Investment Planning

1Investment PlanningPDP

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Investment Planning(Professional Development Program)

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PREFACE

Investment Planning is all about achieving desired rate of returns from investible surplus and existing

assets, matching one’s time frame of goals, age and risk profile. Hence this forms the heart of

comprehensive financial planning process. Investment planning begins with designing a suitable strategy

identifying and selecting various asset classes to grow existing assets and future investible surplus.

Sound investment strategy is based on comprehensive knowledge about various classes of assets,

their unique characteristics and understanding of expected returns and associated risks with each

class of asset. It is important to bear in mind that investment strategy will always be linked to one’s risk

profile.

This program will guide you systematically in understanding the concepts required for preparing a

sound investment plan.


Table of Contents

Chapter - 1 Fundamentals of Investment Planning .................................................................... 8

Chapter - 2 Understanding Investment Risk ............................................................................ 16

Chapter - 3 Measurement of Risk ........................................................................................... 27

Chapter - 4 Managing Risk in Investments .............................................................................. 40

Chapter - 5 Measuring Investment Returns ............................................................................. 54

Chapter - 6 Building an Investment Portfolio ........................................................................... 71

Chapter - 7 Small Saving Schemes ........................................................................................ 94

Chapter - 8 Fixed Income Instruments .................................................................................. 107

Chapter - 9 Life Insurance Products ...................................................................................... 116

Chapter - 10 Mutual Funds ..................................................................................................... 126

Chapter - 11 Stock market investments .................................................................................. 144

Chapter - 12 Derivatives ......................................................................................................... 160

Chapter - 13 Real Estate ........................................................................................................ 188

Chapter - 14 Investment strategies ......................................................................................... 197

Chapter - 15 Asset Allocation.................................................................................................. 205

Chapter - 16 Structuring Portfolio for Investors ....................................................................... 212

Chapter - 17 Regulation of Financial Planners ........................................................................ 219


Chapter 1

8 Investment Planning PDP

What is Investing?

Investment refers to a commitment of funds to one or more assets that will be held over some futuretime period. It is important to understand the difference between Savings and Investments. Anything not

consumed today and saved for future use can be considered as savings. Almost all of us save money. Infact we are a nation of savers where the domestic savings is a high percentage of Gross Domestic Product– sometimes as high as 26-27%. It is important to channel these savings into productive investment avenues.Almost all individuals have wealth of some kind, ranging from the value of their services in the workplace totangible assets to monetary assets.. For our purposes, investment will mean a measurable asset retainedin order to increase one’s personal wealth. A financial asset is one that generates income and contributes toaccumulation and growth of wealth over a period of time. The two elements in investments are generationof income on a periodic basis and/or growth in value over a period of time.

Investment scenario in IndiaA pick-up in investment, reflecting the high business optimism, not only strengthened industrialperformance but also reinforced the growth outlook itself. The rally in gross domestic capital formation(GDCF) that had commenced in 2002-03 continued and as a proportion of GDP it reached a high of 30.1per cent in 2004-05.1

The increasing trend in gross domestic savings, which provided most of the resources for investment,as a proportion of GDP observed since 2001-02 continued with the savings ratio rising from 26.5 percent in 2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in 2004-05.2

India is a nation of savers and the domestic savings is a very high percentage of GDP. That is extremelygood. It is shocking to note that more than 45% of domestic savings is invested in bank deposits andonly about 2/3% in equity and equity related investments. This clearly shows that while as a nation weare very good savers we are very poor investors because it is equally important for the savers to investin avenues that fetch decent returns after considering factors like inflation, taxation, etc. Bank depositsnot only offer lower returns but they are hardly tax efficient and thus do not serve the cause of earninghigh post tax & net of inflation returns. In developed countries the proportion of savings being diverted toequity and equity related instruments is in the region of 20-25% of GDP while around 20% of savings areparked in bank deposits.

Some investors have failed to recognize the less obvious, but potentially more damaging, risk of diminishedincome from staying completely invested in low yielding fixed income securities or bank deposits.

The financial planner should ensure that investors take a hard look at the fixed income components of theirportfolios and rethink this strategy in the context of more comprehensive, long-term objectives. Understandingwhere the clients are coming from, the priorities in their life and the challenges they face in a rapidly changinginvestment horizon. Succeeding in career, planning children’s education, marriages and having more thanenough for an enjoyable retirement are some of the objectives most people aim at.

Fundamentals of Investment Planning

1 Economic Survey 2005-2006 2 Economic Survey 2005-2006


The financial planner in India hence, has a very important role to play. The planner’s job in India is morechallenging because of Indian mind set and the aversion to risk. It will be part of his job to educate hisclients on concepts of risks and returns and their relationship.

Why Invest?We all work for money. It is equally important to ensure that money works for us. We should inculcatethe habit of reliance on a secondary source of income. We invest to improve our future welfare. Fundsto be invested come from assets already owned, borrowed money, and savings or foregone consumption.By foregoing consumption today and investing the savings, we expect to enhance our future consumptionpossibilities. Anticipated future consumption may be by other family members, such as education fundsfor children or by ourselves, possibly in retirement when we are less able to work and produce for ourdaily needs. Regardless of why we invest we should all seek to manage our wealth effectively, obtainingthe most from it. This includes protecting our assets from inflation, taxes and other factors.

Investment fundamentalsSome of the fundamental rules of investments are:

START EARLY

INVEST REGULARLY

ENSURE HIGHER RETURNS ON YOUR INVESTMENTS

The following table will demonstrate the difference, very graphically:

It is assumed that an investor invests Rs 1,000/- p.m., at the end of each month, systematically, indifferent invest plans which yield 5%, 8%, 12% and 15% p.a. returns.

Look at the big difference in the maturity values as the term gets longer and longer and as thereturns are higher.

Indian investors have always preferred fixed income securities where the returns are assured and havecompromised on the returns. In general investors are risk averse and more so Indian investors. It is thejob of the financial planner to advise the investors on the concept of focusing on higher returns for betterstability and higher capital building over a longer period of time. The above table very clearly illustrateshow a higher rate of return over longer period of time can make a world of difference to the capital at theend of the term.


Example

Mr. Sunil Joshi, a very conservative investor, has been religiously investing Rs. 5,000/- p.m. in a providentfund account which gives him interest at the rate of 8% p.a. compounded annually. Mr. Ashwin Shah, onthe advise of his planner, has been investing Rs. 5,000/- p.m. in equity linked investments whichhave given him around 15% p.a. return. Both start at the same age of 25 years and keep investingfor 30 years. Mr. Sunil Joshi will have a capital amount of Rs. 74.50 lacs in his provident fundaccount while Mr. Ashwin Shah will have accumulated Rs. 3.46 crores which is about 5 times theretirement capital of Mr. Sunil Joshi. These dramatic results have been possible because of thefocus on the rate of return. Mr. Sunil Joshi has done well by starting early and investing regularlybut he has not focused on the rate of returns on his investments. While assured returns are importantit is also important to focus on expected returns on investment, even at a risk.

How Do We Invest?If we are making investment decisions today that will directly affect our future wealth, it would makesense that we utilize a plan to help guide our decisions. Surprisingly, the majority of people do not havein place any type of formalized investment plan. Taking some time to put together a financial plan canreap tremendous benefits. First, let’s define financial planning.

Financial planning is the process of meeting one’s life goals through the proper management of yourfinances. Life goals can include buying a home, saving for child’s education or planning for retirement.

Financial planning provides direction and meaning to one’s financial decisions. It allows one to understandhow each financial decision affects other areas of finances. For example, buying a particular investmentproduct might help you pay off your mortgage faster or it might delay your retirement significantly. Byviewing each financial decision as part of a whole, one can consider its short and long-term effects onlife goals. One can also adapt more easily to life changes and feel more secure that goals are on track.

Common Mistakes in the planning processIt may be helpful to be aware of some common mistakes people make when approaching investments:

1. Don’t set measurable financial goals.

2. Make a financial decision without understanding its effect on other financial issues.

3. Confuse financial planning with investing.

4. Neglect to re-evaluate their financial plan periodically.

5. Think that financial planning is only for the wealthy.

6. Think that financial planning is for when they get older.

7. Think that financial planning is the same as retirement planning.

8. Wait until a money crisis to begin financial planning.

9. Expect unrealistic returns on investments.

10. Think that using a financial planner means losing control.

11. Believe that financial planning is primarily tax planning.These are some of the most common misconceptions about financial planning and it the perhaps one ofthe first jobs of the financial planner to clear these areas with the prospective client. The financial plannershould explain the process of planning; the various steps involved and the ultimate objective of theexercise before hand and make the investor comfortable about disclosing his personal information.


What Process Do We Use to Invest?Nobody plans to fail but many fail to plan. It is important for the investor to realize that planning is veryimportant. The financial planner has to spend time in educating the investors about the common mistakesand how to come over them. He has to take the client through the systematic process of financialplanning outlined below.

The financial planning process consists of six steps that help the investor/client take a “big picture” lookat where he is financially. Using these six steps, the investor can work out where he is now, what he mayneed in the future and what he must do to reach his goals. These six steps are:

1. Establishing and defining the client-planner relationship.The financial planner should clearly explain or document the services to be provided to you and defineboth his and the client’s responsibilities. The planner should explain fully how he will be paid and bywhom. The client and the planner should agree on how long the professional relationship should lastand on how decisions will be made.

2. Gathering client data, including goals.The financial planner should ask for information about the client’s financial situation. The client and theplanner should mutually define the personal and financial goals, understand the client’s time frame forresults and discuss, if relevant, how he feels about risk. The financial planner should gather all thenecessary documents before giving the client the advice he needs.

3. Analyzing and evaluating your financial status.The financial planner should analyze the client’s information to assess his current situation and determinewhat he must do to meet his goals. Depending on what services you have asked for, this could includeanalyzing your assets, liabilities and cash flow, current insurance coverage, investments or tax strategies.

4. Developing and presenting financial planning recommendations and/or alternatives.The financial planner should offer financial planning recommendations that address client’s goals, basedon the information collected. The planner should go over the recommendations with the client to helphim understand them and help the client make informed decisions. The planner should also listen to theclient’s concerns and revise the recommendations as appropriate.

5. Implementing the financial planning recommendations.The client and the planner should agree on how the recommendations will be carried out. The plannermay carry out the recommendations or serve as the “coach,” coordinating the whole process with theclient and other professionals such as attorneys or stockbrokers.

6. Monitoring the financial planning recommendations.The client and the planner should agree on who will monitor the progress towards achieving the goals.If the planner is in charge of the process, he should report to the client periodically to review the situationand adjust the recommendations, if needed, along with life changes.

Product selling Vs. Financial planning

Financial planning is the process through which the planner helps his client to achieve his financialgoals. The financial planner may also be an insurance advisor and/or a mutual fund distributor. Theplanner may have a product bias because of the commissions and brokerages and he may try to push


these products rather than act in the best interest of his client. This is not only unethical and immoral butis also not a proper strategy for long term business success for the planner. It is a well established factthat success in marketing any product or service is more dependant on motivating a client to buy theproduct/service rather than resorting to aggressive selling tactics. The client would be better motivatedto opt for your service as a planner if you take care of his long term interest rather than your short terminterest of brokerage/commissions. It is easier for you to achieve your goals if you help a large numberof people achieve their goals.

The financial planner plays a very important role in designing an investment plan that would best suit hisclient’s needs. He tries to understand thoroughly the financial goals of his clients; he discusses thevarious investment options available and finally suggests to his client a financial plan that will serve thepurpose of achieving the client’s goals. This is a very comprehensive process which requires a thoroughunderstanding of the financial products; markets; economy and also an analysis of the client’s riskprofile; needs; goals, etc. Thus financial planning is much superior to selling financial products/services;more comprehensive and more rewarding for the client and the planner in the long term.

In India many investors have a low level of understanding of the concept of financial risk and hence haveconventionally preferred fixed income instruments to market related instruments with uncertain incomeflows. Thus our investors have a very low risk tolerance. It is one of the most important tasks of theplanner to educate his client on the concept of investment risk ; prepare the client mentally to acceptvolatility in the markets in the short term and explain how patience will be rewarded in the long term.Product selling does not involve these steps of educating and increasing the risk tolerance of the investor.Hence a planner will enjoy a long term advantage and better relationship with his client compared to aproduct seller.

Self-Help or Professional Help?Some investors may feel that they understand financial products better and can do the financial planningthemselves rather than entrust the same to a professional financial planner. Investors may prefer somepersonal finance software packages, magazines or self-help books that can help them do their ownfinancial planning. However, they may decide to seek help from a professional financial planner if:

n They need expertise that they don’t possess in certain areas of finances. For example, a plannercan help you evaluate the level of risk in your investment portfolio or adjust your retirement plandue to changing family circumstances.

n They may want to get a professional opinion about the financial plan they have developed forthemselves.

n They may not have the time to spare to do their own financial planning.

n Certain changes take place in the family or an immediate need or unexpected life event such as abirth, inheritance or major illness.

n An investor may feel that a professional adviser could help him improve on how he is currentlymanaging his finances.

n An investor may feel that he should improve his financial position but does not know where to startand how to go about it.

Some of the common problems which are brought before the financial planner are listed below. The listis inclusive and there can a number of other areas as well.

n How should I create and preserve personal wealth?


n How can I achieve a specific lifetime financial objective?

n How should I provide for my children’s education?

n I am receiving a distribution from my employer. What do I do?

n Do I have enough to retire?

n I just received a lump-sum inheritance. What do I Do?

n When should I execute my stock options?

n How should I best leave wealth to my heirs?

Expectations from a financial planner

1. He should believe that a sound financial plan is fundamental to achieving his client’s goals andenhancing the quality of life.

2. He should also believe that money is not everything but having control and confidence aboutmanaging it can allow the client to concentrate on other things like family, career and future.

3. He should recognize that the issues that brought the client to him are unique and he should try totake result oriented approach to solving the client’s concerns.

4. He should adopt a personal, confidential and patient approach to help his client reach decisions oncomplex choices and alternatives in investments.


Review Questions

1. Financial Planning is:

a. Investing assets to receive the highest rate of return possibleb. Keeping taxes as low as possiblec. Planning to retire with the maximum income possibled. A process of solving financial problems and reaching financial goals

2. The main reason people fail to plan is:

a. They keep on postponingb. They are too old to planc. They are too young to pland. They lack the expertise to plan

3. Successful investing can be directly related to

I. Starting earlyII. Investing regularlyIII. Taking unduly high risksIV. Focusing on risk and return in different investment vehiclesa. I & II onlyb. III onlyc. I, II and IV onlyd. All four

Answers:

1. d

2. a

3. c


Chapter 2


Definitions and Concepts

Understanding Risk

In the context of investments “risk” refers not only to the chance that a person may lose his capital butmore importantly to the chance that the investor may not get the desired return on an investment

vehicle. We invest in various investment products which generally comprise: 1. Fixed Income Instrumentsand 2. Growth oriented investments. In the case of Fixed Income Instruments with a definite coupon ratethere is virtually no “risk” of not being able to get the desired returns but in the case of other instrumentsan investor goes with an expectation of a certain amount of return and the term “risk” in this contextrefers to the probability of the investor not getting the desired/expected returns

The notion of risk is an integral and primary concept in the understanding of investments. Risk can bedefined as the uncertainty of an outcome from an investment decision. In making an investment decision,an investor forms an exception regarding that decision’s outcome. Any departure form that expectedoutcome can be considered the risk of that decision. Thus, another way to consider risk is to considerthe possibilities of unexpected outcomes. The outcome form an investment decision may unexpectedlyincrease or decrease the principal amount invested. While most people consider the decrease in valueas the investment risk, we will observe that in measuring risk, both positive and negative unexpectedoutcomes must be considered. Before considering the issues regarding the measurement of risk let usbegin by enumerating the different types of risk that may exist for an investment.

The issue of risk being incorporated in both positive and negative surprises can be explained with asimple example. Assume you are explaining the possible outcomes of an investment decision to a clientwhere the client may receive a return of either 8% (poor outcome) or a 16% (good outcome). You alsoexplain that the client may expect to receive a simple average of the two returns, or 12%, from theinvestment decision. Your client now states that she is averse to the 8% outcome and wants to know ifthe investment can yield 12% or better. That is, the client wishes to remove the poor outcome altogether.Notice that if this were possible, then the simple average of the new investment decision, or the expectedoutcome would now be 14% ((16%+12%)/2) and the new poor outcome would now be 12%. In otherwords, risk, or the unexpected outcomes, cannot go away. It is only meaningful in the context of anexpected outcome and both positive and negative unexpected outcomes. There are many differentways in which the principal invested can be unexpectedly changed. We will now consider each of thesetypes of risk.

Risk AvoidanceInvestment planning is almost impossible without a thorough understanding of risk. There is a risk/returntrade-off. That is, the greater risk accepted, the greater must be the potential return as reward forcommitting one’s funds to an uncertain outcome. Generally, as the level of risk rises, the rate of returnshould also rise, and vice versa.

Before we discuss risk in detail, we should first explain that risk can be perceived, defined and handledin a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses

Understanding Investment Risk


to completely avoid the activity the risk is associated with. An example would be the risk of being injuredwhile driving an automobile. By choosing not to drive, a person could avoid that risk altogether. Obviously,life presents some risks that cannot be avoided. One may view a risk in eating food that might be toxic.Complete avoidance, by refusing to eat at all, would create the inevitable outcome of death, so in thiscase, avoidance is not a viable choice. In the investment world, avoidance of some risk is deemed to bepossible through the act of investing in “risk-free” investments. Short-term maturity Government bondsare usually equated with a “risk-free” rate of return. In the Indian market place “risk free” returns are thereturns available on Treasury Bills of a certain tenor; necessarily less than one year and about 90daysor 180 days. Stock market risk, for example, can be completely avoided by choosing not to investequities and equity related instruments.

Risk TransferAnother way to handle risk is to transfer the risk. An easy to understand example of risk transfer is theconcept of insurance. If one has the risk of becoming severely ill (and unfortunately we all do), then healthinsurance is advisable. An insurance company will allow you to transfer the risk of large medical bills to themin exchange for a fee called an insurance premium. The company knows that statistically, if they collectenough premiums and have a large enough pool of insured persons, they can pay the costs of the minoritywho will require extensive medical treatment and have enough left over to record a profit. Risk transfer canalso occur in investing. One may purchase a put option on a stock or on the market index which allows thatperson to “put to” or sell to someone their stock or the index at a set price, regardless of how much lower thestock or the index may drop. There are many examples of risk transfer in the area of investing.

The Risk Averse InvestorDo investors dislike risk? In economics in general, and investments in particular, the standard assumptionis that investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say thatinvestors dislike risk, but more precisely, we should say that investors are risk averse. A risk-averseinvestor is one who will not assume risk simply for its own sake and will not incur any given level of riskunless there is an expectation of adequate compensation for having done so. Note carefully that it is notirrational to assume risk, even very large risk, as long as we expect to be compensated for it. In fact,investors cannot reasonably expect to earn larger returns without assuming larger risks.

Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to incur.Some investors choose to incur high levels of risk with the expectation of high levels of return. Otherinvestors are unwilling to assume much risk, and they should not expect to earn large returns.

We have said that investors would like to maximize their returns. Can we also say that investors, ingeneral, will choose to minimize their risks? No! The reason is that there are costs to minimizing the risk,specifically a lower expected return. “Lower the risk, lower the return”. Taken to its logical conclusion,the minimization of risk would result in everyone holding risk-free assets such as savings accounts andTreasury bills. Thus, we need to think in terms of the expected return/risk trade-off that results from thedirect relationship between the risk and the expected return of an investment.

Influence of Time on RiskInvestors need to think about the time period involved in their investment plans. The objectives beingpursued may require a policy statement that speaks to specific planning horizons. In the case of anindividual investor this could be a year or two in anticipation of a down payment on a home purchase ora lifetime, if planning for retirement. Generally speaking, the longer the time horizon the more risk canbe incorporated into the financial planning.


Globally as well as in India it is well established on the basis of track record of performance that equitiesas a class of asset has outperformed other asset classes and delivered superior returns over longerperiods of time. With these statistics available why wouldn’t everyone at all times be 100 percent investedin stocks? The answer is, of course, that while over the long term stocks have outperformed, there havebeen many short term periods in which they have underperformed, and in fact, have had negativereturns. Exactly when short term periods of underperformance will occur is unknown and thus there ismore risk in owning stocks if one has a short term horizon than if there exists a long term horizon. Afinancial planner has to take into account the time horizon while structuring investment portfolios andthe general rule is that the younger a person is, the longer can be his time horizon and hence moreexposure to equities – this follows the rule that risk and returns go up with time.

Time has a different effect when analyzing the risk of owning fixed income securities, such as bonds.There is more risk associated with holding a bond long term than short term because of the uncertaintyof future inflation and interest rate levels. If one were to “lock in” a rate of 8 percent for a bond thatmatured in one year, an upward move in inflation or interest rates would have a less adverse effect onthe price of that bond than a 8 percent bond that matured in thirty years. That is because the bond couldbe redeemed in one year and reinvested in a bond with a presumably higher interest rate. The thirty yearbond, however, will continue to pay only 8 percent for the rest of its thirty year life.

Types of Investment Risk

Systematic versus Unsystematic RiskModern investment analysis categorizes the traditional sources of risk causing variability in returns intotwo general types: those that are pervasive in nature, such as market risk or interest rate risk, and thosethat are specific to a particular security issue, such as business or financial risk. Therefore, we mustconsider these two categories of total risk.

The following discussion introduces these terms.

Total risk can be divided into its two components, a general (market) component and a specific (issuer)component. Then we have systematic risk and nonsystematic risk, which are additive:

Total risk = General risk + Specific risk

= Market risk + Issuer risk

= Systematic risk + Unsystematic risk

Systematic RiskAn investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable ornon market part. What is left is the non diversifiable portion or the market risk. Variability in a security’stotal returns that is directly associated with overall movements in the general market or economy iscalled systematic (market) risk.

Virtually all securities have some systematic risk, whether bonds or stocks, because systematic riskdirectly encompasses interest rate, market and inflation risks. The investor cannot escape this part ofthe risk because no matter how well he or she diversifies, the risk of the overall market cannot beavoided. If the stock market declines sharply, most stocks will be adversely affected; if it rises strongly,most stocks will appreciate in value. These movements occur regardless of what any single investordoes. Clearly, market risk is critical to all investors.


Unsystematic RiskThe variability in a security’s total returns not related to overall market variability is called the unsystematic(non market) risk. This risk is unique to a particular security and is associated with such factors asbusiness and financial risk as well as liquidity risk. Although all securities tend to have some nonsystematicrisk, it is generally connected with common stocks.

Remember the difference: Systematic (Market) Risk is attributable to broad macro factors affecting allsecurities. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security.

Market RiskA market is a place where goods and services are traded. Events occur within a market that similarlyaffect all the goods traded in that market. For example, when the Reserve Bank of India unexpectedlychanges interest rates, most financial securities are affected similarly. Other examples of events thataffect all securities are the possibilities of war, severe natural catastrophes, recessions, structural changesin the economy, tax law changes, even changes in consumer preferences etc. When the unexpectedchange in values is systematic to the whole market, that risk is termed as market or systematic risk.

Reinvestment RiskIn the context of bonds investors look at the current yield as well as Yield To Maturity (YTM) – the returnone would get if the security were held till the maturity and redeemed with the issuing institution.

It is important to understand that YTM is a promised yield, because investors earn the indicated yieldonly if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at thecalculated YTM (yield to maturity). It is important to reinvest the periodic payments, at the same rate asthe YTM, to obtain the YTM yield on the security. In the context of long term bonds during the tenor ofwhich the interest rates may fluctuate in any economy it is virtually difficult for the investor to investperiodic coupon payments at YTM and hence the risk of not being able to get the desired return (YTM)and this risk is referred to as reinvestment risk.

Obviously, no trading can be done for a particular bond if the YTM is to be earned. The investor simplybuys and holds. What is not so obvious to many investors, however, is the reinvestment implications ofthe YTM measure. Because of the importance of the reinvestment rate, we consider it in more detail byanalyzing the reinvestment risk.

The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equalto the computed YTM on that bond, thereby earning interest on interest over the life of the bond at thecomputed YTM rate. In effect, this calculation assumes that the reinvestment rate is the yield to maturity.

If the investor spends the coupons, or reinvests them at a rate different from the assumed reinvestmentrate of 10 percent, the realized yield that will actually be earned at the termination of the investment inthe bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested atrates higher or lower than the computed YTM, resulting in a realized yield that differs from the promisedyield. This gives rise to reinvestment rate risk.

This interest-on-interest concept significantly affects the potential total dollar return. The exact impact isa function of coupon and time to maturity, with reinvestment becoming more important as either couponor time to maturity, or both, rises. Specifically:

a. Holding everything else constant, the longer the maturity of a bond, the greater the reinvestment risk.

b. Holding everything else constant, the higher the coupon rate, the greater the dependence of thetotal return from the bond on the reinvestment of the coupon payments.


The notion of reinvestment rate risk is particularly easy to see in the retirement planning process. Inassisting a client with a retirement plan, an assumed rate of return is built into the retirement forecast asto estimate the annual contributions the client will be required to make to the retirement plan. It isassumed that the funds will build at that rate of return until the client retires. What we see in reality isvarying rates of return throughout the life of the portfolio. Some realized rates of return may be betterthan the forecast and some may be worse than the forecast. Either way, as the retirement plan grows,we will not see the steady, forecasted rate of return on the retirement portfolio. If the rates of return areconsistently lower than the original forecast, the clients will not have enough funds at retirement to meettheir need. In this case, the reinvestment risk is the cause of the problem.

Interest Rate RiskThe variability in a security’s return resulting from changes in the level of interest rates is referred to asinterest rate risk. Such changes generally affect securities inversely; that is, other things being equal,security prices move inversely to interest rates. The reason for this movement is tied up with the valuationof securities. Interest rate risk affects bonds more directly than common stocks and is a major risk facedby all bondholders. As interest rates change, bond prices change in the opposite direction.

As a financial planner, while considering investments in various fixed income securities it is desirable toexplain the concepts of interest rate risk as well as reinvestment risk and build the same while structuringclient portfolios. If the current scenario is such that the interest rates may rise in the near future and maykeep rising for some time to come, then may be more of short term debt instruments would find place inthe portfolio and in a scenario where the interest rates have reached historic peaks and may fall in thefuture, then it would make sense to commit funds for long term and hence investors should be advisedto get into long term bonds/annuities of insurance companies, etc. to protect from these two risks thatwe have discussed.

The values of all financial and real assets are in some part dependent on the general levels of interestrates in an economy. Therefore, any unexpected change in the general level of interest rates will alsounexpectedly affect the values of all such assets. Financial assets such as bonds are especially affectedby such changes. As we shall see later, the values of bonds and all other fixed income securities areinversely related to interest rates, i.e. when interest rates increase, these values decrease and viceversa. Values of stocks are also affected by changes in interest rates, though understanding the impactof interest rate changes on stock values is less straightforward than for bonds. Real assets such as realestate are also tremendously impacted by changes in interest rates. When changes in interest rates areunexpected, the uncertain changes in asset values are said to arise form interest rate risk. The readercan appreciate why participants in the financial markets so engrossed in pending activities of the ReserveBank of India which through its policy making decisions, has a considerable influence on interest rates.

Purchasing Power RiskInflation risk is also known as purchasing power risk because the ability to purchase different quantitiesof goods and services is dependent upon the changing levels of prices of all items in an economy. Forexample, assume a client wishes to invest a sum ofRs. 2,90,000 which is expected to result in a certainoutcome of Rs. 3,00,000. Now also consider that the client wishes to purchase a car, either today or oneyear from now and which is valued today also at Rs. 2,90,000. Suppose the price of this car increasesto Rs. 3,10,000 over the year. In this case, the investor would have been better off if she had bought thecar instead of investing the amount. Thus the investor has a choice in how the money may be used. Ifthe money is invested then the client will need an additional Rs. 10,000 to purchase the car. In otherwords, the inflation in the car’s price has eroded the purchasing power of the invested sum. If we


consider that the increase in the price of the car was unexpected, then we can consider the effect of theoutcome as arising out of inflation risk. Inflation risk is especially important to investment decisionswhere the financial securities being utilized are interest rate sensitive. Such as bonds.

A factor affecting all securities is the purchasing power risk also known as inflation risk. This is thechance that the purchasing power of invested money may decline. With uncertain inflation, the real(inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). Thisrisk is related to interest rate risk, since interest rates generally rise as inflation increases, becauselenders demand additional inflation premiums to compensate for the loss of purchasing power.

Liquidity Risk“Liquidity’ in the context of investment in securities is related to being able to sell and realize cash withthe least possible loss in terms of time and money. Liquidity risk is the risk associated with the particularsecondary market in which a security trades. An investment that can be bought or sold quickly andwithout significant price concession is considered liquid. The more the uncertainty about the time elementand the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk,whereas a small cap stock listed in a regional stock exchange may have substantial liquidity risk.

Liquidity is concerned with the ability to convert the value of an asset into cash. Any event or conditionthat affects this ability is termed as liquidity risk. For example, an investor may wish to sell her holding ina stock. If the investor cannot find a buyer for the stock, then her position in that stock cannot beliquidated. Hence, in this example, she faces liquidity risk. Assets differ from each other by liquidity risk.Securities offered by the government (such as Treasury bills) are very liquid because there are manyparticipants seeking to trade in these securities. Treasury bills can be sold almost instantaneously, andhence are considered to be highly liquid. At the other end of the spectrum, stocks of very small and littleknown companies are considered to contain high liquidity risk because they are thinly traded. Wheninvestors make purchase decisions that may require to be quickly converted to cash, they will alwaysseek securities which have low liquidity risk. For example, firms that temporarily place excess cash infinancial (marketable) securities in order to enhance yields will seek highly liquid securities that do notincrease the firm’s liquidity risk exposure.

Regulation RiskSome investments can be relatively attractive to other investments because of certain regulations or taxlaws that give them an advantage of some kind. Interest earned on Public Provident Fund accounts aretotally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a result of that specialtax exemption on the interest as well as the invested amount qualify for deduction from income u/s 80Cthe yield on PPF account is much higher than its current interest rate of 8%. The risk of a regulatorychange that could adversely affect the stature of an investment is a real danger. A special committeehas advised the Government of India to do away with various sections of The Income Tax Act whichallow exclusions and deductions. If its recommendations are accepted by the Government then theattractiveness of this investment avenue will drop dramatically. Dividends on shares and equity mutualfunds are tax free in the hands of investors. These avenues become attractive because of the taxconcessions (which are matters of legislation) and these can change. That is one risk associated withinvestments which cannot be avoided. The best solution lies in periodic review of investment plans.

Business RiskThe risk of doing business in a particular industry or environment is called business risk. For example,some commodities like fertilizers and oil are highly price sensitive in the Indian context and the Government


policies of subsidies substantially affect the profitability of the companies engaged in manufacturing/marketing these products.

The risk associated with the changes in a firm’s abilities to measure up to expectations is known asbusiness risk or unsystematic risk. Business risk can be further segregated into operating risk andfinancial risk. The risk that a business may not be able to meet its fixed operating costs, such as rent,management salaries, etc., is known as operating risk. The risk that the firm may not be able to meet itsfixed financial obligations, such as paying interest on its debt or lease payments, is known as financialrisk. Financial risk is also known as credit risk since lenders or creditors of funds seek to assess theability of the firm to meet its debt services obligations.

International RiskInternational Risk can include both Country risk and Exchange Rate risk.

Exchange Rate RiskAll investors who invest internationally in today’s increasingly global investment arena face the prospectof uncertainty in the returns after they convert the foreign gains back to their own currency. Unlike thepast when most Indian investors ignored international investing alternatives, investors today mustrecognize and understand exchange rate risk, which can be defined as the variability in returns onsecurities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk.

The market for potential assets in which to invest spans the entire globe. Investors are notconstrained to invest only in their home countries. However, when an investor purchases a securityin a foreign country, it must be paid for in a foreign currency. At the time of the purchase, the valueof the foreign security is derived form the current, or spot, exchange rate. The exchange rate thatwill prevail when the investor sells the security in the future cannot be predicted with any certainty,and hence, the conversion value becomes uncertain. This uncertainty can be considered asexchange rate risk. We illustrate this risk by a simple example.

For example, a U.S. investor who buys an Indian stock denominated in Indian Rupees must ultimatelyconvert the returns from this stock back to dollars. If the exchange rate has moved against the investor,losses from these exchange rate movements can partially or totally negate the original return earned. Astable rather than a depreciating foreign currency (in this case Indian Rupee) is what the investor wouldbe looking for while deciding to invest in that country. The returns to an international investor is alwaysthe market returns + or – the foreign currency appreciation or depreciation in the intervening period.

Obviously, the investors who invest only in domestic markets do not face this risk, but in today’s globalenvironment where investors increasingly consider alternatives from other countries, this factor hasbecome important. Currency risk affects international mutual funds, global mutual funds, closed-endsingle country funds, American Depository Receipts, foreign stocks, and foreign bonds.

Country RiskCountry risk, also referred to as political risk, is an important risk for investors today. With more investorsinvesting internationally, both directly and indirectly, the political, and therefore economic, stability andviability of a country’s economy need to be considered. More and more international investors areinvesting in the Indian market because of the political and economic stability of India in the last few yearsand the belief of continued stability on these fronts. Transparent economic policies and political stabilityare key factors for attracting more foreign investments in India.

Many firms operate in foreign political climates that are more volatile than those in the United States.


Firms can face the danger of the foreign operations being nationalized by the local government or canexperience imposed restriction of capital flows from the foreign subsidiary to the parent. Danger from aviolent overthrow of the political party in power can also have an effect on the rate of return investorsreceive on foreign investments. Many countries have also been unable to meet their foreign debtobligations to banks and other foreign institutions which contain important political and economicimplications.

The informed investor must have some feel for the political/economic climate of the foreign country inwhich he or she invests. Political risk represents a potential deterrent to foreign investment. The bestsolution for the investor is to be sufficiently diversified around the world so that a political or economicdevelopment in one foreign country does not have a major impact on his or her portfolio.

Am I Willing to Accept Higher Risk?Every investor needs to find his or her comfort level with risk and construct an investment strategy, withthe help of a financial planner, around that level. A portfolio that carries a significant degree of risk mayhave the potential for outstanding returns, but it also may fail dramatically.

An investor’s comfort level with risk should pass the “good night’s sleep” test, which means the investorshould not worry about the amount of risk in his portfolio so much as to lose sleep over it.

There is no “right or wrong” amount of risk – it is a very personal decision for each investor. However,young investors can afford higher risk than older investors can because young investors have more timeto recover if disaster strikes. If an investor is five years away from retirement, he probably would notwant to be taking extraordinary risks with his nest egg, because he will have little time left to recoverfrom a significant loss.

Of course, a too conservative approach may mean the investor will not achieve his financial goals.

ConclusionInvestors can control some of the risk in their portfolio through the proper mix of stocks and bonds. Mostexperts consider a portfolio more heavily weighted toward stocks riskier than a portfolio that favours bonds.


Review Questions :

1. Which of the following statements concerning investment risk is (are) correct)

I. It is the uncertainty that actual return will differ from the expected return.II. It is composed of two parts: systematic risk and unsystematic risk.a. I onlyb. II onlyc. Both I and IId. Neither I nor II

2. Systematic risk has all the following components EXCEPT:

a. Market riskb. Business riskc. Interest rate riskd. Purchasing power risk

3. All the following statements concerning unsystematic risk are correct EXCEPT:

a. It can not be reduced by diversificationb. It is that portion of total risk that is unique to the particular firmc. It may be affected by changes in consumer preferences and the competence of the firm’s

managementd. Such risk may be independent of factors affecting other industries

4. Unsystematic risk is composed of which of the following:

I. Business riskII. Market riskIII. Financial riska. I onlyb. I & II onlyc. I & III onlyd. I, II and III

5. All the following statements concerning systematic risk are correct EXCEPT:

a. It is typically influenced by the same factors affecting the market prices of many other comparableinvestments

b. It is typically affected by economic, political and sociological factorsc. It is typically found to some extent in nearly all listed securitiesd. It can usually be substantially reduced by a carefully executed program of diversification

6. If Indian Rupee was Rs. 48 to a US$ in 2004 and Rs. 46.50 to a US$ in 2005, which of thefollowing statements is true:

a. Foreign Institutional Investors would not attribute any significance to this change in valuesb. FII’s will perceive the currency risk to be very highc. FII’s will perceive the currency risk to be lowd. FII’s will shy away from Indian markets


7. Inflation is on the rise; interest rates may move up in the near future. An investor seeks youradvice which of the two products would be good for him at this point in time. Government of Indiataxable bonds offering 8% p.a. return for 6 years with no premature repayment option or AAArated corporate Fixed Deposit for one year offering 8% p.a. interest.

What would be your advice?

a. Better let the investor decide because both are safe.b. He should prefer the 1 year FDc. He should prefer the 6 year GOI Bondd. He can choose either of them – there is no difference as the interest rate is the same

Answers:

1. c

2. b

3. a

4. c

5. d

6. c

7. b


Chapter 3


We invest in various investment vehicles expecting some amount of return from these avenues.The investment risk refers to the probability of actually not earning the desired or expected return

and may be a lower or negative return. A particular investment is considered riskier if the chances oflower than expected returns or negative returns are higher.

n Standard deviation (si) measures total, or stand-alone, risk.

n The larger the si, the lower the probability that actual returns will be close to the expected return.

Standard Deviation

When an investor goes in for an investment option, he may do so expecting to get a return of say 15%in one year. This is only a one-point estimate of the entire range of possibilities. Given that an investormust deal with the uncertain future, a number of possible returns can and will occur.

In the case of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment will bemade with 100 per cent certainty barring a financial collapse of the economy. The probability of occurrenceis 1.0, because no other outcome is possible.

With the possibility of two or more outcomes, which is the norm for stock market investment, eachpossible likely outcome must be considered and a probability of its occurrence assessed. The result ofconsidering these outcomes and their probabilities together is a probability distribution consisting of thespecification of the likely returns that may occur and the probabilities associated with these likely returns.

Probabilities represent the likelihood of various outcomes and are typically expressed as a decimal(sometimes fractions are used.) The sum of the probabilities of all possible outcomes must be 1.0,because they must completely describe all the (perceived) likely occurrences.

How are these probabilities and associated outcomes obtained? The probabilities are obtained on thebasis of past occurrences with suitable modifications for any changes expected in the future. In the finalanalysis, investing for some future period involves uncertainty and, therefore, subjective estimates.

Investors and analysts should be at least somewhat familiar with the study of probability distributions.Since the return which an investor earns from investing is not known, it must be estimated. An investormay expect the TR (total return) on a particular security to be 10 per cent for the coming year, but intruth, this is only a “point estimate.”

Probability distributions can be either discrete or continuous. With a discrete probability distribution, aprobability is assigned to each possible outcome. With a continuous probability distribution an infinitenumber of possible outcomes exist. The most familiar continuous distribution is the normal distributiondepicted by the well-known bell-shaped curve often used in statistics. It is a two-parameter distributionin which the mean and the variance fully describe it.

To describe the single most likely outcome from a particular probability distribution, it is necessary tocalculate its expected value. The expected value is the average of all possible return outcomes, whereeach outcome is weighted by its respective probability of occurrence. For investors, this can be described

Measurement of Risk


as the expected return.

Expected ReturnIn the case of a fixed income security like a Government of India Bond or a bank fixed deposit, normallythe expected return is the same as the coupon rate or rate of interest. Hence there, are no uncertaintiesabout being able to get the expected return.

In the case of investments where the returns are market dependant, for example a stock, one will haveto estimate the possible returns and the probability of getting the same, as given here below:

In this case, the expected return is calculated as under:

Expected return = Sum (returns*probability)

= (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1)

= .004+.016+.048+.032+.02

= 0.12 or 12%

It is a normal distribution curve as pictorially depicted below:


Standard DeviationWe have mentioned that it’s important for investors to be able to quantify and measure risk. To calculate thetotal risk associated with the expected return, the variance or standard deviation is used. This is a measureof the spread or dispersion in the probability distribution; that is, a measurement of the dispersion of arandom variable around its mean. Without going into further details, just be aware that the larger thisdispersion, the larger the variance or standard deviation. Since variance, volatility and risk can in this contextbe used synonymously, remember that the larger the standard deviation, the more uncertain the outcome.

Calculating Standard DeviationLet’s use the same table that we did for calculating the expected returns and find out the standarddeviation of the same:

Standard deviation is square root of variance.

Variance = Sum of {Probabilities*(actual return – expected return)2}

Variance = Probability * (actual return – expected return)2

So, based on the figures in the table we can work out the variance as under;

Expected return already calculated to be 12%

Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2

Standard deviation = Square root of variance = 4.3817

Let’s quickly work out another example to understand how to arrive at expected returns and calculatestandard deviation.


Expected return = [-6*.15+0*.2+6*.3+12*.2+18*15)

= [-0.9+0+1.8+2.4+2.7] = 6%

Standard deviation can be worked out as follows:

Variance = (21.6+7.2+0+7.2+21.6) = 57.6

Standard deviation = 7.5895

Calculating a standard deviation using probability distributions involves making subjective estimates ofthe probabilities and the likely returns. However, we cannot avoid such estimates because future returnsare uncertain. The prices of securities are based on investors’ expectations about the future. The relevantstandard deviation in this situation is the ex ante (estimated before the event) standard deviation andnot the ex post (calculated after the events/historic) based on realized returns.

Although standard deviations based on realized returns are often used as proxies for projecting standarddeviations, investors should be careful to remember that the past cannot always be extrapolated into thefuture without modifications. Historic (ex post) standard deviations may be convenient, but they aresubject to errors. One important point about the estimation of standard deviation is the distinction betweenindividual securities and portfolios. Standard deviations for well- diversified portfolios are reasonablysteady across time, and therefore historical calculations may be fairly reliable in projecting the future.Moving from well- diversified portfolios to individual securities, however, makes historical calculationsless reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolioof securities, and the standard deviations of well-diversified portfolios may be more stable.

Something very important to remember about standard deviation is that it is a measure of the total risk ofan asset or a portfolio, including both systematic and unsystematic risk. It captures the total variability inthe assets or portfolios return, whatever the sources of that variability. In summary, the standard deviationof return measures the total risk of one security or the total risk of a portfolio of securities. The


historical standard deviation can be calculated for individual securities or portfolios of securities using totalreturns for some specified period of time. This ex post value is useful in evaluating the total risk for aparticular historical period and in estimating the total risk that is expected to prevail over some future period.

The standard deviation, combined with the normal distribution, can provide some useful informationabout the dispersion or variation in returns. In a normal distribution, the probability that a particularoutcome will be above (or below) a specified value can be determined. With one standard deviation oneither side of the arithmetic mean of the distribution, 68.3 percent of the outcomes will be encompassed;that is, there is a 68.3 percent probability that the actual outcome will be within one (plus or minus)standard deviation of the arithmetic mean. The probabilities are 95 and 99 percent that the actual outcomewill be within two or three standard deviations, respectively, of the arithmetic mean.

In a bell shaped normal distribution the probabilities for values lying within certain bands are as follows:

± 1 S.D. 68.3%

± 2 S.D. 95.4%

± 3 S.D. 99.7%

What Standard Deviation MeansSay a fund has a standard deviation of 4% and an average return of 10% per year. Most of the time (or,more precisely, 68% of the time), the fund’s future returns will range between 6% and 14% (or its 10%average plus or minus its 4% standard deviation). Almost all of the time (95% of the time), its returns willfall between 2% and 18%, or within two standard deviations i.e. [10-(2*4) or 10 + (2*4)]

Limitations of Standard DeviationUsing standard deviation as a measure of risk can have its drawbacks. For starters, it’s possible to owna fund with a low standard deviation and still lose money. In reality, that’s rare. Funds with modeststandard deviations tend to lose less money over short time frames than those with high standarddeviations.


The bigger flaw with standard deviation is that it isn’t intuitive. Certainly, a standard deviation of 7% ishigher than a standard deviation of 5%, but these are absolute figures and one can not reach a conclusionas to whether these are high or low figures. Because a fund’s standard deviation is not a relativemeasure, which means it’s not compared to other funds or to a benchmark, it is not very useful to theinvestor without some context.

Case

Let us consider two stocks: stock X and stock Y whose returns and probability are given as follow:

Stock X

Expected return on stock X is sum of the last column which is 12%

Stock Y

Expected return on stock Y is the sum of the last column which is 12%.

In this example, we find that the expected returns of both stocks are the same.

If the expected returns on two stocks are the same, obviously one should prefer that stock where therisk is less. In other words, we shall go ahead and measure the standard deviation of both the stocks tofind out which stock is more likely to give us the expected returns of 12%.


Variance which is the sum of the last column = 2.1

Standard deviation for stock X = 1.449

Let’s work out for stock Y

Variance of stock Y which is the sum of last column = 0.6

Standard deviation of stock Y = 0.77

Thus, after the calculation of total risk (standard deviation), it is obvious that stock Y is more likely todeliver the expected returns of 12% compared to stock X. This case has been discussed basically tounderstand that while deciding on which stock to invest in, it is important to consider the expected returnas well as the total risk of not getting the desired return stock wise and reach decision accordingly. Allthe same, it may be pertinent to point out here that standard deviation is more seriously considered andis useful in portfolio of stocks rather than individual stocks. We shall consider the portfolio scenario in thesubsequent topics.

Beta

Beta is a measure of the systematic risk of a security that cannot be avoided through diversification.Beta measures non-diversifiable risk. Beta shows the price of an individual stock which performs withchanges in the market. In effect, the more responsive the price of a stock to the changes in the market,the higher is its Beta.

Beta is a relative measure of risk – the risk of an individual stock relative to the market portfolio of allstocks. If the security’s returns move more (or less) than the market’s returns as the latter changes, thesecurity’s returns have more (or less) volatility (fluctuations in price) than those of the market. It isimportant to note that beta measures a security’s volatility, or fluctuations in price, relative to a benchmark,the market portfolio of all stocks.


Securities with different slopes have different sensitivities to the returns of the market index. If the slopeof this relationship for a particular security is a 45-degree angle, the beta is one (1). This means that forevery one percent change in the market’s return, on average, this security’s returns change one (1) percent. The market portfolio has a beta of one (1). A security with a beta of 1.5 indicates that, on average,security returns are 1.5 times as volatile as market returns, both up and down. This would be consideredan aggressive security because when the overall market return rises or falls 10 per cent, this security,on average, would rise or fall 15 per cent. Stocks having a beta of less than 1.0 would be considered amore conservative investment than the overall market.

Betas can be negative or positive. But generally, betas have been found to be positive which means thatthe direction of the movement of individual stock generally tends to be in line with the market: fallingwhen the market is falling and rising when the market is rising.

Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used byinvestors to judge a stock’s risk. Stocks can be ranked by their betas. Because the variance of themarket is a constant across all securities for a particular period, ranking stocks by beta is the same asranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities.

Given below are different scenario showing how the portfolio return moves relative to market for Betaequal to 1, 0.5, and 2.


The beta of a security is a historical measure and it is arrived at by plotting the actual returns on thesecurity over long periods of time with market returns as shown in the earlier charts. A line is drawnwhich depicts beta of the security.

