Stock market is a place where

shares of pubic listed companies

are traded. A stock exchange
facilitates stock brokers to trade
company stocks and other
securities. ... A stock may be
bought or sold only if it is listed on
an exchange.

Introducation
to stock
market

KARTHIKEYAN
Copyright © 2020 Karthikeyan

This book is sold subject to the condition that it shall not, by way of trade
or otherwise, be lent, resold, hired out, or otherwise circulated without the
publisher's prior written consent in any form of binding or cover other than
that in which it is published and without a similar condition including this
condition being imposed on the subsequent purchaser and without limiting
the rights under copyright reserved above, no part of this publication may
be reproduced, stored in or introduced into a retrieval system, or transmitted
in any form or by any means (electronic, mechanical, photocopying,
recording or otherwise), without the prior written permission of both the
copyright owner and the publisher of this book.

All rights reserved.

ISBN: 9798586020017

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TABLE OF CONTENTS
CHAPTER 1: CORE CONCEPTS ........................................................................ 5
➢ What is Risk Return Analysis? .................................................................. 5
➢ What are Investment vehicles? .................................................................. 7
➢ Pitfalls to avoid .......................................................................................... 7
➢ Financial planning ...................................................................................... 9
➢ Insurance & Annuity ................................................................................ 10
➢ Tax Implications ...................................................................................... 11
➢ What is risk management? ....................................................................... 13
➢ Hedging .................................................................................................... 14
➢ Stop loss ................................................................................................... 15
➢ Private equity ........................................................................................... 17
CHAPTER 2: EQUITY CONCEPTS .................................................................. 18
➢ How stock market works? ........................................................................ 18
➢ How are shares traded? ............................................................................ 19
➢ What is Nifty and Sensex? ....................................................................... 21
➢ What are stocks? ...................................................................................... 22
➢ What makes stock price to change? ......................................................... 22
➢ How to do buying and selling of stocks? ................................................. 23
➢ Demat ....................................................................................................... 24
➢ Dematerialization ..................................................................................... 25
➢ Insider Trading ......................................................................................... 29
➢ Corporate Actions .................................................................................... 29
➢ IPO’s ........................................................................................................ 38
➢ Securities lending – Going short .............................................................. 41
CHAPTER 3: MUTUAL FUND CONCEPTS .................................................... 42
➢ What are mutual funds? ........................................................................... 42
➢ Mutual Funds: Structure In India ............................................................. 42
➢ Advantages Of Investing In MFs? ........................................................... 45

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 ➢ Disadvantages of investing in mutual funds ............................................ 47
➢ Types of mutual funds.............................................................................. 50
➢ Growth and dividend options ................................................................... 59
➢ Payout and reinvestment plans ................................................................. 59
➢ Systematic Investment Plan(SIP) ............................................................. 60
➢ Systematic Transfer Plan: ........................................................................ 61
➢ Systematic withdrawal plan(SWP) .......................................................... 62
➢ What is the concept of NAV in mutual funds? ........................................ 62
➢ How is NAV calculated?.......................................................................... 63
➢ How does NAV help investors? ............................................................... 64
➢ Returns in a mutual fund .......................................................................... 64
➢ Cost involved in MF investing ................................................................. 65
➢ What is new fund offer? ........................................................................... 66
➢ Taxation of mutual funds ......................................................................... 66
➢ When to sell your funds? ......................................................................... 68
➢ How to select a fund? ............................................................................... 69
➢ How to read fact sheets? .......................................................................... 78
➢ Portfolio management .............................................................................. 81
CHAPTER 4: ASSET ALLOCATIONS ............................................................. 84
➢ Types of asset classes............................................................................... 84
➢ Risk profiling ........................................................................................... 85
CHAPTER 5: TECHNICAL ANALYSIS ........................................................... 87
➢ Critics of Technical analysis .................................................................... 87
➢ Importance of support and resistance....................................................... 89
➢ Interpreting volumes on a chart ............................................................... 89
➢ Golden Mean Ratio .................................................................................. 90
➢ Importance of charts ................................................................................ 91
➢ Fibonacci Retracements ........................................................................... 91
CHAPTER 6: DERIVATIVES CONCEPTS ...................................................... 93

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 ➢ Types of derivative .................................................................................. 93
➢ What are derivatives................................................................................. 98
➢ How do derivatives work? ....................................................................... 98
➢ Applications of financial derivatives ....................................................... 98
➢ Potential pitfalls of derivatives ................................................................ 99
CHAPTER 7: FUTURES & OPTIONS............................................................. 101
➢ F&O Important terminologies ................................................................ 101
➢ Synthetic short call ................................................................................. 105
➢ Long put ................................................................................................. 106
➢ Short put ................................................................................................. 107
➢ Bull call spread ...................................................................................... 108
➢ Bull put spread ....................................................................................... 109
➢ Bear put spread ...................................................................................... 110
➢ Bear call spread ...................................................................................... 110
➢ Long straddle ......................................................................................... 111
➢ Short straddle ......................................................................................... 112
➢ Long Strangle ......................................................................................... 114
➢ Short Strangle......................................................................................... 116
➢ Future & Forward contract ..................................................................... 118
➢ Moneyness of an option ......................................................................... 122
➢ Types of margins levied in the Futures & Options(F&O) trading ......... 123

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CHAPTER 1: CORE CONCEPTS

➢ What is Risk Return Analysis?

The concept of risk-return analysis is integral to the process of investing
and finance. All financial decisions involve risks of varying degrees. You
may expect to earn returns at 15% per annum, from an asset class like
equity, but the risk of not achieving that will always be there.

Return is simply a reward for shouldering risks

related to investment - greater the risk, more the
returns. Returns are measured by how much investors'
money has grown over the investment period across
asset classes such as equities, ETFs, mutual funds,
bonds and corporate FDs. While you cannot gauge
returns in advance, you can make an educated guess
on the kind of returns that you expect.
Most investment expectations depend on what has happened in the past.
Unfortunately, history doesn’t always repeat itself! Haven't we all seen the
highs of 2007, followed by the lows in 2008?

Even if you are reasonable in your investment expectations for returns,

there is the possibility that actual investing returns turn out different than
expected. You certainly run the risk of losing some or all of your original
investment.

Why is that? It is because of an uncertain future (e.g., the global economic

environment), and uncertainty over the quality and stability of
investments. In general, greater the uncertainty, more the risk. Some
familiar sources of uncertainty (or risks) that we must absorb, while
making investments are:

Business and Industry Risk

There might be an industry-wide slowdown or even a global economic

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recession as we are experiencing now. That presents an uncertain future
for any business. A company might see its earnings drop significantly due
to management ineptitude or wrong decisions. A drop in earnings may
cause the company's stock prices to fall, resulting in investment losses for
investors.

Inflation Risk
The money you earn today is always worth more than the same amount of
money at a future date. This is because goods and services usually cost
more in the future due to inflation. So, your investment return must beat
the inflation rate.

If it merely keeps pace with inflation, then your investment return is not
worth much. We have seen inflation soaring up to 11% in 2008. Now, in
2019, it’s at 1-2%. Perhaps, an average inflation rate over the next ten
years may work out at 5-6%. There's enough uncertainty here too.

Market Risk
Market risk is about the uncertainty faced in the stock market, which
primarily invests in equities. Several macro and micro-economic details -
singularly or plurally - can spook the equity market. We have seen how
the massive mandate in elections has re-invigorated the market. On the
other hand, a fragmented hung parliament may have caused the market to
nosedive.

Even for a well-managed business growing profitably, its equity stock

may drop in value simply because the overall stock market has fallen.

Liquidity Risk
Sometimes you are not able to get out of your investment conveniently
and at a reasonable price. For example, in 2008, you may have found it
tough to sell your house at a price you wanted. In 2007, however, it was a
breeze to have your home sold.

There can be a phase when the equity market is merely inactive or volatile
to keep investors away. It means you can't sell your investment or get the
price you want if you needed to sell it immediately.

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 ➢ What are Investment vehicles?

An investment vehicle is a product that investors use to generate positive

returns.

Investment vehicles can be low-risk (fixed deposits

and bonds) or carry a higher degree of risk as is the
case with equity shares, equity derivatives, options,
and futures.
There are a wide variety of investment vehicles, and many investors
choose to hold several types of investment vehicles in their portfolios.
This can enable diversification while minimizing risk.

➢ Pitfalls to avoid
Successful investors learn to avoid the common pitfalls and follow those
insights that can put them well on their way to becoming a better investor.

Buying Low-Priced Stock

What sounds better? Buying 1,000 equity shares of Rs.1 each or buying 20
equity shares at Rs.50 each? Most would probably vouch for the former,
considering it looks like a bargain as the opportunity for profits increases
from owning more equity shares.

In reality, the money you make does not depend on how many equity
shares you own. Instead, it depends on the amount of money invested.

Many investors have a love affair with cheap stocks, but low-priced stocks
generally miss a crucial ingredient of past stock market winners:
institutional sponsorship.

Stocks can't make significant gains without the buying power of mutual
funds, banks, insurance companies, and other deep-pocketed investors
fuelling their price moves. It's not retail trades of 100, 200, or 300 equity
shares that cause a stock to surge higher in price.

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Institutional investors account for about 70% of the trading volume each
day on the exchanges -- so it's a good idea to fish in the same pond as they
do. Stocks priced at Rs.10, Rs.20 or Rs.30 per share are not on the radar of
institutional investors. Many of these stocks are thinly-traded, so it's hard
for mutual funds to buy and sell big volume equity shares.

Remember: Cheap stocks are cheap for a reason. Stocks sell for what
they’re worth. In many cases, investors who try to grab cheap stocks don’t
realize that they're buying a company marred with no institutional
sponsorship, slow earnings and sales growth, and a shrinking market
share. These are negative traits for a stock to have.

Institutions have research teams that seek great opportunities. Since they
buy in vast quantities over time, consider piggybacking their choices if
you find that these fund managers have better-than-average performance.

The reality is that your prospect of doubling your money in Re.1 stock
sounds good, but your chances are better of winning the lottery. Hence,
focus on institutional-quality stocks.

Avoiding Stocks With High P/E Ratios

"Focus on stocks with low P/E ratios. They're attractively valued, and
there’s a lot of upsides." How many times have you heard this statement
from investment pros?

While it's true that stocks with low P/E ratios can go higher, investors
often misuse this valuation metric. Leaders in an industry group often
trade at a higher premium than their peers for a simple reason: they're
expanding their market share faster because of outstanding earnings and
sales growth prospects.

Stocks on your watch list should have traits of significant stock market
winners from the past: leaders in their industry group, top-notch earnings
and sales growth, and rising fund ownership - to name a few. A dynamic
new product or service doesn't hurt either.

Stocks with ‘high’ P/E ratios share a common trait: their performance
shows there's plenty of bullishness about the company's prospects.

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Letting Small Losses Turn Into Big Ones
Insurance policies help us minimize risk when it comes to our health,
home or car. In the stock market, most people don't even think about
buying insurance policies with individual stocks. However, it's a good
practice.

Averaging Down
Averaging down means you're buying stock as the price falls in the hope
of getting a bargain in the stock market. It's also known as throwing good
money after bad or trying to catch a falling knife. Either way, trying to
lower your average cost in a stock is another risky proposition.

Buying Stocks In A Down Market

Some investors don't pay any attention to the current state of the market
when they buy stocks and equity shares, and it’s a mistake. The goal is to
buy equity shares and stocks when the major indexes are showing signs of
accumulation and to sell when they're showing signs of distribution.

Three-fourth of all stocks follow the stock market's trend, watch it each
day, and don't go against the trend. It's not hard to tell when the indexes
start to show signs of duress.

Distribution days will start to crop up in the stock market where the
indexes close lower on heavier volume than the day before. In this case, a
strong stock market opening will fizzle into weak closes. And leading
stocks in the stock market's leading industry groups will start to sell off on
heavy volume. When you're buying stocks, make sure you're swimming
with the market tide, not against it.

➢ Financial planning
Financial planning is the task of determining how a business will afford to
achieve its strategic goals and objectives through prudent investments in
equity shares, mutual funds and ETFs, among others. Usually, a company
creates a financial plan immediately after the vision and objectives have
been set.

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Tasks involved in financial planning:
- Assess the business environment
- Confirm the business vision and objectives
- Identify the types of resources needed to achieve these objectives
- Quantify the amount of resource (labor, equipment, materials)
- Calculate the total cost of each type of resource
- Summarize the costs to create a budget
- Identify any risks and issues with the budget set

Financial planning is critical to the success of any organization. It provides

the business plan with rigor, by confirming that the objectives set are
achievable from a financial point of view. It also helps the CEO to set
financial targets for the organization, and reward staff for meeting
objectives within the budget set.

➢ Insurance & Annuity

A promise of compensation for specific potential future losses in exchange
for a periodic payment. Insurance is designed to protect the financial well-
being of an individual, company or other entity in the case of unexpected
loss. Some forms of insurance are required by law, while others are
optional. Agreeing to the terms of an insurance policy creates a contract
between the insured and the insurer. In exchange for payments from the
insured (called premiums), the insurer agrees to pay the policyholder a
sum of money upon the occurrence of a specific event. In most cases, the
policyholder pays part of the loss (called the deductible), and the insurer
pays the rest. Examples include car insurance, health insurance, disability
insurance, life insurance, and business insurance.

What is an annuity?
An annuity is a long-term, interest-paying contract offered through an
insurance company or financial institution. An annuity can be ‘deferred’
as a means of accumulating income while deferring taxes, or be
"immediate", meaning it pays you income now at fixed or variable interest
rates as long as you are living. You can contact your insurance agent for
details on current rates.

The Opposite of Life Insurance

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Annuities are sometimes described as the opposite of life insurance. While
they protect you from living too long, life insurance protects you from
dying too soon. With an annuity, you are paid as long as you live, but with
a life insurance policy, you are paid when you die. With an annuity, the
financial risk of living too long is transferred to the insurance company.

A Lifetime Income
With the average retirement period lengthening, annuities are gaining
importance. Only an annuity can pay you an income you can't outlive,
even after all the money you put into the annuity has been exhausted.

Therefore, annuities can help you manage your cash flow and provide a
safe and competitive means to accumulate funds.

➢ Tax Implications

When it’s stated that an investment may have tax

implications, it means that it may affect the tax you
pay.
It's generally used in reference to your federal income tax return filed with
the IRS (& state tax return if your state has an income tax). If receiving a
prize has tax implications, it would likely mean that you need to report the
income on your federal tax return.

Tax Implications of Stock Options

As with any investment, it's considered income. The government levies a
tax on income. How much tax you'll ultimately pay and when you'll pay
them will vary depending on the type of stock options you're offered, and
the rules associated with those options.

There are two basic types of stock options. An incentive stock option
(ISO) offers preferential tax treatment and must adhere to special
conditions set forth by the Internal Revenue Service. This type of stock
option allows employees to avoid paying taxes on the stock they own until
the equity shares are sold.

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When the stock is ultimately sold, short or long-term capital gains taxes
are paid based on the gains earned (the difference between the selling
price and the purchase price).

This tax rate tends to be lower than traditional income tax rates. The long-
term capital gains tax is 10 percent and applies if you sell the equity share
after a year of holding with gains above Rs. 1 lakh. The short-term capital
gains are added to your income and taxed as per the existing income tax
rates.

Nonqualified stock options

NQSOs don't receive preferential tax treatment. Thus, when you purchase
stock (by exercising options), you will pay the regular income tax rate on
the spread between what was paid for the stock and the market price at the
time of exercise.

Employers, however, benefit because they are able to claim a tax

deduction when employees exercise their options. For this reason,
employers often extend NQSOs to employees who are not executives.

Other types of options and stock plans

In addition to the options discussed above, some public companies also
offer Employee Stock Purchase Plans (ESPPs) under Section 423 of the
tax code. It permits the employees to purchase company’s stocks at a
discounted price (up to 15 percent) and receive preferential tax treatment
on the profits earned when the stock is sold later.

Many companies also offer stocks as a part of 401(k) retirement plan. This
plan allows the employees to set aside some money for their retirement
and they’re not taxed on this income until their retirement. Some
employers offer an added perk of matching the employee's contribution to
the 401(k) plan with the company stocks.

Special tax considerations for people with large

gains
The Alternative Minimum Tax (AMT) may apply in cases where an
employee makes large gains from incentive stock options. You should
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consult your personal financial advisor to
know if this tax is applicable to you or not.

➢ What is risk management?

Basically, risk management is the process of identification, analysis and,
either acceptance or mitigation of uncertainty about the investments.

Essentially, risk management occurs anytime an

investor or fund manager analyses and attempts to
quantify the potential for losses in an investment. This
enables the investor to take an appropriate action (or
inaction) based on the investment objectives and risk
tolerance.

Inadequate risk management can result in severe consequences for

companies as well as individuals. For example, the recession of 2008 was
largely caused by loose credit risk management of financial firms.

In simpler words, risk management is a two-step process - determining the

risks in an investment and then handling those risks in a way best-suited to
your investment objectives.

Ideally, risk management is done on a prioritization basis, wherein the

risks with the potential of a bigger loss (or impact) are handled first and
risks with lower probability of occurrence (or that can cause a lesser
damage) are handled thereafter.

Intangible risk management

Intangible risk management identifies the risks that have a 100%
probability of occurring but is ignored by the organization till now.
Consider these few examples:

1. When deficient knowledge is applied to a situation, a knowledge risk materializes

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2. Relationship risk appears when ineffective collaboration occurs

3. Process-engagement risk may be an issue when ineffective operational procedures

are applied

These risks can reduce the productivity of workers and hence decrease
cost effectiveness, profitability, service, quality, reputation, and brand
value. Intangible risk management allows the risk management team to
create immediate value by identifying and reducing the chances of such
risks that can reduce the organisation’s productivity.

Methods of risk management:

Usually, methods of risk management consist of some elements which are,
more or less, performed in the following order:

1. Identify, characterize, and assess threats

2. Assess the vulnerability of critical assets to specific threats
3. Determine the risk (i.e. the expected consequences of specific types of attacks on
specific assets)
4. Identify ways to reduce those risks
5. Prioritize risk reduction measures based on a strategy

➢ Hedging
Hedging is the process that is used to reduce the risk of incurring losses
due to negative outcomes within the stock market.

It is a concept similar to home insurance, wherein you

can protect your assets against negative outcomes like
fire and burglary, by purchasing an insurance policy.
The only difference with hedging is that you are insuring your stocks
against market risks, and you are never fully compensated for your loss.

Hedging is most useful under the following

circumstances:

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1. If you have commodity investment that is subject to price movements, you can use
hedging as a risk management technique

2. It helps set a price level for purchase or sale of an asset prior to the transaction.

3. Hedging will also allow you to make profits from any upward price fluctuations
and protect your investments from downward price movements.

➢ Stop loss
Stop loss is an order of buying or selling shares, once its price rises above
(or drops below) a specified stop loss price. When the specified stop loss
price is reached, the stop loss order is entered as a market order (no limit)
or a limit order (fixed or pre-determined price).

With a stop loss order, the trader does not have to

actively monitor how a stock is performing. However,
since the order is triggered automatically when the
specified price is reached, the stop loss price could be
activated by a short-term fluctuation in a security's
price.
In a volatile market, the price at which the trade is executed can be much
different from the stop loss price in case of a market order. Alternatively,
in the case of a limit order, the trade may or may not get executed at all.
This happens when there are no buyers or sellers available at the limit
price.

Types of Stop Loss order:

1) Stop Loss Limit Order

A stop loss limit order is an order to buy a security at no more (or sell at
no less) than a specified limit price. This gives the trader some control
over the price at which the trade will be executed. However, sometimes, it
may prevent the order from being executed at all.

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A stop loss buy limit order can only be executed by the exchange at the
limit price or lower. For example, if an investor is short and wants to
protect his short position, but doesn't want to pay more than Rs.100 for the
stock, he can place a stop loss buy limit order to buy the stock at any price
up to Rs.100.

By entering a limit order, the investor will not be caught buying the stock
at Rs.110 if the price rises sharply.

