FINANCIAL MARKETS & SERVICES

UNIT-IV
Compiled By:K.Manikanteswara Reddy B.Tech., MBA., APSET., UGC-NET., M.Com., APSET., PGDIBO., PGDHE., (MPA).,
Assistant Professor, Department of Management Studies
Adikavi Nannaya University MSN Campus
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1.0 Credit Rating
Many a times, it has happened that investors in debentures or fixed deposits were shown rosy pictures
of companies and offered very high rates of interests by bogus companies and in the end the investor
neither got his money back nor the promised interest. Actually, it is very difficult for an individual
investor to gather details about creditworthiness of a company, neither he has the time nor the skills
to undertake risk evaluation.
Every investor wants to ensure safety of his investment. Credit rating agencies investigate the
financial position of the company issuing various kinds of instruments and assess risks involved in
investing money in them. In the system of credit rating, the credit rating agency rate the risks involved
in investment in instruments of a particular company, they may rank it from very safe to very risky.
At present credit rating is done only for debt-instruments and rarely for preference or equity shares.

1.1 Definition
Credit rating system can be defined as an act of assigning values to credit instruments by
assessing the solvency i.e., the ability of the borrower to repay debt, and expressing them through
pre- determined symbols.
It is also defined Credit Rating as “An assessment of the creditworthiness of a borrower in
general terms or with respect to a particular debt or financial obligation”. A rating can be assigned to
any entity that seeks to borrow money – an individual, corporation, state or provincial authority, or
sovereign government.

1.2 Characteristics of Credit Rating

1. Assessment of issuer's capacity to repay. It assesses issuer's capacity to meet its financial
obligations i.e., its capacity to pay interest and repay the principal amount borrowed.
2.Based on data. A credit rating agency assesses financial strength of the borrower on the financial
data.
3.Expressed in symbols. Ratings are expressed in symbols e.g. AAA, BBB which can be understood
by a layman too.
4.Done by expert. Credit rating is done by expert of reputed, accredited institutions.
5.Guidance about investment-not recommendation. Credit rating is only a guidance to investors
and not recommendation to invest in any particular instrument.

1.3 What Credit Rating is not

1.Not for company as a whole: Credit rating is done for a particular instrument i.e., for a particular
class of debentures and not for the company as a whole, it is quite possible that two instruments issued
by the same company may carry different rating.
2.Does not create a fiduciary relationship: Credit rating does not create a fiduciary relationship
(relationship of trust) between the credit rating agency and the investor.
3.Not attestation of truthfulness of information provided by rated company: Rating does not
imply that the credit rating agency attests the truthfulness of information provided by the rated
company.
4.Rating not forever. Credit rating is not a one-time evaluation of risk. which remains valid for the
entire life of a security. It can change from time to time.
1.4 Compulsory Credit Rating
Obtaining credit rating is compulsory in the following cases
For debt securities. The Reserve Bank of India and SEBI have made credit rating compulsory in
respect of all non-government debt securities where the maturities exceed 18 months
Public deposits. Rating of deposits in companies has also been made compulsory.
For commercial papers (CPs). Credit rating has also been made compulsory for commercial papers.
As per Reserve Bank of India guidelines rating of P2 by CRISIL or A2 by ICRA or PP2 by CARE is
necessary for commercial papers.
For fixed deposits with non-banking financial institutions (NBFCs). Under the Companies Act,
credit rating has been made compulsory for fixed deposits with NBFs.

1.5 Factors considered in Credit Rating

Issuers ability to service its debt. For this credit rating agencies calculate the following
1.Issuer company's past and future cash flows.
2.Assess how much money the company will have to pay as interest on borrowed funds and how
much will be its earnings.
3.How much are the outstanding debts?
4.Company's short term solvency through calculation of current ratio.
5.Value of assets pledged as collateral security by the company.
6.Availability and quality of raw material used, favourable location, cost advantage.
7.Track record of promoters, directors and expertise of the staff.
Market position of the company. What is the market share of various products of the company,
whether it will be stable, does the company possess competitive advantage due to distribution net-
work, customer base research and development facilities etc.
Quality of management.
Credit rating agency will also take into consideration track record, strategies, competency and
philosophy of senior management.
Legal position of the instrument. It means whether the issued instrument is legally valid, what are
the terms and conditions of issue and redemption; how much the instrument is protected from frauds,
what are the terms of debenture trust deed etc.
Industry risks. Industry risks are studied in relation to position of demand and supply for the products
of that industry (e.g. cars or electronics) how much is the international competition, what
are the future prospects of that industry, is it going to die or expand?
Regulatory environment. Whether that industry is being regulated by government (like liquor
industry), Whether there is a price control on it, whether there is government support for it, can it
take advantage of tax concessions etc.
Other factors. In addition to the above, the other factors to be noted for credit rating of a company
are its cost structure, insurance cover undertaken, accounting quality, market reputation, working
capital management, human resource quality, funding policy, leverage, flexibility, exchange rate
risks etc.

1.6 Credit Rating Process

In India credit rating is done mostly at the request of the borrowers or issuer companies. The borrower
or issuer company requests the credit rating agency for assigning a ranking to the proposed instrument.
The process followed by most of the credit rating agencies is as follows:
1.Agreement. An agreement is entered into between the rating agency and the issuer company.
It covers details about terms and conditions for doing the rating.
2.Appointment of analytical team. The rating agency assigns the job to a team of experts. The team
usually comprises of two analysts who have expert knowledge in the relevant business area and is
responsible for carrying out rating.
3.Obtaining information. The analytical team obtains the required information from the client
company and studies company's financial position, cash flows, nature and basis of competition,
market share, operating efficiency arrangements, managements track cost structure, selling and
distribution record, power (electricity) and labour situation etc.
4.Meeting the officials. To obtain clarifications and understanding the client's business the analytical
team visits and interacts with the executives of the client.
5.Discussion about findings. After completion of study of facts and their analysis by the analytical
team the matter is placed before the internal committee (which comprises of senior analysts) an
opinion about the rating is taken.
6.Meeting of the rating committee. The findings of internal committee are referred to the “rating
committee" which generally comprises of a few directors and is the final authority for assigning
ratings.
7.Communication of decision. The rating decided by the rating committee is communicated to the
requesting company.
8.Information to the public. The rating company publishes the rating through reports and the press.
9.Revision of the rating. Once the issuer company has accepted the rating, the rating agency is under
an obligation to monitor the assigned rating. The rating agency monitors all ratings during the life of
the instrument.

1.7 Types of Credit Rating

1.Rating of bonds and debentures. Rating is popular in certain cases for bonds and debentures.
Practically, all credit rating agencies are doing rating for debentures and bonds.
2.Rating of equity shares. Rating of equity shares is not mandatory in India but credit rating agency
ICRA has formulated a system for equity rating. Even SEBI has no immediate plans for compulsory
credit rating of initial public offerings (IPOs).
3.Rating of preference shares. In India preference shares are not being rated, however Moody's
Investor Service has been rating preference shares since 1973 and ICRA has provision for it.
4.Rating of medium term loans (Public deposits, CDs etc.). Fixed deposits taken by companies are
rated on regular scale in India.
5.Rating of short-term instruments [Commercial Papers (CPs). Credit rating of short term
instruments like commercial papers has been started from 1990. Credit rating for CPs is mandatory
which is being done by CRISIL, ICRA and CARE.
6.Rating of borrowers. Rating of borrowers, may be an individual or a company is known as
borrower’s rating.
7.Rating of real estate builders and developers. A lot of private colonisers and flat builders are
operating in big cities. Rating about them is done to ensure that they will properly develop a colony
or build flats. CRISIL has started rating of builders and developers.
8.Rating of chit funds. Chit funds collect monthly contributions from savers and give loans to those
participants who offer highest rate of interest. Chit funds are rated on the basis of their ability to make
timely payment of prize money to subscribers. CRISIL does credit rating of chit funds.
9.Ratings of insurance companies. With the entry of private sector insurance companies, credit
rating of insurance companies is also gaining ground. Insurance companies are rated on the basis of
their claim paying ability (whether it has high, adequate, moderate or weak claim-paying capacity).
ICRA is doing the work of rating insurance companies.
10.Rating of collective investment schemes. When funds of a large number of investors are
collectively invested in schemes, these are called collective investment schemes. Credit rating about
them means (assessing) whether the scheme will be successful or not. ICRA is doing credit rating of
such schemes.
11.Rating of banks. Private and cooperative banks have been failing quite regularly in India. People
like to deposit money in banks which are financially sound and capable of repaying back the
deposits. CRISIL and ICRA are now doing rating of banks.
12.Rating of states. States in India are now being also rated whether they are fit for investment or
not. States with good credit ratings are able to attract investors from within the country and from
abroad.
13.Rating of countries. Foreign investors and lenders are interested in knowing the repaying capacity
and willingness of the country to repay loans taken by it. They want to make sure that investment in
that country is profitable or not. While rating a country the factors considered are its industrial and
agricultural production, gross domestic product, government policies, rate of inflation, extent of
deficit financing etc. Moody’s, and Morgan Stanley are doing rating of countries.