To determine the beta of any security, you’ll need to know the returns of the security and those of thebenchmark index you are using for the same period. Using a graph, plot market returns on the X-axisand the returns for the stock over the same period on the Y-axis.

Upon plotting all of the monthly returns for the selected time period (usually one year), we draw a best-fit line that comes the closest to all of the points. This line is called the regression line.

Beta is the slope of this regression line. The steeper the slope, the more the systematic risk, the shallowerthe slope, the less exposed the company is to the market factor. In fact, the coefficient (Beta) quantifies


the expected return for the stock, depending upon the actual return of the market.

Calculating BetaRs = a + BsRm

Where,

Rs = estimated return on the stock

a = estimated return when the market return is zero

Bs = measure of the stock’s sensitivity to the market index

Rm = return on the market index

Allowing for random errors, some times beta is calculated as under:

Rs = a + BsRm+ e

Where,

“e” is the random error term embodying all of the factors that together make up the unsystematic return.

If we want to compare the return on the security related to the risk free avenues, then the formula is:

Rs = Rf + Bs (Rm - Rf)

Where the concept of Rf is the risk free return – return that can be obtained by investing in risk freesecurities like treasury bills.

Case

For example, suppose you are considering a private equity investment in a company with a new jobwork. The process is inherently risky, i.e. the standard deviation of the project is 75% per year. The betaof the project is 0.5. The Rf = 5% and the E[Rm] = 14.5%. What is the required rate of return on theproject?

Theory tells us that the answer does not depend upon the volatility associated with the returns. Insteadwe use the beta of the project.

E[Rjob] = 5% + (.5)(14.5% - 5%) = 9.5%

This is the required rate of return on the project. The answer would not change if the range of outcomenext year broadened or narrowed. ß (beta) is the only relevant piece of information — now all thatremains is to estimate it!


Review Questions:

1. Mr. Joshi has analysed a stock for a one-year holding period. The stock is currently quoting atRs 100 and is paying no dividends. There is a 50-50 chance that the stock may quote Rs 100 orRs 120 by year-end. What is the expected return on the stock?

a. 12%b. 10%c. 15%d. 20%

2. A stock is quoting at Rs. 100 and is paying no dividends. The possible year end price and theprobabilities are given below:

Year end price Probabiltiy110 0.1115 0.2120 0.3125 0.2130 0.1What is the expected return on the stock?a. 10%b. 15%c. 8%d. 20%

3. What is the standard deviation of the stock based on the figures in question 2?

a. 14.45b. 5.79c. 16.30d. 33.60

4. Stocks A and B are not paying any dividends. Stock A is quoting at Rs. 100 while B is quoting atRs 50. There is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 50-50 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the year. Which stock willyou buy considering the return and the risk?

a. I shall buy B because it is cheaperb. I will buy Stock B because the risk is lessc. I will buy Stock A because the risk is lessd. The risk and the return in both are same; I shall buy any one

5. Compute the expected return for the stock when the risk free return is 8% and the expected returnfrom the market is 12% for a stock with Beta of 1.2.

a. 15.6%b. 12.8%c. 16.4%d. 22.2%


6. Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an aggressiveinvestor would buy:

a. Either A or B; because in a rising market all stocks will riseb. Stock A because it may deliver superior returns compared to Bc. Stock B because the risk will be less compared to A while the returns would be the samed. Stock B because it may deliver superior returns compared to A

Answers:

1. b

2. c

3. b

4. d - (while deciding you calculate the risk also besides the returns)

5. b - use the formula Rs = Rf + Bs (Rf -Rm)

6. b - higher beta means higher risk and also higher returns compared to market.


Chapter 4


Risk is an integral part of investments. Risk in the context of investments not only refers to thechance of losing one’s capital, but mainly to the chance/probability of getting less than expected

returns from an investment vehicle. Thus, risk in investments can not be avoided but it can be managedto suit one’s risk profile and investment objectives.

“Risk” in investments is categorized as “systematic” and “unsystematic” risk; which are also called nondiversifiable and diversifiable risk. Unsystematic risk can be reduced through diversification whilesystematic risk is a market risk which can not be reduced through diversification.

Investors can resort to different strategies to manage risk in investments. Let’s look at some strategiesthat investors can adopt to manage risk.

Diversification

It is well established in investments that in order to be able to obtain required returns, it is essential toreduce the risk and this can be achieved through diversification. Diversification reduces the risk and canbe achieved through diversifying investments:

n Across different asset classes – equity; debt; commodities; precious metals; real estate and so on.

n Across different countries (geographies) – India; USA; UK; Japan; Singapore; Australia; MiddleEast and so on.

n Across different securities and so on – Different stocks; bonds, etc.

n Across maturities – short term; long term; for life; etc.

Diversification across different asset classes

n As financial planners, we should ensure that the investments are diversified across different assetclasses and that proper allocation among different assets is made as decided in the Asset AllocationPlan.

n It is important to decide the quantum of investments in risky asset classes like equity, real estate,etc. based on the age, risk appetite, etc. of the investor. Over dependence on a particular assetclass can also be quite risky. For example, if an investor is highly risk averse and has little or noexposure to equities, then he will find the going tough if the interest rates in the economy were tofall. He will continue to earn less over a period of time and may even suffer loss on existing investingbecause of fall in bond prices. Hence, exposure to equity should be considered in such cases.

n Similarly, a very high exposure to equity can prove very tricky because the stock market over along period of time may turn bearish and the investor may get very little return and capital appreciationin this period. The chances of capital loss are also quite high in such cases. Equity is a long termasset class and should be accordingly planned while deciding the Asset Allocation Plan.

Portfolio of SecuritiesWhile investing in stocks, it is essential to invest in a number of stocks and not just a few to reduce the

Managing Risk in Investments


risk. But the purpose of diversification will be achieved only if the stocks belong to different sectors andthat some of the sectors are not related to each other. Let us look at the following example to understandthe co-relationship between two securities in a portfolio:

Suppose you live on an island where the entire economy consists of only two companies: one sellsumbrellas while the other sells sunscreen lotion. If you invest your entire portfolio in the company thatsells umbrellas, you’ll have strong performance during the rainy season, but poor performance when it’ssunny outside. The reverse occurs with the sunscreen company, the alternative investment: your portfoliowill be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you’drather have constant, steady returns. The solution is to invest 50% in one company and 50% in theother. Since you have diversified your portfolio, you will get decent performance year round instead of,depending on the season, having either excellent or terrible performance.

It is a well established fact as borne out by the following diagram that diversification across securitiesreduces the risk:

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30stocks will yield the most cost-effective amount of risk reduction. Investing in more securities will stillyield further diversification benefits, albeit at a drastically smaller rate.

So, it is only sensible to hold a certain number of securities and monitor the same periodically ratherthan holding too many securities in a portfolio which will serve the purpose of diversification in a verylimited way.

Further, diversification benefits can be gained by investing in foreign securities because they tend to be lessclosely correlated to domestic investments. For example, an economic downturn in the Indian economymay not affect Japan’s economy in the same way. Therefore, having Japanese investments would allow aninvestor to have a small cushion of protection against losses due to an Indian economic downturn.

The following important conclusions can be drawn regarding diversification across securities:

1. The number of securities should be limited to say 20 to 30 and not more.

2. The securities should ideally belong to different industrial sectors, and if possible, even differentgeographical regions.


3. The co-relation of market movements may be built in selecting stocks in a portfolio (oil marketingcompanies and automobiles; export oriented and import dependant companies; lending companiesand borrowing companies, etc.).

Returns on the portfolioIn a portfolio containing a number of securities, the returns on the same will depend upon the return onindividual securities as well as weightage of each of the security in the total portfolio. While deciding onthe securities to be invested in the weightage of each security, the portfolio is also decided at the pointof investment. The weightage may change over a period of time with change in prices of underlyingsecurities as well the portfolio value. The weights are calculated on the basis of initial investment value.

We can express the same in the following formula for return on the portfolio:

Where

E (RP) is the expected return on the portfolio,

Wi is the weight of security i in the portfolio and,

E(ri) is the expected return on security i

ExampleLet us consider a portfolio with two securities A and B with a weight of 60% assigned to A and 40% tosecurity B. If the following are the probabilities of return for individual securities A and B let us try andfind out the probable return on the portfolio:

Expected return on security A = [ (0.15*25)+(0.2*15)+(0.3*0)+(0.2*-5)+(0.15*-10) ]

= 3.75+3+0-1-1.5

= 4.25%

Expected return on security B = [(0.15*30)+(0.2*20)+(0.3*5)+(0.2*0)+(0.15*-10)

= 4.5+4+1.5+0-1.5

= 8.5%


Return on the portfolio = RAB = WA*RA+WB*RB

= 0.6*4.25+0.4*8.5

= 2.55+3.40

= 5.95%

Where, WA is the weight of A in the portfolio while WB is the weight of B in the portfolio..

Risk of the Portfolio - Measurement

Risk on a portfolio is calculated by considering the standard deviation of individual securities included inthe portfolio as well as interactive risk among securities, measured by covariance.

Variance of Portfolio

Given a portfolio consisting of n securities, the variance of the portfolio can be written as:

Portfolio Risk =Sum of individual securities’ risks + Sum of interaction among securities

Where,

σP2 is the variance of the portfolio.

ri, j is the covariance between securities i and j.

σI is the standard deviation of security i.

is the formula for calculating the standard deviation of a portfolio of two securities x and y where σXY isthe standard deviation of the portfolio, w represents the weight of securities x and y in the portfolio whileCOVxy is the covariance between securities x and y.

ExampleLet us consider a portfolio with two securities X and Y with a weight of 60% assigned to X and 40% tosecurity Y. If the following are the probabilities of return for individual securities X and Y, let us try andfind out the standard deviation of the portfolio:


The same can be done in 3 steps: firstly find out the standard deviation of individual securities; secondlycalculate the covariance between the two securities and thirdly the risk on the portfolio.

Standard deviation of Securities X and YExpected return on security X is = {0.1*30+0.2*20+0.5*10+0.2*(-10)+0.1*(-20)}

= 8%

Expected return on security Y is= {0.1*20+0.2*15+0.5*10+0.2*0+0.1*(-10)}

= 9%

σX2

= Variance of security x = {[.1*(30-8)2]+[0.2*(20-8)2] + [0.5*(10-8)2]+[0.2*(-10-8)2]+[0.1*(-20-8)2]}

= 0.1*484 + 0.2*144 + 0.5*4 + 0.2*324 + 0.1*784

= 48.4+28.8+2+64.8+78.4

= 222.4

Hence, standard deviation of security x is = square root of 222.4 = 14.91%

Similarly, the variance of security y can be calculated as under:

= {[0.1*(20-9)2] + [0.2*(15-9)2] + [0.5*(10-9)2] + [0.2*(0-9)2] + [0.1*(-10-9)2}

= 0.1*121+0.2*36+0.5*1+0.2*81+0.1*361

= 12.1+7.2+0.5+16.2+36.1

= 72.1

Standard deviation of security y is square root of 72.1 = 8.49%

Covariance between securities X and Y

The use of formula is illustrated by actually taking out the figures in the probability of returns on securitiesx and y

COVxy = 0.1*(30-8)(20-9)+ 0.2*(20-8)(15-9) + 0.5*(10-8)(10-9) +

0.2*(-10-8)(0-9) + 0.1 (-20-8)(-10-9)

= 24.2+14.4+1+32.4+53.2

= 125.2


Portfolio Risk

σ2XY = (0.6)2*(14.91)2 + (0.4)2*(8.49)2 + (2*0.6*0.4*125.2)

= (0.36*222.31) + (0.16*72.08) + (60.1)

= 80.03+11.53+60.1

= 151.66

σXY = square root of 151.66

= 12.31%

Expected return on the portfolio

Portfolio Risk and return in a two security scenarioThe calculations may look complicated but in many cases the correlation between the securities is givenand hence, it is easier to work out the portfolio risk and the portfolio return. Let us look at the followingexample to understand things better:

Example 2 security case

= 30% ´ 0.15 + 70% ´ 0.20 = 0.185 or 18.5%

σP2 = wA

2sA2 + wB

2sB2 + 2 wAwBrA,B´sA´B

= (0.3)2´0.05 + (0.7)2´0.06 +2 ´0.3´0.7´0.5´0.224´0.245

= 0.0454248

σP = Square root of 0.0145248 = 0.213 or 21.3%

Thus the portfolio risk is 21.3% while the expected return of the portfolio is 18.5%

Covariance and Correlation CoefficientThe covariance and correlation coefficient measure the extent to which securities move together in the


market. For instance, suppose you own Stock A and B and both are high-tech stocks selling computerchips. Suppose that news breaks about Company A revealing a quality assurance issue with theircomputer chips and the announcement of a major recall. Stock A’s price will probably decrease if themarket had not expected such an announcement. Because Stock B is also in the computer chip industry,its stock may very well decrease as well since investors will respond adversely to the overall market forcomputer chips. The measure of Stock B’s sensitivity to Stock A’s stock price could be measured overtime to see the extent to which they move together. We could use both the covariance and the correlationcoefficient to track the movements.

Stock B could be measured relative to an overall stock market index as well in order to see how sensitive itis to that market’s general movements. The relationship between the movements of two securities or betweena single security and general market movements are critical observations. As we shall see in a later chapter,these observations and measures of co-movements provide the underpinning in constructing efficientportfolios that contain many securities that move together in the same direction to each other (positivecorrelation) tend to do very well in good times and very poorly in bad times. The opposite is true too in thatsecurities which are negatively correlated balance each other out in good time and in bad times as well.Covariance and correlation coefficients are simple to calculate for two securities but become more complicatedas the number of securities increases. That is why it is necessary to use computer programs to conductsuch analysis.

1. Actually, rather than use the standard deviation, we can also use its squared value, termed thevariance to describe risk. That is, we may use a2 (the standard deviation squared) to describe therisk in an individual security.

Covariance

Any two securities whose prices react to information similarly are said to have a positive covariance.Securities with a negative covariance have returns that vary inversely, or that their prices move inopposite directions as reactions to the same information event.

The covariance between two securities is calculated as follows:

As you can see, the covariance of these two securities is 0.14. This means that these two securitiestend to move in opposite directions. Without calculating the correlation coefficient, it is difficult to determinethe extent to which they move together. Since the covariance is calculated similar to the standarddeviation, we know that this is an absolute number. That is why it is necessary to use the covariance tocalculate the correlation coefficient.

Correlation CoefficientThe correlation coefficient measures the strength of the relationship between two securities and thecoefficient is always a value between – 1 and + 1. If the value is –1, it can be said that the returns of thesecurities are perfectly negatively correlated, meaning that the prices change equally but in oppositedirections, where direction implies increase and decrease. If they value is + 1, the two securities areperfectly positively correlated and that the security prices change equally and in the same direction aswell. If the correlation coefficient equals zero, it means that the two securities do not move together inany meaningful way.


The calculation for correlation coefficient is as follows:

Thus we can see that if correlation coefficient is –0.70, it means that these two securities exhibit a strongnegative movement in opposite directions. In this case, barring other issues, these two securities maybe suitable to put in a portfolio in order to project it from general stock market cycles.

FIGURE 5:1 Correlation Analysis

Figure 5:1 demonstrates the concept of correlation. In Panel A, assets i and j are perfectly correlated,with r ij equal to + 1. As i increases in value, so does j in exact proportion to i. Panel B, assets i and jexhibit a perfect negative correlation, with r if equal to – 1. As i increases, j decreases in exact proportionto i. Panel C demonstrates assets i and j having no correlation at all, with r ij equal to 0.

Portfolio EffectAn investor who is holding only investment i may consider adding investment j in the portfolio. If equalamounts are invested in each stock, the new portfolio’s Expected Return will be Kp. We define Kp as theExpected Return of the portfolio:

Kp = XiKi+XjKj

The X values represent the weights assigned by the investor to each component in the portfolio and are50 percent for both investments in this example. The i and j values were determined to be 10 percent.Thus we have:

Kp = 0.5(10%) + 0.5(10%) = 5% + 5% = 10%

What about the standard deviation (ó p ) for the total portfolio? Assume standard deviation of i = 3.9%


and j = 5.1%. If a weighted average were taken of the two investments, the new standard deviationwould be 4.5 percent:

σ¡ Xi + σ¡ Xj

0.5 (3.9%) + 0.5 (5.1%) = 1.95% + 2.55% = 4.5%

The interesting element is that the investor appears to be worse off from the combined investment. HisExpected Return remains at 10 percent, but his standard deviation has increased from 3.9 to 4.5 percent.It appears that he is adding risk rather than reducing it by expanding his portfolio and without anychange in return.

There is one fallacy in the analysis. The standard deviation of a portfolio is not based on the simpleweighted average of the individual standard deviation (as the Expected Return is) rather, it considerssignificant interaction between the investments. If one investment does well during a given economiccondition while the other does poorly and vice versa, there may be significant risk reduction from combiningthe two, and the standard deviation for the portfolio may be less than the standard deviation for eitherinvestment (this is the reason we do not simply take the weighted average of the two).

FIGURE 5:2 Investment Outcomes under Different Conditions

Note : In Figure 5:2 risk-reduction potential from combining the two investments under study. Investmenti alone may produce outcomes anywhere from 5 to 15 percent, and investment j, from 6 to 20 percent.By combining the two, we narrow the range for investment (i, j) from 7.5 to 12.5 percent. Thus, we havereduced the risk while keeping the Expected Return constant at 10 percent.

Coefficient of DeterminationAs we just saw, correlation and covariance are statistical measures that gauge the nature of the relationshipbetween two random variables. Sometimes, the relationships between such variables may be one ofdependence or causality. For example, when our income increases (decreases), our consumption of goodsand services generally also increases (decreases). In this case, we can say that changes in consumptionare caused (is dependent upon), to some extent, on changes in income. In this example, we can thenclassify consumption as the dependent variable and income as the independent variable. A common


procedure to measure the extent of such a dependent relationship between two variables is known assimple regression analysis. Regression analysis provides us with many statistical gauges of the relationshipwhich help us better understand the scope and nature of the relationship. One such measure in a statisticknown as the coefficient of determination, also known as R². This widely used statistical measure (R²),represents the proportion of variation in the dependent variable that has been explained or accounted for bythe independent variable. In the above example of income and consumption, the R² statistic form a simpleregression analysis would tell us how many changes in consumption, are explained by changes in income.

What is interesting to note is that the coefficient of determination, when observed as a result of simpleregression analysis, is also the square of the correlation coefficient, which was discussed previously.Since the correlation coefficient is commonly denoted by the symbol ‘r’, hence the R² for the determinationcoefficient. Also note that since correlation has a value between – l and + l, its squared value must alsonecessarily be a value between o and l. Continuing further, we consider the correlation value of – l torepresent a perfect negative relationship (each change in a variable being matched by an equal butdirectionally opposite change in the other) between two variables and a correlation value of + l to representa perfect positive relationship (each change in a variable being matched by an equal, in both magnitudeand direction, change in the other) between two variables. Thus, the squared values in both thesecases, or their R², would equal l. We can say then that the value of R² being equal to l implies that theindependent variable fully explains all changes in the dependent variable. When the value of R² is equalto zero, we can similarly say that there is absolutely no dependent relationship between the two variables.

In the case where multiple regression analysis is being used, i. e. relationships between and amongmore than two variables, the R² measure similarly interprets the depth of the relationship but is no moresimply the squared correlation value.

Risk Reduction through Product DiversificationIt is important to have a dynamic asset allocation plan diversified among different asset classes. Financialinvestment products comprise direct equity; indirect equity through the mutual fund route; balancedfund which focuses on both debt and equity; debt – corporate and government; fixed income instrumentslike small saving schemes; government bonds, fixed deposits – bank and corporate, etc. Risk on thetotal portfolio is reduced through investments among different products, in a pre-determined proportion,depending upon the risk profile of the investor and managed through periodic review of the proportion.

Risk Reduction through Time DiversificationWhen it comes to equity investments, it is a well established fact, especially in respect of retail investors thatthey cannot time the market. It is the time one stays invested that would determine the returns on equityinvestments over a period of time and not market timing. Many investors tend to take higher exposure toequity at market highs and tend to reduce their exposure during market lows due to emotional swings.These investors invariably end up losing money. The best and time tested solution lies in systematic investmentand sticking to asset allocation plans. The quantum of funds allocated to equities can be invested over aperiod of time through systematic investment plans. Almost all mutual funds offer SIP’s where the peoplecan invest in these funds on a monthly basis at predetermined dates and fixed amounts per month. Autodebit and ECS make it very convenient for investors to invest on a systematic basis. Another very importantstrategy could be parking the available funds in Floating Rate Debt funds and transferring fixed quantum offunds on a monthly basis through a Systematic Transfer Plan out of floaters through SIP’s into equity funds.In this strategy, the funds may earn decent returns in floating rate funds with less interest-rate risk while theequity market timing-risk is reduced through SIP’s.


HedgingDiversification reduces unsystematic risk in a portfolio. Unsystematic refers to a specific individualcorporate or country financial risk event. Therefore, as the number of securities increase in a portfolio,the portfolio’s unsystematic risk decreases. The remaining risk is called systematic or market risk.

Systematic risk cannot be diversified out of a portfolio; however, systematic risk can be hedged.

Consider a portfolio consisting of an indexation of the BSE Sensex. By holding positions in these 30companies, a portfolio has reduced the unsystematic risk. Now the dependence and exposure on thefortune or failure of each company is an approximation of a 1 in 30 chance. The portfolio’s remaining riskis viewed as systematic or market risk. This means that the portfolio value will swing with the benchmarkmarket. A manager can reduce this systematic risk by hedging.

To offset the systematic risk, a fund manager would establish a hedge. This hedge would offset thevalue changes in the underlying portfolio position. Typically, this offset is accomplished with the futures,options, or other derivative markets.

ExampleIf the actual portfolio had a market value of Rs. 12 lacs and the NSE Nifty was trading at 3,000, then fourfuture contracts would be sold to effectively offset the market risk. This is so because each futures contractrepresents the index level times a multiplier of Rs. 3,00,000 per contract at the Nifty level of 3000 (Each Niftycontract size is 100). By selling four (4) contracts; i.e. 400 Nifties, the market value of Rs. 12,00,000/- of theportfolio is protected against a fall in Nifty. When the market falls by 5%, the portfolio will fall by 5% resultingin a loss of Rs. 60,000/- while the Nifty futures contract will earn Rs. 60,000/- on 4 contracts because Niftywould have fallen from 3000 to 2850. This is an example of fully hedging the portfolio through selling theindex futures.

The same effect can be achieved by buying Index puts as well. The “put” option starts gaining when themarket starts falling and in case the market rises, the loss on puts will be to the extent of premium paidonly. In other words, puts can be used to limit the loss in case of a market rise with potential to earnunlimited profits in case of a market fall. The use of futures and options as tools of hedging as well asleveraging portfolios has been explained in a separate topic.


Review Questions:

1. Given the following information, what is the expected return on the portfolio of two securitieswhere both are held in equal weights?

a. 15%b. 19%c. 16%d. 17%

2. What would be the standard deviation of the portfolio comprising of the two securities as perdetails given below?

a. 4.14%b. 3.82%c. 14.13%d.1.78%

3. Diversification among different asset classes will reduce all risks. Is this statement true?

a. Yesb. No; diversification does not serve the purpose of risk reductionc. No; diversification reduces non systematic risk onlyd. No; diversification reduces systematic risk only

4. Hedging is a strategy adopted to reduce all risks. Is this true?

a. Yesb. No; hedging does not serve the purpose of risk reductionc. No; hedging reduces non systematic risk onlyd. No; hedging reduces systematic risk only

5. Hedging, against market loss, in a diversified stock portfolio can be achieved through which oneof the following strategies?

a. By selling index futuresb. By selling index putsc. By buying specific stock futuresd. By buying index futures


6. Mr. Ashok Kulkarni, age 40 years, is a salaried person. He wants to invest Rs. 1,00,000/- inequities and seeks your advice about whether this is the right time to invest in equities and how togo about it. What would be your advice to him?

a. Stay away from stock market because it is a risky place.b. This is not the right time to invest in stocks because the market is likely to fall.c. Invest the funds in a floating rate debt fund and adopt SIP route to invest in mutual funds

systematically on a monthly basis as retail investor cannot time the market.d. Buy shares of Infosys Technologies as the company is doing very well and has declared a

bonus also.

7. Mr. A. G. Doshi has investments in stocks of 50 companies. He wants to invest some moremoney in direct equities and requests you to advice him on how many more companies he shouldinvest in so that he shall have a well diversified equity portfolio. What will be your advice to him?

a. He should have at least another 50 more companies to be adequately diversified.b. He already has too many companies. He should reduce the number to about 20/25 companies

belonging to diverse industrial sectors. Any additional investment he wants to make, he shouldmake in these companies.

c. Diversification cannot be achieved through increasing the number of companies in one’sportfolio.

d. He can continue to hold on to all and add more companies as per funds availability.

8. A small investor wants to participate in the equity market but does not have the expertise or thefunds to have a well diversified equity portfolio. What will be your advice to him?

a. Equity is not the place for small investors as the risks are very high. He should stay away.b. Since funds available are limited, he can buy just one or two stocks of large companies and

participate in the equity boom.c. He should prefer a diversified equity mutual fund as this is where diversification can be achieved

even on a small capital.d. He should first get the expertise by undergoing training programs and then only venture into

stock market.

Answers:

1. c

2. a

3. c

4. d

5. a

6. c

7. b

8. c


Chapter 5


We all make investments to get returns/rewards from the investment vehicles. There are two typesof returns viz. realized return and expected return.

Realized return is what the term implies; it is ex post (after the fact) return, or return that was or could havebeen earned. Realized return has occurred and can be measured with the proper data. Expected return, onthe other hand, is the estimated return from an asset that investors anticipate (expect) they will earn oversome future period. As an estimated return, it is subject to uncertainty and may or may not occur.

The objective of investors is to maximize expected returns, although they are subject to constraints,primarily risk. Return is the motivating force in the investment process. It is the reward for undertakingthe investment.

An assessment of return is the only rational way (after allowing for risk) for investors to compare alternativeinvestments that differ in what they promise. The measurement of realized (historical) returns is necessaryfor investors to assess how well they have done or how well investment managers have done on theirbehalf. Furthermore, the historical return plays a large part in estimating future, unknown returns.

Return on a typical investment consists of two components:

1. Yield: The basic component that usually comes to mind when discussing investing returns is theperiodic cash flows (or income) on the investment, either interest or dividends. The distinguishingfeature of these payments is that the issuer makes the payments in cash to the holder of the asseton a periodic basis. Yield measures relate these cash flows to a price for the security, such as thepurchase price or the current market price.

2. Capital gain (loss): The second component is also important, particularly for stocks but also forlong-term bonds and other fixed-income securities. This component is the appreciation (ordepreciation) in the price of the asset, commonly called the capital gain (loss). It is the differencebetween the purchase price and the price at which the asset can be, or is, sold.

Total return

Given the two components of a security’s return, we need to add them together (algebraically) to formthe total return, which for any security is defined as:

Total return = Yield + Price change where:

the yield component can be nil or positive.

the price change component can be nil, positive or negative.

Measurement of Total returnTotal return = {Cash payments received + Price change over the period}/purchase price of the asset

The price change over the period = end price – open price (can be negative)

Measuring Investment Returns


ExampleThe shares of Alpha were bought on Jan 1 for Rs. 50/-. During the year, Alpha paid a dividend of Rs. 2/- pershare. At the end of the year, Alpha was sold for Rs. 52/- What is the total return on Alpha?

Returns = Dividend + price change = 2 + (52-50) = 2+2 = 4

Total returns = returns/purchase price = 4/50 =0.08 = 8%

This is a conceptual statement for the total return for any security. The important point here is that asecurity’s total return consists of the sum of two components, yield and price change. Investors’ returnsfrom assets can come only from these two components - an income component (the yield) and/or aprice change component, regardless of the asset.

Current YieldIt is a very simple measure of returns on any security and it is obtained by the following formula:

Annual Interest/price of the security

Yield to Maturity (YTM)The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), which isdefined as the promised compounded rate of return an investor will receive from a bond purchased atthe current market price and held to maturity. It captures the coupon income to be received on the bondas well as any capital gains and losses realized by purchasing the bond for a price different from facevalue and holding to maturity. Similar to the Internal Rate of Return (IRR), in financial management, theyield to maturity is the periodic interest rate that equates the present value of the expected future cashflows (both coupons and maturity value) to be received on the bond to the initial investment in the bond,which is its current price.

An investor would use the bond’s coupon rate, price, par value, and term to maturity to determine theyield to maturity, or internal rate of return. For a bond selling at Rs. 1,000 and expected to be redeemedby the issuer at Rs. 1,000, the current yield and the yield to maturity are identical. However, the yield tomaturity will differ from the current yield if the bond sells at a discount or a premium.

Computation of YTM

Where,

P = Price of the security

C = annual interest payments received

r = rate of interest

M = Maturity value (amount receivable on maturity)

n = number of years left for the security to mature

The computation of YTM requires a trial and error procedure. The interest payments are payments ofannuity over a period of time while the maturity value is the future value of the present price of the bondand “r” the YTM has to be worked out substituting different values for r.


Approximate Computation of YTMInstead of following the trial and error basis, one can find out the approximate value of YTM by using theformula:

Where,

YTM is the yield to maturity

C = annual interest payment

M = Maturity value of the bond

P = Present price of the bond

n = number of years to maturity

Arithmetic average returnsA stock not paying dividends, quotes at Rs. 100 at the beginning of the year. It quotes at Rs. 120; Rs. 132;Rs. 118.80 at the end of year 1, 2, and 3 respectively. Let’s find out how the arithmetic average return iscalculated over this period:

Opening price Rs. 100

Year 1 : 20/100 = 20%

Year 2 : (132-120)/120 = 10%

Year 3 : (118.8-132)/132 = -10%

Total returns over 3 years = 20%

Arithmetic average return = 20/3 = 6.66% p.a.

Using the same method, let us calculate the arithmetic average returns based on the following figures:

Opening price Rs. 100;

Year 1 end price Rs. 200;

Year 2 end price Rs. 100

What is the arithmetic average return for this stock?

Year 1 returns 100%

Year 2 returns -50% [(-100/200)*100]

Total returns over 2 years 50%

Arithmetic average returns 50/2 = 25%

This example brings out the limitations of Arithmetic Average Returns because it is obvious that thereturns on the stock can not be 25% when the opening price and price at the end of the second year arethe same at Rs. 100/-.


Therefore, this measure of Arithmetic Average Returns is used for measuring future period returnsrather than past returns.

Geometric Average ReturnsThe formula for measuring Geometric Average Returns is:

G = [(1+R1)(1+R2)(1+R3) …(1+Rn)]1/n -1

Where,

G is the Geometric Average Returns

R1…..Rn is the return over different periods from 1 to n

Let’s try to work out the geometric average return in the following example:

Opening price Rs. 100;

Year 1 end price Rs. 200;

Year 2 end price Rs. 100

R1 = 100% or 1

R2 = -50% or –0.5

G = square root of [(1+1)(1-.5) – 1]

= square root of [(2*0.5) – 1] = 0

Types of Returns

Investors use various methods by which they measure investment returns. We will discuss several typeof returns; the nominal rate of return, the real rate of return, the real after tax rate of return, total returnand risk adjusted return. We will briefly discuss each of these concepts.

Nominal Rate of ReturnThe nominal rate of return is simply the return that one can earn on an investment. If for instance, youinvest your money in a Certificate of Deposit that promises to pay 7 percent per year, a Rs. 100investment will yield Rs 107, one year later. In this example, the nominal rate of return is 7 percent, therate you can earn before considering the effects of inflation or taxes on your investments.

Required Rate of ReturnThe required rate or return is a key concept in investment planning. However, it is also a difficulty andcomplex concept to understand for reasons that require further discussion. Thus, it is worthwhile for usto spend some time on this issue.

When an investor assesses an investment opportunity, they may conduct much research and analysisto gauge the attractiveness of the investment. Ultimately, the investor will boil down the research andanalysis to two factors; the risk of the investment opportunity and the return the investor expects to earnon this investment. The rate of return that an investor expects to earn on a risk-free security (e.g. ATreasury Bill) is the return that an investor expects to earn on a security that is free of default risk. Allother securities contain the possibility of defaulting on their obligations. Hence, an investor will requirereturns in addition to the risk free rate as compensation for assuming the higher risk. We can think of thiscompensatory additional return as the security’s risk premium. Thus we may express the required rateof return as follows:


Required rate of return = risk-free return + risk premiumWhat the planner needs to comprehend is that in arriving at a required rate of return, the primaryassessment is the nature and extent of risk of an investment opportunity. The greater our understandingof the riskiness of a security, the more accurate our understanding of the risk premium we must receive,as compensation, in order to be induced to invest in that particular security. For example, suppose aninvestor, or planner, is considering an investment in two securities – a small cap stock and a highly ratedbond. The planner will understand that the bond contains lower default risk than the small Cap stock andwill provide a greater assurance of an income stream and a redemption value at maturity. On the otherhand, the small cap stock’s price will most likely fluctuate greatly and a higher probability will exist thatthe firm may well go bankrupt. Thus, from the planner’s or investor’s perspective, the bond will beconsidered a much safer investment and the risk premium that the investor will require to invest in thebond will be much lower than what will be assessed for the stock. When these risk premiums are addedto the risk free rate, the rate or return that the investor will require for the small cap stock will be muchhigher than the bond. In summary, the required rate of return may be considered as the gauge of thesecurity’s riskiness.

There are two other related return concepts that are also worth discussing briefly. Under various economicconditions, the performance of securities with varying characteristics will differ. For example, when theeconomy is in a recessionary stage, we expect most stocks to perform poorly, in terms of the returnsthey generate during this period. In this example, this rate would be the stock’s expected rate. If theinvestor’s required rate for this stock was higher than the expected rate, then the investor would notconsider this investment, since the expected rate would not compensate the bearing of the risk of thisparticular security, as determined by the required rate. Similarly, in an economic growth cycle, theexpected rate may equal or exceed the required rate and the investment would be made. Thus, weobserve that both the required rate and the expected rate are assessed and compared and which leadto the eventual trading decision. Finally, note that the assessment of both the required rate and theexpected rate begin before the investment decision and they continue to exist during the tenure of thatdecision, i.e. As long as the security is held. Once the investor sells the security, then the rate that wasactually earned, or the realized rate, can be calculated. The realized rate may well be, and usually is,different form both the expected rate and the required rate.

The Real Rate of ReturnThe decision to invest is, in a sense, decision not to consume. Alternately, an investment decision is adecision that implies a postponement of current consumption. To understand this further, consider thisexample; suppose you made a return of 12 percent in one year and 15 percent the following year, didyou truly do better in the second year? The answer to this question depends on what your earningscould buy at the end of each of those years, or the purchasing power of your earnings. If the generallevel of prices, or inflation was very mild in the first year and severe in the second, your earnings wouldstretch further (purchase more) in the first year than in the second and hence you would have actuallydone better in the first year. Thus, the investment decision is related to the purchasing power of yourearnings. This relationship, in turn, allows us to describe the concept of the real rate of return.

Consider another simple example. Suppose you have Rs. 100 that you are seeking to manage for one yearand that you have two choices of how to use this money. The first choice is to invest the money in a savingsaccount where you will earn a nominal rate of return of 3 percent/year. Thus, in this choice, if you decided toinvest, you would have Rs 103 at the end of the year. The second choice is to buy a watch, which you havealways wanted, and which too costs Rs. 100, today. Had you decided to invest the money, then you wouldbuy the watch one year from today. However, due to the general increase in the level of prices, or inflation,


you may find that at the end of the year, the price of the watch has increased to Rs. 104. In this case, youcannot buy the watch. Further, not having bought the watch before, you have also given up the enjoymentof possessing the watch for the entire year. Thus, at the beginning, if you feel that the price of the watch willincrease to a level that is higher than what you would earn from your investment, you would be prone to notinvest and buy the watch. The only way you would be inclined to invest instead would be if you were beingprovided with a nominal rate that was greater than what you would expect the price to be in a year’s time. Inthe above example, you would invest only if the nominal rate was just greater than 4%. Note that you wouldnot be willing to invest if the nominal rate was just enough (equal to 4% in this example) to offset the costincrease. If that were so, you would rather buy the watch and get to enjoy it for the year.

There are two important observations that we can make form this example. First, the decision to investis always in competition with the decision to consume. That is, the decision to invest can be consideredas a decision to postpone consumption. Second, we will invest only when we expect not only to consumea similar product in the future but that we are also rewarded by a higher earning rate for postponing ourconsumption. If we are not offered this reward, we will always tend to consume and not invest.

In the above example, the rate we earn on the investment is the nominal rate, the rate at which the price ofthe product will rise is the inflation rate and the rate of the reward is the real rate of return. Thus in the aboveexample, if the savings (nominal) rate was 6 percent and the inflation rate was 4 percent, the real rate ofreturn would approximately be 2 percent. This approximate relationship can be expressed as follows:

Nominal rate = real rate + inflation rate

The exact relationship is given by the following equation:

(1 + Nominal rate) = (1 + real rate) x (1 + inflation rate)

or,

The real rate = [ (1 + Nominal rate)/ (1 + inflation rate) ] –1

Real After Tax Rate of ReturnMany of the returns that investors earn are not tax-free. Short-term capital gains are taxed at the investor’smarginal tax rate. Recall that short-term capital gains are those gains that are held for less than oneyear in case of financial assets like equities, Debt etc. and three years in case of real assets like realestate, work of arts etc. Long-term capital gains are gains from increases in security prices where thesecurity was held (owned) for one year, three years or longer. Such gains are currently taxed at 20percent with indexation or 10% flat without indexation for most individuals. In advising a client to sell afinancial instrument, the real after tax rate of return must be taken into consideration in order to relay atrue picture of return to the client. Taxes are relevant to all of us, but those clients in high income taxbrackets are particularly affected by after tax returns.

The formula for the real after tax rate or return is:

r = ( R) (1-t) – I

where r is the real after tax rate or return, R, is the nominal rate of interest, and t is the tax rate at whichthe investment will be taxed and I is the inflation rate for the period.

In this formula, we took the rate of inflation into consideration because it reduces the purchasing powerof our returns. If the nominal rate of interest on a security is yielding 9 percent, the individual ‘s tax rateis 30 percent and the inflation rate is an equal to 4 percent, the real after tax rate of return is:

R = (0.0 0.09) (1- 0.30) – 0. 0.04 = 2.3 %


Total ReturnThe notion of total return centers on the total return that an investment yields. For example, when talkingabout stocks, the total return is equal to any dividends that the stock pays plus the capital gains orlosses that the investor realizes on the sale of the stock. The same notion is true for mutual fundswhereby the fund earns dividends and/or interest as well as capital gains or losses. Total returns areexpressed in whole currency terms. For example, suppose an investor purchased Stock A for Rs. 100per share. Over the next four years, Stock A paid annual dividends of Rs. 20.00 each year. At the end ofthe fourth year the investor decided to sell his stock at market for a price of Rs. 120.00 per share. Thusthe gains are as follows:

Thus, total return over the four years is Rs. 100 / Rs. 100 = 100%

Risk Adjusted ReturnRisk premium is a percentage return that an investment must expect to earn in order for an investor toassume a given level of risk. The risk premium will be different for each investment once all investmenthave different risk profiles and different expected returns. For example, for a deposit at a bank or RBITreasury bill, the risk premium approaches zero. For common stock, the investor’s required return maycarry a 9 -10 percent risk premium in addition to the risk-free rate of return. If the risk-free rate were 8%percent, the investor might have an overall required return of 17 to 18% percent on common stock.

n Real rate 5%

n Anticipated inflation 5%

n Risk – free rate 8%

n Risk premium 9 – 10%

n Required rate of return 19 – 20%

Corporate bonds fall somewhere between short-term government obligations (generally no risk) andcommon stock in terms of risk. Thus, for bonds, the risk premium may be 3 to 4% percent. Like the realof return and the inflation rate, the risk premium is not stagnant but changes from time to time; forinstance, if the issuing company’s risk profile changes or if the macroeconomic outlook becomes moreuncertain, then the risk premium will change. If investors are very fearful about the economic outlook,the risk premium may be 12- 14% percent

Measuring Investment ReturnsIn order to begin to understand the various types of investment returns and their uses, we begin byconsidering a simple investment return for one time period. Recall, that when we discussed stocks, the

Year 1 Rs. 20.00

Year 2 Rs. 20.00

Year 3 Rs. 20.00

Year 4 Rs. 20.00

Total Income Rs. 80.00

Capital Gain: Rs. 20

Total Gain : Rs. 100


total return was equal to any dividends that the stock paid plus the capital gains or losses that theinvestor realized on the sale of the stock. The same notion is true for mutual funds whereby the fundearns dividends and/or interest as well as capital gains or losses.

Suppose you purchase stock X, at a price of Rs. 125. During the year, the stock pays a dividend of Rs3. At the end of the year, you also sell the stock for Rs150 as it has increased in market value. Recallour formula for the Holding Period Return which is:

HPR = P1 –P0 + Dividends/P0

The return on this investment is: (150-125+3) = %4.2212528

=

Time Weighted Returns versus Dollar Weighted ReturnsIn reality we may want to consider investments over a period of time whereby we may have added toour investment positions or reduced our investment positions. If this is the case, measuring investmentreturns is a bit more difficult. With the basic concept of the holding period return, however, we measureinvestment returns where there are series of cash inflows and outflows.

Keeping with the example above, suppose that instead of selling the share of stock at the end of the year,we decide to purchase one more share of stock at the current market value of Rs 150. At the end of theyear, we collect our second Rs 3 dividend, and subsequently sell both shares of our stock for Rs160 each.

The cash outflows for the purchase of stock are as follows.

To - Rs. 125 to purchase first share of stock, where To is our initial cash outflow atTime zero

Ti - Rs. 150 to purchase second share of stockThe cash inflows for the receipt of dividends are as follows:

T1 - Rs. 3 dividend

T2 - Rs. 3 dividend plus Rs320 for selling each share of stock at Rs. 160.Using the discounted cash flow approach, we calculate the average return (r) over two years as follows:

Solving for r, we get

R = 12.95%This value is known as the internal rate of return on the investment and is also known as the compoundedannual growth rate of return on the investment.

The time weighted rate of return (Simple Airithmatic Rate of Return) is a formula which uses the holdingperiod returns of an investment and averages them in order to yield an average rate of return. It isunlike the CAGR of return in that it ignores the number of shares held in each period. It does not takecash inflows/outflows into consideration during any period. Using the numbers from our previousexamples, we find that the holding period return from at the end of period 1 was 20 percent. The returnon the second share of stock was 28-27+3/27 or 14.81 percent.

To calculate the average time weighted rate of return:

Time Weighted Rate of Return = (20% + 14.81%)/2

= 17.41%


In this particular example, the dollar weighted return yielded less return than the time weighted rate ofreturn. Depending upon the individual investment results either measurement could yield a result greaterthan the other. In general the results from these two measures will be different however.

Time weighted returns are generally used in order to measure results of money managers in theirmanagement of particular funds. Because money managers cannot control the timing or the amount ofmoney coming into their funds, time weighted returns are used in order to measure results.

Since investors are particularly interested in the total amount of return that a portfolio or security yieldsover a period of time, the dollar weighted rate of return is generally considered to be the superiormeasure of return for this reason. This measure would thus be used by those wishing to know howinvestment returns fared within a particular portfolio or portfolios.

Arithmetic versus Geometric AveragesA separate set of measures arises from averaging returns on investments. The arithmetic and geometricweighted averages are examples of such returns. The time weighted return discussed in the previoussection is also an example of arithmetic average rate of return. The geometric rate of return considerscash flows generated during the security’s holding period to be reinvested at the security’s required rateof return. Thus, this method includes the effect of compounding into consideration when calculating thereturn. The equation for the geometric is as follows:

Rg = [(1 + HPR year1) X (1 + HPR year2) X (1+HPR year)]¹/n – 1Where Rg is the geometric rate of return and n, stands for the nth period of investment.

The arithmetic rate of return is a simple average of annual returns. Using the same numbers from theprevious example of calculating the time weighted rate of return, we calculate the geometric rate as follows:

Rg = [(1 + 0.2) X (1 + 0.1481)]½ – 1

= 17.38%Notice that the geometric average return is 17.38% whereas the arithmetic rate of return is 17.41%. Itwill always be true that the geometric rate of return will yield a smaller number than the arithmetic rate ofreturn. In general, the lower the returns, the greater is the disparity between the two averages.

SummaryThis chapter began with a description of the different kinds of risk that accompany investments. It isuseful to understand the nature and various types of risk since investors implicitly or explicitly price thisrisk in arriving at required returns investments. Therefore, the description of different types of risk isfollowed by explanations of how risk may be Measured. Once we can identify the types of risk in aninvestment and understand how to measure such risk, we can then proceed to identify what kinds ofreturns we may require from investing in different kinds of investment products.

“How much was the return on your investment?” Before having read this chapter, such a question mayhave been interpreted as a simple question. Not any more. In this chapter, we studied the many differentforms that investment returns may take. Returns may be classified by inflation, as in the real rate return,or by the investment risk, as in the risk-free rate. Other return measures may incorporate taxes, theeffect of time or the means of averaging. Even though the simplicity of the term is no more, the astutestudent should recognize that the various return definitions exist because they are all meaningful toinvestors under different investment circumstances and scenarios. These differing applications wereexplained in the context of defining each of the terms of returns. Armed with such knowledge, a financialplanner cannot only explain investment outcomes to clients more clearly but also help clients identify the


misuse and abuse of these in the description of investment products.

ProblemMr. Ketan bought a share on Jan 1, 2003 for Rs. 45/-. The company did not pay any dividends. The yearend prices were as follows:

2003 = 50

2004 = 55

2005= 48If he sold the share on end 2005 for Rs. 48, what returns did he get on this investment?

SolutionR1 = (5/45)*100 = 11.11% = 0.111

R2 = (5/50)*100 = 10% = 0.1

R3 = (-7/55)*100 = -12.72% = -0.127

Arithmetic Average returns = [11.11+10-12.72]/3 = 2.79665

Geometric Average returns = {cube root of [(0.111+1)*(.01+1)*(-0.127+1)]} -1

= {cube root of 1.0669} - 1

= 1.023-1 = .023 or 2.3%

Yield to CallMost corporate bonds, as well as some government bonds, are callable by the issuers, typically aftersome deferred call period. For bonds likely to be called, the yield-to-maturity calculation is unrealistic. Abetter calculation is the promised yield to call. The end of the deferred call period when a bond can firstbe called, is often used for the yield-to-call calculation. This is particularly appropriate for bonds sellingat a premium (i.e., high-coupon bonds with market prices above par value).

Bond prices are calculated on the basis of the lowest yield measure. Therefore, for premium bondsselling above a certain level, yield to call replaces yield to maturity, because it produces the lowestmeasure of yield.

Compounding vs. DiscountingThe concept of compounding, that is interest on interest, is an important concept, as is its complement,discounting. Compounding involves future value resulting from compound interest. Present value (discounting)is the value today of the Rupee to be received in the future. Such Rupees are not comparable because ofthe time value of money. In order to be comparable, they must be discounted back to the present. Tablesexist for both compounding and discounting, and calculators and computers make these calculations simple.

