Question,Answer
Nature and Definition of Primary Markets ,"6.1 Nature and Definition of Primary Markets The capital of a company is brought in by the promoters and their associates in the initial stages. As the requirement for additional funds go up, it may be necessary to source funds from a wider group of investors. The primary market refers to the market where equity or debt funds are raised by companies from ‘outside’ investors through an offer of securities. ‘Outside’ investors refer to investors who are not associated with the promoters. In primary market, investors purchase the security directly from the issuer. It is also called the “new issue market” since these securities are issued for the first time by the company. The process of expanding the ability of an issuer to raise capital from public investors, who may not have been associated with the initial stages of the business, is also known as “going public.” The issuance of securities in the primary markets expands the reach of an issuer and makes long-term capital available to the issuer from a larger number of investors. Raising capital for a company may also be conducted through a syndicate of institutional investors who buy equity or debt securities through a private placement. This is also a primary market activity but the investors in these securities are a few pre-identified institutional investors. These investors may also seek sale of their holdings, conversion of debt to equity, or may offload their holdings in a public issue on a later date. Private placement of debt is similar to private equity or venture capital deals, except that the security issued is debt in the former and equity in the latter case. The ability of a company to raise funds from external sources will depend upon the performance of the company in the past and the expected performance in the future. Investors may require the flexibility to review their investment and exit the investment if need be. A ‘security’ provides this facility as it may be listed on the exchanges where it is traded between investors at prices that reflect the value of the security as determined by the investors in the market. The company issuing and listing the securities is required to periodically disclose key information about the company to the stock exchange where it is LEARNING OBJECTIVES: After studying this chapter, you should know about: • Nature and definition of Primary Markets • Role and Function of the Secondary Market • Corporate Actions 113 listed. The expectation for its performance tends to reflect in the prices at which its securities trade."
Functions of the Primary Market,"6.1.1 Functions of the Primary Market The primary markets serve the following functions: a. Access to wider markets and investors A primary market issue enables participation of a wider group of investors. Companies move away from known sources of funding that may be restrictive in terms of the amount available or the terms at which capital may be made available. They may be able to raise the funds they require at much more competitive terms. For example, when an Indian company issues a global depository receipt (GDR) in the Euromarkets, it reaches out to institutional and retail investors in those markets who may find the investment in a growing Indian enterprise attractive. b. Transparent Pricing Mechanism Securities are issued for public subscription, at a price that is determined by the demand and supply conditions in the market and the perceived fundamental strengths of the issuer to honour their commitments. The rate of interest a debt instrument will have to offer and the price at which an equity share will be purchased are dependent on the pricing mechanisms. For example, government securities, which are issued by RBI on behalf of the government, are priced through an auction process. Banks and institutional investors are the main buyers of government securities, and they bid the rates they are willing to accept and the final pricing of the instrument on offer depends on the outcome of the auction. This enables fair pricing of securities in the primary market. c. Ownership Diversification As new subscribers of equity capital come in, the stakes of existing shareholders reduces and the ownership of the business becomes more broad-based and diversified. This enables the separation of ownership and management of an enterprise, where professional managers are brought into work in the broad interest of a large group of diverse shareholders. The presence of independent directors on the boards of companies, representing public shareholders, enhances the governance standards of companies. d. Better Disclosures A business that seeks to raise capital from new investors, who may not be familiar with the history and working of the enterprise, has to meet higher standards of disclosure and transparency. Regulations that govern primary markets prescribe the nature and periodicity of disclosures that have to be made. This provides investors with relevant, accurate and 114 verifiable financial and other information about the business and enables them to make informed decisions for investing in the securities of those businesses. e. Evaluation by Investors An issuer that raises money from outside investors is evaluated by a large number of prospective investors. This forms another layer of scrutiny of the operations and performance of the company, apart from its auditors and regulators. Publicly disclosed financial statements, reports, prospectus and other information also come up for scrutiny and discussion by analysts, researchers, activists, and media apart from investors. f. Exit for Early Investors Primary markets provide an exit option for promoters, private and other investors who subscribed to the initial capital issued by the company to fund the early requirements for capital. ‘Early investors’ who take a risk by investing in a company in the initial stages before it has established a record of performance and profitability are thus able to make a profit when they have the choice to sell their holdings in the primary market. A vibrant primary market is thus an incentive for such investors who invest in early-stage business with the intent to nurture the business to a level at which public and other investors would be interested. g. Liquidity for Securities When capital is held by a few inside investors, the equity and debt securities held are not liquid, unless sold in a chunk to another set of interested investors. The costs and effort of finding another investor(s) willing to buy the securities held is high. However, a primary market issue enables distribution of securities to a large number of investors. It is mandatory to list a public issue of securities on the stock exchange. This opens up the secondary market where the securities can be bought and sold between investors easily in small and large quantities. h. Regulatory Supervision Inviting ‘outside investors’ for subscribing to the capital or buying securities of an issuer comes under comprehensive regulatory supervision. The issue process, intermediaries involved, the disclosure norms, and every step of the primary issuance process is subject to regulatory provisions and supervision. The objective is to protect the interest of investors who contribute capital to a business, which they may not directly control or manage. While there is no assurance of return, risk, safety or security, regulatory processes are designed to ensure that fair procedures are used to raise capital in the primary market, adequate and accurate information is provided, and rights of all parties is well defined, balanced and protected."
Types of Issues All primary market,"6.1.2 Types of Issues All primary market issues need not be public issues. The securities can be issued either through public issues or through private placement (which involves issuance of securities to a relatively small number of select investors). Issuance of capital in the primary market can be classified under four broad heads: a. Public issue Securities are issued to the members of the public, and anyone eligible to invest can participate in the issue. “Public issue” means an Initial Public Offer (IPO) or a Further Public Offer (FPO). Initial public offer means an offer of specified securities by an unlisted issuer to the public for subscription and includes an offer for sale of specified securities to the public by any existing holder of such specified securities in an unlisted issuer. ‘Further Public Offer’ means an offer of specified securities by a listed issuer to the public for subscription and includes an offer for sale of specified securities to the public by any existing holders of such specified securities in a listed issuer. b. Private placement Securities are issued to a select set of investors who can bid and purchase the securities on offer. This is primarily a wholesale issue of securities to institutional investors by an unlisted company. c. Preferential issue Preferential issue means an issue of specified securities by a listed issuer to any select person or group of persons on a private placement basis in accordance with SEBI ICDR Regulations, 2018 and does not include an offer of specified securities made through employee stock option scheme, employee stock purchase scheme or an issue of sweat equity shares or depository receipts issued in a country outside India or foreign securities. d. Qualified Institutions Placement Qualified institutions placement means issue of eligible securities by a listed issuer to qualified institutional buyers on a private placement basis and includes an offer for sale of specified securities by the promoters and/or promoter group on a private placement basis. Qualified institutional buyers include institutions such as mutual funds, foreign portfolio investor, insurance company etc.. 116 e. Rights and Bonus issues Securities are issued to existing investors as on a specific cut-off date, enabling them to buy more securities at a specific price (rights) or get an allotment of additional shares without any consideration (bonus)."
Types of Issuers,"6.1.3 Types of Issuers As per the SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2018 “issuer” means a company or a body corporate authorized to issue specified securities under the relevant laws and whose specified securities are being issued and/or offered for sale in accordance with SEBI ICDR Regulations, 2018. An issuer in the primary market has to be eligible to raise capital under the provisions of the regulations that govern it. The issuer has to meet the eligibility conditions specified by the concerned regulator before making an issue. The primary responsibility to meet the obligations associated with the security being issued rests on the issuer. For example, an issuer of bonds is responsible for paying interest and returning the principal on maturity; an issuer of equity shares is responsible to pay dividends as and when declared and notify equity shareholders about resolutions being brought for their approval through voting in the annual general meeting. Issue of securities in the primary market may be made by the following entities: a. Central, State and Local Governments Governments raise funds through government securities (G-Sec). Such securities are short term (usually called treasury bills with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). G-Secs carry no risk of default and, hence, are called risk-free gilt-edged instruments. The central government alone issues treasury bills for different maturities such as 91 days, 182 days and 364 days. b. Public Sector Units Public sector units are companies registered under the Companies Act, in which the government is the majority shareholder. These companies may make an issue of shares where the government offers a portion of the shares held by them to the public. This is called disinvestment. For example, in December 2013, Power Grid Corporation of India made a share issue which comprised of 13% fresh equity offer by the company and a 4% stake sale by the government. These companies also issue bonds. Some of the bonds may provide tax benefits to investors in the form of exemption from tax for interest earned on 117 them or to save on long-term capital gains. For example, the National Highway Authority of India (NHAI) made an issue of tax free bonds in January 2014. The interest earned by investors on these bonds is exempt from tax. c. Private Sector Companies For private sector companies, securities market is the principal source of funds. They raise funds from the markets by issuing equity or debt securities. They can raise funds from domestic and international markets. They may issue ordinary equity shares, preference shares and convertible instruments. Corporate bonds are issued to raise long-term debt capital while commercial papers and securitized papers are issued to raise funds for less than one year (short-term debt capital). d. Banks, Financial Institutions and Non-Banking Finance Companies Banks, Financial Institution and Non-Banking Finance Companies (NBFCS) raise funds by issuing equity shares, preference shares, bonds, convertible bonds, commercial paper, certificates of deposits and securitized paper. Deposit taking institutions such as banks have access to low cost funds from the public and therefore are not dependent too much on the securities markets. However, financial institutions and NBFCs raise short term and long term capital through the issue of securities. They have access to domestic and international markets. e. Mutual Funds Mutual Funds make a new fund offer (NFO) of units in the domestic markets to raise funds for a defined scheme. The funds are raised for a specific period after which the current value of the units is returned to the investors (Closed-end fund) or it may be for perpetuity with investors being given the option to exit at any time at the prevailing value of the units. f. Real Estate Investment Trusts and Infrastructure Investment Trusts Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) may issue units in a public offer or private placement to raise funds for a scheme. REIT invest in real estate while InvIT do so in infrastructure projects. The issue shall be managed by merchant bankers appointed for the purpose. The units will be listed on a stock exchange, where they can be traded at market-determined prices. An important factor to consider in these investments, is that there is a higher minimum amount for investment even when the units are offered in a public offer as compared to a normal IPO. 118 g. Alternative Investment Funds Alternative Investment Funds are privately pooled investments. They raise money through a private placement. An AIF cannot make an invitation to the public at large to raise money. The AIF may also undertake to raise debt through borrowings."
Types of Investors,"6.1.4 Types of Investors Both retail and institutional investors participate in primary market issues. The various categories of investors are: ? Resident individuals ? Hindu Undivided Family (HUF) ? Minors through guardians ? Registered societies and clubs ? Non-resident Indians (NRI) ? Persons of Indian Origin (PIO) ? Banks ? Financial institutions ? Association of persons ? Companies ? Partnership firms ? Trusts ? Foreign portfolio investors (FPIs) ? Limited Liability Partnerships (LLP) Institutional investor” means (i) qualified institutional buyer; or (ii) family trust or intermediaries registered with SEBI, with net worth of more than Rs.500 crore, as per the last audited financial statements, for the purposes of listing and/or trading on innovators growth platform.2 Non-institutional investor means an investor other than a retail individual investor and qualified institutional buyer. As per the SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2018: ‘Retail individual investor’ means an individual investor who applies or bids for specified securities for a value of not more than Rs.2 lakh. “Retail individual shareholder” means a shareholder who applies or bids for specified securities for a value of not more than Rs.2 lakh. 2innovators growth platform means the trading platform for listing and trading of specified securities of issuers that comply with the eligibility criteria specified in Regulation 283 of SEBI (ICDR) Regulations, 2018. 119 Some securities may be available only to specific categories of investors. The information about who can purchase securities being offered is provided in the offer document. Investors require a Permanent Account Number (PAN) issued by the Income Tax authorities to be able to apply in a primary market issue of securities."
Types of Publice Issue of Equity Shares ,"6.1.5 Types of Public Issue of Equity Shares Public issue of equity shares can be categorized as follows: a. Initial Public Offer (IPO) The first public offer of shares made by a company is called an Initial Public Offer (IPO). When a company makes an IPO, the shares of the company become widely held and there is a change in the shareholding pattern. The shares which were privately held by promoters are now held by retail investors, institutions, promoters etc. An IPO can either be a fresh issue of shares by the company or it can be an offer for sale to the public by any of the existing shareholders, such as the promoters or financial institutions, or a combination of the two. ? Fresh Issue of Shares: New shares are issued by the company to public investors. The issued share capital of the company increases. The percentage holding of existing shareholders will come down due to the issuance of new shares. ? Offer for Sale: Existing shareholders such as promoters or financial institutions offer a part of their holding to the public investors. The share capital of the company does not change since the company is not making a new issue of shares. The proceeds from the IPO go to the existing shareholders who are selling the shares and not to the company. The holding of the existing shareholders in the share capital of the company will reduce. Example A company has issued 1000 shares of a face value of Rs. 10 each. The shares are equally held by the two promoters P and Q. A. The company decides to make a fresh issue of 500 shares. B. The company decides to offer 250 shares of each promoter to the public. The fresh issue of shares in the IPO (A) will result in the following post-IPO situation: ? The issued capital of the company will now be 1500 shares with a face value of Rs. 10 each. ? Promoters A and B continue to hold 500 shares each. The percentage holding of each of the promoters in the share capital of the company will change from 50% (500 shares out 120 of 1000 shares issued by the company) to 33.33% (500 shares out of 1500 shares issued by the company). The offer for sale in the IPO (B) will result in the following post-IPO situation: ? The capital of the company will remain at 1000 shares with a face value of Rs.10 each. ? The holding of the promoters will decrease to 250 shares each from 500 shares each pre- issue. They now hold 25% each of the share capital; 50% is held by the public. ? The money raised in the IPO will go to the promoters who have sold the shares and not to the company. The disinvestment of shares by the government in PSUs is an example of an offer for sale. The government offers a portion of its shares to the public in an IPO. The proceeds collected go to the government which is selling the shares and not to the company. There will be no change in the share capital of the company. However, there will be a change in the list of shareholders as new investors buy the shares and a reduction in the government’s holding in the company. An IPO may also be a combination of an offer for sale and a fresh issue of shares by the issuing company. b. Further Public Offer A Further public offer is made by an issuer that has already made an IPO in the past and now makes a further issue of securities to the public. When a company wants additional capital for growth or to redo its capital structure by retiring debt, it raises equity capital through a fresh issue of capital in a follow-on public offer. A further public offer may also be through an offer for sale. This usually happens when it is necessary to increase the public shareholding to meet the requirements laid down in the listing agreement between the company and the stock exchange. Or promoters may dilute their holdings in the company after the lock-in imposed at the time of the IPO is over."
Pricing a Public Issue of Shares,"6.1.6 Pricing a Public Issue of Shares SEBI’s Regulations allow an issuer to decide the price at which the shares will be allotted to investors in a public issue. This can either be fixed by the issuer in consultation with the managers of the issue or it can be determined by a process of bidding by investors. Based on the method used to determine the price, a public issue can be categorized as: a. Fixed Price Issue In a fixed price issue of shares to the public, the company in consultation with the lead manager (who is the merchant banker in-charge of the issue) would decide on the price at 121 which the shares will be issued. The company justifies the price based on the expected performance of the company and the price of shares of comparable companies in the market. This information is made available to the investors when the issue is announced so that investors know the price at which the shares will be allotted to them at the time of making the application. b. Book Built Issue The objective of a book building process is to identify the price that the market is willing to pay for the securities being issued by the company. The company and its issue managers will specify either a floor price (base price) or a price band (price range starting from floor price to 20% above it) within which investors can bid3 . When the issue opens, investors will put in bid applications specifying the price and the number of securities (or total amount) bid at that price. The price bid should be above the floor price or within the price band, as applicable. Retail investors can revise the bids in the period when the issue is open. The issuer, in consultation with the book running lead manager will decide on the cut-off price which is the price at which the issue gets subscribed. All allottees who bid at or above the cut-off price are successful bidders and are eligible for allotment in the respective categories. For example, a company wants to issue 5000 shares through a book built offer within a price band of Rs 120 to Rs 144. Bids are received as follows: Price No. of Shares Total Demand Rs 144 1000 (A) 1000 Rs 140 1500 (B) 2500 (A+B) Rs 135 2500 (C ) 5000(A+B+C) Rs 130 1000 (D) 6000 (A+B+C+D) Rs 120 500 E 6500 (A+B+C+D+E) 3 https://www.nseindia.com/products-services/initial-public-offerings-faqs 122 The offer of 5,000 shares is filled up at the cut-off price of Rs.135. All investors who bid at this price and higher are eligible for allotment in their respective categories. Book built issues may also have a clause which allows allotment to retail investors at a price that is at a discount to the cut off price which cannot however be at a price not lower than by more than ten percent of the price at which shares are allotted to the other category of investors. Reservations to different categories of investors such as Qualified Institutional Buyers, mutual funds etc. are required to be made during the course of the issue. The details may be referred to in SEBI (Issue of Capital and Disclosure Requirements) Regulations (SEBI (ICDR)). 6.1.7 Regulatory Norms"
Regulatory Norms for Public Issue of Shares,"6.1.7 Regulatory Norms for Public Issue of Shares Primary market offerings are subject to regulatory requirements laid down by Securities and Exchange Board of India (SEBI) in the SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2018 and the provisions of the Companies Act, 2013/1956, as applicable for disclosures and raising capital from the public.4 They are also subject to RBI regulations as regards issues to non-resident investors and receipt of money from abroad. The regulations cover the eligibility of a company to make a public issue in terms of networth and track record of profitability, the process of making the issue and the timelines to be adhered to and the usage of the funds raised from the public. A public issue of shares may be credit rated and the rating received is disclosed to the public. The regulations also require the issuer to provide information on a continuous basis to enable evaluation of the shares by existing and new investors and to provide a way for investors to make additional investment or exit from the investment through the mechanism of listing. The company making a public issue of shares has to file with SEBI a document giving all information of the issuer and the proposed issue such as the operations and finances of the company, the current and future projects, the details of the promoters of the company, the proposed use of funds raised and details of the shares being issued such as the number of shares being raised and the price band. This document is called a prospectus. A draft prospectus in the specified format is first filed with SEBI for comments and approval. The modifications, if any, are incorporated before the final prospectus is filed with the Registrar of Companies, SEBI and the stock exchange where the shares are to be listed. The pricing of a public issue may be decided by the issuing company in consultation with the lead managers of the issue in a fixed price offer, or through a bidding process once the offer is open. 4 http://iepf.gov.in/IEPF/Eligibility_norms.html 123 Book building versus Fixed Price Issue A public issue of shares may be made at a fixed price decided by the issuer and the lead manager. The rationale for the price so decided is clearly explained in the offer document and will include qualitative factors such as business strengths and future prospects, and quantitative factors such as current and future earnings and operational numbers. The other method of discovering the price is through a book building process in which the issuer indicates the price band or a base or floor price and investors bid for the desired quantity of shares at a price within the specified band. On closure of the issue, the cut-off price is determined as the price at which the issue gets fully subscribed. All investors who bid at the cut-off price or higher are successful bidders and are allotted shares. Retail investors can bid at ‘cut-off’ price at the time of making the application which means that they are willing to accept the price discovered in the book building process. Period of Subscription A public issue has opening and closing dates, and is expected to garner the stipulated minimum subscription. An issue shall be opened after at least three working days from the date of registering the red herring prospectus, in case of a book built issue and the prospectus, in case of a fixed price issue, with the Registrar of Companies. An initial public offer shall be kept open for at least three working days and not more than ten working days. Allotment of issue After an issue closes, the company and its merchant bankers, along with the stock exchange (where the issue will be listed) and the Registrars and Transfer Agent decides the ‘basis of allotment’. This represents how proportionate allotment will be made for each category of investors, if the issue is over-subscribed. SEBI ICDR specifies the basis of allotment. Role of Registrar in an Issue The registrars to an issue process applications from investors in an issue; keep proper record of applications and money received from investors; and assist the issuer in creating investor records, executing the allotment of shares into the demat account of investors, and sending refund orders for partial allotment, and non-allotment. After the allotment process is complete, the shares are listed on the stock exchange and can be traded thereafter. Listing of Issue The price at which shares list and trade on the secondary markets may be at a premium or discount to the issue price. Investors who have been allotted shares can freely trade in the shares as soon as they are listed. 124 An initial public offer shall be kept open for at least three working days and not more than ten working days. In case of a revision in the price band, the issuer shall extend the bidding (issue) period disclosed in the red herring prospectus, for a minimum period of three working days subject to the total bidding (issue) period not exceeding ten working days. Investors can make applications during this period. In a book built issue investors can also revise bids in this period. SEBI ICDR specifies the eligibility requirements and the general conditions to be met prior to the issue of shares which are required to be followed. SEBI’s regulations require a company making a public issue of shares to enter into an agreement with all the depositories to dematerialize its shares so that investors can be given the option of holding the shares in dematerialized form. SEBI has mandated transfer of securities only in dematerialized form to improve ease, convenience and safety of transactions for investors. With effect from April 01, 2019, transfer of listed securities (except in case of transmission or transposition of securities), is not allowed unless the securities are held in dematerialized form with a depository. Companies making a public offer of shares may get the IPO graded by a credit rating agency registered with SEBI."
Applying to a Public Issue5,"6.1.8 Applying to a Public Issue5 The prospectus or offer document lays down the process of applying to a public issue of securities. Information of a forthcoming public issue is typically available from the mandatory advertisements that the company will have to issue and from the coverage that IPOs get in the press. The soft copies of the offer document are available on SEBI’s website and on the websites of the lead manager to the issue. A public issue is open for subscription during a limited period as specified above. The date on which the issue will open for subscription and the earliest closing date are mentioned in the announcements about the issue. Investors have to make their application during this period. With effect from January 1, 2016 payment for applications made in a public issue must be made only using the ASBA6 (Application Supported by Blocked Amount) facility. ASBA is an application for subscription to an issue containing an authorization to the investors’ bank to block the application money in the bank account and release funds only on allotment. 5 https://www.sebi.gov.in/sebi_data/faqfiles/jan-2017/1485857575075.pdf 6 https://www.nseindia.com/products-services/initial-public-offerings-asba-procedures 125 SEBI has introduced the use of Unified Payment Interface (UPI) with facility of blocking Funds (ASBA facility), as a new payment mechanism for retail investor applications submitted through intermediaries.7 In a book built offer investors must place bids for the minimum bid lot specified by the issuer so that the minimum application value adheres to the SEBI prescribed range of Rs.10,000 to Rs. 15,000. Investors can either specify the bidding price or they may choose to bid at the cut-off. Bidding at the cut-off implies that the price they would accept is the price determined by the bidding process. Once the issue closes, the cut-off price is determined based on the bids received. All investors who bid at the cut-off price or higher are successful bidders and receive allotment at the cut-off price. Investors who bid lower than the cut-off price will receive the refund of their application amount. Bidding at the cut-off ensures that the investor’s application is always accepted. The issue may be over-subscribed, which means that the bids made at the cut-off price and higher were for a higher number of shares than what was offered. In an over-subscribed issue, the shares will be allotted to an investor on a proportionate basis. There will be a refund made to the extent that the shares allotted are lower than the shares applied for. If subscriptions are lower than the offered number of shares, it is undersubscribed and all applying investors, at or above the cut-off price will receive allotments. The issuer credits the shares to the beneficiary demat account of the successful applicants, and refunds for partial or non-allotment."
Public Issue of Debt Securities,"6.1.9 Public Issue of Debt Securities A company can make a public issue of debt securities, such as, debentures by making an offer through a prospectus. The issue of debt securities is regulated by the provisions of the Companies Act, 2013 and Rules framed there under and SEBI (Issue and Listing of Debt Securities) Regulations, 2008, various circulars issued by SEBI in this regard, Listing Regulations, RBI Rules and Regulations and Securities Contracts (Regulation) Act (SCRA) and Securities Contracts (Regulation) Rules (SCRR). The company is required to appoint a lead manager who ensures compliance with all the regulatory requirements for the issue. 7In November 2018, SEBI announced that it would launch UPI as an alternative payment option (with ASBA) for retail investors to buy shares in a public issue w.e.f January 1, 2019. This move was aimed at reducing the listing time for an IPO from six days to three days. It was contemplated that the implementation would be carried out in 3 phases. The first phase was implemented from January 1, 2019 and extended till June 30, 2019. Phase II was implemented from July 1, 2019. In Phase II, the process of physical movement of forms from intermediaries to Self-Certified Syndicate Banks (SCBs) for blocking of funds was discontinued and only the UPI mechanism with existing timeline of T+6 days has been mandated. 126 A public issue of debt securities is possible by a company registered as a public limited company under the Companies Act, 2013. The company files an offer document with SEBI and the Registrar of Companies which gives all the material information of the issue as required under Companies Act 1956/20138 and SEBI Regulations. The final document will be available for download from the website of the stock exchange where the instrument is proposed to be listed prior to the issue opening. The debentures issued under a public offer have to mandatorily be listed on a stock exchange. The company is required to obtain credit rating from at least one credit rating agency and the rating has to be disclosed in the offer document. If the rating has been obtained from more than one rating agency, all the ratings are required to be disclosed. The issuer is required to enter into an agreement with a depository for dematerialization of the securities proposed to be issued. The issuer in consultation with the lead manager may fix the coupon payable on the debenture. The coupon may be determined through a book building process also. Debenture trustees are required to be appointed to oversee the interests of the investors. Trustees are banks and financial institutions who are registered with SEBI to act as debenture trustees. If the debentures are secured, they ensure that the property charged as security is adequate to meet the obligations to the debenture holders at all times. The company is required to create Debenture Redemption Reserve and transfer a portion of profits into it each year till the redemption of the debentures."
Rights offers,"6.1.10 Rights Offer A rights offer is an offer for shares made to the existing shareholders of the company. There is a specific ratio in which the shares are offered to the investor. The guidelines for the right issue has now been streamlined to make it easier for the investor to transact in these issues. The time period for advance notice to the stock exchanges for the rights issue is now a minimum of 3 working days excluding the date of intimation and the record date. There is a new dematerilaised concept of Rights entitlement (RE) that has been introduced. Earlier, if the investor did not want to subscribe to the rights issue they could renounce the rights to someone else. This was a physical process requiring the filling of a separate form. This process has now been dematerialised and a rights entitlement will come into the demat account of the shareholder. The RE has a separate (International Securities Identification Number) ISIN number so these can be traded on the stock exchanges. The investor who does not want to take on the rights issue can sell the RE at the prevailing market price. The RE would be traded with a T+2 rolling 8Companies Act, 2013 has not yet been fully notified. Hence, Companies Act, 1956 will continue to apply in those sections. (to recheck) 127 settlement on the stock exchanges. The investor can thus trade in the RE just like normal shares. The application for a rights issue has to be only through Applications Supported by Blocked Amount (ASBA). The procedure for a rights issue has an application form that is available for investor, which now would have the details of the RE. The investor can also make an application on a piece of paper. In case of fractional entitlement of RE the fraction has to be ignored with rounding down of the number."
Private Placements in Equity and Debt,"6.1.11 Private Placements in Equity and Debt A private placement of securities is an offer made by a company to a select group of investors such as financial institutions, banks and mutual funds. The advantage of private placement as a way to issue securities and raise funds comes from the following: ? Investors are better informed and there are less regulatory compliances in issuances to them ? Issuing securities are less time consuming and cost-efficient since there are fewer procedures to be followed. According to Companies Act, 2013, an offer to subscribe to securities made to less than 50 persons is called private placement of securities. The requirements of SEBI’s regulations with respect to a public issue will not apply to a private placement. A privately placed security can seek listing on a stock exchange provided it meets the listing requirements of SEBI and the stock exchange. A private placement of securities can be done by a company irrespective of whether it has made a public offer of shares or not. Preferential allotment means an issue of shares or other securities, by a company to any select person or group of persons on a preferential basis and does not include shares or other securities offered through a public issue, rights issue, employee stock option scheme, employee stock purchase scheme or an issue of sweat equity shares or bonus shares or depository receipts issued in a country outside India or foreign securities. Preferential allotment requires a resolution to be passed by the existing shareholders. Pricing of the securities will be done according to the formula laid down by SEBI. The shares will be locked-in for a period of one year."
Qualified Institutions Placement,"6.1.12 Qualified Institutions Placement Qualified institutions placement (QIP) is a private placement of shares made by a listed company to certain identified categories of investors known as Qualified Institutional Buyers (QIBs). To be eligible to make such a placement, the company is required to satisfy the eligibility conditions asspecified in SEBI (ICDR) QIBs include financial institutions, mutual funds and banks among others. 128 QIPs are made at a price derived from the share prices according to the formula prescribed by SEBI. Shares allotted in a QIP can be sold only on a recognized stock exchange if the sale happens within one year of allotment."
Role and Function of the Secondary Market,"6.2 Role and Function of the Secondary Market The secondary market is where securities once issued are bought and sold between investors. The instruments traded in secondary markets include securities issued in the primary market as well as those that were not issued in the primary market, such as privately placed debt or equity securities and derivatives of primary securities created and traded by financial intermediaries. Transactions in the secondary market do not result in additional capital to the issuer as funds are only exchanged between investors. The role of the secondary market is to support the capital raising function of the primary market by providing liquidity, price identification, information signalling and acting as a barometer of economic activity."
Function of Secondary Markets,"6.2.1 Functions of Secondary Markets a. Liquidity Secondary markets provide liquidity and marketability to existing securities. If an investor wants to sell off equity shares or debentures purchased earlier, it can be done in the secondary market. Alternately, if new investors want to buy equity shares or debentures that have been previously issued, sellers can be found in the secondary market. Investors can exit or enter any listed security by transacting in the secondary markets. A liquid market enables investors to buy perpetual securities such as equity that are not redeemed by the issuer or long-term instruments maturing far into the future without the risk of the funds getting blocked. Where investors invest in risky securities whose future performance is unknown, a secondary market enables exit if the expectations are not met. Investors can sell their securities at a low cost and in a short span of time, if there is a liquid secondary market for the securities that they hold. The sellers transfer ownership to buyers who are willing to buy the security at the price prevailing in the secondary market. b. Price Discovery Secondary markets enable price discovery of traded securities. The price at which investors undertake buy or sell transaction reflects the individual assessment of investors about the fundamental worth of the security. The collective opinions of various investors are reflected in the real time trading information provided by the exchange. The continuous flow of price data allows investors to identify the market price of equity shares. If an issuing company is performing well or has good future prospects, many investors may try to buy its shares. As 129 demand rises, the market price of the share will tend to go up. The rising price is a signal of expected good performance in the future. If an issuing company is performing poorly or is likely to face some operating distress in the future, there are likely to be more sellers than buyers of its shares. This will push down its market price. Market prices change continuously, and they reflect market judgement about the security. Market valuation benefits issuers when they have to raise further capital from the market, by giving an indication of the price at which new capital could be issued. For example, consider a company with equity shares of face value of Rs.10, which are being traded for around Rs.100 in the market. If the company wants to raise additional capital by issuing fresh equity share, it could issue them at a price close to Rs.100, which is the value determined by investors in the market. c. Information Signalling Market prices provide instant information about issuing companies to all market participants. This information-signalling function of prices works like a continuous monitor of issuing companies, and in turn forces issuers to improve profitability and performance. Efficient markets are those in which market prices of securities reflect all available information about the security. A large number of players trying to buy and sell based on information about the listed security tend to create volatility in prices, but also efficiently incorporate all relevant information into the price. As new information becomes available, prices change to reflect it. d. Indicating Economic Activity Secondary market trading data is used to generate benchmark indices that are widely tracked in the country. A market index is generated from market prices of a representative basket of equity shares. Movements in the index represent the overall market direction. The S&P BSE-Sensex and the NSE-Nifty 50 are the most popularly watched indices in India. A stock market index is viewed as a barometer of economic performance. A sustained rise in key market indices indicate healthy revenues, profitability, capital investment and expansion in large listed companies, which in turn implies that the economy is growing strongly. A continuous decline or poor returns on indices is a signal of weakening economic activity. e. Market for Corporate Control Stock markets function as markets for efficient governance by facilitating changes in corporate control. If management is inefficient, a company could end up performing below its potential. Market forces will push down shares prices of underperforming companies, leading to their undervaluation. Such companies can become takeover targets. Potential acquirers could acquire a significant portion of the target firm’s shares in the market, take 130 over its board of directors, and improve its market value by providing better governance. An actual takeover need not happen; even the possibility of a takeover can be an effective mechanism to ensure better governance."
Market Structure and Participants,"6.2.2 Market Structure and Participants The secondary market consists of the following participants: ? Market Infrastructure Institutions—stock exchanges, clearing corporations and depositories. ? Investors—individuals and institutions that buy and sell securities. ? Issuers—companies that issue securities. ? Financial intermediaries—firms that facilitate secondary market activity. ? Regulator—authority that oversees activities of all participants in the market. a. Market Infrastructure Institutions (Stock Exchange, Clearing Corporations and Depositories) Secondary market transactions have three distinct phases: trading, clearing and settlement. To trade in shares is to buy and sell them through the stock exchanges. Stock exchanges in India feature an electronic order-matching system that facilitates efficient and speedy execution of trades. After the trade is executed, the buyer has a payment obligation and the seller has a delivery obligation. In order to facilitate efficient trading, the execution of trades and the settlement of obligation are separated in modern stock exchanges. Clearing is the process of identifying what is owed to the buyer and seller in a trading transaction; and settlement is the mechanism of settling the obligations of counter parties in a trade. All stock exchanges in India follow a common settlement system which is carried out by the clearing corporations. Most of the cash market trades that take place on a particular day (say, T) are settled after two business days (say, T+2). There is a proposal to shorten this to T+1. In short, the trading, clearing and settlement and risk management in securities is facilitated through the market infrastructure institutions i.e. stock exchanges (securities exchanges), clearing corporation and depositories. Stock Exchanges The core component of any secondary market is the stock exchange. The stock exchange provides a platform for investors to buy and sell securities from each other in an organized and regulated manner. Stock exchanges stipulate rules for trading members who are 131 permitted to transact on the exchange, and for the listed companies (whose securities are permitted to be traded on stock exchange). The trading terminals of the stock exchanges such as Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are present across the country. Clearing Corporations In the modern structure of secondary markets, clearing corporations (also known as clearing houses) function as the counter-parties for all trades executed on a stock exchange. So, all buyers pay funds to the clearinghouse, and all sellers deliver securities to the clearing/corporations. Specialised intermediaries called clearing members complete these transactions. The clearinghouse completes the other leg of the settlement by paying funds to sellers and delivering securities to buyers. Examples of clearing corporations are the National Securities Clearing Corporation Ltd (NSCCL), Indian Clearing Corporation Ltd (ICCL) and Metropolitan Clearing Corporation of India Ltd. Depositories In order for a security to be eligible to trade in the secondary markets, it should be held in electronic or dematerialised form. Issuers get their securities admitted to the depositories, where they are held as electronic entries against investor names, without any paper certificate National Securities Depository Ltd (NSDL) and Central Depository Services Ltd (CDSL) are the two depositories in India. Depositories enable a single point for electronic holding of financial assets. This includes equities, warrants, preference shares, mutual funds held in demat form, corporate bonds, money market instruments, government securities, securitized instruments and postal savings schemes. SEBI has directed that investors should be sent a consolidated account statement (CAS) detailing their holding in the demat account as well as mutual funds units held in physical form in a mutual fund folio as the first step towards consolidating all investments in a single statement. The consolidation is done on the basis of PAN of the first holder and holding pattern. b. Custodians Custodians are institutional intermediaries, who are authorised to hold funds and securities on behalf of large institutional investors such as banks, insurance companies, mutual funds, and foreign portfolio investors (FPIs). They settle the secondary market trades for institutional investors. Several custodians are also clearing members and clearing banks of the exchange and manage both funds and security settlements. 132 c. Depository Participants Investors have to open demat accounts with depository participants (DPs), who are banks, brokers or other institutional providers of this service, to be able to trade in their securities. Demat accounts are similar to bank accounts in securities. Since the entries are electronic, transfer of securities from buyer to seller is easily completed by paper or electronic instruction to the DP. Settlement of securities transactions is done through the demat account held with the DP, who in turn notifies the depositories of the change in ownership of the securities. Payments are made and received through specifically identified clearing banks. d. Members of Stock Exchanges Investors can trade in the secondary markets only through trading members of a stock exchange. The trading members of stock exchanges are also called stock brokers and their affiliates called authorized persons. They bring the buyers and sellers to the stock exchange platform, thus enabling trading in securities. Trading membership of an exchange can be obtained upon fulfilment of minimum requirements for capital, qualification, net worth and other criteria for admission. Stock exchange members can be trading members, clearing members, both trading and clearing member or professional clearing members. Stock exchanges monitor members for their positions, capital, and compliance. e. Investors If investors buy and sell shares among themselves, such trades are called “off-market” and do not enjoy the benefits of regulatory and redressal provisions of the law. These transactions are not settled through the clearing and settlement mechanism of the stock exchange. In order to get a competitive price and a liquid markets in which transactions can be completed efficiently, investors come to the stock exchange through their brokers. Investors complete a KYC (know your customer) process with a registered broker-member and receive a unique client code (UCC). Institutional investors are supported by a distinct arm of the broker-member since they transact in large volumes. Banks, insurance companies, mutual funds, foreign portfolio investors are all large investors who may have their own dealers interacting with member-brokers who put their transactions through the exchange. Brokers also support investors with market information, updates, research reports, analytical tools and other facilities that help in buying and selling securities. f. Issuers Issuers are companies and other entities that seek admission for their securities to be listed on the stock exchange. Equity shares, corporate bonds and debentures as well as securities issued by the government (G-secs and treasury bills) are admitted to trade on stock exchanges. There are specific eligibility criteria to list securities on the stock market. These 133 can be in terms of size, extent of public shareholding, credit rating, ownership pattern, etc. Issuers have to pay a listing fee and also comply with requirement for disclosure of information that may have a bearing on the trading prices of the listed securities. g. Regulators of Securities Markets Secondary markets are regulated under the provisions of the Securities Contract Regulations Act, 1956 and SCR (Rules), 1957. SEBI is authorised by law to implement the provisions of this act and its rules. It has empowered stock exchangesto administer portions of the regulation pertaining to trading, membership and listing. All the intermediaries in the secondary markets are subject to regulatory overview of SEBI and are required to register and comply with the rules as may be stipulated."