1.8 Functions/Importance of Credit Rating

1. It provides unbiased opinion to investors. Opinion of good credit rating agency is unbiased
because it has no vested interest in the rated company.
2. Provide quality and dependable information. Credit rating agencies employ highly qualified,
trained and experienced staff to assess risks and they have access to vital and important information
and therefore can provide accurate information about creditworthiness of the borrowing company.
3. Provide information in easy to understand language. Credit rating agencies gather information,
analyse and interpret it and present their findings in easy to understand language that is in symbols
like AAA, BB, C and not in technical language or in the form of lengthy reports.
4. Provide information free of cost or at nominal cost. Credit ratings of instruments are published
in financial newspapers and advertisements of the rated companies. The public has not to pay for
them. Even otherwise, anybody can get them from credit rating agency on payment of nominal fee.
It is beyond the capacity of individual investors to gather such information at their own cost.
5. Helps investors in taking investment decisions. Credit ratings help investors in assessing risks
and taking investment decision.
6. Disciplines corporate borrowers. When a borrower gets higher credit rating, it increases its
goodwill and other companies also do not want to lag behind in ratings and inculcate financial
discipline in their working and follow ethical practice to become eligible for good ratings, this
tendency promotes healthy discipline among companies.
7. Formation of public policy on investment. When the debt instruments have been rated by credit
rating agencies, policies can be laid down by regulatory authorities (SEBI, RBI) about eligibility of
securities in which funds can be invested by various institutions like mutual funds, provident funds
trust etc. For example, it can be prescribed that a mutual fund cannot invest in debentures of a
company unless it has got the rating of AAA.

1.9 Benefits of Credit Rating

Credit rating offers many advantages which can be classified into
A. Benefits to investors.
B. Benefits to the rated company.
C. Benefits to intermediaries.
D. Benefits to the business world.

A. Benefits to investors
1. Assessment of risk. The investor through credit rating can assess risk involved in an investment.
A small individual investor does not have the skills, time and resources to undertake detailed risk
evaluation himself. Credit rating agencies who have expert knowledge, skills and manpower to study
these matters can do this job for him. Moreover, the ratings which are expressed in symbols like AAA,
BB etc. can be understood easily by investors.
2. Information at low cost. Credit ratings are published in financial newspapers and are available
from rating agencies at nominal fees. This way the investors get credit information about borrowers
at no or little cost.
3. Advantage of continuous monitoring. Credit rating agencies do not normally undertake rating of
securities only once. They continuously monitor them and upgrade and downgrade the ratings
depending upon changed circumstances.
4. Provides the investors a choice of Investment. Credit ratings agencies helps the investors to
gather information about creditworthiness of different companies. So, investors have a choice to
invest in one company or the other.
5. Ratings by credit rating agencies is dependable. A rating agency has no vested interest in a
security to be rated and has no business links with the management of the issuer company. Hence
ratings by them are unbiased and credible.

B. Benefits to the rated company

1. Ease in borrowings. If a company gets high credit rating for its securities, it can raise funds with
more ease in the capital market.
2. Borrowing at cheaper rates. A favourably rated company enjoys the confidence of investors and
therefore, could borrow at lower rate of interest.
3. Facilitates growth. Encouraged by favourable rating, promoters are motivated to go in for plans
of expansion, diversification and growth. Moreover, highly rated companies find it easy to raise funds
from public through issue of ownership or credit securities in future. They find it easy to borrow from
banks.
4. Recognition of lesser known companies. Favourable credit rating of instruments of lesser known
or unknown companies provides them credibility and recognition in the eyes of the investing public.
5. Adds to the goodwill of the rated company. If a company is rated high by rating agencies it will
automatically increase its goodwill in the market.
6. Imposes financial discipline on borrowers. Borrowing companies know that they will get high
credit rating only when they manage their finances in a disciplined manner i.e., they maintain good
operating efficiency, appropriate liquidity, good quality assets etc. This develops a sense of financial
discipline among companies who want to borrow.
7. Greater information disclosure. To get credit rating from an accredited agency, companies have
to disclose a lot of information about their operations to them. It encourages greater information
disclosures, better accounting standards and improved financial information which in turn help in the
protection of the investors.

C. Benefits to intermediaries
1. Merchant bankers' and brokers' job made easy. In the absence of credit rating, merchant
bankers or brokers have to convince the investors about financial position of the borrowing company.
If a borrowing company's credit rating is done by a reputed credit agency, the task of merchant bankers
and brokers becomes much easy.

D. Benefits to the business world

1. Increase in investor population. If investors get good guidance about investing the money in debt
instruments through credit ratings, more and more people are encouraged to invest their savings in
corporate debts.
2. Guidance to foreign investors. Foreign collaborators or foreign financial institutions will invest
in those companies only whose credit rating is high. Credit rating will enable them to instantly identify
the position of the company.
1.10 Credit Rating Agency
A credit rating agency (CRA) is a company that rates debtors on the basis of their ability to pay back
their interests and loan amount on time and the probability of them defaulting. These agencies may
also analyse the creditworthiness of debt issuers and provide credit ratings to only organisations and
not individuals consumers. The assessed entities may be companies, special purpose entities, state
governments, local governmental bodies, non-profit organisations and even countries. Individual
customers are rated by specialised agencies known as credit bureaus that provide a credit score to
every customer based on his/her financial history.
Credit rating agencies in India do not have a distant past. They came into existence
in the second half of the 1980s. As of now, there are six credit rating agencies registered under
SEBI namely, CRISIL, ICRA, CARE, SMERA, Fitch India and Brickwork Ratings. Ratings provided
by these agencies determine the nature and integrals of the loan. Higher the credit rating, lower is the
rate of interest offered to the organisation.
The credit rating agencies in India:
1.CRISIL
CRISIL stands for Credit Rating Information Services of India Limited and it was the
first credit rating agency set up in India in 1987. Today, CRISIL has become a global analytical
company that rates companies, researches the markets and provides risk and policy advisory services
to its clients. At the time of incorporation, the agency was promoted by ICICI Limited, UTI and many
such financial institutions. The agency started operations in 1988.
CRISIL is headquartered in Mumbai. CRISIL provides independent opinion and
efficient solutions by performing data analysis and research. It has a strong track record of growth
and innovation. CRISIL has expanded its business operation to USA, UK, Poland, Argentina, Hong
Kong, China and Singapore apart from India. The majority shareholder of CRISIL is Standard &
Poor’s, one of the biggest credit rating agencies of the world.
CRISIL works with various governments and policy-makers in India and other
developing nations to enhance and improve the infrastructure and meet the demands of the region.
The agency has rated around 5180 SMEs in India and has issued in excess of 10,000 SME ratings
overall. CRISIL commands revenue of Rs 1,110 Crores with a net income of Rs 298 Crores and an
operating income of Rs 320 Crores.

2.ICRA
Originally named as Investment Information and Credit Rating Agency, the organisation
was set up in 1991. It was a joint venture of Moody’s and Indian financial and banking service
organisations. It was renamed to ICRA Limited and was listed in the Bombay Stock Exchange and
National Stock Exchange in April 2007. ICRA, which is an independent professional corporate
investment information and credit rating and advisory agency, is headquartered in Gurugram,
Haryana.
ICRA assigns corporate governance rating, performance ratings, grading and provides
ranking to mutual funds, hospitals and construction and real estate companies. The agency generates
revenue of Rs 2.28 Billion. ICRA has a major focus on the MSME sector. To cater to its clients, the
dedicated team of professionals have developed a linear scale for the concerned sector. It helps the
agency to benchmark peers quite easily. ICRA ratings are used to analyse the credit risk in India. It
does not cater to the international companies and organisations.
3.CARE
Credit Analysis and Research limited was established in 1993 and since then it has
gone on to become India’s second largest credit rating agency. It was promoted by Industrial
Development Bank of India (IDBI), Unit Trust of India (UTI) Bank, Canara Bank and other financial
institutions. CARE has its headquarters in Mumbai and regional offices in New Delhi, Bangalore,
Chennai, Hyderabad, Ahmedabad and Kolkata. CARE has the primary function to perform rating of
debt instruments, credit analysis rating, loan rating, corporate governance rating, claims-paying
ability of insurance companies, etc. It also grades construction entities and courses undertaken by
maritime training institutions. Ratings provided by CARE include financial institutions, state
governments and municipal bodies, public utilities and special purpose vehicles.
The Information and Advisory Service Department of CARE prepares credit rating
and reports on requests from business partners, banks and other financial entities. It also conducts
sector-based studies and provides necessary advisories for valuation, financial restructuring and credit
appraisal systems. CARE conducts an extensive research and rates SMEs based on their financial
health. These ratings are provided under 8 levels where CARE SME 1 signifies excellent financial
health with negligible risks and CARE SME 8 rank signifies lowest credit quality with highest credit
risk.
2.0 Mutual Funds
Mutual funds represent one of the most important institutional forces in the market. They are
institutional investors. They play a major role in today’s financial market. The first mutual fund was
established in Boston in 1924 (USA).