Post Tax Returns (Tax Adjusted Returns)

As an investor, you learn very quickly that taxes can take a big bite out of your investment returns. Afterall, it’s not what you make, but what you keep that really counts. If an investment is made in a taxablevehicle within a taxable account, one should really look at the net after tax return.

ExampleMr. Mukherjee has an investment with an 8% taxable yield. Mr. Mukherjee pays tax at the rate of 30% onhis income. What is Mr. Mukherjee’s post tax return on this investment?


Return = 1

Tax = 0.3

Post tax return = 1-0.3 = 0.7

Taxable yield = 8%

Post tax yield = 8*0.7 = 5.6%

Conversely, let us assume that Mr. Mukherjee gets 8% tax free returns and he is paying tax at 30%.What is his taxable yield on this investment?

Tax free return = 0.7 = 8%

Taxable return = 1 = 8/0.7 = 11.4285%

The formula can be given as:

Taxable return = Tax free return / (1-t)

Where “t” is the marginal rate at which the investor pays tax.

Let us try and find out what would be the yield to Mr. Mukherjee on his 10% tax free bonds if he is payingtax at 20%.

Tax free return = 10%

Taxable return = %5.128.0%10)t1/(%10 ==−

Alternatively: Tax free return / (1-t) = 10/(1-0.2) = 10/0.8 = 12.5%

Case

Mr. Arun Joshi makes it a point to invest Rs. 70,000/- every year in his Public Provident Fund account.He enjoys tax deduction u/s 80C on the amount deposited and he earns 8% p.a. tax free interest,credited annually to his PPF account. He pays income tax at the rate of 30%. What is the tax adjustedyield on PPF deposits to Mr. Arun Joshi?

Tax adjusted yield is = Tax free return / (1-t)

For deduction u/s 80C, the return will be 8/(1-0.3) = 8/0.7 = 11.4285%

But this return is also tax free u/s 10

Hence, additional yield calculation will follow

Yield on PPF to Mr Arun Joshi = 11.4285/0.7 = 16.3265%

Since PPF investment qualifies for tax deduction, the tax adjusted yield in the year of investment is11.4285% as calculated above and since the return is not taxable, the yield works out to 16.3265% ascalculated subsequently.

The three important aspects of tax adjusted yields are:

1. Deduction on amount invested and subsequent saving of income tax.

2. The returns on the investment being taxable or tax free.

3. The capital gain or loss, if any, on maturity/withdrawal and whether the same is taxable or not.


In the case of PPF deposits, there are no capital gain/loss issues and hence maturity value taxability isnot an issue while calculating the yield.

Annualized ReturnAn annualized return is a rate of return over a full calendar year on an investment that is held for lessthan a full calendar year. For example, if an investment produced a return of 5% in 182 days, theannualized yield would be approximately 10%. It is important to note that this return measurementassumes the return could be duplicated over the full year, which may or may not actually be achievable.

ProblemMr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. Calculate hisannualized returns.

SolutionAbsolute returns Rs. 10/110 over 45 days

Annualized returns = (10*365)/(110*45) = 0.7373 or 73.73%

Real (Inflation-Adjusted) Return

All of the returns discussed earlier are nominal returns, or money returns. They measure Rupee amountsor changes but say nothing about the purchasing power of these Rupees. To capture this dimension, weneed to consider real returns, or inflation-adjusted returns.

To calculate inflation-adjusted returns, we divide 1 + nominal total return by 1 + the inflation rate asshown in the following equation. This calculation is sometimes simplified by subtracting rather thandividing, producing a close approximation.

Real return = {(1 + Nominal return)/(1+ Inflation rate)} – 1

ExampleThe rate of return on a stock in a particular year was 19.5 %. The rate of inflation during that year was5.5%. What is the real return on the stock?

Real return = {(1+0.195)/(1+0.055)} – 1

= 1.1327-1 = .1327 = 13.27%

Merely by subtracting inflation rate from the return on the stock, we will get a less accurate return i.e.19.5-5.5 = 14%

Holding Period Return

A holding period return is the total return actually realized or expected from holding a specific asset fora specified period of time (not necessarily one year). The return is measured the same as total return,that is, adding dividends and capital gains and dividing the resulting figure by the purchase price.

ExampleMr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. No dividendwas received by him in this period. Calculate his holding period returns.

Holding period returns = (120-110)/110 = .0909 = 9.09%


Portfolio of Securities - Measures of Return

Portfolio Performance MeasurementWe have been discussing returns on individual securities. Now let us measure portfolio returns.

Benchmark PortfoliosEvaluation of portfolio performance, the bottom line of the investing process, is an important aspect ofinterest to all investors and money managers. The framework for evaluating portfolio performance consistsof measuring both the realized return and the differential risk of the portfolio used to compare a portfolio’sperformance, and recognize any constraints that the portfolio manager may face. A 12% return, byitself, is a fairly meaningless figure. It must be viewed in comparison to the performance, over the sametimeframe, of alternative investments bearing a similar level of risk.

Remember, one can only measure return in relation to the risk taken. Investing is always a two-dimensionalprocess based on return and risk. These two factors are opposite sides of the same coin, and both mustbe evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of aninvestment, there is little we can say about its performance. Although all investors prefer higher returns,they are also risk averse. To evaluate portfolio performance properly, we must determine whether thereturns are large enough given the risk involved. If we are to assess performance carefully, we mustevaluate performance on a risk-adjusted basis.

We must make relative comparisons in performance measurement, and an important related issue isthe benchmark to be used in evaluating the performance of a portfolio. The essence of performanceevaluation in investments is to compare the returns obtained on some portfolio with the returns thatcould have been obtained from a comparable alternative. The measurement process must involve relevantand obtainable alternatives; that is, the benchmark portfolio must be a legitimate alternative thataccurately reflects the objectives of the portfolio owners.

An equity portfolio consisting of BSE Sensex stocks should be evaluated relative to the BSE Sensex orother equity portfolios that could be constructed from the Index, after adjusting for the risk involved. Onthe other hand, a portfolio of small capitalization stocks should not be judged against that same benchmark.

If a bond portfolio manager’s objective is to invest in bonds rated A or higher, it would be inappropriateto compare his or her performance with that of a junk bond manager.

Even more difficult to evaluate are equity funds that hold some midcap and small stocks while holdingmany BSE Sensex stocks. Comparisons for such a widely diversified group can be quite difficult.

Many observers now agree that multiple benchmarks can be more appropriate to use when evaluatingportfolio returns. All investors should understand that even in today’s investment world of computersand databases, exact, precise, universally agreed upon methods of portfolio evaluation remain an elusivegoal. An evaluation is imperative, though it is unfortunate that some studies have indicated that mostinvestors don’t have a good idea how well their portfolios are actually performing.

Risk-adjusted ReturnsRecognizing the necessity to incorporate both return and risk into the analysis of portfolio return, threeresearchers - William Sharpe, Jack Treynor, and Michael Jensen developed measures of portfolioperformance in the 1960s. These measures are often referred to as the composite (risk-adjusted)measures of portfolio performance, meaning that they incorporate both realized return and risk into theevaluation. These measures are still used by mutual funds and money managers.


Sharpe RatioWilliam Sharpe introduced a risk-adjusted measure of portfo lio performance called thereward-to-variability ratio (RVAR). This measure uses a benchmark based on the ex post capital marketline. Sharpe used RVAR to:

n Measure the excess return per unit of total risk (as measured by standard deviation).

n Rank portfolios by RVAR (the higher the RAVR, the better the portfolio performance).

Rp = Return of the portfolio

Rf = Risk free return

SD = Standard Deviation of Portfolio (total risk)

Treynor MeasureJack Treynor presented a similar measure called the reward-to volatility ratio (RVOL). Like Sharpe,Treynor sought to relate the return on a portfolio to its risk. Treynor, however, distinguished betweentotal risk and systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignoresany diversifiable risk. He used as a benchmark the ex post security market line.

Beta is the measure of market risk of the portfolio.

Jensen’s IndexMichael Jensen’s measure of portfolio performance was differential return measure (Alpha). It calculatedthe difference between what the portfolio actually earned and what it was expected to earn given itslevel of systematic risk. Basically, it attempts to measure the constant return that the portfolio managerearned above, or below, the return of an unmanaged portfolio with the same market risk.

The Sharpe and Treynor measures can be used to rank portfolio performance and indicate the relativepositions of the portfolios being evaluated. Jensen’s measure is an absolute measure of performance.

Jensen’s index = Rp – [Rf + (Rm- Rf)*B]

Rp= return on the portfolio

Rf = risk free return

Rm = Market return (Index return)

B = Beta of the portfolio (Beta is the measure of market risk of the portfolio)

RVAR =RP - Rf

SD

RP - Rf

Beta


Review Questions:

1. What is the arithmetic average returns on stock A if the stock was bought for Rs. 75/- and the yearend prices for the last 3 years were Rs. 85, Rs. 95, and Rs. 100/-?

a. 10.11%b. 12. 24%c. 13.4%d. 11.11%

2. What is geometric average returns for stock A given the details above?

a. 11.24%b. 10.01%c. 11.46%d. 13.62%

3. What is the current yield of a bond bearing a coupon rate of 8% payable annually and currentlypriced at Rs. 950 with a face value of Rs. 1000/-?

a. 8%b. 9%c. 13.40%d. 9.12%

4. What is the YTM of the above bond (by using the method of computing the YTM approximately),if the bond will mature after 2 years?

a. 11.24%b. 8%c. 10.82%d. 8.42%

5. Mr. A bought a stock X for Rs. 102/- and sold it after a year for Rs. 115/-. He also received adividend of Rs. 2/- per share in the interim. What is the total return on stock X?

a. 11.30%b. 12.74%c. 14.70%d. 15.0 %

6. Mr. A bought stock X for Rs. 102 and sold it for Rs. 115/- after 120 days. He did not get anydividend on the stock. What is the holding period return on stock X to Mr. A?

a. 12.74%b. 38.76%c. 44.73%d. 25.48%


7. Mr. A bought stock X for Rs. 102 and sold it for Rs. 115/- after 120 days. He did not get anydividend on the stock. What is the annualized return earned by Mr. A?

a. 12.74%b. 38.76%c. 44.73%d. 25.48%

8. Mr. Vasudeo Mumbaikar invested Rs. 10,000/- in his PPF account and saved income tax of Rs.3,000/-. He will get 8% p.a. interest which is tax free on his PPF deposit. What is the tax adjustedyield on PPF deposit of Rs. 10,000/- enjoyed by Mr. Vasudeo Mumbaikar?

a. 8%b. 11.43%c. 16.32%d. 10%

9. Mr. Winston Jones purchased National Saving Certificate for Rs. 10,000/- and saved income taxof Rs. 2,000/-. He will get Rs. 16,010/- on maturity after 6 years which works out to a return of 8%p.a. What is the tax adjusted yield on NSC purchased by Mr. W Jones?

a. 8%b. 11.43%c. 16.32%d. 10%

10. Given the following information about the returns on a portfolio, find out the Sharpe Index:

Return on the portfolio was 15% while risk free return was 8% and the standard deviation of theportfolio was 4%.

a. 3.75b. 2.25c. 1.75d. 5.75

Answers:

1. a

2. b

3. c

4. c

5. c

6. a

7. b

8. c

9. d

10. c


Chapter 6


We now consider how investors go about selecting stocks to be held in portfolios. Individual investorsoften consider the investment decision as consisting of two steps:

n Asset allocation

n Security selectionThe asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in otherwords, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, moneymarket assets, and so forth. Each weight can range from zero percent to 100 percent. If it is possible tomake investments globally, then we have to ask the following questions:

1. What percentage of portfolio funds is to be invested in each of the countries for which financialmarkets are available to investors?

2. Within each country, what percentage of portfolio funds is to be invested in stocks, bonds, bills, andother assets?

3. Within each of the major asset classes, what percentage of portfolio funds goes to various types ofbonds, exchange-listed stocks versus over-the-counter stocks, and so forth?

Many knowledgeable market observers agree that the asset allocation decision may be the most importantdecision made by an investor. According to some studies, for example, the asset allocation decisionaccounts for more than 90 per cent of the variance in quarterly returns for a typical large pension fund.

The rationale behind this approach is that different asset classes offer various potential returns andvarious levels of risk, and the correlation coefficients may be quite low.

Correlation determines the extent to which a variable moves in the same direction as other variable,such as inflation. It is statistically determined and labeled as the correlation coefficient. Correlation canhelp in making decisions concerning diversification among mutual fund categories.

The asset allocation decision involves deciding the percentage of investible funds to be placed in stocks,bonds, and cash equivalents. It is the most important investment decision made by investors because itis the basic determinant of the return and risk taken. This is a result of holding a well-diversified portfolio,which we know is the primary lesson of portfolio management.

The returns of a well-diversified portfolio within a given asset class are highly correlated with the returnsof the asset class itself. Within an asset class, diversified portfolios will tend to produce similar returnsover time. However, different asset classes are likely to produce results that are quite dissimilar. Therefore,differences in asset allocation will be the key factor over time causing differences in portfolio performance.

Factors to consider in making the asset allocation decision include the investor’s return requirements(current income versus future income), the investor’s risk tolerance, and the time horizon. This isdone in conjunction with the investment manager’s expectations about the capital markets andabout individual assets.

According to some analyses, asset allocation is closely related to the age of an investor. Thisinvolves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the

Building an Investment Portfolio


needs and financial positions of workers in their 50s would differ, on average, from those who arestarting out in their 20s. According to the life-cycle theory, for example, as individuals approachretirement, they become more risk averse.

Stated at its simplest, portfolio construction involves the selection of securities to be included in theportfolio and the determination of portfolio funds (the weights) to be placed in each security. The Markowitzmodel provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficientportfolio is one with the highest level of expected return for a given level of risk, or the lowest risk for agiven level of expected return.

Asset Classes

Portfolio construction listing out the asset classes, where money can be invested are:

n Cash (or cash equivalents such as money market funds)

n Stocks

n Bonds

n Real Estate (including Real Estate Investment Trusts)

n Foreign Securities

Each investor must determine which of these major categories of investments is suitable for him/her, inconsultation with the financial planner. The next step, as discussed in the preceding section on assetallocation, is to determine which percentage of total investable assets should be allocated to each categorydeemed appropriate. Only then should individual securities be considered within each asset class.

DiversificationDiversification is the key to the management of portfolio risk because it allows investors to minimize riskwithout adversely affecting return.

Random diversification refers to the act of randomly diversifying without regard to relevant investmentcharacteristics such as expected return and industry classification. An investor simply selects a relativelylarge number of securities randomly.

For randomly selected portfolios, average portfolio risk can be reduced to approximately 19 per cent. Aswe add securities to the portfolio, the total risk associated with the portfolio of stocks declines rapidly.The first few stocks cause a large decrease in portfolio risk. Based on these actual data, 51 per cent ofportfolio standard deviation is eliminated as we go from 1 to 10 securities.

Unfortunately, the benefits of random diversification do not continue as we add more securities. Assubsequent stocks are added, the marginal risk reduction is small. Nevertheless, adding one morestock to the portfolio will continue to reduce the risk, although the amount of the reduction becomessmaller and smaller.

It is also established in the US through studies that by adding foreign securities to the portfolio, the riskis reduced dramatically – to the extent of 33%.

Risk Reduction in the Stock Portion of a Portfolio

1. Law of Large NumbersOne simple way of going about risk reduction is through increasing the number of securities held. As weadd securities to this portfolio, the exposure to any particular source of risk becomes small. According tothe Law of Large Numbers, the larger the sample size, the more likely it is that the sample mean will be


close to the population expected value. Risk reduction in the case of independent risk sources can bethought of as the insurance principle, named for the idea that an insurance company reduces its risk bywriting many policies against many independent sources of risk.

We are assuming here that rates of return on individual securities are statistically independent such thatany one security’s rate of return is unaffected by another’s rate of return.

Unfortunately, the assumption of statistically independent returns on stocks is unrealistic in the realworld. We find that most stocks are positively correlated with each other; that is, the movements in theirreturns are related. Most stocks have a significant level of co-movement with the overall market ofstocks, as measured by such indexes as the BSE Sensex or NSE Nifty. Risk cannot be eliminatedbecause common sources of risk affect all firms.

Modern Portfolio TheoryIn the 1950’s, Harry Markowitz, considered the father of modern portfolio theory, originated the basicportfolio model that underlies modern portfolio theory. Before Markowitz, investors dealt loosely with theconcepts of return and risk. Investors have known intuitively for many years that it is smart to diversify,that is, not to “put all of your eggs in one basket.” Markowitz, however, was the first to develop theconcept of portfolio diversification in a formal way. He showed quantitatively why, and how, portfoliodiversification works to reduce the risk of a portfolio to an investor.

Markowitz sought to organize the existing thoughts and practices into a more formal framework and toanswer a basic question: Is the risk of a portfolio equal to the sum of the risks of the individual securitiescomprising it? Markowitz was the first to develop a specific measure of portfolio risk and to derive theexpected return and risk for a portfolio based on covariance relationships.

Markowitz developed an equation that calculates the risk of a portfolio as measured by the variance orstandard deviation. His equation accounts for two factors:

1. Weighted individual security risks (i.e., the variance of each individual security, weighted by thepercentage of investible funds placed in each individual security).

2. Weighted co-movements between securities’ returns (i.e., the covariance between the securities’returns, again weighted by the percentage of investible funds placed in each security).

2. Combination of securitiesIt is assumed that combination of two securities results in risk reduction. Is it possible to reduce the riskof a portfolio by adding into it a security whose risk is higher than that of any of the investments heldalready? Let us consider the following example:

Obviously, the stock Y is riskier because the standard deviation is higher but the expected return is alsohigher. We will have to analyze and find out whether it would be sensible for an investor who is already


holding Stock X to buy a riskier stock Y; add it in his portfolio to reduce the risk. Whether buying stock Yand adding to one’s portfolio will amount to diversification?

Let us find out by assuming that we shall build a portfolio of 2 securities with weightage of 60% for stockX and weightage of 40% for stock Y.

The expected return on the portfolio Rp would be 0.6*10+0.4*14 = 11.60%

If we assume that stock Y gives good returns when stock X performs badly, then we will have returns of0.6*9+0.4*16 = 11.80%

If it is the other way round, that is, stock X performs well while stock Y does not perform well, we will havea situation when the return will be 0.6*11+0.4*12 = 11.40%. In either case, we have got returns very closeto the expected return with risk virtually being nil. We have assumed a negative correlation between stockX and Stock Y. In other words, when we have two or more securities in a portfolio, the returns will dependupon the interactive risk between / among those securities. If we can find two securities that are perfectlynegatively correlated, then we can have a portfolio of two securities without any risk at all.

Covariance or interactive risk

Where the probabilities are equal the formula can be expressed as:

COVxy is arrived out by using the formula given below:

If it assumed that stock X gives a return of 9% while stock Y gives a return of 16% and stock X gives areturn of 11% when stock Y gives a return of 12%, using the example given above the covariance canbe worked out as under:

½ [(9-10)(16-14)+(11-10)(12-14)]

= ½ [-2-2]

= -2

We have taken two corresponding observations at the same time, determined the variation of each fromits expected value, and multiplied the two deviations together and taken the average of such deviations.

The coefficient of correlation is another measure that would indicate the similarity or dissimilarity in thebehaviour of the two variables.

Rxy = COVxy / (σx * σy)

= -2/(2*4) = -2/8 = -0.25

The stocks X and Y are negatively correlated, which means one stock will perform while the other maynot and vice versa. A perfect correlation will be when Rxy = 1 and a perfect negative correlation will bewhen Rxy = -1.


Rxy lies between -1 and +1.

When Rxy = 0, these two stocks are absolutely not co- related at all and the returns will be independentof each other.

Thus, we can conclude that in order to achieve diversification we should choose stocks with negative orlow covariance. The purpose of diversification will not be served if we add securities that have positiveco-relation or no co-relation at all.

Portfolio effect in a 2 security caseWe have seen that diversification reduces the risk. While achieving risk reduction, one should notcompromise on the returns. In general, the lower the correlation of securities in a portfolio, the less riskythe portfolio will be. True diversification is about choosing correct securities that are negatively correlatedrather than mere increase in number of securities.

Where,

σxy is the portfolio standard deviation

wx = percentage of stock x in the total portfolio value

wy = percentage of stock y in the total portfolio value

σ2x = variance of stock x

σy2 = variance of stock y

COVxy = covariance of stock x and stock y

In the case which we have been discussing, we have already calculated:

COVxy = -2

Weights for stock x and stock y are 0.6 and 0.4 respectively.

Variance for stocks x and y have been given as 4 and 16.

So portfolio variance will be:

(0.6)2*4+(0.4)2*16+[2*.06*.04*(-2)]

1.44+2.56-0.0096 = 3.99

Portfolio risk will be square root of variance which is less than 2.

Thus, by adding a security y with a higher risk to security x and constructing a portfolio, we have achievedrisk reduction without compromising on the returns.

When does Diversification pay?

n Combining securities with perfect positive correlation with each other provides no reduction inportfolio risk. The risk of the resulting portfolio is simply a weighted average of the individual risksof the securities. As more securities are added under the condition of perfect positive correlation,portfolio risk remains a weighted average. There is no risk reduction.


n Combining two securities with zero correlation (statistical independence) with each other reduces therisk of the portfolio. If more securities with uncorrelated returns are added to the portfolio, significantrisk reduction can be achieved. However, portfolio risk cannot be eliminated in this case.

n Combining two securities with perfect negative correlation with each other could eliminate riskaltogether. This is the principle behind hedging strategies.

n Finally, we must understand that in the real world, these extreme correlations are rare. Rather,securities typically have some positive correlation with each other. Thus, although risk can bereduced, it usually cannot be eliminated. Other things being equal, investors wish to find securitieswith the least positive correlation possible. Ideally, they would like securities with negative correlationor low positive correlation, but they generally will be faced with positively correlated security returns.

Markowitz’s theory shows us that the risk for a portfolio encompasses not only the individual securityrisk but also the co-variance between the securities, and that three factors determine portfolio risk:

n The variance of each security.

n The co-variances between securities.

n The portfolio weights for each security.The standard deviation of the portfolio will be directly affected by the correlation between the two stocks.Portfolio risk will be reduced as the correlation coefficient moves from +1.0 downward.

One of Markowitz’s real contributions to portfolio theory is his insight about the relative importance of thevariances and co-variances. As the number of securities held in a portfolio increases, the importance ofeach individual security’s risk (variance) decreases, while the importance of the covariance relationshipsincreases. In a portfolio of 500 securities, for example, the contribution of each security’s own risk to thetotal portfolio risk will be extremely small; portfolio risk will consist almost entirely of the covariance riskbetween securities.

Markowitz’s approach to portfolio selection is that an investor should evaluate portfolios on the basis oftheir expected returns and risk as measured by the standard deviation. He was the first to derive theconcept of an efficient portfolio, defined as one that has the smallest portfolio risk for a given level ofexpected return or the largest expected return for a given level of risk.

Investors can identify efficient portfolios by specifying an expected portfolio return and minimizing theportfolio risk at this level of return. Alternatively, they can specify a portfolio risk level they are willing toassume and maximize the expected return on the portfolio for this level of risk. Rational investors willseek efficient portfolios because these portfolios are optimized on the two dimensions which are of mostimportance to investors: expected return and risk.

3. Rupee Cost AveragingThe systematic investment plans in mutual funds, along with consistent periodic new purchases ofshares, creates risk reduction by creating a lower cost per share owned over time. This is known asrupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market.You invest a fixed amount of money at regular intervals, regardless of whether the market is high or low.By doing so, you end up buying fewer shares when the prices are high and more shares when the pricesare low. Because rupee cost averaging involves regular investments during periods of fluctuating prices,you should consider your financial ability to continue investing when price levels are low. However, this


approach reduces the effects of market fluctuation on the average price you pay for your shares.Additionally, it helps you maintain a regular investment plan.

In order to reduce risk associated with investments for getting a desired level of returns:

n It is essential to be diversified across different asset classes.

n It is pertinent to have more securities in a particular asset class, say equities.

n Co-relation among different securities chosen is more important than mere number of securities inone’s portfolio to achieve diversification.

n It is a fact that risk in investments can be reduced but can not be totally removed throughdiversification.

n Systematic investment – investments in selected securities at regular pre determined intervals willserve the purpose of “Rupee Cost Averaging” and take away the risk of investing at the wrong time.

These are time-tested investment philosophies that should go into building investment portfolios.

Modern portfolio theory begins by combinations of securities, or portfolios, which are superior to othercombinations either from better returns and / of lower risk These superior or “efficient” combinations arethen plotted to determine a “frontier” of all such efficient combinations. Next, each investor’ s personalrisk-return considerations or “utility” is introduced into the construction. Finally, the efficient combinationsare superimposed on the investor’s desired utilities, or benefits, to arrive at one efficient combination, an“optimal portfolio” for the stated investor.

We have seen how the combination of two investments has allowed us to maintain our return of 10percent but reduce the portfolio standard deviation to 1.8 percent. We also saw in the preceding tablethat different coefficient correlations produce many different possibilities for portfolio standard deviations.

A shrewd portfolio manager may wish to consider a large number of portfolios, each with a differentexpected value and standard deviation, based on the expected values and standard deviations of theindividual securities and more importantly, on the correlations between the individual securities. Thoughwe have been discussing a two-asset portfolio case, our example may be expanded to cover 5.,10.,oreven 100-asset portfolios. The major tenets of portfolio theory that we are currently examining weredeveloped by professor Harry Markowitz in the 1950s, and so we refer to them as Markowitz portfoliotheory. In 1990 Markowitz won the Nobel Prize in economics for this work.

Assume we have identified the following risk-return possibilities for eight different portfolios (there mayalso be many more, but we will restrict ourselves to this set for now).

In diagramming our various risk-return points in the table on page 78, we show the values in Figure 6:1.

Although we have only diagrammed eight possibilities, we see an efficient set of portfolios would liealong the ACFH line in Figure 6:1. This line is efficient because the portfolios on this line dominate allother attainable portfolios. This line is called the efficient frontier because the portfolios on the efficientfrontier provide the best risk return trade-off.

The incremental benefit from reduction of the portfolio standard deviation through adding securities appearsto diminish fairly sharply with a portfolio of 10 securities and is quite small with a portfolio as large as 20. Aportfolio of 12 to 14 securities is generally thought to be of sufficient size to enjoy the majority of desirableportfolio effects. See W H. Wagner and S.C. Lau, “the Effect of Diversification on Risk.”


FIGURE 6:1 Diagram of Risk-Return Trade-Offs

That is along this efficient frontier we can receive a maximum return for a given level of risk or a minimumrisk for a given level of return. Portfolios do not exist above the efficient frontier, and portfolios below thisline do not offer acceptable alternatives to points along the line. As an example of maximum return for agiven level of risk, consider point E. Along the efficient frontier, we are receiving a 14 percent return fora 5 percent risk level, whereas directly below point F, portfolio E provides a 13 percent return for thesame 5 percent standard deviation.

To also demonstrate that we are getting minimum risk for a given return level, we can examine point Ain which we receive a 10 percent return for a 2.8 percent risk level, whereas to the right of point A, we get


the same 10 percent return from B, but a less desirable 3.1 percent risk level. One portfolio can consistof various proportions of two assets or two portfolios. For example, we can connect the points betweenA and C by generating portfolios that combine different percentages of portfolio A and portfolio C and soon between portfolios C and F and portfolios F and H. Although we have shown but eight points (portfolios),a fully developed efficient frontier may be based on a virtually unlimited number of observations as ispresented in Figure 6:1.

BenchmarksA first question to be posed to a professional money manager is: Have you followed the basic objectivesthat were established? These objectives might call for maximum capital gains, a combination of growthplus income, or simply income (with many variations in between). The objectives should be set with aneye toward the capabilities of the money managers and the financial needs of the investors. The bestway to measure adherence to these objectives is to evaluate the risk exposure the fund manager hasaccepted . Anyone who aspires to maximize capital gains must, by nature, absorb more risk. An income-oriented fund should have a minimum risk exposure.

A classic study by john McDonald published in the journal of Financial and Quantitative Analysis indicatesthat mutual fund managers generally follow the objectives they initially set. He measured the betas andstandard deviations for 12.3 mutual funds and compared these with the funds’ stated objectives. Forexample, funds with an objective of maximum capital gains had an average beta of 1.22. Those with agrowth objective had an average beta of 1.01, and so on all the way down to an average beta of 0.55 forincome-oriented.

Using betas and portfolio standard deviations, we see that the risk absorption was carefully tailored to thefund’s stated objectives. Funds with aggressive capital gains and growth objectives had high betas andportfolio standard deviations., while the opposite was true of balanced and income-oriented funds. Otherstudies have continually reaffirmed the position established in this seminal study by McDonald.

Adherence to objectives as measured by risk exposure is important in evaluating a fund manager becauserisk is one of the variables a money manager can directly control. While short-run return performancecan be greatly influenced by unpredictable changes in the economy, the fund manager has almost totalcontrol in setting the risk level. He can be held accountable for doing what was specified or promised inregard to risk. Most lawsuits brought against money managers are not for inferior profit performance butfor failure to adhere to stated risk objectives. Although it may be appropriate to shift the risk level inanticipation of changing market conditions (lower the beta at a perceived peak in the market), long-runadherence to risk objectives is advisable.

Measurement of Return in Relation to RiskIn examining the performance of fund managers, the return measure commonly used is excess returns.Though the term excess returns has many definitions the one most commonly used is total return on aportfolio (capital appreciation plus dividends) minus the risk-free rate:

Excess returns = Total portfolio return – Risk-free rate

Thus, excess returns represent returns over and above what could be earned on a riskless asset. Therate on RBI Treasury bills is often used to represent the risk-free rate of return in the financial markets(though other definitions are possible). Thus, a fund that earns 12 percent when the Treasury bill rate is6 percent has excess returns of 6 percent.

Once computed, excess returns are then compared with risk. We look at three different approaches tocomparing excess returns to risk: the Sharpe approach, the Treynor approach, and the Jensen approach.


Sharpe ApproachIn the Sharpe approach, the excess returns on a portfolio are compared with the portfolio standard deviation

The portfolio manager is thus able to view excess returns per unit of risk If a portfolio has a return of 10percent, the risk-free rate is 6 percent, and the portfolio standard deviation is 18 percent the Sharpemeasure is 0.22:

This measure can be compared with other portfolios or with the market in general to assess performance.If the market return per unit of risk is greater than 0.22, then the portfolio manager has turned in aninferior performance. Assume there is a 9 percent total market return, a 6 percent risk-free rate, and amarket standard deviation of 12 percent. Then the Sharpe measure for the overall market is 0.25 or:

The portfolio measure of 0.22 is less than the market measure of 0.25 and represents an inferiorperformance. Of course, a portfolio measure above 0.25 would represent a superior performance.

Treynor ApproachThe formula for the second approach for comparing excess returns with risk (developed by Treynor) is:

The only difference between the Sharpe and Treynor approaches is in the denominator. While Sharpeuses the portfolio standard deviation, Treynor uses the portfolio beta. Thus, one can say that Sharpeuses total risk, while Treynor uses only the systematic risk, or beta Implicit in the Treynor approach isthe assumption that portfolio managers can diversify away unsystematic risk, and only systematic riskremains.

If a portfolio has a total return of 10 percent, the risk-free rate is 6 percent, and the portfolio beta is 0.9,the Treynor measure would be 0.044.

Sharpe measure = = = 0.2210% - 6%

18%

4%

18%

Sharpe measure =Total portfolio return – Risk-free rate

Portfolio standard deviation

= = 0.259% - 6%

12%

3%

12%

Treynor measure =Total portfolio return – Risk-free rate

Portfolio beta

= = = 0.0444 %

0.9

0.04

0.9

10% - 6%

0.9


This measure can be compared with other portfolios or with the market in general to determine whetherthere is a superior performance in terms of return per unit of risk. Assume the total market return is 9percent, the risk-free rate is 6 percent, and the market beta (by definition) is 1; then the Treynor measureas applied to the market is 0.03:

This would imply the portfolio has turned in a superior return to the market (0.044 versus 0.030) Not onlyis the portfolio return higher than the market return (10percent versus 9 percent), but the beta is less(0.9 versus 1.0) Clearly, there is more return per unit of risk.

Jensen ApproachIn the third approach, Jensen emphasizes using certain aspects of the capital asset pricing model toevaluate portfolio managers. He compares their actual excess returns (total portfolio return – risk-freerate) with what should be required in the market, based on their portfolio beta.

The required rate of excess returns in the market for a given beta is shown in Figure 6:2 given below, asthe market line. If the beta is 0, the investor should expect to earn no more than the risk-free rate ofreturn because there is no systematic risk. If the portfolio manager earns only the risk-free rate of return,the excess returns will be 0. Thus, with a beta of 0, the expected excess returns on the market line are0. With a portfolio beta of 1, the portfolio has a excess returns as shown in the following diagram.

FIGURE 6:2 Risk-Adjusted Portfolio Returns

= = = 0.0303 %

1.0

0.03

1.0

9% - 6%

1.0

The expected portfolio excess returns should be equal to market excess returns. If the market return(KM) is 9 percent and the risk-free rate (RF) is 6 percent, the market excess returns are 3 percent. Aportfolio with a beta of 1 should expect to the market rate of excess returns (KM-RF), equal to 3 percent.


Other excess returns expectations are shown for betas ranging from 0 to 1.5.For example, a portfoliowith a beta of 1.5 should provide excess returns of 4.5.

Adequacy of PerformanceUsing the Jensen approach, the adequacy of a portfolio manager’s performance can be edged againstthe market line. Did he or she fall above or below the line?

The vertical difference from a fund’s performance point to the market line can be viewed as a measureof performance. This value, termed alpha or average differential return, indicates the differencebetween the return on the fund and a point on the market line that corresponds to a beta equal to thefund. In the case of fund, the beta of 1.5 indicated an excess return of 4.5 percent along the market, andif the actual excess return was only 3.9 percent, we thus have a negative alpha of 0.6 percent (3.9% to4.5%). Clearly, a positive alpha indicates a superior performance, while a negative alpha leads to theopposite conclusion.

Key questions for portfolio managers in general include the following: Can they consistently perform atpositive alpha levels? That is, can they generate returns better than those available along the marketline, which are theoretically available to anyone?

FIGURE 6:3 Empirical Study of Risk- Adjusted Portfolio Returns- Systematic Risk and Return

The upward-sloping line is the market line, or anticipated level of performance based on risk. The small dotsrepresent performance of the funds. About as many funds under-performed (negative alpha below the line)as over performed (positive alpha above the line). Although a few high-beta funds had an unusually strongperformance on a risk adjusted basis, there is no consistent pattern of superior performance.

Indexing-Buy and HoldIndexing-buy and hold is a concept which is, in most sense, opposite to the concept of market timing.In other words, planners who advocate indexing believe that future price changes or duration of changescannot be predicted with any consistency. Hence, such planners consider market timing as an exercisein futility and instead, advise their clients to buy securities and funds which track broad market indexes.

The basic concept of indexing rests with the assumption that planners cannot outperform the performanceof market indexes such as the S&P 500 Index, the BSE Sensex 30, NSE 50 etc., on a consistent (i.e.year in, year out) basis. Indexers also believe that over the long run the market will generally outperformat least 50% of all fund advisors. Further, the advisors who will outperform the market in any given year


or two will in turn perform worse than the index in subsequent years. Moreover, the fund advisors whomay outperform the market indexes over a future time period of time cannot be identified today withany certainty or reliability. Given these observations, such planners consider the alternative of investingin securities or funds that closely track the performance of underlying market indexes as desirable. Suchplanners also consider holding their investment positions for a longer time period, and hence, they will“buy and hold “their positions. The length of time over which a position is held depends primarily on theclient particulars such as investment objective, investment time-horizon and risk preferencesand the macroeconomic conditions as reflected through the business cycle.

Mutual funds are most popular as securities that track the movement of market or securities indexes. Mostlarge mutual fund companies, offer index mutual funds for investors. These funds provide the appropriatevehicles for both investors and financial planners to buy and hold a basket of securities, in the form of asingle mutual fund, that track financial market indexes. Since indexers may choose to track a wide variety ofindexes such as large and small cap indexes, broad and narrow marker indexes, stock and bond marketindexes, domestic and foreign market indexes, the fund companies offer numerous index funds that covergenerally most indexing needs. The new type of fund has appeared in the markets that also tracks indexes,known as “Exchange Traded Funds”or ETFs, have become very popular tracking tools in this decade,and the number of ETFs being offered in the market are increasing almost daily. The companies that offerETFs claim that ETFs are much easier to trade since they are structured like common stocks, providebenefits in shielding against capital gains taxes and are generally cheaper than index mutual funds.

Indexes which follow a passive buy-and-hold strategy claim a number of benefits in their approach overactive approach to investments. First, and as mentioned earlier, market indexes are generally expectedto outperform most actively managed funds over longer time periods. This is because indexers believethe markets to be efficient and consistently picking winners near impossible. Second, passively investingthrough index tracking securities is considerably cheaper because the costs of researching to find winninginvestments are not expended. Further, since the compositions of indexes do not change very frequently,very little trading and transaction costs are incurred in managing index tracking funds.

On the other hand, funds that are actively managed charge high fees. These fees are paid becausethese funds managers consider their skills at investments to be superior and hence, require higher fees.Moreover, “active” managers continuously produce information about various securities that eitherindicates buying, selling or holding various investment positions. Since such an approach requires frequentalterations in portfolio structure, the costs involved in an active style also increase due to the muchhigher costs of transactions.

Money Manager Selection and MonitoringTo begin with, the search process uses the same objectives used in the investment decision processitself. The first three questions to address, as in the investment decision process, are as follows:

1. What is the primary objective of the investment decision for which you need a money manager?

2. What are the risk/return preferences of the clients?

3. What is the investment time horizon?Understanding the answers to these three questions thoroughly will considerably ease the burden ofplanners in selecting suitable money managers. We will return to the description of how the selection ismade easy, but first let us evaluate each of these three questions in some detail.

There are many reasons to invest. Examples of reasons include savings and investments for retirement, forchildren’s college education, to buy a house or car, to build wealth, etc. Along with each of these reasons isan associated objective. For example, in saving for retirement, an appropriate objective may be to maintain


and/or increase the standard of living that pre-existed before retirement. Similarly, in providing for children’scollege education, provisions may be for public or private colleges and may include the financing of an autofor a child as well. The point being made here is that the need and the objectives help us determine certainaspects of the investments decision which in turn help us evaluate managers.

Consider the example of a parent who can afford to save a limited sum of money towards a child’seducation. Given this limitation (or budget constraint) the parent next has to consider the type of college(public or private) to fund for. Obviously, private colleges cost more and hence the future funding requiredfor a private college education would require a higher rate of growth than the rate required for fundingpublic college education. Thus, the choice of managers in this case would be determined by the style ofthe managers. A growth style manager would be desirable to grow money faster whereas a balancedfund manager may be considered for that same investment, if the objective were to fund the educationat a public college. Being able to tie the objective (private or public education, in this example) allows usto narrow the manager selection criterion to only managers who practice/affirm a certain style ofmanagement. This inclusion reduces the universe of potential managers significantly. Similarly, for theneed to fund for retirement, the objective may differ from maintaining living standard to improving them.

Continue with the example of funding for children’s education. Assume that the limited funds that a parentcan save towards this objective will require the fund to grow at a 12% rate in order to be sufficient to meetthe funding need. This required rate of return of 12% would imply that most of the savings be invested inequity or other high-yielding instruments. An associated feature of such an investment would be a fairlysignificant amount of investment risk that the parent would be exposed to and which in turn would also implythat there would be a higher probability of accumulating insufficient funds. In this case, the risk preferenceof the client would become another input in the process of manager selection. The risk preference of theclient would determine what styles of funds are chosen. The styles that were affirmed when the investmentobjective was considered may either be reinforced or rejected by including the risk preferences of clients.There is another important aspect of including the risk preferences of clients in selecting the fund manager.One of the important variables that enters the process of manager selection is the risk perspective of themanager himself. It is a good idea to evaluate and match the risk preferences of the manager to those of theclient. Once the manager is selected and the investment process begins, the level of comfort, or discomfort,will be considerably influenced by the style of the chosen manager. In this case, matching the manager’srisk preference with that of client can considerably help the planner in managing the client relationships.

Finally, the time horizon of the investment decisions must also be included in the selection process. Inthe college funding example, given some limited amount of funds and given a certain risk preferenceprofile, the shorter the time available to accumulate the funds, the greater will be the need to findmanagers who pursue growth and aggressive growth styles, and vice versa. Another way to considerthis is that if the planner can persuade a client to invest early, whatever the investment need be, then theplanner can have more flexibility in choosing managers. The right choice of managers will ultimatelylead to client satisfaction and retention.

The reader should note that the application of the basics of the investment process serves as screens in themanager selection process. They help us eliminate many managers from the selection process and isolateothers. They help us narrow down the universe of managers to a level where the selection process is moremanageable and where it is feasible to apply other subjective and objective criteria to further narrow theselection process. Finally, and most importantly, the inclusion of the client’s basic inputs in the selectionprocess should generally lead to a much greater level of client satisfaction. In the following sections, otherselection criteria that need to be used on a smaller subset of managers are discussed.

Many planners tend to jump first on assessing the past performances of money managers in selecting a


manager. The relationship between past performance and manager selection has been widely studied.Results of these studies generally support the notion that using past performance as the main criterionin the selection process is, at best, a very poor indicator of future performance potential. In a sense,manager performance should be the last screen in the selection process, the step that affirms a manager’schoice. It is much more prudent to consider other facets of managers that reinforce the investmentobjectives, risk preferences and timing horizon decisions.

There are several subjective and objective criteria that may be applied to further narrow the selectionprocess. Once the general fund style has been identified, managers within that style can be scrutinizedfurther. The main objective at this stage is to identify inconsistencies and incongruencies between thestated style of the managers and the styles that they have actually implemented in their practices. Thefollowing are examples of questions that need to be assessed in determining the selection.

n Has the manager consistently selected securities that are compatible with the stated style?

n If not, how often have they strayed from their paths?

n Does the manager use risk management techniques that are consistent with the fund’s statedobjectives?

n How often have the fund’s operating expenses exceeded both those stated and those that wereexpected?

n How often has the fund’s risk exceeded the stated or expected risk?

n How long has a manager served for a fund?

n Is the manager known to have managed funds of many different styles or have there been transitionswithin similar styles?

n If the manager affirms a passive style, how often has he strayed from that style, and vice versa?

n How consistently does the manager apply security selection techniques, whether qualitative orquantitative or both?

n Has the manager ever violated or has not been in compliance with laws and regulations?

n Does the manager engage in “window dressing” types of activities that are harmful to clients?

n What are the answers to the above question for the investment team members that the managerleads?

n How research oriented is the manager?As the reader can observe, there are many questions that require to be evaluated in selecting a manager.However, it may be useful to categorize these questions along some common themes. Happily, such acategorization is possible. In using the above criteria, the selector is trying to assess two basic traits ofa manager.

Perhaps the most important summation of these criteria is to understand how consistent a manager isand has been. The more consistent a manager has been towards her/his style, trading activity, securityselection techniques, fund expense levels, etc. the better. Alternately, managers who change theiroperating activities often are much more likely to under perform against their expectations. Another wayto consider the issue of consistency is that the manager’s activities are as stable as the investmentdecision inputs of the clients. The client’s retirement objectives or their risk tolerances for those investmentdo not change on a weekly or monthly basis. The basic idea here is that neither should the manager’sattitudes and perceptions change on those scales. In a sense, there is a direct relationship betweenconsistency and competency.


The other important theme to assess is the ethical make-up of the manager. Managers (and funds)whose styles, trading, expenses, selection techniques, etc, change often are also much more likely toengage in activities that are undesirable or even in violation of investment rules and regulations. It isimportant to note that the manager’s ethics is as important as his/her competency. Neither can besacrificed at the expense of the other. Managers who rank high on both the scales are appropriate forfurther consideration in the selection process.

Finally, after the universe of managers has been whittled down to a few, the past performance of managersshould be assessed. As has been noted before, past performance is not a reliable indicator of futureperformance. As it turns out, given the considerations of consistency (competency) and ethics, the issue ofpast performance in predicting future performance, is actually not that daunting a task. In assessing pastperformance, two observations need to be, those that were expected and how different were they from theirpeers? Second, how widely did the past returns vary and in comparison to their peers? In other words, if afund is expected to produce about 12 percent (e.g. growth fund) per year, how many times in the last 5 (or10) years has the fund’s returns been close to 12 percent? Further, if the average return over the pastreturns has indeed been around 12 percent, have the individual (annual) returns been widely divergent fromthe expected 12 percent, even though they average around 12 percent. As the reader can see, the mainpoint being made here is that the consistency and stability of performance and in accord with expectationsis a far more powerful tool in manager selection criteria than trying to find the superstars of yesterday.

It should be fairly clear to the reader that the selection criteria for a manager also define the monitoringcriteria. Monitoring the performance of the manager is akin to ensuring that the manager does notchange any facet of his behavior once he has been selected. Similarly, the planner must note that thevery act of selecting a manager is also a reward for the past consistency, competency and the ethics ofa manager. In the same vein, a planner should not seek to replace a manager whose performance in acertain year has not been up to par, especially if the manager has strayed from the stated and expectedobjectives and behavior. The planner should note that in a longer framework of time, it is the consistentmanagers whose performances are most likely to satisfy the needs and objectives of their clients.

Modern portfolio theory is a method by which assets are selected to be included in a portfolio such thatthe expected portfolio outcome optimizes the individual’s utility. The most powerful concept in thisoptimization process is the benefits of diversification across different asset classes. This benefit showsup primarily as both a reduction in risk and or an increase in return. This in turn leads to the optimalsolution. The portfolio outcomes in terms of risk and return are used to assess the performance ofportfolios both by comparisons with benchmarks and comparisons with peer group performances. Theperformance of portfolios and their managers is one of the criteria used in selecting money managers.Various money manager selection and monitoring criteria were examined and a set of guidelines wereestablished for this very important task.

Asset Allocation and DiversificationThis chapter presents two key investment concepts: Investment Policy Statements (IPS) and AssetAllocation. The former concept is an essential part of any investment plan in that an IPS lays the frameworkand objectives of how an investment plan will be managed, why such a path is chosen and how it willserve the client. The asset allocation decision is the most notable decision managers have to make inmanaging client portfolios. Each of these two concepts are explained in detail, in this chapter. Managerialimplications of these two concepts are also discussed in the latter sections of the chapter.

Investment Policy StatementAn Investment Policy Statement (IPS) serves as a plan that guides the investor and the planner in long-


term financial and investment decisions. While investors may differ in type or form, each requires a clearinvestment policy statement in order to achieve long-term goals and investments objectives.

Investors may be categorized as being either institutional investors or individual investors. Though financialplanners will most often interact with individual investors, there will be occasions when an institutionalinvestor may require the planner’s service and advice. Hence, it is important for the planner to be able tounderstand the needs of both types of clients and articulate IPS’s for both types. Of course, the obviousclient for most financial advisors is the individual investor.