Market Information ,"6.2.3 Market Information a. Market Capitalisation Market capitalisation (or market cap) of a company is the number of shares outstanding multiplied by the market price per share. The market cap of a company measures the market value of its share capital. Traded stocks are often categorised by market capitalisation. ? Blue-chip stocks represent the largest companies by market capitalisation. These stock have a high level of liquidity. These are also known as large cap stocks. ? Mid cap stocks refer to those companies which enjoy a good level of liquidity but are medium in terms of size. ? Small cap stocks are those stocks that are smaller in size and therefore do not enjoy much liquidity. In terms of return performance, large cap stocks tend to be less volatile than mid-cap stocks. In bull markets, mid-caps tend to run ahead of large caps, and in bear markets, they tend to fall more than large caps. If large cap stocks represent liquidity and stability, mid-caps represent momentum and opportunity. Market cap is also used as an indicator of the size and importance of the stock market of a country. The ratio of market cap to GDP of a country is one such measure. b. Market Turnover Market turnover of a stock indicates how much trading activity took place in it on a given business day. Turnover can be represented in rupees or in a number of trades. Higher the turnover in a stock, better the liquidity. The turnover ratio for the market as a whole is computed as the ratio of turnover in rupees to market capitalisation. Higher is the liquidity in the market, higher will be the turnover ratio. 134 Trading activity is measured in two ways—traded values in rupees and traded volume in number of trades. It is usual for large cap stocks to have a high traded value. Sometimes due to specific events or news, certain stocks may also show a high traded volume. The percentage of stocks traded for delivery indicates how much of trading activity resulted in settlement and therefore might have been bought by investors rather than traders or speculators. c. Market Indices A market index tracks the market movement by using the prices of a small number of shares chosen as a representative sample. Most leading indices are weighted by market capitalisation to take into account the fact that more the number of shares issued, greater the number of portfolios in which they may be held. Stocks included in an index are also quite liquid, making it possible for investors to replicate the index at a low cost. Narrow indices are usually made up of the most actively traded equity shares in that exchange. There are other indices to track sectors or different market cap categories. The most widely tracked indices in India are the S&P BSE Sensex and NSE’s Nifty 50. The composition of stocks in the index is reviewed and modified from time to time to keep the index representative of the underlying market. There are also sector indices for banking, information technology, pharma, fast-moving consumer goods and such other sectors, created by the exchanges to enable tracking of specific sectors. A stock market index has several uses: ? Indices are widely reported in the news, financial press and electronic information media and thus real time data on market movements is easily available to the investing public. ? The index value is a leading indicator of overall economic or sector performance and effectively captures the state of financial markets at a point of time. ? A representative index serves as a performance benchmark. The returns earned by equity mutual funds or other investment vehicles are often compared with the returns on the market index."
Risk Management System in Secondary Markets,"6.2.4 Risk Management Systems in the Secondary Markets When a large volume of trades happen on a stock exchange it makes the market very liquid, efficient and low cost. However, the systemic risk also increases. Default by a trading member can have disastrous and catastrophic impact on the other trading members and the exchange as a whole. Risk management systems of stock exchanges are set up to mitigate the risk of members of the exchange defaulting on payment or delivery obligations. 135 Stock exchanges have risk management systems to insure against the event that members of the exchange may default on payment or delivery obligations. Risk containment mechanisms such as maintenance of adequate capital assets by members and regular imposition of margin payments on trades ensure that damages through defaults are minimised. Exchanges thus enable two distinct functions: high liquidity in execution of trades and guaranteed settlement of executed trades. a. Capital Adequacy Norms In order to be eligible as trading and clearing members, individual and corporate entities have to meet and maintain minimum paid-up capital and net worth norms prescribed by the stock exchanges and SEBI. The Capital Adequacy Requirements consists of two components i.e. the Base Minimum Capital (BMC) and the Additional or Optional Capital related to volume of the business. BMC is the deposit given by the members of the exchange against which no exposure for trades is allowed. Additional capital is brought in over and above the BMC which has to be adequate to cover all margin payments. b. Margins A margin is the amount of funds that one has to deposit with the clearing corporation in order to cover the risk of non-payment of dues or non-delivery of securities. Suppose an investor purchases 100 shares of Company X at Rs.100 each on January 1, 2020. He has to pay in Rs.10,000 by January 3, 2020. The risks in this transaction are that: ? The buyer may not be able to bring in the required funds by the due date ? The seller may not be able to deliver securities at the due date In order to minimise this default risk, both buyers and sellers of equity are required to pay a percentage of their dues upfront at the time of placing their order. This payment is known as margin. For example, if the margin is set at 17%, the buyer would pay Rs.1,700 in advance. Margins are collected from the clients by brokers when the order is placed. Stock exchanges collect margins from brokers when the order is executed. The intra-day crystallized losses shall be monitored and blocked by Clearing Corporations from the free collateral on a real-time basis only for those transactions which are subject to upfront margining. For this purpose, crystallized losses can be offset against crystallized profits at a client level, if any.9 All securities are not charged margin at the same rate. This is because the tendency to default on funds payment or delivery of shares is higher when share prices vary a lot, rather than when they are less volatile. An equity share whose price shows greater variation in 9Crystallised obligations are profit/loss on trade. 136 either direction (both up and down) is said to have higher volatility as compared to a share whose prices show less up-and-down movement. Volatility is a measure of riskiness in share prices. Volatility creates default risk because of the probability that share prices may decline between purchase and pay-in period. Suppose, in the above example, assume that the price of the share falls to Rs.80 on January 2, 2020. Then the investor has incurred a notional loss of Rs.2,000 on his purchase. He may be less inclined to pay Rs.10,000 on January 3, 2020. Alternately, if prices go up, the seller may not want to give delivery at the lower price. This means that shares with greater price volatility have higher default risk and therefore higher margin requirements. The margin on equity shares traded on an exchange is imposed on a daily basis, and is the sum of value at risk margin, extreme loss margin and mark to market margin. The margin requirements also keep changing so an investor also needs to know how they should fulfill these requirements when they undertake their transactions. Margins are collected by adjusting payments due against total liquid assets of a trading member (excluding base minimum capital). In case of shortfall of margins, the terminals of the trading member are immediately de-activated. c. Circuit Breakers and Price Bands If there is an abnormal price movement in an index, defined in percentage terms, the exchange can suspend trading. This is called hitting the circuit breaker. The index-based market-wide circuit breaker system applies at 3 stages of the index movement, either way viz. at 10%, 15% and 20%. These circuit breakers when triggered bring about a coordinated trading halt in all equity and equity derivative markets nationwide. The market-wide circuit breakers are triggered by movement of either the BSE Sensex or the Nifty 50, whichever is breached earlier. The period for which trading is suspended depends upon the extent of movement and the time when such move occurred. 137 Trigger limit Trigger time Market halt duration Pre-open call auction session post market halt 10% Before 1:00 pm. 45 Minutes 15 Minutes At or after 1:00 pm upto 2.30 pm 15 Minutes 15 Minutes At or after 2.30 pm No halt Not applicable 15% Before 1 pm 1 hour 45 minutes 15 Minutes At or after 1:00 pm before 2:00 pm 45 Minutes 15 Minutes On or after 2:00 pm Remainder of the day Not applicable 20% Any time during market hours Remainder of the day Not applicable Exchanges compute the Index circuit breaker limits for 10%, 15% and 20% levels on a daily basis based on the previous day's closing level of the index rounded off to the nearest tick size. Price Bands Stock exchanges also impose price bands on individual securities to limit volatility in prices. Daily price bands applicable on securities are as follows: ? Daily price bands on 2%, 5% or 10% either way on securities as specified by the exchange. ? No price bands are applicable on scrips on which derivatives products are available or scrips included in indices on which derivatives products are available. In order to prevent members from entering orders at non-genuine prices in such securities, the exchange may fix operating range of 10% for such securities. ? Price bands of 20% either way on all remaining scrips. 138 d. Settlement Guarantee Mechanism The clearing house/corporation is the counterparty to all trades in the stock exchange. This implies that it assumes counterparty risk completely, by settling all trades even if the trading member defaults on pay-in or pay-out. Some of this counter party risk is managed through the levy of margins. The guaranteed settlement is also ensured through the Core Settlement Guarantee Fund (Core SGF). The primary objective of having Core Settlement Guarantee Fund (SGF) is to guarantee the settlement of trades executed in respective segments of the stock exchange (Cash, equity derivatives, Currency Derivatives). In the event of a clearing member failing to honour settlement commitments, the core SGF shall be used to fund the obligations of that member and complete the settlement without affecting the normal settlement process. e. On-line Monitoring The positions and transactions of the trading members/clearing members are monitored on a real-time basis by the stock exchanges. The on-line monitoring system is designed to give alerts if members build up an abnormal sale or purchase positions or if margins are inadequate relative to their exposure. The clearing house/corporation can proactively carry out a detailed check of members trading and reduce their open positions, if necessary. Any news or media information that leads to unusually large price/volume movements are also scrutinized and investigated by surveillance officers of the stock exchange. f. Price Monitoring and Action On surveillance of abnormal price movements, stock exchanges can take the following actions to minimise volatility: ? Imposition of special margins on scrips that have shown unusually large movements in price or volume. Depending on the situation, the margins may be imposed on client-wise net outstanding purchases, or sales or both. ? Circuit filter limits may be reduced to keep prices under control. This will ensure that trading will halt with a smaller rise in prices than usual. ? Shifting a scrip from settlement to the trade-to-trade segment forces members to give/take delivery in that scrip, and so minimises any volatility due to intra-day closing. g. Inspection of Books The stock exchange conducts an inspection of the books of trading members of each market segment at least once a year. The purpose of the inspection is to check member compliance 139 with the applicable rules and regulations. Any violations observed result in disciplinary action by the Exchange."
Corporate Actions,"6.3 Corporate Actions A company conducts several actions, apart from those related to its business, that have a direct implication for the shareholder. These include sharing of surplus with the shareholders in the form of dividend or bonus, changes in the capital structure through the issue of rights shares, buy backs, mergers and acquisitions and delisting. In a company that has made a public issue of shares the interest of the small investors have to be particularly protected. All corporate actions are regulated by the provisions of the Companies Act, 2013, the relevant regulations of SEBI and the terms of the listing agreement entered into with the stock exchange. All corporate actions therefore require notice to be given to the regulators as specified in the applicable clauses. Corporate benefits and actions apply to all investors holding shares in physical form or in dematerialized form. In order to determine this, the company announces a record date or book closure period and investors whose names appear on the records on this date are eligible shareholders to receive notice of the action and entitled to benefit from it."
Right Issue,"6.3.1 Rights Issue Whenever a company makes a fresh issue of shares, it has an impact on the existing shareholders since their proportionate holding in the share capital of the company gets diluted. For example, a company may have 10 lakhs shares of Rs.10 each, amounting to an issued and paid-up capital of Rs. 1 crore. If it issues another 10 lakhs shares, to increase its capital, the proportion held by existing shareholders will come down by half, as the issued and paid up capital has doubled. This is called as dilution of holdings. To prevent this the Company’s Act requires that a company which wants to raise more capital through an issue of shares must first offer them to the existing shareholders. Such an offer of shares is called a rights issue. The rights shares are offered to the existing investors in a proportion as approved by the board of a company. For example, the company may choose to issue rights at 1 for 1, to double its capital. This means each existing shareholders will get one equity share for every one equity share that they already hold. The issued and paid up capital will double, but proportionate holdings will not change. Ratio of rights issues need not always be one. They can be 1:2, 2:3, and 2:5 and so on, depending on the decision of the board of the company. A rights issue of shares must follow all SEBI’sregulation on issue of shares. A listed company making a rights issue shall fix a record date to determine the eligibility of the shareholders for the rights issue. The company must issue a letter of offer giving details of the issue 140 including the purpose for which funds are being raised. The draft letter of offer must be filed with SEBI. The rights entitlements are credited to the demat account of the investor."
Bonus Issue,"6.3.2 Bonus Issue A bonus issue of shares is made to the existing shareholders of a company without any consideration from them. The entitlement to the bonus shares depends upon the existing shareholding of the investor. A bonus issue in the ratio 1:3 entitles the shareholder to 1 bonus share for every 3 held. The company makes the bonus issue out of its free reserves built from genuine profits. A company cannot make a bonus issue if it has defaulted on the payment of interest or principal on any debt securities issued or any fixed deposit raised. A company has to get the approval of its board of directors for a bonus issue. In some cases, the shareholders of the company also need to approve the issue. Where the shareholders’ approval is not required, the bonus issue must be completed within 15 days of the board’s approval. Where approval of the shareholders is required, the issue must be completed within two months of receiving the board’s approval. A bonus issue once announced cannot be withdrawn. The record date for the bonus issue will be announced and all shareholders as on the record date will be entitled to receive the bonus."
Dividend,"6.3.3 Dividend Dividends are the share of the profits of the company received by its shareholders. A company may declare interim dividends during the financial year and final dividend at the end of the year. A company is allowed to declare dividends out of the profit and loss account and the profits of the year in which the dividends are to be paid. A loss-making company cannot therefore pay a dividend to its shareholder. A company which has failed to redeem its preference shares is prohibited from declaring dividends. Dividends cannot be declared out of the share premium account, revaluation reserve or capital redemption reserve, among others. SEBI has mandated that listed companies shall declare dividends on a per share basis."
Stocks Split,"6.3.4 Stock Split A stock split is a corporate action where the face value of the existing shares is reduced in a defined ratio. A stock split of 1:5 splits an existing share into 5 shares. Accordingly, the face value of the shares will go down to 1/5th the original face value. For example, if an investor holds 100 shares of a company with a face value of Rs.10 each, a stock split in the ratio of 1:5 will increase the number of shares held by the investor to 500 but the face value of each share will go down to Rs.2. From the company’s perspective, there is no change in its share capital since an increase in the number of shares is offset by a fall in the face value. 141 The value of the investor’s holding will not change. For example, if the shares were trading at a price of Rs.1,000 per share prior to the split, post the split the price is likely to come down to Rs.200 per share. The value of the investor’s holding was Rs.100,000 (100 shares x Rs.1,000). Post the split the value will remain at Rs.100,000 (500 shares x Rs.200). The actual price will be around Rs.200 and will depend on market factors of demand and supply. Companies consider a share split if the price of the shares in the secondary markets is seen to be very high and therefore restricting the participation by investors. A share split leads to greater liquidity in the market. A stock split has to be proposed by the board of directors of a company and approved by the shareholders. The additional shares on account of the split get credited to the demat account of the shareholder."
Share Buyback,"6.3.5 Share Buyback A company may buy back its shares listed on a stock exchange from the investors out of the reserves and surplus available with the company. The shares bought back are extinguished by the company and leads to a reduction in its share capital. A share buyback is used by companies to increase the Earning Per Share (EPS) and thereby support the share price in the market. Surplus cash with the company for which there is no productive use, is used to restructure the capital of the company. To be eligible for a share buyback a company should not have defaulted on the payment of interest or principal on debentures, fixed deposits, redemption of preference shares or payment of dividend declared or payment of interest on any outstanding term loan."
Delisting of Shares,"6.3.6 Delisting of Shares Delisting of shares refers to the permanent removal of the shares of a company from being listed on a stock exchange. Delisting may be compulsory or voluntary. In a compulsory delisting, the shares are delisted on account of non-compliance to regulations and the clauses of the listing agreement by the company. In a voluntary delisting, the company chooses to get the shares delisted by buying back the shares in a reverse book building process."
Mergers and Acquisitions,6.3.7 Mergers and Acquisitions The shareholding pattern of a listed company may change due to a substantial acquisition of shares and voting rights by an acquirer and persons acting in concert with the acquirer. There are SEBI Regulations that provide the opportunity to public shareholders to exit from the company if they choose to do so.
Offer for Sale,6.3.8 Offer for Sale Offer for sale means an offer by existing investors in the company to sell their shares to the public. In this case there are no new shares issued by existing shares held by the investor are sold. The money from the sale goes to the investor selling the shares and not the company. This route is adopted by companies to give their existing investors an option to exit either partially or fully.
Types of Investment,"7.1 Types of investment There are many investment opportunities. Broadly, investments can be classified into financial or non-financial investments. Non-financial investments include real estate, gold, commodities etc. Financial Investments are exchange of cash flows for a period of time. Financial instruments are essentially claims on future cash flows. On the basis of claims on the cash flows, there are two generic types of financial instruments: debt and equity. Financial investments can also be classified on the basis of the markets they trade: public versus private markets. Another popular way of classifying the financial opportunities is on the basis of their maturity profile: Capital market versus money market."
Equity,"7.2 Equity Investment characteristics and role Equity Shares represent ownership in a company that entitles its holders share in profits and the right to vote on the company’s affairs. Equity shareholders are residual owners of the firm’s profit after other contractual claims on the firm are satisfied and have ultimate control over how the firm is operated. Equity Shareholders are residual claim holders. Investments in equity shares reward investors in two ways: dividend & capital appreciation. Investments in equities have proven time diversification benefits and considered to be a rewarding long-term investment. Time diversification benefits refers to the notion that fluctuation in investment returns tend to cancel out through time, thus more risk is diversified away over longer holding periods. It follows that investment in equities offer better risk-adjusted return if held for long time periods. The concept of listed versus unlisted equity/ investments are explained in Box 1.1.Box 1.1: Listed versus Unlisted Equities or for that matter any financial investment can also be classified on the basis of the trading platforms. Listed investments are traded on a stock exchange. Unlisted investments are bought and sold over the counter. The key difference between the two is the structure of buying or selling the securities. Listed investments follow the listing rules and requirements. The segment of listed investments is called public market. The mechanism of trading at exchange floors enhances liquidity in listed securities and also leads to continuous pricing. However, prices in the public markets are more prone to market sentiments. Both equity as well as fixed income securities trade in this segment. Unlisted investment space is referred as private market. Pricing of investment in unlisted space is not continuous. It is performed at regular intervals or when the need for the same arises for buying or selling. Since these investments do not trade in stock exchange, they are relatively less liquid in comparison to listed investments. Hence investors may demand an extra compensation for the same called “illiquidity risk premium”. Buying and selling of unlisted investments takes longer time compared to the listed investments."
Fixed Income Debt instruments,"7.3 Fixed Income Debt instruments, also called fixed income instruments, are contracts containing a promise to pay a stream of cashflows during the term of the contract to the investors. The debt contract can be transferable, a feature specified in the contract that permits its sale to another investor, or non-transferable, which prohibits sale to another party. Generally, the promised cash flow of a debt instrument is a periodic payment, but the parties involved can negotiate almost any sort of cash flow arrangement. A debt contract also establishes the financial requirements and restrictions that the borrower must meet and the rights of the holder of the debt instruments if the borrower defaults. Debt securities are issued by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Debt instruments can further be classified on the basis of issuer into government debt securities and corporate debt securities where the issuer is a non-government entity. Government securities form the largest component of debt market in India as well as world over. Government versus corporate Debt Securities A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such securities are short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged instruments. Box 1.1: Listed versus Unlisted Equities or for that matter any financial investment can also be classified on the basis of the trading platforms. Listed investments are traded on a stock exchange. Unlisted investments are bought and sold over the counter. The key difference between the two is the structure of buying or selling the securities. Listed investments follow the listing rules and requirements. The segment of listed investments is called public market. The mechanism of trading at exchange floors enhances liquidity in listed securities and also leads to continuous pricing. However, prices in the public markets are more prone to market sentiments. Both equity as well as fixed income securities trade in this segment. Unlisted investment space is referred as private market. Pricing of investment in unlisted space is not continuous. It is performed at regular intervals or when the need for the same arises for buying or selling. Since these investments do not trade in stock exchange, they are relatively less liquid in comparison to listed investments. Hence investors may demand an extra compensation for the same called “illiquidity risk premium”. Buying and selling of unlisted investments takes longer time compared to the listed investments. 148 A key source of funds for corporates is debt financing. Companies issue debt securities of various maturity profile. Many of these corporate debt papers are listed on stock exchanges. However a bigger component of corporate borrowings lies in the unlisted space. Corporate fixed income securities pay higher interest rates than the government securities due to default risk. The difference between the yield on a government security and the corporate security for the same maturity is called “credit spread”. Higher the probability of default greater would be the credit spread. Credit Spread could also be understood as the “Risk Premium” which the companies are paying to raise the debt, or the investors are charging for bearing default risk. High Yield versus Investment Grade The probability of default on a fixed income paper is captured by ratings given by rating agencies. Table 7.1 gives the rating symbols given by CRISIL a rating agency registered with SEBI. 7.1 Rating Scale and description Rating Description CRISIL AAA (Highest Safety) Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. CRISIL AA (High Safety) Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. CRISIL A (Adequate Safety) Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligation. Such instruments carry low credit risk. CRISIL BBB (Moderate Safety) Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligation. Such instruments carry moderate credit risk. CRISIL BB (Moderate Risk) Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligation. CRISIL B (High Risk) Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligation. 149 CRISIL C (Very High Risk) Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligation. CRISIL D (Default) Instruments with this rating are in default or are expected to be in default soon. As can be observed in the rating description, higher rating denotes lower default risk and vice versa. The convention in the market is to classify bonds with rating BBB and above as investment grade and bonds below the BBB as high yield or junk bonds. Many institutional investors are prohibited from investing in junk bonds as they involve high default risk."
Commodities ,"7.4 Commodities Investments in soft commodities which are grown like corn, wheat, soybean, soybean oil, sugar and also used as inputs in the production of other goods; and hard commodities which are mined like gold, silver, oil, copper and aluminium are other investment avenues available to investors. Soft commodities are perishable hence they exhibit high volatility in their prices. These commodities are subject to higher business cycle risk as their prices are determined by the demand and supply of the end products in which they are consumed. Soft commodities historically have shown low correlation110 to stocks and bonds. Hence, they provide benefits of risk diversification when held in a portfolio along with stock and bonds. Prediction of weather is an important factor while investing in soft commodities. Exposure to these commodities can be taken through derivative contracts like forwards or futures. Hence investors must carefully understand the risk involved in the same. Prices of hard commodities are determined by the interaction between global demand and supply . Hard commodities like gold and silver have been the investment avenues for centuries, as reserve assets. Due to its global acceptability gold has acquired the status safe haven asset. It is viewed as an attractive investment in times of economic uncertainty and geopolitical crisis. Gold has shown diversification benefits historically. Unlike most of the financial investments commodities do not generate any current income and the investor in these commodities would have to count only on capital appreciation."
Real Estates,"7.5 Real Estates Real estate is the largest asset class in the world. It has been a significant driver of economic growth. It offers significant diversification opportunities. It has been historically viewed as a good inflation hedge. Investors can invest into real estate with capital appreciation as an investment objective as well as to generate regular income by way of rents. It is usually a long- term investment. Real estate is classified into two sub-classes: commercial real estate or 10a technical term used to measure movement between two variables. The benefits of diversification rests on correlation between investments. Lower the correlation between investments, higher the benefits of diversification i.e. reduction in risk. 150 residential real estate. It can be further broken down into terms of tier I, tier II and tier III cities. Real estate investments often involve large commitments. Real estate funds or Real Estate Investment Trusts (REIT) have emerged as a good option to enable investors to take exposure to this asset class with smaller outflow commitments."
Structured Products,"7.6Structured products Structured products are customized and sophisticated investments. They provide investors risk-adjusted exposure to traditional investments or to assets that are otherwise difficult to obtain. Structured products greatly use derivatives to create desired risk exposures. Many structured products are designed to provide risk-adjusted returns that are linked to equity market indices, sector indices, basket of stocks with some particular theme, currencies, interest rates, commodity or a basket of commodities. Structured products can be designed for a short term or for long terms. The terms can be customized to meet the requirements of the investing community. These products require investments of a larger denomination. They may offer investment protection from 0% to 100% and/or attractive yields. The performance of the structured product is largely driven by the underlying strategy subject to market conditions. Hence, they must not be taken as capital protection or guaranteed or assured return products."
Distressed Securities,"7.7Distressed Securities Distressed securities are the securities of the companies that are in financial distress or near bankruptcy. Investors can make investments in the equity and debt securities of publicly traded companies. These may be available at huge discounts, however investments in them require higher skills and greater experience in business valuation than regular securities. These securities can be considered from the perspective of diversification of risk. These securities are also referred to as ‘fallen angels’ and many types of funds and institutional investors are prohibited from holding these securities because of the high risk involved. It is a popular investment segment among hedge fund managers as they have deep experience in valuation and credit analysis."
Other investment opportunities,"7.8 Other investment opportunities Art and paintings and rare collectibles are emerging as an attractive long-term investment opportunity. This category of investment has been generating moderate return in the long term. It also has low correlation with financial investment like equities and bonds. Hence it provides a good risk diversification benefit. However, these are big ticket investments. Also, art is not a standard investment product as each work is unique. The market for the same is unregulated. These investments do not provide any income and just like gold, capital appreciation is the only way of reward. In terms of liquidity, this category is relatively more illiquid. To make the rewarding investment decisions, specialized knowledge in arts is more crucial than in traditional financial assets due to higher levels of information asymmetry and 151 adverse selection problems. There are art and painting based investment funds. Investors can take exposure through these funds. Investments are also permitted abroad under the Liberalised Remittance Scheme (LRS) wherein an individual can invest upto $ 250,000 abroad every year. This route allows for geographical as well as currency diversification and also opens up several new choices for investors."
Channels for making investments,"7.9 Channels for making investments Investors can invest in any of the investment opportunities discussed above directly or through intermediary providing various managed portfolio solutions. Direct investments Direct investments are when investors buy the securities issued by companies and government bodies and commodities like gold and silver. Investors can buy gold or silver directly from the sellers or dealers. In case of financial securities, a few fee-based financial intermediaries aid investors buy or sell investments viz. brokers, depositories, advisors etc., for fees or commission. Understanding the role of RIAs Investors can take the advice from SEBI Registered Investment Adviser (RIA). As per the SEBI Regulation relating to RIA which came in the year 2013, only qualified professionals who are licensed by SEBI as Registered Investment Advisers (RIAs) can act as ‘advisers’. These advisers are paid fees by the investors who hire them for investment advice. After this regulation, the distributors of financial products like mutual fund distributors, share brokers and insurance agents who would earlier act as investment advisers, can no longer claim the title. These advisers, like other fee-based professionals, are only accountable to their investors. They are required to follow a strict code of conduct and offer advice in the investors’ best interests. They are also required to disclose any conflict of interest. Advisers do basic risk profiling, assess the needs and requirements of the investors, understand their financial health and develop ‘financial plans’. They help in inculcating a sense of discipline in investors. Thus Investment advisers can help investors create an optimum investment portfolio and help them in making rational investment decisions. Investments through managed portfolios Alternatively, investors can invest through investment vehicles which pool money from investors and invest in a variety of securities and other investments on their behalf. In other words, investors make indirect investments. These investment vehicles are professionally managed. Through these managed portfolios they can avail the professional expertise at much lower costs. The following are examples of managed portfolio solutions available to investors in India: 152 • Mutual Funds (MFs) • Alternative Investment Funds (AIFs) • Portfolio Managers (PMs) • Collective Investment Schemes (CISs) Mutual Fund A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Money collected through mutual fund is then invested in various investment opportunities like shares, debentures and other securities. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Mutual fund is a pass-through intermediary in the true sense. The following are the benefits of investing through mutual funds: • Professional investment Management • Risk reduction through diversification • Convenience • Unit holders account administration and services • Reduction in transaction costs • Regulatory protection • Product Variety However, mutual fund products are not ‘get rich quick’ investments. They are not risk-free investments. Mutual funds are strictly regulated by SEBI under Mutual Fund Regulation 1996. Mutual fund industry offers tremendous variety. There are products for different types of investment objectives and goal. Alternative Investment Fund Alternative Investment Fund or AIF is a privately pooled investment vehicle which collects funds from sophisticated investors, for investing it in accordance with a defined investment policy for the benefit of its investors. The words ‘privately pooled’ denote that the fund is pooled from select investors and not from the general public at large. These private investors are institutions and high net worth individuals who understand the nuances of higher risk taking and complex investment arrangements. The minimum investment value in AIF is one crore rupees. Portfolio Management Services A portfolio manager is a body corporate who advises or directs or undertakes on behalf of the investors the management or administration of a portfolio of securities. There are two types of portfolio management services available. The discretionary portfolio manager individually 153 and independently manages the funds of each investor whereas the non-discretionary portfolio manager manages the funds in accordance with the directions of the investors. The portfolio manager enters into an agreement in writing with the investor, clearly defining the relationship and setting out their mutual rights, liabilities and obligations relating to the management of funds or portfolio of securities. Portfolio management services are regulated by SEBI under Portfolio Manager Regulations. The regulations have not prescribed any scale of fee to be charged by the portfolio manager to its clients. However, the regulations provide that the portfolio manager shall charge fee as per the agreement with the client for rendering portfolio management services. The fee so charged may be a fixed amount or a return based fee or a combination of both. The portfolio manager is required to accept minimum Rs. 50 lakhs or securities having a minimum worth of Rs. 50 lakhs from the client while opening the account for the purpose of rendering portfolio management service to the client. Portfolio manager cannot borrow on behalf of his clients. Portfolio managers provide investment solutions unique to the needs of the investors. Compare and Contrast between Mutual Funds, Alternate Investment Funds and Portfolio Managers Mutual Funds, Alternate Investment Funds (AIFs) and Portfolio Managers (PMs) are managed portfolios. All three provide indirect ways of investing in securities and other investments to investors. All three are regulated by SEBI. However, Mutual funds are more stringently regulated compared to AIF and PMS as mutual funds cater to retail investors. In case of AIF, the minimum amount required for investment is Rs. one crore and in case of PMS it is Rs. Fifty lakhs. AIF and PMS cater to institutional and high net worth investors. These investors are expected to understand complex investment strategy and risks involved. The investment restrictions of PMS and AIF are also relatively less compared to mutual funds. So though, there are some similarities between them, there are important differences too. AIFs and PMS are popularly referred to as rich man’s mutual fund.a"
Equity as an investment ,"8.1 Equity as an investment Security markets enable investors to invest and disinvest their surplus funds in various instruments. These instruments are pre-defined for their features, issued under regulatory supervision, and in most cases have ready liquidity. Liquidity refers to the marketability (meaning existence of sellers when one needs to buy; and buyers when one needs to sell). There are two broad types of securities that are issued by seekers of capital from investors: Equity and Debt. When a company issues equity securities, it is not contractually obligated to repay the amount it receives from shareholders. It is also not contractually obligated to make periodic payments to shareholders for the use of their funds. Equity investors also known as shareholders have a claim on the company’s net assets, i.e. assets after all liabilities have been paid. Equity shareholders have residual claim in the business. Equity investors get voting rights. When equity investors own a sizable amount of shares in a company, they get an opportunity to participate in the management of the business. Investors who purchase equity shares look for capital appreciation and dividend income. There is no assurance of both by the company to the equity investor. While dividend payment depends on the profitability of the company, capital appreciation depends on the share market conditions and peculiarities. Because all residual benefits of deploying capital in a business go to the equity investor, the return to equity investors is likely to be higher than that of the debt investors. Choosing between equity and debt is a trade-off. Investors desiring lower risk, and willing to accept a lower stable return choose debt; if they seek a higher return, they may not be able to earn it without taking on the additional risk of the equity investment. Most investors tend LEARNING OBJECTIVES: After studying this chapter, you should know about: • Understand Equity as an investment • Diversification of risk through equity instruments - Cross sectional versus time series • risks of equity investments • Overview of Equity Market • Know the equity research and stock selection • Understand combining relative valuation and discounted cash flow models • Know about Technical Analysis • Qualitative evaluation of stocks 155 to allocate their capital between these two choices, depending on their expected return, their investing time period, their risk appetite and their needs."
Diversification of risk,"8.2 Diversification of risk through equity instruments - Cross sectional versus time series Equity is inherently riskier compared to bonds and many other asset classes. However there are ways to mitigate the risks in stocks. The most meaningful way to risk reduction is through diversification – both on cross sectional as well as on time series basis. Diversification of equity investment achieves risk reduction. Conceptually, it is achieved due to the relatively less correlated behaviour of various business sectors which underlie each equity investment. This is what the age old ‘Don’t put all your eggs in one basket’ means. Since equity investments enable an investor to own shares of many businesses across sectors and regions, investors can mitigate risk by holding shares in different businesses. Underlying the word ‘diversification’ is the concept of business cycles and counter-cyclical businesses. There is also the understanding of lagging and leading behaviour of investments returns, countries’ economic performance. In the Figure 8.1, a business cycle is shown as a dark line. Some businesses may be at peak when others are at their trough, as shown by the broken line. These products or businesses are called ‘counter-cyclical’ or defensive businesses. Businesses that do better in a recession are called ‘recession-proof’ businesses. Some products, sectors or countries come out of a recession faster than others; other products, sectors or countries may go into recession later than others. Figure 8.1 Counter-cyclical products Empirical research has demonstrated that a significant portion of risk can be reduced through diversification. Cross sectional risk diversification is reducing risk by holding equities in many different kinds of businesses at a point in time. Reaping the benefits of time diversification requires investing in equities for a long period of time. The belief is that bad times will get cancelled out by good times. This is why “time in the market” is suggested for equity investment as against “timing the market”."
Risk of equity investments,8.3 Risks of equity investments Equities are often regarded as riskier than other asset classes. The main types of risks discussed in the context of equity investments are discussed below:
Market risk,"8.3.1. Market risk Market risks arise due to the fluctuations in the prices of equity shares due to various market related dynamics. These factors affect all investments irrespective of their business sector. The degree of impact may be different. Market risk is measured by Beta. Market risks cannot be diversified away, though it can be hedged."
Sector specific risk,8.3.2. Sector specific risk Risks due to sector specific factors are part of non-market risks. These risks can be diversified away. Sector specific risk is due to factors that affect the performance of businesses in a particular sector. Businesses belonging to other sectors do not get affected by them. This risk can be diversified away by investing into other shares of businesses in different sectors.
Company specific risk,8.3.3. Company specific risk Risks due to company specific factors are part of non-market risks. These risks can also be diversified away. Company specific risk is due to factors that affect the performance of a single company. Other firms do not get affected by them. This risk can be diversified away by investing into shares of different companies.
