Core Concepts

Investment Concepts
What is risk return analysis?
What are Investment vehicles?
Pitfalls to avoid
Understanding Market Directions
CAPM
NPV/IRR
Financial planning
Insurance & Annuity
Tax implications
Risk Management
What is Risk Management?
Hedging
Stop Loss
Investment Review
Private Equity

Risk return analysis:

The concept of risk and return analysis is integral to the process of investing and finance. All
financial decisions involve some risk. You may expect to get a return of 15% per annum in
your investment but the risk of "not able to achieve 15% return" will always be there.

Return is simply a reward for investing as all investing involves some risk. The greater the
risk, the greater the return expected. Return is measured by how much one's money has
grown over the investment period. Returns are not known in advance. Instead, you can only
make an educated guess as to what kind of return to expect.

In case of an investment in shares/stocks, few investors accept to get a better return than fixed
deposits but I am also ready to take risk of loosing my money in stock market.

Most expectations are based on what's happened in the past. Unfortunately history doesn’t
always repeat itself! We have all seen the highs of 2007, followed by the lows in 2008.

Even if your return expectations are reasonable, there is the possibility that your actual
returns turn out different than expected. You run the risk of losing some or all of your
original investment.

Why is that? It’s because of an uncertain future (e.g. global economic environment),
uncertainty over the quality and stability of investment, and some other uncertainties. In
general, greater the uncertainty greater will be the risk. Some common sources of uncertainty
or risks that we must absorb, while we learn how to invest, are:

Business and Industry Risk

There might be a industry-wide slowdown, or even a global economic recession as we are
experiencing now. That presents an uncertain future for any business, isn't it. Or the business
might see its earnings dropping significantly say, due to management ineptitude/wrong
decisions. The lower earnings (due to any of the above) may cause the companys stock to
fall.

Inflation Risk
The money you earn today is always worth more than the same amount of money at a future
date. This is because goods and services usually cost more in the future, due to inflation. So
its important that your investment return beats the inflation rate. If it merely keeps pace with
inflation then your investment return is not worth much. We have seen inflation soaring upto
11% in 2008, now in 2009 its at 1 or 2% levels. Perhaps an average inflation rate over next
10 years may work out at 5-6%. Who knows, there's enough uncertainty here too.

Market Risk
Market Risk is about the uncertainty faced in the stock market. Several macro and micro
economic details singularly or plurally can spook the market. We have seen how the massive
mandate in elections 2009 has re-invigorated the market. On the other hand, a fragmented
hung parliament may have caused the market to nosedive? Even for a well-managed business
growing profitably, its stock may drop in value simply because the overall stock market has
fallen.

Liquidity Risk
Sometimes you are not able to get out of your investment conveniently, and at a reasonable
price. For example in 2008, you may have found it tough to sell your house at a price you
wanted. In 2007 however you could have gone laughing to the bank. The market may simply
be inactive or it may be just volatile - and that means you cant sell your investment or get the
price you want, if you needed to sell immediately.

1. Returns are not known in advance. So, you must make your investment decision using
return expectations that are reasonable and mesh with reality

2. Your actual return may not meet your expectations. Be aware of that possibility while
making all investments

3. Risk comes from the uncertainty surrounding the actual outcome of your investment;
greater the uncertainty, greater the risk

4. Business or industry risk, inflation risk, liquidity risk, and market risk - these are the major
sources of risk. All investments face each of these risks, but to varying degrees

5. There is a trade-off between risk and potential return: higher the potential returns, greater
the risk; lower the potential returns, lower the risks. Be wary of claims of high returns, there
may be hidden risks

6. These risks can be reduced significantly through diversification. Always diversify across
asset categories (stocks, bonds, money market instruments), within asset categories, and
across individual securities

7. Diversificationi is also important across market environments — the longer your holding
period, the better. Do not invest in volatile investments like stocks if you cannot remain
invested for atleast three to five years
Investment vehicles:

A product used by investors with the intention of having positive returns. Investment vehicles
can be low-risk, such as certificates of deposit (CDs) or bonds, or can carry a greater degree
of risk such as with stocks, options and futures. Other types of investment vehicles include
annuities, collectibles (art or coins, for example), mutual funds and exchange-traded funds
(ETFs).

Investment vehicle refers to any method by which individuals or businesses can invest and,
ideally, grow their money. There is a wide variety of investment vehicles and many investors
choose to hold at least several types in their portfolios. This can allow for diversification
while minimizing risk.

Five Investing Pitfalls To Avoid:

Successful investors learn to avoid the common pitfalls, and follow these insights that can put
you well on your way to becoming a better investor.

Buying Low-Priced Stocks

What sounds better? Buying 1,000 shares of a $1 stock or buying 20 shares of a $50 stock?
Most people would probably say the former because it seems like a bargain, with more
opportunity for big increases from owning more shares. But the money you make in a stock
isn't based on how many shares you own. It's based on the amount of money invested.

Many investors have a love affair with cheap stocks, but low-priced stocks are generally
missing a key ingredient of past stock market winners: institutional sponsorship.

A stock can't make big gains without the buying power of mutual funds, banks, insurance
companies and other deep-pocketed investors fueling their price moves. It's not retail trades
of 100, 200 or 300 shares that cause a stock to surge higher in price, it's big institutional
block share trades of 10,000, 20,000 or more that cause these great jumps in price when they
buy -- as well as great price drops when they sell.

Institutional investors account for about 70% of the trading volume each day on the
exchanges, so it's a good idea to fish in the same pond as they do. Stocks priced at $1, $2 or
$3 a share are not on the radar screens of institutional investors. Many of these stocks are
thinly traded so it's hard for mutual funds to buy and sell big volume shares.

Remember: Cheap stocks are cheap for a reason. Stocks sell for what they’re worth. In many
cases, investors that try to grab stocks on the cheap don’t realize that they're buying a
company mired in problems with no institutional sponsorship, slowing earnings and sales
growth and shrinking market share. These are bad traits for a stock to have. Institutions have
research teams that seek out great opportunities, and because they buy in huge quantities over
time, consider piggybacking their choices if you find these fund managers have better-than-
average performance.
The reality is that your prospect of doubling your money in $1 stock sure sounds good, but
your chances are better of winning the lottery. Focus on institutional quality stocks.

Avoiding Stocks With High P/E Ratios

"Focus on stocks with low P/E ratios. They're attractively valued and there’s a lot of upside."
How many times have you heard this statement from investment pros?

While it's true that stocks with low P/E ratios can go higher, investors often misuse this
valuation metric. Leaders in an industry group often trade at a higher premium than their
peers for a simple reason: They're expanding their market share faster because of outstanding
earnings and sales growth prospects. Stocks on your watch list should have the traits of past
big stock market winners: leading price performance in their industry group, top-notch
earnings and sales growth and rising fund ownership, to name a few. A dynamic new product
or service doesn't hurt either.

Stocks with "high" P/E ratios share a common trait: their performance shows there's plenty of
bullishness about the company's future prospects. For example: In Aug 2003, stun-gun maker
Taser International had a P/E of 44 before a 900% increase. At the time, the market was
bullish about the firm's earnings and sales growth prospects. The market turned out to be
right. For five straight quarters, Taser has posted triple-digit earnings and sales gains.

More great examples come from the medical, retail, and oil and gas sector, which were all
strong performers in the 2003-2004 period. The table below shows leading stocks in the
sectors that staged big price runs from seemingly high P/E ratios. In every case, it was
explosive fundamentals that drove their stock price. At end-Oct 2004, the average P/E Ratio
of stocks in the S&P 500 Index was around 17.

Letting Small Losses Turn Into Big Ones

Insurance policies help us minimize risk when it comes to our health, home or car. In the
stock market, most people don't even think about buying insurance policies with individual
stocks but it's a good practice.

Cut your losses in any stock at 7% or 8% and you'll never get hit with a big loss. This is your
insurance policy. If you buy stocks at the right time, they should never fall 7-8% below your
purchase price.

A small loss in a stock can easily be overcome. It’s the big ones that can do serious damage
to a portfolio. Take a 50% loss on a stock, and it would need to rise 100% to get back to
break-even. But if you cut your losses at 7% or 8%, a single 25% gain can wipe out three 7%-
8% losses.

Here's a set of hypothetical trades to illustrate the point. Even if you had made these seven
trades over a period of time - and taken losses on five of them - you would still come out
ahead by more than $3,700. That's because the two stocks that worked out resulted in a
combined profit of $5,500. And the five losses - all capped at 7% or 8% - added up to
$1,569.

The rationale for that 7% Sell Rule was never clearer than in the bear market that began in
Mar 2000. It caused unnecessary, severe damage to many investors' portfolios. Small losses
in tech stocks snowballed into huge ones. Some stocks lost 70%-80% or more of their value.
Some will never reclaim their old highs. Others may, but it'll be a long road back. All
successful investors share one trait: they firmly recognize the importance of protecting hard-
earned capital by selling fast when a stock declines 7% or 8% from where they bought it.

If a stock you own starts to fall on expanding trading volume, it's usually better to sell first
and ask questions later, rather than the other way around. Keep losses small to avoid severe
damage. You can always re-enter the game if you've only lost 7%. Don't ever look back after
a smart sell, even if the stock rebounds. You have no way of knowing its future, so you are
best off reacting to what your stock is telling you right now. Learning this trait is hard -- but it
will save you a great deal in the long run.

Averagingi Down

Averaging down means you're buying stock as the price falls in the hopes of getting a
bargain. It's also known as throwing good money after bad or trying to catch a falling knife.
Either way, trying to lower your average cost in a stock is another risky proposition.

For example, take Amazon.com between June and Oct of 2004. Its chart revealed much
institutional selling by mutual funds and other big investors.

In June, it was a $54 stock. In July, it was a $45 stock. Investors who bought in at $45 may
have thought they were getting a bargain, but they weren’t paying attention to multiple
heavy-volume declines in the stock. What's the sense of buying a stock when mutual funds
and other big investors are selling big blocks of shares? That's a tough tide to swim against.

When Amazon released its earnings on Oct 21, it fell another 10% to around $37. In general,
stock charts tell bullish or bearish stories long before headlines do. In Amazon's case, heavy
volume declines between July 8th and 23rd told a bearish story.

Buying Stocks In A Down Market

Some investors don't pay any attention to the current state of the market when they buy
stocks. And that's a mistake. The goal is to buy stocks when the major indexes are showing
signs of accumulation (buying: heavy volume price increases) and to sell when they're
showing signs of distribution (selling: heavy volume price declines). Three-fourths of all
stocks follow the market's trend, so watch it each day, and don't go against the trend. It's not
hard to tell when the indexes start to show signs of duress.

Distribution days will start to crop up in the market where the indexes close lower on heavier
volume than the day before. In this case, a strong market opening will fizzle into weak closes.
And leading stocks in the market's leading industry groups will start to sell off on heavy
volume. This is exactly what happened at the start of the bear market in Mar 2000. When
you're buying stocks, make sure you're swimming with the market tide, not against it.

Capital Asset Pricing Model (CAPM)

A model that describes the relationship between risk and expected return and that is used in
the pricing of risky securities is called Capital Asset Pricing Model. The assumptions of
CAPM are that the market is in equilibrium and the expected rate of return is equal to the
required rate of return for a given level of risk or Betai. CAPM presents a liner relationship
between the required rate of return of a security and relates it to market related risk or Beta,
which cannot be avoided. The equation for the CAPM Theory is
The general idea behind CAPM is that investors need to be compensated in two ways: time
value of money and risk. The time value of money is represented by the risk-free (rf) rate in
the formula and compensates the investors for placing money in any investment over a period
of time. The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is calculated by taking a
risk measure (beta) that compares the returns of the asset to the market over a period of time
and to the market premium (Rm-rf).

If you use CAPM you have to assume that most investors want to avoid risk, (risk averse),
and those who do take risks, expect to be rewarded. It also assumes that investors are "price
takers" who can't influence the price of assets or markets. With CAPM you assume that there
are no transactional costs or taxation and assets and securities are divisible into small little
packets. Had enough with the assumptions yet? One more thing, CAPM assumes that
investors are not limited in their borrowing and lending under the risk free rate of interest.

Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large market,
like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly. Each
company also has a beta. You can find a company's beta at the Yahoo!! Stock quote page. A
company's beta is that company's risk compared to the risk of the overall market. If the
company has a beta of 3.0, then it is said to be 3 times more risky than the overall market.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-
free security plus a risk premium. If this expected return does not meet or beat the required
return, then the investment should not be undertaken. The security market line plots the
results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return
of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the
stock is 2 and the expected market return over the period is 10%, the stock is expected to
return 17% (3%+2(10%-3%)).

Capital Marketi Line (CML)

CML means Capital Market Line. If all investors hold the same risky portfolio, then in
equilibrium, it must be the market portfolio. In that sense RfM straight line is the Capital
Market Line (CML). All investors choose along this line and efficient portfolios will be on
this line. Those which are not efficient will however be below line. The equation of the
capital market line connecting the riskless asset with a risky portfolio is
E(r) denotes the efficient portfolio. E(rM)-rf/sigma(M) can be thought as the extra return that
can be gained by increasing the amount of risk on an efficient portfolio by one unit. Thus,
second part of the formula after plus sign can be taken to represent the market price of risk on
an efficient portfolio. Rf is the risk free return for abstaining consumption for period one.
Thus, rf is the price of time. Sigma is risk on the portfolio.

Securityi Market Line

Security market line (SML) is the graphical representation of the Capital asset pricing model.
It displays the expected rate of return of an individual security as a function of systematic,
non-diversifiable risk (its beta). Incase of portfolios involving complete diversification, where
the unsystematic risk tends to zero, there is only systematic risk measured by beta the only
dimension of a security, which concerns us are expected return and beta. We have seen
earlier that all portfolios of investments lie along a straight line in the return to beta space. To
determine this line we need to connect the intercept (where Beta is zero as its risk less
security), and the market portfolio (Beta of one and return of RM). These points are Rf and M
in the graph below. The equation of that straight line is Security Market Line (SML).
As betas differ according to the market proxy, that they are measured against, then in effect,
CAPM, as not been and cannot be tested. We may recall that CAPM states that return = risk
free rate + beta (market return – risk free rate)
A security with a zero beta should give a risk free return. In actual results these zero beta
results are higher than the risk free return indicating that there are some non-beta risk factors
or some left over unsystematic risk.
Besides, although, in the long run, high beta portfolios have provided larger returns than low
risk ones in the short run, CAPM theory under empirical evidence diverge strikingly and
sometimes the relation between risk and return may turn out to be negative which is contrary
to CAPM theory. It can thus be concluded that CAPM theory is a neat theoretical exposition.
The CML and SML are the lines reflecting the total risk and systematic risk elements in the
portfolio analysis respectively. But in actual world the CAPM is not in conformity with the
real world risk return trends and empirical results have not always supported the theory
atleast in the short run.

Net Present Value (NPV)

The difference between the present value of cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to analyze the profitability of an investment or
project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project
will yield.
In addition to the formula, net present value can often be calculated using tables, and
spreadsheets such as Microsoft Excel.

NPV compares the value of a dollar today to the value of that same dollar in the future, taking
inflation and returns into account. If the NPV of a prospective project is positive, it should be
accepted. However, if NPV is negative, the project should probably be rejected because cash
flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would first
estimate the future cash flows that store would generate, and then discount those cash flows
into one lump-sum present value amount, say $565,000. If the owner of the store was willing
to sell his business for less than $565,000, the purchasing company would likely accept the
offer as it presents a positive NPV investment. Conversely, if the owner would not sell for
less than $565,000, the purchaser would not buy the store, as the investment would present a
negative NPV at that time and would, therefore, reduce the overall value of the clothing
company.

Internal rate of return (IRR)

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure
and compare the profitability of investments. It is also called the discounted cash flow rate of
return (DCFROR) or the rate of return (ROR). In the context of savings and loans the IRR is
also called the effective interest rate. The term internal refers to the fact that its calculation
does not incorporate environmental factors (e.g., the interest rate or inflation).

Internal rates of return are commonly used to evaluate the desirability of investments or
projects. The higher a project's internal rate of return, the more desirable it is to undertake the
project. Assuming all projects require the same amount of up-front investment, the project
with the highest IRR would be considered the best and undertaken first.
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return
follows from the net present value as a function of the rate of return. A rate of return for
which this function is zero is an internal rate of return.
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of
periods N, and the net present value NPV, the internal rate of return is given by r in:

The period is usually given in years, but the calculation may be made simpler if r is
calculated using the period in which the majority of the problem is defined (e.g., using
months if most of the cash flows occur at monthly intervals) and converted to a yearly period
thereafter.
Any fixed time can be used in place of the present (e.g., the end of one interval of an
annuity); the value obtained is zero if and only if the NPV is zero.
In the case that the cash flows are random variables, such as in the case of a life annuity, the
expected values are put into the above formula.
Often, the value of r cannot be found analytically. In this case, numerical methods or
graphical methods must be used.
Example
a) If an investment may be given by the sequence of cash flows
Year (n) Cash flow (Cn)
0 -4000
1 1200
2 1410
3 1875
4 1050

then the IRR r is given by

In this case, the answer is 14.3%.

b) Net present value (NPV)

The NPV method is used for evaluating the desirability of investments or projects.

Where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.
The discount factor r can be calculated using:

Examples:
N.B. At this point the tutor should introduce the net present value tables from any recognised
published source. Do that now.
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative(-): reject the project
Net present value vs Internal rate of return
Independent vs dependent projects
NPV and IRR methods are closely related because:
i) both are time-adjusted measures of profitability, and
ii) their mathematical formulas are almost identical.
So, which method leads to an optimal decision: IRR or NPV?
a) NPV vs IRR: Independent projects
Independent project: Selecting one project does not preclude the choosing of the other.
With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and
IRR lead to the same accept/reject decisions.
Figure 6.1 NPV vs IRR Independent projects
If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project.
If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project.
Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.

Similarly for the same project to be acceptable:

where R is the IRR.
Since the numerators Ct are identical and positive in both instances:
• implicitly/intuitively R must be greater than k (R > k);
• If NPV = 0 then R = k: the company is indifferent to such a project;
• Hence, IRR and NPV lead to the same decision in this case.
b) NPV vs IRR: Dependent projects
NPV clashes with IRR where mutually exclusive projects exist.
Example:
Agritex is considering building either a one-storey (Project A) or five-storey (Project B)
block of offices on a prime site. The following information is available:
Initial Investment Outlay Net Inflow at the Year End
Project A 9,500 11,500
Project B 15,000 18,000
Assume k = 10%, which project should Agritex undertake?
= $954.55

= $1,363.64
Both projects are of one-year duration:
IRRA:
$11,500 = $9,500 (1 +RA)

= 1.21-1
therefore IRRA = 21%
IRRB:

$18,000 = $15,000(1 + RB)

= 1.2-1
therefore IRRB = 20%
Decision:
Assuming that k = 10%, both projects are acceptable because:
NPVA and NPVB are both positive
IRRA > k AND IRRB > k
Which project is a "better option" for Agritex?
If we use the NPV method:
NPVB ($1,363.64) > NPVA ($954.55): Agritex should choose Project B.
If we use the IRR method:
IRRA (21%) > IRRB (20%): Agritex should choose Project A. See figure 6.2.

Figure 6.2 NPV vs IRR: Dependent projects

Up to a discount rate of ko: project B is superior to project A, therefore project B is preferred

to project A.
Beyond the point ko: project A is superior to project B, therefore project A is preferred to
project B
The two methods do not rank the projects the same.
Differences in the scale of investment
NPV and IRR may give conflicting decisions where projects differ in their scale of
investment. Example:
Years 0 1 2 3
Project A -2,500 1,500 1,500 1,500
Project B -14,000 7,000 7,000 7,000
Assume k= 10%.
PVIFA = (1 - 1 / (1 + r)n) * 1/r where n is the number of payment periods; r is the nominal
interest rate for one period

PVIFA means Present value of interest factor of annuity

NPVA = $1,500 x PVFIA at 10% for 3 years

= $1,500 x 2.487
= $3,730.50 - $2,500.00
= $1,230.50.
NPVB = $7,000 x PVFA at 10% for 3 years
= $7,000 x 2.487
= $17,409 - $14,000
= $3,409.00.

IRRA =

= 1.67.
Therefore IRRA = 36% (from the tables)

IRRB =

= 2.0
Therefore IRRB = 21%
Decision:
Conflicting, as:
NPV prefers B to A
IRR prefers A to B
 NPV IRR
Project A $ 3,730.50 36%
Project B $17,400.00 21%
See figure 6.3.

Figure 6.3 Scale of investments

To show why:
i) the NPV prefers B, the larger project, for a discount rate below 20%
ii) the NPV is superior to the IRR
a) Use the incremental cash flow approach, "B minus A" approach
b) Choosing project B is tantamount to choosing a hypothetical project "B minus A".

0 1 2 3
Project B - 14,000 7,000 7,000 7,000
Project A - 2,500 1,500 1,500 1,500
"B minus A" - 11,500 5,500 5,500 5,500
IRR"B Minus A"
= 2.09
= 20%
c) Choosing B is equivalent to: A + (B - A) = B
d) Choosing the bigger project B means choosing the smaller project A plus an additional
outlay of $11,500 of which $5,500 will be realized each year for the next 3 years.
e) The IRR"B minus A" on the incremental cash flow is 20%.
f) Given k of 10%, this is a profitable opportunity, therefore must be accepted.
g) But, if k were greater than the IRR (20%) on the incremental CF, then reject project.
h) At the point of intersection,
NPVA = NPVB or NPVA - NPVB = 0, i.e. indifferent to projects A and B.
i) If k = 20% (IRR of "B - A") the company should accept project A.
• This justifies the use of NPV criterion.
Advantage of NPV:
It ensures that the firm reaches an optimal scale of investment.
Disadvantage of IRR:
It expresses the return in a percentage form rather than in terms of absolute dollar returns, e.g.
the IRR will prefer 500% of $1 to 20% return on $100. However, most companies set their
goals in absolute terms and not in % terms, e.g. target sales figure of $2.5 million.
The timing of the cash flow
The IRR may give conflicting decisions where the timing of cash flows varies between the 2
projects.
Note that initial outlay Io is the same.
0 1 2
Project A - 100 20 125.00
Project B - 100 100 31.25
"A minus B" 0 - 80 88.15
Assume k = 10%
NPV IRR
Project A 17.3 20.0%
Project B 16.7 25.0%
"A minus B" 0.6 10.9%
IRR prefers B to A even though both projects have identical initial outlays. So, the decision is
to accept A, that is B + (A - B) = A. See figure 6.4.
Figure 6.4 Timing of the cash flow

The horizon problem

NPV and IRR rankings are contradictory. Project A earns $120 at the end of the first year
while project B earns $174 at the end of the fourth year.
0 1 234
Project A -100 120 - - -
Project B -100 - - - 174
Assume k = 10%
NPV IRR
Project A 9 20%
Project B 19 15%
Decision:
NPV prefers B to A
IRR prefers A to B.

