contract for Rs. 100 as he thinks its price will go down by the settlement date. And Z is the broker who will be executing the deal on behalf of investors X & Y. Since, derivative trading is about taking a ‘call’ on the upward and downward movement of the price of an underlying asset and not the absolute or actual price of the total contract, the Stock Exchange has to be hedged by investors (X & Y) to the extent of the expected margin of loss that the investor might incur with broker (Z) who is acting as a mediator between investors and exchange. For example in the case illustrated, where the cost of futures is Rs. 100, in all likelihood its value would go up or down by say Rs. 10 either way by the settlement date, based on expected volatility which is calculated mathematically. Hence the margin money sought by the Exchange through the broker from either party would be 10% of the total value (Rs.10 in the given example). Now let’s say by the settlement date, the scrip would be valued at Rs. 108. This means that ‘X’ will make a profit of Rs. 8 while ‘Y’ will incur a loss of Rs. 8. The broker hence credits the investor ‘X’s account by Rs. 8 along with the margin money of Rs 10. Hence, in total, ‘X’ receives Rs 18. On the other hand, ‘Y’ who has incurred a loss will see a debit of Rs. 8 from his margin money which was with the broker and the remaining Rs. 2 will be transferred to his account. Therefore the “funding” that goes to the broker to execute derivative deals is called “Margin Funding” or “Margin Money”. The long call option strategy is the most basic options trading strategy whereby an options trader
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buys call options with the belief that the price of the underlying security will rise significantly beyond the strike price before the expiration date of the option. When compared to buying the underlying shares outright, the call option buyer is able to gain leverage since lower priced calls usually appreciate in value faster for every point rise in the price of the underlying stock. However, call options have a limited lifespan. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthlessly. Maximum profit = Unlimited Profit is achieved when price of Underlying >= Strike Price of Long Call + Premium paid Profit = Price of Underlying - Strike Price of Long Call - Premium paid Maximum loss = Premium paid + Commissions paid Maximum loss occurs when price of Underlying Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put Net Premium Received Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid
Breakeven Point(s) There are 2 breakeven points for the short straddle position. The breakeven points can be calculated using the following formulae. • •
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Anticipations Characteristics Max profit Max profit formula Max loss
Short Straddle ( Straddle Write ) This market outlook anticipates very little underlying asset. Limited profit / unlimited loss. Limited profit / unlimited loss. Net Premium Received - Commissions Paid
Unlimited. Price of Underlying - Strike Price of Short Call Net Premium Received OR Strike Price of Short Max loss formula Put - Price of Underlying - Net Premium Received + Commissions Paid Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Breakeven Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
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➢ Long Strangle The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in options trading that involves the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date. The long options strangle is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience significant volatility in the near term. Maximum Profit = Unlimited Profit achieved when the price of underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying < Strike Price of Long Put Net Premium Paid Profit = price of underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid Max Loss = Net Premium Paid + Commissions Paid Max Loss occurs when the Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put.
Characteristics Max profit -
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Long Strangle ( Strangle Purchase ) A very volatile, immediate, and sharp swing in the price of the underlying asset is expected. The actual market direction is uncertain, so the positions of this strategy will benefit if the underlying asset either rises or falls, direction is uncertain, so the positions of this strategy will benefit if the underlying asset either rises or falls. Unlimited profit / limited loss. Unlimited.
