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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
What is Investing?
I nvestment refers to a commitment of funds to one or more assets that will be held over some future
time 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. In
fact 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 to
tangible assets to monetary assets.. For our purposes, investment will mean a measurable asset retained
in order to increase one’s personal wealth. A financial asset is one that generates income and contributes to
accumulation and growth of wealth over a period of time. The two elements in investments are generation
of income on a periodic basis and/or growth in value over a period of time.
1
Economic Survey 2005-2006 2
Economic Survey 2005-2006
Why Invest?
We all work for money. It is equally important to ensure that money works for us. We should inculcate
the habit of reliance on a secondary source of income. We invest to improve our future welfare. Funds
to 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 consumption
possibilities. Anticipated future consumption may be by other family members, such as education funds
for children or by ourselves, possibly in retirement when we are less able to work and produce for our
daily needs. Regardless of why we invest we should all seek to manage our wealth effectively, obtaining
the most from it. This includes protecting our assets from inflation, taxes and other factors.
Investment fundamentals
Some 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, in
different 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 the
returns are higher.
Indian investors have always preferred fixed income securities where the returns are assured and have
compromised on the returns. In general investors are risk averse and more so Indian investors. It is the
job of the financial planner to advise the investors on the concept of focusing on higher returns for better
stability and higher capital building over a longer period of time. The above table very clearly illustrates
how a higher rate of return over longer period of time can make a world of difference to the capital at the
end of the term.
How Do We Invest?
If we are making investment decisions today that will directly affect our future wealth, it would make
sense that we utilize a plan to help guide our decisions. Surprisingly, the majority of people do not have
in place any type of formalized investment plan. Taking some time to put together a financial plan can
reap tremendous benefits. First, let’s define financial planning.
Financial planning is the process of meeting one’s life goals through the proper management of your
finances. 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 understand
how each financial decision affects other areas of finances. For example, buying a particular investment
product might help you pay off your mortgage faster or it might delay your retirement significantly. By
viewing each financial decision as part of a whole, one can consider its short and long-term effects on
life goals. One can also adapt more easily to life changes and feel more secure that goals are on track.
n They need expertise that they don’t possess in certain areas of finances. For example, a planner
can help you evaluate the level of risk in your investment portfolio or adjust your retirement plan
due to changing family circumstances.
n They may want to get a professional opinion about the financial plan they have developed for
themselves.
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 a
birth, inheritance or major illness.
n An investor may feel that a professional adviser could help him improve on how he is currently
managing his finances.
n An investor may feel that he should improve his financial position but does not know where to start
and how to go about it.
Some of the common problems which are brought before the financial planner are listed below. The list
is inclusive and there can a number of other areas as well.
Answers:
1. d
2. a
3. c
Understanding Risk
I n the context of investments “risk” refers not only to the chance that a person may lose his capital but
more 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 Instruments
and 2. Growth oriented investments. In the case of Fixed Income Instruments with a definite coupon rate
there is virtually no “risk” of not being able to get the desired returns but in the case of other instruments
an investor goes with an expectation of a certain amount of return and the term “risk” in this context
refers 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 be
defined 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 expected
outcome can be considered the risk of that decision. Thus, another way to consider risk is to consider
the possibilities of unexpected outcomes. The outcome form an investment decision may unexpectedly
increase or decrease the principal amount invested. While most people consider the decrease in value
as the investment risk, we will observe that in measuring risk, both positive and negative unexpected
outcomes must be considered. Before considering the issues regarding the measurement of risk let us
begin 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 a
simple example. Assume you are explaining the possible outcomes of an investment decision to a client
where the client may receive a return of either 8% (poor outcome) or a 16% (good outcome). You also
explain that the client may expect to receive a simple average of the two returns, or 12%, from the
investment decision. Your client now states that she is averse to the 8% outcome and wants to know if
the 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 expected
outcome would now be 14% ((16%+12%)/2) and the new poor outcome would now be 12%. In other
words, risk, or the unexpected outcomes, cannot go away. It is only meaningful in the context of an
expected outcome and both positive and negative unexpected outcomes. There are many different
ways in which the principal invested can be unexpectedly changed. We will now consider each of these
types of risk.
Risk Avoidance
Investment planning is almost impossible without a thorough understanding of risk. There is a risk/return
trade-off. That is, the greater risk accepted, the greater must be the potential return as reward for
committing one’s funds to an uncertain outcome. Generally, as the level of risk rises, the rate of return
should also rise, and vice versa.
Before we discuss risk in detail, we should first explain that risk can be perceived, defined and handled
in a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses
Risk Transfer
Another way to handle risk is to transfer the risk. An easy to understand example of risk transfer is the
concept of insurance. If one has the risk of becoming severely ill (and unfortunately we all do), then health
insurance is advisable. An insurance company will allow you to transfer the risk of large medical bills to them
in exchange for a fee called an insurance premium. The company knows that statistically, if they collect
enough premiums and have a large enough pool of insured persons, they can pay the costs of the minority
who will require extensive medical treatment and have enough left over to record a profit. Risk transfer can
also occur in investing. One may purchase a put option on a stock or on the market index which allows that
person to “put to” or sell to someone their stock or the index at a set price, regardless of how much lower the
stock or the index may drop. There are many examples of risk transfer in the area of investing.
Systematic Risk
An investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or
non market part. What is left is the non diversifiable portion or the market risk. Variability in a security’s
total returns that is directly associated with overall movements in the general market or economy is
called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk
directly encompasses interest rate, market and inflation risks. The investor cannot escape this part of
the risk because no matter how well he or she diversifies, the risk of the overall market cannot be
avoided. 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 investor
does. Clearly, market risk is critical to all investors.
Market Risk
A market is a place where goods and services are traded. Events occur within a market that similarly
affect all the goods traded in that market. For example, when the Reserve Bank of India unexpectedly
changes interest rates, most financial securities are affected similarly. Other examples of events that
affect all securities are the possibilities of war, severe natural catastrophes, recessions, structural changes
in the economy, tax law changes, even changes in consumer preferences etc. When the unexpected
change in values is systematic to the whole market, that risk is termed as market or systematic risk.
Reinvestment Risk
In the context of bonds investors look at the current yield as well as Yield To Maturity (YTM) – the return
one 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 yield
only if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at the
calculated YTM (yield to maturity). It is important to reinvest the periodic payments, at the same rate as
the YTM, to obtain the YTM yield on the security. In the context of long term bonds during the tenor of
which the interest rates may fluctuate in any economy it is virtually difficult for the investor to invest
periodic 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 simply
buys and holds. What is not so obvious to many investors, however, is the reinvestment implications of
the YTM measure. Because of the importance of the reinvestment rate, we consider it in more detail by
analyzing the reinvestment risk.
The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal
to the computed YTM on that bond, thereby earning interest on interest over the life of the bond at the
computed 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 reinvestment
rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in
the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at
rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised
yield. This gives rise to reinvestment rate risk.
This interest-on-interest concept significantly affects the potential total dollar return. The exact impact is
a function of coupon and time to maturity, with reinvestment becoming more important as either coupon
or 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 the
total return from the bond on the reinvestment of the coupon payments.
Liquidity Risk
“Liquidity’ in the context of investment in securities is related to being able to sell and realize cash with
the least possible loss in terms of time and money. Liquidity risk is the risk associated with the particular
secondary market in which a security trades. An investment that can be bought or sold quickly and
without significant price concession is considered liquid. The more the uncertainty about the time element
and 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 condition
that affects this ability is termed as liquidity risk. For example, an investor may wish to sell her holding in
a stock. If the investor cannot find a buyer for the stock, then her position in that stock cannot be
liquidated. 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 many
participants seeking to trade in these securities. Treasury bills can be sold almost instantaneously, and
hence are considered to be highly liquid. At the other end of the spectrum, stocks of very small and little
known companies are considered to contain high liquidity risk because they are thinly traded. When
investors make purchase decisions that may require to be quickly converted to cash, they will always
seek securities which have low liquidity risk. For example, firms that temporarily place excess cash in
financial (marketable) securities in order to enhance yields will seek highly liquid securities that do not
increase the firm’s liquidity risk exposure.
Regulation Risk
Some investments can be relatively attractive to other investments because of certain regulations or tax
laws that give them an advantage of some kind. Interest earned on Public Provident Fund accounts are
totally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a result of that special
tax exemption on the interest as well as the invested amount qualify for deduction from income u/s 80C
the yield on PPF account is much higher than its current interest rate of 8%. The risk of a regulatory
change that could adversely affect the stature of an investment is a real danger. A special committee
has advised the Government of India to do away with various sections of The Income Tax Act which
allow exclusions and deductions. If its recommendations are accepted by the Government then the
attractiveness of this investment avenue will drop dramatically. Dividends on shares and equity mutual
funds are tax free in the hands of investors. These avenues become attractive because of the tax
concessions (which are matters of legislation) and these can change. That is one risk associated with
investments which cannot be avoided. The best solution lies in periodic review of investment plans.
Business Risk
The 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
International Risk
International Risk can include both Country risk and Exchange Rate risk.
Country Risk
Country risk, also referred to as political risk, is an important risk for investors today. With more investors
investing internationally, both directly and indirectly, the political, and therefore economic, stability and
viability of a country’s economy need to be considered. More and more international investors are
investing in the Indian market because of the political and economic stability of India in the last few years
and the belief of continued stability on these fronts. Transparent economic policies and political stability
are 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.
Conclusion
Investors can control some of the risk in their portfolio through the proper mix of stocks and bonds. Most
experts consider a portfolio more heavily weighted toward stocks riskier than a portfolio that favours bonds.
Answers:
1. c
2. b
3. a
4. c
5. d
6. c
7. b
W e 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 of
lower than expected returns or negative returns are higher.
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 investor
must 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 be
made with 100 per cent certainty barring a financial collapse of the economy. The probability of occurrence
is 1.0, because no other outcome is possible.