Financial planning
Financial planning is the task of determining how a business will afford to achieve its
strategic goals and objectives. Usually, a company creates a Financial Plan immediately after
the vision and objectives have been set. The Financial Plan describes each of the activities,
resources, equipment and materials that are needed to achieve these objectives, as well as the
timeframes involved.
The Financial Planning activity involves the following tasks:
 • Assess the business environment
• Confirm the business vision and objectives
• Identify the types of resources needed to achieve these objectives
• Quantify the amount of resource (labor, equipment, materials)
• Calculate the total cost of each type of resource
• Summarize the costs to create a budget
• Identify any risks and issues with the budget set

Performing Financial Planning is critical to the success of any organization. It provides the
Business Plan with rigor, by confirming that the objectives set are achievable from a financial
point of view. It also helps the CEO to set financial targets for the organization, and reward
staff for meeting objectives within the budget set.
The role of financial planning includes three categories: 1. Strategic role of financial
management: 2. Objectives of financial management: 3. The planning cycle:

Insurance
A promise of compensation for specific potential future losses in exchange for a periodic
payment. Insurance is designed to protect the financial well-being of an individual, company
or other entity in the case of unexpected loss. Some forms of insurance are required by law,
while others are optional. Agreeing to the terms of an insurance policy creates a contract
between the insured and the insurer. In exchange for payments from the insured (called
premiums), the insurer agrees to pay the policy holder a sum of money upon the occurrence
of a specific event. In most cases, the policy holder pays part of the loss (called the
deductible), and the insurer pays the rest. Examples include car insurance, health insurance,
disability insurance, life insurance, and business insurance.
What is an annuity?
An annuity is a long-term, interest-paying contract offered through an insurance company or
financial institution. An annuity can be "deferred" as a means of accumulating income while
deferring taxes, or it can be "immediate" meaning it pays you income now at fixed or variable
interest rates as long as you are living, contact your insurance agent for details on current
rates.
The Opposite of Life Insurance
Annuities are sometimes described as the opposite of life insurance. Annuities protect you
from living too long, while life insurance protects you from dying too soon. Meaning with an
annuity you are paid as long as you live, but with a Life insurance policy you are only paid
when you die. With an annuity, the financial risk of living too long is transferred to the
insurance company. Some life insurance policies may allow you to collect money while
living.
Banks, stockbrokers, savings and loan institutions and other financial service providers can
sell annuities, but only insurance companies can issue annuities.
A Lifetime Income
With the average retirement period lengthening, annuities are increasing in importance. Only
an annuity can pay you an income you can't outlive, even after all money you put into the
annuity has been exhausted. Therefore, annuities can help you manage your cash flow, and
provide a safe and competitive means to accumulate funds.

Tax implications

When someone states that something has or may have tax implications that simply mean that
it may affect the taxes you pay. It's generally used in reference to your federal income tax
return filed with the IRS (& state tax return if your state has an income tax). If receiving a
prize has tax implications, it would likely mean that you need to report the income on your
federal tax return.

Tax Implications of Stock Optionsi

As with any type of investment, when you realize a gain, it's considered income. Income is
taxed by the government. How much tax you'll ultimately wind up paying and when you'll
pay these taxes will vary depending on the type of stock options you're offered and the rules
associated with those options.
There are two basic types of stock options, plus one under consideration in Congress. An
incentive stock option (ISO) offers preferential tax treatment and must adhere to special
conditions set forth by the Internal Revenue Service. This type of stock option allows
employees to avoid paying taxes on the stock they own until the shares are sold.
When the stock is ultimately sold, short- or long-term capital gains taxes are paid based on
the gains earned (the difference between the selling price and the purchase price). This tax
rate tends to be lower than traditional income tax rates. The long-term capital gains tax is 20
percent, and applies if the employee holds the shares for at least a year after exercise and two
years after grant. The short-term capital gains tax is the same as the ordinary income tax rate,
which ranges from 28 to 39.6 percent.
Tax implications of three types of stock options
 Super stock
ISO NQSO
option
Employee exercises Ordinary income
No tax No tax
options tax (28% - 39.6%)
Tax deduction Tax deduction
Employer gets tax
No deduction upon employee upon employee
deduction?
exercise exercise
Employee sells Long-term
Long-term capital Long-term capital
options after 1 year capital gains tax
gains tax at 20% gains tax at 20%
or more at 20%

Nonqualified stock options (NQSOs) don't receive preferential tax treatment. Thus, when an
employee purchases stock (by exercising options), he or she will pay the regular income tax
rate on the spread between what was paid for the stock and the market price at the time of
exercise. Employers, however, benefit because they are able to claim a tax deduction when
employees exercise their options. For this reason, employers often extend NQSOs to
employees who are not executives.
Taxes on 1,000 shares at an exercise price of $10 per share

ISO NQSO
Employee exercises when
Tax = ($20 -
market value is $20 per No tax paid
$10)*1,000*(0.28) = $2,800
share
Employee sells at $30 per ($30 -
($30 - $20)*1,000*(0.20) =
share after holding one $10)*1,000*(0.20)
$2,000
year or more = $4,000
Total tax paid $4,000 $4,800

Assumes an ordinary income tax rate of 28 percent. The capital gains tax rate is 20 percent.
In the example, two employees are vested in 1,000 shares with a strike price of $10 per share.
One holds incentive stock options, while the other holds NQSOs. Both employees exercise
their options at $20 per share, and hold the options for one year before selling at $30 per
share. The employee with the ISOs pays no tax on exercise, but $4,000 in capital gains tax
when the shares are sold. The employee with NQSOs pays regular income tax of $2,800 on
exercising the options, and another $2,000 in capital gains tax when the shares are sold.
Penalties for selling ISO shares within a year
The intent behind ISOs is to reward employee ownership. For that reason, an ISO can
become "disqualified" - that is, become a nonqualified stock option - if the employee sells the
stock within one year of exercising the option. This means that the employee will pay
ordinary income tax of 28 to 39.6 percent immediately, as opposed to paying a long-term
capital gains tax of 20 percent when the shares are sold later.

Other types of options and stock plans

In addition to the options discussed above, some public companies offer Section 423
Employee Stock Purchase Plans (ESPPs). These programs permit employees to purchase
company stock at a discounted price (up to 15 percent) and receive preferential tax treatment
on the gains earned when the stock is later sold.
Many companies also offer stock as part of a 401(k) retirement plan. These plans allow
employees to set aside money for retirement and not be taxed on that income until after
retirement.
Some employers offer the added perk of matching the employee's contribution to a 401(k)
with company stock. Meanwhile, company stock can also be purchased with the money
invested by the employee in a 401(k) retirement program, allowing the employee to build an
investment portfolio on an ongoing basis and at a steady rate.
Special tax considerations for people with large gains
The Alternative Minimum Tax (AMT) may apply in cases where an employee realizes
especially large gains from incentive stock options. This is a complicated tax, so if you think
it may apply to you, consult your personal financial advisor. More and more people are being
affected.

What is Risk Management?

The process of identification, analysis and either acceptance or mitigation of uncertainty in
investment decision-making. Essentially, risk management occurs anytime an investor or
fund manager analyzes and attempts to quantify the potential for losses in an investment and
then takes the appropriate action (or inaction) given their investment objectives and risk
tolerance. Inadequate risk management can result in severe consequences for companies as
well as individuals. For example, the recession that began in 2008 was largely caused by the
loose credit risk management of financial firms.
Simply put, risk management is a two-step process - determining what risks exist in an
investment and then handling those risks in a way best-suited to your investment objectives.
Risk management occurs everywhere in the financial world. It occurs when an investor buys
low-risk government bonds over more risky corporate debt, when a fund manager hedges
their currency exposure with currency derivatives and when a bank performs a credit check
on an individual before issuing them a personal line of credit.
In ideal risk management, a prioritization process is followed whereby the risks with the
greatest loss (or impact) and the greatest probability of occurring are handled first, and risks
with lower probability of occurrence and lower loss are handled in descending order. In
practice the process of assessing overall risk can be difficult, and balancing resources used to
mitigate between risks with a high probability of occurrence but lower loss versus a risk with
high loss but lower probability of occurrence can often be mishandled.
Intangible risk management identifies a new type of a risk that has a 100% probability of
occurring but is ignored by the organization due to a lack of identification ability. For
example, when deficient knowledge is applied to a situation, a knowledge risk materializes.
Relationship risk appears when ineffective collaboration occurs. Process-engagement risk
may be an issue when ineffective operational procedures are applied. These risks directly
reduce the productivity of knowledge workers, decrease cost effectiveness, profitability,
service, quality, reputation, brand value, and earnings quality. Intangible risk management
allows risk management to create immediate value from the identification and reduction of
risks that reduce productivity.
Risk management also faces difficulties in allocating resources. This is the idea of
opportunity cost. Resources spent on risk management could have been spent on more
profitable activities. Again, ideal risk management minimizes spending (or manpower or
other resources) and also minimizes the negative effects of risks.
Method:
For the most part, these methods consist of the following elements, performed, more or less,
in the following order.
1. identify, characterize, and assess threats
2. assess the vulnerability of critical assets to specific threats
3. determine the risk (i.e. the expected consequences of specific types of attacks on specific
assets)
4. identify ways to reduce those risks
5. prioritize risk reduction measures based on a strategy

Hedging
Hedging is the process that is used to reduce risk of loss against negative outcomes within the
stock market. Hedging is a similar concept to home insurance, where you might protect
yourself against negative outcomes by purchasing fire and peril insurance. The only
difference with hedging is that you are insuring against market risks and you are never fully
compensated for your loss. This occurs when one investment is hedged through the purchase
of another investment.

Hedging is most useful under the following circumstances:

 Those who have commodity investment that are subject to price movements can use hedging as a risk
management technique.
 Hedging helps set a price level for purchase or sale of an asset prior to that transaction occurring.
 Hedging also makes it possible to experience gains from any upward price fluctuations to protect against
downward price movements.

Example:
Currency Hedging:
Assume that a U.S. company enters into a contract to purchase a 100,000 euro machine from
a German company with an expected delivery date in eight months. The company would like
to obtain cost certainty on this future amount, to be paid in U.S. dollars.
A hedge is not about making money. A hedge is about obtaining certainty on the cost of your
German machine. Let's start with the cost of the machine today. A (100,000) euro payable
would cost 157,000 U.S. dollars today, assuming a current EUR/USD exchange rate of
1.57000.
The Hedge
If you enter into a buy 100,000 EUR/USD carry spot trade on an online forex broker’s
system, then you will receive cost certainty in eight months. Here’s how:
When you enter into the “Buy” transaction for 100,000 EUR/USD carry spot trade, you have
bought 100,000 Euros and sold 157,000 USD on an online forex broker’s system.

• If in the future, the EUR/USD price is 1.60 (up from 1.57 when first entered into
the deal), then you will have made $3,000 on your forex hedge trade. When you make
the payment to the German supplier, the 100,000 euro would cost you 160,000 USD.
So your net cost for the machine would be $157,000. (The actual cash payment to the
German supplier of $160,000, less the $3,000 made on the hedging trade.)
• If in the future, the EUR/USD price is 1.50 (down from 1.57), then you will have
lost $(7,000) on your forex hedge trade. When you make the payment to the German
supplier, the 100,000 euro would cost you 150,000 USD. So your net cost for the
machine would still be $157,000. (The actual cash payment to the German supplier of
$150,000, plus the $7,000 lost on the hedging trade.)

The hedge trade’s win or loss is offset by the actual amount of money paid to the German
supplier. With a simple hedge, you have created cost certainty for your company.
The hedging performance must be evaluated based on the overall result. (What is the total
machine cost when you make the final payment? This is the combination of the actual USD
amount needed to buy the 100,000 euros in eight months and the amount lost or gained on the
hedge trade.)
The amounts in this scenario would equal the $157,000 USD, which was your cost certainty
objective. With a hedge, you do not need to be concerned with whether you are making or
losing money on currency fluctations in the time period between when you sign a purchase
agreement and finally take possession of the German machine.

Stop-Loss
Stop loss is an order to buy (or sell) a security once the price of the security climbed above
(or dropped below) a specified stop price. When the specified stop price is reached, the stop
order is entered as a market order (no limit) or a limit order (fixed or pre-determined price).
With a stop order, the trader does not have to actively monitor how a stock is performing.
However because the order is triggered automatically when the stop price is reached, the stop
price could be activated by a short-term fluctuation in a security's price. Once the stop price is
reached, the stop order becomes a market order or a limit order.
In a fast-moving volatile market, the price at which the trade is executed may be much
different from the stop price in the case of a market order. Alternatively in the case of a limit
order the trade may or may not get executed at all. This happens when there are no buyers or
sellers available at the limit price.
Types of Stop Loss order:
1) Stop Loss Limit Orderi
A stop loss limit order is an order to buy a security at no more (or sell at no less) than a
specified limit price. This gives the trader some control over the price at which the trade is
executed, but may prevent the order from being executed.
A stop loss buy limit order can only be executed by the exchange at the limit price or lower.
For example, if an trader is short and wants to protect his short position but doesn't want to
pay more than Rs.100 for the stock, the investor can place a stop loss buy limit order to buy
the stock at any price up to Rs.100. By entering a limit order rather than a market order, the
investor will not be caught buying the stock at Rs.110 if the price rises sharply.
Alternatively a stop loss sell limit order can only be executed at the limit price or higher.

Advantages and disadvantages of the stop loss limit order

The main advantage of a stop loss limit order is that the trader has total control over the price
at which the order is executed. The main disadvantage of the stop loss limit order is that in a
fast moving volatile market your stop loss order may not get executed if there are no
buyers/sellers at the limit price.
2) Stop Loss Market Order
A stop loss market order is an order to buy (or sell) a security once the price of the security
climbed above (or dropped below) a specified stop price. When the specified stop price is
reached, the stop order is entered as a market order (no limit). In other words a stop loss
market order is a order to buy or sell a security at the current market price prevailing at the
time the stop order is triggered. This type of stop loss order gives the trader no control over
the price at which the trade will be executed.
A sell stop market order is a order to sell at the best available price after the price goes below
the stop price. A sell stop price is always below the current market price. For example, if an
trader holds a stock currently valued at Rs.100 and is worried that the value may drop, he/she
can place a sell stop order at Rs.90. If the share price drops to Rs.90, the exchange will sell
the order at the next available price. This can limit the traders losses (if the stop price is at or
below the purchase price) or lock in some of the profits.
A buy stop market order is typically used to limit a loss (or to protect an existing profit) on a
short sale. A buy stop price is always above the current market price. For example, if an
trader sells a stock short hoping the stock price goes down in order to book profits at a lower
price, the trader may use a buy stop order to protect himself against losses if the price goes
too high.
Advantages and disadvantages of the stop loss market order
The main advantage of a stop loss market order is that the stop loss order will always get
executed. The main disadvantage of the stop loss market is that the trader has no control over
the price at which the transaction is executed.
Conclusion
Stop loss orders are great insurance policies that cost you nothing and can save you a fortune.
Unless you plan to hold a stock forever, you should consider using them to protect yourself.
Investment review:
The financial markets are places where corporations can get money from investors who wish
to make money in return.
1. Bonds represent money lent by an investor to a corporation. The bonds earn interest and
can be traded.
2. Stock are a portion of the business sold to investors. Stock can be traded for capital gains.
3. Preferred stock offer the dividend option like a bond's interest with the growth potential
of stock, but are less safe than bonds and get less ownership rights.
4. Savings and GICs are not really investments since they are fairly risk-free and have very
low return, but they're a good way to store money temporarily.
5. Options represent the right to buy or sell stock at a certain price. They are less risky and
have a good potential return, but are complicated to manage.
6. Mutual funds are pools of money from many investors managed buy a professional
manager and invested in many ways. They are safe, but have high administration fees.
The risk/return tradeoff
There is no perfect investment- you either get low risk and low return, or else a high risk but
a potential for great return. If you have the money for it, talk to investment portfolio
managers at your bank, they can help you maximize returns on your money. You'll have to be
ready to take risks, but with a little luck you may become a very wealthy person.
The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some
people can handle the equivalent of financial skydiving without batting an eye, others are
terrified to climb the financial ladder without a secure harness. Deciding what amount of risk
you can take while remaining comfortable with your investments is very important.
In the investing world, the dictionary definition of risk is the chance that an investment's
actual return will be different than expected. Technically, this is measured in statistics by
standard deviation. Risk means you have the possibility of losing some, or even all, of our
original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is
the balance between the desire for the lowest possible risk and the highest possible return.
This is demonstrated graphically in the chart below. A higher standard deviation means a
higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff
tells us that the higher risk gives us the possibility of higher returns. There are no guarantees.
Just as risk means higher potential returns, it also means higher potential losses.
On the lower end of the scale, the risk-free rate of return is represented by the return on U.S.
Government Securities because their chance of default is next to nothing. If the risk-free rate
is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year
over the long run? The answer to this is that even the entire market (represented by the index
fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year,
25% the next year, and so on. An investor still faces substantially greater risk and volatility to
get an overall return that is higher than a predictable government security. We call this
additional return the risk premium, which in this case is 6% (12% - 6%).

Determining what risk level is most appropriate for you isn't an easy question to answer. Risk
tolerance differs from person to person. Your decision will depend on your goals, income and
personal situation, among other factors.

Private Equity
Ownership in a corporation that is not publicly-traded. That is, private equity involves
investing in privately held companies. Most of the time, private equity investors are
institutional investors and high net-worth individuals who have a large amount of capital to
commit to these investments. Private equity is usually held for a long period of time, and
trading in it is useful when a company is in danger of bankruptcy, because it provides access
to a great deal of capital very quickly.
Private equity is an umbrella term for large amounts of money raised directly from accredited
individuals and institutions and pooled in a fund that invests in a range of business ventures.
The attraction is the potential for substantial long-term gains. The fund is generally set up as
a limited partnership, with a private equity firm as the general partner and the investors as
limited partners.
Private equity firms typically charge substantial fees for participating in the partnership and
tend to specialize in a particular type of investment.
For example, venture capital firms may purchase private companies, fuel their growth, and
either sell them to other private investors or take them public. Corporate buyout firms buy
troubled public firms, take them private, restructure them, and either sell them privately or
take them public again.

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Stock Market Concepts

INDIAN MARKET OVERVIEW

How stock market works?
How shares are traded?
What is Nifty and Sensex?
What are stocks?
What makes Stock Price to Change?
How to do Buying and Selling of Stocks?
DEMAT
Dematerialization
Rematerialisation
Insider trading
Corporate actions
IPOs

Price discoveries
SECURITIES LENDING
Going short
Buying limit

Indian market overview:

How stock market works?
If you'd like to buy a share of stock in any publicly traded company you'll most likely need
the services of a brokerage firm. Though it's possible to buy and sell shares of stock on your
own, there are some practical and legal problems with this approach. The securities industry
is highly regulated, so you can't just hang a shingle and start selling stocks to the general
public, unless you're properly registered and licensed.
A brokerage firm is a dealer of stocks and other securities that acts as your agent when you
want to buy or sell stocks. Most trading of stocks happens on a stock exchange. These are
special markets where buyers and sellers are brought together to buy and sell stocks. The best
known stock exchanges are the Bombay Stock Exchange and the National Stock Exchange.
The Bombay Stock Exchange is one of the largest stock exchanges in the world, listing over
4,500 companies. The BSE SENEX is the major stock index of the Bombay exchange,
comparable to the DOW industrials in the US. The National Stock Exchange of India is also
based in Mumbai (Mumbai used to be called Bombay) and regularly trades in volumes
exceeding that of the Bombay Stock Exchange. The main stock index of the National Stock
Exchange of India is the S&P CNX Nifty, or just Nifty for short. Apart from equities, the
NSE also deals with trades of futures, debt and foreign currencies.
When most people think of a stock exchange, they picture a scene of frantic activity, with
traders in funny-looking jackets simultaneously jostling for position, shouting commands,
making strange hand signals, and writing up orders. Behind this frenzied spectacle, however,
is a methodical and organized system of trading, in which the price of any stock is set purely
by rule of supply and demand in an auction setting. Specialists help match buyers and sellers,
but shares are always sold to the highest bidder.
From the perspective of an investor, buying and selling stocks seems pretty simple. If you use
a full-service broker, just call her up on the phone and place an order for 100 shares of Coca-
Cola. Within a few minutes, you'll receive a confirmation that your order has been completed,
and you'll be the proud new owner of Coca-Cola's stock.
Behind the scenes, however, there's a lot of action that takes place between your order and the
confirmation. Here's what has to happen:

1. 1. You place the order with your broker to buy 100 shares of the Coca-Cola
Company.
2. 2. The broker sends the order to the firm's order department.
3. 3. The order department sends the order to the firm's clerk who works on the floor of
the exchange where shares of Coca-Cola are traded (Bombay Stock Exchange).
4. 4. The clerk gives the order to the firm's floor trader, who also works on the
exchange floor.
 5. 5. The floor trader goes to the specialist's post for Coca-Cola and finds another floor
trader who is willing to sell shares of Coca-Cola.
6. 6. The traders agree on a price.
7. 7. The order is executed.
8. 8. The floor trader reports the trade to the clerk and the order department.
9. 9. The order department confirms the order with the broker.
10. 10. The broker confirms the trade with you.

That's how a traditional stock exchange works, but much of the action that takes place when
you buy or sell a stock is being handled with the assistance of computers. Even if you bought
a stock that trades on a stock exchange, your order may be executed with little or no
intervention by humans. You can log on to a brokerage firm's Website, enter an order, have
the trade be executed, and receive a confirmation all within sixty seconds or less.
How shares are traded?

The stock market is the place where buyers and sellers meet (not physically but online) and
decide on a particular stock price and carry out buying and selling. Nowadays buying and
selling takes place online with the help of computer where trades are made electronically
from anywhere as long as your computer is connected to internet. Now days no physical floor
trading takes place.

Further stock markets are classified into two types:

• Primary marketi

• Secondary market.

The primary market is where shares are created (by means of an IPO). So in primary market
company issue an IPO and investor purchase it, while in the secondary market, investor’s
trade previously-issued shares without the involvement of any companies. The secondary
market is what people are referring to when they talk about the stock market trading.

Terms Related to Stock and Stock Market Trading

Open - The first price at which the stock opens when market starts in the morning.
High - The stock price reached at the highest price level in a day.
Low - The stock price reached the lowest price level in a day.
Close - The stock price at which it remains after the end of market timings or the final price
of the stock when the market closes for a day.
Volume - Volume is nothing but quantity of shares.
Bidi - The Buying price is called as Bid price.
Offer - The selling price is called offer price.
Bid Quantity - The total number of shares available for buying is called Bid Quantity.
Offer Quantity - The total number of shares available for selling is called Offer Quantity.
Buying and selling of shares - Buying is also called as demand or bid and selling is also
called as supply or offer.
Short selling - First selling and then buying only happens in day trading or future trading
Share Trading - Buying and selling of shares is called share trading.
Transaction - One cycle of buying and selling of stocks is called One Transaction.
Squaring off - This term is used to complete one transaction. Means if you buy then have to
sell (means square off) and if you sell then you have to buy (means square off).
Limit Orderi - The order get executes at your mentioned price.
Market Order - The order rate gets executes at current market rates.