Generally, institutional investors differ from individuals in the amount and size of the portfolios undermanagement. Within the institutional category of investors, there are subcategories, each of which differin their investment needs. Examples of such sub-categories of institutional investors include mutualfunds, pension funds, endowment funds, insurance companies, etc.

To understand how these institutions differ in their investment need, consider the example between theneeds of a defined benefit pension plan and an endowment fund. The primary goal of pension planmangers is to ensure the availability of cash that requires to be distributed to plan beneficiaries everyyear. Thus, pension plan management and policy is integrally involved in investments that match cashoutflows with inflows. In a pension plan, the amounts of distribution to be made are generally known inadvance; this in turn, determines to a large extent the choice of investment vehicles required to meetthose distribution needs. Thus, IPS’s for pension funds are much more guided by regulatory andcompliance needs, which in turn protect the interests of the plan beneficiaries.

Consider now the issues surrounding the management of investment assets for an endowment fund. Anendowment fund is an accumulation of donations that is provided to a non-profit organization by its donors.Generally the investment objectives of endowment funds are much more attuned to the needs of the non-profit organization, Sometimes, the donors may impose managerial clauses themselves. Typically,endowment funds seek to produce a small stream of income to augment the operating budget of theorganization and to grow the rest of the corpus at a very moderate rate, such that the income may take theform of a perpetual stream. Thus, the IPS of an endowment fund is generally very different from that of apension fund.

Banks and insurance companies are other examples of institutional entities that need investment policies.Both these institutions are similar to pension funds in that their investment needs are dictated by thosewho lend them the investment funds. Insurance companies invest in order to ensure sufficient availabilitiesof future funds required to be distributed as payouts to policy holders. Banks invest in order to meetshort and long term obligations that it promise to pay depositors on specific savings deposits. All typesof investors, their needs and the appropriate investment policies, are discussed in the following sections.

Investment Policies For Individual Investors

Life – Cycle IndentificationInvestment goals of the individual client naturally emerge from the financial planning process. It is importantto note that the goals of an individual will change over time as the client progresses through variousstages of his/her life. Thus, the investment objectives will also change over time as the client ages andsucceeds at achieving previously set goals.

The investment goals that are generally associated with various stages of a client’s life are known as theclient’s life-cycle needs. Generally, the needs of various individuals at certain stages of life tend to besimilar. For example, early career individuals want to accumulate wealth, whereas in the late career stageindividuals seek to protect wealth more. Thus, we can classify these typical investment needs at various life


cycles. These classifications provide us with a tool to apply in the investment planning process.

The first stage of an individual’s earning and career is considered as the accumulation phase. Thisphase begins when an individual first becomes gainfully employed and continues until the client is about40 to 50 years of age. During this time period, investors are generally much more open to assuminggreater investment risk to attain higher returns. Typically, such investors can shrug off losses on theassumption that they have sufficient time to earn and recoup their losses. Further, if the losses are insecurities, they can understand that their investment time horizon permits them to wait out any temporarydownturn in the economy and business cycle since they are expected to be followed by growth cyclesthat will eventually increase their wealth. Further, individuals progressing through their careers alsoobserve increased incomes and savings; these savings augment the growth of their wealth. Essentially,individuals in this phase are the beneficiaries of the power of compounding in the value of their wealth.Common investment goals during this phase are the purchase of a house, saving for children’s educationand accumulating funds for retirement.

The next stage of the client life cycle is the conservation/protection phase. This stage begins seamlesslywith the trailing off of the accumulating phase and remains as the dominant phase until the first fewyears of retired life. During this stage, the client seeks to consolidate the assets that have beenaccumulated. Individual earnings reach their peaks at this stage as does their savings. The aging ofclients is reflected through their investments as they tend to lean toward a reduction in undertaking riskand are content to receive lesser returns. Unlike the accumulation phase, investors recognize thedevastation that can be caused by significant losses of wealth to their well being. Further, they understandthat the time they have left before retirement may not be sufficient to undo losses that result fromexcessive risk taking. Thus, at this stage, loss aversion becomes the dominating trait of the investmentlife cycle. Common investment goals during this time period are children’s education, savings for retirementand the beginnings of the need to gift to their beneficiaries, charities and well wishers.

The last stage is known as the preservation and gifting stage. This stage tends to begin soon afterretirement and continues through life expectancy. During this stage, the investor is primarily concernedwith preserving capital rather than enhancing returns. The loss of earning power and the fixed expensesof retirement loom large during the early parts of this stage. Thus the investments in this stage of lifetend to be more conservative relative to the other life-cycle stages. This is also the phase in which theclient will most likely seek the planner’s assistance in gifting income and property to desired beneficiaries.

The ages mentioned in the above life-cycle discussion are only benchmarks. Similarly, particular goalswill vary by client, life-cycle stage, and age. For instance, over the last 100 years, the age at whichindividuals start families has considerably increased. This implies that the investment goal of saving forchildren’s education has shifted along the entire life cycle. Thus, the educational savings requirementscan be part of the life-cycle phase where the client is primarily interested in conservation and protectionas compared to the traditional notion that this objective is mostly encountered in the accumulationphase. Similarly, emerging healthcare technologies are changing the needs of individuals in the latterstages. The growth of long-term care policies is a reflection of the impact of biotechnology on the longevityof life. The concept of life cycles is important for planners to understand but care must be taken not tocompartmentalize clients by age in order to impose life stage needs without considering the impact ofthe clients’s idiosyncratic or subjective attributes. Rather, careful discussion and analysis based uponclient goals will yield a more accurate measure in which stage or stages the client resides.

Life-cycle planning is thus relevant in the investment processes because it allows the planner to identifywith the client through the various time horizons for each goal within the financial plan. Without timehorizons, an investment policy would not be whole. The client could be subject to too much risk and / or


insufficient funds for current consumption (too much savings), etc. The policy then, would not accuratelyarticulate the goals within the plan and thus would subject the achievement of goals to imminent failure.

Investment ObjectivesOnce the goals, life cycle, and time horizons for the goals have been identified, the investment objectivesbecome easier to identify. Investment objectives identify the goals of the portfolio in relation to thereasons for the individual’s financial needs. Investment objectives can be further classified into fourtypes current income, capital growth, total return, and preservation of capital.

Current income is a strategy whereby the main objective of the portfolio is to generate an immediate andongoing flow of cash to the client. That is, the investor requires income generation from the principalbalance of the portfolio via interest or dividend payments. An investor who relies on the portfolio forincome in this way needs the cash for living purposes. Thus the investments tend to be conservative innature. Common investment securities are corporate bonds, government bonds, government mortgagebacked securities preferred stocks and perhaps stable Blue Chip stocks that pay regular dividends.

Capital growth is a strategy whereby the portfolio funds are invested over the long term with the objectiveof capital appreciation in mind. Because the objective is growth over the long term, the riskiness of theportfolio tends to be higher. The most common securities for this type of approach are equities, particularlythose in high growth companies or sectors. However, it is always a good idea to diversify the portfolioholdings among various sectors and industries. Further, stocks of very large companies that lead theirindustries (blue chip) in this case, can help to diversify the portfolio while achieving some of the samegrowth objectives. Mutual funds, which invest in various sectors or industries can also help to diversitya portfolio at a reasonable cost.

The total return approach is a strategy that blends the current income and capital growth approaches. Thus,the investor wants the portfolio to grow over time, but wishes to have income generated from it right away aswell. Obviously having two objectives from the same portfolio can be challenging to manage, but it can bedone if applied correctly. Thus, this strategy would use a blend of methods of the two strategies above.

Those investors interested in presentation of capital are most interested in ensuring that the amount ofmoney invested in the portfolio does not decrease. Therefore, the investment choices are safe vehicles.Large returns are not important for these clients and types of investments are typically governmentbonds, certificates of deposit money markets (funds), and fixed annuities.

Risk for Individual InvestorsAlthough we may have determined the goals and the investment objectives of our client, we cannotseriously discuss the minute details of an investment policy without first assessing the risk tolerance ofthe client. Without a meaningful assessment of client risk attitudes, the investment policy will be useless.

Finance professionals often think of risk in terms of the standard deviation of returns and stock betas. Insome cases, individual investors may understand these concepts but more often than not, most investorsdo not fully understand these concepts. After all, that is why they seek out investment advisors for suchexpertise. Since the client may not understand the intricacies of integrating investor risk preferences infinancial applications, it is even more important for the advisor to determine the client’s risk preferencebefore structuring appropriate portfolios.

Many clients describe risk in terms of losing money so it may be a good starting point upon which to discussthe notion of risk. This notion of loss can be seen from several perspectives, so it can be helpful if the clientcan articulate risk to the planner in one of these ways. Loss to some individuals occurs when the originalvalue of the portfolio has decreased in either absolute terms or relative return percentages. For instance,


suppose a client started with an initial investment of Rs. 2,50,000 and experienced a Rs. 50,000 decreasein value due to a general downturn in the market. Some investors feel that they have lost Rs. 50,000 andconsider it a total loss. Similarly, they might say that they lost 20 percent of their portfolio.

Other investors who are investing for the long term may not be concerned if the value of the portfoliodecreases for some period of time if they feel that the losses sustained are short tem in nature. Thesetypes of investors often perceive a loss only when they sell assets from the portfolio and therefore havea realized loss.

Risk to clients may also appears in the form of the types of securities that they know of. Therefore suggestingnew types of securities to these clients may appear to the client as a type of risk that they do not wish toengage in. It is a challenge to the advisor to help the client understand why these types of investments arebetter for the client. In the end, the advisor may or may not be successful in persuading the client.

Conversely, clients may have a notion of risk in areas where they have had previous investment losses.For instance, those who lost money in stock market crashes trend to be averse to investing in stocks inthe future. It is up to the advisor to help clients understand why their investments failed in the firstinstance and the measures that the planner can put into place to minimize those types of losses in thefuture. Some investors may mimic the popular or in vogue. Such practices can result in undesirableoutcomes and result in large losses. Thus when an advisor advocates some technique or security asappropriate for the client, the client may consider this to be risky and very poor advice.

Risk is extremely difficult to define. The planner must initially spend a lot of time with the client toascertain what risk means to that client. This can be accomplished through discussion with the clientand is often done with questionnaires, which are used as complements to client/planner conversations,Since each investor is subjectively and idiosyncratically different, risk will have a different meaning toeach investor. When implementing an investment policy, it is valuable to incorporate the risk characteristicsinto the plan. This should be done in such a way so that the investor and the planner can quantify therisk. Thus if certain events occur, such as a portfolio losing 10 percent of its value, the planner andinvestor will have identified, in advance, appropriate actions for that particular event. With such pre-planned and agreed upon actions, further risk to the portfolio value may be minimized.

Other Topical Considerations for Individual Investment Policies

Tax ConsiderationsIncorporating the notion of before and after-tax investment returns in a portfolio is an important conceptin portfolio planning. The after-tax considerations must effectively integrate with other portions of thefinancial plan so that taxes are minimized in years with high expected income. Recall that taxes can bedeferred (paid at a later date when assets are sold at a profit), can be avoided or can be taxed at capitalgains rates (investments held greater than one year) rather than at ordinary rates. It is useful to spell outthe tax consequences in the investments policy. However, the advisor must discuss and incorporateinto the plan the potentiality for changes in the tax law. Because laws change, tax planning relative toportfolio management can be a very challenging aspect to the planner. When the client has a negativebias toward taxes or has complicated transactions the sale and purchase of assets to and from theportfolio. Tax considerations and goals should be spelled out in the investment policy to assist theplanner and the client in quantifying tax consequences of decisions.

Measurement of Returns and Successes of the PlannerThe client and the planner should decide upon a method that measures the success of the advisor inpicking investments. The time weighted rate of return (or the holding period return) is a method used


for fund manager evaluation. This is so because a typical fund manager cannot control the amount offunds he or she has under management (in which case a geometric rate of return could be used). Nomatter what method is used, it should be spelled out in the investment policy so that both the plannerand the investor have appropriate expectations regarding what performance measures are going to beused to judge the advisor.

Macroeconomic FactorsA good planner is always aware of macroeconomic factors that can ultimately affect investments. Thesefactors should be integrated into the plan. For instance, historical inflation rises, which affect the realrate of return on assets, should be discussed in any plan in order to sustain the purchasing power of theclient to the greatest extent possible. Other factors that should be taken into consideration are interestrates, economic growth or decline as a whole or in specific industries, unemployment, political stability,and the legal environment. While this list is not exhaustive, it is meant to give the advisor an appreciationof the areas that can affect the investment policy. As the planner gets to know the client, he or she canintegrate those areas within the macroeconomic environment into the client’s plan.


Review Questions:

1. Which of the following statements concerning diversification is (are) correct?

I. Studies suggest portfolios of 100 or more different common stocks are needed to substantiallyreduce unsystematic risk.

II. The key to effective risk reduction through diversification is combining assets whose returnsshow negative, low or no correlation over time.

a. I onlyb. Both statements are correctc. II onlyd. None of the two statements is correct

2. Which of the following statements concerning correlation coefficients is (are) correct?

I. A correlation coefficient of -1 for the returns of two securities would indicate that both of themshould be carefully considered for inclusion in a portfolio since maximum risk reduction couldbe achieved by including both.

II. The returns of security B would increase 8% if the returns of security A increased 8% and thecorrelation coefficient for the returns of the two securities was +1.

a. I onlyb. II onlyc. Both the statements are correctd. None of the statement is correct

3. Is it possible to reduce the risk by adding a security with a higher risk to a security with a lower riskthat is already held?

a. No, the total risk after the addition will be higherb. The new security will have no impact in reducing the riskc. Yes, provided both the securities are negatively correlatedd. Yes, provided both the securities are positively correlated to each other

4. What is the portfolio standard deviation in the following case of two (2) securities which are heldin equal weights?

Covariance of two securities = -8; Standard deviation of stock x = 2 and Standard deviation ofstock y = 4

a. 1b. 2c. 4d. 0

5. Which of the following statements is (are) correct?

I. “Rupee cost averaging” can be achieved through Systematic Investment PlanII. “Rupee cost averaging” helps in reducing riska. I onlyb. Bothc. II onlyd. None

Answers:

1. b 2. c 3. c 4. a 5. b


Chapter 7


These are ideal investment vehicles for the small investor – the retail resident Indian investors. Nonresident Indians are not allowed to invest in these schemes. Let us look at the salient features of

these schemes.

1. Public Provident Fund

2. Post Office Monthly Income Scheme

3. Post Office Time Deposit

4. National Saving Certificate

5. Kisan Vikas Patra

6. Government of India Taxable Savings Bond

7. Senior Citizen Saving Scheme

1. Public Provident Fund (PPF)

Who can invest?

n An adult individual in his own name

n An adult on behalf of a minor for whom he is the guardian.

n HUF’s can not open new accounts now; with effect from 13.5.2005. Existing PPF accounts openedin the name of HUF shall continue till maturity and deposits can be made in the account as perrules.

n A PPF account is in addition to Employee Provident Fund and GPF for government employees. nother words who contribute to EPF and GPF can also open PPF account.

Where can one open a PPF account?One can open a PPF account in -

n Head Post-Office,

n G.P.O.,

n Any Selection Grade Post Office,

n Any branch of the State Bank of India and

n Selected branches of Nationalised Banks.

How much can one invest?

n Minimum investment Rs. 500 in a financial year

n Maximum of Rs. 70,000/- in a financial year

n Can be invested in a lump sum or in convenient instalments.

n Total number of credits per year is restricted to 12

n Minimum investment each time is Rs. 5/-.

Small Saving Schemes


n The ceiling of Rs. 70,000/- per annum is for each account.

n If an individual has his own account and accounts in the name of minors (where he is the guardian) thetotal investment in a financial year can not exceed Rs 70,000/- in all the accounts taken together.

n A HUF account where he is the karta is considered separate for this purpose.

Interest

n 8% p.a. credited to the account, once a year, as on 31st March of each year.

n Deposits made on or before the 5th of the calendar month are eligible for interest for the month. It isthe date of deposit and not date of realization that is considered for this purpose.

n Interest is calculated on monthly product basis and credited to the account as on 31st March.

n The interest rate can be changed by the Government of India at any time and the new rate willaffect the balance lying in the account from that date.

n Past interest rates were as under:

Upto 14.1.2000 12%

15.1.2000 to 28.2.2001 – 11%

1.3.2001 to 28.2.2002 – 9.5%

1.3.2002 to 28.2.2003 – 9%

1.3.2003 onwards – 8%

Term

n PPF is a 15 year account.

n The term of the account can be extended by 5 years at a time by making an application in aspecified form to the deposit office; within one year.

n An account can be extended any number of times.

n The entire balance can be withdrawn in full after the expiry of 15 years from the close of thefinancial year in which the account was opened.

Loan

n The depositor can take a loan in the third financial year from the financial year in which the accountwas opened.

n Loan can be taken upto 25% of the amount standing at the end of the second preceding financial year.

n The loan shall be repayable in 36 instalments and shall bear interest at the rate of 1%. No loan canbe obtained after the end of 5th year.

Withdrawals

n A depositor is permitted to make one withdrawal every financial year.

n Withdrawal is permitted from the 7th financial year

n Amount of withdrawal can not exceed 50% of the balance to his credit at the end of the fourth yearimmediately preceding the year of withdrawal or at the end of the preceding year, whichever is less.

Tax benefits

n The interest earned on PPF account (including interest during the extension period) is excludedfrom income tax under section 10(11).


n The entire deposit in the account is exempt from Wealth Tax

n The annual contribution to the account is eligible for deduction u/s 80C

Transferability

n A PPF account with one deposit office can be transferred to another deposit office.

n In other words an account can be transferred from Post Office to any bank branch or from any bankbranch to any other branch of any other bank or to post office.

Nomination

n PPF account is necessarily opened in a single name. Nomination facility is available.

n A depositor can nominate more than one person and stipulate the percentage of sharing amongthe nominees.

2. Post Office Monthly Income Scheme:

Who can Invest?

n An adult individual in his own (single account)

n An adult on behalf of a minor for whom he is the guardian

n An adult individual jointly with other adult individuals (joint account) – the total number of accountholders restricted to 3

Where can one invest?

n In all GPO’s

n In all selection grade Post Offices

n In select sub post offices


n Minimum Rs. 1,000/-

n Maximum Rs. 3,00,000/- in single account (including all the deposits made earlier)

n Maximum Rs. 6,00,000/- in joint account (including all the deposits made earlier)

n The maximum limit of Rs. 3,00,000/- is applicable per individual and deposits in joint accounts areconsidered as having been made equally by all the depositors for the purpose of determining theceiling.

Interest

n 8% per annum payable monthly

n In select post offices ECS facility is available where the interest is credited every month directly tothe saving bank account of the depositor automatically through the Electronic Clearing Service.

n A depositor may open a SB account with the same Post Office where he has deposited his POMISamount and give standing instructions for crediting the interest amount directly to this SB accounton a monthly basis.


n Past interest rates were as under:For deposit accounts opened up to

14.1.2000 – 12%

From 15.1.2000 to 28.2.2001 – 11%

From 1.3.2001 to 28.2.2002 – 9.5%

From 1.3.2002 to 28.2.2003 – 9%

Term

n 6 years

n The interest rate as above remains unchanged for the entire term of 6 years

Withdrawals

n No premature repayment is permitted within 1 year of deposit

n After 1 year but before completion of 3 years premature withdrawal of entire balance is permitted

n If withdrawn, prematurely, before 3 years a penalty of 2% of deposit amount is levied – no deductionfrom interest already paid; Example: If a depositor withdraws Rs. 1,00,000/- prematurely after 2years of deposit, he will be paid Rs. 98,000/-, over and above the interest at the rate of 8% p.a.which he has already received for the period for which the deposit was held by Post Office.

n If withdrawn prematurely after 3 years the penalty is restricted to 1% of the deposit amount – nodeduction from interest already paid.

n Part withdrawals are not permitted – if required the depositor will have to withdraw the entiredeposit amount.

Bonus on maturity

n A bonus of 10% of deposit amount is payable on maturity (at the end of 6 years)

n This bonus has been discontinued from 13th February 2006

n No bonus is payable for deposit accounts opened after 13th February 2006

n As per the latest circular 5% Bonus will be payable on new deposit accounts made on or after 8th

December 2007.

Tax benefits

n No tax benefit; the interest is taxable

n Tax is not deducted at source from the interest, presently

Transferability

n A deposit account can be transferred from one post office to any other post office at any time on therequest of the depositor(s).

Nomination

n Nomination facility is available

3. Post office Time Deposit

Who can Invest?

n An adult individual in his own (single account)


n An adult on behalf of a minor for whom he is the guardian

n An adult individual jointly with other adult individuals (joint account) – the total number of accountholders restricted to 3

n Provident funds, charitable trusts, institutions, co-operative societies and Government bodies arenot permitted to invest in this scheme after 13th May 2005.


n Minimum Rs 200/- and thereafter in multiples of Rs. 200/-

n No Maximum Limit - Any amount can be invested

Interest

n Interest is payable once a year

n Interest is compounded on a quarterly basis and hence the effective yield is slightly more than theinterest rate indicated above

Tax benefit

n As per the latest circular tax benefit is available u/s 80C of Income Tax Act from April 1, 2007 ondeposits made for period of 5 years or more.

n Tax is not deducted at source from the interest, presently.

Withdrawals

n No premature repayment before completion of 6 months.

n No interest is payable if withdrawn after 6 months but before 12 months.

n In respect of deposits for 2 years to 5 years the interest payable shall be 2% less than the rateapplicable for the period for which the deposit has been held.

4. National Saving Certificates (NSC) VIII Issue

Who can purchase?

n An adult individual in his own name.

n An adult individual jointly with another – on “Jointly or survivor” basis ( A type).

n An adult individual jointly with another – on “Either or survivor” basis ( B type).

n Parents and guardians on behalf of a minor.

n HUF’s are not allowed to purchase NSC’s from 13th May 2005.


Where can one invest?

n Can be purchased from all post offices which are allowed to open Savings account.

Amount

n National saving certificates are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs. 5,000and Rs. 10,000

n Can be purchased for any amount without any ceiling

n Can be purchased for amounts in multiples of Rs 100

Maturity Value

n Rs. 100 becomes Rs 160.10 after the full term of 6 years

Premature repayment

n Not allowed during the full term of 6 years

n In case of death of the investor premature payment is allowed to nominee at lower rates as perrules

Tax benefit

n Amount invested qualifies for deduction from income u/s 80C within the over all ceiling of Rs. 1,00,000along with other specified investments/expenditure

n Accrued interest also qualifies for deduction u/s 80C -every year from the second year onwards tillthe year before the year of maturity

5. Kisan Vikas Patra

Who can purchase?


n An adult individual jointly with another – on “Jointly or survivor” basis (A type)

n An adult individual jointly with another – on “Either or survivor” basis (B type)

n Parents and guardians on behalf of a minor

n HUF’s, Trusts are not allowed to purchase KVP’s from 13th May 2005

Where can one purchase Kisan Vikas Patra?

n It can be purchased from all post offices which are allowed to open Savings account.

Amount

n Kisan Vikas Patras are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs. 5,000,Rs 10,000 and Rs. 50,000

n Can be purchased for any amount with out any ceiling

n Can be purchased for amounts in multiples of Rs 100

Maturity Value

n Rs. 100 becomes Rs. 200/- after the full term of 8 years & 7 months

Premature repayment

n Not allowed within 2 ½ years of purchase in normal circumstances


n In case of death of the investor premature payment is allowed to nominee at lower rates as perrules

n After 2 ½ years premature encashment is freely allowed and the amounts payable for a certificateof Rs 1,000/- denomination are as follows

Tax benefit

n Tax is not deducted at source on maturity or otherwise – No TDS as of now.

n Interest on KVP is taxable on accrual basis.

6. Government of India 8% Taxable Savings Bonds

Who can purchase?


n An adult individual jointly with another – on “Jointly or survivor” basis

n An adult individual jointly with another – on “Either or survivor” basis type)

n Parents and guardians on behalf of a minor

n Hindu Undivided Family

n Charitable Institutions or a University {approved u/s 80G or 35(1)(ii)/(iii) of Income Tax Act

From where can one purchase these bonds?

n Bonds can be purchased from designated branches of State Bank of India; its subsidiaries andNationalised Banks; ICICI Bank; IDBI Bank; UTI Bank; HDFC Bank and Stock Holding Corporationof India Ltd. (SHCIL)

Amount

n The bonds can be purchased for any amount in multiples of Rs. 1,000/- without any upper limit


TermThe full term of the bond is 6 years

Interest

n The bonds carry interest at the rate of 8% p.a. payable half yearly i.e. 31st January and 31st Julyevery year

n ECS facility is available – banks credit interest directly to bond holder’s account every 6 monthsthrough ECS

n Cumulative option is also available – in which case Rs. 1,000/- becomes Rs. 1601/- at the end ofthe term of 6 years

Liquidity

n Premature encashment is not allowed

n These bonds are not transferable and hence loans can not be availed against security of thesebonds

Tax Benefit

n Interest is taxable

n No Tax is deducted at source(TDS) presently

7. Senior Citizen Savings Scheme, 2004

Who can invest?

n An individual who has attained the age of 60 years or above

n An adult individual who is above 55 years or more and who has retired – voluntarily or otherwise(within one month from the date of receipt of retirement benefit and an amount not exceeding theretirement benefit within the overall ceiling of the account)

n The account can be opened singly or jointly with spouse (the spouse may be below 60 years of age)

n Joint account holder can not be anybody other than spouse

n HUF’s and Non Residents are not allowed to invest

Where can one open this account?

n The account can be opened in Select Post Offices and branches of banks which accept PPF deposits

Amount

n Any number of accounts can be opened with each deposit in multiples of Rs. 1,000/-

n Maximum permissible investment Rs. 15,00,000/-

n Only one deposit account permitted in one calendar month for each depositor

n If both husband and wife are eligible to invest then each of them can invest up to Rs. 15,00,000/-taking the total to Rs. 30 lacs.


Requirements

n Joint photographs (both husband and wife in one photo)

n PAN Card or declaration in Form 60

n Age proof for the first holder

n Retirement Proof along with proof of retirement benefits received for depositors above 55 yearsbut not above 60 years

n Photograph of nominee(s)

Term

n The full term of the account is 5 years which can be extended by 3 years on maturity Interest:

n 9% p.a. payable quarterly on 31st March/30th June/30th September and 31st December

n Only non cumulative option is available

n ECS facility has been made available in many deposit branches and hence interest can be crediteddirectly to the depositor’s bank account

Nomination

n Nomination facility is available

n Joint nomination with percentage allocation is permitted

n Photograph and signature of the nominee(s) are also obtained and kept on the record of the depositoffice

Premature closure

n Permitted only after one year from the date of deposit – in case of extreme emergencies prematureclosure within one year may be permitted on application to Ministry of Finance, Government ofIndia

n In case of closure before 2 years but after 1 year an amount equivalent to 1.5% of the depositamount is deducted as penalty – no deduction from interest already paid

n In case of closure after 2 years but before 5 years an amount equivalent to 15% of the depositamount is deducted – no deduction from interest already paid

n In case of death of depositor full amount is paid without any deduction

Transferability

n A deposit account may be transferred from one deposit office/bank to another in case of change ofresidence, by making an application in specified form along with the pass book

Tax benefit

n Interest is taxable – no tax benefit

n Tax is deducted at source from the interest payable– senior citizens who are not assessed toIncome tax can submit 15 H (if depositor is above 65 years of age) and form 15G (if not above 65years of age) to avoid tax deduction at source from the interest

n Principal Amount can be considered towards the deductions u/s 80C


Review Questions:

1. In respect of a Public Provident Fund account and a Hindu Undivided Family which of thesestatements is true?

a. New account can not be openedb. Yes new account can be openedc. No deposits are allowed in the old PPF accounts of HUFd. The amount that can be deposited in a PPF account of a HUF and that of the karta together

can not exceed Rs. 70,000/- in a year

2. In respect of a PPF account and a Minor which of these statements is true?

a. New PPF account can not be opened in the name of a minorb. No new deposits are allowed to be made in the PPF accounts already held in the name of minorsc. The amounts that can be deposited in a PPF account of a minor and that of the guardian

together can not exceed Rs. 70,000/- in a financial yeard. An individual can deposit amount not exceeding Rs. 70,000/- in a financial year in his account

as well as the account in the name of the minor where he is the guardian

3. Interest on PPF account is payable for the month subject to the following condition getting fulfilled:

a. Deposit should have been made on or before the 10th of the month and the cheque shouldhave been realized by that date

b. Date of deposit should be on or before 10th of the month; date of realization can be laterc. Date of deposit should be on or before 5th day of the month; date of realization can be laterd. Deposit should have been made on or before 5th day of the month and the cheque should

have been realized by that date

4. How many times a PPF account, on the expiry of the full term of 15 years, can be extended for 5years, on an application being made by the depositor?

a. Only onceb. Only twicec. Only thriced. Any number of times

5. Interest rate on a PPF account is 8% p.a. Which of the following statements regarding interestis true?

a. The interest is taxableb. The interest is taxable but not subjected to TDSc. The rate of interest can change at any timed. The rate of interest will remain unchanged for the entire term of 15 years but at the time of

extension, changed rate, if any, will become applicable

6. A bonus of 10% of deposit amount is payable on Post Office Monthly Income Scheme account,on maturity, provided:

a. The deposit account was opened before 11th February 2006b. The deposit account is held in joint namesc. The deposit amount does not exceed the prescribed maximum limits in the schemed. It is payable on all accounts irrespective of number of depositors as well as when the deposit

was made


7. Interest on Post Office Monthly Income Scheme is

a. Tax freeb. Taxable and subject to TDSc. Taxable but not subject to TDSd. None of the above

8. In Post Office Time Deposit the maximum limit on investment is:

a. Rs. 1,00,00/- per personb. No maximum limitc. Rs. 3,00,000/- in single account and Rs. 6,00,000/- in joint accountsd. Rs. 5,00,000/- per person

9. Accrued interest on National Savings Certificates, purchased in the previous years

a. Need not be shown as Income from other sourcesb. Should be shown as Income from other sources but the same is deductible u/s 80L of the

Income Tax Act in all years except the year of maturityc. Should be shown as Income from other sources but can be claimed as deduction from income

u/s 80C of the Income Tax Act, in all years except the year of maturityd. It can be treated as capital gains and accounted for as such in the year of maturity

10. Which of the following statements, in respect of Senior Citizen Saving Scheme, is true?

a. The account can be held jointly with son or daughterb. The account can be held jointly but both the joint holders should above 60 years of agec. An individual below 60 years can not invest in this scheme at alld. An individual above 55 years can invest within one month of receipt of retirement benefits

11. If husband and wife both are above 60 years of age the maximum amount they can invest inSenior Citizen Savings Scheme is:

a. Rs. 15 lacs, totally, between the two of themb. Rs. 30 lacs, totally; each person not exceeding Rs. 15 lacsc. No ceiling on the amount of investment in this schemed. Only one of them can invest and the total can not exceed Rs. 15 lacs

12. Which of the following statements is true regarding interest on Senior Citizen Savings Scheme?

a. Taxable and subject to TDSb. Taxable but not subject to TDSc. Tax freed. Rate of interest can change at any time during the 5 year term

13. Which of the following statements is true in respect of nomination in Senior Citizen SavingsScheme?

a. Only one person can be nominatedb. Nomination is permitted only in case of single accountc. Joint nomination is permitted on successive nomination basisd. Joint nomination is permitted on proportional nomination basis


14. Cumulative interest option is available in Senior Citizen Savings Scheme.

a. Not true; only non cumulative option is availableb. True; but the depositors have to specifically apply for the samec. Available at the option of all the depositors jointlyd. Available only for depositors in the age group of 55 to 60

15. The maximum amount that an individual can deposit in 8% GOI taxable Savings Bond is;

a. Not exceeding Rs. 2 lacs in a financial yearb. Not exceeding Rs. 2 lacsc. No ceiling at all; any amount can be depositedd. Rs 6,00,000/- if held jointly

16. Which out of the following persons are not allowed to invest in 8% GOI Taxable Savings Bonds?

a. Charitable Institution approved u/s. 80G of the Income Tax Actb. Universitiesc. Non Resident Indiansd. All the above

Answers:

1. a

2. c

3. c

4. d

5. c

6. a

7. c

8. b

9. c

10. d

11. b

12. a

13. d

14. a

15. c

16. c


Chapter 8


Short Term Instruments – Money Market Instruments

The following are the short term instruments of less than 1 year maturity. These instruments areessentially institutional plays and retail investors don’t get to participate in this directly.

1. Call Money MarketThis is basically an inter-bank market where the day-to-day surplus funds are made available/lent tobanks that have a short fall. The loans have a maturity of 1 day to about 14 days and are repayable ondemand at the option of either the lender or the borrower. In terms of liquidity this is slightly lower thancash – in other words the liquidity is very high

2. ReposRepos or repurchase agreements (ready forward) are transactions in which one party sells security toanother party simultaneously agreeing to purchase it in future at a specified date and time for apredetermined price. The difference in the prices is the cost of borrowing to one party and income to theparty lending the money. These transactions are secured and hence the counter party risk is highlyreduced. Therefore, the interest rate is also lower compared to call money rates. In repos the purchaseracquires the title to securities and he can enter into further transactions on these securities.

Repos are generally for a period of about 14 days or less though there is no such restriction on themaximum period for which a repo can be done.

Government Securities, Treasury bills and PSU bonds are the instruments used as collateral securityfor repo transactions.

3. Treasury BillsTreasury Bills are borrowings of Government of India for periods of less than 1 year and the normaltenors are 91 days, 182 days and 364 days. The main holders of Treasury Bills are banks and primarydealers, which are required to hold government securities as part of their liquidity requirements (SLR –The statutory liquidity ratio – banks are required to keep a certain percentage of their total demand andtime liabilities invested in government securities – Investments in Treasury banks serve the purpose ofmeeting SLR requirements – currently SLR is 25%) On 91 days Treasury Bills, currently, the yield isaround 5.9% to 6.40% p.a. while the yield on 364 days Treasury bill hovers around 6.9% to about 7.1%p.a. Banks subscribe to Treasury Bills through an auction process and Reserve Bank of India acts onbehalf of Government of India in this regard. Government of India also makes longer term borrowings towhich banks subscribe. The securities where the term is 1 year or more are called Dated Securities.

4. Commercial Paper (CP)CP’s are short term, unsecured, usance promissory notes issued by large corporations. The rate ofinterest will depend on over all short term money market rates as well as credit standing of the issuercompany. Individual investors can invest in Commercial Paper. These are issued at discounts to theface value and the extent of discount will determine the yield on the paper. Banks are not permitted to

Fixed Income Instruments


co-accept or underwrite CP’s issued by companies. The CP’s are regulated by Reserve Bank of Indiaand companies can issue CP’s to meet their short term requirement of funds, subject to norms laid byRBI from time to time. A company is eligible to issue CP only if its tangible net worth is more than Rs. 4crores and if it has a sanctioned working capital limit from a bank or a financial institution. The minimumcredit rating required for CP’s is P-2 of CRISIL or its equivalent of other credit rating agencies. Theperiod is 15 days to less than a year and the denomination is Rs 5 lacs and its multiples.

5. Certificates of Deposit (CD)Instruments very similar to CP’s but issued by banks are called Certificates of Deposit. These arenegotiable short term bearer deposits issued by banks. These are interest bearing, maturity datedobligations forming part of the time deposits of banks. In the past when interest rates on bank depositswere regulated CD’s became handy for banks to raise short term deposits even at rates lower than theregular fixed deposit interest rates.

6. Forward Rate Agreements (FRA)A Forward Rate Agreement(FRA) is a forward contract in which one party pays a fixed interest rate, andreceives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculatedover a notional amount over a certain period of time and netted i.e only the differential is paid. It is paidon the termination date. The reference rate is fixed one or two days before the termination date, dependenton the market convention for the particular currency. FRA’s are over-the-counter derivatives. A swap isa combination of FRA’s.

The payer of the fixed interest rate is also known as the borrower or the buyer whilst the receiver of thefixed interest rate is the lender or the seller.

7. Interest rate swaps (IRS)An Interest Rate Swap is the exchange of one set of cash flows for another. A pre-set index, notionalamount and set of dates of exchange determine each set of cash flows. The most common type ofinterest rate swap is the exchange of fixed rate flows for floating rate flows. A counter-party’screditworthiness is an assessment of their ability to repay money lent to them over time. If a companyhas a good credit rating, they are more likely to be able to pay back a loan over time than a companywith a poor credit rating. This effect is magnified with time. By making it easier for less creditworthyagents to borrow in the short term than in the long term, lenders make sure that they are less exposedto this risk.

Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and receivingfloating is usually the less creditworthy of the two counterparties.

The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longerterm at a cheaper rate than they could raise such funds in the capital markets by taking advantage of theentity’s relative advantage in raising funds in the shorter maturity buckets.

Fixed Income Instruments – Long TermThis segment deals with securities and deposits that have maturity periods one year or longer andwhere coupon/interest is paid periodically, as opposed to discounted prices in case of short terminstruments, discussed earlier. These vehicles are attractive for investors who seek regular income withrelative safety. Some of the most popular avenues of fixed income instruments are as under:


GOI dated securities – Government Bonds

GILT edged securitiesGovernment of India borrows for long term through these securities. Banks, financial institutions, insurancecompanies and mutual funds subscribe to these bonds through the auction process initiated by ReserveBank of India. These bonds are plain vanilla bonds of face value Rs 1000/- where on the coupon/interestis paid to the holders on half yearly basis. These bonds are quoted as “8% GOI bonds 2014” whichindicate the coupon rate and maturity of these bonds. The prices of these bonds fluctuate based on theprevailing interest rates, the nearness to payment of coupon and of course, market factors of liquidity/demand/supply, etc. These bonds are generally issued for periods ranging from 3 years to 20 years.

Because of the longer term, bigger size and illiquidity of these bonds these have not been attractive forretail investors. However, investors can participate in the government securities, indirectly, through themutual fund route. Some mutual funds have launched GILT funds which invest only in Governmentsecurities while Income Funds of mutual funds predominantly invest in fixed income securities includingGovernment securities.

The Government of India issues securities in order to borrow money from the market. One way in whichthe securities are offered to investors is through auctions. The government notifies the date on which itwill borrow a notified amount through an auction. The investors bid either in terms of the rate of interest(coupon) for a new security or the price for an existing security being reissued. Since the process ofbidding is somewhat technical, only the large and informed investors, such as, banks, primary dealers,financial institutions, mutual funds, insurance companies, etc generally participate in the auctions.

PSU Bonds

Public Sector Undertaking, Public Sector Enterprises and local authorities, but supported by State/Central Government issue securities similar to Central Government Securities. Normally the respectiveGovernment offers guarantee for payment of interest and repayment of principal amount of these PSUborrowings. These bonds, as they carry sovereign guarantee, are considered less risky compared tocorporate bonds/debentures but more risky compared to Government securities. Many State Governmentcorporations have floated bonds in the past and have raised moneys for infrastructure projects and theIndian retail investors have participated in the issues in a big way. The investors have received excellentreturns while the corporations could raise much needed capital funds for major projects. It is also expectedthat Government of India will allow Municipal Corporations to raise funds from the market, fordevelopmental projects, through issue of tax free bonds at attractive rates of interest.

Corporate Bonds/Debentures

Companies can borrow directly from the market through issue of securities, subject to capital marketregulations for meeting their capital requirements. These are typically “debentures” which are borrowingsof the companies and these may be secured against a charge on the assets of the company or thesemay be unsecured. The term of the debentures will depend upon the need of the company. Companiescan issue Non Convertible Debentures which are pure fixed income instruments and also partly convertibleor fully convertible debentures. The convertible debentures normally bear interest till the date of conversionand/or on the non-convertible portion till redemption. Where the tenor of the debentures is 18 months ormore credit rating for the debentures is mandatory. The non convertible debentures and the non-convertible portion of partly convertible debentures are redeemed on maturity at par or with a premium.The rate of interest will depend on market conditions as well as creditworthiness of the company and thecredit rating for the debentures. Companies in the past found it convenient to tap the capital market and


raise funds through issue of NCD’s and PCD’s and they preferred this route to long term borrowing frombanks. The investors also preferred NCD’s because the debentures were secured and the interest rateswere quite high. Now that the rates of interest have come down the debentures don’t continue to enjoythe same patronage from the retail investor. To the investor interest on debentures is taxable and alsosubject to TDS. Companies have tapped the market with Zero Coupon Bonds as well Optional FullyConvertible Debentures. These special instruments serve some purpose for the investors as well as thecompanies from the point of taxation as well as postponing interest liabilities, etc.

Corporate DepositsCompanies are allowed to borrow from the public through public deposits for meeting their medium termcapital requirements. The acceptance of deposits by Indian companies is subject to the provisions ofSection 58A and 58AA of the Companies Act, 1956 and Companies (Acceptance of Deposits) Rules,1975 (as amended).

Manufacturing Companies:

n The public deposit mobilized by a company should not exceed 25% of Tangible Net worth of thecompany (capital + free reserves) – this fixes the maximum amount a company can borrow fromthe public through fixed deposits route.

n A company can borrow from its share holders also and this amount should not exceed 10% of itsnet worth taking the total borrowings through public deposits to 35% of the company’s net worth. Inrespect of Government companies the limit is 35% of the company’s net worth.

n The maximum term of deposit cannot exceed a term of 3 years while the minimum term is 6 months

n The company is free to fix the rate of interest payable on its fixed deposits within the overall limitslaid down under the Companies (Acceptance of Deposits) Rules, 1975 and notifications madethere under from time to time

n The interest received by the depositor is taxable

n A company is liable to deduct tax at source where the interest per annum per depositor is likely toexceed Rs. 2,500/-. This limit may change as per provisions of Income Tax Act.

n Credit rating of fixed deposits is not mandatory

n Fixed deposits are unsecured borrowings of the company

Non Banking Finance Companies:

n Only NBFC’s which are registered with RBI can accept fixed deposits

n Credit rating of Fixed Deposits is mandatory

n An NBFC can accept fixed deposits only if credit rating is above Minimum rating fixed by RBI fromtime to time

n These companies are allowed to raise much higher amounts by way of fixed deposits in relation totheir net worth

n To the investor Fixed Deposits with NBFC’s offer a higher risk higher return investment option

n The interest is taxable and subject to TDS

n Housing Finance Companies also accept fixed deposits and TDS is made only when the intereston deposits is likely to exceed Rs. 5,000/- p,a, per depositor whereas in respect of other companiesthe limit is Rs. 2,500/-


Bank deposits

n Banks accept fixed deposits for short term as well long term offering specific fixed rate of interest.

n This is the most popular investment vehicle for the retail investors in India because investors findbanks very convenient to deal with.

n These deposits are perceived to be highly safe and liquid

n Interest rates tend to be lower compared to other fixed income avenues of comparable maturities

n Interest is taxable

n Interest is subject to TDS – where interest on term deposit is likely to exceed Rs 5,000/- per annumper depositor per branch the bank is required to deduct tax at source

n Bank deposits are highly flexible in their features and banks accept term deposits with extremelyinvestor friendly features

n Investment in a Bank Fixed Deposit with a 5 year lock-in period qualifies for deduction from incomeunder sec 80C of Income Tax Act.

n Bank deposits can be insured against risk of default, by bank, with Deposit Insurance and CreditGuarantee Corporation of India Ltd. to the maximum limit of Rs. 1,00,000/- per depositor per bank.Investors in relatively smaller banks and co-operative banks find this an important protection.

Features of fixed income securitiesn The return or the yield which comprises of regular flow through coupon/interest and capital

appreciation or loss, if any, on maturity.

n The liquidity. Investors some times prefer securities of shorter term as well as vehicles where theexit is easier. The fixed income options like Money Market Mutual Funds and call deposits arefound ideal by investors who want to park their money for short term.

n Risk: This is a major factor. The risk of default is a factor which determines where the investorwould like to invest his savings. Unsecured company fixed deposits, especially the ones which arenot rated, can be considered quite risky. The better the credit rating of an instrument the lowercould be the return on the same.

n Taxability and tax deduction at source are also important factors that determine flow of money toa particular avenue. 8% GOI taxable savings bonds and small saving schemes like Post OfficeMonthly Income Schemes have managed to attract huge funds flow because the interest on these,though taxable, is not subjected to tax deduction at source while Public Provident Fund, though alonger term option, attracts substantial investor interest because of tax benefits.

n Convenience of handling is a parameter on which bank deposits score over many other avenues.A large net work of branches and ATM’s make banks very easy to handle.

Valuation of fixed income securities:

Money market securitiesThe valuation of these securities is normally a function of the current interest rate prevailing in themarket on short term debt instruments.

If a 90day treasury bill of R.s 1,00,000/- is available for say 98,186 then the yield on the same would beworked as follows:

Income earned is 1,00,000 – 98,186 = 1,814

Tenor 90 days


The yield therefore is (1814*365)/(98,186*90) = 7.49%

The yield is worked out for a year of 365 days from the discounting at which the treasury bill is available.

The formula for calculating the yield is PV = FV/ [1+ (i*n/365)

Where

PV = present value or the price of the bill/security

FV = face value or the value receivable on maturity

n = number of days to maturity

i = yield per annum

In respect of fixed income securities which have less than 1 year left to maturity when all factors viz. PV,FV and n are known and yield “i” can be calculated using the above formula.

Longer term securitiesIn respect of longer term securities the time between receipts of interest income becomes a significantfactor in its valuation. In market instruments there are no interest payments and the same is built in theprice. In respect of dated securities and bonds interest payments are made at specified intervals. Theamount of interest and the timing of these payments will affect the price of a longer term security.

There are two types of yields which come into play here. The current yield which is nothing but the periodicpayments received on the amount invested or in other words: the coupon divided by purchase price.

The other type of yield is YTM which is calculated as follows:

where

P = Price of the security

C = annual interest payments received

r = rate of interest

M = Maturity value – amount receivable on maturity

n = number of years left for the security to mature

The computation of YTM required a trial and error procedure. The interest payments are payments ofannuity over a period of time while the maturity value is the future value of the present Price of the bondand “r” the YTM has to be worked out substituting different values for r.

ConclusionIt may be pertinent to add here that small investors have little or no exposure to government securitiesand the money market instruments directly. Some investors have been participating in these avenuesthrough the mutual fund route. However investors have found company fixed deposits as well as nonconvertible and convertible debentures easier to invest and have been investing in these vehicles.Public Sector bonds floated by many Government and Semi Government corporations have also receivedgood response from the retail investors. Besides the avenues discussed above fixed income instrumentsinclude Small savings schemes like Post Office Monthly Income Scheme, Public Provident Fund, NationalSaving Scheme, Kisan Vikas Patra and direct borrowing by Government of India through 8% GOI TaxableSavings Bonds and Senior Citizen Savings Scheme. These schemes and their features have beendiscussed in detail under the topic “Small Saving Schemes”.


