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Concepts

Just what is securitisation?


July 06, 2005
'Banks will have to unload bad loans to Asset Reconstruction Companies by FY2007' read a
leading business newspaper headline sometime back. A bank selling its bad loans! This might
sound strange, but it has been made possible by securitisation. This article explains the
concept of securitisation and how it can change the banking business in India.
The concept
Securitisation is the process of conversion of existing assets or future cash flows into
marketable securities. In other words, securitisation deals with the conversion of assets,
which are not marketable into marketable ones. For the purpose of distinction, the conversion
of existing assets into marketable securities is known as asset-backed securitisation and the
conversion of future cash flows into marketable securities is known as future-flows
securitisation. Some of the assets that can be securitised are loans like car loans, housing
loans, et cetera and future cash flows like ticket sales, credit card payments, car rentals or any
other form of future receivables. Suppose Mr X wants to open a multiplex and is in need of
funds for the same. To raise funds, Mr X can sell his future cash flows (cash flows arising
from sale of movie tickets and food items in the future) in the form of securities to raise
money. This will benefit investors as they will have a claim over the future cash flows
generated from the multiplex. Mr X will also benefit as loan obligations will be met from
cash flows generated from the multiplex itself.
The process and participants
Section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002, mandates that only banks and financial institutions can securitise
their financial assets. In the traditional lending process, a bank makes a loan, maintaining it
as an asset on its balance sheet, collecting principal and interest, and monitoring whether
there is any deterioration in borrower's creditworthiness. This requires a bank to hold assets
(loans given) till maturity. The funds of the bank are blocked in these loans and to meet its
growing fund requirement a bank has to raise additional funds from the market.
Securitisation is a way of unlocking these blocked funds.
Consider a bank, ABC Bank. The loans given out by this bank are its assets. Thus, the bank
has a pool of these assets on its balance sheet and so the funds of the bank are locked up in
these loans. The bank gives loans to its customers. The customers who have taken a loan
from the ABC bank are known as obligors. To free these blocked funds the assets are
transferred by the originator (the person who holds the assets, ABC Bank in this case) to a
special purpose vehicle (SPV). The SPV is a separate entity formed exclusively for the
facilitation of the securitisation process and providing funds to the originator. The assets

being transferred to the SPV need to be homogenous in terms of the underlying asset,
maturity and risk profile. What this means is that only one type of asset (eg: auto loans) of
similar maturity (eg: 20 to 24 months) will be bundled together for creating the securitised
instrument. The SPV will act as an intermediary which divides the assets of the originator
into marketable securities.
These securities issued by the SPV to the investors and are known as pass-throughcertificates (PTCs).The cash flows (which will include principal repayment, interest and
prepayments received ) received from the obligors are passed onto the investors (investors
who have invested in the PTCs) on a pro rata basis once the service fees has been deducted.
The difference between rate of interest payable by the obligor and return promised to the
investor investing in PTCs is the servicing fee for the SPV. The way the PTCs are structured
the cash flows are unpredictable as there will always be a certain percentage of obligors who
won't pay up and this cannot be known in advance. Though various steps are taken to take
care of this, some amount of risk still remains. The investors can be banks, mutual funds,
other financial institutions, government etc. In India only qualified institutional buyers
(QIBs) who posses the expertise and the financial muscle to invest in securities market are
allowed to invest in PTCs.
Mutual funds, financial institutions (FIs), scheduled commercial banks, insurance companies,
provident funds, pension funds, state industrial development corporations, et cetera fall under
the definition of being a QIB. The reason for the same being that since PTCs are new to the
Indian market only informed big players are capable of taking on the risk that comes with
this type of investment. In order to facilitate a wide distribution of securitised instruments,
evaluation of their quality is of utmost importance. This is carried on by rating the securitised
instrument which will acquaint the investor with the degree of risk involved. The rating
agency rates the securitised instruments on the basis of asset quality, and not on the basis of
rating of the originator. So particular transaction of securitisation can enjoy a credit rating
which is much better than that of the originator. High rated securitised instruments can offer
low risk and higher yields to investors. The low risk of securitised instruments is attributable
to their backing by financial assets and some credit enhancement measures like
insurance/underwriting, guarantee, etc used by the originator.
The administrator or the servicer is appointed to collect the payments from the obligors. The
servicer follows up with the defaulters and uses legal remedies against them. In the case of
ABC bank, the SPV can have a servicer to collect the loan repayment installments from the
people who have taken loan from the bank. Normally the originator carries out this activity.
Once assets are securitised, these assets are removed from the bank's books and the money
generated through securitisation can be used for other profitable uses, like for giving new
loans. For an originator (ABC bank in the example), securitisation is an alternative to
corporate debt or equity for meeting its funding requirements. As the securitised instruments
can have a better credit rating than the company, the originator can get funds from new
investors and additional funds from existing investors at a lower cost than debt.
Impact on banking

Other than freeing up the blocked assets of banks, securitisation can transform banking in
other ways as well. The growth in credit off take of banks has been the second highest in the
last 55 years. But at the same time the incremental credit deposit ratio for the past one-year
has been greater than one. What this means in simple terms is that for every Rs 100 worth of
deposit coming into the system more than Rs 100 is being disbursed as credit. The growth of
credit off take though has not been matched with a growth in deposits. So the question that
arises is, with the deposit inflow being less than the credit outflow, how are the banks
funding this increased credit offtake? Banks essentially have been selling their investments in
government securities. By selling their investments and giving out that money as loans, the
banks have been able to cater to the credit boom.
This form of funding credit growth cannot continue forever, primarily because banks have to
maintain an investment to the tune of 25 per cent of the net bank deposits in statutory
liquidity ratio (SLR) instruments (government and semi government securities). The fact that
they have been selling government paper to fund credit off take means that their investment
in government paper has been declining. Once the banks reach this level of 25 per cent, they
cannot sell any more government securities to generate liquidity. And given the pace of credit
off take, some banks could reach this level very fast. So banks, in order to keep giving credit,
need to ensure that more deposits keep coming in. One way is obviously to increase interest
rates. Another way is Securitisation. Banks can securitise the loans they have given out and
use the money brought in by this to give out more credit.
A K Purwar, Chairman of State Bank of India, in a recent interview to a business daily
remarked that bank might securitise some of its loans to generate funds to keep supporting
the high credit off take instead of raising interest rates. Not only this, securitisation also helps
banks to sell off their bad loans (NPAs or non performing assets) to asset reconstruction
companies (ARCs). ARCs, which are typically publicly/government owned, act as debt
aggregators and are engaged in acquiring bad loans from the banks at a discounted price,
thereby helping banks to focus on core activities. On acquiring bad loans ARCs restructure
them and sell them to other investors as PTCs, thereby freeing the banking system to focus
on normal banking activities.
Asset Reconstruction Company of India Limited (ARCIL) was the first (till date remains the
only ARC) to commence business in India. ICICI Bank, Karur Vyasya Bank, Karnataka
Bank, Citicorp (I) Finance, SBI, IDBI, PNB, HDFC, HDFC Bank and some other banks have
shareholding in ARCIL. A lot of banks have been selling off their NPAs to ARCIL. ICICI
bank- the second largest bank in India, has been the largest seller of bad loans to ARCIL last
year. It sold 134 cases worth Rs.8450 Crore. SBI and IDBI hold second and third positions.
ARCIL is keen to see cash flush foreign funds enter the distressed debt markets to help
deepen it. What is happening right now is that banks and FIs have been selling their NPAs to
ARCIL and the same banks and FIs are picking up the PTCs being issued by ARCIL and thus
helping ARCIL to finance the purchase. A recent report in a business daily quotes , Rajendra
Kakkar, ARCIL's Chief Executive as saying, "We have got a buyer, we have got a seller, it so
happens that the seller is the loan side of the same institutions and buyer is the treasury side."