For example if you place buy order at market price then the price will get executes with the
current available offer price and when you place “sell market order” then your order get
executes with current available bid price.

Conclusion - The market orders get immediately executed at the current available price while
limit order will execute when the market price will reach your mentioned price.

Stop Lossi Order price - An order placed to sell a share when it reaches a certain price. It is
used to limit an investor's loss. Stop loss order is used with limit order. It is mostly used by
day traders.

For example - Suppose you bought XYZ shares at Rs 100 and unfortunately the price starts
falling so to protect your loss you can make use of a stop loss and put sell limit order of 95
with stop loss of 96. So if price starts falling and touches 96 then your order get executed and
all your shares will get sold in between 95 to 96 and you will get protected from further
decrease in price. So in short stop loss will be used to protect your heavy loss.
Disadvantage - The stop loss may also get executed by short term fluctuation.

What is Nifty and Sensex?

Nifty and Sensex are called Index. Index is basically an indicator. It gives you a general idea
about whether the market is heading towards. In India Mainly there are two major Indices
Nifty and Sensex in India. Most of the stock trading in India is done on NSE and BSE.

The Nifty is related to all major stocks listed at NSE, Delhi.

The Sensex is related to all major stocks listed at BSE, Mumbai.

Nifty consist of group of top 50 stocks while Sensex consist of 30 stocks. If the Sensex goes
up, it means that the prices of the stocks of most of the major companies on the BSE have
gone up. If the Sensex goes down, this tells you that the stock price of most of the major
stocks on the BSE have gone down. Just like the Sensex represents the top stocks of the BSE,
the Nifty represents the top stocks of the NSE.

Besides Sensex and the Nifty there are many other indexes. Like there is an index called Mid
Cap Index for all mid cap stocks and Small Cap Index for all small cap stocks.
Also for all sectors there is separate index like IT, banking, Pharmacy etc. So just by looking
at these indices you will come to know whether the stocks from these sectors are moving up
or down.

What are stocks ?

In simple language a STOCK is a share in the ownership of a company. Being a stock holder
you have a contribution towards company's assets and earnings. If you buy more stocks of a
particular company then your ownership stake in that company becomes greater. The world
“stock” is called by different names with different people like share, equity, scrip and so on
but all these words have same meaning.
Different types of stocks
There are various ways the stocks are categorized
1. Based on size of market capitalization - Large cap, Mid cap and Small cap
2. Depending on sectors - Banking, Pharmacy, IT, Telecommunication.
3. Method of stock issue- Preferred and Common stocks.

What makes Stock Price to Change?

Basic factor to change the stock price is demand and supply. If more people want to buy a
stock (this is called demand) than sell it (this is called supply), then the price moves up and in
exact reverse way if more people wanted to sell a stock than buy then the price would fall.

Following are the important factors and points why stock prices move up and down.

• The variation in buying and selling quantities makes the stock price move up and
down.
• If more people are willing to buy and few people are willing to sell means there is
more demand (buyers) and less supply (sellers) which would make the stock price to
increase.
• If more people are willing to sell and few people are willing to buy means there is
more supply (sellers) and less demand (buyers) which would make the stock price to
decrease.

There could be any reasons why some people want to buy and why some people want to sell
the same stock. Some are listed below.

• News related to company that may be positive or negative. Positive News like major
take over’s, mergers, acquisitions, negative news like low profit and sales figures
declaration in quarter or annual results.
• Some people trade on technical charts and buy and sell on different prices.
• Some people make move on fundamental ratios/factors so this type of trader buy and
sell on different prices.
• Some people enter into market just looking the buying and selling figures(these are
called as volumes) and this type of trader have there different prices to buy and sell.
• Some trader buy and sell based on news.
• So over all different people across the globe have different trading strategies due to
which stock prices move up and down.

How to do Buying and Selling of Stocks

Now we will see how to do transaction (means buying and selling) of shares.

Stock transaction takes place in 3 major steps.

1. You place order (buy or sell) online –
2. The order goes to your broker (broker like indiabulls, 5paisa etc)
3. From broker the order goes to stock exchange (either BSE or NSE)
And finally based on your price your order gets executed.

Now let’s see what you have to do for placing orders. Your role is to place only buy or sell
order. No need to worry about broker part and stock exchange part. You just need to place
your order.
There are two methods for placing orders:

• Online trading and

• Offline trading.

Online Stock Trading - The online stock trading is done by self. If you want to do trading
yourself then you can go for online trading. For online trading you need computer, Internet
connection, demat and trading account. Demat account and trading accounts are must for
trading in stock market.

Offline stock trading - In this method the orders will be placed by the broker on your behalf.
Means you have to tell your broker which stocks to buy and sell and based on your
instruction he carries out transaction. In this method you don’t need any computer and
internet connection.

More details about online trading

Opening Demat account and trading account - Demat account is must if you want to do stock
trading or investment.

Use of demat account - Demat account is used to keep your stocks in electronic format. Now
days as there are no any physical shares in paper form, everything is stored electronically so
Demat account is required.

Trading account - Trading account is required to do buying and selling of stocks. In today’s
markets there are lots of brokers with whom you can open the account.

DEMAT:
Demat account is a safe and convenient means of holding securities just like a bank account
is for funds. Today, practically 99.9% settlement (of shares) takes place on demat mode only.
Thus, it is advisable to have a Beneficiary Owner (BO) account to trade at the exchanges.

Bank Account Vs Demat Account

S.
Basis Of Differentiation Bank Account Demat Account
No.

Form of
1. Funds Securities
Holdings/Deposits

2. Used for Safekeeping of money Safekeeping of shares

Transfer of money (without Transfer of shares (without

3. Facilitates
actually handling money) actually handling shares)

4. Where to open A bank of choice A DP of choice (can be a

 bank)

Requirement of PAN Mandatory (effective from

5. Not Mandatory
Number April 01, 2006)

No interest accruals on
Interest accrual on Interest income is subject to
6. securities held in demat
holdings the applicable rate of interest
account

AQB* maintainance is
Minimum balance
7. specified for certain bank No such requirement
requirement
accounts

Either or Survivor
8. Available Not available
facility

*AQB - Average Quarterly Balance

*DP-Depository Participant

S.
BASIS OF SIMILARITY PARTICULARS
No.

Both are very safe and convenient means of holding

1. Securityi and Convenience
deposits/securities

No legal barrier on the number of bank or demat

2. Number of accounts
accounts that can be opened

Transfer of deposits (funds or Funds/securities are transferred only at the

3.
securities) instruction of the account holder

Physical transfer of
4. Physical transfer of money/securities is not involved
money/securities

5. Nomination Facility Available

Benefits Of Demat Account

1. 1. A safe and convenient way of holding securities (equity and debt instruments both).
 2. 2. Transactions involving physical securities are costlier than those involving
dematerialised securities (just like the transactions through a bank teller are costlier
than ATM transactions). Therefore, charges applicable to an investor are lesser for
each transaction.
3. 3. Securities can be transferred at an instruction immediately.
4. 4. Increased liquidity, as securities can be sold at any time during the trading hours
(between 9:55 AM to 3:30 PM on all working days), and payment can be received in
a very short period of time.
5. 5. No stamp duty charges.
6. 6. Risks like forgery, thefts, bad delivery, delays in transfer etc, associated with
physical certificates, are eliminated.
7. 7. Pledging of securities in a short period of time.
8. 8. Reduced paper work and transaction cost.
9. 9. Odd-lot shares can also be traded (can be even 1 share).
10. 10. Nomination facility available.
11. 11. Any change in address or bank account details can be electronically intimated to
all companies in which investor holds any securities, without having to inform each of
them separately.
12. 12. Securities are transferred by the DP itself, so no need to correspond with the
companies.
13. 13. Shares arising out of bonus, split, consolidation, merger etc. are automatically
credited into the demat account of the investor.
14. 14. Shares allotted in public issues are directly credited into demat account of the
applicants in quick time.

Opening a Demat Account

To start dealing in securities in electronic form, one needs to open a demat account with a DP
of his choice. An investor already having shares in physical form should ensure that he gets
the account opened in the same set of names as appearing on the share certificate; otherwise a
new account can be opened in any desired pattern by the investor.

Getting started Documents to be attached

1. Choose a DP 1. Passport size photographs

2. Fill up an account opening form 2. Proof of residence (POR) - Any one of
provided by DP, and sign an Photo Ration Card with DOB / Photo
agreement with DP in a standard Driving License with DOB / Passport
format prescribed by the depository. copy / Electricity bill / Telephone bill
3. DP provides the investor with a copy 3. Proof of identity (POI) - Any one of
of the agreement and schedule of Passport copy / Photo Driving License
charges for his future reference. with DOB / Voters ID Card / PAN
4. DP opens the account and provides Card / Photo Ration Card with DOB
the investor with a unique account 4. PAN card
number, also known as Beneficiary
Owner Identification Number (BO ID).
Note:

1. 1. The agreement required to be signed by the investor details the rights and duties of
the investor and DP.
2. 2. DP may revise the charges by giving a 30 days prior notice. SEBI has rationalized
the cost structure for isation by removing account opening charges, transaction
charges for credit of securities and custody charges, effective from January 28, 2005.

Maximum Number of holders in a Demat Account

A maximum of three persons are allowed to open a joint demat account in their names.
Dematerialization

Definition
Dematerialisation is the process of converting physical shares (share certificates) into an
electronic form. Shares once converted into dematerialised form are held in a Demat account.

Dematerialisation Process
An investor having securities in physical form must get them dematerialised, if he intends to
sell them. This requires the investor to fill a Demat Request Form (DRF) which is available
with every DP and submit the same along with the physical certificates. Every security has an
ISIN (International Securities Identification Number). If there is more than one security than
the equal number of DRFs has to be filled in. The whole process goes on in the following
manner:
Things Investors Should Know About Account Opening And Dematerialisation:

Providing the bank account details at the time of account opening

It is mandatory for an investor to provide his bank account details at the time of opening a
demat account. This is done to safeguard investor's own interests. There are two major
reasons for this:

1. 1. The interest and dividend warrants can't be en-cashed by any unauthorized person,
as the bank account number is mentioned on it.
2. 2. It is convenient and time saving, as dividends and interests given by the companies
can be directly credited to the investor's bank account (through ECS facility, wherever
available).

Change in bank account details

It is possible for an investor to make changes to the details of his bank account. The investor
must inform any change in his bank account details to his DP. This enables him to receive the
cash corporate benefits (such as dividends, interests) directly into his account in time and
discourages any unauthorized use by any second party.
Change in the address of investor as provided to the DP
Any change in your address should be immediately informed to DP. This enables DP to make
necessary changes in the records and informing the concerned companies about the same.
Opening multiple accounts
An investor is allowed to open more than one account with existing DP or with different DPs.
Minimum balance of securities required in demat account
There is no stipulated minimum balance of securities to be kept in a demat account.

Account opening and ownership pattern of securities

One must make sure to open a demat account in the same ownership pattern in which the
physical securities are held. For example: If you have two share certificates, one in your
individual name (say 'X') and the other held jointly with some other individual (say 'XY'),
then in such a case you will have to open two different accounts in respective ownership
patterns (one in your name i.e. 'X' and the other account in the name of 'XY').
Same combination of names on certificates but different sequence of names on the
certificates or demat account
Regulations provide that the client receives a contract note indicating details like order
number, trade number, time, price, brokerge, etc. within 24 hours.of the trade. In case of any
doubts about the details of the contract note, you (investor) can avail the facility provided by
NSE, wherein you can verify the trades on NSE's website. The Exchange generates and
maintains an audit trail of orders/trades for a number of years.and you can counter check
detais of order/trade with the Exchange.

Holding a joint account on "Either or Survivor" basis like a bank account

No investor can open a demat account on "E or S" basis like a bank account.
Allowing somebody else to operate your Demat account
It is possible for an account holder (Beneficiary Owner) to authorize some other person to
operate the demat account on his behalf by executing a power of attorney. After submitting
the power of attorney to the DP, that person can operate the account on behalf of the
beneficiary owner (BO).
Addition/deletion of the names of the account holders after opening the account
It is not possible to make changes in the names of the account holders of a BO account. A
new account has to be opened in a desired holding/ownership pattern.
Closing a demat account and transfer of securities to another account with same or
different DP
An investor, if he wants, can also close his demat account with one DP and transfer all the
securities to another account with existing or a different DP. As per a SEBI circular issued on
November 09, 2005, there are no charges for account closure or transfer of securities by an
investor from one DP to another
Freezing/Locking a demat account
The account holder can freeze his demat account for a desired time period. A frozen account
prevents securities to be transferred out of (Debit) and transferred into (Credit) the account.
Dematerialised shares do not have any distinctive number
Dematerialised securities are fungible assets. Therefore they are interchangeable and
identical.
Rematerialisation
The process of getting the securities in an electronic form, converted back into the physical
form is known as Rematerialisation. An investor can rematerialise his shares by filling in a
Remat Request Form (RRF). The whole process goes on as follows:

Note:

1. 1. Depository - An organization that facilitates holding of securities in the electronic

form and enables DPs to provide services to investors relating to transaction in
securities. There are two depositories in India, namely NSDL and CDSL. As per a
SEBI guideline, the minimum net worth stipulated for a depository is Rs.100 crore.
2. 2. NSDL/CDSL - The securities are held in depository accounts, like the funds are
held in bank accounts. There are two depositories in India namely NSDL and CDSL.
NSDL (National Securities Depository limited) was established in August 1996 and is
the first depository in India. CDSL (Central Depository Securities Limited) is the
other depository and was established in 1999.
3. 3. DP (Depository Participant) - A Depository Participant can be a financial
organization like banks, brokers, financial institutions, custodians, etc., acting as an
agent of the Depository to make its services available to the investors. There are a
total of 538 DPs registered with SEBI, as on March 31, 2006 and each DP is assigned
a unique identification number known as DP-ID.

Points to remember while opening the Demat and Trading account –

First Very Important - Fast Support - Check for there support. How fast they respond when
you contact them through email or through phone. It’s very important that they should
respond to you very fast. So that your problem should get resolved at the earliest or they
should be able to place orders on your behalf if in case your computer or internet stops
working or they should respond to your queries as early as possible.

Second Very Important - Brokeragei rates- Confirm and go for low brokerage rates. Later if
you show good transaction, means good buy and selling volumes, then some brokers reduce
the brokerage rates.

III. Check the reliability - Check reliability and how easy is the trading platform. Trading
platform is where you put buy and sell order, where you can see your pending orders and
executed orders, etc. Even you can request the brokers to show the demonstration of there
trading platform and after viewing and verifying it you can go for that broker and open
trading account.

In addition to brokerage you also have to pay taxes on every trade. The taxes will be same
with all brokers.

Note 1 - Regulatory charges are calculated on total transaction (buying and selling), which is
also called as total turnover amount.
Note 2 - You have to pay service tax only on brokerage.

Insider Trading:

Insider trading can be illegal or legal depending on when the insider makes the trade: it is
illegal when the material information is still nonpublic--trading while having special
knowledge is unfair to other investors who don't have access to such knowledge. Illegal
insider trading therefore includes tipping others when you have any sort of nonpublic
information. Directors are not the only ones who have the potential to be convicted of insider
trading. People such as brokers and even family members can be guilty.

Insider trading is legal once the material information has been made public, at which time the
insider has no direct advantage over other investors. The SEC (Securities Exchange
Commissioni), however, still requires all insiders to report all their transactions. So, as
insiders have an insight into the workings of their company, it may be wise for an investor to
look at these reports to see how insiders are legally trading their stock.

Corporate actions:

When a publicly-traded company issues a corporate action, it is initiating a process that will
bring actual change to its stock. By understanding these different types of processes and their
effects, an investor can have a clearer picture of what a corporate action indicates about a
company's financial affairs and how that action will influence the company's share price and
performance. This knowledge, in turn, will aid the investor in determining whether to buy or
sell the stock in question.

Corporate actions are typically agreed upon by a company's board of directors and authorized
by the shareholders. Some examples are stock splits, dividends, mergers and acquisitions,
rights issues and spin offs. Let's take a closer look at these different examples of corporate
actions.
Stock Splits :
As the name implies, a stock split (also referred to as a bonus share) divides each of the
outstanding shares of a company, thereby lowering the price per share - the market will adjust
the price on the day the action is implemented. A stock split, however, is a non-event,
meaning that it does not affect a company's equity, or its market capitalization. Only the
number of shares outstanding change, so a stock split does not directly change the value or
net assets of a company.

A company announcing a 2-for-1 (2:1) stock split, for example, will distribute an additional
share for every one outstanding share, so the total shares outstanding will double. If the
company had 50 shares outstanding, it will have 100 after the stock split. At the same time,
because the value of the company and its shares did not change, the price per share will drop
by half. So if the pre-split price was $100 per share, the new price will be $50 per share.

So why would a firm issue such an action? More often than not, the board of directors will
approve (and the shareholders will authorize) a stock split in order to increase the liquidity of
the share on the market.

The result of the 2-for-1 stock split in our example above is two-fold: (1) the drop in share
price will make the stock more attractive to a wider pool of investors, and (2) the increase in
available shares outstanding on the stock exchange will make the stock more available to
interested buyers. So do keep in mind that the value of the company, or its market
capitalization (shares outstanding x market price/share), does not change, but the greater
liquidity and higher demand on the share will typically drive the share price up, thereby
increasing the company's market capitalization and value.

A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1) split can also be
termed a stock split of 100%. A 3 for 2 split (3:2) would be a 50% split, and so on.

A reverse split might be implemented by a company that would like to increase the price of
its shares. If a $1 stock had a reverse split of 1 for 10 (1:10), holders would have to trade in
10 of their old shares for one new one, but the stock would increase from $1 to $10 per share
(retaining the same market capitalization). A company may decide to use a reverse split to
shed its status as a "penny stock". Other times companies may use a reverse split to drive out
small investors.

Dividends:
There are two types of dividends a company can issue: cash and stock dividends. Typically
only one or the other is issued at a specific period of time (either quarterly, bi-annually or
yearly) but both may occur simultaneously. When a dividend is declared and issued, the
equity of a company is affected because the distributable equity (retained earnings and/or
paid-in capital) is reduced. A cash dividend is straightforward. For each share owned, a
certain amount of money is distributed to each shareholder. Thus, if an investor owns 100
shares and the cash dividend is $0.50 per share, the owner will receive $50 in total.

A stock dividend also comes from distributable equity but in the form of stock instead of
cash. A stock dividend of 10%, for example, means that for every 10 shares owned, the
shareholder receives an additional share. If the company has 1,000,000 shares outstanding
(common stock), the stock dividend would increase the company's outstanding shares to a
total of 1,100,000. The increase in shares outstanding, however, dilutes the earnings per
share, so the stock price would decrease.

The distribution of a cash dividend can signal to an investor that the company has substantial
retained earnings from which the shareholders can directly benefit. By using its retained
capital or paid-in capital account, a company is indicating that it can replace those funds in
the future. At the same time, however, when a growth stock starts to issue dividends, the
company may be changing: if it was a rapidly growing company, a newly declared dividend
may indicate that the company has reached a stable level of growth that it is sustainable into
the future.

Rights Issuesi:
A company implementing a rights issue is offering additional and/or new shares but only to
already existing shareholders. The existing shareholders are given the right to purchase or
receive these shares before they are offered to the public. A rights issue regularly takes place
in the form of a stock split, and can indicate that existing shareholders are being offered a
chance to take advantage of a promising new development.

Mergers and Acquisitions:

A merger occurs when two or more companies combine into one while all parties involved
mutually agree to the terms of the merge. The merge usually occurs when one company
surrenders its stock to the other. If a company undergoes a merger, it may indicate to
shareholders that the company has confidence in its ability to take on more responsibilities.
On the other hand, a merger could also indicate a shrinking industry in which smaller
companies are being combined with larger corporations. For more information, see "What
happens to the stock price of companies that are merging together?"

In the case of an acquisition, however, a company seeks out and buys a majority stake of a
target company's shares; the shares are not swapped or merged. Acquisitions can often be
friendly but also hostile, meaning that the acquired company does not find it favorable that a
majority of its shares was bought by another entity.

A reverse merger can also occur. This happens when a private company acquires an already
publicly-listed company (albeit one that is not successful). The private company in essence
turns into the publicly-traded company to gain trading status without having to go through the
tedious process of the initial public offering. Thus, the private company merges with the
public company, which is usually a shell at the time of the merger, and usually changes its
name and issues new shares.

Spin Offs:
A spin off occurs when an existing publicly-traded company sells a part of its assets or
distributes new shares in order to create a newly independent company. Often the new shares
will be offered through a rights issue to existing shareholders before they are offered to new
investors (if at all). Depending on the situation, a spin-off could be indicative of a company
ready to take on a new challenge or one that is restructuring or refocusing the activities of the
main business.

It is important for an investor to understand the various types of corporate actions in order to
get a clearer picture of how a company's decisions affect the shareholder. The type of action
used can tell the investor a lot about the company, and all actions will change the stock itself
one way or another.

Assimilation:
Absorption of a new issue of stock into the parent security where the original shares did not
fully rank pari passu with the parent shares. After the event, the assimilated shares rank pari
passu with the parent. It is also referred to as funging of shares.

Acquisition:
In general, companies will aim to grow. Growth can be achieved organically (the company
simply growths their existing company) or inorganically (by acquiring other already existing
businesses and integrate them with their own).

In order to excecute an acquisition strategy, the acquiring company may use several means: a
merger, a takeover bid (usually by announcing a Tender Offer or an Exchange Offer) which
are all Corporate Actions Events.

Bankruptcy:
The company announces bankruptcy protection and the legal proceedings start in which it
will be decided what pay-outs will be paid to stakeholders. A Bankruptcy (also referred to as
an insolvency or default) is the inability of an individual or entity to pay its debts when they
are due. It does not always result in liquidation. An alternative is reorganization, in which the
firm’s obligations may be re-negotiated.

Usually a specialized and qualified lawyer is appointed who handles the proceedings. This
lawyer is known as an insolvency practitioner.

Any party that has claims outstanding can file a claim. In case of Liquidation, all assets will
be sold by the insolvency practitioner. If - after all the debt has been paid off - there is
something left, this will be paid out as proceeds to equity holders.

Bonusi Issue:
Shareholders are awarded additional securities (shares, rights or warrants) free of payment.
The nominal value of shares does not change.

A Bonus Issue, which is sometimes referred to as "Scrip Issue" or "Capitalisation Issue", is

effectively a free issue of shares - paid for by the company issuing the shares out of capital
reserves.

Please note that a Bonus Issue should NOT be seen as a Dividend, like for example a STOCK
DIVIDEND event.

A company calls a Bonus Issue to increase the liquidity of the company's shares in the
market. Increasing the number of shares in circulation reduces the share price.
The term 'Bonus Issue' is generally used to describe what is technically a capitalisation of
reserves. The company, in effect, issues free shares paid for out of its accumulated profits
(reserves).

