A PROJECT REPORT ON INVESTMENT OPTIONS IN INDIA SUBMITTED BY:- BHUMI VAGHANI T.Y.B.M.S. [Semester V] MITHIBAI COLLEGE OF MANAGEMENT VILE PARLE (W), MUMBAI - 400 056. SUBMITTED TO:- UNIVERSITY OF MUMBAI ACADEMIC YEAR 2012-2013 PROJECT GUIDE PROF. NAVEEN ROHATGI DATE OF SUBMISSION 10 TH DECEMBER, 2012
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A PROJECT REPORT ON
INVESTMENT OPTIONS IN INDIA
SUBMITTED BY:-
BHUMI VAGHANI
T.Y.B.M.S. [Semester V]
MITHIBAI COLLEGE OF MANAGEMENT
VILE PARLE (W), MUMBAI - 400 056.
SUBMITTED TO:-
UNIVERSITY OF MUMBAI
ACADEMIC YEAR
2012-2013
PROJECT GUIDE
PROF. NAVEEN ROHATGI
DATE OF SUBMISSION
10 TH DECEMBER, 2012
DECLARATION
I, Ms. BHUMI VAGHANI, of MITHIBAI COLLEGE OF MANAGEMENT of TYBMS
[Semester V] hereby declare that I have completed my project, titled ‘INVESTMENT
OPTIONS IN INDIA’ in the Academic Year 2012-2013. The information submitted herein
is true and original to the best of my knowledge.
__________________________
Signature of Student
[Bhumi G. Vaghani]
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CERTIFICATE
I, Mr. NAVEEN ROHATGI, hereby certify that Ms. BHUMI VAGHANI of Mithibai
College of TYBMS [Semester V] has completed his project, titled ‘Investment Options in
India’ in the academic year 2012-2013. The information submitted herein is true and original
to the best of my knowledge.
_______________________ ___________________
Signature of the Principal Signature of the Project Guide
[DR. KIRAN V. MANGAONKAR] [Mr. NAVEEN ROHATGI]
______________________
Signature of External Examiner
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ACKNOWLEDGEMENT
Preservation, inspiration and motivation have always played a key role in the success of any
venture. In the present world of cutthroat competition project is likely a bridge between
theoretical and practical working. I feel highly delighted with the way project on topic
Investment Options In India has been completed. Any accomplishment requires the efforts of
many people and this work is not difficult.
This project would not have been a success without the guidance and motivation of my
mentor. I am thankful to all the persons behind this project.
I would like to express my gratefulness to my Prof. Naveen Rohatgi, who acted as a mentor
throughout my project for providing me valuable information and guidance.
Last but not the least; I would like to thank my parents and friends for motivating me all the
time throughout this project.
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EXECUTIVE SUMMARY
Investment refers to the concept of deferred consumption which may involve purchasing an
asset, giving a loan or keeping funds in a bank account with the aim of generating future
returns. Today the spectrum of investment is indeed wide. An investment is confronted with
array of investment avenues. Various investment options available in india are cash
investment, debt securities, stocks, mutual funds, derivatives, commodities, real estate etc.
Considering the importance of investment at each and every stage of life, I have therefore,
selected the topic ‘Investment Options in India’ to be placed before the esteemed educational
institution. My deep interest in indian financial markets, insurance, etc. has encouraged me to
choose this project.
Here I have made my best possible efforts to place the several investments options available
in india in a easy and most understandable manner. The study has been undertaken to analyze
investors’ preferences and as well as the different factors that affect investors decision on the
These are basically savings avenues, where an individual puts his/her savings. These can be
classified in two parts:
a) Small saving schemes: They are designed to provide safe and attractive investment
options to the public and at the same time to mobilize resources for development of
economy.
b) Other saving scheme: These are all other schemes, which are not covered by small saving
schemes like bank fixed deposit, company fixed deposits, etc.
Small Saving Schemes
Traditionally schemes like public provident fund and national saving certificate have been
associated with attractive returns and tax benefits. Most importantly these schemes offer
assured returns thereby appealing to a large section of investor community. National Savings
Organization (NSO) is responsible for national level promotion of small saving schemes.
These schemes are primarily meant for small urban and rural investors. Institutions and NRI’s
are not eligible to invest in small savings schemes. The following schemes come under small
saving schemes:
1. Post Office Savings Account
2. Post Office Time Deposit Account
3. Post Office Recurring Deposit Account
4. National Saving Certificate (NSC)
5. Post Office Monthly Income Scheme (POMIS)
6. Public Provident Fund (PPF)
7. Senior Citizen Saving Scheme.
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Post Office Savings Account
Account can be opened by A single adult or two/three adults jointly
A minor who has attained 10 years of age or guardian on behalf
of minor
Group accounts by provident fund , superannuating fund,
gratuity fund
A cooperative society or a cooperative bank
Public account by a local authority/body, etc
Deposits Account can be opened with minimum of Rs.20
Maturity period There is no lock-in/maturity period prescribed
Withdrawal Any amount subject to keeping minimum balance of Rs.50 in
simple and Rs.500 for cheque facility account
Interest Current interest rate is 4% pa
Nomination Nomination facility is available
Pass Book Depositor is provided with a pass book
Silent Account An account not operated during 3 completed years, shall be
treated as Silent Account. A service charge of Rs.20 per year is
charged on the last day of each year until it is reactivated
Income Tax Benefit Exempted u/s 10 of IT Act
Post Office Time Deposit Account
Types of Accounts 1,2,3 & 5 year maturity
Account can be opened by A single adult or two/three adults jointly
A minor who has attained 10 years of age or guardian on behalf
of minor
Group accounts by provident fund , superannuating fund,
gratuity fund
A cooperative society or a cooperative bank
Public account by a local authority/body, etc
Mode of account holding A depositor can hold more than 1 account in his name or jointly
with another, either in same post office or in different post
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offices.
Deposits Minimum of Rs. 200. Maximum no limit
Transferability Transferable from one person to another
Maturity period The deposited amount is repayable after expiry of the period
Interest 1year- 8.2%
2year- 8.3%
3year- 8.4%
5year- 8.5%
Nomination Nomination facility is available
Pass book Depositor is provided with a pass book
Income Tax benefit Tax exemption u/s 80C for 5 year term deposit
Premature withdrawal Withdrawn within 6 months- No interest
After 6 months- 4%
After 1 year- 1% less rate specified for the period
Post Office Recurring Deposit Account
Account can be opened by A single adult or two adults jointly
A guardian on behalf of a minor or a person of unsound mind
A minor who has attained the age of 10 years in his own
name
Maturity Period of maturity of an account is 5 years
Deposits 60 equal monthly deposits in multiple of Rs.5 subject to
minimum of Rs.10
Defaults in deposit Accounts with not more than 4 defaults can be regularized
within a period of two months on payment of default fee.
Account becomes discontinued after more than 4 defaults
Rate of interest 8.4% pa
Repayment on maturity The deposited amount is repayable after expiry of the period
Nomination Nomination facility is available
Pass book Depositor is provided with a pass book
Loan facility Loan up to half of the deposit may be taken after 1 year and
before maturity. This must be repaid together with the
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interest in one or more installments. Loan not repaid is
deducted together with interest from the amount payable at
the time of closure of the account.
Premature closure Premature closure is permissible after expiry of 3 years
provided that interest rate applicable to post office savings
account shall be payable on such premature closure of
account.
Continuation after maturity Permissible for a maximum period of 5 years
Income Tax benefit No TDS is deducted. Interest received is taxable.
National Saving Certificate
Who can purchase An adult, A minor, A trust, Hindu Undivided Family
Where available Available at Post Offices
Maturity 5 years and 10 years
Nomination Nomination facility is available
Transferability Certificates can be transferred from one post office to another
and also from one person to another.
Deposit limits Certificates are available in denominations of Rs.100,
Rs.500, Rs.1000, Rs.5000, Rs.10000. There is no maximum
limit for purchase of the certificates.
Interest rate 5 years - 8.6% pa
10 years - 8.9% pa
Maturity value Interest accrued on the certificates every year is liable to
income tax but deemed to have been reinvested.