So the risk from the balance sheet of banks and FIs is not being completely removed as their
investments into PTCs issued by ARCIL will generate returns if and only if ARCIL is able to
affect recovery from defaulters. A recent survey by the Economist magazine on International
Banking, says that securitisation is the way to go for Indian banking. As per the survey,
"What may be more important for the economy is to provide access for the 92% of Indian
businesses that do not use bank finance. That represents an enormous potential market for
both local and foreign banks, but the present structure of the banking system is not suitable
for reaching these businesses. Securitising micro-loans- bundling many loans together and
selling the resulting cash flow- may be the way of achieving economies of scale. One private
bank, ICICI, securitised $4.3 million of micro-loans last year. But most Indian banks are
more interested in competing for affluent customers".
In closing
Securitisation is expected to become more popular in the near future in the banking sector.
Banks are expected to sell off a greater amount of NPAs to ARCIL by 2007, when they have
to shift to Basel-II norms. Blocking too much capital in NPAs can reduce the capital
adequacy of banks and can be a hindrance for banks to meet the Basel-II norms. Thus, banks
will have two options- either to raise more capital or to free capital tied up in NPAs and other
loans through securitisation.
Anubhav Arora is a student at ICFAI Business School, Hyderabad. Vivek Kaul is a freelance
writer.
All you wanted to know about book-building
July 11, 2005
Public issue of common shares is essentially carried out in two ways:
Fixed price method, and
Book-building method.
Fixed price issues are issues in which the issuer is allowed to price the shares as he
wishes. The basis for the price is explained in an offer document through qualitative and
quantitative statements. This offer document is filed with the stock exchanges and the
registrar of companies. Book-building is a process of price discovery used in public
offers. The issuer sets a base price and a band within which the investor is allowed to bid
for shares. Take the recent, Yes Bank IPO, the floor price was Rs 38 and the band was
from Rs 38 to Rs 45.

DON'T MISS: What is securitisation?


All you want to know about bonds
All you want to know about financial options
All you want to know about financial futures

The investor had to bid for a quantity of shares he wished to subscribe to within this
band. The upper price of the band can be a maximum of 1.2 times the floor price.
Every public offer through the book-building process has a book running lead manager
(BRLM), a merchant banker, who manages the issue. Further, an order book, in which the
investors can state the quantity of the stock they are willing to buy, at a price within the
band, is built. Thus the term 'book-building.' An issue through the book-building route
remains open for a period of 3 to 7 days and can be extended by another three days if the
issuer decides to revise the floor price and the band.
Cut-off price
Once the issue period is over and the book has been built, the BRLM along with the
issuer arrives at a cut-off price. The cut-off price is the price discovered by the market. It
is the price at which the shares are issued to the investors. Investors bidding at a price
below the cut-off price are ignored. So those investors who apply at a price higher than
the cut-off price have a higher chance of getting the stock. So the question that arises is:
How is the cut-off price fixed? The cut-off price is arrived at by the method of Dutch
auction. In a Dutch auction the price of an item is lowered, until it gets its first bid and
then the item is sold at that price.
Let's say a company wants to issue one million shares. The floor price for one share of
face value, Rs 10, is Rs 48 and the band is between Rs 48 and Rs 55. At Rs 55, on the
basis of the bids received, the investors are ready to buy 200,000 shares. So the cut-off
price cannot be set at Rs 55 as only 200,000 shares will be sold. So as a next step, the
price is lowered to Rs 54. At Rs 54, investors are ready to buy 400,000 shares. So if the
cut-off price is set at Rs 54, 600,000 shares will be sold. This still leaves 400,000 shares
to be sold. The price is now lowered to Rs 53. At Rs53, investors are ready to buy
400,000 shares. Now if the cut-off price is set at Rs 53, all one million shares will be
sold. Investors who had applied for shares at Rs 55 and Rs 54 will also be issued shares at
Rs 53. The extra money paid by these investors while applying will be returned to them.
Types of investors
There are three kinds of investors in a book-building issue. The retail individual investor
(RII), the non-institutional investor (NII) and the Qualified Institutional Buyers (QIBs).
RII is an investor who applies for stocks for a value of not more than Rs 100,000. Any
bid exceeding this amount is considered in the NII category. NIIs are commonly referred
to as high net-worth individuals. On the other hand QIBs are institutional investors who
posses the expertise and the financial muscle to invest in the securities market. Mutual
funds, financial institutions, scheduled commercial banks, insurance companies,
provident funds, state industrial development corporations, et cetera fall under the
definition of being a QIB.
Each of these categories is allocated a certain percentage of the total issue. The total
allotment to the RII category has to be at least 35% of the total issue. RIIs also have an

