Fundamentals of Investment: Discipline Specific Elective (DSE-3) Discipline Specific Elective (DSE-4)

B.Com.(Hons.)/B.Com. (Prog.
) Semester-VI Commerce
Discipline Specific Elective (DSE-3)

Discipline Specific Elective (DSE-4)
Fundamentals of Investment
Unit IV-V
SCHOOL OF OPEN LEARNING

University of Delhi
Department of Commerce
CONTENT
UNIT 4
Chapter 1 Portfolio Analysis
Chapter 2 Portfolio Selection
Chapter 3 Mutual Funds
Chapter-4 Performance Evaluation and Mutual Funds Market in India
Chapter-5 Financial Derivatives–
Derivatives I
Chapter 6 Financial Derivatives-
Derivatives II
Chapter-7 Financial Derivatives-
Derivatives III
UNIT – 5
Chapter-1 SEBI and Investor Protection
Chapter-2 Unfair Trade Practices and Insider Trading
Edited by : Written by :
Sh. K.B.Gupta Silky Jain
SCHOOL OF OPEN LEARNING

University of Delhi
5, Cavalry Lane, Delhi-110007
UNIT 4
CHAPTER 1
PORTFOLIO ANALYSIS
1. Structure of the Chapter
 Introduction
 Portfolio
 Portfolio Management
 Portfolio Analysis- Concept of Portfolio Risk and Return
 Portfolio Return
 Portfolio Risk
 Limitations of Harry Markowitz model of Portfolio Analysis
 Types of Relationships between the Securities
 Constructing a portfolio for a given expected return
 Minimum Variance Portfolio
 Coefficient of correlation
 Coefficient of Correlation and Diversification
 Zero Risk Portfolio
 Solved Illustrations
 Points to Remember
 Review Questions
 Practice Questions
1.1 Introduction
Warren Buffet has rightly quoted- “Don’t put all your eggs in one basket”. The idea
behind the quote is diversification. All investors invest in different type of assets. No
investor invests all his funds in a single asset. They invest in a variety of assets to achieve
their financial goals. This helps in reducing the risks involved in the investments. The
investment of the funds in a variety of assets so as to reduce the risk leads us to the
concept of portfolio.
1.2 Portfolio
Portfolio is a group of various assets like shares, debentures, bonds, fixed deposits, etc. in
which an investor invests his funds to reduce the risks involved in any single investment.
For example, if an investor invests only in shares of X ltd. he is exposed to high risk as
the returns of all his investment will depend upon the performance of X ltd. But instead,
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if he invests his funds equally in the shares of 4 different companies, his risk will be
reduced as the losss in one share may be offset by the profits of the other shares. This is
the idea behind the construction of a portfolio.
1.3 Portfolio Management
Portfolio management is the process of portfolio construction, revision and continuous
evaluation of a portfolio. Portfolio management is done with an objective to achieve a
return commensurate with the risk appetite of the investor. The portfolio manageme
management is
five steps process which are discussed below
below-
Security Analysis
Portfolio Analysis
Portfolio Selection
Portfolio Revision
Performance Evaluation
Figure 11- Process of Portfolio Management

1. Security Analysis- The building block of a portfolio is a security. So, in order to
construct a portfolio, the investor is required to select the securities. There are n number
of securities in the market. Now, the investor has to decide the security in which he
should invest.
st. This decision is based on the risk and return of the individual securities.
There are three approaches to security analysis
analysis- Fundamental Analysis, Technical
Analysis and Efficient Market Hypothesis. These approaches were already discussed in
the previous chapters.
2. Portfolio Analysis- After analysing the securities, an investor can have a list of the
securities in which he can make the investment. But at times, it’s not feasible to invest in
all the shortlisted securities. Therefore, he has to pick a few securities. These securities
can be clubbed in different combinations making different portfolios. Each portfolio will
have its own risk and return. The return of the portfolio is the weighted average of the
returns of individual securities but the ris
risk
k of the portfolio is not simply the weighted
average of the risks of the individual securities. Therefore, different portfolios are formed
at this stage with different risks and returns. However, all these portfolios may not be
efficient. An efficient portfolio
tfolio is one which either has maximum return for a given level
of risk or minimum risk for a given level of return. All such efficient portfolios are
required to be identified.
3. Portfolio Selection- Once the efficient portfolios are identified, the nexnext step is to
select the optimum portfolio. The optimum portfolio is one which optimizes the utility of
the investor given his risk and return constraint. This process is known as the portfolio
selection. An investor needs to construct his utility scores in terms of the indifference
curves and the portfolio that maximises the utility of the investor can be considered as the
optimum portfolio. A rational investor considers Harry Markowitz Model and the Capital
Market Theory as the founding pillars of the port
portfolio selection.
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4. Portfolio Revision- The job of the investor is not over with the portfolio selection.
Rather, portfolio management is a continuous process. With the advent of time, it is
possible that there is a change in the economic conditions which in turn may bring a
change in the financial environment in which the investment decisions are made. With the
change in the financial environment the risk and return of the individual securities will
change which in turn will bring a change in the risk and return of the portfolios. Not only
this the investors preferences, their investment objectives also change with time. This
may bring a change in their utility profile. All this requires that the portfolios should also
be revised accordingly. Therefore, portfolio revision is an integral part of the portfolio
management.
5. Portfolio Evaluation- It is crucial to evaluate the portfolio in order to ascertain
whether they have performed as per the expectation of the investor or not. Portfolio
evaluation means assessing the actual return and risk of the portfolio over a specified
period. It is important to check whether the portfolio is reaping the desired/expected
return or not. For this, periodic evaluation of the of the portfolio is must. The portfolio’s
performance is compared with a benchmark portfolio or market portfolio. The portfolios
which outperform the benchmark portfolios are held and others are revised or sold by the
investor. A number of techniques can be used to evaluate the portfolios. Popular risk
adjusted measures of evaluating the performance of the portfolios are Sharpe’s ratio,
Treynor’s ratio, Jensen’s alpha, etc. These are discussed in detail in the chapter- ‘Mutual
Fund’.
1.4 Portfolio Analysis- Concept of Portfolio Risk and Return
Security analysis has been already done in the previous chapters. Now the next step is
portfolio analysis. Portfolio Analysis starts with the analysis of the risk and return of the
portfolio. Harry Markowitz laid down the foundation for portfolio analysis in terms of
risk and return. Markowitz’s Portfolio theory includes both portfolio analysis and
selection. Portfolio selection will be discussed later in the chapter.
Portfolio Return
Portfolio return is simply the weighted average of the returns of individual securities
forming part of the portfolio. The weight of any particular security is the proportion of
funds invested in that security. Let us understand the concept with the help of an
example. Suppose an investor has 2 securities in his portfolio i.e. Security A and security
B with return 10% and 15%. Now he wish to invest 40% of his funds in Security A and
60% in Security B. So, the weights of A and B will become 0.4 and 0.6. Thus, the return
of the portfolio comprising 40% A and 60% B is-
Portfolio Return= Weight of A x Return of A + Weight of B x Return of B
= 0.4 x 10 + 0.6 x 15 = 13%
Therefore, the formula for portfolio return can be derived as follows-
E(Rp) = ∑ 𝑊 i x E(Ri)
Where,
E(Rp) = Expected Return on Portfolio
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Wi= Weight of ithSecurity
E(Ri) = Expected Return on the individual Security
n = No. of securities
The above equation shows that the portfolio return depends on the following factors-
1. Proportion of funds invested in each security, and
2. Return of each security.
Portfolio Risk
Risk of an individual security is calculated using the standard deviation of its returns.
However, the portfolio risk is not simply the weighted average of the standard deviations
of individual securities. In a portfolio the risk of any individual security cannot be viewed
in isolation of other securities. In a portfolio, the risk depends upon the way the
individual securities interact with each other. The interaction of a security with the other
is measured with the help of covariance. Therefore, while calculating the portfolio risk
the standard deviation of individual securities along with their covariance is taken into
consideration.
2 Security Case-
In case of two securities, the portfolio risk can be calculated as follows-
σp= √(W12 σ12 + W22 σ22 + 2W1W2Cov12)
Where,
σp= Risk of the portfolio consisting of securities 1 and 2
W1= Proportion of funds invested in Security 1
W2 = Proportion of funds invested in Security 2
σ1 = Standard deviation of the returns of Security 1
σ2 = Standard deviation of the returns of Security 2
Cov12= Covariance between security 1 and 2
Covariance between any two variables is the product of their correlation and their
standard deviations. So, the covariance between the returns of the two securities will be-
Cov12= 𝜌12σ1 σ2
Where, 𝜌12= Correlation coefficient between securities 1 and 2
Hence the portfolio risk in terms of coefficient of correlation can be calculated as
follows-
σp= √(W12 σ12 + W22 σ22 + 2W1W2𝜌12σ1 σ2)
It is noteworthy that in case of two securities, there is only one covariance but the
covariances increases with the increase in the number of securities. Like in case of three
securities, we will have three co-variances i.e., Cov12, Cov23 andCov13. In fact, all the
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items on the right hand side of the equation increases with increase in the number of
securities. This prompts us to derive a general formula for calculating the risk of the
portfolio with n number of securities. The formula is as follows-
σp= √( ∑ ∑ 𝑊 iWj𝜌ij σiσj)
where,
σp= Risk of the portfolio consisting of securities 1 to n
Wi= Proportion of funds invested in ith Security
Wj= Proportion of funds invested in jth Security
σi = Standard deviation of the returns of Security i
σj = Standard deviation of the returns of Security j
𝜌ij= Correlation coefficient between ith and jth securities
The above equation shows that the portfolio risk depends on the following factors-
1. Proportion of funds invested in each security
2. Standard Deviation of each security, and
3. Covariance or the coefficient of correlation between the securities.
Limitations of Harry Markowitz model of Portfolio Analysis
As observed earlier, the portfolio analysis is based on the portfolio risk and return which
in turn depends upon the return of securities, standard deviation of securities and the
covariances of the securities. The data required increases with increase in the number of
securities. For n securities, we need n number of returns, n number of standard deviations
and n(n-1)/2 number of covariances. For example, in case of 20 securities, we need 20
returns, 20 standard deviations, 20(20-1)/2 i.e., 190 covariances. So, in totality we need
230 items. However, if the number of securities increases to 50, we need 50 returns, 50
standard deviations and 1225 covariances, i.e., 1325 items in totality. The large data
required under this model for portfolio analysis makes it complicated, which is the major
limitation of this model.
Types of Relationships between the Securities
Suppose there are two securities- A and B. There are three types of relationships between
these two securities-
1. Positive Covariance- If the return of A is above (or below) its average return and at
the same time the return of B is also above (or below) its average return, the
covariance is said to be positive.
2. Zero Covariance- When the returns of the securities A and B do not follow any
pattern, there is no relationship between the two and hence there is no covariance or
zeero covariance.
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3. Negative Covariance- If the return of A is above (or below) its average return and at
the same time the return of B is also below (or above) its average return, the
covariance is said to be negative. It means when the returns of A and B move in
opposite directions, they are known to have negative relationship or negative
covariance.
However, covariance is expressed in terms of specified unit f measurement (in squared
percentages here) and hence is an absolute measure. Being an absolute measure, it is
difficult to compare the covariances of various securities. Therefore, a better technique to
measure the relationship between the returns of the securities is coefficient of correlation.
Constructing a portfolio for a given expected return
A portfolio can be constructed with different weights of the securities. Different weights
of securities lead to different portfolio returns. Therefore, in order to attain a particular
return on a portfolio, the weights of the securities can be adjusted accordingly. This is
illustrated in the following example.
Example 1An investor wishes to have a portfolio return of 15% using Securities A and B
having expected returns 12% and 20% respectively. What should be the proportion of
each security in the portfolio?
Solution Let the weight of the security A be WAand the weight of security B be WB
where,
WB= 1- WA
E(RA) = 12%
E(RB) = 20%
RP= Weight of A x Return of A + Weight of B x Return of B
15 = WAx 12 + (1- WA) 20
15 = 20- 8WA
8WA= 5
WA= 5/8 = 0.625 = 62.5%
WB= 1- WA= 0.375 = 37.5%
Minimum Variance Portfolio
Generally, the investors try to avoid the risk as far as possible. They want to minimize the
risk and maximise the return. They are interested in knowing the proportion in which the
securities can be combined in order to minimize their risk or variance. For a risk averse
investor whose aim is to minimize the risk, minimum variance portfolio also serves as the
optimal portfolio. The weights of the two securities can be estimated using the following
formula in a minimum variance portfolio-
Wmin A=(𝜎 - CovAB)/(𝜎 +𝜎 - 2CovAB)
=(𝜎 – 𝜌AB σAσB)/(𝜎 +𝜎 - 2𝜌AB σAσB)
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WminB = 1 - Wmin A
Example 2Construct a minimum variance portfolio of securities A and B from the
following information. Calculate the risk as well as the return of this portfolio.
Security Expected Return (%) Risk (S.D.)
A 12 2
B 20 5.3
Covariance between the returns of A and B is -10.

SolutionThe weight of security A in minimum variance portfolio can be calculated as
follows-
Wmin A= ( 𝜎 - CovAB)/(𝜎 +𝜎 - 2CovAB)
= (2x2 – (-10))/ (5.32+ 22-2x-10) = 14/52 =0.27 = 27%
WminB = 1 - Wmin A= 1- 0.27 = 0.73 = 73%
The risk of the portfolio so constructed is as follows-
σp= √(WA2 σA2 + WB2 σB2 + 2WAWBCovAB)
= √(0.272 x 5.32 + 0.732 x 22 + 2x 0.27 x 0.73 x -10)
= √0.25 = 0.5
RP= WA x E(RA) + WB x E(RB) = 0.27 x 20 + 0.73 x 12
= 5.4 + 8.76 = 14.16%
Coefficient of Correlation
Coefficient of correlation is independent of unit of measure and therefore it is a relative
measure. It ranges between -1 to +1.
-1 means perfect negative correlation, 0 means no correlation and +1 means perfect
positive correlation. Negative correlation (between -1 to 0) shows a negative relationship
between the returns of the securities whereas positive correlation (between 0 to +1) shows
a positive relationship between the returns of the securities. The coefficient of correlation
can be computed as follows-
𝜌AB= CovAB/σAσB
Where,
𝜌AB = Coefficient of Correlation between A and B
CovAB= Covariance between A and B
σA= Standard deviation of security A
σB= Standard deviation of security B
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The coefficient of correlation has a great impact on the portfolio risk. It can be illustrated
with the help of following example-
Example 3 Suppose an investor invests equally in two securities- A and B. The risk and
return of the securities are as follows-
Security Expected Return (%) Standard Deviation (%)
A 20 5
B 12 2
Examine the portfolio risk if the coefficient of correlation is -1, -0.5, 0, 0.5, 1.
Solution- The return on portfolio will remain same in all the five cases, i.e.,
Where,
E(Rp) = 0.5 x 20 + 0.5 x 12
= 16%
Portfolio Risk
σp= √(WA2 σA2 + WB2 σB2 + 2WAWB𝜌AB σAσB)
= √(0.52 x 52 + 0.52 x 22 + 2 x 0.5 x 0.5 x 𝜌AB x 5 x 2)
=√(7.25 + 5𝜌AB)
a.) When Correlation coefficient = -1
σp=√(7.25 + 2.5𝜌AB) =√(7.25 + 5 x -1) =√2.25 = 1.5%
b.) When Correlation coefficient = -0.5
σp=√(7.25 + 5𝜌AB) =√(7.25 + 5 x -0.5) =√4.75 = 2.18%
c.) When Correlation coefficient = 0
σp=√(7.25 + 5𝜌AB) =√(7.25 + 5 x 0) =√7.25 = 2.69%
d.) When Correlation coefficient = 0.5
σp=√(7.25 + 5𝜌AB) =√(7.25 + 5 x 0.5) =√9.75 = 3.12%
e.) When Correlation coefficient = 1
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σp=√(7.25 + 5𝜌AB) =√(7.25 + 5 x 1) =√12.25 = 3.5%
Hence, the portfolio risk is minimum when the returns on the securities are perfectly
negatively correlated. It increases with increase in the coefficient of correlation and
becomes maximum when the returns on securities are perfectly positively correlated.
Coefficient of Correlation and Diversification
Diversification is a method of minimizing the risk by allocating the total funds available
to different investment options. The basic idea behind diversification is- “Don’t put all
your eggs in one basket.” It means if we invest all the funds at a single place, there is a
high risk of losing the entire money or incurring a heavy loss if that investment does not
go well. Rather a portfolio of securities should be constructed to reap the benefits of
diversification. The benefits of diversification are closely related to the coefficient of
correlation. The diversification is possible only when the coefficient of correlation
between the returns of the securities is less than 1. As we saw in the above example, the
portfolio risk is maximum when the coefficient of correlation between the returns of two
securities is +1. Lower the correlation, lower is the portfolio risk. So, an investor can
benefit by constructing a portfolio where the correlation between the securities is less
than 1. By diversification, the diversifiable risk or unsystematic risk can be eliminated.
The risk is further reduced if the correlation coefficient is negative. Combining the
securities having negative correlation is called hedging. Hedging implies investing in
securities which are negatively correlated with the existing securities. When coefficient of
correlation is perfectly negative, i.e., -1 we have a perfect hedge asset. Including such an
asset can completely eliminate the risk.
 Perfect positive correlation- When the coefficient of correlation is +1, it implies
that the returns of both the securities increases or decreases in the same
proportion. Therefore, there will not be any diversification benefit. Combining
such securities in a portfolio only leads to risk averaging as shown below-
σp= √(W12 σ12 + W22 σ22 + 2W1W2𝜌12 σ1 σ2) = √(W12 σ12 + W22 σ22 + 2W1W2x1xσ1 σ2)
= √(W1𝜎1 + W2𝜎2)2
= W1σ1 + W2σ2
It may be observed that the portfolio risk is simply the weighted average of risk of
individual securities. This is also known as naïve diversification.
 Coefficient of correlation is less than 1 but greater than 0- When the coefficient of
correlation is less than 1 but greater than 0, the returns of the securities move in the
same direction but proportion is not same. In such a case, the investor gets the
benefits of diversification as he is able to reduce the diversifiable risk. Therefore,
the portfolio risk will be lower.
 Zero Correlation or no correlation- When the coefficient of correlation is 0, the
security returns are not related. The movement in the returns of one security has no
relation with the movement of the returns of the other security. In such a case, the
higher degree of diversification can be achieved and the risk of the portfolio will be
reduced further.
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 Coefficient of correlation is less than 0 but greater than -1 – When the coefficient of
correlation between the security returns is less than 0 but greater than -1, the returns
move in opposite directions but in different proportion. It means that when return
on security A increases, the return on security B decreases and vice- versa.
Combining such securities gives a more diversified portfolio with further lower risk.
These securities are also known as Hedge Assets.
 Perfect negative correlation- When the coefficient of correlation is -1, it implies that
the returns of both the securities moves in the opposite direction in same proportion.
This portfolio is called the well diversified portfolio where we are able to eliminate
the diversifiable risk completely.
σp= √(W12 σ12 + W22 σ22 + 2W1W2𝜌12 σ1 σ2) = √(W12 σ12 + W22 σ22 + 2W1W2x-1xσ1 σ2)
= √(W1𝜎1 - W2𝜎2)2
= W1σ1 - W2σ2
If the weights of the securities are taken properly, the portfolio risk can be reduced to
zero. This is discussed in the next section.
Zero Risk Portfolio
Zero risk or zero variance portfolio can be achieved if the following two conditions are
fulfilled-
1. Coefficient of correlation between the two securities is -1, and
2. WA = σB/ (σA + σB)
Let us take an example of two Securities A and B having expected returns of 15% and
20% and standard deviation of returns as 10% and 15% respectively. The coefficient of
correlation between them is -1.
As the 𝜌AB = -1, zero risk portfolio can be constructed if WA = σB/ (σA + σB)
WA= 15/ (10 +15) = 15/25 = 0.6
WB= 1-WA= 1-0.6 = 0.4
Let us verify the portfolio risk.
= √(0.62 x 102 + 0.42 x 152 + 2 x 0.6 x 0.4 x -1 x 10 x 15)
= √(36+ 36 – 72) = 0
Thus, the portfolio risk is completely eliminated.
Following table summarizes the relationship between the coefficient of correlation,
diversification and portfolio risk.
Coefficient of correlation Diversification Portfolio Risk
𝜌AB = +1 No diversification or naïve Portfolio risk is not
reduced. Only Risk
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diversification. averaging is there.
0 <𝜌AB < 1 Diversification is possible. Portfolio risk can be
reduced.
𝜌AB = 0 Diversification is possible Portfolio risk can be further
and better than the previous reduced.
case.
-1 <𝜌AB < 0 Not only diversification, but Portfolio risk will be lower.
hedging is also possible.
𝜌AB = -1 Perfect hedging is possible. Portfolio risk is least and it
is the case when 0 risk
portfolio is possible.
1.5 Solved Illustrations

Q.1. An investor is considering investment in securities X and Y whose details are
given below-
Securities X Y
Expected Return (%) 13 16
Risk measured in S.D. (%) 4 7
If a portfolio of 30% of X and 70% of Y is formed, find the-

i) Expected return of portfolio
ii) Risk of portfolio when correlation is -1
iii) Risk of portfolio when correlation is +1. (B.Com. (H) DU 2015, 2016)
Ans. i.) Portfolio return = Weight of X x Return of X + Weight of Y x Return of Y
= 0.30 x 13 + 0.70 x 16 = 15.1%
ii.) Risk of portfolio when correlation is -1
σp= √(WX2 σX2 + WY2 σY2 + 2WXWY𝜌XYσXσY) = √(0.302 x 42 +0.702 x 72 +2 x 0.3 x 0.7 x
4 x 7 x -1) = 3.7%
iii.) Risk of portfolio when correlation is +1
σp= √(WX2 σX2 + WY2 σY2 + 2WXWY𝜌XYσXσY) = √(0.302 x 42 +0.702 x 72 +2 x 0.3 x 0.7 x
4 x 7 x 1) = 6.1%
Q.2. Mr. A has Rs. 100000 for investment on which he wants to earn return of 16%.
He has two sources available for investment debentures offering return of 15%
and equity shares offering return of 20%. Find the amount invested in each
security to achieve the target rate of return.
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(B.Com. (H) DU 2015)
Ans. Let the proportion of funds invested in debentures be w and that invested in equity
shares be (1-w).
Now, 16 = w x 15 + (1-w) x 20
16 = 20- 5w
5w = 4 or w = 4/5 = 0.8 = 80%
So, the funds invested in debentures is 80% or Rs. 80000 and the funds invested in equity
shares is 20% or Rs. 20000.
Q.3. Two securities A and B have variance of 13 and 15 respectively and expected
return of 15% and 18% respectively. The covariance between the returns is 3,
find out the return and risk of the portfolio if the ratio of investment in two
securities is 70% and 30%.
Ans.-
Security Variance (σ2) Expected Return Weight WiRi
(%) (Wi)
A 13 15 0.7 15 X 0.7 =10.5
B 15 18 0.3 18 X 0.3 = 5.4
Portfolio Return = WiRi 15.9%
Portfolio Risk,
σ = √(WA2 σA2 + WB2 σB2 + 2WAWBCovAB)
= √(0.72 x 13 + 0.32 x 15 + 2 x 0.7 x 0.3 x 3) = √(6.37 + 1.35 + 1.26) = 3 %
Q. 4. The following are the expected return, R and risk, σ, of two securities A and B-
R (%) Σ
A 10 20
B 12 25
The correlation coefficient between the returns of A and B is 0.5. An investor is to
decide about the portfolio of A and B as 75% + 25% or 25% + 75%. Which one should
he accept? (B.Com. (H), 2009)
Ans.- a.) Option 1 - 75% + 25%
Where,
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E(Rp) = 0.75 x 10 + 0.25 x 12
= 10.5%
Portfolio Risk
= √(0.752 x 202 + 0.252 x 252 + 2 x 0.75 x 0.25 x 0.5 x 20 x 25)
= 18.92%
b.) Option 2 - 25% + 75%
E(Rp) = 0.25 x 10 + 0.75 x 12
= 11.5%
Portfolio Risk
= √(0.252 x 202 + 0.752 x 252 + 2 x 0.75 x 0.25 x 0.5 x 20 x 25)
= 21.69%
COMPARATIVE ANALYSIS
Option 1 Option 2
Return 10.5% 11.5%
Risk 18.92% 21.69%
Return/Risk 0.55 0.53
As the return per unit of risk is higher in case of option 1, it is better.
1.6 Points to Remember
 Portfolio is a group of various assets like shares, debentures, bonds, fixed deposits,
etc. in which an investor invests his funds to reduce the risks involved in any single
investment.
 Portfolio management is the process of portfolio construction, revision and
continuous evaluation of a portfolio.
 Portfolio return is simply the weighted average of the returns of individual
securities forming part of the portfolio.
 Portfolio risk is not the weighted average of the risks of individual securities.
 Covariance and the coefficient of correlation plays important role in portfolio risk.
 Covariance between any two variables is the product of their correlation and their
standard deviations.
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 Diversification is a method of minimizing the risk by allocating the total funds
available to different investment options.
 Zero risk or zero variance portfolio can be achieved if the following two conditions
are fulfilled-Coefficient of correlation between the two securities is -1, and WA =
σB/ (σA + σB)
1.7 Review Questions
1. What is a portfolio? How is the portfolio return and risk calculated for a two-
security portfolio?
2. Explain how to construct a minimum variance portfolio with the help of an
example.
3. Elucidate the role played by the coefficient of correlation in construction of a
portfolio.
4. Is it possible to construct a zero-risk portfolio? What are the conditions to construct
a zero risk portfolio?
5. What is Portfolio Management? Briefly explain the process of portfolio
management.
6. State true or false-
a. If two assets have the same risk, a risk averse investor will always choose the
asset with higher expected return.
b. Covariance indicates variability in a particular stock’s return.
c. The portfolio variance is the weighted average of the variance of all the assets
held in the portfolio.
d. When everything is held constant, lower correlation results in a lower portfolio
variance
e. The sum of investment weights must be equal to zero.
f. Covariance plays a measure role in determining the portfolio’s risk.
g. Adding more securities to your portfolio will always make it more diversified.
h. Diversification eliminates the risk completely.
i. Correlation coefficient range between -1 to +1.
j. Minimum variance portfolio is also known as optimal portfolio.
k. Portfolio risk is minimum when investments are done in equal proportion.
(Ans- a.) T, b.) F, c.) F, d.) T, e.) F, f.) T, g.) F, h.) F, i.) T, j.) F, k.) F)
1.8 Practice Questions
Q. 1. Mr. Zahir has selected 2 securities, X and Y, for his portfolio. The following
information is provided by him-
Security Expected Return Standard Deviation
X 12% 5%
Y 18% 7%
If he invested 40% of his funds in X and 60% in Y, find the return of portfolio. Also, find
the maximum and minimum risk of such a portfolio. (B.Com. (H) DU 2017)
(Ans.- Portfolio Return = 15.6 %, Maximum Risk = 6.2%, Minimum Risk = 2.2 %)
14
Q.2. A portfolio is constructed by investing 40% of te funds in Bharat Ltd. and 60%in
India Ltd. The following information regarding the two companies is given below-
Securities Bharat Ltd. India Ltd.
Expected Return (%) 14 22
Risk measured in S.D. (%) 7 10
Compute risk and return of the stated portfolio assuming-
i) Correlation between two stocks is +1
ii) Correlation between two stocks is 0
iii) Correlation between two stocks is -1 (B.Com. (H) DU 2017)
(Ans- Return 18.8%, Risk- i.) 8.8%, ii)6.62% iii.) 3.2%)
15
CHAPTER 2
PORTFOLIO SELECTION