2) Stop Loss Market Order

A stop loss market order is an order to buy (or sell) a security once its
price climbs above (or drops below) a specified stop loss price. In other
words, a stop loss market order is an order to buy or sell a security at the
market price prevailing at the time the stop loss order is triggered. This
type of stop loss order gives the trader no control over the price at which
the trade will be executed.

A sell stop loss market order is an order to sell the stock at the best
available price once the price goes below the stop loss price. A sell stop
loss price is always below the current market price.

For example, if a trader holds a stock currently valued at Rs.100 and is

worried that the value may drop, he can place a sell stop loss order at
Rs.90. If the share price drops to Rs.90, the exchange will sell the order at
the next available price. This can limit the trader's losses (if the stop loss
price is at or below the purchase price) or lock in some of the profits.

A buy stop loss market order is typically used to limit a loss (or to
protect an existing profit) on a short sale. A buy stop loss price is always
above the current market price.

Advantages and disadvantages of the stop loss

market order:
The main advantage of a stop loss market order is that the stop loss order
will always get executed. The main disadvantage of the stop loss market is
that the trader has no control The main advantage of a stop loss market
order is that the stop loss order will always get executed, irrespective of
price fluctuations. However, the disadvantage is that the trader has no
control over the price at which the transaction will be executed.

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Conclusion
Stop loss orders act like great insurance policies that will cost you nothing,
but can save you a fortune. Unless you plan to hold a stock forever, you
should consider using them to protect yourself from probable market
fluctuations.

➢ Private equity
Ownership in a corporation that is not publicly-traded is called private
equity. Private equity involves investing in privately-held companies.

Private equity investors are institutional investors and

high net worth (HNI) individuals who have a large
amount of capital to commit to their investments.
Private equity is usually held for an extended period, and trading in it is
useful when a company faces imminent bankruptcy. That is because it
provides access to substantial capital very quickly. Private equity is an
umbrella term for large sums of money raised directly from accredited
individuals and institutions, and then pooled in a fund that invests across
business ventures.

The fund is generally set up as a limited partnership, with a private equity

firm as the general partner and investors as limited partners.

Private equity firms typically charge substantial fees for participating in

the partnership and tend to specialize in a particular type of investment.

For example, venture capital firms may purchase private companies, fuel
growth and, either sell them to other private investors or take them public.
Corporate buyout firms buy troubled public firms, take them private,
restructure them and, either sell them privately or take them public again.

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CHAPTER 2: EQUITY CONCEPTS

➢ How stock market works?

If you want to buy a share or stock in any publicly-traded company, you'll
most likely need the services of a brokerage firm. Though it's possible to
buy and sell shares on your own, there are some practical and legal issues
associated with this approach.

The securities industry is highly regulated. Trading of stocks happens

through a stock exchange. These are special markets where buyers and
sellers are brought together to buy and sell stocks. The best-known stock
exchanges in India are the Bombay Stock Exchange (BSE) and National
Stock Exchange (NSE).

BSE is one of the largest stock exchanges in the world, listing over 4,500
companies. Sensex is a major stock index of BSE, comparable to the
DOW industrials in the US.

Like BSE, NSE is also based out of Mumbai, and regularly trades in
volumes exceeding that of the former. The main stock index of the NSE is
S&P CNX Nifty50, or just Nifty50. Apart from equities, NSE also deals
with trading of futures, debt and foreign currencies.

When most think of a stock exchange, they picture a

scenario of frantic activity, with traders
simultaneously jostling for positions, shouting
commands, making strange hand signals, and writing
up orders. However, behind this frenzied spectacle,
lies a methodical and organized system of trading,
where the prices of stocks are set purely by the rule of
supply and demand in an auction setting.
From an investor’s perspective, buying and selling stocks may seem pretty
simple. If you’re availing the services of a full-service broker, you can just
call him and place an order for ‘X’ number of equity shares of ‘Y’

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company. Within a few minutes, you'll receive a confirmation that your
order has been completed, and you'll become the proud owner of Y's
stocks.

However, a lot of action takes place behind the scenes from the moment
you place your order and till you receive the confirmation of its execution.

➢ How are shares traded?

Stock market is the platform where buyers and sellers interact and decide
on a particular stock price and conduct trading. Nowadays, the processes
are entirely digital and allow trading from anywhere with functional
access to the internet.

Further stock markets are classified into two

types:
• Primary stock market

• Secondary stock market.

The primary stock market is where equity shares originate (using an Initial
Public Offering). Companies issue an IPO for investors. In the secondary
stock market, investors trade previously-issued equity shares without the
involvement of any company. The secondary stock market is what people
are referring to when they talk about stock market trading.

Common terms related to stock market trading

Open : The first price at which the stock trades when stock market opens
in the morning.

High :The highest mark hit by the price of a stock in a day.

Low : The lowest mark hit by the price of a stock in a day.

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Close : The final price of the stock when the stock market closes for the
day.

Volume : The quantum of equity shares traded.

Bid : The buying price is called bid price.

Offer : The selling price is called offer price.

Bid quantity : The total number of equity shares available for buying is
called bid quantity.

Offer quantity : The total number of equity shares available for selling is
called offer quantity.

Buying and selling of equity shares : Buying is also called demand (or
bid) while selling is also called supply (or offer).

Short selling : This is where an investor borrows and immediately sells a

share, only to buy it back later at a lower price and return it to the lender,
pocketing the difference. This happens only in day trading or future
trading.

Share trading : Buying and selling of equity shares is called share

trading.

Transaction : One cycle of buying and selling of stocks is called a

transaction.

Squaring off : This refers to a trading style that investors or traders use,
mostly in day trading. Here, an investor buys (or sells) a specific quantity
of stocks, only to reverse the transaction later with the objective of earning
a profit.

Limit order : This refers to a type of order to buy (or sell) a security at a
specified price, or better. With a buy limit order, the order will be
executed only at the predetermined limit (or lower). Alternatively, with a
sell limit order, the order will be completed only at the specified limit (or
higher).

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Market order : This refers to an order where it is executed at prevailing
stock market prices.

If you place a buy stock market order, it will be executed at prevailing

offer prices in the stock market. Conversely, if you place a sell stock
market order, it will be executed at currently available bid prices.

Stop loss order: This refers to an automatic order to buy (or sell) a stock
at a specific price level, more commonly called the stop price. Widely
used by intraday traders, this type of order serves to limit excessive
investor losses.

For example - You purchased XYZ equity shares at Rs.100.

Unfortunately, share prices start falling. In a bid to check your loss, you
can use a stop-loss order; put sell limit order of 95 with a stop-loss of 96.
This way, once stock prices start falling and touch 96, your order will get
executed automatically. This can protect you from incurring further losses.

However, a disadvantage is that a stop-loss order may get executed owing

to short-term fluctuations as well.

➢ What is Nifty and Sensex?

Sensex and Nifty are indices of their respective stock markets. An index
serves as an indicator of whether stock prices are going up or down.

The Sensex is the indicator of all the major publicly-

traded companies that are listed on the Bombay Stock
Exchange (BSE). On the other hand, Nifty is an
indicator of the major companies that are listed on the
National Stock Exchange (NSE). In India, most stocks
are traded on the NSE and BSE.
Nifty consists of the top 50 stocks while Sensex consists of 30 stocks. If
the Sensex goes up, it means the prices of the stocks of most of the major
companies on the BSE have gone up. Conversely, a falling Sensex
indicates that most of the stock prices of the major stocks on the BSE have

21 | P a g e
gone down. Just like the Sensex represents the top stocks of the BSE, the
Nifty represents the top stocks of the NSE.

Besides, there are other indexes such as the Mid-Cap Index for all mid-cap
stocks and Small-Cap Index for all small-cap stocks.

Indices vary across sectors. By looking at these indices, you will know
whether the stocks from these sectors are moving up or down.

➢ What are stocks?

In simple language, a stock is a share in the ownership of a company.
Being a stockholder, you have a contribution to the company's assets and
earnings. If you buy more stocks of a particular company, your ownership
stakes in that company become more significant.

Different types of stocks

There are various ways the stocks are categorized
1. Based on size of market capitalization - Large cap, Mid cap and Small cap
2. Depending on sectors - Banking, Pharmacy, IT, Telecommunication.
3. Method of stock issue- Preferred and Common stocks.

➢ What makes stock price to change?

To start with, demand and supply are the

underlying factors that influence stock prices.
1.Variations in buying quantities and selling quantities and patterns affect
stock prices

2. More people willing to buy and few ready to sell indicates increased
demand; something that would push up stock prices

3. More people willing to sell and few eager to buy indicates less demand;
something that would cause stock prices to come down

22 | P a g e
There could be several reasons that push investors
to buy or sell stocks. Some have been listed below:
1. News related to a company that may be positive (takeovers, mergers,
acquisitions) or negative (fewer profits or a waning sales figure as
declared in quarterly or annual results)

2. Some people trade on technical charts and buy and sell at different
prices

3. Some people make a move based on fundamental ratios/factors. These

traders also buy and sell at different prices

4. Some people enter the market after only considering the buying and
selling volumes

5. Some traders buy and sell equity shares based on recent news related to
the economy or a particular company's financials

➢ How to do buying and selling of stocks?

Stock transaction takes place in 3 major steps.

• You place an order (buy or sell) online

• Your broker is intimated about the order

• Your order is then directed to the stock exchange (BSE or NSE) And finally, based
on your price, your order is executed

There are two methods for placing orders:

• Online trading

• Offline trading

Online Stock Trading - Here, you will be doing all the trading. All you
will need is an internet connection, a demat and trading account.

23 | P a g e
Offline stock trading -In this method, the broker places the order on your
behalf. All you will need to do is intimate the broker about the stocks
you'd want to buy or sell. You will have to shell out brokerage fees in lieu
of the services rendered by the broker.

More details about online trading:

Opening Demat account and trading account - With online trading, you
will need a demat account to hold securities and equity shares in an
electronic/dematerialized format. A demat account changes your share
certificates from physical to an electronic format, allowing better
accessibility.

Use of demat account - Demat account is used to keep your stocks in

electronic format. Now days as there are no any physical shares in paper
form, everything is stored electronically.

Trading account - A trading account is fundamental if you want to trade

in the stock market. Previously, the stock market would function on the
'open outcry' system wherein traders used hand signals and verbally
communicated their buy/sell decisions. However, in online trading, you do
not have to be physically present at the stock exchange to trade. You can
open demat and trading account with a registered broker who will conduct
all the transactions on your behalf. Every trading account has a unique ID.

➢ Demat
Demat account is a safe and convenient means of holding your securities
online. Today, practically 99.9% settlement (of equity shares) takes place
in demat mode only. Thus, it is advisable to have a Beneficiary Owner
(BO) account to trade at the stock exchanges.

Benefits Of Demat Account

1. A safe and convenient way of holding debt and equity share instruments

2. Transactions of demat securities are cheaper compared to transactions

in physical forms

3. Immediate transfer of securities is possible online

24 | P a g e
4. Increased liquidity, as securities can be sold at any time during the
trading hours (between 9:00 AM to 3:30 PM Monday - Friday), and
payment can be received in a very short period of time

5. No stamp duty charges

6. Risks like forgery, thefts, bad delivery, delays in transfer, etc,

associated with physical certificates, are eliminated

7. Pledging of securities in a short period of time

8. Reduced administrative cost

9. Odd-lot equity shares can also be traded (can be even 1 share)

10. Nomination facility is available

11. Any change in address or bank account details can be electronically

intimated to all companies in which investor holds any securities, without
having to inform each of them separately.

12. Securities are transferred by the DP itself, so no need to correspond

with the companies

13. Equity shares arising out of bonus, split, consolidation, merger, etc. are
automatically credited to the demat account of the investor

14. Equity shares allotted in public issues are directly credited to the
demat account of the applicant

Maximum Number of holders in a Demat Account

Up to three people are allowed to open demat account jointly in their
names.

➢ Dematerialization
Dematerialization is the process of converting physical share certificates
into electronic form. Shares once dematerialized are held in a demat
account.

25 | P a g e
Dematerialisation Process
An investor holding securities in physical form must get them
dematerialized before the transaction. The process requires the investor to
fill a Demat Request Form (DRF) -- which is available with every DP --
and submit the same along with the physical certificates. Every security
has an ISIN (International Securities Identification Number). If there is
more than one security, then an equal number of DRFs has to be filled in.

Things Investors Should Know About Account

Opening And Dematerialisation:
It is mandatory for an investor to provide bank account details while
opening a demat account. This is done to safeguard investor's own
interests. There are two major reasons for this:

• Interest and dividend warrants can't be en-cashed by any

unauthorized person, as the bank account number is mentioned on
it
• It is convenient and time-saving, as dividends and interests, issued
by companies, can be directly credited to the investor's bank
account (through ECS facility, wherever available)

Change in bank account details

An investor can make changes to the details of his bank account. The
investor must inform any change in bank account details to the DP. It will
help in receiving the corporate cash benefits such as dividends, interests,
etc. directly into his account in time and discourages any unauthorized use
by any second party.

Change in the address of investor as provided to

the DP
Any change in your correspondence address should be informed to DP
immediately. It enables DP to make necessary changes in the records and
inform the concerned companies about the same.

26 | P a g e
Opening multiple accounts
An investor is allowed to open a demat account more than once, either
with the existing DP or with different DPs.

Minimum balance of securities required in demat

account
There is no stipulated minimum balance of securities to be maintained in a
demat account.

Account opening and ownership pattern of

securities
One must make sure to open a demat account in the same ownership
pattern in which the physical securities are held. For example, you have
two share certificates, one in your name (say 'X') and the other held jointly
with someone else (say 'XY').

In such a case, you will have to open demat accounts separately, for
respective ownership patterns (one in your name, i.e. 'X' and the other
account in the name of 'XY').

Same combination of names on certificates but

different sequence of names on the certificates or
demat account
Regulations provide that the client receives a contract note indicating
details like the order number, trade number, time, price, brokerage, etc.
within 24 hours of the trade. In case of any doubts about the details of the
contract note, you can avail of the facility provided by NSE, wherein you
can verify the trades on the NSE website.

The stock exchange generates and maintains an audit trail of orders/trades

for a specific period, and you can counter check details of your
transaction.

27 | P a g e
Holding a joint account on "Either or Survivor"
basis like a bank account
No investor can open a demat account on an ‘either or survivor’ basis like
a bank account.

Allowing somebody else to operate your Demat

account
Account-holders (Beneficiary Owner) can authorize another person to
operate the demat account on their behalf by executing a power of
attorney. After submitting a power of attorney to the DP, that person can
manage the account on behalf of the beneficiary owner (BO).

Addition/deletion of the names of the account

holders after opening the account
It is not possible to make changes in the names of the account holders of a
BO account. At the time an investor opens a demat account , it has to be
done in a desired holding/ownership pattern.

Closing a demat account and transfer of securities

to another account with same or different DP
An investor can close the demat account with one DP and transfer all the
securities to another account with existing or a different DP. As per SEBI
circular issued on November 09, 2005, there are no charges for account
closure or transfer of securities by an investor from one DP to another.

Freezing/Locking a demat account

The account holder can freeze his demat account for the desired period. A
frozen account prevents securities from being transferred out of (debited)
and into (credited) the account.

- Demat equity shares do not have any distinctive number

28 | P a g e
- Demat securities are fungible assets. Therefore they are interchangeable and
identical

➢ Insider Trading
The legitimacy of insider trading depends on when the insider makes the
trade. It is illegal if the material information is yet to be published in the
public domain. Trading with privileged information tips the scale of
competition against those who do not have the same. Illegal insider
trading, therefore, includes tipping others with confidential information.

Directors are not the only ones who have the potential to be convicted of
insider trading. People such as brokers and even family members can be
guilty. However, once the information is available for the public, using it
for stock trading is not illegal.

Insider trading is legal once the material information

has been made public, at which time the insider has
no direct advantage over other investors.
SEBI (Securities & Exchange Board Of India), requires insiders to report
all their transactions. So, as insiders have information about the internal
affairs of the company, it may be wise for potential investors to look at
these reports to find out whether the members of the company are trading
their stocks as per the legal norms.

➢ Corporate Actions
When a publicly-traded company issues a corporate action, it is initiating a
process that will bring actual change to its stock. By understanding these
different types of procedures and their effects, an investor can have a
clearer picture of what a corporate action indicates about a company's
financial affairs and how that action will influence the company's share
price and performance.

This knowledge, in turn, will aid the investor in determining whether to

buy or sell the stock in question.

29 | P a g e
Corporate actions are typically agreed upon by a
company's board of directors and authorized by the
shareholders. Some examples are stock splits,
dividends, mergers and acquisitions, rights issues and
spin-offs.

Let's take a closer look at these different examples of corporate actions.

Stock Splits:
As the name implies, a stock split (also referred to as a bonus share)
divides each of the outstanding shares of a company, thereby lowering the
price per share. The stock market will adjust the price on the day the
action is implemented.

A stock split, however, is a non-event, meaning that it does not affect a

company's equity, or its market capitalization. Only the number of equity
shares outstanding changes; so a stock split does not directly change the
value of net assets of a company.

A company announcing a 2-for-1 (2:1) stock split, for example, will

distribute an additional share for every one outstanding share. So the total
equity shares outstanding will double.

If the company had 50 equity shares outstanding, it would have 100 after
the stock split. At the same time, because the value of the company and its
equity shares did not change, the price per share will drop by half. So if
the pre-split price was Rs.100 per share, the new rate would be Rs.50 per
share.

So why would a firm issue such an action? More often than not, the board
of directors will approve (and the shareholders will authorize) a stock split
to increase the liquidity of the share on the stock market.

The result of the 2-for-1 stock split in our example above is two-fold: first,
the drop in the share price will make the stock more attractive to a broader
pool of investors. Secondly, the increase in available equity shares

30 | P a g e
outstanding on the stock exchange will make the stock more accessible to
interested buyers.

It is essential to consider that the value of the company, or it's market

capitalization (equity shares outstanding x stock market price/share), does
not change. But the greater liquidity and higher demand for the stock will
typically boost its price, thereby increasing the company's market
capitalization and value.

A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1)

split can also be termed a stock split of 100%. Likewise, a 3 for 2 split
(3:2) would be a 50% split, and so on.

A reverse split might be implemented by a company that would like to

increase the price of its equity shares. If a Re.1 stock had a reverse split of
1 for 10 (1:10), holders would have to trade in 10 of their old equity shares
for a new one, but the stock would increase from Rs.1 to Rs.10 per share
(retaining the same market capitalization).

A company may decide to use a reverse split to shed its status of a ‘penny
stock’. Also, companies may use a reverse split to drive out small
investors.

Dividends:
There are two types of dividends a company can issue: cash and stock
dividends. Typically, only one or the other is released at a specific period
(either quarterly, bi-annually or yearly), but both may co-occur. When a
dividend is declared and issued, the equity shares of a company is affected
because the distributable equity (retained earnings and/or paid-in capital)
is reduced.

A cash dividend is straightforward. For each share owned, a certain

amount of money is distributed to each shareholder. Thus, if an investor
owns 100 equity shares and the cash dividend is Rs.0.50 per share, the
owner will receive a total of Rs.50.

A stock dividend also comes from distributable equity, but in the form of
stock instead of cash. A stock dividend of 10%, for example, means that
for every ten equity shares owned, the shareholder receives an additional
share. For example, if the company has 1,000,000 shares outstanding

31 | P a g e
(common stock), the stock dividend will increase the company's
outstanding equity shares to a total of 1,100,000. The increase in equity
shares outstanding, however, dilutes the earnings per share.

The distribution of cash dividends signal that the company has substantial
retained earnings from which the shareholders can directly benefit. By
using its retained capital or paid-in capital account, a company is
indicating that it can replace those funds in the future.

At the same time, when a growth stock starts to issue dividends, it may
indicate that the company is changing. If it is a rapidly growing company,
a newly-declared dividend may indicate that the company has reached
growth stability and that it would be sustainable into the future.

Rights Issues:
A company implementing a rights issue is offering additional and/or new
equity shares, but only to already existing shareholders. The existing
shareholders get the right to purchase or receive these equity shares before
the public. A rights issue regularly takes place in the form of a stock split
and can indicate that existing shareholders are getting a chance to benefit
out of a promising new development.