Transactional Risk,8.3.4 Transactional risk Risks due to the other party not fulfilling the terms of the contract while buying or selling equities is often referred to as transactional risk. This can happen when the other person is either not able to pay the money or deliver the shares. This type of risk can be mitigated by transacting through the stock exchange where there are robust risk mitigation procedures present to take care of such situations.
Liquidity risk,"8.3.5. Liquidity risk Liquidity risk is the risk of not being able to find a buyer or seller for the equity holdings. Liquidity risk is measured by impact cost. The impact cost is the percentage price movement caused by a particular order size (let’s say an order size of Rs.1 Lakh) from the average of the best bid and offer price in the order book snapshot. The impact cost is calculated for both, the buy and the sell side. Less liquid stocks are more thinly traded, and a single large trade can move their prices considerably. Such stocks have high impact costs. A lower market impact implies the stock is more liquid."
Overview of Equity Market,"8.4 Overview of Equity Market Equity securities represent ownership claims on a company’s net assets. A thorough understanding of the equity market is required to make optimal allocation to this asset class. The equity market provides various choices to investors in terms of risk-return-liquidity 157 profile. There are opportunities in listed as well as unlisted equity space available.11 There are about 66,000 unlisted public limited companies and over 5,000 listed domestic companies. Investments in listed companies is relatively more liquid than investment in unlisted companies. Listed companies have to abide by the listing norms, making this investment space more regulated with better disclosures. Market capitalization of listed companies at NSE in India was reported at Rs. 1,12,43,112 crore as of March 2020. In addition to equity shares, companies may also issue preference shares. Preference shares rank above equity shares with respect to the payment of dividends and distribution of company’s net assets in case of liquidation. However, preference shares do not generally have voting rights like equity shares, unless stated otherwise. Preference shares share some characteristics with debt securities like fixed dividend payment. Similar to equity share, preference shares can be perpetual. Dividends on preference shares can be cumulative, non- cumulative, participating, non-participating or some combination thereof (i.e., cumulative participating, cumulative non-participating, non-cumulative participating, non-cumulative non-participating). In case preference stock is cumulative, the unpaid dividends would accumulate to be paid in full at a later time, whereas in non-cumulative stocks the unpaid or omitted dividend does not get paid. A non-participating preference share is one in which a dividend is paid, usually at a fixed rate, and not determined by a company’s earnings. Participating preference share gives the holder the right to receive specified dividends plus an additional dividend based on some prespecified conditions. Participating preference shares can also have liquidation preferences upon a liquidation event. Preference shares can also be convertible. Convertible preference shares entitle shareholders to convert their preference shares into a specified number of equity shares. Since preference shares carry some characteristics of equity share and at the same time some of the debt securities, they are referred to as hybrid or blended securities. The chief characteristic of equity shares is shareholders’ participation in the governance of the company through voting rights. Generally companies issue only one kind of common shares, on the principle of ‘one share, one vote’. Some companies, however, issue shares with Differential Voting Rights (DVRs). Shares with DVRs can either have superior voting rights (i.e. multiple votes on one share) or inferior voting rights (i.e. a fraction of the voting right on one equity share) or differential rights as to dividend. Shares with DVRs are very popular in the western world for many decades. They have not really gained momentum in India. Though way back in 2000, the Companies Act, 1956, was amended to permit issuance of shares with DVRs, not many companies have issued shares with DVRs. Tata Motors was one of the first 11 Listing is a process through which the companies fulfilling the eligibility criteria prescribed by the Exchange are admitted for trading on the Exchange. 158 companies in India to issue DVRs in 2008. These DVRs carried 1/10voting rights and 5% higher dividend than ordinary shares. Since then, Pantaloons Retail (currently Aditya Birla Fashion and Retail Limited), Gujarat NRE Coke Ltd., Jain Irrigation Systems Ltd. have issued DVRs. Companies issuing equity shares can be classified on the basis of size – measured by way of their market capitalization as ultra large cap, large cap, mid-cap, small cap, micro-cap etc., each group represents a particular risk – return- liquidity profile. For example large cap companies as a group have lower variability in return than small cap companies. Technological advancements and integration of global markets have expanded the investment opportunity set for the investors. They can invest in global equities within the restrictions placed by the RBI. 8.5 Equity research and stock selection As there are thousands of opportunities available to investors in the equity market, equity research and stock selection process plays a very important role in identifying stocks which suit the risk-return-liquidity requirements of the investors. Equity research involves thorough analysis and research of the companies and its environment. Equity research primarily means analysing the company’s financials and non-financial information, studying the dynamics of the sector the company belongs to, competitors of the company, economic conditions etc. The idea behind equity research is to come up with intrinsic value of the stock to compare with market price and then decide whether to buy or hold or sell the stock. There are many frameworks/methodologies available for stock selection. Analysts use fundamental analysis - top-down approach or bottom-up approach - quantitative screens, technical indicators etc., to select stocks. 8.5.1. Fundamental Analysis Fundamental analysis is the process of determining intrinsic value for the stock. These values depend on underlying economic factors such as future earnings or cash flows, interest rates, and risk variables. By examining these factors, intrinsic value of the stock is determined. Investors should buy the stock if its market price is below intrinsic value and do not buy, or sell, if the market price is above the intrinsic value, after taking into consideration the transaction cost. In other words, the difference between intrinsic value and market price should be enough to cover the transaction costs. Investors who are engaged in fundamental analysis believe that intrinsic value may differ from the market price but eventually market price will merge with the intrinsic value. An investor or portfolio manager who can do a superior job of estimating intrinsic value will generate above-average returns by acquiring undervalued securities. Fundamental analysis involves"
Top Down approach versus Bottom up Approach,"8.5.1.1. Top Down approach versus Bottom up Approach Analysts follow two broad approaches to fundamental analysis – top down and bottom up. The factors to consider are economic (E), industry (I) and company (C) factors. Beginning at company-specific factors and moving up to the macro factors that impact the performance of the company is called the bottom-up approach. Scanning the macro economic scenario and then identifying industries to choose from and zeroing in on companies, is the top-down approach. EIC framework is the commonly used approach to understanding fundamental factors impacting the earnings of a company, scanning both micro and macro data and information."
Buy side research versus Sell Side Research,"8.5.1.2. Buy side research versus Sell Side Research Sell-side Analysts work for firms that provide investment banking, broking, advisory services for clients. They typically publish research reports on the securities of companies or industries with specific recommendation to buy, hold, or sell the subject security. These recommendations include the analyst’s expectations of the earnings of the company and future price performance of the security (“price target”). Buy-side Analysts work for money managers like mutual funds, hedge funds, pension funds, or portfolio managers that purchase and sell securities for their own investment accounts or on behalf of their clients. These analysts generate investment recommendations for their internal consumption viz. use by the fund managers within the organization. Research reports of these analysts are generally circulated among the top management/investment managers of the employer firms as these reports contain recommendations about which securities to buy, hold or sell."
Sector Classification,8.5.1.3 Sector Classification One way of conducting fundamental analysis is by classifying the companies into various sectors and then analysing the situation related to the sector. A sector consists of a group of companies that make similar products or provide similar services or have a similar technological structure. The economic and market factors related to a sector are analysed and this gives a better idea of the situation prevailing in the sector. Investment decisions are then taken on the basis of this analysis.
Economy Analysis,"8.5.2.1. Economy Analysis Macro-economic environment influences all industries and companies within the industry. Monetary and fiscal policy influences the business environment of the industries and companies. Fiscal policy initiatives like tax reduction encourages spending while removal of subsidies or additional tax on income discourage spending. Similarly, monetary policy may reduce the money supply in the economy affecting the expansionary plans and working capital requirements of all the businesses. Hence a thorough macro-economic forecast is required to value a sector/firm/equity. Any macro-economic forecast should include estimates of all of the important economic numbers, including: • Gross Domestic Product • Inflation rates • Interest rates • Unemployment The most important thing an analyst does is to watch for releases of various economic statistics by the government, Reserve Bank of India and private sources. Especially, they keep a keen eye on the Index of economic indicators like the WPI, CPI, monthly inflation indices, Index of Industrial Production, GDP growth rate etc. Analysts assess the economic and security market outlooks before proceeding to consider the best sector or company. Interest rate volatility affects different industries differently. Financial institution or bank stocks are typically placed among the most interest-sensitive of all stocks. Sectors like pharmaceuticals are less affected by interest rate change. The economy and the stock market have a strong and consistent relationship. The stock market is known as a leading economic indicator. A leading economic indicator is a measure of economic recovery that shows improvement before the actual economy does because stock price decisions reflect expectations for future economic activity, not past or current activity."
Industry/Sector Analysis,"8.5.2.2 Industry/Sector Analysis Industry analysis is an integral part of the three steps of top-down stock analysis. Rates of return and risk measures vary over time in different industries. Industry analysis helps identify both unprofitable and profitable opportunities. Industry analysis involves conducting a macroanalysis of the industry to determine how different industry relates to the business cycle. Performance of industries is related to the stage of the business cycle. Different industries perform differently in different stages of the business cycle. On the basis of the relationship different sectors share with the business cycles, they are classified as cyclical and noncyclical sectors. For example, banking and financial sector perform well towards the end of a recession. During the phase of recovery, consumer durable sectors like producers of cars, personal computers, refrigerators, tractors etc., become attractive investments. Cyclical industries are attractive investments during the early stages of an economic recovery. These sectors employ high degree of operating costs. They benefit greatly during an economic expansion due to increasing sales, as they reap the benefits of economies of scale. Similarly, sectors employing high financial leverage also benefit during this phase, as debt is good in good times. At the peak of the business cycle, inflation increases as demand overtakes supply. Inflation impacts different industries differently. There are industries, which are able to pass on the increase in the costs of products to their consumers by increasing prices. Their revenue and profits may remain unaffected by inflation. Industries producing basic materials such as oil and metals benefits the situation. Rising inflation doesn’t impact the cost of extracting these products. These industries can increase prices and experience higher profit margins. However, there are industries that are not able to charge the increased costs of production to their consumers. Their profitability suffer due to inflation. During a recession phase also, some industries do better than others. Defensive industries like consumer staples, such as pharmaceuticals, FMCG, outperform other sectors. Even though the spending power of consumer is going down, people still spend money on necessities. Analyst also see the stage the Industry is in its life cycle. The number of stages in the life cycle of the industry are depicted in Figure 8.2: 162 Figure 8.2: Industry Life Cycle • Introduction: during this stage industry experiences modest sales and very small or negative profit. The market of the products of the industry is small and the firms in the industry may have high development costs. • Growth: during this stage, market develops for the products or services of the industry. Number of firms in the industry is less during this phase and hence they may have little competition. Profit margins at this stage are generally high. This stage is followed by mature industry growth. The rapid growth of the earlier phase attracts competitors contributing profits margins to go to normal levels. • Maturity: This is generally the longest phase in the life cycle of the industry. During this stage, growth rate in the industry normally matches with the economy’s growth rate. Firms in the industry differ from one another given their cost structure and ability to control costs. Competition is high during this stage reducing the profit margin to normal levels. • Deceleration of growth and decline: This stage observes decline is sales due to shift demand. Profits margins are under pressure and some firms may even witness negative profits. Similar to life cycle analysis, competitive structure of the industry is to be analysed by the analysts. It is a key factor affecting the profitability of the firms in the industry. Competition influences the rate of return on invested capital. If the rate is ""competitive"" it will encourage investment. Michael Porter looked at forces influencing competition in an industry and the elements of industry structure. He described these forces as the industry’s micro- environment."
Porter's Model," 8.3 Porter’s Model Michael Porter suggests that five competitive forces determine the intensity of competition in the industry. Which in turn affects the profitability of the firms in the industry. The impact of these factors can be different for different industries. The first factor is rivalry among the existing competitors. Every industry is analyzed to determine the level of rivalry amongst its firms. Rivalry increases when the industry has many firms of the same size. And hence firms may compete very hard to sell at full capacity. The second factor is the threat of new entrants. The entry barriers influence the entry of new player to the industry. The analysts examine them, as they influence the future competitive structure of the industry and in turn profitability of existing firms. The third factor is the threat of substitute products. Substitute products influence the prices firms can charge for their products. Greater the substitutability of the product, lower the profit margins. The fourth factor is bargaining power of the buyers, which influences the profitability. Buyers can influence the profitability of an industry when they are in position to demand lower prices or higher quality by showing a susceptibility to switch among competitors. The fifth factor is the bargaining power of the supplier. Suppliers are more powerful if they are few and large in size. They can influence future industry returns if they increase prices or 164 reduce the quality of the product."
Company Analysis,"8.5.2.3. Company Analysis Company analysis is the final step in the top-down approach to Stock Analysis. Macroeconomic analysis prepares us to understand the impact of forecasted macro- economic environment on different asset classes. It enables us to decide how much exposure to be made to equity. Industry analysis helps us in understanding the dynamics of different industries in the forecasted environment. It enables us to identify industries that will offer above-average risk-adjusted performance over the investment horizon. If trends are favourable for an industry, the company analysis focusses on firms in that industry that are positioned to benefit from the economic trends. The final investment decision to be made is with regard to which are the best companies in the desirable industries? And are they attractive investments in terms of risk-adjusted returns. Company analysis is to be differentiated from stock valuation. Company analysis is conducted to understand its strength, weaknesses, opportunities and threats. These inputs are used to determine the fundamental intrinsic value of the company’s stock. Then this value is compared with the market price of the stock. If the intrinsic value is higher than the market price, the stock is bought and vice versa. It is very important to note that stocks of good companies need not make good investment opportunities. The stock of a good company with superior management and strong performance measured by current and future sales and earnings growth can be trading at a price much higher to its intrinsic value. It may not make a good investment choice and it should not be acquired. Company analysis is needed to determine the value of the stock. There are many components to company analysis. Financial statement analysis of the company is often the starting point in analysing a company. Analysing the profit and loss account, balance sheet and the cash flow statement of the company is imperative. The financial performance numbers of a company, as presented in the financial statements, can be used to calculate ratios that give a snapshot view of the company’s performance. The ratios of a company have to be seen in conjunction with industry trends and historical averages. Another important component of company analysis is SWOT Analysis. SWOT analysis involves examination of a firm’s strengths, weaknesses, opportunities, and threats. Strengths and weaknesses deal with a company’s internal ability, like a company’s competitive advantage or disadvantages. Opportunities and threats deal with external situations and factors the company is exposed to. Opportunities include a favourable tax environment. An example of threat is stringent government regulation. Company analysis also involves analysing its competitive strategies. A firm may follow a defensive strategy. A defensive strategy is one where the firm positions itself in such a way 165 that its capabilities provide the best means to deflect the effect of competitive forces in the industry. Alternatively, a firm may follow an offensive strategy in which the firm attempts to use its strengths to affect the competitive forces in the industry. Michael Porter suggests two major strategies: Cost Leadership and Differentiation. Cost Leadership: under this strategy the firm seeks to be the low-cost producer, and hence the cost leader in its industry. Cost advantages vary from industry to industry. Differentiation Strategy: Under this strategy, the firm positions itself as unique in the industry. Again, the possibilities of differentiation differ from industry to industry. Another very important component of company analysis is understanding the business model of the company. As part of it the following questions need to be asked. • What does the company do and how does it do? • Who are the customers and why do customers buy those products and services? • How does the company serve these customers? Almost all successful investors and fund managers repeat this thought that one must invest only in such firms where one understands the business. In the checklist for research, this is one of the most prominent questions – ‘Do I understand the business?’ No analyst should move to the next question if he/she can’t address what a company does in a line with preciseness and clarity. There are over 5,000 companies listed on Indian exchanges. It is not possible to track and understand all of them. Investors should consider buying shares of few companies they understand rather than invest in a number of companies they don’t understand. Further, each sector has its own unique parameters for evaluation. For the retail sector, footfalls and same store sales (SSS) are important parameters, whereas for banking it is Net Interest Income (NII)/ Net Interest Margin (NIM). For telecom, it is Average Revenue per User (ARPU) and for hotels, it is average room tariffs etc. Analysts must possess an in-depth knowledge of the sectors while researching companies. Further, each company will have its unique way of doing business. The efficiency with which products and services are produced and delivered to the customers may vary from one business to another and will significantly impact its earnings. Therefore, it becomes imperative for analysts to understand the entire business model of companies."
Fundamentals Driven model,"8.5.3. Fundamentals Driven model - Estimation of intrinsic value Once the analysis of the economy, industry and company is completed, the analyst can go ahead with estimating intrinsic value of the firm’s stock. Price and value are two different concepts in investing. While price is available from the stock market and known to all, value 166 is based on the evaluation and analysis of the valuer at a point in time. There are various approachesto valuation. There are uncertainties associated with the inputs that go into these valuation approaches. As a result, the final output can at best be considered an educated estimate, provided adequate due diligence associated with valuing the asset has been complied with. That is the reason, valuation is often considered an art as well as a science. It requires the combination of knowledge, experience, and professional judgment in arriving at a fair valuation of any asset. The purpose of valuation is to relate the market price of the stock to its intrinsic value and estimate if it is fairly priced, over-priced or under-priced."
Discounted Cash Flow Model,"8.5.3.1. Discounted Cash Flow Model Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate approach for valuations when three things are known: • Stream of future cash flows • Timings of these cash flows, and • Expected rate of return of the investors (called discount rate). Once these three pieces of information are available, it is simple mathematics to find the present value of these cash flows which a potential investor would be willing to pay today to receive the expected cash flow stream over a period of time. In valuing a business, the cash flows (outflows and inflows) at various stages over its expected life is considered. A rational way to find the value of a business , to put it simply, is to find the inflows and outflows at different points in time and then bringing them to today at an appropriate rate of return (Discount Rate - DR) (find present Value – PV). This is called Discounted Cash Flow (DCF) method to value a project or a business/firm. The two principal factors that drive the valuation of a firm using DCF are estimating the expected cash flows and the second is the determination of the rate used to discount these cash flows. The value estimated using the DCF can vary across analysts if there are differences in estimating these two factors. There are two ways to look at the cash flows of a business. One is the free cash flows to the firm (FCFF), where the cash flows before any payments are made on the debt outstanding are taken into consideration. This is the cash flow available to all capital contributors-both equity and debt. The second way is to estimate the cash flows that accrue to the equity investors alone. Interest payments on debt are deducted from the FCFF and net borrowings added to it to arrive at the free cash flows for equity (FCFE). It is to be noted that the cash flows to the equity investors is not taken to be the dividends alone. It is extended to include the residual cash flows after meeting the obligations to the debt holders and dividends to preference shareholders. FCFF may be used for valuation if FCFE is likely to be negative or if the capital structure of the firm is likely to change significantly in the future. FCFF is computed as: 167 Earnings Before Interest & Tax (EBIT) less Tax plus Depreciation & Non-cash charges less Increase (Decrease) in working capital less Capital Expenditure Incurred (Sale of assets) FCFE is computed as: FCFF Less Interest plus Net borrowing Apart from depreciation, other non-cash charges include amortization of capital expenses and loss on sale of assets, which are added back. Gains on the sale of assets is deducted from the FCFF and FCFE calculations. Valuation requires a forecast of the cash flows expected in the future. This can be done by applying the historical growth rate exhibited by the company or a rate estimated by the analysts based on their information and analysis. A more robust way is to look at the internal determinants of growth, namely, the proportion of earnings ploughed back into the business and the return on equity that it is expected to earn. The growth rate can be calculated as the product of the retention rate and the return on equity. A firm may have a period of high growth in revenues, profitability, capex and other performance parameters and then stabilize to a steady growth. Since equity is for perpetuity and it is not possible to forecast the cash flows forever, the practice is to calculate a terminal value for the firm once the high growth period is over. The terminal value may be calculated using the perpetuity growth method where the cash flow is expected to grow forever at a steady though modest rate once the high growth period is over. The average long term GDP growth rate or inflation rate is a good proxy for this rate. The terminal value is calculated by multiplying the cash flow for the last year of the high growth period by (1+ Normal Growth rate) and dividing the resultant value by (Discounting rate- Growth rate). The other method is to calculate the terminal value by applying a multiple to a parameter such as the EBITDA at the end of the high growth period. The value of the multiple is picked from that of the comparable firms. The terminal value is added as an additional independent component, occurring at the last year; to the stream of cash flows projected during the growth period or the projection period, and then all of these cashflows are discounted to the present value. The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and also the expectations of the investors. To calculate the value of the firm, the FCFF is discounted by the weighted average cost of capital (WACC) that considers both debt and equity. To calculate the value of equity, FCFE is discounted using the cost of equity. In most of the valuation exercises, cost of debt is taken as the prevailing interest rates in the economy for borrowers with comparable credit quality. And, cost of equity is the rate of return on investment that is required by the company's common shareholders. Capital Asset 168 Pricing Model - CAPM, which establishes the relationship between risk and expected return forms the basis for cost of equity. As per Capital Asset Pricing Model (CAPM), the cost of equity is computed as follows: Ke = Rf + ? * (Rm – Rf) Where: Rf = Risk Free Rate, (Rm – Rf) = Market risk premium (MRP), and ? = Beta The Weighted Average Cost of Capital of the firm (WACC) is then calculated as under: WACC = [Ke * Equity / (Equity+ Debt)] + [Kd * (1-Tax)* Debt / (Equity+ Debt)] = [Ke * We] + [Kd * (1-Tx)*Wd] Where Ke = Cost of Equity, Kd = Cost of Debt, Wd = Weight of Debt, We = Weight of Equity The free cash flows for the firm (FCFF) are then discounted at the appropriate cost of capital (Ko) discount rate to arrive at the Firm Value."
Asset Based Valuation,"8.5.3.2. Asset Based Valuation Asset Based valuation methodology is used in some businesses which are extremely asset oriented such as real estate, shipping, aviation etc. Under this method the value of the business is found out by subtracting the value of its liabilities from its assets."
Relative Valuation,"8.5.4. Relative Valuation Relative valuation is conducted by identifying comparable firms and then obtaining market values of equity of these firms. These values are then converted into standardized values which are in form of multiples, w.r.t any chosen metric of the company’s financials, such as earnings, cash flow, book values or sales. These multiples are then applied to the respective financials of the target company for valuation. Based on the value arrived and the market price of the equity shares of the company it is decided whether it is over-valued or under- valued. Relative valuation techniques implicitly contend that it is possible to determine the value of an economic entity by comparing it to similar entities on the basis of several important ratios."
P/E Ratio,"8.5.4.1. P/E Ratio The most common stock valuation measure used by analysts is the price to earnings ratio, or P/E. For computing this ratio, the stock price is divided by the EPS figure. For example, if the stock is trading at Rs. 100 and the EPS is Rs. 5, the P/E is 20 times. Historical or trailing P/Es are computed by dividing the current price with the sum of the EPS for the last four quarters. Forward or leading P/Es are computed by dividing the current stock price with the sum of the EPS estimates for the next four quarters. For example, consider a company whose fiscal year ends in March. In order to compute the forward P/E for financial year ending 2019 (technically called FY19), an investor would add together the quarterly EPS estimates for its quarters ended June 2018, September 2018, December 2018 and March 2019. He could use the current price divided by this number to arrive at the FY19P/E. A stock's P/E tells us how much an investor is willing to pay per rupee of earnings. In other words, a P/E ratio of 10 suggests that investors in the stock are willing to pay Rs. 10 for every Re. 1 of earnings that the company generates. The PE ratio of a stock is evaluated relative to the market PE ratio (Nifty 50, S&P Sensex, SX40, among others), average PE ratio of the industry to which it belongs and to the PE ratios of peer group companies to determine whether it is fairly valued. For example, all things being equal, a Rs. 10 stock with a P/E of 75 is considered more ""expensive"" than a Rs. 100 stock with a P/E of 20. P/E ratios change constantly and the ratio needs to be recomputed every time there is a change in the price or earnings estimates. There are certain limitations to using the PE ratio as a valuation indicator. The projected P/E ratios are calculated based on analyst estimates of future earnings that may not be accurate. PE ratios of companies that are not profitable, and consequently have a negative EPS, are difficult to interpret. The average P/E ratio in the market and among industries fluctuates significantly depending on economic conditions."
Price to Book Value Ratio to Book Value (P/BV),"8.5.4.2. Price to Book Value Ratio Price to Book Value (P/BV) is another relative valuation ratio used by investors. It compares a stock's price per share (market value) to its book value (shareholders' equity). The P/BV ratio is an indication of how much shareholders are paying for the net assets of a company. The book value per share is calculated by dividing the reported shareholders' equity by the number of common shares outstanding. 170 If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities. The first scenario is that the stock is being incorrectly undervalued by investors and represents an attractive buying opportunity at a bargain price. On the other hand, if the company is correctly valued in the opinion of the investors, then it will be regarded as a losing proposition. The use of book value as a valuation parameter is also limited because a company's assets are recorded at historical cost less depreciation. Depending on the age of these assets and their physical location, the difference between current market value and book value can be substantial. Also, assets like intellectual property are difficult to assess in terms of value. Hence, book value may undervalue these kinds of assets, both tangible and intangible. The P/B ratio therefore has its shortcomings but is still widely used as a valuation metric especially in valuing financial services and banking stocks where the assets are marked to market."
P/S Ratio ,"8.5.4.3. P/S Ratio The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company's total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. Sometimes concerns are raised regarding the tendency of the firms to manipulate earnings. In such situations, price to sales ratio can be used instead of earning based ratios as sales are less prone to manipulation. Also, in case of companies not earning profits yet, or companies in high volume low margin businesses instead of earning based ratios investors can look at the P/S ratio to determine whether the stock is undervalued or overvalued. Pt = end of the year stock price for the firm St+1 = annual sales per share for the firm"
PEG Ratio,"8.5.4.4. PEG Ratio This valuation measure takes three factors into account - the price, earnings and earnings growth rates. The formula used to compute the PEG ratio is as below: 171 (EPS is calculated as Profit after tax (PAT)/Number of outstanding common shares of the company) This ratio may be used to express the extent to which price that an investor is willing to pay for a company, is justified by the growth in earnings. The assumption with high P/E stocks is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio helps investors determine the degree of reliability of that growth assumption. The thumb rule is that if the PEG ratio is 1, it means that the market is valuing a stock in accordance with the stock's estimated EPS growth. If the PEG ratio is less than 1, it means that EPS growth is potentially able to surpass the market's current valuation and the stock's price is undervalued. On the other hand, stocks with high PEG ratios can indicate just the opposite -that the stock is currently overvalued. This is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. The PEG ratio may show that one company, compared to another, may not have the growth rate to justify its higher P/E, and its stock price may appear overvalued. The efficacy of the PEG ratio as a valuation measure will depend upon the accuracy with which the earnings growth numbers are estimated. Overestimation or underestimation of future earnings will lead to erroneous conclusions about the valuation of the share."
EVA and MVA,"8.5.4.5. EVA and MVA There are many ways analysts can estimate the value of a company. EVA and MVA are the most common metrics used to determine a company's value. Economic value added (EVA) attempts to measure the true economic profit produced by a company. It is also referred to as ""economic profit"". Economic profit can be calculated by taking a company's net after-tax operating profit and subtracting from it the product of the company's invested capital multiplied by its percentage cost of capital. EVA provides a measurement of a company's economic success over a period of time. This measure is useful for investors who wish to determine how well a company has produced value for its investors. Market Value Added (MVA) is the difference between the current market value of a firm and the original capital contributed by investors. If the MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value added needs to be greater than the firm's investors’ opportunity cost. The opportunity cost is calculated by estimating the return the investors would have got by investment in the market portfolio adjusted for the leverage of the firm."
EBIT/EV and EV/EBITDA Ratio,"8.5.4.6. EBIT/EV and EV/EBITDA Ratio EV is an important component of many ratios analysts use to compare companies, such as the EBIT/EV multiple and EV/EBITDA. The EV of a business is: Market capitalization + Total Debt - All cash and cash equivalents So the EV tells how much money would be needed to buy the whole company. The EV can be compared with Earnings available to the entire capital (equity and debt holders) - Earnings before Interest and taxes called EBIT. EBIT/EV is the earning yield, higher the better as this indicates that the company has low debt levels and higher amounts of cash. This measure is useful to compare firms that have different capital structures, since the earnings are taken before the interest payout. Sometimes market participants use EBITDA instead of EBIT as a measure of return on applied capital given that Depreciation/Amortization is a non-cash expense. In that case, they talk about EV as EBITDA multiple as a measure of value of businesses. Higher ratio conveys that the company is valued high in the perceptions of market participants, and whether it is overvalued or undervalued can only be decided by comparing this value with the industry average, or relevant decile or quintile."
EV/S Ratio,"8.5.4.7. EV/S Ratio Enterprise value-to-sales (EV/sales) compares the enterprise value (EV) of a company to its annual sales. The EV/sales multiple enables investors to value a company based on its sales, while taking account of both the company's equity and debt. This ratio is more comprehensive than Price to Sales Ratio because it takes into consideration company's debt while P/S does not take into account the company’s equity and debt when valuing the company."
Dividend yield,8.5.4.8 Dividend yield The dividend yield is obtained by dividing the dividend per share declared by the company by the market price of the company. Thus it will show what would be return from dividend for an investor why buys the shares of the company at the current market price. The dividend yield gives a better picture of the return from dividend for the investor as compared to just looking at the dividend per share. Dividend yield = Dividend per share/ Market price of the share *100 For example a company which is trading at Rs 40 and declaring a dividend of Rs 2 per share will have a dividend yield of 5 per cent.
Earnings yield,"8.5.4.9 Earnings yield The earnings yield for a company is determined by dividing the earnings per share of a company by the market price of the company. This shows the earnings that are generated by the company at the current market price. It is one of the factors that is seen to determine the undervaluation or overvaluation of a stock. Earnings yield = Earnings per share/Market price per share * 100 For example, a company with an earnings per share of Rs 2.5 when the market price if Rs 25 gives an earnings yield of 10 per cent. This ratio is the inverse of the P/E ratio."
Industry/sector specific valuation metrices,"8.5.4.10. Industry/sector specific valuation metrices As discussed above, there are different valuation tools. No one method is perfect for all the sectors and companies. Different sectors are valued on different metrices. Non-cyclical sectors like FMCG and Pharma which generate predictable cashflows can be valued using discounted cashflow technique. Replacement cost method is applied for valuing businesses which are capital intensive like cement and steel. Relative valuation tools like P/E Ratio are used as add on metrics across all sectors. It is also popularly used to comment on the valuation of market, comparing it with other markets and also doing comparison over a period of time. Often newspapers and media report the P/E ratio of the market and comment that it is expensive or cheap, compare to other emerging markets. P/B ratio is very popular among banks and financial service sector. Investors/analyst should understand the characteristics and attributes of the sector before they select a particular valuation tool."
Combining relative valuation and discounted cash flow models,"8.6 Combining relative valuation and discounted cash flow models Discounted cash flow models are used to estimate the intrinsic value of the stock or entity. The relative valuation metrices are used to determine the value of an economic entity (i.e., the market, an industry, or a company) by comparing it to similar entities. Discounted cash flow models are dependent on (1) the growth rate of cash flows and (2) the estimate of the discount rate. Relative Valuation techniques compare the stock price to relevant variables that affect a stock’s value, such as earnings, cash flow, book value, and sales etc., A deeper look into the two techniques will reveal that multiples are merely a simplified version of DCF. All of the fundamental drivers of business value are incorporated in both techniques. Let us look at the P/E ratio to understand the connection between discounted cash flow techniques and relative valuation metrices: P/E Ratio = Price / Expected Earnings Per Share This ratio compares the price of the stock to the earning it generates. The rationale lies in the fundamental concept that the value of an asset is the present value of its future return. 174 This ratio is also influenced by the same variables that influence the value under the discounted cash flow techniques. Intrinsic value is calculated as follow: Price is calculated as follow: D1= next period dividend calculated as D0*(1+g) where g denote expected growth in dividend, and D0 indicates current dividend, k is the discount rate. By dividing both the sides of the equation by (expected earnings during the next time period) we will get- Thus P/E Ratio is affected by two variables: 1. Required rate of return on its equity (k) 2. Expected growth rate of dividends (g) Higher the expected growth rate of dividends, higher would be the P/E ratio. Higher the required rate of return on equity, lower would be the P/E ratio. Hence, we can conclude that these two approachesto valuation are complementary in nature rather than competing with each other. It often happens that the calculated intrinsic values are substantially above or below prevailing prices. As a small change in estimation of growth rate or discount rate, can have a significant impact on the estimated value. In these models, inputs are very critical as the saying goes “GIGO: garbage in, garbage out!” In such situations, relative valuation metrics can help in understanding the gaps. Relative valuation techniques provide information about how the market is currently valuing stock."
Technical Analysis,"8.7 Technical Analysis Technical analysis is based on the assumption that all information that can affect the performance of a stock, company fundamentals, economic factors and market sentiments, is reflected already in its stock prices. Accordingly, technical analysts do not care to analyse the fundamentals of the business. Instead, the approach is to forecast the direction of prices through the study of patterns in historical market data - price and volume. Technicians 175 (sometimes called chartists) believe that market activity will generate indicators in price trends that can be used to forecast the direction and magnitude of stock price movements in future. There are three essential elements in understanding price behaviour: 1. The history of past prices provides indications of the underlying trend and its direction. 2. The volume of trading that accompanies price movements provides important inputs on the underlying strength of the trend. 3. The time span over which price and volume are observed factors in the impact of long term factors that influence prices over a period of time. Technical analysis integrates these three elements into price charts, points of support and resistance in charts and price trends. By observing price and volume patterns, technical analysts try to understand if there is adequate buying interest that may take prices up, or vice versa. Technical Analysis is a specialized stream in itself and involves study of various trends- upwards, downwards or sideways, so that traders can benefit by trading in line with the trend. Identifying support and resistance levels, which represent points at which there is a lot of buying and selling interest respectively, and the implications on the price if a support and resistance level is broken, are important conclusions that are drawn from past price movements. For example, if a stock price is moving closer to an established resistance level, a holder of the stock can benefit by booking profits at this stage since the prices are likely to retract once it is close to the resistance level. If a support or resistance is broken, accompanied by strong volumes, it may indicate that the trend has accelerated and supply and demand situation has changed. Trading volumes are important parameters to confirm a trend. An upward or downward trend should be accompanied by strong volumes. If a trend is not supported by volumes or the volumes decrease, it may indicate a weakness in the trend. Technical analysis converts the price and volume data into charts that represent the stock price movements over a period of time. Some of the charts used include line charts, bar charts, candlestick chart. The patterns thrown up by the charts are used to identify trends, reversal of trends and triggers for buying or selling a stock. Typically, chartists use moving average of the price of the stock to reduce the impact of day to day fluctuations in prices that may make it difficult to identify the trend."
Assumptions of technical analysis,"8.7.1 Assumptions of technical analysis From the above discussion on what technical analysts do, the following assumption are delineated: 1. The market price is determined by the interaction of supply and demand. 176 2. Supply and demand are governed by many rational and irrational factors. 3. Price adjustments are not instantaneous and prices move in trends 4. Trends persist for appreciable lengths of time. 5. Trends change in reaction to shifts in supply and demand relationships. 6. These shifts can be detected in the action of the market itself."
Technical versus Fundamental Analysis,8.7.2 Technical versus Fundamental Analysis Fundamental analysis involves determining the intrinsic worth of the stock and comparing it with the prevailing market price to make investment decisions. Fundamental analysts believe that prices will move towards their intrinsic value sooner or later. Technical analysis is not concerned if the stock is trading at a fair price relative to its intrinsic value. It limits itself to the future movements in prices as indicated by the historical data. It is used for short-term term trading activities and not necessarily long-term investing.
Advantages of technical Analysis,"8.7.3 Advantages of technical Analysis Technicians feel that the major advantage of their method is that it is not heavily dependent on financial accounting statements. They feel that a great deal of information is lacking in financial statements. They also contend that a lot of non-financial information and psychological factors do not appear in the financial statements. Technicians also feel that unlike fundamental analysts, they do not need to collect information to derive the intrinsic value of the stocks. They only need to quickly recognize a movement to a new equilibrium value for whatever reason. Hence, they save time in collecting enormous information and data which is a prerequisite for fundamental analysis."