 Introduction
 Portfolio Selection
 Harry Markowitz Model of Portfolio Selection
 Capital Market Line
 Capital Asset pricing Model
 Security Market Line
 Capital Market Line and Security Market Line
 Limitations of CAPM
2.1 Introduction
In the previous chapter we studied about the portfolio analysis, concept of risk and return,
diversification, etc. Once the process of portfolio analysis is over, the next step is to select
the optimal portfolio. As studied in the previous chapter, portfolio risk and portfolio
return are the two important pillars of the portfolio analysis. The portfolio selection also
depends on the portfolio risk and return. The two building blocks of portfolio selection
considered by a rational investor are Harry Markowitz Model and Capital Market theory.
These are discussed in detail in this chapter.
2.2 Portfolio Selection
The optimal portfolio is one which optimizes the utility of the investor given his risk and
return constraint. This process of finding this optimal portfolio is known as the portfolio
selection.
Every investor is basically risk averse. However, their risk return attitude is different, i.e.,
they have different preferences towards risk and return. Some investors are aggressive
investors i.e., they are less risk averse. While other investors are conservative or more
risk averse. Depending upon the risk aversion of a particular investor, the same security
may provide different utilities or satisfaction to different investors. An investor needs to
construct his utility scores in terms of the indifference curves and the portfolio that
maximises the utility of the investor can be considered as the optimum portfolio. The
16
fundamental principal while selecting the optimal portfolio is that the portfolio should
either maximise return for a given level of risk or minimize risk for a given level of
return. A rational investor
vestor considers Harry Markowitz Model and the Capital Market
Theory as the founding pillars of the portfolio selection.
2.3 Harry Markowitz Model of portfolio selection or Mean-Variance
Variance Optimisation
Model
The seminal work by Harry Markowitz published in apaper titled “Portfolio Selection” in
Journal of Finance in 1952, sets the foundation for the selection of optimal portfolio by a
rational investor. This theory is popularly known as Markowitz Model. It provides the
logical and analytical tool for the sel
selection
ection of an optimal portfolio. As this theory is based
on the risk and return, it is also known as Mean Variance Optimisation model.
This theory relies on the following assumptions
assumptions-
 Markets are efficient, and investors have access to all the available inf information
regarding the expected return, standard deviation, and covariances of securities or
assets.
 Investors are risk-averse,
averse, i.e., they will tend to avoid unnecessary risks.
 Investors are rational, i.e., given two securities with the same standard deviation, an
investor would choose the highest expected return.
 There is a fixed single--time horizon.
 There are no taxes or transaction costs.
 There is a risk free rate of interest in the market and any amount of capital can be
borrowed or invested at the risk free rate.
 Investors make their decisions solely based on expected returns and variance.
With the help of above assumptions, the Harry Markowitz Model of portfolio selection
can be presented in following four steps-
• Setting the portfolio opportunity set (or

Step 1 investment opportunity set)
• Determining the efficient set of portfolios (i.e.
Step 2 efficient frontier)
• Constructing indifference curves of the investor

Step 3
• Selecting the Optimal Portfolio

Step 4
Figure 11- Steps in Portfolio Selection

Step 1- Setting the portfolio opportunity set (or investment opportunity set)
17
The model starts with the preparation of a portfolio opportunity set which exhibits the
risks and returns of all possible portfolios which can be made from a set of existing
securities. Infinite number of portfolios can be constructed with N number of securities.
Even with only 2 securities A and B, a large number of portfolios are possible by
changing the weights of the securities. For example, 10% of A and 90 % of B can be
combined to make a portfolio or 50% of A and 50% of B can be combined to make
another portfolio and a large number of portfolios can be constructed in similar manner
by only two securities. However, if the number of securities increases to let say 50 or
100, the possible portfolios will increase exponentially.
In the following figure, we can see the portfolio opportunity set in case of N securities. It
must be noted tattere is a region of portfolio opportunity set in case of N securities. Every
point in this region belongs to a particular portfolio. There are many feasible portfolios in
which an investor can invest.
Figure 2- Portfolio opportunity set in case of N securities

Step 2- Determining the efficient set of portfolios (i.e. efficient frontier)
Once the portfolio opportunity set consisting of all the feasible portfolios is determined,
the next step is to determine the portfolios which are efficient. It might be possible that all
feasible portfolios are not efficient. The efficient portfolio is the one which either
maximises the return for a given level of risk or minimizes the risk for a given level of
return. At every level of return, investors will prefer a portfolio that offers the least
possible risk. Similarly, for every level of risk, investors will prefer a portfolio that offers
maximum return. For example, in above figure, all the portfolios above Q will give
higher return for the same level of risk as Q is having. Similarly, all the portfolios to the
left of Q will have lesser risk for the same level of return as the Q is giving. Selecting all
such portfolios will give us the efficient frontier, which is a graphical representation of all
possible combinations of risky securities for an optimal level of return given a particular
level of risk. Therefore, we are pushed to the curve APBC which is our efficient portfolio.
All the portfolios on the efficient frontier are considered as optimal portfolios. Any
portfolio that falls outside the Efficient Frontier is considered sub-optimal for one of two
reasons: it carries too much risk relative to its return, or too little return relative to its risk.
A portfolio that lies below the Efficient Frontier doesn’t provide enough return when
18
compared to the level of risk. Portfolios found to the right of the Efficient Frontier have a
higher level of risk for the defined rate of return.
Step 3- Constructing indifference curves of the investor
The efficient portfolio shows all the efficient portfolios from which the investor will
choose his optimal portfolio. The optimal portfolio is one out of the many efficient
portfolios. Different investors have different risk return appetite. Some of them are more
risk averse while the others are less risk averse. But the objective of every investor is to
select the portfolio that maximises his utility or satisfaction. The utility or satisfaction of
the investors is shown using the indifference curves. An indifference curve shows all
those combinations of risk and return which generate same utility for an investor. Since
all investors are risk averse, the indifference curves of the investor will be upward sloping
as shown in the figure below. However, the slope of the indifference curve changes with
the change in the risk preference of the investor. The indifference curve for a less risk
averse investor will be flatter as compared to the indifference curve for a more risk averse
investor which is quite steeper. As we know that indifference curves cannot intersect each
other They are parallel. All the points on the same indifference curve provides same level
of satisfaction. However, higher the indifference curve, higher is the utility. As shown in
figure 3, S1 and S2 are on the same curve so they provide same utility. But the utility
increases as we move to higher indifference curve. Therefore indifference curve C3
provides maximum satisfaction and C! provides least satisfaction.
Figure 3- Indifference curves of a risk averse investor

Step 4- Selecting the optimal portfolio
Now the last step is to select the optimal portfolio. The aim of every investor is to select
the portfolio that maximises his utility. So the investor wants to achieve the highest
indifference curve. But the optimal portfolio is one which is efficient i.e., it must lie on
the efficient frontier. Therefore, two conditions must be satisfied for selection of optimal
portfolio. These are-
i.) It must lie on efficient frontier, and
ii.) It must maximise the utility of the investor.
19
To attain this optimal portfolio, we can superimpose the efficient frontier on the
indifference map. As shown in the below figure, the objective of the investor is to
maximise his utility. So he would like to attain the indifference curve C3. However, on C3
both X and R provide same level of satisfaction but X is not efficient as it is not lying on
the efficient frontier. Therefore, the portfolio R would be the optimal portfolio as it is
lying on the efficient frontier as well as providing maximum satisfaction to the investor.
We can now generalize that under Markowitz model, the optimal portfolio for an investor
is the point of tangency between the efficient frontier and the highest possible
indifference curve.
Figure 4- Selection of Optimal portfolio

Limitations of Markowitz Model
Markowitz model explains the identification of efficient portfolios and the selection of
optimal portfolio in a logical manner. However, this model suffers from the following
limitations-
1. This model requires a huge quantum of data to analyze the risk return of the
portfolios. For n securities, we need n number of returns, n number of standard
deviations and n(n-1)/2 number of tycovariances. For example, in case of 20
securities, we need 20 returns, 20 standard deviations, 20(20-1)/2 i.e., 190
covariances. So, in totality we need 230 items. However, if the number of securities
increases to 50, we need 50 returns, 50 standard deviations and 1225 covariances,
i.e., 1325 items in totality. The large data required under this model for portfolio
analysis makes it complicated, which is the major limitation of this model.
2. As per this model, there are as many optimal portfolios as there are number of
investors. However, this limitation is removed when we introduce a risk-free asset
in the capital market.
2.4 Capital Market Line
Capital market theory was developed by Sharpe through his paper “Capital Asset Prices-
A Theory of Market Equilibrium under Conditions of Risk” in 1964 in Journal of
Finance. This theory is more or less an extension of the Markowitz’s Portfolio theory
with inclusion of risk-free lending and borrowing. Capital Market theory also assumes
20
investorsasrationalandmeanvarianceoptimizersasassumedbyMarkowitzPortfolioTheory.
Followingare the main assumptions of Capital Market theory:
i. Investors are rational as they make decision primarily on the basis of the
assessments of risk and return.
ii. Securities are infinitely divisible.
iii. Short selling is not restricted.
iv. There are large number of investors and the buying or selling action of any
investor will not affect the price of the securities.
v. There are no transaction costs or taxes.
vi. Besides risky assets, there is a risk-free asset in the market.
vii. Investors have homogeneous or identical expectations about the returns,
variances of returns and co-variances of all pairs of securities. This is an
important assumption so as to have unique efficient frontier.
As we know that the efficient frontier is a concave curve as shown in figure 5. When a
risk free asset is introduced in the capital market, then the efficient frontier becomes a
straight line originating from risk free return on Y axis and tangent to the original
efficient frontier at point M. This new straight- line frontier is known as the capital
market line.
The capital market line is given in the following equation:
E(Rp)=Rf +[E (Rm) -Rf ]. σp
σm
where,
E (Rp) = expected return of a portfolio
Rf=risk free rate of interest
E (Rm) = expected return on market portfolio
σp=standard deviation of the portfolio
σm=standard deviation of the market portfolio
The capital market line shows that the return from a portfolio depends upon the risk-ree
rate, reward per unit of market risk and total risk of the portfolio. The higher the risk the
higher will be the expected return.
The CML has the following features
 CML exhibits a positive and linear relationship between the risk of portfolio
and its expected return.
 It originates from Rf, hence the slope of CML is Rf.
21
 The slope of CML is the ratio of reward to variability which is measured as-
[E(Rm)-Rf]/ σm
 CML is tangent to original efficient frontier at point M
 Only efficient port folios consisting of risk-free as set and portfolio Mlies on
CML.
 CML slopes upward because price of a risk must be positive since investors are
risk averse.
Figure 5- Capital Market Line

All the portfolios lying on the CML are efficient portfolios. All these portfolios are a
combination of the Efficient portfolio M (i.e., the optimal portfolio of risky assets) and a
risk-free asset. Portfolios to the left of point M include risk free lending and hence are
relevant for a more risk averse investor. These portfolios are termed as Lending
Portfolios or Defensive Portfolios. Portfolios to the right of M involves risk free
borrowing and therefore more appropriate for the investors who are less risk averse.
These are termed as Borrowing Portfolios or Aggressive Portfolios. At point M there is
neither borrowing nor lending.
Example 1– The details of three portfolios are provided to an investor-
Portfolio Expected Return Total Risk (S.D.)

A 8% 3%
B 18% 6%
C 20% 10%
It is further given that the risk-free rate of return is 4% and expected market return is
12%. Market portfolio is having a Risk of 5%. Find out whether these portfolios are
efficient or not.
22
Solution- A portfolio is known as an efficient portfolio if it lies on CML It is possible
only when the given expected returns of these portfolios is equal to the return as
calculated by the CML. Expected return of CML is calculated as follows-
E(Rp)=Rf +[E (Rm) -Rf ]. σp
σm
where,
Portfolio Given Expected Expected return as per Efficient or not

Return CML
A 8% 4 + (12-4)3/5 =8.8% Not Efficient
B 18% 4 + (12-4)6/5 =13.6% Not Efficient
C 20% 4 + (12-4)10/5 =20% Efficient
Here, Portfolio A has actual return less than the return as per CML, so it is overpriced.
While, portfolio B has actual return more than the CML return, so it is underpriced.
Only portfolio C is efficient as its expected return is equal to the return calculated as per
CML.
2.5 CAPMModel:
CAPM model is used to predict expected return on a security or portfolio. It shows the
linear relationship between the return required on a security and its systematic risk. As
discussed in unit 1, there are two types of risk in a capital market i.e., systematic risk
and unsystematic risk. Unsystematic risk can be diversified by constructing portfolio but
the systematic risk cannot be diversified. The CAPM model asserts that as the
unsystematic risk can be diversified, it should not be priced and therefore, investor is
rewarded for bearing the systematic risk only. In other words, CAPM model emphasizes
that there is no unsystematic risk in a market portfolio because it is properly diversified.
Assumptions of CAPM:
CAP Misbased on the following assumptions that:
1. All the investors aim to maximize economic utilities.
2. The investors are ration a land risk-averse.
23
3. The investors invest in broadly diversified portfolios across a range of
investments.
4. The investors are price takers, i.e., they cannot influence prices in their
individual capacities.
5. Unlimited lending and borrowing can be done at the risk free under the risk
free rate of interest.
6. There are no taxes and transaction costs.
7. Securities are perfectly divisible.
8. Investors have homogeneous expectations about the price movements.
9. Free flow of information i.e., all information is available simultaneously to all

investors.
CAPM model shows the positive linear relationship between the expected return of an
asset and te systematic risk represented by 𝛽. This relationship is represented by the
following formula:
E(Ri) = Rf+ [E(RM) - Rf] 𝛽 i
Where,
E(Ri) = Expected return on security or asset
Rf= Risk free rate of return
E(RM) = Expected return on market portfolio
𝛽 I = Beta coefficient of security i
Asper CAPM,
Expected return= risk free rate + market risk premium * systematic risk Expected
return =risk free rate+risk premium
Expected return=reward for time+reward for risk
For example, Assume the following for security X:
Rf=4%
Rm=10%
β=0.75
By using CAPM, we calculate that the following rate of return must be required to invest
in security X.
E (ri) = 0.04 + [0.75 * (0.10 - 0.03)] =0.0925=9.25%
24
Decision criteria-
If the actual return from a security is less than the return calculated as per the CAPM, the
security is overpriced and must be sold. On the contrary, if the actual return from a
security is more than the return calculated as per the CAPM, the security is underpriced
and must be bought.
2.6 Security Market Line
Security market line is the graphical representation of the Capital Asset Pricing Model. It
exhibits the expected return on a security as a function of systematic risk or non-
diversifiable risk. As the CAPM model shows the linear relationship between the
expected return and the systematic risk, the Security Market line (SML) is a straight line
by taking systematic risk on X-axis and Expected return on Y-axis. The slope of SML is
market risk premium i.e., [E(RM) - Rf].
Figure 7- Security Market Line

When used in portfolio management, the SML represents the investment's opportunity
cost (investing in a combination of the market portfolio and the risk-free asset). As shown
in figure 7, all the correctly priced securities are plotted on the SML. The assets above the
line are undervalued because for a given amount of risk (beta), they yield a higher return.
The assets below the line are overvalued because for a given amount of risk, they yield a
lower return.
Example 2- From the data given below, find which of the following securities is
overpriced/ underpriced/ correctly priced using SML equation or CAPM.
Security Beta Actual Return (%)

A 1.2 20
B 1,0 15
C 1.6 22
D 2.0 24
25
E 0.5 8
The return on the market index is 15% and risk-free return is 6%. (B.Com. (H), DU,
2017)
Solution- As per SML,
E(Ri) = Rf+ [E(RM) = Rf]𝛽 I = 6 + [15-6]𝛽 I = 6 + 9𝛽 I
Where,
Security Beta Actual Return as per SML Underpriced/Overpriced

Return
(%)
A 1.2 20 6 + (9 x 1.2)= 16.8 Underpriced
B 1.0 15 6 + (9 x 1)= 15 Correctly priced
C 1.6 22 6 + (9 x 1.6)= 20.4 Underpriced
D 2.0 24 6 + (9 x 2)= 24 Correctly priced
E 0.5 8 6 + (9 x 0.5)= 10.5 Overpriced
In case of Security E, the actual return from the security is less than the return calculated
as per the CAPM, therefore security E is overpriced and must be sold. On the contrary, in
case of Security A and C, the actual return from the security is more than the return
calculated as per the CAPM, therefore these securitiesare underpriced and must be
bought. However, security B and D have actual return equal to the CAPM return and
therefore, they are correctly priced.
2.7 Capital Market Lineand Security Market Line
1. The CML is a line that is used to show the rates of return, which depends on risk-
free rates of return and levels of risk for a specific portfolio. SML, which is also
called a Characteristic Line, is a graphical representation of the market’s risk and
return at a given time.
2. In CML, risk is measured using standard deviation while in SML, the risk is
measured using Beta coefficient.
3. The Capital Market Line graphs define efficient portfolios, whereas the Security
Market Line graphs define both efficient and non-efficient portfolios.
26
4. The slope of SML is Market Risk Premium whereas, the slope of CML is the
reward to variability ratio.
5. SML is used to find out the expected return of a security whereas CML is used to
find the expected return of a portfolio.
2.8 Limitations of CAPM
CAPM is a popular model of price discovery of the assets. However, it suffers from
following limitations-
1. The assumptions of CAPM are quite simplified and unrealistic. Many of them may
not hold true in the real life. Assumptions like no transaction cost, no taxes,
unlimited lending and borrowing at risk free rate are not feasible now a days.
2. CAPM requires calculation of beta coefficient which is a tedious process.
Q 1. Based on the following information, determine which of the securities are overpriced
and which underpriced in terms of Security Market Line (SML)-
Security Actual Return Beta Standard Deviation

A 0.33 1.7 0.50
B 0.13 1.4 0.35
C 0.26 1.1 0.40
D 0.12 0.95 0.24
E 0.21 1.05 0.28
F 0.14 0.70 0.18
Nifty 0.13 1.00 0.20
T-Bills 0.09 0 0
Ans- As per SML, E(Ri) = Rf+ [E(RM) = Rf]𝛽 I = 0.09 + [0.13-0.09]𝛽 I = 0.09 + 0.04𝛽 I
Where,
Security Actual Beta Return as per SML Underpriced/Overpriced

Return
A 0.33 1.7 0.09 + 0.04 x 1.7 = Underpriced
27
0.158
B 0.13 1.4 0.09 + 0.04 x 1.4 = Overpriced
0.146
C 0.26 1.1 0.09 + 0.04 x 1.1 = Underpriced
0.134
D 0.12 0.95 0.09 + 0.04 x 0.95 = Overpriced
0.128
E 0.21 1.05 0.09 + 0.04 x 1.05 = Underpriced
0.132
F 0.14 0.70 0.09 + 0.04 x 0.70 = Underpriced
0.118
In case of Security B and D, the actual return from the security is less than the return
calculated as per the CAPM, therefore securities b and Dare overpriced and must be sold.
On the contrary, in case of Security A, C, E and F, the actual return from the security is
more than the return calculated as per the CAPM, therefore these securitiesare
underpriced and must be bought.
Q.2. Consider the following data in respect of three portfolios A, B and C-
Portfolio Return (%) Portfolio Risk in terms of Standard Deviation
(%)
A 26 30
B 29 18
C 19 16
The return on market index (Rm) is 18% and the risk on market index σp is 10%. The
risk free rate is 7% and unlimited lending and borrowing is possible at this rate. Using
Capital Market, comment on the efficiency of the above portfolios.
Ans.- As per Capital Market /line,
E(Rp)=Rf +[E (Rm) -Rf ]. σp= 7 + (18-7)σp/10 = 7 +1.1σp
σm
where,
28
Portfolio Return S. D. (%) E(Rp) Remarks
(%)
A 26 30 7 +1.1σp = 7 + 1.1 (30) =40 Overpriced
B 29 18 7 +1.1σp = 7 + 1.1 (18) Underpriced
=26.8
C 19 16 7 +1.1σp = 7 + 1.1 (16) Overpriced
=24.6
A portfolio is efficiently priced if that portfolio has actual return same as expected return
as per CML. Here, Portfolio A and C has actual return less than the return as per CML,
so they are overpriced. While, portfolio B has actual return more than the CML return,
so it is underpriced.
Q.3. From the following data given below find which of the following securities are
overpriced or underpriced using SML equation-
Security P Q R S T
Beta 1.6 0.5 1.2 3.0 1.9
Return 15 10 18 25 15
The return on market index is 12% and the return on risk free asset is 8%. (B.Com. (H)
DU 2019)
Ans- Ans- As per SML, E(Ri) = Rf+ [E(RM) = Rf]𝛽 I
Where,
E(Ri) = 0.08 + [0.12-0.08]𝛽 I = 0.08 + 0.04𝛽 I
Security Actual Beta Return as per SML Underpriced/Overpriced

Return
(%)
P 15 1.6 0.08 + 0.04 x 1.6 = Underpriced
0.144 = 14.4%
Q 10 0.5 0.08 + 0.04 x 0.5 = 0.10 Fairly priced
= 10%
R 18 1.2 0.08 + 0.04 x 1.2 = Underpriced
29
0.128 = 12.8%
S 25 3.0 0.08 + 0.04 x 3.0 = 0.20 Underpriced
= 20%
T 15 1.9 0.08 + 0.04 x 1.9 = Overpriced
0.156 = 15.6%
In case of Security T, the actual return from the security is less than the return calculated
as per the CAPM, therefore security T is overpriced and must be sold. On the contrary, in
case of Security P, Q and S, the actual return from the security is more than the return
calculated as per the CAPM, therefore these securitiesare underpriced and must be
bought. However, security Q is having actual return equal to the CAPM return and
therefore, this security is fairly priced or correctly priced.
 The optimal portfolio is one which optimizes the utility of the investor given his
risk and return constraint. This process is known as the portfolio selection.
 Markowitz Model provides the logical and analytical tool for the selection of an
optimal portfolio. As this theory is based on the risk and return, it is also known as
Mean Variance Optimisation model.
 When a risk free asset is introduced in the capital market, then the efficient
frontier becomes a straight line originating from risk free return on Y axis and
tangent to the original efficient frontier at point M. This new straight- line
frontier is known as the capital market line.
 CAPM model is used to predict expected return on a security or portfolio. It
shows the linear relationship between the return required on a security and its
systematic risk.
 If the actual return from a security is less than the return calculated as per the
CAPM, the security is overpriced and must be sold. On the contrary, if the actual
return from a security is more than the return calculated as per the CAPM, the
security is underpriced and must be bought.
 Security market line is the graphical representation of the Capital Asset Pricing
Model. It exhibits the expected return on a security as a function of systematic
risk or non- diversifiable risk.
 All the correctly priced securities are plotted on the SML. The assets above the
line are undervalued because for a given amount of risk (beta), they yield a higher
return. The assets below the line are overvalued because for a given amount of
risk, they yield a lower return.
 There are many points of difference between Capital Market Line and the Security
market line. One of the major differences is that the CML is a line that is used to
show the rates of return, which depends on risk-free rates of return and levels of
risk for a specific portfolio. Whereas SML, which is also called a Characteristic
Line, is a graphical representation of the market’s risk and return at a given time.
 CAPM Model is often criticized because of its unrealistic assumptions and also
because it requires calculation of beta coefficient which is a tedious process
30
1. What is efficient portfolio in the context of Harry Markowitz Model. Explain the
role of investor’s preference in identifying optimal portfolio.(B.Com. (H) DU 2013)
2. Differentiate between Security Market Line and Capital Market Line. (B.Com. (H)
DU 2012)
3. Examine critically Harry Markowitz Model giving its assumptions and limitations.
(B.Com. (H) DU 2012)
4. “All efficient portfolios are feasible but all feasible portfolios are not efficient”. Do
you agree? Explain in the context of Harry Markowitz Model. (B.Com. (H) DU
2011)
5. Explain the Capital Asset pricing model along with its assumptions and limitations.
6. State True or False-
a. Security market line is based on total risk.
b. Capital market line also shows individual securities besides efficient
portfolios.
c. If a security lies below SML, it is underpriced.
d. If a portfolio lies below CML, it is inefficient.
(Ans- a.) F, b.) F, c.) F, d.) T)
7. Write a short note on-
I. Harry Markowitz Model
II. CAPM
III. Portfolio Risk
IV. Diversification
V. Capital Market Theory
Q.1. If the risk-free return is 5% and return on Sensex is 15% with a risk of 8%, find the
proportion of funds to be invested in each of the above two alternatives so as to have a
portfolio with a return of 13%. Also find the risk of the portfolio so formed. (B.Com.
(H) DU 2015)
(Ans- 20% in risk free asset and 80% in market portfolio. Risk is 6.4%.)
Hint- Calculate Risk using CML
Q.2. From the following data given below find which of the following securities are
overpriced or underpriced using SML equation-
Security P Q R S T
Beta 1.4 0.8 1.1 2.5 2.0
Return 12 11 17 22 16
31
The return on market index is 11% and the return on risk free asset is 5%.(B.Com. (H)
DU 2017)
(Ans- P and T are overpriced, Q, R and S are underpriced)
32
CHAPTER 3
MUTUAL FUNDS