Mergers and Acquisitions:

A merger occurs when two or more companies combine into one, on
mutually agreed terms. The merger usually occurs when one company
surrenders its stock to the other. If a company undergoes a merger, it may
indicate its ability to undertake more significant responsibilities.

On the other hand, it may also mean a shrinking industry in which smaller
companies are being combined with larger corporations to increase
chances of survival in a highly competitive scenario.

For more information, see ‘What happens to the stock price of companies
that are merging together?’

A reverse merger occurs when a private company acquires an already

publicly-listed company (albeit one that is not successful). The private
company in essence turns into the publicly-traded company to gain trading

32 | P a g e
status without having to go through the tedious process of initial public
offering (IPO).

In case of an acquisition, however, a company seeks out and buys a

majority stake of the target company's equity shares. In this case, the
stocks are not swapped or merged. Acquisitions can be either friendly or
hostile. In the case of hostile takeovers, the acquired company is
compelled to transfer majority stake to another entity.

Spin Offs:
A spin off occurs when an existing publicly-traded company releases a
part of its assets or distributes new equity shares to create an independent
business entity. Often, the new equity shares will be offered through a
rights issue to existing shareholders before they are presented to new
investors (if at all).

Depending on the situation, a spin-off could be indicative of a company

ready to take on a new challenge or one that is restructuring or refocusing
core business activities.

An investor needs to understand the various types of corporate actions to

get a clearer picture of how a company's decisions affect the shareholder.
The type of measure used can tell the investor a lot about the company,
and all actions will change the stock itself -- one way or another.

Assimilation:
It refers to the absorption of a new issue of stock into the parent security
where the original equity shares did not rank pari passu with the parent
equity shares. Once assimilated, the equity shares then rank on an equal
footing with the parent equity shares. Assimilation is also referred to as
funding of equity shares.

Acquisition:
Acquisition is marked by one company buying all (or most) of another
company's shares to retain full ownership of that company.

33 | P a g e
When a firm acquires 50% of the target firm's stock, the acquirer becomes
eligible to decide on the newly-acquired assets without having to wait for
approval from the acquired company's shareholders.

To execute an acquisition strategy, the acquiring company may resort to

corporate action events such as a merger or a takeover bid (usually by
announcing a tender offer or an exchange offer).

Bankruptcy:
A company files for bankruptcy when it fails to honour its financial
commitments or pay its creditors their dues. A petition is filed in court,
where the company's outstanding debts are paid off (either partially or
fully) from its assets. However, bankruptcy might not always result in
liquidation.

An alternative is a reorganization, in which the firm’s obligations may be

re-negotiated. Usually, a specialized and qualified lawyer (insolvency
practitioner) will handle the proceedings.

Any outstanding creditor can file a claim. In case of liquidation, the

insolvency practitioner will go on to sell the company's assets. Only after
all the debts have been cleared will the company's equity shares will be
honored.

Bonus Issue:
A bonus issue, also called scrip issue or capitalization issue, is effectively
a free issue of equity shares -- paid for by the company out of its capital
reserves. The shareholders are awarded additional securities (equity
shares, rights or warrants) free of payment. However, the nominal value of
equity shares does not change.

Please note that a bonus issue should NOT be confused with dividends. A
company calls for a bonus issue to increase the liquidity of its equity
shares in the market. Increasing the number of equity shares in circulation
reduces the share price.

34 | P a g e
Bonus issue is generally used to describe what is technically a
capitalization of reserves. The company, in effect, issues free equity shares
paid for out of its accumulated profits (reserves).

Bonus Rights:
It refers to the distribution of rights that give existing shareholders the
privilege to subscribe to additional equity shares at a discounted rate. This
corporate action is similar in features to a bonus and rights issue.

Class Action
It refers to a lawsuit filed against the company, usually by a large group of
shareholders, a representative person, or an organization. Class action may
result in a payment to the shareholders.

Delisting
It is the process of removing the security from a stock exchange. Delisting
can be done mandatorily by the stock exchange or voluntarily by the
company itself. After delisting, a stock can no longer be traded on the
stock exchange.

De-merger
Converse to an acquisition or a merger, a demerger is a type of corporate
restructuring wherein a company's business operations are segregated into
two (or more) smaller components -- typically as result of dissolution of
an earlier merger.

A demerger can take place through a spin off (a divestiture strategy

wherein a parent company's undertaking is segregated into another
independent company) and split up (wherein a firm splits into one or
multiple independent companies).

Equity shares of the new company will be booked according to a

predetermined ratio.

General Announcement

35 | P a g e
A general announcement is used to convey a company's shareholders of
any event that takes place.

Initial Public Offering (IPO)

It refers to the first corporate action event whereby a private company
decides to go public by getting listed on the stock exchange and making
the equity shares accessible to the general public.

With an IPO, a company can raise adequate equity shares capital by

issuing its equity shares to the public. After IPO, the company's equity
shares can then be traded on the stock exchange.

Liquidation
It refers to a process by which a debt-laden firm decides to initiate
proceedings to wind up operations and use its assets to pay off liabilities
and other financial obligations.

A company goes into liquidation when it is inevitable that it is in no

financial shape to run business operations anymore. The residual balance -
- after paying off the company's creditors -- is then used to pay the
shareholders. The person responsible for liquidating the company and
dissolving its operations is called a liquidator.

Mandatory Exchange / Mandatory Conversion

It refers to the conversion of securities (generally convertible bonds or
preferred equity shares) into an agreed-upon number of other types of
securities (usually common equity shares).

Merger
It is a type of corporate restructuring whereby two (or more) companies
are consolidated into a single company. There are primarily two types of
mergers: horizontal mergers and vertical mergers.

Mergers aim at maximizing market share, expanding to newer territories,

unifying current product lines, growing revenues and bettering profit

36 | P a g e
margins. After a merger, equity shares of the newly-formed company are
distributed among existing shareholders of the merged businesses,
according to a set ratio.

Par Value Change

Par value refers to the amount per share of a company's stock. It is usually
listed on stock certificates. However, par value is not reflective of the
actual cost of the stock.

Par value change happens when a company's stocks are split-up.

Scheme of Arrangement
It refers to an agreement, approved by the court, between the company,
and its creditors and shareholders. A scheme of arrangement might alter
creditor and shareholder rights.

Scrip Dividend
This is the UK version of an optional dividend. No stock
dividends/coupons are issued, but shareholders can elect to receive either
cash or new equity shares based on the ratio or by the net dividend divided
by the reinvestment price.

The default is always cash.

Scrip Issue
Shareholders are awarded additional securities (equity shares, rights or
warrants) free of payment. The nominal value of equity shares does not
change.

Corporate may raise capital in the primary stock market by way of an

initial public offering, rights issue or private placement. Initial Public
Offerings (IPO) involves selling of securities to the public in the primary
stock market.

37 | P a g e
 ➢ IPO’s
IPO or Initial Public Offering is a way for a company to raise money from
investors for its future projects and get listed on the Stock Exchange.

Initial Public Offering (IPO) is the selling of

securities to the public in the primary stock market.

From an investor’s point of view, IPO gives a chance to buy equity shares
of a company, directly from the company at the price of their choice.

From a company perspective, IPO helps them to identify their real value
which is decided by millions of investors once their equity shares are
listed on the stock exchanges. IPOs also provide funds for their future
growth or paying their previous borrowings.

There are two types of Public Issues:

ISSUE
OFFER PRICE DEMAND PAYMENT RESERVATIONS
TYPE
Price at which 50 % of the shares
100 % advance
securities are Demand for the offered are
payment is
offered and securities reserved for
Fixed required to be
would be offered is applications below
Price made by the
allotted is made known only Rs. 1 lakh and the
Issues investors at the
known in after the closure balance for higher
time of
advance to the of the issue amount
application.
investors applications.
A 20 % price 10 % advance
Demand for the
band is offered payment is 50 % of shares
securities
by the issuer required to be offered are
offered, and at
Book within which made by the reserved for QIBS,
various prices,
Building investors are QIBs along 35 % for small
is available on a
Issues allowed to bid with the investors and the
real time basis
and the final application, balance for all
on the BSE
price is while other other investors.
website during
determined by categories of

38 | P a g e
 the issuer only the bidding investors have
after closure of period. to pay 100 %
the bidding. advance along
with the
application.

Price Band:
Companies with the help of lead managers (merchant bankers or syndicate
members) decide on the price or price band of an IPO.

SEBI does not play any role in fixing the price of a public issue. It
validates the content of the IPO prospectus.

Companies and lead managers conduct stock market research and

roadshows before they decide the appropriate price for the IPO. It involves
a high risk of IPO failure if they ask for a higher premium. Often,
investors do not like the company or the issue price, and subsequently
don't apply for it, resulting in an undersubscribed issue. In this case,
companies either revise the issue price or suspend the IPO.

Date of the issue:

Once the draft prospectus of an IPO is cleared by SEBI and approved by
the stock exchanges, it’s up to the company going public to finalize the
date and duration of the IPO. The company consults with the lead
managers, registrar of the issue and the stock exchanges before it decides
the time.

The role of the registrar of an IPO:

Registrar of a public issue is an independent financial institution,
registered with SEBI and the stock exchanges. The registrar is appointed
by the company going public.

The responsibility of a registrar for an IPO mainly involves the processing

of IPO applications, allocating equity shares to applicants based on SEBI
guidelines, processing refunds through ECS or cheque and transferring
allocated equity shares to the investor’s demat account.

39 | P a g e
The role of Lead Managers in an IPO:
Lead managers are independent financial institutions appointed by the
company going public. Companies appoint more than one lead manager to
manage big IPOs. They are usually called book running lead manager and
co-book running lead managers.

Their primary responsibilities are to initiate the IPO processing, helping

the company in roadshows, creating draft offer documents, getting them
approved by SEBI and stock exchanges, and assisting the company in
listing equity shares on the stock market.

Follow-on public offering or FPO:

Follow-on public offering (FPO) is the public issue of equity shares for an
already listed company.

Primary & secondary market:

The primary stock market is the market where equity shares are offered
investors by the issuer company in a bid to raise adequate capital.

The secondary stock market is where stocks are traded after they are
initially offered to investors in the primary stock market. The secondary
stock market comprises equity and debt markets.

The secondary stock market is a platform to trade listed equities, while the
primary stock market is a way for companies to enter into the secondary
stock market.

Benefits of IPO’s:
For businesses:

Issuing stocks is a fast way to raise revenue for business expansion and
growth. By becoming a publicly-traded company, a business can take
advantage of new, more substantial opportunities, and can start working
towards worldwide expansion.

40 | P a g e
IPO gives a company fast access to public capital. While public offering
can be costly and time-consuming, its tradeoffs are appealing to
companies. IPOs are a relatively low-risk strategy for businesses and have
the potential to open up a sea of opportunities in the future.

For investors:
The primary reason why IPOs are attractive is that they are undervalued.
Initially, companies might undervalue their IPO -- sell their equity shares
at a price lower than the market value -- to make it more attractive.
It often helps to encourage investors into buying the IPO. That's because
investors may believe that the new publicly-traded company could
generate substantial profits and become the next big thing. As the price
and demand for the IPO's grow, early investors stand to make quick
profits.
If you hope to invest in equity of companies, understanding the ins and
outs of an IPO is critical to your success. Since IPOs are in some cases
undervalued, they can often be sold within a short period for a good profit.
When a publicly-traded company issues a corporate action, it is initiating a
process that will bring actual changes to its stock. By understanding the
different types of procedures and their effects, an investor can have a
clearer picture of what a corporate action indicates about a company's
financial affairs and how that action will influence the company's share
price and performance.
This knowledge, in turn, will aid the investor in determining whether to
buy or sell the stock in question.

➢ Securities lending – Going short

Shorting stock, also known as short selling, refers to the sale of stocks that
the seller doesn't own, or equity shares that the seller has loaned from a
broker. The investor anticipates buying (covering the short) the equity
shares back at a lower price than what they were sold for, recognizing the
difference as a profit.

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CHAPTER 3: MUTUAL FUND
CONCEPTS

➢ What are mutual funds?

A mutual fund is a type of professionally managed collective investment
scheme that pools money from many investors and invests it across stocks,
bonds, short-term money market instruments and other securities.

Mutual funds have a fund manager who invests the money on behalf of the
investors by buying/selling stocks, bonds, etc.

The investor invests in a mutual fund scheme which

in turn takes the responsibility of investing in stocks
and shares after due analysis and research. The
investor need not bother with researching hundreds of
stocks and can leave it to the professional fund
management team.
Another reason why investors prefer mutual funds is that mutual funds
offer diversification. Investor money is invested by the mutual fund in a
variety of shares, bonds and other securities, thereby diversifying
investors' portfolio across different companies and sectors. This helps in
reducing the overall risk of the portfolio. Also, it is less expensive to
invest in mutual funds. Some mutual fund houses allow a minimum
investible amount of only Rs.500.

➢ Mutual Funds: Structure In India

Mutual funds in India follow a 3-tier structure. There is a sponsor (first-
tier) who thinks of starting a mutual fund. The sponsor approaches the
Securities and Exchange Board of India (SEBI), the market regulator and
also the regulator for mutual funds.

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The sponsor and trustee are two separate entities. A sponsor is only the
promoter of the mutual fund, which brings in the required capital, starts a
mutual fund and sets up the AMC.

On the other hand, the mutual fund trustee's role is not to manage the
money. A trustee's role is to supervise whether the money is being
managed as per the stated objectives. In other words, a trustee can be
considered the internal regulator of a mutual fund.

Once SEBI is convinced, the sponsor creates a

public trust (the second-tier) as per the Indian
Trusts Act, 1882. Trusts have no legal identity in
India and cannot enter into contracts; hence,
trustees are authorized to act on behalf of the
trust. Contracts are entered into in the name of
the mutual fund’s trustees. Once the trust is set
up, it is registered with SEBI. Following this, the
trust is formally considered as the mutual fund.
The AMC manages investors' money
Trustees appoint the Asset Management Company (the third-tier) to
manage investors' money on a day-to-day basis. The AMC -- in return of
services -- charges a fee. The investors bear this fee.

Fifty per cent of the AMC’s board of directors must be independent

directors. Once approved by SEBI, the AMC functions under the
supervision of its board of directors, trustees and SEBI.

It is the AMC that floats new schemes and manages these by buying and
selling securities. For this, the AMC needs to follow the rules and
regulations prescribed by SEBI. Besides, the AMC also has to adhere to
the terms of the agreement it signs with the trustees.

The AMC cannot deal with a single broker beyond a specific limit of
transactions. Appointments of intermediaries, including independent
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financial advisers (IFA's), national and regional distributors and banks, is
also done by the AMC. Finally, it is the AMC that is responsible for the
actions of its employees and service providers.

When the mutual fund intends to launch a new scheme, the AMC has to
submit a draft offer document to SEBI. After the necessary approval from
SEBI, this document becomes the offer document of the mutual fund
scheme. An offer document is a legal document that investors rely upon
for investing in the mutual fund scheme.

The compliance officer has to sign the due diligence certificate in the offer
document.

A Custodian
A mutual fund custodian is a trust, bank or a similar financial institution
responsible for holding and safeguarding securities owned by a mutual
fund. A mutual fund's custodian may also act as the mutual fund's transfer
agent, maintaining records of shareholder transactions and balances.

Role of a custodian

Since a mutual fund is essentially a large pool of funds collected from

different investors, it requires a third-party custodian to hold and
safeguard the securities that are mutually owned by all the investors. This
structure mitigates the risk of fraudulent activity by separating the fund
managers from the physical securities and investor records.

The custodian holds only the physical securities. Delivery and receipt of
mutual fund units are done by the custodian or a depository participant,
subject to instructions issued by the AMC. The trustees provide the overall
direction and responsibility. Regulations provide that the sponsor and
custodian must be separate entities.

Role of Registrar and Transfer Agents

Registrar and Transfer agents (RTA) perform the vital role of maintaining
investor records. All New Fund Offer (NFO) forms, redemption forms (i.e.
when an investor wants to exit from a mutual fund scheme, it requests for
redemption) go to the RTA’s office where the information is converted

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from physical to electronic format. It acts as a single-window system for
investors.

The RTA takes care of aspects such as the number of mutual fund units an
investor gets, the price at which the investor gets the mutual fund units,
applicable NAV, the amount an investor would get in case of redemption,
exit loads, folio number, etc.

Registrar and Transfer agents also help investors with information and
details on new fund offers, dividend distributions and maturity dates in
case of fixed maturity plans. While such details are also available with the
mutual fund houses, RTA is a one-stop-shop for all the information.
Investors can get information about various investments in different
schemes of different mutual fund houses at a single place.

➢ Advantages Of Investing In MFs?

Investing in mutual funds has its share of advantages. They have been
listed below:

Expert fund management

Besides the necessary skill set, investing in mutual funds requires a
continuous study of market dynamics and thorough research into the
different industries and companies within them. But when you invest in a
mutual fund, you are also choosing a professional money manager.

With the money that you invest in a mutual fund, the manager buys and
sells securities that he/she has thoroughly researched on. It saves you the
time and effort of having to conduct a detailed study every time you
decide to buy and sell stocks. Instead, a professional mutual fund manager
does it for you.

Diversification of risks
Diversification involves mixing investments within a portfolio as a way to
mitigate risks. For example, by choosing to buy stocks in the retail sector
and offsetting them with stocks in the industrial sector, you can reduce the
impact of the performance of any one security on your entire portfolio.

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To achieve a truly diversified portfolio, you may have to buy stocks across
capitalizations from different industries, and bonds with varying maturity
periods from different issuers. For an individual investor, this can be quite
costly. However, a mutual fund spreads its risk by investing in several
stocks or bonds.

A mutual fund typically invests in companies across a wide range of

industries, so the risk is diversified. You can diversify across asset classes
at a very low cost. Within the various asset classes also, mutual funds hold
hundreds of different securities (a diversified equity mutual fund, for
example, would typically have around a hundred different shares).

Cost-Efficiency
Mutual funds collect money from a large pool of investors, and that is how
they achieve economies of scale. This way, mutual funds can offer you a
low-cost alternative for managing and investing your funds.

Mutual funds take advantage of their buying and selling sizes, and thereby
reduce transaction costs for investors. When you invest in a mutual fund,
you can diversify without the numerous commission charges. With an
investment in mutual funds, you can make transactions on a larger scale,
for less money.

Liquidity
Unless you choose a close-ended mutual fund, it is undoubtedly easy to
invest in and exit a particular mutual fund scheme. Mutual funds are
typically very liquid investments. Unless they have a pre-specified lock-in,
you can sell your units at any given point in time (when the market is
high).

Typically mutual funds take a couple of days for returning your money to
you. Since they are well-integrated with the banking system, most mutual
funds can send money directly to your banking account.

Transparency
Statutory authorities require mutual fund companies to disclose their Net
Asset Value (NAV). NAVs are calculated on a daily basis and published
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through available media. Mutual fund companies disclose their financial
statements to their investors and others.

Full disclosure of investments periodically, flexibility in terms of needs-

based choices, stringent SEBI regulations and strict compliance to
investor-friendly norms make mutual fund relatively high on transparency.

Tax Benefits
Investment in mutual funds also enjoys several tax advantages. Dividends
from mutual funds are tax-free in the hands of the investor (this, however,
depends upon changes in Finance Act).

Also, as mentioned under Sec 80C of the IT Act, you can invest up to
Rs.1.5 lakh in tax-saving mutual funds (ELSS, for instance).

While a long-term capital gains (LTCG) tax of 10% is applicable on

returns more than Rs.1 lakh beyond one year, mutual funds have
consistently delivered better returns vis-a-vis other tax-efficient
instruments.

Well-Regulated
Mutual funds are highly regulated. The mutual fund manager has to
submit all necessary documents to the statutory authorities for their
approval, to make an investment in the required securities.