2.1 Concept of Mutual Funds

Small investors generally do not have adequate time, knowledge, experience and resources
for directly entering the capital market. Hence they depend on an intermediary. This financial
intermediary is called mutual fund. Mutual funds are corporations that accept money from savers and
then use these funds to buy stocks, long term funds or short term debt instruments issued by firms or
governments. These are financial intermediaries that collect the savings of investors and
invest them in a large and well diversified portfolio of securities such as money market instruments,
corporate and government bonds and equity shares of joint stock companies. They invest the funds
collected from investors in a wide variety of securities i.e. through diversification. In this way it
reduces risk.
Mutual fund works on the principle of “small drops of water make a big ocean”. It is a
form of collective investment. To get the surplus funds from investors, it adopts a simple technique.
Each fund is divided into a small share called ‘units’ of equal value. Each investor is allocated units
in promotion to the size of his investment.

2.2 Meaning of Mutual Funds

Mutual fund is a trust that pools the savings of investors. The money collected is then invested in
financial market instruments such as shares, debentures and other securities. The income earned
through these investments and the capital appreciations realized are shared by its unit holders in
proportion to the number of units owned by them. Thus mutual fund invests in a variety of securities
(called diversification). This reduces risk. Diversification reduces the risk because all stock and/ or
debt instruments may not move in the same direction. In short, a mutual fund collects the savings
from small investors, invests them in government and other corporate securities and earns income
through interest and dividends, besides capital gains.

2.3 Definition of Mutual Funds

According to the Mutual Fund Fact Book (published by the Investment Company Institute of USA),
“a mutual fund is a financial service organization that receives money from shareholders, invests it,
earns return on it, attempts to make it grow and agrees to pay the shareholder cash demand for the
current value of his investment”.
SEBI (mutual funds) Regulations, 1993 defines a mutual fund as ‘a fund established in the form of a
trust by a sponsor, to raise monies by the trustees through the sale of units to the public, under one or
more schemes, for investing in securities in accordance with these regulations.

2.4 Scope & Importance of Mutual Funds

Return Potential: Over a medium to long-term, Mutual Funds have the potential to provide a higher
return as they invest in a diversified basket of selected securities.
Low Costs: Mutual Funds are a relatively less expensive way to invest compared to directly
investing in the capital markets because the benefits of scale in brokerage, custodial and other fees
translate into lower costs for investors.
Liquidity: I n o p en - en d s ch emes , th e inv es to r g ets th e mo n ey b ack pr o mp tly at n et
ass et value related prices from the Mutual Fund. In close-end schemes, the units can be sold on a
stock exchange at the prevailing market price or the investor can avail of the facility of direct
repurchase at NAV related prices by the Mutual Fund.
Transparency: Reg u lar in fo r matio n o n th e v alu e o f y ou r inv es tmen t in add ition to
disclosure on the specific investments made by your scheme, the proportion invested in
each class of assets and the fund manager's investment strategy and outlook.
Flexibility: Through features such as regular investment plans, regular withdrawal plans and dividend
reinvestment plans, you can systematically invest or withdraw funds according to your needs and
convenience.
Affordability: Investors individually may lack sufficient funds to invest in high-grade stocks. A mutual
fund because of its large corpus allows even a small investor to take the benefit of its investment
strategy.
Choice of Schemes: Mutual Funds offer a family of schemes to suit our varying needs over a lifetime.
Well Regulated: A l l M u t u a l F u n d s a r e r e g i s t e r e d w i t h S E B I a n d t h e y f u n c t i o n
w i t h i n t h e p r ov is io ns o f s tr ict r eg ulations d es ign ed to p ro tect the in teres ts of
in v es tor s. Th e operations of Mutual Funds are regularly monitored by SEBI.
Net Asset Value (NAV): The net asset value of the fund is the cumulative market value of the assets
fund net of its liabilities. In other words, if the fund is dissolved or liquidated, by selling off
all the assets in the fund, this is the amount that the shareholders would collectively own.

2.5 Features of Mutual Funds

Mutual fund possesses the following features:
1. Mutual fund mobilizes funds from small as well as large investors by selling units.
2. Mutual fund provides an ideal opportunity to small investors an ideal avenue for investment.
3. Mutual fund enables the investors to enjoy the benefit of professional and expert management of
their funds.
4. Mutual fund invests the savings collected in a wide portfolio of securities in order to maximize
return and minimize risk for the benefit of investors.
5. Mutual fund provides switching facilities to investors who can switch from one scheme to another.
6. Various schemes offered by mutual funds provide tax benefits to the investors.
7. In India mutual funds are regulated by agencies like SEBI.
8. The cost of purchase and sale of mutual fund units is low.
9. Mutual funds contribute to the economic development of a country.