With the possibility of two or more outcomes, which is the norm for stock market investment, each
possible likely outcome must be considered and a probability of its occurrence assessed. The result of
considering these outcomes and their probabilities together is a probability distribution consisting of the
specification 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 the
basis of past occurrences with suitable modifications for any changes expected in the future. In the final
analysis, 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 investor
may expect the TR (total return) on a particular security to be 10 per cent for the coming year, but in
truth, this is only a “point estimate.”
Probability distributions can be either discrete or continuous. With a discrete probability distribution, a
probability is assigned to each possible outcome. With a continuous probability distribution an infinite
number of possible outcomes exist. The most familiar continuous distribution is the normal distribution
depicted by the well-known bell-shaped curve often used in statistics. It is a two-parameter distribution
in which the mean and the variance fully describe it.
To describe the single most likely outcome from a particular probability distribution, it is necessary to
calculate its expected value. The expected value is the average of all possible return outcomes, where
each outcome is weighted by its respective probability of occurrence. For investors, this can be described
Expected Return
In the case of a fixed income security like a Government of India Bond or a bank fixed deposit, normally
the expected return is the same as the coupon rate or rate of interest. Hence there, are no uncertainties
about being able to get the expected return.
In the case of investments where the returns are market dependant, for example a stock, one will have
to estimate the possible returns and the probability of getting the same, as given here below:
= (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%
So, based on the figures in the table we can work out the variance as under;
Expected return already calculated to be 12%
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%
Case
Let us consider two stocks: stock X and stock Y whose returns and probability are given as follow:
Stock X
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 the
risk is less. In other words, we shall go ahead and measure the standard deviation of both the stocks to
find out which stock is more likely to give us the expected returns of 12%.
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 with
changes 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 all
stocks. If the security’s returns move more (or less) than the market’s returns as the latter changes, the
security’s returns have more (or less) volatility (fluctuations in price) than those of the market. It is
important to note that beta measures a security’s volatility, or fluctuations in price, relative to a benchmark,
the market portfolio of all stocks.
Calculating Beta
Rs = 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 free
securities like treasury bills.
Case
For example, suppose you are considering a private equity investment in a company with a new job
work. The process is inherently risky, i.e. the standard deviation of the project is 75% per year. The beta
of the project is 0.5. The Rf = 5% and the E[Rm] = 14.5%. What is the required rate of return on the
project?
Theory tells us that the answer does not depend upon the volatility associated with the returns. Instead
we 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 outcome
next year broadened or narrowed. ß (beta) is the only relevant piece of information — now all that
remains is to estimate it!
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.
R isk is an integral part of investments. Risk in the context of investments not only refers to the
chance 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 managed
to suit one’s risk profile and investment objectives.
“Risk” in investments is categorized as “systematic” and “unsystematic” risk; which are also called non
diversifiable and diversifiable risk. Unsystematic risk can be reduced through diversification while
systematic 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 strategies
that 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 to
reduce the risk and this can be achieved through diversification. Diversification reduces the risk and can
be 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; Middle
East and so on.
n Across different securities and so on – Different stocks; bonds, etc.
n Across maturities – short term; long term; for life; etc.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30
stocks will yield the most cost-effective amount of risk reduction. Investing in more securities will still
yield 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 rather
than holding too many securities in a portfolio which will serve the purpose of diversification in a very
limited way.
Further, diversification benefits can be gained by investing in foreign securities because they tend to be less
closely correlated to domestic investments. For example, an economic downturn in the Indian economy
may not affect Japan’s economy in the same way. Therefore, having Japanese investments would allow an
investor 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:
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
Example
Let us consider a portfolio with two securities A and B with a weight of 60% assigned to A and 40% to
security B. If the following are the probabilities of return for individual securities A and B let us try and
find out the probable return on the portfolio:
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,
sP2 is the variance of the portfolio.
ri, j is the covariance between securities i and j.
sI 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 sXY is
the standard deviation of the portfolio, w represents the weight of securities x and y in the portfolio while
COVxy is the covariance between securities x and y.
Example
Let us consider a portfolio with two securities X and Y with a weight of 60% assigned to X and 40% to
security Y. If the following are the probabilities of return for individual securities X and Y, let us try and
find out the standard deviation of the portfolio:
1. Actually, rather than use the standard deviation, we can also use its squared value, termed the
variance to describe risk. That is, we may use a2 (the standard deviation squared) to describe the
risk 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 in
opposite 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 securities
tend to move in opposite directions. Without calculating the correlation coefficient, it is difficult to determine
the extent to which they move together. Since the covariance is calculated similar to the standard
deviation, we know that this is an absolute number. That is why it is necessary to use the covariance to
calculate the correlation coefficient.
Correlation Coefficient
The correlation coefficient measures the strength of the relationship between two securities and the
coefficient is always a value between – 1 and + 1. If the value is –1, it can be said that the returns of the
securities are perfectly negatively correlated, meaning that the prices change equally but in opposite
directions, where direction implies increase and decrease. If they value is + 1, the two securities are
perfectly positively correlated and that the security prices change equally and in the same direction as
well. If the correlation coefficient equals zero, it means that the two securities do not move together in
any meaningful way.
Thus we can see that if correlation coefficient is –0.70, it means that these two securities exhibit a strong
negative movement in opposite directions. In this case, barring other issues, these two securities may
be suitable to put in a portfolio in order to project it from general stock market cycles.
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 j
exhibit a perfect negative correlation, with r if equal to – 1. As i increases, j decreases in exact proportion
to i. Panel C demonstrates assets i and j having no correlation at all, with r ij equal to 0.
Portfolio Effect
An investor who is holding only investment i may consider adding investment j in the portfolio. If equal
amounts are invested in each stock, the new portfolio’s Expected Return will be Kp. We define Kp as the
Expected Return of the portfolio:
Kp = XiKi+XjKj
The X values represent the weights assigned by the investor to each component in the portfolio and are
50 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%
Note : In Figure 5:2 risk-reduction potential from combining the two investments under study. Investment
i 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 have
reduced the risk while keeping the Expected Return constant at 10 percent.
Coefficient of Determination
As we just saw, correlation and covariance are statistical measures that gauge the nature of the relationship
between two random variables. Sometimes, the relationships between such variables may be one of
dependence or causality. For example, when our income increases (decreases), our consumption of goods
and services generally also increases (decreases). In this case, we can say that changes in consumption
are caused (is dependent upon), to some extent, on changes in income. In this example, we can then
classify consumption as the dependent variable and income as the independent variable. A common
Example
If the actual portfolio had a market value of Rs. 12 lacs and the NSE Nifty was trading at 3,000, then four
future contracts would be sold to effectively offset the market risk. This is so because each futures contract
represents the index level times a multiplier of Rs. 3,00,000 per contract at the Nifty level of 3000 (Each Nifty
contract size is 100). By selling four (4) contracts; i.e. 400 Nifties, the market value of Rs. 12,00,000/- of the
portfolio is protected against a fall in Nifty. When the market falls by 5%, the portfolio will fall by 5% resulting
in a loss of Rs. 60,000/- while the Nifty futures contract will earn Rs. 60,000/- on 4 contracts because Nifty
would have fallen from 3000 to 2850. This is an example of fully hedging the portfolio through selling the
index futures.
The same effect can be achieved by buying Index puts as well. The “put” option starts gaining when the
market starts falling and in case the market rises, the loss on puts will be to the extent of premium paid
only. In other words, puts can be used to limit the loss in case of a market rise with potential to earn
unlimited profits in case of a market fall. The use of futures and options as tools of hedging as well as
leveraging portfolios has been explained in a separate topic.
a. 15%
b. 19%
c. 16%
d. 17%
2. What would be the standard deviation of the portfolio comprising of the two securities as per
details 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. Yes
b. No; diversification does not serve the purpose of risk reduction
c. No; diversification reduces non systematic risk only
d. No; diversification reduces systematic risk only
4. Hedging is a strategy adopted to reduce all risks. Is this true?
a. Yes
b. No; hedging does not serve the purpose of risk reduction
c. No; hedging reduces non systematic risk only
d. No; hedging reduces systematic risk only
5. Hedging, against market loss, in a diversified stock portfolio can be achieved through which one
of the following strategies?
a. By selling index futures
b. By selling index puts
c. By buying specific stock futures
d. By buying index futures
Answers:
1. c
2. a
3. c
4. d
5. a
6. c
7. b
8. c
W e all make investments to get returns/rewards from the investment vehicles. There are two types
of 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 have
been earned. Realized return has occurred and can be measured with the proper data. Expected return, on
the other hand, is the estimated return from an asset that investors anticipate (expect) they will earn over
some 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 undertaking
the investment.
An assessment of return is the only rational way (after allowing for risk) for investors to compare alternative
investments that differ in what they promise. The measurement of realized (historical) returns is necessary
for investors to assess how well they have done or how well investment managers have done on their
behalf. 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 the
periodic cash flows (or income) on the investment, either interest or dividends. The distinguishing
feature of these payments is that the issuer makes the payments in cash to the holder of the asset
on a periodic basis. Yield measures relate these cash flows to a price for the security, such as the
purchase price or the current market price.
2. Capital gain (loss): The second component is also important, particularly for stocks but also for
long-term bonds and other fixed-income securities. This component is the appreciation (or
depreciation) in the price of the asset, commonly called the capital gain (loss). It is the difference
between 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 form
the 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.
Current Yield
It is a very simple measure of returns on any security and it is obtained by the following formula:
Annual Interest/price of the security
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 of
annuity over a period of time while the maturity value is the future value of the present price of the bond
and “r” the YTM has to be worked out substituting different values for r.
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
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 type
of returns; the nominal rate of return, the real rate of return, the real after tax rate of return, total return
and risk adjusted return. We will briefly discuss each of these concepts.
