Fractional Reserve System and Narrow Banking

In a fractional reserve system, the banks keep a part of their deposits as reserves and use
the rest for lending to different borrowers. The presumption is that at any point in time,
only a part of the depositors would turn up to take their money back. So what’s the point
in keeping the rest of the money idle? Banks working on a fractional reserve system earn
their bread and butter by lending their surplus money to borrowers of all shapes and sizes.

But fractional reserve banking has its own problems. First, the borrower may default
in repayment, leading to a loss for the bank, and second, the bank may face a long
queue of depositors seeking their money back. On any normal day the reserves of
the bank are more than enough to take care of redemptions. But on a really bad day
the bank may exhaust all its reserves. How does one deal with a situation like this?
First, banks working on a fractional reserve system use the provision of deposit
insurance to reassure their depositors that a part of their deposit will always remain
safe even if the bank actually fails. This really helps in avoiding panic among
depositors. Second, banks rely on central banks that play the role of the lender of
last resort if the banks actually run out of reserves. But deposit insurance or
presence of lender of last resort in itself can’t eliminate all bank failures.

In the narrow banking system, banks accept deposits and invest only in highly liquid
safe securities most commonly issued by governments. In all other aspects, a narrow
bank is just like any other bank. They provide services such as cash deposit and
withdrawal, cheque payment and settlement, transfer of funds electronically and all
other services that a depositor can use. However, narrow banks do not provide any
loans to borrowers like you and me. This is the biggest difference between a narrow
bank and a bank working on a fractional reserve system.

There are two main advantages of narrow banking. First, narrow banks do not face
any problem in meeting any magnitude of withdrawals from depositors because all
their money is invested in highly liquid securities that can be quickly converted into
cash with a very low transaction cost. Second, narrow banks do not face any
problem of bad debts because all their investments are in government securities. So
there can’t be a bank failure unless the government itself fails.

But their biggest disadvantage is that narrow banks earn less income on their
investments than what their peers in fractional reserve banking earn and
consequently, their depositors have to be satisfied with low interest on deposits. But
for a highly liquid and safe investment you should always be ready to pay a price.

Take the example of postal savings schemes, the closest example of narrow banking
that we can find in our locality. Although post offices do not strictly fall under the
definition of banks, they practically do the same things that any narrow bank does.

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They mobilize small savings which are ultimately utilized by our government. But in
one respect postal savings are better off than a strictly narrow bank. The rates of
interest on their deposits are as competitive as any other commercial bank.
However, their depositors may have to compromise on liquidity.

Understanding Leverage
How does a lever work? If you have to budge a heavy stone, you simply use a long stick
as a lever through a supporting point. If your lever is positioned correctly, you can budge
even a heavy stone by using minimum force. So leveraging is all about putting the right
force at the right position through a lever. In business and finance also, leverage seeks to
achieve the same objective. It enables you to enhance your financial force by using the
lever of borrowed money. In other words, the term leverage signifies the extent to which
you are able to use borrowed money for your business. You have only Rs100 in your
pocket but you are able to borrow Rs1,000 more from others. How are you able to do
that?
Well, you show your Rs100 to Peter and ask him to lend you Rs100 more. Now you
have Rs200 in your pocket, which you show to Paul to borrow Rs200 more. In this
manner, you just keep on borrowing. Anyone who is able to borrow many times
more than his own money is called highly leveraged.

You can use derivative instruments for getting leverage in the financial markets. Let
us try to understand this through an example. Suppose you have Rs1,000, which you
want to invest for a month in the stock market. Suppose you want to purchase the
stocks of a company, which is presently trading at a price of Rs10 per share in the
spot market.

If you purchase the shares directly from the spot market, you can purchase only 100
shares. But take a look at another strategy. Instead of purchasing the shares from
the spot market, you purchase one-month futures contracts of the same shares at
the future price of, say, Rs12 per share.

For entering into a futures contract, you are not required to pay the whole future
price of the shares. You only pay the initial margin money and marked-to-market
margin on a day-to-day basis. Initial margin is what you pay upfront and marked-to-
market margin is what you pay on the day-to-day value of your derivative contract.

If your broker is taking 10% as initial margin money, your Rs1,000 will fetch you
shares worth Rs10,000. Even at a future price of, say, Rs12 per share, which is
higher than the spot price, you would end up controlling more than 800 shares by
following this strategy.

By using derivatives, you can earn a profit or suffer a loss, many times more than
what you could have earned or lost by trading with the same amount of money in
the spot market. This is how leverage through derivatives works.

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Understanding Commodity Exchanges and Futures

Globally, the value of commodities futures contracts traded on commodity exchanges

is many times more than the value of commodities actually produced. No surprise
then that the Bank of International Settlements (BIS), in one of its studies (2007),
pointed out that the value of exchange traded derivatives for precious metals such as
gold exceeded 30 times the value of actual production of gold in 2005.