Premature encashment Not permissible except in case of death of the holder,
forfeiture by pledgee and when ordered by a court of law.
Place of encashment Can be enchased at the place of post office where it is
registered or any other post office.
Income Tax benefit Deduction for amount invested u/s 80C of IT Act. This
deduction can be claimed by the person who has contributed
the money out of his chargeable Income Tax. It can be
claimed by the first name person in joint holding if first name
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of the person has contributed the amount.
Post Office Monthly Income Scheme
Who can open A single adult or two adults jointly
A minor who has attained age of 10 years or a guardian on
behalf of minor
More than one account can be opened subject to maximum
deposit limits
Where can be opened At any post office
Maturity 5 years
Deposits Only one deposit
Deposit limit Minimum Rs.1500 and maximum Rs.450000 in case of
single and Rs.900000 in case of joint account.
Interest 8.5% pa
Bonus Discontinued
Premature closure After 1 year but before 3 years – deduction of 2% deposit
amount
After 3 years – deduction of 1% deposit
amount
Nomination Nomination facility is available
Closure of account Account shall be closed after expiry of 5 years
Income tax benefit No TDS is deducted. Interest received is taxable.
Public Provident Fund Scheme
Account can be opened by An individual in his/her own name or on behalf of a minor
Accounts can be opened At post offices and at branches of public sector banks
Maturity period 15 years
Extension after maturity Account can be continued with or without subscriptions after
maturity for block periods of 5 years.
With subscription- Withdrawal allowed up to 60% of balance
at the beginning of each extended period. The money can be
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withdrawn in a lump sum or in installments but not more
than one withdrawal in a year.
Without subscription- One can withdraw the entire sum in
lump sum or in installments but not more than one
withdrawal a year.
Nomination Nomination facility is available
Deposit limits Minimum Rs.1000 and maximum Rs.100000
Maximum number of deposits is 12 in a financial year
Loans Loan from the amount at credit in PPF account can be taken
after completion of one year from the end of financial year of
opening of the account and before completion of fifth year.
The amount of loan that can be availed is 25% of amount that
stood to his credit to at the end of the second year
immediately preceding the year in which the loan is applied
for.
Interest on loan shall be 2% pa from 1.12.2011
Withdrawal Premature withdrawal is permissible every year after
completion of five years from the end of the year of opening
the account.
One withdrawal per year after 6 years i.e. from 7th year
The amount of withdrawal is limited to 50% of the balance at
credit at the end of 4th year immediately preceding the year in
which the amount is withdrawn or at the end of preceding
year, whichever is lower.
Transferability Account can be transferred from one post office to another,
from one bank to another and from bank to post office and
vice verse.
Interest 8.8% pa
Bankruptcy Courts in case of bankruptcy or default on any loan payment
cannot attach the amount in PPF account
Income tax benefit Deductions for deposit made u/s 80C of IT Act. Interest
credited every year is tax free.
Wealth tax Exempt
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Senior Citizen Savings Scheme
Account can be opened by
individual
Who has attained age of 60 years
Who has attained 55 years of age or more but less than 60
years and has retired under VRS
No age limit for retired personnel of Defense service
NRI’s and HUF are not eligible.
Point of sale 24 nationalized banks, 1 private sector bank and post offices
Deposit limit Maximum Rs.15 lakhs and in multiple of Rs.1000
Maturity Maturity 5years and depositor may extend the account for
further period of 3 years. No withdrawal shall be permitted
Premature closure After 1 year but before 2 years – deduction of 1.5% of the
deposit
After 2 years but before maturity – deduction of 1% of the
deposit
In case of death before maturity, the account shall be closed
and deposit is refunded without any deduction along with
interest.
Interest 9.3% pa
Nomination Nomination facility is available
Income tax benefit Investment eligible for deduction u/s 80C. Interest earned is
liable for TDS.
Wealth tax No wealth tax exemption
Fixed Income Instruments
Government of India Savings Bonds
Eligibility An individual, not being an NRI
A Hindu Undivided Family
Charitable Institution and University
Point of sale Bonds are sold by RBI through designated banks and stock
holding corporation of India ltd on behalf of government of
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India
Interest 8% pa
Issue price Bonds are issued at par and have face value of Rs.1000. No
upper limit on investment.
Maturity 6 years
Nomination Nomination facility is available
TDS Tax is deducted at source from interest amount if interest
exceeds Rs.10000 in a year.
Wealth tax Exempt
Bank Fixed Deposits
Eligibility Resident Individuals
Non Resident Indians
Minor through guardians
Hindu Undivided Family
Sole Proprietorship firm
Partnership firm
Limited Companies
Trust
Interest rate Interest rate differs from bank to bank
Maturity From 7 days to 5 years
TDS TDS is deducted if interest exceeds Rs.10000 in any financial
year. Individuals can file form 15H or 15G to claim
exemption from TDS deduction
Income tax benefit Fixed deposit of term 5 years or more are eligible for
deduction u/s 80C.
Company Fixed Deposits
Who can accept deposit? Manufacturing Companies
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Housing Finance Companies
Non-Banking Finance Companies
Financial Institutions
Government Companies
Eligibility Resident Individuals
Non Resident Indians
Minor through guardians
Hindu Undivided Family
Sole Proprietorship firm
Partnership firm
Limited Companies
Trust
Nomination Nomination facility is available
Maturity Manufacturing Company - 6 months to 3 years
Housing Finance Company - 1 to 7 years
Non-Banking Finance Company - 1 to 5years
Interest rate It differs from company to company
Premature withdrawal Is allowed after completion of 3 months from date of deposit
Loan Is available after 3 months of placing deposit
TDS Tax is deducted at source from interest amount if interest
exceeds Rs.5000 in a year. Individuals can file form 15H or
15G to claim exemption from TDS deduction
KYC Compliance Latest photograph, proof of identity and proof of address
Income tax benefit Investments up to Rs.100000 qualify for deduction u/s 80C of
IT Act.
CAPITAL MARKET
Definition of a Stock
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Stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing. Over the last few decades, the average person's interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth? This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own stocks.
Being an owner
Holding a company's stock means that you are one of the many owners (shareholders) of a
company and, as such, you have a claim to everything the company owns. As an owner, you
are entitled to your share of the company's earnings as well as any voting rights attached to
the stock.
A stock is represented by a share certificate. This is a fancy piece of paper that is proof of
your ownership. In today's computer age, you won't actually get to see this document because
your broker or DP keeps these records electronically, which is also known as holding shares
"in street name".
The importance of being a shareholder is that you are entitled to a portion of the company’s
profits and have a claim on assets. Profits are sometimes paid out in the form of dividends.
The more shares you own, the larger the portion of the profits you get. Your claim on assets
is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left
after all the creditors have been paid.
Another extremely important feature of stock is its limited liability, which means that, as an
owner of a stock, you are not personally liable if the company is not able to pay its debts.
Owning stock means that, no matter what, the maximum value you can lose is the value of
your investment. Even if a company of which you are a shareholder goes bankrupt, you can
never lose your personal assets.
Debt vs. Equity
It is important that you understand the distinction between a company financing through debt
and financing through equity. When you buy a debt investment such as a bond, you are
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guaranteed the return of your money (the principal) along with promised interest payments.
This isn't the case with an equity investment. By becoming an owner, you assume the risk of
the company not being successful - just as a small business owner isn't guaranteed a return,
neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This
means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any
money until the banks, bondholders and other creditors have been paid out; we call this
absolute priority. Shareholders earn a lot if a company is successful, but they also stand to
lose their entire investment if the company isn't successful.
Risk and Return
Returns on equity are affected by risks like Business Risk, Financial Risk, Industry Risk,
Management Risk, Political, Economical and Exchange Rate Risk, Market Risk, etc. It must
be emphasized that there are no guarantees when it comes to individual stocks. Some
companies pay out dividends, but many others do not. And there is no obligation to pay out
dividends even for those firms that have traditionally given them. Without dividends, an
investor can make money on a stock only through its appreciation in the open market. On the
downside, any stock may go bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking greater risk
demands a greater return on your investment. This is the reason why stocks have historically
outperformed other investments such as bonds or savings accounts. Over the long term, an
investment in stocks has historically had an average return of around 10-12% annually.