Thus, total return over the four years is Rs. 100 / Rs. 100 = 100%
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) and
common stock in terms of risk. Thus, for bonds, the risk premium may be 3 to 4% percent. Like the real
of return and the inflation rate, the risk premium is not stagnant but changes from time to time; for
instance, if the issuing company’s risk profile changes or if the macroeconomic outlook becomes more
uncertain, then the risk premium will change. If investors are very fearful about the economic outlook,
the risk premium may be 12- 14% percent
28
The return on this investment is: (150-125+3) = = 22 .4 %
125
To - Rs. 125 to purchase first share of stock, where To is our initial cash outflow at
Time zero
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:
Summary
This chapter began with a description of the different kinds of risk that accompany investments. It is
useful to understand the nature and various types of risk since investors implicitly or explicitly price this
risk in arriving at required returns investments. Therefore, the description of different types of risk is
followed by explanations of how risk may be Measured. Once we can identify the types of risk in an
investment and understand how to measure such risk, we can then proceed to identify what kinds of
returns 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 may
have been interpreted as a simple question. Not any more. In this chapter, we studied the many different
forms 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, the
effect of time or the means of averaging. Even though the simplicity of the term is no more, the astute
student should recognize that the various return definitions exist because they are all meaningful to
investors under different investment circumstances and scenarios. These differing applications were
explained in the context of defining each of the terms of returns. Armed with such knowledge, a financial
planner cannot only explain investment outcomes to clients more clearly but also help clients identify the
Problem
Mr. Ketan bought a share on Jan 1, 2003 for Rs. 45/-. The company did not pay any dividends. The year
end prices were as follows:
2003 = 50
2004 = 55
2005= 48
If he sold the share on end 2005 for Rs. 48, what returns did he get on this investment?
Solution
R1 = (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
Example
Mr. Mukherjee has an investment with an 8% taxable yield. Mr. Mukherjee pays tax at the rate of 30% on
his income. What is Mr. Mukherjee’s post tax return on this investment?
Let us try and find out what would be the yield to Mr. Mukherjee on his 10% tax free bonds if he is paying
tax at 20%.
10 %
Taxable return = 10 % /(1 - t ) = = 12 .5 %
0 .8
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 adjusted
yield 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 is
11.4285% as calculated above and since the return is not taxable, the yield works out to 16.3265% as
calculated subsequently.
The three important aspects of tax adjusted yields are:
Annualized Return
An annualized return is a rate of return over a full calendar year on an investment that is held for less
than a full calendar year. For example, if an investment produced a return of 5% in 182 days, the
annualized yield would be approximately 10%. It is important to note that this return measurement
assumes the return could be duplicated over the full year, which may or may not actually be achievable.
Problem
Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. Calculate his
annualized returns.
Solution
Absolute returns Rs. 10/110 over 45 days
Annualized returns = (10*365)/(110*45) = 0.7373 or 73.73%
Example
The rate of return on a stock in a particular year was 19.5 %. The rate of inflation during that year was
5.5%. 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%
Example
Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. No dividend
was received by him in this period. Calculate his holding period returns.
Holding period returns = (120-110)/110 = .0909 = 9.09%
Benchmark Portfolios
Evaluation of portfolio performance, the bottom line of the investing process, is an important aspect of
interest to all investors and money managers. The framework for evaluating portfolio performance consists
of measuring both the realized return and the differential risk of the portfolio used to compare a portfolio’s
performance, and recognize any constraints that the portfolio manager may face. A 12% return, by
itself, is a fairly meaningless figure. It must be viewed in comparison to the performance, over the same
timeframe, 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-dimensional
process based on return and risk. These two factors are opposite sides of the same coin, and both must
be evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of an
investment, 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 the
returns are large enough given the risk involved. If we are to assess performance carefully, we must
evaluate performance on a risk-adjusted basis.
We must make relative comparisons in performance measurement, and an important related issue is
the benchmark to be used in evaluating the performance of a portfolio. The essence of performance
evaluation in investments is to compare the returns obtained on some portfolio with the returns that
could have been obtained from a comparable alternative. The measurement process must involve relevant
and obtainable alternatives; that is, the benchmark portfolio must be a legitimate alternative that
accurately reflects the objectives of the portfolio owners.
An equity portfolio consisting of BSE Sensex stocks should be evaluated relative to the BSE Sensex or
other equity portfolios that could be constructed from the Index, after adjusting for the risk involved. On
the 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 inappropriate
to 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 holding
many 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 evaluating
portfolio returns. All investors should understand that even in today’s investment world of computers
and databases, exact, precise, universally agreed upon methods of portfolio evaluation remain an elusive
goal. An evaluation is imperative, though it is unfortunate that some studies have indicated that most
investors don’t have a good idea how well their portfolios are actually performing.
Risk-adjusted Returns
Recognizing the necessity to incorporate both return and risk into the analysis of portfolio return, three
researchers - William Sharpe, Jack Treynor, and Michael Jensen developed measures of portfolio
performance 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 the
evaluation. These measures are still used by mutual funds and money managers.
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 - Rf
RVAR =
SD
Treynor Measure
Jack 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 between
total risk and systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignores
any diversifiable risk. He used as a benchmark the ex post security market line.
RP - Rf
Beta
Jensen’s Index
Michael Jensen’s measure of portfolio performance was differential return measure (Alpha). It calculated
the difference between what the portfolio actually earned and what it was expected to earn given its
level of systematic risk. Basically, it attempts to measure the constant return that the portfolio manager
earned 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 relative
positions 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)
Answers:
1. a
2. b
3. c
4. c
5. c
6. a
7. b
8. c
9. d
10. c
W e now consider how investors go about selecting stocks to be held in portfolios. Individual investors
often consider the investment decision as consisting of two steps:
n Asset allocation
n Security selection
The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other
words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money
market assets, and so forth. Each weight can range from zero percent to 100 percent. If it is possible to
make 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 financial
markets are available to investors?
2. Within each country, what percentage of portfolio funds is to be invested in stocks, bonds, bills, and
other assets?
3. Within each of the major asset classes, what percentage of portfolio funds goes to various types of
bonds, 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 important
decision made by an investor. According to some studies, for example, the asset allocation decision
accounts 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 and
various 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 can
help 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 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.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. 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 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 is
done in conjunction with 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
involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the
Asset Classes
Portfolio construction listing out the asset classes, where money can be invested are:
Diversification
Diversification is the key to the management of portfolio risk because it allows investors to minimize risk
without adversely affecting return.
Random diversification refers to the act of randomly diversifying without regard to relevant investment
characteristics such as expected return and industry classification. An investor simply selects a relatively
large number of securities randomly.
For randomly selected portfolios, average portfolio risk can be reduced to approximately 19 per cent. As
we 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 of
portfolio 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. As
subsequent stocks are added, the marginal risk reduction is small. Nevertheless, adding one more
stock to the portfolio will continue to reduce the risk, although the amount of the reduction becomes
smaller and smaller.
It is also established in the US through studies that by adding foreign securities to the portfolio, the risk
is reduced dramatically – to the extent of 33%.
1. Weighted individual security risks (i.e., the variance of each individual security, weighted by the
percentage 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 securities
It is assumed that combination of two securities results in risk reduction. Is it possible to reduce the risk
of a portfolio by adding into it a security whose risk is higher than that of any of the investments held
already? Let us consider the following example:
Obviously, the stock Y is riskier because the standard deviation is higher but the expected return is also
higher. We will have to analyze and find out whether it would be sensible for an investor who is already
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 a
return of 11% when stock Y gives a return of 12%, using the example given above the covariance can
be 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 from
its 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 the
behaviour of the two variables.
Rxy = COVxy / (sx * sy)
= -2/(2*4) = -2/8 = -0.25
The stocks X and Y are negatively correlated, which means one stock will perform while the other may
not and vice versa. A perfect correlation will be when Rxy = 1 and a perfect negative correlation will be
when Rxy = -1.
Where,
sxy 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
s2x = variance of stock x
sy2 = 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 achieved
risk reduction without compromising on the returns.
That is along this efficient frontier we can receive a maximum return for a given level of risk or a minimum
risk for a given level of return. Portfolios do not exist above the efficient frontier, and portfolios below this
line do not offer acceptable alternatives to points along the line. As an example of maximum return for a
given level of risk, consider point E. Along the efficient frontier, we are receiving a 14 percent return for
a 5 percent risk level, whereas directly below point F, portfolio E provides a 13 percent return for the
same 5 percent standard deviation.
To also demonstrate that we are getting minimum risk for a given return level, we can examine point A
in which we receive a 10 percent return for a 2.8 percent risk level, whereas to the right of point A, we get
Benchmarks
A first question to be posed to a professional money manager is: Have you followed the basic objectives
that were established? These objectives might call for maximum capital gains, a combination of growth
plus income, or simply income (with many variations in between). The objectives should be set with an
eye toward the capabilities of the money managers and the financial needs of the investors. The best
way to measure adherence to these objectives is to evaluate the risk exposure the fund manager has
accepted . 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 indicates
that mutual fund managers generally follow the objectives they initially set. He measured the betas and
standard deviations for 12.3 mutual funds and compared these with the funds’ stated objectives. For
example, funds with an objective of maximum capital gains had an average beta of 1.22. Those with a
growth objective had an average beta of 1.01, and so on all the way down to an average beta of 0.55 for
income-oriented.
Using betas and portfolio standard deviations, we see that the risk absorption was carefully tailored to the
fund’s stated objectives. Funds with aggressive capital gains and growth objectives had high betas and
portfolio standard deviations., while the opposite was true of balanced and income-oriented funds. Other
studies 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 because
risk is one of the variables a money manager can directly control. While short-run return performance
can be greatly influenced by unpredictable changes in the economy, the fund manager has almost total
control in setting the risk level. He can be held accountable for doing what was specified or promised in
regard to risk. Most lawsuits brought against money managers are not for inferior profit performance but
for failure to adhere to stated risk objectives. Although it may be appropriate to shift the risk level in
anticipation of changing market conditions (lower the beta at a perceived peak in the market), long-run
adherence to risk objectives is advisable.