2.6 Classification of Mutual Funds

There are three different types of classification of mutual funds.
(1) Functional
(2) Portfolio and
(3) Ownership. Each classification is mutually exclusive.
Functional Classification: Funds are divided into Open ended funds and Close ended funds
In an open ended scheme, the investor can make entry and exit at any time. Also, the capital of the
fund is unlimited and the redemption period is indefinite. On the contrary, in a close ended scheme,
the investor can buy into the scheme during Initial Public offering or from the stock market after the
units have been listed. The scheme has a limited life at the end of which the corpus is liquidated. The
investor can make his exit from the scheme by selling in the stock market, or at the expiry of the
scheme or during repurchase period at his option. Interval schemes are a cross between an open ended
and a close ended structure. These schemes are open for both purchase and redemption during pre-
specified intervals (viz. monthly, quarterly, annually etc.) at prevailing NAV based prices. Interval
funds are very similar to close-ended funds, but differ on the following points:
• They are not required to be listed on the stock exchanges, as they have an in-built redemption
window.
• They can make fresh issue of units during the specified interval period, at the prevailing NAV based
prices.
• Maturity period is not defined.
Portfolio Classification: Funds are classified into Equity Funds, Debt Funds and Special Funds.
Equity funds invest primarily in stocks. A share of stock represents a unit of ownership in a company.
If a company is successful, shareholders can profit in two ways:
• the stock may increase in value, or
• the company can pass its profits to shareholders in the form of dividends.
If a company fails, a shareholder can lose the entire value of his or her shares; however, a
shareholder is not liable for the debts of the company.
Equity Funds are of the following types viz.
(a) Growth Funds: They seek to provide long term capital appreciation to the investor and are best
to long term investors.
(b) Aggressive Funds: They look for super normal returns for which investment is made in start-ups,
IPOs and speculative shares. They are best to investors willing to take risks.
(c) Income Funds: They seek to maximize present income of investors by investing in safe stocks
paying high cash dividends and in high yield money market instruments. They are best to investors
seeking current income.
(d) Balanced Funds: They are a mix of growth and income funds. They buy shares for growth and
bonds for income and best for investors seeking to strike golden mean.
Debt Funds are of two types viz.
(a) Bond Funds: They invest in fixed income securities e.g. government bonds, corporate debentures,
convertible debentures, money market. Investors seeking tax free income go in for government bonds
while those looking for safe, steady income buy government bonds or high grade corporate bonds.
Although there have been past exceptions, bond funds tend to be less volatile than stock funds and
often produce regular income. For these reasons, investors often use bond funds to diversify, provide
a stream of income, or invest for intermediate-term goals. Like stock funds, bond funds have risks
and can make or lose money.
(b) Gilt Funds: They are mainly invested in Government securities.
Special Funds are of four types viz.
(a) Index Funds: Every stock market has a stock index which measures the upward and downward
sentiment of the stock market. Index Funds are low cost funds and influence the stock market. The
investor will receive whatever the market delivers.
(b) International Funds: A mutual fund located in India to raise money in India for investing globally.
(c) Offshore Funds: A mutual fund located in India to raise money globally for investing in India.
(d) Sector Funds: They invest their entire fund in a particular industry e.g. utility fund for
utility industry like power, gas, public works.
(e) Money Market Funds: These are predominantly debt-oriented schemes, whose main objective
is preservation of capital, easy liquidity and moderate income. To achieve this objective, liquid funds
invest predominantly in safer short-term instruments like Commercial Papers, Certificate of Deposits,
Treasury Bills, G-Secs etc.
These schemes are used mainly by institutions and individuals to park their surplus funds for short
periods of time. These funds are more or less insulated from changes in the interest rate in the
economy and capture the current yields prevailing in the market.
(f) Fund of Funds: Fund of Funds (FoF) as the name suggests are schemes which invest in other
mutual fund schemes. The concept is popular in markets where there are number of mutual fund
offerings and choosing a suitable scheme according to one’s objective is tough. Just as a mutual fund
scheme invests in a portfolio of securities such as equity, debt etc, the underlying investments for a
FoF is the units of other mutual fund schemes, either from the same fund family or from other fund
houses.
(g) Capital Protection Oriented Fund: The term ‘capital protection oriented scheme’ means a
mutual fund scheme which is designated as such and which endeavours to protect the capital invested
therein through suitable orientation of its portfolio structure. The orientation towards protection of
capital originates from the portfolio structure of the scheme and not from any bank guarantee,
insurance cover etc. SEBI stipulations require these types of schemes to be close-ended in nature,
listed on the stock exchange and the intended portfolio structure would have to be mandatory rated
by a credit rating agency. A typical portfolio structure could be to set aside major portion of the assets
for capital safety and could be invested in highly rated debt instruments. The remaining portion would
be invested in equity or equity related instruments to provide capital appreciation. Capital Protection
Oriented schemes are a recent entrant in the Indian capital markets and should not be confused with
‘capital guaranteed’ schemes.
(h) Gold Funds: The objective of these funds is to track the performance of Gold. The units represent
the value of gold or gold related instruments held in the scheme. Gold Funds which are generally in
the form of an Exchange Traded Fund (ETF) are listed on the stock exchange and offers investors an
opportunity to participate in the bullion market without having to take physical delivery of gold.
2.7 Types of Mutual Funds (Classification of Mutual Funds)
Mutual funds (or mutual fund schemes) can be classified into many types. The following chart shows
the classification of mutual funds:
These may be briefly described as follows:
A. On the basis of Operation
1. Close ended funds: Under this type of fund, the size of the fund and its duration are fixed in
advance. Once the subscription reaches the predetermined level, the entry of investors will be closed.
After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are distributed
to the unit holders in proportion to their holding.
Features of Close ended Funds
(a) The period and the target amount of the fund is fixed beforehand.
(b) Once the period is over and/ or the target is reached, the subscription will be closed (i.e. investors
cannot purchase any more units).
(c) The main objective is capital appreciation.
(d) At the time of redemption, the entire investment is liquidated and the proceeds are liquidated and
the proceeds are distributed among the unit holders.
(e) Units are listed and traded in stock exchanges.
(f) Generally the prices of units are quoted at a discount of upto 40% below their net asset value.
2. Open-ended funds: This is the just reverse of close-ended funds. Under this scheme the size of
the fund and / or the period of the fund is not fixed in advance. The investors are free to buy and sell
any number of units at any point of time.
Features of Open-ended Funds
(a) The investors are free to buy and sell units. There is no time limit.
(b) These are not trade in stock exchanges.
(c) Units can be sold at any time.
(d) The main motive income generation (dividend etc.)
(e) The prices are linked to the net asset value because units are not listed on the stock exchange.
Difference between Open-ended and Close-ended Schemes
1. The close-ended schemes are open to the public for a limited period, but the open-ended schemes
are always open to be subscribed all the time.
2. Close-ended schemes will have a definite period of life. But he open-ended schemes are transacted
in the company.
3. Close-ended schemes are transacted at stock exchanges, where as open-ended schemes are
transacted (bought and sold) in the company.
4. Close-ended schemes are terminated at the end of the specified period. Open-ended schemes can
be terminated only if the total number of units outstanding after repurchase fall below 50% of the
original number of units.
B. On the basis of return/ income
1. Income fund: This scheme aims at generating regular and periodical income to the members. Such
funds are offered in two forms. The first scheme earns a target constant income at relatively low risk.
The second scheme offers the maximum possible income.
Features of Income Funds
(a) The investors get a regular income at periodic intervals.
(b) The main objective is to declare dividend and not capital appreciation.
(c) The pattern of investment is oriented towards high and fixed income yielding securities like bonds,
debentures etc.
(d) It is best suited to the old and retired people.
(e) It focuses on short run gains only.
2. Growth fund: Growth fund offers the advantage of capital appreciation. It means growth fund
concentrates mainly on long run gains. It does not offers regular income. In short, growth funds aim
at capital appreciation in the long run. Hence they have been described as “Nest Eggs” investments
or long haul investments.
Features of Growth Funds
(a) It meets the investors’ need for capital appreciation.
(b) Funds are invested in equities with high growth potentials in order to get capital appreciation.
(c) It tries to get capital appreciation by taking much risk.
(d) It may declare dividend. But the main objective is capital appreciation.
(e) This is best suited to salaried and business people.
3. Conservative fund: This aims at providing a reasonable rate of return, protecting the value of the
investment and getting capital appreciation. Hence the investment is made in growth oriented
securities that are capable of appreciating in the long run.
C. On the basis of Investment
1. Equity fund: it mainly consists of equity based investments. It carried a high degree of risk.
Such funds do well in periods of favourable capital market trends.
2. Bond fund: It mainly consists of fixed income securities like bonds, debentures etc. It concentrates
mostly on income rather than capital gains. It carries lower risk. It offers secure and steady income.
But there is no chance of capital appreciation.
3. Balanced fund: It has a mix of debt and equity in the portfolio of investments. It aims at
distributing regular income as well as capital appreciation. This is achieved by balancing the
investments between the high growth equity shares and also the fixed income earning securities.
4. Fund of fund scheme: In this case funds of one mutual fund are invested in the units of other
mutual funds.
5. Taxation fund: This is basically a growth oriented fund. It offers tax rebates to the investors. It is
suitable to salaried people.
6. Leverage fund: In this case the funds are invested from the amounts mobilized from small
investors as well as money borrowed from capital market. Thus it gives the benefit of leverage to the
mutual fund investors. The main aim is to increase the size of the value of portfolio. This occurs when
the gains from the borrowed funds are more than the cost of the borrowed funds. The gains are
distributed to unit holders.
7. Index bonds: These are linked to a specific index of share prices. This means that the funds
mobilized under such schemes are invested principally in the securities of companies whose securities
are included in the index concerned and in the same proportion. The value of these index linked funds
will automatically go up whenever the market index goes up and vice versa.
8. Money market mutual funds: These funds are basically open ended mutual funds. They have all
the features of open ended mutual funds. But the investment is made is highly liquid and safe
securities like commercial paper, certificates of deposits, treasury bills etc. These are money market
instruments.
9. Off shore mutual funds: The sources of investments for these funds are from abroad.
10. Guilt funds: This is a type of mutual fund in which the funds are invested in guilt edged securities
like government securities. It means funds are not invested in corporate securities like shares, bonds
etc.

2.8 Objectives of Mutual Funds

1. To mobilise savings of people.
2. To offer a convenient way for the small investors to enter the capital and the money market.
3. To tap domestic savings and channelize them for profitable investment.
4. To enable the investors to share the prosperity of the capital market.
5. To act as agents for growth and stability of the capital market.
6. To attract investments from the risk aversers.
7. To facilitate the orderly development of the capital market.

2.9 Functions of Mutual Funds

The functions of Mutual Fund Organizations (MFO) can be described as
(a) Collection of funds from public
(b) Investment of funds collected from public in capital market
(c) Proper management of investment portfolio as a trustee to the investor’s money.
The investment made by the public/investors in the AMC under a scheme is divided into
number of units. The investor will be allotted number units in the scheme proportionate to total
investment in the scheme. The investor is thus called unit holders. The Mutual Fund Organizations
(MFO)s with huge resource of investments of public and a team of experts in their employees roll,
analyses investment opportunities in various securities, bonds and other overhead expenses.

2.10 Parties in Mutual Funds

Besides investors the following three parties are involved in Mutual Funds Set up.
Sponsor: A Sponsor establishes the Mutual Fund, along with any individual/body corporate. The
Sponsor''s liability is restricted to his contribution. Sponsor must contribute a minimum 40% to the
net worth of AMC.
1.Trustees: Refers to Board of Trustees who hold property of the Mutual Fund, for the benefit of the
unit holders.
2.Asset Managing Company (AMC): Can be a company registered under the Companies Act 1956
approved by SEBI. The AMC is entrusted with the task of the managing the various schemes and
operations of the AMC. The AMC should have minimum Net Worth of Rs 5 crores. At least 50% of
the Board of the AMC should be independent directors, i.e. not connected with the Sponsoring
organization. No person can be a Director on more than one AMC.
3.Custodian: Person holding a certificate to carry on business of custodian of securities under SEBI.