Different types of stock
a. Common Stock (Equity Shares)
When people talk about stocks they are usually referring to this type. In fact, the majority of
stock is issued is in this form. Common shares represent ownership in a company and a claim
(dividends) on a portion of profits. Investors get one vote per share to elect the board
members, who oversee the major decisions made by management. The holder of common
stock has limited liability up to amount of share capital contributed.
Over the long term, common stock, by means of capital growth, yields higher returns than
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almost every other investment. This higher return comes at a cost since common stocks entail
the most risk. If a company goes bankrupt and liquidates, the common shareholders will not
receive money until the creditors, bondholders and preferred shareholders are paid.
b. Preferred stock (Preference Share)
Preferred stock represents some degree of ownership in a company but usually doesn't come
with the same voting rights. (This may vary depending on the company.) With preferred
shares, investors are usually guaranteed a fixed dividend forever. This is different than
common stock, which has variable dividends that are never guaranteed.
Another advantage is that in the event of liquidation, preferred shareholders are paid off
before the common shareholder (but still after debt holders). Preferred stock may also be
callable, meaning that the company has the option to purchase the shares from shareholders at
anytime for any reason (usually for a premium).
Investment in equities
1. Through the primary market
2. Through the secondary market
Primary market
Primary market provides an opportunity to the issuers of securities, both Government and
corporations, to raise resources to meet their requirements of investment. It's in this market
that firms sell new stocks to the public for the first time. For our purposes, you can think of
the primary market as being synonymous with an initial public offering (IPO). An IPO occurs
when a private company sells stocks to the public for the first time.
Securities, in the form of equity can be issued in domestic /international markets at face value
with discount or premium. The primary market issuance is done either through public issues
or private placement. Under Companies Act, 1956, an issue is referred as public if it results in
allotment of securities to 50 investors or more. However, when the issuer makes an issue of
securities to a select group of persons not exceeding 49 and which is neither a right issue nor
a public issue, it is called a private placement.
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The important thing to understand about the primary market is that securities are purchased
directly from an issuing company.
Secondary Market
Secondary market refers to a market where securities are traded after being offered to the
public in the primary market or listed on the Stock Exchange. Secondary market comprises of
equity, derivatives and the debt markets. The secondary market is operated through two
mediums, namely, the Over-the-Counter (OTC) market and the Exchange-Traded Market.
OTC markets are informal markets where trades are negotiated.
The secondary market is what people are talking about when they refer to the "stock market".
This includes the National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and other
major exchanges around the world. That is, in the secondary market, investors trade
previously issued securities without the involvement of the issuing companies.
Types of Investors in Equity Market
a. The Bull Market
A bull market is when everything in the economy is great, people are finding jobs, gross
domestic product (GDP) is growing, and stocks are rising. Picking stocks during a bull
market is easier because everything is going up. Bull markets cannot last forever though, and
sometimes they can lead to dangerous situations if stocks become overvalued. If a person is
optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a
"bullish outlook".
b. The Bear Market
A bear market is when the economy is bad, recession is looming and stock prices are falling.
Bear markets make it tough for investors to pick profitable stocks. One solution to this is to
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make money when stocks are falling using a technique called short selling. Another strategy
is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to
buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going
to drop, he or she is called a "bear" and said to have a "bearish outlook".
c. The Other Animals on the Farm - Chickens and Pigs
Chickens are afraid to lose anything. Their fear overrides their need to make profits and so
they turn only to money-market securities or get out of the markets entirely. While it's true
that you should never invest in something over which you lose sleep, you are also guaranteed
never to see any return if you avoid the market completely and never take any risk,
Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy
on hot tips and invest in companies without doing their due diligence. They get impatient,
greedy, and emotional about their investments, and they are drawn to high-risk securities
without putting in the proper time or money to learn about these investment vehicles.
Professional traders love the pigs, as it's often from their losses that the bulls and bears reap
their profits.
Investment StylesDifferent investor invests differently. Two most common ways of investment style in equity
are-
a. Value Investing - Value investing is wherein fund managers or investors tend to look
for companies trading below their intrinsic value, but whose true worth they believe will
eventually be recognized. These securities typically have low prices relative to earnings
or book value and a higher dividend yield.
b. Growth Investing - Growth investing is wherein fun managers or investors look for
companies with above average earnings growth and profits, which they believe will be
even more valuable in the future. They also look for companies that are well position to
capitalize on long term growth trends that may drive earnings higher. Because these
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companies tend to grow earnings at a fast pace, they typically have higher prices relative
to earnings.
Investment Approach
a. Top down approach - Under this investment approach, fund managers or investors start
from big horizon in the economy and the financial world and then go on breaking these
into smaller parts to find a good company to invest in. After looking at the bigger horizon,
the different industrial sectors are analyzed and indentified in order to select those that are
expected to outperform market. After deciding on the industry and sector, the stock of
specific companies within the sector or industry is further analyzed and those that are
believed to be worth investing are chosen as investments.
b. Bottom up approach - This is opposite of top down approach, instead of looking at big
horizon and then at industry and then at companies with the industry, this approach
focuses on identifying the stock directly and believes that an individual company in any
industry can do well even if the sector is not performing.
Tools for Equity Analysis
a. Technical Analysis
Technical analysis is a method of evaluating securities by analyzing the statistics generated
by market activity, such as past prices and volume. Technical analysts do not attempt to
measure a security's intrinsic value, but instead use charts and other tools to identify patterns
that can suggest future activity.
The behavior of price movement of a stock is studied to predict its future movement. The
theory being that by plotting the price movements over the time, they can discern certain
patterns which will help them to predict the future price movement of the stocks. Technical
studies are based on prices and do not include balance sheets, profit and loss accounts.
b. Fundamental Analysis
A method of evaluating a security that entails attempting to measure its intrinsic value by
examining related economic, financial and other qualitative and quantitative factors.
pepper, cotton, etc) and Energy products (crude oil, heating oil, natural gas, etc)
Equity derivatives
A derivative instrument with underlying assets based on equity securities. An equity
derivative's value will fluctuate with changes in its underlying asset's equity, which is usually
measured by share price.
Investors can use equity derivatives to hedge the risk associated with taking a position in
stock by setting limits to the losses incurred by either a short or long position in a company's
shares. If an investor purchases a stock, he or she can protect against a loss in share value by
purchasing a put option. On the other hand, if the investor has shorted shares, he or she can
hedge against a gain in share price by purchasing a call option.
Interest rate derivatives
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Types of DerivativesExchange TradedCommoditiesAgricultural commoditiesNon-agricultural commoditiesFinancialsEquity Interest rateCurrencyOver the Counter
A financial instrument based on an underlying financial security whose value is affected by
changes in interest rates. Interest-rate derivatives are hedges used by institutional investors
such as banks to combat the changes in market interest rates. Individual investors are more
likely to use interest-rate derivatives as a speculative tool - they hope to profit from their
guesses about which direction market interest rates will move.
Currency derivatives
Currency derivatives can be described as contracts between the sellers and the buyers whose
value are derived from the underlying exchange rate. They are mostly designed for hedging
purposes, although they are also used as instruments for speculation.
Types of Derivative Contracts
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.
Over the past couple of decades several exotic contracts have also emerged but these are
largely the variants of these basic contracts. Let us briefly define some of the contracts.
1. Forward Contracts
These are promises to deliver an asset at a pre- determined date in future at a predetermined
price. Forwards are highly popular on currencies and interest rates. The contracts are traded
over the counter (i.e. outside the stock exchanges, directly between the two parties) and are
customized according to the needs of the parties. Since these contracts do not fall under the
purview of rules and regulations of an exchange, they generally suffer from counterparty risk
i.e. the risk that one of the parties to the contract may not fulfill his or her obligation.
2. Futures Contracts
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in future at a certain price. These are basically exchange traded, standardized contracts.
The exchange stands guarantee to all transactions and counterparty risk is largely eliminated.
