UNIT 1

INTRODUCTION TO INVESTMENT MANAGEMENT

Investment is employment of funds with aim of achieving additional income or growth in value.
It’s a long term commitment , where essential quality is waiting for a reward. It’s a commitment
of resources which have been saved or put away from current consumption in the hope that
some benefit will occur in future. It can also be defined as “The act of committing money or
capital to an endeavor with the expectation of obtaining an additional income or profit. Giving up
consumption today and putting money into assets that will bring greater wealth and
consumption in the future”. Investment can be defined in Economic and Financial sense as
follows.

Investment in economic sense:

Investment is a Net addition to the economy’s capital stock, which consists of goods and
services that are used in the production of other goods and services. It’s a formation of
productive capital. Net additions to the capital stock of the society ( those goods which are
used in the production of other goods)

Investment in financial sense:

Investment is a Monetary assets purchased with the idea that the asset will provide an income
and capital appreciation. Its an exchange of financial claims like stock, bonds, real estate etc.
Investment is parting with one’s fund to be used by another party for productive activity.
Investment is a conversion of money or cash into a monetary asset on a claim on future money
for a return.

The term ‘investing” could be associated with the different activities, but the common target in
these activities is to “employ” the money (funds) during the time period seeking to enhance the
investor’s wealth. Funds to be invested come from assets already owned, borrowed money and
savings. By foregoing consumption today and investing their savings, investors expect to
enhance their future consumption possibilities by increasing their wealth. But it is useful to make
a distinction between real and financial investments. Real investments generally involve some
kind of tangible asset, such as land,machinery, factories, etc. Financial investments involve
contracts in paper or electronic form such as stocks, bonds, etc.

There are two types of investors:

 Individual investors;
 Institutional investors.

Individual investors are individuals who are investing on their own.Sometimes individual
investors are called retail investors. Institutional investors are entities such as investment
companies, commercial banks, insurance companies, pension funds and other financial
institutions.

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Direct versus indirect investing

Investors can use direct or indirect type of investing. Direct investing is realized using financial
markets and indirect investing involves financial intermediaries. The primary difference between
these two types of investing is that applying direct investing investors buy and sell financial
assets and manage individual investment portfolio themselves. Consequently, investing directly
through financial markets investors take all the risk and their successful investing depends on
their understanding of financial markets, its fluctuations and on their abilities to analyze and to
evaluate the investments and to manage their investment portfolio. Contrary, using indirect type
of investing investors are buying or selling financial instruments of financial intermediaries
(financial institutions) which invest large pools of funds in the financial markets and hold
portfolios. Indirect investing relieves investors from making decisions about their portfolio. As
shareholders with the ownership interest in the portfolios managed by financial institutions
(investment companies, pension funds, insurance companies, commercial banks) the investors
are entitled to their share of dividends, interest and capital gains generated and pay their share
of the institution’s expenses and portfolio management fee. The risk for investor using indirect
investing is related more with the credibility of chosen institution and the professionalism of
portfolio managers. In general, indirect investing is more related with the financial institutions
which are primarily in the business of investing in and managing a portfolio of securities (various
types of investment funds or investment companies, private pension funds). By pooling the
funds of thousands of investors, those companies can offer them a variety of services, in
addition to diversification, including professional management of their financial assets and
liquidity.

Together with the investment the term speculation and Gambling is frequently used.
Speculation can be described as investment too, but it is related with the short-term investment
horizons and usually involves purchasing the salable securities with the hope that its price will
increase rapidly, providing a quick profit. Speculators try to buy low and to sell high, their
primary concern is with anticipating and profiting from market fluctuations.

Speculation:

Investment and speculation are somewhat different and yet similar because speculation
requires an investment and investments are at least somewhat speculative. Both are leading to
claim on money, aims at maximizing return. Investment is putting money in an asset not
necessarily in marketable in short run, where as speculation is selecting an investment with
higher risk in order to profit from an anticipated price movement. If investment is done with long
term objective, speculation is of short term objective. investment, a well grounded and
carefully planned speculation.

Investment and speculation both involve the purchase of assets such as shares and securities,
with an expectation of return. However, investment can be distinguished from speculation by
risk bearing capacity, return expectations, and duration of trade. The capacity to bear risk
distinguishes an investor from a speculator. An investor prefers low risk investments, whereas a
speculator is prepared to take higher risks for higher returns. Speculation focuses more on
returns than safety, thereby encouraging frequent trading without any intention of owning the
investment. The speculator’s motive is to achieve profits through price change, that is, capital
gains are more important than the direct income from an investment. Thus, speculation is
associated with buying low and selling high with the hope of making large capital gains.

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Investors are careful while selecting securities for trading. Investments, in most instances,
expect an income in addition to the capital gains that may accrue when the securities are traded
in the market.

Investment is long term in nature. An investor commits funds for a longer period in the
expectation of holding period gains. However, a speculator trades frequently; hence, the holding
period of securities is very short.

The identification of these distinctions helps to define the role of the investor and the speculator
in the market. The investor can be said to be interested in a good rate of return on a consistent
basis over a relatively longer duration. For this purpose the investor computes the real worth of
the security before investing in it. The speculator seeks very large returns from the market
quickly. For a speculator, market expectations and price movements are the main factors
influencing a buy or sell decision. Speculation, thus, is more risky than investment.

In any stock exchange, there are two main categories of speculators called the bulls and bears.
A bull buys shares in the expectation of selling them at a higher price. When there is a bullish
tendency in the market, share prices tend to go up since the demand for the shares is high. A
bear sells shares in the expectation of a fall in price with the intention of buying the shares at a
lower price at a future date. These bearish tendencies result in a fall in the price of shares. A
share market needs both investment and speculative activities. Speculative activity adds to the
market liquidity. A wider distribution of shareholders makes it necessary for a market to exist.
Based on the above discussion, the following differences can be identified between
Investment and speculation.

Difference between Investment and Speculation

Basis Investment Speculation

Basis of acquisition Outright purchase On margin

Length of commitment Long term Short term

Source of income Earnings of enterprise Change in market price

Quantity of risk Small Large

Stability of income Very stable Uncertain

Reason for purchase Scientific analysis Tips, inside information etc

Psychological attitude Cautious and conservative Daring and careless

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Gambling

Gambling is a High risk venture, where the investor plays for high stakes. Reckless venture to
look for very quick profits in the short term. Gambling is based upon tips, rumors , its un
planned, unscientific, and without the knowledge of the exact nature of risk.