option of applying at the cut-off price. This option is not available to other classes of
investors. NIIs are to be given at least 15% of the total issue. And the QIBs are to be
issued not more than 50% of the total issue. Allotment to RIIs and NIIs is made through a
proportionate allotment system. The allotment to the QIBs is at the discretion of the
BRLM. Lately there have been some complaints by the QIBs of BRLMs resorting to
favouritism while allocating shares. The Securities and Exchange Board of India (Sebi) is
in the process of reviewing this mechanism.
Let's suppose, A Ltd, makes an offer for 200,000 shares. The issue is oversubscribed -i.e. there is demand for more shares than the issuer plans to issue. Further, a minimum
allotment of 100 shares is to be made for every investor. The cut-off price has been
decided and now the allotments are to be made. In the RII category, 1,500 applicants have
applied for 100 shares each, i.e. there is a demand for 150,000 shares. A Ltd plans to issue
35% of the total issue to this category, i.e. 70,000 shares. In the NII category, 200
applicants have applied for 500 shares each, i.e. 100,000 shares. A Ltd plans to issue 15%
of the total issue to this category, i.e. 30,000 shares. The cut-off price has already been
decided, so adjusting the quantity remains the only way of reaching the equilibrium.
Applying the proportionate allotment system each investor in the RII category will get
46.67 shares [(70,000/ 150,000) x 100)]. But the minimum allotment has to be 100
shares. So through a lottery, 700 investors are chosen and allotted 100 shares each,
making a total of 70,000 shares. In the NII category every investor will get 150 shares
[(30,000/100,000) x 500)]. And that is how equilibrium is reached.
Green shoe option
In case the issue has been oversubscribed, as was the case with A Ltd, the company has to
exercise a green shoe option to stabilize the post-listing price. When a particular issue is
oversubscribed the appetite of investors for the stock has not been satisfied and once it
gets listed they tend to pick up the stock from the secondary market. Since the demand is
greater than supply the prices tend to rise way beyond what the fundamentals of the stock
would justify. So in order to stabilise the post-issue price of the stock, the issuer has to
issue more shares in case of oversubscription. These shares are taken from the pre-issue
shareholders or promoters and are issued to the investors who have come in through the
public offer on a prorata basis. The green shoe option can be a maximum of 15% of the
public offer.
The author is a freelance writer

All you want to know about bonds


June 28, 2005
Individuals have surplus funds in the form of savings which they want to invest.
Companies need funds to undertake good projects with high returns. Companies provide
individuals with instruments to invest their savings in. One such instrument is corporate
bonds. Similarly, governments also need funds for various developmental projects.
Further, the government also needs to raise money to finance the fiscal deficit. They too
tap the savings by issuing various kinds of bonds.
Characteristics of a bond
A bond, whether issued by a government or a corporation, has a specific maturity date,
which can range from a few days to 20-30 years or even more. Based on the maturity
period, bonds are referred to as bills or short-term bonds and long-term bonds. Bonds
have a fixed face value, which is the amount to be returned to the investor upon maturity
of the bond. During this period, the investors receive a regular payment of interest, semiannually or annually, which is calculated as a certain percentage of the face value and
know as a 'coupon payment.' A story goes that in the old days, bond certificates used to
come with coupons to claim interest from the issuer of the bond; hence, the name coupon
payments. However, nowadays, with paperless issues of scrips (demat), coupons are no
longer in use, but the name has stuck and the interest payments are still known as coupon
payments.
Issuing a bond
The government, public sector units and corporates are the dominant issuers in the bond
market. The central government raises funds through the issue of dated securities
(securities with maturity period ranging from two years to 30 years, long-term) and
treasury bills (securities with maturity periods of 91 or 364 days, short-term). The central
government securities are issued for a minimum amount of Rs 10, 000 (face value).
Thereafter they are issued in multiples of Rs 10,000. They are issued through an auction
carried out by the Reserve Bank of India. State governments go about raising money
through state development loans. Local bodies of various states like municipalities also
tap the bond market from time to time. Bonds are also issued by public sector banks and
PSUs. Corporates on the other hands raise funds by issuing commercial paper (shortterm) and bonds (long-term). Bonds can be issued at par, which means that the price at
which one unit of the bond is being sold is same as the face value. Alternatively, they can
be issued at a discount (less than the face value) or a premium (more than the face value).
For example, a bond with a face value of Rs 100, if issued at Rs 100, is said to be issued
at par. If it is issued at, say, Rs 95, it will be said to have been issued at a discount and
conversely, if issued for, say, Rs 110, at a premium.
Investors

Banks are the largest investors in the bond market. In the low-interest scenario that
prevailed, it made more sense for banks to invest in government bonds than to give out
loans. Mutual funds, in order capitalise on low interest rates, started a good number of
debt funds that mobilised a significant amount of money from the investors. Thus, mutual
funds emerged as important players in the bond markets. However, in the recent past with
the interest rates on their way up, the performance of debt funds has not been good and so
the presence of mutual funds in the bond market has been limited. Foreign institutional
investors are also allowed to invest in the bond market, though within certain limits. Also,
regulations mandate provident funds and pension funds to invest a significant proportion
of their funds mobilised in government securities and PSU bonds. Hence, they continue
to remain large investors in the bond market in India. The same holds true for charitable
institutions, societies and trusts.
Since January 2002, individuals categorised by RBI as retail investors can participate in
the auction carried out by RBI. They can submit bids through banks or primary dealers to
invest in these securities on a non-competitive basis. The minimum bid has to be for an
amount of Rs 10,000 (and there on in multiples of Rs 10,000) and a single bid cannot
exceed Rs 1 crore (Rs 10 million).
Secondary market
Bonds issued by corporates and the Government of India can be traded in the secondary
market. Most of the secondary market trading in government bonds happens on the
negotiated dealing system (an electronic platform provided by the RBI for facilitating
trading in government securities) and the wholesale debt market (WDM) segment of the
National Stock Exchange. Corporate bonds and PSU bonds can also be traded on the
WDM. The secondary market transactions in the bond market for the year 2003-04 was
Rs 27,21,470.6 crore (Rs 272,147.06 billion), an increase of 36.6 per cent over the
previous year. Of this, government securities accounted for 98.4 per cent of the total
turnover. The number of retail trades in the year 2003-04 formed an insignificant 73 per
cent of the total number of trades (189,518) in the secondary market.
Returns from the bond
The return on investment into bonds is in the form of coupon payments, as already
mentioned before, and through capital gains. Capital gain occurs when the bond is bought
at a discount. Bonds bought at a premium would result in capital loss. And bonds bought
at par would have no capital gain or loss. Together, the total return is known as the Yield
from the bond. Let us explain this with the help of an example. Let's say, that an investor
buys one unit of a Long-term bond issued by a Company X Ltd for Rs 95 (i.e at a
discount). The face value of the bond is Rs 100. The coupon is 5 per cent per annum, paid
annually, and the maturity period of the bond is two years. This means, that the investor
will get a payment of Rs 5 every year (calculated as 5 per cent of the face value) and at
the end of the second year, he will receive Rs 100, the face value. The yield on this longterm bond can be calculated by solving for r in the equation below.