The buyers of futures contracts are considered having a long position whereas the sellers are
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considered to be having a short position. It should be noted that this is similar to any asset
market where anybody who buys is long and the one who sells in short.
Futures contracts are available on variety of commodities, currencies, interest rates, stocks
and other tradable assets. They are highly popular on stock indices, interest rates and foreign
exchange.
3. Options Contracts
Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future.
Options are of two types - calls and puts. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future
date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date. One can buy and sell each of the
contracts. When one buys an option he is said to be having a long position and when one sells
he is said to be having a short position.
It should be noted that, in the first two types of derivative contracts (forwards and futures)
both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset
to the seller and the seller needs to deliver the asset to the buyer on the settlement date. In
case of options only the seller (also called option writer) is under an obligation and not the
buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put
options) the asset from / to the seller of the option but he may or may not exercise this right.
In case the buyer of the option does exercise his right, the seller of the option must fulfill
whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of
the option and for a put option the seller has to receive the asset from the buyer of the option).
An option can be exercised at the expiry of the contract period (which is known as European
option contract) or anytime up to the expiry of the contract period (termed as American
option contract).
4. Swaps Swaps are private agreements between two parties to exchange cash flows in
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the future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
a. Interest rate swaps : These entail swapping only the interest related cash flows between
the parties in the same currency.
b. Currency swaps : These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the
opposite direction.
5. WarrantsOptions generally have lives of up to one year; the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
6. LEAPSThe acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of up to three years.
7. BasketsBasket options are options on portfolios of underlying assets. The underlying asset is usually
a moving average or a basket of assets. Equity index options are a form of basket options.
8. SwaptionsSwaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.
Participants in a Derivative Market
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The derivatives market is similar to any other financial market and has following three broad
Categories of participants:
1. Hedgers These are investors with a present or anticipated exposure to the underlying asset which is
subject to price risks. Hedgers use the derivatives markets primarily for price risk
management of assets and portfolios.
2. Speculators These are individuals who take a view on the future direction of the markets. They take a
view whether prices would rise or fall in future and accordingly buy or sell futures and
options to try and make a profit from the future price movements of the underlying asset.
3. Arbitrageurs They take positions in financial markets to earn riskless profits. The arbitrageurs take short
and long positions in the same or different contracts at the same time to create a position
which can generate a riskless profit.
Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same price.
Other contract details like delivery date, price and quantity are negotiated bilaterally by the
parties to the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are as given below:
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
• The contract price is generally not available in public domain.
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• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same counter-
party, which often results in high prices being charged.
Limitations of forward markets
• Lack of centralization of trading
• Illiquidity and
• Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market, in which any two consenting adults can form
contracts against each other. This often makes them design the terms of the deal which are
convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. When
forward markets trade standardized contracts, though it avoids the problem of illiquidity, still
the counterparty risk remains a very serious issue.
Introduction to Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. But unlike forward contracts, the futures contracts are
standardized and exchange traded. To facilitate liquidity in the futures contracts, the
exchange specifies certain standard features of the contract. It is a standardized contract with
standard underlying instrument, a standard quantity and quality of the underlying instrument
that can be delivered, (or which can be used for reference purposes in settlement) and a
standard timing of such settlement. A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction. The standardized items in a futures contract
are:
• Quantity of the underlying
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• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price change
• Location of settlement
Distinction between Futures and Forwards Contracts
Forward contracts are often confused with futures contracts. The confusion is primarily
because both serve essentially the same economic functions of allocating risk in the presence
of future price uncertainty. However futures are a significant improvement over the forward
contracts as they eliminate counterparty risk and offer more liquidity.
Follows daily settlement Settlement happens at end of period
The exchange, on which these are traded
becomes counter party and guarantees
settlement.
There is a risk of counter party default
Contract can be reversed on Stock
Exchange.
Contract can be reversed with the same
counter party.
Futures Payoffs
Futures contracts have linear or symmetrical payoffs. It implies that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are
fascinating as they can be combined with options and the underlying to generate various
complex payoffs.
Payoff for buyer of futures: Long futures
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The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who buys a two-month Nifty index futures contract
when the Nifty stands at 2220.
The underlying asset in this case is the Nifty portfolio. When the index moves up, the long
futures position starts making profits, and when the index moves down it starts making
losses.
Payoff for a buyer of Nifty futures
The above figure shows the profits/losses for a long futures position. The investor bought
futures when the index was at 2220. If the index goes up, his futures position starts making
profit. If the index falls, his futures position starts showing losses.
Payoff for seller of futures: Short futuresThe payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two-month Nifty index futures contract
when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When
the index moves down, the short futures position starts making profits, and when the index
moves up, it starts making losses.
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Payoff for a seller of Nifty futures
The above figure shows the
profits/losses for a short futures position. The investor sold futures when the index was at
2220. If the index goes down, his futures position starts making profit. If the index rises, his
futures position starts showing losses.
Options Contracts
Options are the most recent and evolved derivative contracts. They have non linear or
asymmetrical profit profiles making them fundamentally very different from futures and
forward contracts. Option contracts help a hedger reduce his risk with a much wider variety
of strategies.
An option gives the holder of the option the right to do something in future. The holder does
not have to exercise this right. In contrast, in a forward or futures contract, the two parties
have committed themselves or are obligated to meet their commitments as specified in the
contract. Whereas it costs nothing (except margin requirements) to enter into a futures
contract, the purchase of an option requires an up-front payment. This chapter first introduces
key terms which will enable the reader understand option terminology. Afterwards futures
have been compared with options and then payoff profiles of option contracts have been
defined diagrammatically.
Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased.
After this, he only has an upside. There is no possibility of the options position generating
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any further losses to him (other than the funds already paid for the option). This is different
from futures, which is free to enter into, but can generate very large losses. This characteristic
makes options attractive to many occasional market participants, who cannot put in the time
to closely monitor their futures positions.
Comparison between Futures and Options
FUTURES OPTIONS
Exchange traded Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
Options Payoffs
The optionality characteristic of options results in a non-linear payoff for options. It means
that the losses for the buyer of an option are limited; however the profits are potentially
unlimited. For a writer, the payoff is exactly the opposite. Profits are limited to the option
premium; and losses are potentially unlimited. These non-linear payoffs are fascinating as
they lend themselves to be used to generate various payoffs by using combinations of options
and the underlying.
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot price of
the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit.
Higher the spot price more is the profit. If the spot price of the underlying is less than the
strike price, the option expires un-exercised. The loss in this case is the premium paid for
buying the option. Figure below gives the payoff for the buyer of a three month call option
(often referred to as long call) with a strike of 2250 bought at a premium of 86.60.
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Payoff for buyer of call option
The figure above shows the profits/losses for the buyer of a three-month Nifty 2250 call
option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon
expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and
profit to the extent of the difference between the Nifty-close and the strike price. The profits
possible on this option are potentially unlimited. However if Nifty falls below the strike of
2250, he lets the option expire. The losses are limited to the extent of the premium paid for
buying the option.
Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds
the strike price, the buyer will exercise the option on the writer. Hence as the spot price
increases the writer of the option starts making losses. Higher the spot price, more are the
losses. If upon expiration the spot price of the underlying is less than the strike price, the
buyer lets his option expire unexercised and the writer gets to keep the premium. Figure
below gives the payoff for the writer of a three month call option (often referred to as short
call) with a strike of 2250 sold at a premium of 86.60.
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Payoff for writer of call option
The figure above shows the profits/losses for the seller of a three-month Nifty 2250 call
option. As the spot Nifty rises, the call option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the Nifty-
close and the strike price. The loss that can be incurred by the writer of the option is
potentially unlimited, whereas the maximum profit is limited to the extent of the up-front
option premium of Rs.86.60 charged by him.
Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot price of
the underlying. If upon expiration, the spot price is below the strike price, there is a profit.
Lower the spot price more is the profit. If the spot price of the underlying is higher than the
strike price, the option expires un-exercised. His loss in this case is the premium he paid for
buying the option. Figure below gives the payoff for the buyer of a three month put option
(often referred to as long put) with a strike of 2250 bought at a premium of 61.70.