Bonus Rights:
Distribution of rights which provide existing shareholders the privilege to subscribe to
additional shares at a discounted rate. This corporate action has similar features to a bonus
and rights issue.

Class Action
A lawsuit is being made against the company (usually by a large group of shareholders or by
a representative person or organisation) that may result in a payment to the shareholders.

Delisting
The process of removing the security from a stock exchange. This can be done on a
mandatory basis by the Exchange or on a voluntary basis by the company itself. After a stock
has been delisted it can no longer be traded on that exchange and no official on-exchange
price building is being tracked.

De-merger
One company de-merges itself into 2 or more companies. The shares of the old company are
booked out and the shares of the new companies will be booked in according to a set ratio.

General Announcement
An event used by the company to notify its shareholders of any events that take place. This
event type is used to communicate several types of information to the shareholders.

Initial Public Offering (IPO)

This is the first corporate actions event in the history of any company. The first time that a
company gets listed on a stock exchange is regarded as an event in itself. Underwriters will
try to get as many buyers for the newly listed shares for a price as high as possible. Any
shares they can not sell, will be bought by the underwriters.

Liquidation
Liquidation proceedings consist of a distribution of cash and/or assets. Debt may be paid in
order of priority based on preferred claims to assets specified by the security e.g. ordinary
shares versus preferred shares.

Mandatory Exchange / Mandatory Conversion

Conversion of securities (generally convertible bonds or preferred shares) into a set number
of other forms of securities (usually common shares).

Merger
Merger of 2 or more companies into one new company. The shares of the old companies are
consequently exchanged into shares in the new company according to a set ratio.

Par Value Change

Similar to stock splits where the share nominal value is changed which normally results in a
change in the number of shares held.

Scheme of Arrangement
Occurs when a parent company takes over its subsidiaries and distributes proceeds to its
shareholders.

Scrip Dividend
The UK version of an optional dividend. No stock dividends / coupons are issued but the
shareholder can elect to receive either cash or new shares based on the ratio or by the net
dividend divided by the re-investment price. The default is always cash.

Scrip Issue
Shareholders are awarded additional securities (shares, rights or warrants) free of payment.
The nominal value of shares does not change.

IPO’s:

Corporate may raise capital in the primary market by way of an initial public offer, rights
issue or private placement. An Initial Public Offer (IPO) is the selling of securities to the
public in the primary market.
IPO or Initial Public Offer is a way for a company to raise money from investors for its
future projects and get listed to Stock Exchange. Or An Initial Public Offer (IPO) is the
selling of securities to the public in the primary stock market.
Company raising money through IPO is also called as company ‘going public'.
From an investor point of view, IPO gives a chance to buy shares of a company, directly from
the company at the price of their choice (In book build IPO's). Many a times there is a big
difference between the price at which companies decides for its shares and the price on which
investor are willing to buy share and that gives a good listing gain for shares allocated to the
investor in IPO.
From a company prospective, IPO help them to identify their real value which is decided by
millions of investor once their shares are listed in stock exchanges. IPO's also provide funds
for their future growth or for paying their previous borrowings.

IPO Process:

1. Issuer Company - IPO Process Initialization

1. Appoint lead manager as book runner.

2. Appoint registrar of the issue.

3. Appoint syndicate members.

2. Lead Manager's - Pre Issue Role - Part 1

1. Prepare draft offer prospectus document for IPO.

2. File draft offer prospectus with SEBI.

3. Road shows for the IPO.

3. SEBI – Prospectus Review

1. SEBI review draft offer prospectus.

2. Revert it back to Lead Manager if need clarification or changes (Step 2).

3. SEBI approve the draft offer prospectus, the draft offer prospectus is now become Offer
Prospectus.

4. Lead Manager - Pre Issue Role - Part 2

 1. Submit the Offer Prospectus to Stock Exchanges, registrar of the issue and get it approved.

2. Decide the issue date & issue price band with the help of Issuer Company.

3. Modify Offer Prospectus with date and price band. Document is now called Red Herring
Prospectus.

4. Red Herring Prospectus & IPO Application Forms are printed and posted to syndicate
members; through which they are distributed to investors.

5. Investor – Bidding for the public issue

1. Public Issue Open for investors bidding.

2. Investors fill the application forms and place orders to the syndicate members (syndicate
member list is published on the application form).

3. Syndicate members provide the bidding information to BSE/NSE electronically and bidding
status gets updated on BSE/NSE websites.

4. Syndicate members send all the physically filled forms and cheques to the registrar of the
issue.

5. Investor can revise the bidding by filling a form and submitting it to Syndicate member.

6. Syndicate members keep updating stock exchange with the latest data.

7. Public Issue Closes for investors bidding.

6. Lead Manager – Price Fixing

1. Based on the bids received, lead managers evaluate the final issue price.

2. Lead managers update the 'Red Herring Prospectus' with the final issue price and send it to
SEBI and Stock Exchanges.

7. Registrar - Processing IPO Applications

1. Registrar receives all application forms & cheques from Syndicate members.

2. They feed applicant data & additional bidding information on computer systems.

3. Send the cheques for clearance.

4. Find all bogus application.

5. Finalize the pattern for share allotment based on all valid bid received.

6. Prepare 'Basis of Allotment'.

7. Transfer shares in the demat account of investors.

8. Refund the remaining money though ECS or Cheques.

8. Lead manager – Stock Listing

1. Once all allocated shares are transferred in investors dp accounts, Lead Manager with the help
of Stock Exchange decides Issue Listing Date.
 2. Finally share of the issuer company gets listed in Stock Market.

Initial Public Offering can be made through the fixed price method, book building method or
a combination of both. There are two types of Public Issues:

ISSUE TYPE OFFER PRICE DEMAND PAYMENT RESERVATIONS

Fixed Price Price at which Demand for 100 % advance 50 % of the shares offered
Issues the securities the securities payment is are reserved for
are offered and offered is required to be applications below Rs. 1
would be known only made by the lakh and the balance for
allotted is after the investors at the higher amount
made known in closure of the time of applications.
advance to the issue application.
investors
Book A 20 % price Demand for 10 % advance 50 % of shares offered are
Building band is offered the securities payment is reserved for QIBS, 35 %
Issues by the issuer offered , and at required to be for small investors and the
within which various prices, made by the balance for all other
investors are is available on QIBs along with investors.
allowed to bid a real time the application,
and the final basis on the while other
price is BSE website categories of
determined by during the investors have to
the issuer only bidding pay 100 %
after closure of period.. advance along
the bidding. with the
application.

Price Band:
Company with help of lead managers (merchant bankers or syndicate members) decides the
price or price band of an IPO.
SEBI, the regulatory authority in India or Stock Exchanges do not play any role in fixing the
price of a public issue. SEBI just validate the content of the IPO prospectus.
Companies and lead managers does lots of market research and road shows before they
decide the appropriate price for the IPO. Companies carry a high risk of IPO failure if they
ask for higher premium. Many a time investors do not like the company or the issue price and
doesn't apply for it, resulting unsubscribe or undersubscribed issue. In this case companies'
either revises the issue price or suspends the IPO.
Date of the issue:
Once ‘Draft Prospectus' of an IPO is cleared by SEBI and approved by Stock Exchanges then
it's up to company going public to finalize the date and duration of an IPO. Company consult
with the Lead Managers, Registrar of the issue and Stock Exchanges before decides the date.
Role of registrar of an IPO:
Registrar of a public issue is a prime body in processing IPO's. They are independent
financial institution registered with SEBI and stock exchanges. They are appointed by the
company going public.
Responsibility of a registrar for an IPO is mainly involves processing of IPO applications,
allocate shares to applicants based on SEBI guidelines, process refunds through ECS or
cheque and transfer allocated shares to investors Demat accounts.
Role of Lead Managers in an IPO:
Lead managers are independent financial institution appointed by the company going public.
Companies appoint more then one lead manager to manage big IPO's. They are known as
Book Running Lead Manager and Co Book Running Lead Managers.
Their main responsibilities are to initiate the IPO processing, help company in road shows,
creating draft offer document and get it approve by SEBI and stock exchanges and helping
company to list shares at stock market.
Follow on public offering or FPO:
Follow on public offering (FPO) is public issue of shares for already listed company.
Primary & secondary market:
Primary market is the market where shares are offered to investors by the issuer company to
raise their capital.
Secondary market is the market where stocks are traded after they are initially offered to the
investor in primary market (IPO's etc.) and get listed to stock exchange. Secondary market
comprises of equity markets and the debt markets.
Secondary market is a platform to trade listed equities, while Primary market is the way for
companies to enter in to secondary market.
Life cycle of an IPO prospectus:
Stage 1: Draft Offer document
"Draft Offer document" is prepared by Issuer Company and the Book Building Lead
Manager of the public issue. This document is submitted to SEBI for review. After reviewing
this document either SEBI ask lead managers to make changes to it or approve it to go ahead
with IPO processing.
Draft document are available on SEBI's website in the section of ‘Reports -> Public Issues:
Draft Offer Documents filed with SEBI" at: http://www.sebi.gov.in/SectIndex.jsp?
sub_sec_id=70
"Draft Offer document" is usually a PDF file having information of an investor who needs to
know about the public issue. It mainly contain information about the company, its business,
management, risk involve in applying to this issue, company financials and the reason why
company is raising money through IPO.
Stage 2: Offer Document
Once the ‘Draft Offer document' cleared by SEBI, it becomes "Offer Document". Offer
Document is the modified version of ‘Draft Offer document' with SEBI suggestions.
"Offer Document" is submitted to the registrar of the issue and stock exchanges where Issuer
Company is willing to list.
Stage 3: Red Herring Prospectus
Once "Offer Document" gets clearance from Stock Exchanges, Issuer Company add Issue
size and price of the issue to the document and make it available to the public. The issue
prospectus is now called "Red Herring Prospectus"
Benefits of IPO’s:
For businesses, stocks and shares are a fast way to raise revenue for business expansion and
growth. They also can take a business to the next level. By becoming a publicly traded
company a business can take advantage of new, larger opportunities and can start working
towards incorporation and even worldwide expansion. IPO gives a company fast access to
public capital. Even though public offering can be costly and time consuming, the tradeoffs
are very appealing to companies. IPOs are also a relatively low risk for businesses and have
the potential for huge gains and for huge opportunities. The more investors wish to invest in a
company, the more the company stands to or from IPOs and other stock offerings.
For the investor, IPOs are attractive mainly because they may be undervalued. Initially, to
make IPOs more attractive, many companies will offer their initial public offering at a low
rate. This helps to encourage investors, and investors will often buy IPOs, thinking that the
new company or the newly public company will be the next big thing with a huge profit
margin. As prices grow and demand for the IPOs grows, early investors stand to make a lot of
profit -- and very quickly.

If you hope to invest in companies, understanding the answer to the question what is an IPO?
is essential to your success. An initial public offering, the first time a company offers shares
to the general public, is a great way to start building profit. Since IPOs are in some cases
undervalued they can often be sold with it a short period for good profit.
Price Discovery:
The most important, yet most difficult, part of the initial public offering (IPO) process is
setting the offer price. In an IPO, the issuer, aided by an intermediating investment bank,
plans to sell a relatively large number of shares of common stock in which there is at that
point no market. However, they know that soon after the IPO process the secondary market
will impute all the information in the market in an efficient manner. Investors who believe the
price to be too high will sell; investors who believe the price to be too low will buy. The key
outcome of this competitive trading is the market price of the stock.
Naturally, the issuing team (the issuer and its investment bank would like to know the market
price in advance. If they had a crystal ball, they would set the price at a small discount (say
3%) to the future market price, so as to generate sufficient interest from buy-side clients, and
place the issue. In fact this is exactly what issuers do when they sell securities which already
have a market price. Unfortunately, there is no secondary market for IPO shares, and neither
are there crystal balls.
To estimate the market price as best as they can, issuers and their advisers conduct a costly
analysis to estimate the value of the firm. We call this process price discovery.
Note that not only do the issuer and its investment bank analyze the firm. Prospective
investors also conduct costly analysis to predict the future market price. Naturally, a good
estimate of the future market price gives them a substantial advantage in their dealings with
the issuer: If they have strong indications that the offer price is set too high, they stay away
from the offering. If they believe the price to be below the future market price, they sign up
for IPO shares enthusiastically.
Securities lending:

Going short
Selling stock that an investor does not own by borrowing shares from a broker. The
assumption is that the price will fall. The investor anticipates buying (covering the short) the
shares back at a lower price than what they were sold for, recognizing the difference as a
profit. Antithesis is going long.

Buying Limit
A limit order is an order to buy a security at no more than a specific price, or to sell a
security at no less than a specific price. This gives the trader (customer) control over the price
at which the trade is executed; however, the order may never be executed ("filled"). Limit
orders are used when the trader wishes to control price rather than certainty of execution.
A buy limit order can only be executed at the limit price or lower. For example, if an investor
wants to buy a stock, but doesn't want to pay more than $20 for it, the investor can place a
limit order to buy the stock at $20 "or better". By entering a limit order rather than a market
order, the investor will not buy the stock at a higher price, but, may get fewer shares than he
wants or not get the stock at all.

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Mutual Funds

Mutual Fund
Mutual Funds: Structure In India
Advantages Of Investing In MFs
Disadvantages Of Investing In MFs
Types of Mutual Fund
Plans and Optionsi
Growth and Dividend Options
Payout and Reinvestment Plans
Systematic Investment Plan (SIP)
Systematic Transfer Plan (STP)
Systematic Withdrawal Plan (SWP)
NAV of A Fund
What Is NAV?
How Is It Calculated?
How Do You Use It?
Returns In A Mutual Fund
Cost Involved In MF Investing
New Fund Offer (NFO)
What Is NFO?
How Do I Buy?
Taxation of Mutual Funds
Indexation Benefit
Why Fixed maturity plans (FMP) Are Popular?
When To Sell Your Fund?
How to Select A Fund?
MF Portfolioi
Where to Find?
How to Read Fact Sheet?
Portfolio Management

Mutual Fund
A mutual fund is a professionally managed type of collective investment scheme that pools
money from many investors and invests it in stocks, bonds, short-term money market
instruments and other securities. Mutual funds have a fund manager who invests the money
on behalf of the investors by buying / selling stocks, bonds etc.
The investor invests in a mutual fund scheme which in turn takes the responsibility of
investing in stocks and shares after due analysis and research. The investor need not bother
with researching hundreds of stocks. It leaves it to the mutual fund and it’s professional fund
management team. Another reason why investors prefer mutual funds is because mutual
funds offer diversification. An investor’s money is invested by the mutual fund in a variety of
shares, bonds and other securities thus diversifying the investors’ portfolio across different
companies and sectors. This diversification helps in reducing the overall risk of the portfolio.
It is also less expensive to invest in a mutual fund since the minimum investment amount in
mutual fund units is fairly low (Rs. 500 or so).

Mutual Funds: Structure In India

Mutual Funds in India follow a 3-tier structure. There is a Sponsor (the First tier), who thinks
of starting a mutual fund. The Sponsor approaches the Securities & Exchange Board of India
(SEBI), which are the market regulator and also the regulator for mutual funds. Once SEBI is
convinced, the sponsor creates a Public Trust (the Second tier) as per the Indian Trusts Act,
1882. Trusts have no legal identity in India and cannot enter into contracts, hence the
Trustees are the people authorized to act on behalf of the Trust. Contracts are entered into in
the name of the Trustees. Once the Trust is created, it is registered with SEBI after which this
trust is known as the mutual fund. The Sponsor and the Trust are two separate entities.
Sponsor is not the Trust; i.e. Sponsor is not the Mutual Fund. It is the Trust, which is the
Mutual Fund. The Trustees role is not to manage the money. Their job is only to see, whether
the money is being managed as per stated objectives. Trustees may be seen as the internal
regulators of a mutual fund.

Investors’ money is managed by the AMC

Trustees appoint the Asset Management Company (AMC) (the Third tier), to manage
investor’s money on a day-to-day basis. The AMC in return charges a fee for the services
provided and this fee are borne by the investors as it is deducted from the money collected
from them. The AMC’s Board of Directors must have at least 50% of Directors who are
independent directors. The AMC has to be approved by SEBI. The AMC functions under the
supervision of its Board of Directors, and also under the direction of the Trustees and SEBI.
It is the AMC, which in the name of the Trust, floats new schemes and manage these schemes
by buying and selling securities. In order to do this the AMC needs to follow all rules and
regulations prescribed by SEBI and as per the Investment Management Agreement it signs
with the Trustees. The AMC cannot deal with a single broker beyond a certain limit of
transactions. Appointments of intermediaries like independent financial advisors (IFAs),
national and regional distributors, banks, etc. is also done by the AMC. Finally, it is the
AMC, which is responsible for the acts of its employees and service providers. Whenever the
fund intends to launch a new scheme, the AMC has to submit a Draft Offer Document to
SEBI. This draft offer document, after getting SEBI approval becomes the offer document of
the scheme. The Offer Document (OD) is a legal document and investors rely upon the
information provided in the OD for investing in the mutual fund scheme. The Compliance
Officer has to sign the Due Diligence Certificate in the OD.
A Custodian
A trust company, bank or similar financial institution responsible for holding and
safeguarding the securities owned within a mutual fund. A mutual fund's custodian may also
act as the mutual fund's transfer agent, maintaining records of shareholder transactions and
balances. Since a mutual fund is essentially a large pool of funds from many different
investors, it requires a third-party custodian to hold and safeguard the securities that are
mutually owned by all the fund's investors. This structure mitigates the risk of dishonest
activity by separating the fund managers from the physical securities and investor records.
Only the physical securities are held by the Custodian. The deliveries and receipt of units of a
mutual fund are done by the custodian or a depository participant at the instruction of the
AMC and under the overall direction and responsibility of the Trustees. Regulations provide
that the Sponsor and the Custodian must be separate entities.
Role of A Registrar And Transfer Agents
Registrars and Transfer Agents (RTAs) perform the important role of maintaining investor
records. All the New Fund Offer (NFO) forms, redemption forms (i.e. when an investor
wants to exit from a scheme, it requests for redemption) go to the RTA’s office where the
information is converted from physical to electronic form. It acts as single-window system
for investors. How many units will the investor get, at what price, what is the applicable
NAV, how much money will he get in case of redemption, exit loads, folio number, etc. is all
taken care of by the RTA. An RTA also helps investors with information and details on new
fund offers, dividend distributions or even maturity dates in case of FMPs (fixed maturity
plans). While such details are also available from fund houses, an RTA is a one-stop shop for
all the information. Investors can get information about various investments in different
schemes of different fund houses at a single place.
Advantages Of Investing In MFs
Professional Management
Investing requires skill. It requires a constant study of the dynamics of the markets and of the
various industries and companies within it. But when you buy a mutual fund, you are also
choosing professional money manager. This manager will use the money that you invest to
buy and sell stocks that he or she has carefully researched. Therefore, rather than having to
thoroughly research every investment before you decide to buy or sell, you have a mutual
fund's money manager to handle it for you.
Diversificationi
Diversification involves the mixing of investments within a portfolio and is used to manage
risk. For example, by choosing to buy stocks in the retail sector and offsetting them with
stocks in the industrial sector, you can reduce the impact of the performance of any one
security on your entire portfolio. To achieve a truly diversified portfolio, you may have to
buy stocks with different capitalizations from different industries and bonds with varying
maturities from different issuers. For the individual investor, this can be quite costly.
However, a mutual fund will spread its risk by investing a number of sound stocks or bonds.
A fund normally invests in companies across a wide range of industries, so the risk is
diversified. You can diversify across asset classes at very low cost. Within the various asset
classes also, mutual funds hold hundreds of different securities (a diversified equity mutual
fund, for example, would typically have around hundred different shares).
Low costs
Since mutual funds collect money from millions of investors, they achieve economies of
scale. The cost of running a mutual fund is divided between a larger pool of money and hence
mutual funds are able to offer you a lower cost alternative of managing your funds. Mutual
funds are able to take advantage of their buying and selling size and thereby reduce
transaction costs for investors. When you buy a mutual fund, you are able to diversify
without the numerous commission charges. With mutual funds, you can make transactions on
a much larger scale for less money.
Liquidity
Another advantage of mutual funds is the ability to get in and out with relative ease. Mutual
funds are typically very liquid investments. Unless they have a pre-specified lock-in, your
money will be available to you anytime you want. Typically funds take a couple of days for
returning your money to you. Since they are very well integrated with the banking system,
most funds can send money directly to your banking account.
Transparency
The statutory authorities have compelled all the mutual fund companies to disclose their Net
Assets Value (NAV). The NAVs are calculated on daily basis and published through the
available media. Mutual Fund companies disclose their financial statements to their investors
and to others. As funds have to make full disclosure of investments on a periodic basis,
flexibility in terms of needs based choices, very well regulated by SEBI with very strict
compliance requirements to investor friendly norms, makes mutual fund relatively high on
transparency.
Tax Benefits
Investment in mutual funds also enjoys several tax advantages. Dividends from Mutual Funds
are tax-free in the hands of the investor (This however depends upon changes in Finance
Act). Also Capital Gaini accrued from Mutual Fund investment for a period of over one year
is treated as long term capital appreciation and is tax free (in case of equity schemes, in case
of debt funds it will depend on whether you would like to use indexation or not.
Well Regulated
Mutual funds are highly regulated. The mutual fund manager has to submit all necessary
documents to the statutory authorities for their approval, to make investment in the required
securities.
Disadvantages Of Investing In MFs
Fees and Commissions
An administrative fee is required by all kinds of funds to meet the expenses. There are many
funds which even charge commission on sales or "loads" to pay financial consultants,
brokers, financial institutions or financial planners. If you buy stocks or shares from Load
Fund, you have to pay a commission on sales irrespective of the fact that you are consulting a
financial advisor or a broker.
Taxes
In a typical year, the mutual funds which are most efficiently managed have the capacity to
sell anywhere from 20 - 70 % of their portfolio securities. If your fund makes a profit on its
sales, you will pay taxes on the income you receive, even if you reinvest the money you
made.
The tax incidence depends on the type of mutual funds. For more information see Taxation
of Mutual Funds.
Management Risk
When you invest in a mutual fund, you depend on the fund's manager to make the right
decisions regarding the fund's portfolio. If the manager does not perform as well as you had
hoped, you might not make as much money on your investment as you expected. Of course,
if you invest in Index Funds, you forego management risk, because these funds do not
employ managers.
Risks Involved In Investing
Credit Risk
Credit risk or Default risk refers to the situation where the borrower fails to honour either one
or both of his obligations of paying regular interest and returning the principal on maturity. A
bigger threat is that the borrower does not repay the principal. This can happen if the
borrower turns bankrupt. This risk can be taken care of by investing in paper issued by
companies with very high Credit Rating. The probability of a borrower with very high Credit
Rating defaulting is far lesser than that of a borrower with low credit rating. Government
paper is the ultimate in safety when it comes to credit risk (hence the description-‘risks free
security’). This is because the Government will never default on its obligations. If the
Government does not have cash (similar to a company going bankrupt), it can print more
money to meet it’s obligations or change the tax laws so as to earn more revenue (neither of
which a corporate can do!).
It refers to the risk that an issuer of a fixed income security may default (i.e. the issuer will be
unable to make timely principal and interest payments on the security). Because of this risk
corporate debentures are sold at a higher yield above those offered on Government Securities,
which are sovereign obligations and free of credit risk. Normally, the value of a fixed income
security will fluctuate depending upon the changes in the perceived level of credit risk as well
as any actual event of default. The greater the credit risk, the greater the yield required for
someone to be compensated for the increased risk.
Interest rate risk
In case of Fixed Income Investment, changes, in the prevailing rates of interest will likely
affect the value of the Scheme(s) holdings and thus the value of the Scheme(s') Units.
Increased rates of interest, which frequently accompany inflation and /or a growing economy,
are likely to have a negative effect on the value of the Units. The value of securities held by a
Scheme(s) generally will vary inversely with changes in prevailing interest rates. As with
debt instruments, changes in interest rate may affect the Scheme's net asset value as the prices
of instruments generally increase as interest rates decline and generally decrease as interest
rates rise. Prices of long-term securities generally fluctuate more in response to interest rate
changes than do short-term securities. Indian debt and government securities markets can be
volatile leading to the possibility of price movements up or down in fixed income securities
and thereby to possible movements in the NAV.
The best way to mitigate interest rate risk is to invest in papers with short-term maturities, so
that as interest rate rises, the investor will get back the money invested faster, which he can
reinvest at a higher interest rates in newer debt paper. However, this should be done, only
when the investor is of the opinion that interest rates will continue to rise in future otherwise
frequent trading in debt paper will be costly and cumbersome.
Market riski
Systemic risks or market risks refer to risks that affect the entire market and have an impact
on the entire class of assets. The value of an investment may decline over a period of time
because of economic changes or other events that affect the overall market. Systemic risks
include risks related to interest rates, inflation, exchange rates and political events, etc.
Inflation Risk
Inflation Risk is the uncertainty over the future real value (after inflation) of your investment.
This is the risk that inflation will undermine the performance of your investment. Inflation
risk happens when increases in the cost of living make the yields from mutual fund
investments worth much less, adjusted against inflation, than they would have been
otherwise.
Liquidity risk
Liquidity risk is the type of investment risk an investor takes when she buys an investment
that perhaps may not be easily sold again. It is a risk stemming from the lack of marketability
of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.
The liquidity of the Scheme's investment may be inherently restricted by trading volumes,
transfer procedures and settlement periods.
Policy risk
Policy risk refers to the risk in investment due to change in policies. Changes in government
policy and political decision can change the investment environment.
Types of Mutual Fund
Open-ended
In open-ended MFs, the fund house continuously buys and sells units from investors. Open-
ended funds can issue and redeem units any time during the life of the scheme. New units are
created and issued if there is demand, and old units are eliminated if there is redemption
pressure. There is no fixed date on which the units would be permanently redeemed or
terminated. If you want to invest in an open-ended fund, you buy units from the fund house.
Similarly, when you redeem your units, the fund house directly pays you the value of the
units. In other words, new investors can join the scheme by directly applying to the mutual
fund at applicable net asset value related prices in case of open-ended schemes.
Close ended
The units of a close-ended scheme are issued only at the time of the New Fund Offer (NFO).
These units are issued with a fixed tenure or duration, for example, 5 years. New units are not
issued on an ongoing basis, and existing units are not eliminated before the term of the fund
ends. At the time of an NFO, you can buy the units from the fund house, and at the time of
the closure of the scheme (and at some other pre-defined intervals, like once every six
months), you can redeem the units with the fund house.
But if you want to buy or sell the units of a close-ended scheme during the lifetime of the
units, you have to do that on a stock exchange. The units of such schemes are listed on the
stock exchanges just like ordinary shares, and can be bought and sold through a broker.
Index Funds
Equity Schemes come in many variants and thus can be segregated according to their risk
levels. At the lowest end of the equity funds risk – return matrix come the index funds while
at the highest end come the sectoral schemes or specialty schemes. These schemes are the
riskiest amongst all types’ schemes as well. However, since equities as an asset class are
risky, there is no guaranteeing returns for any type of fund.
A mutual fund scheme that faithfully buys the index without making any judgmental
decisions on which stocks to buy more, or less off or whether to keep cash or invest is known
as an index fund. The fund makes no effort to beat the index (“passive investing”). The fund
may be an open- ended mutual fund scheme. Unlike actively managed equity funds, index
funds do not attempt to outperform the benchmark index. Measure of performance of an
index fund is the tracking error, which is the difference between the performances of the
index fund versus the underlying benchmark Index.
Diversified Large Cap Funds
These are funds, which restrict their stock selection to the large cap stocks – typically the top
100 or 200 stocks with highest market capitalization and liquidity. It is generally perceived
that large cap stocks are those, which have sound businesses, strong management, globally
competitive products and are quick to respond to market dynamics. Therefore, diversified
large cap funds are considered as stable and safe. However, since equities as an asset class are
risky, there are no guaranteeing returns for any type of fund. These funds are actively
managed funds unlike the index funds which are passively managed, In an actively managed
fund the fund manager pores over data and information, researches the company, the
economy, analyses market trends, takes into account government policies on different sectors
and then selects the stock to invest. This is called as active management.
A point to be noted here is that anything other than an index funds are actively managed
funds and they generally have higher expenses as compared to index funds. In this case, the
fund manager has the choice to invest in stocks beyond the index. Thus, active decision-
making comes in. Any scheme which is involved in active decision-making is incurring
higher expenses and may also be assuming higher risks. This is mainly because as the stock
selection universe increases from index stocks to largecaps to midcaps and finally to
smallcaps, the risk levels associated with each category increases above the previous
category. The logical conclusion from this is that actively managed funds should also deliver
higher returns than the index, as investors must be compensated for higher risks. But this is
not always so. Studies have shown that a majority of actively managed funds are unable to
beat the index returns on a consistent basis year after year. Secondly, there is no guaranteeing
which actively managed fund will beat the index in a given year.
Midcap Funds
After largecap funds come the midcap funds, which invest in stocks belonging to the mid cap
segment of the market. Many of these midcaps are said to be the ‘emerging bluechips’ or
‘tomorrow’s largecaps’. There can be actively managed or passively managed mid cap funds.