95 = 5/(1 + r) + 5/(1 + r)2 + 100/(1 + r)2


We get r=7.8%
If we notice, in the above equation, the coupon payments are fixed, the face value is
fixed; the maturity of the bond is fixed. Hence the yield from the bond effectively
depends on the price of the bond. The price of the bond is determined by the issuer, by
taking the market forces into account. For example, if the price of a similar bond is Rs 94
in the market (all other characteristics being same) no one will be willing to pay Rs 95 for
the bond being issued by company X (assuming similar risk as well). Hence, company X
must ensure that the price, at which they are offering their Bond, is competitive with
similar bonds in the market, and should provide similar yield to the investors.
Interest rate risk
Price and Yield share an inverse relationship. When price is high, yield is lower and when
price is low, yield is higher (As can be seen in the way equation 1 would work). This
brings us to the problem of Interest rate risk faced by bonds. If the government suddenly
decides to raise the prevailing interest rates, the expected yield from bonds held by the
investors would go up. This would result in a drop in the price of the bonds. And if the
investor wants to sell the bond for some reason, instead of holding it till maturity, he will
have to suffer a capital loss. On the contrary, if the interest rates are falling, the price of
the bonds will rise and the investors can sell their bonds at higher prices in the secondary
market than the price at which they bought the bond initially.
The reason for this inverse relationship is that, when interest rates are raised, the newer
bonds issued by the government and the corporates, other investments like fixed deposits,
post office savings schemes, et cetera offer greater return, with more or less the same
kind of risk. So an existing bond becomes less attractive. Investors want to sell off their
existing investment in bonds and switch to other more attractive investments. The selling
pressure in the bond market causes the prices of the bonds to drop. Similarly, when
interest rates are dropped, price of bonds increases due to increase in demand. Over the
last few years the treasury departments of banks in India have been responsible for a
substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest
rates fell, the yield on 10-year government bonds fell, from 13 per cent to 4.9 per cent.
With yields falling, the banks made huge profits on their bond portfolios.
Conclusion
As the reader must have realised by now, bonds are not really a retail investor friendly
type of investment. In our next article we will take a look at what is probably the
friendliest form of investment for the retail investor, the mutual fund.
Nupur Hetamsaria is Visiting Research Scholar, Syracuse University, NY; and Vivek Kaul
is a freelance writer.

All you want to know about financial options


May 23, 2005

Options are the most popular class of derivatives around the world. But, surprisingly,
options are not very popular in India. At present option contracts are available on 108
individual stocks and the Nifty and CNXIT Indices. The index options and stock options
together account for just 12 per cent of the derivatives market segment on National Stock
Exchange. In this article, we will try and explain the trading mechanism of options
contract in a simple manner.
Introduction
Options are contracts which give the holder or the buyer of the contract the right to buy
(Call option) or sell (Put option) the underlying at a certain price (strike or exercise price)
at a certain date (expiry date) or within a certain period in future. (For details, see All you
wanted to know about derivatives). However, the holder is not obligated to buy or sell
the underlying. Thus, an option gives the holder a cushion from any unfavourable price
movements in the underlying and also allows the holder of the contract to take advantage
of any favorable price movements. This flexibility of course comes at a premium. The
buyer of the option is required to pay a premium to the seller of the option in order to
acquire this option.
There are two major types of options. These are American Options and European
Options. American options allow the holder the flexibility to exercise the option at any
time before the expiry. On the other hand, European Options allow the holder to exercise
the option only upon expiry. Needless to say, American Options give more flexibility to
the holder. The underlying in case of financial options can be either an index or the stock
of an individual company. An option contract, whose underlying is the stock of an
individual company, is known as stock option. Similarly, if the underlying is a stock
market index, the contract is known as an Index options contract. On the National Stock
Exchange, the index options are European in nature i.e. they can be exercised only upon
expiry, where as the stock options are American in style, i.e. they can be exercised any
time before the expiry. The seller of the option contract is known as the writer of the
contract. He receives the premium from the buyer, and that is his maximum profit in all
circumstances as we will see later. But the losses can be unlimited for a person who is
writing an option. Lets see understand all this with the help of an example.
Call Options
Let us look at an investor (say, Mr Bull) who believes that the share price of Infosys is
going to rise. So on May 13, 2005, he decides to buy 100 shares of Infosys which are
selling for say Rs 2,040. His investment will be Rs 204,000. The person sells the shares
on May 26, 2005 when the share price is Rs 2,100. The profit for Mr Bull, will be
100*(2,100-2040) = Rs 6,000 on an investment of Rs2,04,000. This implies a return of

2.9 per cent. Now instead, lets say Mr Bull buys Infosys Call options at a premium of Rs
40 per option (100 is the minimum contract size for stock options on NSE, although the
contract size varies from stock to stock) from an investor (say, Mr Bear) who expects the
price of the Infosys stock to fall. The premium paid by Mr Bull to Mr Bear is Rs 4,000
(Rs 40*100).
The Call options give Mr Bull the right to buy 100 shares of Infosys at Rs 2,040 (strike
price) each from Mr Bear, upon expiration on May 26, 2005. The value of the contract
stands at Rs 204,000 (Rs 2040*100). Now, if the price of an Infosys share is Rs 2,100
each (spot price) on the expiry date, the holder of the option contract, i.e. Mr Bull will
exercise his option. Mr Bear will have to hand over 100 shares of Infosys to Mr Bull at
the strike price, i.e. Rs 2,040. Mr Bull can then sell these shares in the market for Rs
2,100 and make a profit of Rs 6,000 (as he makes a profit of Rs 60 per share). But since
all the financial derivative contracts on NSE are settled in cash, no delivery of the
underlying is made.
Hence, the contract will be settled by the seller of the option paying an amount of Rs
6,000 to the buyer of the contract. The Rs 6,000 is calculated as the difference between
the spot and the strike price, multiplied by the number of options. The net profit of the
buyer will be Rs6,000 less the premium paid (Rs 4,000), i.e. Rs 2,000. Mr Bull makes a
profit of Rs2,000 on an investment of Rs 4,000, i.e. return of 50 per cent. Mr Bull, the
buyer of the option will exercise his option in two cases: a) when he makes a profit (As
has been clearly shown in the above example) b) when he can minimize his loss.
Lets say on May 26, 2005 (the expiry date), the spot price of Infosys is Rs 2,070 (instead
of Rs 2,100 in the earlier example). Mr Bull exercises his option. Mr Bear pays Mr Bull
Rs 3,000 [(Rs.2070-Rs.2040)*100]. But Mr Bull has already paid Mr Bear a premium of
Rs 4,000.So he makes a loss of Rs 1,000. But if he had not exercised his option he would
have made a loss of Rs 4,000. So even though he ended up making an overall loss it made
more sense for him to exercise the option. Given this, it always makes sense for the
buyer of the Call option to exercise the option as long as the spot price (on the expiry
date) is greater than the strike price. Since the stock option traded on NSE are American
options, Mr Bull can exercise the option on any day before expiry.
On the other hand, if the spot price of Infosys on the expiry date, is less than the strike
price, lets say Rs 2,000, the investor will not exercise the option and let it expire. In this
case, his maximum loss is Rs 4,000; the amount of premium that he had paid. Thus, the
loss is limited to the premium paid, and gain can be unlimited, depending on how much
greater the spot price of the share on the date of the expiry of the option is vis a vis the
strike price. The position will be reversed for the seller of the option. The seller of the
option is obligated to buy or sell the underlying if the buyer decides to exercise the
option. So the loss for the seller of the option is unlimited (The greater the spot price is
vis a vis the strike price, the greater the loss for the seller of the Call option). Also, the
seller will have to pay an initial margin to the exchange. This is because the seller of the
contract can have unlimited losses.