Commodity exchanges work just like our stock exchanges, but instead of trading in
stocks and bonds, commodity exchanges provide a facility for trading in commodities
futures. Commodities futures contracts are standardized derivative contracts for
buying or selling the underlying commodity on a future date at a predetermined
price. They provide an effective mechanism of price discovery and price hedging. For
instance, if you want to purchase 100g of gold bar after three months but feel that
the price of gold in the meantime is likely to go through the roof, then you can hedge
your price risk by buying a futures contract for gold. Futures contracts remove
uncertainty because you know in advance what price you have to pay to buy gold
three months from now. You will, in fact, make a profit if the price of gold after three
months moves higher than the price fixed under your futures contract, but you would
lose money if the price moves lower. .

Advantages of Futures Contracts and Trading Mechanism

There’s no need to buy if you don’t actually require the thing now; similarly, there’s
no need to sell unless you really want to sell now. Waiting has its own rewards. If
you buy gold now, you would be required to pay its full price, which means that your
money would get unnecessarily locked for three months. To buy commodities
futures, you need to pay only the initial margin, which is generally between 5% and
8% of the price that you have to finally pay. The rest of the money remains at your
disposal. However, for the remaining period of your contract, you are required to
bring in additional mark-to-market margin if the value of your contract really goes
down. This ensures that you have to just take one bite at a time. Even if you have to
lose money in commodities futures, you lose it slowly, day by day.

The trading mechanisms of commodities futures are similar to stocks. You can trade
commodities futures online just like stocks through any trading member of the
commodity exchange. For that you need to open a trading account with a broker and
a demat account with a depository. Many stockbrokers also provide a facility to trade
commodities, so you can start trading stocks and commodities futures side by side.

But before you actually jump, it would be better to do some more research. For
instance, you need to find out which commodities are available for trading on the
commodity exchanges. The list of commodities available for trading keeps changing.
What are the fundamental drivers of price of the commodity you want to trade in?

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Different commodities have different fundamental drivers. What’s the settlement
procedure? Most of the commodity futures are settled by cash but in some contracts
the seller has the option of making physical delivery, and in some contracts physical
delivery has been made compulsory.

Bid-ask spread: all about what a buyer will pay, a seller will accept

“Bid-ask spread” signifies the progress of negotiation between buyers and sellers. To
start with, a buyer may quote the bid price, the price at which he is willing to buy,
and the seller may quote the ask price, the price at which he is willing to sell. The
difference between the bid price and the ask price is known as “bid-ask spread”. In
financial markets, where most of the trades now take place electronically, it is not
necessary for buyers and sellers to directly quote their price to each other. In fact,
buyers and sellers quote their bid and ask price independent of each other. Most
often the same person, a market maker or broker, may be separately quoting both
the bid and ask price for the same instrument. So whenever you ask for a quote of
any instrument you get separate quotes in which quote for buy is higher than quote
for sell.

The Dow theory: charting market trends

The Dow theory believes that stock market prices follow a trend. Dow, through his
observations, arrived at the conclusion that prices move in a pattern. If the market is
going through an uptrend, then the prices will continue to rise until the uptrend
changes into a downtrend. The evidence of any change in the trend can be gathered
by observing price charts.

In a way, the Dow theory is based on the presumption that stock prices convey
everything that is worth knowing about the stock. Be it future earnings or fear of the
future or just hope, almost everything is reflected in the current stock price. But the
focus of the Dow theory is always on the changes in average price as reflected by
some market index.

The Dow theory relies upon the Dow Jones Industrial Average and the Dow Jones
Transport Average for its analysis. But the theory should work as well with any other
market index. The focus on a market index helps in minimizing discrepancies that
might creep in when observing individual securities.

The Dow theory says that three kinds of trends are seen working in the market. The
first is the primary trend, which lasts from a few months to many years, and could
be either bullish or bearish. Then we have a secondary trend that lasts from a few
weeks to some months and that moves in the direction opposite to the direction of
the primary trend.

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So if the primary trend is bullish, then the secondary trend would come in the form
of temporary corrections or fall in prices, and if the primary trend is bearish then the
secondary trend would bring a temporary rally or rise in prices. But once the
secondary trend is over, the market continues its march in the direction of the
primary trend.

Apart from primary and secondary trends, the market also sees day-to-day
fluctuations that can last from one day to a week, during which the prices could
move either in the direction of the primary trend or in the opposite direction.
Interestingly, day-to-day fluctuations don’t have much of a role in the Dow theory.
The main focus lies on identifying the primary trend and making investments based
on that. Changes in the secondary trend are observed for deciding the direction of
the primary trend. You can know about the overall direction of the market by
watching both the trends simultaneously.

When you watch both primary and secondary trends, you would observe something
like this: The overall direction of the market over a period of, say, one year or two is
decided by the direction of the primary trend, with the secondary trend acting as a
temporary pull-back.

So the movement of a stock index would look like someone taking two steps forward
and one step backward. In a market trending up, the market rises then falls a bit,
then rises once again and reaches a point higher than the previous high.

In a down-trending market, the whole movement is reversed. The market falls then
rises a bit, then falls once again to reach a point lower than the previous low.