Characteristics of gambling

•It is typical, chronic and repetitive experience

•Gambling Absorb all other interests

•Displays persistent optimism without winning

•Never stops while winning

•Risks more than what can be afforded

•Enjoys a strange thrill, a combination of pleasure and pain.

Investment can also to be distinguished from gambling. Examples of gambling are horse race,
card games, lotteries, and so on. Gambling involves high risk not only for high returns but also
for the associated excitement. Gambling is unplanned and unscientific, without theknowledge of
the nature of the risk involved. It is surrounded by uncertainty and a gambling decision is taken
on unfounded market tips and rumours. In gambling, artificial and unnecessary risks are created
for increasing the returns. Investment is an attempt to carefully plan, evaluate, and allocatefunds
to various investment outlets that offer safety of principal and expected returns over a long
period of time. Hence, gambling is quite the opposite of investment even though the stock
market has been euphemistically referred to as a “gambling den”.

Characteristics of Investment

The features of economic and financial investments can be summarised as return, risk,
safety, and liquidity.

Return: All investments are characterised by the expectation of a return. In fact, investments
are made with the primary objective of deriving a return. The expectation of a return may be
from income (yield) as well as through capital appreciation. Capital appreciation is the difference
between the sale price and the purchase price of the investment. The dividend or interest from
the investment is the yield. Different types of investments promise different rates of return. The
expectation of return from an investment depends upon the nature of investment, maturity
period, market demand, and so on. The purpose for which the investment is put to use
influences, to a large extent, the expectation of return of the investors. Investment in high
growth potential sectors would certainly increase such expectations. The longer the maturity
period, the longer is the duration for which the investor parts with the value of the investment.
Hence, the investor would expect a higher return from such investments.

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Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment
of capital, non-payment of interest, or variability of returns. While some investments such as
government securities and bank deposits are almost without risk, others are more risky. The risk
of an investment is determined by the investment’s maturity period repayment capacity, nature
of return commitment, and so on. The longer the maturity period, greater is the risk. When the
expected time in which the investment has to be returned is a long duration, say 10 years,
instead of five years, the uncertainty surrounding the return flow from the investment increases.
This uncertainty leads to a higher risk level for the investment with longer maturity rather than
on an investment with shorter maturity.

Safety: The safety of investment is identified with the certainty of return of capital without loss
of money or time. Safety is another feature that an investor desires from investments. Every
investor expects to get back the initial capital on maturity without loss and without delay.
Investment safety is gauged through the reputation established by the borrower of funds. A
highly reputed and successful corporate entity assures the investors of their initial capital. For
example, investment is considered safe especially when it is made in securities issued by the
government of a developed nation.

Liquidity: An investment that is easily saleable or marketable without loss of money and
without loss of time is said to possess the characteristic of liquidity. Some investments such as
deposits in unknown corporate entities, bank deposits, post office deposits, national savings
certificate, and so on are not marketable. There is no well-established trading mechanism that
helps the investors of these instruments to subsequently buy/sell them frequently from a market.
Investment instruments such as preference shares and debentures (listed on a stock exchange)
are marketable. The extent of trading, however, depends on the demand and supply of such
instruments in the market for the investors. Equity shares of companies listed on recognised
stock exchanges are easily marketable. A well-developed secondary market for securities
increases the liquidity of the instruments traded therein. An investor tends to prefer
maximisation of expected return, minimisation of risk, safety of funds, and liquidity of
investments.

Investment Objectives

The options for investing savings are continually increasing, yet every single investment vehicle
can be easily categorized according to three fundamental characteristics - safety, income and
growth - which also correspond to types of investor objectives. While it is possible for an
investor to have more than one of these objectives, the success of one must come at the
expense of others. Let's examine these three types of objectives, the investments that are used
to achieve them and the ways in which investors can incorporate them in devising a strategy.

1 Safety
Perhaps there is truth to the axiom that there is no such thing as a completely safe and secure

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investment. Yet we can get close to ultimate safety for our investment funds through the
purchase of government-issued securities in stable economic systems, or through the purchase
of the highest qualitycorporate bonds issued by the economy's top companies. Such securities
are arguably the best means of preserving principal while receiving a specified rate of return.

The safest investments are usually found in the money market, which includes such securities
as Treasury bills (T-bills), certificates of deposit (CD),commercial paper or bankers'
acceptance slips, or in the fixed income (bond) market in the form of municipal and other
government bonds, and in corporate bonds. The securities listed above are ordered according
to the typical spectrum of increasing risk and, in turn, increasing potential yield. To compensate
for their higher risk, corporate bonds return a greater yield than T-bills.

It is important to realize that there's an enormous range of relative risk within the bond
market. At one end are government and high-grade corporate bonds, which are considered
some of the safest investments around; at the other end are junk bonds, which have a
lower investment grade and may have more risk than some of the more speculative stocks. In
other words, it's incorrect to think that corporate bonds are always safe, but most instruments
from the money market can be considered very safe.

2 Income
The safest investments are also the ones that are likely to have the lowest rate of income return
or yield. Investors must inevitably sacrifice a degree of safety if they want to increase their
yields. This is the inverse relationship between safety and yield: as yield increases, safety
generally goes down and vice versa.

In order to increase their rate of investment return and take on risk above that of money market
instruments or government bonds, investors may choose to purchase corporate bonds
or preferred shares with lower investment ratings. Investment grade bonds rated at A or AA are
slightly riskier than AAA bonds, but presumably also offer a higher income return than AAA
bonds. Similarly, BBB rated bonds can be thought to carry medium risk but offer less potential
income than junk bonds, which offer the highest potential bond yields available but at the
highest possible risk. Junk bonds are the most likely to default.

Most investors, even the most conservative-minded ones, want some level of income
generation in their portfolios, even if it's just to keep up with the economy's rate of inflation. But

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maximizing income return can be an overarching principle for a portfolio, especially for
individuals who require a fixed sum from their portfolio every month. A retired person who
requires a certain amount of money every month is well served by holding reasonably safe
assets that provide funds over and above other income-generating assets, such as pension
plans, for example.

3 Growth of Capital
This discussion has thus far been concerned only with safety and yield as investing objectives,
and has not considered the potential of other assets to provide a rate of return from an increase
in value, often referred to as a capital gain. Capital gains are entirely different from yield in that
they are only realized when the security is sold for a price that is higher than the price at which it
was originally purchased. Selling at a lower price is referred to as a capital loss. Therefore,
investors seeking capital gains are likely not those who need a fixed, ongoing source of
investment returns from their portfolio, but rather those who seek the possibility of longer-term
growth.