So to prevent any default from the seller, the exchange takes this margin, which is
refunded upon the expiry of the contract. Just like in the futures contracts, the seller's
account is marked to market (MTM) on a daily basis. The seller is liable to pay to the
exchange on a daily basis any loss due to the change in the price of the contract and
receives any gains. (For details, see All about financial futures).
In the above example, the seller will sell the option for a premium of Rs 4,000. Plus he
will have to pay an initial margin of say 10 per cent of the contract value to the exchange,
which will be Rs 20,400 (10% of Rs 204,000, the value of the contract). This is of course
refunded when the contract expires. On final settlement, the seller will have to pay the
buyer the difference between the exercise price (Rs 2,040) and the market price of the
share(Rs 2,100), multiplied by the number of options (Rs 100), i.e. Rs 6,000 (Rs 60*100).
But, his maximum profit can only be the amount of premium received, i.e. Rs 4,000. In
spite of this, the seller sells the option because he thinks that the price of Infosys will fall
and the buyer will not exercise the option, thus he can easily pocket the Rs 4,000
premium received.
Put Options
Put option is bought by an investor who believes that the share price of a company is
going to fall. The counterparty is a person who believes that the share price of the same
company is going to rise, hence he writes a Put option. The Put option works exactly
opposite to the Call option. The buyer of the Put option will exercise the option if the
share price drops below the exercise price. His profit will be the difference between the
exercise price and the spot price at maturity, less the premium paid for the option. For the
writer of the Put, the maximum profit is once again only the premium received, but the
loss is equal to the difference between the exercise price and the spot price, multiplied by
the number of options. Call options in India are more popular than Put options.
Conclusion
There are various combinations of Options, which are used to make money in different
circumstances. But the fact remains that derivatives in general and options in particular
are fairly risky investments (As our examples have shown). Investors should invest in
them if and only if they have a fairly good understanding of the stock market, the
economy and the instrument itself. Happy investing.
Nupur Hetamsaria is Visiting Research Scholar, Syracuse University, NY; and Vivek Kaul
is a freelance writer.

All you wanted to know about derivatives!


April 19, 2005

'By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of financial derivatives. These instruments
enhance the ability to differentiate risk and allocate it to those investors most able and
willing to take it - a process that has undoubtedly improved national productivity growth
and standards of living.' -- Alan Greenspan, Chairman, Board of Governors of the US
Federal Reserve System.
Understanding Derivatives
The primary objectives of any investor are to maximise returns and minimise risks.
Derivatives are contracts that originated from the need to minimise risk. The word
'derivative' originates from mathematics and refers to a variable, which has been derived
from another variable. Derivatives are so called because they have no value of their own.
They derive their value from the value of some other asset, which is known as the
underlying. For example, a derivative of the shares of Infosys (underlying), will derive its
value from the share price (value) of Infosys. Similarly, a derivative contract on soybean
depends on the price of soybean. Derivatives are specialised contracts which signify an
agreement or an option to buy or sell the underlying asset of the derivate up to a certain
time in the future at a prearranged price, the exercise price.
The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the
date of commencement of the contract. The value of the contract depends on the expiry
period and also on the price of the underlying asset. For example, a farmer fears that the
price of soybean (underlying), when his crop is ready for delivery will be lower than his
cost of production. Let's say the cost of production is Rs 8,000 per ton. In order to
overcome this uncertainty in the selling price of his crop, he enters into a contract
(derivative) with a merchant, who agrees to buy the crop at a certain price (exercise
price), when the crop is ready in three months time (expiry period). In this case, say the
merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative
contract will increase as the price of soybean decreases and vice-a-versa.
If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will
be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the
contract becomes even more valuable. This is because the farmer can sell the soybean he
has produced at Rs .9000 per tonne even though the market price is much less. Thus, the
value of the derivative is dependent on the value of the underlying. If the underlying asset
of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or
for that matter even weather, then the derivative is known as a commodity derivative. If
the underlying is a financial asset like debt instruments, currency, share price index,
equity shares, etc, the derivative is known as a financial derivative. Derivative contracts
can be standardized and traded on the stock exchange. Such derivatives are called

exchange-traded derivatives. Or they can be customised as per the needs of the user by
negotiating with the other party involved.
Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the
example of the farmer above, if he thinks that the total production from his land will be
around 150 quintals, he can either go to a food merchant and enter into a derivatives
contract to sell 150 quintals of soybean in three months time at Rs 9,000 per ton. Or the
farmer can go to a commodities exchange, like the National Commodity and Derivatives
Exchange Limited, and buy a standard contract on soybean. The standard contract on
soybean has a size of 100 quintals. So the farmer will be left with 50 quintals of soybean
uncovered for price fluctuations. However, exchange traded derivatives have some
advantages like low transaction costs and no risk of default by the other party, which may
exceed the cost associated with leaving a part of the production uncovered.
Some of the most basic forms of Derivatives are Futures, Forwards and Options.
Futures and Forwards
As the name suggests, futures are derivative contracts that give the holder the opportunity
to buy or sell the underlying at a pre-specified price some time in the future. They come
in standardized form with fixed expiry time, contract size and price. Forwards are similar
contracts but customisable in terms of contract size, expiry date and price, as per the
needs of the user.
Options
Option contracts give the holder the option to buy or sell the underlying at a pre-specified
price some time in the future. An option to buy the underlying is known as a Call Option.
On the other hand, an option to sell the underlying at a specified price in the future is
known as Put Option. In the case of an option contract, the buyer of the contract is not
obligated to exercise the option contract. Options can be traded on the stock exchange or
on the OTC market.
History of derivatives
The history of derivatives is surprisingly longer than what most people think. Some texts
even find the existence of the characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in incidents that date back
to the ages before Jesus Christ. However, the advent of modern day derivative contracts
is attributed to the need for farmers to protect themselves from any decline in the price of
their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be
traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently
standardised contracts, which made them much like today's futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardised

around 1865. From then on, futures contracts have remained more or less in the same
form, as we know them today. Derivatives have had a long presence in India. The
commodity derivative market has been functioning in India since the nineteenth century
with organized trading in cotton through the establishment of Cotton Trade Association in
1875. Since then contracts on various other commodities have been introduced as well.
Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges.
National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in
December 2003, to provide a platform for commodities trading. The derivatives market in
India has grown exponentially, especially at NSE. Stock Futures are the most highly
traded contracts on NSE accounting for around 55% of the total turnover of derivatives at
NSE, as on April 13, 2005.
Risk Management Tools
Derivatives are powerful risk management tools. To illustrate, lets take the example of an
investor who holds the stocks of Infosys, which are currently trading at Rs 2,096. Infosys
options are traded on the National Stock Exchange of India, which gives the owner the
right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th
June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the
contract would be worthless for the owner and he would lose the money he paid to buy
the option, known as premium. However, the premium is the maximum amount that the
owner of the contract can lose. Hence he has limited his loss. On the other hand, if the
share price of Infosys goes above Rs 2,220, the owner of the call option can exercise the
contract, buy the share at Rs 2,220 and make profits by selling the share at the market
price of Infosys. The upward gain can be unlimited. Say the share price of Infosys zooms
to Rs .3,000 by June 2005, the owner of the call option can buy the shares at Rs 2,220,
the exercise price of the option, and then sell it in the market for Rs 3,000. Making a
profit of Rs 780 less the premium that has been paid. If the premium paid to buy the call
option is say Rs 10, the profit would be Rs 770.
Looking Forward
Derivatives are an innovation that has redefined the financial services industry and it has
assumed a very significant place in the capital markets. However, trading in derivatives is
complicated and risky. The derivatives have been blamed for the loss of fortunes at many
times in history. We will look at derivatives as a vehicle of investment available to
investors, risks and returns associated with them, in our next article.
Nupur Hetamsaria is Visiting Research Scholar, Syracuse University, NY; and Vivek Kaul is a
freelance writer.

All you want to know about financial futures


May 16, 2005

The

Securities
Contract
Regulation Act (SCRA) was amended in December 1999 to include derivatives within the
definition of securities.
The passage of this Act made derivatives legal as long as they were traded on a recognized
stock exchange. Exchange Traded Financial Derivatives were introduced in India, in June
2000, on the National Stock Exchange and the Bombay Stock Exchange.
The beginning was made with index futures contracts based on S&P CNX Nifty Index (Nifty)
and BSE Sensitive Index (Sensex). Since then, the rise in the turnover of derivative contracts
traded on NSE has been exponential (See graph, data source: www.nseindia.com).
It is worth mentioning here that NSE has around 99.5% of the market share of exchange
traded financial derivatives market in India.
Stock futures and Index futures are two of the most popular contracts traded on NSE, having
a market share of 59% and 29% (by turnover) respectively of the total derivatives market
segment. In this article, we will concentrate on the trading mechanism of the futures
contracts.
Trading mechanism of futures contracts
A futures contract gives the holder the right and the obligation to buy or sell the underlying at
a certain price upon maturity. The underlying in case of a financial futures contract can either
be an index or the stock of an individual company.
(For further details refer to our article All you wanted to know about derivatives!)
A futures contract, whose underlying is the stock of an individual company, is known as stock
futures. Similarly, if the underlying is a stock market index, the contract is known as an Index
Futures contract.

Let us understand futures trading with the help of an investor (say, Mr Bull) who is of the
opinion that the stock market will go up in the days to come. He wants to take advantage of
this.
The market is represented by an index. An index constitutes of various stocks from different
sectors that trade in the market. Each stock has a certain weightage in the index and
depending on the movement of these stocks the index moves up or goes down.
To cash in on the rising markets, Mr Bull can invest in stocks that constitute the index in a
proportion that is equivalent to their proportion in the index. However, investing in all the
member companies of the Index will be a very expensive and a time consuming process.
The alternative is to invest in Index futures. So Mr Bull decides to invest in Nifty futures. Let
us say that Nifty is currently at 2,000 mark. Mr Bull gets into a futures contract, expiring on
August 25, 2005, to buy 200 units (The permitted lot size of Nifty futures contracts is 200 and
multiples thereof) of Nifty Index at Rs 2,010.
Let us say that the initial margin that the investor needs to pay is 10%. Thus, the initial
investment is only 10% of 200 times 2,010 (Rs 4.02 lakh, the value of the contract); which is
Rs 40,200.
For any market to work, every buyer needs a seller. So the other side of the coin is an
investor (say Mr Bear), who believes that the market will go down in the days to come. Mr
Bear gets into a futures contract, expiring on August 25, 2005, to sell 200 units of the Nifty
index at Rs 2,010. The seller also has to pay an initial margin of 10%, hence his initial
investment is also 10% of 200 times 2,010; which is Rs 40,200.
Before we go any further, we will need to understand an important feature of futures
contracts, Mark-to-Market (MTM). MTM is a fancy term used for adjusting the value of an
investor's investment on a daily basis.
This means that the difference between the settlement price (the closing price of the futures
contract) of the previous day and the settlement price of today is settled in cash daily. Any
gain or loss made by the investor on a day has to be settled in cash.
Taking the example further, let us look at the table below to see how MTM works:

Table 1: Mark-to-Market (From Mr Bull's perspective)

Day

Daily
Difference to be
Exercise Closing
(paid)/received Notes
Price
Price
of
in cash
Index futures

2010

2000

-10

On the first day,


gain or loss is
calculated as the
difference between
the Exercise Price
and the Settlement
price (The Closing
Price of the futures
contract).
From the second
day onwards, the
gain or loss is
calculated as the
difference between
previous
day's
settlement
price
and
today's
settlement price.

2025

25

2030

2010

Expiration
day

70

On the expiration
date,
the
final
settlement is the
difference between
previous
day's
settlement
price
and the spot price
(Spot Price is the
current market price
of the underlying at

any point in time) of


the underlying. In
this example, the
spot price of the
index is Rs 2,080
on expiration date.

