Insurance Products Credit Products

Investment

Products

Session 1

Direct Equity Sectoral Equity Funds Diversified Equity Funds Hybrid Funds Gold Long Term Debt Funds Short Term Debt Funds Unsecured Debentures Secured Debentures Fixed Maturity Plans Liquid Funds

Risk

Bank Fixed Deposits

Savings Bank Deposits

Lets begin with the simplest of the

Risk

Retail Financial Products -

Bank Fixed Deposits

Savings Bank Deposits

At the very base of the risk scale.

Repayment of principal and payment of interest on bank deposits is a contractual obligation of the bank. Therefore, bank deposits carry the least of risk.

Risk

Since the savings deposits are essentially of a shorter term as compared to the fixed deposits, they carry a relatively lower risk. As time passes the chances of deterioration of financial health of the bank increase; therefore the risk tends to increase with the term of the deposits. Bank Fixed Deposits

Savings Bank Deposits

Two types of risk

- Default risk

- Market risk

Default risk is the possibility of the principal not being repaid or interest not being paid.

Market risk arises in case of investment products that are traded in a market; it is the risk of the price of the products falling. If the price falls the investor loses.

Bank deposits are not traded; so they do not have market risk; they have only default risk.

Risk bears an unique relationship with return risk and return vary in the same direction. That is, as risk increases, return also increases; and vice versa.

To understand the risk return relationship, we need to look into the composition of return.
Reward for risk bearing

n r u Ret

Compensation for inflation

Reward for waiting

Reward for waiting

Every investment requires us to make a choice :

To use the purchasing power in our hands to buy goods and services for consumption. OR

To save and invest it.

If we use the purchasing power to buy goods and services for consumption, we get satisfaction from it.

If we decide to save and invest the purchasing power, we need to postpone this satisfaction.

Investment, therefore, involves waiting, sacrificing.

And why should we wait, unless we are sufficiently rewarded for the wait ?

That is the reward for waiting that the return on investment needs to give us. This is the first component of the return on investment.

But we do not usually reason this out continuously; this time preference is built into our psyche.

As a result we prefer liquidity we prefer to hold our purchasing power in a liquid form ( in a form that lets us deploy it easily for purchase of goods and services), unless we have a reason not to.

That is why, the reward for waiting is also called the liquidity premium.

Compensation for inflation

Investment means parting with our purchasing power NOW and getting it back LATER.

But the purchasing power we get back later may not be equal to the purchasing power we had parted with, if in the intervening period inflation has eroded the value of money.

Therefore investment can result in loss of purchasing power.

Therefore the return on investment needs to compensate us for this loss, so that the purchasing power we get back is equal to the purchasing power we had parted with.

That is the compensation for inflation that the return on investment needs to give us. This is the second component of the return on investment.

But investment also involves risk of principal not being repaid and / or interest not being paid. When we invest, we have to necessarily bear this risk.

So, we will invest if, and only if, we are rewarded for bearing this risk.

That is the reward for risk bearing that the return on investment needs to give us. This is the third component of the return on investment.

The return from those investments which do not carry any risk, will therefore have only two components : reward for waiting and compensation for inflation. Such investments are called risk free investments and the rate of return from such investments is called the risk free rate of risk return. return Short term investments guaranteed by the government, pay a risk free rate of return.

All other investments pay a rate higher than the risk free rate, depending upon the risk that they carry.

Bank deposits pay a rate very close to the risk free rate of return. Weaker the bank, higher will be the rate of interest that it pays.

Higher the risk, higher the risk premium, higher the return.
Risk premium Compensation for inflation Reward for waiting Risk Risk premium premium Compensation for inflation Reward for waiting

Total return

Compensation for inflation

Reward for waiting

Risk free rate of return

The rate of return also bears a relationship to the liquidity of investment.

Liquidity refers to the ease and cost of converting any invetsment into cash; greater the ease and lower the cost, higher is the liquidity.

Other things remaining the same, higher the liquidity, lower is the rate of return, and vice versa.

This is why, given a bank, the rate of interest on savings deposits is lower than the rate of interest on fixed deposits.

Risk

+
Fixed Fixed Maturity Maturity Plans Plans Liquid Liquid Funds Funds

Let us now move further on the risk scale in the investment products spectrum, to products that carry higher levels of risk.

Fixed Maturity Plans Liquid Funds

Both these products are Mutual Fund schemes. A mutual fund is a company that pools investment from many investors and invests it in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these securities.

The combined holdings of securities held by the MF are known as its portfolio.

The total investments collected by a MF from the investors is known as its corpus or AUM ( Assets Under Management).

The total corpus of a MF is divided into units. Each unit represents an investor's proportionate ownership of the portfolio held by the MF. The unit holder has a right to the income those holdings generate; the unit holder also bears the erosion in the value of holdings, if any.

Investor Investor Investor Investor

Investor

Investor

Mutual Fund

Investor

Investor Investor Investor Investor

Investor

SECURITIES SECURITIES AND AND EXCHANGE EXCHANGE BOARD BOARD OF OF INDIA INDIA

MUTUAL FUNDS REGULATIONS, 1996

7.

For the purpose of grant of a certificate of registration, the applicant has to fulfill the following conditions, namely :

(a) the sponsor should have a sound track record and general reputation of fairness and integrity in all his business transactions;

(e) appointment of trustees to act as trustees for the mutual fund in accordance with the provisions of the regulations;

(f) appointment of asset management company to manage the mutual fund and operate the schemes of such funds in accordance with the provisions of these regulations;

(g) appointment of a custodian in order to keep custody of the securities or gold and gold related instruments and carry out the custodian activities as may be authorised by the trustees.

Sponsor
Provides the initial capital to start the fund. Appoints

Appoints

Trustees

Supervise the fund on behalf of the unitholders.

Mutual Fund

AMC
Manages the portfolio of the fund.

Provides custodial services

Custodian

14.

A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908), executed by the sponsor in favour of the trustees named in such an instrument.

20.

The sponsor or, if so authorised by the trust deed, the trustee, shall appoint an asset management company, which has been approved by the Board.

26.

The mutual fund shall appoint a Custodian to carry out the custodial services for the schemes of the fund.

16(4). No person who is appointed as a trustee of a mutual fund shall be eligible to be appointed as a trustee of any other mutual fund.

16(5). Two-thirds of the trustees shall be independent persons and shall not be associated with the sponsors or be associated with them in any manner whatsoever.

21(1)(d). The board of directors of such asset management company shall have at least fifty per cent directors, who are not associate of or associated in any manner with, the sponsor or any of its subsidiaries or the trustees.

Sponsor

Trustees

The purpose of these regulations is to keep an arms length distance between the different entities in the mutual fund structure; so that they do not collude to harm the investors interest.

AMC

Custodian

Direct Equity

At the end of session Sectoral1, Equity Funds we have reached here on the Diversified Equity Funds Balanced Funds spectrum of Investment Products.
Gold Long Term Debt Funds Short Term Debt Funds Unsecured Debentures Secured Debentures Fixed Maturity Plans Liquid Funds

Risk

Bank Fixed Deposits

Savings Bank Deposits

We still need to look deeper into Liquid funds and FMPs.