➢ Disadvantages of investing in mutual funds

Fees and commissions:

An administrative fee is required by all kinds of funds to meet the
expenses. There are many mutual funds which even charge a commission
on sales or "loads" to pay financial consultants, brokers, financial
institutions or financial planners. If you buy stocks or shares from a load
fund, you have to pay a commission on sales irrespective of the fact that
you are consulting a financial advisor or a broker.

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Taxes:
In a typical year, most efficiently-managed mutual funds can sell
anywhere from 20 - 70 % of their portfolio. If your mutual fund makes a
profit, you will pay taxes on the income you receive, even if you reinvest
the money you made.

The tax incidence depends on the type of mutual funds.

Management Risk:
When you invest in a mutual fund, you depend on the fund manager to
make the right decisions. If the manager does not perform as per your
expectations, you might fall short on your projected returns from the
mutual fund. Of course, if you invest in index funds, you forego
management risk, because these funds do not employ managers.

Risks Involved In Investing:

Credit Risk:

Credit risk or default risk refers to the situation where the borrower fails to
honor either one or both of his obligations of paying regular interest and
returning the principal on maturity. It can happen in the case of the
borrower turning bankrupt. Credit risk can be taken care of by investing in
instruments issued by companies with very high credit rating.

The probability of default by a borrower with a high credit rating is

comparatively lower than the one with a low credit rating.

Government paper is the ultimate safe bet when it comes to credit risk.
That’s because if the government does not have cash (similar to a
company going bankrupt), it can print more money to meet its obligations
or change tax laws so as to earn more revenue (neither of which a
corporation can do!).

Default risk is the risk that an issuer of fixed income security may default
(i.e. the issuer will be unable to make timely principal and interest
payments on the security). Because of this risk, corporate debentures are

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issued at a higher yield above those offered on government securities,
which are sovereign obligations and free of credit risk.

Typically, the value of fixed-income security will fluctuate depending

upon the changes in the perceived level of credit risk as well as any actual
event of default. Higher the credit risk, higher the yield required in return
as compensation.

Interest rate risk:

In the case of fixed-income investment, any change in the prevailing rates

of interest is likely to affect the value of the fund's holdings, and thus
value of the fund's units. Increased rates of interest, that frequently
accompany inflation and a growing economy, are likely to hurt the value
of the units.

Generally, the value of securities held by funds will vary inversely with
changes in prevailing interest rates.

As with debt instruments, changes in interest rates may affect the scheme's
net asset value. The prices of financial instruments are inversely
proportional to interest rates. generally, the prices of long-term securities
fluctuate more in response to interest rate changes as compared to short-
term securities.

In India, debt and government securities markets can be volatile, leading

to price fluctuations of fixed income securities, and thereby possible
variations in the NAV.

The best way to mitigate interest rate risk is to invest in papers with short-
term maturities. As the interest rate rises, the investor will get back the
invested funds faster. He can then reinvest the money in debt papers that
offer a higher interest rate.

However, this should be done only when the investor believes that interest
rates will continue to rise in the future. Otherwise, frequent trading in debt
paper will be costly and cumbersome.

Market risk:

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Systemic risks or market risks refer to risks that affect the entire market
and have an impact on the whole class of assets. The value of an
investment may decline over time because of economic changes or other
events that affect the overall market. Systemic risks include risks related to
interest rates, inflation, exchange rates, and political events.

Inflation Risk:

Inflation risk is the uncertainty over the inflation-adjusted future value of

your investment. There is always a chance that rising inflation will
undermine the performance of your investment. Inflation risk happens
when increasing cost of living renders mutual fund investments yields
lesser than what was expected.

Liquidity risk:

Liquidity risk is a type of investment risk that investors undertake while

buying assets with low resale opportunities. Liquidity risk stems from the
lack of marketability of an investment that cannot be traded quickly
without adversely impacting its market price. Liquidity of an investment
may be inherently restricted by trading volumes, transfer procedures and
settlement periods.

Policy risk:

Policy risk refers to the uncertainty in investment due to a change in

policies. Changes in government policy, political unrest or major political
rejigs can change the investment environment.

➢ Types of mutual funds

Open-ended
In open-ended MFs, the mutual fund house continuously buys and sells
units from investors. With open-ended funds, mutual fund units can be
redeemed or issued at any time during the life of the scheme. New units
are created and issued if there is demand; else, old units are eliminated if
there is redemption pressure.

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There is no fixed date on which the mutual fund units would be
permanently redeemed or terminated.

If you want to invest in open-ended funds, you need to buy those units
from the mutual fund house. Similarly, when you want to redeem your
units, the mutual fund house will directly pay you the value of the units. In
other words, new investors can join the scheme by directly buying the
mutual funds at its Net Asset Value (NAV), in case of open-ended
schemes.

Close-ended
The mutual fund units of a close-ended scheme are issued only at the time
of NFO. These units are issued for a fixed tenure or duration. New units
are not issued on a continuous basis, and existing units are not eliminated
before the end of the mutual fund's term.

At the time of an NFO, you can buy close-ended units from the mutual
fund house, and redeem the units at the time of the closure of the scheme.

However, if you want to buy or sell the mutual fund units of a close-ended
scheme during its lifetime, you have to do that through a stock exchange.
The units of close-ended schemes are listed on the stock exchanges, just
like ordinary shares, and can be purchased or sold through a broker.

Index funds
Equity schemes come in many variants, and thus, can be segregated
according to their risk levels. At the lowest end of the equity funds risk
spectrum lie index funds, while at the highest end lie sectoral schemes or
specialty schemes. These schemes are considered the riskiest.

A mutual fund scheme that faithfully buys the index, without making any
judgment on which stocks to buy more (or less), is known as an index
fund. The mutual fund makes no effort to beat the index (passive
investing). Unlike actively-managed equity funds, index funds do not
attempt to outperform the benchmark index.

Measure of performance for an index fund is the tracking error (difference

between the performances of index fund versus the underlying benchmark

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index. Theoretically speaking, these funds ensure performance identical to
that of the index which is the benchmark.

Diversified large cap funds

These are mutual funds that restrict their stock selection to large cap
stocks – typically the top 100 or 200 stocks with the highest market
capitalization and liquidity. It is generally perceived that large cap stocks
have sound businesses, strong management, globally competitive products
and are quick to respond to market dynamics.

Hence, diversified large cap funds are considered stable and safe for
investment. However, since equities as an asset class are risky, there is no
guaranteed return for any type of fund. These are actively-managed
mutual funds, unlike index funds that are passively managed.

In an actively-managed mutual fund, the fund manager pores over all the
data and information, researches about the company, analyses market
trends, factors in government policies on different sectors, and then selects
the stock to invest.

Apart from index funds, all other mutual funds are actively managed, and
therefore, entail higher expenses as compared to index funds. In this case,
the fund manager has the choice to invest in stocks beyond the index.
Thus, active decision-making comes in.

Any mutual fund scheme that is involved in active decision-making, is

incurring higher expenses and may also carry higher risks. This is mainly
because, as the stock selection universe increases from index stocks to
large cap stocks, followed by mid cap and finally to small cap stocks, the
risks associated with each also increase.

The logical conclusion that can be drawn is that while actively-managed

mutual funds usually produce higher returns than the index, it is not
compulsory. Studies have shown that a majority of actively managed-
funds are unable to beat index returns consistently.

Mid cap funds

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Mid cap mutual funds invest in stocks belonging to the mid cap segment
of the market. Many of these midcaps are said to be the ‘emerging blue-
chips’ or ‘tomorrow’s large caps’. Mid cap funds can be managed actively
or passively.

Sectoral Funds
Mutual funds that invest in stocks from a single sector or related sectors
are called sectoral funds. Examples of such funds are IT funds, pharma
funds, infrastructure funds, etc. Regulations do not permit such mutual
funds to invest over 10% of their NAV in a single company. This is to
ensure that these mutual fund schemes are adequately diversified so that
the investors are not subjected to undue risks.

Arbitrage funds
These mutual funds invest simultaneously in the cash and derivatives
market, and take advantage of the difference in prices between a stock and
a derivative by taking opposite positions in both the markets.

Multicap funds
Theoretically, these mutual funds can possess the qualities of small cap
funds today and large cap funds tomorrow. The mutual fund manager has
total freedom to invest in stocks from any sector.

Quant funds
A typical description of this type of mutual fund scheme is: ‘The system is
the fund manager’. It means that there are some predefined conditions that
are entered into the system and as and when the user enters ‘buy’ or ‘sell’
command, the scheme enters or exits those stocks.

P/ E Ratio fund
It refers to a mutual fund that invests in stocks, based upon their P/E
ratios. Therefore, when a stock is trading at a historically low P/E
multiple, the mutual fund will buy the stock. Alternatively, when the P/E

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ratio is at the upper end of the band, the mutual fund will seek to sell the
stock.

International equities fund

Such a mutual fund invests in stocks of companies based out of India
(investor's country of residence). It can either be a Fund of Fund
(whereby, you invest in a fund, that in turn acts as a ‘feeder’ for other
funds) or a fund that directly invests in overseas equities.

International equities fund may be further categorized into International

Commodities Securities Fund, World Real Estate Fund, etc.

Growth schemes
Growth mutual funds aim at capital appreciation over the medium to long-
term. Usually, such mutual fund schemes invest a primary portion of their
corpus in equities.

Generally entailing a higher degree of risk, growth funds provide options -

- capital appreciation, dividend option, etc. -- to investors. As an investor,
you will have to indicate your preference in the application form.

Growth funds are appropriate for investors who have a long-term

investment outlook and seek capital appreciation over time.

ELSS
Equity-linked savings scheme (ELSS) is a diversified equity mutual fund
that offers the investor tax benefits up to Rs.1.5 lakh annually. Of the
entire mutual fund landscape, only ELSS qualifies for tax deductions.

These are open-ended schemes with a lock-in period of 3 years, indicating

that investors cannot, under any circumstance, redeem or reinvest before
three years from the date of investment.

Investment in these mutual fund schemes serve the dual purpose of wealth
accumulation coupled with tax benefits.

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Fund of Funds
As the name suggests, Fund of Funds is a mutual fund scheme that,
instead of investing directly in bonds or equities, invests in other schemes
of mutual funds. The fund might invest in a mutual fund scheme
belonging to the same fund house or any other fund house, for that matter.

A diversified portfolio is designed to suit investors across financial

objectives and risk appetite. This mutual fund scheme can invest in equity
or debt, depending on the investor's investment objectives.

Fixed maturity plans

Fixed maturity plans (FMPs) -- that have become popular over time -- are
close-ended debt schemes. It necessarily implies that investments are
allowed only during a new fund offer.

FMPs entail a fixed maturity period, investing across debt instruments

such as corporate bonds and high-rated securities. While fund managers
are free to sell the securities prior to the date of maturity, they typically
hold onto the debt papers in most cases.

Investors can assess the risk exposure of the portfolio by looking at credit
ratings of securities. Indicative yield is the return that investors can expect
from FMPs. However, an important point to note here is that indicative
yields are pre-tax.

FMPs are designed to make sure investors can earn stable, tax-efficient
returns.

Capital protection funds

Capital protection funds, a classification of close-ended hybrid funds, aim
at capital appreciation coupled with safeguarding investor-interests during
times of slowdown in the economy.

Considering its nature, such a mutual fund checks chances of capital loss
by investing a significant share in AAA-rated bonds that have historically
exhibited minimal chances of defaulting.

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The portfolio is a mix of debt and equity, with a significant portion
invested in debt while a small fraction is parked in equities. It is this
component that provides a potential for higher returns.

The mutual fund lock-in period and maturity of the debt portfolio are
aligned, thereby further guarding against volatility and interest rate
fluctuations.

Consider, an investor invests Rs.100 in a capital protection fund, with a

tenure of 12 months. The goal of the fund is to ensure that at redemption,
its assets are no less than the initial investment of Rs.100.

Experienced fund managers will actively manage the equity allocation.

It is this structure that offers investors a shot at investing in equities

without fearing capital erosion.

Gilt funds
Gilt funds invest across fixed-income securities that are issued by the State
and Central Governments. Generally, the money goes towards building
infrastructure and funding other government expenses.

Gilt funds are ideal for investors who want to keep risks in check while
earning reasonable returns. While gilt funds don't carry any credit risk,
their performance depends on the fluctuation of interest rates. Therefore,
the best time to invest in gilt funds is during a falling interest rate regime.

Balanced funds
Balanced funds, also known as hybrid funds, invest in equity and debt
instruments. Typically equity-oriented balanced funds aim at optimizing
capital appreciation while keeping volatility from equity exposure in
check.

Leading balanced mutual funds invest anywhere between 50-70% of the

portfolio in equity and the remainder in debt instruments. It is this
strategic blend of debt and equity that offers diversification to the investor.

MIPs
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Typically debt-oriented monthly income plans (MIPs) belong to the
category of hybrid mutual funds. It essentially means that the majority of
the corpus is invested across debt funds and other money-market
instruments.

MIPs aim at considerable liquidity while providing regular dividends at

the same time. However, unlike the name suggests, MIPs don't guarantee a
steady monthly income. Dividends, like with other market-linked
instruments, are paid out from profits. Being a debt-oriented mutual fund,
both short-term capital gains (STCG) and long-term capital gains (LTCG)
taxes apply to MIPs.

Investments in MIPs don't have a limit, and investors don't have to pay an
entry load. An experienced fund manager will take a call on when to
switch to equities (or debt) and by what margin.

Child benefit plans

These are debt-oriented mutual funds, with very little component invested
in equities. Child benefit plans aim at capital protection and steady
appreciation.

Parents can invest in child benefit plans with a 5-15-year horizon, thereby
ensuring their children can access a formidable corpus to meet expenses
related to higher education.

Exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) are necessarily index funds that are listed
and traded on exchanges like stocks. Globally, ETFs have opened a whole
new panorama of investment opportunities to retail as well as institutional
investors.

Investing in ETFs enables investors to gain exposure to the stock markets

as well as specific sectors with relative ease, on a real-time basis and at a
lower cost than many other forms of investing.

An ETF is a basket of stocks that reflects the composition of an index, like

S&P CNX Nifty, BSE Sensex, CNX Bank Index, CNX PSU Bank Index,
etc. The ETF's trading value is based on the net asset value of the

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underlying stocks that it represents. It can be compared to a share that can
be bought or sold on a real-time basis during the market hours.

Practically any asset class can be used to create ETFs. Globally, there are
ETFs on silver, gold, indices etc. India has ETFs on gold and indices
(Nifty, Bank Nifty, etc.) as well as those that are similar to liquid funds.

Gold ETFs are a particular type of ETF that invests in gold and gold-
related securities. This product gives the investor an option to diversify
investments into a different asset class, other than equity and debt.

Liquid funds
Liquid funds invest in short-term money market instruments that provide a
fixed-interest income. These instruments include treasury bills,
commercial paper, etc. that have a maturity period of 91 days.

Liquid funds aim at capital safety and providing high liquidity. With this
objective in mind, experienced fund managers invest in debt instruments
that enjoy a high credit rating. The allocations are in keeping with the
mandate of the mutual fund.

Considering average portfolio maturity is three months, investing in liquid

mutual funds reduces the sensitivity of returns to fluctuations in interest
rates. Besides, portfolio maturity is aligned with that of the underlying
securities, thereby opening up a potential for higher returns.

Liquid funds are ideal for parking investors' surplus, considering these are
low-risk havens that mimic a savings bank account's liquidity. Besides,
liquid mutual funds don't attach any exit load, implying investors can
withdraw money according to convenience.

Historically, liquid funds have generated returns in the range of 7-9%.

Usually, an expense ratio is charged to manage investments in liquid
funds. According to a SEBI mandate, the upper limit of expense ratio has
been capped at 1.05%.

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 ➢ Growth and dividend options

Mutual fund houses have two types of schemes

on offer: Growth and dividend
In the former, profits registered by the mutual fund scheme are re-invested
in it, resulting in the Net Asset Value (NAV) increasing over time. When
the mutual fund scheme gains, NAV rises. Alternatively, in case of a loss,
the NAV decreases. The only option to realize profits is to sell or redeem
your mutual fund investments.

With the dividend option, profits are not reinvested. Gains or dividends
are distributed to the investor from time to time. However, the amount and
frequency of dividend payouts are never guaranteed. Only when the
mutual fund scheme gains, are dividends declared, paid out from the NAV
of the unit.

➢ Payout and reinvestment plans

What is the payout option in mutual funds?

The dividend option of mutual fund has sub-options such as dividend
payout and reinvestment. Under the payout option, profits made by the
mutual fund scheme are given to investors at periodic intervals and not
reinvested in the mutual fund. These dividends are not guaranteed. The
fund may choose to dole out dividends in one year and not offer anything
the following year; it is entirely at the discretion of the mutual fund.
Further, the amount of dividend paid may also vary. Contrary to popular
belief, dividends paid out are a cut from the NAV. So, the NAV will fall to
the extent of dividend paid and dividend distribution tax (DDT), if any.

Suppose, a mutual fund with a face value per unit of Rs.10 is trading at a
NAV of Rs 40. It declares a dividend of 30%, which means investors will
earn Rs.3 per unit. Subsequently, if you choose to sell your holdings, you
will get only Rs.37 per unit, as the NAV of the mutual fund scheme will
have fallen from Rs.40 to Rs.37.

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What is the reinvestment option in mutual
funds?
Under the reinvestment option, any dividend paid out by the mutual fund
is ploughed back into the scheme. It implies that you buy additional units
in the scheme, from the dividend amount, at the prevailing NAV (ex-
dividend) of the scheme.

The mutual fund scheme's NAV will fall after payment of dividend, even
if the same is reinvested. So, the NAV of both dividend payout and
dividend reinvestment options is the same.

➢ Systematic Investment Plan(SIP)

What is SIP?
Systematic investment plan (SIP) is an investment vehicle that allows
investors to invest in a mutual fund in fixed amounts, periodically. A SIP
can be weekly, monthly or quarterly.

Investors can initiate a SIP after identifying the mutual fund that they want
to invest in and determining the amount required to achieve financial
goals. A herd mentality in the stock market is to buy stocks when prices
are low, and sell them when prices go up. However, timing the market can
be risky and time-consuming at the same time.

A more successful investment strategy is to adopt the Rupee Cost

Averaging method. Systematic investing, through SIP, can help investors
access the powers of compounding.

SIP is a convenient way to "invest as you earn"

and allows averaging of the acquisition cost of
units.

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 ➢ Systematic Transfer Plan:

What is a Systematic Transfer Plan (STP)?

A Systematic Transfer Plan (STP) is a smart investing strategy that helps
to stagger your investments, over a particular period, to balance returns
and keep risks in check. For instance, if you invest in equities
‘systematically’, you can earn low-risk (or risk-free) returns even during
volatile market conditions.

An AMC allows you to invest a lump sum in one fund, and then
systematically transfer fixed sums from it to another mutual fund scheme.
While the former is called a 'source scheme' or 'transferor scheme', the
latter is called a 'target' or 'destination scheme'.

To apply for an STP, you have to carry out at least six capital transfers
from one mutual fund scheme to another. You can get into a weekly,
monthly or quarterly systematic transfer plan, as per your needs.

The mutual fund deducts the number of units, equal to the specified
amount, from the scheme you plan to transfer money. At the same time,
the amount transferred is utilized to buy units of the mutual fund scheme
that you plan to transfer money to, at the applicable NAV.

Say you have to invest Rs.1 lakh in an equity mutual fund. For this, you
select a liquid fund or an ultra short-term fund. It allows earning a better
return as compared to a saving bank account. After this, you determine a
fixed amount that is to be transferred weekly, monthly or quarterly.

While no entry load is charged, SEBI permits fund houses to subject exit
load up to 2%. The exit load is calculated basis the tenure of investment
and type of fund.

A systematic transfer plan enables a planned fund transfer between two

mutual fund schemes. More often than not, investors initiate an STP to
transfer funds from debt to equity.

STP is a useful tool for a step-by-step exposure to equities or to reduce

equity-exposure over time.

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 ➢ Systematic withdrawal plan(SWP)

What is a Systematic Withdrawal Plan

(SWP)?
A Systematic Withdrawal Plan (SWP) enables the investors to redeem
their mutual fund investments in a phased and disciplined manner. Unlike
withdrawals made in lump sums, an SWP helps to withdraw money in
fixed installments. In essence, an SWP is the opposite of SIP.