Price – Earnings ratio

For calculating EPS, you first need to know the net earnings of the company.
Analysts generally take the net earnings from the most recent four quarters, or 12
months, to calculate what is known as trailing EPS.

However, some analysts use the projected earnings to calculate what is known as
forward EPS. Trailing and forward P-E multiples can be calculated by using trailing
and forward EPS, respectively. For the sake of simplicity, here we are referring to
past earnings only.

Once you have the net earnings figure, you need to subtract the dividend that is
payable to preference shareholders and divide the result with the number of
outstanding equity shares to get EPS.

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For instance, if the net earnings of a company after paying preference dividend is
Rs1 lakh, and the total number of equity shares is 10,000, then EPS would be 10.

Companies report the EPS figure in their income statements. Once you know EPS,
you can calculate the P-E multiples.

You need to just divide the present market price of the shares with EPS.

If the present market price is Rs200 and EPS is 10, then the P-E multiple would be
20. That’s it. But, what does it tell you? If you look at the P-E multiples like an
investor, you will understand that for purchasing a share that is earning Rs10 every
year, you’re paying a price that is 20 times its earning.

So, the higher the gap between the price and the earnings, the higher the P-E
multiple. That’s why people call stocks that have higher P-E multiples overvalued,
and those with lower P-E multiples, undervalued.

Some shares with higher P-E multiples may still be undervalued and some at even
low levels may be overvalued. It all depends upon the company you are looking at.

As a thumb rule, you need to compare the P-E multiple of the company with that of
peer group companies in the same sector or industry. But, this may also not give you
the true picture if the sector, as a whole, has been overpriced by the market.

In case the present looks surreal, you can look at the historic figures of the P-E
multiples of the same company to see whether the present is in sync with the past.

What is DMA ?

Direct market access, or DMA, is a facility by which a client can directly place his
orders in the trading system of a stock exchange. Such a facility has already been in
existence in many international stock markets, but DMA is a new discovery for the
Indian stock market. Before you understand how DMA works, you need to have some
idea of how trading takes place in our stock exchanges.

Trading of securities, just like that of any other good, can take place only when
buyers are able to meet sellers on a common ground called the market. For trading
of securities, we have designated places called stock exchanges where buyers are
able to meet sellers. But in stock exchanges, buyers meet sellers only through a
broker, who acts as an intermediary.

Earlier, all trading used to take place by physical interaction among brokers on the
trading floor of stock exchanges. But things have changed now, with no need for

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face-to-face interaction. Our stock exchanges—National Stock Exchange and Bombay
Stock Exchange—use electronic trading systems which automatically match the best
buy order with the best sell order, without buyers and sellers or their brokers
actually coming in contact with each other.

Once you call your broker for placing an order, your broker has to manually place
your order into the trading system of the stock exchange through his trading
terminal. If you are more of a “do-it-yourself” kind, then you can use the online
trading facility provided by some brokers, in which case you place the order by
accessing your broker’s website. Online trading may not involve any manual
intervention by your broker, but before your order reaches the trading system of the
stock exchange, it has to be validated by the online trading system of your broker.

In other words, even online trading requires some form of intervention by your
broker at the end and hence it might take some time before your order is actually
placed in the trading system of the stock exchange.

How to place your order directly.

For that you need to have DMA. But this facility can be currently offered by brokers
only to institutional clients such as mutual funds, insurance firms and foreign
institutional investors. Under this facility, the brokers install trading terminals with
direct access to the trading system of the stock exchange at the premises of the
institutional investors; these can be used for placing orders without any further
intervention by the broker. That’s why it is called DMA.

This facility has many advantages. Firstly, it provides direct control over your orders.
For example, it reduces the risk of wrong feeding of the order in the trading system
by your broker. There is no need to worry if your broker sometimes forgets to count
zeros, the task of pressing the right key at the right time is now entirely in your
hands.

Secondly, DMA provides better execution of your trading strategy. You would not find
your broker running ahead of you to buy or sell when he comes to know about your
big orders. In other words, DMA leaves no scope for what is called front-running.
Your broker would, in fact, not even know which stocks you are currently picking or
which stocks you are currently dumping.

Thirdly, DMA provides faster execution of orders. You are placing your order directly
in the electronic trading system of the stock exchange; this curtails any loss of time
in calling your broker. Better still, DMA also enables you to use what is called
algorithm trading or program trading in which computer programs take decisions of
buying and selling in split seconds without waiting for your command.

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Institutional investors using program trading can take advantage of price
discrepancies that last for only fractions of seconds. DMA might unleash the true
power of computer programs.

What is a PONZI scheme

The term Ponzi scheme is used to describe any fraudulent investment scheme that
does not generate any actual profit and which pays back investors either by using
their own money or by using the money of subsequent investors. The modus
operandi is simple—pay Peter by using the money invested by Paul and pay Paul by
using the money invested by Mary. It is obvious that such a scheme of paying back
one investor by taking money from the other is, sooner or later, bound to fail. But
Ponzi schemes may, in fact, succeed in attracting a large number of investors before
they fold up.