The portfolio manager is thus able to view excess returns per unit of risk If a portfolio has a return of 10
percent, the risk-free rate is 6 percent, and the portfolio standard deviation is 18 percent the Sharpe
measure is 0.22:
10% - 6% 4%
Sharpe measure = = = 0.22
18% 18%
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 an
inferior performance. Assume there is a 9 percent total market return, a 6 percent risk-free rate, and a
market standard deviation of 12 percent. Then the Sharpe measure for the overall market is 0.25 or:
9% - 6% 3%
= = 0.25
12% 12%
The portfolio measure of 0.22 is less than the market measure of 0.25 and represents an inferior
performance. Of course, a portfolio measure above 0.25 would represent a superior performance.
Treynor Approach
The 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 Sharpe
uses the portfolio standard deviation, Treynor uses the portfolio beta. Thus, one can say that Sharpe
uses total risk, while Treynor uses only the systematic risk, or beta Implicit in the Treynor approach is
the assumption that portfolio managers can diversify away unsystematic risk, and only systematic risk
remains.
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.
10% - 6% 4% 0.04
= = = 0.044
0.9 0.9 0.9
9% - 6% 3% 0.03
= = = 0.030
1.0 1.0 1.0
This would imply the portfolio has turned in a superior return to the market (0.044 versus 0.030) Not only
is 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 Approach
In the third approach, Jensen emphasizes using certain aspects of the capital asset pricing model to
evaluate portfolio managers. He compares their actual excess returns (total portfolio return – risk-free
rate) 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, as
the market line. If the beta is 0, the investor should expect to earn no more than the risk-free rate of
return 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 are
0. With a portfolio beta of 1, the portfolio has a excess returns as shown in the following diagram.
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. A
portfolio with a beta of 1 should expect to the market rate of excess returns (KM-RF), equal to 3 percent.
Adequacy of Performance
Using the Jensen approach, the adequacy of a portfolio manager’s performance can be edged against
the 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 measure
of performance. This value, termed alpha or average differential return, indicates the difference
between the return on the fund and a point on the market line that corresponds to a beta equal to the
fund. In the case of fund, the beta of 1.5 indicated an excess return of 4.5 percent along the market, and
if the actual excess return was only 3.9 percent, we thus have a negative alpha of 0.6 percent (3.9% to
4.5%). Clearly, a positive alpha indicates a superior performance, while a negative alpha leads to the
opposite conclusion.
Key questions for portfolio managers in general include the following: Can they consistently perform at
positive alpha levels? That is, can they generate returns better than those available along the market
line, 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 dots
represent 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 strong
performance on a risk adjusted basis, there is no consistent pattern of superior performance.
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 of
planners in selecting suitable money managers. We will return to the description of how the selection is
made 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, for
children’s college education, to buy a house or car, to build wealth, etc. Along with each of these reasons is
an associated objective. For example, in saving for retirement, an appropriate objective may be to maintain
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 stated
objectives?
n How often have the fund’s operating expenses exceeded both those stated and those that were
expected?
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 transitions
within 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 or
quantitative 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 manager
leads?
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 a
categorization is possible. In using the above criteria, the selector is trying to assess two basic traits of
a manager.
Perhaps the most important summation of these criteria is to understand how consistent a manager is
and has been. The more consistent a manager has been towards her/his style, trading activity, security
selection techniques, fund expense levels, etc. the better. Alternately, managers who change their
operating activities often are much more likely to under perform against their expectations. Another way
to consider the issue of consistency is that the manager’s activities are as stable as the investment
decision inputs of the clients. The client’s retirement objectives or their risk tolerances for those investment
do not change on a weekly or monthly basis. The basic idea here is that neither should the manager’s
attitudes and perceptions change on those scales. In a sense, there is a direct relationship between
consistency and competency.
Investment Objectives
Once the goals, life cycle, and time horizons for the goals have been identified, the investment objectives
become easier to identify. Investment objectives identify the goals of the portfolio in relation to the
reasons for the individual’s financial needs. Investment objectives can be further classified into four
types 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 and
ongoing flow of cash to the client. That is, the investor requires income generation from the principal
balance of the portfolio via interest or dividend payments. An investor who relies on the portfolio for
income in this way needs the cash for living purposes. Thus the investments tend to be conservative in
nature. Common investment securities are corporate bonds, government bonds, government mortgage
backed 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 objective
of capital appreciation in mind. Because the objective is growth over the long term, the riskiness of the
portfolio tends to be higher. The most common securities for this type of approach are equities, particularly
those in high growth companies or sectors. However, it is always a good idea to diversify the portfolio
holdings among various sectors and industries. Further, stocks of very large companies that lead their
industries (blue chip) in this case, can help to diversify the portfolio while achieving some of the same
growth objectives. Mutual funds, which invest in various sectors or industries can also help to diversity
a 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 as
well. Obviously having two objectives from the same portfolio can be challenging to manage, but it can be
done 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 of
money 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 government
bonds, certificates of deposit money markets (funds), and fixed annuities.
Tax Considerations
Incorporating the notion of before and after-tax investment returns in a portfolio is an important concept
in portfolio planning. The after-tax considerations must effectively integrate with other portions of the
financial plan so that taxes are minimized in years with high expected income. Recall that taxes can be
deferred (paid at a later date when assets are sold at a profit), can be avoided or can be taxed at capital
gains rates (investments held greater than one year) rather than at ordinary rates. It is useful to spell out
the tax consequences in the investments policy. However, the advisor must discuss and incorporate
into the plan the potentiality for changes in the tax law. Because laws change, tax planning relative to
portfolio management can be a very challenging aspect to the planner. When the client has a negative
bias toward taxes or has complicated transactions the sale and purchase of assets to and from the
portfolio. Tax considerations and goals should be spelled out in the investment policy to assist the
planner and the client in quantifying tax consequences of decisions.
Macroeconomic Factors
A good planner is always aware of macroeconomic factors that can ultimately affect investments. These
factors should be integrated into the plan. For instance, historical inflation rises, which affect the real
rate of return on assets, should be discussed in any plan in order to sustain the purchasing power of the
client to the greatest extent possible. Other factors that should be taken into consideration are interest
rates, 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 appreciation
of the areas that can affect the investment policy. As the planner gets to know the client, he or she can
integrate those areas within the macroeconomic environment into the client’s plan.
Answers:
1. b 2. c 3. c 4. a 5. b
T hese are ideal investment vehicles for the small investor – the retail resident Indian investors. Non
resident Indians are not allowed to invest in these schemes. Let us look at the salient features of
these schemes.
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/-.
Transferability
n A deposit account can be transferred from one post office to any other post office at any time on the
request of the depositor(s).
Nomination
n Nomination facility is available
Tax benefit
n As per the latest circular tax benefit is available u/s 80C of Income Tax Act from April 1, 2007 on
deposits 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 rate
applicable for the period for which the deposit has been held.
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
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.
Interest
n The bonds carry interest at the rate of 8% p.a. payable half yearly i.e. 31st January and 31st July
every year
n ECS facility is available – banks credit interest directly to bond holder’s account every 6 months
through ECS
n Cumulative option is also available – in which case Rs. 1,000/- becomes Rs. 1601/- at the end of
the 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 these
bonds
Tax Benefit
n Interest is taxable
n No Tax is deducted at source(TDS) presently
Premature closure
n Permitted only after one year from the date of deposit – in case of extreme emergencies premature
closure within one year may be permitted on application to Ministry of Finance, Government of
India
n In case of closure before 2 years but after 1 year an amount equivalent to 1.5% of the deposit
amount 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 deposit
amount 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 of
residence, 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 to
Income tax can submit 15 H (if depositor is above 65 years of age) and form 15G (if not above 65
years of age) to avoid tax deduction at source from the interest
n Principal Amount can be considered towards the deductions u/s 80C
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
T he following are the short term instruments of less than 1 year maturity. These instruments are
essentially institutional plays and retail investors don’t get to participate in this directly.
2. Repos
Repos or repurchase agreements (ready forward) are transactions in which one party sells security to
another party simultaneously agreeing to purchase it in future at a specified date and time for a
predetermined price. The difference in the prices is the cost of borrowing to one party and income to the
party lending the money. These transactions are secured and hence the counter party risk is highly
reduced. Therefore, the interest rate is also lower compared to call money rates. In repos the purchaser
acquires 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 the
maximum period for which a repo can be done.
Government Securities, Treasury bills and PSU bonds are the instruments used as collateral security
for repo transactions.
3. Treasury Bills
Treasury Bills are borrowings of Government of India for periods of less than 1 year and the normal
tenors are 91 days, 182 days and 364 days. The main holders of Treasury Bills are banks and primary
dealers, 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 and
time liabilities invested in government securities – Investments in Treasury banks serve the purpose of
meeting SLR requirements – currently SLR is 25%) On 91 days Treasury Bills, currently, the yield is
around 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 on
behalf of Government of India in this regard. Government of India also makes longer term borrowings to
which banks subscribe. The securities where the term is 1 year or more are called Dated Securities.