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Payoff for buyer of put option
The above figure shows the profits/losses for the buyer of a three-month Nifty 2250 put
option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon
expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and
profit to the extent of the difference between the strike price and Nifty-close. The profits
possible on this option can be as high as the strike price. However if Nifty rises above the
strike of 2250, the option expires worthless. The losses are limited to the extent of the
premium paid for buying the option.
Payoff profile for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to
be below the strike price, the buyer will exercise the option on the writer. If upon expiration
the spot price of the underlying is more than the strike price, the buyer lets his option go un-
exercised and the writer gets to keep the premium. Figure below gives the payoff for the
writer of a three month put option (often referred to as short put) with a strike of 2250 sold at
a premium of 61.70.
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Payoff for writer of put option
The above figure shows the profits/losses for the seller of a three-month Nifty 2250 put
option. As the spot Nifty falls, the put option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the strike
price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum
extent of the strike price (Since the worst that can happen is that the asset price can fall to
zero) whereas the maximum profit is limited to the extent of the up-front option premium of
Rs.61.70 charged by him.
Taxation of Derivative Transaction in Securities
Prior to Financial Year 2005–06, transaction in derivatives were considered as speculative
transactions for the purpose of determination of tax liability under the Income-tax Act. This is
in view of section 43(5) of the Income-tax Act which defined speculative transaction as a
transaction in which a contract for purchase or sale of any commodity, including stocks and
shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of
the commodity or scripts.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives
carried out in a “recognized stock exchange” for this purpose. This implies that income or
loss on derivative transactions which are carried out in a “recognized stock exchange” is not
taxed as speculative income or loss. Thus, loss on derivative transactions can be set off
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against any other income during the year. In case the same cannot be set off, it can be carried
forward to subsequent assessment year and set off against any other income of the subsequent
year. Such losses can be carried forward for a period of 8 assessment years.
Securities transaction tax on derivatives transactions
As per Chapter VII of the Finance (No. 2) Act, 2004, Securities Transaction Tax (STT) is
levied on all transactions of sale and/or purchase of equity shares and units of equity oriented
fund and sale of derivatives entered into in a recognized stock exchange. As per Finance Act
2008, the following STT rates are applicable w.e.f. 1st June, 2008 in relation to sale of a
derivative, where the transaction of such sale in entered into in a recognized stock exchange.
Sl. No. Taxable securities transaction Rate Payable by
1. Sale of options in securities 0.017% Seller
2. Sale of options in securities,
Where option is exercised. 0.125%
Purchaser
3. Sale of futures in securities 0.017% Seller
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MUTUAL FUNDS
Concept of Mutual FundMutual funds are a vehicle to mobilize moneys from investors, to invest in different markets
and securities, in line with the investment objectives agreed upon, between the mutual fund
and the investors.
Role of Mutual FundsMutual funds perform different roles for different constituencies:
Their primary role is to assist investors in earning an income or building their wealth, by
participating in the opportunities available in various securities and markets. It is possible for
mutual funds to structure a scheme for any kind of investment objective. Thus, the mutual
fund structure, through its various schemes, makes it possible to tap a large corpus of money
from diverse investors. The money that is raised from investors, ultimately benefits
governments, companies and other entities, directly or indirectly, to raise moneys to invest in
various projects or pay for various expenses.
As a large investor, the mutual funds can keep a check on the operations of the investee
company, their corporate governance and ethical standards.
The projects that are facilitated through such financing, offer employment to people; the
income they earn helps the employees to buy goods and services offered by other companies,
thus supporting projects of these goods and services companies. Thus, overall economic
development is promoted.
The mutual fund industry itself, offers livelihood to a large number of employees of mutual
funds, distributors, registrars and various other service providers. Higher employment,
income and output in the economy boost the revenue collection of the government through
taxes and other means. When these are spent prudently, it promotes further economic
development and nation building.
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Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from
foreign investors. Mutual funds are therefore viewed as a key participant in the capital market
of any economy.
How do Mutual Fund Schemes Operate?
Mutual fund schemes announce their investment objective and seek investments from the
public. Depending on how the scheme is structured, it may be open to accept money from
investors, either during a limited period only or at any time.
The investment that an investor makes in a scheme is translated into a certain number of
‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.
Under the law, every unit has a face value of Rs10. The face value is relevant from an
accounting perspective. The number of units multiplied by its face value (Rs10) is the
capital of the scheme – its Unit Capital.
Running the scheme leads to its share of operating expenses
When the investment activity is profitable, the true worth of a unit goes up; when there
are losses, the true worth of a unit goes down. The true worth of a unit of the scheme is
otherwise called Net Asset Value (NAV) of the scheme.
When a scheme is first made available for investment, it is called a ‘New Fund Offer’
(NFO). During the NFO, investors may have the chance of buying the units at their face
value. Post-NFO, when they buy into a scheme, they need to pay a price that is linked to
its NAV.
The money mobilized from investors is invested by the scheme as per the investment
objective committed. Profits or losses, as the case might be, belong to the investors. The
investor does not however bear a loss higher than the amount invested by them.
Various investors subscribing to an investment objective might have different
expectations on how the profits are to be handled. Some may like it to be paid off
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regularly as dividends. Others might like the money to grow in the scheme. Mutual funds
address such differential expectations between investors within a scheme, by offering
various options, such as dividend payout option, dividend re-investment option and
growth option.
The relative size of mutual fund companies is assessed by their assets under management
(AUM). When a scheme is first launched, assets under management would be the amount
mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its
AUM goes up; a negative profitability metric will pull it down.
Further, if the scheme is open to receiving money from investors even post-NFO, then
such contributions from investors boost the AUM. Conversely, if the scheme pays any
money to the investors, either as dividend or as consideration for buying back the units of
investors, the AUM falls.
The AUM thus captures the impact of the profitability metric and the flow of unit-holder
money to or from the scheme.
Advantages of Mutual Funds for Investors
1. Professional Management
Mutual funds offer investors the opportunity to earn an income or build their wealth through
professional management of their investible funds. There are several aspects to such
professional management viz. investing in line with the investment objective, investing based
on adequate research, and ensuring that prudent investment processes are followed.
2. Affordable Portfolio Diversification
Units of a scheme give investors exposure to a range of securities held in the investment
portfolio of the scheme. Thus, even a small investment of Rs 5,000 in a mutual fund scheme
can give investors a diversified investment portfolio.
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With diversification, an investor ensures that all the eggs are not in the same basket.
Consequently, the investor is less likely to lose money on all the investments at the same
time. Thus, diversification helps reduce the risk in investment. In order to achieve the same
diversification as a mutual fund scheme, investors will need to set apart several lakh of
rupees. Instead, they can achieve the diversification through an investment of a few thousand
rupees in a mutual fund scheme.
3. Economies of Scale
The pooling of large sums of money from so many investors makes it possible for the mutual
fund to engage professional managers to manage the investment. Individual investors with
small amounts to invest, cannot, by themselves afford to engage such professional
management.
Large investment corpus leads to various other economies of scale. For instance, costs related
to investment research and office space get spread across investors. Further, the higher
transaction volume makes it possible to negotiate better terms with brokers, bankers and other
service providers.
4. Liquidity
At times, investors in financial markets are stuck with a security for which they can’t find a
buyer –worse; at times they can’t find the company they invested in! Such investments,
whose value the investor cannot easily realise in the market, are technically called illiquid
investments and may result in losses for the investors.
Investors in a mutual fund scheme can recover the value of the moneys invested, from the
mutual fund itself. Depending on the structure of the mutual fund scheme, this would be
possible, either at any time, or during specific intervals, or only on closure of the scheme.
Schemes where the money can be recovered from the mutual fund only on closure of the
scheme are listed in a stock exchange. In such schemes, the investor can sell the units in the
stock exchange to recover the prevailing value of the investment.
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5. Tax Deferral
Mutual funds are not liable to pay tax on the income they earn. If the same income were to be
earned by the investor directly, then tax may have to be paid for the same financial year.