Technical Rules and Indicators,"8.7.4 Technical Rules and Indicators There are numerous trading rules and indicators. There are indicators of overall market momentum, used to make aggregate market decisions. There are trading rules and indicators to be applied for individual securities. Some of the popular ones are: • Trend-line analysis • Moving averages • Bollinger-Band Analysis Trend-Line Analysis: The graph shows a peak and trough, along with a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would ideally want to trade. 177 Stock price trend line Moving-Average Analysis Moving-Average Analysis is the most popular technical indicator. The moving average of a time series of past prices can provide a nonlinear graph of price movements. Generally, a 5, 10, 30, 50, 100, and 200 days moving averages are calculated. One simple strategy for using the moving-average analysis is to buy when the price is sufficiently below the moving average and sell when the price is sufficiently above the moving average. Bollinger-Band Analysis Bollinger bands use normal distribution to calculate the deviation of the market price from the moving average. For example, when the price goes two standard deviations above the moving average, the stock might be regarded as overbought. If the price goes two standard deviations below the moving average, the stock might be regarded as oversold."
Fixed income securities and Technical analysis,"8.7.5 Fixed income securities and Technical analysis Technical analysts use past prices and trading volume or both to predict future prices. A broad range of techniques and indicators based on price and volume data such as chart analysis, moving averages, filters and oscillators are used to identify predictable patterns in stock prices. These techniques can also be applied to the fixed income securities as long as price and volume data is available. The theory and rationale for technical analysis of bonds are the same as for stocks, and many of the same trading rules are in fact used by analysts in bond"
Qualitative evaluation of stocks,"8.8 Qualitative evaluation of stocks While analysing companies, the qualitative aspects of the companies are equally important if not more. Corporate governance practices are the cornerstone in evaluating a business. Corporate governance has become a well-discussed topic in the business world. Newspapers and media report detailed accounts of corporate fraud, accounting scandals, and excessive 178 compensation etc., some leading to even bankruptcy of the companies fraught in such mis governance. Corporate governance includes a wide array of mechanisms and expectations that are of importance to businesses, the economy, and society. World over economies are dominated by companies of different sizes. How these companies are governed affects not only the shareholders of the companies but also thousands of people who work with such companies, buy products of these companies or are affected by them implicitly. Governance aspects are reflected in acts, rules and regulations, contracts, and in important institutions such as stock exchange listing standards and the audit process. The components of corporate governance vary by country, over time, and by company type, size, and ownership. Analysts and investors play a very important role in driving good practices and highlighting companies with poor governance practices. There are some important aspects analysts should look for. For example, they should also pay attention to the quality of independent directors in a business. Analysts should focus on the qualifications and experiences of these independent directors, how many meetings they attend and what are their contributions to the business. It may be good practice to interact with some of them to understand them better. Good governance practices can also be used as filters for selecting the investment universe."
Debt Market,"9.1 Debt market and its need in financing structure of Corporates and Government The Debt market refers to the market where the borrowers issue new debt securities and investors buy those new securities or buyers buy the already issued debt securities and sellers sell the various debt instruments already issued by entities like Governments and private firms in lieu of funding availed by them. The development of a vibrant debt market is essential for a country’s economic progress as the debt market helps to reallocate resources from savers to investors (high-risk takers). The banking channel is safer for savers as bank failures are not very common, but the debt market is a market for direct transfer of risk to the lenders. However, unlike the equity market, the debt market exposes an investor or lender to relatively moderate risk as the physical assets of the company are typically secured against such debt. The equity market that operates majorly through electronic trading platforms with efficient price discovery and significant involvement of intermediary brokers, the debt market is more like an opaque Over the Counter (OTC) market with institutions mostly trading directly with other institutions. Debt market is a large value market with a small number of entities but the equity market deals with a large number of investors with a smaller average stake. In order to expand and achieve faster economic and commercial growth, it is necessary for firms to get financial resources at a reasonable cost. Business owners can utilize a variety of financing resources, generally divided into two broad categories: debt and equity. ""Debt"" involves borrowed money to be repaid, plus interest, while ""Equity"" involves raising money by selling interests in the company. Debt is a charge on income for the firm while the return on equity is an allocation / appropriation of profit made by the company. Debt investors do not share profit while equity investors have a right over it. Similarly, governments also borrow LEARNING OBJECTIVES: After studying this chapter, you should know about: • Debt market and its need in financing structure of Corporates and Government • Know the Bond market ecosystem • Various kinds of risks associated with fixed income securities • Pricing of bond • Traditional Yield Measures • Concepts of Yield Curve • Concept of Duration • Introduction to Money Market • Introduction to Government Debt Market • Introduction to Corporate Debt Market • Small-savings instruments 180 so that they can finance higher spending for development of the society and country. Borrowing at both firm and government levels can be either to fund temporary liquidity shortfall or for funding long-term asset creation. Depending upon the duration and purpose of borrowing, a variety of debt instruments can be used for raising the funds. The debt market facilitates borrowing of funds using such instruments to investors having varied risk appetite. In any economy, the Government generally issues the largest amount of debt to fund its expenditure. The well developed debt market helps the Government to issue papers at a reasonable cost. A liquid debt market lowersthe borrowing cost for all and it provides greater pricing efficiency. Equity and debt are two useful sources of financing for the corporate sector that cater to investors having different risk appetites and requirements. Investors in debt are typically very long investors, specifically investors on long gestation infrastructure projects which require substantial debt funding, while traditionally the equity holders look for short term gains. Debt is funded either by bank loans or bond issuances. A corporate bond market dealing in issuance of pure corporate papers helps an economic entity to raise funds at cheaper cost vis-à-vis syndicated loansfrom banks. The debt market bringstogether a large number of buyers and sellers to price the debt instruments efficiently. A well-developed debt market provides a good alternative to banking–support business models as risk is well distributed among many investors while in the banking support economy, the huge risk is on the banks. Since banks raise funds through deposits which are generally short or medium term, their obligations are generally short and medium term and hence these banks may not be able to fund very long period capital expenditure of corporates through bank loans. However, banks can easily invest in debt instruments issued by corporates and a well- developed debt market helps these investors to liquidate the instruments easily. The development of a liquid and well-functioning corporate debt market helps to channelize the collective investment schemes to invest in the market and also facilitate in bringing retail investors to invest directly in quality debt. The well developed and liquid debt market also helps various long term investors like pension funds, insurance companies which have different investment objectives as they invest very long term to match and immunize their liabilities. A well-functioning and liquid debt market makes the cost of debt efficient and cheaper. The primary debt market helpsthe Government and corporates to directly sell their securities to investors. Typically, Governments issue debt through “Auctions” while corporates issue debt papers through “Private Placement”. The secondary debt market provides an exit route to the investors and it also provides important information not only on price discovery but also on many other factors like credit risk appetite, spread, default probability, etc. The tradability of bonds issued by a borrower helps the market in getting required information on the firm. Traditionally, commercial banks have been providing capital to corporates and these banks play a very dominant role in developing and emerging market economies where the debt markets are not very well developed. A liquid corporate debt market requires well 181 defined insolvency codes / laws while availability of well-defined credit migration history / details help international investors compare the relative riskiness of the debt markets across the world. The establishment of a good Credit Default Swap (CDS) market helps investors to buy insurance against failures of companies and these investors participate in unbundling the inherent credit risk and reselling the same at the market driven rates. The failures of the companies can be well priced in the market through risk transfer. However, in practice, issuance of debt is a multi-level process adhering to various regulations. It may involve underwriting, credit rating, listing with stock exchanges, coordinating with issue managers to distribute to the right investors, liquidity in the market, banking support. A well-functioning debt market would require a developed and sustainable legal framework with clear bankruptcy codes. The regulatory cost of the debt can be at times prohibitive for smaller borrowers. Hence, small and medium firms usually prefer bank borrowing vis-a-vis debt issuances. Indian Debt market has typically has three distinct segments – (a) Government debt, known as “G-sec” market with Government of India issuing dated papers, Treasury Bills and State governments issuing State Development Loans of various maturities; (b) Public sector units (PSU) and Banks issuing instruments to raise resources from the market; and (c) private sector raising resources through issuance of debt papers. Government of India also issues Floating Rate Bonds, Inflation Indexed Bonds, Special Securities, and Cash management Bills while State Governments raise funds using UDAY Bonds. PSU Bonds are popular among investors because of their perceived low risk and Commercial Banks issue short term papers like Certificate of Deposits (CDs) as well as long term bonds to fund their various business needs. The private corporates issue instruments like Bonds, Debentures, Commercial Papers (CPs), Floating Rate Notes (FRNs), Zero Coupon Bonds (ZCBs), etc."
Bond Market,"9.2 Bond market ecosystem Since bonds create fixed financial obligations on the issuers, they are referred as fixed income securities. The issuer of a bond agrees to 1) pay a fixed amount of interest (known as coupon) periodically and 2) repay the fixed amount of principal (known as face value) at the date of maturity. The fixed obligations of the security are the most defining characteristic of bonds. Most bonds make semi-annual interest payments, though some may make annual, quarterly or monthly interest payments (except zero coupon bonds which make no interest payment). Typically, par value of the bond is paid on the maturity date. Bonds have fixed maturity dates beyond which they cease to exist as a legal financial instrument. (except perpetual bonds, which have no maturity date). On the basis of term to maturity, bonds with a year or less than a year maturity are terms as money market securities. Long-term obligations with maturities in excess of 1 year, are referred to as capital market securities. Thus, long term bonds as they move towards maturity become money market securities. 182 The coupon, maturity period and principal value are important intrinsic features of a bond. The coupon of a bond indicates the interest income/coupon income that the bond holder will receive over the life (or holding period) of the bond. The term to maturity is the time period before a bond matures (or expires). All G-Secs are normally coupon (interest rate) bearing and have semi-annual coupon or interest payments with a tenor of between 5 to 30 years. Maturity period is also known as tenor or tenure. The principal or par value of the bond is the original value of the obligation. Principal value of the bond is different from the bond’s market price, except when the coupon rate of the bond and the prevailing market rate of interest is exactly the same. When coupons and the prevailing market rate of interest are not the same, market price of the bond can be lower or higher than principal value. If the market interest rate is above the coupon rate, the bond will sell at a discount to the par value. If the market rate is below the bond’s coupon, the bond will sell at a premium to the par value. The interest rate here is assumed to be for the remaining maturity of the bond. Another interesting thing about bonds is that unlike equity, companies can issue many different bond issues outstanding at the same time. These bonds can have different maturity periods and coupon rates. These features of the bonds will be part of the indenture.12 Bonds with options Bonds can also be issued with embedded options.13 Some common types of bonds with embedded options are: bonds with call option, bonds with put option and convertible bonds. A callable bond gives the issuerthe right to redeem all or part of the outstanding bonds before the specified maturity date. The details about the call provision would be mentioned in the indenture. Callable bonds are advantageous to the issuer of the security. In other words, callable bonds present investors with a higher level of reinvestment risk than non-callable bonds. As can be understood here, the issuer will call the bond before its maturity only when the interest rates for similar bonds fall in market. The investor will receive the face value of 12 Indenture is the legal agreement between two parties, in case of bond indenture the two parties are the bond issuer (borrower) and the investors (lender). 13 Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. 183 the bond before the maturity. Now if the investor wants to invest that money for the remaining period, it would be possible only in bonds offering lower interest rates. 14 A put provision gives the bondholders the right to sell the bond back to the issuer at a pre- determined price on specified dates. Puttable bonds are beneficial for the bondholder by guaranteeing a pre-specified selling price at the redemption dates. A convertible bond is a combination of a plain vanilla bond plus an embedded equity call option. It gives the bondholder the right to exchange the bond for a specified number of common shares of the issuing company."
Risks associated,"9.3 Risks associated with fixed income securities Investors need to understand the risks involved in a fixed income asset before investing in it. Government bonds are considered as risk free and hence provide low return on investment while corporate bonds in general being riskier provide higher returns to the investor (assuming both were held from issue date till the maturity date). Entities like public sector undertakings or banks are relatively less risky vis-à-vis the pure corporate firms and thus provide returns higher than the government bonds but lower than the corporate papers. Understanding the relative risk involved in fixed income assets helps investors to decide the type of risk they are willing to take while investing. Major risk comes from changes in interest rate levels in the economy and change in the creditworthiness of the borrower. The first group of risk is known as Market Risk while the second group of risk is known as Credit Risk or Default Risk. However, investors can hedge various risks in the fixed income assets by entering into various derivative contracts."
Interest Rate Risk,"9.3.1 Interest Rate Risk The bonds are subject to risk emanating from interest rate movements. The price of the bond is inversely related to the interest rate movement. If the interest rate rises, the price of the bond will fall. Any investment in bonds has two risks – market risk and credit risk. Market risk can be explained by the change in the price of the bond resulting from change in market interest rates. Further, the coupons that would be received at different points in time in future need to be re-invested at the rate prevailing at the time of receipt of such coupons. An investors holding bonds would face an erosion in value if the interest rates rise and this can lead to a 14 Re-investment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. The risk is that intermediate cash flows may be reinvested at a lower return as compared to the original investment. The rate at which the re-investment of these periodic cash flows is made will affect the total returns from the investment. The reinvestment rates can be high or low, depending on the levels of interest rate at the time when the coupon income is received. This is the reinvestment risk. 184 capital loss if the bonds are sold below their purchase price. On the other hand, a fall in interest rates would push up the bond prices and this can raise the overall returns for the investor."
Call Risk,"9.3.2. Call risk The Call risk is the risk of a bond being prematurely called or repaid by the issuer exercising the right provided in the indenture of the issuance. The Call risk gives the right to the issuer to call back the bond and repay all the required amount under the indenture specifications. This typically happens when a company decides either to go as a zero debt company or wants to refinance its liabilities with low cost of borrowing. This low cost of borrowing may be possible if the company’s credit rating has improved or if the market condition has changed in a manner that would help the company to source funds at a low interest rate. The call risk makes the bond unattractive to the investor vis-à-vis a non-embedded option bond. The call risk increases uncertainties for the investor. The issuer has to pay a risk premia for the comfort or right it enjoys for repaying the debt when the market replacement cost falls. In order to compensate for the call risk, the investor would receive a higher return on the callable bond vis-à-vis a non-callable one. Callable Bonds carry “Call Premia” as it is in favour of the issuer and if the interest rate falls, the issuer can refinance the loan with lower interest rate from the market. The same will happen when the interest rate falls and the price of the bond appreciates in value. Investor loses the chance of making money out of the bond as it is called back by the issuer."
Reinvestment Risk,"9.3.3. Reinvestment Risk Reinvestment risk arises when the periodic income received from bonds or other fixed income securities are reinvested after their receipt at the rate prevailing in the market at the time of such receipts. If the interest rate is higher at the time of receipt of periodic coupon, the reinvestment would happen at a higher rate that would be beneficial to the investor but if the market interest rate is low at the time of receipt of the coupons, the investor would be reinvesting the coupons at a lower rate. However, it may be remembered that higher interest rate vis-à-vis the coupon would mean capital loss in the market value of the bond if the investor wants to sell in the market. Therefore, reinvestment risk is the risk that interest rates may decrease during the life of the bond. If an investor wants to hold the security till maturity, then reinvestment risk is very high. Reinvestment risk is an important part of bond investment."
Credit Risk,"9.3.4. Credit Risk Bonds are essentially certificates of debt or in other words loans from the investors to the issuers who promise to repay the principal amount with periodic interest/coupon payments. 185 Particularly for bonds issued by non-government corporates, the repayment of the principal back to the investor relies heavily on the issuer’s ability to repay that debt. The price of these bonds depend on the credibility of the company issuing it and often offer a yield higher than the risk-free government bonds as the investors are at a risk of losing their capital if the financials of the issuer deteriorate. For example, in India, Corporate Deposits and NCDs offer higher rates on investment. Types of credit risk include: Downgrade Risk, Spread Risk and Default Risk"
Downgrade Risk,"9.3.4.1. Downgrade Risk A company's ability to operate and repay its debt (and individual debt) issues is frequently evaluated by major ratings agencies. Downgrade risk arises for investors when the rating of an issuer is lowered after they have purchased its bonds. If a company's credit rating is downgraded by the rating agency on account of deterioration in its financials, the issuing company faces higher cost for raising new resources. The existing bond holders would be facing this drop in price of their bonds issued by this company as the cost of funds for the company increases in the market. An example of this is the cascading effect of the rating downgrades in the IL&FS case in July-August 2018."
Spread Risk ,"9.3.4.2. Spread Risk Corporate bonds or non-Government bonds pay a spread (depending on its Credit rating) over comparable Government securities as the risk increases. The spread keeps on changing dynamically as the situation changes in the market. In good times when the business is doing very well and there is no shortage of liquidity in the system, the risk of corporate failures due to market conditions is very rare. A corporate can fail to perform the debt service or equity service to investors only when the performance of the company drops significantly due to bad management or bad market conditions or both. In such situations, the riskiness of the company’s instruments in the market increases. Bad performance means the company would face cash flow problems and may not be able to meet its obligations of interest payment and redemption payments. This would make the company’s debt very costly. The spread over comparable Government securities would change keeping in mind the possible default of the company. The spread charged for higher rated papers would be far lower compared to the lower rated papers in the market. In tight liquidity situations or when the general market condition is bad, the risk appetite drops in the market and the spread increases."
Default Risk,"9.3.4.3. Default Risk Default risk is the possibility of non-payment of coupon or principal when due. Default arises when the company fails to meet its financial obligations towards interest and principal 186 repayments. While credit ratings help to measure an issuer’s risk of default, there is still always a risk that some unforeseen event can force the issuer to default. The spread measures the default risk of a bond. If the market considers the possibility of default for a bond, the interest rate for the bond would increase in the market. Junk bonds with very high credit risk or default risk pay very high interest rate s to investors."
Liquidity risk,"9.3.5. Liquidity Risk Liquidity risk is the risk involved with an instrument that the investor would not be able to sell the investment at the time of need. Every investment is an action to defer the present consumption by an investor for a future date. Hence, when the consumption time arises, the investor must be able to monetize the investment and convert the same to cash without loss of much of its intrinsic value. If the market is liquid to absorb the selling, then the investor would not lose substantially as there would be other investors willing to take the risk on the asset by buying the same from one investor selling the asset. When liquidity is tight in the market, investors find it difficult to sell the asset and at times, the investors have to fire sell the asset at a much lower price. Hence, liquidity risk is very common on long-term bonds. Short-term instruments are more liquid as they are like cash instruments whose cash flows would come to the investors shortly but long-term investments pose risk of selling."
Exchange Rate Risk,"9.3.6. Exchange Rate Risk Bonds issued in foreign currency are exposed to currency risk or exchange rate risk. When the issuer of a foreign currency bond has to pay back the bond principal or pay a promised periodic coupon, the company has to acquire foreign currency from the market to fulfil its obligations. The cost of acquiring such foreign exchange may increase if the domestic currency has depreciated against the currency in which bonds have been issued. Currency risk is an inherent risk for bonds issued in non-domestic currency by domestic borrowers in the international market. Masala Bonds issued by Indian entities expose the investors to the Exchange rate risk as the Rupee amount if fixed and the investors who are foreign entities would receive Indian Rupee and have to buy the foreign currency for repatriation. Exchange rate risk is very important for foreign currency denominated bonds."
Inflation Risk,"9.3.7. Inflation Risk Inflation risk is the risk faced by an investor of inadequacy of funds received from the bond investment to fulfil the deferred needs. While investing in the bond, the investor expected a return level keeping in mind the stable interest rate as the assumption of stable inflation would have helped him in such assumptions. However, if suddenly the inflation rate increases, the cost of goods would increase and the real return comes down. The nominal return may remain the same but the real income after adjustment of inflation would be far lower. A fixed 187 rate bond does not take into account changing future scenarios while a floating rate bond can take care of such changes as the new interest rate would be keeping in sync with the market rate. When expected inflation levels are higher, investors prefer floating rate bonds or inflation-indexed bonds to save themselves from the risk of higher inflation."
Volatility Risk,"9.3.8. Volatility Risk Volatility risk affects the bonds with embedded options. The pricing of an embedded option bond takes into account the volatility level to price the same. However, a normal plain vanilla bond is not exposed to interest rate volatility. However, if an investor wants to buy a credit default swap against the investment, the price can be substantially high if the volatility is high. If volatility is low, the credit default swap would be cheaper."
Political or Legal Risk,"9.3.9. Political or Legal Risk The bonds with tax benefits would be exposed to such risks. Tax free bonds become taxable because, changesin Government rules would impact the price of such tax free bonds. Further, if a Government decided not to pay a coupon due to its tight cash position or plan to roll over its debt or pay a coupon in the form of new bonds, this can lead to substantial value change for the bonds as investors face higher risk of non-receipt of required cash on planned dates. Government changing repatriation rules may affect the foreign bond investors in a domestic economy."
Even Risk,"9.3.10. Event Risk An event risk refers to an unexpected or unplanned event that forces the value of an investment to drop substantially. Certain events may force companies to seek moratorium on repayment as their business gets affected by such unplanned events. For example, during the recent Covid-19 pandemic, the travel industry was severely impacted and many companies could not service their debt. This type of risk is different for each sector and the amount of exposure depends on the sector."
Pricing of Bond,"9.4 Pricing of Bond The value of bonds can be determined in terms of rupee values or the rates of return they promise under some set of assumptions. Since bonds are fixed income securities, generating a series of pre-specified cashflows, we determine the value of the bond using the present value model. The present value model computes the value for the bond using a single discount rate. Alternatively, the yield model can be applied, which computes the promised rate of return based on the bond’s current price and a set of assumptions.a"
"The concept of ""Par Value""","9.4.1 The concept of “Par Value”. “Par” is the Face value of a debt instrument which is promised to be paid as Principal at the maturity of the debt instrument. Typically, it is ?100 for a Government bond but ?10000 for a corporate bond. This is the amount that an issuer is bound to pay back to the bond investor as per the indenture of the debt issuance. The periodic interest/coupon paid on a debt instrument is on the basis of the Face value. The Face Value is also known as the redemption value for a plain vanilla bond. The market trades bonds as a percentage of price. If a trader quotes a Bid price of 106.35, the trader is willing to buy the security at 106.35% of the Face Value of the security. Bonds are considered as premium ones when they trade above their Face value or Par value and are known as discount bonds when they trade below the Face Value. During the life of the bond (from the date of issuance to date of maturity), the bond price may move from Par value to Premium or Discount but at the end, the bond will be pulled to the Par value of 100. Many debt instruments are issued at a discount to the Par value – Treasury Bills, Commercial papers, etc. are always issued at a discount to the Par value and the investor pays less than Par value at the time of buying the instrument but at the maturity receives Par value. The difference between the Par Value and the purchase price is the return that the investor gets for the investment."
Determining Cash Flow,"9.4.2 Determining Cash Flow, Yield and Price of bonds A bond is valued using future known cash flows. The future cash flows are calculated using the promised coupon on the Principal. We will use the below equation to price a bond. Let us assume an Annual coupon paying Bond with a 10% promised rate at the time of issuance and the residual maturity is 5 years from today. Currently, the similar type of securities are available in the market at the yield or interest rate of 8% in the market. Now we have to find the cash flows, discount factors and ultimately the price of the bond assuming a Face Value or Par Value of 100. The cash flows are: Yearly 10 and in the last year at the time of maturity, we get back 100 along with the last coupon. Now the Year 1 Discount Factor would be This means 1 Rupee to be received after 1 year from now would be valued at 0.9259 today with 8% current interest rate. The same way we compute Discount Factors as follows: 189 Year Discount factors using 8% Yield 1 0.9259 2 0.8573 3 0.7938 4 0.7350 5 0.6806 The Cash flows to be received in future years would be as follows along with their respective Present value using the present yield of 8% for such investment: Year Discount factors using 8% Yield (DF) Cash flows Value=DF*Cash flow 1 0.9259 10 9.2593 2 0.8573 10 8.5734 3 0.7938 10 7.9383 4 0.7350 10 7.3503 5 0.6806 110 74.8642 Now the value of the bond in our example would be sum of all discounted value of future cash flows as given in the above table. The same would work out as follows: Year Discount factors using 8% Yield (DF) Cash flows Value=DF*Cash flow 1 0.9259 10 9.2593 2 0.8573 10 8.5734 3 0.7938 10 7.9383 4 0.7350 10 7.3503 5 0.6806 110 74.8642 3.9927 107.9854 The sum of all Discount Factors (3.9927) in this case would be known as PVIF or Present value interest factor. This 3.9927 is arrived at using (8% , 5) with annual cash flows. We can use the above PFIV to calculate the bond as follows: Value = Annual Coupon cash flow * PVIF + Par Value or Face value or Redemption Value * PV of last maturity Or Value of the Bond with 10% Coupon with 5 years maturity and present yield of 8% = 10*3.9927 + 100*0.6806 = 39.9271 +68.0583 = 107.9854. 190 Bond Pricing The price of a bond is sum of the present value of all future cash flows of the bond. The interest rate used for discounting the cash flows is the Yield to Maturity (YTM) of the bond. Pm= Market Price of the of bond Ci = annual interest payable on the bond Pp= Par value of the bond i = discount factor (The prevailing yield to maturity) n= maturity of the bond in years Price of a bond can be also calculated using the excel function ‘price’ (Illustration 9.1). Illustration 9.1: Calculating Price of a Bond in excel Duration of the bond is 6.0361 years. 191 Bond Yield Measures Bond holders receive return from one or more of the following sources, when they buy bonds: 1. The coupon interest payments made by the issuer; 2. Any capital gain (or capital loss) when the bond is sold/matured; and 3. Income from reinvestment of the interest payments that is interest-on-interest. There are yield measures commonly used to measure the potential return from investing in a bond are briefly described below: Coupon Yield The coupon yield is the coupon payment as a percentage of the face value. It is the nominal interest payable on a fixed income security like G-Sec. Coupon yield = Coupon Payment / Face Value Illustration: Coupon: Rs. 8.24 Face Value: Rs. 100 Market Value: Rs. 103.00 Coupon yield = 8.24/103 *100= 8% 9.4.3 Valuation and pricing of bonds Consider a bond paying coupons with frequency n maturing in year T. The cash flows associated with the bond are: coupon C paid with frequency n up to year T, plus the principal M, paid at T. We can use the same bond price equation to describe the value of a Semi-annual coupon paying Bond. If the bond is paying a coupon twice in a year, then the investor will receive only 5 (half of 10) every 6 months and the same can be reinvested at the current market interest rate of 8%. 192 Valuation of bonds with semi-annual compounding is given in the table below: Year Discount Factors using 8% Yield (DF) Cash flows (?) Value = Cash Flow * DF (?) 0.5 0.961538462 5 4.8077 1 0.924556213 5 4.6228 1.5 0.888996359 5 4.4450 2 0.854804191 5 4.2740 2.5 0.821927107 5 4.1096 3 0.790314526 5 3.9516 3.5 0.759917813 5 3.7996 4 0.730690205 5 3.6535 4.5 0.702586736 5 3.5129 5 0.675564169 105 70.9342 SUM of DF 8.110895779 Total Value 108.1109 The Discount Factor for the first period is calculated as = 0.9615 The bond can be valued as 5 * PVIF + face value * DF for the maturity year. The same would be = 5*8.1109 + 100*0.675564 = 40.5545 + 67.5564 = ?108.1109. The semi- annual coupon paying bond is valued more at 108.1109 than the annual coupon paying bond at 107.9854 with similar maturity, yield and coupon rate due to the greater frequency of compounding. The valuation rule for valuing semiannual bonds can be extended to valuing bonds paying interest more frequently – like once in a quarter. Hence, if “n” is the frequency of payments per year, “t” the maturity in years, and, as before, R the present interest quoted on an annual basis, then the formula for valuing the bond would be: When n becomes very large, this approaches continuous compounding. 193 Valuation of zero coupon bonds A zero-coupon bond has a single cash flow resulting from an investment. The zero-coupon pricing formula can be modified to calculate YTM. The coupon rate (CR), current yield (CY) and yield-to-maturity (YTM) are related such that: Bond Selling at Relationship Par CR = CY = YTM Discount CR < CY < YTM Premium CR > CY > YTM Valuing Bonds at Non Coupon Dates Bonds are generally valued in between coupon dates when they are traded. Hence the concept of Clean price and Dirty price has to be established. The Dirty price is the sum of clean price and accrued interest. In this formula, the accrued interest is not discounted to arrive at the Clean Price as there is no intervening cash flow in the first coupon to be received after an investor buys the bond. The market convention is the amount the buyer would pay to the seller the clean price plus the accrual interest. This amount is often called the full-price or invoice price. The price of a bond excluding accrued interest would be the clean price. The market typically trades a bond on the basis of clean price. All yield, and price formulas are on the basis of clean price. In order to price a bond in between coupon days, the following principles are followed. Firstly, take the settlement date (buying date) to the previous coupon date and value the bond using the coupon, yield and the residual maturity from the last coupon date. Secondly, bring the said price or value to the future date (settlement date or buying date) with a Future Value Factor. Thirdly, deduct the accrued interest from the total value to arrive at the clean price or trade price or invoice price. ÷ ø ö ç è æ + = 365 Days toMaturity 1 r* 100 P *100 Days tomaturity 365 * P 100 P YTM - = 194 We will use the following example. Trade value (Settlement) date: 12-Aug-2020, Maturity date: 11-May-2030, Coupon: 5.79%, present yield: 5.90%. The bond pays semi-annual coupon. The market convention for day count is 30/360 European (i.e., every month is 30 days and year is 360 days). Last coupon Date = 11-May-2020 Time from 11-May-2020 to 11-May-2030 = 10 years Time between Last coupon date (11-May-2020) and Settlement date (12-Aug-2020) = 91 days = 0.252778 years using 30/360E day count rule. Price of the bond on the last coupon date (11-May-2020) with 5.90% yield would be Rs. 99.1779. The same is arrived at by using the PVIF of 14.94648 for half of the coupon (2.895*14.94648 = 43.27007) and face value Rs. 100 multiplied by the PV factor or Discount Factor of last maturity (100*0.5590787 = 55.90787). The total of Rs. 43.27007 and Rs. 55.90787 works out to be Rs. 99.1779 for our bond. Present interest rate being higher than the coupon makes this bond a discount bond at the moment. Now we will use the Future value factor to determine the value of this Bond at the settlement date taking the value of 11-May-2020 to 12-Aug-2020 using the yield of the Bond at 5.90% for 91 days. This would giving us the Dirty Price of the bond at the settlement date = Rs. 100.64644. Now for 91 days, the accrued interest will be Deducting accrued interest from the dirty price will provide the clean price of the bond. Clean price would be Rs. 100.64644 – Rs. 1.46358= Rs. 99.18286."
Price -Yield relationship and the Pricing matrix,"9.4.4 Price-Yield relationship and the Pricing Matrix The price yield relationship is inverse. When we calculate the relationship, we use the Clean price only and all price and yield formulas use only Clean price. If we want to plot the price – yield relationship of two bonds, we can compare their relative effective riskiness. 195 The price-yield relationship can be summarized as follows: - The inverse relation between a bond's price and rate of return is given by the negative slope of the price-yield curve. The movement across the curve is non-linear. - The bond having larger maturity time would have higher sensitivity to interest rate changes. - The lower a bond's coupon rate, the greater is its price sensitivity. 196 Relation between Coupon Rate, Required Rate, Value, and Par Value Bonds can trade at Par when the coupon and yield are same. But, if the Coupon is lower than the current market yield, then the bond would be trading at Discount. If the coupon is higher than the current market yield, it would be trading at premium. Bond-Price Relation 1: if CR = R = F: Bond valued at par. if CR < R < F: Bond valued at discount. if CR > R > F: Bond valued at premium.a"
Perpetual bonds and pricing of perpetual bonds,"9.4.5 Perpetual bonds and pricing of perpetual bonds A perpetual bond is an instrument that continuously pays the agreed coupons but it never pays the Face value and has no maturity date affixed to the bond. For a simple perpetuity paying regular coupons, the payment is the same as the interest payment of the one-year bond. Hence, a perpetual bond is an instrument issued without any finite maturity date. Perpetual bonds promise to pay a coupon indefinitely as the issuer is not bound to pay back the principal. This Value of a perpetuity would be calculated as: If Coupon of a Perpetuity is 8% on a face Value of 100 and if the investor would like to have an annual yield of 6%, then the perpetuity would be valued as (100*8%)/6% = 133.33."
Traditional Yield Measures,9.5 Traditional Yield Measures 9.5.1 Current Yield The current yield is the coupon payment as a percentage of the bond’s current market price. Current yield = (Annual coupon rate / current market price of the bond) *100% Illustration: The current yield for a 10 year 8.24% coupon bond selling for Rs. 103.00 per Rs. 100 par value is calculated below: Annual coupon interest = 8.24% x Rs. 100 = ?8.24 Current yield = (8.24/103) X 100 = 8.00%
Yield to Maturity,"9.5.2 Yield to Maturity Yield to Maturity (YTM) is the discount rate which equates the present value of the future cash flows from a bond to its current market price. It is the expected rate of return on a bond if it is held until its maturity. The price of a bond is simply the sum of the present values of all its remaining cash flows. Present value is calculated by discounting each cash flow at a rate; this rate is the YTM. It is also known as the internal rate of return of the bond. Pm= Market Price of the of bond Ci = annual interest payable on the bond Pp= Par value of the bond i = yield to maturity n= maturity of the bond in years The calculation of YTM involves a trial-and-error procedure. A calculator or software can be used to obtain a bond’s YTM easily. Illustration Take a two year bond bearing a coupon of 8% and a market price of Rs. 102 per face value of Rs. 100; the YTM could be calculated by solving for ‘r’ below. Typically, it involves trial and error by taking a value for ‘r’ and solving the equation and if the right hand side is more than 102, take a higher value of ‘r’ and solve again. Linear interpolation technique may also be used to find out exact ‘r’ once we have two ‘r’ values so that the price value is more than 102 for one and less than 102 for the other value. Since the coupon is paid semi-annually, there will be 4 payments of half of yearly coupon amount. Market Price = C/(1+r/2)1 + C/(1+r/2)2 + C/(1+r/2)3 + (C+FV)/(1+r/2)4 In the MS Excel programme, the following function could be used for calculating the yield of periodically coupon paying securities, given the price. 198 YIELD (settlement, maturity, rate, price, redemption, frequency, basis) Wherein; Settlement is the security's settlement date. The security settlement date is the date on which the security and funds are exchanged. Maturity is the security's maturity date. The maturity date is the date when the security expires. Rate is the security's annual coupon rate. Price is the security's price per Rs. 100 face value. Redemption is the security's redemption value per Rs. 100 face value. Frequency is the number of coupon payments per year. (2 for Government bonds in India) Basis is the type of day count basis to use. (4 for Government bonds in India which uses 30/360 basis) [The day count convention is explained in Box 9.1) Box 9.1: Day Count convention Day count convention refers to the method used for arriving at the holding period (number of days) of a bond to calculate the accrued interest. As the use of different day count conventions can result in different accrued interest amounts, it is appropriate that all the participants in the market follow a uniform day count convention. For example, the conventions followed in Indian market for bonds is 30/360, which means that irrespective of the actual number of days in a month, the number of days in a month is taken as 30 and the number of days in a year is taken as 360. Whereas in the money market the day count convention followed is actual/365, which means that the actual number of days in a month is taken for number of days (numerator) whereas the number of days in a year is taken as 365 days. Hence, in the case of T-Bills, which are essentially money market instruments, money market convention is followed. In some countries, participants use actual/actual, some countries use actual/360 while some use 30/actual. Hence the convention changes in different countries and in different markets within the same country (e.g. Money market convention is different than the bond market convention in India)."
Effective Yield ,"9.5.3 Effective Yield Deposit taking institutions often quote two quantities when they advertise interest rates on various products they are selling. The first would be the actual annualized interest rate which is nothing but the nominal rate or the stated rate. The second rate would be an equivalent rate that would produce the same final amount at the end of 1 year if simple interest is applied. This is called the “effective yield”. A bond paying 4.20% annual coupon would be worth 4.28% if the is coupon is paid every month. One must bear in mind that multiplying semi-annual yield by 2 will give an underestimate of the effective annual yield. The proper way to annualize the semi-annual yield is by applying the following formula: For a semiannual- pay bond, the formula can be modified as follows: Similarly, semiannual yield is:Semiannual Yield ( (1 Annualint erestrate )2 1 ) * 2"
Yield to call,9.5.4 Yield to call A bond with an embedded call option increases the risk for the investors. Yield to call measures the estimated rate of return for bonds held to the first call date. It is calculated as below:
Yield to Put Yield,9.5.5 Yield to Put Yield to Put is the exact opposite of Yield to call but the principle is the same. It gives the investor the right to redeem the bond if the after a certain date and such papers trade in the market by adjusting their maturity till the first Put option date.