First, Ponzi schemes generally flourish when the overall investment climate is good,
which makes investors think that this time it is really going to be different. Second,
Ponzi schemes do offer something that many investors, high on adrenalin, can’t
refuse: a high rate of return matched with consistent performance. To add credibility
to such a mouth-watering promise, Ponzi schemes may sound as if they have
discovered some secret formula that is not yet publicly accessible.

Early investors of Ponzi schemes are treated like members of an exclusive club
where only a lucky few can get in. This acts as an inducement for others to join.
Things become merrier with an ever-increasing flow of money from new investors
joining every day, which keeps the whole scheme going.

But ironically, the ever-increasing number of investors brings the day of final
downfall closer. A day comes when the scheme finally evaporates into thin air.

How do electronic trading systems work on bourses?

The screen-based electronic trading systems being used in our stock exchanges are
order-driven, in which the order matching is done by a computer. An order-driven
system is one in which all buy and sell orders are entered into a trading system,
which finally chooses the best buy orders and the best sell orders. The best buy
order is the highest bid price for buying a security. The best sell order is the lowest
asking price at which someone is willing to sell. In this kind of a system, orders of
buyers and sellers ultimately drive the market.

Two types of orders reach the trading system. One is called a “limit order” and the
other a “market order”.

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A limit order is one in which the buyer or seller specifies the quantity and the price at
which he desires to buy or sell. A limit order is executed only at the indicated price or
at a better price. Say, for instance, that someone is placing a limit order for buying a
stock at Rs10, then the order would get executed only at a price of Rs10 or at a
lower price. However, if someone is placing a limit order for selling a stock at Rs10,
then the order would get executed only at a price of Rs10 or at a higher price. All
limit orders to buy or sell that are not able to find opposite orders to sell or buy at
the indicated or better price are kept pending in the trading system. It is quite
possible for a limit order to remain totally unexecuted or to get only partially
executed in terms of the indicated quantity. The trading system maintains all
pending limit orders in the form of an order book on the basis of price and time
priority. Better price gets the first priority. For instance, an order to buy a stock at a
price of Rs10 gets priority over an order to buy the same stock at a price of Rs9.
Likewise, an order to sell a stock at Rs11 gets priority over an order to sell the same
stock at Rs12. In case two orders have been placed at the same price, then an order
placed earlier in time gets priority over an order placed later.

Market orders and limit orders nicely complement each other. A market order is one
in which someone is willing to buy or sell at the best available price. The buyer or
seller only indicates the quantity without indicating the price. It is for the system to
match it against the best available price. So a market order to buy a particular stock
would get matched against a limit order offering to sell at the lowest price. A
continuous flow of both market and limit orders is essential for the normal
functioning of the market.

What is Beta To put it simply, beta is the return generated by your stocks due to
market forces. It is the return your stocks earn simply because they are part of the market.
You could think of the market as an ocean and your stocks as a boat.

When the market tide comes, it simply lifts all the boats. Your stocks also benefit
from the high market tide. But there are two things we should always keep in mind
while talking about beta. First, the tide that lifts the boat can also sink it. In a way,
the fate of your stocks is tied up with the fate of the broader market. It rises with
the market but it could also fall with the market. Second, the market tides do not lift
every stock equally. Some stocks called high beta stocks rise or fall more than the
rise or fall of the broader market. Similarly, there are low beta stocks that rise or fall
less than the broader market. We could say that beta denotes the volatility of a
particular stock, that is to say, how much a particular stock is likely to rise or fall in
comparison with the broader market. In other words, high beta stocks are more
volatile than low beta stocks.

Think of a market index, say, the S&P CNX Nifty, as a representative of the broader
market. Every rise and fall in the Nifty would have some correlation with the rise and

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fall of your stock, which we express in terms of beta. Suppose you own a stock that
has a beta of 1.5. Then whenever the Nifty rises by 10%, your stock is likely to rise
by almost 15%. Likewise, whenever the Nifty falls by 10%, your stock is likely to fall
almost by 15%. A stock with a beta less than one would rise and fall less than the
rise and fall of the broader market. For instance, if the beta of your stock is 0.5, then
for every 10% rise and fall of the market, your stock is likely to experience a rise
and fall of 5%. Theoretically speaking, a beta of zero would denote that a particular
stock is not affected in any way by movements in the broader market, and a
negative beta would mean that a particular stock moves in the opposite direction to
the broader market.

If the broader market is falling, a stock with negative beta is expected to rise, and
vice versa. In reality, it is tough to find stocks that have negative beta in relation to
the broader market. Some stocks may temporarily exhibit negative beta, but in the
long run stocks go along with the market, some steps ahead or some steps behind.

You can use beta for managing the overall risk of your portfolio. You can know about
beta of a particular stock from the website of stock exchanges or from any good
website providing information about company stocks. A portfolio consisting of only
high beta stocks obviously has a chance to earn better returns than the overall
market but it also carries more risk. Once you know about beta of different stocks,
you can use it for constructing a portfolio that suits your risk appetite. But I would
like to add a few words of caution. You should know that beta is calculated by using
a regression analysis against a particular stock market index, which means that the
entire process relies on past data.