Sectoral Funds
Funds that invest in stocks from a single sector or related sectors are called Sectoral funds.
Examples of such funds are IT Funds, Pharma Funds, Infrastructure Funds, etc. Regulations
do not permit funds to invest over 10% of their Net Asset Value in a single company. This is
to ensure that schemes are diversified enough and investors are not subjected to undue risk.
This regulation is relaxed for sectoral funds and index funds.
Arbitrage Funds
These invest simultaneously in the cash and the derivatives market and take advantage of the
price differential of a stock and derivatives by taking opposite positions in the two markets
(for e.g. stock and stock futures).
Multicap Funds
These funds can, theoretically, have a smallcap portfolio today and a largecap portfolio
tomorrow. The fund manager has total freedom to invest in any stock from any sector.
Quant Funds
A typical description of this type of scheme is that ‘The system is the fund manager’, i.e.
there are some predefined conditions based upon rigorous back testing entered into the
system and as and when the system throws ‘buy’ and ‘sell’ calls, the scheme enters, and/ or
exits those stocks.
P/ E Ratio Fund
A fund, which invests in stocks, based upon their P/E ratios. Thus when a stock is trading at a
historically low P/E multiple, the fund will buy the stock, and when the P/E ratio is at the
upper end of the band, the scheme will sell.
International Equities Fund
This is a type of fund, which invests in stocks of companies outside India. This can be a Fund
of Fund, whereby, we invest in one fund, which acts as a ‘feeder’ fund for some other
fund(s), i.e. invests in other mutual funds, or it can be a fund, which directly invests, in
overseas equities. These may be further designed as ‘International Commodities Securities
Fund’ or ‘World Real Estate Fund’ etc.
Growth Schemes
Growth schemes invest in those stocks of those companies whose profits are expected to
grow at a higher than average rate. For example, infrastructure sector is a growth sector; we
do not have well connected roads all over the country, neither do we have best of ports or
airports. For our country to move forward, this infrastructure has to be of world class. Hence
companies in these sectors may potentially grow at a relatively faster pace. Growth schemes
will invest in stocks of such companies.
ELSS
Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit
upto Rs. 1 Lakh under section 80C of the Income Tax Act. These are open-ended schemes
but have a lock in period of 3 years. These schemes serve the dual purpose of equity investing
as well as tax planning for the investor; however it must be noted that investors cannot, under
any circumstances, get their money back before 3 years are over from the date of investment.
Fund Of Funds
These are funds which do not directly invest in stocks and shares but invest in units of other
mutual funds which they feel will perform well and give high returns. In fact such funds are
relying on the judgment of other fund managers.
Fixed Maturity Plans
FMPs have become very popular in the past few years. FMPs are essentially close-ended debt
schemes. The money received by the scheme is used by the fund managers to buy debt
securities with maturities coinciding with the maturity of the scheme. There is no rule, which
stops the fund manager from selling these securities earlier, but typically fund managers
avoid it and hold on to the debt papers till maturity.
Investors must assess the risk level of the portfolio by looking at the credit ratings of the
securities. Indicative yield is the return, which investors can expect from the FMP.
Regulations do not allow mutual funds to guarantee returns, hence mutual funds give
investors and idea of what returns can they expect from the fund. An important point to note
here is that indicative yields are pre-tax. Investors will get lesser returns after they include the
tax liability.
Capital Protection Funds
These are close-ended funds, which invest in debt as well as equity or derivatives. The
scheme invests some portion of investor’s money in debt instruments, with the objective of
capital protection. The remaining portion gets invested in equities or derivatives instruments
like options. This component of investment provides the higher return potential.
The way the Capital Protection Funds works is that the fund manager invests in safe debt
instruments such that, at least, value equal to your original investment can be delivered to you
at the time of maturity. Let us assume an investor invested Rs 100 in a Capital Protection
Oriented Fund with tenure of 12 months. The goal of the fund is to ensure that at redemption,
its assets are no less than the initial investment of rupees hundred.
The first step here is to construct a quality debt portfolio that matures about the same time as
the fund's maturity. Let us assume that such a debt portfolio can give yield of 8% in current
scenario.
This means that if Rs 68 is invested in this debt portfolio, one can be assured of having at
least Rs 100 at the end of one year.
The other part of your original investment will be invested in equity markets. This equity
allocation will be actively managed in diversified portfolio by experienced fund managers.
This structure gives an investor chance to invest in equity markets without fear of capital
erosion.
Gilt Funds
These are those funds, which invest only in securities issued by the Government. This can be
the Central Government or even State Governments. Gilt funds are safe to the extent that they
do not carry any Credit Risk. However, it must be noted that even if one invests in
Government Securities, interest rate risk always remains.
Balanced Funds
These are funds, which invest in debt as well as equity instruments. These are also known as
hybrid funds. Balanced does not necessarily mean 50:50 ratio between debt and equity. There
can be schemes like MIPs or Children benefit plans which are predominantly debt oriented
but have some equity exposure as well. From taxation point of view, it is important to note
how much portion of money is invested in equities and how much in debt.
MIPs
Monthly Income Plans (MIPs) are hybrid funds; i.e. they invest in debt papers as well as
equities. Investors who want a regular income stream invest in these schemes. The objective
of these schemes is to provide regular income to the investor by paying dividends; however,
there is no guarantee that these schemes will pay dividends every month. Investment in the
debt portion provides for the monthly income whereas investment in the equities provides for
the extra return, which is helpful in minimising the impact of inflation.
Child Benefit Plans
These are debt-oriented funds, with very little component invested into equities. The
objective here is to capital protection and steady appreciation as well. Parents can invest in
these schemes with a 5 – 15 year horizon, so that they have adequate money when their
children need it for meeting expenses related to higher education.
Exchange Traded Funds (ETFs)
Exchange Traded Funds (ETFs) are essentially index funds that are listed and traded on
exchanges like stocks. Globally, ETFs have opened a whole new panorama of investment
opportunities to retail as well as institutional investors. ETFs enable investors to gain broad
exposure to entire stock markets as well as in specific sectors with relative ease, on a real-
time basis and at a lower cost than many other forms of investing.
An ETF is a basket of stocks that reflects the composition of an index, like S&P CNX Nifty,
BSE Sensex, CNX Bank Index, CNX PSU Bank Index, etc. The ETF's trading value is based
on the net asset value of the underlying stocks that it represents. It can be compared to a stock
that can be bought or sold on real time basis during the market hours. The first ETF in India,
Benchmark Nifty Bees, opened for subscription on December 12, 2001 and listed on the NSE
on January 8, 2002.
Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver,
Gold, Indices etc. In India, we have ETFs on Gold and Indices (Nifty, Bank Nifty etc.). We
also have ETFs which are similar to Liquid Funds.
Gold ETFs are a special type of ETF which invests in Gold and Gold related securities. This
product gives the investor an option to diversify his investments into a different asset class,
other than equity and debt.
In case of Gold ETFs, investors buy Units, which are backed by Gold. Thus, every time an
investor buys 1 unit of Gold-ETFs, it is similar to an equivalent quantity of Gold being
earmarked for him somewhere.
Liquid Funds
Liquid funds (also know as Money Market Mutual Funds) come under the category of debt
schemes offered by mutual funds. The basic objective of a liquid fund is to manage the short
term cash surplus of investors and provide optimal returns with moderate levels of risk and
high liquidity. Liquid Funds generate income primarily through interest accrual by investing
in money market instruments like Commercial Papers, Certificate of Deposits, CBLO/ Repos
and in short term debt instruments of corporates and NBFCs.
Liquid funds have maturities not exceeding 1 year. Hence liquid funds have portfolios having
average maturities of less than or equal to 1 year. Thus such schemes normally do not carry
any interest rate risk. Liquid funds do not carry entry / exit loads. Other recurring expenses
associated with liquid funds are also kept to a bare minimum.
Plans and Options
Growth and Dividend Options
Mutual fund houses offer two kinds of schemes: Growth and dividend. In the growth option,
profits made by the scheme are invested back into it. This results in the net asset value (NAV)
of the scheme rising over time. When the scheme gains, the NAV rises and in case of a loss,
it goes down. The only option to realise the profit in the growth option is to sell or redeem
your investments. The dividend option does not re-invest the profits made by the fund. Profits
or dividends are distributed to the investor from time to time. The amount and frequency of
dividends is never guaranteed. Dividends are declared only when the scheme makes a profit
and it is at the discretion of the fund manager. The dividend is paid from the NAV of the unit.
Payout and Reinvestment Plans
Dividend option of mutual fund has sub-options such as dividend payout and reinvestment.
Under the payout option, profits made by the mutual fund scheme are given to investors at
periodic intervals and are not reinvested in the fund. Such dividends are not guaranteed. The
fund may dole out these in one year but may not offer anything the next year; it is entirely at
the discretion of the fund. The amount of dividend paid may also vary. Contrary to what
some people perceive to be an added benefit, the dividend from a mutual fund is actually cut
from the net asset value (NAV). So, the NAV will fall to the extent of dividend paid and the
dividend distribution tax (DDT), if any. Suppose, a fund with a face value per unit of Rs 10 is
trading at an NAV of Rs 40. It declares dividend of 30%, which means investors, will earn Rs
3 per unit. If, subsequently, you choose to sell your holdings, you will get only Rs 37 per
unit, as the NAV of the scheme will have fallen from Rs 40 to Rs 37.
Under the reinvestment option, any dividend paid out by the fund is automatically ploughed
back into the same scheme. This means that you buy additional units in the scheme from the
dividend amount at the prevailing NAV (ex-dividend) of the scheme. As is the case with
dividend payout, NAV of the scheme will fall subsequent to payment of dividend, even if the
same is reinvested into the scheme. So, the NAV of a dividend payout and dividend
reinvestment scheme is the same.
Systematic Investment Plan (SIP)
Systematic Investment Plan (SIP) is an option where you invest a fixed amount in a mutual
fund at regular intervals. It could be monthly or quarterly.
Once you identify the funds you want to invest in and the amount required achieving your
financial goals. Most investors want to buy stocks when the prices are low and sell them
when prices are high. But timing the market is time consuming and risky. A more successful
investment strategy is to adopt the method called Rupee Cost Averagingi. Systematic
investing can help put the power of compounding on your side.
This facility enables investors to save and invest periodically over a longer period of time. It
is a convenient way to "invest as you earn" and affords the investor an opportunity to enter
the market regularly, thus averaging the acquisition cost of Units.
Imagine John invests Rs. 1000 every month in an equity mutual fund scheme starting in
January. His friend, Rajesh, invests Rs. 12000 in one lump sum in the same scheme. The
following table illustrate how their respective investments would have performed from Jan to
Dec:

Rajesh’s
John’s Investment Investment

Amoun Amoun
Month NAV t Units t Units

Jan-07 9.345 1000 107.0091 12000 1284.109

Feb-07 9.399 1000 106.3943

 Mar-07 8.123 1000 123.1072

Apr-07 8.75 1000 114.2857

May-07 8.012 1000 124.8128

Jun-07 8.925 1000 112.0448

Jul-07 9.102 1000 109.866

Aug-07 8.31 1000 120.3369

Sep-07 7.568 1000 132.1353

Oct-07 6.462 1000 154.7509

Nov-07 6.931 1000 144.2793

Dec-07 7.6 1000 131.5789

At the end of the 12 months, John has more units than Rajesh, even though they invested the
same amount. That’s because the average cost of John’s units is much lower than that of
Rajesh. Rajesh made only one investment and that too when the per-unit price was high.
John’s average unit price = 12000/1480.6012 = Rs. 8.105
Rajesh’s average unit price = Rs. 9.345
Systematic Transfer Plan (STP)
Under Systematic Transfer Plan (STP), at regular intervals, an amount you opt for is
transferred from one mutual fund scheme to another of your choice. Typically, a minimum of
six such transfers are to be agreed on by investors. You can get into a weekly, monthly or a
quarterly transfer plan, as per your needs.
You may choose to transfer a fixed sum from one scheme to another. The mutual fund will
reduce the number of units equal to the amount you have specified from the scheme you
intend to transfer money. At the same time, the amount such transferred will be utilised to
buy the units of the scheme you intend to transfer money into, at the applicable NAV. Some
fund houses allow you to transfer only the capital appreciation to be transferred at regular
intervals.
STP is a useful tool to take a step by step exposure into equities or to reduce exposure over a
period of time. Say you have Rs 10 lakh to invest in equity over a period of time. You could
put this amount in the liquid fund of a mutual fund or a short-term bond fund. This gives an
opportunity to earn a better than saving bank account rate of return. You than start an STP
where every month a pre-determined amount will be invested into an equity fund. This helps
in deploying funds at regular intervals in equities with minimum timing risk.
As seen in the table, by investing through SIP, you end up buying more units when the price
is low and fewer units when the price is high. However, over a period of time these market
fluctuations are generally averaged. And the average cost of your investment is often
reduced.
Systematic Withdrawal Plan (SWP)
Systematic Withdrawal Plan (SWP) enable an investor in a mutual fund to withdrawn
amounts periodically from the investments made in a scheme. An investor has to register for
an SWP with the mutual fund, indicating the scheme and the period of the SWP.
SWP has to be registered with a specific date, amount and frequency. A retired investor can
seek monthly withdrawal from his folio, over the next year.
The amount being withdrawn has to be indicated upfront. It can be a fixed amount, or limited
to the extent of appreciation in the value of the investment. SWPs for fixed amount may
result in paying out the capital invested. SWP for appreciation amount will vary in value
depending on how much appreciation is available.
SWP is redemption from a scheme, so tax provisions apply accordingly. SWP is tax efficient
for an investor who likes to save on dividend distribution tax.

NAV of A Fund
What Is NAV?
Everything you buy has a price, and this is true for investing too. But what is the price of a
mutual fund? How much do you need to pay to invest in a fund's scheme? This amount will
depend on the fund's net asset value or NAV, which is the price at which the fund is bought
and sold in the open market. The NAV represents the price of one unit of the mutual fund.
For example, if a fund's NAV is Rs 20 and you want to invest Rs 10,000, you will be allotted
500 units in the fund.
The NAVs of funds are reported widely in newspapers and investment portals. In fact, open-
ended funds are mandated to disclose their NAVs on a daily basis while close-ended schemes
usually disclose their NAVs on a weekly basis.
How Is It Calculated?
The asset allocation mix of a mutual fund includes securities and cash. Securities comprise of
equities, bonds and other debt instruments. The values of these securities change at every
trading interval and so does the NAV of the mutual fund. The NAV is the total market value
of all the assets held in the mutual fund portfolio less the liabilities, divided by all the
outstanding units. The market value of the investments is calculated according to the last
traded or closing price of the securities.
Usually, the calculation of an NAV is tedious during trading hours as the price of the
underlying holdings (especially stocks) keeps changing. Though it is theoretically possible to
calculate the NAV during trading hours, it is bound to change the next minute. Given this, the
NAVs are usually declared after market closing. The costs and expenses of the fund, such as
management fee and operating expenses (registrar and transfer agent fee, marketing and
distribution fee, audit fee and custodian fee) are deducted while calculating the NAV.
The NAV of an open-ended fund does not state whether a fund is overpriced or under-priced.
In other words, a fund with a high NAV does not mean that it is more expensive in relation to
a fund that has a low NAV. It only indicates the market value of the investment portfolios,
and has nothing to do with valuation terminology of premium or discount.
Closed-ended funds issue a fixed number of units that are traded on the stock exchanges or in
the over-the-counter market. Typically, such funds do not trade at their NAVs and their prices
tend to generate premium or discount relative to their NAVs due to the demand and supply
factors.
How Do You Use It?
The NAV helps in assessing the performance of the fund. Various analysis tools like point-to-
point return, CAGR and ROI, are derived using the NAV of the fund. Moreover, advanced
analysis of risk-adjusted returns, such as Sharpe and Treynor ratios, alpha and beta are not
possible without the NAV.
A fund's NAV helps the investors to assess the worth of their investments and determine how
the value of the investments has moved over time. For instance, in 2010, you purchased 1,000
units of a fund at Rs 15, so your investment was Rs 15,000. After two years, the NAV rises to
Rs 20. This means that the value of your investment has grown to Rs 20,000 and if you
redeem the units now, you will make a profit of Rs 5,000. Moreover, the base of investment
strategies like SIP, SWP and STP rests on the NAV of the fund.
Returns In A Mutual Fund
Dividends
The dividend option does not re-invest the profits made by the fund. Profits or dividends are
distributed to the investor from time to time. The amount and frequency of dividends is never
guaranteed. Dividends are declared only when the scheme makes a profit and it is at the
discretion of the fund manager. The dividend is paid from the NAV of the unit.
Capital gains
Profit that results when the price of a security held by a mutual fund rises above its purchase
price and the security is sold (realized gain). If the security continues to be held, the gain is
unrealised. A capital loss would occur when the opposite takes place. Capital gains can be
long term or short term depending on the time when the units are sold. If the units are held for
more than a year they generate long-term capital gain while if the units are redeemed within
one year they generate short-term capital gains and are accordingly taxed.
Cost Involved In MF Investing
Loads:
Investors have to bear expenses for availing of the services (professional management) of the
mutual fund. The first expense that an investor has to incur is by way of Entry Load. This is
charged to meet the selling and distribution expenses of the scheme. A major portion of the
Entry Load is used for paying commissions to the distributor. The distributor (also called a
mutual fund advisor) could be an Independent Financial Advisor, a bank or a large national
distributor or a regional distributor etc. They are the intermediaries who help an investor with
choosing the right scheme, financial planning and investing in scheme s from time to time to
meet one’s requirements.