Concept of Yield Curve,"9.6 Concept of Yield Curve Yield curve is typically an upward sloping curve in a two dimensional surface plotting the relationship between time and interest rate. The slope of the curve gives us the relative risk Effective Annual Yield (1 periodicint erestrate ) 1 n = + - Effective Annual Yield (1 semiannualint erestrate ) 1 2 = + - Semiannual Yield ( (1 Annualint erestrate )2 1 ) * 2 1 = + - 200 premia for additional time we are out of money. In the yield curve presented below, taking a higher risk of investing for 2 years as against 1 year results in a risk premia of 22bps. But, if we invest for 3 years as against 2 year, we get a risk premia of only 13bps and the same risk premia is maintained for our investment for 4 years as against 3 years. The risk premia depicts the perception of risk of investment that is depicted in the slope of the yield curve. Typically, in sovereign bond market, we see the yield curve flattens after 5-7 years as the risk of default is zero and investor only want a small premia to cover the liquidity risk of the investment. However, for corporate bonds, the risk premia significantly increases as the time to maturity increases. The slope instead of flattening shows a good upward movement. The yield curves are never smooth and people have different expectations about the future and may demand different rates for the same maturity investment even if the rating remains the same. If investors are expecting higher inflation in future, they would require higher nominal yield to compensate them for the expected higher expenditure as they are pushing their present consumption to a future date through investing. A positively sloped yield curve is the most preferred yield curve for the economy as the shorter term would demand a lower interest rate while long term would demand a higher interest rate. Typically, the yield curves take 4 shapes: 1. Normal Yield curve: This is an upward sloping yield curve indicating higher interest rate for higher maturity. Long term rates are higher compared to short term yields as the risk premia is higher for higher maturities. 2. Inverted Yield curve: In this kind of curve, we find the short term rates are higher than the long term rates. At times, the policy rates are kept high to bring down 201 excess demand and reduce bubbles. At times, severe Asset Liability mismatch may also produce an inverted yield curve. 3. Flat Yield Curve: When the yield remains constant irrespective of time to maturity, such a curve would be flat. There is no difference between short term yield and long term yield. 4. Humped yield curve: At times, yield curves can be humped and the short term and long term yields would be lower than medium term yield."
Concept of Duration Bond prices,"9.7 Concept of Duration Bond prices are sensitive to changes in interest rates. As market rates of interest increase (decrease) the market values of the bond portfolios decrease (increase). Duration (also known as Macaulay Duration) of a bond is a measure of the time taken to recover the initial investment in present value terms. In simplest form, duration refers to the payback period of a bond to break even, i.e., the time taken for a bond to repay its own purchase price. Duration is expressed in number of years. The price sensitivity of a bond to changes in interest rates is approximated by the bond's duration. The significance of the duration is that greater the duration, more volatile is the portfolio’s return in respect to changes in the level of interest rates. A step by step approach for working out duration is given below. 1. Calculate the present value of each of the future cash flow. 2. The present values of future cash flows are to be multiplied with their respective time periods in years (these are the weights). 3. Add the weighted Present Values of all cash flows and divide it by the current price of the bond. The resultant value is bond duration in no. of years. Duration does not increase exponentially with increase in maturity of a bond and stagnates after a maturity level is reached. Duration is the weighted average term (time from now to payment) of a bond's cash flows or of any series of linked cash flows. It is always less than or equal to the overall life (to maturity) of the bond in years. Only a zero coupon bond (a bond with no coupons) will have duration equal to its remaining maturity. Modified duration shows the change in the value of a security in response to a change in interest rates. It is thus measured in percentage change in price. Modified duration can be calculated by dividing the Macaulay duration of the bond by 1 plus the periodic interest rate, which means a bond’s Modified duration is generally lower than its 202 Macaulay duration. Convexity measures the degree of the curve in the relationship between bond prices and bond yields."
Introduction to Money Market,"9.8 Introduction to Money Market The money market provides an avenue for ultra-short term to short-term lending and borrowing of funds with maturity ranging from overnight to one year. Participation in the money market can be broadly divided into two parts: fund raising and asset acquisition. The first refers to short term fund borrowings either by posting collateral or unsecured borrowing using one’s credit standing in the market. The second part addresses the market for short maturity assets. Money market transactions are generally used for including the government securities market and for meeting short term liquidity mismatches. Funding purchase transactions in other markets to tide over these mismatches is the most common reasons for participating in the money market. Being a primary source of funding, a liquid money market is critical to financial stability. In fact, a trigger for the Global Financial Crisis of 2008 was the seizing up of the lending in the international overnight money markets. The money market is integral to a country’s financial infrastructure and is the primary transmission channel of the central banks’ monetary policy."
Key players in the money market,"9.8.1 Key players in the money market Participants in the Indian money market include: Public Sector Banks, Private Sector Banks, Foreign Banks, Co-operative Banks, Financial Institutions, Insurance Companies, Mutual Funds, Primary Dealers, Bank cum Primary Dealers, Non-Banking Financial Companies (NBFCs), Corporates, Provident/ Pension Funds, Payment Banks, Small Finance Banks, etc."
Types of Instruments,"9.8.2 Types of Instruments The various products considered to be the part of the Indian money market are: Certainly! Here's the tabular data converted into sequential form: 1. Call Money: - Duration: Overnight - Trading & Reporting: NDS-CALL - Settlement: RBI - Face Value: Minimum market order ?1 lakh 2. Notice Money: - Duration: 2-14 days - Trading & Reporting: NDS-CALL - Settlement: RBI - Face Value: Minimum market order ?1 lakh 3. Term Money: - Duration: 15 days - 1 year - Trading & Reporting: NDS-CALL - Settlement: RBI - Face Value: Minimum market order ?1 lakh 4. Market Repo (G-Sec): - Duration: Overnight - 1 year - Trading & Reporting: CROMS - Settlement: CCIL - Face Value: Minimum market order ?1 crore 5. TREP: - Duration: Overnight - 1 year - Trading & Reporting: TREPS - Settlement: CCIL - Face Value: ?5 lakh and multiples thereof 6. Corporate Bond Repo: - Duration: Overnight - 1 year - Trading & Reporting: OTC/Stock Exchanges, Reported on F-TRAC - Settlement: Authorized clearing houses of Stock Exchanges - Face Value: Market lot size ?1 crore 7. CMBs (Certificate of Deposit): - Duration: Upto 90 days - Trading & Reporting: NDS-OM - Settlement: CCIL - Face Value: ?10,000 and multiples thereof 8. T-Bills (Treasury Bills): - Duration: 91 day - 364 days - Trading & Reporting: NDS-OM - Settlement: CCIL - Face Value: ?10,000 and multiples thereof 9. CPs (Commercial Papers): - Duration: 7 days - 1 year - Trading & Reporting: OTC, Reported on F-TRAC - Settlement: Authorized clearing houses of Stock Exchanges - Face Value: ?5 lakh and multiples thereof 10. CDs (Certificate of Deposit): - Duration: Banks: 7 days - 1 year, FIs: 1 year - 3 years - Trading & Reporting: OTC, Reported on F-TRAC - Settlement: Authorized clearing houses of Stock Exchanges - Face Value: ?1 lakh and multiples thereof Call Money: The call money market is an avenue for unsecured lending and borrowing of funds. This market is a purely interbank market in India restricted only to Scheduled Commercial Banks (SCBs) and the Primary Dealers (PDs). Call money transactions are dealt/ reported on the Reserve Bank of India’s (RBI) NDS-CALL platform which is managed by CCIL and are predominantly overnight (tenor of borrowing may be extended to account for weekends and holidays). Notice Money: This is an extension of the interbank call market with uncollateralized lending and borrowing of funds for a period beyond overnight and upto 14 days. Notice money transactions are dealt/ reported on the RBI’s NDS-CALL platform which is managed by CCIL. Term Money: This is an extension of the interbank call market for uncollateralized lending and borrowing of funds for a period between 15 days and 1 year. Term money transactions are dealt/ reported on the RBI’s NDS-CALL platform which is managed by CCIL. Market Repo: Repo also known as a ready forward contract refers to borrowing funds via sale of securities with an agreement to repurchase the same at a future date with the interest for the borrowings incorporated in the repurchase price. Reverse repo is the exact opposite 204 transaction which is essentially a collateralized lending of funds. Each repo/ reverse repo deal thus has 2 parts / legs. The repo period is the time between the 2 legs. The interest is computed on the actual amount borrowed by the repo seller which is the consideration amount in the repo’s first leg. The lender receives the interest in the second leg when the security is bought back by the borrower at a higher consideration that includes the interest. RBI regulates the repo market in India and major participants are SCBs, PDs, Mutual Funds, NBFCs, Financial Institutions (FIs), Insurance Companies, Corporates, Provident/ Pension Funds, Payment Banks, Small Finance Banks, etc. Repo transactions against G-secs are traded/ reported on the Clearcorp Repo Order Matching System (CROMS) electronic platform of the Clearcorp Dealing Systems. These are settled by CCIL along with G-secs. Triparty Repo: ""Triparty repo"" is a type of repo contract with a third party intermediary between the borrower and lender known as the Triparty Agent (TPA). The TPA does the collateral selection, payment and settlement, custody and management during repo period. Following RBI’s authorization to CCIL to act as a TPA, the ‘Collateralized Borrowing and Lending Obligation’ (CBLO) launched by CCIL on January 20, 2003 was converted into TREP on November 5, 2018. . The Tri Party Repo Dealing System (TREPS) anonymous order matching trading platform is provided by Clearcorp Dealing Systems (India) Ltd with CCIL as the Central Counterparty (CCP) for borrowing and lending of funds against government securities in India with a triparty arrangement. All the repo eligible entities can trade on TREPS and the funds borrowed on TREPS are exempted from RBI’s CRR/SLR computation and the security acquired under the deal is eligible for SLR. Stock Exchanges have also introduced Triparty Repo on Corporate Bonds for the benefit of investors. Treasury Bills (T-bills): In India Treasury bills or T-bills are used for short term borrowing by the Government of India and are considered to be a part of the money market as they mature within a year from issue. These are basically zero coupon securities which are issued at a discount and are redeemed at par. Normally RBI conducts weekly auctions for three tenors of T-bills: 91, 182 and 364 days. The 14 Day T-bills are not available for public consumption. RBI may use the same for parking short term surplus funds of State Governments. Cash Management Bills (CMBs): Essentially very short term T-bills, Cash Management Bills (CMBs) are issued by the Government of India to fund the temporary mismatches in its cash flow. CMBs have maturities less than 91 days. 205 Commercial Paper (CP): A Commercial Paper (CP) is used by Indian corporates to raise short-term unsecured funds. CPs are also discounted instruments like T-bills and are issued for ?5 lakh and multiples thereof for maturities between 7 days and one year. CP issuances are governed by RBI regulations. The corporate entities with a good credit rating (typically the minimum is the Second highest credit rating) and required minimum net-worth can issue CPs. It is used as a part of working capital resources for corporates. Certificate of Deposit (CD): A Certificate of Deposit (CD) is issued against funds deposited at a bank or eligible FIs. CDs are issued for ?1 lakh and in multiples of ?1 lakh thereafter for maturities of 7 days to one year by banks and for 1 year to 3 years by FIs. Banks and Financial institutions issue CDs. Banks issue CDs upto one year while Financial Institutions can issue upto 2 years. Corporate Bond Repo (CBR): Repo in corporate bonds was introduced by RBI in 2010 and the eligible securities for CBR include: (i) Listed corporate bonds and debentures, (however, participants cannot borrow against the collateral of their own securities or those of related entities); (ii) CPs and CDs; and (iii) Units of Debt ETFs. Triparty repo in corporate bonds was launched in India in 2017 by stock exchanges and currently includes only select AAA category bonds, A1+ rated CPs and CDs. CBR trading can be done OTC or on stock exchanges."
Introduction to Government Debt Market,"9.9 Introduction to Government Debt Market The government securities (G-Sec) market is the most active segment of the Indian fixed income securities market. Regular structural and infrastructural measures by the Government and Reserve Bank of India (RBI) have contributed to its substantial growth and expansion over the last two decades. Along with meeting the governments’ funding needs, it provides the benchmark interest rates in the market for pricing of various products and schemes and is also an indirect channel for monetary policy."
Key players in the Government debt market,"9.9.1 Key players in the Government debt market Primary participants in the Indian G-Sec market are large institutional players like banks, Primary Dealers (PDs) and insurance companies. Historically, commercial banks invest in Government securities because of Statutory Liquidity Ratio (SLR) requirements as well as diversification towards safe assets. However, RBI has made many calibrated changes to SLR requirements giving more operational room to Banks for managing the liabilities and SLR has been reduced keeping in mind the phased implementation of Basel norms. Primary Dealers (PDs) play a very important role in the form of market making and they provide firm two way (buy and sell) quotes for the Government securities. Other participants include Co-operative 206 Banks (after the change of application of SLR norms for them), Mutual Funds, Corporates, Provident and Pension Funds and Foreign Portfolio Investors (FPIs). Reserve Bank of India is also a very large holder of Government securities as it has to operate market liquidity window."
Types of Instruments,"9.9.2 Types of Instruments A Government Security (G-Sec) in Indian markets implies a debt instrument issued either by the Central Government of India or the State Governments which is tradeable in nature. The Central Government issues both bills (original maturities of less than one year) and bonds while the State Governments issue only bonds also known as the State Development Loans (SDLs). G-Secs are considered risk-free with nearly no risk of default. Each security is known by a unique number - ISIN (International Security Identification Number) – which is tagged to an instrument at the time of issuance. Over the years a variety of instruments have been introduced to match the diverse risk appetites and investment horizons of the markets participants. These instruments have been discussed in detail below. Treasury Bills (T-bills) Treasury bills or T-bills are short term money market instruments issued by the Government of India at a discount to its face value and are zero coupon securities issued to be redeemed at par (100) at maturity. The RBI issues three T-Bills for the investors – 91D, 182D and 364D. RBI conducts weekly auctions for these T-bills. RBI announces issuance calendar every quarter and issues the said T-bills as per the notified amount mentioned in the said issuance calendar. Cash Management Bills (CMBs) Cash Management Bills (CMBs) are basically unstructured T-bills maturing within 91 days. It was launched in 2010 in order to meet the temporary shortage in the cash flow for the Government of India. CMBs have been extensively used by RBI for smoothening systemic issues such as liquidity management post demonetization in 2016, forex market volatility in 2013, etc. Dated G-Secs Government securities are issued on the basis of issuance calendar notified by RBI in the month of March (for sale of securities between April and September) and in the month for September (for the sake of securities between October and March). The notified amounts are informed to the market well in advance. Long term bonds are usually referred to as dated securities and these are the largest component of the Indian G-Sec market. With maturities ranging from one to forty years, these securities pay a fixed or floating coupon on a semi- annual basis. Public Debt Office (PDO) of RBI handles the issue, makes coupon payment and principal repayment. RBI is the depository of Government securities as per the legal provisions. RBI plays the role of the Merchant banker as well the role of Registrar and Transfer 207 Agent (RTA) for the issue of Government securities. When coupon payment dates fall on holidays, the coupon amount is paid on the next working day. However, redemption proceeds are paid on the previous working day if a maturity date falls on a holiday. The following types of dated G-Secs have been issued in India. Fixed Rate Bonds The largest component within dated securities are fixed coupon securities or fixed rate bonds. These securities pay a fixed coupon over their entire life but all coupons are paid semi- annually. For example: Consider the case of “5.77% GS 2030” issued on August 3, 2020 and maturing on August 3, 2030. This 10-year security pays a coupon every six months i.e. on February 3rd and August 3rd each year till its maturity at 2.8850% (half yearly payment being half of the annual coupon of 5.77%) of the ?100 face value. Coupons for these bonds are fixed on the date of the issue and typically, the cut-off rate for the bond in the primary auction becomes the Coupon for the security. Floating Rate Bonds (FRB) First introduced by the Government of India in September 1995, FRBs pay interest at a variable coupon rate that is reset at pre-announced intervals. While majorly linked to the 6- month rate i.e. the 182 Day T-Bill rate, FRBs coupons at each semi-annual date are currently determined in various ways: (a) As the average of the implicit cut-off yields of the last three 182 Day T-Bill auctions; (b) Base rate equivalent to weighted average yield of last three 182 Day T-Bills auctions of plus a fixed spread; (c) Reset every five years at the prevailing 5 year G-Sec yield as on the last working day prior to commencement of each period of five years. FRBs are not preferred for investment in the market. Since retail participation in the market is very low, the success of FRB is also not satisfactory. Zero Coupon Bonds (ZCBs) ZCBs do not pay any fixed coupon and are issued at a discount and redeemed at par like T- Bills. These had last been issued by Government of India in 1996. Currently, these securities are not the favour of the market. Capital Indexed Bonds (CIBs) The principal amount of a CIB is linked to an inflation index to protect it from inflation. RBI had experimented with a 5 year CIB issued in December 1997. Inflation Indexed Bonds (IIBs) In IIBs both the principal amount and coupon flows are protected against inflation. Globally, while the United Kingdom first introduced IIBs in 1981, in India, the first IIBs (linked to Wholesale Price Index (WPI)) were issued in June 2013. In December 2013, IIBs linked to the 208 Consumer Price Index (CPI) were issued exclusively for retail customers. However, like the Zero Coupon Bonds and Capital Indexed Bonds these bonds did not find wider acceptance and were discontinued after the initial issues and the Government repurchased most of the bonds that had already been issued. Bonds with Call/Put Options The Government of India has also experimented with bonds with embedded options. The first such embedded option bond with both call and put option - 6.72% GS 2012 was issued on July 18, 2002 in which the Government had the right to buy-back the bond (call option) at par while the investors had the right to sell back the bond (put option) to the Government at par on any of the semi-annual coupon dates beginning July 18, 2007. Currently, Government does not issue any embedded option bonds. Special Securities Occasionally, the Government of India may issue bonds as compensation in lieu of cash subsidies to entities like the Food Corporation of India, Oil Marketing Companies, Fertilizer Companies, etc. (also known as food, oil bonds and fertilizer bonds respectively). Government of India also issues Bank recapitalization bonds under the special securities. These are not eligible as SLR securities and thus pay a marginally higher coupon over the yield of the similar maturity G-Secs. Separate Trading of Registered Interest and Principal of Securities (STRIPS) STRIPS are essentially separate ZCBs created by breaking down the cash flows of a regular G- Sec. For example, when ?100 of the 5.77% GS 2030 mentioned earlier is stripped, the ?100 principal payment at maturity becomes a principal STRIP while each coupon cash flow (?2.885) becomes a coupon STRIP, which can all then be traded separately as independent securities in the secondary market. STRIPS can be created out of all existing fixed coupon SLR eligible G-Secs. STRIPS can be attractive to retail/non-institutional investors as being ZCBs, they have zero reinvestment risk. Sovereign Gold Bond (SGB) SGBs are unique instruments with commodity (gold) linked prices. Part of budgeted borrowing, these are issued in tranches and are denominated in units of one gram of gold and multiples thereof. They pay a fixed coupon per annum on the nominal value paid on semi- annual basis and are redeemed at simple average of closing price published by the India Bullion and Jewellers Association Limited of gold (999 purity) of the previous 3 business days from the date of repayment. 209 Savings (Taxable) Bonds Specially issued for retail investors at par for a minimum amount of ?1,000 (face value) and in multiples thereof, while these bonds have no maximum limit for investment, the interest paid is taxable under the Income Tax Act, 1961From FY21, these bonds bear a floating rate of interest which is reset every 6 months. State Development Loans (SDLs) Market borrowings of State Governments / Union Territories through semi-annual coupon paying dated securities are known as State Development Loans (SDLs). These are eligible for SLR and borrowing under the LAF window. Uday bonds were special securities issued by State Governments for financial turnaround of power distribution companies (DISCOMs). Uday bonds are not eligible for SLR status."
Introduction to Corporate Debt Market,"9.10 Introduction to Corporate Debt Market Corporate debt continues to have a low share of the total debt issuance in India. Investment demand is largely restricted to institutional investors whose investments are in turn limited by prudential norms for investment issued by their respective regulators. On the other hand, the multitude of steps to be adhered to, push the potential suppliers i.e. the corporates to opt for bank financing or overseas borrowing to meet their funding requirements in a time constrained fund raising environment. Despite these inherent constraints, the Indian corporate debt market has witnessed significant growth in recent years due to the regulators’ focus on enhanced transparency, expanded issuer and investor base as well as availability of better market infrastructure. Low outstanding stock of individual debt issuances and non-availability of trading platforms with guaranteed central counterparty (CCP) facility are primary obstacles to an active secondary market."
Key Players in the Corporate Bond Ecosystem in India,"9.10.1 Key Players in the Corporate Bond Ecosystem in India: Issuer The ""Issuer” is the entity that issues a debt instrument to borrow money from the investors against a promise of paying back the principal on the maturity date along with the periodic interest. The issuer may issue the bond either using a private placement option or using public issue protocol of SEBI. If issued to the public, then it must be listed in a stock exchange for liquidity purposes. Privately placed debt may or may not be listed in a stock exchange. 210 Debenture Trustee In India, the terms ‘debenture’ and ‘corporate bond’ are used interchangeably and both are identified as the same in the Companies Act. Like a bond, a debenture is also a debt instrument issued by a company to repay the borrowed sum at a specified date along with payment of interest. A Debenture Trustee (DT) is registered with SEBI. A DT holds the secured property on behalf of the debt issuer and for the benefit of debenture holders who though the beneficiaries, have no access to the mortgaged property. Scheduled banks carrying on commercial activity, insurance companies, public financial institutions or corporate bodies can act as DTs. DTs have the responsibility to protect the interest of the debenture holders as they have to ensure that the property charged is available and sufficient in value terms to discharge the interest and principal amounts during the life of the debenture. They call for periodic reports from the issuers and also ensure that the issuers comply with the provisions of the trust deed, the Companies Act and the listing agreements of the stock exchanges. DTs on noticing any breach of the trust deed or law have to act immediately to protect the interest of the debenture holders. In the event of default, DTs can appoint nominee directors on the issuer’s board and also have the power and authority to sell the secured property to redeem the debentures. The SEBI (Debenture Trustees) Regulations, 1993 govern DTs in India. As per the provisions of Companies Act, appointment of a DT is compulsory if any debentures/bonds are issued with a maturity of more than18 months. Unsecured debentures/bonds are treated as fixed deposits, if received from individual investors. In India, the issuer pays fees to the DT for its services. Qualified Institutional Buyer (QIB) QIBs in the Indian market include: * Scheduled Commercial Banks *Insurance Companies registered with the Insurance Regulatory and Development Authority of India (IRDAI) *Mutual Funds *State Industrial Development Corporations *Multilateral and bilateral Development Financial Institutions *Provident Funds with minimum corpus of ?25 crore *Pension Funds with minimum corpus of ?25 crore *Public Financial Institution as defined in the Companies Act *Foreign Institutional Investor registered with SEBI *Venture Capital Funds registered with SEBI *Foreign Venture Capital Investors registered with SEBI 211 Retail Individual Investors “Retail Individual Investor” refers to investors who bid/apply for securities for ?2 lakh or less. Designated stock exchange “Designated stock exchange” means a stock exchange with nationwide trading terminals on which debt securities are listed."
Corporate debt instruments,"9.10.2 Corporate debt Instruments Company deposits These are time deposits issued by companies for a specific time period which is usually 1, 2 and 3 years. Since they are issued by companies they are known as company deposits. There is a fixed rate of interest that is paid on these deposits, which is usually higher than the bank fixed deposit rate depending on the financial position of the company. Investors need to look at the company and its financial situation before making a decision about investing in these deposits. Bonds and debentures These are bonds and debentures that are issued by companies and they are usually for a slightly longer time frame. Another factor that is present for bonds and debentures is that many of them are secured in nature. This means that there is the security of an asset behind these issues so there is an additional level of comfort for the investor. The risk of a credit default needs to be considered by investors when they look at such issues Infrastructure Bonds The infrastructure bonds are very long term bonds that are issued and they can be for 10 to even 20 years, these are meant to finance infrastructure projects and hence they are long term in nature. Specific companies that operate in this space are the ones who issue these bonds and they are often traded in the secondary market. Investors need to analyse these in a different light in the consideration of the projects for which the money would be used. Inflation indexed bond The inflation indexed bonds set themselves apart as they do not have a fixed rate of interest on them. At a specified time interval the interest rate on these bonds will change depending on the inflation rate in the economy. This ensures that the real rate of return for the investor is protected."
Small Saving Instruments ,"9.11 Small Saving Instruments Bank Deposits A bank fixed deposit (FD) is also called a term or time deposit, as it is a deposit account with a bank for a fixed period of time. It entitles the investor to pre-determined interest payments and return of the deposited sum on maturity. Fixed bank deposits offer higher returns than savings accounts as the money is available for use by the bank for a longer period of time. Fixed deposits are preferred by investors who like the safety that a bank provides, want to know how much they will earn and do not have an immediate need for the funds. Bank FDs are considered to be a safe investment option. This is because each depositor is insured up to Rs.5 lakh by the Deposit Insurance and Credit Guarantee Corporation (DICGC). It includes all deposits and interest on them, held across branches of a given bank. The limit of Rs 5 lakh per bank is a significant sum that provides an element of comfort for the investor as they know that their money is not going to be lost if the bank goes down. A fixed deposit is created by opening an FD account with the bank which in turn issues an FD receipt. Interest on an FD can be paid into the depositor’s savings bank account at a predefined frequency, or accumulated and paid at the end of the term. On maturity, the lump sum deposit amount is returned to the investor. Investors can also choose to renew the deposit on the maturity date. The minimum deposit amount varies across banks. The duration of deposits can range from 7 days to 10 years though FDs longer than 5 years are not very common. Interest Rates on FDs Interest rates depend on the duration of deposit, amount deposited and policies of the bank. In general, longer term deposits pay a higher rate than shorter term deposits. There could be a specific time bracket that could have a higher interest rate because the bank wants to attract money for that specific duration. However, banks might also introduce deposits with specific terms like 333 days or 777 days which can have a special rate of interest. Banks also offer special rates to senior citizens, defined as those who are over 60 years of age. The special rate is usually an amount ranging from 0.25% to 0.75% extra interest above the normal applicable one. Interest rates also vary from bank to bank. The interest rate paid by a bank depends on its need for funds for a particular tenor. Interest rates do not remain unchanged. Deposit rates offered by banks for various tenors change over time, depending on the economic cycle, their need for funds and demand for credit (loans) from banks. However, a rate committed to be payable for a tenor, until maturity, 213 does not change even if market interest rates change. New rates usually apply only for fresh deposits. Banks may also prescribe a minimum lock-in period during which funds cannot be withdrawn from the FD account. They may levy a penalty on depositors for pre-mature withdrawals. FD holders may enjoy additional benefits such as loan facility against the security of their FD receipts, or cash overdraft facility. Investment in specified (under Section 80C of the Income Tax Act) 5-year bank FDs are eligible for tax deductions up to a maximum amount of Rs.1.5 lakh, along with other investment options listed under the same section. These deposits are subject to a lock-in period of 5 years. Floating rate Government of India Bond The Government of India has launched a bond for investment, which investors can use to earn a regular sum of interest. This bond was launched on July 1, 2020 with an interest rate of 7.15 per cent. Unlike earlier bond series, where the interest rate was fixed for the entire duration of the bond the situation is different with this issue. The interest rate on this floating rate bond will be set twice a year based on the changes in the benchmark rate. The interest on the bond is payable every six months and after the payment is done the interest rate would be reset for the next six months. The first payment of interest would take place on January 1, 2021 and then continue according to the schedule. The interest rate on the bond has been linked to the rate prevailing on the National Savings Certificate (NSC). The rate here would be 35 basis points or 0.35% over the NSC rate. A resident Indian can make an investment in these bonds while Non Resident Indians (NRIs) are not allowed to invest. The bonds can be bought from designated branches of a few public and private sector banks and will be held only in demat form. This is also called a bond ledger account which are opened only with a bank for holding government securities. The minimum amount of purchase has to be Rs 1,000 while there is no maximum limit for investment in these bonds. They can be bought in cash only upto Rs 20,000 otherwise by using demand draft, cheque or online payments. The tenure of these bonds is 7 years. Earlier redemption of these bonds is possible only for senior citizens. Those who are above 80 years of age can redeem them after completion of 4 years, those between 70 and 80 years of age can redeem them after 5 years while those above 60 years can redeem them after 6 years. These bonds are not tradeable or used as collateral against loans. 214 The interest earned on these bonds is taxable and it is added to the income under the head of Income from other sources. Small Saving Instruments15 The Indian government has instituted a number of small saving schemes to encourage investors to save regularly. The main attraction of these schemes is the implicit guarantee of the government, which is the borrower. These schemes are offered through the post office and select banks. The saving schemes currently offered by the government are: • Public Provident Fund (PPF) • Senior Citizens’ Saving Scheme (SCSS) • National Savings Certificate (NSC) • Post Office Schemes and Deposits • Kisan Vikas Patra (KVP) • Sukanya Samriddhi Account Public Provident Fund Instituted in 1968, the objective of the PPF is to provide a long term retirement planning option to those individuals who may not be covered by the provident funds of their employers or may be self-employed. PPF is a 15-year deposit account that can be opened with a designated bank or a post office. It can also be opened online with a few banks. A person can hold only one PPF account in their name except an account in the name of a minor child to whom he or she is a guardian. An individual can open a PPF account at any age. HUFs and NRIs are not allowed to open PPF accounts. If a resident subsequently becomes an NRI during the prescribed term, he/she may continue to subscribe to the fund till its maturity on a non-repatriation basis. Joint account cannot be opened, however nomination facility is available. Minimum amount that needs to be deposited in this account is Rs.500 per financial year. The maximum limit is Rs.1,50,000. Subscription should be in multiples of Rs.5 and can be paid in one lump sum or in instalments. There is no limit now on the number of instalments that can be made in the financial year. Regular deposits have to be made in the account over the term of the fund. Penalties apply if the minimum deposit is not made in a financial year. 15 http://nsiindia.gov.in/InternalPage.aspx?CircularId=9999 215 Interest is calculated on the lowest balance available in the account between 5th of the month and the last day of the month, however, the total interest in the year is added back to PPF only at year end. Interest is cumulated and not paid out. The account matures after expiry of 15 years from the end of financial year in which the account was opened. It can be extended in blocks of 5 years. A PPF account can be closed prematurely after the completion of 5 years for specific purposes such as medical treatment for the account holder and dependents and higher education of children. One withdrawal in a financial year is permissible from the seventh financial year. Maximum withdrawal can be 50% of the balance amount at the end of the fourth year or the immediate preceding year, whichever is lower. Premature closure of the PPF is allowed in cases such as serious ailment, education of children and such. This shall be permitted with a penalty of a 1% reduction in the interest payable on the whole deposit and only for deposits that have completed 5 years from the date of opening. On completion of term, the account can be closed or continued, with or without additional subscription, for further blocks of 5 years. Once an account is continued without contribution for more than a year, the option cannot be changed. Loan facility is available from 3rd financial year up to 6th financial year. In the event of the death of the account holder during the term of the scheme, the balance in the account shall be paid to the nominee or to the legal heir if the account does not have a nomination. Contribution to PPF is eligible for deduction under sec 80C of Income Tax Act 1961. Interest is completely tax free. Unlike other instruments which are eligible for tax deduction under Section 80C, PPF enjoys an exempt-exempt-exempt (EEE) status, where withdrawal on maturity is also not taxed. A PPF account is not subject to attachment (seizure of the account by Court order) under any order or decree of a court. National Savings Certificate (NSC) National Savings Certificates are issued by the government and available for purchase at the post office. NSCs are issued with a tenor of 5 years (NSC VIII issue amended as of December 1, 2011). Interest is compounded annually and accumulated and paid on maturity. The certificates can be bought by individuals on their own account or on behalf of minors. NRI, HUF, Companies, trusts, societies, or other institutions are not allowed to purchase the NSCs. If a resident holder becomes an NRI subsequent to the purchase, the certificate can be 216 held till maturity. However, the maturity value cannot be repatriated. Joint holding is allowed and the certificate can be held jointly by up to two joint holders on joint basis or either or survivor basis. Certificates are available in denominations of Rs.100, 500, 1,000, 5,000, and 10,000. The minimum investment is Rs.100 without any maximum limit. The certificates can be bought by cash or through cheques. Investments made in the NSC VIII issue enjoy tax benefits under section 80C of Income Tax Act, 1961. Accrued interest is taxable, but is it deemed to be reinvested and therefore the interest becomes eligible for Section 80C benefits. There is no tax deducted at source at the time of redeeming the certificate value. NSCs can be transferred from one person to another with the consent of a designated official of the post office under situations such as transfers to heirs of a deceased holder, under a court order, to near relatives such as wife, lineal ascendant or descendant and transfer to a bank, housing company or other specified institution as security. Premature encashment is allowed only in case of death of the holder, forfeiture by a pledgee, or under orders of court of law. If the encashment happens within a period of one year from the date of the certificate, only the face value will be paid. If the encashment happens after one year but before three years, simple interest is paid at the rates applicable to Post office savings accounts. After three years, the certificates will be encashed at a discounted value specified in the rules. Nomination is allowed in the certificates, which can be done at the time of the purchase or subsequently. There shall be no nomination allowed on a certificate held on behalf of a minor. A nomination can be cancelled or changed by making an application to this effect at the post office where the certificates stands registered. The certificates are also accepted as collateral for taking a loan. The government has enabled holding NSCs in demat form. Senior Citizens’ Saving Scheme (SCSS) The Senior Citizens’ Saving Scheme is a savings product available to only senior citizens of age 60 years or above on the date of opening the account. Proof of age and a photograph of account holder are required. The age limit is reduced to 55 years in case of an individual retiring on superannuation or otherwise, or under VRS or special VRS, provided the account is opened within one month of date of receipt of retirement benefits. The retired personnel of Defence Services, excluding Civilian Defence Employees, shall be eligible irrespective of age limit. The account can be opened at any post office undertaking savings bank work and a branch of a bank authorized to do so. The scheme can be held in individual capacity or jointly 217 with the spouse. The age restrictions apply only to the first holder. NRIs, PIOs and HUF are not eligible to invest in this scheme. The term for the scheme is 5 years. A one-time extension of three years is allowed, if applied within one year of its maturity. Maximum limit of investment is Rs.15 lakhs. However, in case of retirees before the age of 60 years the limit is restricted to retirement benefits or Rs.15 Lakhs, whichever is less. An investor can open more than one account subject to the condition, that amount in all accounts taken together does not at any point of time exceed Rs.15 Lakhs. The deposit can be made in cash if the amount is less than Rs. 1 lakh, or cheques. The interest rate applicable on the scheme is announced on a quarterly basis. The benefit of section 80C is available on investment but interest is fully taxable. Premature closure is allowed after expiry of one year subject to following conditions: • After expiry of 1 year but before 2 years, 1.50 % of deposit shall be deducted. • After expiry of 2 years, 1% of the deposit shall be deducted. • No deduction is made in case of closure of account due to the death of the account holder. Nomination facility is available even in case of joint account. In case of a jointly held account, the right of the joint holder to receive the amount will rank above that of the nominee. The nomination can be cancelled or changed at any time. The investment is non-transferable and non-tradable. National Savings Schemes / Post Office Schemes and Deposits a) National Savings Monthly Income Account / Post Office Monthly Income Scheme (POMIS) The Post Office Monthly Income Scheme provides a regular monthly income to the depositors. This scheme has a term of 5 years. Minimum amount of investment in the scheme is Rs.1,500, and the maximum amount is Rs.4.5 lakhs for a singly held account and Rs.9 lakhs if the account is held jointly. A depositor can have multiple accounts, but the aggregate amount held in the scheme across all post offices cannot exceed the maximum permissible limits. The deposit can be made in cash or cheque. The applicable interest rate is announced every quarter and is payable on a monthly basis with no bonus on maturity. Nomination facility is available and can be made at the time of opening the account or subsequently at any time before maturity. Premature withdrawal of the invested amount is allowed after 1 year of opening the account. If the account is closed between 1 and 3 years of opening, 2% of the deposited amount is 218 deducted as penalty. If it is closed after 3 years of opening, 1% of the deposited amount is charged as penalty. b) National Savings Time Deposit Account/ Post Office Time Deposits (POTD) National Savings Time Deposit Account / Post Office Time Deposits are similar to fixed deposits of commercial banks. The post office accepts deposits with terms of one year, two years, three years and five years. The account can be held singly in individual capacity or jointly by a maximum of two holders. Single account can be converted into Joint and vice versa. The minimum deposit amount is Rs.100. There is no maximum limit. The interest rates on these deposits are subject to changes every quarter as announced by the government. Interest rates are compounded quarterly and are subject to tax. The five year term deposit is eligible for tax benefits under Section 80C of the Income Tax Act, 1961. c) National Savings Recurring Deposit Account /Post Office Recurring Deposit National Savings Recurring Deposit Account /Post Office Recurring Deposit (RD) accounts can be opened by resident individuals, and a maximum of two people can hold an account jointly or on either or survivor basis. An individual can hold any number of RD accounts, singly or jointly. Deposits can be made at a minimum amount of Rs.10 per month and in multiples of Rs.5 thereafter for every calendar month. There is no maximum investment limit. Interest is payable on a quarterly compounded basis. The maturity amount with interest is paid at the end of the term. Interest is taxable. Deposits have to be made regularly on a monthly basis, and penalties apply for non-payment of instalment. One withdrawal is allowed after the deposit has been in operation for at least one year and 12 monthly deposits have been made. Interest as applicable will apply on the withdrawal and the repayment can be in lump sum or in instalments. An account can be extended for another 5-year term after maturity. Kisan Vikas Patra (KVP) The KVP can be purchased by an adult for self or by two adults for a minor investor. NRIs, HUFs and other entities are not eligible to invest in the KVP. It can be purchased from any departmental post office or bank through cash, local cheque. The minimum investment is Rs.1,000 and in multiples of Rs. 1,000/-. There is no maximum limit. The instrument maturity depends on the applicable rate of interest. The effective interest rate is announced on a quarterly basis. The facility of nomination and joint holding is available in the KVP and the certificate can be transferred from one person to another and one post office to another by endorsement and delivery. KVP can be prematurely encashed 2 1?2 years from the date of 219 issue. There is no tax incentive for the investment made and the interest earned is taxed on accrual basis. Sukanya Samriddhi Account Scheme The Sukanya Samriddhi Account is a scheme launched for the benefit of girl children. The account has to be opened in the name of the girl child by a natural or legal guardian. The account is opened with an authorized list of banks. Only one account can be opened in the name of a child and a guardian can open a maximum of two accounts in the name of two different girl children. The age of the child cannot be more than 10 years at the time of opening the account. The minimum investment in the account is Rs.250 in a financial year and a maximum of Rs.1,50,000. Investments can be made in a lumpsum or in tranches. There is no limit on the number of deposits that can be made in a financial year in multiples of Rs.100. The account can be transferred to any place in India. The account will mature on the completion of 21 years from the date of opening the account. If the girl child gets married before the completion of 21 years then the account is closed. Partial withdrawal is allowed after the holder attains 18 years of age, to the extent of 50% of the amount in balance at the end of the preceding financial year. Any amount deposited in the account is eligible for deduction under section 80C of the Income Tax Act."