Sometimes the past may not provide the right guidance for the future.

What is Alpha

Alpha, which represents the return generated by a stock over and above what was
contributed by market forces. Market volatility has no role in alpha and so we can
say that it represents risk-adjusted return generated by an investment.

In other words, seeking alpha means getting extra return on your investments
without taking extra market risk. That’s the real challenge for active fund
management.

What has seeking alpha to do with active fund management?

Well, every active fund manager aspires to beat the broader market. But just
beating the market in itself can’t tell you much about the performance of a fund
manager. If the broader market, say, an index, generated a return of 10% over a

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period of time and your fund manager generated a return of, say, 15% during the
same period, then at first glance your fund manger obviously looks like a winner. But
you also need to consider how much additional risk the fund manager took for
generating the additional return. We can’t consider the fund manager successful if he
generated additional return by undertaking higher risk than the broader market. You
need to look at additional returns on a risk-adjusted basis. A fund manager
generating alpha adds value by generating a return higher than that of a broader
market without taking extra risk. A fund manager generating positive alpha adds
more value to the return generated by beta, hence the overall return is higher. But a
fund manager generating negative alpha eats into the return generated by beta,
hence the overall return is lower.

Why some fund managers end up with a positive alpha and some with a negative
alpha?

The first thing that you should keep in mind is that no stock can be permanently
classified as an alpha generating stock. Some stocks at some point in time might
generate a return higher than the return justified by their market risk. But the same
stocks would not continue generating extra return for all time to come. Efficient
markets quickly eliminate extra returns. So generating a positive alpha is a tough
job.

The second thing is that finding alpha-generating stocks is a zero-sum game. A

positive alpha generated by a fund manager comes at the cost of negative alpha
generated by some other fund manager. You should keep in mind that everybody is
competing to get a bigger share of the same pie but some would be getting a bigger
piece only at the cost of someone getting a smaller portion. If some investors are
generating higher return by assuming lower risk then there might be some investors
who are generating lesser return by assuming higher risk. In the overall market,
high return versus low risk and low return versus high risk cancel each other out. But
why assume higher risk for lower return? You can call it wrong selection or error of
judgement. But you should also keep in mind that the market works only because
market participants differ in their judgement. Some win, some lose.

What does a Portfolio Manager do

Portfolio managers take care of your investments by providing many services under
one roof. First and foremost, portfolio managers help in identifying the investment
objectives of each individual client. With professional help by your side, it becomes
much easier to look at the big picture.

Second, portfolio managers actually look after the day-to-day management of a

portfolio of securities or the funds of their clients, as the case may be, in line with

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their investment objectives. All portfolio managers must have a certificate of
registration from the Securities and Exchange Board of India, or Sebi, the stock
market regulator. A class of portfolio managers known as “discretionary” portfolio
managers, as per Sebi regulations, enjoys considerable freedom in taking day-to-day
decisions of investments under the overall terms and conditions of a contract.

Another class of portfolio managers known as “non-discretionary” portfolio managers

acts more like an accountant and has to take all investment decisions as per the
directions of the client.

how portfolio managers are different from mutual funds?

. There are many differences, some of which might have become strikingly apparent to
you by now. Mutual funds pool the money of different investors for a common ready-
made scheme. There is no focus on the needs of individual clients. What’s good for Peter
is also good for Paul.

There is no one-to-one interaction between the mutual fund manager and the client.
You can’t call your mutual fund manager to discuss a forthcoming IPO, or initial
public offering. In contrast, portfolio managers provide customized service, keeping
in view the needs of each client.

Each client has his or her own individual portfolio. There is also a constant one-to-
one interaction with the client. That’s what makes a difference. You feel as if you are
the only passenger on a chartered flight.

Before you start thinking about using portfolio management services, I would like to
clarify some things. First, as per Sebi regulations, portfolio managers can only accept
a minimum investment of Rs5 lakh from their clients. This investment can be either
in the form of money or in the form of securities worth Rs5 lakh.

No portfolio manager can accept an investment below that amount, so there is no

point in looking for a portfolio manager if you do not carry at least Rs5 lakh in your
pocket. In fact, many portfolio managers provide more customized services if you
have much more to invest.

So you need to check the details of services offered for different amounts of
investments by different portfolio managers. A list of portfolio managers is available
on the Sebi website (www.sebi.gov.in).

Second, portfolio managers charge fees which may be a fixed amount or a return-
based fee or a combination of both as per the agreement with the client. For
instance, a portfolio manager may charge a flat fee of, say, 1% of the value of
assets under management and a 10% fee on all profits above a certain amount.

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This is just a hypothetical example; in fact, Sebi regulations have not prescribed any
scale of fees to be charged by the portfolio manager and the fees charged vary
greatly from one portfolio manager to another. You should actually find out about the
fee structure before choosing any portfolio manager.

All portfolio managers have to provide a disclosure document at least two days prior
to entering into an agreement with the client. This, among other things, tells you
about the fee structure, the performance of the portfolio manager and the audited
financial statement of the portfolio managers for the preceding three years.