Review Questions:

1. If the yield on 90 days Treasury Bills is currently 6.9% what should be the price of the Treasury Billof Rs 1,00,000/- in the market?

a. Rs. 93,100b. Rs. 98,327c. Rs. 1,06,900d. Rs. 96,549

2. Bank deposits, at the option of the bank, can be insured with DICGC and the maximum coveravailable per depositor is;

a. No insurance cover is available on bank depositsb. Rs. 2,00,000/- per branch of the bankc. Rs. 1,00,000/- per branch of the bankd. Rs. 1,00,000/- per bank

3. Interest on bank deposits is

a. Tax free u/s 10b. Deduction is available u/s 80L for individual investorsc. Taxable and subject to TDS where the interest is likely to exceed Rs. 5,000/- p.a. per depositor

per branchd. Taxable and subject to TDS where the interest is likely to exceed Rs. 5.000/- p.a. per depositor

per bank

4. A Manufacturing company can accept fixed deposits subject to the following conditions:

a. Not exceeding 20 times the net worth of the companyb. Not exceeding 25% of its net worth from the public and not exceeding 10% of net worth from

its share holdersc. No such restrictions – the company may decide the quantumd. Not exceeding 5 times the net worth of the company.

5. If the market price of the bond, bearing coupon of 8%, is Rs. 985, face value of the bond is Rs. 1,000and if there are two years to maturity then YTM would be:

a. Equal to 8%b. Less than 8%c. Cant sayd. More than 8%

6. If the interest rate in the economy rises then the prices of existing bonds will

a. Riseb. Fallc. Remain steadyd. The fall or rise will depend upon the coupon rate and the maturity date of the bond


7. Commercial Papers (CP) are:

a. Long term instruments issued by banksb. Long term instruments issued by companiesc. Short term instruments issued by eligible companiesd. Short term instrument which can be issued by any company

8. Interest on short term money market instruments:

a. Is paid periodically by the issuerb. It is discounted in the pricec. It is paid by the issuer, as agreed between the issuer and the investor, but subject to Tax

Deduction at sourced. Is paid on a quarterly basis

9. How frequently is interest on Government securities (Dated Securities) paid?

a. Once a yearb. Half yearlyc. Quarterlyd. On maturity

10. It is expected that interest rates may rise in the near future. Which of the following instrumentswould you choose?

a. One year bank FD offering 8% p.a.b. 5 year Bank FD offering 8.5%c. 6 year GOI bonds offering 8% p.a.d. Keep money locked in long term securities

Answers:

1. b

2. d

3. c

4. b

5. d

6. b

7. c

8. b

9. b

10. a


Chapter 9


Life insurance is a misunderstood concept in India. Basically Life Insurance Plans should provideinsurance cover to protect the dependants of the Life Assured. But conventionally Life Insurance

policies have been sold as investment products where the Life Assured gets a lump sum at the end of afixed term or periodic returns on a regular basis during the term. The emphasis has been more on theinvestment aspects than on life cover. The private players in Life Insurance sector in India they havebrought in newer concepts like adding riders to life insurance policies but they also continue to sellinsurance plans with more emphasis on the investment features.

Let us look at some of the standard policies offered by Life Insurance Companies.

Endowment Policy

n An endowment policy covers risk for a specified period, at the end of which the sum assured is paidback to the policyholder, along with the bonus accumulated during the term of the policy.

n The method of bonus payment is called reversionary bonus. The quantum of bonus is not assuredand it is based on the investment out come of Life insurance companies.

n It is insurance-cum-investment product where the emphasis is more on investment because lifecover for a given premium is less compared to a whole life policy with more focus on maturitybenefit compared to death benefit.

n Endowment life insurance pays the sum assured in the policy either at the insured’s death or at acertain age or after a number of years of premium payment.

n Ideally this policy is used by investors who would like to have a certain amount of capital at the endof a fixed term and protect the end capital through life insurance of the saver.

n This has been the most popular life insurance plan of LIC of India before the private players enteredlife insurance sector and popularized Unit Linked Insurance Plans

Whole Life Insurance Policy

n A whole life policy runs as long as the policyholder is alive.

n As risk is covered for the entire life of the policyholder, therefore, such policies are known as wholelife policies.

n A simple whole life policy requires the insurer to pay regular premiums throughout the life.

n Whole Life plans with limited payment options are also available where the insured is required topay premium for a specific term after which premium payment will stop but life cover will continue

n In a whole life policy, the insured amount and the bonus is payable only to the nominee of thebeneficiary upon the death of the policyholder.

n There is no survival benefit as the policyholder is not entitled to any money during his / her ownlifetime.

Life Insurance Products


Term Life Insurance Policy

n Term life insurance policy covers risk only during the selected term period.

n The sum assured becomes payable only on death of the policy holder and not on end of the termas in an endowment plan

n The term life insurance policy offers maximum life insurance cover for a given premium paymentas this is pure life insurance without any investment built in

n Term life policies are primarily designed to meet the needs of those people who are initially unableto pay the larger premium required for a whole life or an endowment assurance policy.

n No surrender, loan or paid-up values are granted under term life policies because reserves are notaccumulated.

n If the premium is not paid within the grace period, the policy lapses without acquiring any paid-upvalue.

Money Back Policy

n Money back policy provides for periodic payments of partial survival benefits during the term of thepolicy, as long as the policyholder is alive.

n They differ from endowment policy in the sense that in endowment policy survival benefits arepayable only at the end of the endowment period.

n An important feature of money back policies is that in the event of death at any time within thepolicy term, the death claim comprises full sum assured without deducting any of the survivalbenefit amounts, which may have already been paid as money-back components. The bonus isalso calculated on the full sum assured

n This is an insurance plan with emphasis on investments and periodic return.

n A segment of investor population finds the periodic receipts from Life Insurance Company attractiveand hence prefers this plan.

Joint Life Insurance Policy

n These plans are ideal for a married couple especially when both are bread winners or business partners.

n Joint life insurance policies are similar to endowment policies offering maturity benefits as well asdeath benefits.

n In case of death of one of the persons the sum assured becomes payable.

n The sum assured is paid again on death of the surviving policy holder or on policy maturity.

n The premiums payable cease on the first death or on the expiry of the selected term, whichever isearlier.

n If one or both the lives survive to the maturity date, the sum assured as well as the vested bonusesare payable on the maturity date.

Group Insurance

n Group insurance offers life insurance protection under group policies to various groups such asemployers-employees, professionals, co-operatives, weaker sections of society, etc.

n It also provides insurance coverage for people in certain approved occupations at the lowest possiblepremium cost.


n Group insurance plans have low premiums. Such plans are particularly beneficial to those forwhom other regular policies are a costlier proposition.

n Companies with a large workforce have preferred to provide life insurance to their less sophisticatedemployees/workers through Group Insurance Plans.

n Group insurance plans extend cover to large segments of the population including those whocannot afford individual insurance.

n A number of group insurance schemes have been designed for various groups.

Loan Cover Term Assurance Policy

n Loan cover term assurance policy is an insurance policy, which covers a home loan.

n In the event of unfortunate death of the policy holder, before the full repayment of the housing loan,the amount outstanding in the housing loan is paid in full.

n The cover on such a policy keeps reducing with the passage of time as individuals keep payingtheir EMIs (equated monthly instalments) regularly, which reduces the loan amount.

n This plan provides a lump sum in case of death of the life assured during the term of the plan. Thelump sum will be a decreasing percentage of the initial sum assured as per the policy schedule.

n Since this is a non-participating (without profits) pure risk cover plan, no benefits are payable onsurvival to the end of the term of the policy.

Term Assurance Plans

n Under this plan, in case of death of the policy holder during the policy term, the sum assured will bepaid to the beneficiary.

n There are no maturity benefits. Hence on survival, the policy will terminate.

n The life insured will need to pay the regular annual premium for the term chosen.

n These are typically low cost bare insurance plans with no investment frills

n For a little additional cost some companies offer Term assurance plans with return of premium andhere on survival till maturity all the premiums paid will be returned

n Some term assurance plans provide extended life cover rider where after the end of term, insuranceup to certain percentage of sum assured, continues for a specified term , say 5 years, withoutpayment of any premium

n Insurance companies tend to place a number of restrictions on term plans like:

1. Maximum life cover; say Rs 50 lacs

2. Maximum term – say 25 years

3. Maximum age at maturity – say 55 years and so on ...

Unit Linked Insurance Plans

n ULIPs are market-linked insurance plans with a life cover thrown in.

n The said insurance cover is lower than most plain-vanilla plans (like endowment plans) as a sizableportion of the premium goes towards investments in market-linked instruments like stocks, corporatebonds and government securities.

n On death sum assured together with market related returns on the investments is paid – in otherwords the death benefit could be more than sum assured


n Generally, the choice of extent of life cover is left to the insured/policy holder

n The choice of investment plans is also left to the policy holder with an option to switch betweendifferent investment plans, a number of times, during the entire term of the plan. For example aninvestor may choose the aggressive or equity plan at his young age and later on switch toconservative or protective or debt plan at a later age.

n ULIP provides multiple benefits to the consumer. The benefits besides life protection include:

1. Investment and Savings

2. Flexibility

3. Adjustable Life Cover

4. Investment Options

5. Transparency

6. Options to take additional cover against

n Death due to accident

n Disability

n Critical Illness

n Surgeries

n ULIPs have managed to outsell plain vanilla plans by quite a margin. For some private insurancecompanies, they account for up to 70% of new business generated.

n ULIPs by their very nature are long term investment vehicles because of costs involved as well asthe nature of underlying investments especially equities.

n Investors while choosing ULIPs should very carefully study the loads charged by Life InsuranceCompanies because past performance shown by these companies is essentially on the netinvestment portion of the premium paid by the policy holder. So if the charges are high naturallythe lump sum receivable at the end of the term will also be affected substantially.

n The policy holders should pay premium continuously for a minimum period of 3 years. The insurancecover will continue even if the policy holder fails to pay the annual premium after a minimum periodof at least 3 years. The policy becomes paid up after 3 years and upon surrender the market valuebecomes payable.

How Unit Linked Insurance Plans work?Let’s assume that Mr. Vikas Joshi, aged 30 years, is prepared to pay life insurance premium of Rs20,000/- per annum. In a ULIP he can choose the extent of life cover he wants and where he wants hisfund to be invested. Let us also assume that Mr. Joshi presently opts for the Aggressive plan where hisentire amount will be invested in equities and he chooses life cover of Rs. 2,00,000/-.

From the premium paid by Mr. Joshi expenses under the following heads will be deducted.

n Sales and marketing expenses

n Administration expenses

n Underwriting expense

n Mortality charges

n Fund management expenes

The quantum of mortality charges will depend upon extent of life cover opted while the fund management


expenses will also depend upon the investment option exercised – the cost could be low for a debt fundand higher for an equity fund.

In some cases out of Rs. 20,000/- paid by Mr. Joshi expenses will account for nearly Rs. 5,000/- in thefirst year or first two years and only the balance amount of Rs. 15,000/- will be invested as per his option.The quantum of administration, selling and marketing expenses go down dramatically from the thirdyear onwards but in the initial 2 years they tend to be quite high and this can alter the returns on theULIP substantially. It is very important for Mr. Joshi to study the fine print regarding expenses thoroughlybefore choosing a specific Plan.

Mr. Joshi should also realize that he will get better returns only if he invests for a long period for thefollowing important reasons:

n Expenses, as a percentage of premium, tend to go down dramatically over longer period time

n Equity as an asset class will perform better over longer period of time

n In the short term equity may perform erratically and may not deliver superior returns

Where ULIPs invest?Each investment fund is composed of units. All the units in a fund are identical. You can choose from thefollowing funds:

Liquid fundThe Liquid fund invests 100% in bank deposits and high quality short-term money market instruments.The fund is designed to be cash secure and has a very low level of risk; however unit prices mayoccasionally go down due to the use of short-term money market instruments. The returns on the fundsalso tend to be lower.

Secure Managed /Protector FundThe Secure Managed fund invests 100% in Government Securities and Bonds issued by companies orother bodies with a high credit standing, however a small amount of working capital may be invested incash to facilitate the day-to-day running of the fund. This fund has a low level of risk but unit prices maystill go up or down. The risk that this fund may face is the interest rate risk. If after investment the interestrates rise that may lead to a fall in unit prices temporarily.

Hybrid Fund / Moderate fund / Defensive Managed15% to 30% of the Defensive Managed fund will be invested in high quality Indian equities. The remainderwill be invested in Government Securities and Bonds issued by companies or other bodies with a highcredit standing. In addition, a small amount of working capital may be invested in cash to facilitate theday-to-day running of the fund. The fund has a moderate level of risk with the opportunity to earn higherreturns in the long term from some equity investment. Unit prices may go up or down.

Balanced Fund30% to 60% of the Balanced Managed fund will be invested in high quality Indian equities. The remainderwill be invested in Government Securities and Bonds issued by companies or other bodies with a highcredit standing. In addition a small amount of working capital may be invested in cash to facilitate theday-to-day running of the fund. The fund has a higher level of risk with the opportunity to earn higherreturns in the long term from the higher proportion it invests in equities.


Growth fund / Aggressive FundThe Growth fund invests 80% to 100% in high quality Indian equities. In addition a small amount ofworking capital may be invested in cash to facilitate the day-to-day running of the fund. The fundhas a higher level of risk with the opportunity to earn higher returns in the long term from theinvestment in equities.

n The past performance of any of the funds is not necessarily an indication of future performance.

n There are no investment guarantees on the returns of unit linked funds.

Who can opt for ULIPs?

n Individuals who are already adequately insured

n Individuals who are well informed regarding the market and are in a position to take a call on theperformance of equity and or debt markets over a period of time

n Investors who are prepared to take more risk for better returns compared to pure endowment plans

Insurance plans for child’s future

Life insurance plans help in servicing various needs in an individual’s financial planning exercise. Onesuch need happens to be planning for his children’s future. Children’s insurance plans help in addressingmany of these needs.

While individuals might have a financial plan for themselves in place, it is equally important that they securethe financial future of their children. For example, suppose an individual wants to plan for his son’s education.A child plan will serve in achieving this goal. An illustration will help understand this better.

n A parent saves regularly every year or every month for a fixed term

n The plan offers to pay lump sum amounts every year which could be spent on child’s education onthe child reaching a certain age

n There are plans that pay a single lump sum on the child attaining a certain age – typically plannedto provide for marriage expenses

n The most important insurance feature in a child care plan is that in the event of unfortunate deathof premium paying parent further premium payments are waived (at the option of the policy holderwhile entering the plan) and the lump sums are paid as planned so that the child’s educationexpenses are met

n Some plans also offer a rider called Accidental Disability Guardian Benefit rider where the futurepremiums are waived in case the parent is disabled because of an accident

n It is the life insurance of the parent that is important and not that of the child because the childshould not face financial problems on death of the parent - many people tend to insure the child tosecure the child’s feature.

n The returns on some products are market linked and not assured and therefore it is important tounderstand cost factors, track record of performance and other features before choosing a plan

Pension Plans

n A pension plan is a retirement plan

n An investor can start planning for retirement from an early age or look at the options close to retirement

n Ideally, investments should start from an early age through regular instalments on yearly basis


n Lump sum single premium payment is also allowed for investors, past a particular minimum agelimit – minimum age limit for starting of pension – in many cases it happens to be 40 years

n The pension payments can start immediately or after a time lag – Immediate annuity or deferredannuity

n In case of deferred annuities, at the end of the term of deferment the pensioner can exercise anoption of getting some lump sum and pension on the balance amount or pension on the full amount– part payment of capital is allowed

n The pension payments are at guaranteed rates for entire life of the pensioner or for a fixed term ofsay 10/15/20 years

n Some pension plans provide for paying increased rates of pension over a period of time – idealhedge against inflation

n The pension payments can be monthly, quarterly, half yearly or yearly – at the option of the pensioner.

n The pension payments can continue to spouse on the death of the pensioner, at the same rates orreduced rates, as prescribed by Life Insurance companies – this option can be exercised by pensioner

n The capital sum may be returned to the nominee on the death of the pensioner (return of purchaseprice) or forfeited – the rate of return on annuity plans will depend on which option the pensionerexercises – the rate of returns are lower when the pensioner wants return of purchase price

n In case of immediate pension – the quantum of pension depends on the age, at entry, of thepensioner – the higher the age at entry the higher the amount of pension

n Pension plans typically offer no life insurance cover but some plans do have term assurance riderfor deferred pension plans, at an additional cost

n The most important factor that should be considered while choosing a pension plan is that itprovides protection from interest rate risk – insurance companies guarantee a specific return forthe entire life of the pensioner where as in other avenues like fixed deposits/small savings, etc.the interest rates may go down disrupting the budget of the pensioner – these plans “cover therisk of living too long”


Review Questions:

1. In a Whole life plan with limited payments, the sum assured becomes payable:

a. At the end of premium paying termb. Only on death of the policy holderc. At the end of the premium term or on death of the policy holder which ever is earlierd. The sum assured is not payable at all if the policy holder survives the premium paying term

2. In an Endowment Assurance Plan the sum assured becomes payable:

a. Only at the end of the term of the policyb. On death of the policy holder or at the end of the term of the policy which ever is earlierc. Only on death of the policy holderd. No sum is payable if policy holder survives the full term

3. In a Term Assurance Plan the sum assured becomes payable:

a. Only at the end of the term of the policyb. On death of the policy holder or at the end of the term of the policy which ever is earlierc. Only if the policy holder dies after the end of the termd. Only if the policy holder dies before the end of the term for which he has been insured

4. The best way to take care of a child’s future through insurance plans is to

a. Insure the life of the child for maximum possible amountb. Life insurance plans can not protect the child’s future at allc. Invest in a child care plan with premium waiver benefit, where upon death of the parent further

premium need not be paid but the child will get all benefits of the policyd. Invest in a child care plan but not opt for premium waiver rider because that involves additional

cost

5. Unit Linked Insurance Plans are most suited under which of the following conditions?

a. Ideal for under insured personsb. Suitable for persons who are adequately insured and are prepared to take some risks for

better returnsc. Suitable for investors with short term objectived. Suitable for people looking for maximizing insurance cover on minimum premium payments

6. Unit Linked Insurance Plans are basically:

a. Short term and Low cost insurance plansb. Low cost investment plans with no riskc. Market related plans with emphasis on investmentsd. Market related plans with emphasis on insurance

7. In respect of Unit Linked Insurance Plans which of the following statements is true?

a. The returns are assuredb. No risk investment plansc. The return shown by way of past performance is on the entire amount of premium paid by the

policy holderd. Only a certain percentage of premium is invested in securities and a good amount, is deducted

for various expenses, especially in the first few years


8. A young and aggressive investor, who is already adequately insured, should choose which of thefollowing options in a ULIP plan?

a. Aggressive/Growth plan which predominantly invests in equitiesb. A conservative or protector plan which predominantly invests in bonds and government

securitiesc. The choice is immaterial as all funds tend to perform equally well over longer periods of timed. A higher insurance cover with lower risk investment option ; say liquid fund/bond fund

9. An investor who wants to invest in immediate pension plan seeks your advice on what option tochoose. He is 50 years of age and he expects to live for another 30 years at least. Which one ofthe following options is suitable to him?

a. Guaranteed pension for 5 years - offering 7% p.a.b. Guaranteed pension for 20 years - offering 6.5% p.a.c. Guaranteed pension for life and there after to his spouse -offering 7% p.a.d. He should be advised to invest in a mutual fund rather than pension plan of a life insurance

company

Answers:

1. b

2. b

3. d

4. c

5. b

6. c

7. d

8. a

9. c


Chapter 10


A Mutual fund is a collective investment vehicle where the resources of a number of unit holders arepooled and invested as per objectives disclosed in the offer document. A mutual fund is set up as

a trust which supervises the function of An Asset Management Company (AMC) which manages theinvestments collected in the mutual fund schemes.

A mutual fund investor enjoys the following advantages

1. Professional managementThe funds are invested by professional fund management team that analyses the performance andprospects of companies and selects suitable investments in line with the objectives of the schemes.

2. DiversificationIt is impossible for a small investor to diversify across different investment vehicles as well as over alarge number of companies. He invariably runs the risk of non diversification on his investments becauseof low capital. The mutual fund provides him the best option where on a small capital invested the unitholder gets a diversified portfolio.

3. Regulated operationThe mutual fund administration and fund management are subject to stringent regulations by SelfRegulatory Organisation voluntarily set up mutual funds – viz. Association of Mutual Funds of India(AMFI) and also by Securities and Exchange Board of India (SEBI). Thus the interest of the investors iskept protected.

4. Higher returnsAs these funds are well managed and well diversified they tend to perform better than the market overa longer period of time; there is potential for the unit holders to get better returns compared to fixedincome avenues over a longer period of time.

5. TransparencyThe NAV’s of open ended funds are disclosed on a daily basis while the portfolio is disclosed on amonthly basis ensuring transparency to the investors.

6. LiquidityOpen ended funds can be redeemed at any time; there is no lock-in period; provides excellent liquidity;the redemptions are also very fast and investors in equity funds tend to get money back

7. Tax BenefitsMutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The unitholders also enjoy certain tax benefits on the income earned; the capital gains made and on amountinvested in certain types of funds.

Mutual Funds


8. FlexibilityMutual funds offer a lot of flexibility where the investments can be lump sum investments or Systematicinvestment Plans on a monthly/quarterly basis with very small amounts of investments. Withdrawal canbe also full or part or on a systematic basis.

What is the history of Mutual Funds in India and role of SEBI in mutual funds industry?Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Governmentallowed public sector banks and institutions to set up mutual funds.

In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives ofSEBI are – to protect the interest of investors in securities and to promote the development of andregulation of the securities market.

As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds toprotect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter,mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulationswere fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issuedguidelines to the mutual funds from time to time to protect the interests of investors.

All mutual funds whether promoted by public sector or private sector entities including those promotedby foreign entities are governed by the same set of Regulations. There is no distinction in regulatoryrequirements for these mutual funds and all are subject to monitoring and inspections by SEBI. Therisks associated with the schemes launched by the mutual funds sponsored by these entities are ofsimilar type.

How is a mutual fund set up?A mutual fund is set up in the form of a trust, which has sponsor, trustees, an asset managementcompany (AMC) and a custodian. The trust is established by a sponsor or more than one sponsor whois like promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unitholders. Asset Management Company (AMC) approved by SEBI manages the funds by makinginvestments in various types of securities. Custodian, who is registered with SEBI, holds the securitiesof various schemes of the fund in its custody. The trustees are vested with the general power ofsuperintendence and direction over AMC. They monitor the performance and compliance of SEBIRegulations by the mutual fund.

SEBI Regulations require that at least two thirds of the directors of trustee company or board of trusteesmust be independent i.e. they should not be associated with the sponsors. Also, 50% of the directors ofAMC must be independent. All mutual funds are required to be registered with SEBI before they launchany scheme.

What is Net Asset Value (NAV) of a scheme?The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV). Mutualfunds invest the money collected from the investors in securities markets. In simple words, Net Asset Valueis the market value of the securities held by the scheme. Since market value of securities changes everyday, NAV of a scheme also varies on day to day basis. The NAV per unit is the market value of securities ofa scheme divided by the total number of units of the scheme on any particular date. For example, if themarket value of securities of a mutual fund scheme is Rs 300 lakhs and the mutual fund has issued 10 lakhsunits of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.30. NAV is required to bedisclosed by the mutual funds on a regular basis - daily or weekly - depending on the type of scheme.


Different types of mutual fund schemes

Schemes according to Maturity PeriodA mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending onits maturity period.

Open-ended Fund/ SchemeAn open-ended fund or scheme is one that is available for subscription and repurchase on a continuousbasis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell unitsat Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.

Close-ended Fund/ SchemeA close-ended fund or scheme has a stipulated maturity period e.g. 3- 5 years. The fund is open forsubscription only during a specified period at the time of launch of the scheme. Investors can invest inthe scheme at the time of the initial public issue and thereafter they can buy or sell the units of thescheme on the stock exchanges where the units are listed. In order to provide an exit route to theinvestors, some close-ended funds give an option of selling back the units to the mutual fund throughperiodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exitroutes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges.These mutual funds schemes disclose NAV generally on weekly basis. The market prices in respect oflisted close ended funds tend to be at a discount to NAV. Similarly when mutual funds offer limitedrepurchase on a periodic basis at intervals they charge a hefty exit load especially in the first few yearssince inception – the loads tend to get smaller as more time elapses. Thus the liquidity in close endedfund comes with a cost higher than open ended funds.

Schemes according to expensesLoad funds and no load funds: Funds which collect charges at the time of entry or exit or both from theinvestors are known as load funds. Funds which do not collect any of these charges at all are called “Noload funds” - Issue expenses; distribution and marketing expenses are borne by AMC’s or sponsors.However AMC’s are allowed to charge higher management fees in respect of no load funds comparedto load funds. Load charged at the time of purchase is called entry load while load charged at the timeof redemption is called exit load. Mutual funds want investors to invest for longer terms with them.Hence some times they charge a Contingent Deferred Sales Charge (CDSC) which will be charged onlyif the investor exits the fund before a certain period of time – say 6 months; this motivates the investorsto stay invested in the fund for at least that period of time.

SEBI has stipulated the maximum load that can be charged by mutual funds and how the same can belevied. Initial expenses should not exceed 6% of initial resources raised/funds mobilized under the scheme.

In respect of a New Fund Offer (NFO) – launch of a new mutual fund scheme – the offer documentwhich is also called KIM (Key information memorandum) should contain all details regarding expenses.If the fund charges entry load of say 2.25% then the initial investors in the fund will be sold units of FaceValue Rs 10.00 at a price of Rs 10.225 and in respect of existing fund the load will be charged atspecified rates on closing NAV for the day.

Schemes according to Investment ObjectiveA scheme can also be classified as growth scheme, income scheme, or balanced scheme consideringits investment objective. Such schemes may be open-ended or close-ended schemes as described


earlier. Such schemes may be classified mainly as follows:

Growth / Equity Oriented SchemeThe aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemesnormally invest a major part of their corpus in equities. Such funds have comparatively high risks.Growth schemes are good for investors having a long-term outlook seeking appreciation over a periodof time.

Income / Debt Oriented SchemeThe aim of income funds is to provide regular and steady income to investors. Such schemes generallyinvest in fixed income securities such as bonds, corporate debentures, Government securities andmoney market instruments. Such funds are less risky compared to equity schemes. These funds are notaffected because of fluctuations in equity markets. However, opportunities of capital appreciation arealso limited in such funds. The NAVs of such funds are affected because of change in interest rates inthe country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and viceversa. However, long term investors may not bother about these fluctuations.

Balanced FundThe aim of balanced funds is to provide both growth and regular income as such schemes invest both inequities and fixed income securities in the proportion indicated in their offer documents. These areappropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debtinstruments. These funds are also affected because of fluctuations in share prices in the stock markets.However, NAVs of such funds are likely to be less volatile compared to pure equity funds.

Money Market or Liquid FundThese funds are also income funds and their aim is to provide easy liquidity, preservation of capital andmoderate income. These schemes invest exclusively in safer short-term instruments such as treasurybills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc.Returns on these schemes fluctuate much less compared to other funds. These funds are appropriatefor corporate and individual investors as a means to park their surplus funds for short periods.

Gilt FundThese funds invest exclusively in government securities. Government securities have no default risk.NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as isthe case with income or debt oriented schemes.

Index FundsIndex Funds are equity funds and they replicate the portfolio of a particular index such as the BSE Sensex,S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising anindex. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though notexactly by the same percentage due to some factors known as “tracking error” in technical terms. Thesefunds are also called “passive funds” as not much fund management skills are involved and these funds areexpected to perform in line with the market. The expenses of fund management tend to be lower in indexfunds and these funds are suitable to investors who are happy with market returns.

Exchange Traded Funds (ETF)ETF’s are traded like stocks and thus offer more flexibility than conventional mutual funds. Investorscan purchase or sell ETF’s at real time prices as against day end NAV’s in case of open ended mutual


funds. ETF’s provide investors an opportunity to take advantage of intra day swings in the market andcan be used to hedge their long positions in the equity market. ETf’s are cheaper than even Index fundsbut in the Indian market place this concept has not picked up. NIFTY Bees and UTI SUNDER are twolisted ETF’s. These are traded on very low volumes with a high spread between bid and offer prices –higher spread increases the cost and decreases the attractiveness of the ETF.

Sectoral FundsA mutual fund house may feel that a particular industrial sector may perform better than other sectors andthat this sector offers tremendous growth opportunities over a period of time compared to other sectors.They may launch a sector specific fund and the funds mobilized in this scheme would be invested in equitiesof companies of that sector. For example a Pharma fund will invest in equities of pharmaceutical companiesonly and not in other industrial sectors. These are high risk funds and the returns can also be higher.

Thematic FundsA fund house may feel that some sectors as a theme may outperform other securities because ofgovernment policies, consumer preferences, over all market conditions, etc. The fund house may launcha thematic fund and invest the funds collected only in companies which are connected with the specifictheme. For example An infrastructure fund is not a sectoral fund as it will not fund only in one sector butinvest in companies which are involved in infrastructure – cement, steel; engineering; construction,telecommunication, etc. These are slightly less risky compared to sectoral funds but more risk incomparison with diversified equity funds. Funds classified on the lines of market caps like Small CapFund; Mid Cap Fund or Large Cap funds can also be considered as thematic where the theme is“market capitalization”.

Offshore fundsIndian mutual funds have been permitted to invest overseas. Some mutual fund houses have alreadylaunched schemes which seek to invest a certain percentage of their corpus in foreign companies whichare listed and traded outside India. These funds are unique in that they offer diversification acrossgeographies, for the first time, to Indian investors.

Commodity FundsThese funds make investments in different commodities directly or through commodities futures contractsand also invest shares of companies dealing in commodities. Typically they must invest in one commodityor a diversified set of commodities – A gold fund invests only in gold whereas a metal fund may invest inprecious metals and base metals like gold, silver, platinum, copper, nickel, zinc, etc. These funds servethe purpose of diversification across asset classes as direct investments by retail investors in commoditiesis virtually impossible due to various physical constraints.

Real Estate FundsThese funds invest in properties directly or indirectly by lending to real estate developers or buyingshares of real estate and/or housing finance companies which are expected to benefit from real estateboom. Mutual funds in India are all set real estate funds as the norms have been cleared recently bySEBI. Retail investors can take advantage of real estate boom through this indirect investment in realestate even on a lower capital.

Tax Saving FundsEquity linked Saving Schemes of mutual funds with a lock in period of 3 years come with a tax benefitalso. Investments in these schemes qualify for deduction u/s 80C of the Income Tax Act within the


overall ceiling of Rs. 1,00,000/-. Many fund houses have launched ELSS and these funds have rewardedthe investors handsomely. These schemes tend to get open ended after the initial lock in period of 3years for the investors.

Approved pension plans of mutual funds also enjoy tax benefit u/s 80C of the Income Tax Act. Pensionfunds designed by UTI mutual fund called “Retirement benefit plan” and that of Templeton Investmentscalled ‘Templeton India Pension Plan” are basically balanced funds where the investors tend to save incometax at the time of investment – these plans are suitable to long term investors who would like to takemoderate risk as against high risk in ELSS tax saving plans. The lock in period is 3 years but mutual fundshave fixed age limits for entry as well for getting pension – as these plans are retirement plans in nature.

Expenses charged by mutual fundsMutual fund investors in India tend to assess a fund’s performance based only on the NAV basis. The firstand last question on their minds is ‘what returns has the fund given?’ Rarely, if ever, do they ask questionslike ‘how much is the fund charging me? What goes into the expenses? Is it possible for the fund house tolower the expenses?’ The returns to the investor can sometimes change substantially through lower expensescharged by the AMCs especially in debt funds or under-performing equity markets.

Mutual funds charge 3 kinds of expenses to the funds:

1. Initial issue expenses

2. Investment management and advisory fees charged by AMC

3. Recurring expenses marketing and selling expenses, audit fees, custodial charges, Trustee fees, etc.Initial issue expenses were allowed to the extent of 6% of funds mobilized and these expenses wereallowed to be charged to the fund over a period of 5 years. These expenses were being charged overa period of time and are typically borne by investors who stay invested and not by some initial investorswho might have redeemed and exited the fund in a short span of time. This provision had the effect ofpenalizing long term investors and was proving beneficial to short term investors. It has been recentlyamended by SEBI – now open ended funds can not charge issue expenses to the fund separately overa period of time and the initial expenses will be part of the recurring expenses permitted to be incurredby them as well as entry load, if any. However close ended funds can charge initial issue expenses asper prescribed maximum limit of 6% and amortize the same over the term of the plan and charge thesame to the investors exiting the funds as entry load before the end of the term for which the fund willremain close ended.

Investment management charges

Fund management expenses for equity funds


Fund management expenses for “No Load’ equity funds

The percentage is computed on weekly average net assets managed by the AMC.

Total expenses that can be charged to the funds are subject to the following ceilings:

Total expenses permitted on equity funds

Average weekly Net Assets

Valuation of mutual fundsMutual funds are required to declare their NAV’s on daily/weekly basis. The reported NAV is a functionof valuation of underlying securities and therefore it is relevant to know how a mutual fund should valuetheir securities. SEBI has issued guidelines regarding valuations of assets held.

Valuation of traded securities: The closing price on the stock exchange where it is mainly traded is takenfor valuation purpose. If it is not traded on a given date the value of the previous day is used.

Valuation of non-traded securities: Where a security is not traded on any stock exchange for 60 days ormore prior to valuation date, it is treated as “Non Traded security”. Such a security will be valued “ingood faith” on the basis of appropriate valuation method, which shall be periodically evaluated by thetrustees and reported by Auditors as fair and reasonable.

Debt instruments and Government securities are valued on a Yield to maturity basis with adequatediscounts for illiquidity, if any, in respect of a given security.

Many Money market instruments are valued at cost plus accrual basis and some instruments, of mediumterm, at current yield basis.

Taxation of mutual fundsIncome earned by mutual funds is tax free u/s 10 (23D) of the Income Tax Act.

Taxation of investors

Equity Oriented fundsEquity oriented funds are growth funds, equity funds; derivative funds, etc. where 65% or more of thetotal corpus has been invested in equities. Previously this limit was 50%.


Dividends distributed by these funds are tax free in the hands of the investor u/s 10 (35) of the IncomeTax Act. The mutual fund is also not required to pay any Dividend Distribution Tax.

Taxation on equity oriented funds of different entities:

STCG indicates Short Term Capital gains made on selling the equity-oriented fund within one year ofpurchase

LTCG – Long Term Capital Gains made on selling the equity oriented fund after having held it for oneyear or more from the date of purchase. This is applicable to all equity oriented funds including closeended funds

DDT – Dividend Distribution Tax payable by the mutual fund

Other than equity oriented funds

Where STCG – indicates short term capital gain wherein the mutual fund has been sold within one yearof purchase.

LTCG* – Long Term Capital Gain, where the mutual fund has been sold after a holding period of 1 yearor more – 10% tax is payable without indexation or 20% with indexation.

DDT – dividend distribution tax is payable on the amount of dividend to be distributed – the rate oftaxation depends on the identity of the investor and class of assets held under fund management.

Dividends of Non equity funds are also tax free in the hands of investor but dividend distribution tax ispayable by the mutual funds. It may be noted that DDT impacts the return to the investor indirectlybecause DDT is paid out of the funds thereby affecting NAV of the fund.

Double Indexation BenefitDouble indexation benefit in respect of debt funds and fixed maturity plans: Investors who are riskaverse prefer debt funds. But these funds also face interest rate risk especially at a time when the


interest rates are not stable and showing signs of moving up. Hence investors prefer to lock in theirfunds in debt funds which are fixed maturity plans where the mutual funds invest the corpus in debts thatshall mature at a fixed time in future, say 18 months or 24 months or 36 months. The yield on thesebonds/government securities are typically Held to Maturity (HTM) yields and hence there is no risk ofcapital loss on account of interest rate fluctuations. The investors are sure of the return that can beexpected from these FMP’s. Further indexation benefits are also available on these plans and hence therate of taxation is also lower.

Example:

n An investor invests in a 15 month FMP in March 2005 maturing in May 2006. If he invests Rs.10,000/- and if the return expected FMP is about 8% p.a. he will get Rs. 11,000/- after 15 months.

n If the investor is in the 30% tax bracket even when he earns 8% p.a. on fixed income instrumentshis tax adjusted yield will be only 5.6%.

n However in an FMP Rs. 1,000/- earned by him will be treated as Short Term Capital Gain and thetax payable is 20% of the taxable capital gains after applying inflation index.

n The Inflation index for FY 2004 -2005 is applicable for purchase; which we shall assume to be 1.Assuming inflation rate of 5% p.a. the inflation index for FY 2006-2007 will be 1.1025.

n In the given example Rs. 10,000/- has given capital appreciation of Rs. 1,000/-. The indexed costof acquisition works out to 10000*1.1025/1 = Rs 11,025/-

n The maturity value is Rs. 11,000/-

n Thus the taxable short term capital gains is 11000-11025 = -25 resulting in a nominal loss.

n Hence tax payable on this investment is NIL.

n The investor in this FMP has earned 8% virtually tax free because of indexation benefits.

Short term loss on Dividend StrippingInvestors used to resort to tax planning through dividend stripping in equity funds. They invested infunds that declared a very high percentage of dividends. They used to purchase these units cum dividendand sell them at ex dividend NAV’s almost immediately with very little market risk involvement. Thus,these investors received tax free dividends from mutual funds and suffered notional short term capitalloss because ex dividend NAV’s used to be substantially lower compared to cum dividend NAV’s atwhich the units were purchased. But now with amendment in the Income Tax act in respect of allowingcapital loss on mutual funds these planning methods have become virtually impossible. Short termcapital loss will be allowed only if the investor had bought the units at least 3 months before record datefor dividend or sold the units at least 9 months after the record date for dividend purpose. If transactionsof purchase and sale of mutual funds have been done within the period specified above resulting incapital loss then the same will be treated as dividend stripping and actual loss, if any, in excess ofdividend amount only will be allowed as short term capital loss.

ExampleMr. Devesh Patel buys 1000 units of a fund for Rs. 12.50 cum dividend on 10th March 2006; he receivesdividend of Rs. 2.00 per unit on 14th March 2006 and he sells the units on 15th March 2006 at a price ofRs. 10.20. What is the short term capital loss incurred by Mr Patel for income tax purpose?

Mr. Patel has not bought 3 months prior to record date for dividend nor has he sold 9 months after the record


date for dividend. Hence short term capital loss will be limited to actual loss as per calculations given below;

Sale Value Rs. 10200

Purchase value Rs. 12500

Loss Rs. 2300

Dividend received Rs. 2000

Permitted short term Rs. 300 and not Rs. 2300

capital loss

Short term loss on bonus strippingIf a person acquires units of UTI or any mutual fund, within a period of 3 months prior to the record datefor distribution of bonus units and sells or transfers any of the originally acquired units within a period ofnine months after such record date, while retaining all or any of the bonus units, then loss, if any, arisingfrom such transactions shall be ignored and the amount of such loss shall be deemed to be the cost ofacquisition of the bonus units.

Wealth Tax: Ownership of units of mutual funds is not wealth as per definitions of Wealth Tax Act andhence mutual funds are not chargeable to wealth tax.

Service standards of mutual fundsMatters of dispatch of statement of accounts, redemption cheques, etc. are promptly attended to byRegistrars who are appointed by Mutual funds for providing these services. Forms for fresh investmentsare collected through the collection centres and designated banks and sent to centralized processingoffices of the Registrars.

Telephonic access: Almost all mutual funds have provided toll free numbers or customer help desk telephonenumbers in major cities to help the investors with their queries relating to their mutual fund investments.

Internet access: Mutual funds provide investors with PIN (Personal identification Number) and enablethem to watch their investments, online, through the internet. They can contact mutual funds through email for various investment related services.

Transparency: SEBI has made many mandatory provisions that shall ensure that the interest of thesmall investors in mutual fund is protected. Disclosure of daily NAV’s in open ended funds; weeklyNAV’s of close ended funds; Monthly fact sheets; detailed annual account statements; etc. are someexamples of transparency efforts.

Redemptions: Liquidity is a very great attraction in mutual funds. An investor in an open ended fund canredeem his holdings partly or fully at any time without giving any notice to the mutual fund and the redemptionsin most equity funds take place on T+2 basis while in respect of debt funds it is even better at T+1 basis inmost cases. T is the day when redemption request is received before fixed hours. The additional number ofworking days for actual payment of redemption is just 2 in many cases, which is extremely good from aliquidity point of view. In respect of liquid funds; money market funds, etc. the redemptions received beforea stipulated time are made in a matter of hours – here the time is the essence.

In general, the service standards set by the mutual fund industry in India are quite high and the investorshave little to complain about.


Types of Investment plans

Automatic Reinvestment Plans (ARP): Mutual funds generally offer Growth Plans and Dividend Plansin their schemes. Under Dividend Plan an investor may opt for Dividend Pay Out or DividendReinvestment. In growth plan no dividend distribution is made and the NAV keeps on growing. In Dividendplan the fund may choose to declare a dividend after the NAV has appreciated substantially. UnderARP these dividends are automatically invested in units at ex dividend NAV’s and here the number ofunits keeps on increasing. Under Dividend Pay out option the investor gets cash payment of dividend.The financial planner would be in the best position to advise the investor on which option to choose.

Systematic Investment Plan (SIP): Mutual fund investments, especially equity funds, are essentiallylong term in nature. In the short term the equity funds may yield negative returns as well. Investors whomight have made lump sum investments at market peaks may feel let down by the mutual funds – It isalso our experience that mutual fund collections in equity funds are the highest around market peaks.The retail investors cannot time the market. Further most investors receive their incomes on a monthlybasis and would be more comfortable investing on a monthly basis rather than lump sums at intervals.To meet all these needs mutual funds offer SIP’s where the investors can invest in select funds onsystematic basis (monthly or quarterly) on pre determined dates for a pre determined period say 6months; 1 year; 5 years and so on. Thus SIP’s serve the purpose of “Rupee Cost Averaging’ strategy ininvestments and investors get much better returns without the heart burn of falling markets, in the shortterm. In order to encourage SIP’s funds were not charging any loads when investors opted for this routebut now most funds treat SIP’s on par with lump sum investments regarding expenses, etc.

Systematic Withdrawal Plans (SWP): Many investors need periodic income; say on a monthly basis ontheir investments. These people tend to invest in a lump sum, mainly in income funds or floating rate funds,etc. and opt for SWP. In SWP they specify the amount and the periodicity of payments – part of the unitholdings are redeemed automatically at prevailing NAV’s and paid to the investor as systematic withdrawal– subject to a minimum balance to be maintained by the investor. These are convenient for retired persons.

Systematic Transfer Plans (STP): These plans are suitable for investors who would like to invest largesums in equity funds but who do not want to time the markets. These investors prefer to park the lumpsum amounts in a debt fund/floating rate funds and opt for STP where on a periodic basis, a fixedamount is transferred, on a specified date from Debt fund to a chosen equity fund. This serves theadvantage of SIP while the lump sum enjoys market related returns.

Mutual funds offer a variety of products to suit almost every conceivable need of the investor. Theoptions are so many in number that they tend to confuse the retail investor. A financial planner has avery important role in helping the investor select the funds, plans, strategies, etc. most suitable to him,from the point of risk profile, taxation, meeting the investment objectives, achieving financial goals, etc.

Performance of mutual funds

MeasurementInvestors are very keen on fund performance and the alert ones keep watching the fund performancevery frequently – even on a daily basis. Each fund is evaluated and compared with the performance ofthe market and other funds in the market. The performance of a fund manager is generally evaluated ontwo counts:

1. The ability to out perform the market and deliver superior returns

2. The ability to eliminate unsystematic risk through diversification.


Change in NAV is the most common performance measure used by investors. However the limitationhere is that this formula does not take into considerations the dividends distributed during the period.Hence NAV’s of growth plans are considered for the purpose of measuring performance. Sometimesdividend distribution is added to the difference in NAV’s to measure the performance.

ExampleLet us assume that Mr. Bose had invested Rs. 10,000/- in a new fund offer at a unit price of Rs. 10/- witha load of 2.5%. After one year he finds that the NAV has gone up to Rs 15/-. The total returns earned byMr. Bose will be calculated as follows:

Unit price paid by Mr. Bose will be Rs. 10+0.25 (entry load) = Rs. 10.25

No of units allotted to him in NFO will be Rs. 10,000/10.25 = 975.61

If he sells after one year he will get 975.61*15 = 14634.15

Gains made by Mr Bose = 14634.15 – 10,000 = 4,634.15 assuming no exit load and no dividend pay outduring the one year period

Even though the NAV has gained 50% in one year the actual returns to Mr. Bose works out to 46.34%due to the entry load.

Please remember that when funds announce on a periodic basis the returns earned over one year; twoyears; three years; since inception etc. it is assumed that units have been bought at Rs. 10/- and loadshave been ignored in this calculation of performance.

Risk adjusted performance measurementMany magazines and internet sites rank funds on the basis of performance over a given period of time.These performances are absolute performances and the risks taken by fund managers are not takeninto consideration in this evaluation and comparison. Two funds may show same returns but their riskcharacteristics could be dramatically different and these funds may perform very differently when themarket goes up or down. A useful comparison can be achieved only when risk adjusted returns arecalculated. We have dealt with measuring risk adjusted returns in earlier topics. It may be worthwhile torecall some very important performance measures here.

Sharpe Index

Rp – Return of the portfolio

Rf – Risk free return

SD – Standard Deviation of Portfolio (total risk)

Treynor Index

RP - Rf

Beta

RP - Rf

SD


Beta is the measure of market risk of the portfolio

Jensen’s index = Rp –[Rf + (Rm- Rf)*B]

Rp – return on the portfolio

Rf – risk free return

Rm – Market return (Index return)

B – Beta of the portfolio

ExampleLet us try to compare two funds with the following information on returns and the risk; given that risk freereturn is 8%.

Sharpe Index

Fund A = (14-8)/10 = 0.6

Fund B = (18-8)/18 = 10/18 = 0.555

Market = (12-8)/8 = 4/8 = 0.5

Treynor Index

Fund A = (14-8)/1 = 6

Fund B = (18-8)/1.5 = 6.66

Market = (12-8)/1 = 4

Jensen’s index

Fund A = 14% - [8%+(12-8)*1] = 2%

Fund B = 18% -[8%+ (12-8)*1.5] = 4%

Other performance measuresExpense ratio: The expense ratio is an indicator of the fund’s cost effectiveness and efficiency. It isthe ratio of total expenses to average net assets of the fund. Expense ratio must be evaluated from thepoint of fund size, average account size and portfolio composition – equity or debt. Funds with smallcorpus will have a higher expense ratio compared to a fund with a large corpus. Naturally higherexpense ratio will affect fund performance adversely. It is important to note that brokerage andcommissions on the fund’s transactions are not included in the expenses figure of the fund whilecomputing the expense ratio.

Income Ratio: Income ratio is defined as fund’s net investment income divided by net assets for theperiod. This ratio is a useful measure for evaluating income oriented funds, particularly debt funds. Thisratio is used in conjunction with ratios like total return and expense ratios.


Benchmarking relative to marketIndex Funds: An investor expects an index fund to perform in line with the market and he does notexpect the fund to out perform the bench mark index. Any difference between fund returns and themarket returns is tracking error. The lower the tracking error, the better the performance of the fund inreplicating the underlying market index.