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 respective
Government offers guarantee for payment of interest and repayment of principal amount of these PSU
borrowings. These bonds, as they carry sovereign guarantee, are considered less risky compared to
corporate bonds/debentures but more risky compared to Government securities. Many State Government
corporations have floated bonds in the past and have raised moneys for infrastructure projects and the
Indian retail investors have participated in the issues in a big way. The investors have received excellent
returns while the corporations could raise much needed capital funds for major projects. It is also expected
that Government of India will allow Municipal Corporations to raise funds from the market, for
developmental 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 market
regulations for meeting their capital requirements. These are typically “debentures” which are borrowings
of the companies and these may be secured against a charge on the assets of the company or these
may be unsecured. The term of the debentures will depend upon the need of the company. Companies
can issue Non Convertible Debentures which are pure fixed income instruments and also partly convertible
or fully convertible debentures. The convertible debentures normally bear interest till the date of conversion
and/or on the non-convertible portion till redemption. Where the tenor of the debentures is 18 months or
more 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 the
credit rating for the debentures. Companies in the past found it convenient to tap the capital market and
Corporate Deposits
Companies are allowed to borrow from the public through public deposits for meeting their medium term
capital requirements. The acceptance of deposits by Indian companies is subject to the provisions of
Section 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 the
company (capital + free reserves) – this fixes the maximum amount a company can borrow from
the public through fixed deposits route.
n A company can borrow from its share holders also and this amount should not exceed 10% of its
net worth taking the total borrowings through public deposits to 35% of the company’s net worth. In
respect 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 limits
laid down under the Companies (Acceptance of Deposits) Rules, 1975 and notifications made
there 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 to
exceed 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
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 of
annuity over a period of time while the maturity value is the future value of the present Price of the bond
and “r” the YTM has to be worked out substituting different values for r.
Conclusion
It may be pertinent to add here that small investors have little or no exposure to government securities
and the money market instruments directly. Some investors have been participating in these avenues
through the mutual fund route. However investors have found company fixed deposits as well as non
convertible 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 received
good response from the retail investors. Besides the avenues discussed above fixed income instruments
include Small savings schemes like Post Office Monthly Income Scheme, Public Provident Fund, National
Saving Scheme, Kisan Vikas Patra and direct borrowing by Government of India through 8% GOI Taxable
Savings Bonds and Senior Citizen Savings Scheme. These schemes and their features have been
discussed in detail under the topic “Small Saving Schemes”.
Answers:
1. b
2. d
3. c
4. b
5. d
6. b
7. c
8. b
9. b
10. a
L ife insurance is a misunderstood concept in India. Basically Life Insurance Plans should provide
insurance 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 a
fixed term or periodic returns on a regular basis during the term. The emphasis has been more on the
investment aspects than on life cover. The private players in Life Insurance sector in India they have
brought in newer concepts like adding riders to life insurance policies but they also continue to sell
insurance 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 paid
back 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 assured
and 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 life
cover for a given premium is less compared to a whole life policy with more focus on maturity
benefit compared to death benefit.
n Endowment life insurance pays the sum assured in the policy either at the insured’s death or at a
certain 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 end
of 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 entered
life insurance sector and popularized Unit Linked Insurance Plans
Group Insurance
n Group insurance offers life insurance protection under group policies to various groups such as
employers-employees, professionals, co-operatives, weaker sections of society, etc.
n It also provides insurance coverage for people in certain approved occupations at the lowest possible
premium cost.
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 the
following funds:
Liquid fund
The 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 may
occasionally go down due to the use of short-term money market instruments. The returns on the funds
also tend to be lower.
Balanced Fund
30% to 60% of the Balanced Managed fund will be invested in high quality Indian equities. The remainder
will be invested in Government Securities and Bonds issued by companies or other bodies with a high
credit standing. In addition a small amount of working capital may be invested in cash to facilitate the
day-to-day running of the fund. The fund has a higher level of risk with the opportunity to earn higher
returns in the long term from the higher proportion it invests 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 the
performance 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
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 on
the child reaching a certain age
n There are plans that pay a single lump sum on the child attaining a certain age – typically planned
to provide for marriage expenses
n The most important insurance feature in a child care plan is that in the event of unfortunate death
of premium paying parent further premium payments are waived (at the option of the policy holder
while entering the plan) and the lump sums are paid as planned so that the child’s education
expenses are met
n Some plans also offer a rider called Accidental Disability Guardian Benefit rider where the future
premiums 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 child
should not face financial problems on death of the parent - many people tend to insure the child to
secure the child’s feature.
n The returns on some products are market linked and not assured and therefore it is important to
understand 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
Answers:
1. b
2. b
3. d
4. c
5. b
6. c
7. d
8. a
9. c
A Mutual fund is a collective investment vehicle where the resources of a number of unit holders are
pooled 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 the
investments collected in the mutual fund schemes.
1. Professional management
The funds are invested by professional fund management team that analyses the performance and
prospects of companies and selects suitable investments in line with the objectives of the schemes.
2. Diversification
It is impossible for a small investor to diversify across different investment vehicles as well as over a
large number of companies. He invariably runs the risk of non diversification on his investments because
of low capital. The mutual fund provides him the best option where on a small capital invested the unit
holder gets a diversified portfolio.
3. Regulated operation
The mutual fund administration and fund management are subject to stringent regulations by Self
Regulatory 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 is
kept protected.
4. Higher returns
As these funds are well managed and well diversified they tend to perform better than the market over
a longer period of time; there is potential for the unit holders to get better returns compared to fixed
income avenues over a longer period of time.
5. Transparency
The NAV’s of open ended funds are disclosed on a daily basis while the portfolio is disclosed on a
monthly basis ensuring transparency to the investors.
6. Liquidity
Open 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 Benefits
Mutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The unit
holders also enjoy certain tax benefits on the income earned; the capital gains made and on amount
invested in certain types of funds.
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, Government
allowed 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 of
SEBI are – to protect the interest of investors in securities and to promote the development of and
regulation of the securities market.
As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to
protect 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 regulations
were fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issued
guidelines 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 promoted
by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory
requirements for these mutual funds and all are subject to monitoring and inspections by SEBI. The
risks associated with the schemes launched by the mutual funds sponsored by these entities are of
similar type.
Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in
equities and fixed income securities in the proportion indicated in their offer documents. These are
appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt
instruments. 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.
Gilt Fund
These 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 is
the case with income or debt oriented schemes.
Index Funds
Index 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 an
index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not
exactly by the same percentage due to some factors known as “tracking error” in technical terms. These
funds are also called “passive funds” as not much fund management skills are involved and these funds are
expected to perform in line with the market. The expenses of fund management tend to be lower in index
funds and these funds are suitable to investors who are happy with market returns.
Sectoral Funds
A mutual fund house may feel that a particular industrial sector may perform better than other sectors and
that 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 equities
of companies of that sector. For example a Pharma fund will invest in equities of pharmaceutical companies
only and not in other industrial sectors. These are high risk funds and the returns can also be higher.
Thematic Funds
A fund house may feel that some sectors as a theme may outperform other securities because of
government policies, consumer preferences, over all market conditions, etc. The fund house may launch
a thematic fund and invest the funds collected only in companies which are connected with the specific
theme. For example An infrastructure fund is not a sectoral fund as it will not fund only in one sector but
invest 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 in
comparison with diversified equity funds. Funds classified on the lines of market caps like Small Cap
Fund; Mid Cap Fund or Large Cap funds can also be considered as thematic where the theme is
“market capitalization”.
Offshore funds
Indian mutual funds have been permitted to invest overseas. Some mutual fund houses have already
launched schemes which seek to invest a certain percentage of their corpus in foreign companies which
are listed and traded outside India. These funds are unique in that they offer diversification across
geographies, for the first time, to Indian investors.
Commodity Funds
These funds make investments in different commodities directly or through commodities futures contracts
and also invest shares of companies dealing in commodities. Typically they must invest in one commodity
or a diversified set of commodities – A gold fund invests only in gold whereas a metal fund may invest in
precious metals and base metals like gold, silver, platinum, copper, nickel, zinc, etc. These funds serve
the purpose of diversification across asset classes as direct investments by retail investors in commodities
is virtually impossible due to various physical constraints.
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
Taxation of investors
STCG indicates Short Term Capital gains made on selling the equity-oriented fund within one year of
purchase
LTCG – Long Term Capital Gains made on selling the equity oriented fund after having held it for one
year or more from the date of purchase. This is applicable to all equity oriented funds including close
ended funds
DDT – Dividend Distribution Tax payable by the mutual fund
Where STCG – indicates short term capital gain wherein the mutual fund has been sold within one year
of purchase.
LTCG* – Long Term Capital Gain, where the mutual fund has been sold after a holding period of 1 year
or 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 of
taxation 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 is
payable by the mutual funds. It may be noted that DDT impacts the return to the investor indirectly
because DDT is paid out of the funds thereby affecting NAV of the fund.
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 instruments
his 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 the
tax 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 cost
of 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.
Example
Mr. Devesh Patel buys 1000 units of a fund for Rs. 12.50 cum dividend on 10th March 2006; he receives
dividend of Rs. 2.00 per unit on 14th March 2006 and he sells the units on 15th March 2006 at a price of
Rs. 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
Measurement
Investors are very keen on fund performance and the alert ones keep watching the fund performance
very frequently – even on a daily basis. Each fund is evaluated and compared with the performance of
the market and other funds in the market. The performance of a fund manager is generally evaluated on
two counts:
1. The ability to out perform the market and deliver superior returns
2. The ability to eliminate unsystematic risk through diversification.
Example
Let us assume that Mr. Bose had invested Rs. 10,000/- in a new fund offer at a unit price of Rs. 10/- with
a load of 2.5%. After one year he finds that the NAV has gone up to Rs 15/-. The total returns earned by
Mr. 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 out
during 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; two
years; three years; since inception etc. it is assumed that units have been bought at Rs. 10/- and loads
have been ignored in this calculation of performance.
Sharpe Index
RP - Rf
SD
Treynor Index
RP - Rf
Beta
Example
Let us try to compare two funds with the following information on returns and the risk; given that risk free
return 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 measures
Expense ratio: The expense ratio is an indicator of the fund’s cost effectiveness and efficiency. It is
the ratio of total expenses to average net assets of the fund. Expense ratio must be evaluated from the
point of fund size, average account size and portfolio composition – equity or debt. Funds with small
corpus will have a higher expense ratio compared to a fund with a large corpus. Naturally higher
expense ratio will affect fund performance adversely. It is important to note that brokerage and
commissions on the fund’s transactions are not included in the expenses figure of the fund while
computing the expense ratio.