One of the many advantages of an SWP is that it helps investors customize

cash flow in keeping with their financial requirements. Investors can either
withdraw a fixed amount or just the capital gains on their mutual fund
investment. This way, investors can not only have money invested in the
mutual fund scheme but also access steady income and returns. The
amount to be withdrawn should be indicated up front. SWP is redemption
from a scheme, so tax provisions apply accordingly. SWP is tax-efficient
for an investor who likes to save on dividend distribution tax.

Mutual fund investments are subject to market

fluctuations. These can adversely affect fund
NAV. More importantly, fund returns can erode
if they aren't withdrawn on time. An SWP can
help time withdrawals in keeping with financial
needs.
➢ What is the concept of NAV in mutual funds?
Everything you buy has a price, and this is true for investing too. But what
is the price of a mutual fund? How much do you need to pay to invest in a
mutual fund scheme? This amount depends on the fund's net asset value or
NAV. It is the price at which a mutual fund is bought and sold in the open
market.

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NAV basically represents the price of one unit of
the mutual fund. For example, if a fund's NAV is
Rs.20 and you want to invest Rs.10,000, you will
be allotted 500 units in the fund.
The NAV of mutual funds are reported widely in newspapers and
investment portals. Open-ended funds are mandated to disclose their NAV
daily while close-ended funds usually disclose their NAV weekly.

➢ How is NAV calculated?

The asset allocation mix of a mutual fund includes securities and cash.
Securities comprise equities, bonds and other debt instruments. The values
of these securities change at every trading interval, and so does the NAV
of the mutual fund. The NAV is the total market value of all the assets
held in the mutual fund portfolio less liabilities, divided by the outstanding
units. The market value of the investments is calculated according to the
last traded or closing price of the securities.

Usually, calculating NAV of mutual fund is tedious during trading hours

as the price of the underlying holdings (especially stocks) keeps changing.
Therefore, NAVs are usually declared after the closing of market. The
costs and expenses of the fund, including management fees and operating
expenses (registrar and transfer agent fee, marketing and distribution fee,
audit fee and custodian fee) are deducted while calculating the NAV.

The NAV of an open-ended fund does not indicate whether a fund is

overpriced or underpriced. In other words, a fund with a high NAV does
not mean that it is more expensive than a fund with lower NAV. Close-
ended funds issue a fixed number of units that are traded on the stock
exchanges or over-the-counter (OTC). Typically, such funds are not traded
at their NAVs, and their prices tend to generate premium or discount
relative to their NAVs due to demand and supply factors.

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 ➢ How does NAV help investors?
NAV helps in assessing the performance of mutual fund. Various analysis
tools like point-to-point return, CAGR and ROI are derived using the
fund's NAV. Moreover, the advanced analysis of risk-adjusted returns is
not possible without the NAV of a fund.

A fund's NAV helps investors assess the worth of their investments and
determine how the value of such investments has moved over time.

For instance, in 2010, you purchased 1,000 units of a mutual fund at

Rs.15. According to this figure, your investment was worth Rs.15,000.
After two years, the NAV rises to Rs. 20. It means that the value of your
investment has grown to Rs.20,000, and if you redeem the units now, you
make a profit of Rs.5,000.

➢ Returns in a mutual fund

Dividends
The dividend option does not reinvest the profits made by the mutual fund.
Profits or dividends are distributed to the investor from time to time.
However, the amount and frequency of dividends are never guaranteed.

These are declared only when the scheme makes a profit, and are at the
discretion of the fund manager. The dividend is paid from the NAV of a
mutual fund unit.

Capital gains
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These are profits that result when a security, price of which increases over
its purchase price, is sold. If the security is not sold, gains remain
unrealized.

A capital loss would occur when the opposite takes place. Capital gains
can be long-term or short-term, depending on the time when the units are
sold. If the units are held for more than a year, they generate long-term
capital gains (LTCG) while if redeemed within a year, generate short-term
capital gains (STCG).

LTCG and STCG are accordingly taxed.

➢ Cost involved in MF investing

Loads
Investors have to bear expenses for availing professionally-managed
services of the mutual fund. One of these is entry load, a fee that is
charged to meet the selling and distribution expenses of the scheme. A
significant portion of the entry load goes towards paying commissions to
the fund distributor (can be an independent financial advisor, bank or a
large national/regional distributor). They are the intermediaries who help
investors choose the right scheme and invest in them from time to time, in
keeping with their financial requirements.

The second type of expense is exit load - a fee that reduces the in-hand
investor returns. However, not all schemes have exit loads. Some schemes
have a Contingent Deferred Sales Charge (CDSC). It is a modified exit
load, wherein investors have to pay different charges depending on the
investment period. Usually, exit loads increase if investors redeem
investments early (before the lock-in period). Therefore, longer the
investment horizon, lesser will be the exit load. After some time, the exit
load reduces to nil, i.e. if the investor exits after a specified period, he/she
will not have to bear any exit load.

Expense Ratio
Among other things, which an investor must look into before investing in
a mutual fund, is the Expense Ratio of the scheme. Expense Ratio is
defined as the ratio of expenses incurred by a scheme to its Average

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Weekly Net Assets. It represents the ratio of the amount of investors'
money that is going for expenses to the amount that is getting invested.
Expense ratio of a mutual fund should be as low as possible.

➢ What is new fund offer?

The launch of a new mutual fund scheme is known as a New Fund Offer
(NFO). It is like an invitation to the investors to put their money into a
particular mutual fund scheme by subscribing to its units. When a scheme
is launched, the distributors talk to potential investors and collect money
from them by way of cheques or demand drafts.

Mutual funds cannot accept cash. (Mutual funds units can also be
purchased online through a number of intermediaries who offer online
purchase/redemption facilities). However, before investing, you must read
the Offer Document (OD) carefully to understand the risks associated with
the scheme.

➢ Taxation of mutual funds

Income from mutual funds can be divided into 2 parts: Capital gains
(increase in value of your investment) and Dividends (amount that
investors receive on regular intervals from dividend plans). So taxation of
mutual funds in India can also be divided into 2 parts: Capital gains and
Dividends.

Capital gain is appreciation in the value of asset. If you buy something for
Rs. 1 lakh and sell it for Rs. 1.5 lakh, you have made a capital gain of Rs.
50,000. Capital gains are further divided into short term and long term
capital gains, depending on their investment horizon.

• Short term capital gain arises if the investments are held for less
than one year or, in simple words, sold before completion of 1
year. Here, 1 year means 365 Days.
• Long term capital gain arises if investment is sold after 1 year.

Mutual fund capital gain tax further depends on the type of fund it is –
Equity or Debt.

Capital Gain Tax on Equity Mutual Funds

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Equity mutual funds are those funds in which equity holding is more than
65% of the total portfolio. So, even balanced funds can be categorized as
equity funds. Fund of Funds (mutual funds which invest in other funds)
and International Funds (mutual funds which have more than 35%
exposure to international equities) are kept under debt category for tax
purposes.

Long term capital gain tax on equity mutual funds: If you buy and hold
an equity mutual fund for more than 1 year, the tax will be NIL. For
example, if you invest Rs. 1 lakh in XYZ Fund and after 1 year, its value
is Rs. 1.3 Lakh, there will be zero tax on capital appreciation of Rs.
30,000. This is a very big advantage of equity mutual funds.

Short term capital gain tax on equity mutual funds: If you sell an
equity mutual fund before the completion of one year, you will need to
pay a tax of 15% on capital gains. In the above example where the gain
was Rs. 30,000, if this was a short-term capital gain, the investor would
have to pay Rs. 4,500 as short term capital gain tax.

Capital Gain Tax on Debt Mutual Funds

All other funds that do not qualify as equity funds, including Fund of
Funds and International Funds, are classified as debt mutual funds.

Short term capital gain tax on debt mutual funds: Any short term
capital gain that arises due to selling of debt mutual funds before 1 year
will be added to the investor’s income. Once it is added, it will be taxed
according to the tax slab of that individual.

Long term capital gain on debt mutual funds: Here, taxation depends
on whether investor would like to use indexation or not.

• Without Indexation – 10% tax on capital gains

• With Indexation – 20% tax on capital gains

Mutual Fund Dividend Taxation

Again, this taxation will depend on which type of mutual fund you are
investing in – equity or debt. There is no dividend distribution tax on

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equity mutual funds and also, the dividend received by investors is tax
free. So, again it’s a bonus for equity mutual fund investors.

Even in the case of debt mutual funds, dividends received by investors are
tax free in their hands and they don’t need to show it as taxable income.
However, a dividend distribution tax is paid by mutual fund companies to
income tax departments.

➢ When to sell your funds?

Constant Underperformance
You can think of selling your mutual fund if it has consistently
underperformed as compared to its benchmark. Investors should study the
performance of a fund for four consecutive quarters before arriving at a
decision. If there is no substantial improvement in its performance relative
to its benchmark or peers, you may want to get out. Benchmarking is an
important factor in gauging a mutual fund’s performance and determining
whether it has kept up to its overall investment objective.

Benchmarks can provide investors a perspective on the expected risk-

adjusted performance of fund portfolios and help them take investment-
related decisions. So, if your portfolio warrants investing in an index fund
as a passive strategy, compare its performance with the index and not with
its diversified equity counterparts. Even if the index has underperformed,
you should remain invested since it serves a particular purpose in your
portfolio.

You may also consider exiting a mutual fund if the management changes.
The entry or exit of fund managers could have a bearing on its
performance.

Repositioning
It may be worthwhile to evaluate your investment strategy periodically to
ensure that it meets your objectives at every stage of life. It could be
buying a house, marriage, birth of a child, education or retirement. If your
financial objective has been met, it may be time to modify your portfolio,
say, move to debt funds as you get closer to retirement.

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Change In Your Goals
Mutual fund investments are based on financial goals; you follow a certain
investment philosophy and allocate your assets in a way that they fulfill
your objectives. For instance, if you are single, in your early 20s and your
first goal is to buy a car, you might invest a higher percentage in equities.
Once you have reached your goal, even if it is earlier than you thought, it
makes sense to sell your funds and actualise it.

➢ How to select a fund?

Return Measurements
Point To Point Returns

These are calculated by considering NAVs at two points in time - entry

date and exit date. To know how your investment has grown on an annual
basis, you will need to check the Compounded Annual Growth Rate
(CAGR).

While CAGR can be calculated for any period, a simple point-to-point

return is preferred when the holding period is less than one year. CAGR is
ideal for more extended holding periods.

While calculating point-to-point return is more comfortable, and the

method is used extensively to analyze fund’s performance, it is not fool-
proof. It fails to determine the consistency of historical returns.

Rolling Returns

In case of rolling returns, returns are calculated continuously for each

defined interval -- which can be days, weeks, months, quarters, or even
years.

The resultant amount can be compared to Category Average Rolling

Return. So, if a particular mutual fund has delivered a 12%-yearly rolling
return, while its category average one-year rolling return is 14%, it implies
that the fund has fared worse than its category average.

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An analysis of rolling returns also throws light on other relevant statistics,
the most important ones being the maximum (the highest of yearly
returns) and minimum returns (the lowest figure). It not only helps to
determine performance consistency but also assesses the fund's best and
worst periods, in terms of returns.

Risk Measures
Standard Deviation
Standard deviation measures the total risk associated with a mutual fund
(market and company-specific). It measures the extent to which fund
returns vary across the average. Fund returns constitute the percentage
change in its NAV, and it can be calculated on a daily, weekly, monthly or
yearly basis.

A high standard deviation implies that the periodic returns are fluctuating
significantly from the average return, thereby indicating a higher degree of
volatility. On the other hand, a low standard deviation implies that the
periodic returns are fluctuating close to the average return, thereby
suggesting a lesser degree of risk.

Downside Probability
It calculates the probability of negative returns from the portfolio.
Downside probability is equal to the total number of negative returns in a
period/Total number of returns in a period.

Since the figure hints at the probability of negative returns, a higher

number is considered bad, whereas a lower value is deemed favorable. A
statistical tool -- Frequency Distribution Method -- is generally used for
computing the probability.

Maximum Drawdown (MDD)

Maximum drawdown (MDD) is the most significant drop of your portfolio
from the peak to the bottom in a specific period. A drawdown, the amount
by which your portfolio declines from a peak reading to its lowest value
before attaining a new peak, is one of the real measures of the risks you
are taking in your investment program.

Maximum drawdown is always smaller than or equal to the difference

between maximum loss and maximum gain. It depends on the chosen time
interval (be it annually, monthly or daily) and observation period.

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Maximum drawdown is an excellent way to compare the inherent
volatility of different strategies.

Tracking Error
It is the difference between the price behavior of a portfolio or position
and that of the benchmark. It can be easily calculated on a standard MS
Office spreadsheet. In other words, tracking error refers to the standard
deviation percentage difference between the returns that an investor
receives and that of the benchmark or index it was intended to mimic/beat.

The fund manager may buy/sell securities anytime during the day,
whereas the underlying index will be calculated based on the closing
prices of the Nifty 50 stocks. Therefore, there will be a difference between
the returns of the scheme and the index.

Also, there may be a divergence in returns because of cash position held

by the fund manager. It will lead to investors' money not being allocated
precisely as per the index, but only very close to it.

If the index’s portfolio composition changes, it will take some time for the
fund manager to exit the earlier stock and replace it with the new entrant
in the index. These and other reasons, like dividend accrued but not
distributed, and accrued expenses result in returns of the scheme being
different from those delivered by the underlying index. This difference
should be as low as possible.

Investors prefer the fund with the least tracking error, considering it is
tracking the index closely. Tracking error is also a function of the scheme
expenses. Therefore, lower the costs, lower the tracking error of a mutual
fund.

Performance Evaluation
Sharpe Ratio
Risk premium refers to returns exceeding the risk-free rate of return that
an asset class is expected to yield. Therefore, a risk premium is a type of
compensation that investors enjoy for tolerating that additional risk, as
opposed to a risk-free asset class.

Sharpe ratio uses Standard Deviation as a measure of risk. It is calculated

as:

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(Rs minus Rf) ÷ Standard Deviation, where Rs is the return from an
investment and Rf is the risk-free rate of return.

Thus, if the risk-free return is 5% and a scheme with a standard deviation

of 0.5 earned a return of 7%, its Sharpe Ratio would be: (7% - 5%) ÷ 0.5 =
4%.

Sharpe ratio is effectively the risk premium per unit of risk. Higher the
Sharpe ratio, better the scheme. However, exercise caution while carrying
out Sharpe ratio comparisons between schemes. For instance, don't equate
the Sharpe ratio of an equity scheme to that of a debt scheme.

Treynor Ratio
Also known as the reward-to-volatility ratio, Treynor ratio is a metric
deployed to calculate excess returns generated for every additional unit of
risk that a portfolio assumes. Similar to Sharpe ratio, excess returns here
indicate additional returns earned over and above the gains from a risk-
free investment.

However, unlike Sharpe ratio that uses standard deviation as a measure of

risk, Treynor ratio uses beta.

Treynor Ratio is calculated as:

(Rs minus Rf) ÷ Beta

For example, risk-free return (Rf) is 5%, and a scheme with a beta of 1.2
earned a return of 8%. Here, Treynor Ratio would be:

(8% - 5%) ÷ 1.2 = 2.5%.

Higher the Treynor ratio, better the scheme. However, the ratio should
ideally be restricted to diversified equity schemes.

Information Ratio
Also known as appraisal ratio, Information ratio seeks to measure the
performance of an investment relative to its benchmark index, after
accounting for additional risks. In other words, Information ratio (IR)
measures a portfolio manager's ability to generate excess returns relative
to a benchmark and assess investor consistency.

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Higher the ratio, more consistent is the portfolio manager.

Rp = Return of the portfolio

Ri = Return of the index or benchmark

Sp-i = Tracking error (standard deviation of the difference between Rp

and Ri)

Therefore, IR = (Rp - Ri)/Sp-i

A high IR can be achieved by high portfolio returns, low index returns and
little tracking error.

For example:

1. Manager A might have returns of 13% and a tracking error of 8%

2. Manager B has returns of 8% and tracking error of 4.5%

3. The index has returns of -1.5%

In this case, Manager A's IR = [13-(-1.5)]/8 = 1.81, and Manager B's IR =

[8-(-1.5)]/4.5 = 2.11

Here, Manager B has lower active returns but a better IR. A higher ratio
signifies the ability of the manager to generate higher returns by taking on
additional risks.

Equity Portfolio Attributes

- Stock Concentration

- Sector Concentration

- Market Cap Concentration

- Asset Calls

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Professional portfolio managers, who work for an investment management
company, do not have a choice about the general investment philosophy
that is used to govern the portfolios they manage. An investment firm may
have strictly-defined parameters for stock selection and investment
management. An example would be a firm defining a value investment
selection style using specific trading guidelines.

Furthermore, portfolio managers are also usually constrained by market

capitalization guidelines. For example, small-cap managers may only
select stocks in the Rs.200-500 crore market-cap range.

Therefore, the first step in portfolio management is to understand the

universe from which investments are selected.

Some portfolios use a bottom-up approach, wherein investment decisions

are made primarily by selecting stocks without considering the sector
economic forecasts. Other styles may be top-down oriented, wherein
portfolio managers consider analyzing entire sectors or macroeconomic
trends as a starting point for analysis and stock selection. Other methods
use a combination of these approaches.

Debt Portfolio Attributes

Issuer Concentration
The debt market comprises broadly two segments, viz., Government
securities market or G-Sec market and corporate debt market. The latter is
further classified as a market for PSU bonds and private sector bonds.

Maturity Profile
A bond fund maintains a weighted average maturity, which is the average
of all the current maturities of the bonds held in the fund. The longer the
average maturity, the more sensitive the fund tends to be to changes in
interest rates. Also defines the weighted average maturity, maximum and
maturity for certain asset types like a corporate bond, Gilts etc.

Credit quality
The overall credit quality of a bond fund will depend on the credit quality
of the securities in the portfolio. Bondi credit ratings can range from
speculative—often referred to as high-yield—to very high, generally
referred to as investment-grade bonds. Funds that invest in lower-quality
securities can potentially deliver higher yields and returns, but will also

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likely experience greater volatility, due to the fact that their interest
payments and principal are at greater risk.

The relative credit risk of a bond is reflected in ratings assigned by

independent rating companies such as CRISIL, ICRA, CARE, Fitch etc.
These rating companies use a letter scale to indicate their opinion of the
relative credit risk of a bond, with the highest credit rating being AAA.

Style
Growth Style
Growth investing entails looking for companies that have a potential to
grow faster than others. The optimism is reflected in the premium
valuation commanded by the market price of such companies. Typically,
growth stocks have low dividend yields and above-average valuations as
measured by price-to-earnings (P/E), market capitalisation-to-sales and
price-to-book value ratios (P/B), reflecting the market's high expectations
of superior growth. Growth investors are more apt to subscribe to the
efficient market hypothesis which maintains that the current market price
of a stock reflects all the currently knowable information about a company
and, so, is the most reasonable price for that stock at that given point in
time.

They seek to enjoy their rewards by participating in what the growth of the
underlying company imparts to the growth of the price of its stock. Only
aggressive investors, or those with enough time to make up for short-term
market losses, should buy these funds.

Value Style
A value investor, on the other hand, buys undervalued stocks that have a
potential for appreciation but are usually ignored by the investing
community. Value investors put more weight on their judgments about the
extent to which they think a stock is mispriced in the marketplace. If a
stock is underpriced, it is a good buy; if it is overpriced, it is a good sell.

They seek to enjoy their rewards by buying stocks that are depressed
because their companies are going through periods of difficulty; riding
their prices upward, if, when, and as such companies recover from those
difficulties; and selling them when their price objectives are reached.
Value stocks usually have above-average dividend yields and low P/Es.
Value funds are most suitable for more conservative, tax-averse investors.