Growth of capital is most closely associated with the purchase of common stock, particularly
growth securities, which offer low yields but considerable opportunity for increase in value. For
this reason, common stock generally ranks among the most speculative of investments as their
return depends on what will happen in an unpredictable future. Blue-chip stocks, by contrast,
can potentially offer the best of all worlds by possessing reasonable safety, modest income and
potential for growth in capital generated by long-term increases in corporate revenues and
earnings as the company matures. Yet rarely is any common stock able to provide the near-
absolute safety and income-generation of government bonds.

It is also important to note that capital gains offer potential tax advantages by virtue of their
lower tax rate in most jurisdictions. Funds that are garnered through common stock offerings, for
example, are often geared toward the growth plans of small companies, a process that is
extremely important for the growth of the overall economy. In order to encourage investments in
these areas, governments choose to tax capital gains at a lower rate than income. Such
systems serve to encourage entrepreneurship and the founding of new businesses that help the
economy grow.

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Secondary Objectives

A Tax Minimization
An investor may pursue certain investments in order to adopt tax minimization as part of his or
her investment strategy. A highly-paid executive, for example, may want to seek investments
with favorable tax treatment in order to lessen his or her overall income tax burden. Making
contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an
effective tax minimization strategy.

B Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they cannot
be immediately sold and easily converted into cash. Achieving a degree of liquidity, however,
requires the sacrifice of a certain level of income or potential for capital gains.

Common stock is often considered the most liquid of investments, since it can usually be sold
within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds
are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments
may only be redeemable at the precise date at which the fixed term ends. If an investor seeks
liquidity, money market assets and non-tradable bonds aren't likely to be held in his or her
portfolio.

As we have seen from each of the five objectives discussed above, the advantages of one often
comes at the expense of the benefits of another. If an investor desires growth, for instance, he
or she must often sacrifice some income and safety. Therefore, most portfolios will be guided by
one pre-eminent objective, with all other potential objectives occupying less significant weight in
the overall scheme. Choosing a single strategic objective and assigning weightings to all other
possible objectives is a process that depends on such factors as the investor's temperament,
his or her stage of life, marital status, family situation and so forth. Out of the multitude of
possibilities out there, each investor is sure to find an appropriate mix of investment
opportunities.

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Investment Process
Investment process is the process of managing money or funds.
The investment process describes how an investor should go about
making decisions. Investment process can be disclosed by five-step procedure,
which includes following stages:

1. Setting of investment policy.

2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.

1 Setting of investment policy is the first and very important step in investment management
process. Investment policy includes setting of investment objectives. The investment policy
should have the specific objectives regarding the investment return requirement and risk
tolerance of the investor. For example, the investment policy may define that the target of the
investment average return should be 15 % and should avoid more than 10 % losses. Identifying
investor’s tolerance for risk is the most important objective, because it is obvious that every
investor would like to earn the highest return possible. But because there is a positive
relationship between risk and return, it is not appropriate for an investor to set his/ her
investment objectives as just “to make a lot of money”. Investment objectives should be stated
in terms of both risk and return.
The investment policy should also state other important constrains which could influence the
investment management. Constrains can include any liquidity needs for the investor, projected
investment horizon, as well as other unique needs and preferences of investor. The investment
horizon is the period of time for investments.
Projected time horizon may be short, long or even indefinite. Setting of investment objectives for
individual investors is based on the assessment of their current and future financial objectives.
The required rate of return for investment depends on what sum today can be invested and how
much investor needs to have at the end of the investment horizon. Wishing to earn higher
income on his / her investments investor must assess the level of risk he /she should take and
to decide if it is relevant for him or not. The investment policy can include the tax status of the
investor. This stage of investment management concludes with the identification of the potential
categories of financial assets for inclusion in the investment portfolio.
The identification of the potential categories is based on the investment objectives, amount of
investable funds, investment horizon and tax status of the investor. We could see that various
financial assets by nature may be more or less risky and in general their ability to earn returns
differs from one type to the other. As an example, for the investor with low tolerance of risk
common stock will be not appropriate type of investment.

2 Analysis and evaluation of investment vehicles. When the investment policy is set up,
investor’s objectives defined and the potential categories of financial assets for inclusion in the
investment portfolio identified, the available investment types can be analyzed. This step
involves examining several relevant types of investment vehicles and the individual vehicles
inside these groups. For example, if the common stock was identified as investment vehicle
relevant for investor, the analysis will be concentrated to the common stock as an investment.
The one purpose of such analysis and evaluation is to identify those investment vehicles that
currently appear to be mispriced. There are many different approaches how to make such

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analysis. Most frequently two forms of analysis are used: technical analysis and fundamental
analysis. Technical analysis involves the analysis of market prices in an attempt to predict future
price movements for the particular financial asset traded on the market. This analysis examines
the trends of historical prices and is based on the assumption that these trends or patterns
repeat themselves in the future. Fundamental analysis in its simplest form is focused on the
evaluation of intrinsic value of the financial asset. This valuation is based on the assumption that
intrinsic value is the present value of future flows from particular investment. By comparison of
the intrinsic value and market value of the financial assets those which are under priced or
overpriced can be identified. This step involves identifying those specific financial assets in
which to invest and determining the proportions of these financial assets in the investment
portfolio.

3 Formation of diversified investment portfolio is the next step in investment management

process. Investment portfolio is the set of investment vehicles, formed by the investor seeking
to realize its’ defined investment objectives. In the stage of portfolio formation the issues of
selectivity, timing and diversification need to be addressed by the investor. Selectivity refers to
micro forecasting and focuses on forecasting price movements of individual assets. Timing
involves macro forecasting of price movements of particular type of financial asset relative to
fixed-income securities in general. Diversification involves forming the investor’s portfolio for
decreasing or limiting risk of investment. 2 techniques of diversification:
• random diversification, when several available financial assets are put to the portfolio at
random;
• objective diversification when financial assets are selected to the portfolio following investment
objectives and using appropriate techniques for analysis and evaluation of each financial asset.
Investment management theory is focused on issues of objective portfolio diversification and
professional investors follow settled investment objectives then constructing and managing their
portfolios.