Income Ratio: Income ratio is defined as fund’s net investment income divided by net assets for the
period. This ratio is a useful measure for evaluating income oriented funds, particularly debt funds. This
ratio is used in conjunction with ratios like total return and expense ratios.
Investors seem to prefer mutual funds compared to other investment vehicles – that is obvious from the
fact that total assets under management of mutual funds have gone up by a whopping 225% over a
period 3 ¼ years. Investors are willing to take more risk for the sake of higher returns as evidenced from
the fact that equity funds account for 31% of total AUM of mutual funds as on 31st July 2006 compared
to just 11.21% in April 2003.
Answers:
1. b
2. c
3. b
4. d
5. d
6. d
7. a
8. c
9. b
10. a
O ne 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 the
choice between primary and secondary markets to invest in stocks.
Primary market
Certain eligible companies may tap the capital market for their capital requirements. Eligibility criteria
have 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 the
capital market. The merchant bankers advise the company on matters of regulation, compliance with
statues, marketing, pricing, timing and other issues which are of vital importance. Where the issue size
is large companies prefer to appoint more than one merchant banker for this purpose – with specific
functions. As per the advice of the merchant banker a company may choose to issue shares with fixed
price or a price band where the price will be discovered in a book building process. The company may
be entering the capital market for the first time where upon its shares are to be listed on the stock
exchanges – such an issue is called Initial Public Offering (IPO). An existing listed company may come
out 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 subscription
from the public to its issue of equity capital at a fixed price – at par or at a premium. Fixed price issues
was the norm until some years ago, especially before the book building concept was introduced in India
but 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 can
exercise their options in the application and bid for the same at whatever price they are prepared to pay
for the issue – but within the price band. The price band essentially consist of two prices the floor price
and the cap price. The difference between the two cannot be more than 20%. In case of an FPO the
listed company can announce the price band just a day before the issue opens for subscription while in
the 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 of
shares shall bid in multiples of prescribed lot sizes and within the price band. The bidder can make three
bids in the prescribed application form and can also revise or withdraw his bid before the close of the
offer. Here the investor has the freedom to decide the price at which he shall be interested, of course
within 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 apply
for the issues. In order to present a level playing field for the small investors SEBI has stipulated that a
certain minimum percentage of the issued shares should be reserved for allotment to “Retail Individual
Investors” 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 at
least 35% of the shares are allotted to retail individual investors. ‘Retail individual investor’ means an
Client registration
An investor can invest in shares through the secondary market. He can invest in a stock which is already
listed in one of the stock exchanges. In India there are 23 stock exchanges but only two of them are
most important viz. National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE). Investors
who would like to buy or sell shares directly from the market will have to register themselves as clients
with brokers or sub brokers. Brokers are members of stock exchanges while sub brokers work under a
specific 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 SEBI
called KYC – Know Your Client. Personal information of the client is obtained in this specified format and
proof 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 client
and broker enter into an agreement – in the format prescribed by SEBI for this purpose. Thereafter the
client is registered with the market participant and allotted a unique client ID. Now the client can trade on
the stock exchange through the broker/sub broker.
Trading
There are basically two trading mechanisms adopted by stock exchanges the world over to provide
liquidity to investors. The two mechanisms are:
Types of orders
Market order – the trader decides to buy or sell a particular scrip at the current market price; he can
place 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 changing
very fast with time.
Risk management
Brokers are required to have Base Minimum Capital (BMC) with the respective stock exchanges. Brokers
also bring in additional capital over and above the BMC in the form of cash, bank fixed deposits and/or
securities. The brokers are set intra day trading limits, called Gross Exposure (GE) based on the total
margin money lying with the stock exchanges. The extent of trading a broker can do is a function of his
capital – 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. The
brokers also take margin money from active clients along the same principles of restricting exposures
beyond certain times the margin thus controlling the speculation and reducing the risk. SEBI has laid
down mandatory rules for brokers to collect margins from clients who trade in volumes beyond some
minimum limits – currently collection of client margins is compulsory if a client at any point in time has
net outstanding positions in excess of Rs 5 lacs (unless the same is to result in delivery) and the margin
should be at least 10% of net outstanding position. Stock exchanges also collect VaR and M2M margins
on the outstanding positions – VaR – value at risk and M2M – mark to market margins. The extent of
margins may vary and generally tends to increase as the market gets more and more volatile.
Corporate benefits
Companies declare book closure or record dates for determining eligibility for corporate benefits like
dividend, bonus, rights entitlements, stock splits, etc. On the stock exchanges the stocks remain cum
dividend, cum bonus or cum rights up to a certain date and all investors who buy the particular stock on
or before this specific date will be entitled to that corporate benefit. The next day onwards the stock
starts quoting ex dividend, ex bonus or ex rights – meaning investors who buy after these dates will not
get the respective corporate benefit; alternatively if a share holder of the company sells the stock cum
benefit he won’t be entitled to it but if sells ex benefit he shall get the benefit. The stock for some time on
the exchanges may trade on “no delivery” basis – all trades entered during the no delivery period are
clubbed and settled, on a particular day, after the end of no delivery period. In other words, the pay in
and pay out of funds and securities in respect of this particular stock which is trading on a no delivery
basis 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
Example
Let’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.
Valuation of shares
It is very important to understand how the shares are valued on the stock exchanges. Investors would
like 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 of
shares. Many methods are followed for valuing shares. Let us look at a few of them.
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 can
be sold after one year at a price P1
Example
If an investor expects to receive a dividend of 2.50 per share and year end price to be Rs. 150 and
needs a return of 15% p.a. on his share investment at what price should he buy this share?
Example
The 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 price
should we buy the stock?
We may add here that D1 is the expected dividend for the next year; given the current year’s dividend one
can work out the next year’s expected dividend by applying the rate of growth of dividends as follows:
D1 = D0*(1+g)
Example
If a company has been currently paying dividend at the rate of Rs. 2/- per share and if the growth rate is
However, this constant growth model is rarely used in the market place for valuing the stocks mainly
because it is very difficult to estimate the growth rate and that too in perpetuity.
where b is the plough back ratio or the proportion of retained profits out of total profits, r the required rate
of 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 securities
including stock as the interest rates rise. When the interest rate rises security prices will fall. The relation
between interest rates and P/E ratios is inverse.
Riskier stocks have lower P/E multiples. Riskier a stock the higher the returns expectations and hence
lower the P/E ratio. This is typically true in the market place of mid cap and small cap stocks; these are
high risk stocks and tend to trade at lower P/E multiples compared to large cap stocks because the
return 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 price
projections are done for stock valuations, as follows:
1. Estimate the EPS for the current financial year based on company’s past track record, statements
regarding future out look, orders on hand, market price trends for the product, reported profits for
the completed quarters, etc. This is a very highly skilled job and many researchers keep on estimating
and revising, on a periodic basis because of the numerous elements involved.
Fundamental Analysis
Fundamental analysis is based on the premise that any security (and the market as a whole) has an
intrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlying
variables, which combine to produce an expected return and an accompanying risk. By assessing these
fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined.
Technical analysis
Technical analysis can be defined as the use of specific market-generated data for the analysis of both
aggregate 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 trends
which 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 trend
changes at an early stage and to maintain an investment posture until the weight of the evidence indicates
that the trend is reversed.
Technical analysis is sometimes called market or internal analysis, because it utilizes the record of the
market 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 gradual
adjustment toward a new (equilibrium) price. As the stock adjusts from its old equilibrium level to its new
level, the price tends to move in a trend. The central concern is not why the change is taking place, but
rather the very fact that it is taking place at all. Technical analysts believe that stock prices show identifiable
trends that can be exploited by investors. They seek to identify changes in the direction of a stock and
take 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 analyzing
movements in the aggregate market, industry average, or stock. In contrast, fundamental analysis focuses
on 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 move
in trends as the stock price adjusts to a new equilibrium level. These trends can be analyzed, and
changes 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 technical
trading rules and indicators.
Price and volume are the primary tools of the pure technical analyst, and the chart is the most important
mechanism for displaying this information. Technicians believe that the forces of supply and demand
result in particular patterns of price behavior, the most important of which is the trend or overall direction
in price. Using a chart, the technician hopes to identify trends and patterns in stock prices that provide
trading signals.
Taxation
Income derived from equity shares comprises dividends and capital appreciation. Dividends of Indian
companies are tax free in the hands of share holders. The companies declaring dividends are required
to pay Dividend Distribution Tax at rates prescribed from time to time; currently 12.5% + Surcharge of
5%. 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. In
respect of securities listed and traded on the stock exchanges the holding period is 12 months for
determining 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 delivery
of shares. These transactions are considered speculative in nature. The income earned is taxed at the
rate 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 buying
prices will be short term capital gain. STCG is taxed at the rate of 10% & @ 15% w.e.f. from financial
year 2008-09 in respect of securities which are traded on the exchanges and where Securities Transaction
Tax 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 capital
asset, held for more than 12 months, and sold on a stock exchange where STT has been levied on the
transaction.
Answers:
1. a 2. d 3. b 4. b 5. b 6. c
7. d 8. b 9. d 10. b 11. a
D erivatives have become very important in the field of investments. They are very important financial
instruments 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 the
contract should be able to identify all the risks involved before the contract is agreed. It is also important
to remember that derivatives are derived from an underlying asset. This means that risks in trading
derivatives 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 reference
rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the
settlement price of a derivative is based on the stock price of a stock for e.g. Tata Steel which frequently
changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that
derivative risks and positions must be monitored constantly.