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Debt portfolio attributes
Issuer concentration
The aptitude and proficiency of a fund manager are what differentiates the
top performing funds from the worst ones. Investors must consider the
past performance of the fund manager before investing in a mutual fund. If
a fund manager has recently joined an AMC, his previous fund
management experience should be evaluated. In the same category of
funds, say equity diversified, you should pick funds whose alpha values
are greater than zero. This is because the higher the value of alpha, the
better is the performance of the fund manager.

Maturity profile
A bond fund maintains a weighted average maturity, which is the average
of all the current maturities of the bonds held in the fund. Longer the
average maturity, more sensitive is the fund to changes in interest rates.

Credit quality
The overall credit quality of a bond fund will depend on the credit quality
of the securities in the portfolio. Bond credit ratings can range from
speculative (often termed high-yield) to very high (referred to as
investment-grade bonds).

Funds that invest in lower-quality securities can potentially yield higher

returns, but also experience greater volatility, considering interest
payments and principal face an increased risk.

The relative credit risk of a bond reflects in ratings assigned by

independent rating companies such as CRISIL, ICRA, CARE, Fitch, etc.
These rating companies indicate their opinions on the relative credit risk
of a bond, with the highest credit rating being AAA.

Growth Style
Growth investing entails looking for companies that have the potential to
grow faster than others. The optimism reflects in the premium valuation
commanded by the market price of such companies. Typically, growth
stocks have low dividend yields and an above-average valuation, as
measured by their price-to-earnings (P/E), market capitalization-to-sales,
and price-to-book value ratios (P/B).

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Growth investors subscribe to the efficient market hypothesis which
maintains that the current market price of a stock reflects all the currently
knowable information about a company and, so, is the most reasonable
price for that stock at that given point in time.

Growth investors participate in the value that the growth of the particular
company imparts to the price of the stock. Aggressive investors, or those
with enough time to make up for short-term market losses, should buy
these mutual funds.

Value Style
A value investor, on the other hand, buys undervalued stocks that have a
potential for appreciation but are usually ignored by the investing
community. Value investors put more weight to their judgment about the
extent to which a stock is under-priced in the marketplace. If a stock is
underpriced, it is a good buy; if it is overpriced, it is a good sell.

Value investors buy depressed stocks, steer their prices upward, and sell
them when they meet their price objectives.

Value stocks usually have above-average dividend yields and low P/E
ratios. Value funds are suitable for a more conservative, risk-averse
investor.

Know Your Fund Manager

Years of Experience
While experience is not a fool-proof predictor of future performance, fund
managers who have been managing the same mutual fund (or the same
style) for at least ten years, tend to do win out — longer the tenure, better
the performance and consistency.

Performance of funds managed

A fund manager's proficiency is what differentiates the top-performing
mutual funds from the worst ones. Investors must consider the past
performance of the fund manager before investing in a mutual fund. If a
fund manager has recently joined an AMC, his previous fund management
experience should be evaluated.

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In the same category of funds - say equity diversified - you should pick
funds whose alpha values are greater than zero. That's because, higher the
value of alpha, better is the performance of the fund manager.

➢ How to read fact sheets?

Fact Sheet is a monthly document which all mutual funds have to publish.
This document gives all details as regards the AUMs of all its schemes,
top holdings in all the portfolios of all the schemes, loads, minimum
investment, performance over 1, 3, 5 years and also since launch,
comparison of scheme’s performance with the benchmark index (most
mutual fund schemes compare their performance with a benchmark index
such as the Nifty 50) over the same time periods, fund managers outlook,
portfolio composition, expense ratio, portfolio turnover, risk-adjusted
returns, equity/ debt split for schemes, YTM for debt portfolios and other
information which the mutual fund considers important from the
investor’s decision-making point of view.

The Fact Sheet would consist of the following

sections by which investors can evaluate the
schemes.
Investment Objective:
The investment objective establishes whether the fund meets the intended
investment objective, i.e. for investing for growth, income or capital
preservation.

Fund Index:
The Index, also known as the Fund Benchmark, is an indicator of how the
Fund is performing relative to its peers. A benchmark is usually a
predetermined set of securities based on published indexes (Eg: S&P 500)
or a customized set to suit the Fund's investment strategy.

Dividend Information:
Dividend is a share of a company's net profits distributed by the company
to a class of its stockholders. The dividend is paid in a fixed amount for
each share of stock held.

Net Asset Value:

The net asset value per share usually represents the fund's market price,
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subject to a possible sales or redemption charge. The term is used to
describe the value of an entity's assets less the value of its liabilities.

Total Expense Ratio:

Total Expense Ratio (TER) is measuring the total costs of a fund
investment. Total costs may include various fees (trading, auditing) and
other expenses. The TER is calculated by dividing the total cost by the
fund's total assets and is denoted as a percentage. It may vary from year to
year.

Graph:
The graph depicts the performance of the fund relative to the fund
benchmark since inception.

Performance Table:
This table depicts the performance of the Fund relative to the Fund
benchmark since inception and over a set of standard time periods.

Portfolio Composition:
It provides the high-level breakdown of the Fund's holdings into Equity,
Fixed Income & Cash. The Cash component shown may include Financial
Instruments with duration of less than 1 year.

Fund Characteristics:
It is given in a tabular form summarizing characteristics of the portfolio of
investments held by the Fund. The table includes information on the Fund
size, the number of securities held by the Fund and statistics applicable to
those securities. For Equity Funds, the statistics shown include Price/
Earning Ratio and Price/Cash Flow Ratio, wherever applicable. Fixed
Income Funds show statistics relevant to the portfolio of fixed income
securities held by the Fund, including their Weighted Average Credit
Quality. All portfolio statistics are weighted averages relative to the size of
the Fund's investment in the security, where appropriate. Not all statistics
are available for all securities or Funds because of restrictions on data
sourcing.

Top Holdings:
The top 10 or all the holdings according to underlying fund exposure are
captured. This gives an indication of the broadness of the fund exposure.
Industry breakdown shows the investments made in various Industries.

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What is a fact sheet?
A fact sheet is a monthly document that all mutual funds have to publish.
This document gives out details such as:

• AUMs of schemes
• Top holdings in all the portfolios of schemes
• Loads
• Minimum investment
• Performance details over 1, 3 and 5 years
• Comparison of scheme’s performance with the benchmark index (most
mutual fund schemes compare their performance with a benchmark index
such as the Nifty 50) over the same periods
• Fund manager's outlook
• Portfolio composition
• Expense ratio
• Portfolio turnover
• Risk-adjusted returns
• Equity/debt split for schemes
• YTM for debt portfolios
• Other information that the mutual fund house considers vital from the
investor’s decision-making point of view

The fact sheet consists of the following sections by which investors can
evaluate the schemes:

• Investment Objective: The investment objective establishes whether the

mutual fund meets the intended investment objective, i.e. investing for
growth, income or capital preservation.
• Fund Index: Also known as the fund benchmark, it is an indicator of how the
fund is performing relative to its peers. A benchmark is usually a
predetermined set of securities based on published indexes (Eg: S&P 500) or
a customized set to suit the fund's investment strategy.
• Dividend Information: Dividend is a share of a company's net profits
distributed by the company to a class of its stockholders. The dividend is a
fixed amount paid for each share of stock held.
• Net Asset Value: Net asset value (value of assets minus liabilities) per share
usually represents the fund's market price, subject to a possible sales or
redemption charge.
• Total Expense Ratio: Total Expense Ratio (TER) measures the total costs of
a fund investment. These costs include various fees (trading, auditing) and
other expenses. TER is calculated by dividing the total cost by the fund's
total assets and denoted as a percentage. TER usually varies across years.

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 • Graph: The graph depicts the performance of a mutual fund relative to the
benchmark since inception.
• Performance Table: This table charts the performance of a mutual fund
relative to its benchmark, since inception and over a set of standard periods.
• Portfolio Composition: It provides a detailed breakdown of the fund's
holdings into equity, fixed income and cash. The cash component may
include financial instruments with a maturity period of less than one year.
• Fund Characteristics: Presented in a tabular format, it summarizes the
characteristics of the portfolio of investments held by the fund. The table
includes information about the size of a mutual fund, number of securities
held by it, and statistics applicable to those securities.

For equity funds, the statistics may include price-to-earnings ratio and
price-to-cash flow ratio, wherever applicable. Fixed-income funds exhibit
statistics relevant to the portfolio of fixed income securities that are held
by the mutual fund (including their Weighted Average Credit Quality.)

All portfolio statistics are weighted averages relative to the size of the
fund's investment in the security, wherever appropriate. Not all statistics
are available for every security or fund, because of restrictions on data
sourcing.

• Top Holdings: The top 10 holdings (or all the holdings) according to
underlying fund exposure are captured. It indicates broadness of fund
exposure.
• Industry breakdown: It shows the investments made across industries.

➢ Portfolio management

Model Portfolio
There is no ideal or model mutual fund portfolio that can suit every
individual investor's needs and risk appetite. While there is no dearth of
mutual funds in the market today, building a portfolio depends on the
preferences and objectives of each individual. The factors that come into
play include the age of the investor, risk appetite, investment horizon,
immediacy, and, more importantly, the objective of the investment. The
model portfolio, as explained below, can be constructed for four types of
investors based on their risk-return appetite.

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Mutual Fund Model Portfolio

1) Aggressive:

Aggressive investors tend to be risk-takers. They are willing to embrace

risky investments, considering their objective is to maximize returns in the
long run. These investors seek above-average returns by focusing their
investments in stocks and certain types of mutual funds. Aggressive
investors should invest in small and mid-cap funds as these have the
potential to yield above-average returns, and are risky at the same time.
Small and mid-cap funds can spruce up one's portfolio, considering these
are future large-cap stocks. These funds tend to grow faster than large-cap
funds; however, they entail a higher degree of volatility.

2) Moderately Aggressive:

Moderately aggressive investors usually have similar investment

objectives as their aggressive counterparts. However, they are
characterized by a lower risk tolerance than aggressive investors. As such,
their preference may be for equities (or mutual funds) or a mix of both.
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Moderately aggressive investors should ideally have their investments
focused on large/blue chip funds and mid-cap funds.

3) Moderately Conservative:

Moderately conservative investors are willing to take on limited risks, but

usually seek to balance this with investments that preserve the principal
investment. It means that these investors may invest in stocks but also
seek a constant income stream. In keeping with their objectives,
moderately conservative investors should invest in balanced funds. Also,
they can park their funds in large-cap funds or MIP for a regular income
stream. Monthly income plans and balanced funds limit equity exposure
and allocate a significant portion to debt instruments. This provides
stability to the portfolio, while the equity portion enables capital
appreciation and wealth accumulation.

4) Conservative:

Conservative investors tend to be risk-averse, and their primary objective

is to preserve the capital invested. In keeping with their goals,
conservative investors should ideally invest in debt mutual funds and MIP
that can generate a constant income stream.

Fund Recommendation
You purchase a mobile phone (or any consumer durable) only after
considering your needs and budget. Likewise, you should choose a mutual
fund that meets your risk tolerance and investment objectives. You can
read expert articles to understand how to zero in on a mutual fund that
fulfills your investment-related goals as well as meets your risk appetite.
Moreover, you can also follow the gamut of factors to consider while
evaluating a mutual fund investment. An investor should work towards
building a stable portfolio, one that includes large-cap funds to provide his
portfolio the desired stability, funds with a proven track record, and some
aggressive funds to enable capital appreciation.

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CHAPTER 4: ASSET ALLOCATIONS

➢ Types of asset classes

Below is the list of different asset classes one can consider for investing in
Indian markets for building a balanced portfolio. One has to understand
different asset classes and build the portfolio as per risk appetite.

In this image, you find the different asset classes and their subcategories
with risk potential.

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Note: The above chart is not an exhaustive list of products and asset
classes.

➢ Risk profiling
In financial markets, an individual's risk profile indicates his ability to
stomach risks while investing. It is one of the critical variables that a
financial planner will focus on before recommending a product to an
investor. An individual's risk profile will indicate whether he is a
conservative, moderate or aggressive investor.

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How is risk profiling carried out?
Wealth management service providers use psychometric questionnaires --
comprising queries on day-to-day situations -- to assess investor risk
profile. Generally, the individual taking the test is asked to choose one
option that best describes his response to a particular situation. These
responses help financial planners and wealth managers judge how the
individual will react when subject to a specific scenario. That forms the
basis of the individual's ability to take risks. These questionnaires,
therefore, minimize the probability of any bias that may be introduced by
wealth managers in the financial planning process. While taking the test,
an individual should be honest and select an option that best describes the
probable response.

Challenges of risk profiling

There are instances when the individual might get carried away by
ambient factors while responding to the questionnaires. Peer pressure and
market sentiment are some factors that can influence the process. For
example, an individual may appear to be a risk-taker when the stock
market exhibits an upward trend. However, the same person may appear
risk-averse in times of falling stock markets. The changing moods of
individuals thus make risk profiling problematic for wealth managers and
financial planners. If other factors remain the same, an individual's ability
to take risk will usually go down with increasing age.

But some instances do not adhere to the observation. For example, a

wealthy middle-aged investor, with no family liabilities, may be
comfortable investing in equity. To understand the changes in an
individual's risk profile that happen with increasing age and a changing
asset-liability structure, wealth managers prefer to conduct investor risk
profiling every three years.

In conclusion
Once an individual's risk profile is established, the financial planner will
suggest a financial plan, in keeping with the investor’s investment horizon
and financial goals. But such a plan is likely to change with the changing
risk profile of the individual.

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CHAPTER 5: TECHNICAL ANALYSIS

➢ Critics of Technical analysis

In spite of extensive use across investment research and trading advisory
business, technical analysis has its share of critics and detractors. A wide
range of technical indicators and diverse prognosis of chart patterns make
technical analysis more of an art than a science. Exact and accurate
prognosis of a particular chart formation is challenging, considering the
judgement of such formation is subjective. Even if the chartist is well-
versed with the intricate dynamics of chart formation, the inferences
drawn might still be far from the truth.

However, due to increased volatility in the financial markets following the

boom in information technology, charts are becoming increasingly popular
for analysing pricing action in the markets. So despite the criticism,
charting analysis has been only gaining in relevance with every passing
day.

Significance of support and resistance

Support and resistance are two of the most critical aspects of a trade set-
up. The importance of these two corresponding dynamics can be
understood by the fact that any primary technical study or a combination
of indicators eventually intends to arrive at supports and resistances for the
underlying security.

In simple terms, support is the level at which the security is expected to

witness buying, thereby cushioning its fall; while resistance is the level at
which the security is expected to witness selling, ensuring that the price
does not rise above the levels of resistance.

Technical analysis indicators

The basic tops and bottoms formation is the simplest way to arrive at the
supports or resistances on any price chart. The other studies for arriving at
the supports and resistances are pivot points, Fibonacci Retracement,
moving averages and long-term trendlines.

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Interpreting volumes on a chart
Volumes could have a sizable bearing on a chart. At times, analysing price
fluctuations in conjunction with movement in volumes of the security can
accurately identify key reversal points.

For instance, if the security is witnessing a massive surge in volumes at a

particular price point, there is a chance that a sizeable portion of market
participants consider that particular price point to be a critical support
level.

Often, volumes can surge after prices successfully breach a critical level
and then trade above it. It magnifies the importance of volumes as an
indicator of crowd psychology.

Golden Ratio
There exists a special ratio, one that can be used to describe the
proportions of anything and everything; from nature's smallest building
blocks to the most intricate patterns out there in the universe - celestial
bodies, for instance.

While nature relies on this proportion to maintain the fine balance in its
scheme of things, financial markets also conform to this ratio, called the
Golden ratio.

The mathematics behind the ratio

Scientists and mathematicians have known the golden ratio since
centuries. The ratio is derived from something called the Fibonacci
Sequence, named after the Italian founder, Leonardo Fibonacci.

In this sequence, each number is simply the sum of its two preceding
numbers/terms. For example, the sequence (1,1,2,3,5,8,13) adheres to the
Fibonacci Sequence.

However, the sequence is not all that important. Instead, it is the quotient
of the adjacent terms that has a definitive proportion, an estimated 1.618
or 0.618 (inverse).

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This proportion has come to be known by many names; some call it the
golden mean, some call it PHI, while others have named it the divine
proportion.

Why is the ratio so significant?

That is because everything around us has dimensional properties that
arrange in this ratio of 1.618. Therefore, the golden ratio appears to play a
fundamental role across nature's building blocks.

➢ Importance of support and resistance

Supports and resistance are two of the most critical aspects in a trade set
up. The importance of these two corresponding dynamics could be
underlined by the fact that any primary technical study or a combination of
indicators eventually intends to arrive at supports and resistances for the
underlying security.

In simple terms, support is the level at which the

security is expected to witness buying, thereby
cushioning its fall while resistance is the level at
which the security is expected to witness selling,
ensuring that the price does not rise above the
levels of resistance.
The basic tops and bottoms formation is the simplest way to arrive at the
supports or resistances on any price chart. The other studies for arriving at
the supports and resistances are Pivot Points, Fibbonaci Ratio, moving
averages and long-term trendlines.

➢ Interpreting volumes on a chart

Volumes could have a sizable bearing on chart. At times, analyzing price

moves in conjunction with the movement in volumes on the security could
give an exact and accurate idea in terms of identifying key reversal points.

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If the security is witnessing a massive surge in volumes at a particular
point of price, there may be chances that a substantial chunk of the market
participants believe that point in price to be a critical support level. At
times the volumes tend to surge after prices successfully breach a critical
level and tend trade above it. This magnifies the importance of volumes as
an indicator of the crowd psychology.

➢ Golden Mean Ratio

The Golden mean, represented by the Greek letter phi, is one of those
mysterious natural numbers, like e or pi, that seem to arise out of the basic
structure of our cosmos. Unlike those abstract numbers, however, phi
appears clearly and regularly in the realm of things that grow and unfold
in steps, and that includes living things.

There is a special ration that can be used to

describe the proportions of everything from
nature's smallest building blocks, such as atoms,
to the most advanced patterns in the universe,
such as unimaginably large celestial bodies.
Nature relies on this innate proportion to
maintain balance, but the financial markets also
seem to conform to this 'golden ratio.'
It's derived from something known as the Fibonacci sequence, named after
its Italian founder, Leonardo Fibonacci (whose birth is assumed to be
around 1175 AD and death around 1250 AD). Each term in this sequence
is simply the sum of the two preceding terms (1, 1, 2, 3, 5, 8, 13, etc.).

But this sequence is not all that important; rather, it is the quotient of the
adjacent terms that possesses an amazing proportion, roughly 1.618, or its
inverse 0.618. This proportion is known by many names: the golden mean,
PHI and the divine proportion, among others. So, why is this number so
important? Well, almost everything has dimensional properties that adhere

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to the ratio of 1.618, so it seems to have a fundamental function for the
building blocks of nature.

➢ Importance of charts
There are several reasons why charts have assumed significance in
financial market research and analysis over the last couple of decades.

• One of the primary reasons for this was the widespread boom in
the information technology during the 1990s that facilitated the use
of charting software and while contributing to increased awareness
about the use of charts as an efficient indicator to track financial
markets.
• Also, considering the giant strides that financial reporting has
taken in recent times coupled with the penetration of financial
media in emerging economies, market movements across the world
have become more 'responsive' to micro trends.

Importantly, this has been witnessed in seemingly unrelated sectors and

segments in the global economy.

Therefore, as news flow increased multifold, the most reliant indicator as

to where the prices could be moving turned out to be the price itself. Also,
the rapid boom in global news networks and the rise of social media have
blurred the lines between nations, and financial markets around the world
started reflecting generalized sentiments in world asset markets.

➢ Fibonacci Retracements
Fibonacci sequences are generally meant to find out reversals in charts.
The main area to look for in a chart with Fibonacci retracements is
corrections or pullbacks. In simple words, the basic purpose of these
retracements is to find supports and resistances.

The retracements are 100%, 61.8%, 50% and 38.2%. Now let’s look at the
daily chart of Copper. Fibonacci levels built from the bottom of Rs 397.1,
i.e. 100% of the value to Rs 433.7 per kg.