Sectoral funds: A sector specific fund is expected to perform in line with sector index. For example aPharma fund should perform in line with Pharmaceutical Index. It is easier to evaluate performancebecause many sector indices are available facilitating easy comparison.

Active Equity Funds: Most equity funds are actively managed. The offer document generally spellsout the relevant market index they will be bench marking their performance to. While disclosingperformance on a periodic basis fund houses give out the fund performance as well as that of therelevant bench mark index and this facilitates easy comparison. It becomes easier for the investor tofind out the extent of under performance or out performance of the specific fund in relation to benchmark index.

Debt Funds: Generally investors have used interest rates on term deposits with banks as bench markfor assessing the returns on debt funds for a matching maturity. However the debt funds comprise ofcorporate debt securities and/or government securities. Ideal bench marking would depend up on thecomposition of debt instruments in the debt – for example A GSec Fund of GILT fund should bebenchmarked to returns on Government Securities rather than bank fixed deposits.

Money Market Funds: These funds have invested in short term instruments. Hence, performance ofmoney market funds is usually bench marked against the treasury bill of matching period.

Benchmarking relative to other similar mutual fundsWhile choosing investors have preferred to invest funds that have performed better in relation to otherfunds in the same category. There is a tendency to rank funds on the basis of their past performanceover a given period of time; say 1 year; 2 years ; 3 years or 5 years and invest in top performing funds inthat category. It is important to keep track of the nature of underlying investments; investment objectivesof the funds and risk profile also while comparing different funds.

Choosing the right mutual fundThere are a large number of mutual funds. Their number is increasing day by day. The financial plannershould have clear idea of relative merits of various funds in terms of risk, returns, track record ofperformance, etc.

He should have a good idea of the investment objectives of his client taking into consideration factorslike time horizon, risk appetite, return expectations, etc

Then he should arrive at an optimal mix of asset classes that would best meet the investment objectives.

Based on these factors and his evaluation of performance of funds he should suggest a portfolio offunds that will add value, over time, through strategic asset allocation.

The real skill of a financial planner is in first arriving at a good mix of investment options and thenselecting the best funds that would deliver the desired results.

Latest changes in mutual fund industryOnly close-ended schemes will be allowed to charge initial issue expenses from investors. Even here,when a close-ended scheme is amortizing such expenses over a period, if an investor somehow exits


the scheme before such amortization is complete, the remaining part of the expenses attributable to himmust be recovered from him; which is done through gradually reducing exit loads.

This is a positive move and will prevent the likelihood of shifting the burden of expenses from oneinvestor to another. Till now, open-ended schemes were also allowed to amortize the expenses and if asignificant part of the investors of an NFO redeemed their units, this had the potential to increase theburden of the initial issue expenses upon the remaining investors tremendously. But with the newregulation, that will no longer be the case and the expenses will be rightfully borne by the person who issupposed to pay them.

In another amendment, SEBI has standardized the process of declaring and distributing dividends.Among other guidelines related to the communication of dividend distribution, SEBI has stated that thenotice of dividend should be issued by the AMC within one day of the decision by the trustees todistribute the dividend. Further, the record date for such dividend should be 5 days from the issuanceof the notice. Before the issuance of notice, no communication indicating the probable date of thedividend declaration should be made.

It has been observed over years that New fund offers manage to collect substantial subscription duringthe NFO period while existing funds with very good track record do not manage to collect additionalinvestments at the same rate, Hence fund houses have developed tendencies to come out with NFO’sto boost the Assets Under Management (AUM). SEBI has stipulated that a mutual fund may come outwith NFO’s only if the new fund has something new to offer to the investors and the investment objectivesare unique and different from the funds already managed by the fund house. SEBI has placed theresponsibilities on Trustees of mutual fund that they should declare that the NFO is new in terms of itsinvestment objective and does not in any way replicate the existing funds of the mutual fund.

Mutual fund industry has recorded tremendous growth over the last few years. It is expected to maintainthe growth rate in future. A look at the following figures will prove the popularity of mutual funds in India.

Investors seem to prefer mutual funds compared to other investment vehicles – that is obvious from thefact that total assets under management of mutual funds have gone up by a whopping 225% over aperiod 3 ¼ years. Investors are willing to take more risk for the sake of higher returns as evidenced fromthe fact that equity funds account for 31% of total AUM of mutual funds as on 31st July 2006 comparedto just 11.21% in April 2003.


Review Questions:

1. How many units will be allotted to Mr. Chaturvedi if he invests Rs. 1 lakh in a New Fund offer of anequity fund, which charges entry load of 2.25%?

a. 10,000 unitsb. 9779.951 unitsc. 9756.098 unitsd. 9779 units

2. The risk measure used for calculating Treynor Index is:

a. Alphab. Variancec. Betad. Standard Deviation

3. Which of the following is a self regulatory organization in mutual fund industry?

a. SEBIb. AMFIc. RBId. Company Law Board

4. Which one among following funds can be considered riskier than the others?

a. Debt Fundsb. Index Fundc. Diversified equity fundd. Sector specific equity fund

5. Which one of the following statements is not true about mutual funds?

a. Mutual fund can lend securitiesb. Mutual fund can trade in derivativesc. Mutual fund can invest in foreign equitiesd. Mutual fund can lend money to unit holders

6. While seeking SEBI approval for new funds which of the following is required to give a declarationthat the new fund is unique in its investment objectives?

a. Directors of Asset Management Companyb. Directors of Sponsor Companyc. Registrarsd. Trustees

7. Initial issue expenses, not exceeding 6% of funds collected, can be amortized in the subsequentyears, in the following cases only:

a. Close ended fundsb. Open ended equity fundsc. Open ended debt fundsd. Exchange Traded Funds.


8. In respect of index funds the difference between fund performance and the market performanceis called:

a. Under performance of the fundb. Out performance of the fundc. Tracking errord. Superior returns over market returns

9. Which of the following is the best measure of a fund performance?

a. NAV related performance over the periodb. Risk adjusted performancec. Absolute returns in comparison with bank depositsd. Absolute returns in comparison with risk free returns

10. In respect of a “No load fund” which one of the statements is not true?

a. Asset management, custodial, registrar and administrative and selling expenses are not chargedto the fund

b. Asset management and other recurring expenses are charged to the fundc. “No load” funds are permitted to charge higher fund management expenses compared to

“Load funds”d. No load refers to the entry load at the time of NFO – the units are allotted at par to the NFO unit

holders

Answers:

1. b

2. c

3. b

4. d

5. d

6. d

7. a

8. c

9. b

10. a


Chapter 11


One of the most important asset classes is equity shares. In a client’s portfolio the equity investments– direct and indirect form an essential component. We have discussed indirect equity investments

through the mutual fund route. We shall now deal with direct investments in shares. An investor has thechoice between primary and secondary markets to invest in stocks.

Primary market

Certain eligible companies may tap the capital market for their capital requirements. Eligibility criteriahave been laid down by SEBI – the capital market regulator, and discussed in this chapter elsewhere.The eligible companies who need funds approach SEBI registered Merchant Bankers for tapping thecapital market. The merchant bankers advise the company on matters of regulation, compliance withstatues, marketing, pricing, timing and other issues which are of vital importance. Where the issue sizeis large companies prefer to appoint more than one merchant banker for this purpose – with specificfunctions. As per the advice of the merchant banker a company may choose to issue shares with fixedprice or a price band where the price will be discovered in a book building process. The company maybe entering the capital market for the first time where upon its shares are to be listed on the stockexchanges – such an issue is called Initial Public Offering (IPO). An existing listed company may comeout with a subsequent issue to raise capital and such an issue is called “Follow on Public Offering (FPO)

Fixed price issues: These are issues where a company enters the capital market and invites subscriptionfrom the public to its issue of equity capital at a fixed price – at par or at a premium. Fixed price issueswas the norm until some years ago, especially before the book building concept was introduced in Indiabut now we find more and more companies adopting the book building route to raise capital.

Book building issues: Here the companies announce a price band for the issue and the investors canexercise their options in the application and bid for the same at whatever price they are prepared to payfor the issue – but within the price band. The price band essentially consist of two prices the floor priceand the cap price. The difference between the two cannot be more than 20%. In case of an FPO thelisted company can announce the price band just a day before the issue opens for subscription while inthe case of IPO’s the price bands are mentioned in the application form itself.

The bid lots are also decided by the issuer. Essentially a person applying for a book building offer ofshares shall bid in multiples of prescribed lot sizes and within the price band. The bidder can make threebids in the prescribed application form and can also revise or withdraw his bid before the close of theoffer. Here the investor has the freedom to decide the price at which he shall be interested, of coursewithin a band. Individuals in single or joint names, HUF’s, Body Corporate, Banks and Financial Institutions,Mutual funds, Non Resident Indians, Insurance Companies, Venture capital funds and others can applyfor the issues. In order to present a level playing field for the small investors SEBI has stipulated that acertain minimum percentage of the issued shares should be reserved for allotment to “Retail IndividualInvestors” in case of over subscription of the issue. The reservation for retail individual investors is 35%of the net public offer and in the event of the issue getting oversubscribed it should be ensured that atleast 35% of the shares are allotted to retail individual investors. ‘Retail individual investor’ means an

Stock market investments


investor who applies or bids for securities of or for a value of not more than Rs.1,00,000 The allocationfor non institutional investors, who are not retail investors, the reservation is 15% and the reservation forqualified institutional bidders (QIB) the reservation is 50%.

Subscription list for public issues shall be kept open for at least 3 working days and not more than 10working days. In case of Book built issues, the minimum and maximum period for which bidding will beopen is 3–7 working days extendable by 3 days in case of a revision in the price band. The public issuemade by an infrastructure company may be kept open for a maximum period of 21 working days. Rightsissues shall be kept open for at least 30 days and not more than 60 days – “rights” issues are issues ofcompanies to raise further capital but only existing share holders of the company are entitled to apply forthe same; the rights can be renounced by an existing share holder, in which case the renouncee getsthe right to apply for the shares. The retail investor can tender his bids at the specified centres where hisbids will be accepted and registered in the book. Many broking houses have provided facilities forapplying to an IPO/FPO through the internet; applications can be made online also.

One of the important advantages is, book building is a transparent process and while the book is openit is easy for the potential investor to know the details of bids already received; the prices at which thebids have been made; extent of subscription in relation to the issue size (over subscription or undersubscription levels) etc. Many times the extent of subscription already received and the quantum ofinstitutional participation influence investor decisions. After the book is closed the price of the issue isdiscovered. If the issue is over subscribed, at the cap price, then it is up to the company (in consultationwith the Book Running Lead Manager) to decide the price at which shares would be allotted. Manytimes it is done at the cap price but some times it is even done at prices lower than the cap price. Theshares can be allotted at discounts in relation to the discovered price for the retail individual investors –some public sector companies which came out with issues offered shares to retail individual investors atdiscount to the discovered price. Even if a person has bid at prices higher than discovered price theperson will be allotted at discovered price only and not at the highest bid price.

In case of fixed price issues, the investor is intimated about the allotment/refund within 30 days of theclosure of the issue. In case of book built issues, the basis of allotment is finalized by the Book Runninglead Managers within 2 weeks from the date of closure of the issue. The registrar then ensures that thedemat credit or refund as applicable is completed within 15 days of the closure of the issue. The listingon the stock exchanges is done within 7 days from the finalization of the issue. Banks offer to lend to theinvestor in select IPO’s in which case the investor pays only the margin money, of about 40%, while thebank pays the balance and puts in the application – thus leveraging is possible while applying to IPO/FPO’s with attendant risks and costs.

Some investors traditionally have preferred to invest in stocks through the IPO/FPO route only. Theseinvestors believe that this process is less risky. It is a well established fact that IPO’s are more riskybecause the availability of information to the investing public compared to existing listed companies ismuch lower in IPO’s. Decisions based purely on information provided in the offer document (theprospectus) can prove to be tricky when the pricing is free. It is less risky to invest in an existing listedcompany because price history and performance history can be studied, in detail, whereas that does nothappen to be the case in IPO’s. It is also true that issuers price the issue in such a way that they “leavesomething on the table” for the IPO investors. But it is not the case all the time. Hence investors shouldstudy the offer documents carefully; understand the pricing and the future potential of the company verywell before deciding to apply in a public issue of shares.


Secondary market

Client registrationAn investor can invest in shares through the secondary market. He can invest in a stock which is alreadylisted in one of the stock exchanges. In India there are 23 stock exchanges but only two of them aremost important viz. National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE). Investorswho would like to buy or sell shares directly from the market will have to register themselves as clientswith brokers or sub brokers. Brokers are members of stock exchanges while sub brokers work under aspecific broker – both should be SEBI registered Stock market intermediaries.

It is mandatory for the market participant to get the full details of the client in a format prescribed by SEBIcalled KYC – Know Your Client. Personal information of the client is obtained in this specified format andproof of the supplied information like residence proof, personal identity proof, Income Tax PAN details,demat account and bank account details, etc. are taken along with duly filled KYC form. Then the clientand broker enter into an agreement – in the format prescribed by SEBI for this purpose. Thereafter theclient is registered with the market participant and allotted a unique client ID. Now the client can trade onthe stock exchange through the broker/sub broker.

TradingThere are basically two trading mechanisms adopted by stock exchanges the world over to provideliquidity to investors. The two mechanisms are:

n Quote Driven Mechanism of Trading &

n Order Driven Mechanism of TradingQuote Driven Mechanism is adopted by less liquid and emerging stock exchanges where trading requiressome stock brokers to provide two-way quotes. These liquidity providers, who trade on their own account,are called market makers or specialists or jobbers (in India). This is a less efficient mechanism becausethe price spread between bid and offer tends to be high thanks to lower liquidity and less competition.This mechanism is generally adopted in stock exchanges where trading is done on the floor of theexchange on a face to face basis. In India this was the mechanism adopted by BSE for more than acentury before moving over to the more efficient Order Driven Mechanism of trading in line with newerNational Stock Exchange. In India, now on both NSE and BSE we follow the Order Driven Mechanismof trading where the trader places his order through his broker’s trading terminal. The trader is alsoallowed to trade on the internet and he can place his orders on a particular stock exchange through theinternet by special trading facilities provided by the stock broker.

The order placed by the registered client is accepted first by the broker - the acceptance is subject to theorder meeting certain requirements in terms of trading limits set for the client (based on the margin lyingwith the broker), etc. Then the order goes into the trading system of the stock exchange and getsstacked on a time price priority basis. It is mandatory that the order entered in the system is clearlyidentifiable to the specific client through the usage of unique client ID. The order will get executed if theprice condition, if any, specified by the trader, is met.

Types of orders

Market order – the trader decides to buy or sell a particular scrip at the current market price; he canplace a market price order; such orders get executed instantly at prices close to the last traded price –but it is difficult to estimate the price at which the order will be executed, as the price keeps changingvery fast with time.


Limit Order – The trader would place a buy order at a price lower than the last traded price or a saleorder at a price higher than the last traded price for a particular stock.

Stop Loss Order – This type of order enables the trader to limit his loss or protect his profits. This orderenters the system on a trade being executed at a particular price, called trigger price. The trigger priceshould be higher than current market price for buying orders and lower than market price for sellingorders. Technical traders and day traders use Stop Loss Order facility more frequently.

Disclosed Quantity – There is a facility in the trading system that while placing an order for sale orpurchase the quantity disclosed in the trading system could be lower than the actual size of the order –the maximum possible reduction in this type of stipulation is 90% - In other words, if somebody wants tobuy 1000 shares of a scrip he can use DQ facility and specify that quantity that should be shown in thesystem – but the specified quantity in this case should be 100 shares or more - which is 10% or more ofthe actual order size.

All the orders placed in the system are day orders – valid for the day and all pending orders getautomatically cancelled at the end of the day.

An order once placed in the system can be modified or cancelled any time before execution. Modificationin factors like quantity, price, etc. are permitted but client code modifications are not allowed – an orderwith a wrong client code will have to be cancelled.

Risk managementBrokers are required to have Base Minimum Capital (BMC) with the respective stock exchanges. Brokersalso bring in additional capital over and above the BMC in the form of cash, bank fixed deposits and/orsecurities. The brokers are set intra day trading limits, called Gross Exposure (GE) based on the totalmargin money lying with the stock exchanges. The extent of trading a broker can do is a function of hiscapital – thus restricting over trading and over exposures – as the first containment measure. Similarly,the net exposure of any broker, at any point in time is also limited to a certain times his capital. Thebrokers also take margin money from active clients along the same principles of restricting exposuresbeyond certain times the margin thus controlling the speculation and reducing the risk. SEBI has laiddown mandatory rules for brokers to collect margins from clients who trade in volumes beyond someminimum limits – currently collection of client margins is compulsory if a client at any point in time hasnet outstanding positions in excess of Rs 5 lacs (unless the same is to result in delivery) and the marginshould be at least 10% of net outstanding position. Stock exchanges also collect VaR and M2M marginson the outstanding positions – VaR – value at risk and M2M – mark to market margins. The extent ofmargins may vary and generally tends to increase as the market gets more and more volatile.

Pay in and pay out, settlements, etc.Both NSE and BSE follow rolling settlement system as against fixed period settlements which werefollowed earlier. Each day’s obligations are settled independently and not clubbed with any other day’spositions to arrive at settlement’s net obligations for each broker.

It is a matter of compliance of SEBI regulation that a broker issues confirmation of day’s trades to aclient in a specified format. This contract note should carry the trade details like Order Number, TradeNumber, Trade Time, Scrip Name, whether bought or sold, the quantity, Market rate, brokerage, netrate along with all details of the client, his code number, address, PAN number, settlements details, etc.

It is also mandatory that the broker should issue contract note to the client within 24 hours of the end ofday of trade and should obtain client’s confirmation on the duplicate copy. Brokers may send contractsby post or through courier but should maintain proof that the same were dispatched within the stipulated


time. Electronic mailing of contracts shall also serve the purpose but the same also should be donewithin the time limit of 24 hours.

Brokers collect the payments from clients who might have bought shares (pay in obligations) and creditthe same in Brokers’ account exclusive marked for client transactions. Brokers use the funds in theclients accounts to meet Pay in obligations to the stock exchange through another account called ClearingAccount. The funds pay in is done before specified hours on T+2 basis – that is within two working days,before stipulated hours, after trading day (T).

Similarly securities pay in for shares sold by clients is also required to be made before a specified timeon T+2 basis – through the pool account of the broker maintained for meeting clearing obligations. Thusfunds pay in and securities pay in take place on T+2 basis but in the early part of the day.

Pay out of funds and securities are made on T+2 basis and the funds and securities are credited tobrokers’ accounts at the later half of 2nd working day after the trade day.

It may be worthwhile to know that a broker is required to make payments to a client who might have soldshares within 48 hours of pay out day – in other words the trade takes place on trade day (T), brokerreceives payments/deliveries 2 days later (T+2) and client should receive payments/deliveries within 48hours of T+2.

It is important for a stock market investor to know his duties to the brokers like placing order specifically,keeping cash margins with brokers while trading beyond certain limits, making payments/deliveringsecurities with in the prescribed time limit and also his rights to receive contracts, payments/securitieswithin the SEBI stipulated time frame. We may add here that each stock exchange has provided meansby which a client can verify the trade on the same day from the web site of the stock exchange concerned.www.bseindia.com and www.nseindia.com.

A broker can not charge brokerage in excess of 2.5% of the market price of stock bought or sold. Abroker may charge all other charges over and above the brokerage. These charges include Service Taxon brokerage which is currently 12.36% (including education cess of 3%), Regulatory charges, Stampduty & Securities Transaction Tax. STT is currently 0.125% of turn over on delivery based trades;0.025% of turn over of all non delivery trades in the cash segment and 0.017% of turn over of all nondelivery trades in the derivatives segment.

Corporate benefitsCompanies declare book closure or record dates for determining eligibility for corporate benefits likedividend, bonus, rights entitlements, stock splits, etc. On the stock exchanges the stocks remain cumdividend, cum bonus or cum rights up to a certain date and all investors who buy the particular stock onor before this specific date will be entitled to that corporate benefit. The next day onwards the stockstarts quoting ex dividend, ex bonus or ex rights – meaning investors who buy after these dates will notget the respective corporate benefit; alternatively if a share holder of the company sells the stock cumbenefit he won’t be entitled to it but if sells ex benefit he shall get the benefit. The stock for some time onthe exchanges may trade on “no delivery” basis – all trades entered during the no delivery period areclubbed and settled, on a particular day, after the end of no delivery period. In other words, the pay inand pay out of funds and securities in respect of this particular stock which is trading on a no deliverybasis is delayed to the extent of no delivery period and settled together, at a later date.

Types of securities

Equity shares – the most common form of securities ; (the conventional stock or common stock or

http://www.bseindia.com

http://www.nseindia.com


ordinary share) is the equity share issued by a company and the investors in equity shares are ownersof the company to the extent of their share holding. These share holders are entitled to dividend andother benefits declared by the company and are also entitled to vote. Companies may issue shareswithout voting rights also. Normally the shares traded are fully paid up but in certain cases partly paidshares are also listed and traded on the stock exchanges.

Convertible debentures: A company may choose to issue debentures which could be converted partlyor fully into equity shares at a later date. These securities are also listed and traded on the stock exchanges.

Warrants are essentially issued to share holders and the holder of the warrant will be able to exercisehis right to purchase shares of the company at a future date. Till the prescribed date for exercising therights to additional shares these warrants are also traded on the stock exchanges.

Preference shares can also be issued by a company. This is a not a popular instrument with the stockmarket investors because this is essentially a fixed income instrument with no scope for capitalappreciation.

Bonus Shares: Companies reward the share holder by issuing bonus shares. Bonus shares are freeshares distributed by the company to its share holders, as on a given date, in a proportion which isdecided by the board and approved by the share holders and subject to certain limits, as prescribed bySEBI in this regard. A 1:1 bonus implies that a share holder having 100 shares will get another 100shares free of cost ; similarly a 2:3 bonus implies that a share holder having 3 shares will get 2 bonusshares. As a point of valuation a bonus per se does not add value to share holders because the price ofthe stock adjusts for the bonus shares after the same are issued. However, a bonus declaration is asignal, to the market, from the company management that they are very confident about their futureperformance and that they will be able to service the expanded capital. In the market place it is commonto find that companies that reward the share holders with frequent bonuses get better valuations comparedto similar but conservative companies.

Rights Shares – Issue of additional shares to existing share holders to raise capital is called Rights Issue.The difference is that compared to bonus shares which are issued free here the share holder has to pay aprice for getting additional shares – the price could be market related and may be at a discount to the marketprice of the stock. If the company issues rights shares to raise money for expansion/modernization/newacquisitions, etc then that is considered quite positive. It may be worth while to understand how the marketprice gets adjusted for rights issues when trading on cum right and ex right basis.

ExampleLet’s assume the cum rights price to be Rs. 200

Rights in the ratio of 1:2 at a price of Rs. 110

The ex rights price will be calculated as under:

1:2 means one share will be offered on two shares already held

Two shares cum rights will cost 2*200 = 400 ; no of cum right shares 2

One rights share will cost = 110 ; no of right shares 1

Total cost =510; no of ex right shares 3

The price per share ex rights = 510/3 = 170/-

Thus the stock will start quoting at an ex right price of Rs 170 if it closed at cum right price of Rs. 200/-on the above terms.


Stock splits: Normally the nominal value or the face value of a share is Rs. 10/- but a company maychoose to have the face value as Rs. 5 or Rs. 4 or Rs. 2 or even Re 1. Companies with low floating stockand/or companies whose shares are highly priced and not traded in huge volumes on the stock exchangemay consider reducing the face value and increasing the number of shares. The stock splits does notnecessarily result in value addition to the investor but all the same it improves the liquidity and invariablyleads to better prices on the market place.

If a share holder is holding 100 shares of a company – FV Rs 10/- and the company announces a stocksplit of 5:1; then the number of stocks held by the investor will rise 5 fold to 500 while the face value willcome down to Rs. 2/- and the market price will come down ex split to one fifth of cum split price. This isconsidered an investor friendly move and such companies command better valuations on the market.

Valuation of sharesIt is very important to understand how the shares are valued on the stock exchanges. Investors wouldlike to buy “under-valued” stocks and sell ‘over-valued’ stocks held by them. It is easier said than done.To label a stock at a price as under-valued or over-valued requires an understanding of valuation ofshares. Many methods are followed for valuing shares. Let us look at a few of them.

Dividend discount modelOne of the widely followed valuation models is the dividend discount model. According to this model thepresent value of the share will be equal to the present value of the dividend and the expected sale priceof the stock.

Let us begin with the case where the investor expects to hold the equity share for one year. The price ofthe equity share will be;

Where,

P0 = current price of the equity share

D1 = dividend expected a year hence

P1 = price of the share expected a year hence

r = rate of the return required on the equity share

the underlying assumptions are the dividend of D1 will be paid at the end of the year and the share canbe sold after one year at a price P1

ExampleIf an investor expects to receive a dividend of 2.50 per share and year end price to be Rs. 150 andneeds a return of 15% p.a. on his share investment at what price should he buy this share?

here D1 = 2.5; P1 is 150 and r = 0.15

then P0 = [2.5(1+0.15)]+ [150(1+0.15)] = (1.5/1.15) + (150/1.15)

= 2.173 +130.43 = 132.60


We have considered for a single period of one year; we can extend the same to multi periods where thepresent value of each year’s dividend will be discounted at the required rate of return and so will be thesale price at the end of the period.

Stock prices and dividends have a tendency to grow over a period of time; we can factor in these growthrates in our calculation of share value:

If the current price, P0, becomes P0 (1+g) a year hence, for g the rate of growth, we get:

Simplifying the above equation we get:

The steps in simplification are:

ExampleThe dividend paid out by a company has been growing at the rate of 10% p.a. over the last few years.The next year’s dividend is expected to be Rs. 2/- per share. The expected return is 16%. At what priceshould we buy the stock?

We may add here that D1 is the expected dividend for the next year; given the current year’s dividend onecan work out the next year’s expected dividend by applying the rate of growth of dividends as follows:

D1 = D0*(1+g)

ExampleIf a company has been currently paying dividend at the rate of Rs. 2/- per share and if the growth rate is


10% and expected return is 15% what should be present price of the share?

D1 = D0*g = 2*(1.10) = 2.20

However, this constant growth model is rarely used in the market place for valuing the stocks mainlybecause it is very difficult to estimate the growth rate and that too in perpetuity.

Earnings Multiplier ApproachAnother and more popular approach to stock valuation is the earnings multiplier approach. Price toearnings ratio is calculated as follows:

P/E ratio = Market Price /EPS

Where EPS is = Profit After Tax/No. of shares

Market Price/PE ratio is the P/E multiple for the stock.

P0 = E1 * (P0/E1)

Where

P0 is the estimated price

E1 is the estimated EPS &

P0/E1 is the reasonable P/E ratio

The P/E ratio can be worked out as follows on the basis of dividend discounting model:

where b is the plough back ratio or the proportion of retained profits out of total profits, r the required rateof return and g the growth rate, (1-b) is the dividend pay out ratio.

Thus the P/E multiple of a stock price is directly proportional to the dividends distributed by the company.

Another factor that influences the P/E ratio is the interest rate. The required rate of return on securitiesincluding stock as the interest rates rise. When the interest rate rises security prices will fall. The relationbetween interest rates and P/E ratios is inverse.

Riskier stocks have lower P/E multiples. Riskier a stock the higher the returns expectations and hencelower the P/E ratio. This is typically true in the market place of mid cap and small cap stocks; these arehigh risk stocks and tend to trade at lower P/E multiples compared to large cap stocks because thereturn expectations from mid cap and small cap stocks are higher.

P/E multiplier is a very common tool used for value purposes and we can summarise how the priceprojections are done for stock valuations, as follows:

1. Estimate the EPS for the current financial year based on company’s past track record, statementsregarding future out look, orders on hand, market price trends for the product, reported profits forthe completed quarters, etc. This is a very highly skilled job and many researchers keep on estimatingand revising, on a periodic basis because of the numerous elements involved.


2. Find out the growth rate of earnings – based on track record and other factors listed above

3. Find out the average P/E ratio of other comparable companies in the industry

4. Find out the historic P/E ratio at which this stock has been quoting

5. Arrive at a reasonable multiple for this stock based on the industry average and this stock’s ownP/E in the past; one of the thumb rules for a reasonable P/E ratio is the growth rate of EPS,worked out in step 2 above – if the EPS grows at 20% p.a. a P/E ratio of 20 is reasonable

6. Multiply the P/E multiple arrived in step 5 by earnings estimated in step 1 to arrive at the projectedprice for the stock at the end of the year.

n An investor can reach his decision on buying/holding/selling the stock based on the followingfactors:

n Current market price

n Required return

n Estimated market price at the year end, as worked out aboveIf the estimated market price is greater than or equal to (Current market price*required return) then it isworth buying the stock ; but if it is estimated to be less then buying can be avoided.

The valuations are much more complex than as listed above because the crucial factors of earningsprojections and the multiples are influenced by various events some of which could be emotional ratherthan rational.

Other Valuation Techniques

Investors use other valuation techniques, based on fundamental analysis concepts. Three that are fairlyoften referred to are price to book value, price/sales ratio and economic value added. Price to bookvalue is calculated as the ratio of price to stockholders’ equity as measured on the balance sheet. It issometimes used to value companies, particularly financial companies. Banks have often been evaluatedusing this ratio because the assets of banks have book values and market values that are similar. If thevalue of this ratio is 1.0, the market price is equal to the accounting (book) value. It is also used inmerger and acquisition analysis.

The price/sales ratio is a valuation technique that has received increased attention recently. This ratio iscalculated as a company’s total market value (price times number of shares) divided by it sales, Ineffect, it indicates what the market is willing to pay for a firm’s revenues.

The newest technique for evaluating stocks is to calculate the economic value added, or EVA. In effect,EVA is the difference between operating profits and a company’s true cost of capital for both debt andequity and reflects an emphasis on return on capital. If this difference is positive, the company hasadded value. Some studies have shown that stock price is more responsive to changes to EVA than tochanges in earnings, the traditional variable of importance; some mutual funds are now using EVAanalysis as the primary tool for selecting stocks for the fund to hold. One recommendation for investorsinterested in this approach is to search for companies with a return of capital in excess of twenty percentbecause this will in all likelihood exceed the cost of capital, and, therefore, the company is adding value.

Fundamental AnalysisFundamental analysis is based on the premise that any security (and the market as a whole) has anintrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlyingvariables, which combine to produce an expected return and an accompanying risk. By assessing thesefundamental determinants of the value of a security, an estimate of its intrinsic value can be determined.


This estimated intrinsic value can then be compared to the current market price of the security. Similarto the decision rules used for bonds, decision rules are employed for common stocks when fundamentalanalysis is used to calculate intrinsic value.

In equilibrium, the current market price of a security reflects the average of the intrinsic value estimatesmade by investors. An investor whose intrinsic value estimate differs from the market price is, in effect,differing with the market consensus as to the estimate of either expected return or risk, or both. Investorswho can perform good fundamental analysis and spot discrepancies should be able to profit by acting,before the market consensus reflects the correct information.

Fundamental analysis is based on the premise that any security (and the market as a whole) has anintrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlyingvariables, which combine to produce an expected return and an accompanying risk. By assessing thesefundamental determinants of the value of a security, an estimate of its intrinsic value can be determined.This estimated intrinsic value can then be compared to the current market price of the security. Similarto the decision rules used for bonds, decision rules are employed for common stocks when fundamentalanalysis is used to calculate intrinsic value.

In equilibrium, the current market price of a security reflects the average of the intrinsic value estimatesmade by investors. An investor whose intrinsic value estimate differs from the market price is, in effect,differing with the market consensus as to the estimate of either expected return or risk, or both. Investorswho can perform good fundamental analysis and spot discrepancies should be able to profit by acting,before the market consensus reflects the correct information.

Under either of the two fundamental approaches, an investor will have to work with individual companydata. Does this mean that the investor should plunge into a study of company data first and then considerother factors such as the industry within which a particular company operates or the state of the economy,or should the reverse procedure be followed? In fact, each of these approaches is used by investors andsecurity analysts when doing fundamental analysis. These approaches are referred to as the “top-down” approach and the “bottom-up” approach.

With the “bottom-up” approach, investors focus directly on a company’s basics, or fundamentals.Analysis of such information as the company’s products, its competitive position, and its financial statusleads to an estimate of the company’s earnings potential, and, ultimately, its value in the market.

Considerable time and effort are required to produce the type of detailed financial analysis needed tounderstand even relatively small companies. The emphasis in this approach is on finding companieswith good long-term growth prospects, and making accurate earnings estimates. To organize this effort,bottom-up fundamental research is often broken into two categories, growth investing and value investing.

Growth stocks carry investor expectations of above-average future growth in earnings and above-average valuations as a result of high price/ earnings ratios. Investors expect these stocks to performwell in the future, and they are willing to pay high multiples for this expected growth.

Value stocks, on the other hand, feature cheap assets and strong balance sheets. Value investing canbe traced back to the value-investing principles laid out by the well-known Benjamin Graham, who wrotea famous book on security analysis that has been the foundation for many subsequent security analysts.Growth stocks and value stocks tend to be in vogue over different periods, and the advocates of eachcamp prosper and suffer accordingly.

In many cases bottom-up investing does not attempt to make a clear distinction between growth andvalue. Many companies feature strong earnings prospects and a strong financial base or asset value,


and therefore have characteristics associated with both categories.

The top-down approach is the opposite to the bottom-up approach. Investors begin with the economy andthe overall market, considering such important factors as interest rates and inflation. They next considerlikely industry prospects, or sectors of the economy that are likely to do particularly well (or particularlypoorly). Finally, having decided that macro factors are favourable to investing, and having determinedwhich parts of the overall economy are likely to perform well, individual companies are analyzed.

There is no “right” answer to which of these two approaches to follow. However, fundamental analysiscan be overwhelming in its detail, and an investor should decide which approach seems more reasonableand try to develop a consistent method of action.

Technical analysisTechnical analysis can be defined as the use of specific market-generated data for the analysis of bothaggregate stock prices (market indices or industry averages) and individual stocks.

The technical approach to investing is essentially a reflection of the idea that prices move in trendswhich are determined by the changing attitudes of investors toward a variety of economic, monetary,political and psychological forces. The art of technical analysis - for it is an art - is to identify trendchanges at an early stage and to maintain an investment posture until the weight of the evidence indicatesthat the trend is reversed.

Technical analysis is sometimes called market or internal analysis, because it utilizes the record of themarket itself to attempt to assess the demand for, and supply of, shares of a stock or the entire market.Thus, technical analysts believe that the market itself is its own best source of data.

Technicians believe that the process by which prices adjust to new information is one of a gradualadjustment toward a new (equilibrium) price. As the stock adjusts from its old equilibrium level to its newlevel, the price tends to move in a trend. The central concern is not why the change is taking place, butrather the very fact that it is taking place at all. Technical analysts believe that stock prices show identifiabletrends that can be exploited by investors. They seek to identify changes in the direction of a stock andtake a position in the stock to take advantage of the trend.

The following points summarize technical analysis:

Technical analysis is based on published market data and focuses on internal factors by analyzingmovements in the aggregate market, industry average, or stock. In contrast, fundamental analysis focuseson economic and political factors, which are external to the market itself.

The focus of technical analysis is identifying changes in the direction of stock prices which tend to movein trends as the stock price adjusts to a new equilibrium level. These trends can be analyzed, andchanges in trends detected, by studying the action of price movements and trading volume across time.The emphasis is on likely price changes.

Technicians attempt to assess the overall situation concerning stocks by analyzing breadth indicators,market sentiment, and momentum. Technical analysis includes the use of graphs (charts) and technicaltrading rules and indicators.

Price and volume are the primary tools of the pure technical analyst, and the chart is the most importantmechanism for displaying this information. Technicians believe that the forces of supply and demandresult in particular patterns of price behavior, the most important of which is the trend or overall directionin price. Using a chart, the technician hopes to identify trends and patterns in stock prices that providetrading signals.


Volume data are used to gauge the general condition in the market and to help assess its trend. Theevidence seems to suggest that rising (falling,) stock prices are usually associated with rising, (falling)volume. If stock prices rose but volume activity did not keep pace, technicians would be skeptical about theupward trend. An upward surge on contracting volume would be particularly suspect. A downside movementfrom some pattern or holding point, accompanied by heavy volume, would be taken as a bearish sign.

Taxation

Income derived from equity shares comprises dividends and capital appreciation. Dividends of Indiancompanies are tax free in the hands of share holders. The companies declaring dividends are requiredto pay Dividend Distribution Tax at rates prescribed from time to time; currently 12.5% + Surcharge of5%. DDT is an indirect tax on the dividend income of the share holders.

Capital gains on shares can be classified as Short Term Capital Gains and Long Term Capital Gains. Inrespect of securities listed and traded on the stock exchanges the holding period is 12 months fordetermining whether the security is a long term capital asset or otherwise.

Day trading: A trader may buy and sell the shares on the same day without receiving or giving deliveryof shares. These transactions are considered speculative in nature. The income earned is taxed at therate applicable – say 30% if the annual income is in excess of Rs. 2,50,000/-

STCG: If a stock has been sold within 12 months of purchase the difference between selling and buyingprices will be short term capital gain. STCG is taxed at the rate of 10% & @ 15% w.e.f. from financialyear 2008-09 in respect of securities which are traded on the exchanges and where Securities TransactionTax has been levied on the transactions.

LTCG : Long term capital gains are tax exempt u/s 10(38), where the asset sold is a long term capitalasset, held for more than 12 months, and sold on a stock exchange where STT has been levied on thetransaction.


Review Questions:

1. A company paid dividend of Rs 2.50 per share which is expected to grow at the rate of 8% p.a. Ifthe expected rate of return is 12% what should be current price of the stock according to thedividend discounting model?

a. 67.50b. 62.50c. 70.25d. 65.00

2. A “Stop loss order” is generally used for

a. protecting profitsb. limiting lossesc. technical reasons of support and/or resistanced. all the three above

3. While trading on screen based trading systems which one of the following statements about“orders” is not true?

a. Orders pending at the end of the trading day are automatically cancelledb. Orders once placed in the system can not be modified or cancelledc. Once an order is placed it is not possible to modify the client coded. The quantity that would be disclosed in the system can be shown to be less than the true

quantity of the order

4. The present mechanism of trading used in NSE and BSE is

a. Quote driven mechanism of tradingb. Order driven mechanism of tradingc. Institution oriented mechanism of tradingd. Jobber oriented mechanism of trading

5. A stock is quoting at Rs 100/- cum rights. What will be the price ex rights if the company offersrights shares in the ratio 1:2 at a price of Rs 70/ (assuming the market price is steady)?

a. 100b. 90c. 80d. 70

6. A company fixes record date for bonus and stock split simultaneously. If the bonus is in the ratioof 1:2 and the stocks to be split from FV of Rs 10 to Rs 2 and if the cum bonus and cum split pricewas Rs 900 what should be the ex bonus and ex stock split price?

a.100b. 110c. 120d. 300


7. An investor received 10 bonus shares of an infotech company on 10th March 2005. The cost ofacquisition is NIL being bonus shares. He sold the bonus shares through a member of NSE, on10th May 2006, for a price of Rs. 3200 each. What will be capital gains tax payable by the investoron the sale?

a. Rs. 3200 + education cessb. Rs. 6400 + education cessc. The rate of taxation will depend upon the tax slab at which the investor is being taxed on his

total incomed. NIL – this is LTCG and hence no tax is payable

8. A company is growing at an average rate of 20% on the top and bottom lines. The current marketprice is Rs. 225 while the EPS for the last year was Rs. 12. Is it advisable to buy the stock if therequired return is 18%?

a. The stock may quote at Rs. 240 after one year and hence do no buyb. The stock may quote at Rs. 288 at a P/E of 20 on the next year’s EPS – given that the growth

rate is 20% – hence buyc. It can not be predicted – the risks seem to be high – do not buyd. There is no certainty that the growth rate will be maintained – the required return is very high

– do not buy

9. Interest rate has the following effect on share valuation:

a. As the interest rises the stock prices will riseb. Interest rate rise or fall has no impact on stock pricesc. Stock market has nothing to do with interest ratesd. As the interest rate rises the stock prices tend to fall

10. Which one of the following statements regarding market capitalization and P/E multiples is true?

a. As Mid cap stocks are riskier the P/E multiple tends to be higher as compared to large cap stocksb. As mid cap stocks are riskier the P/E multiple tends to be lower as compared to large cap stocksc. As mid cap stocks are less risky their P/E multiples tend to be lower as compared to large cap

stocksd. As mid cap stocks are less risky their P/E multiples tend to be higher as compared to large

cap stocks

11. The spread between floor price and cap price in respect of book built IPO’s should not exceed

a. 20%b. 15%c. 10%d. No such limit

Answers:

1. a 2. d 3. b 4. b 5. b 6. c

7. d 8. b 9. d 10. b 11. a


Chapter 12


Derivatives have become very important in the field of investments. They are very important financialinstruments for risk management as they allow risks to be separated and traded. Derivatives are

used to shift risk and act as a form of insurance. This shift of risk means that each party involved in thecontract should be able to identify all the risks involved before the contract is agreed. It is also importantto remember that derivatives are derived from an underlying asset. This means that risks in tradingderivatives may change depending on what happens to the underlying asset.

A derivative is a product whose value is derived from the value of an underlying asset, index or referencerate. The underlying asset can be equity, forex, commodity or any other asset. For example, if thesettlement price of a derivative is based on the stock price of a stock for e.g. Tata Steel which frequentlychanges on a daily basis, then the derivative risks are also changing on a daily basis. This means thatderivative risks and positions must be monitored constantly.

We will try and understand

n What are derivatives?

n Why have derivatives at all?

n How are derivatives traded and used?A derivative security can be defined as a security whose value depends on the values of other underlyingvariables. Very often, the variables underlying the derivative securities are the prices of traded securities.

Let us take an example of a simple derivative contract:

n Mr. Kulkarni buys a futures contract, of 100 shares lot size

n He will make a profit of Rs. 1000 if the price of Tata Steel rises by Rs. 10

n If the price is unchanged Mr. Kulkarni will receive nothing.

n If the stock price of Tata Steel falls by Rs. 9 he will lose Rs. 900.As we can see, the above contract depends upon the price of the Tata Steel scrip in the cash market –referred to, in market parlance, as the spot price – the price of the security in the futures segment couldbe different from cash market but it moves in line with the cash market price. Similarly, futures trading isdone on Sensex futures and Nifty futures. The underlying securities in this case are the BSE Sensexand NSE Nifty.

Derivatives and futures are basically of 3 types:

n Forwards and Futures

n Options

n Swaps

Derivatives


Forward contractA forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell anasset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when thecontract is entered into.

ExampleMr. Kulkarni wants to buy a car, which costs Rs. 2,00,000 but he has no cash to buy it outright. He can onlybuy it 3 months hence. He, however, fears that prices of cars will rise 3 months from now. So in order toprotect himself from the rise in prices Mr. Kulkarni enters into a contract with the car dealer that 3 monthsfrom now he will buy the car for Rs. 2,00,000. What Mr. Kulkarni is doing is that he is locking the currentprice of a car for a forward contract. The forward contract is settled at maturity. The dealer will deliver the carto Mr. Kulkarni at the end of three months and Mr. Kulkarni in turn will pay Rs. 2,00,000/- to the car dealeron delivery.

ExampleMr Patel is an importer who has to make a payment for his consignment in six months time. In order tomeet his payment obligation he has to buy dollars six months from today. However, he is not sure whatthe Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bankto buy dollars six months from now at a decided rate. As he is entering into a contract on a future date itis a forward contract and the underlying security is the foreign currency.

The difference between a share and derivative is that shares/securities is an asset while derivativeinstrument is a contract.

To understand the use and functioning of the index derivatives markets, it is necessary to understandthe underlying index. A stock index represents the change in value of a set of stocks, which constitutethe index. A market index is very important for the market players as it acts as a barometer for marketbehavior and as an underlying in derivative instruments such as index futures.

The Sensex and NiftyIn India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has30 stocks comprising the index which are selected based on market capitalization, industry representation,trading frequency etc. It represents 30 large well-established and financially sound companies. TheSensex represents a broad spectrum of companies in a variety of industries. It represents 14 majorindustry groups. Then there is a BSE national index and BSE 200. However, trading in index futures hasonly commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty was launched by the NationalStock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of sharesof 50 companies with each having a market capitalization of more than Rs 500 crore.

Futures and stock indicesFor understanding of stock index futures a thorough knowledge of the composition of indexes is essential.Choosing the right index is important in choosing the right contract for speculation or hedging. Since forspeculation, the volatility of the index is important whereas for hedging the choice of index dependsupon the relationship between the stocks being hedged and the characteristics of the index.

Choosing and understanding the right index is important as the movement of stock index futures is quitesimilar to that of the underlying stock index. Volatility of the futures indexes is generally greater thanspot stock indexes.


Every time an investor takes a long or short position on a stock, he also has an hidden exposure to theNifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise whenthe market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index with theirportfolio/stock and low cost associated with using index futures for hedging.

Understanding index futuresA futures contract is an agreement between two parties to buy or sell an asset at a certain time in thefuture at a certain price. Index futures are all futures contracts where the underlying is the stock index(Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buya futures contract and hope for a price rise on the futures contract when the rally occurs.

We have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 monthsduration contracts are available at all times. Each contract expires on the last Thursday of the expirymonth and simultaneously from the next day onwards a new contract is introduced for trading.

ExampleFutures contracts in Nifty in August 2006

The settlement day is the last Thursday of the month or the previous working day if last Thursdayhappens to be a holiday.

The permitted lot size is 100 or multiples thereof for the Nifty. That is if you buy one Nifty contract, thetotal deal value will be 100*3400 (Nifty futures price) = Rs. 3,40,000

Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefitof trading in index futures is to hedge your portfolio against the risk of trading. In order to understandhow one can protect his portfolio from value erosion let us take an example.

Stocks carry two types of risk – company specific and market risk. Company specific risk can be reducedthrough diversification while market risk is reduced through hedging.

Beta is the measure of market risk. Beta measures the relationship between movement of the index tothe movement of the stock. The beta measures the percentage impact on the stock prices for 1%change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goesdown by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolioincreases 11%. The strategy of hedging is resorted to with the objective of reducing portfolio beta tozero and reducing the market risk.

Hedging involves protecting an existing equity portfolio from future adverse price movements in thestock market. In order to hedge the portfolio, a market player needs to take an equal and opposite


Less: Purchase Cost: 3400*100 = Rs. 3,40,000

Net Gain Rs. 6,000

position in the futures market to the one held in the cash market. Every portfolio has a hidden exposureto the index, which is denoted by the beta. Assuming you have a portfolio of Rs. 20 lacs, which has abeta of 1.2, you can factor a complete hedge by selling Rs. 24 lacs of S&P CNX Nifty futures.

Steps in hedging

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume thatit is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset thelosses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolioby the market value of his holdings.

Therefore in the above scenario we have to short sell 1.2 * 20 lacs = 24 lacs worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues:

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment.But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Thenwhy does one invest in equities if all the gains will be offset by losses in futures market. The idea is thateveryone expects his portfolio to outperform the market. Irrespective of whether the market goes up ornot, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of the scrip and taking areverse position in the futures market.

Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

Speculation

Speculators are those who do not have any position on which they enter in futures and options market.They only have a particular view on the market, stock, commodity etc. In short, speculators put theirmoney at risk in the hope of profiting from an anticipated price change. They consider various factorssuch as demand supply, market positions, open interests, economic fundamentals and other data totake their positions.

ExampleKirit is a trader but has no time to track and analyze stocks. However, he fancies his chances in predictingthe market trend. So instead of buying different stocks he buys Nifty Futures.

On Sept 1, 2006 he buys 100 Nifty futures @ 3400 on expectations that the index will rise in future. OnSept 16,2006 Nifty rises to 3460 and at that time he sells Nifty futures and squares his position.

Selling Price : 3460*100 = Rs. 3,46,000


Kirit has made a profit of Rs. 6,000 by taking a call on the future value of the Nifty. However, if Nifty hadfallen he would have made a loss.

Similarly, if Kirit had a bearish view on the market he could have sold Nifty futures and bought the sameback after the expected market fall and made a profit from a falling market.

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits.When markets are imperfect, buying in one market and simultaneously selling in other market givesriskless profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower pricedmarket and selling at the higher priced market. In index futures arbitrage is possible between the spotmarket and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in thespot market)

n Take the case of the NSE Nifty.

n Assume that Nifty is at 3400 and 3 month’s Nifty futures is at 3500.

n The futures price of Nifty futures can be worked out by taking the interest cost of 3 months intoaccount.

n If there is a difference then arbitrage opportunity exists.If we assume 8% interest rate then Nifty three months futures should be quoting at Rs. 3468 but isactually quoting at Rs. 3500; which is higher than the correct price thus providing an arbitrageur anopportunity – he will sell 3 months futures at 3500 and buy spot at 3400 and should make Rs 32 per Niftybecause of the difference between the actual price and the “correct price:.

These kind of imperfections continue to exist in the markets but one has to be alert to the opportunitiesas they tend to get exhausted very fast.

Pricing of Index FuturesThe index futures are the most popular futures contracts as they can be used in a variety of ways byvarious participants in the market.

The cost of carry modelThe cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves awayfrom the fair value, there would be chances for arbitrage.

If Nifty is quoting at Rs. 3400 and the 3 months futures of Nifty is Rs 3500 then one can purchaseNifty at Rs. 3400 in spot by borrowing @ 8% annum for 3 months and sell Nifty futures for 3 monthsat Rs. 3500.


Here F=3400+68=3468 and is less than prevailing futures price and hence there are chances of arbitrage.

However, one has to remember that the components of holding cost vary with contracts on differentassets.

Futures pricing in case of dividend yieldWe have seen how we have to consider the cost of finance to arrive at the futures index value. However,the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equityfutures, the holding cost is the cost of financing minus the dividend returns.

ExampleSuppose a stock portfolio has a value of Rs. 100 and has an annual dividend yield of 3% which isearned throughout the year and finance rate =12% the fair value of the stock index portfolio after oneyear will be

F= Rs. 100 + Rs. 100 * (0.12 – 0.03)

Futures price = Rs. 109

If the actual futures price of one-year contract is Rs. 112. An arbitrageur can buy the stock at Rs. 100,borrowing the fund at the rate of 12% and simultaneously sell futures at Rs. 112. At the end of the year,the arbitrageur would collect Rs. 3 for dividends, deliver the stock portfolio at Rs 112 and repay the loanof Rs. 100 and interest of Rs. 12.

The net profit would be Rs. 112 + Rs. 3 - Rs. 100 - Rs. 12 = Rs. 3

Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies

SpeculationWe have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculationand arbitrage. In this module we will see one can trade in index futures and use forward contracts ineach of these instances.

Taking a view of the marketIf you are bullish on the market buy index futures

If you are bearish on the market sell index futures

Example

BullishOn August 13, 2006, ‘X’ feels that the market will rise so he buys 100 Nifties with an expiry date ofAugust 31 at an index price of 3350 costing Rs. 3,33,500 (100*3350).

On August 21 the Nifty futures have risen to 3362 so he squares off his position at 3362

Sale = 3500

Cost =3400 + 68 = 3468

Arbitrage profit = 32


‘X’ makes a profit of Rs. 1200 (100*12)

BearishOn August 13, 2006, ‘X’ feels that the market will fall so he sells 100 Nifties with an expiry date of August31 at an index price of 3350 costing Rs. 3,33,500 (100*3350).

On August 21 the Nifty futures have fallen to 3312 so he squares off his position at 3312.

X makes a profit of Rs. (100*38) = Rs. 3,800/-

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of profiting from ananticipated price change.

MarginsThe margining system is based on the JR Verma Committee recommendations. The actual margininghappens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/lossThe computation of initial margin on the futures market is done using the concept of Value-at-Risk(VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand tolose within a certain horizon time period (one day for the clearing corporation) due to potential changesin the underlying asset market price. Initial margin amount computed using VaR is collected up-front.

The daily settlement process called “mark-to-market” provides for collection of losses that have alreadyoccurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstandingpositions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the marginspayments that would occur.

n A client purchases 100 units of FUTIDX NIFTY 31 Aug 2006 at Rs. 3400.

n The initial margin payable as calculated by VaR is 15%.

Total long position = Rs. 3,40,000 (100*3400)

Initial margin (15%) = Rs. 51,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Nifty closed on Day 1 at 3450

Nifty closed on Day 2 at 3350

Nifty was sold on Day 3 at 3425

Position on Day 1Close Price 3450*100 = 3,45,000

Market to market profit = 50*100 = 5,000

Day end margin on open position = 345000*.15 = 51750

Additional margin = 51750 -51000 = 750


Receivable by client = 5000 – 750 = 4250

New position on Day 2Value of new position = 3350*100= 3,35,000

Margin = 50,250

Margin at end of day1 = 51750

Mark to market loss = 345000 – 335000 = 10,000

Amount payable by client = 10000-1500 {less margin payable [51750-50250]} = 8500

Net position on Day 3

Profit on sale 342500 – 335000 = 7500

Release of margin = 50,250

Amount receivable by client = 7500+50250 = 57,750

Net profit on the whole deal:

Initial margin out go = -51,000

End of day 1 = 4,250

End of day 2 = -8,500

End of day3 = 57,750

Net profit = (-51000+4250-8500+57750) = 2,500

Which is 100*(3425-3400) = the lot size*(difference between sale and purchase price of the index)

SettlementsAll trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are notclosed out will be marked-to-market. The closing price of the index futures will be the daily settlementprice and the position will be carried to the next day at the settlement price.

The most common way of liquidating an open position is to execute an offsetting futures transaction bywhich the initial transaction is squared up. The initial buyer liquidates his long position by selling identicalfutures contract.

In index futures the other way of settlement is cash settled at the final settlement. At the end of thecontract period the difference between the contract value and closing index value is paid.

OptionsThe markets are volatile and huge amount of money can be made or lost in very little time. Derivativeproducts are structured precisely for this reason — to curtail the risk exposure of an investor. Indexfutures and stock options are instruments that enable an investor to hedge his portfolio or open positionsin the market. Option contracts allow an investor to run his profits while restricting his downside risk.

Apart from risk containment, options can be used for speculation and investors can create a wide rangeof potential profit scenarios.

What are options?Some people remain puzzled by options. The truth is that most people have been using options forsome time, because options are built into everything from mortgages to insurance.


An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of theunderlying security at a specific price on or before a specific date.

‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if he sochooses to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Calloptions are like security deposits. If, for example, you wanted to rent a certain property, and left a securitydeposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreedupon when you returned. If you never returned, you would give up your security deposit, but you would haveno other liability. Call options usually increase in value as the value of the underlying instrument rises.

When you buy a Call option, the price you pay for it, called the option premium, secures your right to buythat certain stock at a specified price called the strike price. If you decide not to use the option to buy thestock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Putoptions are like insurance policies

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence,protected if the car is damaged in an accident. If this happens, you can use your policy to regain theinsured value of the car. In this way, the put option gains in value as the value of the underlying instrumentdecreases. If all goes well and the insurance is not needed, the insurance company keeps your premiumin return for taking on the risk.

With a Put Option, you can “insure” a stock by fixing a selling price. If something happens which causesthe stock price to fall, and thus, “damages” your asset, you can exercise your option and sell it at its“insured” price level. If the price of your stock goes up, and there is no “damage,” then you do not needto use the insurance, and, once again, your only cost is the premium. This is the primary function oflisted options, to allow investors ways to manage risk.

Technically, an option is a contract between two parties. The buyer receives a privilege for which hepays a premium. The seller accepts an obligation for which he receives a fee.

ExampleNow let us see how one can profit from buying an option. Mr. Shah feels that the market will go up. Heis bullish on Nifty but he does not want to lose money if he is turned wrong and if the market goes down.

n He buys an Options Contract September 2006 Nifty for a strike price of 3450 paying a premium ofRs. 50.

n In about 15 days time Nifty goes up and therefore he sells the option for Rs. 75 making a profit ofRs. 25 per Nifty.

n The contract size being 100 he will make a profit of Rs. 25*100 = Rs. 2,500/-.

n If he had not sold and if the Nifty had gone up further he would have made even more profits.

n If the Nifty were to fall his maximum loss would have been restricted to Rs. 50*100 = Rs. 5,000/-the premium paid by him for having bought the call option.

n Thus, you can see that the profit potential in a call option is unlimited while the loss is limited to theactual premium paid.


Call Options-Long & Short PositionsWhen you expect prices to rise, then you take a long position by buying calls. You are bullish.

When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put OptionsA Put Option gives the holder of the right to sell a specific number of shares of an agreed security at afixed price for a period of time.

Example: Mr. Dutt purchases one contract of Infoysys Technologies Sep 2006 1800 Put —PremiumRs. 50 (contract size 100 shares)

This contract allows Sam to sell 100 shares Infosys Technologies at Rs. 1800 per share at any timebetween the current date and the expiry of Sep 2006 series. To have this privilege, Sam pays a premiumof Rs. 5,000 (Rs. 50 a share for 100 shares).

He will make a profit if the share price of Infosys Technologies falls during this period. He has thepotential to make high profits as there is a potential for the stock price to fall by any amount but in casethe price of the share goes up; he will suffer a loss but the loss will be limited to Rs. 5,000/- premium paidby him for purchasing the right to sell (buy a put option)

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Put Options-Long & Short PositionsWhen you expect prices to fall, then you take a long position by buying Puts. You are bearish.

When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

The following table will summarise the actions to be taken depending upon your view on the stock price:

Summary


Option stylesSettlement of options is based on the expiry date. However, there are three basic styles of options youwill encounter which affect settlement. The styles have geographical names, which have nothing to dowith the location where a contract is agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell the underlyinginstrument only on the expiry date. This means that the option cannot be exercised early. Settlementis based on a particular strike price at expiration. Currently, in India only index options are European innature.

Example: Mr. Dutt purchases 1 NIFTY SEP 2006 3450 Call — Premium 20. The exchange will settlethe contract on the last Thursday of August. Since there are no shares for the underlying, the contract iscash settled.

American: These options give the holder the right, but not the obligation, to buy or sell the underlyinginstrument on or before the expiry date. This means that the option can be exercised early. Settlementis based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are “American Options” whilethe options on the Index are “European Options”.

Example: Mr Patel purchases 1 TATA STEEL SEP 06 - 520 Call —Premium 20

Here Mr. Patel can close the contract any time from the current date till the expiration date, which is thelast Thursday of September.

American style options tend to be more expensive than European style because they offer greaterflexibility to the buyer.

Option Class & SeriesGenerally, for each underlying, there are a number of options available: For this reason, we have theterms “class” and “series”.

An option “class” refers to all options of the same type (call or put) and style (American or European) thatalso have the same underlying.

Example: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same underlying,the same expiration date and the same exercise price.

Example: ACC SEP 2006 900 refers to one series and trades take place at different premiums

Concepts

Important TermsStrike price: The Strike Price denotes the price at which the buyer of the option has a right to purchaseor sell the underlying. Five different strike prices will be available at any point of time. The strike priceinterval will be of 20. If the index is currently at 3,410, the strike prices available will be 3,370; 3,390;3,410; 3,430; 3,450. The strike price is also called Exercise Price. This price is fixed by the exchangefor the entire duration of the option depending on the movement of the underlying stock or index in thecash market.

In-the-money: A Call Option is said to be “In-the-Money” if the strike price is less than the market price of


the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.

Example: Ram purchases 1 ACC SEP 900 Call —Premium 50

In the above example, the option is “in-the-money”, till the market price of ACC is ruling above the strikeprice of Rs. 900, which is the price at which Ram would like to buy 100 shares anytime before the expiryof Sep 2006 series.

Similary, if Ram had purchased a Put at the same strike price, the option would have been “in-the-money”, if the market price of ACC was lower than Rs. 900 per share.

Out-of-the-Money: A Call Option is said to be “Out-of-the-Money” if the strike price is greater than themarket price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.

At-the-Money: The option with strike price equal to that of the market price of the stock is considered asbeing “At-the-Money” or Near-the-Money.

If the index is currently at 3,410, the strike prices available will be 3,370; 3,390; 3,410; 3,430; 3,450. Thestrike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 3430 and 3450 considering that the underlying is at 3410. Similarly in-the-moneystrike prices will be 3,370 and 3,390, which are lower than the underlying of 3,410 while the strike priceof 3410 is ‘at the money’.

At these prices one can take either a positive or negative view on the markets i.e. both call and put optionswill be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and consideringthat there are three series a total number of 30 options will be available to take positions in.

Covered Call OptionCovered option helps the writer to minimize his loss. In a covered call option, the writer of the calloption takes a corresponding long position in the stock in the cash market; this will cover his loss in hisoption position if there is a sharp increase in price of the stock. Further, he is able to bring down hisaverage cost of acquisition in the cash market (which will be the cost of acquisition less the optionpremium collected).

Example: Mr. Rajan believes that HLL has hit rock bottom at the level of Rs. 232 and it will move in anarrow range. He can take a long position in HLL shares and at the same time write a call option with astrike price of 235 and collect a premium of Rs. 5 per share. This will bring down the effective cost ofHLL shares to 227 (232-5). If the price stays below 235 till expiry, the call option will not be exercisedand the writer will keep the Rs.5 he collected as premium. If the price goes above 235 and the Option isexercised, the writer can deliver the shares acquired in the cash market.

Covered Put OptionSimilarly, a writer of a Put Option can create a covered position by selling the underlying security (if it isalready owned). The effective selling price will increase by the premium amount (if the option is notexercised at maturity). Here again, the investor is not in a position to take advantage of any sharpincrease in the price of the asset as the underlying asset has already been sold. If there is a sharpdecline in the price of the underlying asset, the option will be exercised and the investor will be left onlywith the premium amount. The loss in the option exercised will be equal to the gain in the short positionof the asset.

Pricing of optionsOptions are used as risk management tools and the valuation or pricing of the instruments is a careful


balance of market factors.

There are four major factors affecting the Option premium:

n Price of Underlying

n Time to Expiry

n Exercise Price Time to Maturity

n Volatility of the UnderlyingAnd two less important factors:

n Short-Term Interest Rates

n Dividends

The Intrinsic Value of an OptionThe intrinsic value of an option is defined as the amount by which an option is in-the-money, or theimmediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strikeprice must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0.For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlyingThe premium is affected by the price movements in the underlying instrument. For Call options (the rightto buy the underlying at a fixed strike price) as the underlying price rises so does its premium. As theunderlying price falls so does the premium.

For Put options as the underlying price rises, the premium falls; as the underlying price falls thepremium rises.

The following chart summarises the above for Calls and Puts.

The Time Value of an OptionGenerally, the longer the time remaining until an option’s expiration, the higher its premium will be. Thisis because the longer an option’s lifetime, greater is the possibility that the underlying share price mightmove so as to make the option in-the-money. All other factors affecting an option’s price remaining the


same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life. When an optionexpires in-the-money, it is generally worth only its intrinsic value.

VolatilityVolatility is the tendency of the underlying security’s market price to fluctuate either up or down. Itreflects a price change’s magnitude; it does not imply a bias toward price movement in one direction orthe other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of theunderlying stock, the higher the premium because there is a greater possibility that the option will movein-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both callsand puts overlying that stock increase, and vice versa.

Higher volatility = Higher premium

Lower volatility = Lower premium

Interest ratesIn general interest rates have the least influence on options and equate approximately to the cost ofcarry of a futures contract. If the size of the options contract is very large, then this factor may becomeimportant. All other factors being equal as interest rates rise, premium costs fall and vice versa. Therelationship can be thought of as an opportunity cost. In order to buy an option, the buyer must eitherborrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest ratesare rising, then the opportunity cost of buying options increases and to compensate the buyer premiumcosts fall. Why should the buyer be compensated? Because the option writer receiving the premium canplace the funds on deposit and receive more interest than was previously anticipated. The situation isreversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.


The options premium is determined by the three factors mentioned earlier – intrinsic value, time valueand volatility. But there are more sophisticated tools used to measure the potential variations of optionspremiums. They are as follows:

n Delta

n Gamma

n Vega

n Rho

DeltaDelta is the measure of an option’s sensitivity to changes in the price of the underlying asset. Therefore,it is the degree to which an option price will move given a change in the underlying stock or index price,all else being equal.

Change in option premiumDelta = —————————————

Change in underlying priceFor example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlyingstock or index.

ExampleA trader is considering buying a Call option on a futures contract, which has a price of Rs. 20. Thepremium for the Call option with a strike price of Rs. 19 is 0.80. The delta for this option is +0.5. Thismeans that if the price of the underlying futures contract rises to Rs. 21 – a rise of Re 1 – then thepremium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs. 1.30.

Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is notlikely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1.

While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and theunderlying stock price are inversely related. This is because if you buy a put your view is bearish andexpect the stock price to go down. However, if the stock price moves up it is contrary to your viewtherefore, the value of the option decreases. The put delta equals the call delta minus 1.

It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price.On the contrary, if delta is negative, you want the underlying asset’s price to fall.


Uses: The knowledge of delta is of vital importance for option traders because this parameter is heavilyused in margining and risk management strategies. The delta is often called the hedge ratio. e.g. if youhave a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls youwould need to be short (i.e. need to write) to create a riskless hedge – i.e. a portfolio which would beworth the same whether the stock price rose by a very small amount or fell by a very small amount.

In such a “delta neutral” portfolio any gain in the value of the shares held due to a rise in the share pricewould be exactly offset by a loss on the value of the calls written, and vice versa.

Note that as the delta changes with the stock price and time to expiration, the number of shares wouldneed to be continually adjusted to maintain the hedge.

GammaThis is the rate at which the delta value of an option increases or decreases as a result of a move in theprice of the underlying instrument.

Change in option deltaGamma = —————————————

Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of ±1 in the underlyingmeans the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is rather like the rateof change in the speed of a car – its acceleration – in moving from a standstill, up to its cruising speed,and braking back to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) andfalls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill).

ThetaIt is a measure of an option’s sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generallyused to gain an idea of how time decay is affecting your portfolio.

Change in an option premiumTheta = ———————————————

Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases. This isdue to the fact that the uncertainty element in the price decreases.

Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the secondday to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter thepremium. Theta is only concerned with the time value. Unfortunately, we cannot predict with accuracy thechange’s in stock market’s value, but we can measure exactly the time remaining until expiration.

VegaThis is a measure of the sensitivity of an option price to changes in market volatility. It is the change ofan option premium for a given change – typically 1% – in the underlying volatility.

Change in an option premiumVega = ——————————————

Change in volatility


Example: If stock X has a volatility factor of 30% and the current premium is 3, a vega of .08 wouldindicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%. As thestock becomes more volatile the changes in premium will increase in the same proportion. Vega measuresthe sensitivity of the premium to these changes in volatility.

What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it ispossible to trade options purely in terms of volatility – the trader is not exposed to changes in underlyingprices.

RhoThe change in option price given a one percentage point change in the risk-free interest rate. Rhomeasures the change in an option’s price per unit increase –typically 1% – in the cost of funding theunderlying.

Change in an option premiumRho = ———————————————————

Change in cost of funding underlying

Options Pricing ModelsThere are various option pricing models which traders use to arrive at the right value of the option. Someof the most popular models have been enumerated below.

The Binomial Pricing ModelThe binomial model is an options pricing model which was developed by William Sharpe in 1978. Today,one finds a large variety of pricing models which differ according to their hypotheses or the underlyinginstruments upon which they are based (stock options, currency options, options on interest rates).

The binomial model breaks down the time to expiration into potentially a very large number of timeintervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration.At each step it is assumed that the stock price will move up or down by an amount calculated usingvolatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlyingstock prices. The tree represents all the possible paths that the stock price could take during the life ofthe option.

At the end of the tree – i.e. at expiration of the option — all the terminal option prices for each of the finalpossible stock prices are known as they simply equal their intrinsic values.

Next the option prices at each step of the tree are calculated working back from expiration to the present.The option prices at each step are used to derive the option prices at the next step of the tree using riskneutral valuation based on the probabilities of the stock prices moving up or down, the risk free rate andthe time interval of each step. Any adjustments to stock prices (at an ex-dividend date) or option prices(as a result of early exercise of American options) are worked into the calculations at the required pointin time. At the top of the tree you are left with one option price.

Advantage: The big advantage the binomial model has over the Black-Scholes model is that it can beused to accurately price American options. This is because, with the binomial model it’s possible tocheck at every point in an option’s life (ie at every step of the binomial tree) for the possibility of earlyexercise (eg where, due to a dividend, or a put being deeply in the money the option price at that pointis less than its intrinsic value).

Where an early exercise point is found it is assumed that the option holder would elect to exercise and


the option price can be adjusted to equal the intrinsic value at that point. This then flows into the calculationshigher up the tree and so on.

Limitation: As mentioned before the main disadvantage of the binomial model is its relatively slowspeed. It’s great for half a dozen calculations at a time but even with today’s fastest PCs it’s not apractical solution for the calculation of thousands of prices in a few seconds which is what’s required forthe production of the animated charts.

The Black & Scholes ModelThe Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of themost popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation:unlike the binomial model, it does not rely on calculation by iteration.

The intention of this section is to introduce you to the basic premises upon which this pricing model rests.

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during thelife of the option) using the five key determinants of an option’s price: stock price, strike price, volatility,time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

OP = SN(d1) - XertN(d2 )

Where:

The variables are:

S = stock price

X = strike price

t = time remaining until expiration, expressed as a percent of a year

r = current continuously compounded risk-free interest rate

v = annual volatility of stock price (the standard deviation of the short-term returns over one year).

ln = natural logarithm

N(x) = standard normal cumulative distribution function

e = the exponential function

Lognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed toa normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution ofbetween zero and infinity (ie no negative prices) and has an upward bias (representing the fact that astock price can only drop 100 per cent but can rise by more than 100 per cent).

Risk-neutral valuation: The expected rate of return of the stock (ie the expected rate of growth of theunderlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-Scholes model (or any other model for option valuation). The important implication is that the price of anoption is completely independent of the expected growth of the underlying asset. Thus, while any two


investors may strongly disagree on the rate of return they expect on a stock they will, given agreement tothe assumptions of volatility and the risk free rate, always agree on the fair price of the option on thatunderlying asset.

The key concept underlying the valuation of all derivatives — the fact that price of an option is independentof the risk preferences of investors — is called risk-neutral valuation. It means that all derivatives can bevalued by assuming that the return from their underlying assets is the risk free rate.

Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widelyused adaptations to the original formula, which enable it to handle both discrete and continuous dividendsaccurately.

However, despite these adaptations the Black-Scholes model has one major limitation: it cannot beused to accurately price options with an American-style exercise as it only calculates the option price atone point in time — at expiration. It does not consider the steps along the way where there could be thepossibility of early exercise of an American option.

As all exchange traded equity options have American-style exercise (ie they can be exercised at anytime as opposed to European options which can only be exercised at expiration) this is a significantlimitation.

The exception to this is an American call on a non-dividend paying asset. In this case the call is alwaysworth the same as its European equivalent as there is never any advantage in exercising early.

Advantage: The main advantage of the Black-Scholes model is speed — it lets you calculate a verylarge number of option prices in a very short time.

Bull Market Strategies

Calls in a Bullish StrategyAn investor with a bullish market outlook should buy call options. If you expect the market price of theunderlying asset to rise, then you would rather have the right to purchase at a specified price and selllater at a higher price than have the obligation to deliver later at a higher price.

The investor breaks even when the market price equals the exercise price plus the premium.

Puts in a Bullish StrategyAn investor with a bullish market outlook can also go short on a Put option. Basically, an investoranticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying assetincreases and the option expires worthless. The maximum profit is limited to the premium received.

However, the potential loss is unlimited. Because a short put position holder has an obligation topurchase if exercised. He will be exposed to potentially large losses if the market moves against hisposition and declines.

The break-even point occurs when the market price equals the exercise price: minus the premium. Atany price less than the exercise price minus the premium, the investor loses money on the transaction.At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your return. As an option writer, thehigher price you will be forced to pay in order to buy back the option at a later date, lower is the return.


Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with differentexercise prices.

To “buy a call spread” is to purchase a call with a lower exercise price and to write a call with a higherexercise price. The trader pays a net premium for the position.

To “sell a call spread” is the opposite, here the trader buys a call with a higher exercise price and writesa call with a lower exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should buy a call spread. The “Bull Call Spread” allows theinvestor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. Thecombination of these two options will result in a bought spread. The cost of Putting on this position willbe the difference between the premium paid for the low strike call and the premium received for thehigh strike call.

The investor’s profit potential is limited. When both calls are in-the-money, both will be exercised andthe maximum profit will be realised. The investor delivers on his short call and receives a higher pricethan he is paid for receiving delivery on his long call.

The investor’s potential loss is limited. At the most, the investor can lose is the net premium. He pays ahigher premium for the lower exercise price call than he receives for writing the higher exercise price call.

The investor breaks even when the market price equals the lower exercise price plus the net premium.At the most, an investor can lose the net premium paid. To recover the premium, the market price mustbe as great as the lower exercise price plus the net premium.

An example of a Bullish call spreadLet’s assume that the cash price of a scrip is Rs. 100 and you buy a September call option with a strikeprice of Rs. 90 and pay a premium of Rs. 14. At the same time you sell another September call option onthe same scrip with a strike price of Rs. 110 and receive a premium of Rs 4. Here you are buying a lowerstrike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 atthe time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the firstposition established in the spread is the long lower strike price call option with unlimited profit potential.At the same time to reduce the cost of puchase of the long position a short position at a higher call strikeprice is established. While this not only reduces the outflow in terms of premium but his profit potentialas well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakevenpoint of this spread would be as follows:

Maximum profit = Higher strike price - Lower strike price - Net premium paid

= 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100


Bullish Put Spread StrategiesA vertical Put spread is the simultaneous purchase and sale of identical Put options but with differentexercise prices.

To “buy a put spread” is to purchase a Put with a higher exercise price and to write a Put with a lowerexercise price. The trader pays a net premium for the position.

To “sell a put spread” is the opposite: the trader buys a Put with a lower exercise price and writes a putwith a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should sell a Put spread. The “vertical bull put spread” allowsthe investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

Bear Market Strategies

Puts in a Bearish StrategyWhen you purchase a put you are long and want the market to fall. A put option is a bearish position. It willincrease in value if the market falls. An investor with a bearish market outlook shall buy put options. Bypurchasing put options, the trader has the right to choose whether to sell the underlying asset at the exerciseprice. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor’s profit potential is practically unlimited. The higher the fall in price of the underlying asset,higher the profits.

Calls in a Bearish StrategyAnother option for a bearish investor is to go short on a call with the intent to purchase it back in thefuture. By selling a call, you have a net short position and needs to be bought back before expiration andcancel out your position.

For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lowermarket price.

The investor’s profit potential is limited because the trader’s maximum profit is limited to the premiumreceived for writing the option.

Here the loss potential is unlimited because a short call position holder has an obligation to sell ifexercised, he will be exposed to potentially large losses if the market rises against his position.

The investor breaks even when the market price equals the exercise price: plus the premium. At anyprice greater than the exercise price plus the premium, the trader is losing money. When the marketprice equals the exercise price plus the premium, the trader breaks even.

Bearish Put Spread StrategiesA vertical put spread is the simultaneous purchase and sale of identical put options but with differentexercise prices.

To “buy a put spread” is to purchase a put with a higher exercise price and to write a put with a lowerexercise price. The trader pays a net premium for the position.

To “sell a put spread” is the opposite. The trader buys a put with a lower exercise price and writes a putwith a higher exercise price, receiving a net premium for the position.


An example of a bearish put spread.Lets assume that the cash price of the scrip is Rs. 100. You buy a September put option on a scrip with astrike price of Rs. 110 at a premium of Rs. 15 and sell a September put option with a strike price of Rs. 90at a premium of Rs. 5.

In this bearish position the put is taken as long on a higher strike price put with the outgo of somepremium. This position has huge profit potential on downside, if the trader may recover a part of thepremium paid by him by writing a lower strike price put option. The resulting position is a mildly bearishposition with limited risk and limited profit profile. Though the trader has reduced the cost of taking abearish position, he has also capped the profit portential as well. The maximum profit, maximum lossand breakeven point of this spread would be as follows:

Maximum profit = Higher strike price option - Lower strike price option - Net premium paid

= 110 - 90 - 10 = 10

Maximum loss = Net premium paid

= 15 - 5 = 10

Breakeven Price = Higher strike price - Net premium paid

= 110 - 10 = 100

Bearish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with differentexercise prices.

To “buy a call spread” is to purchase a call with a lower exercise price and to write a call with a higherexercise price. The trader pays a net premium for the position.

To “sell a call spread” is the opposite: the trader buys a call with a higher exercise price and writes acall with a lower exercise price, receiving a net premium for the position.

To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sellsthe lower strike and buys the higher strike of either calls or puts to put on a bear spread.

The investor’s profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the netpremium: The premium he receives for the call at the higher exercise price.

Here the investor’s potential loss is limited. If the market rises, the options will offset one another. At anyprice greater than the high exercise price, the maximum loss will equal high exercise price minus lowexercise price minus net premium.

The investor breaks even when the market price equals the lower exercise price plus the net premium.The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium,the market price does not have to fall as low as the lower exercise price to breakeven.

Volatile Market Strategies

Straddles in a Volatile Market OutlookVolatile market trading strategies are appropriate when the trader believes the market will move butdoes not have an opinion on the direction of movement of the market. As long as there is significantmovement upwards or downwards, these strategies offer profit opportunities. A trader need not be


bullish or bearish. He must simply be of the opinion that the market is volatile.

n A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the othera put.

1. To “buy a straddle” is to purchase a call and a put with the same exercise price andexpiration date.

2. To “sell a straddle” is the opposite: the trader sells a call and a put with the same exerciseprice and expiration date.

A trader, viewing a market as volatile, should buy option straddles. A “straddle purchase” allows thetrader to profit from either a bull market or from a bear market.

Here the investor’s profit potential is unlimited. If the market is volatile, the trader can profit from an up-or downward movement by exercising the appropriate option while letting the other option expire worthless.(Bull market, exercise the call; bear market, the put.)

While the investor’s potential loss is limited. If the price of the underlying asset remains stable instead ofeither rising or falling as the trader anticipated, the most he will lose is the premium he paid for theoptions.

In this case the trader has long two positions and thus, two breakeven points. One is for the call, whichis exercise price plus the premiums paid, and the other for the put, which is exercise price minus thepremiums paid.

Strangles in a Volatile Market OutlookA strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually,both the call and the put are out-of-the-money.

To “buy a strangle” is to purchase a call and a put with the same expiration date, but different exerciseprices.

To “sell a strangle” is to write a call and a put with the same expiration date, but different exercise prices.

A trader, viewing a market as volatile, should buy strangles. A “strangle purchase” allows the trader toprofit from either a bull or bear market. Because the options are typically out-of-the-money, the marketmust move to a greater degree than a straddle purchase to be profitable.

The trader’s profit potential is unlimited. If the market is volatile, the trader can profit from an up- ordownward movement by exercising the appropriate option, and letting the other expire worthless. (In abull market, exercise the call; in a bear market, the put).

The investor’s potential loss is limited. Should the price of the underlying remain stable, the most thetrader would lose is the premium he paid for the options. Here the loss potential is also very minimalbecause, the more the options are out-of-the-money, the lesser the premiums.

Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevenswhen the market price equal the high exercise price plus the premium paid, and for the put, when themarket price equals the low exercise price minus the premium paid.

Advantages of option tradingRisk management: Put options allow investors holding shares to hedge against a possible fall in theirvalue. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call


option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares.Likewise the taker of a put option has time to decide whether or not to sell the shares.

Speculation: The ease of trading in and out of an option position makes it possible to trade options withno intention of ever exercising them. If an investor expects the market to rise, they may decide to buycall options. If expecting a fall, they may decide to buy put options. Either way the holder can sell theoption prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as thereis no stamp duty payable unless and until options are exercised.

Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay thaninvesting directly. However, leverage usually involves more risks than a direct investment in the underlyingshares. Trading in options can allow investors to benefit from a change in the price of the share withouthaving to pay the full price of the share.

Income generation: Shareholders can earn extra income over and above dividends by writing calloptions against their shares. By writing an option they receive the option premium upfront. While theyget to keep the option premium, there is a possibility that they could be exercised against and have todeliver their shares to the taker at the exercise price.

Strategies: By combining different options, investors can create a wide range of potential profit scenarios.To find out more about options strategies read the module on trading strategies.


Review Questions:

1. In an options contract the option lies with which one of the following:

a. Buyerb. Sellerc. Bothd. The stock exchange

2. The potential returns on a futures contract are:

a. Limitedb. Unlimitedc. A function of the volatility of the indexd. None of the above

3. On 13th August 2006 Mr. Ashwin Mehta bought a Aug Nifty futures contract of 100 Nifties whichcost him Rs. 3,40,000/-. He paid a margin of Rs. 51,000/- On expiry date Nifty closed at 3430.How much profit/loss Mr. Ashwin Mehta made in this transaction?

a. Profit of Rs. 6000b. Profit of Rs. 300c. Profit of Rs. 3000d. Loss of Rs. 6000

4. A stock currently sells at Rs. 240. The put option to sell the stock at Rs. 255 costs Rs 19. The timevalue of the option is:

a. Rs. 19b. Rs. 5c. Rs. 4d. Rs. 15

5. A put option gives the ———————— the right but not the obligation to —————— theunderlying asset at a specified price:

a. seller, buyb. seller, sellc. owner, buyd. owner, sell

6. If spot Nifty is 3400 and the interest rate is 12% p.a. what should be the fair price of One monthNifty futures contract?

a. 3412b. 3424c. 3434d. 3452


7. A speculator thinks that India Cements is going to rise sharply. He has a long position on the cashmarket in India Cements to the extent of Rs. 20 lacs. India Cements has a beta of 1.3. Which ofthe following positions on Index futures gives him a complete hedge?

a. Long Nifty Rs. 26 lacsb. Short Nifty Rs. 26 lacsc. Long Nifty Rs. 20 lacsd. Short Nifty Rs. 20 lacs

8. In the first week of September you observe that the spread between the September and Octoberof Siemens futures has narrowed down to Rs.10 as against the usual Rs. 20. How can you profitfrom this observation?

a. By buying the September futures and selling October futuresb. By selling the September futures and buying the October futuresc. By bothd. None of the above

9. On 1st September 2006 a call option of Nifty with a strike price of Rs 3400 is available for trading.Expiry date for September 2006 contracts is 27. The “T” that is used in Black- Sholes formulashould be:

a. 27b. 0.074c. 0.061d. None of the above

10. An American Option can be exercised :

a. At any time till expiryb. Only on expiryc. It is not used in Indiad. None of the above

11. An European Option can exercised :

a. At any timeb. Only on expiryc. Both at any time and on expiryd. None of the above

12. At any given time the F&O segment of NSE provides trading facility for ——— Nifty futures contracts:

a. 1b. 3c. 2d. 9


13. An investor buys two market lots of Sep 3400 Nifty calls at Rs. 76 per call and sells two marketlots of Sep 3400 Nifty call at Rs. 40 a call. Each market lot of Nifty is 100. If Nifty closes at 3460on the expiration date, the pay off, net of costs from this bull spread will be :

a. profit of 4,800b. loss of 4,800c. loss of 2,400d. profit of 2,400

14. A bull spread is created by

a. buying a call and buying a putb. buying a call and selling a callc. buying two putsd. buying two calls

Answers:

1. a

2. b

3. c

4. c

5. d

6. c

7. b

8. b

9. b

10. a

11. b

12. b

13. a

14. b


Chapter 13


Let’s look at real estate as an investment vehicle where the income earning capacity and capitalappreciation over time become more important than occupation for self use.

Characteristics of real estate investments

Higher capital requirementIt is possible for an investor to participate in debt or equity through small investments; say Rs. 5,000/-where as in the case of direct investment in real estate the amounts required will be much higher. Thatalso essentially means that this asset class would some time become the most important (heavilyweighted) in value terms in one’s portfolio. The heavy capital cost keeps a large number of small investorsaway and that also contributes in reducing the number of investors who participate in real estate. Indirectinvestments in real estate through Mutual fund realty funds have cleared the legal requirements and areset to be launched in India where after retail participation in realty may become easier.

IlliquidityReal estate is difficult to acquire and more difficult to sell because of absence of organized markets as in thecase of bonds and equities That makes it a tall task for the investor to search for real estate worth investing;time and money are spent in finding investment options – same is the case at the time of sale. The realestate then becomes essentially a long term investment option where liquidity is a very big problem.

Title and legal problemsThe property laws are not investor friendly. Buying property involves not just selection of a good propertywith scope for income and or appreciation but also with a good marketable title. Numerous cases havecome up where titles have been challenged many decades after deals on the properties have beenentered into. With the judiciary taking a long time to settle matters of title in properties the laws in respectto real estate are cumbersome and can easily put off enthusiastic investors. “Buyers beware” is themost applicable jargon and can prove quite tricky in real estate deals.

Government controls; policies, etc.Real estate holdings involve a lot of legislation on who can own; etc. Many of these are State legislationsand hence require specialist advice on these matters. Documentation involving payment of stamp duties,at arbitrary rates fixed by Stamp offices, mandatory registration, etc. not only increase the cost oftransactions but involve physical presence of the buyers and sellers for executing the transfer documents.In other words, physical inconvenience and heavy costs make real estate investments that much lessattractive.

Legal complexitiesThe legal contracts between property owners, financiers and tenants are quite complex and requirelegal interpretation and construction. This aspect of real estate brings in not only additional costs but thechoice of right legal consultant.

Real Estate


Management burdenBuying real estate is a complex process but holding on to it is also not easy. It involves considerable costof maintenance; taxes – municipal and other charges, etc. Being able to retain possession, especially incase of vacant lands, can be a challenging management task where many times “possession is consideredownership” and the onus then falls on the owner to prove his title – in legal battles for possession thatcan stretch to decades.

Inefficient marketReal estates don’t have a market place as equities or bonds have. The market is not properly structured.Because of the very nature of immovable properties the market is also highly localized where localfactors play a very vital role. A national market has not developed in real estate because of physicallimitations as they exist today – in other words a person in New Delhi may find real estate in Bangalorea very attractive proposition but it will be physically impossible for him to participate in this investmentopportunity. There is a need for a national and structure market to emerge in order to attract large scaleinvestments – but because of typical state laws it may become difficult in India to have a very dynamicand liquid real estate market.

Advantages of real estate

1. Scope for capital appreciation – the longer one holds on to properties, it has been observed, higher thecapital appreciation – demand for houses has been on the rise thanks to increasing income levels andlower cost of housing loans and the input costs like steel, cement, etc. have also been rising.

2. Income stream – where the property can be rented out – property rentals have been going upbecause of large scale employment generation in urban centres where people from smaller placesmove in to rental accommodation as ownership is beyond them at least in the initial years ofemployment.

3. Sense of security – properties are considered less volatile compared to paper securities like bondsor shares – falling prices are quite rare – capital loss may not be incurred – obviously these areperceptions and may not be right.

4. Sense of pride – It gives a sense of pride to the individual that he stays in a house owned by himand this can not be measured in monetary terms.

5. Self occupation – house properties are bought more for self occupation than for reasons of investment– at the point of self occupation these are not investments – but at the time of retirement peoplemay shift to smaller cities in which case the ownership houses in bigger cities can be sold atsubstantially higher prices and this shall provide retirement capital as well. Sometimes people mayshift from smaller homes to bigger ones or from one locality to another when their older homesfetch them handsome prices compared to purchase costs thus making them a very good investment.

6. Tax shelter – the income earned on rented properties is subject to some deduction; the tax oncapital gains made on real estate can be saved totally through planning; a housing loan gives theinvestor tax advantages – which we shall consider in greater details later. These tax advantagesmake real estate an attractive proposition for high net worth individuals, corporates, e tc .Numerous tax advantages exist in the case of agricultural land – agricultural income being exemptfrom Income tax even though it may have a nominal impact of taxation in the lower income taxbracket while capital gains on sale of agricultural land is fully exempt.

If an investor is able to analyze carefully take professional advice and legal help and invests for longterm the scope for appreciation is quite high and this vehicle can yield handsome returns not only in


percentage terms but in quantitative terms as well because of inherent high value investment involved.

Disadvantages of real estate

Legal issuesThere are a large number of legal issues involved in investing in real estate. Many of the legislations areState legislations and hence a good understanding of local laws is essential. For example lands can bebought and registered only in the name of farmers – i.e. you can buy agricultural land only if you alreadyown agricultural land in that state. Land ceiling laws are applicable in certain states which makes buyinga large piece of land highly risky. Popular tenancy laws exist in many states where the tiller becomes theowner of the agricultural land. These legal issues are complex and an investment in agricultural land,not withstanding the tax advantages, can be considered only if an investor has a thorough understandingof these complex legal issues.

High cost of maintenanceUrban house property owners are required to pay maintenance charges to co operative housing societiesfor common facilities – like lifts, security, water, common lighting, etc. These are essential costs ofmaintenance and these costs are rising at alarming rates. If one holds house properties for just capitalappreciation and not for self use or renting out then the costs become all the more heavy and can impactthe over all returns on this property investment.

Municipal and other leviesAn owner of land or house property is required to pay the local authority certain taxes on a regular basis.These are essentially charges for the services such as drainage, water supply, etc. that are provided bythe local bodies. These costs have also risen substantially over time. Besides usage based chargeslocal bodies charge property tax and there are proposals that these taxes could become “ad valorem” -that is on value – in other words if a house property is of high value then it may attract very highmunicipal property tax. This means that holding costs in respect of high value house properties can goup astronomically making it uneconomical to hold them as long term investments.

There are numerous other disadvantages such as higher investment quantum, illiquidity, lack of organizedmarket, absence of uniform laws, etc. which we have discussed under the “characteristics of real estateinvestments”.

Real estates essentially involve high capital outlay. In order to attract retail investors the market playershave found many ways. Some of them are listed below:

Realty fundsMutual funds have now been permitted by SEBI, the regulator, to launch realty funds. These fundscollect corpus from retail investors and large investors – pool the funds and invest directly in properties– residential and or commercial; shares and bonds of housing finance companies and real estate andproperty companies. In other words through the mutual funds route it has now become possible for asmall investor to participate in the property market and reap the benefits of the same in an indirect way.

Time ShareSome companies have floated novel schemes where an investor can own properties for a part of theyear; say for enjoying holidays for a few days in a year. There is rotational ownership with maintenanceand other matters being managed by the company itself. The returns you get on this is essentially costfree holidays without hassles of maintaining the properties. You own it on a right to use concept.


Lease back arrangementsSome builders sell house properties to investors and they assure a minimum guaranteed lease rental onthese properties. The investor makes a lump sum investment and buys a house property and in returnthe builder arranges to rent out the property at a fixed rent ensuring that the investor gets a minimumassured return on the property. This helps the investor in arriving at an investment decision because heknows the possible returns on the property and he is saved the trouble of hunting for an occupant. Thebuilders normally assure through this process a fixed rental income per month for a fixed period of time.These concepts have become very popular especially in tourist centres like Goa, etc.

Valuation of real estateIt is important to have a clear idea of valuation of a property both at the time of purchase as well as atthe time of sale. The parameters of valuation are complex and the valuations are many times highlysubjective. The price for a property is arrived at mutually by the buyer and the seller while the valuecould be different. They tend to be very close to each other if both the buyer and seller are makinginformed decisions.

Considerations for value

1. Location – accessibility to public conveyance (nearness to local railway station in the case ofMumbai city) – nearness to schools, work place, hospitals, temples, bus stand, railway station,gardens, parks, etc. are important considerations. Many housing complexes try to provide most ofthese facilities like schools, shopping centres, play grounds, hospitals, etc. inside the complex tomake it an attractive investment at a good price.

2. Proximity to employment opportunities: Shuttle cities near major cities have developed into goodcentres because of nearness to mega cities. Investors who cannot afford property investments inmega cities tend to invest in these suburbs or shuttle cities. Because major employment opportunitiesgenerally exist in major cities these shuttle cities also develop over a period of time providingappreciation and income to the investors in these smaller cities/towns. Values of properties incities like Bangalore have gone up because IT sector companies have moved into the city in a bigway, providing huge employment opportunities.

3. Environment – the general environment is also considered while making investment decision –whether the area is growing in importance or static or declining.

4. Infrastructure: Easy accessibility through good road, drainage, water and power supply, cleansurroundings, etc. are important considerations.

5. The quality of construction, amenities provided, quality of other facilities provided.. etc. are importantfactors while buying house property.

Traditional approaches to valuation

a. Capitalization approachIt is important to find out based on a market research what kind of yields are obtainable on comparableproperties. Secondly it is required to work out the net income derived from the property by deductingexpenses like repairs, insurance, etc. from the gross income and finally capitalize the net income for themarket yield on the property.

ExampleLet’s presume that rent fetched is generally around 8.5% of property values.


If rental income of say Rs. 20,000/- p.m. is earned on a property and expenses to the tune of sayRs. 20,000/- are incurred every year on insurance, repairs, etc. then the net annual rental incomefrom the property would amount to 12*20000 -20000 = 220000/-

Capitalising net income of Rs. 2,20,000/- for an yield of 8.5% as follows, we get the capital value of theproperty: 2,20,000/0.085 = Rs. 25,88,235/-

b. Discounted cash flow methodIf the property was bought earlier and has been earning regular income on a year on year basis we haveto work out the present value of cash flows using our standard formula used in annuity calculations.Value of the property is the present values of all cash flows to be received by owning the property as wellas expected cash flow on sale of the property after a definite period of time. It is difficult to predict thefuture prices while a reasonable estimation of possible rental income can be made. Rentals also tend tofluctuate and normally go up over a period of time. If we are given the present price, expected price atwhich the property will be sold after a few years and the quantum of rental income on a yearly basis thenwe can work out the return on this investment the same way as we calculate the YTM of bonds.

ExampleAn investor wants to purchase a property which will fetch him a net rental income of Rs. 25,000/- p.a.steadily for the next 3 years at the end of which he will be able to sell the property for Rs. 3,00,000. If theinvestor wants a return of 12% p.a. what price he should pay for the property?