We will try and understand
Example
Mr. Kulkarni wants to buy a car, which costs Rs. 2,00,000 but he has no cash to buy it outright. He can only
buy it 3 months hence. He, however, fears that prices of cars will rise 3 months from now. So in order to
protect himself from the rise in prices Mr. Kulkarni enters into a contract with the car dealer that 3 months
from now he will buy the car for Rs. 2,00,000. What Mr. Kulkarni is doing is that he is locking the current
price of a car for a forward contract. The forward contract is settled at maturity. The dealer will deliver the car
to Mr. Kulkarni at the end of three months and Mr. Kulkarni in turn will pay Rs. 2,00,000/- to the car dealer
on delivery.
Example
Mr Patel is an importer who has to make a payment for his consignment in six months time. In order to
meet his payment obligation he has to buy dollars six months from today. However, he is not sure what
the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank
to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it
is 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 derivative
instrument is a contract.
To understand the use and functioning of the index derivatives markets, it is necessary to understand
the underlying index. A stock index represents the change in value of a set of stocks, which constitute
the index. A market index is very important for the market players as it acts as a barometer for market
behavior and as an underlying in derivative instruments such as index futures.
Example
Futures contracts in Nifty in August 2006
The settlement day is the last Thursday of the month or the previous working day if last Thursday
happens to be a holiday.
The permitted lot size is 100 or multiples thereof for the Nifty. That is if you buy one Nifty contract, the
total 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 benefit
of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand
how 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 reduced
through diversification while market risk is reduced through hedging.
Beta is the measure of market risk. Beta measures the relationship between movement of the index to
the 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 goes
down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio
increases 11%. The strategy of hedging is resorted to with the objective of reducing portfolio beta to
zero and reducing the market risk.
Hedging involves protecting an existing equity portfolio from future adverse price movements in the
stock market. In order to hedge the portfolio, a market player needs to take an equal and opposite
Steps in hedging
1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that
it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the
losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio
by 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. Then
why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that
everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or
not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a
reverse 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 their
money at risk in the hope of profiting from an anticipated price change. They consider various factors
such as demand supply, market positions, open interests, economic fundamentals and other data to
take their positions.
Example
Kirit is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting
the 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. On
Sept 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
Less: Purchase Cost: 3400*100 = Rs. 3,40,000
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 gives
riskless 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 priced
market and selling at the higher priced market. In index futures arbitrage is possible between the spot
market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the
spot market)
Sale = 3500
Arbitrage profit = 32
However, one has to remember that the components of holding cost vary with contracts on different
assets.
Example
Suppose a stock portfolio has a value of Rs. 100 and has an annual dividend yield of 3% which is
earned throughout the year and finance rate =12% the fair value of the stock index portfolio after one
year 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 loan
of 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
Speculation
We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation
and arbitrage. In this module we will see one can trade in index futures and use forward contracts in
each of these instances.
Example
Bullish
On August 13, 2006, ‘X’ feels that the market will rise so he buys 100 Nifties with an expiry date of
August 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
Bearish
On August 13, 2006, ‘X’ feels that the market will fall so he sells 100 Nifties with an expiry date of August
31 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 an
anticipated price change.
Margins
The margining system is based on the JR Verma Committee recommendations. The actual margining
happens 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/loss
The 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 on
99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to
lose within a certain horizon time period (one day for the clearing corporation) due to potential changes
in 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 already
occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding
positions. 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 margins
payments 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 1
Close 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
Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not
closed out will be marked-to-market. The closing price of the index futures will be the daily settlement
price 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 by
which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical
futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the
contract period the difference between the contract value and closing index value is paid.
Options
The markets are volatile and huge amount of money can be made or lost in very little time. Derivative
products are structured precisely for this reason — to curtail the risk exposure of an investor. Index
futures and stock options are instruments that enable an investor to hedge his portfolio or open positions
in 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 range
of potential profit scenarios.
Example
Now let us see how one can profit from buying an option. Mr. Shah feels that the market will go up. He
is 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 of
Rs. 50.
n In about 15 days time Nifty goes up and therefore he sells the option for Rs. 75 making a profit of
Rs. 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 the
actual premium paid.
Put Options
A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a
fixed price for a period of time.
Example: Mr. Dutt purchases one contract of Infoysys Technologies Sep 2006 1800 Put —Premium
Rs. 50 (contract size 100 shares)
This contract allows Sam to sell 100 shares Infosys Technologies at Rs. 1800 per share at any time
between the current date and the expiry of Sep 2006 series. To have this privilege, Sam pays a premium
of 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 the
potential to make high profits as there is a potential for the stock price to fall by any amount but in case
the price of the share goes up; he will suffer a loss but the loss will be limited to Rs. 5,000/- premium paid
by 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.
Summary
Concepts
Important Terms
Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase
or sell the underlying. Five different strike prices will be available at any point of time. The strike price
interval 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 exchange
for the entire duration of the option depending on the movement of the underlying stock or index in the
cash 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
Pricing of options
Options are used as risk management tools and the valuation or pricing of the instruments is a careful
n Price of Underlying
n Time to Expiry
n Exercise Price Time to Maturity
n Volatility of the Underlying
And two less important factors:
Price of underlying
The premium is affected by the price movements in the underlying instrument. For Call options (the right
to buy the underlying at a fixed strike price) as the underlying price rises so does its premium. As the
underlying price falls so does the premium.
For Put options as the underlying price rises, the premium falls; as the underlying price falls the
premium rises.
The following chart summarises the above for Calls and Puts.
Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It
reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or
the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the
underlying stock, the higher the premium because there is a greater possibility that the option will move
in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls
and puts overlying that stock increase, and vice versa.
Higher volatility = Higher premium
Lower volatility = Lower premium
Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of
carry of a futures contract. If the size of the options contract is very large, then this factor may become
important. All other factors being equal as interest rates rise, premium costs fall and vice versa. The
relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either
borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates
are rising, then the opportunity cost of buying options increases and to compensate the buyer premium
costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can
place the funds on deposit and receive more interest than was previously anticipated. The situation is
reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.
n Delta
n Gamma
n Vega
n Rho
Delta
Delta 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.
Example
A trader is considering buying a Call option on a futures contract, which has a price of Rs. 20. The
premium for the Call option with a strike price of Rs. 19 is 0.80. The delta for this option is +0.5. This
means that if the price of the underlying futures contract rises to Rs. 21 – a rise of Re 1 – then the
premium 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 not
likely 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 the
underlying stock price are inversely related. This is because if you buy a put your view is bearish and
expect the stock price to go down. However, if the stock price moves up it is contrary to your view
therefore, 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.
Gamma
This is the rate at which the delta value of an option increases or decreases as a result of a move in the
price of the underlying instrument.
Theta
It 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 generally
used to gain an idea of how time decay is affecting your portfolio.
Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of
an option premium for a given change – typically 1% – in the underlying volatility.
Rho
The change in option price given a one percentage point change in the risk-free interest rate. Rho
measures the change in an option’s price per unit increase –typically 1% – in the cost of funding the
underlying.
n A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other
a put.
1. To “buy a straddle” is to purchase a call and a put with the same exercise price and
expiration date.
2. To “sell a straddle” is the opposite: the trader sells a call and a put with the same exercise
price and expiration date.
A trader, viewing a market as volatile, should buy option straddles. A “straddle purchase” allows the
trader 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 of
either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the
options.
In this case the trader has long two positions and thus, two breakeven points. One is for the call, which
is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the
premiums paid.
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
L et’s look at real estate as an investment vehicle where the income earning capacity and capital
appreciation over time become more important than occupation for self use.
Illiquidity
Real estate is difficult to acquire and more difficult to sell because of absence of organized markets as in the
case 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 real
estate then becomes essentially a long term investment option where liquidity is a very big problem.
Legal complexities
The legal contracts between property owners, financiers and tenants are quite complex and require
legal interpretation and construction. This aspect of real estate brings in not only additional costs but the
choice of right legal consultant.
Inefficient market
Real 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 local
factors play a very vital role. A national market has not developed in real estate because of physical
limitations as they exist today – in other words a person in New Delhi may find real estate in Bangalore
a very attractive proposition but it will be physically impossible for him to participate in this investment
opportunity. There is a need for a national and structure market to emerge in order to attract large scale
investments – but because of typical state laws it may become difficult in India to have a very dynamic
and liquid real estate market.
Legal issues
There are a large number of legal issues involved in investing in real estate. Many of the legislations are
State legislations and hence a good understanding of local laws is essential. For example lands can be
bought and registered only in the name of farmers – i.e. you can buy agricultural land only if you already
own agricultural land in that state. Land ceiling laws are applicable in certain states which makes buying
a large piece of land highly risky. Popular tenancy laws exist in many states where the tiller becomes the
owner 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 understanding
of these complex legal issues.
Realty funds
Mutual funds have now been permitted by SEBI, the regulator, to launch realty funds. These funds
collect 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 and
property companies. In other words through the mutual funds route it has now become possible for a
small investor to participate in the property market and reap the benefits of the same in an indirect way.
Time Share
Some companies have floated novel schemes where an investor can own properties for a part of the
year; say for enjoying holidays for a few days in a year. There is rotational ownership with maintenance
and other matters being managed by the company itself. The returns you get on this is essentially cost
free holidays without hassles of maintaining the properties. You own it on a right to use concept.
a. Capitalization approach
It is important to find out based on a market research what kind of yields are obtainable on comparable
properties. Secondly it is required to work out the net income derived from the property by deducting
expenses like repairs, insurance, etc. from the gross income and finally capitalize the net income for the
market yield on the property.
Example
Let’s presume that rent fetched is generally around 8.5% of property values.
Example
An 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 the
investor 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 purchases
the property now for Rs. 2,73,400/- sells it after 3 years for Rs. 3,00,000/-
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 occupied
properties 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 up
to 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 occupied
property as well deduction u/s 80C are allowed for each one in the same proportion. In other words
increased tax benefit and each of the joint holders can enjoy tax advantages.