4 Portfolio revision. This step of the investment management process concerns the periodic
revision of the three previous stages. This is necessary, because over time investor with long-
term investment horizon may change his / her investment objectives and this, in turn means that
currently held investor’s portfolio may no longer be optimal and even contradict with the new
settled investment objectives. Investor should form the new portfolio by selling some assets in
his portfolio and buying the others that are not currently held. It could be the other reasons for
revising a given portfolio: over time the prices of the assets change, meaning that some assets
that were attractive at one time may be no longer be so. Thus investor should sell one asset ant
buy the other more attractive in this time according to his/ her evaluation. The decisions to
perform changes in revising portfolio depend, upon other things, in the transaction costs
incurred in making these changes. For institutional investors portfolio revision is continuing and
very important part of their activity. But individual investor managing portfolio must perform
portfolio revision periodically as well. Periodic reevaluation of the investment objectives and
portfolios based on them is necessary, because financial markets change, tax laws and security
regulations change, and other events alter stated investment goals.

5 Measurement and evaluation of portfolio performance. This the last step in investment
management process involves determining periodically how the portfolio performed, in terms of
not only the return earned, but also the risk of the portfolio. For evaluation of portfolio
performance appropriate measures of return and risk and benchmarks are needed. A
benchmark is the performance of predetermined set of assets, obtained for comparison
purposes. The benchmark may be a popular index of appropriate assets – stock index, bond
index. The benchmarks are widely used by institutional investors evaluating the performance of

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their portfolios. It is important to point out that investment management process is continuing
process influenced by changes in investment environment and changes in investor’s attitudes
as well. Market globalization offers investors new possibilities, but at the same time investment
management become more and more complicated with growing uncertainty.

Financial assets
Conducive economic environment attracts investment, which in turn influences the development
of the economy. One of the essential criteria for the assessment of economic development is
the quality and quantity of assets in a nation at a specific time. There are two broad types of
assets: (1) real assets, (2) financial assets. Real assets comprise the physical and intangible
items available to a society.

Physical assets are used to generate activity and result in positive or negative contribution to
the owner of the asset. Intangible assets also result in a positive or negative contribution to the
owner, but are different in that they do not have a physical shape or form. Besides real assets,
the economy is supported by another group of assets called financial assets. The major
component of the financial assets is cash, also called money. Financial assets help the physical
assets to generate activity. Some examples of financial assets besides cash are deposits, debt
instruments, shares, and foreign currency reserves. Assets in any economy can thus be broadly
grouped into physical, financial, and tangible assets, based on their distinct characteristics.
Physical assets can be classified into fixed assets and working capital assets, based on the
length of their life. Fixed assets, such as land, building, machinery and other infrastructure
facilities, are utilized by the society over a long period of time when compared with working
capital assets. Movable/circulating capital assets are produced and consumed by the society
within a financial year. Examples of movable/circulating capital assets include materials,
merchandise, durable goods, jewellery (gold), and similar items. Intangible assets are
goodwill, patents, copyrights, and royalties.

In a macro sense, financial assets are regulated by the government of a country. Financial
assets smoothen the trade and transaction of an economy and give the society a standard
measure of valuation. Money or cash is the basic financial asset created by the government of
an economy. The extent of flow of this financial asset has to be regulated in a country for the
demand for and supply of funds to match the macro level, financial assets also represent the
current/ future value of physical and intangible assets. The current/future value of financial
assets depends on the current/future return expectations from these financial instruments. All
the financial assets in an economy represent a real asset either in the present context or in the
context of the future. Their dependence on real assets requires the financial assets to be valued
differently. The distinctive value determination of financial instruments also requires a specific
market to patronise them. Financial assets have specific properties that distinguish them from
physical and intangible assets. These properties are monetary value, divisibility, convertibility,
reversibility, liquidity, and cash flow.

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 CLASSIFICATION OF SECURITIES
Financial claims or financial assets like shares debentures etc dealt in a financial
market are referred to as financial instruments or securities. Securities refer to
claims of periodical payments of certain sum of money by way of payment of
principal, interest or dividend. The payments relating to financial securities
depending on the nature of financial instruments held. For instance, in the case of
bonds, debentures or bank deposits, the investor receives regular interest and the
principal repayment at the end of a specified maturity period. In the case of
irredeemable bonds, the holder regularly receives interest payments and the
principal is returned only at the time of winding up of the company. In the case of
ordinary shares, companies make regular dividends payment and capital
appreciation can be expected. Important characteristics of securities are as below.
I. Liquidity: This feature allows for the easy and fast conversion of
securities into cash
2. Marketability: which facilitates easy trading of the security in the
secondary market.
3. Collateral value: which allows for pledging of instruments for obtaining
loans from financial institutions.
4. Maturity period: which is either long term, medium-term or short -term
depending on the type of instrument held by the investor
5. Transferability: which allows for easy and quick transfer of instruments
from one person to another without much formalities
6. Cost: which implies the expenses involved in buying and selling of
financial instruments.
7. Provision of options: such as callback or buyback options where by
companies can buy or sell the securities from investors.
8. Tax provision: Return earned on the instruments which are dealt is either
taxable or tax-free

Types of Securities
Securities can be broadly classified in to
(a) Money market instrument/ Securities
(b) Capital market Securities/instruments.

(a) Money Market Securities/ Instruments

The most liquid, short-term debt obligations that are traded in the money market
are called money market instruments. Some of these instruments are briefly
described below:
1. Treasury Bills (T-Bills): Treasury Bills, one of the safest money market
instruments, are short term borrowing instruments of the Central Government of the
Country issued through the Central Bank (RBI in India). They are zero risk
instruments, and hence the returns are not so attractive. It is available both in

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primary market as well as secondary market. It is a promise to pay a said sum after
a specified period. T-bills are short-term securities that mature in one year or less
from their issue date. They are issued with three -month, six-month and one-year
maturity periods. The Central Government issues T- Bills at a price less than their
face value (par value). They are issued with a promise to pay full face value on
maturity. T-Bills are issued through a bidding process at auctions. At present, the
Government of India issues three types of treasury bills through auctions, namely,
91-day, 182-day and 364-day. Treasury bills are available for a minimum amount of
Rs.25K and in its multiples.
2 Commercial Papers: Commercial paper is a low-cost alternative to bank
loans. It is a short term unsecured promissory note issued by corporate and
financial institutions at a discounted value on face value. They are usually issued
with fixed maturity between one to 270 days and for financing of accounts
receivables, inventories and meeting short term liabilities. Commercial paper being
an instrument not backed by any collateral, only firms with high quality credit
ratings will find buyers easily without offering any substantial discounts. They are
issued by corporates to impart flexibility in raising working capital resources at
market determined rates. Commercial Papers are actively traded in the secondary
market since they are issued in the form of promissory notes and are freely
transferable in demat form.