As there are Entry Loads, there exist Exit Loads as well. As Entry Loads increase the cost of
buying, similarly Exit Loads reduce the amount received by the investor. Not all schemes
have an Exit Load, and not all schemes have similar exit loads as well. Some schemes have
Contingent Deferred Sales Charge (CDSC). This is nothing but a modified form of Exit Load,
wherein the investor has to pay different Exit Loads depending upon his investment period.
If the investor exits early, he will have to bear more Exit Load and if he remains invested for
a longer period of time, his Exit Load will reduce. Thus the longer the investor remains
invested, lesser is the Exit Load. After some time the Exit Load reduces to nil; i.e. if the
investor exits after a specified time period, he will not have to bear any Exit Load.
Expense Ratio
Among other things that an investor must look at before finalising a scheme, is that he must
check out the Expense Ratio. Expense Ratio is defined as the ratio of expenses incurred by a
scheme to its Average Weekly Net Assets. It means how much of investors money is going
for expenses and how much is getting invested. This ratio should be as low as possible.
NFOs
What Is NFO?
The launch of a new scheme is known as a New Fund Offer (NFO). We see NFOs hitting
markets regularly. It is like an invitation to the investors to put their money into the mutual
fund scheme by subscribing to its units. When a scheme is launched, the distributors talk to
potential investors and collect money from them by way of cheques or demand drafts. Mutual
funds cannot accept cash. (Mutual funds units can also be purchased on-line through a
number of intermediaries who offer on-line purchase / redemption facilities). Before
investing, it is expected that the investor reads the Offer Document (OD) carefully to
understand the risks associated with the scheme.
How Do I Buy?
Investors before investing in NFO should look whether it would be suitable for achieving
their investment objective and also the asset class required to build the corpus for achieving
the investment objective.
Before buying the units in NFO, investors should look into aspects such as asset allocation,
investment options available, asset allocation, fund managers track record, investment
strategy and exit load structure.
Taxation of Mutual Funds
Income from Mutual Fund can be divided into 2 parts Capital Gain (increase in value of your
investment) or dividends that investors receive on regular intervals if they have opted for
dividend plans. So taxation of Mutual Funds in India can be divided in 2 parts Capital Gain &
Dividends.

Capital Gains Taxation

Equity Scheme Debt Scheme

 Minimum 65% invested in
Indian Equities

Long Term Capital Gains 0% 10% - Without Indexation

(More than 12 months holding 20% - With Indexation

period)

Short Term Capital Gains 15% Marginal Rate of Tax

(Less than or equal to 12 Profit added to income

months holding period)

Capital Gain is appreciation in the value of asset – if you buy something for Rs 1 lakh & sell
it for Rs 1.5 lakh, you have made a Capital Gain of Rs 50000. Capital Gains are further
divided into short term & long term depending on their investment horizon.
Short term capital Gain arises if investment is hold for less than 1 year or in simple words
sold before completion of 1 year. Here 1 year means 365 Days.
Long Term Capital Gain arises if investment is sold after 1 year.
Mutual Fund Capital Gain Tax further depends on which type of fund it is – Equity or Debt.
Capital Gain Tax on Equity Mutual Funds
Equity Mutual Funds are those funds where equity holding is more than 65% of the total
portfolio so even balanced funds will be categorized in Equity Funds. Fund of Funds (mutual
funds which invests in other funds) & international funds (funds which have more than 35%
exposure to international equities) will be kept under debt category for tax purpose.
Long Term Capital gain on Equity Mutual Funds – if you buy & hold an equity Mutual Fund
for more than 1 year, there will be NIL Tax. Eg. If you invest Rs 1 lakh in XYZ Fund & after
1 year, its value is Rs 1.3 Lakh – there will be zero tax on capital appreciation of Rs 30000.
This is a very big advantage of equity mutual funds.
Short Term Capital gain on Equity Mutual Funds – if you sell equity mutual fund before
completion of 1 year you need to pay tax of 15% on capital gains. In the above example
where gain was Rs 30000 – if this was a short term capital gain, investor would have paid Rs
4500 as short term Capital Gain.
Capital Gain Tax on Debt Mutual Funds
All other funds which will not qualify as equity fund, including Fund of Fund & international
Fund will be part of debt mutual funds. Definition of Short Term & Long Term is same as
mentioned in equity category.
Short Term Capital gain on Debt Mutual Funds – any short term capital gain that arises due
to selling of debt fund before 1 year will be added to investor’s income. Once it is added to
income it will be taxed according to tax slab of that individual.
Long Term Capital gain on Debt Mutual Funds – here taxation depends on whether investor
would like to use indexation or not.
• Without Indexation – 10% tax on capital gains
• With Indexation – 20% tax on capital gains

Mutual Fund Dividend Taxation

Again this taxation will depend on which type of mutual fund you are investing in – equity or
debt.
There is no dividend distribution tax on equity mutual funds and also the dividend received
by investors is tax free. So, its again a bonus for equity mutual fund investors.
Even in case of debt mutual funds – dividends received by investor are tax free in their hand
or they don’t need to show it as a taxable income. But there is dividend distribution tax paid
by mutual funds to income tax departments.
Indexation Benefit
Indexation is a procedure by which the investor can get benefit from the fact that inflation has
eroded his returns.
Indexation works on the simple concept that if an investor buys a unit @ Rs. 10 and sells it @
Rs. 30 after 5 years, then his profit of Rs. 20 per unit needs to be adjusted for the inflation
increase during the same time period. This is because inflation reduces purchasing power.
What Rs. 100 could have bought when he bought the unit @ Rs.10, would now have
increased in price due to inflation. Thus he can now buy less for the same Rs. 100.
Why FMPs Are Popular?
Fixed maturity plans (FMPs) have been very popular with investors because they are more
tax efficient than fixed deposits. If the FMP term exceeds one year, the income is treated as
long-term capital gains and taxed at a flat 10% or 20% after indexation. In case of fixed
deposits, the interest earned is clubbed with the income of the investor and taxed at the
normal rate. That is why the 370-day FMP is the most common maturity in this category.
When To Sell Your Fund?
Constant Underperformance
One reason to sell a fund is if your fund has consistently underperformed its benchmark.
Investors should study the performance of a fund for four consecutive quarters before
arriving at a decision. If there is no substantial improvement in its performance relative to its
benchmark or peers, you may want to get out. Benchmarking is an important factor in
gauging a fund’s performance and determining whether it has kept up to its overall
investment objective.
Benchmarks can provide investors a perspective on the expected risk-adjusted performance
of fund portfolios and help them take investment decisions. So, if your portfolio warrants
investing in an index fund as a passive strategy, compare its performance with that of the
index and not of its diversified equity counterparts. Even if the index has underperformed,
you should remain invested since it serves a particular purpose in your portfolio.
You may also consider exiting a fund if the management changes. The entry or exit of fund
managers could have a bearing on your fund’s performance.
Repositioning
It may be worthwhile to evaluate your investment strategy periodically to ensure that it meets
your objectives at every stage of life. It could be buying a house, marriage, birth of a child,
education or retirement. If an investor’s objective has been met, it may be time to modify his
portfolio, say, move to debt as he gets closer to retirement.
Change In Your Goals
Fund investments are based on financial goals; you follow a certain investment philosophy
and allocate your assets in a way that they fulfil your objectives. For instance, if you are
single, in your early 20s and your first goal is to buy a car, you might invest a higher
percentage in equities. Once you have reached your goal, even if it is earlier than you
thought, it makes sense to sell your fund and actualise it.
How to Select A Fund?
Comparison with Benchmark & Comparison with Peers
Though the past performance of a fund does not define its future performance, it is important
to consider how it has performed with respect to its benchmark or other similar funds. A fund
should be compared with the same category of funds. So, the performance of a mid-cap fund
cannot be compared with that of a large-cap fund as the former is more volatile compared
with the latter.
Past performance also helps in assessing the quality of fund management, the skills of the
fund manager and his team. The stock picking and market timing abilities of the manager can
be judged by comparing the fund performance with its benchmark.
The funds that perform better than their benchmarks are considered outperformers, whereas
the funds that yield less than their benchmarks are underperformers.
Return Measurements
Point To Point Returns
These returns are calculated by considering the NAVs at two points in time-entry date and
exit date. Suppose you invested in the growth option of a mutual fund scheme in January
2005 at a NAV of Rs 12. Now, if the NAV were to rise to Rs 32 on the exit day, say, January
2012, using point-to-point returns you'll find that your fund has generated an absolute return
of 166.67%.
To know how your investment has grown on an annual basis, you'll need to check the
compounded annual growth rate (CAGR), in this case, 15.04%. Though CAGR can be
calculated for any time period, a simple point-to-point return is preferred when the holding
period is less than one year and CAGR is ideal for longer holding periods.

Though it's easy to calculate the point-to-point return and is extensively used to analyse fund
performance, be warned that it's not a fool-proof method. It fails to determine the consistency
of the historical returns. If you consider the graph, both Fund A and Fund B have the same
entry and exit NAVs.
So a simple CAGR calculation would yield identical results, that is, 10.41%, while the
absolute return for both funds is 100%. What's different between the two funds is the
consistency of their respective performance-Fund A is consistently rising whereas Fund B,
after showing a robust growth for the first four years, declines consistently after 2009.
Clearly, Fund A is a better choice, which you'd never know by relying on the point-to-point
return measures.
Rolling Returns
This is where rolling returns come to the rescue. In this case, returns are calculated on a
continuous basis for each defined interval, which can be days, weeks, months, quarters, even
years. Consider the calculation of yearly rolling returns. Going back to the first example
(mutual fund with the 2005-12 holding period), the yearly return is calculated on a daily
basis, from 1 January 2005, to 1 January 2006, then 2 January 2005 to 2 January 2006, and so
on, till the end of the time period, that is 1 January 2011 to 1 January 2012.
Assuming 250 trading days in a year, this exercise will throw up around 1,500 yearly point-
to-point returns, and the average of all these returns is used as the one-year rolling return.
This figure can be compared with the category average rolling return. So, if the fund has
delivered a 12% yearly rolling return, while its category average one-year rolling return is
14%, it implies that the fund has fared worse than its average.
An analysis of rolling returns also throws up other relevant statistics, the most important ones
being the maximum return (highest of the 1,500 yearly returns) and the minimum return
(lowest figure). The maximum/minimum return not only helps determine the consistency of a
fund's performance, but also assess its best and worst periods (years, months, quarters) in
terms of returns. Rolling returns can be calculated for any interval.
If the defined interval is three years, the point-to-point returns will be calculated from 1
January 2005 to 1 January 2008, and so on, till the end of the holding period. The average of
all the figures will help arrive at the three-year rolling return. Hence, calculating rolling
returns is a better way to ferret out consistent performers.
Risk Measures
Standard Deviation
Standard deviation measures the total risk associated with a fund (market and company
specific). It measures the extent to which the fund return varies across its average return. The
return of a fund is the percentage change in its NAV and it can be calculated on a daily,
weekly, monthly or yearly basis. A high standard deviation implies that the periodic returns
are fluctuating significantly from the average return and this signifies risk. On the other hand,
a low standard deviation implies that the periodic returns are fluctuating close to the average
return, which implies a low probability of loss.
Downside Probability
It calculates the probability that the portfolio would get a negative return.
Downside Probability = Total number of negative returns in a period/ Total number of returns
in a period.
While higher figure is considered bad, lower figure is considered favourable.
A statistical tool, frequency distribution method is generally used for computing the
probability.
Maximum Drawdown (MDD)
The maximum drawdown can be loosely defined as the largest drop from the peak to a
bottom in a certain time period. Drawdown, the amount by which your portfolio declines
from a peak reading to its lowest value before attaining a new peak, is one of the truer
measures of the risks you are taking in your investment program. Maximum drawdown is
always smaller than or equal to the difference between loss and maximum gain. It is highly
dependent on the time interval chosen (annual, monthly, daily and so on) as well as the
observation period. Maximum drawdown is an excellent way to compare the inherent
riskiness of different strategies.
Tracking Error
Tracking Error is the Standard Deviation of the difference between daily returns of the index
and the NAV of the scheme. This can be easily calculated on a standard MS office
spreadsheet, by taking the daily returns of the Index, the daily returns of the NAV of the
scheme, finding the difference between the two for each day and then calculating the standard
deviation of difference by using the excel formula for ‘standard deviation’. In simple terms it
is the difference between the returns delivered by the underlying index and those delivered by
the scheme. The fund manager may buy/ sell securities anytime during the day, whereas the
underlying index will be calculated on the basis of closing prices of the Nifty 50 stocks. Thus
there will be a difference between the returns of the scheme and the index. There may be a
difference in returns due to cash position held by the fund manager. This will lead to
investor’s money not being allocated exactly as per the index but only very close to the index.
If the index’s portfolio composition changes, it will require some time for the fund manager
to exit the earlier stock and replace it with the new entrant in the index. These and other
reasons like dividend accrued but not distributed, accrued expenses etc. all result in returns of
the scheme being different from those delivered by the underlying index. This difference is
captured by Tracking Error. As is obvious, this should be as low as possible.
The fund with the least Tracking Error will be the one which investors would prefer since it is
the fund tracking the index closely. Tracking Error is also function of the scheme expenses.
Lower the expenses, lower the Tracking Error. Hence an index fund with low expense ratio,
generally has a low Tracking Error.
Performance Evaluation
Sharpe Ratio
An investor can invest with the government, and earn a risk-free rate of return (Rf). T-Bill
index is a good measure of this risk-free return.
Through investment in a scheme, a risk is taken, and a return earned (Rs).
The difference between the two returns i.e. Rs – Rf is called risk premium. It is like a
premium that the investor has earned for the risk taken, as compared to government’s risk-
free return.
This risk premium is to be compared with the risk taken. Sharpe Ratio uses Standard
Deviation as a measure of risk. It is calculated as
(Rs minus Rf) ÷ Standard Deviation
Thus, if risk free return is 5%, and a scheme with standard deviation of 0.5 earned a return of
7%, its Sharpe Ratio would be (7% - 5%) ÷ 0.5 i.e. 4%.
Sharpe Ratio is effectively the risk premium per unit of risk. Higher the Sharpe Ratio, better
the scheme is considered to be. Care should be taken to do Sharpe Ratio comparisons
between comparable schemes. For example, Sharpe Ratio of an equity scheme is not to be
compared with the Sharpe Ratio of a debt scheme.
Treynor Ratio
Like Sharpe Ratio, Treynor Ratio too is a risk premium per unit of risk.
Computation of risk premium is the same as was done for the Sharpe Ratio. However, for
risk, Treynor Ratio uses Betai.
Treynor Ratio is thus calculated as:
(Rf minus Rs) ÷ Beta
Thus, if risk free return is 5%, and a scheme with Beta of 1.2 earned a return of 8%, its
Treynor Ratio would be (8% - 5%) ÷ 1.2 i.e. 2.5%.
Higher the Treynor Ratio, better the scheme is considered to be. Since the concept of Beta is
more relevant for diversified equity schemes, Treynor Ratio comparisons should ideally be
restricted to such schemes.
Information Ratio
A ratio of portfolio returns above the returns of a benchmark (usually an index) to the
volatility of those returns. The information ratio (IR) measures a portfolio manager's ability
to generate excess returns relative to a benchmark, but also attempts to identify the
consistency of the investor. This ratio will identify if a manager has beaten the benchmark by
a lot in a few months or a little every month. The higher the IR the more consistent a manager
is and consistency is an ideal trait.
Rp = Return of the portfolio
Ri = Return of the index or benchmark
Sp-i = Tracking error (standard deviation of the difference between returns of the portfolio
and the returns of the index)
A high IR can be achieved by having a high return in the portfolio, a low return of the index
and a low tracking error.
For example:
Manager A might have returns of 13% and a tracking error of 8%
Manager B has returns of 8% and tracking error of 4.5%
The index has returns of -1.5%
Manager A's IR = [13-(-1.5)]/8 = 1.81
Manager B's IR = [8-(-1.5)]/4.5 = 2.11
Manager B had lower returns but a better IR. A high ratio means a manager can achieve
higher returns more efficiently than one with a low ratio by taking on additional risk.
Additional risk could be achieved through leveraging.
Equity Portfolio Attributes
Stock Concentration, Sector Concentration, Market Cap Concentration & Asset Calls
Professional portfolio managers who work for an investment management company generally
do not have a choice about the general investment philosophy used to govern the portfolios
they manage. An investment firm may have strictly defined parameters for stock selection
and investment management. An example would be a firm defining a value investment
selection style using certain trading guidelines. Furthermore, portfolio managers are also
usually constrained by market capitalization guidelines. For example, small-cap managers
may be limited to selecting stocks in the Rs 200 crore to Rs 500 crore market cap range.
Therefore, the first step in portfolio management is to understand the universe from which
investments may be selected.
Some firms or portfolios use a bottom-up approach, where investment decisions are made
primarily by selecting stocks without consideration to sector selection or economic forecasts.
Other styles may be top-down oriented and portfolio managers pay primary attention to
analyzing entire sectors or macroeconomic trends as a starting point for analysis and stock
selection. Many styles use a combination of these approaches.
Debt Portfolio Attributes
Issuer Concentration
The debt market comprises broadly two segments, viz., Government securities market or G-
Sec market and corporate debt market. The latter is further classified as market for PSU
bonds and private sector bonds.
Maturity Profile
A bond fund maintains a weighted average maturity, which is the average of all the current
maturities of the bonds held in the fund. The longer the average maturity, the more sensitive
the fund tends to be to changes in interest rates. Also defines the weighted average maturity,
maximum and maturity for certain asset types like corporate bond, Gilts etc.
Credit quality
The overall credit quality of a bond fund will depend on the credit quality of the securities in
the portfolio. Bondi credit ratings can range from speculative—often referred to as high-yield
—to very high, generally referred to as investment-grade bonds. Funds that invest in lower-
quality securities can potentially deliver higher yields and returns, but will also likely
experience greater volatility, due to the fact that their interest payments and principal are at
greater risk.
The relative credit risk of a bond is reflected in ratings assigned by independent rating
companies such as CRISIL, ICRA, CARE, Fitch etc. These rating companies use a letter
scale to indicate their opinion of the relative credit risk of a bond, with the highest credit
rating being AAA.
Style
Growth Style
Growth investing entails looking for companies that have a potential to grow faster than
others. The optimism is reflected in the premium valuation commanded by the market price
of such companies. Typically, growth stocks have low dividend yields and above-average
valuations as measured by price-to-earnings (P/E), market capitalisation-to-sales and price-to-
book value ratios (P/B), reflecting the market's high expectations of superior growth. Growth
investors are more apt to subscribe to the efficient market hypothesis which maintains that the
current market price of a stock reflects all the currently knowable information about a
company and, so, is the most reasonable price for that stock at that given point in time. They
seek to enjoy their rewards by participating in what the growth of the underlying company
imparts to the growth of the price of its stock. Only aggressive investors, or those with
enough time to make up for short-term market losses, should buy these funds.
Value Style
A value investor, on the other hand, buys undervalued stocks that have a potential for
appreciation, but are usually ignored by the investing community. Value investors put more
weight on their judgments about the extent to which they think a stock is mispriced in the
marketplace. If a stock is underpriced, it is a good buy; if it is overpriced, it is a good sell.
They seek to enjoy their rewards by buying stocks that are depressed because their companies
are going through periods of difficulty; riding their prices upward, if, when, and as such
companies recover from those difficulties; and selling them when their price objectives are
reached. Value stocks usually have above-average dividend yields and low P/Es. Value funds
are most suitable for more conservative, tax-averse investors.
Know Your Fund Manager
Years of Experience
While experience isn't a 100% accurate predictor of future performance, in general, fund
managers who have been managing the same fund or same style for at least ten years on their
own tend to do win out. The longer the tenure, the better the performance, and a consistency
in results.
Performance Of Funds Managed
The aptitude and proficiency of a fund manager is what differentiates the top performing
funds from the worst ones. Investors must consider the past performance of the fund manager
before investing in a mutual fund. If a fund manager has recently joined an AMC, his
previous fund management experience should be evaluated. In the same category of funds,
say equity diversified, you should pick funds whose alpha values are greater than zero. This
is because the higher the value of alpha, the better is the performance of the fund manager.
MF Portfolio
Where to Find?
The 'Fact Sheet' is like a monthly report card that every mutual fund house publishes where
they provide key information about how various schemes are performing and where is the
money being deployed.
It is a useful update not only for existing investors but can also be helpful for new investors in
evaluating a fund house before they decide to invest.
The fact sheet will give a clear picture on where the money is being deployed.
How to Read Fact Sheet?
Fact Sheet is a monthly document which all mutual funds have to publish. This document
gives all details as regards the AUMs of all its schemes, top holdings in all the portfolios of
all the schemes, loads, minimum investment, performance over 1, 3, 5 years and also since
launch, comparison of scheme’s performance with the benchmark index (most mutual fund
schemes compare their performance with a benchmark index such as the Nifty 50) over the
same time periods, fund managers outlook, portfolio composition, expense ratio, portfolio
turnover, risk adjusted returns, equity/ debt split for schemes, YTM for debt portfolios and
other information which the mutual fund considers important from the investor’s decision
making point of view.
The Fact Sheet would consist of the following sections by which investors can evaluate the
schemes.
Investment Objective: The investment objective establishes whether the fund meets the
intended investment objective, i.e. for investing for growth, income or capital preservation.
Fund Index: The Index, also known as the Fund Benchmark, is an indicator of how the Fund
is performing relative to its peers. A benchmark is usually a predetermined set of securities
based on published indexes (Eg: S&P 500) or a customised set to suit the Fund's investment
strategy.
Dividend Information: Dividend is a share of a company's net profits distributed by the
company to a class of its stockholders. The dividend is paid in a fixed amount for each share
of stock held.
Net Asset Value: The net asset value per share usually represents the fund's market price,
subject to a possible sales or redemption charge. The term is used to describe the value of an
entity's assets less the value of its liabilities.
Total Expense Ratio: Total Expense Ratio (TER) is measuring the total costs of a fund
investment. Total costs may include various fees (trading, auditing) and other expenses. The
TER is calculated by dividing the total cost by the fund's total assets and is denoted as a
percentage. It may vary from year to year.
Graph: The graph depicts the performance of the fund relative to the fund benchmark since
inception.
Performance Table: This table depicts the performance of the Fund relative to the Fund
benchmark since inception and over a set of standard time periods.
Portfolio Composition: It provides the high level breakdown of the Fund's holdings into
Equity, Fixed Income & Cash. The Cash component shown may include Financial
Instruments with duration of less than 1 year.
Fund Characteristics: It is given in a tabular form summarizing characteristics of the
portfolio of investments held by the Fund. The table includes information on the Fund size,
the number of securities held by the Fund and statistics applicable to those securities. For
Equity Funds, the statistics shown include Price/ Earning Ratio and Price/Cash Flow Ratio,
wherever applicable. Fixed Income Funds show statistics relevant to the portfolio of fixed
income securities held by the Fund, including their Weighted Average Credit Quality. All
portfolio statistics are weighted averages relative to the size of the Fund's investment in the
security, where appropriate. Not all statistics are available for all securities or Funds because
of restrictions on data sourcing.
Top Holdings: The top 10 or all the holdings according to underlying fund exposure are
captured. This gives an indication of the broadness of the fund exposure.
Industry breakdown shows the investments made in various Industries.
Portfolio Management
Model Portfolio
There is no such thing as an ideal or model mutual fund portfolio that can suit need and risk
appetite of each and every individual. While there is no dearth of good mutual funds in the
market today, building a portfolio depends on preferences and objectives of each individual.
The factors that come into play include age of the investor, risk appetite, time at hand to let
investment grow, need for money- immediate or later – and more importantly, the purpose of
making such an investment.
Model portfolio can be constructed for four types of investors based on their risk-return
appetite, which are explained below:
Mutual Fund Model Portfolio