Basics of Derivatives,"10.1 Basics of Derivatives Derivative is a contract or a product whose value is derived from the value of some other asset known as underlying. Derivatives are based on a wide range of underlying assets. These include: * Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc. * Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas, etc. * Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and * Financial assets such as Shares, Bonds and Foreign Exchange. In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines ""derivative"" to include- 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. The term derivative has also been defined in section 45U(a) of the RBI Act 1934 as follows: An instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign"
Underlying concepts,"10.2 Underlying concepts in derivatives Zero Sum Game In a futures contract, the counterparties who enter into the contract have opposing views and needs. The seller of gold futures thinks prices will fall, and benefits if the price falls below the price at which she entered into the futures contract. The buyer of gold futures thinks prices will rise, and benefits if the price rises beyond the price at which she has agreed to buy gold in the future. The sum of the two position’s gain and loss is zero assuming zero transaction costs and zero taxes. Settlement Mechanism Earlier most derivative contracts were settled in cash. Cash settlement is a settlement method where upon expiration or exercise of the derivatives contract, the counterparties to the contract settle their position through exchange of the price differentials and do not deliver the actual (physical) underlying asset. However, SEBI has mandated physical settlement (settlement by delivery of underlying stock) for all stock derivatives i.e. all the stock derivatives which are presently being cash settled shall move compulsorily to physical settlement in a phased manner. The stock exchanges have initiated the transition from cash settlement to physical settlement based on the criteria notified by the relevant SEBI circulars.16 Arbitrage The law of one price states that two goods (assets) that are identical, cannot trade at different prices in two different markets. If not, it will be easy to buy from the cheaper market and sell at the costlier market, and make riskless profits. However, such buying and selling itself will reduce the gap in prices. The demand in the cheaper market will increase prices there and the supply into the costlier market will reduce prices, bringing the prices in both markets to the same level. Arbitrageurs are specialists who identify such price differential in two markets and indulge in trades that reduce such differences in price. Prices in two markets for the same tradable asset will be different only to the extent of transaction costs. These costs can include transportation, storage, insurance, interest costs and any other cost that impacts the activities of buying and selling. In the derivative market, the underlying asset is the same as it is in the cash market. But the price to buy the same asset in the derivative market can be different from that of the cash 16 Vide SEBI Circular No.: SEBI/HO/MRD/DP/CIR/P/2018/67 dated April 11, 2018, SEBI/HO/MRD/DOPI/CIR/P/2018/161 dated Dec 31, 2018 and SEBI/HO/MRD/DOP1/CIR/P/2019/28 dated February 8, 2019. 222 market due to the presence of other costs such as physical warehousing or interest costs. The pricing of derivatives takes into account these costs. Margining Process Margin is defined as the funds or securities which must be deposited by Clearing Members as collateral before executing a trade. The provision of collateral is intended to ensure that all financial commitments related to the open positions of a Clearing Member can be offset within a specified period of time. There are different kinds of margins. The initial margin is charged to the trading account on the assumption that the position will be carried out till the expiry of the contract. The initial margin has two components; SPAN17 margins and ELM margins based on exposure. Both margins have to be mandatorily deposited before taking a trade. The initial margin should be large enough to cover the loss in 99 per cent of the cases. The greater the volatility of the stock, greater the risk and, therefore greater is the initial margin. In addition to Initial Margin, a Premium Margin is charged to trading members trading in Option contracts. The premium margin is paid by the buyers of the Options contracts and is equal to the value of the options premium multiplied by the quantity of Options purchased. Open Interest Open interest is commonly associated with the futures and options markets. Open interest is the total number of outstanding derivative contracts that have not been settled. The open interest number only changes when a new buyer and seller enter the market, creating a new contract, or when a buyer and seller meet—thereby closing both positions. Open interest is a measure of market activity. However, it is to be noted that it is not trading volume. Open interest is a measure of the flow of money into a futures or options market. Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market."
Types of derivative products,10.3 Types of derivative products The four commonly used derivative products are: • Forwards • Futures 17 The margin calculation is carried out using a software called - SPAN® (Standard Portfolio Analysis of Risk). It is a product developed by Chicago Mercantile Exchange (CME) and is extensively used by leading stock exchanges of the world. 223 • Options • Swaps
Forwards ,"10.3.1 Forwards Forward contract is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. Forwards are widely used in commodities, foreign exchange, equity and interest rate markets. Let us understand with the help of an example. What is the basic difference between the cash market and forwards? Assume on March 9, 2018 you wanted to purchase gold from a goldsmith. The market price for gold on March 9, 2018 was Rs. 30,425 for 10 gram and goldsmith agrees to sell you gold at market price. You paid him Rs. 30,425 for 10 gram of gold and took gold. This is a cash market transaction at a price (in this case Rs. 30,425) referred to as spot price. Now suppose you do not want to buy gold on March 9, 2018, but only after 1 month. Goldsmith quotes you Rs. 30,450 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have bought forward or you are long forward, whereas the goldsmith has sold forwards or short forwards. There is no exchange of money or gold at this point of time. After 1 month, you come back to the goldsmith, pay him Rs. 30,450 and collect your gold. This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the point of delivery. Essential features of a Forward contract are: · It is a contract between two parties (Bilateral contract). · All terms of the contract like price, quantity and quality of underlying, delivery terms like place, settlement procedure etc. are fixed on the day of entering into the contract. In other words, Forwards are bilateral over-the-counter (OTC) transactions where the terms of the contract, such as price, quantity, quality, time and place are negotiated between two parties to the contract. Any alteration in the terms of the contract is possible if both parties agree to it. Corporations, traders and investing institutions extensively use OTC transactions to meet their specific requirements. The essential idea of entering into a forward is to fix the price and thereby avoid the price risk. Thus, by entering into forwards, one is assured of the price at which one can buy/sell an underlying asset. 224 Major limitations of forward contracts Liquidity Risk As forwards are tailor made contracts i.e. the terms of the contract are according to the specific requirements of the parties, other market participants may not be interested in these contracts. Forwards are not listed or traded on exchanges, which makes it difficult for other market participants to easily access these contracts or contracting parties. Counterparty risk Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil its contractual obligation. For example, A and B enter into a bilateral agreement, where A will purchase 100 kg of rice at Rs.20 per kg from B after 6 months. Here, A is counterparty to B and vice versa. After 6 months, if the price of rice is Rs.30 in the market then B may forego his obligation to deliver 100 kg of rice at Rs.20 to A. Similarly, if the price of rice falls to Rs.15 then A may purchase from the market at a lower price, instead of honouring the contract. Thus, a party to the contract may default on his obligation if there is incentive to default. This risk is also called default risk or credit risk. In addition to the illiquidity and counterparty risks, there are several issues like lack of transparency, settlement complications as it is to be done directly between the contracting parties. Simple solution to all these issues lies in bringing these contracts to the centralized trading platform. This is what futures contracts do."
Futures ,"10.3.2 Futures Futures markets were innovated to overcome the limitations of forwards. A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price. Simply, futures are standardised forward contracts that are traded on an exchange. Exchange becomes counterparty to both buyer and seller of a futures contract through a clearing house. Futures create an obligation on both buyer and seller’s part. The terms of the contract are specified by the exchange and are subjected to change as and when necessary. The clearing corporation associated with the exchange guarantees settlement of these trades. A trader, who buys futures contract, takes a long position and the one, who sells futures, takes a short position. The words buy and sell are figurative only because no money or underlying asset changes hands, between buyer and seller, when the deal is signed. 225 Features of futures contract In the futures market, exchange decides all the contract terms of the contract other than price. Accordingly, futures contracts have following features: • Contract between two parties through Exchange • Centralised trading platform i.e. exchange • Price discovery through free interaction of buyers and sellers • Margins are payable by both the parties • Quality decided today (standardized) • Quantity decided today (standardized)"
Options,"10.3.3 OptionsAn Option is a contract that gives its buyers the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a stated price, for a premium (price). The party taking a long position i.e. buying the option is called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/ writer of the option. The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation to its commitment in the contract. Therefore, option buyer/ holder will exercise his option only when the situation is favourable to her, but, when she decides to exercise, option writer is legally bound to honour the contract. Options are of mainly two types:- • Call Option • Put Option Option, which gives buyer a right to buy the underlying asset, is called Call option and the option which gives buyer a right to sell the underlying asset, is called Put option. Option Terminology Arvind buys a call option on the Nifty index from Salim, to buy the Nifty at a value of Rs. 10,000, three months from today. Arvind pays a premium of Rs 100 to Salim. What does this mean? • Arvind is the buyer of the call option. • Salim is the seller or writer of the call option. • The contract is entered into today, but will be completed three months later on the settlement date. • Rs. 10,000 is the price Arvind is willing to pay for Nifty, three months from today. This is called the strike price or exercise price. 226 • Arvind may or may not exercise the option to buy Nifty at Rs. 10,000 on the settlement date. • But if Arvind exercises the option, Salim is under the obligation to sell Nifty at Rs. 10,000 to Arvind. • Arvind pays Salim Rs.100 as the upfront payment. This is called the option premium. This is also called as the price of the option. • On the settlement date, Nifty is at Rs. 10,200. This means Arvind’s option is “in-the- money.” He can buy the Nifty at Rs.10,000, by exercising his option. • Salim earned Rs.100 as premium, but lost as he has to sell Nifty at Rs.10,000 to meet his obligation, while the market price was Rs. 10,200. • On the other hand, if on the settlement date, the Nifty is at Rs. 9,800, Arvind’s option will be “out-of-the-money.” • There is no point paying Rs.10,000 to buy the Nifty, when the market price is Rs. 9,800. Arvind will not exercise the option. Salim will pocket the Rs.100 he collected as premium."
Swaps,"10.3.4 Swaps A swap is a contract in which two parties agree to a specified exchange of cash flows on a future date(s). Swaps are common in interest rate and currency markets. Example: A borrower has to pay a quarterly interest rate defined as the Treasury bill rate on that date, plus a spread. This floating rate interest payment means that the actual obligation of the borrower will depend on what the Treasury bill rate would be on the date of settlement. The borrower however prefers to pay a fixed rate of interest. She can use the interest rate swap markets to get into the following swap arrangement: • Pay a fixed rate to the swap dealer every quarter • Receive T-bill plus spread from the swap dealer every quarter The swap in this contract is that one party pays a fixed rate to the other, and receives a floating rate in return. The principal amount on which the interest will be computed is agreed upon between counterparties and is never exchanged. Only the interest rate on this amount is exchanged on each settlement date (every quarter) between counterparties. The principal amount is also known as notional amount. The borrower will use the floating rate that she has received from the swap market and pay the floating rate dues on her borrowing. These two legs are thus cancelled, and her net obligation is the payment of a fixed interest rate to the swap dealer. By using the swap market, the borrower has converted his floating rate borrowing into a fixed rate obligation. 227 Swaps are very common in currency and interest rate markets. Though swap transactions are OTC, they are governed by rules and regulations accepted by Swap Dealer Associations. Role of FIMMDA: FIMMDA stands for The Fixed Income Money Market and Derivatives Association of India (FIMMDA). It is an Association of Commercial Banks, Financial Institutions and Primary Dealers. FIMMDA is a voluntary market body for the bond, Money and Derivatives Markets. The objectives of FIMMDA are: 1. To function as the principal interface with the regulators on various issues that impact the functioning of these markets. 2. To undertake developmental activities, such as, introduction of benchmark rates and new derivatives instruments, etc. 3. To provide training and development support to dealers and support personnel at member institutions. 4. To adopt/develop international standard practices and a code of conduct in the above fields of activity. 5. To devise standardized best market practices. 6. To function as an arbitrator for disputes, if any, between member institutions. 7. To develop standardized sets of documentation. 8. To assume any other relevant role facilitating smooth and orderly functioning of the said markets."
Structure of derivative markets,"10.4 Structure of derivative markets A derivative market is formed when different players with different needs to manage their risks come together and try to secure themselves from the respective risky events that they fear in the future. In India the following derivative products are available on various stock exchanges: • Equity index options • Equity index futures • Individual stock options • Individual stock futures • Currency options and futures on select currency pairs • Interest rate futures • Commodity futures for a select set of commodities 228 Apart from the above, forward markets for agricultural commodities and swap markets for interest rates are available in the OTC markets. OTC Markets Some derivative contracts are settled between counterparties on terms mutually agreed upon between them. These are called over the counter (OTC) derivatives. They are non- standard and they depend on the trust between counterparties to meet their commitment as promised. These are prevalent only between institutions, which are comfortable dealing with each other. Exchange Traded Markets Exchange-traded derivatives are standard derivative contracts defined by an exchange, and are usually settled through a clearing house. The buyers and sellers maintain margins with the clearing-house, which enables players that do not know one another (anonymous) to enter into contracts on the strength of the settlement process of the clearing house. Forwards are OTC derivatives; futures are exchange-traded derivatives."
Purpose of Derivatives,"10.5 Purpose of Derivatives A derivative is a risk management tool used commonly in transactions where there is risk due to an unknown future value. Derivatives are typically used for three purposes—Hedging, Speculation and Arbitrage. Hedging When an investor has an open position in the underlying, he can use the derivative markets to protect that position from the risks of future price movements. This is particularly true when the underlying portfolio has been built with a specific objective in mind, and unexpected movements in price may place those objectives at risk. Speculation A speculative trade in a derivative is not supported by an underlying position in cash, but simply implements a view on the future prices of the underlying, at a lower cost. A buyer of a futures contract has the view that the price of the underlying would move up and she would gain having bought it at a lower price, earlier. The cost of this long position is the cost incurred doing margin management. Arbitrage Arbitrageurs are specialist traders who evaluate whether the difference in price is higher than the cost of borrowing. If yes, they would exploit the difference by borrowing and buying in the cheaper market, and selling in the expensive market. If they settle both trades on the expiry date, they will make the gain less the interest cost, irrespective of the settlement price on the contract expiry date, as long as both legs settle at the same price."
"Benefits,Costs and risk of Derivatives","10.6 Benefits, Costs and risks of Derivatives The applications of derivatives in hedging, speculation and arbitrage demonstrate the following key benefits and costs of derivative: * Enable hedging and better management of risk, by providing various alternative ways to structure symmetrical and asymmetrical pay offs. * Enhance the liquidity of underlying markets and reduce overall costs of trading for cash and derivatives. The availability of derivatives increases participation, information dissemination and price discovery. * Over the counter contracts and poorly regulated derivative markets have led to several instances of liquidity crises and counter party risks when large positions are sought to be unwound at short notice, after the risk surfaces. * Complexity of the product makes participation, monitoring and regulation a challenge for the exchanges and regulators. In addition, like other segments of Financial Market, Derivatives Market serves following specific functions: Derivatives market helps in improving price discovery based on actual valuations and expectations. Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite. For example, hedgers want to give away the risk where as traders are willing to take risk. Derivatives market helps shift speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system. Various risks faced by the participants in derivatives Market Participants must understand that derivatives, being leveraged instruments, have risks like counterparty risk (default by counterparty), price risk (loss on position because of price move), liquidity risk (inability to exit from a position), legal or regulatory risk (enforceability of contracts), operational risk (fraud, inadequate documentation, improper execution, etc.) and may not be an appropriate avenue for someone of limited resources, trading experience and low risk tolerance. A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters. Market participants, who trade in derivatives are advised to carefully read the Model Risk Disclosure Document, given by the broker to his clients at the time of signing agreement. Model Risk Disclosure Document is issued by the members of Exchanges and contains important information on trading in Equities and F&O Segments of exchanges. All prospective participants should read this document before trading on Capital Market/Cash Segment or F&O segment of the Exchanges. 230 10.7 Equity, Currency and Commodity derivatives The basic concept of a derivative contract remains the same for all the underlying assets, whether the underlying happens to be a commodity or currency."
"Equity,Currency and Commodity Derivatives","10.7 Equity, Currency and Commodity derivatives The basic concept of a derivative contract remains the same for all the underlying assets, whether the underlying happens to be a commodity or currency. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity derivative”. When the underlying is an exchange rate, the contract is termed a “currency derivative”. Both future and options contracts are available on commodities and as well as on currencies. Commodity derivatives Derivatives have become an integral part of today’s commodity trading and are used for various types of risk protection and in innovative investment strategies. Commodity derivatives markets play an increasingly important role in the commodity market value chain by performing key economic functions such as risk management through risk reduction and risk transfer, price discovery and transactional efficiency. Commodity derivatives markets allow market participants such as farmers, traders, processors, etc. to hedge their risk against price volatility through commodity futures and options. Commodity Futures contracts are highly uniform and are well-defined. These contracts explicitly state the commodities (quantity and quality of the goods) that have to be delivered at a certain time and place (acceptable delivery date) in a certain manner (method for closing the contract) and define their permissible price fluctuations (minimum and maximum daily price changes). Therefore, a commodity futures contract is a standardized contract to buy or sell commodities for a particular price and for delivery on a certain date in the future. For instance, if a Biscuit manufacturer wants to buy 10 tonnes of wheat today, he can buy the wheat in the spot market for immediate use. If he wants to buy 10 tonnes of wheat for future use, he can buy wheat futures contracts at a commodity futures exchange. The futures contracts provide for the delivery of a physical commodity at the originally contracted price at a specified future date, irrespective of the actual price prevailing on the actual date of delivery. Futures trading in commodities can be conducted between members of an approved exchange only. Futures trading in commodities is organized by these exchanges after obtaining a certificate of registration from the SEBI. The national exchanges in which commodity derivatives are currently traded in India are: Multi Commodity Exchange of India Limited (MCX), National Commodity & Derivatives Exchange Limited (NCDEX), Indian Commodity Exchange Limited (ICEX), National Stock Exchange of India Limited (NSE) and BSE Limited (Bombay Stock Exchange). Commodities that are traded on Indian exchanges can be grouped into four major categories: Bullion, Metals, Energy and Agriculture. An indicative list of commodities traded in the Indian derivatives exchanges are: 231 Bullion: Gold, Silver, Diamond Metals: Aluminium, Brass, Copper, Lead, Nickel, Steel, Zinc Energy: Crude Oil, Natural Gas Agriculture: Barley, Chana, Maize, Wheat, Guar Seed, Guar Gum, Isabgul Seed, Pepper, Cardamom, Coriander, Jeera, Turmeric, Sugar, Copra, Rubber, Jute, Cotton, Cotton Seed Oilcake, Castor Seed Oil, Mentha Oil, Soy Bean, Soy Bean Oil, Refined Soy Oil, Degummed Soy Oil, Rape/Mustard Seed, Crude Palm Oil, RBD Palmolein. Commodity options in India devolve into Commodity Futures. That means, buyers of commodity options would get a right to have a position in underlying commodity futures rather than getting a right to outrightly buy/sell the actual commodity on expiry. Therefore, the underlying for a commodity options contract is a commodity futures contract of a specified month traded on the corresponding exchange. This is one example where a derivative has another derivative as underlying. Such an instrument is also called Exotic Option in this case. Currency derivatives: Unlike any other traded asset class, the most significant part of the currency market is the concept of currency pairs. In the currency market, while initiating a trade you buy one currency and sell another currency. Every trade in FX market is a currency pair: one currency is bought with or sold for another currency. In case of currency derivatives, the underlying is an exchange rate. Currency risks could be managed through any of the currency derivatives i.e. forwards, futures, swaps and options. Each of these instruments has its role in managing the currency risk. A currency future, also known as FX future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Currency Options are contracts that grant the buyer of the option the right, but not the obligation, to buy or sell underlying currency at a specified exchange rate during a specified period of time. For this right, the buyer pays a premium to the seller of the option. Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Cross Currency Futures & Options contracts on EUR-USD, GBP-USD and USD-JPY are also available for trading in Currency Derivatives segment."
Derivative markets,"10.8 Derivative markets, products and strategies Derivative trading was introduced in India in June2000 and turnover has increased dramatically since then. India's equity derivative markets are thus among the largest in the world. Pricing a Futures Contract The pricing of a futures contract is based on the simple principle of carry cost. Suppose a stock is selling for Rs.100 in the spot equity markets today. We can buy this stock in the spot market and the price to be paid is the spot price (S). There is another market, namely the equity futures market, where it is possible to trade in the same stock, for delivery on a future date. Let us say the stock future is selling for Rs. 120, delivery date being 20 days away. This is the futures price of the same stock (F). The difference between the two prices is nothing but the interest rate on the money for those 20 days. Therefore the relationship between the two can be shown as: 120 = 100 + (interest for 20 days) F = S + carry costs The logic for such pricing is that given the same amount of information about the stock at a point in time, there is no arbitrage profit to be made between the spot and the futures market. The law of one price stipulates that if the same good is traded in two markets, the price has to be the same, unless there are costs involved in buying in one market and selling in another. The presence of these costs makes it impossible to make money by buying the same good in one market and selling it at another. If the spot price is Rs. 100 and the futures price is Rs. 120, traders would like to buy spot and sell futures, to take advantage of the difference in price. However, if the cost of borrowing funds to buy spot and repay the borrowing after selling the futures, is equal to Rs. 20, there is no profit in the trade. The difference between the spot and the futures price thus adjusts to the market rates of interest, for the period between spot and futures delivery. This interest is called as 'carry cost'. The carry cost is not a risk-free rate or a fixed interest rate, but a market-driven rate that is driven by the risk assumed by the lenders to the trading position. The difference between the spot price and the futures price is called basis. If futures trade at a level higher than spot prices, the basis is positive. The gains to the trader will be equal to the difference between the two prices. If the trader’s cost of carry is different from the basis, there is arbitrage profit to be made on the basis. For example, assume that spot Nifty is 8,900 and near month future expiring 20 days from today is at 9,000. The implicit carry cost in this transaction is: 233 (9,000 – 8,900)/8,900 * 365/20 = 20.5% To a trader who can obtain funds at a rate lower than 20.5%, there is a profit to be made by buying Nifty spot (i.e., buying the underlying constituents of Nifty in the same ratio as they make-up the Nifty index) and selling the futures. If the basis is negative (futures are lower than spot), money is made by buying the futures and selling spot. After the trade, the spot and future prices are bound to change. However, given that opposite positions have been locked into, that net position will remain unaltered on settlement date. On settlement date, both the spot and the futures are at the same level. This is known as the spot-future convergence. The carry cost of buying spot and selling futures on settlement date is zero, since settlement is on the same day as the contract expiration day. Therefore, on expiration day, spot and future prices of the same underlying is identical. Spot-Future Arbitrage Sometimes the spot price and the futures price for the same stock vary much more than what is justified by a normal rate of interest (cost of carry). There is then the scope to create equal but opposite positions in the cash and futures market (arbitrage) using lower cost funds. For example, on March 3rd, 2017, stock XYZ was selling in the cash market at Rs. 3,984 and on the same date, futures (delivery March30th) were selling at Rs. 4,032. Buy XYZ in the cash market Rs. 3,984 Sell XYZ futures Rs. 4,032 Difference in prices Rs. 48 Profit from the transaction: (48/3,984) *365/24 = 18.32% p.a. On the settlement date, the contract will expire and be closed out automatically at the settlement price. Since opposite positions have been taken in the two markets, the profit is locked in provided both the positions are closed at the same price, which is possible given the spot-future convergence at settlement. Arbitrage funds work on this principle. Option Pay-offs An option contract features an asymmetric pay-off. The upside and the downside are not uniform. Pay off Charts for Options The payoff profile of various option positions is explained below. 234 Long on option Buyer of an option is said to be “long on option”. As described above, a person would have a right and no obligation with regard to buying/ selling the underlying asset in the contract. When you are long on equity option contract: You have the right to exercise that option. Your potential loss is limited to the premium amount you paid for buying the option. Profit would depend on the level of underlying asset price at the time of exercise/expiry of the contract. Short on option Seller of an option is said to be “short on option”. As described above, he/she would have obligation but no right with regard to selling/buying the underlying asset in the contract. When you are short (i.e., the writer of) an equity option contract: • Your maximum profit is the premium received. • You can be assigned an exercised option any time during the life of option contract (for American Options only). All option writers should be aware that assignment is a distinct possibility. • Your potential loss is theoretically unlimited as defined below. Hedging Using Futures The investor looks up the markets to find the price of the index futures (Nifty 50 futures, S&P BSE Sensex futures or SX40 futures) contracts expiring one year from today and sells enough lots to lead to a delivery position of Rs. 11.5 lakhs (after factoring in 15% return on his portfolio of 10 lakh over the next year, he hedges his portfolio for Rs.11.5 lakh). He finds a buyer who is willing to pay that price. The investor has entered into a contract to sell the index one year later, at a value of Rs. 11.5 lakhs. This is a hedge that uses a futures contract. The index equity portfolio that the investor holds is his long position. It is already invested and it has a value that changes as the index changes in value over time. The future is the derivative position on the index. How does the derivative modify the profit or loss to the investor? Consider the portfolio position of Rs. 10 lakhs. A year from now, there are three possibilities: The value goes up, goes down or remains the same. Assume the following: The index goes up, leading to a portfolio value of Rs. 15 lakhs. The index remains the same, leading to a portfolio value of Rs. 10 lakhs. The index goes down, leading to a portfolio value of Rs. 5 lakhs. 235 • Payoff Structure What happens a year later, when the investor also holds derivative positions as we had proposed earlier? Sale of index Futures at Rs. 11.5 Lakhs (Futures Position) The investor had already decided the price at which he will sell index, a year earlier. Therefore this contract will be executed at the current market price, and the difference in cash will be paid to the investor. The profit or loss will be as follows: * If the index goes up, leading to a portfolio value of Rs. 15 lakhs • The futures contract will result in a loss as the investor will sell at Rs. 11.5 lakhs, while the market is at Rs. 15 lakhs leading to a loss of Rs. 3.5 lakhs. * If the index remains the same, leading to a portfolio value of Rs. 10 lakhs. • The futures contract will result in a profit, as the investor will sell at Rs. 11.5 lakhs, leading to a profit of Rs. 1.5 lakhs. * The index goes down, leading to a portfolio value of Rs. 5 lakhs. • The futures contract will result in a profit as the investor will sell at Rs. 11.5 lakhs, while the market is at Rs.5 lakhs, leading to a profit of Rs. 6.5 lakhs. Let’s see what the net position of the investor is if he sold the index at Rs. 11.5 lakhs in the futures market while his underlying cash position was Rs. 10 lakhs.Certainly! Here's the tabular data converted into sequential form: 1. Rs. 10 lakhs: - Market Price: Sell at Rs. 10 lakhs - Portfolio Position: No profit or loss - Short Futures Position: Sell at Rs. 10 lakhs - Net Position: No profit or loss 2. Rs. 10 lakhs: - Market Price: Sell at Rs. 11.5 lakhs - Portfolio Position: Buy at Rs. 10 lakhs - Short Futures Position: Profit Rs. 1.5 lakhs - Net Position: Rs. 11.5 lakhs (No profit or loss from portfolio + Rs. 1.5 lakhs from futures) 3. Rs. 15 lakhs: - Market Price: Sell at Rs. 15 lakhs - Portfolio Position: Profit Rs. 5 lakhs - Short Futures Position: Sell at Rs. 11.5 lakhs - Net Position: Buy at Rs. 15 lakhs, Loss Rs. 3.5 lakhs (Rs. 11.5 lakhs - Rs. 5 lakhs from portfolio - Rs. 3.5 lakhs for futures) 4. Rs. 5 Lakhs: - Market Price: Sell at Rs. 5 lakhs - Portfolio Position: Loss Rs. 5 lakhs - Short Futures Position: Sell at Rs. 11.5 lakhs - Net Position: Buy at Rs. 5 lakhs, Profit Rs. 6.5 lakhs (Rs. 11.5 lakhs - Rs. 5 lakhs from portfolio + Rs. 6.5 lakhs from futures) When the investor sold futures at Rs. 11.5 lakhs, he ensured that he got a net amount of Rs. 11.5 lakhs from the investment, no matter how the market behaved. This is called hedging. By using a futures contract what the investor managed was to protect the value of his investments from adverse market movements. • Hedging Using Options A similar outcome, but with asymmetrical payoffs (not a uniform 11.5 lakhs net position irrespective of the market) can be achieved using options. The investor likes to benefit from a possible increase in the index. He is only worried about a possible loss if the index were to fall. In other words, he likes to participate in the upside, but seeks protection from any downside risk. He can buy a put option on the index for an exercise price of Rs. 11.5 lakhs, exercisable in a year. He pays a premium for this position. The investor may or may not sell the index a year from now. It depends on the value of the index in the market. If the value is more than Rs. 11.5 lakhs, he will not exercise the option to sell, because the market price is more than what he would get if he sold. If the value is less than Rs. 11.5 lakhs, he will exercise the option and sell the index at Rs. 11.5 lakhs. In this case, he gets Rs. 11.5 lakhs even if the market falls.Certainly! Here's the tabular data converted into sequential form: 1. Rs. 10 lakhs: - Market Price: Sell at Rs. 10 lakhs - Portfolio Position: No profit or loss - Long Put Option Position: Option is exercised as it is in the money, Profit of Rs. 1.5 lakh - Net Position: Rs. 11.5 lakhs (No profit or loss from portfolio + Profit of Rs. 1.5 lakhs from put option exercised - Less cost of premium on option position) 2. Rs. 15 lakhs: - Market Price: Sell at Rs. 15 lakhs - Portfolio Position: Profit Rs. 5 lakhs - Long Put Option Position: Option expires unexercised as it is out of the money - Net Position: Rs. 15 lakh (Profit of Rs. 5 lakhs from portfolio - Less cost of option premium) 3. Rs. 5 Lakhs: - Market Price: Sell at Rs. 5 lakhs - Portfolio Position: Loss Rs. 5 lakhs - Long Put Option Position: Exercise the option to sell at Rs. 11.5 lakhs, Profit Rs. 6.5 lakhs - Net Position: Rs. 11.5 lakhs (Loss of Rs. 5 lakhs on portfolio position - Profit of Rs. 6.5 lakhs less premium from option position)"
Meaning and Features of Mutual Fund,"11.1 Meaning and features of Mutual Fund Mutual funds are investment products available to investors through which they can invest in an asset class of their choice such as equity, debt, gold or real estate. Investors who may not want to invest directly in financial markets may instead get exposure to the same securities through a mutual fund. Similarly, investors can diversify their portfolio holdings even with small amounts, by investing in gold and real estate through mutual funds. An investor may choose to invest through a mutual fund to be able to use the services of the fund manager who will make the investment decisions relating to selection of securities, timing of investments, reviewing and rebalancing the portfolio periodically and executing the operational decisions related to the portfolio. These services are provided to the investor by charging a fee. There are multiple entities involved in the activities of a mutual fund business. All these entities are regulated by SEBI for their eligibility in terms of experience and financial soundness, range of responsibilities and accountability. A mutual fund is set up by a sponsor, who is its promoter. Trustees are appointed to take care of the interests of the investors in the various schemes launched by the mutual fund. An asset management company (AMC) is appointed to manage the activities related to launching a scheme, marketing it, collecting funds, investing the funds according to the scheme’s investment objectives and enabling investor transactions. In this, they are assisted by other entities such as banks, registrars to an issue and transfer agents, investor service centres (ISC), brokers or members of stock exchanges, custodians, among others. LEARNING OBJECTIVES: After studying this chapter, you should know about: • Know about Mutual funds and its features • Concepts and Terms Related to Mutual Funds • Features of and differences between Open-ended schemes, Close-ended schemes, Interval schemes and Exchange Traded Funds (ETFs) • Regulatory Framework of Mutual Funds • Mutual Fund Products • Mutual Fund Investment Options • Triggers in Mutual Fund Investment • Process associated with Investment in Mutual Funds • Systematic transactions • Investment Modes 242 The AMC creates a product with the approval of the trustees and SEBI. The mutual fund invites subscription from investors by issuing an offer document that gives all details of the proposed fund, including its investment objective, investment pattern in different asset classes to reflect the objective, the strategy of the fund manager to manage the fund, the costs and fees associated with managing the fund and all other information prescribed by SEBI as essential for an investor to make an investment decision. This is the New Fund Offer (NFO) of the scheme and it is kept open for a period not exceeding 15 days. The investor will assess the suitability of the fund for their investment needs and make an investment decision. The application form along with the abridged offer document called the Key Information Memorandum (KIM) is available with the AMC, investor service centres and other distribution points, the details of which are available in the KIM. The units are allotted to investors within 5 business days of the NFO closing and an account statement giving details of the investment is sent to them. The activities related to maintaining investor records and investment details and communicating with the investors is done by the R&T agent of the scheme. The funds collected from multiple investors are invested in a portfolio of securities or assets that reflect the stated investment objective of the fund. This portfolio is owned only by the investors who have contributed the funds, in proportion to their contribution. Investors can invest in the fund even after the NFO in case of open ended schemes. The mutual fund will indicate the minimum amount that needs to be invested and the multiples in which investment can be made. The investors participate in the benefits and costs in proportion to the units held by them. The value of the portfolio will depend upon the value of the securities held in it. If the price of the securities goes up, the value of the portfolio will also increase and vice versa. Depending upon the structure of the mutual fund, investors can redeem or withdraw their investment from the mutual fund at any time, and make additional investments into the fund."