The Harry Markowitz way to portfolio selection

Markowitz is a well known name among portfolio managers, institutional investors or

anybody even remotely interested in understanding how the risk-return trade-off
works. Markowitz laid down the foundation of risk-return trade-off in his doctoral
thesis Portfolio Selection, which was published in 1952 in The Journal of Finance.
This important work hardly aroused any interest for many years after its publication,
but with the passage of time, it became the raw material for what became popular as
Modern Portfolio Theory. Markowitz believed that merely looking at the average
return of an investment may not be enough.

What we also need to look at is “variance of return” for different investments, which
tells us how much the actual return has fluctuated over the period. High variance of
return or high volatility means the actual returns over the period may have
fluctuated wildly.

Speculators no doubt like such opportunities where the upside is high, but for
common investors such wild fluctuations or variance of return represents what we
call risk.

So, Markowitz was the one who suggested that it is possible to understand what
exactly risk is. But more than this, it was Markowitz who showed how to think about
risk in terms of numbers. By using past data, it is possible to know in terms of
numbers how much the variance of return is for any particular investment.

Quantifying risk by calculating “standard deviation” or variance of return is just one

step. Markowitz suggested that for actually choosing a diversified portfolio you also
need to calculate the “covariance of return” for different investments.

Now you may be wondering what this covariance of return is. Covariance of return is
also known as correlation of return for different assets. Those who are good at
crunching numbers already know what correlation means. But for the benefit of

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many like you who believe that numbers are our worst enemies I will briefly explain
what it is.

Correlation of return for different assets is expressed as a number lying between +1

and -1. There could be three different scenarios: the correlation could be positive,
negative or zero. If the correlation of return for two assets is positive, then the
returns from the two assets are likely to move in tandem, that is, if the return from
one asset is rising, the return from the other asset would also rise, and if the return
from one asset is falling, the return from the other asset would also fall.

Assets having a negative correlation show just the opposite relationship. When the
return from one asset is rising, the return from the other asset falls. Assets having
zero correlation do not show any relationship. The rise or fall of return from one
asset has no effect on the rise or fall of return from the other asset.

What role does correlation of return from different assets play in the selection of
the right portfolio?

Well, once you know the correlation, you can use it for diversifying your portfolio.
We can summarize the whole process suggested by Markowitz in three steps.

First, you need to find out the expected return from different investments over a
period.

Second, you need to find out how much the return from each investment has varied
from the average over the period. In other words, you need to find out the standard
deviation of return from each investment.

Third, you need to find out the correlation of return for different investments, that is,
how returns from different assets have moved in comparison with each other. Once
you are through with all these calculations, you can use Markowitz’s prescription for
selecting your portfolio—choose the investment that enjoys high expected return
with low standard deviation and also low correlation with other assets in your
portfolio.

The basic idea is that, overall, a portfolio of uncorrelated assets faces less risk than a
portfolio of correlated assets. I hope you now understand why it is so.

Improvement over Markowitz by Sharpe

Sharpe recognized that finding out how the return from asset A is correlated with
that from asset B, or return from asset C is correlated with that from asset B, is a
tiring job. You can go on counting the stars but will never be able to find their exact

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number. Sharpe suggested that instead of using the correlation of return of different
pairs of individual assets, we can use the correlation of return of different assets with
a common index for the whole market. So, if I is the index for the market, you need
to find out how asset A is correlated with I or asset B is correlated with I and so on.
In all cases, I remains common. If A is positively correlated with I, then its return
would rise or fall in tandem with the rise or fall of I, and if A is negatively correlated,
then its return would move in the opposite direction of rise or fall of I.

This greatly reduced the number of calculations required for Markowitz’s original
model and with the advent of faster computers, things became merrier for
professional fund managers and institutional investors who relied on the application
of this model for making allocations for different assets. But common investors, who
are not very computer savvy, have to mainly rely on the services of investment
advisers to utilize this model for selecting a well-diversified portfolio.

Fundamental, technical analyses help investors find winning stocks

Before making any investment decision, all of us need some method of finding out
the next success story. There are two most common methods of analysing securities
—fundamental analysis and technical analysis. These two kinds of analyses greatly
differ from one another. While fundamental analysts try to find the real long-term
worth of securities by looking at financial information such as earnings, assets value
and so on, technical analysts look at the past and present price movements along
with volumes to discover the short-term market trend. Fundamental analysts use
financial statements such as balance sheet, cash flow statement and income
statement whereas technical analysts use charts as well as other technical indicators
like MACD (moving average convergence-divergence), which can help in identifying a
pattern in the price movements.