3 Certificate of Deposit:
It is a short term borrowing more like a bank term deposit account. It is a
promissory note issued by a bank in form of a certificate entitling the bearer to
receive interest. The certificate bears the maturity date, the fixed rate of interest
and the value. It can be issued in any denomination. They are stamped and
transferred by endorsement. Its term generally ranges from three months to five
years and restricts the holders to withdraw funds on demand. However, on payment
of certain penalty the money can be withdrawn on deman d also. The returns on
certificate of deposits are higher than T-Bills because it assumes higher level of
risk.

4 Repo/Reverse Repo: Repurchase transactions, called Repo or Reverse Repo

are transactions or short term loans in which two parties agree to sell and
repurchase the same security. They are usually used for overnight borrowing.
Repo/Reverse Repo transactions can be done only between the parties approved
by RBI and in RBI approved securities viz. GOI and State Govt Securities, T -Bills,
PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the
seller sells specified securities with an agreement to repurchase the same at a
mutually decided future date and price. Similarly, the buyer purchases the
securities with an agreement to resell the same to the seller on an agreed date at a
predetermined price. Such a transaction is called a Repo when viewed from the
perspective of the seller of the securities and Reverse Repo when viewed from the
perspective of the buyer of the securities. Thus, whether a given agreement is
termed as a Repo or Reverse Repo depends on which party initiated the
transaction. The lender or buyer in a Repo is entitled to receive compensation for
use of funds provided to the counterparty.

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Dr. Mukund Sharma, BNMIT
5 Call Money
Call money is mainly used by the banks to meet their temporary requirement of
cash. They borrow and lend money from each other normally on a daily basis. It is
repayable on demand and its maturity period varies in between one day to a
fortnight. The rate of interest paid on call money loan is known as call rate.
• Call Money Money lent for one day
• Notice Money Money lent for a period exceeding one day
• Term Money Money lend for 15 days or more in Inter-bank market

(b) Capital Market Securities/ Instruments

Some of the important securities of capital market are

Equity Shares

Equity shares, commonly referred to as ordinary share also represents the form of fractional
ownership in which a shareholder, as a fractional owner, undertakes the maximum
entrepreneurial risk associated with a business venture. The holder of such shares is the
member of the company and has voting rights. Equity shares, other than non-voting shares,
have voting rights at all general meetings of the company. These votes have the affect on the
controlling of the company. Equity shares have the right to share the profits of the company in
the form of dividend (cash) and bonus shares. However even equity shareholders cannot
demand declaration of dividend by the company which is left to the discretion of the Board of
Directors. When the company is wound up, payment towards the equity share capital will be
made to the respective shareholders only after payment of the claims of all the creditors and the
preference share capital

Preference Shares

It is an unique type of long term financing instrument which combines some of the
characteristics of equity shares as well as debentures. It is similar to debenture because, It
carries fixed dividend, It is ranked higher than equity on the basis of claim and It does not have
any voting rights. It is similar to equity capital because Not obligatory to pay dividend and
Irredeemable type does not have any maturity. Preference share can be Redeemable and
irredeemable preference shares, Convertible and non convertible preference shares and
Participative and non-participative preference shares

Debentures/ Bonds

Section 2(12) of the Companies Act, 1956 defines debentures as “Debenture includes
debenture stock, bonds and any other securities of a company, whether constituting a charge
on the assets of the company or not.” Debenture is a document evidencing the debt of an
organization. It is issued by a company as a certificate of indebtedness and It usually indicates
the date of redemption and also provides for the repayment of principal and payment of interest
at specified date or dates. Debenture usually creates a charge on the undertaking or the assets
of the company. In such a case the lenders of money to the company enjoy better protection as
secured creditors, i.e. if the company does not pay interest or repay principal amount, the

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Dr. Mukund Sharma, BNMIT
lenders may either directly or through the debenture trustees bring action against the company
to realise their dues by sale of the assets/ undertaking earmarked as security for the debt.

Debentures are issued in the following forms:

 Naked or unsecured debentures.

 Secured debentures.
 Redeemable debentures.
 Irredeemable/ Perpetual debentures.
 Non convertible/ Fully convertible/ Partly convertible debentures
 Bearer debentures.
 Registered debentures.
 Zero interest debentures/bonds (ZIB):-
 Deep discount bonds:
 Secured premium notes:
 Floating rate bonds:

ADR / GDR
An American depositary receipt (ADR) or global depositary receipt (GDR) is a simple way
for investors to invest in companies whose shares are listed abroad. The ADR or GDR is
essentially a certificate issued by a bank that gives the owner rights over a foreign share. It can
be listed on a stock exchange and bought and sold just like a normal share. The holder of an
ADR or GDR is entitled to all benefits such as dividends and rights issues from the underlying
shares. They are sometimes – but not always – able to vote. As you might expect from the
name, an ADR is listed in the US. A GDR is typically listed in London or Luxembourg. A
depositary receipt where the issuing bank is European will sometimes be called a European
Depositary Receipt (EDR), although this term is less common. For a real example, let’s look at
ICICI Bank. This stock is listed in India and isn’t available to most foreign investors. However it
has a depositary receipt issued in New York and traded on the New York stock exchange, which
almost anyone can buy. The depositary receipt for ICICI is issued by Deutsche Bank. For each
depositary receipt in circulation, Deutsche Bank holds the equivalent number of India-listed
shares on behalf of the owners of the ADR. One ADR or GDR does not always equal one share
of underlying stock. And with ICICI, the ADR actually represents two India-listed shares of ICICI
and is priced accordingly.

Foreign Currency Convertible Bonds (FCCBs)

A Foreign Currency Convertible Bond (FCCB) is a quasi debt instrument which is issued by any
corporate entity, international agency or sovereign state to the investors all over the world.
They are denominated in any freely convertible foreign currency. Euro Convertible Bonds are
usually issued as unsecured obligation of the borrowers. FCCBs represent equity linked debt
security which can be converted into shares or into depository receipts. The investors of FCCBs
has the option to convert it into equity normally in accordance with pre-determined formula and
sometimes also at a pre-determined exchange rate. The investor also has the option to retain
the bond. The FCCBs by virtue of convertibility offers to issuer a privilege of lower interest cost
than that of similar non convertible debt instrument. By issuing these bonds, a company can

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Dr. Mukund Sharma, BNMIT
also avoid any dilution in earnings per share that a further issue of equity might cause whereas
such a security still can be traded on the basis of underlying equityvalue.