PV = [25000/(1.12)] +[ 25000/(1.12)2]+ [(25000+300000)/(1.12)3]

= 22321.42 +(25000/1.2544)+(325000/1.405)

=22321.42 +19929..84 + 231316.72

= 273356.98 say Rs. 2,73,400/-

He will get desired return of 12% p.a. on a rent of Rs. 25,000/- p.a. for the next 3 years if he purchasesthe property now for Rs. 2,73,400/- sells it after 3 years for Rs. 3,00,000/-

Taxability of real estate investments

Taxability of income

n Rental income is taxable.

n Certain deductions are permitted from the income in computing taxable income on house property.

1. The permitted deductions are:

2. 30% of rent as a standard deduction

3. Interest paid on borrowed capital – the limit of Rs. 1,50,000/- is applicable for self occupiedproperties where the rental income is NIL.

4. Municipal taxes actually paid

n Repayment of principal amount of housing loan is entitled to be deducted from income u/s 80C upto a maximum limit of Rs. 1,00,000/- p.a.

n In case of joint ownership of house property deductions of interest amounts as loss on self occupiedproperty as well deduction u/s 80C are allowed for each one in the same proportion. In other wordsincreased tax benefit and each of the joint holders can enjoy tax advantages.


Taxability of capital gainsIt is defined that if a piece of land or house property had been held for a minimum period of 36 monthsbefore selling then it is long term capital gains and if sold with in 36 months the gains on sale shall betreated as Short Term Capital Gains.

Short term capital gains = Sale consideration (sale price) *

n Expenses like brokerage, advertisement on sale

n Expenses like society transfer charges

n Cost of acquisition

n Cost of improvement

Long Term capital gains = Sale consideration (sale price)*

n Expenses like brokerage, advt, etc on sale

n Expenses like society transfer charges

n Indexed cost of acquisition#

n Indexed cost of improvement*Sale consideration shall be the actual sale price as mentioned in the sale deed or value adopted bystamp duty valuation authority whichever is higher.

# Indexed cost of acquisition is arrived at by multiplying the actual cost with the inflation index (aspublished from time to time) for the year of sale and dividing by the inflation index in the year of purchase.In case of properties bought/acquired/inherited before 1st April 1981 the market value, as per approvedvaluer, shall be taken as the cost of purchase.

Rate of Tax

1. STCG is added to income under the head “Income from other sources” and taxed at the rateapplicable to the tax payer.

2. LTCG is taxed at 20% after arriving at the figure of taxable LTCG as shown above

Saving tax on LTCGIt is possible to save tax payable on LTCG and the provisions have been laid down below:

Sec 54 – Sell a house property and buy or construct another house property

n Applicable for individuals and HUF

n The sold house need not be a self occupied house property

n The sold house need not be the only house property

n The sold house should have been held for more than 36 months from purchase

n New house should be purchased within one year before sale or two years after sale

n New house, if constructed, should be within 3 years after sale

n If the cost of the new house is lower than net sale consideration then the difference will be taxableas LTCG

n If the assessee sells the new house within three years of its purchase then this becomes STCGand the cost of acquisition will be taken as NIL (if the cost of new house is lower than LTCG madeon old house)


n In the previous explanation if the cost of new house was equal to or more than LTCG on old housethe cost of new house will be computed as actual cost – LTCG on the old house

n It may take some time to purchase or construct a new house – the amount of LTCG will have tokept in a special account designated as “Capital Gains Account” with a specified bank before filingreturns for the Previous year in which the old house was sold – the funds in the account can beutilized for buying the new house.

Sec 54 B – sell agricultural land and buy agricultural land -deals with sale of agricultural land, LTCG onsale can be saved by buying another agricultural land as per same terms and conditions listed above fora house property.

Sec 54 EC – sell any long term asset and invest in infrastructure bonds .

An assessee might have made LTCG on sale of any long term capital asset like house, gold and jewellery,land, etc.

n If the entire sale proceeds are invested in bonds of Government companies like Rural ElectrificationCorporation Ltd. and/or National Highway Authority of India, Ltd. then the tax on LTCG can besaved fully.

n If part of the proceeds are invested in such bonds proportionate deduction from LTCG will beallowed

n The investment in bonds u/s 54EC should be made within 6 months of sale

n The lock in period for the bonds will be minimum of 3 years

n The interest on the bonds is taxable

n The rate of interest is decided by the PSU companies – it is currently around 5 -5.5% p.a.Sec 54 F – sell any long term asset and buy a house property

n The tax payer should be individual or HUF

n The LT asset sold should not be a house property

n The new residential house should be purchased with in one year prior to sale or two year after thesale of the old asset or

n The new house should be constructed with in 3 years from the sale of the old asset

n The deduction is applicable to an assessee even if he is already owning a house property.

n If the cost of the new house property is less than LTCG made on the old asset then a proportionaldeduction will be available under this section and balance tax will have to be paid as tax on LTCG.

n If the tax payer sells the new house with in 3 years of purchase the conditions as spelt out earlieru/s 54E will become applicable.

n It may take some time to purchase or construct a new house – the amount of LTCG will have to bekept in a special account designated as “Capital Gains Account” with a specified bank before filingreturns for the Previous year in which the old asset was sold – the funds in the account can beutilized only for buying the new house property.


Review Questions:

1. Mr. Wankhede is planning to sell his house and buy a bigger new house. When should he buy anew house with reference to sale of his old house in order to avail of full benefit of Sec 54 of theIncome Tax Act?

a. With in 1 year after saleb. Within 3 years after salec. Within one year prior to sale or 2 years after saled. Within two years prior to sale or 2 years after sale

2. An investor is considering a purchase of house property which shall fetch him a rental income ofRs. 15,000/- p.m. The investor is looking for 10% returns and he is confident that he can sell theproperty after 3 years for Rs. 5,00,000/- What price should he pay for this house property now?

a. Rs. 4,12,000/-b. Rs. 3,66,000/-c. Rs. 3,87,000/-d. Rs. 4,32,000/-

3. If an individual who has made LTCG wants to save the tax on the same fully, he should investwithin what period of sale to avail benefit u/s 54EC of IT Act?

a. 6 monthsb. 12 monthsc. 3 yearsd. 2 years

4. Husband and wife have together bought a new house and have availed of housing loan from a bank.They have contributed 50% each to cost of the house. If the total amount of interest paid by them onthe home loan for self occupied house property during a financial year has been Rs. 2,40,000/- whatdeduction will each one get from income as ‘Loss under house property”?

a. Either one of them can get a deduction not exceeding Rs. 1.50 lacs but not bothb. Both can get deduction – but the deduction will be restricted to Rs. 1,20,000/- eachc. Only the first holder on the loan will get a deduction and it will be restricted to Rs. 1,50,000/-d. Both can get deduction – but the deduction will be Rs. 1,50,000/- each

Answers:

1. c

2. a

3. a

4. b


Chapter 14


Passive strategy

Some investors perceive that the securities markets, particularly the equity markets, are efficient.There is a belief that the stock market is a barometer of the economy and that the market perfectly

reflects the strengths and weaknesses of the economy over long term while in the short term there canbe temporary aberrations (and over reactions of optimism and pessimism). In an efficient market, theprices of securities do not depart for any length of time from the justified economic values that investorscalculate for them. Economic values for securities are determined by investor expectations about earnings,risks, and so on, as investors grapple with the uncertain future. If the market price of a security doesdepart from its estimated economic value, investors act to bring the two values together. Thus, as newinformation arrives in an efficient marketplace, causing a revision in the estimated economic value of asecurity, its price adjusts to this information quickly and, on balance, correctly. In other words, securitiesare efficiently priced on a continuous basis and the long term investors who are holding on to securitiesneed not resort to any action of buying and selling but continue to hold.

These investors believe that it is not worth their efforts in terms of time and cost to trade on the temporaryaberrations but hold on to qualitative securities that shall perform in line with the market over a period oftime. That is, after acting on information to trade securities and subtracting all costs (transaction costsand taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy.If the market is economically efficient, securities could depart somewhat from their economic (justified)values, but it would not pay investors to take advantage of these small discrepancies.

A natural outcome of this belief in efficient markets is to employ some type of passive strategy in owningand managing common stocks. If the market is totally efficient, no active strategy should be able to beatthe market on a risk-adjusted basis. The Efficient Market Hypothesis has implications for fundamentalanalysis and technical analysis, both of which are active strategies for selecting common stocks.

Passive strategies do not seek to outperform the market but simply to do as well as the market. Theemphasis is on minimizing transaction costs and time spent in managing the portfolio because anyexpected benefits from active trading or analysis are likely to be less than the costs. Passive investorsact as if the market is efficient and accept the consensus estimates of return and risk, accepting currentmarket price as the best estimate of a security’s value.

In adopting the passive strategy the investor will simply follow a buy-and-hold strategy for whateverportfolio of stocks is owned. Alternatively, a very effective way to employ a passive strategy with commonstocks is to invest in an indexed portfolio. We will consider each of these strategies in turn.

Buy And Hold StrategyA buy-and-hold strategy means exactly that - an investor buys stocks and basically holds them untilsome future time in order to meet some objective. The emphasis is on avoiding transaction costs,additional search costs, and so forth., The investor believes that such a strategy will, over some periodof time, produce results as good as alternatives that require active management whereby some securitiesare deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction

Investment strategies


costs and involve inevitable mistakes.

Notice that a buy-and-hold strategy is applicable to the investor’s portfolio, whatever its composition. Itmay be large or small, and it may emphasize various types of stocks. Also note that an important initialselection must be made to implement the strategy. The investor must decide initially to buy certainstocks and not to buy certain other stocks.

Note that the investor will, in fact, have to perform certain functions while the buy-and-hold strategy is inexistence. For example, any income generated by the portfolio may be reinvested in other securities.Alternatively, a few stocks may do so well that they dominate the total market value of the portfolio andreduce its diversification. If the portfolio changes in such a way that it is no longer compatible with theinvestor’s risk tolerance, adjustments may be required. The point is simply that even under such astrategy investors must still take certain actions. In other words a passive strategy also requires someaction on the part of the investors – much less frequently compared to active strategies.

An interesting variant of this strategy is to buy-and-hold the 10 highest dividend-yielding stocks amongthe BSE Sensex at the beginning of the year, hold for a year, and replace any stocks if necessary at thebeginning of the next year with the newest highest-yielding stocks in the BSE Sensex. This strategydoes not require stock selection since it is based only on using the easily calculated dividend yield for 30identified stocks, and making substitutions when necessary.

Index FundsSome investors prefer indirect investment to direct investment in equities. For this class of investorsthe best passive strategy could be buying into an Index Fund. In an Index fund the fund manager poolsthe resources of a number of investors and invests in stocks that comprise the index in the sameweightage as in the Index. These funds are designed to duplicate as precisely as possible theperformance of some market index.

A stock-index fund may consist of all the stocks in a well-known market average such as the NSE Nifty.No attempt is made to forecast market movements and act accordingly, or to select under-or overvaluedsecurities. Expenses are kept to a minimum, including research costs (security analysis), portfoliomanagers’ fees, and brokerage commissions. Index funds can be run efficiently by a small staff.Surprisingly, at times the passive index funds have been found to perform better than some most activelymanaged funds – mainly because the active funds might have under performed the market during thatperiod of time. These are open ended funds where the loads are the least and the returns in line with themarket index which they propose to replicate.

Active strategyInvestors, who do not accept the Efficient Market Hypothesis and those who believe that it is possible toout perform the market consistently over a period of time through active management of stocks selected,pursue active investment strategies. These investors believe that they can identify undervalued securitiesand that lags exist in the market’s adjustment of these securities’ prices to new (better) information.These investors generate more search costs (both in time and money) and more transaction costs, butthey believe that the marginal benefit outweighs the marginal costs incurred. Investors adopt two prongedstrategies to perform better than the market – proper stock selection and timing the entry and exit points.

Stock SelectionMost investment techniques involve an active approach to investing. In the area of common stocks theuse of valuation models to value and select stocks indicates that investors are analyzing and valuingstocks in an attempt to improve their performance relative to some benchmark such as a market index.


They assume or expect the benefits to be greater than the costs.

Pursuit of an active strategy assumes that investors possess some advantage relative to other marketparticipants. Such advantages could include superior analytical or judgment skills, superior information,or the ability or willingness to do what other investors, particularly institutions, are unable to do.

Individual investors enjoy certain advantages over institutional investors:

n They can invest in small cap stocks

n They need not have highly diversified portfolio

n They have go short on the market

For example, many large institutional investors cannot take positions in very small companies, leavingthis field for individual investors. Furthermore, individuals are not required to own diversified portfoliosand are typically not prohibited from short sales or margin trading as are some institutions.

Most investors still favour an active approach to common stock selection and management, despite theaccumulating evidence from efficient market studies and the published performance results of institutionalinvestors. The reason for this is obvious - the potential rewards are very large, and many investors feelconfident that they can achieve such awards even if other investors cannot.

The most traditional and popular form of active stock strategies is the selection of individual stocksidentified as offering superior return-risk characteristics. Such stocks typically are selected usingfundamental security analysis or technical analysis and sometimes a combination of the two. Manyinvestors have always believed, and continue to believe despite evidence to the contrary from theEfficient Market Hypothesis, that they possess the requisite skill, patience, and ability to identifyundervalued stocks.

We know that a key feature of the investments environment is the uncertainty that always surroundsinvesting decisions. Most stock pickers recognize the pervasiveness of this uncertainty and protectthemselves accordingly by diversifying. Therefore, the standard assumption of rational, intelligent investorswho select stocks to buy and sell is that such selections will be part of a diversified portfolio.

How important is stock selection in the overall investment process? Most active investors, individuals orinstitutions, are, to various degrees, stock selectors. The majority of investment advice and investmentadvisory services are geared to the selection of stocks thought to be attractive candidates at the time.

Stocks are, of course, selected by both individual investors and institutional investors. Rather than dotheir own security analysis, individual investors may choose to rely on the recommendations of theprofessionals. Many brokerage houses employ research personnel and put up research reports onvarious companies.

One of the most important responsibilities of an analyst is to forecast earnings per share for particularcompanies because of the widely perceived linkage between expected earnings and stock returns.Earnings are critical in determining stock prices, and what matters is expected earnings). Therefore, theprimary emphasis in fundamental security analysis is on expected earnings, and analysts spend muchof their time forecasting earnings.

Studies indicate that current expectations of earnings, as represented by the average of the analysts’forecasts, are incorporated into current stock prices.

An active strategy that is similar to stock selection is group or sector rotation. This strategy involvesshifting sector weights in the portfolio in order to take advantage of those sectors that are expected to dorelatively better, and avoid or de-emphasize those sectors that are expected to do relatively worse.


Investors employing this strategy are betting that particular sectors will repeat their price performancerelative to the current phase of the business and credit cycle.

Timing The Market

n Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equitysecurities. One has only to observe a chart of stock prices over time to appreciate the profit potentialof being in the stock market at the right times and being out of the stock market at bad times.

n When equities are expected to do well, timers shift from cash equivalents such as money marketfunds to common stocks.

n When equities are expected to do poorly, the opposite occurs.

n Alternatively, timers could increase the Betas of their portfolios when the market is expected to riseand carry most stocks up, or decrease the Betas of their portfolio when the market is expected togo down.

n One important factor affecting the success of a market timing strategy is the amount of brokeragecommissions and taxes paid with such a strategy as opposed to those paid with a buy-and-holdstrategy.

n Like many issues in the investing arena, the subject of market timing is controversial. Evidenceindicates it is difficult for investors to regularly time the market efficiently enough to provide excessreturn on a risk-adjusted basis.

n On a pure timing basis, only a small percent of the stock timing strategies tracked over the mostrecent five-and eight-year periods outperformed a buy-and-hold approach.

Much of the empirical evidence on market timing comes from studies of mutual funds. A basic issue iswhether fund managers increase the beta of their portfolios when they anticipate a rising market andreduce the beta when they anticipate a declining market. Several studies found no evidence that fundswere able to time market changes and change their risk level in response.

Considerable research now suggests that the biggest risk of market timing is the investors will not be in themarket at critical times, thereby significantly reducing their overall returns. Investors who miss only a fewkey months may suffer significantly. If anybody thinks that market timing as a strategy suitable for theaverage individual investor he is wrong and the market has proved this time and again all over the world. Ithas been proved without doubt that security market returns will depend more on the “time” than “timing” .

LeveragingAggressive investors adopt the bank financing route to invest in stock s a certain number of times theirown capital through the process of buying stocks and pledging with bank, raising money on the stocksand buying more stocks. Thus, on a given capital, thanks to bank borrowing against stocks they are ableto build a portfolio much higher in value but at a cost, namely the interest cost. These investors arehighly aggressive and are always under pressure that the stocks selected by them should perform anddeliver returns superior to the rate of interest payable on the borrowal accounts – banks lend againstsecurities at a much higher rate of interest compared to priority lending or prime lending rates.

This route of bank borrowing is used by many investors in India when they apply to new issues ofshares, through the book building route of Initial Public Offerings (IPO) or Follow up Public Offerings(FPO) of existing listed companies. These investors while applying for the IPO essentially put in themargin money alone; which is around 40% of the application money and thus manage to increase thenumber of shares for which they could apply with a given capital, thereby increasing the chances of


allotment of shares. These investors shall benefit only if they get substantial allotment and only if theshares list at prices much higher than the issue price because they incur interest costs on the moneyfinanced by the banks. These costs are incurred, in any case, not withstanding whether these investorsare allotted any shares in the public offering or not.

Some investors use the futures market route to leverage on the available capital. A trader in the futuressegment of the market, when he takes a position is not required to pay the full market value of thisposition but only a certain percentage. Thus in the futures segment the trader gains a market exposurewhich is much higher than his available capital. The potential to earn returns as the market goes up ordown increases because of leveraging. This is a high risk high return game – not suitable for averagemarket investors but only for those with very high risk appetite.

We have essentially discussed the two types of strategies namely the passive strategy and active strategyfollowed in investing. The success lies in developing the right strategy that would suit the investor’s riskprofile and his financial goals. It has been proved without doubt, the world over, that success in investingis about following a disciplined approach with clearly spelt out goals and the manner of achieving thesame. One of the time tested strategies for success in investing is an “Asset Allocation Plan” decidedwell in advance before making the investments and sticking to same and acting on it periodically inconsultation with a financial advisor. In a later topic we shall discuss in detail about the types of assetallocation models and how we go about implementing the same.

Maturity SelectionInvestors make investments to meet specific demand on funds over a certain period of time. Some ofthese time horizon related needs could be:

1. Buying a bigger house in about 5 years

2. Regular income flows every year after a term to meet education expenses of the children

3. Lump sum requirement after a few years to meet marriage expenses of children especially thedaughter

4. Regular flow of income, on a monthly basis, after a certain period of time – post retirement needsand so on …

The investment strategy involved in meeting this type of time related fund requirements would dependupon the time span after which the requirement will arise:

a. Short term – say requirement within 3/5 years

b. Long term – not less than 5 yearsThe investment vehicle will be decided upon whether the need is expected to arise over short term orlong term. If the need is short term then it may not be wise to park the funds in equity and equity relatedinstruments as the risk associated with this avenue is especially higher in the short term. A debt fund ora fixed income instrument is preferred in such cases.

If the need is medium, say, for meeting education and/or marriage expenses of children over the next 5to 10 years then an investor can invest in Balanced funds or specific child care funds of mutual funds orspecific children plans of life insurance companies.

The equity or equity related instruments would be ideal for building capital over long period of time. It isa well established fact that equities have delivered superior returns compared to other asset classesover longer period of time – while in the short term the returns can be erratic and even negative. At thesame time since this is a high risk avenue the returns also tend to be higher and hence capital building


becomes that much easier.

There are specific deferred annuity plans of life insurance companies where investments are made ona systematic basis while in service, by the salaried class of investors, so that a certain amount ofpension becomes payable on retirement. These are essentially long term low risk low return kind ofplans most suited for the conservative investors.

Thus one can conclude that the strategy of investments can not only be classified as Passive and Activebut also based on the Time Horizon of the investible funds and the requirements for the funds over time.Many times it is the time based requirement of funds that determines where the money is invested.


Review Questions:

1. In respect of investing in “Index funds” which one of the following statements is not true?

a. It is suitable to investors who seek returns much in excess of market returns.b. It is a very aggressive investment strategyc. It is an active investment strategyd. It is suitable to investors who expect market returns on the investment

2. “Buy and hold” is a strategy suitable for which of the following type of investors?

a. Investors who want short term returnsb. Investors who want their shares to out perform the marketc. Investors who believe that market is an efficient place and that over long period this strategy paysd. Aggressive investors

3. Adopting the bank financing route for applying to IPO’s would amount to which of the following?

a. Active strategy of investmentsb. Passive strategy of investmentsc. Low risk low return strategyd. “Rupee Cost Averaging” strategy

4. Trading in stock futures in the derivatives segment of the market would amount to which one ofthe following strategies?

a. Activeb. Passivec. Low Risk low returnd. “Rupee Cost Averaging”

5. Which one of the following statements is true regarding market timing?

a. It is easy for the small investor to time the market and maximize the gainsb. “Market Timing” is the most important factor for success in investment decisions for small investorsc. It is the “time” more than the “timing” that has benefited the investors – investors stand to

benefit if they are prepared to invest for longer term rather trying to time the marketd. “Timing” is the key for long term investors

6. An investor plans to invest some capital to meet a requirement that is most likely to crop up withinthe next one or two years. He is not very keen on high returns on this investment. Which out of thefollowing could be the most suitable option for him?

a. A. floating rate debt fundb. A sector specific equity fundc. Direct investment in select stocks from the marketd. Keep the money liquid in a saving bank account because returns over this period can be quite

uncertain.

Answers:

1. d 4. a

2. c 5. c

3. a 6. a


Chapter 15


The important decision that an investor is required to take is on Asset Allocation. There are differentasset classes like equities, bonds, real estate, cash and even foreign investments … to a limited

extent available to Resident Indian investors now. It has been a well established fact that Asset allocationhas been primarily responsible for portfolio performance more than even stock selection and timingissues. Asset allocation is the key to portfolio returns and hence it is of paramount importance.

The asset allocation decision involves deciding the percentage of investable funds to be placed instocks, bonds and cash equivalents. It is the most important investment decision made by investorsbecause it is the basic determinant of the return and risk taken. This is a result of holding a well-diversified portfolio, which we know is the primary lesson of portfolio management. Thus asset allocationserves the purpose of diversification among different asset classes and diversification among differentsecurities within an asset class.

The returns of a well-diversified portfolio within a given asset class are highly correlated with the returnsof the asset class itself. In other words the returns on a stock portfolio will depend on the market returnsto a great extent – no stock is expected to give phenomenal returns when the market returns are low ornegative. Within an asset class diversified portfolios will tend to produce similar returns over time. However,different asset classes are likely to produce results that are quite dissimilar. Therefore, differences inasset allocation will be the key factor, over time, causing differences in portfolio performance.

Factors to consider in making the asset allocation decision include the investor’s return requirements (currentincome versus future income), the investor’s risk tolerance, and the time horizon. This is done in conjunctionwith the investment manager’s expectations about the capital markets and about individual assets.

According to some analyses, asset allocation is closely related to the age of an investor. This involvesthe so-called life-cycle theory of asset allocation. This makes intuitive sense because the needs andfinancial positions of workers in their 50s should differ, on average, from those who are starting out intheir 20s. According to the life-cycle theory, for example, as individuals approach retirement they becomemore risk averse and hence they should allocate fewer amounts in percentage terms to equity andequity related instruments in their portfolio.

Asset class risk

Risk in the context of investments has different meanings for different people. To the common investorrisk means the probability that he may lose his capital or suffer loss on the investment. To the analyst itis the chance that the investment vehicle may not deliver the required or expected returns and thus notfulfill the financial goals. It is also well established through research over long periods that equity as anasset class, international as well as domestic, is the most volatile of asset classes. In equities the rangeof returns as well as the potential for capital loss is the greatest, especially in the short term.

While equity may be riskier asset class it also has the potential to earn superior returns over long term. It isalso well established that over the long term equities, foreign as well as domestic, have delivered returnsmuch higher than other classes of financial assets. Hence equities will find a place in every body’s portfoliobut the extent could vary depending on the risk profile, age, need for higher returns, time frame, etc.

Asset Allocation


Types of asset allocation

The two models of asset allocation are Strategic Asset Allocation and Tactical Asset Allocation.

Strategic Asset Allocation

n It is essentially a long term investment plan

n It is the structuring the individual asset classes within a portfolio to meet long term investment objectives.

n No switches between securities or asset classes is normally done in the short term

n Defined exposures are made to different assets providing for some minor adjustments within theasset class without shifting the focus of the portfolio.

n A right allocation among different classes of assets shall ensure that investors’ investment objectivesare met.

Tactical Asset Allocation

n TAA is a dynamic portfolio technique that seeks to take advantage of the short term movementsand opportunities in the market.

n The asset allocation of a portfolio is changed, in this process, on a short term basis to take advantageof perceived differences in the values of various asset class changes.

n It works on the underlying principle that in the short term the securities market may not be properlyvalued resulting in under valuation and over valuations – it is possible to take advantage of theseaberrations through switches between asset classes and within securities.

n All the same a balance is maintained and it is ensured that each asset class in the model ismaintained within the permitted range for that asset class

n A range for each asset class is fixed and short term movements/switches are made within therange to take advantage of market movements.

Let’s look at both types of Asset Allocation models in a tabular form to understand the essential differences:

Thus you will find that while the asset classes are the same the difference lies in the manner of allocationamong assets – fixed allocation in SAA while a ranged allocation in TAA.

Let’s look at TAA allocations at different equity market levels:


Thus, at any point in time, investments will be there in all asset classes but the percentage will varydepending upon the market condition and the out look for the market over the short term but the variationwill be within the fixed limits set for each asset class. We have looked at an example of stock marketvaluations affecting allocation to equities similarly interest rate out look and current interest rates willinfluence investment in fixed income securities. If the interest levels in the economy hover around veryhigh levels it is only natural that the fixed income portion would be close to the upper band of allocationwhich in the given example is 60%. As the interest rates start falling bonds will fetch capital appreciationwhile yields will fall and the weightage will gradually shift from bond to equity.

Obviously while TAA strategy has the potential to earn higher returns it also calls for a very goodunderstanding of the movements bonds/securities market and the equity market and also swift decisionsof moving funds from one asset class to the other and moving back.

Comparison between SAA and TAATAA can be expected to deliver superior on returns. But TAA involves research inputs which are veryvital and also entails frequent transactions. Both these come at substantial cost to the investor. Thusone needs to work out whether TAA as compared to SAA has given superior returns after taking intoaccount all the efforts in terms of time and money that has been put in.

TAA essentially deals with timing issues. It is very vital to be able to time entries and exits in bonds aswell as equities consistently to be able to outperform the markets. This is a tough call and very fewspecialists have done it consistently over long periods of time.

The taxation issues also need to be considered. Many short term transactions would result in shortgains which are essentially taxed at higher rates.

SAA as being necessarily long term is better on the following counts:

n No great issues of skills of timing the market decisions

n Does not test the competency of the portfolio managers/advisor to the extent required under TAA

n Costs are lower

n Taxation will be lower

n Chances of success are better as compared to TAA where wrong decisions and costs can prove tobe very costly.

We may conclude the discussions on suitable asset allocation models as under:

n Some aggressive clients may be inclined towards TAA as the model, on paper, looks superior – butthe financial planner should make the short comings of TAA clear to the client.

n Advise the clients to essentially adopt a disciplined approach to investment through SAA ratherthan TAA

The proportion of allocation to risk instruments, where the returns are uncertain and market related, sayequities is essentially a function of risk appetite, age, time factors, return expectations, etc.

Fixed and flexible allocation“Fixed allocation” is sticking to an allocation proportion among asset classes and following the samereligiously, till the same is revised based on the changed requirements, advancing age, sudden changesin the economy, etc. “Flexible allocation” is something similar to TAA where the range is fixed for differentasset classes and periodic switching between asset classes is done. The “flexible asset allocation” isnot necessarily an aggressive investment planning. This helps the alert investor to make use of some


opportunities that come periodically in the market due to random developments which simply cannot bepredicted in advance.

Asset Allocation is an Investment Planning Tool, not an Investment Strategy... Investment Strategies areused to select and to manage the securities that are “allocated” to either the Equity or Debt/fixed incomesecurities.

An Asset Allocation Formula is a long-range, semi-permanent, planning decision that has absolutely nothingto do with market timing or “hedging” of any kind. Certainly, a 40% asset allocation to Fixed Income maysoften the fall in the portfolio bottom line during a stock market downturn, but that has nothing to do with thepurpose of Fixed Income Securities nor is it in any way related to the reasons for having an asset allocationplan in the first place. Similarly, the movement of a person’s assets from a falling bond market to a risingstock market or vice versa is about as far away from the principles of asset allocation as one can get!

n Investors should arrive upon the most suitable Asset Allocation Plan

n Investors should not focus exclusively on “market value”,

n Investors should not dwell upon comparisons of one’s own unique portfolio with Market Averages

n Investors should not expect “performance” during specific time intervals as this investment plan isexpected to perform over a long period of time

Portfolio rebalancingOnce an asset allocation plan is finalized; then securities are chosen for investments and the investmentprocess is completed. Thereafter the portfolio of investments comprising of debt, equity, etc. should bemonitored on a periodic basis. The frequency of review could be once in 6 months or even once a year– a higher frequency is generally not necessary for a long term investment plan but sometimes, someeconomic developments may necessitate an urgent review.

One of the most important factors that will have a big influence on the performance of the portfolio is theinterest rate (which generally moves with inflation). Whenever large scale, protracted interest ratemovements are expected then a rebalancing will become absolutely essential – in a rising interest ratescenario the corporate profitabilites will suffer and consequently the stock prices will fall. Bond prices dipto adjust to the current yields of the market. Reducing equity exposure of the portfolio may becomenecessary and moving from long term debt swiftly into short term or from fixed rate long term debt fundsto floating rate and short term debts could also become necessary. If economic slow down is seen,through falling growth rates, then portfolio rebalancing will become necessary again. These economicfactors are external factors that will have to be taken into account as their long term impact on theportfolios will be severe and hence suitable rebalancing will have to be done. It should simultaneouslybe remembered these are turn around situations and these happen over long term.

There can be some internal family developments also that may make portfolio rebalancing necessary.A portfolio is built to meet certain financial objectives; not all objectives are met at the same time. Oneafter the other the financial goals get completed, over a period of time, as the investor gets older andolder. Some of the common objectives are buying a bigger home; buying a new car; education ofchildren; marriage of children; retirement capital etc. As these objectives are fulfilled the returnrequirements may come down and it may be necessary to switch to less aggressive asset allocationplan – reducing the exposure to equities and increasing the exposure to debt may be made. .

It is an established fact that the proposition, that a rebalancing strategy can increase expected return isincorrect but on the contrary rebalancing costs definitely reduces expected returns.


Probably the best rule of thumb on rebalancing is to look at the overall stock/bond ratio quarterly, since itis the primary determinant of expected returns, and examine individual equity asset classes once ayear, or so. Rebalance only when asset classes, and particularly, the equity/fixed ratio, gets out ofbalance far enough to produce a significant expected difference in returns.

Monitoring and revision of portfoliosIt is the financial planners’ function to monitor clients’ portfolios. When the portfolios are monitored itcould be observed that the proportion among different asset classes has changed substantially.

For example if the original Asset allocation was Equity 40%, Debt 55% and Cash 5% but on monitoringif it was found to have changed to Equity 50% Debt 45% and Cash 5% then it amounts to higherexposure to equity than originally planned. This situation might have arisen mainly because of risingstock market and the appreciation of stocks held in the portfolio. While deciding on an asset allocationplan a formula is generally discussed and agreed upon. This formula for revision essentially hinges ondefining “substantial shift in emphasis of a particular asset class” or even a particular security in an assetclass. It could be, say 5% which means that if the Equity proportion has moved above the fixed proportionof 40% by 5% or more, then a rebalancing would be done by selling excess equity and moving to debtor cash to maintain the Asset allocation proportions decided earlier. Thus monitoring helps in maintaininga balanced portfolio all the time but also ensures profit booking when the markets are high and buyingwhen the market prices fall substantially. The formula could vary from investor to investor but it isessential so that portfolios are properly monitored to deliver the desired returns over the long term.

A portfolio revision may become necessary because of government policy changes; economic factors ofgrowth rate; budget and fiscal deficits; inflation and interest rates, strength of domestic currency, etc.While implementing the investment plan certain securities were bought based on their and the over alleconomic fundamentals. These factors may change over time; fortunes of companies also fluctuate,generally in line with the over all economy but some times on their own as well. For example a strongdomestic currency may not be good for export oriented companies but will benefit import dependantcompanies. A lower interest rate on loans may not be good news for banks and financial institutions butgood news for consumer durables; automobiles and housing sector as the same spurs demand. Whilea Buy and Hold strategy is fine it makes sense to observe crucial economic factors that may specificallyaffect some of the securities held and it would be prudent at time to switch out of these securities andmove into others.


Review Questions:

1. Which of the following statements is not true of Strategic Asset Allocation?

a. It is a long term investment planb. The proportion of each asset class is fixed in advancec. The transaction costs are very high because of frequent switchesd. Taxation will be lower because short term transactions are generally not done

2. Which of the following statement is not true of Tactical Asset Allocation?

a. It is a conservative, long term investment planb. The proportion of each asset class is set in a range of valuesc. The transaction costs are very high because of frequent switchesd. Taxation will be higher because of short term transactions

3. An investor is very keen on adopting Tactical Asset Allocation plan. What should be your adviseto such an investor?

a. The risks are high and the chances of success are lowb. Requires exceptional skills of timing which nobody in fact can claim to possessc. Strategic Asset Allocation has a better success rate – as proved in a majority of casesd. All of the above

4. Frequent portfolio rebalancing will cause which one of the following?

a. Increase the costs without necessarily contributing to increased returnsb. Increase the potential to earn higher returnsc. Decrease the costsd. Will ensure that investment objectives are achieved quickly

5. Which one of the following could be the rule of thumb for portfolio rebalancing?

a. Keep switching between debt and equity on a quarterly basisb. Keep on removing and adding securities on a half yearly basisc. Look at the equity/debt ratio every quarter and individual stock once a yeard. The more frequently it is done the better

Answers:

1. c

2. a

3. d

4. a

5. c


Chapter 16


Identification of client needs

A financial planner can go about his job after understanding his client’s needs thoroughly. It is necessaryto collect information from the client about his financial background, investment objectives, time

horizon, expected returns on investments, etc. All clients generally have some existing investments inshares, mutual funds, fixed income products, tax saving instruments, life insurance, house property,etc. It is essential to obtain information in respect of the same because while constructing the financialplan restructuring of existing portfolio is equally important.

Information from clients, therefore, basically comprises of the following components:

n Personal information – name, age, names of other family members, ages, occupation of all familymembers, address, telephone number, e mail ID, and such other information that are matters ofrecord and which shall be helpful in assessing general needs

n Information on their existing investments and levels of income and taxation for each member of thefamily.

n Investment objectives – buying a luxury car, bigger apartment, children’s education, children’smarriage, retirement planning, holidays especially abroad, etc.

n Risk profile; attitude, intentions, required/expected returns on investments, etc.Information is collected in a manner that is suitable for the investor and the planner. However, in order toavoid time delays and to facilitate more meaningful discussions, it may be a good idea to obtain personalinformation and details of existing investments (the first two out of the parameters listed above in advance).The financial planners, normally, have a data sheet format where the columns/questions of personalinformation are already provided and it is easier for the client to fill the same. The data collection format mayalso be made available online or mailed electronically to the client. The client may be encouraged to fill thesame and send through e mail, before the meeting. Thus before the personal meeting the financial plannerhas a good idea of the background of the client. This advance collection of information and that too in aspecified format saves a lot of time which other wise is lost during the meeting with the client.

Information on the other two parameters namely the objectives/goals and risk profile, etc. is best gatheredthrough a personal, informal talk with the client. It may be more useful if both – husband and wife, arepresent during the discussions, so that it becomes easier to identify the objectives, etc. (in case ofmarried clients). It may become necessary to educate the investors primarily, some times, on matters ofrisk and return. Many clients may prefer the ultra conservative route – while there is nothing with thatapproach, the client in such circumstance should be made to realize the kind of compromise he ismaking on returns and whether he can afford to make such compromises.

The ultimate objective of understanding a whole lot of investment avenues available, the risks involved,the returns that be expected, how to measure the risk and returns on different investment products, etc.is to empower the financial planner so that he can understand the client’s needs and suggest an investmentplan that shall be able to achieve the investment goals of the investors.

The ultimate financial plan will revolve around the risk profile of the client and the required return. If a

Structuring Portfolio for Investors


client is inclined to take a higher risk the same may be advised and accordingly incorporated by thefinancial planner in the investment plan provided in the opinion of the planner it is necessary to do so forgetting the desired return. The planner may advise a more conservative approach if high returns are notrequired. In case the client is not inclined towards riskier investments and if higher returns are requiredto meet the financial goals then the financial planner should explain the consequences of a veryconservative approach and the need for taking risk in a certain proportion.

Quantum of risk is subjective and it is bound to be different for different client profiles. But in general theextent of risk that a client may be prepared to take is a function of the following factors:

n Age

n Socio economic status

n Background – academic and work place

n General nature – aggressive, modest, timid, humble, practical, etc.

Some economic factors that point towards risk profile of the client are:

n Liquidity – a high concern for liquidity will imply a more conservative approach.

n Income – many investors would prefer to have an income flow on all their investments and toopreferably guaranteed returns. This again is a very conservative approach. Income flow should beclose to the required level and anything received in excess of requirement needs to be deployedfor productive purposes to earn higher returns

n Inflation – a lower concern for inflation will mean more exposure to debt/income oriented investmentsand less to growth.

n Taxation – a high concern for taxation will mean higher exposure to growth and equity orientedinstruments where the incidence of taxation is lower compared to deb/income oriented instruments.

n Volatility – some clients are very concerned about loss of capital – that would mean that even astock portfolio should contain more defensive and large cap stocks – lower on risk and return.

Asset allocation plan- in structuring client portfoliosAfter having assessed the clients needs, background, risk profile etc. the next step is deciding on anAsset Allocation plan that shall best serve the client’s needs. We have studied in detail about variousfinancial products available in our market - from the point of risk, return, taxability, etc. We have alsostudied about the two types of Asset Allocation plans. Based on the client’s background informationwhich we have obtained though data sheet and meetings we should prepare an Asset Allocation Planspecifically for the client. The ultimate success of the financial planning process that helps the investorto meet his financial objectives depends to a large extent on the right Asset Allocation Plan. Hence duecare and lot of thoughts should go into preparing the same.

Basically financial assets are equity oriented and debt oriented. The equity oriented assets whetherdirect investment in equities or indirect investments in equities through the mutual funds do not assureany returns; the returns are market oriented and these act as ideal hedge against inflation. Equity, as anasset class has delivered superior returns over long periods of time. Hence, equity shall form an integralpart of any portfolio – the proportion will vary according to the profile of the investor. Debt oriented arefixed income instruments and many of these assets like bank deposits, small savings schemes, corporatedebentures and fixed deposits carry fixed rates of interest and as such there are no uncertainties aboutthe same. However the indirect investments in debts through the mutual fund route do not offer anyfixed rate of return. These investments are relatively safer with lower rate of return and market oriented


securities like Government Securities, corporate bonds, etc. face interest rate risk over time. Realestate/property/commodity/bullion, etc. are not financial assets and hence not considered in structuringAn Asset Allocation Plan but many people do resort to investments in these classes of assets as well.While considering these assets in evaluating portfolio risk and return it has to be borne in mind thatthese assets are risky and the returns are not assured – hence resemble equities rather than debts.

Here are some thoughts how Asset Allocation Plans are made, for different classes of investors:

Example 1

n Old couple

n Age around 60 years

n Retired

n Children financially independent

n Preserving capital; regular income and inflation are their concerns

n Conservative approach – Asset allocation can be as under:

Example 2

n Mature couple with grown children:


n Children undergoing education

n Capital growth at a moderate rate and some income flow are their requirements

n Around this age the income level is quite high; the capacity to invest is high

n Commencement of some retirement planning is also essential

n Moderate risk – The asset allocation suggested can be as under:


The actual portfoliosOnce the asset allocation is finalized then the next step is selecting the right products under each assetclass. The financial planner should be fully informed about the various financial products, the risk, thereturn, track record of performance, suitability to the client and such other features that are relevant.Based on his assessment, research and the asset allocation plan, as decided, the planner shallrecommend to the client a list of securities – bonds, shares, mutual funds, etc. for investment.

After finalizing the list of securities or the actual investment plan the planner shall forward the same to

Example 3

n Young couple with small children


n Income flow reasonable

n Outgo on account of home loans, etc. on the higher side

n Expenses high because of small children

n Reasonably aggressive portfolio with emphasis on growth – asset allocation suggested is :

Example 4

n Young single professional

n Age around 20/25 years

n Can afford to take risk

n No liabilities built up

n Need to save on a systematic basis

n High risk portfolio desirable – Asset allocation may be as under:


the client for his perusal. It is desirable to meet after the plan is sent to the client and discuss with theclient the rationale for the selection of securities and the structure of the portfolio. The client may havesome doubts and concerns on certain issues or in respect of some products that have been recommended.The meeting will serve the purpose of clearing such doubts and making the client understand the reasonsfor the selection. All issues of related risks and expected returns also should be discussed in the meeting.If necessary some changes may be made in the suggested portfolio within the broad Asset AllocationPlan already finalized. The portfolio is then finalized and the plan is put into action through purchase ofsecurities, making the investments, etc.

Monitoring and reviewThis is a very important step in the investment process. A proper monitoring and review system is ascritical to the success of the investment plan as selecting the right securities and going ahead with theright mix of assets.

While monitoring performance of the funds is considered carefully. Funds and stocks have been selectedon the basis of certain criteria. A review is to ensure that these funds/stocks are performing in line withthe expectations. This exercise will enable the investors to take into consideration the developments inthe capital market and various economic factors such as inflation, interest rates, performance ofcompanies, performance of the economy, etc. Gradual changes in some of these economic fundamentalfactors will drive portfolio restructuring decisions.

The portfolio has been created with certain objectives. The percentage of assets within the asset class– for example the percentage of equity in the portfolio may undergo changes because of changes in thevalues of these assets with the market movements. For example when the stock market goes up thevalues of equities will go up and consequently the proportion of equities in the total portfolio will also goup. This will necessitate some selling of equity shares and moving funds to debts to bring down theproportion of equities to the desired level, as per the asset allocation plan. Thus a rebalancing becomesnecessary in a constant proportion asset allocation model. Rebalancing may be required to adjust themarket risks in a portfolio or because of maturity selection as well.

The client and the planner while implementing the financial plan can lay down certain parameters forreview – generally time based and at times event based. A review can be more frequent; say once in 3months if active strategies are being employed otherwise a periodic review of debts say once a year andstocks and equity funds, say once in 3 months could be a good suggestion to the client.


Review Questions:

1. A retired couple should ideally prefer which of the following asset allocation plans?

a. 60% equity, 35% debt and 5% cashb. 50% equity, 40% debt and 10% cashc. 80% equity, 20% debtd. 30% equity, 60% debt and 10% cash

2. A young man, of 25 years, who has just joined an IT company as a programmer should preferwhich kind of investment planning?

a. Systematic investment plans that take care of capital growth and life insuranceb. Should invest all his monthly savings in Life insurance plansc. He should leave the job of investments to his father and concentrate on his own job – he is too

young to understandd. Make lump sum investments in index funds

3. A financial planner should concentrate on which of the following?

a. Understanding the clients’ needs and preparing an asset allocation plan that shall best meetthe client’s financial objectives

b. Distributing financial products to his clients to meet his targets with mutual funds and insurancecompanies

c. Constant restructuring and rebalancing of clients’ portfolios resulting in frequent selling andbuying of securities

d. None of the above

Answers:

1. c

2. a

3. a


Chapter 17


The profession of financial planning does not require any licence nor is it regulated in India. Now,however SEBI is considering regulation of investment advisor and a process of registration so that

the investors get proper advice from qualified, trained, informed investment advisors who will beaccountable to SEBI and the investors.

The financial planners may be selling financial products and providing financial services. Some of theproducts are small saving instruments, mutual funds, stocks, insurance linked products, governmentbonds, etc.

A mutual fund distributor is required to be registered with Association of Mutual Funds of India (AMFI).A mutual fund distributor is required to qualify for an examination conducted by National Stock Exchangeon mutual funds before being registered with AMFI. The AMFI registered mutual fund distributor isrequired to abide by the code of conduct stipulated by AMFI. The distributor is also required to give anundertaking on a yearly basis to each mutual fund with whom he is registered that he is abiding by thecode of conduct set by AMFI. Thus mutual fund distributors are regulated and AMFI ensures thatdistributors are informed about mutual fund functioning, their products, etc. and that the distributors donot resort to undesirable practices to push the sales of mutual fund products. If a distributor employsmarketing people/counter staff to market mutual funds it is required that each one of them has passed aspecific examination conducted by NSE. A mutual fund distributor can be inspected by AMFI to ensurethat he complies with all the regulations and code of conduct. The mutual funds are regulated by SEBI.

Stock markets are regulated by stock exchanges in the first place and ultimately by SEBI. Stock brokersand sub brokers are required to be registered with SEBI. SEBI has clearly spelt out the terms ofoperations of stock brokers and sub brokers. One of the most important conditions is client registration.SEBI has stipulated that all brokers/sub brokers should obtain information from clients in a specifiedformat along with documentary evidence in support of client personal information – called Know YourClient (KYC) norms. Then the broker is required to enter into an agreement with the client in a specifiedformat and allot a unique client ID number to the client. The client’s dealings on the stock exchangesthrough the broker will be allowed only after compliance with the above. SEBI has laid down a numberof conditions in the interest of investor protection and the brokers have to comply with the same.

Small savings mobilizations are done through small savings agents. These agents are appointed byrespective state governments on behalf of the Government of India and are subject to terms and conditionslaid by Ministry of Finance, Government of India, on this behalf.

Insurance advisors are registered and subject to the regulations of Insurance Regulatory DevelopmentAuthority of India (IRDA). IRDA has laid down the conditions under which an advisor will perform. IRDAis also the supreme authority in respect of insurance companies as well.

A Certified Financial Planner voluntarily submits himself to a code of conduct laid down by the parentbody “Financial Planning Standards Board, India” and vows to abide by the ethics while practicing as aCertified Financial Planner.

One of the most important purposes of the regulation of market players in insurance, mutual funds,

Regulation of Financial Planners


stock markets, etc. is that the investor should get informed advice and quality service. It is stipulated byall the regulators that each distributor/advisor/broker should have investor service departments andinvestor grievance redressal mechanisms in place in their respective workplaces.

You will observe that the financial services profession is evolving. In future it will be a much betterregulated place where the advisors will essentially be well informed players who value professionalethics the most.

Investment Planning

Documents

investment portfolio

pdp investment planning

investment scenario

investment strategies

preface investment planning

understanding investment

sound investment strategy

measuring investment