Technical analysts use three most basic assumptions. Their first assumption is that
prices of securities reflect all known and unknown factors and hence a separate
analysis for finding out their true worth is not necessary. Their second assumption is
that prices are not random but follow a trend over a period of time and their third
and more revolutionary assumption is that past trends in all probability repeat
themselves. So the real art of the technical analyst lies in identifying the exact spot
on a price chart where the prices are likely to either move up or down. Fundamental
analysis on the other hand relies on different assumptions. First of all, fundamental
analysts believe that it is really possible to find out the true worth of a security by
carefully analysing all available financial information along with general
macroeconomic conditions. Second, fundamental analysts believe that in the daily
push and pull of the market, the prices of securities often get out of sync with the
true value of securities. So the aim of fundamental analysis is to identify stocks that

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are either overvalued or undervalued. Fundamental analysts believe that in the long
run, the market price of securities converge with their true value.

Fundamental analysis can only work if you can patiently wait and watch the market
for a couple of years, whereas technical analysis can work if you can take decisions
in a day or hours or even seconds. It seems as if these two approaches are poles
apart. But there is indeed common ground between the two. You can always use the
insight of both the analyses together for making a more balanced decision. If a stock
is undervalued as per fundamental analysis and at the same time undergoing
downward momentum as per technical analysis, then it makes sense to wait before
you buy. Tomorrow, you can buy the same undervalued stock at an even cheaper
price. So, long-term investors can actually increase their gains by using technical
analysis for timing their entry in the market. Short-term investors, on the other
hand, can use fundamental analysis to see whether the short-term trends are due to
some freak momentum or due to fundamental reasons. No doubt, the presence of
fundamental analysis on their side puts the feet of technical analysts on a much
firmer ground.

What are Derivatives

Options, as the term suggests, are a special kind of derivative instrument in which a
purchaser has the option, but not the obligation, of buying or selling the underlying
asset or instrument at a predetermined price, which is also called the strike price.
Options are of two types: put options and call options. Put options give you the right,
but no obligation to sell. Likewise, call options give you the right, but no obligation to
purchase. You can also classify options on the basis of their underlying assets or
instruments. For instance, if the underlying of an option contract is a stock index
such as the Sensex or NSE Nifty, then it is called an index option, and if the
underlying asset is individual equity shares, then it is called a stock option. All these
options, with simple straightforward features such as right to put or call at a strike
price, are also called “plain vanilla” options. You could also have options of a more
“exotic” kind with tailor-made features that are mostly traded privately over the
counter (OTC). For instance, in one type of option called a “chooser option”, or
“preference option”, the purchaser is provided an opportunity to choose whether the
option is for put or call during the period of the option. In fact, there are so many
exotic options that even a lengthy book may not be able to fully describe them.

What about European and American options? Do we have options for different
geographical boundaries, too?

European or American options have nothing to do with geographical boundaries.

Their main difference lies in the time frame during which the option has to be
exercised. A European option can be exercised only at the expiry date or the

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settlement date, whereas an American option can be exercised at any time before
the expiry date. Much can happen between the day you purchase the option and the
day you exercise it. So, American options give you better flexibility in exercising your
rights.

Options give you the right but no obligation. No risk, all gains. Tell me, how is this
possible?

This is possible because somebody else is there to take your risk. But, nothing
comes for free. The purchaser of the option has to pay the seller a premium to
acquire the right to buy or sell the underlying instrument or asset at the strike price.
The seller of the option undertakes the corresponding obligation to sell or buy. The
purchaser of an option can always compel the seller to fulfil his obligation, whereas
the purchaser himself is totally free of any obligation. At the settlement date, the
purchaser can either exercise his option, or let it simply expire. He is not going to
lose anything more than the premium, which he has already paid to the seller of
options. You might have noticed that the purchaser of an option pays a fixed price
but enjoys the possibility of unlimited gains, whereas the seller receives fixed profit
but runs the risk of unlimited loss.

OK! Let’s try to understand how this works by taking an example. Suppose, I
purchase a call option for a stock from you to be exercised at the strike price of
Rs100. I pay you Rs10 as a premium for purchasing the option. Now, take a look at
our respective positions. At the settlement date, I have a right to purchase the
underlying stock at the price of Rs100 from you. I can exercise that right or simply
let it expire. By common sense, I will exercise my right only if the price of the stock
on the settlement date remains higher than the strike price. If the market price is
Rs150 on the settlement date, I can purchase the same stock from you for Rs100 by
exercising my option. The higher the price, the more my profit. In case the price of
the stock falls below the strike price at the settlement date, I simply let the option
expire. In that case, my loss is limited to the Rs10 paid as premium. Now, let’s
consider your position. In your case, the more the prices rise, the more loss you
suffer. But, in case of a fall in price, your profit is limited to whatever premium you
have received. This is what makes you feel like the dumbest guy in the room.

What is NAV

Very well then, let’s try to understand the concept of NAV by taking an example.
Suppose any scheme of a mutual fund initially offers 10 units at a face value of Rs10
each. The total corpus mobilized under the scheme would thus be Rs100. Out of this
Rs100, suppose Rs10 each is invested in 10 different stocks. The value of the
investment of your scheme in 10 different stocks is what we know as the assets of

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your scheme. The present value of your assets depends upon the present market
value of the stocks in which your scheme has invested. Some of the stocks may
trade at a value higher than the purchase price, leading to a rise in your assets,
whereas some of the stocks may trade at a lower value, leading to a loss.