Mutual funds offer options, whereby the investor can let the moneys grow in the scheme for
several years. By selecting such options, it is possible for the investor to defer the tax
liability. This helps investors to legally build their wealth faster than would have been the
case, if they were to pay tax on the income each year.
6. Tax benefits
Specific schemes of mutual funds (Equity Linked Savings Schemes) gives investors the
benefit of deduction of the amount invested, from their income that is liable to tax. This
reduces their taxable income, and therefore the tax liability. Further, the dividend that the
investor receives from the scheme is tax-free in their hands.
7. Convenient Options
The options offered under a scheme allow investors to structure their investments in line with
their liquidity preference and tax position.
8. Investment Comfort
Once an investment is made with a mutual fund, they make it convenient for the investor to
make further purchases with very little documentation. This simplifies subsequent investment
activity.
9. Regulatory Comfort
The regulator, Securities & Exchange Board of India (SEBI) has mandated strict checks and
balances in the structure of mutual funds and their activities. Mutual fund investors benefits
from such protection.
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10.Systematic Approach to Investments
Mutual funds also offer facilities that help investor to invest amounts regularly through a
Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic
Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a
Systematic Transfer Plan (STP). Such systematic approaches promote an investment
discipline, which is useful in long term wealth creation and protection.
Limitations of a Mutual Fund
1. Lack of Portfolio Customization
Some securities houses offer Portfolio Management Schemes (PMS) to large investors. In a
PMS, the investor has better control over what securities are bought and sold on his behalf.
On the other hand, a unit-holder is just one of several thousand investors in a scheme. Once a
unit-holder has bought into the scheme, investment management is left to the fund manager
(within the broad parameters of the investment objective). Thus, the unit-holder cannot
influence what securities or investments the scheme would buy.
Large sections of investors lack the time or the knowledge to be able to make portfolio
choices. Therefore, lack of portfolio customization is not a serious limitation in most cases.
2. Choice overload
Over 800 mutual fund schemes offered by 38 mutual funds – and multiple options within
those schemes – make it difficult for investors to choose between them. Greater
dissemination of industry information through various media and availability of professional
advisors in the market should help investors handle this overload.
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3. No control over costs
All the investor's moneys are pooled together in a scheme. Costs incurred for managing the
scheme are shared by all the Unit-holders in proportion to their holding of Units in the
scheme. Therefore, an individual investor has no control over the costs in a scheme.
SEBI has however imposed certain limits on the expenses that can be charged to any scheme.
These limits vary with the size of assets and the nature of the scheme.
Open-Ended Funds, Close-Ended Funds and Interval Funds
Open-ended funds are open for investors to enter or exit at any time, even after the NFO.
When existing investors buy additional units or new investors buy units of the open ended
scheme, it is called a sale transaction. It happens at a sale price, which is equal to the NAV.
When investors choose to return any of their units to the scheme and get back their equivalent
value, it is called a re-purchase transaction. This happens at a re-purchase price that is linked
to the NAV.
Although some unit-holders may exit from the scheme, wholly or partly, the scheme
continues operations with the remaining investors. The scheme does not have any kind of
time frame in which it is to be closed. The ongoing entry and exit of investors implies that the
unit capital in an open-ended fund would keep changing on a regular basis.
Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme,
from the fund, only during its NFO. The fund makes arrangements for the units to be traded,
post-NFO in a stock exchange. This is done through a listing of the scheme in a stock
exchange. Such listing is compulsory for close-ended schemes. Therefore, after the NFO,
investors who want to buy Units will have to find a seller for those units in the Stock
Exchange. Similarly, investors who want to sell Units will have to find a buyer for those units
in the stock exchange.
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Interval funds combine features of both open-ended and close ended schemes. They are
largely close-ended, but become open ended at pre-specified intervals. For instance, an
interval scheme might become open-ended between January 1 to 15, and July 1 to 15, each
year. The benefit for investors is that, unlike in a purely close-ended scheme, they are not
completely dependent on the stock exchange to be able to buy or sell units of the interval
fund.
Minimum duration of an interval period in an interval scheme/plan is 15 days. No
redemption/repurchase of units is allowed except during the specified transaction period (the
period during which both subscription and redemption may be made to and from the scheme).
The specified transaction period will be of minimum 2 working days, as per revised SEBI
Regulations.
Actively Managed Funds and Passive Funds
Actively managed funds are funds where the fund manager has the flexibility to choose
the investment portfolio, within the broad parameters of the investment objective of the
scheme. Since this increases the role of the fund manager, the expenses for running the fund
turn out to be higher. Investors expect actively managed funds to perform better than the
market.
Passive funds invest on the basis of a specified index, whose performance it seeks to track.
Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the
composition of the BSE Sensex. The proportion of each share in the scheme’s portfolio
would also be the same as the weightage assigned to the share in the computation of the BSE
Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are
not designed to perform better than the market. Such schemes are also called index schemes.
Since the portfolio is determined by the index itself, the fund manager has no role in deciding
on investments. Therefore, these schemes have low running costs.
Debt, Equity and Hybrid Funds
Schemes with an investment objective that limits them to investments in debt securities like
Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.
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A scheme might have an investment objective to invest largely in equity shares and equity-
related investments. Such schemes are called equity funds.
Hybrid funds have an investment charter that provides for a reasonable level of investment in
both debt and equity.
Types of Debt Funds
Gilt funds invest in only treasury bills and government securities, which do not have a
credit risk (i.e. the risk that the issuer of the security defaults).
Diversified debt funds on the other hand, invest in a mix of government and non-
government debt securities.
Junk bond schemes or high yield bond schemes invest in companies that are of poor credit
quality. Such schemes operate on the premise that the attractive returns offered by the
investee companies makes up for the losses arising out of a few companies defaulting.
Fixed maturity plans are a kind of debt fund where the investment portfolio is closely
aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-
identified investments. Further, like close-ended schemes, they do not accept moneys post-
NFO. Thanks to these characteristics, the fund manager has little ongoing role in deciding on
the investment options. Such a portfolio construction gives more clarity to investors on the
likely returns if they stay invested in the scheme until its maturity. This helps them compare
the returns with alternative investments like bank deposits.
Floating rate funds invest largely in floating rate debt securities i.e. debt securities where
the interest rate payable by the issuer changes in line with the market. For example, a debt
security where interest payable is described as ‘5-year Government Security yield plus 1%’,
will pay interest rate of 7%, when the 5- year Government Security yield is 6%; if 5-year
Government Security yield goes down to 3%, then only 4% interest will be payable on that
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debt security. The NAVs of such schemes fluctuate lesser than debt funds that invest more in
debt securities offering a fixed rate of interest.
Liquid schemes or money market schemes are a variant of debt schemes that invest only in
debt securities where the moneys will be repaid within 91-days. These are widely recognized
to be the lowest in risk among all kinds of mutual fund schemes.
Types of Equity Funds
Diversified equity fund is a category of funds that invest in a diverse mix of securities
that cut across sectors.
Sector funds however invest in only a specific sector. For example, a banking sector fund
will invest in only shares of banking companies. Gold sector fund will invest in only shares
of gold-related companies.
Thematic funds invest in line with an investment theme. For example, an infrastructure
thematic fund might invest in shares of companies that are into infrastructure construction,
infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more
broad-based than a sector fund; but narrower than a diversified equity fund.
Equity Linked Savings Schemes (ELSS), offer tax benefits to investors. However, the
investor is expected to retain the Units for at least 3 years.
Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate
less, and therefore, dividend represents a larger proportion of the returns on those shares. The
NAV of such equity schemes are expected to fluctuate lesser than other categories of equity
schemes.
Arbitrage Funds take contrary positions in different markets / securities, such that the risk
is neutralized, but a return is earned. For instance, by buying a share in BSE, and
simultaneously selling the same share in the NSE at a higher price. Most arbitrage funds take
contrary positions between the equity market and the futures and options market.
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Types of Hybrid Funds
Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely
in debt securities. However, a small percentage is invested in equity shares to improve the
scheme’s yield.