Term Loan
Term Loan is a method of debt financing by banks or financial institutions with maturity period
of over one year to about 10 years. It provides for a fixed and often large amount of loan
required either for setting up a new unit for financing the expansion / diversification /
modernization of a project in terms of land, building, plant and machinery or permanent addition
to current assets. Hence, term loan is also called Project Financing. Term loan carries floating
rate of interest.

External Commercial Borrowing

An external commercial borrowing (ECB) is an instrument used in India to facilitate the
access to foreign money by Indian companies. ECBs include commercial bank loans, buyers'
credit, suppliers' credit, securitised instruments such as floating rate notes and fixed rate bonds
etc. It also includes credit from official export credit agencies and commercial borrowings from
the private sector window of multilateral financial Institutions such as International Finance
Corporation (Washington), ADB, AFIC, CDC, etc. ECBs cannot be used for investment in stock
market or speculation in real estate. The DEA (Department of Economic Affairs), Ministry of
Finance, Government of India along with Reserve Bank of India, monitors and regulates ECB
guidelines and policies.

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Dr. Mukund Sharma, BNMIT
 DERIVATIVES
Meaning and definition
In finance, a derivative is a financial instrument derived from some other asset; rather
than trade or exchange the asset itself, market participants enter into an agreement to
exchange cash, assets or some other value at some future date based on the
underlying asset. The term derivatives indicates that it has no independent value ie., its
value is entirely derived from value of underlying asset. The underlying asset can be
securities, commodities, bullion, currency, indices, live stock etc. Derivative means a
forward, future, option or any other hybrid contract of pre determined fixed duration,
linked for the purpose of contract fulfilment to the value of a specified real or financial
asset or to an index of securities.

There are many types of financial instruments that are grouped under the term
derivatives, but options/futures and swaps are among the most common.

BASIC FEATURES OF DERIVATIVES

1. As derivatives are not physical assets , transactions are setteled by

offsetting/squaring transactions. The difference in value of derivative is cash
setteled.
2. There is no limit on number of units transacted in derivative market because
there is no physical asset to be transacted.
3. Derivative markets are usually the screen based /computarised.
4. Derivatives are secondary market securities and and cannot help raising funds to
a firm.
5. Derivative market is quiet liquid and transactions can be effected easily.
6. Derivative provides a hedging against different risks.

The participants in a derivatives market

• Hedgers use futures or options markets to reduce or eliminate the risk associated with
price of an asset.

• Speculators use futures and options contracts to get extra leverage in betting on
future movements in the price of an asset. They can increase both the potential gains
and potential losses by usage of derivatives in a speculative venture.

• Arbitrageurs are in business to take advantage of a discrepancy between prices in

two different markets. If, for example, they see the futures price of an asset getting out
of line with the cash price, they will take offsetting positions in the two markets to lock in
a profit.

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 TYPES OF DERIVATIVES

FORWARDS
Forward contract is an agreement entered today between two parties namely buyer and
seller wherein buyer agrees to buy a particular asset at a particular price on a particular
date. In a forward contract, two parties irrevocably agree to settle a trade at a future
date, for a stated price and quantity. No money changes hands at the time the trade is
agreed upon. Suppose a buyer L and a seller S agree to do a trade in 100 grams of
gold on 31 Dec 2001 at Rs.5,000/tola. Here, Rs.5,000/tola is the “forward price of 31
Dec 2001 Gold”. The buyer L is said to be long and the seller S is said to be short.

Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec
2001, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to
accept Rs.500,000 on 31 Dec 2001, and give 100 tolas of gold in exchange.

Features

 It’s a unique contract between two parties buyer and seller

 Forward is unique in terms of size, time and types of asset.
 Price fixation may not be transparent and is publicly not disclosed.
 Forwards are traded off the exchanges and exposed to default risk.

Forward markets tend to be afflicted by poor liquidity and from unreliability deriving

from “counterparty risk” (also called “credit risk”).

FUTURES
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts

Features

 Futures are organized or standardized contract in terms of quantity, quality,

delivery time and place of settlement
 Three parties are involved buyer, seller and clearing house.
 Contract expires on a pre-specified date which is called the expiry date of
the contract.
 On expiry futures can be settled by delivery of the underlying asset or cash.

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Dr. Mukund Sharma, BNMIT
  Cash settlement enables the settlement of obligations arising out of the
futures/option contract in cash.
 Futures are traded in organized exchanges only.
 Exchange provides counter party guarantee through its clearing house.
 Participating parties have to deposit an initial cash margin as well as the
difference in traded price and actual price on daily basis.

OPTIONS
The right but not the obligation to buy (sell) some underlying cash instrument at a pre-
determined rate on a pre-determined expiration date in a pre-set notional amount. An
option is the right, but not the obligation, to buy or sell something at a stated date at a
stated price. A “call option” gives one the right to buy, a “put option” gives one the right
to sell.

The buyer /holder of the option purchases the right from seller / writer for a
consideration which is called a premium. The seller / writer of an option is obligated to
settle the option as per the terms of contract when the buyer /holder exercises his right.
The underlying asset could be an index, security etc.

Features

 Options are organized or standardized contract

 Three parties are involved buyer, seller and clearing house.
 Contract expires on a pre-specified date which is called the expiry date of
the contract.
 Futures are traded in organized exchanges only.
 Exchange provides counter party guarantee through its clearing house.

Call option ( an option to buy )

A call option is a financial contract giving the owner the right but not the obligation to
buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-
set maturity date.

Put Option ( an option to sell)

A put option is a financial contract giving the owner the right but not the obligation to sell
a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set
maturity date.

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European Style Option
It is an option that has to be exercisable only on expiry date An option that can be
exercised only at expiry as opposed to an American Style option that can be exercised
at any time from inception of the contract. European Style option contracts can be
closed out early, mimicking the early exercise property of American style options in
most cases.

American Style Option

It is an option that can be exercisable on or before expiry date. An option that can
be exercised at any time from inception as opposed to a European Style option which
can only be exercised at expiry. Early exercise of American options may be warranted
by arbitrage. European Style option contracts can be closed out early, mimicking the
early exercise property of American style options in most cases. Premium charged in
case of American option is more compared to that of European option. This is because,
in case of American option can be exercised at any time before expiry date.