In the above example, on the first day, the settlement price is 2000, so Mr Bull will have to
pay Rs 10 per of contract (Rs 2,000 - Rs 2,010) i.e. a total of Rs 2,000 for 200 contracts to
the exchange.
The exchange in turn passes on this money to Mr Bear, who holds an opposite contract and
thus has made a profit. On the second day of the futures contract, the settlement price is Rs
2,025. So Mr Bull in this case gains Rs 25 (Rs 2,025 Rs 2,000) per contract, i.e. a total of
Rs 5,000 for 200 units of contract.
In this case Mr Bear has to pay Rs 5,000 to exchange which will be passed onto Mr Bull. All
this settlement is done with the help of intermediaries (known as Clearing Members).
In India, all the exchange traded financial derivatives are cash settled. This is because
physical delivery would be highly inconvenient or impossible. For example, in the case of an
index futures contract, physical delivery would mean delivering the shares of the
components of the index, in the weights that it placed on them in calculating the index.
Also, it would involve enormous amount of regulatory and administrative formalities.
Upon the expiration of the contract, a final settlement is made where the investor gets back
his initial margin, along with the gain or loss on the last day.
The gain or loss on the last day is calculated as the difference between the previous day's
settlement price and the spot price of the underlying (in this case the index) in the cash
market.
Now suppose upon the expiry of the contract on August 25th, the index is at the 2,080 mark.
Mr Bull will receive his initial deposit of Rs 40,200 plus the gain on the futures contract. The
gain will be (2,080-2,010)*200 units, i.e. Rs 14,000.
There are some brokerages charges to be paid for trading in futures contracts, which are
2.5% of the contract value. Thus the net gain will be Rs 14,000 less 2.5% of Rs 4,02,000 (Rs
10,050). The profit for Mr Bull will be Rs 3,950 (Rs 14,000 Rs 10,050). The return is 9.8%
on the investment of Rs 40, 200 for Mr Bull.
Now look at Mr Bear. For him, the losses far exceed the gains made my Mr Bull. Mr Bear not
only has to bear a loss of Rs 14,000 due to the movement of index in direction opposite to
his expectations, but he also has to pay the brokerage charges.
The brokerage charges are once again 2.5% of the contract value (which is Rs 10,050).
Hence the total loss for Mr Bear is Rs 24,050 (Rs 14,000 + Rs 10,050). A loss of 59.8% on
an investment of Rs 40,200.

This is the reason why derivatives are considered very risky investments. While there are
opportunities to get higher returns, the losses can far exceed the gains if the strategy goes
wrong.
At present individual stock futures contracts are offered on 87 stocks. Investments in stock
futures contracts work in similar way as the index futures.
Conclusion
In this article, we have tried to look at exchange traded financial futures contracts as a tool of
investment. The popularity of futures contracts in India is contrary to the trend in other parts
of the world, where option contracts are more popular than the futures contracts.
We think that one reason behind options not picking up in India could be because options
are more complicated to trade in. With this in mind, we will devote our next article to
simplifying options trading for our readers.
DON'T MISS:

All about commodity derivatives


FMPs and how to save tax
A guide to right investment

Nupur Hetamsaria is Visiting Research Scholar, Syracuse University, NY; and Vivek Kaul is a
freelance writer.

All about commodity derivatives


May 05, 2005

Trading in derivatives first started to protect farmers from the risk of the value of their crop
going below the cost price of their produce. Derivative contracts were offered on various
agricultural products like cotton, rice, coffee, wheat, pepper, et cetera.
The first organised exchange, the Chicago Board of Trade (CBOT) -- with standardised
contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce
Exchange -- which is now known as Chicago Mercantile Exchange -- was formed (CME).
CBOT and CME are two of the largest commodity derivatives exchanges in the world.
The Indian scenario
Commodity derivatives have had a long and a chequered presence in India. The commodity
derivative market has been functioning in India since the nineteenth century with organised
trading in cotton through the establishment of Cotton Trade Association in 1875. Over the
years, there have been various bans, suspensions and regulatory dogmas on various
contracts.

There are 25 commodity derivative exchanges in India as of now and derivative contracts on
nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs
5 lakh crore (Rs 5 trillion) by the end of 2004-2005.
National Commodity and Derivatives Exchange (NCDEX) is the largest commodity
derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight.
It is only in the last decade that commodity derivatives exchanges have been actively
encouraged. But, the markets have suffered from poor liquidity and have not grown to any
significant level, till recently.
However, in the year 2003, four national commodity exchanges became operational;
National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT),
National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange
(MCX).
The onset of these exchanges and the introduction of futures contracts on new commodities
by the Forwards Market Commission have triggered significant levels of trade. Now the
commodities futures trading in India is all set to match the volumes on the capital markets.
Investing in commodity derivatives
Commodity derivatives, which were traditionally developed for risk management purposes,
are now growing in popularity as an investment tool. Most of the trading in the commodity
derivatives market is being done by people who have no need for the commodity itself.
They just speculate on the direction of the price of these commodities, hoping to make
money if the price moves in their favour.
The commodity derivatives market is a direct way to invest in commodities rather than
investing in the companies that trade in those commodities.
For example, an investor can invest directly in a steel derivative rather than investing in the
shares of Tata Steel. It is easier to forecast the price of commodities based on their demand
and supply forecasts as compared to forecasting the price of the shares of a company -which depend on many other factors than just the demand -- and supply of the products they
manufacture and sell or trade in.
Also, derivatives are much cheaper to trade in as only a small sum of money is required to
buy a derivative contract.
Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the
prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on
his investment, which is 3.4%. Compare this to the scenario if the investor had decided to
buy soybean futures instead.
Before we look into how investment in a derivative contract works, we must familiarise
ourselves with the buyer and the seller of a derivative contract. A buyer of a derivative
contract is a person who pays an initial margin to buy the right to buy or sell a commodity at
a certain price and a certain date in the future.

On the other hand, the seller accepts the margin and agrees to fulfil the agreed terms of the
contract by buying or selling the commodity at the agreed price on the maturity date of the
contract.
Now let us say the investor buys soybean futures contract to buy one tonne of soybean for
Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial
margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here.
On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price
-- Spot Price is the current market price of the commodity at any point in time).
The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell
it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs
870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end
up making a loss of 34.5%.
If the investor wants, instead of taking the delivery of the commodity upon maturity of the
contract, an option to settle the contract in cash also exists. Cash settlement comprises
exchange of the difference in the spot price of the commodity and the exercise price as per
the futures contract.
At present, the option of cash settlement lies only with the seller of the contract. If the seller
decides to make or take delivery upon maturity, the buyer of the contract has to fulfil his
obligation by either taking or making delivery of the commodity, depending on the
specifications of the contract.
In the above example, if the seller decides to go for cash settlement, the contract can be
settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of
the commodity and the exercise price. Once again, the return on the investment of Rs 870 is
34.5%.
The above example shows that with very little investment, the commodity futures market
offers scope to make big bucks. However, trading in derivatives is highly risky because just
as there are high returns to be earned if prices move in favour of the investors, an
unfavourable move results in huge losses.
The most critical function in a commodity derivatives exchange is the settlement and clearing
of trades. Commodity derivatives can involve the exchange of funds and goods. The
exchanges have a separate body to handle all the settlements, known as the clearing house.
For example, the seller of a futures contract to buy soybean might choose to take delivery of
soyabean rather than closing his position before maturity. The function of the clearing house
or clearing organisation, in such a case, is to take care of possible problems of default by the
other party involved by standardising and simplifying transaction processing between
participants and the organisation.
In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of
work in terms of policy liberalisation, setting up the right legal system, creating the necessary
infrastructure, large-scale training programs, et cetera still needs to be done in order to catch
up with the developed commodity derivative markets.