Concepts and Terms Related to Mutual Funds,"11.2 Concepts and Terms Related to Mutual Funds18 11.2.1 Investment Objective An investor’s decision to invest in a mutual fund scheme should be determined by the suitability of the scheme to their needs. A mutual fund scheme is defined by its investment objective. The investment objective states what the scheme intends to achieve. The asset class that the fund will invest in, the type of securities that will be selected and the way the fund will be managed will depend upon the investment objective. The features of the 18 Mutual fund details can be found by looking at the Key Information Memorandum of the fund at https://www.sebi.gov.in/sebiweb/other/OtherAction.do?doMutualFund=yes&mftype=3 All the details about the fund is available and then additional details like the portfolio composition and fund performance can also be seen from the fund house website. 243 portfolio in terms of the level and type of returns and the risks involved in the fund will also depend upon its investment objective."
Units Just as an investor's,"11.2.2 Units Just as an investor’s investments in equity of a company is represented in number of shares, or investments in debt is represented in number of bonds or debentures, each investor’s holding in a mutual fund is represented in terms of units that is derived from the amount invested. Each unit represents one share of the fund. For example, A &B invests in GTX Equity fund when the price of each unit is Rs.10. A invests Rs.5,000 and B Rs.10,000. The number of units allotted is calculated as amount invested/price per units. A : Rs.5,000/Rs.10 = 500 units B : Rs.10,000/Rs.10= 1000 units The units are first offered to the investors at the time the scheme is launched through a new fund offer (NFO). Subsequently, depending upon the structure of the scheme, the fund may or may not issue fresh units to investors. Units can be allotted in decimals too which ensures that the investor gets value for their entire investment."
Net Assets ,"11.2.3 Net Assets The assets of a mutual fund scheme are the current value of the portfolio of securities held by it. There may be some current assets such as cash and receivables. Together they form the total assets of the scheme. From this, the fees and expenses related to managing the fund such as fund manager’s fees, charges paid to constituents, regulatory expenses on advertisements and such are deducted to arrive at the net assets of the scheme. This belongs to the investors in the fund who have been allotted units and no other entity has a claim to it. The Net assets of a scheme will go up whenever investors buy additional units in the scheme and bring in funds, or when the value of the investments held in the portfolio goes up, or when the securities held in the portfolio earns income such as dividends from shares or interest on bonds held. Similarly, the net assets of the scheme will go down if investors take out their investments from the scheme by redeeming their units or if the securities held in the portfolio fall in value or when expenses related to the scheme are accounted for. The net assets of the scheme are therefore not a fixed value but keep changing with a change in any of the above factors."
Net Assets Value (NAV),"11.2.4 Net Asset Value (NAV) The net asset per unit of a scheme is calculated as Net assets/Number of outstanding units of the scheme. This is the Net asset value (NAV). The NAV of the scheme will change with every 244 change in the Net Assets of the scheme. All investor transactions are conducted at the current NAV of the scheme. For example, NUM Equity Fund collects Rs.100,000 from investors and allots 10,000 units. The funds are invested in a portfolio of securities. Consider the table below. 1. Initial State: - Net Assets (Rs): 100,000 - Units Outstanding: 10,000 - NAV (Rs): 10 - Comments: Value of the portfolio goes up 2. After Increase in Net Assets: - Net Assets (Rs): 120,000 - Units Outstanding: 10,000 - NAV (Rs): 12 - Comments: An increase in net assets has led to a rise in NAV. 3. Investor Redeems 1000 Units: - Net Assets (Rs): 108,000 - Units Outstanding: 9,000 - NAV (Rs): 12 - Comments: No change in NAV. A decrease in net assets because of investor redeeming is offset by a decrease in the outstanding units. 4. After Decrease in Portfolio Value: - Net Assets (Rs): 100,000 - Units Outstanding: 9,000 - NAV (Rs): 11.11 - Comments: A decrease in net assets has led to a fall in NAV. 5. Investor Buys 1000 Units: - Net Assets (Rs): 111,110 - Units Outstanding: 10,000 - NAV (Rs): 11.11 - Comments: No change in NAV since the addition to net assets brought in by the investor is offset by an increase in units. The value of a mutual fund investor’s investment is calculated using the NAV. If an investor has invested 1,000 units in the scheme at Rs.10, the value of the investment is Rs.10,000. When the NAV goes up to Rs.12, the value of the investment also goes up to Rs.12,000 and when the NAV goes down to Rs.11.11 the value of the investment comes down to Rs.11,110. A redemption or additional investment will not directly affect the NAV since the transactions are conducted at the NAV. In the above example, consider the impact if the investor buying 1,000 units when the NAV is Rs.11.11, is allotted units at the face value of Rs.10. The investor will bring in Rs.10,000 (100* Rs.10). The net assets will go up by this Rs.10,000 to Rs.110,000. The number of units outstanding will go up by 1,000 to 10,000 units. The NAV post this transaction will be Rs.11. The NAV of the scheme has come down because the units were 245 allotted at a price different from the NAV and will have an impact on all the investors in the scheme. The NAV of a scheme (other than liquid schemes where NAV is calculated on a daily basis) is calculated every business day so that investors can value their portfolio holdings and conduct transactions on this basis."
Cut off timings,"11.2.5 Cut off timings The value of a mutual fund investor’s investment is calculated using the NAV. If an investor has invested 1,000 units in the scheme at Rs.10, the value of the investment is Rs.10,000. When the NAV goes up to Rs.12, the value of the investment also goes up to Rs.12,000 and when the NAV goes down to Rs.11.11 the value of the investment comes down to Rs.11,110. A redemption or additional investment will not directly affect the NAV since the transactions are conducted at the NAV. In the above example, consider the impact if the investor buying 1,000 units when the NAV is Rs.11.11, is allotted units at the face value of Rs.10. The investor will bring in Rs.10,000 (100* Rs.10). The net assets will go up by this Rs.10,000 to Rs.110,000. The number of units outstanding will go up by 1,000 to 10,000 units. The NAV post this transaction will be Rs.11. The NAV of the scheme has come down because the units were 245 allotted at a price different from the NAV and will have an impact on all the investors in the scheme. The NAV of a scheme (other than liquid schemes where NAV is calculated on a daily basis) is calculated every business day so that investors can value their portfolio holdings and conduct transactions on this basis."
Mark to Market,"11.2.6 Mark to Market The current value of the portfolio forms the base of the net assets of the scheme and therefore the NAV. It means that if the portfolio was to be liquidated, then this would be the value that would be realised and distributed to the investors. Therefore, the portfolio has to reflect the current market price of the securities held. This process of valuing the portfolio on a daily basis at current value is called marking to market. The price is taken from the market where the security is traded. If the security is not traded or the price available is stale, then SEBI has laid down the method for valuing such securities."
Open- ended and Closed-end Schemes Mutual fund schemes,"11.3 Features of and differences between Open-ended schemes, Close-ended schemes, Interval schemes and Exchange Traded Funds (ETFs) 11.3.1 Open- ended and Closed-end Schemes Mutual fund schemes can be structured as open-ended or closed-end schemes. An open- ended scheme allows investors to invest in additional units and redeem investment continuously at current NAV. The scheme is for perpetuity unless the investors decide to wind up the scheme. The unit capital of the scheme is not fixed but changes with every investment or redemption made by investors. A closed-end scheme is for a fixed period or tenor. It offers units to investors only during the new fund offer (NFO). The scheme is closed for transactions with investors after this. The units allotted are redeemed by the fund at the prevalent NAV when the term is over and the fund ceases to exist after this. In the interim, if investors want to exit their investment they can do so by selling the units to other investors on a stock exchange where they are mandatorily listed. The unit capital of a closed end fund does not change over the life of the scheme since transactions between investors on the stock exchange does not affect the fund."
Interval funds,"11.3.2. Interval funds Interval funds are a variant of closed end funds which become open-ended during specified periods. During these periods investors can purchase and redeem units like in an open-ended fund. The specified transaction periods are for a minimum period of two days and there must be a minimum gap of 15 days between two transaction periods. Like closed-ended funds, these funds have to be listed on a stock exchange."
Exchange Traded Funds ,11.3.3 Exchange Traded Funds Exchange Traded Funds (ETFs) are mutual funds that have the features of a mutual fund but can be traded. Like a stock they are listed on the stock exchange so they can be traded all day long. Beneath this feature is the fact that the ETF is a mutual fund that has its value derived from the value of the holdings in its portfolio. ETFs usually track some index when it comes to equity oriented funds while they can also track the price of a commodity like gold. Instead of a single NAV for a day that the investor gets in a normal open ended fund there are multiple prices they can get in an ETF. In an ETF it is actually investors trading with each other while in case of an open ended fund it is the investor on one side of the transaction and the mutual fund on the other side.
Regulatory Framework of Mutual Funds,"11.4 Regulatory Framework of Mutual Funds The Securities and Exchange Board of India (SEBI) is the primary regulator of mutual funds in India. SEBI’s Regulations called the SEBI (Mutual Funds) Regulations, 1996, along with amendments made from time to time, govern the setting up a mutual fund and its structure, launching a scheme, creating and managing the portfolio, investor protection, investor services and roles and responsibilities of the constituents. Apart from SEBI, other regulators such as the RBI are also involved for specific areas which involve foreign exchange transactions such as investments in international markets and investments by foreign nationals and the role of the banking system in the mutual funds industry in India. The Association of Mutual Funds in India (AMFI) is the industry body that oversees the functioning of the industry and recommends best practices to be followed by the industry members. It also represents the industry’s requirements to the regulator, government and other stakeholders."
Investor Service Standards,11.4.1 Investor Service Standards An investor has multiple financial and non-financial transactions with a mutual fund. SEBI has prescribed the turnaround time for the services given to investors. The regulations also define 247 the type of information that mutual funds must mandatorily provide investors and their periodicity.1. Allotment of Units in NFO: - Period: 5 days from closing date - Transaction/Information: Scheme opening for continuous transactions 2. Confirmation of Unit Allotment: - Period: 5 business days from allotment - Transaction/Information: Despatch of consolidated account statement for each calendar month - On or before tenth day of succeeding month if there is a transaction in the folio. Else every six months 3. Confirmation of Unit Allotment (SMS or Email): - Period: 5 days from purchase application 4. Despatch of Dividend Warrants: - Period: 30 days from dividend declaration 5. Despatch of Redemption Proceeds: - Period: 10 business days from redemption request 6. Daily NAV of Scheme: - Period: Available by 9.00 pm - Transaction/Information: on mutual fund and AMFI’s website. 7. Monthly Portfolio Disclosure: - Period: Scheme portfolio at the end of the month - Transaction/Information: made available on the mutual fund’s website on or before 10th of the following month. 8. Unaudited Half-Yearly Financial Results and Portfolio: - Period: Within one month from the close of each half-year.
Mutual Fund Products SEBI,"11.5 Mutual Fund Products SEBI has defined the process of categorizing open-end mutual fund products broadly as equity schemes, debt schemes, hybrid schemes, solution oriented schemes and other schemes. 248 Open-ended schemes are classified based on the asset class/sub-asset class, the strategy adopted to select and manage the schemes or the solutions offered by the scheme. Only one scheme per category is permitted for each mutual fund. The exceptions are Index funds and Exchange Traded Funds (ETF) tracking different indices, Fund of Funds with different underlying schemes and sectoral/thematic funds investing in different sectors or themes."
Equity Funds,"11.5.1 Equity Funds Equity funds invest in a portfolio of equity shares and equity related instruments. Since the portfolio comprises of the equity instruments, the risk and return from the scheme will be similar to directly investing in equity markets. Equity funds can be further categorized on the basis of the strategy adopted by the fund managers to manage the fund. a) Passive & Active Funds Passive funds invest the money in the companies represented in an index such as Nifty or Sensex in the same proportion as the company’s representation in the index. There is no selection of securities or investment decisions taken by the fund manager as to when to invest or how much to invest in each security. Active funds select stocks for the portfolio based on a strategy that is intended to generate higher return than the index. Active funds can be further categorized based on the way the securities for the portfolio are selected. b) Diversified Equity funds Diversified equity funds invest across segments, sectors and sizes of companies. Since the portfolio takes exposure to different stocks across sectors and market segments, there is a lower risk in such funds of poor performance of few stocks or sectors. Some equity diversified funds can also be closed ended schemes which are in operation for a specific time period. The assets are redeemed after the time period of the scheme is over and returned to the investors. c) Based on market capitalisation Equity funds may focus on a particular size of companies to benefit from the features of such companies. Equity stocks may be segmented based on market capitalization as large- cap, mid-cap and small-cap stocks. The open-end equity schemes (based on market capitalisation) are classified by SEBI as follows: • Large cap funds invest in stocks of large, liquid blue-chip companies with stable performance and returns. Large-cap companies are those ranked 1 to 100th in terms of full market capitalization in the list of stocks prepared by AMFI. To be classified as 249 a large cap fund, at least 80% of the total assets should be invested in such large cap companies. • Mid-cap funds invest in mid-cap companies that have the potential for faster growth and higher returns. These companies are more susceptible to economic downturns and therefore, evaluating and selecting the right companies becomes important. Funds that invest in such companies have a higher risk of the companies selected not being able to withstand the slowdown in revenues and profits. Similarly, the price of the stocks also fall more when markets fall. Mid-cap companies are those ranked 101st to 250th in terms of full market capitalization in the list of stocks prepared by AMFI. To be classified as a mid-cap fund, at least 65% of the total assets should be invested in such companies. • Large and Mid-cap funds invest in equity-related securities of a combination of large and mid-cap companies. To be classified as a large and mid-cap fund, a minimum of 35% of the total assets should be invested in large cap companies and a minimum of 35% in mid-cap companies. • Small-cap funds invest in companies with small market capitalisation with intent of benefitting from the higher gains in the price of stocks. The risks are also higher. Companies ranked from 251 onwards in terms of total market capitalization in the list of stocks prepared by AMFI are defined as small-cap companies. To be classified as a small cap fund, at least 65% of the total assets should be invested in such companies. • Multi cap funds invest across large, mid and small cap companies. Earlier to be classified as a multi cap fund at least 65% of the total assets should be invested in equity related instruments of such companies. Under the revised guidelines at least 75% of the assets to be invested in equity related instruments with a minimum of 25 % in large caps, 25% in mid-caps and 25% in small caps. • A new category of Flexicap funds has also been introduced where there is no minimum investment limits across market caps and the funds are free to invest according to their requirements. Overall at least 65% of the corpus has to be invested in equities. d) Based on Sectors and Industries Sector funds invest in companies that belong to a particular sector such as technology or banking. The risk is higher because of lesser diversification since such funds are concentrated in a particular sector. Sector performances tend to be cyclical and the return from investing in a sector is never the same across time. For example, Auto sector, does well, when the economy is doing well and more cars, trucks and bikes are bought. It does not do well, when demand goes down. Banking sector does well, when interest rates are low in the market; they don’t do well when rates are high. Investments in sector funds have to be timed well. Investment in sector funds should be made when the fund manager expects the related sectors, to do well. They could out-perform the market, if the call on sector performance plays 250 out. In case it doesn’t, such funds could underperform the broad market. An open end sector fund should invest at least 80% of the total assets in the equity and equity-related instruments of the identified sector. XYZ Banking Fund, ABC Magnum Sector Funds are examples of sector funds. e) Based on Themes Theme-based funds invest in multiple sectors and stocks that form part of a theme. For example, if the theme is infrastructure then companies in the infrastructure sector, construction, cement, banking and logistics will all form part of the theme and be eligible for inclusion in the portfolio. They are more diversified than sector funds but still have a high concentration risks. An open-end thematic fund should invest at least 80% of the total assets in the equity and equity-related instruments of the identified sector. f) Based on Investment Style The strategy adopted by the fund manager to create and manage the fund’s portfolio is a basis for categorizing funds. The investment style and strategy adopted can significantly impact the nature of risk and return in the portfolio. Passive fund invests only in the securities included in an index and does not feature selection risks. However, the returns from the fund will also be only in line with the market index. On the other hand, active funds use selection and timing strategies to create portfolios that are expected to generate returns better than the market returns. The risk is higher too since the fund’s performance will be affected negatively if the selected stocks do not perform as expected. The open-end equity funds (based on strategies and styles for selection of securities) are classified by SEBI as follows: • Value Funds seek to identify companies that are trading at prices below their inherent value with the expectation of benefiting from an increase in price as the market recognizes the true value. Such funds have lower risk. They require a longer investment horizon for the strategy to play out. At least 65% of the total assets of the value fund should be invested in equity and equity-related instruments. • Contra Funds adopt a contrarian investment strategy. They seek to identify under- valued stocks and stocks that are under-performing due to transitory factors. The fund invests in such stocks at valuations that are seen as cheap relative to their long- term fundamental values. Mutual fund houses can either offer a contra fund or a value fund. • Dividend yield funds invest in stocks that have a high dividend yield. These stocks pay a large portion of their profits as dividend and these appeals to investors looking for income from their equity investments. The companies typically have high level of stable earnings but do not have much potential for growth or expansion. They therefore pay high dividends while the stock prices remain stable. The stocks are bought for their dividend pay-out rather than for the potential for capital 251 appreciation. At least 65% of the total assets of the dividend yield fund should be invested in equity and equity-related instruments. • Focussed funds hold a concentrated portfolio of securities. SEBI’s regulation limits the number of stocks in the portfolio to 30. The risk in such funds may be higher because the extent of diversification in the portfolio is lower. g) Equity Linked Savings Schemes (ELSS) ELSS is a special type of open-end equity fund scheme which provides the investor with the tax deduction benefits under section 80C of the Income Tax Act up to a limit of Rs.1,50,000 per year. An ELSS must hold at least 80% of the portfolio in equity securities. The investment made by the investor is locked-in for a period of three years during which it cannot be redeemed, transferred or pledged."
Debt Funds,"11.5.2 Debt Funds Debt funds invest in a portfolio of debt instruments such as government bonds, corporate bonds and money market securities. Debt instruments have a pre-defined coupon or income stream. Bonds issued by the government have no risk of default and thus pay the lowest coupon income relative to other bonds of same tenor. These bonds are also the most liquid in the debt markets. Corporate bonds carry a credit risk or risk of default and pay a higher coupon to compensate for this risk. Fund managers have to manage credit risk, i.e. the risk of default by the issuers of the debt instrument in paying the periodic interest or repayment of principal. The credit rating of the instrument is used to assess the credit risk and higher the credit rating, lower is the perceived risk of default. Government and corporate borrowers raise funds by issuing short and long-term securities depending upon their need for funds. Debt instruments may also see a change in prices or values in response to changes in interest rates in the market. The degree of change depends upon features of the instrument such as its tenor and instruments with longer tenor exhibit a higher sensitivity to interest rate changes. Fund managers make choices on higher credit risk for higher coupon income and higher interest rate risk for higher capital gains depending upon the nature of the fund and their evaluation of the issuer and macro-economic factors. Debt funds can be categorized based on the type of securities they hold in the portfolio, in terms of tenor and credit risk. Short Term Debt Funds aim to provide superior liquidity and safety of the principal amount in the investments. It does this by keeping interest rate and credit risk low by investing in very liquid, short maturity fixed income securities of highest credit quality. The objective is to generate a steady return, mostly coming from accrual of interest income, with minimal NAV volatility. The open-end debt schemes (investing in securities with maturity ranging from one day to one year) are classified by SEBI as follows: 252 • Overnight Funds invest in securities with a maturity of one day. • Liquid Funds invest in debt securities with less than 91 days to maturity. • Ultra Short Duration Funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 3 months and 6 months. • Low Duration Fund invest in debt and money markets instruments such that the Macaulay duration of the fund is between 6 months to 12 months. • Money Market Fund invest in money market instruments having maturity up to one year. The next category of debt funds combines short term debt securities with a small allocation to longer term debt securities. Short term plans earn interest from short term securities and interest and capital gains from long term securities. Fund managers take a call on the exposure to long term securities based on their view for interest rate movements. If interest rates are expected to go down, these funds increase their exposure to long term securities to benefit from the resultant increase in prices. The volatility in returns will depend upon the extent of long-term debt securities in the portfolio. Short term funds may provide a higher level of return than liquid funds and ultra-short term funds, but will be exposed to higher mark to market risks. Open-end debt schemes investing in the above stated manner are categorised by SEBI in the following manner: • Short duration funds invest in debt and money market instruments such that the Macaulay duration of the fund is between 1 year - 3 years. • Medium duration fund invests in debt and money market instruments such that the Macaulay duration of the fund is between 3 years- 4 years. • Medium to Long duration fund invests in debt and money market instruments such that the Macaulay duration of the fund is between 4 years- 7 years. o If the fund manager has a view on interest rates in the event of anticipated adverse situations then the portfolio’s Macaulay duration may be reduced to one year for Medium and Medium to Long duration funds. Long Term Debt Funds Long term debt funds are structured to generate total returns made up of both interest income and capital appreciation from the securities held. Since the price of securities may go up or down resulting in gains or losses, the total returns tend to be more volatile than short term debt funds that focus primarily on earning coupon income. The value of bond held in a long term portfolio, changes with change in interest rates. Since market interest rates and value of a bond are inversely related, any fall in the interest rates causes a mark-to-market gain in a bond portfolio and vice versa. 253 Therefore in a falling interest rate scenario, when investors in most fixed income products face a reduced rate of interest income, long term debt funds post higher returns. This is because the interest income is augmented by capital gains and result in a higher total return. The extent of change in market prices of debt securities is linked to the average tenor of the portfolio - higher the tenor, greater the impact of changes in interest rates. Long term debt funds choose the tenor of the instruments for the portfolio, and manage the average maturity of the portfolio, based on scheme objectives and their own interest rate views. Corporate debt securities enable higher interest income due to the credit risk associated with them. In the corporate bond market, an income fund tries to manage interest income from buying bonds at a spread to Government securities and manages capital gains by taking a view on the interest rate movements and credit spread. Thus, income funds feature both interest rate risk and credit risk. Open-end debt schemes investing in the above stated manner are categorised by SEBI in the following manner: • Long Duration fund invests in debt and money market securities such that the Macaulay duration of the portfolio is greater than 7 years. • Corporate bond fund invests at least 80% of total assets in corporate debt instruments with rating of AA+ and above. • Credit Risk Funds invest a minimum of 65% of total assets in corporate debt instruments rated AA and below. • Banking and PSU fund invests a minimum of 80% of total assets in debt instruments of banks, Public Financial Institutions and Public Sector Undertakings and municipal bonds. • Open-end gilt funds invest at least 80% of the total assets in government securities across maturities. There is no risk of default and liquidity is considerably higher in case of government securities. However, prices of government securities are very sensitive to interest rate changes. Long term gilt funds have a longer maturity and therefore, higher interest rate risk as compared to short term gilt funds. Gilt funds are popular with investors mandated to invest in G-secs such as provident funds or PF trusts. • Gilt fund with 10 year constant duration invest a minimum of 80% of total assets in government securities such that the Macaulay duration of the portfolio is equal to 10 years. • Dynamic bond funds seek flexible and dynamic management of interest rate risk and credit risk. That is, these funds have no restrictions with respect to security types or maturity profiles that they invest in. Dynamic or flexible debt funds do not focus on long or short term segment of the yield curve, but move across the yield curve depending on where they see the opportunity for exploiting changes in yields duration of these portfolios are not fixed, but are dynamically managed. If the 254 manager believes that interest rates could move up, the duration of the portfolio is reduced and vice versa. According to SEBI Categorisation, an open-end dynamic bond fund invests across durations. The open-end floating rate funds invest a minimum of 65% of total assets in floating rate debt instruments. In these instruments the coupon is not fixed for the term of the instrument but is periodically revised with reference to the market rate. If interest rates in the markets go up, the coupon for these instruments are also revised upwards and vice versa. The reset period is defined when the bond is issued, say every 6 months, as also the market benchmark which will be referred to determine current rates. Since the coupon of the bond will be in line with the market rates, there is low interest rate risk in the bonds. These funds give the benefit of higher coupon income when interest rates are on the rise, without the risk of falling bond prices. Fixed maturity plans (FMPs) are closed-end funds that invest in debt securities with maturities that match the term of the scheme. The debt securities are redeemed on maturity and paid to investors. FMPs are issued for various maturity periods ranging from 3 months to 5 years. Mutual fund companies typically keep FMPs in the pipeline, issuing one after another, particularly depending upon demand from corporate investors in the market. The return of an FMP depends on the yield it earns on the underlying securities. The investments may be spread across various issuers, but the tenor is matched with the maturity of the plan. An FMP structure eliminates the interest rate risk or price risk for investors if the fund is held passively until maturity. Therefore, even if the price of bonds held in the portfolio moves up or down, as long as the fund receives the interest pay-outs and the original investment on maturity, the FMP does not suffer significant risks. This makes FMPs the preferred investment in a rising interest rate environment, as investors can lock into high yields. "
Hybrid Fuds,"11.5.3 Hybrid Funds Hybrid funds invest in a combination of debt and equity securities. The allocation to each of these asset classes will depend upon the investment objective of the scheme. The risk and return in the scheme will depend upon the allocation to equity and debt and how they are managed. A higher allocation to equity instruments will increase the risk and the expected returns from the portfolio. Similarly, if the debt instruments held are short term in nature for generating income, then the extent of risk is lower than if the portfolio holds long-term debt instruments that show greater volatility in prices. SEBI has classified open-end hybrid funds as follows: • Conservative hybrid funds invest minimum of 75% to 90% in a debt portfolio and 10% to 25% of total assets in equity and equity-related instruments. The debt component 255 is conservatively managed with the focus on generating regular income, which is generally paid out in the form of periodic dividend. The credit risk and interest rate risk are taken care of by investing into liquid, high credit rated and short term debt securities. The allocation to equity is kept low and primarily in large cap stocks, to enable a small increase in return, without the high risk of fluctuation in NAV. These attributes largely contribute accrual income in order to provide regular dividends. Debt-oriented hybrids are designed to be a low risk product for an investor. These products are suitable for traditional debt investors, who are looking for an opportunity to participate in equity markets on a conservative basis with limited equity exposure. These funds are taxed as debt funds. • Balanced Hybrid Fund invests 40% to 60% of the total assets in debt instruments and 40% to 60% in equity and equity related investments. • Aggressive Hybrid Funds are predominantly equity-oriented funds investing between 65% and 80% in the equity market, and invest between 20% up to 35% in debt, so that some income is also generated and there is stability to the returns from the fund. Mutual funds are permitted to offer either an Aggressive Hybrid fund or Balanced Hybrid fund. • Dynamic Asset Allocation or Balanced Advantage fund dynamically manage investment in equity and debt instruments • Multi Asset Allocation Funds invest in at least three asset classes with a minimum of 10% of the total assets invested in each of the asset classes. The fund manager takes a view on which type of investment is expected to do well and will tilt the allocation towards either asset class. Within this, foreign securities will not be treated as separate asset class. • Arbitrage funds aim at taking advantage of the price differential between the cash and the derivatives markets. Arbitrage is defined as simultaneous purchase and sale of an asset to take advantage of difference in prices in different markets. The difference between the future and the spot price of the same underlying is an interest element, representing the interest on the amount invested in spot, which can be realized on a future date, when the future is sold. Funds buy in the spot market and sell in the derivatives market, to earn the interest rate differential. For example, funds may buy equity shares in the cash market at Rs. 80 and simultaneously sell in the futures market at Rs.100, to make a gain of Rs. 20. If the interest rate differential is higher than the cost of borrowing there is a profit to be made. The price differential between spot and futures is locked-in if positions are held until expiry of the derivative cycle. On settlement date both positions are closed at the same price, to realize the difference. A completely hedged position makes these funds a low-risk investment proposition. They feature lower volatility in NAV, 256 similar to that of a liquid fund. The fund will hold a minimum of 65% of total asset in equity and equity-related instruments. • Equity Savings fund invest in equity, debt and arbitrage opportunities to generate returns. A minimum of 65% of total assets will be invested in equity and equity related instruments and a minimum of 10% in debt investments. Close-end Hybrid Funds Capital Protection Funds are closed-end hybrids funds. In these types of funds, the exposure to equity is typically taken through the equity derivatives market. The portfolio is structured such that a portion of the principal amount is invested in debt instruments so that it grows to the principal amount over the term of the fund. For example, Rs.90 may be invested for 3 years to grow into Rs.100 at maturity. This provides the protection to the capital invested. The remaining portion of the original amount is invested in equity derivatives to earn higher returns."
Solution Oriented Schemes,11.5.4 Solution Oriented Schemes: SEBI has categorised the open-end solution oriented schemes as follows: o Retirement Fund are schemes oriented towards saving for retirement. Schemes will have a lock-in for at least 5 years or till retirement age whichever is earlier. o Children’s Fund are schemes oriented towards saving for children’s needs. Schemes will have a lock-in of 5 years or till the age of majority whichever is earlier.
Other Funds,"11.5.5 Other Funds Other open-end funds categorised by SEBI in ‘Other Fund’ Category is as Fund of Fund and Exchange Traded Fund: • A Fund of Funds (FoF) is a mutual fund that invests in other mutual funds. It does not hold securities in its portfolio, but other funds that have been chosen to match its investment objective. These funds can be either debt or equity, depending on the objective of the FoF. 95% of the total assets should be invested in the underlying fund. A FoF either invests in other mutual funds belonging to the same fund house or belonging to other fund houses. FoFs belonging to various mutual fund houses are called multi-manager FoFs, because the AMCs that manage the funds are different. A FoF looks for funds that fit into its investment objective. It specialises in analyzing funds, their performance and strategy and adds or removes funds based on such analysis. A FoF 257 imposes additional cost on the investor, as the expenses of the underlying funds are built into their NAV. Equity FoFs do not enjoy the tax concessions available to equity funds on dividends and long term capital gains. • Exchange Traded Funds (ETFs) hold a portfolio of securities that replicates an index and are listed and traded on the stock exchange. At least 95% of the total assets should be in securities represented in the index being tracked. The return and risk on ETF is directly related to the underlying index or asset. The expense ratio of an ETF is similar to that of an index fund. ETFs are first offered in a New Fund Offer (NFO) like all mutual funds. Units are credited to demat account of investors and ETF’s are listed on the stock exchange. On-going purchase and sale is done on the stock exchange through trading portals or stock brokers. Settlement is like a stock trade, and debit or credit is done through the demat account. ETF prices are real-time and known at the time of the transaction, unlike NAV which is computed at the end of a business day. Their value changes on a real-time basis along with changes in the underlying index. • Gold ETFs have gold as the underlying asset so as to provide investment returns that, closely track the performance of domestic prices of gold. Each ETF unit typically represents one gram of gold. For every unit of ETF issued, the fund holds gold in the form of physical gold of 99.5 % purity or gold receipts. They are also allowed to invest in the gold deposit schemes of banks to a limit of 20% of the net assets of the scheme. The custodian of the fund is responsible for the safe keeping of the assets. The actual returns from gold ETF may be lower than market returns due to the effect of fund management expense charged and cash holdings. 1. Physical Gold: - Impurity Risk: Present - Liquidity: Low - Transaction Cost: High - Short-Term Capital Gains (STCG): - If held for not more than 36 months 2. Gold ETF: - Impurity Risk: Absent - Liquidity: High - Transaction Cost: Low - Short-Term Capital Gains (STCG): - If held for not more than 36 months 3. Physical Gold: - Long-Term Capital Gains (LTCG): - If held for more than 36 months 4. Gold ETF: - Long-Term Capital Gains (LTCG): - If held for more than 36 months In summary, both Physical Gold and Gold ETF have different characteristics in terms of impurity risk, liquidity, and transaction cost. However, the tax implications for Short-Term and Long-Term Capital Gains are the same for both, regardless of the holding duration. The definition of equity-oriented funds in the Income Tax Act refers only to investment in equity shares of domestic companies. • Real Estate Mutual Funds invest in real estate either in the form of physical property or in the form of securities of companies engaged in the real estate business. SEBI’s regulations require that at least 35% of the portfolio should be held in physical assets. Securities that these funds can invest in include mortgage-backed securities and debt issuances of companies engaged in real estate projects. Not less than 75% of the net assets of the scheme shall be in physical assets and such securities. These funds are closed-end funds and have to be listed on a stock exchange. • Infrastructure Debt Schemes are closed-ended schemes with a tenor of at least five years that invest in debt securities and securitized debt of infrastructure companies. 90% of the fund’s portfolio should be invested in the specified securities. The remaining can be invested in the equity shares of infrastructure companies and in money market instruments. The NAV of the scheme will be disclosed at least once each quarter. The minimum investment allowed in these schemes is for Rs. one crore and the minimum face value of each unit shall be Rs. ten lakh. As a closed-ended scheme the units of the scheme will be listed on a stock exchange. An Infrastructure Debt Scheme can be set up by an existing mutual fund or a new fund set up for this purpose. The sponsor and key personnel must have adequate experience in the infrastructure sector to be able to launch the scheme."
Mutual Fund Investment Options,"11.6 Mutual Fund Investment Options The nature of primary return that an investor earns from a mutual fund investment, whether dividend or capital gain, and the impact of tax on their returns, will depend upon the choices they make on structuring their return. Mutual funds offer investment options for each scheme that define how the investor will take the returns from the investment. Most mutual funds offer an Income Distribution cum Capital Withdrawal (earlier known as dividend) option and growth option. The Income Distribution cum Capital Withdrawal option implies that the funds will pay-out the returns generated in the form of periodic dividends. There is an Income Distribution cum Capital Withdrawal re-investment option too where the dividend declared is not paid out but re-invested in the scheme. The NAV of the scheme will fall to the extent of the dividend that is paid out of its net assets. Investors should know that the amount paid as dividend can also include a part of their capital so they should check the breakup of the amount received. In the growth option, the returns generated are retained in the scheme and 259 translates into an appreciation in the NAV, and hence the value of the investment. The investor can realize this appreciation at any time by redeeming the units."
Triggers in Mutual Fund Investment,"11.7 Triggers in Mutual Fund Investment Another factor to consider are various trigger options that ensure that on achieving a particular situation, the redemption of units are automatically triggered. The trigger can be something like a specified percentage return over the cost of the investment or it can be a specific value that has been set by the investor. There can be a NAV based trigger, when this reaches a certain level the sell decision is automatically made. Another variation is a specific date trigger or an index level trigger, when the index hits a specific level. The setting of the condition ensures that when this is reached the fund will act automatically and redeem or transfer the units. It allows the investor to achieve their aim without having to track the investment continuously since the trigger conditions are set in advance."
Process associated with Investment in Mutual Fund,"11.8 Process associated with Investment in Mutual Funds 11.8.1 Fresh Purchase of Mutual Fund Units An investor can make an initial investment in a mutual fund either in the new fund offer (NFO) or subsequently when the open-ended fund opens for transactions. A fresh purchase of units is made by submitting an application form in which mandatory information has to be provided such as name, date of birth, status, occupation of the first holder, PAN details, address and contact details, signature and bank account details of the first holder. The application form provides for joint holder details to be provided for two joint holders (a folio can have up to three holders) and the mode of holding and operating the folio will have to be provided for the records. The investment details such as the name of the scheme, option and payment mode have to be filled in. The investor can also make nominations in the application form. The form has to be signed by all the holders, irrespective of the mode of holding chosen. The information provided in the application form is used by the R&T agent of the mutual fund to create the investor folio. Purchase of Units in an NFO An investor can buy units in an NFO by submitting the application form along with the payment, at the AMCs office or designated collection centres during the NFO period. NFOs are kept open for a period of 15 days (except for the ELSS, which is kept open for 30 days). Allotment of units at the issue price (typically at the face value of the units) is made within 5 business days from the closure of the NFO. 260 Purchase of Units in the Continuous Offer Period Open-ended schemes have to be available for ongoing transactions within 5 business days of the allotment of units in an NFO. Once the scheme opens for transactions investors can buy units of the scheme or redeem investment or conduct other financial and non-financial transactions with the fund. The application form for purchase of units, along with the payment has to be submitted at the AMC’s office or the investor service centres. The units will be allotted to investors at the applicable NAV for the transaction. The applicable NAV will depend upon a) type of scheme, b) day of transaction, c) time of making the application, d) availability of clear funds to the mutual fund for all liquid fund purchases and for non-liquid purchases."