SWAPS
Swap is a transaction in which two or more parties swap ( exchanges) one set of
predetermined payments for another. Swaps are of recent origin and basically there are
two types of swaps
Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are :

• Interest rate swaps: These entail swapping only the interest related cash flows

between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the
parties, with the cashflows in one direction being in a different currency than those in
the opposite direction.

A swap is a cash-settled OTC derivative. Except for forwards, swaps are the most
simple form of OTC derivative.

A swap is an agreement between two counter parties to exchange two streams of cash
flows—the parties "swap" the cash flow streams. Those cash flow streams can be
defined in almost any manner. All that matters is that their present values be equal
(except for a bid-ask spread, if one party to the swap is a dealer). While swaps are used
for various purposes—from hedging to speculation—their fundamental purpose is to
change the character of an asset or liability without liquidating that asset or liability.

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 MUTUAL FUNDS

For the investors who does not have the expertise to to invest the money in equity
market , mutual funds have become the talk of the day. Mutual funds help the investors
to reap the benefit of equity investment without taking much risk and witout possessing
much expertise in capital market. A Mutual Fund is a trust that pools the savings of a
number of investors who share a common financial goal. The money thus collected is
then invested in capital market instruments such as shares, debentures and other
securities. The income earned through these investments and the capital appreciation
realised are shared by its unit holders in proportion to the number of units owned by
them. Thus a Mutual Fund is the most suitable investment for the common man as it
offers an opportunity to invest in a diversified, professionally managed basket of
securities at a relatively low cost. The flow chart below describes broadly the working of
a mutual fund:

FEATURES OF MUTUAL FUND

1) MOBILISATION OF SAVINGS: Mutual funds mobilizes funds by selling its shares

popularly known as units. This in turn encourages the household savings and
investment.

2) PROVIDES INVESTMENT AVENUE: Mutual funds provides investment

avenues for small and retail investors who does not have the expertise of investing
in equity market.

3) DIVERSIFICATION IN INVESTMENT: Mutual funds invest the funds

collected from retail investors in securities of different industries. This diversification
leads to reduction in the risk associated with investment.

4) PROFESSIONAL MANAGEMENT: Panel of experts who possesses

professional knowledge manages mutual funds. This leads to professional and
profitable management of mutual funds.

5) REDUCES RISK: Mutual funds reduces the risk associated with

investment by going for better liquidity of units, professional management and
diversification.

6) BETTER LIQUIDITY: Mutual fund units can be sold/liquidated easily as

they possess ready market.

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 7) PROVIDES TAX BENEFITS: Investing in many schemes of Mutual funds
provides tax exemptions.

ADVANTAGES OF MUTUAL FUNDS

The advantages of investing in a Mutual Fund are:

 Diversification: The best mutual funds design their portfolios so individual

investments will react differently to the same economic conditions. For
example, economic conditions like a rise in interest rates may cause certain
securities in a diversified portfolio to decrease in value. Other securities in the
portfolio will respond to the same economic conditions by increasing in value.
When a portfolio is balanced in this way, the value of the overall portfolio should
gradually increase over time, even if some securities lose value.

 Professional Management: Most mutual funds pay topflight professionals to

manage their investments. These managers decide what securities the fund will
buy and sell.

 Regulatory oversight: Mutual funds are subject to many government

regulations that protect investors from fraud.

 Liquidity: It's easy to get your money out of a mutual fund. Write a check,
make a call, and you've got the cash.

 Convenience: You can usually buy mutual fund shares by mail, phone, or over
the Internet.

 Low cost: Mutual fund expenses are often no more than 1.5 percent of your
investment. Expenses for Index Funds are less than that, because index funds
are not actively managed. Instead, they automatically buy stock in companies
that are listed on a specific index

 Transparency

 Flexibility

 Choice of schemes

 Tax benefits

 Well regulated

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DIFFERENT TYPES OF MUTUAL FUNDS IN INDIA

 Closed-end funds
 Open-end funds
 Large cap funds
 Mid-cap funds
 Equity funds
 Balanced funds
 Growth funds
 No load funds
 Exchange traded funds
 Value funds
 Money market funds
 International mutual funds
 Regional mutual funds
 Sector funds
 Index funds
 Fund of funds

Closed-End Mutual Funds

A closed-end mutual fund has a set number of shares issued to the public through an
initial public offering. These funds have a stipulated maturity period generally ranging
from 3 to 15 years.

The fund is open for subscription only during a specified period. Investors can invest in
the scheme at the time of the initial public issue and thereafter they can buy or sell the
units of the scheme on the stock exchanges where they are listed.

Once underwritten, closed-end funds trade on stock exchanges like stocks or bonds.
The market price of closed-end funds is determined by supply and demand and not by
net-asset value (NAV), as is the case in open-end funds. Usually closed mutual funds
trade at discounts to their underlying asset value.

Open End Mutual Fund

An open-end mutual fund is a fund that does not have a set number of shares. It
continues to sell shares to investors and will buy back shares when investors wish to
sell. Units are bought and sold at their current net asset value.

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Dr. Mukund Sharma, BNMIT
Open-end funds keep some portion of their assets in short-term and money market
securities to provide available funds for redemptions. A large portion of most open
mutual funds is invested in highly liquid securities, which enables the fund to raise
money by selling securities at prices very close to those used for valuations.

Large Cap Funds

Large cap funds are those mutual funds, which seek capital appreciation by investing
primarily in stocks of large blue chip companies with above-average prospects for
earnings growth.

Different mutual funds have different criteria for classifying companies as large cap.
Generally, companies with a market capitalisation in excess of Rs 1000 crore are known
large cap companies. Investing in large caps is a lower risk-lower return proposition
(vis-à-vis mid cap stocks), because such companies are usually widely researched and
information is widely available.

Mid Cap Funds

Mid cap funds are those mutual funds, which invest in small / medium sized companies.
As there is no standard definition classifying companies as small or medium, each
mutual fund has its own classification for small and medium sized companies.
Generally, companies with a market capitalization of up to Rs 500 crore are classified
as small. Those companies that have a market capitalization between Rs 500 crore and
Rs 1,000 crore are classified as medium sized.

Big investors like mutual funds and Foreign Institutional Investors are increasingly
investing in mid caps nowadays because the price of large caps has increased
substantially. Small / mid sized companies tend to be under researched thus they
present an opportunity to invest in a company that is yet to be identified by the market.
Such companies offer higher growth potential going forward and therefore an
opportunity to benefit from higher than average valuations.