 Introduction
 Mutual Funds- Features, Importance, Working
 Mutual Fund Schemes
 Systematic investment Plan
 Systematic Withdrawal Plan
 Systematic Transfer Plan
 Net Asset Value
 Mutual Fund Fees and Expenses
 Return from Mutual Funds
3.1 Introduction
Mutual funds are the most popular investment types for an ordinary investor. It is because
they are simple investments to understand and easy to use. The simplicity of investing in
mutual funds is not just an attractive feature for first time investors; the accessibility,
versatility and easy-to-understand structure of mutual funds makes them powerful
investing vehicles for all kinds of investors. It can be appropriate for a variety of
individuals with varying savings and investing objectives that includes college students
and retired people.
3.2 Mutual Funds
A mutual fund is an investment vehicle made up of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds, money market
instruments and similar assets. The SEBI (Mutual Funds) Regulations, 1996, defines a
Mutual fund as "a fund established in the form of a trust to raise money through the sale
of units to the public or a section of the public under one or more schemes for investing in
securities, including money market instruments." As an investment intermediary, they
offer a variety of services to the relatively small investors who on their own cannot
successfully construct and manage investment portfolio mainly due to the small size of
the funds, lack of expertise and experience, etc. The mutual funds have emerged as a
33
significant avenue of finance for industry and a notable intermediary in the Indian capital
markets.
The objective of mutual fund is to provide continuous liquidity and higher yields with a
high degree of safety to the investors. Based on this objective, different types of mutual
fund schemes have evolved.
Mutual funds are operated by money managers who invest the fund's capital and attempt
to produce capital gains for the fund's investors. A mutual fund's portfolio is structured
and maintained to match the investment objectives stated in its prospectus.
One of the main advantage of mutual funds is that they give small investors access to
professionally managed, diversified portfolios of equities, bonds and other securities.
Each shareholder, therefore, participates proportionally in the gain or loss of the fund.
Mutual funds invest in a wide amount of securities. Its performance is usually tracked as
the change in the total market cap of the fund derived by aggregating performance of the
underlying investments.
Features of Mutual Fund: On the basis of the above discussion, it is clear that the
mutual fund has some distinct features as compared to other intermediaries. Some of
these features are as follows:
1. Pool of Funds- A mutual fund is an investment vehicle made up of a pool of
funds collected from many investors for the purpose of investing in various
financial assets.
2. Professional Management- The funds gathered by the mutual funds are managed
by the professional managers who are experts in investment.
3. Diversified Portfolio- Mutual funds diversify the portfolio across different types
of investments, multiple companies and sectors. Equity mutual funds invest in
shares of various companies whereas debt funds invest in government securities,
CDs, CPs bonds and other fixed income securities. Thus, an investor has a
diversified investment basket.
4. Indirect Investment- A mutual fund invests the funds collected from various
investors in various securities as per the scheme. These securities are owned by
the mutual funds and not the investor. By investing in a mutual fund, an individual
investor gets units of mutual funds in proportion to the funds invested by them.
So, it is a form of indirect investment.
5. Representative of Investors- Mutual fund is the representative of investors. It
can invest the funds only as per the designated scheme and not anywhere else.
6. Mutual Fund is not a Borrower- Investors do not lend to the mutual funds.
Rather, they invest, and therefore, are the owners of the mutual fund. Hence, there
does not exist a borrower-lender relationship between the mutual funds and the
investor.
Importance of Mutual Fund- Mutual Fund is an important part of Indian financial
system. Some of the reasons for its growing importance are as follows:
 It helps to reduce risk through the collection of fund from different securities and
invests in different stocks.
34
 It provides the benefit of diversification of investment to the investor because it
can make investment in different securities.
 It helps to maximize the return of the portfolio because mutual fund is managed
by a professional and expert team.
 Itt provides opportunity to reinvest the return.
 It has the feature of marketing and liquidity on the shares.
 It cultivates saving and investment habits among the investors.
 It is useful for saving tax for the investor as the government permits tax
exemption.
 The investor feels safe because mutual funds operation and management is closely
observed by a stock exchange center.
Working of Mutual FundsFunds- Mutualfunds poolthe resources rces of individual investors and
invest the funds in a portfolio of securities that satisfies the desires of the investors. The
returns generated from these securities are distributed to the investors and capital gain, if
any, also belong to the investor. This process is shown in the following diagram:
Investors
Returns Fund
Securities
Exhibit 33.1: Working of Mutual Funds
3.3 Mutual Fund Schemes

These days various schemes are being offered by mutual funds to attract the investors.
These schemes have their own peculiar features to satisfy different types of investment
needs. These are explained below:
1. On the basis of Structure:
 Open Ended Schemes
Schemes-This
This scheme allows investors to buy or sell units at any
point in time. This does not have a fixed maturity date.
35
 Close Ended Schemes
Schemes- These are schemes that have a fixed maturity. The money
of the investor is locked in for the period. Occasionally, closed
closed-end schemes
provide a re-purchase
purchase option to the investors, either for a specified period or after
a specified period. Liquidity in th
these
ese schemes is provided through listing in a
stock market.
 Interval Schemes- These combine the features of open
open-ended
ended and close-
close ended
schemes. They may be traded on the stock exchange or may be open for sale or
redemption during pre
pre-determined intervals att NAV related prices.
Mutual Funds
Objectives of Location of Special

Structure Load
Investors Investors Schemes
Open-ended Growth Funds Load Domestic Index Schemes
Sectoral
Close -ended Income Funds No Load Off Shore
Schemes
Interval Balanced Tax Saving

Schemes Funds Schemes
Money Market
Gilt Scemes
Funds
Funds of Funds
ETFs
Exhibit 33.2: Mutual Funds Schemes

2. On the basis of the objectives of Investors:
 Growth Schemes- Growth schemes aim to provide capital appreciation over a
medium to long-term
term period. These schemes normally invest a majority of their
funds in equities and are willing to bear short
short- term decline in value for possible
future appreciation. These schemes are not for investors seeking regular income
or need their money back in the short
short-term.
term. These are ideal for the investors who
seek growth over long
long-term.
term. They are also known as equity schemes.
 Income Schemes- These schemes aim to provide a regular and steady income to
investors. These schemes generally invest in fixed income securities such as
bonds and corporate debentures. Capital appreciation in such schemes may be
limited. These are also called debt schemes and such types of mutual funds are
ideal for retired people and others with a need for capital stability and regular
income, and for investors who need some income to supplemen
supplementt their earnings.
 Balanced Schemes - These mutual funds aim to provide both growth and income
by periodically distributing a part of the income and capital gains they earn. They
36
invest in both shares and fixed income securities in the proportion indicated in
their offer documents. In a rising stock market, the NAV of these schemes may
not normally keep pace, or fall equally when the market falls. These are ideal for
the investors looking for a combination of income and moderate growth.
 Money Market Mutual Funds- These aim to provide easy liquidity, capital
preservation and moderate income. These schemes generally invest in safer,
short-term instruments such as treasury bills, certificates of deposit, commercial
paper and inter- bank call money. Returns on these schemes may fluctuate
depending upon the interest rates prevailing in the market. These are ideal for
corporates and individual investors as a means to park their surplus funds for a
short period or while awaiting a more favourable investment alternative.
3. On the basis of Load-

 Load Funds- A mutual fund load is a fee charged for the purchase or sale of a
mutual fund. Loads charged upon purchase of fund shares are called front-end
loads and loads charged upon the sale of a mutual fund are called back-end loads.
Funds that charge loads are generally referred to as "load funds".
 No Load Funds- Funds that do not charge any load are called "no-load funds." A
no-load fund is a mutual fund in which shares are sold without a commission or
sales charge. This occurs because the shares are distributed directly by the
investment company instead of going through a secondary party.
4. On the basis of location of investors-
 Domestic Funds- Domestic funds are those which can be subscribed only by the
native investors of the country. Most of the Indian mutual funds are domestic
mutual funds.
 Offshore Funds- These are the funds which are subscribed by the people living
abroad. They are a valuable source of attracting much needed foreign capital in
the country.
5. Special Schemes-
 Tax Saving Schemes -These schemes offer tax rebates to the investors under tax
laws as prescribed from time to time. This is made possible because the
Government offers tax incentives for investment in specified avenues. For
example, Equity Linked Savings Schemes (ELSS) and Pension Schemes.
Recent amendments to the Income Tax Act provide further opportunities to
investors to save capital gains by investing in Mutual Funds. The details of such
tax savings are provided in the relevant offer documents. These are ideal for
investors seeking tax rebates.
 Sectoral Funds- Sectoral funds are those with the objective to invest only in the
equity of those companies existing in a specific sector, as laid down in the fund’s
offer document. For example, an FMCG sector fund shall invest in companies like
HLL, Cadbury’s, Nestle etc., while a technology fund will invest in software
companies like Infosys Technologies, Satyam Computers etc. There are also funds
that invest in basic sectors/industries such as Cement, Steel and Petrochemicals.
37
 Index Funds- Index Funds try to mirror the performance of a particular index
such as the BSE Sensex or the NSE Nifty 50. Index funds will invest in only those
scrips that constitute a particular index. Investment in these scrips is also made in
proportion to each stocks weight in the index. Investing in an index fund is a form
of passive investing.
The primary advantage of such a strategy is the lower management expense ratio
on an index fund. Since the fund managers of an index fund are simply replicating
the performance of a benchmark index, they do not need the services of research
analysts and others that assist in the stock selection process. Actively managed
funds do need to utilize a research team. In these cases, the extra costs of fund
management get reflected in the fund's expense ratio and get passed on to
shareholders. Also, a majority of mutual funds fail to beat broad indexes, such as
the BSE Sensex or Nifty 50.
 Exchanged Traded Funds- ETFs are a phenomenon which impart a lot of
liquidity to an existing market. They are passively managed funds tracking and
investing in the stocks of a particular benchmark index. ETFs offer the best
features of open and close end funds. They represent units of beneficial interest in
Unit Investment Trusts that hold the component stocks of the representative index.
As the name suggests, they are listed and traded on an exchange like a common
stock, which is their biggest advantage. Therefore, they can be bought and sold
throughout the trading day as the price fluctuates and can be bought on margin,
sold short, or traded using stop orders and limit orders. An ETF’s annual expenses
and trading costs are usually lower than non-index mutual funds. One ETF can
give exposure to a group of equities, market segments or styles. An ETF can track
a broader range of stocks.
However, many ETFs participate in over diversification. ETFs are generally not
actively managed but are programmed to follow a specific index. The index, and
therefore the ETF, may not own the very best stocks. Also, long-term investors
could have a time horizon of 10 to 15 years, so they may not benefit from the
intraday pricing changes.
 Fund of Funds- This is a scheme where investment is made in other mutual fund
schemes. These schemes could be of the same mutual fund or a different mutual
fund. SBI Gold Fund is an example of Fund of Funds launched by SBI. It is a
multi-manager investment where investment is made in a portfolio that contains
different underlying assets instead of investing directly in bonds, stocks and other
types of securities.
This type of well diversified fund spreads out risk. Whereas owning one mutual
fund reduces risk by owning several stocks, a fund of funds spreads risk among
hundreds or even thousands of stocks contained in the mutual funds it invests in.
These funds also provide the opportunity to reduce the risk of investing with a
single fund manager.
The emergence of FOFs is being pushed by demand from investors to have more
safety while trying to keep up with or beat the market. However, it must be said
that the benefit of more safety is not endless. If the overall market takes a tumble,
so may mutual funds and the FOFs that have invested in them.
38
Fund of funds incurs expenses just like any other mutual fund schemes. But unlike
mutual funds, there is extra cost involved. Apart from the usual management and
administrative costs, there is an added expense pertaining to the underlying funds.
Also, fund of funds invests in many funds which further invest in a number of
securities. This gives rise to the possibility of the fund of funds ending up owning
the same stocks and securities through different funds. This reduces the potential
for diversification.
Fund of funds can be a good investment choice for an investor with limited
experience and limited funds. Fund of funds, like mutual funds are subject to
market risk and therefore, mandate the investor acquaint him/herself with the
market risks and the strategies of investment.
 Gilt Funds-Gilt Funds are mutual funds that invest only in government securities.
They are preferred by risk averse and conservative investors who wish to invest in
the shadow of secure government bonds. Since gilt funds invest only in
government bonds, investors are protected from credit risk. The instruments
where these funds invest have sovereign guarantee. Hence no default risk is
associated with these instruments. These funds can have different maturity
profiles. Some may be short term while others are medium term or long-term.
Like any other bond funds, these funds too have interest rate risk ingrained in
them. SBI Magnum Gilt, JM G-Sec Fund, Reliance Gilt-Sec, etc. are some of the
examples of gilt funds in India.
3.4 Systematic Investment Plan

SIP is a method of investing a fixed sum, regularly, in a mutual fund scheme. SIP allows
one to buy units on a given date each month, so that one can implement a saving plan for
oneself. The biggest advantage of SIP is that one need not time the market. In timing the
market, one can miss the larger rally and may stay out while markets are doing well or
may enter at a wrong time when either valuation has peaked or markets are on the verge
of declining. Rather than timing the market, investing every month will ensure that one is
invested at the high and the low, and make the best out of an opportunity that could be
tough to predict in advance.
An investor can invest a pre-determined fixed amount in a scheme every month or

quarterly, depending on his convenience through post-dated cheques or through ECS
(auto-debit) facility. Investors need to fill up an application form and SIP mandate form
on which they need to indicate their choice for the SIP date (on which the amount will be
invested). Subsequent sips will be auto-debited through a standing instruction given or
post-dated cheques. The forms and cheques can be submitted to the office of the Mutual
Fund / Investor Service Centre or nearest service centre of the Registrar & Transfer
Agent. The amount is invested at the closing Net Asset Value (NAV) of the date of
realisation of the cheque.
Benefits of SIP- It offers following benefits to the investors:
 Rupee-Cost Averaging- With volatile markets, most investors remain skeptical
about the best time to invest and try to 'time' their entry into the market. Rupee-
39
cost averaging allows you to opt out of the guessing game. Since you are a regular
investor, your money fetches more units when the price is low and lesser than
when the price is high. During volatile period, it may allow you to achieve a lower
average cost per unit.
 Power of Compounding- Albert Einstein once said, "Compound interest is the
eighth wonder of the world. He who understands it, earns it... he who doesn't...
pays it." The rule for compounding is simple - the sooner one starts investing, the
more time one's money has to grow.
 Disciplined Saving - Discipline is the key to successful investments. When an
individual invests through SIP, he/she commits himself/herself to save regularly.
Every investment is a step towards attaining your financial objectives.
 Flexibility- While it is advisable to continue SIP investments with a long-term
perspective, there is no compulsion. Investors can discontinue the plan at any
time. One can also increase/ decrease the amount being invested.
 Long-Term Gains- Due to rupee-cost averaging and the power of compounding
SIPs have the potential to deliver attractive returns over a long investment
horizon.
 Convenience- SIP is a hassle-free mode of investment. One can issue a standing
instruction to his/her bank to facilitate auto-debits from his/her bank account.
3.5 Systematic Withdrawal Plan (SWP)

Systematic Withdrawal Plan (SWP) refers to a plan which allows an investor to withdraw
a fixed or variable amount from his mutual fund scheme on a preset date monthly,
quarterly, semi-annually or annually as per his needs.
An investor can customize the cash flows as desired; he can either withdraw a fixed
amount or just the capital gains on his investments. SWP provides the investor with a
regular income and returns on the money that is still invested in the scheme.
For Example: An investor has 10,000 units in a mutual fund scheme. He has given
instructions to the fund house that he wants to withdraw Rs. 5,000 every month through
SWP.
On 1 January, 2017 the NAV of the scheme is Rs. 10.
Equivalent number of MF units = Rs. 5,000/Rs. 10 = 500. 500 units would be redeemed
and Rs. 5,000 would be given to him.
The remaining units = 10,000 - 500 = 9500
Now, on 1 February, 2017, the NAV is Rs. 20. Thus, Equivalent number of units = Rs.
5000/Rs. 20 = 250. So, 250 units would be redeemed from his MF holdings, and Rs.
5,000 would be given to him.
The remaining units = 9500 - 250 = 9250
And this process will continue till the time the investor wants the withdrawals.
3.6 Systematic Transfer Plan (STP)
40
Systematic Transfer Plan or STP enables an investor to invest lump sum amount in a
scheme and regularly transfer a fixed or variable amount into another scheme. In cases
where the money is already invested in units of mutual funds, the process to switch from
one fund to another happens through STP.
In case of a volatile market, STP helps the investors to periodically transfer funds from
one scheme (source scheme) to another (target scheme) and help them save the effort and
time by compressing multiple instructions (required for redemption from one scheme to
invest in the other) into a single instruction.
Transfers are usually made from debt funds to equity funds if the market is doing well
and vice versa if the market is not performing well. The STP can be classified based on
the amount transferred from the source scheme to the target scheme. If a fixed sum is
transferred from the source to the target scheme, then it's called Fixed STP, and if the sum
transferred is the profit part of the investment of source scheme, then it is called Capital
Appreciation STP.
3.7 Net Asset Value (NAV)

Net asset value (NAV) is the value of a fund's asset minus the value of its liabilities per
unit.
NAV = (Value of Assets-Value of Liabilities)/number of units outstanding
NAV of a mutual fund helps an investor to determine if the fund is overvalued or
undervalued. In case of open-end funds, NAV is crucial. NAV gives the fund's value that
an investor will be entitled to at the time of withdrawal of investment. In case of a close-
end fund, which is a mutual fund with a fixed number of units, price per unit is
determined by market and is either below or above the NAV.
Example1 An amount of Rs. 40,00,000 has been collected by a mutual fund by the issue
of units of Rs. 8 each. The amount was invested in different securities. Currently, the
market value of these securities is Rs. 45,60,000 and the liabilities of mutual fund in
respect of expenses, amounted to Rs. 1,60,000. Find the NAV.
Solution-
Then the NAV of the fund is-
NAV = (Value of Assets-Value of Liabilities)/number of units outstanding
Where, the number of units outstanding = 40,00,000/8 = 5,00,000
So, NAV = (45,60,000-1,60,000)/5,00,000

= Rs. 8.80
3.8 Mutual Fund Fees and Expenses
Running a business involves costs. Mutual fund is also a business. So, it also involves
costs. For example, costs are incurred in relation with specific investor transactions, like
purchases by investors, exchanges, and redemptions of mutual fund units by an investor.
41
Some operating costs are regular and recurring in nature. These costs are not always
related to any particular investor transaction. Some of these costs are investment advisory
fees, brokerage fees, marketing and distribution expenses, and custodial, fees of transfer
agency, legal fees, and accountants’ fees.
Some mutual funds cover the costs associated with the transactions and account of an
individual investor by imposing charges and fees directly on the investor either at the
time of the transactions or periodically as account fees.
Generally, funds pay their routine and recurring, fund related operating expenses out of
the assets of the fund, rather than by directly imposing separate charges and fees and on
investors. These expenses are called "Annual Fund Operating Expenses".
Expense Ratio =
Note that, average assets under management is calculated by finding the average of
NAVs at the beginning and at the end of the period.
Example 2 A mutual fund has an NAV of Rs. 18 in the beginning of the period and Rs.
22 at the end of the same period. During the period, it incurred expenses at the rate of
0.60 per unit. Find out the expense ratio.
Solution-
Average assets under management = (Opening NAV + Closing NAV)/2
= (18 +22)/2
= Rs. 20
Expense Ratio =
.
= x 100 = 3%

Q.1. A no load fund has an NAV of Rs. 32 and Rs. 36 in the beginning and at the end of
the period respectively. During this period, it incurred expenses at the rate of Rs. 1.70 per
unit. Calculate Expense Ratio.
Ans. Average assets under management = (Opening NAV + Closing NAV)/2
= (32 +36)/2
= Rs. 34
Expense Ratio =
.
= x 100 = 5%
Q.2. Following information is available in respect of investments made by a mutual fund-
42
10% Debentures Rs. 9,00,000
5% Government Bonds Rs. 9,20,000
Equity Capital (75,000 shares of Rs. 80 each) Rs. 60,00,000
Total Rs. 78,20,000
During the year, the mutual fund received dividends of Rs. 12,00,000 on equity shares.
Interest on Government bonds and debentures was also 9AUMreceived. The debentures
were quoted at 95% in the market. The mutual fund made an issue of Rs. 8,00,000 units
of Rs. 10 each on January 1, 2020. Calculate NAV given the operating expenses incurred
during the year Rs. 5,00,000. What would be the NAV if mutual fund distribute dividend
of Rs. 0.50 during the year to the unit holders.
Solution-
Cash balance at the beginning of the year = 80,00,000- 78,20,000 = 1,80,000
Cash Balance at the end of the year is-
Cash balance at the beginning of the year 1,80,000
+ Dividend on Equity Shares 12,00,000
+ Interest on 10% Debentures (10% of 9,00,000) 90,000
+ Interest on 5% Government Bonds (5% of 9,20,000) 46,000
Cash Balance at the end of the year 1516000
Calculation of NAV-
Cash Balance at the end of the year 1516000
Market Value of Assets under Management (AUM) –
10% Debentures 9,00,000
5% Government Bonds 9,20,000
Equity Capital 60,00,000
Total AUM 93,36,000
Less- Expenses 5,00,000
Market Value of AUM 88,36,000
No. of units 8,00,000
NAV per unit (88,36,000/ 8,00,000) Rs. 11.045
NAV when dividend of 0.50 per unit is paid-
Dividend Paid (800000 x 0.50) 4,00,000
Total Market Value of AUM (88,36,000- 4,00,000) 84,36,000
NAV per unit (84,36,000/ 8,00,000) Rs. 10.54
43
Q.3. Following information is available in respect of a mutual fund. Find out the NAV
Cash and Bank balance 5,00,000
Unlisted bonds and debentures 6,50,000
Current Market Value of Equities 13,50,000
Quoted Government Securities 10,00,000
Expenses Accrued 1,00,000
No. of outstanding units 2,50,000
Solution-
Cash and Bank balance 5,00,000
Unlisted bonds and debentures 6,50,000
Current Market Value of Equities 13,50,000
Quoted Government Securities 10,00,000
Total Assets under Management 35,00,000
Less- Outstanding Expenses (1,00,000)
Net Assets 34,00,000
No. of outstanding units 2,50,000
NAV = 34,00,000/2,50,000 = Rs. 13.60
Q.4. The following particulars are given relating to a mutual fund-
Opening NAV per unit Rs. 22

Closing NAV per unit Rs. 28
Administrative expenses including fund manager Rs. 134 lakhs
remuneration
Management advisory fees Rs. 85 lakhs
Publicity and documentation Rs. 51 lakhs
Total units issued by the fund 200 lakhs
Ascertain the expense ratio. (B.Com. (H), DU, 2018)

Ans.- Expenses = 134 + 85 + 51 = Rs. 270 lakhs
Expenses per unit = 270/200 = Rs. 1.35
Average AUM = (22 + 28)/ 2 = 25
Expense Ratio = (Expenses/Average AUM) x 100 = (1.35/25) x 100 = 5.4%
44
 Amutual fund is an investment vehicle made up of a pool of funds collected from
many investors for the purpose of investing in securities such as stocks, bonds,
money market instruments and similar assets.
 As an investment intermediary, mutual funds offer a variety of services to the
relatively small investors who on their own cannot successfully construct and
manage investment portfolio mainly due to the small size of the funds, lack of
expertise and experience, etc.
 The objectives of mutual funds are to provide continuous liquidity and higher yields
with a high degree of safety to investors. Based on these objectives, different types
of mutual fund schemes have evolved.
 One of the main advantages of mutual funds is that they give small investors access
to professionally managed, diversified portfolios of equities, bonds and other
securities.
 These days, various schemes are offered by mutual funds to attract the investors.
These schemes have their own peculiar features, to satisfy different types of
investment needs.
 SIP is a method of investing a fixed sum, regularly, in a mutual fund scheme.
 Systematic Withdrawal Plan (SWP) refers to a plan which allows an investor to
withdraw a fixed or variable amount from his mutual fund scheme on a preset date
every month, quarterly, semi-annually or annually as per his needs.
 Systematic Transfer Plan or STP enables an investor to invest lump sum amount in
a scheme and regularly transfer a fixed or variable amount into another scheme.
 Net Asset Value (NAV) is the value of a fund's asset minus the value of its
liabilities per unit.
 Generally, funds pay their routine and recurring, fund related operating expenses
out of the assets of the fund, rather than by directly imposing separate charges and
fees and on investors. These expenses are called "Annual Fund Operating
Expenses".