2.11 Advantages (Importance) of Mutual Funds

Mutual funds are growing all over the world. They are growing because of their importance to
investors and their contributions in the economy of a country. The following are the advantages of
mutual funds:
1. Mobilise small savings: Mutual funds mobilize small savings from the investors by offering
various schemes. These schemes meet the varied requirements of the people. The savings of the
people are channelized for the development of the economy. In the absence of mutual funds, these
savings would have remained idle.
2. Diversified investment: Small investors cannot afford to purchase the shares of the highly
established companies because of high market price. The mutual funds provide this opportunity to
small investors. Even a very small investor can afford to invest in mutual funds. The investors can
enjoy the wide portfolio of the investments held by the fund. It diversified its risks by investing in a
variety of securities (equity shares, bonds etc.) The small and medium investors cannot do this.
3. Provide better returns: Mutual funds can pool funds from a large number of investors. In this
way huge funds can be mobilized. Because of the huge funds, the mutual funds are in a position to
buy securities at cheaper rates and sell securities at higher prices. This is not possible for individual
investors. In short, mutual funds are able to give good and regular returns to their investors.
4. Better liquidity: At any time the units can be sold and converted into cash. Whenever investors
require cash, they can avail loans facilities from the sponsoring banks against the unit certificates.
5. Low transaction costs: The cost of purchase and sale of mutual fund units is relatively less. The
brokerage fee or trading commission etc. are lower. This is due to the large volume of money being
handled by mutual funds in the capital market.
6. Reduce risk: There is only a minimum risk attached to the principal amount and return for the
investments made in mutual funds. This is due to expert supervision, diversification and liquidity of
units.
7. Professional management: Mutual funds are managed by professionals. They are well trained.
They have adequate experience in the field of investment. Thus investors get quality services from
the mutual funds. An individual investor would never get such a service from the securities market.
8. Offer tax benefits: Mutual funds offer tax benefits to investors. For instance, under section 80 L
of the Income Tax Act, a sum of Rs. 10,000 received as dividend from a mutual fund (in case of UTI,
it is Rs. 13,000) is deductible from the gross total income.
9. Support capital market: The savings of the people are directed towards investments in capital
markets through mutual funds. They also provide a valuable liquidity to the capital market. In this
way, the mutual funds make the capital market active and stable.
10. Promote industrial development: The economic development of any nation depends upon its
industrial advancement and agricultural development. Industrial units raise funds from capital
markets through the issue of shares and debentures. Mutual funds supply large funds to capital
markets. Besides, they create demand for capital market instruments (share, debentures etc.). Thus
mutual funds provide finance to industries and thereby contributing towards the economic
development of a country.
11. Keep the money market active: An individual investor cannot have any access to money market
instruments. Mutual funds invest money on the money market instruments. In this way, they keep the
money market active.

2.12 Mutual Fund Risks

Inspite of the advantages offered by mutual funds, there are some risks also. This is so because mutual
funds invest their funds in the stock market on shares. These shares are subject to risks. Hence, the
following risks are inherent in the dealings of mutual funds:
1. Market risks: These risks are unavoidable. These arise due to fluctuations in share prices.
2. Investment risks: Generally mutual funds make investments on the advice sought from Asset
Management Company. If the advice goes wrong, the fund has to suffer a loss.
3. Business risk: Mutual funds invest mostly in equity shares of companies. If the business of the
companies suffers any set back, they cannot declare dividend. Ultimately, such companies may be
wound up. As a result, mutual funds will suffer.
4. Political risk: Change in government policies brings uncertainty in the economy. Every player
including mutual funds has to face this risk and uncertainty.
5. Scheme risks: There are certain risks in the schemes themselves. Risks are greater in certain
schemes, e.g., growth schemes.

2.13 Management of Mutual Funds

A mutual fund invites the prospective investors to participate in the fund by offering various schemes.
It offers different schemes to suit the varied requirements of the investors. The small and medium
resources from the investors are pooled together. Then the pool of fund is divided into a large number
of equal shares called units. These are issued to investors. The amount so collected is invested in
capital market instruments like shares, debentures, government bonds etc. Investment is
also made in money market instruments like treasury bills, commercial papers etc. Usually the money
is invested in diversified securities so as to minimize the risk and maximize return. The income earned
on these securities (after meeting the fund expenses) is distributed to unit holders (investors) in the
form of interest as well as capital appreciation. The return on the units depends upon the nature of the
mutual fund schemes.

2.13.1Mutual Funds in India

In India the first mutual fund was UTI. It was set up in 1964 under an Act of parliament. During the
year 1987-1992, seven new mutual funds were established in the public sector. In 1993, the
government changed its policy to allow the entry of private corporates and foreign institutional
investors into the mutual fund segment. Now the commercial banks like the SBI, Canara Bank, Indian
bank, Bank of India, Punjab National Bank etc. have entered into the field. LIC and GIC have also
entered into the market. By the end of March 2000, there was 36 mutual funds, 9 in the public sector
and 27 in the private sector. However UTI dominated the mutual fund sector. In India mutual funds
are being regulated by agencies like SEBI. Mutual funds play an important role in promoting saving
and investment within the country. There are around 196 mutual fund schemes, and the amount of
assets under their management was Rs. 47,000 crores in 1993, Rs. 80,590 crores in 2003 and it went
up to Rs. 2, 17,707crores by 31.3.2006. Thus mutual funds are growing in India. However, their
growth rate is very slow.

2.14 Reasons for Slow Growth of Mutual Funds in India

1. There is no standard formula for calculating Net Asset Value. Different companies apply different
formulae. Thus there is no uniformity in the calculation of NAV.
2. Mutual funds in India are not providing adequate information and materials to the investors. There
is not good rapport between mutual funds and investors. In short, there is no transparency in the
dealings of mutual funds.
3. Mutual funds are rendering poor services to investors. Hence mutual funds fail to build up investor
confidence.
4. In India, most of the funds depend upon outside agencies for collecting data and conducting
research.
5. In India, professional experts in security analysis and portfolio management are rare.
6. Investors do not know that units are low-risk long term investment. They do not have the patience
to wait for long time to get good returns. They always want return in the short run. Hence units are
not much popular in India.

2.15 Mutual Funds Industry in India

Mutual Fund in India was first started by Unit Trust of India (UTI) in the year 1964 in the
form of investment trust. UTI initially started with open-ended mutual fund; the first unit scheme
offered was the “US-64” and the face value of a single unit was ` 10, to attract the medium and low
income group people. UTI enjoyed the monopoly of Mutual fund till 1987 and later the Government
of India by amending the Banking Regulation Act, permitted commercial banks in the public sector
to set up subsidiaries operating as trusts to perform the functions of mutual funds.
Before, the monopoly of the market had seen an ending phase; the Assets under
Management (AUM) were ` 67 billion. The private sector entry to the fund family raised the AUM to
` 470 billion in March 1993 and at the end of April 2004; it reached the height of 1,540 billion.
Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than the
deposits of SBI alone and less than 11% of the total deposits held by the Indian banking industry. The
main reason for its poor growth is that the mutual fund industry in India is new to the country. Hence,
it is the prime responsibility of all mutual fund companies, to market correctly the product besides
selling. The growth of mutual fund industry in India is broadly put into four phases. The description
of each phase is as under:
(i)First Phase - 1964-87
In 1963, Unit Trust of India (UTI) was established by an Act of Parliament. It functioned
under the Regulatory and administrative control of the Reserve Bank of India. In 1978, the Industrial
Development Bank of India (IDBI) took over the regulatory and administrative control from RBI.
The first scheme launched by UTI was Unit Scheme 1964. The detailed notes about UTI are given
separately in this unit.
(ii)Second Phase - 1987-1993 (Entry of Public Sector Funds)
Entry of Non-UTI Mutual Funds SBI Mutual Fund was the first public sector mutual
funds followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89),
Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92),
LIC (1989) and GIC (1990). The end of 1993 marked ` 47, 004 crores as assets under management.
(iii)Third Phase - 1993-2003 (Entry of Private Sector Funds)
During 1993, a new era started in the Indian mutual fund industry due to the
entry of private sector funds. The Mutual Fund Regulations came into existence under which all
mutual funds were to be registered and governed except UTI. The erstwhile Kothari Pioneer (now
merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993. In
1996, SEBI (Mutual Fund) Regulations were framed. During this phase, many foreign mutual funds
were set up in India and the industry witnessed several mergers and acquisitions. As at the end of
January 2003, there were 33 mutual funds with total assets of ` 1, 21,805 crores out of which the
assets of UTI alone were ` 44,541 crores.
(iv)Fourth Phase - since February 2003
In February 2003, UTI was bifurcated into two separate entities. One is the
Specified Undertaking of the Unit Trust of India with AUM (Asset Under Management) of ` 29,835
crores (as on January 2003). The Specified Undertaking of Unit Trust of India, functioning under an
administrator and under the rules framed by Government of India does not come under the purview
of the Mutual Fund Regulations. The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB,
BOB and LIC. It was registered under SEBI Mutual Fund Regulations Act 1996.