1) Aggressive: Aggressive investors tend to be risk lovers. They are willing to embrace risky
investments as their objective is to maximize returns in the long run. These investors seek
above average returns by focusing investment in stocks and certain types of mutual funds.
Such investors should invest in Small & Midcap Funds as they give above average return, yet
at the same time tend to be risky.
Small & Mid cap funds can add spice to ones portfolio, as mid cap stocks are future large cap
stocks. The growth of these small & mid cap funds will be much higher than the large cap
funds; however the risk is quite high.
2) Moderately Aggressive: Moderately aggressive investors usually have similar investment
objectives as aggressive investors. However, they are characterized by a lower risk tolerance
than aggressive investors. As such, the preference may be for equities (or mutual funds) or a
mix of both. Such investors should have their investments in Large/Bluechip funds and
Midcap Funds.
3) Moderately Conservative: Moderately conservative investors are willing to take on some
amount of risk but usually seek to balance this risk with investments that preserve the
principal investment. This means that these investors may invest in stocks but also seek a
constant income stream. For such investors, investing in Balanced Funds is the safest option.
Also they can park their funds in Large cap Funds or MIP for regular income stream.
Monthly income plans and balanced funds category of funds restrict the investment into
equity to minimum and have more allocation into debt instruments. The investment into debt
instruments provides stability to the portfolio, while the equity portion enables capital
appreciation.
4) Conservative: Conservative investors tend to be risk averse. They seek to preserve their
principal investment by avoiding risky investments. Therefore investments such as Debt
Funds/MIP that promise a constant income stream is preferred.
Fund Recommendation
Just as you would buy a mobile or any consumer durables that fits your needs and budget,
you should choose a mutual fund that meets your risk tolerance and your risk capacity levels
(i.e. has similar investment objectives as your own). Typical investment objectives of mutual
funds include fixed income or equity, general equity or sector-focused, high risk or low risk,
blue-chips or turnarounds, long-term or short-term liquidity focus.
You can read experts article on Investment in Mutual Funds to understand how best to find a
mutual fund to meet your needs and what other factors to consider while evaluating mutual
funds for investment.
An individual should work towards building a stable portfolio which includes large cap
funds to provide your portfolio required stability, funds with proven track record and maybe
some aggressive funds to spice up your portfolio.

Click here for adding Referrals.

Asset Allocation

Types of Asset classes

Risk Profiling

Types of Asset classes

Below is the list of different Asset classes one can consider for investing in Indian markets.
For a building a successful balanced portfolio once has to understand different asset classes
and as per their risk appetite, one has to build his/her portfolio so that its optimal from his
risk return point. In this post you will look at different asset classes and their sub categories
with their risk potential .This is not an exhaustive list of categories; however it covers most of
the things. See the Chart Below
Points to Remember
• The above chart does not contain exhaustive list of products and asset classes. See what is
Asset Allocation .
• REIT and REMF are yet to come to India, they are not there in market yet.
• Mutual funds classification is not complete. There are different ways to classify mutual
funds, the one I have shown is one of the way. Here is the list if good Equity Funds and Debt
oriented Mutual funds

Risk profiling

Risk profile indicates ability to take risk while investing. In financial markets, the risk profile
of an individual indicates his ability to take risk while investing. It is one of the important
variables that a financial planner will focus on before recommending a product to an investor.
Risk profile categorizes the individuals in various segments such as conservative, moderate
or aggressive. Wealth management services providers use psychometric questionnaires to
assess the risk profile of a client.

The questionnaires comprise queries on day-to-day situations. Generally, the individual

taking the test is told to choose one option that best describes his response to the situation out
of the multiple options provided along with the question. The responses help the financial
planners and wealth managers’ judge how the individual will react in a given situation. That
forms the basis of the individual's ability to take risks. The questionnaires thus minimize the
probability of any biases being introduced by wealth managers in the financial-planning
process. An individual taking the test should be honest while answering to the extent that he
should select an option that best describes him and not the one he thinks is the right option.

There are instances where the individuals get carried away by the environmental factor while
responding to the questionnaires. Peer pressure and market sentiment are some such factors
that influence the risk-profiling process. For example, an individual may appear to be a risk-
taker when the stock market is in an uptrend. But the same person may appear absolutely
risk-averse in times of falling stock markets. The changing moods of individuals thus make
risk-profiling a difficult process for wealth managers and financial planners. Other things
remaining the same, with rising age, an individual's ability to take risk goes down.

But there are instances that do not adhere to the observation. For example, a wealthy senior
citizen with no family liabilities may be comfortable investing in equities. To understand the
changes in the risk profile of an individual with rising age and changing asset liability
structure, wealth managers prefer to do risk-profiling almost every three years. Once the
financial planner decides the risk profile of an individual, he suggests him a financial plan,
taking into account his financial goals and the time horizon on hand. The financial plans
undergo changes with the changing risk profile of the individual.

Click here for adding Referrals.

Asset Allocation

Types of Asset classes

Risk Profiling
Types of Asset classes

Below is the list of different Asset classes one can consider for investing in Indian markets.
For a building a successful balanced portfolio once has to understand different asset classes
and as per their risk appetite, one has to build his/her portfolio so that its optimal from his
risk return point. In this post you will look at different asset classes and their sub categories
with their risk potential .This is not an exhaustive list of categories; however it covers most of
the things. See the Chart Below
Points to Remember
• The above chart does not contain exhaustive list of products and asset classes. See what is
Asset Allocation .
• REIT and REMF are yet to come to India, they are not there in market yet.
• Mutual funds classification is not complete. There are different ways to classify mutual
funds, the one I have shown is one of the way. Here is the list if good Equity Funds and Debt
oriented Mutual funds

Risk profiling

Risk profile indicates ability to take risk while investing. In financial markets, the risk profile
of an individual indicates his ability to take risk while investing. It is one of the important
variables that a financial planner will focus on before recommending a product to an investor.
Risk profile categorizes the individuals in various segments such as conservative, moderate
or aggressive. Wealth management services providers use psychometric questionnaires to
assess the risk profile of a client.

The questionnaires comprise queries on day-to-day situations. Generally, the individual

taking the test is told to choose one option that best describes his response to the situation out
of the multiple options provided along with the question. The responses help the financial
planners and wealth managers’ judge how the individual will react in a given situation. That
forms the basis of the individual's ability to take risks. The questionnaires thus minimize the
probability of any biases being introduced by wealth managers in the financial-planning
process. An individual taking the test should be honest while answering to the extent that he
should select an option that best describes him and not the one he thinks is the right option.

There are instances where the individuals get carried away by the environmental factor while
responding to the questionnaires. Peer pressure and market sentiment are some such factors
that influence the risk-profiling process. For example, an individual may appear to be a risk-
taker when the stock market is in an uptrend. But the same person may appear absolutely
risk-averse in times of falling stock markets. The changing moods of individuals thus make
risk-profiling a difficult process for wealth managers and financial planners. Other things
remaining the same, with rising age, an individual's ability to take risk goes down.

But there are instances that do not adhere to the observation. For example, a wealthy senior
citizen with no family liabilities may be comfortable investing in equities. To understand the
changes in the risk profile of an individual with rising age and changing asset liability
structure, wealth managers prefer to do risk-profiling almost every three years. Once the
financial planner decides the risk profile of an individual, he suggests him a financial plan,
taking into account his financial goals and the time horizon on hand. The financial plans
undergo changes with the changing risk profile of the individual.

Click here for adding Referrals.

Futures & Options (F&O)

INTRODUCTION

Derivative
Application of Financial Derivatives
Potential Pitfalls of derivatives
Types of derivative
F&O - Important terminologies

UNDERSTANDING MARGINS
Customer Margin
Types of Margins levied in the Futures & Options (F&O) trading

OPTION STRATEGIES:
Single Options
Long Call
Synthetic Short Call
Long Put
Short Put
Bull call spread
Bull Put Spread
Bear Put Spread
Bear Call Spread
Straddles
Long straddle
Short straddle
Strangles
Long strangle
Short strangle

Derivative

A derivative is a financial instrument that derives or gets it value from some real good or
stock (underlying asset). It is in its most basic form simply a contract between two parties to
exchange value based on the action of a real good or service. Common examples of
underlying assets are stocks, bonds, corn, pork, wheat, rainfall, etc.

When one enters into a derivative product arrangement, the medium and rate of repayment
are specified in detail. For instance, repayment may be in currency, securities or a physical
commodity such as gold or silver. Similarly, the amount of repayment may be tied to
movement of interest rates, stock indexes or foreign currency.

Application of Financial Derivatives

Risk Management

Risk management is not about the elimination of risk rather it is about the management of
risk. Financial derivatives provide a powerful tool for limiting risks that individuals and
organizations face in the ordinary conduct of their businesses. Successful risk management
with derivatives requires a thorough understanding of the principles that govern the pricing of
financial derivatives. Used correctly, derivatives can save costs and increase returns.

Trading Efficiency
Derivatives allow for the free trading of individual risk components, thereby improving
market efficiency. Traders can use a position in one or more financial derivatives as a
substitute for a position in the underlying instruments. In many instances traders find
financial derivatives to be a more attractive instrument than the underlying security. Reason
being, the greater amount of liquidity in the market offered by the financial derivatives and
lower transaction costs associated with trading a financial derivative as compared to the costs
of trading the underlying instrument.

Speculation

Serving as a speculative tool is not the only use, and probably not the most important use, of
financial derivatives. Financial derivatives are considered to be risky. However, these
instruments act as a powerful instrument for knowledgeable traders to expose themselves to
properly calculated and well understood risks in pursuit of a reward i.e. profit.

Potential Pitfalls of derivatives

The concept of derivatives is a good one. However, irresponsible use by those in the financial
industry can put investors in danger. Famed investor Warren Buffet actually referred to them
as “instruments of mass destruction” (although he also feels many securities are mislabeled as
derivatives). Investors considering derivatives should be wary of the following:

Volatile Investments: Most derivatives are traded on the open market. This is problematic
for investors, because the security fluctuates in value. It is constantly changing hands and the
party who created the derivative has no control over who owns it. In a private contract, each
party can negotiate the terms depending on the other party’s position. When a derivative is
sold on the open market, large positions may be purchased by investors who have a high
likelihood to default on their investment. The other party can’t change the terms to respond to
the additional risk, because they are transferred to the owner of the new derivative. Due to
this volatility, it is possible for them to lose their entire value overnight.

Overpriced Options: Derivatives are also very difficult to value because they are based off
other securities. Since it’s already difficult to price the value of a share of stock or any other
underlying asset, it becomes that much more difficult to accurately price a derivative based
on that stock or any other underlying asset. Moreover, because the derivatives market is not
as liquid as the stock market, and there aren’t as many “players” in the market to close them,
there are much larger bid-ask spreads.

Time Restrictions: Possibly the biggest reason derivatives are risky for investors is that they
have a specified contract life. After they expire, they become worthless. If your investment
bet doesn’t work out within the specified time frame, you will be faced with a 100% loss.

Potential Scams: Many people have a hard time understanding derivatives. Scam artists
often use derivatives to build complex schemes to take advantage of both amateur and
professional investors.
Types of derivative

Forward Contracts
These are the simplest form of derivative contracts. A forward contract is an agreement
between parties to buy/sell a specified quantity of an asset at a certain future date for a certain
price. One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset at a certain future date for a certain price. The other party to the contract
assumes a short position and agrees to sell the asset on the same date for the same price. The
specified price is referred to as the delivery price. The contract terms like delivery price and
quantity are mutually agreed upon by the parties to the contract. No margins are generally
payable by any of the parties to the other.

Futures contracts

A futures contract is one by which one party agrees to buy from / sell to the other party at a
specified future time, a specified asset at a price agreed at the time of the contract and
payable on maturity date. The agreed price is known as the strike price. The underlying asset
can be a commodity, currency, debt or equity security etc. Unlike forward contracts, futures
are usually performed by the payment of difference between\ the strike price and the market
price on the fixed future date, and not by the physical delivery and the payment in full on that
date.

Forward Contract Future Contract

 Each contract is custom designed, and  Standardized contract terms viz. the
hence is unique in terms of contract size, underlying asset, the time of maturity and
maturity date and the asset type and the manner of maturity etc.,
quality,

 On the expiration date, the contract is  Cash Settled

normally settled by the delivery of the
asset,

 Forward contracts being bilateral contracts  Traded through an organized exchange

are exposed to counter party risk, and If and thus have greater liquidity. Existence
the party wishes to cancel the contract or of a regulatory authority & the
change any of its terms, it has clearinghouse, being the counter party to
necessarily to go to the same counter both sides of a transaction, provides a
party. mechanism that guarantees the
honouring of the contract and ensuring
very low level of default. Margin
requirements and daily settlement to act
as further safeguard.

Types of Future Contracts

Common types of ‘futures contracts’ are stock index futures, currency futures, and interest
futures depending on their underlying assets.

Index Futures
Index Futures are future contracts where the underlying asset is the Index. This is of great
help when one wants to take a position on market movements. Suppose you feel that the
markets are expected to rise and say the Sensex would cross 5,000 points. Instead of buying
shares that constitute the Index you can buy the market by taking a position on the Index
Future.
Currency Futures

Currency futures

Currency futures are contracts to buy or sell a specific underlying currency at a specific time
in the future, for a specific price. Currency futures are exchange-traded contracts and they are
standardized in terms of delivery date, amount and contract terms. Currency Futures have a
minimum contract size of 1000 foreign underlying currency (i.e. US$1000). Currency future
contracts allow investors to hedge against foreign exchange risk. Since these contracts are
marked-to-market daily, investors can--by closing out their position--exit from their
obligation to buy or sell the currency prior to the contract's delivery date.

Interest Futures

Interest rate futures (IRF) is a standardized derivative contract traded on a stock exchange to
buy or sell an interest bearing instrument at a specified future date, at a price determined at
the time of the contract. The interest rate future allows the buyer and seller to lock in the
price of the interest-bearing asset for a future date. IRFs can be on underlying as may be
specified by the Exchange and approved by SEBI from time to time and it can be based on: 1)
Treasury Bills in the case of Treasury Bill Futures traded; 2) Treasury Bonds in the case of
Treasury Bond Futures traded; 3) other products such as CDs, Treasury Notes are also
available to trade as underlying assets in an interest rate future. Because interest rate futures
contracts are large in size (i.e. $1 million for Treasury Bills), they are not a product for the
less sophisticated trader.
Determination of Future Prices

The price of the futures refers to the rate at which the futures contract will be entered into.
The basic determinants of futures price are spot rate and other carrying costs. In order to find
out the futures prices, the costs of carrying are added / deducted to the spot rate. The costs of
carrying depend upon the time involved and rate of interest and other factors. On the
settlement date, the futures price would be the spot rate itself. However, before the settlement
day, the futures price may be more or less than the prevailing spot rate. In case, the demand
for future is high, the buyer of futures will be required to pay a price higher than the spot rate
and the additional charge paid is known as the contango charge. However, if the sellers are
more, the futures price may be lower than the spot rate and the difference is known as
backwardation. For example, with reference to the Stock Index Futures, the pricing would be
such that the investors are indifferent between owning the share and owning a futures
contract. The price of stock index futures should equate the price of buying and carrying such
shares from the share settlement date to the contract maturity date. The financing cost of
buying the shares would generally be more than the dividend yield. This means that there is a
cost of carrying the shares purchased. So, the price of a futures contract will be higher than
the price of the shares.

The carrying cost of Stock Index Futures may be written as:

Index value X (Financing Cost – Dividend yieldi) X t

Where t is the time period from share settlement date to the maturity date of the futures
contract.

For example, if the Index level is 4500, rate of interest (financing cost is 12%), the dividend
yield is 4% and the futures contract is for a period of 4 months, the carrying cost in terms of
basic points is:
Carrying cost = 4500 (12% – 4%) X 4/12 = 120 basis points.

The value of the futures contract is 4500 + 120 = 4620 points for a period of 4 months.

Swaps

A swap can be defined as a barter or exchange. A swap is a contract whereby parties agree to
exchange obligations that each of them have under their respective underlying contracts or
we can say a swap is an agreement between two or more parties to exchange sequences of
cash flows over a period in the future. The parties that agree to the swap are known as
counter parties. There are two basic kinds of swaps - 1) Interest rate swaps and 2) Currency
swaps.

An interest rate swap contract involves an exchange of cash flows related to interest
payments, or receipts, on a notional amount of principal, that is never exchanged, in one
currency over a period of time. Settlements are often made through net cash payments by one
counterparty to the other.

Currency swap/Foreign exchange swap contracts involve a spot sale/purchase of currencies

and a simultaneous commitment to a forward purchase/sale of the same currencies.
Option Contracts

The literal meaning of the word ‘option’ is ‘choice’ or we can say ‘an alternative for choice’.
In derivatives market also, the idea remains the same. An option contract gives the buyer of
the option a right (but not the obligation) to buy / sell the underlying asset at a specified price
on or before a specified future date. As compared to forwards and futures, the option holder is
not under an obligation to exercise the right. Another distinguishing feature is that, while it
does not cost anything to enter into a forward contract or a futures contract, an investor must
pay to the option writer to purchase an option contract. The amount paid by the buyer of the
option to the seller of the option is referred to as the premium. For this reward i.e. the option
premium, the option seller is under an obligation to sell / buy the underlying asset at the
specified price whenever the buyer of the option chooses to exercise the right.

Option contracts having simple standard features are usually called plain vanilla contracts.
Contracts having non-standard features are also available that have been created by financial
engineers. These are called exotic derivative contracts. These are generally not traded on
exchanges and are structured between parties on their own. The final difference between
exotic options and regular options has to do with how they trade. Regular options consist of
calls and puts and can be found on major exchanges such as the Chicago Board Options
Exchange. Exotic options are mainly traded over the counter, which means they are not
listed on a formal exchange, and the terms of the options are generally negotiated by
brokers/dealers and are not normally standardized as they are with regular options.
Moneyness of an Option:

Options can also be characterised in terms of their moneyness.

I. An in-the-money option is one that would lead to a positive cash flow to the buyer of the
option if the buyer of the option exercises the option at the current market price.

II. An at-the-money option is one that would lead to a zero cash flow to the buyer of the
option if the buyer of the option exercises the option at the current market price.

III. An out-of-the-money option is one that would lead to a negative cash flow to the buyer of
the option if the buyer of the option exercises the option at the current market price.

Call Optioni Put Optioni

In-the-money M>E M<E

At-the-money M=E M=E

Out-of-the-money M<E M>E

Where M is the prevalent market price for the option contract, and E is the exercise price of the option
contract. For a seller / writer of the option the >, < signs will reverse.