1. What do you mean by a mutual fund? How does it work?
2. "Mutual fund is an indirect investment". Comment on the statement in view of the
various features of a mutual fund.
3. Briefly explain the various types of mutual fund schemes available in India.
(B.Com. (H), DU, 2011)
4. What are mutual funds? Explain their advantages.
5. What do you understand by systematic investment plan? What are its benefits?
(B.Com. (H), DU, 2019)
6. Differentiate between the following:
45
A) Open-ended and close-ended mutual funds.
B) SIP and SWP
C) Growth and Income funds
7. Write short notes on:
A) Load funds
B) Net Asset Value
C) Exchange Traded Funds.
D) Money market mutual funds
Q.1. Calculate NAV of a mutual fund when following information is provided-
Cash Balance- 400000
Bank Balance- 200000
Bonds/ Equity Shares (Realisable Value)- 1000000
Expenses- 100000
No. of outstanding units- 200000
(Ans- Rs. 7.50) (B.Com. (H), DU,
2007)
Q.2. Calculate NAV of the following mutual fund-
Cash Balance- 530000
Bank Balance- 270000
Market Value of Investments- 700000
Expenses- 120000
No. of outstanding units- 100000
(Ans- Rs. 13.80) (B.Com. (H), DU (Correspondence), 2007)
Q.3. A mutual fund has an NAV of Rs. 18 per unit in the beginning of the period and
Rs. 22 per unit at the end of the period. It has incurred expenses at the rate of Rs.
0.80 per unit. Find the expenses ratio.
(Ans- 40%) (B.Com. (H), DU, 2015)
Q.4. A mutual fund made an issue of 1000000 units of Rs. 10 each on January 1,2011.
No entry load was charged. It made the following investments-
I. 50000 equity shares of Rs. 100 each @ Rs. 160 – 8000000
II. 7% Government Securities- 800000
III. 9% debentures (unlisted)- 500000
46
IV. 10% debentures (listed)- 500000
9800000
During the year, dividends of Rs. 1200000 were received on equity shares. Interest on all
type of debt securities was received aas and when due. At the end of the year, the quity
share and the 10% debentures were quoted at 175% and 90% respectively.
Find out the Net Asset Value (NAV) per unit given that the operating expenses paid
during the year amounted to Rs. 500000.
(Ans- Rs. 11.55) (B.Com. (H), DU, 2012)
Q.5. Calculate NAV per unit of a mutual fund scheme when the following information is
provided-
Cash Balance 400000

Bank Balance 200000
10% Debentures 1000000
Equity Shares (FV = Rs. 100) 1000000
Accrued Expenses 100000
Number of units outstanding 200000
10% Debentures and Equity shares are currently traded in the market at 90% and 120%
respectively. (B.Com. (H), DU, 2019)
(Ans- Rs. 13 per unit)
Q.6. The following particulars are given relating to a mutual fund-
Opening NAV Rs. 104 crores

Closing NAV Rs. 162 crores
Administrative expenses including fund manager Rs. 253 lakhs
remuneration
Management advisory fees Rs. 132 lakhs
Publicity and documentation Rs. 70 lakhs
Ascertain the expense ratio. (B.Com. (H), DU, 2019)

(Ans.- 3.42%)
Q.7. Calculate the NAV from the following information for the year ending 31st March,
2016-
Cash and Bank Balance Rs. 7,50,000
47
Bonds and Debentures Rs. 8,00,000
Equity (Current Market Value) Rs. 16,50,000
Quoted Government Securities Rs. 12,05,000
Expenses Rs. 9,50,000
Number of units 2,00,000
If the NAV on 1st April, 2015 was Rs. 20 per unit, calculate the expense ratio.
(B.Com. (H), DU, 2017)
(Ans- NAV at the end of the year = Rs. 22.025, Expense Ratio = 22.60%)
48
CHAPTER 4
PERFORMANCE EVALUATION AND MUTUAL FUNDS MARKET IN INDIA

 Introduction
 Return from Mutual Fund
 Performance Evaluation of Mutual funds
 Evolution of Mutual Funds in India
 Structure of Mutual Funds in India
 Role of Mutual funds in Indian Capital Market
 Regulation of Mutual Funds in India
 Association of Mutual Funds in India
 Recent Developments in the Indian Mutual Fund Industry
4.1 Introduction
Performance evaluation is an important dimension of investment in mutual funds. An
investor or prospective investor takes decision on the basis of the performance of the
mutual funds. But before evaluating the performance of the mutual funds, it is important
to have an understanding of the returns from mutual funds. Present chapter deals with the
returns from mutual funds and the performance evaluation of the mutual funds. Besides
this, this chapter focusses on the Mutual Fund market in India.
History of mutual funds in India dates back to 1963. It is a fast-growing Industry in India.
As per the Association of Mutual Funds in India – “The Industry’s AUM had crossed
the milestone of ₹10 Trillion (₹10 Lakh Crore) for the first time in May 2014 and in a
short span of about three years, the AUM size had increased more than two folds and
crossed ₹ 20 trillion (₹20 Lakh Crore) for the first time in August 2017. The AUM size
crossed ₹ 30 trillion (₹30 Lakh Crore) for the first time in November 2020. The Industry
AUM stood at ₹35.32 Trillion (₹ 35.32 Lakh Crore) as on July 31, 2021.”
4.2 Return from Mutual Fund
The return from the mutual fund comprises of the following three components-
a.) Dividends,
49
b.) Change in NAV over period, and
c.) Capital gains distributed.
Return from the mutual fund is calculated as a percentage over the beginning NAV.
( )
Return = ℎ
x 100
Example 1An open-ended Mutual Fund scheme had a NAV of Rs. 50 at the beginning of
the year. During the year, a sum of Rs. 10 was distributed as dividend and Rs. 3 as capital
gains. At the end of the year the NAV was Rs. 45. Find out the Return of the mutual fund.
Solution-
( )
Return = ℎ
x 100
( )
= x 100
= 16%
4.3 Performance Evaluation of Mutual Funds
In the previous section, we have seen how to calculate the return from a mutual fund.
After calculating the return, its risk can also be calculated using standard deviation. In
order to track the sensitivity of the returns of mutual fund to market portfolio returns, beta
can also be calculated. With the help of risk, return and beta, performance of the mutual
fund can be evaluated using the following measures of performance evaluation-
1. Absolute Return
2. Risk adjusted return- It can be calculated using any of the following method
 Sharpe’s Ratio
 Treynor’s Ratio
 Jensen’s Alpha
Sharpe Ratio- The Sharpe ratio is the average return earned in excess of the risk-free rate
per unit of total risk. In order to calculate this ratio, the risk-free return is subtracted from
the portfolio return and is known as the excess return. Afterwards, the excess return is
divided by the standard deviation of the portfolio returns. It is used to measure the excess
return on every additional unit of risk taken. It is denoted by ‘S’ and calculated as
follows-
S=
Treynor’s Ratio- The Treynor’s ratio is the average return earned in excess of the risk-
free rate per unit of systematic risk. Just like Sharpe’s Ratio, the excess return is
calculated by subtracting the risk-free return from the portfolio return. Now instead of
dividing the excess return by the standard deviation of the portfolio returns, the excess
returns are divided by the beta factor. It is used to measure the excess return on every
50
additional unit of systematic risk taken. This ratio is denoted by ‘T’. It is calculated as
follows-
T=
Jensen’s Alpha- It is another risk adjusted measure used to evaluate the performance of
the mutual fund. Jensen’s alpha (denoted by α) is the actual return earned over and above
the return earned by the CAPM model. Jensen’s alpha is calculated by subtracting
expected return under CAPM from the actual return.
α = Actual Return – Expected return under CAPM
Example 2- The following information s available in respect of the Mutual funds A, B
and C.
Mutual Fund Actual Return (%) Beta Standard Deviation (%)

A 16 0.5 20
B 29 1.1 30
C 22 1.2 25
The return on market index is 24% and standard deviation of returns is 28%. The risk free
rate is 6%.
You are required to-
1. Calculate Sharpe Ratio for all the three mutual funds and market index and rank
them.
2. Calculate Treynor’s Ratio for all the three mutual funds and market index and
rank them.
3. Calculate Jensen’s alpha for all the three mutual funds and market index and rank
them.
Solution-
1. Sharpe Ratio
S=
Mutual Return Standard Sharpe Ratio Rank Remarks

Fund (%) Deviation (including
(%) Market
index)
A 16 20 (16-6)/20 = 0.5 4 Underperformed
the market
B 29 30 (29-6)/30 = 0.76 1 Outperformed
the market
51
C 22 25 (22-6)/25= 0.64 3 Underperformed
the market
Market 24 28 (24-6)/28= 0.643 2
Index
2. Treynor’s Ratio
T=
Mutual Return Beta Treynor’s Rank Remarks

Fund (%) Ratio (including
Market
index)
A 16 0.5 (16-6)/0.5 = 20 2 Outperformed
the market
B 29 1.1 (29-6)/1.1 = 1 Outperformed
20.91 the market
C 22 1.2 (22-6)/1.2= 4 Underperformed
13.33 the market
Market 24 1 (24-6)/1= 18 3
Index
Jensen’s Alpha
Expected return as per CAPM = Risk Free Return + (Market Return – Risk free Return) x
Beta
Mutual Return Beta CAPM Return α Rank Remarks

Fund (%) (including
Market
index)
A 16 0.5 6+(24-6)0.5= 16-15 2 Outperformed
15 =1 the market
B 29 1.1 6+(24-6)1.1= 29-25.8 1 Outperformed
25.8 = 3.2 the market
C 22 1.2 6+(24-6)1.2= 22-27.6 4 Underperformed
27.6 = -5.6 the market
Market 24 1 6+(24-6)1= 24 24-24 3
Index =0
52
Note that the Jensen’s Alpha for Market Index is always equal to Zero.
4.4 Evolution of Mutual Funds in India
The mutual fund industry in India started in 1963 with the formation of Unit Trust of
India, at the initiative of the Government of India and the Reserve Bank of India. The
history of mutual funds in India can be broadly divided into four distinct phases.
First Phase - 1964-1987
Unit Trust of India (UTI) was established in 1963 by an Act of Parliament. It was set up
by the Reserve Bank of India and functioned under the regulatory and administrative
control of the Reserve Bank of India. In 1978, UTI was de-linked from the RBI and the
Industrial Development Bank of India (IDBI) took over the regulatory and administrative
control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the
end of 1988, UTI had Rs. 6,700 crores of assets under management.
Second Phase - 1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non-UTI, public sector mutual funds set up by public sector
banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation
of India (GIC). SBI Mutual Fund was the first non-UTI Mutual Fund established in June
1987, followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund
(Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda
Mutual Fund (Oct 92). LIC established its mutual fund in June 1989, while GIC had set
up its mutual fund in December 1990.
At the end of 1993, the mutual fund industry had assets under management of Rs. 47,004
crores.
Third Phase - 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the
year in which the first Mutual Fund Regulations came into being, under which all mutual
funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer
(now merged with Franklin Templeton) was the first private sector mutual fund registered
in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive
and revised Mutual Fund Regulations in 1996. The industry now functions under the
SEBI (Mutual Fund) Regulations 1996.
The number of mutual fund houses went on increasing, with many foreign mutual funds
setting up funds in India and also the industry witnessed several mergers and acquisitions.
As at the end of January 2003, there were 33 mutual funds with total assets of Rs.
1,21,805 crores. The Unit Trust of India with Rs. 44,541 crores of assets under
management was way ahead of other mutual funds.
Fourth Phase - since February 2003
53
In February 2003, following the repeal of the Unit Trust of India Act 1963, UTI was
bifurcated into two separate entities. One is the specified undertaking of the Unit Trust of
India with assets under management of Rs. 29,835 crores as at the end of January 2003,
representing broadly, the assets of US 64 scheme, assured return and certain other
schemes. The specified undertaking of Unit Trust of India, functioning under an
administrator and under the rules framed by Government of India, does not come under
the purview of the Mutual Fund Regulations.
The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is
registered with SEBI and functions under the Mutual Fund Regulations. With the
bifurcation of the erstwhile UTI which had in March 2000 more than Rs. 76,000 crore
worth of assets under management, with the setting up of a UTI Mutual Fund and with
recent mergers taking place among different private sector funds, the mutual fund
industry has entered its current phase of consolidation and growth.
4.5 Structure of Mutual Funds in India
Indian mutual funds are regulated by SEBI. The SEBI (Mutual Funds) Regulations, 1993,
define a mutual fund (MF) as a fund established in the form of a trust by a sponsor to
raise monies by the trustees through the sale of units to the public under one or more
schemes for investing in securities in accordance with these regulations.
These regulations have since been replaced by the SEBI (Mutual Funds) Regulations,
1996. These regulations stipulate that a mutual fund must be a three-tiered structure
consisting of:
I. A Sponsor
Ii. A Trustee
Iii. An asset management company (AMC)
While the above mentioned play the most important roles in creating and running a fund
house, the custodian, registrar and transfer agent (RTA), auditors and the fund
accountants play a vital supporting role in aiding the smooth functioning of a mutual
fund.
I. Fund Sponsor – The Sponsor is the main body that establishes the Mutual fund. The
Sponsor can be compared to a promoter of a company. The responsibility of the sponsor
includes appointing the trustees with the approval of SEBI and setting up an AMC under
the Companies Act, 1956, while getting the trust registered with SEBI. For example,
ICICI Bank and Prudential Plc are sponsors for ICICI Mutual Fund. For Birla Sun Life
Mutual Fund, Aditya Birla Financial Services and Sun Life (India) AMC Investments Inc.
are the sponsors.
Since the Sponsors play the most important role in the functioning of a mutual fund,
SEBI has a set of strict guidelines for the eligibility of a sponsor. Some of them are as
follows:
1. The sponsor should have a sound track record of carrying out business in the
financial services space for not less than five years.
54
2. A sponsor also need to have made profits in at least three of the five years including
the latest year. During the same period, it is also important that the sponsor has had
a positive net worth.
3. It should be contributing a minimum of 40 per cent net worth of the AMC. It is also
important that the sponsor has a good track record of fairness and integrity in all its
transactions.
II. Trustee – The mutual fund needs to be constituted in the form of a trust and the
instrument of the trust should be in the form of a deed registered under the provisions of
the Indian Registration Act, 1908. It is the responsibility of trustees to appoint the AMC.
The main role of a trustee is to ensure that the interest of the unit holders is protected
while making sure that the mutual fund complies with all the regulations of SEBI. Either
the sponsor should appoint four trustees or establish a trustee company with at least four
independent directors. Additionally, at least two thirds of the trustees or the directors
should be independent and not associated with the sponsor in any way.
III. Asset Management Company (AMC) – The AMC is the investment manager of the
trust. It takes care of the day-to-day operation of the mutual fund and management of the
investors’ money as well. The AMC is appointed either by the trustee or the sponsor after
obtaining the approval of SEBI. The AMC consists of the Chief Investment Officer, the
fund managers and analysts, who are together responsible for managing the various
schemes launched. The compliance officer ensures compliance of all the activities of the
AMC in line with SEBIs rules and regulations. For example, HDFC AMC is the Asset
Management Company for HDFC Mutual Fund.
IV. Custodian – The custodian has the custody of all the shares and various other
securities bought by the AMC. The custodian is responsible for the safekeeping of all the
securities. The custodian is liable for keeping the investment account of the mutual fund.
V. Registrar and Transfer Agent (RTA) – The RTA maintains and updates all the
investors' records. The main function is investor servicing through its office and various
other branches. Its functions include processing of investor application, purchase and
redemption transactions by investors in various schemes and plans. For example, Karvy
Fintech Private Limited (KFPL) and myCAMS are two popular RTAs in India.
The auditors are responsible for auditing of the AMC’s accounts while ensuring that the
accounts of schemes are maintained independently from that of the AMC. The fund
accountants are responsible for calculating the NAV of the schemes based on the
information regarding the assets and liabilities of each scheme.
Thus, it can be noted that the mutual funds in India are a well-regulated entity with a
clearly defined structure comprising several components whose roles and responsibilities
are properly defined under the preview of SEBI.
4.6 Role of Mutual Funds in Indian Capital Market
Financial institutions play a significant role as a capital market intermediary and
contribute substantially to the process of macro-economic developments. Mutual funds
have emerged as a strong financial intermediary. Their role in the development of capital
markets is explained below:
55
(i) Channelizing Savings for Investment
Mutual funds act as a vehicle in galvanizing the savings of the people by offering various
schemes suitable to various classes of customers for the development of the economy as a
whole. A number of schemes are being offered by MFs to meet the varied requirements
of the masses, and thus, savings are directed towards capital investments directly. In the
absence of MFs, these savings would have remained idle. Thus, the whole economy
benefits due to the cost efficient, optimum use and allocation of scarce financial and real
resources in the economy for its speedy development.
(ii) Offering Wide Portfolio Investment
Small and medium investors used to burn their fingers in stock exchange operations with
a relatively modest outlay. If they invest in a select few shares, some may even sink
without a trace, never to rise again. Now, these investors can enjoy the wide portfolio of
the investment held by the mutual fund. The fund diversifies its risks by investing on a
large variety of shares and bonds which cannot be done by small and medium investors.
This is in accordance with the maxim ‘Not to lay all eggs in one basket’. These funds
have large amounts at their disposal, and so, they carry a clout in respect of stock
exchange transactions. They are in a position to have a balanced portfolio which is free
from risks. Thus, MFs provide instantaneous portfolio diversification. The risk
diversification which a pool of savings through mutual funds can achieve cannot be
attained by a single investor’s savings.
(iii) Lower Transaction Costs
Mutual Funds enjoy the economies of large scale and can reduce the cost of capital
market participation. The transaction costs of large investments are definitely lower than
that of small investments. In fact, all the profits of a mutual fund are passed on to the
investors by way of dividends and capital appreciation. The expenses pertaining to a
particular scheme alone are charged to the respective scheme.
(iv) Better Yields
The pooling of funds from a large number of customers enables the fund to have large
funds at its disposal. Due to these large funds, mutual funds are able to buy cheaper and
sell dearer than the small and medium investors. Thus, they are able to command better
market rates and lower rates of brokerage. So, they provide better yields to their
customers.
56
(v) Providing Greater Liquidity
Mutual fund units have greater liquidity. Units can be sold to the fund at anytime at the
Net Asset Value and thus quick access to liquid cash is assured. Besides, branches of the
sponsoring bank are always ready to provide loan facility against the unit certificates.
(vi) Acting as a Substitute for Initial Public Offerings (IPOs)
In most cases, investors are not able to get allotment in IPOs of companies because they
are oversubscribed many a time. Moreover, they have to apply for a minimum number of
shares, say 500 shares, which is very difficult particularly for small investors. But, in
mutual funds, allotment is more or less guaranteed. Mutual Funds are also guaranteed a
certain percentage of IPOs by companies. Thugs, by participating in MFs, investors are
able to get the satisfaction of participating in hundreds of varieties of companies.
(vii) Reducing the Marketing Cost of New Issues
The Mutual Funds help to reduce the marketing cost of the new issues. The promoters
used to allot a major share of the IPO to the mutual funds and thus they are saved from
the marketing cost of such issues.
(viii) Supporting Capital Market
Mutual funds play a vital role in supporting the development of capital markets. The
mutual funds make the capital market active by means of providing a sustainable
domestic source of demand for capital market instruments. In other words, the savings of
the people are directed towards investments in capital markets through these mutual
funds. Thus, funds serve as a conduit for dis-intermediating bank deposits into stocks,
shares and bonds. Mutual Funds also provide a valuable liquidity to the capital market,
and thus, the market is made very active and stable. When foreign investors and
speculators exit and re-enter the markets en masse, mutual funds keep the market stable
and liquid. In the absence of mutual funds, the prices of shares would be subject to wide
price fluctuation due to the exit and re-entry of speculators into the capital market. Thus,
it is rending an excellent support to the capital market and helping in the process of
institutionalization of the market.
4.7 Regulation of Mutual Funds in India
In India, Mutual funds are regulated by SEBI. In 1996, the SEBI Mutual Fund
Regulations were formed after the Securities and Exchange Board of India (SEBI) Act of
1992 was passed. This along with the foreign institutions setting up companies in India
through joint ventures and properties, resulted into the exponential growth of mutual
funds.To protect the interests of mutual fund investors, SEBI made regulations regarding-
1. The registration of mutual funds.
2. Constitution of mutual funds.
3. Management of mutual funds.
4. Operation of trustees.
5. Constitution of AMC and custodian.
57
6. Management of AMC and custodian.
7. Mutual Fund Schemes (including Real estate mutual fund schemes and
Infrastructure debt fund schemes).
8. Investment objectives and valuation policies.
9. General obligations of mutual funds.
10. Audit and inspection of mutual funds.
11. Procedure for action in case of default.
4.8 Association of Mutual Funds in India
In 1995, as the mutual fund industry developed, the Association of Mutual Funds in
India (AMFI), a non-profit organization, was established with an objective of
encouraging healthy and ethical marketing practices in the Indian mutual fund industry.
The certificate of AMFI has been made mandatory by the SEBI for all those who are
engaged in marketing mutual fund products. The Association of Mutual Funds in India
(AMFI) has been formed to flourish the Indian Mutual Fund Industry on ethical and
professional ground and to strengthen and maintain standards in all aspectsin order to
safeguard and promote the interests of mutual funds and their unitholders. AMFI has been
formed for the following objectives-
1. To define and maintain high professional and ethical standards in all areas of
operation of mutual fund industry.
2. To recommend and promote best business practices and code of conduct to be
followed by members and others engaged in the activities of mutual fund and asset
management including agencies connected or involved in the field of capital
markets and financial services.
3. To interact with the Securities and Exchange Board of India (SEBI) and to represent
to SEBI on all matters concerning the mutual fund industry.
4. To represent to the Government, Reserve Bank of India and other bodies on all
matters relating to the Mutual Fund Industry.
5. To undertake nation-wide investor awareness programme so as to promote proper
understanding of the concept and working of mutual funds.
6. To disseminate information on Mutual Fund Industry and to undertake studies and
research directly and/or in association with other bodies.
7. To regulate conduct of distributors including disciplinary actions for violations of
Code of Conduct.
8. To protect the interest of investors/unit holders.
4.9 Recent Developments in the Indian Mutual Fund Industry
Following were the major developments in Indian mutual funds industry-
1. Change in the multi cap funds’ investment mandate- Earlier, multicap funds
were required to invest 65% in the equity without any market cap limit. In
September 2020, SEBI changed this portfolio mandate through a circular. Now, the
58
mutual funds are required to invest a minimum of 25% in each large, medium and
small cap equities making an aggregate of minimum 75% investment in the equity.
2. Change in the calculation of NAV- SEBI twisted the rules regarding the NAV. As
per the new rules, the NAV applicable in respect of purchase of mutual fund units
of any scheme shall be subject to realization & availability of the funds in the bank
account of mutual fund before the applicable cut off timings for purchase
transactions, irrespective of the amount of investment.
3. Strict inter-scheme transfer norms- Earlier many funds used to maintain the
liquidity by transferring bad credit to either long term schemes or balanced funds.
To protect the interests of the investors, SEBI tightened this norm. Now, inter
scheme transfer in close-ended funds can be done only within 3 working days of the
allotment of units of any scheme to the investor and not afterwards.
4. Transparency in debt securities transaction- The disclosure norms for debt
mutual funds were also tightened. Now the mutual fund houses are required to
disclose the portfolio and yields of the underlying assets on fortnightly basis. Earlier
the portfolio was disclosed on monthly baasis and the yield was disclosed on
indicative basis.
4.10 Solved Illustration
Q.1. The following information s available in respect of the Mutual funds X,Y and Z.
Mutual Fund Actual Return (%) Beta Standard Deviation

(%)
X 20 0.5 10
Y 15 0.8 8
Z 25 1.25 20
Market Index 18 1 15
The risk free rate is 5%.
You are required to-
1. Calculate Sharpe Ratio for all the three mutual funds and market index and rank
them.
2. Calculate Treynor’s Ratio for all the three mutual funds and market index and
rank them.
3. Calculate Jensen’s alpha for all the three mutual funds and market index and rank
them.
Solution-
1. Sharpe Ratio
S=
Mutual Return Standard Sharpe Ratio Rank Remarks
59
Fund (%) Deviation (including
(%) Market
index)
A 20 10 (20-5)/10 = 1 Outperformed
1.5 the market
B 15 8 (15-5)/8 = 2 Outperformed
1.25 the market
C 25 20 (25-5)/20= 1 3 Outperformed
the market
Market 18 15 (18-5)/15= 4
Index 0.87
2. Treynor’s Ratio
T=
Mutual Return Beta Treynor’s Rank Remarks