2.16 Organization of Mutual Funds

Mutual Fund is formed by a trust body. The business is set up by the sponsor, the money invested by
the asset management company and the operations monitored by the trustee. There are five principal
constituents and three market intermediaries in the formation and functioning of mutual fund.
The five constituents are:
1 Sponsor: A company established under the Companies Act forms a mutual fund.
2 Asset Management Company: An entity registered under the Companies Act to manage the money
invested in the mutual fund and to operate the schemes of the mutual fund as per regulations. It carries
the responsibility of investing and managing the investors’ money. Professional money managers are
appointed by the asset management company to take care that the investor’s corpus are invested in
profitable securities based on the risk appetite of the investors and according to the mutual fund
scheme. The AMC typically has three departments viz. (a) Fund Management (b) Sales & marketing
(c) Operations & Accounting.
3 Trustee: The trust is headed by Board of Trustees. The trustee holds the property of the mutual fund
in trust for the benefit of unit holders and looks into the legal requirements of operating and
functioning of the mutual fund. The trustee may also form a limited company under the Companies
Act in some situations. The trustees have the duty to monitor the actions of the AMC to ensure
compliance with the SEBI regulations and to see that the decisions of the AMC are not against the
interests of the unit holders.
4 Unit Holder: A person/entity holding an undivided share in the assets of a mutual fund scheme.
5 Mutual Fund: A mutual fund established under the Indian Trust Act to raise money through the
sale of units to the public for investing in the capital market. The funds thus collected are passed on
to the Asset Management Company for investment. The mutual fund has to be registered with SEBI.
The three market intermediaries are:
(a) Custodian; (b) Transfer Agents; (c) Depository.
(a) Custodian: A custodian is a person who has been granted a Certificate of Registration to conduct
the business of custodial services under the SEBI (Custodian of Securities) Regulations 1996.
Custodial services include safeguarding clients’ securities along with incidental services provided.
Maintenance of accounts of clients’ securities together with the collection of benefits / rights accruing
to a client falls within the purview of custodial service. Mutual funds require custodians so that AMC
can concentrate on areas such as investment and management of money.
(b) Transfer Agents: A transfer agent is a person who has been granted a Certificate of Registration
to conduct the business of transfer agent under SEBI (Registrars to an Issue and Share Transfer Agents)
Regulations Act 1993. Transfer agents’ services include issue and redemption of mutual fund units,
preparation of transfer documents and maintenance of updated investment records. They also record
transfer of units between investors where depository does not function.
(c) Depository: Under the Depositories 1996, a depository is body corporate who carries out the
transfer of units to the unit holder in dematerialised form and maintains records thereof.

2.17 Guidelines for Mutual Funds

Investors looking for investment avenues must be aware of certain rules and regulations that govern
the Indian mutual fund sector – SEBI guidelines for mutual funds.
In India, the SEBI MF Regulations of 1996 govern the workings of mutual funds. These
guidelines treat mutual funds like Public Trusts that fall under the Indian Trust Act of 1982. For
handling mutual funds and to ensure accountability on the trustees, the guidelines specify a three-tier
set up comprising of the fund managers, the investors, and the representatives. The Securities and
Exchange Board (SEBI) is the designated regulatory body for finance and markets in India. The
primary function of the board is to protect the interests of the investors in securities and promote and
regulate the securities market. SEBI has laid the ground rules for investors to become aware of the
functioning of the mutual funds by providing necessary information. They serve to simplify the broad
spectrum of mutual fund schemes that may often seem quite confusing to the investors. The guidelines
on the merger and consolidation of mutual fund schemes issued by SEBI are aimed at simplifying the
process of comparing various mutual fund schemes that are on offer by fund houses. The SEBI
guidelines define the Guarantor as one who, in his capacity as an individual or in partnership with a
different entity or entities, launches a mutual fund. The role of the guarantor is to make revenue by
putting together a mutual fund and handing it to the fund manager. A sponsor sets up the mutual funds
as per the guidelines of the Indian Trust Act, 1882, for Public Trust. They are responsible for listing
with the SEBI, having provisions for resource management and ensuring the functioning of the fund
takes place as per the SEBI guidelines.
The Trustee or Trust is established through a trust deed that is implemented by the sponsors
of the funds and is accountable to all the investors of the mutual fund. The trustee company is
regulated by the Indian Companies Act 1956, while the firm and the board members are overseen by
the Indian Trust Act, 1882. The Investment management of the trust is done through an Asset
Management Company which is to be listed as per the regulations of Companies Act of 1956.As far
as Mutual funds are concerned, SEBI makes the policies for mutual funds and also regulates the
industry. It lays guidelines for the mutual funds to safeguard the investors’ interest. Mutual funds are
very distinct in terms of their investment strategy and asset allocation activities. This requires bringing
about uniformity in the functioning of the mutual funds that may be similar in schemes. This will
assist the investors in taking investment decisions more clearly.

2.18 SEBI Guidelines to invest in Mutual Funds

SEBI keeps in place the regulatory framework and guidelines that govern and regulate the financial
markets in the country. The guidelines for investors are listed below.
a) Assessment your personal financial situation
Mutual funds present the most diversified form of investment options and therefore may carry a
certain amount of risk factor with it. Investors must be very clear in their assessment of their financial
position and the risk-bearing capacity in the event of poor performance of such schemes. Investors
must, therefore, consider their risk appetite in accordance with the investment schemes.
b) Obtain researched information on the mutual funds’ investment schemes
Before venturing into mutual fund investment, it is imperative for you as an investor to obtain detailed
information about the mutual fund scheme option. Having the right information when required to
make the necessary decision is the key to making good investments. This may help in choosing the
right schemes, knowing the guidelines to follow and also be informed of the investors’ rights.

c) Diversify your portfolios

Diversification of portfolios allows investors to spread out their investments over various schemes
thereby increasing chances of maximizing profits or mitigating risk of potentially huge losses.
Diversification is crucial to gaining long-term and sustainable financial advantage.

d) Avoid the clutter of portfolios

Choosing the right portfolio of funds requires managing and monitoring these schemes individually
with care. The investor must not clutter the portfolio and decide on the right number of schemes to
hold so as to avoid overlap and be able to manage each one of them equally well.

e) Assign a time dimension to the investment schemes

It is advisable for the investors to assign a time frame to each scheme to encourage the financial
growth of the plan. It may help in containing the volatility and fluctuations in the market if the plans
are maintained stably over a period of time.
3.0 Securitisation of Debt/Assets
Loans given to customers are assets for the bank. They are called loan assets. Unlike investment assets,
loan assets are not tradable and transferable. Thus loan assets are not liquid. The problem is how to
make the loan of a bank liquid. This problem can be solved by transforming the loans into marketable
securities. Now loans become liquid. They get the characteristic of marketability. This is done through
the process of securitization. Securitization is a financial innovation. It is conversion of existing or
future cash flows into marketable securities that can be sold to investors. It is the process by which
financial assets such as loan receivables, credit card balances, hire purchase debtors, lease receivables,
trade debtors etc. are transformed into securities. Thus, any asset with predictable cash flows can be
securitized.

3.1 Definition
Securitization is defined as a process of transformation of illiquid asset into security
which may be traded later in the opening market. In short, securitization is the transformation of
illiquid, non- marketable assets into securities which are liquid and marketable assets. It is a process
of transformation of assets of a lending institution into negotiable instruments. Securitization is
different from factoring. Factoring involves transfer of debts without transforming debts into
marketable securities. But securitization always involves transformation of illiquid assets into liquid
assets that can be sold to investors.

3.2 Parties to a Securitisation Transaction

There are primarily three parties to a securitisation deal, namely -
a. The Originator: This is the entity on whose books the assets to be securitised exist. It is the
prime mover of the deal i.e. it sets up the necessary structures to execute the deal. It sells the assets
on its books and receives the funds generated from such sale. In a true sale, the Originator transfers
both the legal and the beneficial interest in the assets to the SPV.
b. The SPV: The issuer also known as the SPV is the entity, which would typically buy the assets
(to be securitised) from the Originator. The SPV is typically a low-capitalised entity with narrowly
defined purposes and activities, and usually has independent trustees/directors. As one of the main
objectives of securitisation is to remove the assets from the balance sheet of the Originator, the SPV
plays a very important role is as much as it holds the assets in its books and makes the upfront
payment for them to the Originator.
c. The Investors: The investors may be in the form of individuals or institutional investors like FIs,
mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating
interest in the total pool of receivables and receive their payment in the form of interest and
principal as per agreed pattern. Besides these three primary parties, the other parties involved in a
securitisation deal are given below:
a) The Obligor(s): The Obligor is the Originator's debtor (bor’ower of the original loan). The
amount outstanding from the Obligor is the asset that is transferred to the SPV. The credit standing
of the Obligor(s) is of paramount importance in a securitisation transaction.
b) The Rating Agency: Since the investors take on the risk of the asset pool rather than the Originator,
an external credit rating plays an important role. The rating process would assess the strength of the
cash flow and the mechanism designed to ensure full and timely payment by the process of selection
of loans of appropriate credit quality, the extent of credit and liquidity support provided and the
strength of the legal framework.
c) Administrator or Servicer: It collects the payment due from the Obligor/s and passes it to the
SPV, follows up with delinquent borrowers and pursues legal remedies available against the
defaulting borrowers. Since it receives the instalments and pays it to the SPV, it is also called the
Receiving and Paying Agent.
d) Agent and Trustee: It accepts the responsibility for overseeing that all the parties to the
securitisation deal perform in accordance with the securitisation trust agreement. Basically, it is
appointed to look after the interest of the investors.
e) Structurer: Normally, an investment banker is responsible as structurer for bringing together the
Originator, credit enhancer/s, the investors and other partners to a securitisation deal. It also works
with the Originator and helps in structuring deals.
The different parties to a securitisation deal have very different roles to play. In fact, firms
specialise in those areas in which they enjoy competitive advantage. The entire process is broken up
into separate parts with different parties specialising in origination of loans, raising funds from the
capital markets, servicing of loans etc. It is this kind of segmentation of market roles that introduces
several efficiencies securitisation is so often credited with.