Price of Underlying - Strike Price of Long Call Net Premium Paid OR Strike Price of Long Put Price of Underlying - Net Premium Paid Limited to the net debit required to establish the Max loss position Max loss formula Net Premium Paid + Commissions Paid Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Breakeven Lower Breakeven Point = Strike Price of Long Put Net Premium Paid
Max profit formula
Breakeven Point(s) There are 2 breakeven points for the long strangle position. The breakeven points can be calculated using the following formulae. Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Summary Long Strangle ( Strangle Purchase ) A very volatile, immediate, and sharp swing in the price of the underlying asset is expected. The actual market direction is uncertain, so the positions of this strategy will Anticipations benefit if the underlying asset either rises or falls, the direction is uncertain, so the positions of this strategy will benefit if the underlying asset either rises or falls. Characteristics Unlimited profit / limited loss. Max profit -
Max profit formula
Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid
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Limited to the net debit required to establish the position
Max loss formula
Net Premium Paid + Commissions Paid Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Breakeven Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
➢ Short Strangle The short strangle, also known as sell strangle, is a neutral strategy in options trading that involves the simultaneous selling of a slightly out-ofthe-money put and a slightly out-of-the-money call of the same underlying stock and expiration date. The short strangle is a 'limited profit unlimited risk' options trading strategy that the options trader uses when he believes that the underlying stock is likely to experience little short-term volatility. Max profit = Net premium received - Commissions paid Max profit is achieved when the price of the underlying is in between the strike price of the short call and strike price of the short put. Maximum loss = Unlimited Loss is when the price of the underlying is more than (>) strike price of short call + net premium received, OR the price of the underlying is less than (E
M, < signs will reverse.
➢ Types of margins levied in the Futures & Options(F&O) trading
Initial margin The futures/options contract specifies a trade taking place in the future. The purpose of the Futures Exchange Institution is to act as an intermediary and minimize the risk of default by either party. Thus, the exchange requires both parties to put up an initial amount of cash which is called margin. Initial margin for each contract is set by the Exchange. Exchange has the right to vary initial margins at its discretion, either for the whole market or for individual members. The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the day of the futures transaction. Initial margin for the FnO segment is calculated on a portfolio (a collection of futures and options positions) based approach. The margin 123 | P a g e
calculation is carried out using a software called – SPAN (Standard Portfolio Analysis of Risk). It is developed by the Chicago Mercantile Exchange (CME) and is extensively used by leading stock exchanges of the world. SPAN uses a scenario-based approach to arrive at margins. The value of futures and options positions depend on the volatility and price of the security in cash market, among others. To put it simply, SPAN generates about 16 different scenarios by assuming different values of price and volatility. For each of these scenarios, a possible loss that the portfolio can suffer is calculated. The initial margin required to be paid by the investor would be equal to the highest loss the portfolio would suffer in any of the scenarios considered. The margin is monitored and collected at the time of placing the buy / sell order. The SPAN margins are revised 6 times in a day - once at the beginning of the day, four times during market hours and finally at the end of the day. Obviously, higher the volatility, higher the margins are.
Exposure margin In addition to the initial margin, exposure margin is also collected. Exposure margins in respect of index futures and index options sell positions are 3% of the notional value. For futures and options on individual securities, the exposure margin is 5% or 1.5 standard deviation of the LN returns of the security (in the underlying cash market) over the past six months period and is applied to the notional value of position.
Premium and Assignment margins The premium margin is an amount calculated by multiplying the value of option premium with that of option quantity and is charged to the buyers of option contracts. For example, if 1000 call options on ABC Ltd are purchased at Rs. 20/-, and the investor has no other positions, then the premium margin will be Rs. 20,000. The margin has to be paid at the time of trade. Assignment Margin is collected on assignment from the sellers of contracts.
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Since the futures price generally changes daily, the difference in the prior agreed-upon price and the daily futures price is settled and t on the day and his margin is known as variation margin. The exchange draws money out of one party's margin account and transfer it into the other’s so that each party has his/her appropriate daily loss or profit.
Mark-to-market (MTM) If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market (MTM). Thus on the delivery date, the amount exchanged is not the specified price on the contract but its spot value (since any gain or loss has already been previously settled by marking to market).
Additional Margin In case of sudden higher than expected volatility, an additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the market has become too volatile and may result in some crisis. This is a preemptive move by exchange to prevent breakdown.
Clearing margin Clearing margin is a financial safeguard to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins as individual buyers and sellers of futures and options contracts are required to deposit it with the brokers.
Maintenance margin Maintenance margin refers to a set minimum margin per outstanding futures contract that a customer must maintain in his margin account.
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