Capital Protected Schemes are close-ended schemes, which are structured to ensure that
investors get their principal back, irrespective of what happens to the market. This is ideally
done by investing in Zero Coupon Government Securities whose maturity is aligned to the
scheme’s maturity. The investment is structured, such that the principal amount invested in
the zero-coupon security together with the interest that accumulates during the period of the
scheme would grow to the amount that the investor invested at the start.
Suppose an investor invested Rs 10,000 in a capital protected scheme of 5 years. If 5-year
government securities yield 7% at that time, then an amount of Rs 7,129.86 invested in 5-year
zero coupon government securities would mature to Rs 10,000 in 5 years. Thus, by investing
Rs. 7,129.86 in the 5-year zero-coupon government security, the scheme ensures that it will
have Rs 10,000 to repay to the investor in 5 years. After investing in the government security,
Rs 2,870.14 is left over (Rs 10,000 invested by the investor, less Rs 7129.86 invested in
government securities). This amount is invested in riskier securities like equities. Even if the
risky investment becomes completely worthless (a rare possibility), the investor is assured of
getting back the principal invested, out of the maturity moneys received on the government
security.
Gold FundsThese funds invest in gold and gold-related securities in either of the following formats:
Gold Exchange Traded Fund, which is like an index fund that invests in gold. The NAV
of such funds moves in line with gold prices in the market.
Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining
and processing. Though gold prices influence these shares, the prices of these shares are more
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closely linked to the profitability and gold reserves of the companies. Therefore, NAV of
these funds do not closely mirror gold prices.
Real Estate FundsThey take exposure to real estate. Such funds make it possible for small investors to take
exposure to real estate as an asset class. Although permitted by law, real estate mutual funds
are yet to hit the market in India.
Commodity FundsCommodities, as an asset class, include:
• Food crops like wheat and chana
• Spices like pepper and turmeric
• Precious metals (bullion) like gold and silver
The investment objective of commodity funds would specify which of these commodities it
proposes to invest in. As with gold, such funds can be structured as Commodity ETF or
Commodity Sector Funds. In India, mutual fund schemes are not permitted to invest in
commodities. Therefore, the commodity funds in the market are in the nature of Commodity
Sector Funds, i.e. funds that invest in shares of companies that are into commodities. Like
Gold Sector Funds, Commodity Sector Funds too are a kind of equity fund.
International Funds
These are funds that invest outside the country. For instance, a mutual fund may offer a
scheme to investors in India, with an investment objective to invest abroad.
One way for the fund to manage the investment is to hire the requisite people who will
manage the fund. Since their salaries would add to the fixed costs of managing the fund, it
can be justified only if a large corpus of funds is available for such investment.
An alternative route would be to tie up with a foreign fund (called the host fund). If an Indian
mutual fund sees potential in China, it will tie up with a Chinese fund. In India, it will launch
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what is called a feeder fund. Investors in India will invest in the feeder fund. The moneys
collected in the feeder fund would be invested in the Chinese host fund. Thus, when the
Chinese market does well, the Chinese host fund would do well, and the feeder fund in India
will follow suit.
Such feeder funds can be used for any kind of international investment. The investment could
be specific to a country (like the China fund) or diversified across countries. A feeder fund
can be aligned to any host fund with any investment objective in any part of the world,
subject to legal restrictions of India and the other country.
In such schemes, the local investors invest in rupees for buying the Units. The rupees are
converted into foreign currency for investing abroad. They need to be re-converted into
rupees when the moneys are to be paid back to the local investors. Since the future foreign
currency rates cannot be predicted today, there is an element of foreign currency risk.
Investor's total return in such schemes will depend on how the international investment
performs, as well as how the foreign currency performs. Weakness in the foreign currency
can pull down the investors' overall return.
Fund of Funds
The feeder fund was an example of a fund that invests in another fund. Similarly, funds can
be structured to invest in various other funds, whether in India or abroad. Such funds are
called fund of funds. These ‘fund of funds’ pre specify the mutual funds whose schemes they
will buy and / or the kind of schemes they will invest in. They are designed to help investors
get over the trouble of choosing between multiple schemes and their variants in the market.
Thus, an investor invests in a fund of funds, which in turn will manage the investments in
various schemes and options in the market.
Exchange Traded Funds
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Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock
exchange.
A feature of open-ended funds, which allows investors to buy and sell units from the mutual
fund, is made available only to very large investors in an ETF.
Other investors will have to buy and sell units of the ETF in the stock exchange. In order to
facilitate such transactions in the stock market, the mutual fund appoints some intermediaries
as market makers, whose job is to offer a price quote for buying and selling units at all times.
If more investors in the stock exchange want to buy units of the ETF, then their moneys
would be due to the market maker. The market maker would use the moneys to buy a basket
of securities that is in line with the investment objective of the scheme, and exchange the
same for chapters of the scheme from the mutual fund. Thus, the market maker can offer the
units to the investors.
If there is more selling interest in the stock exchange, then the market maker will end up with
units, against which he needs to make payment to the investors. When these units are offered
to the mutual fund for extinguishment, corresponding securities will be released from the
investment portfolio of the scheme. Sale of the released securities will generate the liquidity
to pay the unit holders for the units sold by them.
In a regular open-ended mutual fund, all the purchases of units by investors on a day happen
at a single price. Similarly, all the sales of units by investors on a day happen at a single
price. The market however keeps fluctuating during the day. A key benefit of an ETF is that
investors can buy and sell their units in the stock exchange, at various prices during the day
that closely track the market at that time. Further, the unique structure of ETFs, make them
more cost-effective than normal index funds, although the investor would bear a brokerage
cost when he transacts with the market maker
Dividend Payout, Growth and Dividend Re-Investment Options
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Most mutual fund schemes offer two options – Dividend and Growth. A third option which is
possible is the Dividend reinvestment Option. These are different options within a scheme;
they share the same portfolio. Therefore the portfolio returns are the same for all three
options. However, they differ in the structure of cash flows and income accruals for the unit-
holder, and therefore, the Unit-holder’s taxability, number of units held and value of those
units.
In a dividend payout option, the fund declares a dividend from time to time. When a dividend
is paid, the NAV of the units falls to that extent. Debt schemes need to pay an income
distribution tax on the dividend distributed. This tax payment too reduces the NAV. The
reduced NAV, after a dividend payout is called ex-Dividend NAV. After a dividend is
announced, and until it is paid out, it is referred to as cum-Dividend NAV. In a dividend
payout option, the investor receives the dividend in his bank account. However, the dividend
payout does not change the number of units held by the investor. The dividend received in the
hands of the investor does not bear any tax.
In a dividend re-investment option, as in the case of dividend payout option, NAV declines to
the extent of dividend and income distribution tax. The resulting NAV is called ex-dividend
NAV. However, the investor does not receive the dividend in his bank account; the amount is
re-invested in the same scheme.
Dividend is not declared in a growth option. Therefore, nothing is received in the bank
account (unlike dividend payout option) and there is nothing to re-invest (unlike dividend re-
investment option). In the absence of dividend, there is no question of income distribution
tax. The NAV would therefore capture the full value of portfolio gains.
Systematic Investment Plan (SIP)
It is considered a good practice to invest regularly. SIP is an approach where the investor
invests constant amounts at regular intervals. A benefit of such an approach, particularly in
equity schemes, is that it averages the unit-holder’s cost of acquisition.
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Suppose an investor were to invest Rs 1,000 per month for 6 months. If, in the first month,
the NAV is Rs 10, the investor will be allotted Rs 1,000 ÷ Rs 10 i.e. 100 units. In the second
month, if the NAV has gone up to Rs 12, the allotment of units will go down to Rs 1,000 ÷
Rs 12 i.e.83.333 units. If the NAV goes down to Rs 9 in the following month, the unit-holder
will be allotted a higher number of Rs 1,000 ÷ Rs 9 i.e. 111.111 units.
Thus, the investor acquires his Units closer to the average of the NAV on the 6 transaction
dates during the 6 month period – a reason why this approach is also called Rupee Cost
Averaging.
Through an SIP, the investor does not end up in the unfortunate position of acquiring all the
units in a market peak. Mutual funds make it convenient for investors to lock into SIPs by
investing through Post-Dated Cheques (PDCs), ECS or standing instructions.