3.3 The advantages of securitisation

1. Additional source of fund – by converting illiquid assets to liquid and marketable assets.
2. Greater profitability- securitisation leads to faster recycling of fund and thus leads to higher
business turn over and profitability.
3. Enhancement of CAR- Securitisation enables banks and financial institutions to enhance their
capital adequacy ratio(CAR) by reducing their risky assets.
4. Spreading Credit Risks- securitisation facilitates the spreading of credit risks to different parties
involved in the process of securitisation such as SPV, insurance companies(credit enhancer) etc.
5. Lower cost of funding- originator can raise funds immediately without much cost of borrowing.
6. Provision of multiple instruments – from investors point of view, securitisation provides
multiple instruments so as to meet the varying requirements of the investing public.
7. Higher rate of return- when compared to traditional debt securities like bonds and debentures,
securitised assets provides higher rates of return along with better liquidity.
8. Prevention of idle capital- in the absence of securitisation, capital would remain idle in the form
of illiquid assets like mortgages, term loans etc.

4.1Depository Meaning
A depository is an institution that facilitates the investors in holding securities in a book
entry form, which is maintained electronically. It is similar to a bank where one can deposit cash and
can be withdrawn and/or transferred to any body at your instruction by issuing a cheque. Similarly
your investment can be sold in the stock exchange or transferred to any body at your instruction
through a Depository Participant (DP).
On the simplest level, depository is used to refer to any place where something is deposited
for storage or security purposes. More specifically, it can refer to a company, bank or an institution
that holds and facilitates the exchange of securities. Or a depository can refer to a depository
institution that is allowed to accept monetary deposits from customers.
Central security depositories allow brokers and other financial companies to deposit securities where
book entry and other services can be performed, like clearance, settlement and securities borrowing
and lending. Depository functions like a securities bank, where the dematerialized physical securities
are traded and held in custody. This facilitates faster, risk free and low cost settlement. Depository is
much like a bank and perform many activities that are similar to a bank.

4.2 Basics of Depository

Depository is an institution or a kind of organization which holds securities with it, in which trading
is done among shares, debentures, mutual funds, derivatives, F&O and commodities. The
intermediaries perform their actions in variety of securities at Depository on behalf of their clients.
These intermediaries are known as Depositories Participants. Fundamentally, There are two sorts of
depositories in India. One is the National Securities Depository Limited(NSDL) and the other is the
Central Depository Service (India) Limited(CDSL). Every Depository Participant(DP) needs to be
registered under this Depository before it begins its operation or trade in the market.

4.3 Operation of Depositories

Depository interacts with its clients / investors through its agents, called Depository Participants
normally known as DPs.For any investor / client, to avail the services provided by the Depository,
has to open Depository account, known as Demat A/c, with any of the Dps. A demat account is opened
on the same lines as that of a Bank Account. Prescribed Account opening forms are available with the
DP, needs to be filled in. Standard Agreements are to be signed by the Client and the DP, which details
the rights and obligations of both parties. Along with the form the client requires to attach Photographs
of Account holder, Attested copies of proof of residence and proof of identity needs to be submitted
along with the account opening form.
In case of Corporate clients, additional attachments required are true copy of the
resolution for Demat a/c opening along with signatories to operate the account and true copy of the
Memorandum and Articles of Association is to be attached.

4.4 Services provided by Depository

1.Dematerialisation (usually known as demat) is converting physical certificates to electronic form
2.Rematerialisation, known as remat, is reverse of demat, i.e. getting physical certificates from the
electronic securities
3.Transfer of securities, change of beneficial ownership
4.Settlement of trades done on exchange connected to the Depository

4.5 Depositories in India

Currently there are two depositories operational in the country.
1. National Securities Depository Ltd. - NSDL - Having 1.25 crores Demat A/c as on 01-12-2012 –
288 DPs in India
2. Central Depository Services Ltd. - CDSL - Having 80 lakhs Demat A/c as on 31-08-2011 - 643
DPs in India
At present there are two depositories in India, National Securities Depository Limited (NSDL) and
Central Depository Services (CDS).
(i)NSDL
The Government of India enacted the Depositories Act, in August 1996, paving the way for setting
up of depositories in India. Thus, pioneering the concept of depositories and ushering in an era of
paperless settlement of securities, National Securities Depository Ltd. (NSDL) was inaugurated as
the first depository in India on November 1996. Trading in dematerialized securities on the National
Stock Exchange (NSE) commenced on December 26, 1996. The Stock Exchange, Mumbai (BSE)
also extended the facility of trading in dematerialized securities from December 29, 1997.
NSDL is the first Indian depository, it was inaugurated in November 1996. NSDL was set up with an
initial capital of US$28mn,promoted by Industrial Development Bank of India (the largest
development financial institution in India) Unit Trust of India (the largest Mutual Fund in India),
National Stock Exchange of India (the largest Stock Exchange in India), State Bank of India (the
largest Commercial Bank in India), and the major other stake holders are Canara Bank, Citibank NA
Dena Bank, Deutsche Bank AG, Global Trust Bank Limited, HDFC Bank Limited, Hongkong and
Shanghai Banking Corporation Limited and Standard Chartered Bank.
(ii)CDSL
The other depository is Central Depository Services (CDSL).CDSL is promoted by Bombay Stock
Exchange Limited (BSE) jointly with State Bank of India, Bank of India, Bank of Baroda, HDFC
Bank, Standard Chartered Bank, Union Bank of India and Centurion Bank. CDSL was set up in
1999.Central Depository Services Limited (CDSL), is the second Indian central securities depository
based in Mumbai. Its main function is the holding securities either in certificated or un-certificated
(dematerialized) form, to enable book entry transfer of securities.It is still in the process of linking
with the stock exchanges. It has registered around 20 DPs and has signed up with 40 companies. It
had received a certificate of commencement of business from SEBI on February 8, 1999.
These depositories have appointed different Depository Participants (DP) for them. An
investor can open an account with any of the depositories’ DP. But transfers arising out of trades on
the stock exchanges can take place only amongst account-holders with NSDL’s DPs. This is because
only NSDL is linked to the stock exchanges (nine of them including the main ones-National Stock
Exchange and Bombay Stock Exchange).
In order to facilitate transfers between investors having accounts in the two existing
depositories in the country the Securities and Exchange Board of India has asked all stock exchanges
to link up with the depositories. Sebi has also directed the companies’ registrar and transfer agents to
effect change of registered ownership in its books within two hours of receiving a transfer request
from the depositories. Once connected to both the depositories the stock exchanges have also to
ensure that inter-depository transfers take place smoothly. It also involves the two depositories
connecting with each other. The NSDL and CDS have signed an agreement for inter-depository
connectivity.

4.5.1 Depository Participant

NSDL carries out its activities through various functionaries called business partners who include
Depository Participants (DPs), Issuing corporates and their Registrars and Transfer Agents, Clearing
corporations/ Clearing Houses etc. NSDL is electronically linked to each of these business partners
via a satellite link through Very Small Aperture Terminals (VSATs). The entire integrated system
(including the VSAT linkups and the software at NSDL and each business partner’s end) has been
named as the “NEST” (National Electronic Settlement & Transfer) system.
The investor interacts with the depository through a depository participant of NSDL. A DP can be a
bank, financial institution, a custodian or a broker. Just as one opens a bank account in order to avail
of the services of a bank, an investor opens a depository account with a depository participant in order
to avail of depository facilities.

4.6 Depository System in India

 India has adopted the Depository System for securities trading in which book entry is
done electronically and no paper is involved. The physical form of securities is extinguished and
shares or securities are held in an electronic form. Before the introduction of the depository system
through the Depository Act, 1996, the process of sale, purchase and transfer of securities was a huge
problem, and there was no safety at all.