Fund (%) Ratio (including
Market
index)
X 20 0.5 (20-5)/0.5 = 30 1 Outperformed
the market
Y 15 0.8 (15-5)/0.8 = 4 Underperformed
12.5 the market
Z 25 1.25 (25-5)/1.25= 2 Outperformed
16 the market
Market 18 1 (18-5)/1= 13 3
Index
Jensen’s Alpha
Expected return as per CAPM = Risk Free Return + (Market Return – Risk free Return) x
Beta
Mutual Return Beta CAPM Return α Rank Remarks

Fund (%) (including
Market
index)
60
X 20 0.5 5+(20-5)0.5= 20-12.5 1 Outperformed
12.5 = 7.5 the market
Y 15 0.8 5+(15-5)0.8= 15-13 = 2 Outperformed
13 2 the market
Z 25 1.25 5+(25-5)1.25= 25-30 = 4 Underperformed
30 -5 the market
Market 18 1 5+(18-5)1= 18 18-18 = 3
Index 0
Q.2. NAV of an equity scheme of a mutual fund was Rs. 15 in the beginning and Rs. 19
at the end of the year. The dividend distributed during the year was Rs. 2 per unit. Find
out the return of the scheme.
Solution-
( )
Return = ℎ
x 100
( )
= x100
= x100 = 40%
Q.3. A new mutual fund scheme is launched with initial expenses 5% and annual
recurring expenses of 1 %. The minimum required rate of return of the investors in the
market is 12%. How much should the mutual fund earn annually in order to satisfy the
investor’s expectation?
Solution-
Here, if the mutual fund issues units of Rs. 100, then the expenses of Rs. 5 would be
payable immediately and recurring expenses of Rs. 1 thereafter. It should also be able to
pay Rs. 12 to the investors. The required rate of return of the mutual fund is-
Return for the investors Rs. 12
Recurring Expenses (1% of Rs. 95) Rs. 0.95
Total Return Required Rs 12.95
Funds available (Rs. 100- Rs. 5) Rs. 95
% Return = 12.95/95
= 0.1363 =13.63%
 Return from the mutual fund is calculated as a percentage over the beginning NAV.
 With the help of risk, return and beta, performance of the mutual fund can be
evaluated using the following risk adjusted measures of performance evaluation-
Sharpe Ratio, Treynor’s Ratio and Jensen’s Alpha.
61
 The mutual fund industry in India started in 1963 with the formation of Unit Trust
of India, at the initiative of the Government of India and the Reserve Bank of India.
The history of mutual funds in India can be broadly divided into four distinct phases
 A mutual fund must be a three-tiered structure consisting of a sponsor, a trustee, and
an asset management company (AMC).
 Mutual Funds play a significant role as a capital market intermediary and
contributes substantially to the process of macro-economic developments.
 In India, Mutual funds are regulated by SEBI. In 1996, the SEBI Mutual Fund
Regulations were formed after the Securities and Exchange Board of India (SEBI)
Act of 1992 was passed.
 In 1995, The Association of Mutual Funds in India (AMFI) has been formed to
flourish the Indian Mutual Fund Industry on ethical and professional ground and to
strengthen and maintain standards in all aspects in order to safeguard and promote
the interests of mutual funds and their unitholders.
 Many developments are seen in the Indian Mutua funds industry recently. Some of
these are change in the multi cap funds’ investment mandate, transparency in debt
securities transaction, strict inter scheme transfer norms and change in the
calculation of NAV, etc.
1. Comment on the role of mutual funds in the Indian Economy.
2. Describe the structure of mutual funds in India. (B.Com. (H), DU, 2015)
3. What are the phases in the evolution and growth of mutual funds in India?
4. Mutual Funds are extremely important in the financial system of an economy. Do
you agree?
5. Explain the recent developments in the Indian mutual funds industry.
6. “Mutual Funds have seen its share of ups and downs in India.” Discuss the
statement in the light of its evolution and present status.
7. How do we calculate the return from a mutual fund?
8. What are the different measures of portfolio performance? Which of these, in your
opinion, is a more appropriate measure of performance?
(B.Com. (H), DU, 2016)
9. Write a short note on-
a. Asset Management Company
b. Sharpe’s Ratio
c. Treynor’s Ratio
d. Trustee of Mutual Fund
e. Fund Sponsor
at the end of the year. The dividend distributed during the year was Rs. 2 per unit.
Find out the return of the scheme.
(Ans- 30 %)
62
Q.2. An open-ended Mutual Fund scheme had a NAV of Rs. 60 at the beginning of the
year. During the year, a sum of Rs. 10 was distributed as dividend and Rs. 5 as
capital gains. At the end of the year the NAV was Rs. 65. Find out the return of the
mutual fund.
(Ans- 33.33%)
at the end of the year. The dividend distributed during the year was Rs. 2 per unit.
Find out the return of the scheme.
(Ans- 20 %)
63
CHAPTER -5
FINANCIAL DERIVATIVES– I

 Introduction
 Derivatives
 Characteristics of Derivatives
 Classification of Derivatives
 Types of Financial Derivatives
 Forwards
 Futures
 Pricing of Futures
 Solved illustrations
 Review Qestions
5.1 Introduction
Derivatives are not new to India. They exist since a long period of time. Indian
Derivatives market dates back to 1875. The future trading was started by Bombay Cotton
Trading Association in this year. However, post-independence, the Indian government
put an official ban on cash settlement and options trading in 1952. Finally in 2000, this
ban on commodities future trading was uplift.
5.2 Derivatives
Derivatives are the assets whose value depends on the value of an underlying asset, group
of assets or a benchmark.They are basically a contract between two parties which derive
their value from the value of the underlying asset. Prices of these derivatives depend on
the fluctuations in the underlying assets. Not only the prices of derivatives, but the risk
and returns from investment in a derivative also depend on the underlying assets. Or, we
can say that the performance of the derivatives depends upon the performance of the
underlying asset. These underlying assets may be tangible (like gold, silver, wheat, crude
oil, etc.) or intangible (like shares, index, interest rates, exchange rates, etc.).
There is no physical existence of a derivative. Rather, it emerges out of a contractual
relationship between the parties entering into derivative contract. The parties to the
derivative contract are different from the issuer or dealer in the underlying asset.
Derivatives can be exchange traded or over the counter (OTC).
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Derivatives are of various types depending upon the underlying asset. When the
underlying asset is a commodity, it is known as a commodity derivative like gold
futures, silver futures, agricultural derivatives, etc. When the underlying asset is a
financial asset like shares, currency, interest rate, stock index, etc., then the derivative is
called financial derivative. Financial derivatives can be in the form of forward, futures,
options and swaps.
5.3 Characteristics of Derivatives

1. Leveraging- Derivatives provide the benefit of ofGearing or Leveraging to the
investors. The investors can deal big volumes even with a meagre initial outlay of
funds ( which is a small percentage of the entire contract value). So the investors
can make huge profits with a relatively small investment. However, there is also a
probability of huge losses.
2. Complexity- Derivatives trading is a complex processwhich requires a thorough
understanding of the price behaviour of the underlying asset. Adequate knowledge
of the product structure of the underlying asset is also an essential pre-requisite to
dealing with these products.
3. Value- Derivatives do not have their independent value. Their value depends upon
the value of the underlying assets.
4. Transfer of risk- One of the major motives to invest in the derivatives is to mitigate
the risk involved in the securities trading due to changing prices. Investors purchase
and sell the derivatives to offset this risk by taking a counter position in the
derivative market. For example, Mr. A has a portfolio of stocks. Due to the adverse
market condition, the value of this portfolio may decline. This risk can be shifted if
the investor takes a short position in an index which is the representative of his
stocks (Eg., Sensex, Nifty 50, etc.). Now if the market falls, he would make profit
by squaring off his short position in the index and could compensate for the loss that
he suffers due to fall in value of his portfolio.
5. No counterparty risk- Derivative markets are standardized markets. Trading in
derivatives is done through recognized stock exchanges and settlement and clearing
is done by the clearing corporations like NSE Clearing. These clearing houses
become the counterparty tor both the sides of each transaction and guarantees the
trade.
6. Low transaction cost- Since derivatives are normally settled by squaring off the
transaction, physical delivery of the assets is not there. Therefore, there is no limit
on the number of units to be transferred in derivatives trading and hence the
transaction cost is very low.
5.4 Classification of Derivatives
The derivatives can be broadly classified as follows-
1. Commodity Derivatives and Financial Derivatives- On the basis of underlying asset,
the derivatives can be classified as commodity derivatives and financial derivatives.
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When the underlying asset is a commodity (like gold, siver, wheat, oil,etc.), it is known
as a commodity derivative like gold futures, silver futures, agricultural derivatives, etc.
When the underlying asset is a financial asset like shares, currency, interest rate, stock
index, etc., then the derivative is called financial derivative. Financial derivatives can be
in the form of forward, futures, options and swaps.
 Forward-A forward contract is an agreement between two parties to buy or sell
underlying assets at specified date, at the agreed upon rate in future.
 Futures- A futures contract is a standardized contract, traded on exchange, to buy
or sell underlying instrument at a certain date in future, at specified
 Options- Option is the most important part of derivatives contract. An Option
contract gives the right but not an obligation to buy/sell the underlying assets. The
buyer of the options pays the premium to buy the right from the seller, who
receives the premium with an obligation to sell the underlying assets if the buyer
exercises his right.
 Swaps- A swap is a derivative contract made between two parties to exchange
cash flows in the future. Interest rate swaps and currency swaps are the most
popular swap contracts, which are traded over the counters between financial
institutions. These contracts are not traded on exchanges. Retail investors
generally do not trade in swaps.
2. Elementary derivatives and Complex derivatives- Those derivatives which are
simple to trade and easy to understand are called elementary derivatives. Futures and
options are examples of elementary derivatives. However, the derivatives with
complicated features and provisions are called complex features. These are difficult to
understand by the investor. Exotic options, synthetic futures and options are certain
examples of complex derivatives.
3. Exchange traded and OverThe Counter (OTC) derivatives- As the name suggests,
Exchange traded derivatives are the instruments which are traded on recognized
exchanges. These are the standardized contracts as they are traded as per the rules and
regulations of the exchange. Some of the commonly exchange traded derivatives in India
are stock index future, stock index options, interest rate futures and interest rate options.
On the other hand Over The Counter or OTC derivatives are the private bilateral contracts
between two parties. These are customized contracts where the parties can negotiate the
terms and conditions of the contract as per their requirements. Since these are not
governed by the rules and regulations of the exchanges, there exists higher counter-party
risk in these contracts. Forwards and swaps are the examples of Over The Counter
derivatives.
5.5 Types of Financial Derivatives
Forward, futures, options and swaps are the types of financial derivatives. However, in
this chapter we will focus only on the first two derivatives, i.e. Futures and Forwards.
Options will be dealt in the next chapter. Swaps are out of the scope of this book.
5.6 Forwards
A forward contract is a private bilateral contract between two parties to purchase and sell
a particular asset at a pre-determine on a specified date in future.
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Let suppose Mr. X is a rice producer in West Bengal. He is expecting to grow 10 quintals
of rice this year. He can sell tis rice in the market at whatever be the market price of rice
at that time. But he wants to get an assurance of a minimum price. So he enters into a
contract with ‘Dawat Basmati’ to sell the rice to them at Rs. 50/kg at the time of harvest.
This contract is known as forward contract. If at the time of harvest the market price falls
to Rs. 40/kg, he will gain Rs.10000. However, if the market price is Rs. 55/kg (or more)
he will lose Rs. 5000 (or more depending upon the market price of rice). So, there is a
possibility of both loss and gain. Where on the one side he is able to play safe and insure
himself against the downside losses, on the other side he is also losing the opportunity to
make super profits. The loss of one party is the gain of the other party. The contract is
private contract between Mr. X and the ‘Dawat Basmati’. It is an Over The Counter
transaction where no exchange is involved. There is a risk of default on the part of any
party.
When we talk about the financial derivatives, financial forward contracts are the contracts
where the underlying asset is a financial instrument like currency. Let’s take an example
of ABC co. which has to pay its import bills of 10000 Euros after 2 months. In this
transaction, risk of currency devaluation exists for the company. If the rupee devaluates
after 2 months, the company wil face a loss as Euro will go up. In order to hedge its
position, the company enters into an agreement with another company to buy 10000
Euros at Rs. 90 per Euro after 2 months. If the currency rate rises to Rs. 92 per Euro in
the market after 2 months, the company will gain from the currency forward. But there is
also an equal probability of loss if on the specified future date the rupee appreciates.
However, the ABC co. has insured itself from the risk of loss by fixing up the prices.
Features of Forward Contracts-
 Bilateral Contract- These are the contracts between to parties.
 Customised- Forward contracts are customized as per the needs of the person
entering into the contract. They can decide the terms and conditions as per their
mutual consent.
 Underlying asset- In a financial forward contract, the underlying asset could be a
tock, interest rate, currency or any combination of these.
 Equal rights and obligations- Both the parties to the agreement have equal rights
and obligations. If the purchaser has the right to purchase (or an obligation to
purchase), the seller is obliged to sale (or has the right to sell). They have the right
to enforce each other to perform the contract.
 Non regulated market- Forward contracts are the private contracts between two
parties which are not traded on any exchange. So, they are not regulated by the
rules and regulations of any exchange. Forward contracts are popular amongst
banks, financial institutions, government and corporations.
 Risk of default or counter party risk- Being a private contract, these are not
regulated by any exchange and hence there exists a risk of non-performance of the
duties by any party. If the market price is substantially lower than the contract
price, there is a possibility tatthte purchaser could make a default and vice-versa.
There is also a risk that purchaser could make a default in payment or the supplier
could make a default in delivery.
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 Liquidity- The forward contracts are customized contracts. They are not traded
on any exchange. So the liquidity of these contracts is low.
 Cannot be squared off- The forward contracts are usually held till maturity.
These contracts cannot be squared off at the wish of any one party. These
contracts can only be cancelled with te consent of the other party.
 Settlement of contract- The forward contracts can be either settled through
physical delivery or cash settled. Most of the times, the forward contracts are
settled through the delivery where the seller supplies or delivers the
predetermined quantity of the goods on a prespecified date to the buyer and buyer
performs his duty by making the payment to the seller as per the contract. In cash
settlement, no delivery of goods take place. Rather, the difference in the price i.e.
the difference between the market price and the forward price is paid by the one
party to the other.
5.7 Futures Contract
A future contract is an improved or modernized version of forward contract. It is a
contract between two parties to buy or sell a specified quantity of an asset at a
predetermined price on a future specified date. But it is an exchange traded derivatives
and thus they are standardized contract which are regulated by the rules and regulations
of the exchange.In case of commodity futures underlying asset is any commodity like
gold, silver, wheat, etc. In case of a financial future, the underlying asset is a financial
instrument like stock, currency, interest rate, etc. For Example, an investor buys BSE
Sensex futures at Rs 50,000 with an expiry date of a month. If the Sensex rises to 55,000,
he is able to make a profit of Rs 5,000. If it goes down to Rs 40,000, in that case, his
losses would be Rs 10,000. Index futures are used by portfolio managers to hedge their
equity positions should share prices fall. A futures contract allows a trader to speculate on
the direction of movement of a commodity's price.
Features of a Future Contract-
 Exchange Traded- These contracts are traded on exchanges and are therefore
governed by the rules and regulations of the exchange. There prices are known to
general public.
 Standardized Contract- These contracts are standardized as the terms and
conditions of these contracts are specified by the exchange where they are traded.
The quantity, price and the maturity date is also predetermined by the exchange.
 Underlying asset- In case of commodity futures underlying asset is any
commodity like gold, silver, wheat, etc. In case of a financial future, the
underlying asset is a financial instrument like stock, currency, interest rate, etc.
 Zero default risk or counter party risk-Since these contracts are not private
contracts, there is no risk of default. The exchange acts as an intermediary
between the buyer and seller and guarantees the payment and delivery with the
help of a clearing house.
 Clearing house- Clearing house safeguards the interest of the parties by making it
compulsory to deposit margin money. The gains and losses of the parties are
settled out of the margin (or mark to margin the positions of the investors) on
daily basis.
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 Liquidity- Since these contracts are continuously traded on exchange, they are
highly liquid. Any party can square off his position at any time without the
consent of other party.
 Settlement before maturity- It is not necessary that the parties have to keep the
futures contract till maturity. They can offset their position by entering into an
opposite transaction before the maturity of the contract.
 Margin requirement- All future contracts have mandatory margin requirements
where both the buyer and the seller are required to deposit margin money with the
exchange at the time of entering into the future contract. This margin is required
to protect the interests of the investor against the default risk or counterparty risk.
There are two types of margin- initial margin and maintenance margin. Initial
margin is deposited at the time of entering into futures contract ad maintenance
margin is deposited later. Let us assume that a future contract is worth Rs. 100000
with an initial margin of 5% and maintenance margin of 2%. Then the buyer of
the contract has to deposit Rs.5000 with the exchange in his margin account. Now
margin account is settled on daily basis i.e. mark to margin settlement. If margin
amount in the account on any day falls below the maintenance marginofRs. 2000,
then a variable call is made to replenish the margin amount to the level of initial
margin.
 Settlement mechanism-Future derivatives can be settled in two ways-through
delivery or through cash settlement. The future contracts are rarely settled through
the delivery where the seller supplies or delivers the predetermined quantity of the
goods on a prespecified date to the buyer and buyer performs his duty by making
the payment to the seller as per the contract. Most of the future contracts are
settled through cash, where no physical delivery of goods take place. Rather, the
difference in the price is paid or received by the parties to settle the contract.
Terminology of Futures Contract
 Spot price- It is the price at which an underlying asset trades in the spot market.
 Futures price- It is a predetermined price at which the buying and selling of an
underlying asset will take place on a future specified date.
 Contract cycle- A contract cycle is the period for which the futures contract trades
on an exchange. Stock and index futures have one-month (near month), two-
month (next month) and three-month (far month) contract cycles. A new contract,
which is for three months, is introduced after the expiry of the near month
contract.
 Contract Size- It is the minimum quantity of the underlying asset that is required
to be purchased or sold in a futures contract. It is also referred to a lot size.
 Expiry date- It is the last date on which contract is required to be settled. It expires
and ceases to exist after the expiry date. In India, equity futures are settled on the
last Thursday of every month.
 Price Band- The maximum and the minimum price change allowed in a day is
known as price band.
Futures vs Forward contracts
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Both Future and Forward contracts are the agreement between to parties to buy/sell
specified quantity of an asset at a future specified date at a predetermined price. However,
there are a lot of differences between these two. These differences are listed below-
Basis Future Contracts Forward Contracts

OTC/ Exchange Future Contracts are traded on Forward contracts are traded Over
Traded exchanges. The Counter.
Standardization These contracts are standardized Forward contracts are customized
as the terms and conditions of as per the needs of the person
these contracts are specified by entering into the contract.
the exchange where they are
traded.
Counter party Since these contracts are not There exists a risk of default of
Risk private contracts, there is no risk non-performance of the duties by
of default. the parties.
Clearing House Clearing house is there to There is no concept of clearing
safeguard the interests of the house.
parties against the default risk.
Settlement Mostly settled in cash. Mostly settled through physical
delivery of the asset.
Liquidity These are continuously traded on Since these are not exchange
exchange and hence are highly traded these are highly illiquid.
liquid.
Margin There is a requirement to deposit There is no such margin
Requirement the initial margin and requirement.
maintenance margin by the
parties.
Before maturity It is not necessary that the parties The forward contracts are usually
settlement have to keep the futures contract held till maturity. These contracts
till maturity. They can offset their cannot be squared off at the wish
position by entering into an of any one party. These contracts
opposite transaction before the can only be cancelled with te
maturity of the contract. consent of the other party.
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Types of Financial Futures-
Depending upon the underlying asset, financial futures are of the following 4 types-
a) Stock Futures- These are the futures that have individual stocks as the underlying
asset. For example, SBI stock is the underlying asset of SBI stock futures.
b) Index Futures- Where the underlying asset of a future contract is stock index, it is
termed as index future. For example, futures on Nifty, Bank Nifty, BSE Sensex, etc.
c) Currency Futures- Currency futures are a exchange-traded futures contract that
specify the price in one currency at which another currency can be bought or sold at
a future date.
d) Interest Rate Futures- An Interest Rate Futures contract is "an agreement to buy
or sell a debt instrument at a specified future date at a price that is fixed today." The
underlying security for Interest Rate Futures is either Government Bond or T-Bill.
5.8Pricing of Futures Contract
Pricing of futures contract refers to determine the specified price at which contract will be
executed. The cost of carry model is used to determine the fair price or theoretical price
of the fututres contract. However, the actual prices are determined in the market using the
market forces of demand and supply.
As per the cost of carry model, the fair value or the price of a futures contract is equal to
the current price of underlying asset plus an amount known as ‘cost of carry’. This cost of
carry is the holding cost i.e. incurred while holding the underlying asset over the period
of futures contract reduced by the amount that would be received by the asset holder in
the form of income or dividend on the underlying asset during the holding period.
On the basis of the payment or non- payment of dividend, the pricing of futures can be
done in different situations as follows-
1. When the underlying asset does not provide any income or dividend, the price of
future will be- F= Sert
2. When the income/dividend provided by the underlying asset is known, then the
price of the future contract will be- F= (S-I)ert
3. When the underlying asset provides known income yield or dividend yield, then the
price of the future contract will be- F= Se(r-q)t
Where,
F= Future price
S= Spot price
e= base of natural logarithm= 2.71828
r= Continuously compounding rate of interest p.a.
t= time duration of futures in years
I= Present value of income or dividend discounted at the rate r
q= Income yield (or dividend yield)
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Investment decision- An investor can decide whether to invest in the futures or not by
comparing the fair value of the future (as determined by the cost of carry model) with the
actual market price of the future. If the fair value is more than the actual market price, the
future is undervalued and must be bought. If the fair value is less than the actual market
price, the future contract is overvalued and should not be bough
Example 1The shares of ABC ltd. is currently trading at Rs. 100 in the spot market. The
futures contract of the same shares matures in 3 months and the continuously
compounded risk-free rate is 8% per annum. Calculate the price of the future contract
having the lot size of 50, if no dividend is paid. (e0.02 = 1.0202)
Solution F= Sert= 100e(0.08)3/12 = 100e0.02 = 100(1.0202) = Rs. 102.02
Lot size =50. So, the price of futures contract= 50x 102.02 = Rs. 5101
Example 2 Consider a 3-month stock index futures contract NIFTY Index. The current
value of the index is 500 and continuously compounded dividend yield expected on the
underlying shares is 5% per annum and continuously compounded risk-free rate is 11%
per annum. Calculate the price of one futures contract if lot size is 100. (e0.015 = 1.015)
SolutionF= Se(r-q)t = 100x 500e(0.11-0.05)3/12 = 50000x1.015= Rs. 50750
Example 3 The spot price of the equity shares of XYZ Ltd. is Rs. 100 and the company is
expected to declare a dividend of Rs. 20 after a month. What would be the price of the
three months future of the same share if continuously compounded risk-free rate is 12%?
(e0.03 = 1.03, e0.01 =1.01)
Solution The dividend will be received after a month. So, the present value of the
dividend will be-
I = 20e-rt = 20e-0.12/12 = 20e-0.01 = 20/e0.01 = 20/1.01 = 19.80
The price of future will be-
F= (S - I)ert= (100-19.80)e0.12x3/12 = 80.20 x e0.03 = 80.20 x 1.03 = 82.606
Q.1.The shares of a company are currently trading at Rs. 40 in the spot market. The
futures contract of the same shares matures in 2 months and the continuously
compounded risk-free rate is 12% per annum. Calculate the price of the future contract
having the lot size of 100, if no dividend is paid. (e0.02 = 1.0202)
Ans.F= Sert= 40e(0.12)2/12 = 40e0.02 = 40(1.0202) = Rs. 40.81
Lot size =50. So, the price of futures contract= 100 x 40.81 = Rs. 4081
Q.2. The shares of ABC ltd. is currently trading at Rs. 50 in the spot market. The futures
contract of the same shares matures in 3 months and the continuously compounded risk-
free rate is 8% per annum. Calculate the price of the future contract having the lot size of
200, if no dividend is paid. (e0.02 = 1.0202)
Ans.F= Sert= 50e(0.08)3/12 = 50e0.02 = 50(1.0202) = Rs. 51.01
Lot size =200. So, the price of futures contract= 200 x 51.01 = Rs. 10202
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Q.3. Consider a 3-month stock index futures contract NIFTY Index. The current value of
the index is 400 and continuously compounded dividend yield expected on the underlying
shares is 6% per annum and continuously compounded risk-free rate is 10% per annum.
Calculate the price of one futures contract if lot size is 100. (e0.01 = 1.01)
Ans. Future Price,F = Se(r-q)t= 100 x 400e(0.10-0.06)3/12 = 40000 x 1.01= Rs. 40400
Q.4. The stock index is currently valued at Rs. 600 and the risk free rate is 9%. Find the
futures price for a 2 months contract if the dividend yield is 3%. (e0.015 = 1.015)
Ans. Future Price,F = Se(r-q)t= 600e(0.09-0.03)3/12 = 600 x 1.015= Rs. 609
Q.5. The spot price of the equity shares of XYZ Ltd. is Rs. 80 and the company is
expected to declare a dividend of Rs. 10 after a month. What would be the price of the
three months future of the same share if continuously compounded risk-free rate is 12%?
(e0.03 = 1.03, e0.01 =1.01)
Ans. The dividend will be received after a month. So, the present value of the dividend
will be-
I = 10e-rt = 10e-0.12/12 = 10e-0.01 = 10/e0.01 = 10/1.01 = 9.90
F= (S - I)ert= (80-9.90)e0.12x3/12 = 71.10 x e0.03 = 71.10 x 1.03 = Rs. 73.23
Q.6. The spot price of the equity shares of Ceramic Ltd. is Rs. 1200 and the company is
expected to declare a dividend of Rs. 80 after 12 months. What would be the price of the
12 months future of the same share if continuously compounded risk-free rate is 10%
p.a.? (e0.10 =1.105)
Ans. The dividend will be received after a year. So, the present value of the dividend will
be-
I = 80e-rt = 80e-0.10x1 = 80e-0.1 = 80/e0.10 = 80/1.105 = 72.40
F= (S - I)ert= (1200-72.40)e0.10x1 = 1127.60 x e0.10 = 1127.60 x 1.105 = Rs. 1246
 Derivatives are the assets whose value depends on the value of an underlying asset,
group of assets or a benchmark. They are basically a contract between two parties
which derive their value from the value of the underlying asset.
 When the underlying asset is a commodity (like gold, siver, wheat, oil,etc.), it is
known as a commodity derivative like gold futures, silver futures, agricultural
derivatives, etc.
 When the underlying asset is a financial asset like shares, currency, interest rate,
stock index, etc., then the derivative is called financial derivative.
 Exchange traded derivatives are the instruments which are traded on recognized
exchanges.
On the other hand, Over The Counter or OTC derivatives are the private bilateral
contracts between two parties.
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 Financial derivatives can be in the form of forward, futures, options and swaps.
 A forward contract is an agreement between two parties to buy or sell underlying
assets at specified date, at the agreed upon rate in future.
 A futures contract is a standardized contract, traded on exchange, to buy or sell
underlying instrument at a certain date in future, at specified.
 Both Future and Forward contracts are the agreement between to parties to buy/sell
specified quantity of an asset at a future specified date at a predetermined price.
However, there are a lot of differences between these two.
 Pricing of futures contract refers to determine the specified price at which contract
will be executed. The cost of carry model is used to determine the fair price or
theoretical price of the futures contract. However, the actual prices are determined
in the market using the market forces of demand and supply.
Q.1 What are Financial Derivatives?
Q.2 What are futures contracts? How would you distinguish between futures and
forwards?
Q.3 What do you mean by forwards? What are their features?
Q.4 How the futures contracts can be priced under different situation?
Q.1. An investor buys a NIFTY futures contract for Rs. 2,80,000 (lot size 50 futures). On
the settlement date, the NIFTY closes at 5512. Find the profit/loss if he pays Rs.
1000 as brokerage.
(Ans- loss of s. 5400)
Q.2. An underlying asset is currently being traded at Rs. 1860 per unit. Risk free rate of
return is 6%. Find out the price of a 4 months futures.
(Ans- Rs. 1897.58)
Q.3. Risk free rate of interest in the market is 8% and the market price of the share is Rs.
355. What is the price of a futures contract for 3 months period if the dividend yield
is 4% p.a.?
(Ans- Rs. 358.57)
Q.4. An investor buys 300 shares of XYZ Ltd. at the rate of Rs. 280 per share. In the spot
market, in order to hedge his position, he sells 200 futures of XYZ Ltd. at the rate of
Rs. 270 each. The share price and the future price decline by 5% and 4% the very
next day. He closes his position by counter transaction. Find out his profit or loss.
(Ans- Net Loss- Rs. 2040)
Q.5. An investor buys Nifty Future contract for Rs. 3 lakhs. Lot size is of 200 shares. On
the settlement date, the Nifty closes at 1570. Find out his profit or loss, if he pays
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Rs. 1500 as brokerage. What would be his position, if he has sold the future
contract.
(Ans- Profit- Rs. 12500, loss- Rs. 15500)
Q.6. The market price of equity shares of a company is Rs. 100 and the expected
dividend to be declared by the company after 1 month is Rs. 20. What should be the
futures price of a three month future contract if continuously compounded risk free
rate is 12%. [e0.03 = 1.03, e0.01 = 1.0]
(Ans- Rs. 82.61 approximately)
Q.7. An investor buys 500 shares of ABC Ltd. at the rate Rs. 210 per share in the cash
market. In order to hedge his position, he sells 300 futures of ABC Ltd at the rate
Rs. 195 each. The share price and the future price declined by 5% and 3%
respectively the very next day. He closes his position by counter transactions. Find
out his net profit or loss. (B.Com. (H), DU, 2008, 2012)
(Ans- Net Loss- Rs. 3495)
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CHAPTER 6
FINANCIAL DERIVATIVES- II