F&O - Important terminologies

Call Option : A call option gives the buyer of the option the right (but not the obligation) to buy the
underlying asset on or before a certain future date for a specified price.
Put Option: A put option gives the buyer of the option the right (but not the obligation) to sell the
underlying asset on or before a certain future date for a specified price.
American Option : An american option can be exercised at any time upto the expiration date. Most
of the option contracts traded on exchanges are of the type of american option.
European Option: A European option can be exercised only on the expiration date itself.
Strike Pricei or Exercise Price - The strike or exercise price of an option is the specified/ pre-
determined price of the underlying asset at which the same can be bought or sold if the option buyer
exercises his right to buy/ sell on or before the expiration day.
Option Premiumi - Premium is the price paid by the buyer to the seller to acquire the right to buy or
sell.
Expiration date - The date on which the option expires is known as Expiration Date. On Expiration
date, either the option is exercised or it expires worthless.
Exercise Date – is the date on which the option is actually exercised. In case of European Options
the exercise date is same as the expiration date while in case of American Options, the options
contract may be exercised any day between the purchase of the contract & its expiration date (see
European/ American Option)
Open Interest - The total number of options contracts outstanding in the market at any given point of
time.
Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the right
to buy or sell the underlying asset at a specified price on or before specified time. His upside potential
is unlimited while losses are limited to the Premium paid by him to the option writer.
Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case of
call option), the underlying asset in case the buyer of the option decides to exercise his option. His
profits are limited to the premium received from the buyer while his downside is unlimited.
Option Class: All listed options of a particular type (i.e., call or put) on a particular underlying
instrument, e.g., all Sensex Call Options (or) all Sensex Put Options
Option Series: An option series consists of all the options of a given class with the same expiration
date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options
that are traded with Strike Price of 3600 & Expiry in May.
Underlying: The specific security / asset on which an options contract is based.
Contract multiplier : The contract multiplier for Sensex Futures is 50 and for Sensex Options is 100.
This means that the Rupee value of a Sensex futures contract would be 50 times the contracted value
and in case of Sensex Options, the rupee value would be 100 times the contracted value. The
following table gives a few examples of this notional value.
Ticket Size : The tick size is "0.1" for Sensex Futures. This means that the minimum price fluctuation
in the value of a future can be only 0.1. In Rupee terms, this translates to minimum price fluctuation of
Rs. 5 (Tick size X Contract Multiplier = 0.1 X Rs. 50). Likewise, the tick size is “0.05” for Nifty
Futures.Margin in F&O trading
Margin in F&O trading
Customer margin
Within the futures industry, financial guarantees required of both buyers and sellers of futures
contracts and sellers of options contracts to ensure fulfillment of contract obligations. Margins are
determined on the basis of market risk and contract value also referred to as performance bond
margin.
For example let’s say there are three parties X (Buyer i), Y (Selleri) and Z (Broker), X is interested in
buying a futures contract for Rs 100 as he thinks its price would go up by the settlement date, Y, on
the other hand, wants to sell the futures contract for Rs 100 as he thinks its price will go down by the
settlement date. And Z is the broker who will be executing the deal on behalf of investors X & Y.
Since, derivative trading is about taking a ‘call’ on the upward and downward movement of the price of
an underlying and not the absolute or actual price of the total contract, the Stock Exchange has to be
hedged by investors (X & Y) to the extent of the expected margin of loss that the investor might incur
with broker (‘Z’) acting as a mediator between investors and exchange.
For example in the case illustrated, where the cost of futures is Rs 100, in all likelihood its value would
go up or down by say Rs 10 either way by the settlement date based on expected volatility which is
calculated mathematically. Hence the margin money sought by the Exchange through the broker from
either party would be 10% of the total value (Rs.10 in the given example).
Now let’s say by the settlement date, the scrip would be valued at Rs. 108. This means ‘X’ would
have made a profit of Rs 8 while ‘Y’ would have incurred a loss of Rs. 8. The broker hence credits the
investor ‘X’s account by Rs 8 along with the margin money of Rs 10. Hence in total ‘X’ receives Rs
18. On the other hand ‘Y’ who has incurred a loss will debit Rs. 8 from his margin money which was
with the broker and the remaining Rs. 2 will be transferred to the investor’s account.
Therefore the “funding” that goes to the broker to execute derivative deals is called “Margin Funding”
or “Margin Money”.
Types of Margins levied in the Futures & Options (F&O) trading
Margins on both Futures and Options contracts comprise of the following: 1) Initial Margin & 2)
Exposure margin. In addition to these margins, in respect of options contracts the following additional
margins are collected 1) Premium Margin & 2) Assignment Margin.
Initial margin
The futures/option contract specifies a trade taking place in the future, the purpose of the futures
exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the
exchange requires both parties to put up an initial amount of cash which is called margin. Initial
margin for each contract is set by the Exchange. Exchange has the right to vary initial margins at its
discretion, either for the whole market or for individual members
The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller
have to deposit margins. The initial margin is deposited before the opening of the day of the Futures
transaction.
Initial margin for F&O segment is calculated on a portfolio (a collection of futures and option positions)
based approach. The margin calculation is carried out using a software called – SPAN (Standard
Portfolioi Analysis of Risk). It is a product developed by Chicago Mercantile Exchange (CME) and is
extensively used by leading stock exchanges of the world. SPAN uses scenario based approach to
arrive at margins. Value of futures and options positions depend on, among others, price of the
security in the cash market and volatility of the security in cash market. It is agreed that both price and
volatility keep changing.
To put it simply, SPAN generates about 16 different scenarios by assuming different values to the
price and volatility. For each of these scenarios, possible loss that the portfolio would suffer is
calculated. The initial margin required to be paid by the investor would be equal to the highest loss the
portfolio would suffer in any of the scenarios considered. The margin is monitored and collected at the
time of placing the buy / sell order.
The SPAN margins are revised 6 times in a day - once at the beginning of the day, 4 times during
market hours and finally at the end of the day. Obviously, higher the volatility, higher the margins.
Exposure margin
In addition to initial margin, exposure margin is also collected. Exposure margins in respect
of index futures and index option sell positions is 3% of the notional value. For futures on
individual securities and sell positions in options on individual securities, the exposure
margin is higher of 5% or 1.5 standard deviation of the LN returns of the security (in the
underlying cash market) over the last 6 months period and is applied on the notional value of
position.
Premium and Assignment margins
The premium margin is an amount arrived by multiplication of value of option premium with
that of option quantity and is charged to buyers of option contracts. For example, if 1000 call
options on ABC Ltd are purchased at Rs. 20/-, and the investor has no other positions, then
the premium margin is Rs. 20,000. The margin is to be paid at the time trade. Assignment
Margin is collected on assignment from the sellers of the contracts.
Others
Variation margin
Additionally, since the futures price will generally change daily, the difference in the prior
agreed-upon price and the daily futures price is settled daily also (variation margin). The
exchange will draw money out of one party's margin account and put it into the others so that
each party has the appropriate daily loss or profit.
Mark-to-market (MTM)
If the margin account goes below a certain value, then a margin call is made and the account
owner must replenish the margin account. This process is known as marking to market. Thus
on the delivery date, the amount exchanged is not the specified price on the contract but the
spot value (since any gain or loss has already been previously settled by marking to market).
Additional Margin
In case of sudden higher than expected volatility, additional margin may be called for by the
exchange. This is generally imposed when the exchange fears that the markets have become
too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive
move by exchange to prevent breakdown.
Clearingi margin
Clearing margin are financial safeguards to ensure that companies or corporations perform on
their customers' open futures and options contracts. Clearing margins are distinct from
customer margins that individual buyers and sellers of futures and options contracts are
required to deposit with brokers.
Maintenance margin
A set minimum margin per outstanding futures contract that a customer must maintain in his
margin account.
Option Strategies:
Single Options

Long Call:
The long call option strategy is the most basic option trading strategy whereby the options trader buy
call options with the belief that the price of the underlying security will rise significantly beyond the
strike price before the option expiration date. Compared to buying the underlying shares outright, the
call option buyer is able to gain leverage since the lower priced calls appreciate in value faster
percentage wise for every point rise in the price of the underlying stock.
However, call options have a limited lifespan. If the underlying stock price does not move above the
strike price before the option expiration date, the call option will expire worthless.
 Maximum Profit = Unlimited
 Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid
 Profit = Price of Underlying - Strike Price of Long Call - Premium Paid
 Max Loss = Premium Paid + Commissions Paid
 Max Loss Occurs When Price of Underlying <= Strike Price of Long Call.
 Breakeven Point = Strike Price of Long Call + Premium Paid
Summary:

Long Call
A strong, upward move in the underlying asset is
Anticipations anticipated.
Characteristics Unlimited profit / limited loss.
Max profit - Unlimited.
Price of Underlying - Strike Price of Long Call -
Max profit formula Premium Paid
Limited to the net debit required to establish the
Max loss position.
Max loss formula Premium Paid + Commissions Paid
Breakeven Strike Price of Long Call + Premium Paid

Synthetic Short Call:

A synthetic short call is created when short stock position is combined with a short put of the same
series. The synthetic short call is so named because the established position has the same profit
potential a short call.
 Max Profit = Premium Received - Commissions Paid
 Max Profit Achieved When Price of Underlying <= Strike Price of Short Put
 Maximum Loss = Unlimited
 Loss Occurs When Price of Underlying > Sale Price of Underlying + Premium Received
 Loss = Price of Underlying - Sale Price of Underlyingl - Premium Received + Commissions
Paid.
 Breakeven Point = Sale Price of Underlying + Premium Received
Summary:

Synthetic Short Call

Anticipations A downward move in the underlying asset is anticipated.
Characteristics Limited profit / unlimited loss.
Max profit - Limited to the net credit received.
Max profit formula Premium Received - Commissions Paid
Max loss Unlimited.
Price of Underlying - Sale Price of Underlying - Premium
Max loss formula Received + Commissions Paid.
Breakeven Sale Price of Underlying + Premium Received
Long Put:
The long put option strategy is a basic strategy in options trading where the investor buy put options
with the belief that the price of the underlying security will go significantly below the striking price
before the expiration date.
 Maximum Profit = Unlimited
 Profit Achieved When Price of Underlying = 0
 Profit = Strike Price of Long Put - Premium Paid
 Max Loss = Premium Paid + Commissions Paid
 Max Loss Occurs When Price of Underlying >= Strike Price of Long Put.
 Breakeven Point = Strike Price of Long Put - Premium Paid
Summary:

Long Put
A strong, downward move in the underlying asset
Anticipations is anticipated.
Characteristics Unlimited profit / limited loss.
Max profit - Unlimited.
Max profit
formula Strike Price of Long Put - Premium Paid
Limited to the net debit required to establish the
Max loss position.
Max loss formula Premium Paid + Commissions Paid
Breakeven Strike Price of Long Put - Premium Paid

Short Put:
 Short Put is sometimes known as a Put Write, Naked Put, Write Put, or Uncovered Put Write.

Maximum Gain: Limited to the premium received for selling the put option.

 Maximum Loss: Unlimited in a falling market.

 Breakeven = Strike Price - premium value of put options sold.
Summary:

Short Put
An upward move in the underlying asset is
Anticipations anticipated.
Characteristics Limited profit / unlimited loss.
Max profit - Limited to the net credit received.
Max profit formula
Max loss Unlimited in a falling market
Max loss formula
Breakeven Strike Price - premium value of put options sold.

Bull call spread:

An options strategy that involves purchasing call options at a specific strike price while also selling the
same number of calls of the same asset and expiration date but at a higher strike. A bull call spread is
used when a moderate rise in the price of the underlying asset is expected.
 Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid -
Commissions Paid
 Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
 Max Loss = Net Premium Paid + Commissions Paid
 Max Loss Occurs When Price of Underlying <= Strike Price of Long Call
 Breakeven Point = Strike Price of Long Call + Net Premium Paid
Summary:
Bull Call Spread ( Bull Debit Spread )
An upward move in the underlying asset, but the extent of
Anticipations
the move is uncertain.
Characteristics Limited profit / limited loss.
Difference between the strike prices less net debit of
Max profit -
spread.
Strike Price of Short Call - Strike Price of Long Call - Net
Max profit formula
Premium Paid - Commissions Paid

Max loss Limited to the net debit required to establish the position.

Max loss formula Net Premium Paid + Commissions Paid

Breakeven Strike Price of Long Call + Net Premium Paid

Bull Put Spread:

This strategy is constructed by purchasing one put option while simultaneously selling another put
option with a higher strike price. A type of options strategy that is used when the investor expects a
moderate rise in the price of the underlying asset.
The goal of this strategy is realized when the price of the underlying stays above the higher strike
price, which causes the short option to expire worthless, resulting in the trader keeping the premium.
 Max Profit = Net Premium Received - Commissions Paid
 Max Profit Achieved When Price of Underlying >= Strike Price of Short Put
 Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium Received +
Commissions Paid
 Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
 Breakeven Point = Strike Price of Short Put - Net Premium Received
Summary:
Bull Put Spread ( Bull Credit Spread )
An upward move in the underlying asset, but the extent of
Anticipations
the move is uncertain.
Characteristics Limited profit / limited loss.
Max profit - Limited to the net credit received
Max profit formula Net Premium Received - Commissions Paid

Max loss difference between the strike prices less net credit received
Strike Price of Short Put - Strike Price of Long Put Net
Max loss formula
Premium Received + Commissions Paid
Breakeven Strike Price of Short Put - Net Premium Received

Bear Put Spread:

Bear Put Spread is achieved by purchasing put options at a specific strike price while also selling the
same number of puts at a lower strike price. A type of options strategy used when an option trader
expects a decline in the price of the underlying asset.
 Maximum Profit: High strike - low strike - net premium paid
 Maximum Loss: Net premium paid
 Breakeven = long put strike - net debit paid
Bear Debit Spread ( Bear Put Spread )
A downward move in the underlying asset, but the extent of
Anticipations
the move is uncertain.
Characteristics Limited profit / limited loss.
Limited to difference between the strike prices less net
Max profit -
debit of the spread.
Max profit formula High strike - low strike - net premium paid

Max loss Limited to the net debit required to establish the position

Max loss formula Net premium paid

Breakeven long put strike - net debit paid

Bear Call Spread:

It is achieved by selling call options at a specific strike price while also buying the same number of
calls, but at a higher strike price. A type of options strategy used when a decline in the price of the
underlying asset is expected.
 Max Profit = Net Premium Received - Commissions Paid
 Max Profit Achieved When Price of Underlying <= Strike Price of Short Call
 Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received +
Commissions Paid
 Max Loss Occurs When Price of Underlying >= Strike Price of Long Call
 Breakeven Point = Strike Price of Short Call + Net Premium Received
Summary:
Bear Credit Spread ( Bear Call Spread )
A downward move in the underlying asset, but the extent of
Anticipations
the move is uncertain.
Characteristics Limited profit / limited loss.
Max profit - Limited to the net credit received.
Max profit formula Net Premium Received - Commissions Paid
Difference between the strike prices less net credit
Max loss
received.
Strike Price of Long Call - Strike Price of Short Call - Net
Max loss formula
Premium Received + Commissions Paid
Breakeven Strike Price of Short Call + Net Premium Received
Straddles:
Long straddle:
A strategy of trading options whereby the trader will purchase a long call and a long put with the same
underlying asset, expiration date and strike price. The strike price will usually be at the money or near
the current market price of the underlying security. The strategy is a bet on increased volatility in the
future as profits from this strategy are maximized if the underlying security moves up or down from
present levels. Should the underylying security's price fail to move or move only a small amount, the
options will be worthless at expiration.
 Maximum Profit: Unlimited
 Maximum Loss: Premiums paid
  Breakeven: This strategy breaks even if, at expiration, the stock price is either above or below
the strike price by the amount of premium paid. At either of those levels, one option's intrinsic
value will equal the premium paid for both options while the other option will be expiring
worthless.
 Upside breakeven = strike + premiums received
 Downside breakeven = strike - premiums received
Summary:
Long Straddle ( Straddle Purchase )

A very volatile, immediate, and sharp swing in the price of

the underlying asset is expected. The actual market
Anticipations
direction is uncertain, so the positions of this strategy will
benefit if the underlying asset either rises or falls.

Characteristics Unlimited profit / limited loss.

Max profit Unlimited.
Max profit formula

Max loss Limited to the net debit required to establish the position.

Max loss formula Premiums paid

Upside breakeven = strike + premiums received
Breakeven
Downside breakeven = strike - premiums received
Short straddle:
An options strategy carried out by holding a short position in both a call and a put that have the same
strike price and expiration date. The maximum profit is the amount of premium collected by writing the
options.
 Max Profit = Net Premium Received - Commissions Paid
 Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put
 Maximum Loss = Unlimited
 Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received
OR Price of Underlying < Strike Price of Short Put - Net Premium Received
 Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price
of Short Put - Price of Underlying - Net Premium Received + Commissions Paid
Breakeven Point(s): There are 2 break-even points for the short straddle position. The breakeven
points can be calculated using the following formulae.
 Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
 Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Summary:
Short Straddle ( Straddle Write )
This market outlook anticipates very little movement in the
Anticipations
underlying asset.
Characteristics Limited profit / unlimited loss.
Max profit - Limited profit / unlimited loss.
Max profit formula Net Premium Received - Commissions Paid
Max loss Unlimited.

Price of Underlying - Strike Price of Short Call - Net

Max loss formula Premium Received OR Strike Price of Short Put - Price of
Underlying - Net Premium Received + Commissions Paid

Upper Breakeven Point = Strike Price of Short Call + Net

Premium Received
Breakeven
Lower Breakeven Point = Strike Price of Short Put - Net
Premium Received
Strangles
Long strangle:
The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in options
trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-
the-money call of the same underlying stock and expiration date. The long options strangle is an
unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying
stock will experience significant volatility in the near term.
 Maximum Profit = Unlimited
 Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR
Price of Underlying < Strike Price of Long Put - Net Premium Paid
 Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of
Long Put - Price of Underlying - Net Premium Paid
 Max Loss = Net Premium Paid + Commissions Paid
 Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike
Price of Long Put.
Breakeven Point(s): There are 2 break-even points for the long strangle position. The breakeven
points can be calculated using the following formulae.
 Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
 Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Summary:
Long Strangle ( Strangle Purchase )

A very volatile, immediate, and sharp swing in the price of

the underlying asset is expected. The actual market
direction is uncertain, so the positions of this strategy will
Anticipations
benefit if the underlying asset either rises or falls, direction
is uncertain, so the positions of this strategy will benefit if
the underlying asset either rises or falls.

Characteristics Unlimited profit / limited loss.

Max profit - Unlimited.
Price of Underlying - Strike Price of Long Call - Net
Max profit formula Premium Paid OR Strike Price of Long Put - Price of
Underlying - Net Premium Paid

Max loss Limited to the net debit required to establish the position

Max loss formula Net Premium Paid + Commissions Paid

Upper Breakeven Point = Strike Price of Long Call + Net
Premium Paid
Breakeven
Lower Breakeven Point = Strike Price of Long Put - Net
Premium Paid

Short strangle:
The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the
simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same
underlying stock and expiration date. The short strangle option strategy is a limited profit, unlimited
risk options trading strategy that is taken when the options trader thinks that the underlying stock will
experience little volatility in the near term.
 Max Profit = Net Premium Received - Commissions Paid
 Max Profit Achieved When Price of Underlying is in between the Strike Price of the Short Call
and the Strike Price of the Short Put
 Maximum Loss = Unlimited
 Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received
OR Price of Underlying < Strike Price of Short Put - Net Premium Received
 Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price
of Short Put - Price of Underlying - Net Premium Received + Commissions Paid
Breakeven Point(s): There are 2 break-even points for the short strangle position. The breakeven
points can be calculated using the following formulae.
 Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
 Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Summary:
Short Strangle ( Strangle Write )
This market outlook anticipates little movement in the
Anticipations
underlying asset.
Characteristics Limited profit / unlimited loss.
Max profit - Limited to the net credits received.
Max profit formula Net Premium Received - Commissions Paid
Max loss Unlimited

Price of Underlying - Strike Price of Short Call - Net

Max loss formula Premium Received OR Strike Price of Short Put - Price of
Underlying - Net Premium Received + Commissions Paid

Upper Breakeven Point = Strike Price of Short Call + Net

Premium Received
Breakeven
Lower Breakeven Point = Strike Price of Short Put - Net
Premium Received
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Technical Analysis

Critics of Technical Analysis

Importance of supports and resistance
Interpreting volumes on a chart
Golden Mean Ratio
Importance of chart
FIBONACCI RETRACEMENTS

Critics of technical analysis

Though used widely into investment research and trading advisory business, technical
analysis has its skeptics. The wide range of technical indicators along with diverse prognosis
of the chart patterns makes it more of an art than a science. Exact and accurate prognosis of a
particular chart formation is a difficult activity as the judgment of the formation is
subjective. Even if the chartist is well versed with the underlying dynamics in a formation,
there is a possibility that the inference he or she might have drawn using his skills could not
turn out to be true. However, due to increased volatility in the financial markets following the
boom in information technology, charts are becoming quite a popular mode of analyzing
pricing action in the financial markets. Despite the numerous critics against Technicians, it is
a well-known fact that the popularity of charting analysis is increasing day by day.

Importance of supports and resistance

Supports and resistance are two of the most critical aspects in a trade set up. The importance
of these two corresponding dynamics could be underlined by the fact that any primary
technical study or a combination of indicators eventually intends to arrive at supports and
resistances for the underlying security. In simple terms, support is the level at which the
security is expected to witness buying, thereby cushioning its fall while resistance is the level
at which the security is expected to witness selling, ensuring that the price does not rise above
the levels of resistance. The basic tops and bottoms formation is the simplest way to arrive at
the supports or resistances on any price chart. The other studies for arriving at the supports
and resistances are Pivot Points, Fibbonaci Ratio, moving averages and long-term trendlines.

Interpreting volumes on a chart

Volumes could have a sizable bearing on chart. At times, analyzing price moves in
conjunction with the movement in volumes on the security could give an exact and accurate
idea in terms of identifying key reversal points. If the security is witnessing a massive surge
in volumes at a particular point of price, there may be chances that a substantial chunk of the
market participants believe that point in price to be a critical support level. At times the
volumes tend to surge after prices successfully breach a critical level and tend trade above it.
This magnifies the importance of volumes as an indicator of the crowd psychology.

Golden Mean Ratio

The Golden mean, represented by the Greek letter phi, is one of those mysterious natural
numbers, like e or pi, that seem to arise out of the basic structure of our cosmos. Unlike those
abstract numbers, however, phi appears clearly and regularly in the realm of things that grow
and unfold in steps, and that includes living things.

There is a special ration that can be used to describe the proportions of everything from
nature's smallest building blocks, such as atoms, to the most advanced patterns in the
universe, such as unimaginably large celestial bodies. Nature relies on this innate proportion
to maintain balance, but the financial markets also seem to conform to this 'golden ratio.' It's
derived from something known as the Fibonacci sequence, named after its Italian founder,
Leonardo Fibonacci (whose birth is assumed to be around 1175 AD and death around 1250
AD). Each term in this sequence is simply the sum of the two preceding terms (1, 1, 2, 3, 5, 8,
13, etc.).

But this sequence is not all that important; rather, it is the quotient of the adjacent terms that
possesses an amazing proportion, roughly 1.618, or its inverse 0.618. This proportion is
known by many names: the golden mean, PHI and the divine proportion, among others. So,
why is this number so important? Well, almost everything has dimensional properties that
adhere to the ratio of 1.618, so it seems to have a fundamental function for the building
blocks of nature.
Importance of chart

There is a particular reason why charts have assumed significant importance in the realms of
financial market research and analysis over the last couple of decades. One of the major
reasons for this was the widespread boom in the information technology during the 1990’s
that facilitated the use of charting softwares and also contributed to an increased awareness
about the use of charts as an efficient indicator to track the financial markets. Also, given the
increased boom in financial reporting and the penetration of financial medias in emerging
economies, market movements across the world became much more “responsive” to micro
trends in seemingly unrelated sectors and segments in global economy. Therefore, as the
news flow increased multifold, the most reliant indicator as to where the prices are moving
turned out to be the price itself. We can say that the rapid boom in global news networks and
the rise of the social media blurred the lines between the nations and financial markets around
the world started reflecting generalized sentiments in world asset markets. The information
revolution in last two decades as put the focus right back onto one of the basics of technical
analysis – the most critical indicator of where the prices are moving is the price itself.

FIBONACCI RETRACEMENTS

Fibonacci sequences are generally meant to find out reversals in charts. The main area to look
for in a chart with Fibonacci retracements is to find corrections or pullbacks. In simple words,
the basic purpose of these retracements is to find supports and resistances. The retracements
are 100%, 61.8%, 50% and 38.2%. Now let’s look at the daily chart of Copper, Fibonacci
levels were build from bottom of Rs 397.1 i.e 100% of the value to Rs 433.7 per kg.

This is also the immediate bullish wave after the downtrend. If one has to look at the supports
and resistances for Copper from top i.e Rs 433.7, he will first consider the levels of Rs 419.9,
which is also the 38.2% corrective level. Although, 23.6% is one retracement level in
between it is not considered very important in Fibonacci series. The two levels that are
looked are 38.2% and 61.8%.

If Copper falls further below Rs 419.9 levels it is expected that it will try to find supports at
Rs 411 or somewhere near that as it is the 61.8% correction point. Similarly, a bounce from
Rs 411 will find hurdles at Rs 415 and Rs 419.9 per kg that are 50% and 31.8% pullback
points for Copper.
Note: Though 61.8% and 38.2% are given much weightage in Fibonacci series, it depends on
individual analysts to give weightage to 50% and 23.6% retracements if other technical
indicators indicate the same levels.

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