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This is also the immediate bullish wave after the downtrend. If one has to
look at the supports and resistances for copper from the top, i.e. Rs 433.7,
he will have to consider the levels of Rs 419.9, that is also the 38.2%
corrective level. Although 23.6% is one retracement level in between, it is
not considered very important in the Fibonacci series. The two levels that
are considered are 38.2% and 61.8%.

If copper falls further below the Rs.419.9 level, it is expected that it will
try to find support at Rs.411 or somewhere near that, considering it is the
61.8% correction point. Similarly, a bounce from Rs.411 will find hurdles
at Rs.415 and Rs.419.9 per kg, that are the 50% and 31.8% pullback points
for Copper.

Note: Though 61.8% and 38.2% have been given much weight in the
Fibonacci series, it depends on individual analysts to also consider 50%
and 23.6% retracements, if other technical indicators indicate the same
levels.

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CHAPTER 6: DERIVATIVES CONCEPTS

➢ Types of derivative

Forward Contracts
These are the simplest form of derivative contracts. A forward contract is
an agreement between parties to buy/sell a specified quantity of an asset at
a certain future date for a certain price. One of the parties to a forward
contract assumes a long position and agrees to buy the underlying asset at
a certain future date for a certain price. The other party to the contract
assumes a short position and agrees to sell the asset on the same date for
the same price. The specified price is referred to as the delivery price. The
contract terms like delivery price and quantity are mutually agreed upon
by the parties to the contract. No margins are generally payable by any of
the parties to the other.

Futures contracts
A futures contract is one by which one party agrees to buy from / sell to
the other party at a specified future time, a specified asset at a price agreed
at the time of the contract and payable on the maturity date. The agreed
price is known as the strike price. The underlying asset can be a
commodity, currency, debt or equity security etc. Unlike forward
contracts, futures are usually performed by the payment of difference
between the strike price and the market price on the fixed future date, and
not by the physical delivery and the payment in full on that date.

Forward Contract Future Contract

• Each contract is custom
• Standardized contract terms
designed, and hence is
viz. the underlying asset, the
unique in terms of contract
time of maturity and the
size, maturity date and the
manner of maturity etc.,
asset type and quality,

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 • On the expiration date, the
contract is normally settled • Cash Settled
by the delivery of the asset,

• Traded through an organized

exchange and thus have
greater liquidity. The
existence of a regulatory
• Forward contracts being
authority & the
bilateral contracts are
clearinghouse, being the
exposed to counter party
counter party to both sides of
risk, and If the party wishes
a transaction, provides a
to cancel the contract or
mechanism that guarantees
change any of its terms, it
the honoring of the contract
has necessarily to go to the
and ensuring a very low level
same counter party.
of default. Margin
requirements and daily
settlement to act as further
safeguard.

Types of Future Contracts

Common types of ‘futures contracts’ are stock index futures, currency
futures, and interest futures depending on their underlying assets.

Index Futures

Index Futures are future contracts where the underlying asset is the Index.
This is of great help when one wants to take a position on market
movements. Suppose you feel that the markets are expected to rise and say
the Sensex would cross 5,000 points. Instead of buying shares that
constitute the Index you can buy the market by taking a position on the
Index Future.

Currency futures

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Currency futures are contracts to buy or sell a specific underlying currency
at a specific time in the future, for a specific price. Currency futures are
exchange-traded contracts and they are standardized in terms of delivery
date, amount and contract terms. Currency Futures have a minimum
contract size of 1000 foreign underlying currency (i.e. INR
1000). Currency future contracts allow investors to hedge against foreign
exchange risk. Since these contracts are marked-to-market daily, investors
can--by closing out their position--exit from their obligation to buy or sell
the currency prior to the contract's delivery date.

Interest Futures

Interest rate futures (IRF) is a standardized derivative contract traded on a

stock exchange to buy or sell an interest bearing instrument at a specified
future date, at a price determined at the time of the contract. The interest
rate future allows the buyer and seller to lock in the price of the interest-
bearing asset for a future date. IRFs can be on underlying as may be
specified by the Exchange and approved by SEBI from time to time and it
can be based on 1) Treasury Bills in the case of Treasury Bill Futures
traded; 2) Treasury Bonds in the case of Treasury Bond Futures traded; 3)
other products such as CDs, Treasury Notes are also available to trade as
underlying assets in an interest rate future. Because interest rate futures
contracts are large in size (i.e. INR 1 million for Treasury Bills), they are
not a product for the less sophisticated trader.

Determination of Future Prices

The price of the futures refers to the rate at which the futures contract will
be entered into. The basic determinants of futures price are spot rate and
other carrying costs. In order to find out the futures prices, the costs of
carrying are added/deducted to the spot rate. The costs of carrying depend
upon the time involved and rate of interest and other factors. On the
settlement date, the futures price would be the spot rate itself. However,
before the settlement day, the futures price may be more or less than the
prevailing spot rate. In case, the demand for future is high, the buyer of
futures will be required to pay a price higher than the spot rate and the
additional charge paid is known as the contango charge. However, if the
sellers are more, the futures price may be lower than the spot rate and the
difference is known as backwardation. For example, with reference to the
Stock Index Futures, the pricing would be such that the investors are
indifferent between owning the share and owning a futures contract. The

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price of stock index futures should equate the price of buying and carrying
such shares from the share settlement date to the contract maturity date.
The financing cost of buying the shares would generally be more than the
dividend yield. This means that there is a cost of carrying the shares
purchased. So, the price of a futures contract will be higher than the price
of the shares.

The carrying cost of Stock Index Futures may be written as:

Index value X (Financing Cost – Dividend yield) X

Where t is the time period from share settlement date to the maturity date
of the futures contract.

For example, if the Index level is 4500, the rate of interest (financing cost
is 12%), the dividend yield is 4% and the futures contract is for a period of
4 months, the carrying cost in terms of basic points is:
Carrying cost = 4500 (12% – 4%) X 4/12 = 120 basis points.

The value of the futures contract is 4500 + 120 = 4620 points for a period
of 4 months.

Swaps

A swap can be defined as a barter or exchange. A swap is a contract

whereby parties agree to exchange obligations that each of them has under
their respective underlying contracts or we can say a swap is an agreement
between two or more parties to exchange sequences of cash flows over a
period in the future. The parties that agree to the swap are known as
counter parties. There are two basic kinds of swaps - 1) Interest rate swaps
and 2) Currency swaps.

An interest rate swap contract involves an exchange of cash flows related

to interest payments, or receipts, on a notional amount of principal, that is
never exchanged, in one currency over a period of time. Settlements are
often made through net cash payments by one counterparty to the
other. Currency swap/Foreign exchange swap contracts involve a spot
sale/purchase of currencies and a simultaneous commitment to a forward
purchase/sale of the same currencies.

Option Contracts

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The literal meaning of the word ‘option’ is ‘choice’ or we can say ‘an
alternative for choice’. In derivatives market also, the idea remains the
same. An option contract gives the buyer of the option a right (but not the
obligation) to buy/sell the underlying asset at a specified price on or before
a specified future date. As compared to forwards and futures, the option
holder is not under an obligation to exercise the right. Another
distinguishing feature is that, while it does not cost anything to enter into a
forward contract or a futures contract, an investor must pay to the option
writer to purchase an options contract. The amount paid by the buyer of
the option to the seller of the option is referred to as the premium. For this
reward i.e. the option premium, the option seller is under an obligation to
sell/buy the underlying asset at the specified price whenever the buyer of
the option chooses to exercise the right.

Option contracts having simple standard features are usually called plain
vanilla contracts. Contracts having non-standard features are also
available that have been created by financial engineers. These are called
exotic derivative contracts. These are generally not traded on exchanges
and are structured between parties on their own. The final difference
between exotic options and regular options has to do with how they trade.
Regular options consist of calls and puts and can be found on major
exchanges such as the Chicago Board Options Exchange. Exotic options
are mainly traded over the counter, which means they are not listed on a
formal exchange, and the terms of the options are generally negotiated by
brokers/dealers and are not normally standardized as they are with regular
options.

Moneyness of an Option:

Options can also be characterized in terms of their moneyness.

1. An in-the-money option is one that would lead to a positive cash flow to the
buyer of the option if the buyer of the option exercises the option at the
current market price.
2. An at-the-money option is one that would lead to a zero cash flow to the
buyer of the option if the buyer of the option exercises the option at the
current market price.
3. An out-of-the-money option is one that would lead to a negative cash flow to
the buyer of the option if the buyer of the option exercises the option at the
current market price.
4.

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 Call Option Put Option
In-the-money M>E M<E
At-the-money M=E M=E
Out-of-the-money M<E M>E

Where M is the prevalent market price for the option contract, and E is the
exercise price of the option contract. For a seller/writer of the option the >,
< signs will reverse.

➢ What are derivatives

A derivative is a financial instrument that derives its value from an
underlying entity. The underlying entity, in this case, can be an asset or a
group of assets, interest rate or an index.
In investing, derivatives are used to speculate and transfer risks as well.
The underlying asset value generally changes in keeping with the market
conditions. The primary objective of entering into a derivatives contract is
to make a profit by speculating on the underlying asset value at a future
date.

➢ How do derivatives work?

Say you invest in a stock, the price of which will fluctuate. In this case,
you might incur a loss if the stock price nosedives. That is precisely why
you enter into a derivative contract to make a profit by placing a straight
bet, or hedge against losses in the spot market.
When one enters into a derivatives contract, the medium and rate of
repayment are specified in detail. For instance, repayment may be in
currency, securities or a physical commodity such as gold or silver.
Similarly, the amount of repayment may be tied to the movement in
interest rates, stock indexes or foreign currency.

➢ Applications of financial derivatives

Risk management
Risk management is not about the elimination of risk. Instead, it is the
efficient management of risks. Financial derivatives are a powerful risk-

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limiting vehicle that individuals and organizations face in the ordinary
conduct of their businesses.

Successful risk management with derivatives requires a thorough

understanding of the principles that govern the pricing of financial
derivatives. If used correctly, derivatives can save costs and increase
returns.

Trading efficiency
Derivatives allow for the free trading of individual risk components,
thereby improving market efficiency. Traders can use a position in one or
more financial derivatives as a substitute for a position in the underlying
instruments.

In many instances, traders find financial derivatives to be a more attractive

instrument than the underlying security. That is because financial
derivatives offer a higher degree of liquidity and entail lower transaction
costs as compared to an underlying instrument.

Speculation
Financial derivatives enable investors to speculate on the price of the
underlying asset at a future date and make a profit. Financial derivatives
act a powerful instrument for
knowledgeable traders, helping them expose themselves to calculated and
well-understood risks in pursuit of a reward (profit).

➢ Potential pitfalls of derivatives

Volatile investments
Most derivatives trade in the open market. It is problematic for investors
because of the security fluctuating in value. It is constantly changing
hands, and therefore, the party who created the derivative has no control
over who owns it.

In a private contract, each party can negotiate the terms, depending on the
other party’s position. When a derivative is sold in the open market, large

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positions may be purchased by investors who have a high likelihood to
default on their investment.

The other party can’t change the terms to respond to the additional risk
because they will then be transferred to the owner of the new derivative.
Due to this volatility, investors can lose their entire value overnight.

Overpriced options
Derivatives are also complicated to value because they derive their value
from an underlying security. Since valuing a share of stock (or any other
underlying asset) is challenging, it becomes more challenging to assess the
value of a derivative accurately.

Moreover, since the derivatives market is not as liquid as the stock market,
and there aren’t as many 'players' in the market to close them, there are
larger bid-ask spreads.

Time restrictions
Possibly the biggest reason derivatives are risky for investors is that they
have a shelf contract life. After they expire, they become worthless. If
your investment bet doesn’t work out within the specified time frame, you
can incurr a total loss.

Potential scams
Investors have a hard time understanding derivatives. Scam artists often
use derivatives to build complex schemes to take advantage of both
amateur and professional investors.

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CHAPTER 7: FUTURES & OPTIONS

➢ F&O Important terminologies

Call Option: A call option gives the buyer of the option the right (but not
the obligation) to buy the underlying asset on or before a certain future
date for a specified price.

Put Option: A put option gives the buyer of the option the right (but not
the obligation) to sell the underlying asset on or before a certain future
date for a specified price.

American Option: An American option can be exercised at any time up

to the expiration date. Most of the option contracts traded on exchanges
are of the type of American option.

European Option: A European option can be exercised only on the

expiration date itself.

Strike Price or Exercise Price : The strike or exercise price of an option

is the specified/ pre-determined price of the underlying asset at which the
same can be bought or sold if the option buyer exercises his right to buy/
sell on or before the expiration day.

Option Premium : Premium is the price paid by the buyer to the seller to
acquire the right to buy or sell.

Expiration date : The date on which the option expires is known as

Expiration Date. On the Expiration date, either the option is exercised or it
expires worthless.

Exercise Date : The date on which the option is actually exercised. In

case of European Options the exercise date is same as the expiration date
while in case of American Options, the options contract may be exercised
any day between the purchase of the contract & its expiration date (see
European/ American Option).

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Open Interest : The total number of options contracts outstanding in the
market at any given point of time.

Option Holder : One who buys an option which can be a call or a put
option. He enjoys the right to buy or sell the underlying asset at a
specified price on or before specified time. His upside potential is
unlimited while losses are limited to the Premium paid by him to the
option writer.

Option seller/ writer : is the one who is obligated to buy (in case of Put
option) or to sell (in case of call option), the underlying asset in case the
buyer of the option decides to exercise his option. His profits are limited
to the premium received from the buyer while his downside is unlimited.

Option Class : All listed options of a particular type (i.e., call or put) on a
particular underlying instrument, e.g., all Sensex Call Options (or) all
Sensex Put Options

Option Series : An option series consists of all the options of a given

class with the same expiration date and strike price. E.g. BSXCMAY3600
is an options series which includes all Sensex Call options that are traded
with Strike Price of 3600 & Expiry in May.

Underlying : The specific security/asset on which an options contract is

based.

Contract multiplier : The contract multiplier for Sensex Futures is 50

and for Sensex Options is 100. This means that the Rupee value of a
Sensex futures contract would be 50 times the contracted value and in case
of Sensex Options, the rupee value would be 100 times the contracted
value. The following table gives a few examples of this notional value.

Ticket Size : The tick size is "0.1" for Sensex Futures. This means that the
minimum price fluctuation in the value of a future can be only 0.1. In
Rupee terms, this translates to minimum price fluctuation of Rs. 5 (Tick
size X Contract Multiplier = 0.1 X Rs. 50). Likewise, the tick size is
“0.05” for Nifty Futures.

Customer margin

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Within the futures industry, financial guarantees of both buyers as well as
sellers of futures and options contracts are required to ensure fulfillment of
contract obligations. Margins are determined on the basis of market risks
and contract value. It is also referred to as ‘Performance Bond Margin’.

For example let’s say there are three parties X (Buyer), Y (Seller) and Z
(Broker). X is interested in buying a futures contract for Rs. 100 as he
thinks its price would go up by the settlement date. Y, on the other hand,
wants to sell the futures contract for Rs. 100 as he thinks its price will go
down by the settlement date. And Z is the broker who will be executing
the deal on behalf of investors X & Y.

Since, derivative trading is about taking a ‘call’ on the upward and

downward movement of the price of an underlying asset and not the
absolute or actual price of the total contract, the Stock Exchange has to be
hedged by investors (X & Y) to the extent of the expected margin of loss
that the investor might incur with broker (Z) who is acting as a mediator
between investors and exchange.

For example in the case illustrated, where the cost of futures is Rs. 100, in
all likelihood its value would go up or down by say Rs. 10 either way by
the settlement date, based on expected volatility which is calculated
mathematically. Hence the margin money sought by the Exchange through
the broker from either party would be 10% of the total value (Rs.10 in the
given example).

Now let’s say by the settlement date, the scrip would be valued at Rs.
108. This means that ‘X’ will make a profit of Rs. 8 while ‘Y’ will incur a
loss of Rs. 8. The broker hence credits the investor ‘X’s account by Rs. 8
along with the margin money of Rs 10. Hence, in total, ‘X’ receives Rs 18.
On the other hand, ‘Y’ who has incurred a loss will see a debit of Rs. 8
from his margin money which was with the broker and the remaining Rs.
2 will be transferred to his account.

Therefore the “funding” that goes to the broker to execute derivative deals
is called “Margin Funding” or “Margin Money”.

The long call option strategy is the most basic options trading strategy
whereby an options trader

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buys call options with the belief that the price of the underlying security
will rise significantly beyond the strike price before the expiration date of
the option. When compared to buying the underlying shares outright, the
call option buyer is able to gain leverage since lower priced calls usually
appreciate in value faster for every point rise in the price of the underlying
stock.

However, call options have a limited lifespan. If the underlying stock price
does not move above the strike price before the option expiration date, the
call option will expire worthlessly.

Maximum profit = Unlimited

Profit is achieved when price of Underlying >= Strike Price of Long Call
+ Premium paid

Profit = Price of Underlying - Strike Price of Long Call - Premium paid

Maximum loss = Premium paid + Commissions paid

Maximum loss occurs when price of Underlying <= Strike Price of Long
Call

Breakeven Point = Strike Price of Long Call + Premium paid

H4 Summary:

Parameters Long Call

A strong, upward move in the underlying asset is

Anticipations
anticipated

Characteristics Unlimited profit / limited loss

Max profit - Unlimited

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Max profit Price of Underlying - Strike Price of Long Call -
formula Premium Paid

Limited to the net debit required to establish the

Max loss
position

Max loss formula Premium Paid + Commissions Paid

Breakeven Strike Price of Long Call + Premium Paid

➢ Synthetic short call

Synthetic short call is created when a short stock position is combined
with a short put of the same series. The synthetic short call is named so
because the established position has the same profit potential as a short
call.

Maximum profit = Premium received - Commissions paid

Maximum profit is achieved when price of Underlying <= Strike Price of

Short Put

Maximum loss = Unlimited

Loss occurs when price of Underlying > Sale Price of Underlying +

Premium received

Loss = Price of Underlying - Sale Price of Underlying - Premium received

+ Commissions paid.

Breakeven Point = Sale Price of Underlying + Premium received

Summary:

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Parameters Synthetic Short Call

A downward move in the underlying asset is

Anticipations
anticipated.

Characteristics Limited profit / unlimited loss.

Max profit - Limited to the net credit received.

Max profit
Premium Received - Commissions Paid
formula

Max loss Unlimited.

Max loss Price of Underlying - Sale Price of Underlying -

formula Premium Received + Commissions Paid.

Breakeven Sale Price of Underlying + Premium Received

➢ Long put
The long put option investment strategy is a basic strategy in options
trading where the investor buys put options with the belief that the price of
the underlying security will go significantly below the striking price
before the expiration date.

H4- Essential features of long put

Parameters Long Put

A strong, downward move in the underlying asset is

Anticipations
anticipated

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 Characteristic Unlimited profit / limited loss

Max profit Unlimited

Max profit
Strike Price of Long Put - Premium Paid
formula

Limited to the net debit required to establish the

Max loss
position

Max loss formula Premium Paid + Commissions Paid

Breakeven Strike Price of Long Put - Premium Paid

➢ Short put
Short put is sometimes known as a Put Write, Naked Put, Write Put, or
Uncovered Put Write. This option refers to the condition when a trader
commences an options trade by writing or selling a put option. Traders
buying the put option are long, while those writing it are short.

Essential features of short put

Parameters Short put

Anticipations An upward move in the underlying asset is anticipated

Characteristics Limited profit / unlimited loss

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Max profit Limited to the net credit received

Max loss Unlimited in a falling market

Breakeven Strike Price - Premium value of put options sold

➢ Bull call spread

An options strategy that involves purchasing call options at a specific
strike price while also selling the same number of calls of the same asset
and expiration date but at a higher strike is known as a bull call spread .

A bull call spread is used when a moderate rise in the price of the
underlying asset is expected.