Rate of Tax
1. STCG is added to income under the head “Income from other sources” and taxed at the rate
applicable to the tax payer.
2. LTCG is taxed at 20% after arriving at the figure of taxable LTCG as shown above
n If the entire sale proceeds are invested in bonds of Government companies like Rural Electrification
Corporation Ltd. and/or National Highway Authority of India, Ltd. then the tax on LTCG can be
saved fully.
n If part of the proceeds are invested in such bonds proportionate deduction from LTCG will be
allowed
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
Answers:
1. c
2. a
3. a
4. b
Passive strategy
S ome 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 can
be temporary aberrations (and over reactions of optimism and pessimism). In an efficient market, the
prices of securities do not depart for any length of time from the justified economic values that investors
calculate 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 does
depart from its estimated economic value, investors act to bring the two values together. Thus, as new
information arrives in an efficient marketplace, causing a revision in the estimated economic value of a
security, its price adjusts to this information quickly and, on balance, correctly. In other words, securities
are efficiently priced on a continuous basis and the long term investors who are holding on to securities
need 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 temporary
aberrations but hold on to qualitative securities that shall perform in line with the market over a period of
time. That is, after acting on information to trade securities and subtracting all costs (transaction costs
and 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 owning
and managing common stocks. If the market is totally efficient, no active strategy should be able to beat
the market on a risk-adjusted basis. The Efficient Market Hypothesis has implications for fundamental
analysis 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. The
emphasis is on minimizing transaction costs and time spent in managing the portfolio because any
expected benefits from active trading or analysis are likely to be less than the costs. Passive investors
act as if the market is efficient and accept the consensus estimates of return and risk, accepting current
market 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 whatever
portfolio of stocks is owned. Alternatively, a very effective way to employ a passive strategy with common
stocks is to invest in an indexed portfolio. We will consider each of these strategies in turn.
Index Funds
Some investors prefer indirect investment to direct investment in equities. For this class of investors
the best passive strategy could be buying into an Index Fund. In an Index fund the fund manager pools
the resources of a number of investors and invests in stocks that comprise the index in the same
weightage as in the Index. These funds are designed to duplicate as precisely as possible the
performance 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 overvalued
securities. Expenses are kept to a minimum, including research costs (security analysis), portfolio
managers’ 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 actively
managed funds – mainly because the active funds might have under performed the market during that
period of time. These are open ended funds where the loads are the least and the returns in line with the
market index which they propose to replicate.
Active strategy
Investors, who do not accept the Efficient Market Hypothesis and those who believe that it is possible to
out 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 securities
and 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, but
they believe that the marginal benefit outweighs the marginal costs incurred. Investors adopt two pronged
strategies to perform better than the market – proper stock selection and timing the entry and exit points.
Stock Selection
Most investment techniques involve an active approach to investing. In the area of common stocks the
use of valuation models to value and select stocks indicates that investors are analyzing and valuing
stocks in an attempt to improve their performance relative to some benchmark such as a market index.
Leveraging
Aggressive investors adopt the bank financing route to invest in stock s a certain number of times their
own capital through the process of buying stocks and pledging with bank, raising money on the stocks
and buying more stocks. Thus, on a given capital, thanks to bank borrowing against stocks they are able
to build a portfolio much higher in value but at a cost, namely the interest cost. These investors are
highly aggressive and are always under pressure that the stocks selected by them should perform and
deliver returns superior to the rate of interest payable on the borrowal accounts – banks lend against
securities 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 of
shares, 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 the
margin money alone; which is around 40% of the application money and thus manage to increase the
number of shares for which they could apply with a given capital, thereby increasing the chances of
Maturity Selection
Investors make investments to meet specific demand on funds over a certain period of time. Some of
these time horizon related needs could be:
T he important decision that an investor is required to take is on Asset Allocation. There are different
asset 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 allocation
has been primarily responsible for portfolio performance more than even stock selection and timing
issues. 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 in
stocks, bonds and cash equivalents. It is the most important investment decision made by investors
because 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 allocation
serves the purpose of diversification among different asset classes and diversification among different
securities within an asset class.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. In other words the returns on a stock portfolio will depend on the market returns
to a great extent – no stock is expected to give phenomenal returns when the market returns are low or
negative. 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 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 is done in conjunction
with 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 involves
the so-called life-cycle theory of asset allocation. This makes intuitive sense because the needs and
financial positions of workers in their 50s should differ, on average, from those who are starting out in
their 20s. According to the life-cycle theory, for example, as individuals approach retirement they become
more risk averse and hence they should allocate fewer amounts in percentage terms to equity and
equity related instruments in their portfolio.
Thus you will find that while the asset classes are the same the difference lies in the manner of allocation
among assets – fixed allocation in SAA while a ranged allocation in TAA.
Let’s look at TAA allocations at different equity market levels:
n Some aggressive clients may be inclined towards TAA as the model, on paper, looks superior – but
the 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 rather
than TAA
The proportion of allocation to risk instruments, where the returns are uncertain and market related, say
equities is essentially a function of risk appetite, age, time factors, return expectations, etc.
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 is
expected to perform over a long period of time
Portfolio rebalancing
Once an asset allocation plan is finalized; then securities are chosen for investments and the investment
process is completed. Thereafter the portfolio of investments comprising of debt, equity, etc. should be
monitored 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, some
economic 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 the
interest rate (which generally moves with inflation). Whenever large scale, protracted interest rate
movements are expected then a rebalancing will become absolutely essential – in a rising interest rate
scenario the corporate profitabilites will suffer and consequently the stock prices will fall. Bond prices dip
to adjust to the current yields of the market. Reducing equity exposure of the portfolio may become
necessary and moving from long term debt swiftly into short term or from fixed rate long term debt funds
to 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 economic
factors are external factors that will have to be taken into account as their long term impact on the
portfolios will be severe and hence suitable rebalancing will have to be done. It should simultaneously
be 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. One
after the other the financial goals get completed, over a period of time, as the investor gets older and
older. Some of the common objectives are buying a bigger home; buying a new car; education of
children; marriage of children; retirement capital etc. As these objectives are fulfilled the return
requirements may come down and it may be necessary to switch to less aggressive asset allocation
plan – 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 is
incorrect but on the contrary rebalancing costs definitely reduces expected returns.
Answers:
1. c
2. a
3. d
4. a
5. c
A financial planner can go about his job after understanding his client’s needs thoroughly. It is necessary
to 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 in
shares, 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 financial
plan 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 family
members, address, telephone number, e mail ID, and such other information that are matters of
record 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 the
family.
n Investment objectives – buying a luxury car, bigger apartment, children’s education, children’s
marriage, 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 to
avoid time delays and to facilitate more meaningful discussions, it may be a good idea to obtain personal
information 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 personal
information are already provided and it is easier for the client to fill the same. The data collection format may
also be made available online or mailed electronically to the client. The client may be encouraged to fill the
same and send through e mail, before the meeting. Thus before the personal meeting the financial planner
has a good idea of the background of the client. This advance collection of information and that too in a
specified 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 gathered
through a personal, informal talk with the client. It may be more useful if both – husband and wife, are
present during the discussions, so that it becomes easier to identify the objectives, etc. (in case of
married clients). It may become necessary to educate the investors primarily, some times, on matters of
risk and return. Many clients may prefer the ultra conservative route – while there is nothing with that
approach, the client in such circumstance should be made to realize the kind of compromise he is
making 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 investment
plan 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
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 too
preferably guaranteed returns. This again is a very conservative approach. Income flow should be
close to the required level and anything received in excess of requirement needs to be deployed
for productive purposes to earn higher returns
n Inflation – a lower concern for inflation will mean more exposure to debt/income oriented investments
and less to growth.
n Taxation – a high concern for taxation will mean higher exposure to growth and equity oriented
instruments 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 a
stock portfolio should contain more defensive and large cap stocks – lower on risk and return.
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 Age around 45 years
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:
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:
Answers:
1. c
2. a
3. a
T he 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 be
accountable to SEBI and the investors.
The financial planners may be selling financial products and providing financial services. Some of the
products are small saving instruments, mutual funds, stocks, insurance linked products, government
bonds, 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 Exchange
on mutual funds before being registered with AMFI. The AMFI registered mutual fund distributor is
required to abide by the code of conduct stipulated by AMFI. The distributor is also required to give an
undertaking on a yearly basis to each mutual fund with whom he is registered that he is abiding by the
code of conduct set by AMFI. Thus mutual fund distributors are regulated and AMFI ensures that
distributors are informed about mutual fund functioning, their products, etc. and that the distributors do
not resort to undesirable practices to push the sales of mutual fund products. If a distributor employs
marketing people/counter staff to market mutual funds it is required that each one of them has passed a
specific examination conducted by NSE. A mutual fund distributor can be inspected by AMFI to ensure
that 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 brokers
and sub brokers are required to be registered with SEBI. SEBI has clearly spelt out the terms of
operations 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 specified
format along with documentary evidence in support of client personal information – called Know Your
Client (KYC) norms. Then the broker is required to enter into an agreement with the client in a specified
format and allot a unique client ID number to the client. The client’s dealings on the stock exchanges
through the broker will be allowed only after compliance with the above. SEBI has laid down a number
of 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 by
respective state governments on behalf of the Government of India and are subject to terms and conditions
laid by Ministry of Finance, Government of India, on this behalf.
Insurance advisors are registered and subject to the regulations of Insurance Regulatory Development
Authority of India (IRDA). IRDA has laid down the conditions under which an advisor will perform. IRDA
is 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 parent
body “Financial Planning Standards Board, India” and vows to abide by the ethics while practicing as a
Certified Financial Planner.
One of the most important purposes of the regulation of market players in insurance, mutual funds,