 Introduction
 Options
 Types of Options
 Options Terminologies
 Payoffs from the options
6.1 Introduction
In the previous chapter, we have studied about the derivatives and their two important
components i.e. forwards and futures. In this chapter we will study about the last but not
the least component of a derivative, i.e., options.
6.2 Options
An option is a contract between two parties where one party (option holder) gets the right
(not the obligation) to buy/sell an asset on or before a future date at a pre-determined
price to option writer. This option contract is sold by the option writer to option holder
for a price called option premium. By paying the premium, option holder gets the right to
buy or sell the asset. The option holder is not obliged to buy or sale the specified assets.
Depending upon the market conditions, he can let the option to lapse. However, in case
the option is lapsed he suffers a loss which is restricted to option premium paid by him at
the time of entering into the contract. On the other hand, the option writer sells the right
to the holder and gets a premium in return of that. This makes the writer obliged to
perform his duty in case the option holder exercises his right. In case the option is lapsed,
he will earn a profit in the form of the premium as the option premium is non-refundable.
However, if the option is exercised by the holder, the writer could suffer a loss
(depending on the market price of the asset). The loss of the one party is the gain of the
other party and vice-versa.
This is the major basis of distinction between the future contracts and the option
contracts. In future contracts both the parties have equal rights and duties. Both of them
can enforce the other party to perform their duties. Whereas, in option contracts one party
has the right while the other has the obligation. These differences are discussed in detail
in the next chapter
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Types of options- Options can be categorized in different groups as follows-
1. Call Options and Put Options-Call option is a contract which gives a right to option
holder to buy the underlying asset at a predetermined price on or before the exercise date
from the writer. He is not obliged to buy the asset. If the market price of the asset on the
exercise date is less than the exercise price, the holder will buy the asset from the market
and will let the option lapse. The option writer will get the benefit of the premium in
such a case. On the other hand, if the market price on the maturity date is more than the
exercise price, the holder will exercise the option and buy the asset from the writer. In
that case the writer may incur the loss depending upon the difference between the
exercise price and market price.
Put option is a contract which gives a right to option holder to sell the underlying asset at
a predetermined price on or before the exercise date to the writer. He is not obliged to sell
the asset. If the market price of the asset on the exercise date is more than the exercise
price, the holder will sell the asset in the market and will let the option lapse. The option
writer will get the benefit of the premium in such a case. On the other hand, if the market
price on the maturity date is less than the exercise price, the holder will exercise the
option and sell the asset to the writer. In that case the writer may incur the loss depending
upon the difference between the exercise price and market price.
2. American option and European option- The American option grants option holder
the right to exercise the contract at any time on or before the expiry date. But the
European options are the options in which the option holder can exercise the contract
only on the date of maturity and not before that. This feature of early exercise of the
American options make them more valuable as compared to European option. The profit
potentials are greater in American options as compared to European options. All financial
options being traded at NSE and BSE are European options with effect from December
2010.
3. Naked options and Covered Options- A call option is called the covered option when
the option is covered against the assets owned by the option writer. In other words, the
covered call is the call option where the option writer owns the underlying asset. But if
the option writer does not owns te underlying asset, the call option is a naked call option.
Similarly, a put option is called the covered option when the option is covered against the
assets owned by the option holder. In other words, the covered put is the put option where
the option holder holds the underlying asset. But if the option holder does not owns the
underlying asset, the put option is a naked put option.
4. Stock, Interest Rate, Currency and Index options- On the basis of the underlying
assets, the financial options can be classified as stock, interest and index options. If the
underlying asset is a stock, then the option is called stock option (example- TCS ICICI
BANK). In case of the interest rate options, the underlying asset is any interest rate like
repo rate, reverse repo rate, etc. Currency options are the options where the underlying
asset is any currency like US Dollar, Pound, Euro, etc. And, the index options are the
options which have stock indices as the underlying asset like SENSEX and NIFTY are
the indices on which options are available in India.
Option Terminologies
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1. Exercise Price (or Strike price)- Exercise price means the pre-determined future price
at which the contract will be exercised at the time of maturity. It is also known as strike
price. In case of call option, exercise price is the price at which the option holder can buy
the asset at the maturity date, whereas in put option, exercise price is the price at which
the option holder can sell the asset at the maturity date. The decision of whether to
exercise an option or not depends upon the difference between the market price and the
exercise price.
2. Expiration date (or Maturity date)-It is the date on or before which the option can be
exercised by the holder. After this date, the option holder cannot exercise the option. His
right ceases to exist after this date. The option holder wil exercise the option only if the
conditions are favourable for him on or before the expiration date. If he does not exercise
the option it will be lapsed.
3. Option Premium- An option contract gives the option holder a right to buy (in case of
call option) or sell (in case of put option) an asset at a pre-specified price to the option
writer on expiration date. If the holder exercises his option, the writer cannot refuse. Even
if he is incurring heavy losses, he is obliged to perform his duty. So, the market risk is
transferred to the writer and option holder hedges his position. In order to bear this risk,
the option holder pays a premium to the writer called option premium. The profit of the
option writer is restricted to this premium. However, the loss of the option holder is also
limited to the premium paid as it is non- refundable even if the option is lapsed. This
option premium depends on a number of factors like spot price, strike price, risk free
return, time to expiration, market volatility, etc. (These factors are discussed later in this
chapter)
Payoffs from the options
In the stock market, buying an option means long position ad selling an option means
short position. Payoff means the profit/loss earned by the option holder and option writer
in different market situations. The payoffs of the call option holder, call option writer, put
option holder and the put option writer is discussed below-
1. Call Option- As we know that in call option the option holder has the right to buy the
underlying asset at the strike price from the option writer. Now this decision depends on
the market conditions. The payoffs also depend on the decision whether to exercise the
option or not.
(a) Call option holder (Buying a call option or holding a long position in call)
Let us take an example to understand the position of option holder. Suppose an investor
buys a call option consisting of shares of XYZ ltd at a strike price of Rs. 50 with an
option premium of Rs. 2. It means that at the expiry date the option holder can buy the
shares of X at Rs. 50 from the option writer. If the market price on the expiration date is
less than Rs. 50, the holder can buy the share from the market and let the option lapse. In
that case, the premium of Rs. 2 is the loss for the holder. However, if the market price is
more that Rs. 50, the option holder will buy the shares from the writer and can sell them
in the market immediately at a higher price and make a profit. The holder will be
indifferent if the market price is equal to the strike price. So, the payoff of the call option
holder is-
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Payoff of the call option holder = Market Price (X)- Strike Price (SI), if X>SI
Or
= 0, if X ≤ SI
But the option holder has to pay a premium (denoted by C) to the writer. This premium is
a sunk cost and therefore must be deducted from the payoffs to find the net payoffs. So
the net payoff will be-
Net Payoff of the call option holder = Market Price (X)- Strike Price (SI)- Premium (C),
if X>SI
Or
= 0- Premium (C) = - C, if X ≤ SI
The investor would break even if the market price is equal to the strike price plus the
option premium. The call option holder will make a profit when the market price is
greater than the break-even point. Otherwise, the holder will incur a loss.
Break-Even point = Strike Price + Option premium
In our example, the break-even point will be achieved when the market price is equal to
Rs.52. If the market price is more than Rs. 52, the option holder will earn the profit. If the
market price is less than Rs. 52, he will incur a loss. If the market price is Rs. 52, there
will be no profit no loss.
The net payoff of the call option holder at different market price is as follows-
Market Price (X) 48 50 52 54 56

Strike price (SI) 50 50 50 50 50
Whether to exercise the option or not No No Yes Yes Yes
Premium paid 2 2 2 2 2
Net payoff -2 -2 0 2 4
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Net Payoff to Call Option Holder
5
4
3
2
Net Payoffs
1
0
-1 47 48 49 50 51 52 53 54 55 56 57
-2
-3
Market Price
Figure 6.1- Net Payoff to the buyer of call option

In the figure 1 above, it could be observed that if the share price is less than the exercise
price, the loss of the option holder is constant and is limited to the option premium
already paid. However, as the market price increases beyond the strike price, the loss
starts decreasing and the break even point is achieved when the market price is equal to
the share price plus premium. When the market price increases beyond the share price
plus premium, the call option holder earns profit. There is no limit on the profit. Higher
the market price, higher would be the profit of the option holder. Thus, we can conclude
that the loss of the call option holder is limited to the premium paid but his profit
potentials are unlimited.
(b) Call option writer (Selling a call option or Short call)
The call option writer has opposite position as compared to call option buyer. He receives
a fixed premium for selling the call option. If the market price of the share on the expiry
date is less than the strike price, the holder will not exercise the option and in that case
the option writer will earn the profit in the form of premium. However, if the market price
of the share starts increasing, the profit of the writer starts decreasing and will finally turn
into loss after the break even point. In the above example of XYZ ltd., if the market price
on the expiration date is less than Rs. 50, the holder can buy the share from the market
and let the option lapse. In that case, the premium of Rs. 2 is the profit for the option
writer. However, if the market price is more that Rs. 50, the option writer will have to
buy the shares from the market and sell them to the option holder at Rs. 50 and could
incur a loss. The holder will be indifferent if the market price is equal to the strike price.
So, the payoff of the call option writer is-
Payoff of the call option writer = -(Market Price (X)- Strike Price (SI)), if X>SI
Or
= 0, if X ≤ SI
But the option writer also receives a premium (denoted by C) irrespective of the outcome
of the call option. So, the net payoff for the option writer will be-
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Net Payoff of the option writer = -(Market Price (X)- Strike Price (SI))+ Premium (C), if
X > SI
Or
= 0 + Premium (C) = C, if X ≤ SI
So, the position of call option writer is exactly opposite to the call option holder. The gain
of one party is the loss of the other. The break even point of the option writer is same as
that of the option holder. The writer would also break even if the market price is equal to
the strike price plus the option premium. The call option writer will make a profit when
the market price is less than the break-even point. Otherwise, the writer will incur a loss.
Break-Even point = Strike Price + Option premium
Rs.52. If the market price is more than Rs. 52, the option writer will incur a loss. If the
market price is less than Rs. 52, he will have a profit. If the market price is Rs. 52, there
The net payoff of the call option writer at different market price is as follows-
Market Price (X) 48 50 52 54 56

Strike price (SI) 50 50 50 50 50
Whether the option will be exercised or not No No Yes Yes Yes
Premium earned 2 2 2 2 2
Net payoff 2 2 0 -2 -4
Net Payoff to Call Option Writer

4
2
Net Payoffs
0
-2 46 48 50 52 54 56 58
-4
-6
Market Price
Figure 6.2- Net payoff for a call option writer or Short call
In the figure 2 above, it could be observed that if the share price is less than the exercise
price, the profit of the option writer is constant and is limited to the option premium
already received. However, as the market price increases beyond the strike price, the
profit starts decreasing and the break even point is achieved when the market price is
equal to the share price plus premium. When the market price increases beyond the share
price plus premium, the call option writer incurs a loss. There is no limit on this loss.
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Higher the market price, higher would be the loss of the option writer. Thus, we can
conclude that the profit of the call option writer is limited to the premium received but his
loss potentials are unlimited.
2. Put Option- Put option gives the option holder the right to sell the underlying asset at
the strike price to the put option writer on or before the expiration date. Now this decision
depends on the market conditions. The payoffs also depend on the decision whether to
exercise the option or not.
(a) Put option holder (Buying a put option or holding a long position in put)
Let us take an example to understand the position of put option holder. Suppose an
investor buys a put option consisting of shares of XYZ ltd at a strike price of Rs. 50 with
an option premium of Rs. 2. It means that at the expiry date the option holder can sell the
shares of X at Rs. 50 to the option writer. If the market price on the expiration date is
more than Rs. 50, the holder can sell the share in the market and let the option lapse. In
that case, the premium of Rs. 2 is the loss for the option holder. However, if the market
price is less than Rs. 50, the option holder can buy the shares from the market and sell the
shares to the option writer immediately at a higher price and make a profit. The holder
will be indifferent if the market price is equal to the strike price. So, the payoff of the put
option holder is-
Payoff of the Put option holder = Strike Price (SI)- Market Price (X), if X < SI
Or
= 0, if X ≥ SI
But the put option holder has to pay a premium (denoted by P) to the writer. This
premium is a sunk cost and therefore must be deducted from the payoffs to find the net
payoffs. So, the net payoff will be-
Net Payoff of the Put option holder = Strike Price (SI)- Market Price (X)- Premium(P), if
X < SI
Or
= 0-Premium (P)= - P, if X ≥ SI
The investor would break even if the market price is equal to the strike price minus the
option premium. The put option holder will make a profit when the market price is less
than the break-even point. Otherwise, the holder will incur a loss.
Break-Even point = Strike Price - Option premium
Rs.48. If the market price is less than Rs. 48, the option holder will earn the profit. If the
market price is more than Rs. 48, he will incur a loss. If the market price is Rs. 48, there
The net payoff of the put option holder at different market price is as follows-
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Market Price (X) 44 46 48 50 52 54
Strike price (SI) 50 50 50 50 50 50
Whether to exercise the option or not Yes Yes Yes No No No
Premium paid 2 2 2 2 2 2
Net payoff 4 2 0 -2 -2 -2
60 Net payoffs of Put option Holder

50
40
Net Payoffs
30
20
10
0
0 10 20 30 40 50 60
-10
Market Price
Figure 6.3- Net payoffs of Long Put

As it is evident from the above figure, the option holder of a put option exercises his
option as long as the stock price is lower than the exercise price. But he will not make the
profit unless te difference between the strike price and the market price is more than the
put option premium paid. The profit of the put option holder equals to the strike price
minus the sum of market price and the premium paid. If the strike price is less than the
market price, the option holder will not exercise the option and let the option lapse. In
that case the loss is limited to the option premium already paid by him.. The maximum
loss the put option holder can have is the premium paid (i.e. Rs. 2 in the above example).
However, the maximum gain the holder can have would be in the situation when the
market price of the share becomes zero. This maximum gain would be market price
minus the premium i.e. Rs. 48 in the above example.
(b) Put option writer (Selling a put option or holding a short position in put)
The put option writer has opposite position as compared to put option buyer. He receives
a fixed premium for selling the put option. If the market price of the share on the expiry
date is more than the strike price, the holder will not exercise the option and in that case
the option writer will earn the profit in the form of premium. However, if the market price
of the share starts decreasing, the profit of the writer also starts decreasing and will finally
turn into loss if the market price falls beyond the break-even point. Let us continue with
our example to understand the position of put option writer. Suppose an investor sells a
put option consisting of shares of XYZ ltd at a strike price of Rs. 50 with an option
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premium of Rs. 2. It means that at the expiry date the option holder can sell the shares of
X at Rs. 50 to the option writer. If the market price on the expiration date is more than Rs.
50, the holder can sell the share in the market and let the option lapse. In that case, the
premium of Rs. 2 is the gain for the put option writer. However, if the market price is less
than Rs. 50, the option holder can buy the shares from the market and sell the shares to
the option writer immediately at a higher price and make a profit. The writer will incur a
loss in such situation. So, the payoff of the put option writer is-
Payoff of the put option writer = -(Strike Price (SI)- Market Price (X)), if X < SI
Or
= 0, if X ≥ SI
But the option writer also receives a premium (denoted by P) irrespective of the outcome
of the put option. So, the net payoff for the option writer will be-
Net Payoff of the put option writer = -(SI- X)+ Premium(P), if X < SI
Or
= 0+ Premium(P)= P, if X ≥ SI
The investor would break even if the market price is equal to the strike price minus the
option premium. The put option writer will make a profit when the market price is more
than the break-even point. Otherwise, the writer will incur a loss.
Break-Even point = Strike Price - Option premium
Rs.48. If the market price is more than Rs. 48, the option writer will earn the profit. If the
market price is less than Rs. 48, he will incur a loss. If the market price is Rs. 48, there
The net payoff of the put option writer at different market price is as follows-
Market Price (X) 44 46 48 50 52 54

Strike price (SI) 50 50 50 50 50 50
Whether to exercise the option or not Yes Yes Yes No No No
Premium Received 2 2 2 2 2 2
Net payoff -4 -2 0 2 2 2
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Net payoff of Put Option Writer
10
0
-10 0 10 20 30 40 50 60 70
Net Payoffs
-20
-30
-40
-50
-60
Market Price
Figure 4- Net payoffs of Short Put

The net payoff for the put writer is negative if market price of the stock is less than (SI-
P). He has substantial loss potential which depends upon the magnitude of the fall in the
stock price. Since, the stock price cannot be negative, the maximum loss is the strike
price minus premium. Hence in our example, the maximum loss the put option writer can
have will be Rs. 48 which is the maximum gain of the put option holder. The maximum
gain of put option writer will be the premium i.e. Rs. 2 in the above example (which is
the maximum loss of the put option holder).
Q.1. Three months call option premium is Rs. 2 and 3 months put option premium is Rs.
3. Assume that the exercise price for both the cases is Rs. 50, find out the net payoff of
the call option buyer, call option writer, put option buyer as well as put option writer
when the spot price of the share on the exercise price day is Rs. 47, Rs. 49, Rs. 50, Rs. 52,
Rs. 53, Rs. 55 and Rs. 60. (B.Com (H) DU 2013)
Ans. a.)Call Option
Premium = Rs. 2
Exercise Price= Rs. 50.
The call option holder will exercise the optiononly when market price is more than Rs.
50. Otherwise he will not exercise the option and let it lapse.
Call option Holder
Market Price 47 49 50 52 53 55 60
Strike Price 50 50 50 50 50 50 50
Premium Paid 2 2 2 2 2 2 2
Whether Option is exercised or not No No No Yes Yes Yes Yes
Net Payoff -2 -2 -2 0 1 3 8
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Call Option Writer
Market Price 47 49 50 52 53 55 60
Strike Price 50 50 50 50 50 50 50
Premium Received 2 2 2 2 2 2 2
Whether Option is exercised or not No No No Yes Yes Yes Yes
Net Payoff 2 2 2 0 -1 -3 -8
b) Put Option
Premium = Rs. 3
Exercise Price= Rs. 50.
The put option holder will exercise the option only when market price is less than Rs. 50.
Otherwise he will not exercise the option and let it lapse.
Put Option Holder

Market Price 47 49 50 52 53 55 60
Strike Price 50 50 50 50 50 50 50
Premium Paid 3 3 3 3 3 3 3
Whether Option is exercised or not Yes Yes No No No No No
Net Payoff 0 -2 -3 -3 -3 -3 -3
Put Option Writer

Market Price 47 49 50 52 53 55 60
Strike Price 50 50 50 50 50 50 50
Premium Received 3 3 3 3 3 3 3
Whether Option is exercised or not Yes Yes No No No No No
Net Payoff 0 2 3 3 3 3 3
Q.2. The shares of Blue Diamonds Ltd. are quoted at Rs. 25. Mr. Grover writes a call
option at a strike price of Rs. 29 and a premium of Rs. 3. Calculate his net pay off if the
market price on the expiration date is Rs. 24 or Rs. 26 or Rs 32 or Rs. 35. At what market
price Mr. Grover will be in no profit no loss situation? What would be the net pay off of
call option holder?(B. Com. (H), DU, 2017)
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Ans- Premium = Rs. 3
Strike Price= Rs. 29
The call option holder will exercise the option only when market price is more than Rs.
29. Otherwise he will not exercise the option and let it lapse.
Call Option Writer
Market Price 24 26 32 35
Strike Price 29 29 29 29
Premium Received 3 3 3 3
Whether Option is exercised or not No No Yes Yes
Net Payoff 3 3 0 -3
Call option Holder