To arrive at the total market value of the assets of the scheme, you multiply the
current market price of a particular stock with the number of units of that stock in
the portfolio. The sum total of the market value of different stock portfolios, along
with any dividend or income received, will give you the total market value of your
assets under a particular scheme. For arriving at the NAV, you deduct the
management fees and other expenses from the total market value of your assets.
This is how you arrive at the NAV of a particular scheme.

Johnny: What do you mean by “management fees” and “other expenses”?

Jinny: Mutual funds employ professional fund managers to look after your
investments. Lots of people, whom you will probably never meet, work day and night
to make your investment grow. All these people expect a reward for doing your job,
which you pay in terms of management fees. Further, mutual funds—like any other
business enterprise—incur expenditures in the form of telephone bills, rent for the
office, and so on. Who will bear these expenses? Mutual funds are running their shop
for your benefit. So, apart from management fees, the mutual funds also charge
other expenses to you. The management fees and other expenses are deducted from
the value of your assets. Further, the funds can also levy an entry fee when you
purchase a scheme or an exit fee when you redeem your investment. The entry fee,
in technical terms, is known as front-end load and the exit fee is known as back-end
load.

what is this front-end load and back-end load all about?

Front-end load is charged at the time of entry to pay the brokerage fee to the agent who
“advised” you to choose that particular mutual fund. Investors think they should not be
the ones to pay the piper. But, mutual funds take the money out of investors’ pockets in
the name of front-end load to pay the bill. Some funds ask you to pay the brokerage at the
time you leave their scheme, which is known as back-end load. The sooner you leave, the
higher you pay. Charging an entry or exit fee discourages non-serious investors. But,
many funds do not charge any front- or back-end load. So you should examine all the
costs and benefits involved before making any investment.

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Volatility index helps gauge market mood and design derivative products

Some people enjoy dancing in the rain but some really hate getting drenched. Some
people enjoy the stock market volatility but some get killed by the same volatility.
Different people view the same thing differently.

Can you tell me what a volatility index is?

Volatility denotes the extent to which the value of our investment may be subject to
the mood of the market over a given period. A volatility index tells us about the
market expectations over the short term, usually a month. It tries to capture the
sentiments of the market—whether the market is in a complacent or anxious mood.
Volatility is what makes our short-term investments look more dangerous than our
long-term investments. John Maynard Keynes famously said that in the long run we
are all dead. But that does not mean that in the short run we are absolutely safe.
Some investors feel that surviving short-term market volatility is more challenging.

Volatile markets can turn upside down, making our whole investment look like a
monkey doing acrobatics. In fact, Keynes himself once said that markets can remain
irrational longer than you can remain solvent. So every now and then, we may see
investors getting caught on the wrong side of market irrationality. A volatility index
captures implied volatility in the market.

Implied volatility draws its conclusions from the present pricing of options and not
from historic volatility figures. It is expressed in terms of a percentage like 20%,
30%, etc. In a range-bound market, where prices are moving gradually, the volatility
index remains low. It is believed that when the volatility index is less than 20%, the
market is in a complacent mood and is not expecting any catastrophe. A low
volatility index is therefore, associated with price rise.

But when the volatility index is greater than 30%, then the market is in the fear
zone. A high volatility index is associated with a fall in market prices. In this manner,
a volatility index helps investors gauge the mood of the market.

what is the India volatility index?

India Vix is the first volatility index launched in India by the National Stock
Exchange. As you might be aware, the Chicago Board of Options Exchange (Cboe)
introduced the first volatility index for the US markets in 1993. Cboe Vix uses the
Standard and Poor’s 500 Index Options for calculating implied volatility, which is
reflected by the changes in pricing of options. India Vix is based on the Nifty 50
Index Option prices. It calculates the percentage of volatility by using a detailed
computational methodology which relies on the best bid and offer price of the Nifty

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50 index call and put options. If you are interested, I can tell you about computation
of volatility index in detail.

what could the other uses of a volatility index be?

Other than gauging the mood of the stock market, a volatility index can also be used
to design derivative products in which the volatility index is used as an underlying.

Investors who are averse to volatility can hedge their portfolio by purchasing
derivative products based on the volatility index. And investors with a good appetite
for volatility can take the risk by selling the same derivatives product. All in all, a
volatility index provides a new game of hedging and trading for market participants.
But how is hedging through volatility index derivatives different from hedging
through single stock or index derivatives? Well, hedging through single stock or
index derivatives is like purchasing a comprehensive insurance which covers many
risks that you may not be even aware of. But a derivative product based on volatility
index keeps its focus narrow—it provides a hedge against only market volatility.

So if the prices of your company’s shares are likely to fall due to poor quarterly
results, then purchasing volatility index derivatives may not protect you. The market
may remain calm even though your own individual portfolio may be performing
badly. This is because a volatility index does not measure the volatility of a single
instrument but uses a wide range of different instruments.

So if the prices of your stocks are likely to fall due to poor market sentiments and
not due to any company-specific reason, then a volatility index derivative may be
your right bet.

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