Essential features of bull call spread

Parameters Bull Call Spread ( Bull Debit Spread )

An upward move in the underlying asset, but the extent

Anticipations
of the move is uncertain

Characteristics Limited profit / limited loss

Difference between the strike prices less net debit of

Max profit -
spread

Max profit Strike Price of Short Call - Strike Price of Long Call -
formula Net Premium Paid - Commissions Paid

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 Max loss Limited to the net debit required to establish the position

Max loss
Net Premium Paid + Commissions Paid
formula

Breakeven Strike Price of Long Call + Net Premium Paid

➢ Bull put spread

This options trading strategy is constructed by purchasing one put option
while simultaneously selling another put option with a higher strike price.
It is a type of options strategy that is used when the investor expects a
moderate rise in the price of the underlying asset.

The goal of this strategy is realized when the price of the underlying stays
above the higher strike price, which causes the short option to expire
worthless, resulting in the trader keeping the premium.

Summary:
Bull Put Spread ( Bull Credit Spread )
An upward move in the underlying asset, but the
Anticipations
extent of the move is uncertain.
Characteristics Limited profit / limited loss.
Max profit - Limited to the net credit received
Max profit
Net Premium Received - Commissions Paid
formula
difference between the strike prices less net
Max loss
credit received
Strike Price of Short Put - Strike Price of Long
Max loss formula
Put Net Premium Received + Commissions Paid
Strike Price of Short Put - Net Premium
Breakeven
Received

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 ➢ Bear put spread
Bear put spread is achieved by purchasing put options at a specific strike
price while also selling the same number of puts at a lower strike price.
It’s a type of options strategy used when an option trader expects a decline
in the price of the underlying asset.

Summary:
Bear Debit Spread ( Bear Put Spread )
A downward move in the underlying asset, but
Anticipations
the extent of the move is uncertain.
Characteristics Limited profit / limited loss.
Limited to the difference between the strike
Max profit -
prices less net debit of the spread.
Max profit
High strike - low strike - net premium paid
formula
Limited to the net debit required to establish the
Max loss
position
Max loss formula Net premium paid
Breakeven long put strike - net debit paid

➢ Bear call spread

It is achieved by selling call options at a specific strike price while also
buying the same number of calls, but at a higher strike price. A type of
options strategy used when a decline in the price of the underlying asset is
expected.

Max Profit = Net Premium Received - Commissions Paid

Max Profit achieved when the price of underlying <= Strike Price of Short
Cal

lMax Loss = Strike Price of Long Call - Strike Price of Short Call - Net
Premium Received + Commissions Paid

Max Loss Occurs When Price of Underlying >= Strike Price of Long Call

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Breakeven Point = Strike Price of Short Call + Net Premium Received

Summary:
Bear Credit Spread ( Bear Call Spread )
A downward move in the underlying asset, but
Anticipations
the extent of the move is uncertain.
Characteristics Limited profit / limited loss.
Max profit - Limited to the net credit received.
Max profit
Net Premium Received - Commissions Paid
formula
Difference between the strike prices less net
Max loss
credit received.
Strike Price of Long Call - Strike Price of Short
Max loss formula Call - Net Premium Received + Commissions
Paid
Strike Price of Short Call + Net Premium
Breakeven
Received

➢ Long straddle
A strategy of trading options whereby the trader will purchase a long call
and a long put with the same underlying asset, expiration date, and strike
price. The strike price will usually be at the money or near the current
market price of the underlying security. The strategy is a bet on increased
volatility in the future as profits from this strategy are maximized if the
underlying security moves up or down from present levels. Should the
underlying security's price fail to move or move only a small amount, the
options will be worthless at expiration.

Maximum Profit: Unlimited

Maximum Loss: Premiums paid

Breakeven
This strategy breaks even if, at expiration, the stock price is either above
or below the strike price by the amount of premium paid. At either of

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those levels, one option's intrinsic value will equal the premium paid for
both options while the other option will be expiring worthless.

Upside breakeven = strike + premiums received

Downside breakeven = strike - premiums received​

Summary:
Long Straddle ( Straddle Purchase )
A very volatile, immediate, and sharp swing in
the price of the underlying asset is expected. The
Anticipations actual market direction is uncertain, so the
positions of this strategy will benefit if the
underlying asset either rises or falls.
Characteristics Unlimited profit / limited loss.
Max profit Unlimited.
Limited to the net debit required to establish the
Max loss
position.
Max loss formula Premiums paid
Upside breakeven = strike + premiums received
Breakeven Downside breakeven = strike - premiums
received

➢ Short straddle
An options strategy carried out by holding a short position in both a call
and a put that have the same strike price and expiration date. The
maximum profit is the amount of premium collected by writing the
options.

Features of the short straddle strategy

• Max Profit = Net Premium Received - Commissions Paid
• Max Profit Achieved When Price of Underlying = Strike Price of
Short Call/Put
• Maximum Loss = Unlimited

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Loss Occurs When Price of Underlying > Strike Price of Short Call + Net
Premium Received OR Price of Underlying < Strike Price of Short Put -
Net Premium Received

Loss = Price of Underlying - Strike Price of Short Call - Net Premium

Received OR Strike Price of Short Put - Price of Underlying - Net
Premium Received + Commissions Paid

Breakeven Point(s)
There are 2 breakeven points for the short straddle position. The
breakeven points can be calculated using the following formulae.

• Upper Breakeven Point = Strike Price of Short Call + Net Premium

Received
• Lower Breakeven Point = Strike Price of Short Put - Net Premium
Received

Summary:
Short Straddle ( Straddle Write )
This market outlook anticipates very little
Anticipations
underlying asset.
Characteristics Limited profit / unlimited loss.
Max profit - Limited profit / unlimited loss.
Max profit
Net Premium Received - Commissions Paid
formula
Max loss Unlimited.
Price of Underlying - Strike Price of Short Call -
Net Premium Received OR Strike Price of Short
Max loss formula
Put - Price of Underlying - Net Premium
Received + Commissions Paid
Upper Breakeven Point = Strike Price of Short
Call + Net Premium Received
Breakeven
Lower Breakeven Point = Strike Price of Short
Put - Net Premium Received

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 ➢ Long Strangle
The long strangle, also known as buy strangle or simply "strangle", is a
neutral strategy in options trading that involves the simultaneous buying of
a slightly out-of-the-money put and a slightly out-of-the-money call of the
same underlying stock and expiration date. The long options strangle is an
unlimited profit, limited risk strategy that is taken when the options trader
thinks that the underlying stock will experience significant volatility in the
near term.

Maximum Profit = Unlimited

Profit achieved when the price of underlying > Strike Price of Long Call +
Net Premium Paid OR Price of Underlying < Strike Price of Long Put -
Net Premium Paid

Profit = price of underlying - Strike Price of Long Call - Net Premium

Paid OR Strike Price of Long Put - Price of Underlying - Net Premium
Paid

Max Loss = Net Premium Paid + Commissions Paid

Max Loss occurs when the Price of Underlying is in between Strike Price
of Long Call and Strike Price of Long Put.

Summary:
Long Strangle ( Strangle Purchase )
A very volatile, immediate, and sharp swing in the
price of the underlying asset is expected. The actual
market direction is uncertain, so the positions of this
Anticipations strategy will benefit if the underlying asset either
rises or falls, direction is uncertain, so the positions
of this strategy will benefit if the underlying asset
either rises or falls.
Characteristics Unlimited profit / limited loss.
Max profit - Unlimited.

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 Price of Underlying - Strike Price of Long Call -
Max profit formula Net Premium Paid OR Strike Price of Long Put -
Price of Underlying - Net Premium Paid
Limited to the net debit required to establish the
Max loss
position
Max loss formula Net Premium Paid + Commissions Paid
Upper Breakeven Point = Strike Price of Long Call
+ Net Premium Paid
Breakeven
Lower Breakeven Point = Strike Price of Long Put -
Net Premium Paid

Breakeven Point(s)
There are 2 breakeven points for the long strangle position. The breakeven
points can be calculated using the following formulae.

Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid

Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Summary

Long Strangle ( Strangle Purchase )

A very volatile, immediate, and sharp swing in the price of

the underlying asset is expected. The actual market
direction is uncertain, so the positions of this strategy will
Anticipations
benefit if the underlying asset either rises or falls, the
direction is uncertain, so the positions of this strategy will
benefit if the underlying asset either rises or falls.

Characteristics Unlimited profit / limited loss.

Max profit - Unlimited.
Price of Underlying - Strike Price of Long Call - Net
Max profit
Premium Paid OR Strike Price of Long Put - Price of
formula
Underlying - Net Premium Paid

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Max loss Limited to the net debit required to establish the position

Max loss
Net Premium Paid + Commissions Paid
formula
Upper Breakeven Point = Strike Price of Long Call + Net
Premium Paid
Breakeven
Lower Breakeven Point = Strike Price of Long Put - Net
Premium Paid

➢ Short Strangle
The short strangle, also known as sell strangle, is a neutral strategy in
options trading that involves the simultaneous selling of a slightly out-of-
the-money put and a slightly out-of-the-money call of the same underlying
stock and expiration date.

The short strangle is a 'limited profit unlimited risk' options trading

strategy that the options trader uses when he believes that the underlying
stock is likely to experience little short-term volatility.

Max profit = Net premium received - Commissions paid

Max profit is achieved when the price of the underlying is in between the
strike price of the short call and strike price of the short put.

Maximum loss = Unlimited

Loss is when the price of the underlying is more than (>) strike price of
short call + net premium received, OR the price of the underlying is less
than (<) strike price of short put - net premium received.

Loss = Price of the underlying - Strike price of short call - Net premium
received, OR Strike price of short put - Price of the underlying - Net
premium received + Commissions paid

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Breakeven point(s)
There are 2 breakeven points for a short strangle position. The breakeven
points can be calculated using the following formulae:

• Upper breakeven point = Strike price of short call + Net premium

received
• Lower breakeven point = Strike price of short put - Net premium
received

Summary:
Short Strangle (Strangle Write)
This market outlook anticipates little movement
Anticipations
in the underlying asset.
Characteristics Limited profit / unlimited loss.
Max profit - Limited to the net credits received.
Max profit
Net Premium Received - Commissions Paid
formula
Max loss Unlimited
PPrice of underlying - Strike price of short call -
Net premium received

Max loss formula OR

Strike price of short put - Price of the underlying

- Net premium received + Commissions paid
Upper breakeven point = Strike price of short
call + Net premium received
Breakeven
Lower breakeven point = Strike price of short
put - Net premium received

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 ➢ Future & Forward contract

Forward contracts
Forward contracts are the simplest form of derivative contracts. A forward
contract is an agreement between the parties to buy/sell a specified
quantity of an asset at a specific future date for a certain price.

One of the parties to a forward contract assumes a long position and

agrees to buy the underlying asset at a specific price in the future. The
other party to the contract assumes a short position and decides to sell the
asset on the same date for the same price.

The specified price is called the delivery price. The contract terms,
including delivery price and quantity, are mutually agreed upon by the
parties to the contract. No margins are generally payable by any of the
parties to the other.

Futures contracts
A futures contract is an arrangement by which one party agrees to buy/sell
to the other party an asset at a specified future date, and at a price that is
agreed upon at the time of the contract, payable on maturity. The agreed
price is known as the strike price.

The underlying asset can be a commodity, currency, debt, equity or any

other security. Unlike forward contracts, futures are usually performed by
the payment of the difference between the strike price and the market price
on a fixed future date.

Forward contract Future contract

Each contract is custom
designed, and hence unique in Standardized contract terms, including
terms of contract size, maturity the underlying asset, time of maturity
date, asset type and quality
On the expiration date, the
contract is normally settled by Cash settled
the delivery of the asset

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 These are traded through an organized
Forward contracts, being
exchange, and thus have greater liquidity.
bilateral contracts, are exposed
Margin requirements and daily settlement
to counterparty risk
act as further safeguards against risks

Types of future contracts

Common types of futures contracts, depending on the underlying asset,
can be categorized as stock index futures, currency futures and interest
futures.

Index futures
Index futures are futures contracts where the underlying asset is the index
itself. Investors who want to take a position on market movements can
particularly benefit from index futures.

For instance, you feel that the markets are expected to rise, and the Sensex
could go beyond 5,000 points. Here, by taking a position on index futures,
you can buy the market instead of buying shares that constitute the index.

Currency futures
Currency futures are contracts to buy or sell a specific underlying
currency, at a particular time in the future, and for a specific price.
Currency futures are exchange-traded contracts, and they are standardized
in terms of the delivery date, amount and agreement terms.

Currency future contracts allow investors to hedge against foreign

exchange risk. Since these contracts are marked-to-market daily, investors
can--by closing out their position--exit from their obligation to buy or sell
the currency before the contract's delivery date.

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Interest futures
Interest rate futures (IRF) is a standardized derivative contract, traded on a
stock exchange to buy or sell an interest-bearing instrument at a specified
future date, and at a price determined at the time of the contract. Interest
futures allow the buyer and seller to lock the interest-bearing asset's price
for a future date.

Determination of futures prices

The price of the futures refers to the rate at which the futures contract will
be entered into. The basic determinants of futures price are spot rate and
other carrying costs. To find out the futures prices, the costs of carrying
are added/deducted to the spot rate.

The costs of carrying depend upon the time involved, rate of interest and
other factors. On the settlement date of your investment, the futures price
would be the spot rate itself.

Things to note
However, note that before the settlement day, the futures price may be
more or less than the prevailing spot rate. In case, the demand for futures
is high, the investor of futures will be required to pay a price higher than
the spot rate, and the additional charge paid is known as the contango
charge.

However, if the sellers are more, the futures price may be lower than the
spot rate. The difference is known as backwardation.

For example, with reference to the stock index futures, the pricing would
be such that the investors are indifferent between owning the share and
owning a futures contract. The price of stock index futures should equate
the price of buying and carrying such shares from the share settlement date
to the contract maturity date.

The financing cost to buy a share would generally be more than the
dividend yield. This means that there is a cost of carrying the shares
purchased. So, the price of a futures contract will be higher than the price
of the shares.

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Formula to calculate carrying cost of stock index
futures
The carrying cost of Stock Index Futures may be written as:

Index value X (Financing Cost – Dividend yield) X t/12

Where t is the time period from share settlement date to the maturity date
of the futures contract.

For example, if the Index level is 4500, the rate of interest (financing cost
is 12%), the dividend yield is 4% and the futures contract is for a period of
4 months, the carrying cost in terms of basic points is:

Carrying cost = 4500 X (12% – 4%) X 4/12 = 120 basis points.

The value of the futures contract is 4500 + 120 = 4620 points for a period
of 4 months.

Swaps
A swap can be defined as a barter or exchange. A swap is a contract
whereby the parties agree to exchange obligations that each of them has
under their respective underlying contracts. Simply put, swap is an
agreement between two or more parties to exchange sequences of cash
flows over a period in the future.

The parties that agree to the swap are known as counterparties. There are
two basic kinds of swaps; interest rate swap and currency swap

An interest rate swap contract involves an exchange of cash flows that are
related to interest payments or receipts, on a notional amount of principal
that is never exchanged, in one currency over a period of time. Settlements
are done through net cash payments by one counterparty to the other.

Currency swap/Foreign exchange swap contracts, on the other hand,

involve a spot sale/purchase of currencies and a simultaneous commitment
to a forward purchase/sale of the same currencies.

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Option contracts
The literal meaning of the word ‘option’ is ‘choice,’ or we can say ‘an
alternative for choice.’ In the derivatives market also, the idea remains the
same. An option contract gives the buyer of the option a right (but not the
obligation) to buy/sell the underlying asset at a specified price on or before
a specified future date.

As compared to forwards and futures, the option holder is not under an

obligation to exercise the right.

Notable feature of option contracts

Another notable feature is that, while it does not cost anything to enter into
a forward contract or a futures contract, an investor must pay to the option
writer to purchase an options contract. The amount paid by the buyer of
the option to the seller of the option is referred to as the premium.

For this reward i.e., the option premium, the option seller is under an
obligation to sell/buy the underlying asset at the specified price, whenever
the buyer of the option chooses to exercise the right.

Option contracts having simple standard features are usually called plain
vanilla contracts. Contracts having non-standard features are also
available that have been created by financial engineers. These are called
exotic derivative contracts.

➢ Moneyness of an option

Moneyness of an option
Options can also be characterized in terms of their moneyness:

• An in-the-money option is one that would lead to positive cash

flow to the buyer of the option, if the buyer of the option exercises
the option at the current market price
• An at-the-money option is one that would lead to a zero cash flow
to the buyer of the option, if the buyer of the option exercises the
option at the current market price

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 • An out-of-the-money option is one that would lead to a negative
cash flow to the buyer of the option, if the buyer of the option
exercises the option at the current market price.

Call Option Put Option

In-the-money M>E M<E

At-the-money M=E M=E

Out-of-the-money M<E M>E

where M is the prevalent market price for the option contract, and E is the
exercise price of the option contract. For a seller/writer of the option the >,
< signs will reverse.

➢ Types of margins levied in the Futures &

Options(F&O) trading

Initial margin
The futures/options contract specifies a trade taking place in the future.
The purpose of the Futures Exchange Institution is to act as an
intermediary and minimize the risk of default by either party. Thus, the
exchange requires both parties to put up an initial amount of cash which is
called margin. Initial margin for each contract is set by the Exchange.
Exchange has the right to vary initial margins at its discretion, either for
the whole market or for individual members.

The basic aim of initial margin is to cover the largest potential loss in one
day. Both buyer and seller have to deposit margins. The initial margin is
deposited before the opening of the day of the futures transaction.

Initial margin for the FnO segment is calculated on a portfolio (a

collection of futures and options positions) based approach. The margin

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calculation is carried out using a software called – SPAN (Standard
Portfolio Analysis of Risk). It is developed by the Chicago Mercantile
Exchange (CME) and is extensively used by leading stock exchanges of
the world. SPAN uses a scenario-based approach to arrive at margins. The
value of futures and options positions depend on the volatility and price of
the security in cash market, among others.

To put it simply, SPAN generates about 16 different scenarios by

assuming different values of price and volatility. For each of these
scenarios, a possible loss that the portfolio can suffer is calculated. The
initial margin required to be paid by the investor would be equal to the
highest loss the portfolio would suffer in any of the scenarios considered.
The margin is monitored and collected at the time of placing the buy / sell
order.

The SPAN margins are revised 6 times in a day - once at the beginning of
the day, four times during market hours and finally at the end of the day.
Obviously, higher the volatility, higher the margins are.

Exposure margin
In addition to the initial margin, exposure margin is also collected.
Exposure margins in respect of index futures and index options sell
positions are 3% of the notional value. For futures and options on
individual securities, the exposure margin is 5% or 1.5 standard deviation
of the LN returns of the security (in the underlying cash market) over the
past six months period and is applied to the notional value of position.

Premium and Assignment margins

The premium margin is an amount calculated by multiplying the value of
option premium with that of option quantity and is charged to the buyers
of option contracts. For example, if 1000 call options on ABC Ltd are
purchased at Rs. 20/-, and the investor has no other positions, then the
premium margin will be Rs. 20,000. The margin has to be paid at the time
of trade. Assignment Margin is collected on assignment from the sellers of
contracts.

Variation margin

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Since the futures price generally changes daily, the difference in the prior
agreed-upon price and the daily futures price is settled and t on the day
and his margin is known as variation margin. The exchange draws money
out of one party's margin account and transfer it into the other’s so that
each party has his/her appropriate daily loss or profit.

Mark-to-market (MTM)
If the margin account goes below a certain value, then a margin call is
made and the account owner must replenish the margin account. This
process is known as marking to market (MTM). Thus on the delivery date,
the amount exchanged is not the specified price on the contract but its spot
value (since any gain or loss has already been previously settled by
marking to market).

Additional Margin
In case of sudden higher than expected volatility, an additional margin
may be called for by the exchange. This is generally imposed when the
exchange fears that the market has become too volatile and may result in
some crisis. This is a preemptive move by exchange to prevent
breakdown.

Clearing margin
Clearing margin is a financial safeguard to ensure that companies or
corporations perform on their customers' open futures and options
contracts. Clearing margins are distinct from customer margins as
individual buyers and sellers of futures and options contracts are required
to deposit it with the brokers.

Maintenance margin
Maintenance margin refers to a set minimum margin per outstanding
futures contract that a customer must maintain in his margin account.

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