Market Price 24 26 32 35
Strike Price 29 29 29 29
Premium Paid 3 3 3 3
Whether Option is exercised or not No No Yes Yes
Net Payoff -3 -3 0 3
So, at the market price of Rs. 32, there will be the break even point when the call option
holder will be at no profit no loss situation
6.4 Points to remember
 An option is a contract between two parties where one party (option holder) gets the
right (not the obligation) to buy/sell an asset on or before a future date at a pre-
determined price to option writer. This option contract is sold by the option writer to
option holder for a price called option premium.
 Call option is a contract which gives a right to option holder to buy the underlying
asset at a predetermined price on or before the exercise date from the writer. He is
not obliged to buy the asset. Put option is a contract which gives a right to option
holder to sell the underlying asset at a predetermined price on or before the exercise
date to the writer. He is not obliged to sell the asset.
 Exercise price means the pre-determined future price at which the contract will be
exercised at the time of maturity. It is also known as strike price.
 Expiration date is the date on or before which the option can be exercised by the
holder. After this date, the option holder cannot exercise the option.
 The option premium depends on a number of factors like spot price, strike price,
risk free return, time to expiration, market volatility, etc.In the stock market, buying
an option means long position and selling an option means short position.
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 Payoff means the profit/loss earned by the option holder and option writer in
different market situations.
1. What is an option? Differentiate between a put option and call option.
2. Show the payoff diagrams of a call option holder, call option writer, put option
holder and put option writer.
3. Differentiate between American option and European option.
Q.1 An investor purchases a two months call option of 100 of Skylight ltd. at a strike
price of Rs. 350 per share on paying a premium of Rs. 20 per share. Find the expected
gain/loss per share if the actual price per share on the exercise day is Rs. 300, Rs. 310,
Rs. 370, Rs. 380 or Rs. 400. Also calculate the expected gain/loss of the option writer at
these prices. (B.Com. (H), DU, 2015)
(Ans- Call option Holder- -20, -20, 0, 10, 30 and call option writer 20, 20, 0, -10, -30)
Q.2. John paid a premium of Rs. 5 per share for a 6-month Call Option contract (i.e., total
premium of Rs. 500 for 100 shares) of Mohan Corporation. At the time of purchase,
Mohan’s share price was Rs. 57 per share and the exercise price of the call option was Rs.
56.
i. Determine John’s profit or loss if, when the option is exercised, Mohan’s share
price is Rs. 53.
ii. What is John’s profit or loss if, when the option is exercised, Mohan’s share price
is Rs. 63? (B.Com.
(H), DU, 2016)
(Ans- Loss of Rs. 500, Profit of Rs. 2000)
Q.3. Kirthi is bearish on the stock of Vinay Corporation. Therefore, he purchases five put
option contracts on Vinay Corporation’s shares at a premium of Rs. 3. The exercise price
is Rs. 41 and the maturity period is 3 months. The current market price of the stock is Rs.
40. The lot size is 100. If Kirthi’s prediction turns out to be correct and Vinay’s stock
price falls to Rs. 30, how much profit will Kirthi earn over a three-month period?
(B.Com. (H), DU, 2016)
(Ans- Profit of Rs. 800 per contract i.e. a total profit of Rs. 4000 for 5 contracts)
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CHAPTER 7
FINANCIAL DERIVATIVES- III

 Introduction
 Few Practical Aspects of Options
 Moneyness of Options
 Factors affecting option price or option premium
 Components of option premium or option value
 Difference between futures and options
 Derivatives Market in India
 Why do investors enter derivative contracts?
 Functions of derivatives
 Participants in the derivative markets
7.1 Introduction
India is a developing country. The inception and growth of derivatives market in India is
a recent phenomenon. However, since its inception in 2000, the Indian derivatives market
has shown exponential growth and offers a variety of instruments to cater the needs of
various investors. The present chapter deals with the development of derivatives market
in India. However, few topics related to the practical aspects of options are also dealt in
this chapter.
7.2 Few Practical Aspects of Options
This section deals with some of the practical dimensions of the options which could not
be covered in the previous chapter. These are moneyness of options, factors affecting
option prices or option premium, components of option premium or option value and
lastly, the difference between futures and options.
Moneyness of Options
The moneyness of the options is a measure to evaluate whether an option is beneficial to
the option holder initially i.e., in the beginning itself or not. This assessment is based
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upon the relationship between the spot price of the underlying asset (or the market price
of the share at the time of entering into the contract) and strike price. If the option
contract is favourable to the option holder initially, it is termed as In the money. If it is
not favourable to the option holder at the beginning, then it is termed as Out of the
money. If the option contract is neither favourable nor unfavourable t the option holder, it
is termed as At the money.
Moneyness of the call option and put option is explained below in different scenarios.
Relationship Call Option Put Option
Spot price> Strike Price In the Money Out of Money
Spot price< Strike Price Out of Money In the Money
Spot price= Strike Price At the Money At the Money
Let us examine the following situations-

Situation 1- An investor buys a 3 months call option on the stock of ABC Ltd. at an
exercise price of Rs. 100 for a premium of Rs. 5. The current market price of the stock is
Rs. 95.
 The current stock price or the spot price (i.e., Rs. 95) is less than the exercise price
(i.e., Rs. 100). Therefore, the call option is “Out of Money” call option.
Rs. 110.
 The current stock price or the spot price (i.e., Rs. 110) is more than the exercise
price (i.e., Rs. 100). Therefore, the call option is “In the Money” call option.
Rs. 100.
 The current stock price or the spot price (i.e., Rs. 100) is equal to the exercise
price (i.e., Rs. 100). Therefore, the call option is “At the Money” call option.
Situation 4- An investor buys a 3 months put option on the stock of XYZ Ltd. at an
Rs. 95.
 The current stock price or the spot price (i.e., Rs. 95) is less than the exercise price
(i.e., Rs. 100). Therefore, the put option is “In the Money” put option.
Situation 5- An investor buys a 3 months put option on the stock of XYZ Ltd. at an
Rs. 105.
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 The current stock price or the spot price (i.e., Rs. 105) is more than the exercise
price (i.e., Rs. 100). Therefore, the put option is “Out of Money” put option.
Situation 6- An investor buys a 3 monthsput option on the stock of XYZ Ltd. at an
Rs. 100.
 The current stock price or the spot price (i.e., Rs. 100) is equal than the exercise
price (i.e., Rs. 100). Therefore, the put option is “At the Money” put option.
Factors affecting Option Price or Option Premium
The option holder pays a premium to the option writer to get the right to exercise the
option. The option premium is also known as the option price or the value of the option.
The following factors affect the option premium-
1. Current price of the underlying asset- The value of the call option and put option
depends upon the price movement of the underlying asset. If the current price of the
underlying asset is high, the call option is more valuable to the buyer and therefore,
the value of the call option is high. So the call option premium increases with an
increase in the stock price and decreases with a decrease in the stock price.
Whereas, in the case of put option the value of the put option decreases with the
increase in the stock price and increases with the decrease in the stock price.
2. Exercise price or Strike price- Another important factor influencing the value of an
option is the exercise price. Exercise price is the predetermined price at which the
call option holder can buy the stocks from the writer and the put option holder can
sell the stocks to the option writer. Lower the exercise price, more is the profit
potential for call option holder and therefore, the call option premium is high. On
the other hand, put option holder will benefit when the exercise price is high and
thus, higher the exercise price, more is the profit potential for put option holder and
therefore, the put option premium is high. So, the call option premium increases
with decrease in the exercise price while the put option premium increases with the
increase in exercise price.
3. Volatility in the prices of the underlying asset- Volatility in the price means the
degree and the magnitude of the movement in the prices of the underlying asset,
regardless of the direction of the change. It is difficult to predict the future prices of
the volatile assets and therefore, they are quite risky. Therefore, for such risky
assets the option writer would like to charge higher premium whether it’s a call
option or a put option. So, the option premium increases with increase in the
volatility of the asset for both call option and the put option.
4. Time to expiry- Higher the time to expiry, more are the chances for movement in
the prices of the underlying asset and therefore, the higher would be the risk for the
option writer. As the risk of the option writer increases, the option premium also
increases both for the call option and the put option. So, longer the time to maturity,
higher would be the call option premium and put option premium.
5. Rate of interest- The option holder does not pay the strike price at the time of
buying the option. Rather, he pays it at the time of exercising the option. Thus, the
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present value of the strike price will depend upon the risk free interest rate as well.
The higher the interest rates, the present value of exercise price shall be less.
Consequently, the value of the call option rises. The effect shall be reversed for put
option. The higher the risk free interest rate, the higher will be the call option
premium and vice-versa. Further, the higher the risk free interest rate, the lower will
be the put option premium and vice-versa.
6. Income from the underlying asset- If the underlying asset pays any income, the
value of the option will be affected. Like if a share pays dividends, the share prices
decrease post payment of the dividend. In such a case, lower the price of the share,
lower would be the call option premium and vice-versa. Conversely, lower the price
of the share, higher would be the put option premium and vice-versa.
Components of Option Premium or Option Value
Option premium comprises of the intrinsic value and time value. These are discussed
below-
1. Intrinsic value- The intrinsic value is the difference between the current market price of
the underlying asset and the strike price. However, the intrinsic value cannot be negative.
In case of a call option, the intrinsic value is equal to the underlying asset price minus the
strike price or zero, whichever is higher. In case of a put option, the intrinsic value is
equal to the strike price minus the underlying asset price or zero, whichever is higher.
Intrinsic value (Call)= Max [(Market Price- Exercise Price),0]
Intrinsic value (Put)= Max [(Exercise Price- Market Price),0]
2. Time value- Time value is the difference between the option price and the intrinsic
value both for call option and put option. So, time value is equal to option price –
intrinsic value.
Time value= Option price – intrinsic value
Example 1An option is available at a strike price of Rs. 384 at a premium of Rs. 12 for a
share having current market price of Rs. 388. Find out the intrinsic value and time value
of the option if-
a.) It is a call option, and
b.) It is a put option
Solution a.) Call Option
Strike Price- Rs. 384
Market price of the underlying share- Rs. 388
So, Intrinsic value= Max [(Market Price- Exercise Price),0]
= Max [(388-384),0] = Max [4,0] = Rs. 4
Time value= Option price – intrinsic value = 12-4 = Rs.8
b.) Put Option
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Strike Price- Rs. 384
So, Intrinsic value = Max [(Exercise Price- Market Price),0]
= Max [(384-388),0] = Max [-4,0] = 0
Time value= Option premium – Intrinsic value = 12-0 = Rs. 12
Difference between futures and options
Basis Futures Options
Rights Both the parties have equal right to Only the option holder has the right
enforce the other for the to buy or sell the specified asset.
performance of the contract. Option writer does not have any
right.
Obligations Both the parties have equal Only the option writer is obliged to
obligations to perform the contract. perform his duties if the option is
exercised by the option holder.
Option holder has no obligation.
Premium There is no premium paid by any of Option holder has to pay a premium
the parties. to te writer to get the right to buy or
sell the asset.
Margin Both the parties are required to Only the option writer is required to
Requirement deposit a margin money with the deposit the margin money with the
exchange. exchange since he is obliged to
perform is duties when asked by the
holder to do so.
Potentials Both the parties have equal The loss of the option holder is
for Profit possibility of profit and loss. Profit limited to the premium paid but he
and loss of one party is the loss of the other has a chance to earn all the upside
and vice- versa. profits. The profits of the option
writer is limited to the option
premium but he is exposed to all
the downside losses.
Execution of Future contracts are executed either The option holder may or may not
the contract by physical delivery or by cash exercise the option. If it is not
settlement. exercised, it will be lapsed. If
exercised, it can be settled either by
physical delivery or by cash
settlement.
Purpose Future contracts are used both for Options are used for hedging.
hedging and speculation purposes.
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7.3 Derivatives Market in India
Till the year 1993, the forward trading was popular in India. However, in 1993, after the
Harshad Mehta Scam in Indian Stock Market, SEBI banned forward trading and carry
forward or badla system. At that time there was a lack of hedging instrument in the Indian
stock market. In order to attract the inflow of institutional investors and the participation
of foreign investors, the need for some hedging instrument was felt to enhance the
liquidity of the market. At that time many countries were introducing derivatives as
hedging instruments in their stock market. India also adopted the same path. By providing
issuers and investors with a broader array of tools for raising capitals and managing risks,
derivatives improve the allocation of credit and the sharing of risk in the global economy,
lowering the cost of capital formation and stimulating economic growth. Now as the
global markets for finance and trade have become more integrated, derivatives have
strengthened these important linkages between global markets, increasing market
liquidity and efficiency, and have facilitated the flow of trade and finance.
In order to regulate the derivatives market in India, SEBI formed a committee under the
chairmanship of Dr. L.C. Gupta in 1997 with an objective to examine the feasibility of
introducing derivatives in the Indian Stock Market. This committee was popularly
known as the L.C. Gupta Committee. It came out with its recommendations in the year
1998. The committee suggested that the following derivatives must be introduced in the
phased manner-
i. Index Futures
ii. Index Options
iii. Stock Options
iv. Stock Futures
In December 1999, the Securities Control (Regulations) Act, 1956 was amended to
include derivatives within the definition of Securities under section 2(h). SEBI also
introduced the regulatory framework for the introduction of derivatives products.
Finally in 2000, equity derivatives started trading in India. BSE created history on June 9,
2000 by launching the first Exchange-traded Index Derivative Contract in India i.e.
futures on the capital market benchmark index - the BSE Sensex. NSE followed the same
and commenced derivatives trading with the launch of futures on its benchmark index
Nifty 50 on June 12, 2000.
In sequence of product innovation, BSE commenced trading in Index Options on Sensex
on June 1, 2001, The NSE introduced trading in Index Options that was also based on
Nifty 50, on June 4, 2001. NSE became the first exchange to launch trading in options on
individual securities from July 2, 2001. Futures on individual securities were introduced
on November 9, 2001 by NSE. Stock Options were introduced by BSE on 31 stocks on
July 9, 2001 and Single Stock Futures were launched on November 9, 2002.
The NSE also launched its currency futures trading platform on 29th August, 2008.
Currency futures on USD-INR were introduced for trading and subsequently the Indian
rupee was allowed to trade against other currencies such as euro, pound sterling and the
Japanese yen. On October 1, 2008 BSE launched its currency derivatives segment in
dollar-rupee currency futures.
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Currency Options was introduced by NSE on October 29, 2010.
BSE also introduced 'Long Dated Options' on its flagship index - Sensex -on February 29,
2008, whereby the Members can trade in Sensex Options contracts with an expiry of up
to 5 years.
In addition to the SENSEX, BSE provides futures and options on 5 sectoral indices as
well. These are-
 BSE TECK,
 BSE FMCG,
 BSE Metal,
 BSE Bankex, and
 BSE Oil & Gas.
At present, the NSE provides trading in Futures and Options contracts on 3 major indices
(i.e., Nifty 50, Nifty Bankex, and Nifty Financial Services) and more than 100 securities.
7.4 Why do investors enter derivative contracts?
No doubt that the profit making is the major objective behind any investment decision.
However, there are a number of other reasons that motivates the investment in derivative
contracts. Some of these motives are as follows:
1. Arbitrage advantage: Arbitrage is a process of undertaking two opposite actions
simultaneously in two different markets i.e. buying in one market and selling in
other at the same time, so as to benefit from the price difference. Sometimes there
exists the difference in the prices of a security in cash and derivatives market. This
gives an opportunity to arbitragers to make profit.
2. Protection against market volatility: Fluctuation in the prices of an underlying asset
may expose the investor to greater losses. Derivatives provide a mechanism to the
investors where they can safeguard themselves from the risk of price fluctuations by
entering into contracts to offset their loss. Here, without actually selling the
underlying share, the investor can take advantage of the price fluctuations.
3. Vehicle to park surplus funds: Derivatives also provide a good source of investment
to engage the surplus funds of the investor. Some individuals use derivatives as a
means of transferring risk. However, others use it for speculation and making
profits.
7.5 Functions of Derivatives
Derivatives serve the following important functions-
1. Derivatives are often used to mitigate the risk as they shift the risk from the buyer
of the derivative product to the seller and therefore, they are very effective tools of
risk management.
2. Derivatives enhance the saleability or the liquidity of the underlying assets.
Derivatives perform a very important economic function of price discovery. Better
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opportunities for raising money are also provided by the derivatives. They have a
substantial contribution in increasing the market depth.
7.6 Participants in a Derivative Market
There are four important participants in the derivative markets. These are-
Hedgers: To hedge means to reduce the risk of price movements of a security. Therefore,
the main aim of hedgers is to mitigate the risk. In stock market, hedgers are considered as
the most risk-averse traders. They enter into the derivative markets to secure their
investment portfolio against the market risk and price movements. This can be done by
taking an opposite position in the derivatives market. In this manner, the risk of loss is
transferred to those others who are ready to take it. To get this benefit of hedging, the
hedger is required to pay a premium to the risk-taker. Options are the best instruments of
hedging. Let us assume that X holds 500 shares of ABC company which are currently
priced at Rs. 200 in the stock market. He expects to sell these shares after a month at Rs.
250 per share. However, there is an equal probability of loss in the stock market if the
price falls below Rs. 200. X neither wants to make losses due to a fall in market price.
Nor does he want to lose an opportunity to earn profits by selling them at a higher price in
future. In this situation, he can buy a put option by paying a nominal premium that will
take care of both the above requirements. If the market price increases, he will not avail
the put option however, if the market price falls, he can avail the put option and offset his
loss from the sale of shares.
Speculators: Speculators are known as the risk-lovers of the derivative market. They can
undertake high risk for a relatively high profit. There point of view completely contrasts
the hedgers. This difference of opinion helps them to make huge profits if the bets turn
correct. In the above example, hedger bought a put option to secure himself from a fall in
the prices of the share. However, his counterparty i.e., the speculator will expect that the
stock price won’t fall. If the stock prices don’t fall, then the hedger won’t exercise his put
option. Hence, the speculator earns a profit in the form of option premium.
Margin traders: In order to participate in the derivative market, an investor is required
to deposit a minimum amount with the broker. This minimum amount is called margin.
This margin is used to reflect the losses and gains of the investor on a daily basis as per
market movements. It enables to get leverage in derivative trades and maintain a large
outstanding position. For example, an investor can buy 100 shares of ABC Ltd. of Rs
1000 each with a sum of Rs. 1 lakh in the stock market. However, in the derivative
market, with same Rs, 1 lakh, the margin trader can buy 300 shares. Therefore, a slight
price increase (or decrease) will lead to much higher gains (or losses) in the derivative
market as compared to the stock market.
Arbitrageurs: They try to make profits from the low-risk market imperfections. They
simultaneously buy low-priced securities in one market and sell them at a higher price in
another market. This can happen only when the same security is quoted at different prices
in different markets. Suppose an equity share is quoted at Rs 1000 in the stock market
and at Rs 1050 in the futures market. An arbitrageur would buy the stock at Rs 1000 in
the stock market and sell it at Rs 1050 in the futures market. In this process, he/she earns
a low-risk profit of Rs 50.
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Q.1. An option is available at a strike price of Rs. 500 at a premium of Rs. 10 for a share
having current market price of Rs. 495. Find out the intrinsic value and time value of the
option if-
a.) It is a call option, and
b.) It is a put option
Ans. a.) Call Option
Exercise Price- Rs. 500
So, Intrinsic value= Max [(Market Price- Exercise Price),0]
= Max [(495-500),0] = Max [-5,0] = 0
Time value= Option price – intrinsic value =10-0 = Rs. 10
b.) Put Option
Exercise Price- Rs. 500
So, Intrinsic value = Max [(Exercise Price- Market Price),0]
= Max [(500-495),0] = Max [5,0] = Rs. 5
Time value= Option premium – Intrinsic value = 10-5 = Rs. 5
Q.2. Sanjay has bought a call and put options. Each contract is of 100 shares. (i) He has
purchased 3 months call with a strike price of 52 and paid Rs. 2 as premium. (ii) He has
paid Re. 1 per share premium for buying a three-months put with a strike price of Rs. 50.
Find out
a. What would be Sanjay’s position if the stock price moves upto Rs. 53 in three
months?
b. What would be his position if the stock price falls to Rs. 46 in 3 months.
Sol. Lot size=100
Call Premium= Rs. 2
Put option premium = Re. 1
Strike price for call option = Rs. 52
Strike price for put option = Rs. 50
Total premium paid on both put and call= 100x (1+2) = Rs. 300
a.) When market price is Rs. 53, Sanjay will exercise call option only and let the put
option lapse. So, the payoff from call option = 53-52= Re. 1
Hence the net payoff = 100 x 1 – 300 = Rs. (200)
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Sanjay will suffer a loss of Rs. 200
b.) When the market price is Rs. 46, he will exercise the put option only and let the call
option lapse.
So, the payoff from put option = 50- 46 = Rs. 4
Hence the net payoff = 100 x 4 – 300 = Rs. 100
Here, Sanjay will earn a profit of Rs. 100.
Q.3. An investor buys a 3 months call option at a strike price of Rs. 1000 at a premium of
Rs. 50. Examine whether the investor is Out of Money, In the Money or At the money
when the current stock price is-
a) Rs. 1020
b) Rs. 1000
c) Rs. 1070
d) Rs. 950
Ans. In case of call option moneyness of the option can be examined with the help of
following relationship-
Relationship Call Option
Spot price> Strike Price In the Money
Spot price< Strike Price Out of Money
Spot price= Strike Price At the Money
Therefore, in case a) and c) when the spot price is more than the strike price, the call
option is “In the Money” call option. In case b), since the spot price is equal to the strike
price, the call option is at the money. And in case d), since the spot price is less than the
strike price, the call option is “Out of Money”.
Q.4. An investor buys a 3 months put option at a strike price of Rs. 500 at a premium of
Rs. 20. Examine whether the investor is Out of Money, In the Money or At the money
when the current stock price is-
a) Rs. 480
b) Rs. 500
c) Rs. 450
d) Rs. 580
Ans. In case of put option moneyness of the option can be examined with the help of
following relationship-
Relationship Put Option
Spot price> Strike Price Out of Money
Spot price< Strike Price In the Money
Spot price= Strike Price At the Money
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Therefore, in case a) and c) when the spot price is less than the strike price, the put option
is “In the Money” put option. In case b), since the spot price is equal to the strike price,
the put option is at the money. And in case d), since the spot price is more than the strike
price, the put option is “Out of Money”.
 The moneyness of the options is a measure to evaluate whether an option is
beneficial to the option holder initially i.e., in the beginning itself or not. This
assessment is based upon the relationship between the spot price of the underlying
asset (or the market price of the share at the time of entering into the contract) and
strike price.
 If the option contract is favourable to the option holder initially, it is termed as In
the money. If it is not favourable to the option holder at the beginning, then it is
termed as Out of the money. If the option contract is neither favourable nor
unfavourable t the option holder, it is termed asAt the money.
 Option premium comprises of the intrinsic value and time value.
 The intrinsic value is the difference between the current market price of the
underlying asset and the strike price. However, the intrinsic value cannot be
negative.
 Time value is the difference between the option price and the intrinsic value both
for call option and put option. So, time value is equal to option price – intrinsic
value.
 In 1993, after the Harshad Mehta Scam in Indian Stock Market, SEBI banned
forward trading and carry forward or badla system. At that time there was a lack of
hedging instrument in the Indian stock market.
 In order to regulate the derivatives market in India, SEBI formed a committee under
the chairmanship of Dr. L.C. Gupta in 1997 with an objective to examine the
feasibility of introducing derivatives in the Indian Stock Market.
 The L.C. Gupta Committeecame out with its recommendations in the year 1998.
 In December 1999, the Securities Control (Regulations) Act, 1956 was amended to
include derivatives within the definition of Securities under section 2(h).
 Finally in 2000, equity derivatives started trading in India. BSE created history on
June 9, 2000 by launching the first Exchange-traded Index Derivative Contract in
India.
 In sequence of product innovation, BSE commenced trading in Index Options on
Sensex on June 1, 2001,
 NSE became the first exchange to launch trading in options on individual securities
from July 2, 2001.
 Futures on individual securities were introduced on November 9, 2001 by NSE.
 Stock Options were introduced by BSE on 31 stocks on July 9, 2001 and Single
Stock Futures were launched on November 9, 2002.
 The NSE also launched its currency futures trading platform on 29th August, 2008,
whileon October 1, 2008, BSE launched its currency derivatives segment in dollar-
rupee currency futures.Currency Options was introduced by NSE on October 29,
2010.
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 BSE also introduced 'Long Dated Options' on its flagship index - Sensex
 In addition to the SENSEX, BSE provides futures and options on 5 sectoral indices
as well and the NSE provides trading in Futures and Options contracts on 3 major
indices.
 Derivatives are often used to mitigate the risk as they shift the risk from the buyer
of the derivative product to the seller and therefore, they are very effective tools of
risk management.
 Derivatives enhance the saleability or the liquidity of the underlying assets.
Derivatives perform a very important economic function of price discovery.
 There are four important participants in the derivative markets. These are- hedgers,
speculators, arbitrageurs and margin traders.
1. How would you distinguish between futures and options?
2. Elaborate the development of financial derivatives market in India.
3. Present a timeline of the introduction of various instruments in Indian derivatives
market.
4. Who all are the major participants in te derivative market?
5. Why do the investors enter derivative contracts?
6. What are the functions of derivatives?
7. Explain when a call option and a put option is in the money, at the money and out of
the money?
Q.1. An investor buys a 3 months call option at a strike price of Rs. 500 at a premium of
Rs. 30. Examine whether the investor is Out of Money, In the Money or At the
money when the current stock price is Rs. 520, 500, 570 and 490.
(Ans- In the Money, At the money, In the money, Out of Money)
Q.2. An investor buys a 3 months put option at a strike price of Rs. 1000 at a premium of
Rs. 50. Examine whether the investor is Out of Money, In the Money or At the
money when the current stock price is Rs. 1020, 1000, 1070 and 990.
(Ans- Out of Money, At the money, Out of Money, In the money)
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UNIT – 5
CHAPTER 1
SEBI AND INVESTOR PROTECTION
1. Structure of the chapter