Additional Purchases in a Mutual Fund,"11.8.2 Additional Purchases in a Mutual Fund Investors can make additional investments in an open-ended scheme after the fresh purchase made in the NFO or continuous offer period. The folio number created at the time of the fresh purchase is the unique identity of the investor with the mutual fund under which all personal information such as name, signature, address, contact details and regulatory compliance on PAN and KYC norms are recorded. Quoting the folio number at the time of making the additional purchase eliminates the need for providing all the information again. Additional investment will be added to the existing folio number. A transaction slip can be used to make the additional investment. It is used by investor for all subsequent transactions with the mutual fund after the initial investment. The transaction slip is sent to the investor along with confirmation of the original investment through the statement of accounts. It can also be downloaded from the website of the mutual fund. It has a simple format that provides for the folio number to be mentioned and the details of the transaction to be conducted. Investors can also use the application form to make additional investments by just filling up the folio number in the space provided."
Redemptions from a Mutual Fund ,"11.8.3 Redemptions from a Mutual Fund Investments in open-ended schemes of mutual funds can be realized at any time by redeeming the units. A redemption request can be for all the units held or for a part of it. The redemption request can specify the number of units to be redeemed or the amount in rupees to be redeemed. The request may be made using the transaction slip and submitted at an y point of acceptance or online. It has to be signed by the holders according to the mode of holding registered in the folio. The applicable NAV for valid transactions received on a day is the NAV calculated for the day. The NAV is adjusted for exit load, if any. 261 The redemption amount is sent either through a cheque with pre-printed details of the first holder or credited to the bank account of the first holder registered with the mutual fund. The investor can choose the mode of receiving redemption and other pay-outs, such as dividend, from the mutual fund at the time of making the application. The IFSC code of the account has to be given to receive the proceeds electronically through ECS, NEFT or direct credit. Direct credit facility is provided only with such banks that the mutual fund has a tie up with. Instant Access Facility (IAF) credits the redemption amount on the day of the redemption request from liquid funds for resident individual investors only. The limit for the use of this facility is Rs.50,000 or 90% of the latest value of investment in the scheme, whichever is lower, per day per scheme per investor. In case of redemptions by an NRI, the bank account into which the redemption proceeds will be credited will depend upon whether the original investment was made from repatriable funds or domestic funds. If investments were made from an NRO or rupee account, redemption proceeds can only be credited to a similar account from which repatriation is regulated. If the investment was made from repatriable funds then the redemption proceeds will be credited to an NRO or NRE account specified by the investor. Mutual funds specify the minimum redemption amount for each transaction. They may also specify the minimum balance to be maintained in the folio. If redemption will result in the folio balance falling below the minimum balance required, mutual funds retain the right to redeem all the units held and close the folio. Mutual funds may restrict redemptions from schemes when there is a systemic crisis or events that constricts market liquidity. This includes situations when the market at large becomes illiquid and it is not restricted to a specific issuer, market failures and closures and unexpected operational issues. The restrictions for a period not exceeding 10 days in a 90 day period and requires the approval of the board of directors of the AMC and Trustees and should be informed to SEBI immediately. The restrictions will not apply to redemptions up to Rs.2 lakhs and where the redemption request is above Rs.2 lakhs then there will be no restriction on the first Rs.2 lakh and the remaining amount will be subject to restrictions. In a circular issued in May 2020 SEBI has said that all schemes that are being wound up would need to be listed on the stock exchanges in order to provide an exit route to investors. There can be quite some time before the entire assets of a wound up scheme are realised and given to the investors. This facility is meant to provide liquidity to the investors in the interim period."
Switch,"11.8.4 Switch A switch is a single transfer from one scheme or option of a scheme to another mutual fund scheme, or option of the same scheme. The investor redeems units from scheme and simultaneously invests it in another scheme of the same mutual fund in an inter-scheme switch. In an intra-scheme switch, the investor redeems from one option of a scheme and invests in another option of the same scheme. In a switch, an investor can transfer all or a portion of the funds held in the investment. The applicable NAV for the switch-out 262 (redemption) from the source scheme or option and switch-in (purchase) into the target scheme or option will depend upon the type of schemes. Since there is a redemption that happens in a switch, exit loads and taxes will apply. The investor will need to specify the source and target schemes and options and the amount to be switched."
Dividend Reinvestment,"11.8.5 Dividend Reinvestment One option that is provided for mutual fund investors is that of dividend reinvestment. This consists of a process where the dividend that is declared by a mutual fund scheme is actually used to purchase more units of the scheme instead of this being received as a pay-out. It is a way of ensuring that there is compounding of returns since no amount is taken out of the investment but it keeps getting invested back. The entire process consists of two transactions for the investor, both of which happen automatically without them having to do anything. The first involves the declaration of the dividend. Once this happens then the second part is completed, where the amount that is earned as dividend gets converted into new units at the NAV post the dividend declaration."
Systematic Transactions,"11.9 Systematic Transactions Mutual funds offer investors the facility to automate their investment and redemption transactions to meet their needs from the investment. Investors may choose to invest periodically rather than in a lump sum to benefit from volatility in prices, they may choose to redeem periodically to generate regular pay-out from the investment or they may want to rebalance the portfolio periodically to align or re-align the asset allocation to their situation. Systematic investment plans (SIP), systematic withdrawal plans (SWP), systematic transfer plans (STP) and switches are some of the facilities provided. Systematic transactions require investors to commit to a set of transactions in advance. The value of each investment, the periodicity of the transaction and the day of execution transaction will be decided at the time of commitment. The transaction will be executed at the applicable NAV at the time of execution of each transaction. Systematic transactions which have been initiated can be cancelled at any time by the investor after giving due notice."
Systematic Investment Plans (SIP),"11.9.1 Systematic Investment Plans (SIP) In a systematic investment plan, investors commit to invest a fixed sum of money at regular intervals over a period of time in a mutual fund scheme. It enables investors to build a corpus over time even with small sums invested. Through SIP, investment is made at different prices over the term chosen and this allows investors to benefit from the volatility in the market. Since the same amount is being invested in each instalment, investors buy more units when the price is low and less units when the price is high. Overtime, the average cost of acquisition 263 per unit comes down. This is called rupee cost averaging and is the primary advantage that SIPs provides investors.1. SIP Date: 10-Feb-21 - Investment Amount (Rs): 2500 - NAV (B): 10.50 - Units Allotted (A/B): 238.10 2. SIP Date: 10-Mar-21 - Investment Amount (Rs): 2500 - NAV (B): 11.70 - Units Allotted (A/B): 213.68 3. SIP Date: 10-Apr-21 - Investment Amount (Rs): 2500 - NAV (B): 12.30 - Units Allotted (A/B): 203.25 4. SIP Date: 10-May-21 - Investment Amount (Rs): 2500 - NAV (B): 12.10 - Units Allotted (A/B): 206.61 5. SIP Date: 10-Jun-21 - Investment Amount (Rs): 2500 - NAV (B): 11.95 - Units Allotted (A/B): 209.21 6. SIP Date: 10-Jul-21 - Investment Amount (Rs): 2500 - NAV (B): 10.25 - Units Allotted (A/B): 243.90 7. Total Investment: - Investment Amount (Rs): 15,000 - Total Units Allotted: 1314.74 8. Average Cost per Unit: - Average cost per unit: 11.41 The above table shows the monthly investments made by an investor in mutual funds at different NAVs. The investor is able to reduce the average cost of acquisition per unit by just investing regularly, without having to adopt any market timing strategy. This is possible because the same sum of money invested buys more units when the NAV is low and less units when the NAV is high. This reduces the average cost of purchase of units for the investor. The investor is able to use market volatility to his advantage. This is the benefit of rupee cost averaging and SIPs. An investor enrolling for an SIP has to make the following decisions: a) The scheme, plan and option: Mutual funds mention the schemes in which SIPs is allowed. b) The amount to be invested in each instalment: The minimum investment for each instalment will be specified by the mutual fund. This is usually lower than the minimum amount of investment for a lump sum investment. 264 c) The periodicity of the investment: The intervals at which the investment can be made, say monthly or quarterly, is defined by the mutual fund. Investors can choose the periodicity that is most suitable. d) The date of investment each period: The investor has to choose the dates from those specified by the mutual fund. e) The tenor of the plan: The date of commencement of the SIP and the term over which the SIP will run has to be selected by the investor. The mutual fund usually specifies the minimum commitment period. f) The mode of payment: The payment mode for an SIP can be the following i. Post-dated cheques: Each cheque will bear the date of the instalment and mentions the specified SIP amount. The set of cheques equalling the number of instalments over the term of the in the SIP have to be handed over along with the SIP enrolment form. ii. Electronic Clearing Service (ECS): ECS is an electronic payment method in which the investor instructs the bank to credit a beneficiary account with a fixed amount on specified date. The investor has to submit the bank account details of the beneficiary such as name, bank, branch, account number, MICR code of the destination bank branch, date on which credit is to be afforded to the beneficiaries and the amount. Investors fill up the ECS mandate form and submit it with their SIP application. ECS facility is available only in select cities as provided by the AMC. iii. Standing Instructions (SI): SI is a payment option for an SIP if the investor and the mutual fund hold bank accounts with the same bank. The investor instructs the bank to credit the SIP instalment amount on each SIP date to the mutual fund’s account. Electronic payment options require an instruction to be given to the bank that is signed by all the account holders. This form is part of the SIP enrolment form and registered by the mutual fund with the bank. To start an SIP in an existing folio, the SIP enrolment form along with the post-dated cheques or instruction form for electronic payment has to be registered with mutual fund. If a fresh investment is being made in the scheme through the SIP, the first instalment will be used to open the folio. The investor has to submit the application form duly filled along with the SIP enrolment form. The cheque for the first instalment alone will bear the date on which the enrolment form is submitted. An SIP can also be initiated along with an investment in an NFO. The first instalment will be the allotment in the NFO and the subsequent instalment after the scheme reopens for continuous purchase. The amount of each instalment of the SIP, whether in the NFO or subsequently, will be the same. The SIP enrolment form will require the SIP commencement date, periodicity and tenor of the SIP, date selected, instalment amount and details of payment to be provided. The enrolment form along with the payment mandate has to be submitted at the official points of acceptance. 265 An SIP can be discontinued or cancelled by the investor giving notice of the same in writing to the mutual fund and to the bank, in case of electronic payment instructions. The mutual fund specifies the notice in days required before the next instalment to process the cancellation. Dishonour of cheques and insufficient funds in the bank account of the investor are other ways in which an SIP is discontinued. If the payment for one or more instalment does not go through, the mutual fund may cancel the SIP. The mutual fund will notify the investor to renew an SIP in force when it is close to completion of its term. Investors can choose to renew it on different terms with respect to investment amount, frequency, term and payment mode."
Systematic Withdrawal Plan (SWP),"11.9.2 Systematic Withdrawal Plan (SWP) Investors can structure a regular pay-out from the balance held in a mutual fund investment by registering for a systematic withdrawal plan. An SWP enables recurring redemptions from a scheme over a period of time at the applicable NAV on the date of each redemption. It is a facility that provides a defined pay-out from a fund for investors who need it. Investors seeking to redeem units from a scheme can also use this facility to eliminate the price risk associated with redeeming all the required units at one point. In an SWP since the withdrawal happens at different points, the investor will be able to benefit from the NAV volatility in the period. When the NAV is high, fewer units are redeemed to pay-out the same amount of money and vice versa. Investors can register for an SWP using the transaction slip. They need to specify the following to the mutual fund: a) Mutual fund scheme, plan & option. b) Amount to be redeemed: The mutual fund will specify the minimum amount that can be withdrawn in one instalment. c) Frequency of withdrawal from the options provided by the mutual fund such as monthly, quarterly and so on. d) Date of redemption for each instalment has to be selected from the options provided by the mutual fund. e) The period or tenor of the SWP over which the redemption will be done. The mutual fund may specify a minimum period for the SWP. f) Date of commencement of the SWP. Mutual funds specify a minimum period before the first redemption for the SWP request to be registered with them. The SWP is redemption from a scheme. Exit loads will apply to each redemption transaction and there will be tax implications for the investor on redemption in the form of capital gains. The redemption amount will be credited to the investor’s bank account registered with the mutual fund. The SWP will cease automatically if the balance in the folio falls below a specified 266 amount. Mutual funds may offer variations to the SWP such as the facility to withdraw only the appreciation in a folio in the period between one instalment and the next. Investors can cancel an SWP by notifying the mutual fund of the same."
Systematic Transfer Plan (STP),"11.9.3 Systematic Transfer Plan (STP) A systematic transfer plan combines redemption from one scheme and an investment to another scheme of the same mutual fund for a defined period of time. The scheme from which units are redeemed is called the source scheme and the scheme into which investments are made is called the target scheme. For example, an investor who has been accumulating funds in an equity fund may decide to transfer it over a period of time to a less risky fund such as a short term debt fund as the time to use the corpus comes near. Instead if the units were redeemed at one point, there is a risk of the NAV being low at that point in time and the resultant fall in the value of the corpus. The folio under which the investment in the target scheme will be made will be the same folio from which the redemption is done from the source scheme. The investor registers an STP with the mutual fund by specifying the following: a) Source and target scheme including plan and option. The schemes that are eligible for STP will be specified by the mutual fund. b) The amount to be redeemed and invested in each instalment. The mutual fund will specify the minimum amount that can be transferred. c) The frequency of the STP has to be selected from the options provided by the mutual fund. d) The period over which the STP has to be conducted has to be specified. Mutual funds may fix a minimum period for the STP. e) The commence date for the STP has to be specified and due notice has to be given to the mutual fund before the commencement of the first transfer. The redemption of units from the source scheme and the investment into the target scheme will happen at the applicable NAV in force. The redemption will attract exit loads and taxes as applicable."
Dividend Transfer Plan (DTP),"11.9.4 Dividend Transfer Plan (DTP) The Income Distribution cum Capital Withdrawal (Dividend) Transfer Plan (DTP) involves an investment in a particular scheme in the Income Distribution cum Capital Withdrawal option. When the fund declares a dividend, then this amount is transferred to a target fund. The initial investment in the original scheme remains intact with the dividend that is mainly earnings from the scheme being transferred to some other scheme. This is actually similar to the dividend reinvestment process, but the difference here is that the target fund where the 267 amount is being transferred is some other scheme and not the one where the dividend originates. The DTP can be used to transfer dividends from an equity scheme to a debt scheme. In this case, the investor would be ensuring that the gains from the equity scheme are being invested in the debt scheme, thus constantly booking profit from the equity investment. On the other hand dividends from a debt scheme can also be used to invest in an equity scheme. This could be a way of regularly investing in an equity scheme to get the benefit of averaging of cost."
Value Averaging Investment Plan,"11.9.5 Value Averaging Investment Plan The normal process of systematic investment calls for a sum of money to be invested at the same time after a specific time interval. This could mean a regular investment of say Rs 1,000 every month on the 25th of the month. Value averaging goes a step further than a normal systematic investment plan and it does this by putting in more money when the market is down and a lesser amount when this is high. To understand this in an easy manner consider an example where there is a sum of Rs 10,000 being invested each month. In a SIP this amount will remain constant over the time period of the SIP. In case of value averaging there is a need to consider a growth rate for the investment. Let us assume this to be 1 per cent per month for simplification purposes. This means that at the end of the first month the Rs 10,000 that was invested under the value averaging investment plan would be worth Rs 10,100. If there is a comparison, then the first month has a similar amount being invested in a SIP and the value averaging investment plan but the figures start diverging thereafter. In the second month the SIP amount in the example above will remain Rs 10,000. The value averaging calculation will look at the value that was supposed to be present, which is Rs 10,100 and the actual value of the investment which let us assume is Rs 9,900. There is a difference of Rs 200 in this calculation and to make up for this the plan will invest Rs 10,200 in this month. Instead of Rs 9,900 consider a situation where the value of the investment was Rs 10,400. In this case this is more than the value that it was supposed to be. So the second month investment in this case will turn out to be Rs 9,700 which is Rs 300 less because of the extra value that has been witnessed in the fund. This automatically ensures that the investment is more when the prices are down and less when the prices are up. There are two main challenges in this approach where the first one is the complexity of the calculations. As the number of instalments increase, the calculations can get pretty complicated. The other thing is that mutual funds do not allow this kind of changes every month in a normal SIP, so the investor will have to take care of the difference in their own way. This can prove to be a very tough task in terms of trying to manage the investment."
Investment Modes,11.10 Investment Modes Investors can directly invest in a mutual fund scheme by choosing the ‘Direct Plan’ option provided in the application form and submitting the application to the official point of acceptance. All mutual fund schemes have to offer a direct plan which features a lower expense ratio for investors who do not use the distribution network set up by the mutual fund. Investors can also choose to use the services of a distributor who will assist in making the investment and provide advice and service on maintaining the investment. If investors invest through the distributor then they opt for the ‘regular plan’ of the scheme.
Direct and Regular Plan,"11.10.1 Direct and Regular Plan A normal scheme of a mutual fund with its operation is a regular plan. This is the standard plan that has been in operation and it represents the plan which pays out distribution commission to various distributors and makes various expenses in the course of its operations. As against this a direct plan is a separate plan where the investor can invest directly with the fund house or its Registrar and Transfer agent. There is no distributor who helps the investor to make the investment in this plan. The cost of this plan is less in terms of the expense ratio, that is charged to the scheme each year. The portfolio of both the regular plan and the direct plan are the same. So at one level the invested amount is earning the same return. The lower cost in the direct plan will however lead to a larger net return for the investor because a larger part of the gains remain for the investor after the various expenses are deducted. The key feature that differentiates the two plans is that the regular plan has a broker or intermediary through whom the investor can buy the plan. There are investors who need the assistance of someone in making the investment. This is required especially for the completion of the process related to the investment. The regular plan is the way in which these investors can use help in finishing the requirements. Investors who are knowledgeable and familiar with the workings of mutual funds would want to consider the direct plan. They will not get the benefit of the help of the distributor but if the investor is able to manage the transactions online then they can use the direct route. It will translate into lower cost as the expense ratio is lower for these plans."
Role of Investment Adviser,"11.10.2 Role of Investment Adviser There has to be a clear understanding of the difference between the direct and the regular plan for the investor. The Investment adviser has to make the investor aware of this. The 269 Investment adviser has to bring out the point that looking at the cost aspect is just one angle, because this comes with its own set of conditions. In a regular plan there is an intermediary or a distributor who is there to help the investor in case there is a need for anything or if there is a problem with the investment and the process is stuck. This can happen either at the time of making a transaction or it can happen when there are changes in guidelines, which require the investor to take some specific additional action. The Investment adviser also has to clarify that the direct plan on the other hand is a ‘Do it yourself approach’ where there is no one around to help. The investor has to go and complete the process by themselves and even in the future after the investment is made if there are some problems then they need to tackle it themselves. They have to monitor their own investments and make the necessary decisions about any transactions in their funds. The role of the investment adviser becomes critical in this entire process. The adviser has to see the exact situation of the investor and then determine if they are able to handle the work related to the mutual fund investment. There are some investors who might have the required knowledge and understanding but there is also the issue of having the time and the space to actually complete the different requirements related to the investment. There has to be a long term look at the entire position and then a decision has to be made whether the investor should be going towards the direct plan or the regular plan. In case the investment adviser is providing the investor with the necessary advice on where to invest and they are using a distributor to invest in a regular plan then this would take care of the entire process. On the other hand if the investor is doing things by themselves they need to be told about the pros and the cons of this step. The investment advisers should also be able to tell the investor how they can transact through direct plans. They need to know the details that will be required and they can demonstrate how this will actually take place. It will give the investor a clear idea of what is required and whether they can handle this. Undertaking the investment online and then monitoring this would require some effort and there could be issues with log in and other technical matters. The investment adviser has to be able to explain the impact of these issues to the investor. The investor can then decide on whether they want to try and save some of the expense on the direct plan or stick to the regular plan."
Overview of portfolio managers in India,"12.1 Overview of portfolio managers in India Risk and return are the two important aspects of financial investment. Portfolio management involves selecting and managing a basket of assets that minimizes risk, while maximizing return on investments. A portfolio manager plays a pivotal role in designing customized investment solutions for the clients. A portfolio manager is a body corporate which, pursuant to a contract or arrangement with a client, advises or directs or undertakes on behalf of the client(discretionary portfolio manager or otherwise) , the management or administration of a portfolio of securities or the client’s funds. Portfolio managers are registered and regulated under SEBI (Portfolio Managers) Regulations, 2020. According to SEBI guidelines PMS can be offered only by SEBI registered entities. January 1993, marked the beginning of Portfolio Management Service when SEBI issued Securities and Exchange Board of India (Portfolio Managers) Regulations, 1993. These were one of the first few regulations issued by the regulators. These regulations came even before the mutual fund regulations. This shows the importance of the sector to the regulator. In India the major providers of portfolio management services are big brokerage firms, asset management companies and independent experts. According to the Asia-Pacific Wealth Report 2017, the Asia-Pacific region is recognized as having the highest net worth individuals (HNIs) and as being the region with the highest HNI wealth. As per the report, India is home to the fourth largest population of HNIs in the Asia- Pacific region. According to report, India’s HNI population and wealth increased by 9.6 per cent and 10 per cent respectively during 2016. This is evident in the expanding clientele base of the portfolio management industry. The total number of clients jumped by more than three LEARNING OBJECTIVES: After studying this chapter, you should know about: • Overview of portfolio managers in India • Types of portfolio management services • Structure of PMS in India • Registration requirements of a Portfolio Manager • Responsibilities of a Portfolio Manager • Costs, expenses and fees of investing in PMS • Direct access facility offered by PMS • SEBI Requirements on performance disclosure 271 times, during a span of five years, to 1,49,720 at the end of March 2019 from 46,707 at the end of March 2015. The asset under management AUM has also been growing steadily year on year as can be observed in the table 12.1 below:"
Types of portfolio management services,12.2 Types of portfolio management services On the basis of provider of the services PMS can be classified as: 1. PMS by asset management companies 2. PMS by brokerage houses 3. Boutique (independent) PMS houses They can further be classified on the basis of product class as: 1. Equity based PMS 2. Fixed Income based PMS 3. Commodity PMS 4. Mutual Fund PMS 5. Multi Asset based PMS Portfolio managers may classify their clients on the basis of their net-worth. Another way which also finds mention in the regulation also is on the basis of the services provided by the portfolio managers. The following are the types of portfolio management services:
Discretionary services,"12.2.1 Discretionary services As per SEBI’s portfolio managers regulation “discretionary portfolio manager” means a portfolio manager who under a contract relating to portfolio management, exercises or may exercise, any degree of discretion as to the investment of funds or management of the portfolio of securities of the client, as the case may be. In other words, discretionary portfolio manager individually and independently manages the funds of each investor as per the contract. This could be based on an existing investment approach or strategy which the portfolio manager is offering or can be customized based on client’s requirement."
Non-discretionary services,"12.2.2 Non-discretionary services Non-discretionary portfolio manager manages the funds in accordance with the directions of the client. The portfolio manager does not exercise his/her discretion for the buy or sell decisions. He/she has to consult the client for every transaction. Decisions like what to buy/sell? And when to buy/sell? Rest with the Investor. The execution of trade is done by the portfolio manager. So, in this case the Portfolio manager provides investment management services with the consent of the client."
Advisory services,"12.2.3 Advisory services In advisory role, the portfolio manager suggests the investment ideas or provides non-binding investment advice. The investor take the decisions. The investors also executes the transactions. These kind of services are typically used for institutional clients, who manage portfolios on their own, but typically hire country experts in each country."
Structure of PMS in India19,"12.3 Structure of PMS in India19 A portfolio manager is a body corporate who, pursuant to a contract or arrangement with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise), the management or administration of a portfolio of securities or the funds of the client. Body corporate broadly means a corporate entity which has a legal existence. The companies Act has provided an extensive definition of the term body corporate. The term ""body corporate"" is defined in Section 2(11) of the Companies Act, 2013. 19 The details about the existing PMS in operation can be found at https://www.sebi.gov.in/sebiweb/other/OtherAction.do?doRecognisedFpi=yes&intmId=33 This mentions the name plus the registration number with the contact details. The address and the name of the contact person is also present. There is also the monthly PMS report which is available at https://www.sebi.gov.in/sebiweb/other/OtherAction.do?doPmr=yes This can be used to check that the PMS is functioning and the kind of returns that it is generating. 273 “body corporate” or “corporation” includes a company incorporated outside India, but does not include— (i) a co-operative society registered under any law relating to co-operative societies; and (ii) any other body corporate (not being a company as defined in this Act), which the Central Government may, by notification, specify in this behalf; In simple terms the term body corporate includes a private company, public company, one persona company, small company, Limited Liability Partnerships, foreign company etc. “body corporate” or “corporation” also includes a company incorporated outside India. A body corporate means any entity that has its separate legal existence apart from the persons forming it. It enjoys a completely different legal status apart from its members."
Registration requirements of a Portfolio Manager,"12.4 Registration requirements of a Portfolio Manager To act as a portfolio manager, obtaining certificate of registration from SEBI under the Portfolio Managers regulations is a mandatory requirement. The application for obtaining the certificate needs to be made to the Securities and Exchange Board of India along with non-refundable fee. The application needs to be made in Form A of Schedule I. Form A is a very detailed form. It requires mainly the following information.1. Particulars of the Applicants: - Name of the Applicant - PAN No. - Address of Registered office - Address for Correspondence - Address - Principal place of business (Where PMS activity shall be carried out) - Details of Branch Offices (if applicable) 2. Organization Structure: - Objectives of the entity seeking registration - Memorandum and Articles of Association/Partnership Deed - Date and Place of Incorporation (ROC Registration No.) - Status of the Applicant (e.g., Limited Company-Private/Public, LLP, etc.) - Organization Chart - Particulars of Directors/Partners, Key Management Personnel, Promoters, Compliance Officer, Principal Officer - Area of work, nature of work, experience, shareholdings, etc. - Information on the total number of employees and employees for Portfolio Management services - Name and activities of associate companies/entities - List of major shareholders/partners holding 5% or more voting rights 3. Infrastructural Facilities: - Principal Place of Business and Branch Office (if applicable) - Office Space, Equipment, Furniture, Fixtures - Communication Facilities - Data Processing Capacity - Computer facility: hardware and software - Details of Disaster Recovery Set up/Business Continuity Plan 4. Business Plan (for three years): - History, Major events, and present activities - Proposed business plan and means of achieving the same - Projected Profitability for the next three years 5. Financial Information: - Capital Structure, Paid-up capital & Free Reserves - Net worth of Applicant - Deployment of Resources in Fixed assets, investments, etc. - Major Sources of Income - Net Profit - Particulars of Principal Banks - Particulars of Auditors 6. Other Information: - Details of settled and pending disputes of the previous 3 years - Indictment of involvement in any economic offenses in the last three years - Any other relevant information to the nature of services rendered by the company - Details of Membership with recognized Stock Exchanges 7. Business Information: - Type of activity carried on/proposed to be carried on - Facilities for making decisions on portfolio investment - Details of risk profiling procedure - Details of grievance redressal and dispute resolution mechanism - List of approved share brokers for Portfolio Management activities - Accounting system for Portfolio Management Services - Research and database facilities - Details of activities proposed to be outsourced 8. Experience: - Experience in financial services rendered: details of activity, etc. 9. Additional Information: - Copy of Draft Agreement with Client - Copy of Draft Disclosure Document - Details of Custodian - Details of Registration with other Regulatory bodies 10. Declaration: - Declaration of compliance with Regulation 7(2) - Declaration for Fit and Proper Person - Declaration of Compliance with clause 12(b) of Schedule III - Declaration of Compliance with SEBI circular on fees and charges - Declaration of the type and frequency of reports sent to clients - Declaration of time taken for transfer of securities into client accounts - Declaration of submission of periodic reports and Disclosure Document to SEBI - Declaration of compliance with clause (e) of sub-regulation (1) of Regulation 27 - Declaration of availability of Disclosure document on the website of Portfolio ManagerIn addition to the information required to be furnished as discussed above, the regulator may require the applicant to furnish further information or clarification regarding matters relevant to his activity of a portfolio manager. The applicant or its principal officer if required, need to appear before the regulator for personal representation. Before issuing a certificate of registration, the regulator will ensure that the: 1. the applicant is a body corporate; 2. the applicant has the necessary infrastructure like adequate office space, equipment and the manpower to effectively discharge the activities of a portfolio manager; 3. the applicant has appointed a compliance officer; 278 4. the principal officer of the applicant has a professional qualification in finance, law, accountancy or business management, experience of at least five years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor, research analyst or as a fund manager; and the relevant NISM certification as specified by the regulator from time to time. 5. In addition to the Principal Officer and Compliance Officer, the applicant has in its employment at least one person who has a graduation from a university or an institution recognized by the Central Government or any State Government or a foreign university; and an experience of at least two years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor or as a fund manager: 6. Any disciplinary action has been taken by the regulator against a person directly or indirectly connected with the applicant 7. The applicant fulfils the net worth requirement (five crore rupees) 8. The applicant, its director or partner, principal officer, compliance officer or the employee is involved in any litigation connected with the securities market that has an adverse bearing on the business of the applicant; 9. The applicant, its director or partner, principal officer, compliance officer or the employee has at any time been convicted for any offence involving moral turpitude or has been found guilty of any economic offence; 10. The applicant is a fit and proper person; The grant of certificate to the applicant is in the interest of investors. The certificate of registration granted under shall be valid unless it is suspended or cancelled by the regulator."
Responsibilities of a Portfolio Manager,"12.5 Responsibilities of a Portfolio Manager The Portfolio Managers regulation by SEBI has enumerated the following responsibilities on the portfolio managers: * The discretionary portfolio manager shall individually and independently manage the funds of each client in accordance with the needs of the client, in a manner which does not partake character of a Mutual Fund, whereas the non-discretionary portfolio manager shall manage the funds in accordance with the directions of the client. * The portfolio manager shall not accept from the client, funds or securities worth less than fifty lakh rupees: 279 * The portfolio manager shall act in a fiduciary capacity with regard to the client's funds. * The portfolio manager shall segregate each client’s holding in securities in separate accounts. * The portfolio manager shall keep the funds of all clients in a separate account to be maintained by it in a Scheduled Commercial Bank. * The portfolio manager shall transact in securities within the limitation placed by the client himself with regard to dealing in securities under the provisions of the Reserve Bank of India Act, 1934 (2 of 1934). * The portfolio manager shall not derive any direct or indirect benefit out of client's funds or securities. * The portfolio manager shall not borrow funds or securities on behalf of the client. * The portfolio manager shall not lend securities held on behalf of the clients to a third person except as provided under these regulations. * The portfolio manager shall ensure proper and timely handling of complaints from his clients and take appropriate action immediately. * The portfolio manager shall ensure that any person or entity involved in the distribution of its services is carrying out the distribution activities in compliance with these regulations and circulars issued thereunder from time to time."
"Cost, expenses and fees of investing in PMS","12.6 Cost, expenses and fees of investing in PMS Fixed cost The fixed cost is the amount that has to be paid by the investor to the PMS fund manager no matter what is the outcome of the entire investment. This is usually a fixed percentage of the amount that is actually being managed or invested into the PMS. It could be something like 1 per cent of the amount invested. In addition, there are other costs that are related to the investment which will be charged to the investor based on the actual amount. For example, the brokerage and other costs involved when the assets are bought and sold become a fixed cost for the investor. Performance linked costs The performance linked costs or the profit sharing fee are an additional amount of fees that the investor has to pay to the PMS . This is present in order to incentivise the fund manager to give a better performance. There are targets that are set and decided upon when the PMS 280 agreement is signed. If these are met then a certain percentage of the profits could be taken by the PMS fund manager as additional fees. These become the cost for the investor and they need to be aware of how much they are actually paying at the end of the day because the performance linked costs can turn out to be quite high. High watermark principle The PMS usually collects a percentage of the assets as a fee so the calculation for this purpose becomes important. High watermark is usually the corpus investment value or the NAV at which fees have been paid historically. The PMS should not be collecting fees for some recent poor performance and this is where the high watermark principle comes in. According to this principle once the fees are calculated on a specific level of assets then the next payment would only come about when the previous higher level is passed. For example, if there are profit sharing fees are to be calculated on the gains of the corpus invested at Rs 50 lakh and if in one year this rises to Rs 60 lakh then Rs 10 lakh would be the basis for the calculation. Next year if the portfolio value drops to Rs 55 lakh then till it crosses the previous high of Rs 60 lakh the profit sharing fee would not be calculated. Hurdle rate This is the rate which would need to be crossed if the PMS would charge extra fees to the investor. This is mentioned in the PMS agreement. For example, it could be that the hurdle rate is 8 per cent. In this case till the return is 8 per cent there is no profit sharing fee calculation and then only when this rate is crossed would the calculation start. Catch up/no catch up concept This is used by the PMS for the purpose of calculation of the fees. There is a hurdle rate that is usually present which is the rate till which no extra fees would be charged. Once this rate is crossed the question arises as to whether the full gains or only the gains above the hurdle rate would be used for the calculation. The no catch up concept is that only the incremental amount above the hurdle rate would be considered while the catch up concept would then look at the fees right from the first earning which would need to catch up to the total earnings."
Direct access facility offered by PMS,"12.7 Direct access facility offered by PMS Difference with regular plan The direct plan way of investing is popular with mutual fund investors. In a direct plan the investor does not use the services of an intermediary like a broker or a distributor but goes directly to the service provider. This cuts out the need for commission for the intermediary and there is a separate value for such plans because the cost for these will be lower. All this goes on to increase the net returns for the investor. 281 There is now a provision for direct access facility in PMS too whereby there are no distributors who are involved in the selling of the plan. This will have a situation where the investor goes and directly puts money into the PMS without any intermediary. The direct access facility has the same benefit in the PMS as in a mutual fund which is that the cost for this will be lower. The lower amount of expenses will lead to a lower amount being charged as expenses to the investor. The PMS has to offer this direct access facility so that any investor who wants to skip the intermediaries can directly approach the PMS provider and then put their money. The rest of the process of the management of the funds does not differ and hence this is a route that the investors can adopt. The regular plan of the PMS will operate in the traditional way with its normal expenses including that paid to the distributors. Role of Investment Advisers The role of Investment Advisers in empowering the investor is pretty significant. They are the ones who are guiding the investors in various steps that are in their interest and which also helps them to save cost while getting the best services at the same time. When it comes to the PMS the investment adviser has to consider the position of the client. The need for the client to get into a PMS as compared to various other instruments has to be checked. Once it is clear that the investor needs to have a PMS then the suitability of the direct access plan has to be considered. There is often no need to go through an intermediary especially when the client is aware about the nature of the investment and what it involves. When it comes to advising on the exposure to a PMS the investment adviser can ask their clients to take the direct access facility as it will enable them to save on costs. The other factor related to the PMS do not change and hence this is not going to have any impact as far as performance is concerned. In addition, depending on the client’s situation the Investment Adviser has to guide them as to whether they should go in for a discretionary plan or a non-discretionary one or even the advisory service. This could result in a higher net return for the investor which will be a beneficial thing for them."
SEBI requirements on performance disclosure,"12.8 SEBI requirements on performance disclosure The Portfolio Manager, before taking up an assignment of management of portfolio on behalf of a client is required to enter into an agreement in writing with the client specifying the details stated in the SEBI (Portfolio Managers Regulations), 2020. The Portfolio Manager is also required to provide the client with a Disclosure Document containing specified particulars. The Disclosure Document is required to include, inter alia, the quantum and manner of payment of fees payable to the client for each activity for which service is 282 rendered, portfolio risks specific to each investment approach, disclosures with respect to related parties as required under Accounting Standards issued by Institute of Chartered Accounts of India etc. This document is required to be made available on the website of the portfolio manager as well as filed with the SEBI. The portfolio manager shall report its performance uniformly in the disclosures to the SEBI, marketing materials and reports to the clients and on its website. The portfolio manager shall disclose the range of fees charged under various heads in the disclosure document."