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Dr. Mukund Sharma, BNMIT
But mid cap funds are very volatile and tend to fall like a pack of cards in bad times. So,
caution should be exercised while investing in mid cap mutual funds.

Equity Mutual Funds

Equity mutual funds are also known as stock mutual funds. Equity mutual funds invest
pooled amounts of money in the stocks of public companies.

Stocks represent part ownership, or equity, in companies, and the aim of stock
ownership is to see the value of the companies increase over time. Stocks are often
categorized by their market capitalization (or caps), and can be classified in three basic
sizes: small, medium, and large. Many mutual funds invest primarily in companies of
one of these sizes and are thus classified as large-cap, mid-cap or small-cap funds.

Equity fund managers employ different styles of stock picking when they make
investment decisions for their portfolios. Some fund managers use a value approach to
stocks, searching for stocks that are undervalued when compared to other, similar
companies. Another approach to picking is to look primarily at growth, trying to find
stocks that are growing faster than their competitors, or the market as a whole. Some
managers buy both kinds of stocks, building a portfolio of both growth and value stocks.

Balanced Fund
Balanced fund is also known as hybrid fund. It is a type of mutual fund that buys a
combination of common stock, preferred stock, bonds, and short-term bonds, to provide
both income and capital appreciation while avoiding excessive risk.

Balanced funds provide investor with an option of single mutual fund that combines both
growth and income objectives, by investing in both stocks (for growth) and bonds (for
income). Such diversified holdings ensure that these funds will manage downturns in
the stock market without too much of a loss. But on the flip side, balanced funds will
usually increase less than an all-stock fund during a bull market.

Growth Funds
Growth funds are those mutual funds that aim to achieve capital appreciation by
investing in growth stocks. They focus on those companies, which are experiencing
significant earnings or revenue growth, rather than companies that pay out dividends.

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Dr. Mukund Sharma, BNMIT
Growth funds tend to look for the fastest-growing companies in the market. Growth
managers are willing to take more risk and pay a premium for their stocks in an effort to
build a portfolio of companies with above-average earnings momentum or price
appreciation.

In general, growth funds are more volatile than other types of funds, rising more than
other funds in bull markets and falling more in bear markets. Only aggressive investors,
or those with enough time to make up for short-term market losses, should buy these
funds.

Exchange Traded Funds

Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an
exchange. An exchange traded fund is similar to an index fund in that

it will primarily invest in the securities of companies that are included in a selected
market index. An ETF will invest in either all of the securities or a representative sample
of the securities included in the index. The investment objective of an ETF is to achieve
the same return as a particular market index.

Exchange traded funds rely on an arbitrage mechanism to keep the prices at which they
trade roughly in line with the net asset values of their underlying portfolios.

Value Funds
Value funds are those mutual funds that tend to focus on safety rather than growth, and
often choose investments providing dividends as well as capital appreciation. They
invest in companies that the market has overlooked, and stocks that have fallen out of
favour with mainstream investors, either due to changing investor preferences, a poor
quarterly earnings report, or hard times in a particular industry.

Value stocks are often mature companies that have stopped growing and that use their
earnings to pay dividends. Thus value funds produce current income (from the
dividends) as well as long-term growth (from capital appreciation once the stocks
become popular again). They tend to have more conservative and less volatile returns
than growth funds.

Money Market Mutual Funds

A money market fund is a mutual fund that invests solely in money market instruments.
Money market instruments are forms of debt that mature in less than one year and are

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Dr. Mukund Sharma, BNMIT
very liquid. Treasury bills make up the bulk of the money market instruments. Securities
in the money market are relatively risk-free.

Money market funds are generally the safest and most secure of mutual fund
investments. The goal of a money-market fund is to preserve principal while yielding a
modest return. Money-market mutual fund is akin to a high-yield bank account but is not
entirely risk free. When investing in a money-market fund, attention should be paid to
the interest rate that is being offered.

International Mutual Funds

International mutual funds are those funds that invest in non-domestic securities
markets throughout the world. Investing in international markets provides greater
portfolio diversification and let you capitalize on some of the world's best opportunities.
If investments are chosen carefully, international mutual fund may be profitable when
some markets are rising and others are declining.

However, fund managers need to keep close watch on foreign currencies and world
markets as profitable investments in a rising market can lose money if the foreign
currency rises against the dollar.

Regional Mutual Fund

Regional mutual fund is a mutual fund that confines itself to investments in securities
from a specified geographical area, usually, the fund's local region. A regional mutual
fund generally looks to own a diversified portfolio of companies based in and operating
out of its specified geographical area. The objective is to take advantage of regional
growth potential before the national investment community does.

Regional funds select securities that pass geographical criteria. For the investor, the
primary benefit of a regional fund is that he/she increases his/her diversification by
being exposed to a specific foreign geographical area.

Sector Mutual Funds

Sector mutual funds are those mutual funds that restrict their investments to a particular
segment or sector of the economy. These funds concentrate on one industry such as
infrastructure, heath care, utilities, pharmaceuticals etc. The idea is to allow investors to
place bets on specific industries or sectors, which have strong growth potential.
These funds tend to be more volatile than funds holding a diversified portfolio of
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Dr. Mukund Sharma, BNMIT
securities in many industries. Such concentrated portfolios can produce tremendous
gains or losses, depending on whether the chosen sector is in or out of favour.

Index Funds
An index fund is a type of mutual fund that builds its portfolio by buying stock in all the
companies of a particular index and thereby reproducing the performance of an entire
section of the market. The most popular index of stock index funds is the Standard &
Poor's 500. An S&P 500 stock index fund owns 500 stocks-all the companies that are
included in the index. Investing in an index fund is a form of passive investing. Passive
investing has two big advantages over active investing. First, a passive stock market
mutual fund is much cheaper to run than an active fund. Second, a majority of mutual
funds fail to beat broad indexes such as the S&P 500.

Fund of Funds
A fund of funds is a type of mutual fund that invests in other mutual funds. Just as a
mutual fund invests in a number of different securities, a fund of funds holds shares of
many different mutual funds.
Fund of funds are designed to achieve greater diversification than traditional mutual
funds. But on the flipside, expense fees on fund of funds are typically higher than those
on regular funds because they include part of the expense fees charged by the
underlying funds. Also, since a fund of funds buys many different funds which
themselves invest in many different stocks, it is possible for the fund of funds to own the
same stock through several different funds and it can be difficult to keep track of the
overall holdings.

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Dr. Mukund Sharma, BNMIT