4.6.1 Key Features of the Depository System in India:

1. Multi-Depository System: The depository model adopted in India provides for a competitive
multi- depository system. There can be various entities providing depository services. A depository
should be a company formed under the Company Act, 1956 and should have been granted a certificate
of registration under the Securities and Exchange Board of India Act, 1992. Presently, there are two
depositories registered with SEBI, namely:
National Securities Depository Limited (NSDL), and
Central Depository Service Limited (CDSL)
2. Depository services through depository participants: The depositories can provide their services
to investors through their agents called depository participants. These agents are appointed subject to
the conditions prescribed under Securities and Exchange Board of India (Depositories and
Participants) Regulations, 1996 and other applicable conditions.
3. Dematerialization: The model adopted in India provides for dematerialisation of securities. This
is a significant step in the direction of achieving a completely paper-free securities market.
Dematerialization is a process by which physical certificates of an investor are converted into
electronic form and credited to the account of the depository participant.
4. Fungibility: The securities held in dematerialized form do not bear any notable feature like
distinctive number, folio number or certificate number. Once shares get dematerialized, they lose their
identity in terms of share certificate distinctive numbers and folio numbers. Thus all securities in the
same class are identical and interchangeable. For example, all equity shares in the class of fully paid
up shares are interchangeable.
5. Registered Owner/ Beneficial Owner: In the depository system, the ownership of securities
dematerialized is bifurcated between Registered Owner and Beneficial Owner. According to the
Depositories Act, ‘Registered Owner’ means a depository whose name is entered as such in the
register of the issuer. A ‘Beneficial Owner’ means a person whose name is recorded as such with the
depository. Though the securities are registered in the name of the depository actually holding them,
the rights, benefits and liabilities in respect of the securities held by the depository remain with the
beneficial owner. For the securities dematerialized, NSDL/CDSL is the Registered Owner in the
books of the issuer; but ownership rights and liabilities rest with Beneficial Owner. All the rights,
duties and liabilities underlying the security are on the beneficial owner of the security.
6. Free Transferability of shares: Transfer of shares held in dematerialized form takes place freely
through electronic book-entry system.

4.7 Evolution of Depository System

Although India had a vibrant capital market which is more than a century old, the paper-
based settlement of trades caused substantial problems such as bad delivery and delayed transfer of
title. The enactment of Depositories Act in August 1996 paved the way for establishment of National
Securities Depository Limited (NSDL), the first depository in India. It went on to established
infrastructure based on international standards that handles most of the securities held and settled in
de-materialised form in the Indian capital markets.
NSDL has stated it aims are to ensuring the safety and soundness of Indian marketplaces
by developing settlement solutions that increase efficiency, minimise risk and reduce costs. NSDL
plays a quiet but central role in developing products and services that will continue to nurture the
growing needs of the financial services industry.
 In the depository system, securities are held in depository accounts, which are similar
to holding funds in bank accounts. Transfer of ownership of securities is done through simple account
transfers. This method does away with all the risks and hassles normally associated with paperwork.
Consequently, the cost of transacting in a depository environment is considerably lower as compared
to transacting in certificates. In August 2009, number of Demat accounts held with NSDL crossed
one crore.

4.8 Merits/ Advantages of the Depository System:

The advantages of dematerialization of securities are as follows:
1.Share certificates, on dematerialization, are cancelled and the same will not be sent back to the
investor. The shares, represented by dematerialized share certificates are fungible and, therefore,
certificate numbers and distinctive numbers are cancelled and become non-operative.
2.It enables processing of share trading and transfers electronically without involving share
certificates and transfer deeds, thus eliminating the paper work involved in scrip-based trading and
share transfer system.
3.Transfer of dematerialized securities is immediate and unlike in the case of physical transfer where
the change of ownership has to be informed to the company in order to be registered as such, in case
of transfer in dematerialized form, beneficial ownership will be transferred as soon as the shares are
transferred from one account to another.
4.The investor is also relieved of problems like bad delivery, fake certificates, shares under litigation,
signature difference of transferor and the like.
5.There is no need to fill a transfer form for transfer of shares and affix share transfer stamps.
6.There is saving in time and cost on account of elimination of posting of certificates.
7.The threat of loss of certificates or fraudulent interception of certificates in transit that causes
anxiety to the investors, are eliminated.

4.9 Demerits of Depository System

Some disadvantages were about the depository system were known beforehand. But since the
advantages outweighed the shortcomings of dematerialisation, the depository system was given the
go-ahead.
i. Lack of control: Trading in securities may become uncontrolled in case of dematerialized securities.
ii. Need for greater supervision: It is incumbent upon the capital market regulator to keep a close
watch on the trading in dematerialized securities and see to it that trading does not act as a detriment
to investors. The role of key market players in case of dematerialized securities, such as stock brokers,
needs to be supervised as they have the capability of manipulating the market.
iii. Complexity of the system: Multiple regulatory frameworks have to be confirmed to, including the
Depositories Act, Regulations and the various Bye Laws of various depositories. Additionally,
agreements are entered at various levels in the process of dematerialization. These may cause anxiety
to the investor desirous of simplicity in terms of transactions in dematerialized securities.
Besides the above-mentioned disadvantages, some other problems with the system have been
discovered subsequently. With new regulations people are finding more and more loopholes in the
system.
iv. Current regulations prohibit multiple bids or applications by a single person. But investors open
multiple demat accounts and make multiple applications to subscribe to IPOs in the hope of getting
allotment of shares.
v. Some listed companies had obtained duplicate shares after the originals were pledged with banks
and then sold the duplicates in the secondary market to make a profit.
vi. Promoters of some companies dematerialised shares in excess of the company’s issued capital.
vii. Certain investors pledged shares with banks and got the same shares reissued as duplicates.
viii. There is an undue delay in the settlement of complaints by investors against depository
participants.This is because there is no single body that is in charge of ensuring full compliance by
these companies.

4.10 Risks/Problems involved trading of shares :

Indian investor community has undergone sea changes in the past few years. India now has a very
large investor population and ever increasing volumes of trades. However, this continuous growth in
activities has also increased problems associated with stock trading. Most of these problems arise due
to the intrinsic nature of paper based trading and settlement, like theft or loss of share certificates.
This system requires handling of huge volumes of paper leading to increased costs and inefficiencies.
Risk exposure of the investor also increases due to this trading in paper.
Some of these risks are :
1.Delay in transfer of shares.
2.Possibility of forgery on various documents leading to bad deliveries, legal disputes etc.
3.Possibility of theft of share certificates.
4.Prevalence of fake certificates in the market.
5.Mutilation or loss of share certificates in transit.
The physical form of holding and trading in securities also acts as a bottleneck for broking community
in capital market operations. The introduction of NSE and BOLT has increased the reach of capital
market manifolds. The increase in number of investors participating in the capital market has
increased the possibility of being hit by a bad delivery. The cost and time spent by the brokers for
rectification of these bad deliveries tends to be higher with the geographical spread of the clients. The
increase in trade volumes lead to exponential rise in the back office operations thus limiting the
growth potential of the broking members. The inconvenience faced by investors (in areas that are far
flung and away from the main metros) in settlement of trade also limits the opportunity for such
investors, especially in participating in auction trading. This has made the investors as well as broker
wary of Indian capital market. In this scenario dematerialized trading is certainly a welcome move.

4.11 Dematerialization
Dematerialization or “Demat” is a process whereby your securities like shares, debentures etc, are
converted into electronic data and stored in computers by a Depository. Securities registered in your
name are surrendered to depository participant (DP) and these are sent to the respective companies
who will cancel them after “Dematerialization” and credit your depository account with the DP. The
securities on Dematerialization appear as balances in your depository account. These balances are
transferable like physical shares. If at a later date, you wish to have these “demat” securities converted
back into paper certificates, the Depository helps you to do this.

4.11.1 Benefits of Dematerialization

Transacting the depository way has several advantages over the traditional system of transacting using
share certificates. Some of the benefits are:
1.Trading in demat segment completely eliminates the risk of bad deliveries, which in turn eliminates
all cost and wastage of time associated with follow up for rectification. This reduction in risk
associated with bad delivery has lead to reduction in brokerage to the extent of 0.5% by quite a few
brokerage firms.
2.In case of transfer of electronic shares, you save 0.5% in stamp duty.
3.It can also avoid the cost of courier/ notarization/ the need for further follow-up with your broker
for shares returned for company objection In case the certificates are lost in transit or when the share
certificates become mutilated or misplaced, to obtain duplicate certificates, you may have to spend at
least Rs500 for indemnity bond, newspaper advertisement etc, which can be completely eliminated
in the demat form.
4.You can also receive your bonuses and rights into your depository account as a direct credit, thus
eliminating risk of loss in transit.
5.You can also expect a lower interest charge for loans taken against demat shares as compared to the
interest for loan against physical shares. This could result in a saving of about 0.25% to 1.5%. Some
banks have already announced this.
6.RBI has increased the limit of loans against dematerialized securities as collateral to Rs2mn per
borrower as against Rs1mn per borrower in case of loans against physical securities.
7.RBI has also reduced the minimum margin to 25% for loans against dematerialized securities as
against 50% for loans against physical securities.

4.12 Process of Dematerialization

Step I: Investor surrenders the share certificates to a DP.
Step II: DP generates an electronic request to NSDL.
Step III: DP forwards the physical certificate to the Company/RT.
Step IV: Company/RT cancels the certificates and forwards the credits in demat form to NSDL. Step
V: NSDL releases the credit to the investor's account with the DP.

For diagrams refer class running notes

4.13 Process of Rematerialization

Step I: Investor forwards a physical remat request to his DP.
Step II: DP will generate an electronic request to NSDL.
Step III: DP will forward the physical remat request to the Company/RT.
Step IV: NSDL will confirm the company/RT about the change and nullifies the security electronically.
Step V: On receipt of the confirmation from NSDL, company/RT will print new certificate and
forward it directly to the investor.