Systematic Withdrawal Plan
Just as investors do not want to buy all their units at a market peak, they do not want all their
units redeemed in a market trough. Investors can therefore opt for the safer route of offering
for repurchase, a constant value of units.
Suppose an investor were to offer for re-purchase Rs 1,000 per month for 6 months. If, in the
first month, the NAV is Rs 10, the investor’s unit-holding will be reduced by Rs 1,000 ÷ Rs
10 i.e. 100 units. In the second month, if the NAV has gone up to Rs 12, the unit-holding will
go down by fewer units viz. Rs 1,000 ÷ Rs 12 i.e. 83.333 units. If the NAV goes down to Rs
9 in the following month, the unit-holder will be offering for re-purchase a higher number of
units viz. Rs 1,000 ÷ Rs 9 i.e. 111.111 units. Thus, the investor repurchases his Units at an
average NAV during the 6 month period. The investor does not end up in the unfortunate
position of exiting all the units in a market trough.
Mutual funds make it convenient for investors to manage their SWPs by indicating the
amount, periodicity (generally, monthly) and period for their SWP. Some schemes even offer
the facility of transferring only the appreciation or the dividend. Accordingly, the mutual
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fund will re-purchase the appropriate number of units of the unit-holder, without the
formality of having to give a re-purchase instruction for each transaction.
Systematic Transfer Plan
This is a variation of SWP. While in a SWP the constant amount is paid to the investor at the
pre-specified frequency, in a STP, the amount which is withdrawn from a scheme is re-
invested in some other scheme of the same mutual fund. Thus, it operates as a SWP from the
first scheme, and a SIP into the second scheme.
Since the investor is effectively switching between schemes, it is also called “switch”. If the
unit-holder were to do this SWP and SIP as separate transactions
• The Unit-holder ends up waiting for funds during the time period that it takes to receive the
re-purchase proceeds, and has idle funds, during the time it takes to re-invest in the second
scheme. During this period, the market movements can be adverse for the unit-holder.
• The Unit-holder has do two sets of paper work (Sale and Repurchase) for every period.
Taxability of Mutual Fund
The mutual fund trust is exempt from tax. The trustee company will however pay tax in the
normal course on its profits. For example, SBI Mutual Fund is exempt from tax; SBI Mutual
Fund Trustee Company however is liable to tax.
Some aspects of taxation of schemes are dependent on the nature of the scheme. The
definitions under the Income Tax Act, for the purpose are as follows:
Equity-oriented scheme is a mutual fund scheme where at least 65% of the assets are invested
in equity shares of domestic companies. For calculating this percentage, first the average of
opening and closing percentage is calculated for each month. Then the average of such value
is taken for the 12 months in the financial year.
For Money market mutual funds / Liquid schemes, income tax goes by the SEBI definition,
which says that such schemes are set up with the objective of investing exclusively in money
market instruments (i.e. short term debt securities).
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Securities Transaction Tax (STT)
This is a tax on the value of transactions in equity shares, derivatives and equity mutual fund
units. Applicability is as follows:
On equity-oriented schemes of mutual funds
Rate
On purchase of equity shares in stock exchange 0.125%
On sale of equity shares in stock exchange 0.125%
On sale of futures & options in stock exchange 0.017%
On investors in equity oriented schemes of mutual fund
Rate
On purchase of the units in stock exchange 0.125%
On sale of the units in stock exchange 0.125%
On re-purchase of units (by AMC) 0.250%
STT is not payable on transactions in debt or debt-oriented mutual fund units.
Additional Tax on Income DistributedThis is a tax on dividend distributed by debt-oriented mutual fund schemes. Applicability is
as follows:
Money Market Mutual Funds / Liquid Schemes:
25% + Surcharge + Education Cess
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Other debt funds (investors who are individual / HUF):
12.5% + Surcharge + Education Cess
Other debt funds (other investors):
20% + Surcharge + Education Cess
This additional tax on income distributed (referred to in the market as dividend distribution
tax) is not payable on dividend distributed by equity-oriented mutual fund schemes. Dividend
Distribution Tax (DDT) on dividends distributed to corporate investors by all categories of
debt funds have been increased to 30%, w.e.f. June 1, 2011.
Capital Gains Tax
Capital Gain is the difference between sale price and acquisition cost of the investment. Since
mutual funds are exempt from tax, the schemes do not pay a tax on the capital gains they
earn. Investors in mutual fund schemes however need to pay a tax on their capital gains as
follows:
Equity-oriented schemes
• Nil – on Long Term Capital Gains (i.e. if investment was held for more than a year) arising
out of transactions, where STT has been paid
• 15% plus surcharge plus Education Cess – on Short Term Capital Gains (i.e. if investment
was held for 1 year or less) arising out of transactions, where STT has been paid
• Where STT is not paid, the taxation is similar to debt-oriented schemes
Debt-oriented schemes
• Short Term Capital Gains (i.e. if investment was held for 1 year or less) are added to the
income of the investor. Thus, they get taxed as per the tax slabs applicable. An investor
whose income is above that prescribed for 20% taxation would end up bearing tax at 30%.
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Investors in lower tax slabs would bear tax at lower rates. Thus, what is applicable is the
marginal rate of tax of the investor.
• In the case of Long Term Capital Gain (i.e. if investment was held for more than 1 year),
investor pays tax at the lower of the following:
10% plus surcharge plus Education Cess, without indexation
20% plus surcharge plus Education Cess, with indexation
Indexation means that the cost of acquisition is adjusted upwards to reflect the impact of
inflation. The government comes out with an index number for every financial year to
facilitate this calculation.
For example, if the investor bought units of a debt-oriented mutual fund scheme at Rs 10 and
sold them at Rs 15, after a period of over a year. Assume the government’s inflation index
number was 400 for the year in which the units were bought; and 440 for the year in which
the units were sold. The investor would need to pay tax on the lower of the following:
• 10%, without indexation viz. 10% X (Rs 15 minus Rs 10) i.e. Rs 0.50 per unit
• 20%, with indexation.
Indexed cost of acquisition is Rs 10 X 440 ÷ 400 i.e. Rs11. The capital gains post indexation
is Rs 15 minus Rs 11 i.e. Rs 4 per unit. 20% tax on this would mean a tax of Rs 0.80 per unit.
The investor would pay the lower of the two taxes i.e. Rs0.50 per unit.
Wealth TaxInvestments in mutual fund units are exempt from Wealth Tax.
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INSURANCE
Introduction
It is the wish of most individuals to have enough assets, so that one can meet life’s necessities
and luxuries. Individual save to provide for these necessities and luxuries. The earning power
of an individual is reduced in retirement or by unforeseen disability or for any unexpected
happening. Many individuals also love to leave enough assets to assure continuation of these
necessities and luxuries to their dependents. Insurance takes care of these risks. Insurance
allows a person to join a large group of people to share losses. The group guarantees to pay a
sum of money to the person, to his family or to other beneficiaries as intended by the insured
upon the happening of an uncertain specified event like death, fire, etc. In return, the person
pays an agreed risk premium, also called premium to the insurance company. Japanese ranks
first in life insurance ownership in the world, while USA and Canada are second and third.
What is Insurance?Insurance is risk transfer mechanism wherein insured transfers the risk of unexpected
financial loss to insurers by paying premium.
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An individual buys an insurance policyIndividual pays a premium to the insurance companyThe insurer agrees to pay a specifies amount of money in case of a loss.
Types of Insurance
Insurance can be broadly classified into two categories:
Life Insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the
insurer promises to pay a designated beneficiary sum of money upon the death of the insured
person.
Life insurance deals with two risks that an individual faces
a) Dying prematurely, leaving a dependent family and
b) Living long without adequate means of support.
It enables the head or earning member of the family to discharge the sense of responsibility
that he feels for those dependent on him.
Life insurance includes Term insurance, Whole life insurance, Endowment plan, Money back
plan, Annuities and pension and Unit linked insurance plans.
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Types on InsuranceLife InsuranceGeneral InsuranceMotor InsuranceFire InsuranceHealth InsuranceMarine Insurance