Also, trading in commodity options is prohibited in India. The regulators should look towards
introducing new contracts in the Indian market in order to provide the investors with choice,
plus provide the farmers and commodity traders with more tools to hedge their risks.
Nupur Hetamsaria is Visiting Research Scholar, Syracuse University, NY, and Vivek Kaul is a
freelance writer
DON'T MISS!

A Guide to right investment


All you wanted to know about derivatives

A guide to right investment


April 13, 2005

What would you prefer: Rs 10,000 right now or Rs 10,000 five years from now?
Common sense tells us that we should take Rs 10,000 today because we know that there is
a certain time value of money. The Rs 10,000 received now provides us with an opportunity
to put it to work immediately and earn a certain return on it.
A single rupee today is worth more than a single rupee a few years down the line. Given this,
households that have surplus funds in the form of savings want to invest those funds so that
the value of the funds over the years does not go down.
There are various forms of investments at the disposal of individuals. These include real
assets like a house, a car, a television, or financial assets like stocks in companies, bonds,
units of funds, et cetera.
Traditionally, term deposits in banks, post office savings schemes, bonds and common
stocks are the most accessible forms of investments available to the investors. Term
deposits, post office savings schemes and bonds give a fixed return over a period of time.
Risk and Return
Investors would typically want to invest in an asset, which gives them maximum return on
their investment. However, life is not as simple as that. Different assets come with different
risk profiles.
Risk in a practical way can be defined as the chance that the expected outcome may not
happen and the actual outcome may not be as good as the expected outcome.
For example, the risk of driving a vehicle too fast may lead the driver getting a speeding
ticket or it might even lead to an accident. The New Oxford Dictionary of English defines risk
as 'a situation involving exposure to danger.' Thus risk is always looked at in negative terms.
In case of investments the definition of risk is much broader. Risk in case of investment can
be defined as the likelihood that the investor will receive a return on his investment that is
different from the return he expects to make.
So risk not only includes bad outcomes when the returns are lower than what was expected,
but it also includes good outcomes when returns are more than expected.
When investors are making an investment they expect to earn a certain return over the
period the investment is made. But their actual returns may be different from the expected
return and this is the source of risk.
For example, an investor invests a certain amount in a fixed deposit for a period of one year
and expects a return of 5% (i.e. the interest on a one year fixed deposit that the bank gives is

5%). At the end of one year when the investment matures the investor will get a return 5%.
So this is a risk less investment.
Instead of investing in the fixed deposit, the investor decides to invest the same amount of
money in a particular stock. The investor having done his research expects say a return of
25% in one year's time (dividend and capital gains).
The actual return over this period might turn out to be greater than 25% or lesser. The
company may not pay the dividend on time or the price of the stock may not rise as much as
was expected. Herein he carries the risk. The actual return is not guaranteed.
The figure 1 below shows the returns analysis of BSE Sensex over a period of 9 years, from
1997 to 2005. We can clearly see that the returns have varied from a negative 21% to
positive 73% over these years. On the other hand, the returns on treasury bills (Treasury bills
are securities with maturity period of less than or equal to one year. Issued by the
government) just varied from about 13% to around 5% in 2004 (See figure 2).
Figure 1: Returns of BSE Sensex over 9 years

Source: The graph has been compiled from yearly closing price data on www.bseindia.com (The
returns for 2005 is up to April 8th, 2005)

Figure 2: Returns of Government of India Treasury Bills over 9 years

Source: The graph has been compiled from the Bloomberg Data Terminal using Government of
India Treasury Bills Index (The returns for 2005 is up to April 8th, 2005)

So, treasury bills give a fixed return over a period of time but common stocks do not. So,
investors demand a premium from the common stocks for taking on extra risk.
In India, the investors on an average demand a premium of around 10.5% above the risk
free rate. The risk free rate is generally taken to be the rate of return on treasury bills, as they
are considered virtually risk free.
Common stocks are riskier because of various reasons. For one, the companies are not
obligated to pay a dividend to the common stock holders, and secondly, in the case of
liquidation, shareholders are the last to get paid after all the other security holders have been
paid.
Thus the decision to invest in an asset with maximum return becomes difficult, as high
returns come with high risk. The task of investment becomes formidable for the investors
who must balance the returns from and risk involved in an asset.
Alternative investments
A major part of the household savings gets channeled into the so called traditional
investments like fixed deposits (FDs), post office saving schemes, Public Provident Fund
(PPF), etc.
But since the mid-90s interest rates have come down considerably and investments like FDs
have been giving lesser return than the existing rate of inflation, or just a few basis points
above the rate of inflation.
For example, the current inflation rate prevailing in India is around 5.1%, whereas the largest
bank of India, the State Bank of India offers a return of 5.00% on deposits for more than 182
days but less than 1 year.

The rate for deposits of more than 1 year but less than 3 years is 5.5%. Another
disadvantage with such forms of investment is that the lock in period is considerably high.
However, many other forms of investments are available to investors. Exchange traded
funds, derivatives, real estate, gold, art, are just a few of the alternatives. With the spread of
technology, investing in some of these alternative investments has become comparatively
easier than before.
These investments are also good means of diversification. Diversification refers to the act of
reducing risk by spreading the total investment across many different investments.
The idea of diversification is very old. It has even been mentioned by Shakespeare as early
as the 16th century in his one of the most celebrated plays, The Merchant of Venice:
'My Ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year;
Therefore, my merchandise makes me not sad.'
-- Antonio in Merchant of Venice, Act I, Scene 1
This shows that merchants did realise the importance of not putting all their eggs in one
basket early on.
Conclusion
Diversification and investment in alternative forms of investments have become more
important in recent times when the stock markets have proven to be more volatile and the
government bonds are barely able to match the inflation rate.
Investors are looking to put their money in assets which give decent returns even if the stock
markets are tumbling. For example, the value of a piece of art may rise if the inflation is on
the rise irrespective of the performance of stock markets.Similarly, gold does well in time of
global tension. In this way, even if the investor loses money in the stock market, it is offset by
the gains in his alternative investments. A lot of these alternative investments have
consistently given a higher return than the traditional investment securities.
For example, the real estate investments in the National Capital Region of Delhi have
consistently provided a return of more than 10% over the last three years, in both the
commercial and residential segments.This is much more than the 5-6% return provided by
government bonds and fixed deposits. At the same time, the returns are not as volatile as
that witnessed in the stock markets.But many of these investment types still remain a
mystery to the investors. This is a first in a series of articles through which we hope to
explain the nature of various forms of such alternative investments that are available to the
investors.
Vivek Kaul is Research Scholar, ICFAI, and Nupur Hetamsaria is Visiting Research Scholar,
Syracuse University, NY.