 Introduction
 Securities and Exchange Board of India (SEBI)
 Objectives of SEBI
 Powers and Functions of SEBI
 Investors’ Grievances and Redressal System of SEBI
 Investor Grievances
 Handling of investor complaints in SEBI
 Types of Grievances handled by SEBI
 SCORES (SEBI Complaints Redress System)
 Investor Education and Protection Fund (IEPF)
 Utility of the Investor Education and Protection Fund
 Investor Education and Protection Fund Authority
 Investor Awareness
 Investor Awareness Program
 Role of Stock Exchanges in Investors’ Protection
 Investors’ protection measures by BSE
 Investors’ protection measures by NSE
1.1 Introduction
With the objective of improving market efficiency, increasing transparency, integration of
national markets and prevention of unfair practices regarding trading; a package of
reforms comprising measures to liberalise, regulate and develop capital market was
introduced. One of the most important stepsin the development of the Indian Capital
Market has been the establishment of the Securities and Exchange Board of India (SEBI)
in 1992 as the regulator for equity markets.
1.2 Securities and Exchange Board of India (SEBI)
101
Upto 1992, the Controller of Capital Issue (CCI) formed under the Capital Issues
(Control) Act, 1947, controlled the capital primary market. During that period, the pricing
of capital issues was controlled by CCI. The premium on issue of equity shares issued
through the primary markets was done in accordance with the Capital Issues (Control)
Act. The biggest disadvantage of the CCI was that it was governed by bureaucrats since
inception and these civil servants had a limited understanding of how the stock markets
should be run. The CCI guidelines were abolished with the introduction of Securities &
Exchange Board of India (SEBI) formed under the SEBI Act, 1992, with the prime
objective of protecting the interests of investors in securities, promoting the development
and regulation of the securities market and for matters connected therewith or incidental
thereto. The Securities and Exchange Board of India was established on April 12, 1992,
in accordance with the provisions of the Securities and Exchange Board of India Act,
1992. It is the prime regulator of Indian securities market. SEBI is managed by its board
members with its management defined under Section 4 of the act, which consists of the
following:
A) A Chairman who shall be appointed by the Central Government.
B) Two members from Ministry of Central Government dealing with Finance (and
administration of the Companies Act, 1956).
C) One member from The Reserve Bank of India.
D) Five other members appointed by Central Government, out of which at least three
shall be its whole-time members.
Objectives of SEBI
The Preamble of the Securities and Exchange Board of India describes the basic functions
of the Securities and Exchange Board of India as "...to protect the interests of investors in
securities and to promote the development of, and to regulate the securities market and
for matters connected therewith or incidental thereto." The primary objective of SEBI is
to promote a healthy and orderly growth of the securities market and secure investor
protection. However, other objectives of SEBI can be categorized as:-
 Ensuring fair practices in the securities market.
 Promoting efficient, competitive and professional services by merchant bankers,
brokers, advisors, underwriters, portfolio managers and other intermediaries.
 Formulate rules and regulations for the securities market in India.
 Settlement of investors' grievances in securities market.
Powers and Functions of SEBI.
In order to achieve its objectives, SEBI Act, 1992 has conferred some important powers
to SEBI. As per section 11 of the Securities and Exchange Board of India Act, 1992 [as
amended by the Securities Laws(Amendment) Act,2014], the board can initiate the
following actions:
(1) Subject to the provisions of this Act, it shall be the duty of the Board to protect the
interests of investors in securities and to promote the development of, and to
regulate the securities market, by such measures as it thinks fit.
102
(2) Without prejudice to the generality of the foregoing provisions, the measures
referred to therein may provide for—
(a) Regulating the business in stock exchanges and any other securities markets;
(b) Registering and regulating the working of stock brokers, sub-brokers, share
transfer agents, bankers to an issue, trustees of trust deeds, registrars to an
issue, merchant bankers, underwriters, portfolio managers, investment
advisers and such other intermediaries who may be associated with securities
markets in any manner;
1
[(ba) Registering and regulating the working of the depositories,
2
[participants], custodians of securities, foreign institutional investors, credit
rating agencies and such other intermediaries as the Board may, by
notification, specify in this behalf;]
(c) Registering and regulating the working of 3[venture capital funds
and collective investment schemes], including mutual funds;
(d) Promoting and regulating self-regulatory organisations;
(e) Prohibiting fraudulent and unfair trade practices relating to securities markets;
(f) Promoting investors’ education and training of intermediaries of securities
markets;
(g) Prohibiting insider trading in securities;
(h) Regulating substantial acquisition of shares and takeover of companies;
(i) Calling for information from, undertaking inspection, conducting inquiries and
audits of the 4[stock exchanges, mutual funds, other persons associated with
the securities market], intermediaries and self-regulatory organisations in the
securities market;
(ia) Calling for information and records from any person including any bank or
any other authority or board or corporation established or constituted by or
under any Central or State Act which, in the opinion of the Board, shall be
relevant to any investigation or inquiry by the Board in respect ofany
transaction in securities;
(ib) Calling for information from, or furnishing information to, other authorities,
whether in India or outside India, having functions similar to those of the
Board, in the matters relating to the prevention or detection of violations in
respect of securities laws, subject to the provisions of other laws for the time
being in force in this regard:
1
Inserted by Securities Laws (Amendment) Act 1995, w.r.e.f. 25-1-1995.
2
Inserted by the Depositories Act, 1996,w.r.e.f. 20-9-1995.
3
Substituted for ―collective investment schemes by Securities Laws (Amendment) Act 1995, w.e.f. 25-1-
1995.
4
Substituted for ―stock exchanges and by the Securities Laws (Amendment) Act 1995, w.e.f. 25-1-1995.
103
Provided that the Board, for the purpose of furnishing any information to any
authority outside India, may enter into an arrangement or agreement or
understanding with such authority with the prior approval of the Central
Government;
(j) Performing such functions and exercising such powers under the provisions of
the Securities Contracts (Regulation) Act, 1956 (42 of 1956), as may be
delegated to it by the Central Government;
(k) Levying fees or other charges for carrying out the purposes of this section;
(l) Conducting research for the above purposes;
(la) Calling from or furnishing to any such agencies, as may be specified by the
Board, such information as may be considered necessary by it for the efficient
discharge of its functions;
(m) Performing such other functions as may be prescribed.
1.3 Investors’ Grievances and Redressal System of SEBI5

Investor Grievances
An investor may have a complaint against any intermediary registered with SEBI or a
listed company. In such a situation the investor must first approach that particular
company or that intermediary against whom the investor is having the complaint.
Investors who are not satisfied with the response to teir grievances received from the
brokers or DPs or the companies, can lodge their grievances with the stock exchanges or
depositories. The grievance can be lodged at any of the offices of the BSE/ NSE located
at Chennai, Mumbai, Kolkata and New Delhi. In case the redressal is unsatisfactory,
BSE/NSE has designated Investor Grievance Redressal Committee (IGRCs), or Regional
Investor Complaints Resolution Committees (RICRCs). This forum acts as a mediator to
resolve the claims, disputes and differences between entities and complainants. Stock
exchanges provide a standard format to the complainant for referring the matter to IGRC/
RICRC. The committee calls for te parties and acts as a nodal point to resolve the
grievances.
If the grievance is still unresolved, an investor can file the arbitration under the rules, Bye
laws and regulations of the respective Stock Exchange/ Depository.
Handling of investor complaints in SEBI
SEBI has a dedicated department viz., Office of Investor Assistance and Education
(OIAE) to receive investor grievances and to provide assistance to investors by way of
education. Investors who are not satisfied with the response to their grievances received
from the Stock Exchanges/ Depositories can lodge their grievances with SEBI.
Grievances pertaining to stock brokers and depository participants are taken up with
respective stock exchange and depository for redressal and are monitored by SEBI
5
https://investor.sebi.gov.in/inv-grie-redre.html
104
through periodic reports obtained from them. Grievances pertaining to other
intermediaries are taken up with them directly for redressal and are continuously
monitored by SEBI. Grievances pertaining to the listed companies are taken up with the
respective listed company for redressal and are continuously monitored by SEBI.
Types of complaints handled by SEBI
Complaints arising out of activities that are covered under SEBI Act,1992; Securities
Contract Regulation Act,1956; Depositories Act,1996and Rules and Regulations made
there under and the provisions that are covered under Section 55A of Companies
Act,1956arehandledbySEBI. SEBI handles the complaints against the following
registered entities-
 Stockbroker/Authorized agent
 Stock Exchange
 Debenture trustees
 Depository
 Depository participants
 Mutual funds
 Registrar to anissue/share transfer agent
 Banker to anissue
 Merchant bankers
 Portfolio managers
 Collective investment schemes
 Custodian of securities
 KRA registration agency
 Credit rating agency
 Investment Advisers etc.
1.4 SCORES (SEBI Complaints Redress System)
SCORES is a web based centralized grievance redressal system of SEBI. An investor
who is not familiar with or does not have access to SCORES can lodge complaints in
physical form by visiting or sending the complaint to any of the offices of SEBI. Such
complaints would be scanned and uploaded in SCORES for processing. The salient
features of SCORES are:
 SCORES is enabled by web.
 Online access 24 x 7
 Online complaints and reminders can be lodged on SCORES at anytime from
anywhere.
 An email and SMS is generated instantaneously acknowledging the receipt of
complaint and allotting a unique complaint registration number to the complain-
ant for future reference and tracking.
 The complaint is forwarded online to the concerned entity for its redressal.
 The concerned entity uploads an Action Taken Report called ATR and closes the
complaint if it is satisfied that there is an adequate redressal of the complaint.
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 Investors can view the status online by logging in the unique complaint
registration number and provides for sending reminders.
 The concerned investor and the concerned entity can seek and provide
clarification regarding the complaint to each other.
 Audit trail of each complaint.
 All the complaints are saved in a central database which generates relevant MIS
reports enabling SEBI to take appropriate policy decisions and or remedial
actions, if any.
1.5 Investor Education and Protection Fund (IEPF)
Investor protection measures by SEBI includes a fund established by the Government of
India called Investor Education and Protection Fund (IEPF) under Companies Act. This
fund is maintained under the consolidated fund of India. The amounts which have
remained unpaid or unclaimed for a period of seven years that are inter alia required to be
transferred to IEPF are:
 Unpaid or unclaimed dividend lying in the unpaid dividend account.
 Matured deposits with companies other than banking companies along with
accrued interest.
 Matured debentures with companies along with interest accrued.
 Sale proceeds of fractional shares, redemption amount of preference shares.
 Unpaid or unclaimed application money received by companies for allotment of
shares and due for refund, etc.
Section 124(6) of the Companies Act, 2013 requires that shares in respect of which
dividend has not been paid or claimed for seven or more consecutive years shall be
transferred by the company to IEPF Authority.
1.6 Utility of The Investor Education and Protection Fund (IEPF)

The amount collected in the Fund shall be utilised for
(a) the refund in respect of unclaimed dividends, matured deposits, matured debentures,
the application money due for refund and interest thereon;
(b) promotion of investors’ education, awareness and protection;
(c) distribution of any disgorged amount among eligible and identifiable applicants for
shares or debentures, shareholders, debenture holders or depositors who have
suffered losses due to wrong actions by any person, in accordance with the orders
made by the Court which had ordered disgorgement;
(d) reimbursement of legal expenses incurred in pursuing class action suits under
sections 37 and 245 by members, debenture-holders or depositors as may be
sanctioned by the Tribunal; and
(e) any other purpose incidental thereto, in accordance with such rules as may be
prescribed:
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1.7 Investor Education and Protection Fund Authority
The Government of India has established Investor Education and Protection Fund (IEPF)
Authority on 7th September, 2016 under the provisions of Section 125 of the Companies
Act, 2013. The Authority is mandated to promote Investor’s Education, Awareness and
Protection and to make refunds of shares, unclaimed dividends, matured
deposits/debentures etc. that have been transferred to IEPF.
IEPF Authority has undertaken a proactive approach to achieve its mandate of promoting
investor education, awareness and protection. The Authority has taken a 360 degree
approach to sensitize stakeholders to include household investors, housewives,
professionals, etc. across the country in rural and urban areas through direct investor
awareness programs, media campaign and engaging with other stakeholders with the
common goal.
1.8 Investors’ Awareness
With the advancement in technology and digitalization of the financial system, corporate
scams and scandals are increasing. Investors are often caught by various dubious and
ponzi schemes. Therefore, it is important to make the investors aware about the general
market conditions and economic environment so that they can make an informed
investment decision. Also, they must be made aware about the fraudulent practices
prevalent in the market so as to safeguard their hard-earned money. In order to spread
awareness among the investors SEBI, National Securities Depository Limited, Ministry
of corporate Affairs and Stock Exchanges have taken various initiatives. These are
discussed in detail in the following section.
1.9 Investor Awareness Program
To reach out to citizens from all walks of life and create awareness about savings and
investments Investor Awareness Programs (IAP) are organized through various partners.
Some of the key initiatives are as follows-
1. Securities and Exchange board of India- SEBI has taken following initiatives to
create awareness among the investors-
 Regional Seminars are conducted by SEBI at various places across the country
where experts make the people aware about the various dimensions of investment.
They are often conducted in regional languages also.
 Visit to SEBI- SEBI also allows visit to SEBI office. Through this many
educational institutions can visit to the SEBI office where awareness programs are
conducted specially for the students.
 Audio/ video material- In order to educate the investors and make them aware,
SEBI has created various audios and videos which are often broadcasted on
televisions, radios, and various social networking sites to reach the masses.
 Joint programs- SEBI also conducts awareness programs in the form of webinars,
workshops, etc. in joint collaboration with stock exchanges, CDSL, NSDL, RBI
etc. at various places throughout the nation.
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 Through Investor Association- SEBI also conducts awareness programs through
various investor associations.
2. National Securities Depository Limited (NSDL) – One of the largest depositories in
the world is NSDL. It was established in August 1996 after the enactment of the
depositories Act in 1996. Most of the securities held and settled in the demat form are
handled by NSDL. Through its flexible and innovative technology systems, NSDL
provides support to the investors and brokers in the Indian capital market. NSDL aims to
safeguard the interests of the investors.
NSDL conducts various awareness programsfor the investors in the form of seminars.
These seminars try to spread awareness not only about the depository process, but also
about the safety and advantages of the depositories. Through these seminars, investors get
an opportunity to interact with NSDL and the depository participants and their queries are
resolved directly by the senior officials from NSDL. Investor depository meets (IDMs) is
an important communication channel used by the NSDL for communication with the
investors.
3. Stock Exchanges- Bombay Stock Exchange (BSE) and the National Stock Exchange
(NSE) are two major stock exchanges in India. Both of them try to educate the investors
and spread awareness among the investors by their efforts like guide to investors’,
specifying do’s and don’ts, you’re your rights and obligations, sending investment alerts,
etc. They conduct various seminars, workshops, educational campaigns, etc. to educate
the investors.
A lot of educational material is also provided on various topics like how to invest in
initial public offers, how to invest in right issues, depository services, introduction to
mutual funds investing, introduction to securities markets, etc.
In an interesting move by NSE, the stock exchange collaborated with the metro trains and
railways to reach out to passengers expected to travel on these trains as part of their
investment education campaign. The campaign to spread awareness on crucial do’s and
don’ts with respect to online transactions and NSE traded products- with the motto
“Sochkar, SamajhKar, Invest kar”. NSE also organises SME conclave to spread
awareness.
BSE organizes Investor Awareness Programs on its own as well as also invites other
capital market constituents like SEBI, Depositories,Investor Associations registered with
SEBI, Industry Associations like CII, IMC, FICCI, PHDIC,ASSOCHAM, etc., Media
and educational institutions like schools, colleges and universities to these programmes.
4. Ministry of Corporate Affairs- Following initiatives are taken by the Ministry of
Corporate affairs to spread the awareness among the investors-
 In order to create awareness amongst the investors about dubious and ponzi
schemes and to facilitate informed investment decisions, various Investor
Awareness Programs are organised by the Ministry of Corporate Affairs (MCA).
These Programs are organised in collaboration with the three professional
institutes, namely, Institute of Company Secretaries of India, Institute of
Chartered Accountants of India and Institute of Cost Accountants of India.
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 The Ministry also hosts a website to provide simplified and user friendly
educational and awareness content to all the investors. Useful and insightful
information on various investment dimensions such as role of capital market,
investing in IPO, investing in mutual funds, investing in stocks, trading in
securities, derivatives, indices, debt market, depository account, index funds,
investor grievances and arbitration (stock exchanges), Rights and obligations of
investors, Do’s and Don’ts of investing, etc is available on this website.
 MCA also publishes a comprehensive guide in English and two smaller booklets
in Hindi English, and 11 vernacular languages for the benefit of investors. These
study materials are distributed to all the investors participating in the Investor
Awareness Program.
 A facility has also been created by the ministry on MCA21 website to lodge the
complaints by the investors and to track the status of their complaints.
1.10 Role of Stock Exchanges in Investors’ Protection
Stock exchange is regarded as an essential part of the economy. It is indispensable for the
proper functioning of corporate enterprises. In Indian Stock Market, most of the trading
takes place on BSE and NSE. Established in 1875, BSE (formerly known as Bombay
Stock Exchange Ltd.) is Asia's first and the fastest stock exchange in the world.National
Stock Exchange (NSE) is the leading stock exchange in India.
Investors’ Protection Measures by BSE6
BSE has taken following initiatives for protecting the interest of the investors-
1. BSE has established a Department of Investors Services (DIS) to redress
investors' grievances. Since its establishment in 1986, the DIS has played a pivotal
role in enhancing and maintaining investors' faith and confidence by resolving
their grievances either against listed companies or against BSE's Trading
Members.
2. Any investor having grievance against Trading Member/ company can register
complaint with BSE in respect of transactions executed on BSE in the prescribed
Complaint form to the nearest Regional Investor Service Centre of BSE along
with necessary supporting documents.
3. Investor can also lodge a complaint through email or through the facility provided
on BSE’s website under Investor section " e-Complaint Registration"
4. The complaints of investors against BSE's Trading Members are forwarded to the
concerned Trading Members for resolution. In case no reply is received from the
Trading Member or the reply received from the Trading Member does not satisfy
the complainant or the matter is not getting settled amicably, the same is placed
before Investors' Grievances Redressal Committee (IGRC)
5. The Exchange has formed separate IGRCs, for each Regional Investor Service
Centre to deal with the complaints referred to it.
6. The Exchange levies penalties on the Trading Member for not replying within the
specified period to the complaints forwarded or not attending the IGRC meetings.
Further, in case the Trading member fails to implement what is agreed before
6
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IGRC as recorded in the said minutes of the IGRC, the Exchange places the same
before the Member Committee levies the penalties.
7. BSE regularly organizes visits of Registrars & Transfer Agents (RTAs) at its
Registered Office to allow Trading Members and / or Investors to have direct
interface with Registrars of listed companies for redressal of complaints against
companies listed on BSE.
8. With a view to ensuring speedy and effective resolution of claims, differences and
disputes between non-Trading Members and Trading Members and Trading
Members inter-se, BSE has laid down an Arbitration Mechanism. This mechanism
is duly embodied in the Rules, Bye-laws and Regulations of BSE, and duly
approved by the Government of India/SEBI, under the Securities Contracts
(Regulation) Act, 1956.
9. BSE set up an Investor Protection Fund (IPF) on July 10, 1986 to compensate the
clients who suffer financial loss due to their member being declared as defaulter,
in accordance with the Guidelines issued by the Ministry of finance, Government
of India. IPF is managed by the Trustees appointed by BSE
10. BSE regularly conducts investor Awareness Program at different places across the
nation to educate them and spread awareness among the investors about the
working of the stock market and the stock exchanges.
11. BSE Training institute organises investor education programs periodically on
various topics related to capital markets derivatives, debt market, etc.
Investors’ Protection Measures by NSE7
NSE has taken following initiatives for protecting the interest of the investors-
1. Investor Service Cell
To cater to the needs of investors, NSE has established its Investor Services Cell
at Mumbai, Chennai, Kolkata, New Delhi, Ahmedabad, Hyderabad, Indore,
Kanpur, Pune, Bangalore, Jaipur, Vadodara, Patna, Lucknow, Chandigarh,
Dehradun, Kochi, Guwahati, Bhubaneswar, Ranchi, Panaji, Raipur, Jammu and
Shimla.
The Investor Services Cell facilitates resolution of complaints of investors against
the listed corporate entities and NSE members. NSE has accorded high priority
for resolution of investor complaints and the activities of Investors Services Cell
are overseen by Regulatory Oversight Committee.The Investor Services Cell also
renders administrative assistance to arbitration proceedings in respect of
arbitration cases that are admitted.
2. Grievance Redressal Committee
At each of the above ISC Centre, Exchange has constituted Grievance Redressal
Committee (GRC).All complaints which do not get resolved within fifteen
working days from the date of registration of complaint by Exchange or cases
where parties are aggrieved by the resolution worked out would be referred to
GRC.
3. Investor Protection Fund
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NSE has established an Investor Protection Fund with the objective of
compensating investors in the event of defaulters' assets not being sufficient to
meet the admitted claims of investors, promoting investor education, awareness
and research. The Investor Protection Fund is administered by way of registered
Trust created for the purpose. The Investor Protection Fund Trust is managed by
Trustees comprising of Public representative, investor association representative,
Board Members and Senior officials of the Exchange.
 The Securities and Exchange Board of India (SEBI) was established on April 12,
1992, in accordance with the provisions of the Securities and Exchange Board of
India Act, 1992.
 The primary objective of SEBI is to promote a healthy and orderly growth of the
securities market and secure investor protection.
 In order to achieve its objectives, SEBI Act, 1992, has conferred some important
powers to SEBI.
 An investor may have a complaint against any intermediary registered with SEBI or
a listed company. In such a situation the investor must first approach that particular
company or that intermediary against whom the investor is having the complaint.
 SEBI has a dedicated department viz., Office of Investor Assistance and Education
(OIAE) to receive investor grievances and to provide assistance to investors by way
of education.
 ComplaintsarisingoutofactivitiesthatarecoveredunderSEBIAct,1992;Securities
Contract RegulationAct,1956; DepositoriesAct,1996and Rules and
Regulationsmade there under and the provisions that arecovered under Section 55A
of Companies Act,1956arehandledbySEBI. SEBI handles the complaints against
various registered entities.
 SCORES is a web based centralized grievance redressal system of SEBI. An
investor who is not familiar with or does not have access to SCORES can lodge
complaints in physical form by visiting or sending the complaint to any of the
offices of SEBI.
 Investor protection measures by SEBI includes a fund established by the
Government of India called Investor Education and Protection Fund (IEPF) under
Companies Act. This fund is maintained under the consolidated fund of India.
 It is important to make the investors aware about the general market conditions and
economic environment so that they can make an informed investment decision.
 In order to spread awareness among the investors SEBI, National Securities
Depository Limited, Ministry of corporate Affairs and Stock Exchanges have taken
various initiatives.
 All these bodies organize a number of seminars, webinars, workshops, etc. at
various places across the nation to create awareness among the investors and also
distribute material for investors’ education containing information on different
aspects of investing like role of capital market, investing in IPO, investing in mutual
funds, investing in stocks, trading in securities, derivatives, indices, debt market,
depository account, index funds, investor grievances and arbitration (stock
exchanges), Rights and obligations of investors, Do’s and Don’ts of investing, etc.
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 The Ministry also hosts a website to provide simplified and user friendly
educational and awareness content to all the investors.
 The Government of India has established Investor Education and Protection Fund
(IEPF) Authority on 7th September, 2016 under the provisions of Section 125 of the
Companies Act, 2013.
 The Authority is mandated to promote Investor’s Education, Awareness and
Protection and to make refunds of shares, unclaimed dividends, matured
deposits/debentures etc. that have been transferred to IEPF.
 Investor Education and Protection Fund (IEPF), Ministry of Corporate Affairs
(MCA) in collaboration with various professional Institutes and CSC e-Governance
Services India Limited across various states of the country in rural, semi-rural and
urban areas is implementing a project to improve the financial knowledge and
investment aspects for the rural citizens.
 BSE has established a Department of Investors Services (DIS) to redress investors'
grievances.
 Any investor having grievance against Trading Member/ company can register
complaint with BSE in respect of transactions executed on BSE in the prescribed
Complaint form to the nearest Regional Investor Service Centre of BSE.
 To cater to the needs of investors, NSE has established its Investor Services Cell at
various places in India and at each of the ISC Centre, Exchange has constituted
Grievance Redressal Committee (GRC).
 The Investor Services Cell facilitates resolution of complaints of investors against
the listed corporate entities and NSE members.
 NSE has established an Investor Protection Fund with the objective of
compensating investors in the event of defaulters' assets not being sufficient to meet
the admitted claims of investors, promoting investor education, awareness and
research.
1. Briefly explain the powers and functions of SEBI.
2. What are the objectives of the constitution of SEBI.
3. Discuss the measures taken by SEBI in the recent past for investors’ protection.
(B.Com.(H) DU, 2013, 2016)
4. What is Investor Education and Protection Fund? Specify the areas where this fund
can be utilized.
5. Write a short note on Investor Awareness Program.
6. What are the initiatives taken by SEBI to spread awareness among the investors?
7. Briefly explain the initiatives taken by the Ministry of Corporate Affairs to spread
awareness among the investors.
8. Write a short note on the role of Stock Exchanges and NSDL in Investors’
Awareness.
9. Briefly describe the role of Bombay Stock Exchange in Investor protection.
10. Discuss the initiatives taken by the National Stock Exchange to protect the interests
of the investors.
11. Write the types of investors’ grievances dealt by SEBI. (B.Com.(H) DU, 2008)
12. What is SCORES? Explain the procedure to lodge complaint under SCORES.
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13. State the sources from which the contribution to Investors Education and Protection
Fund is made.
14. State True or False-
a. Investors’ protection is about how to handle investors’ complaints.
b. Securities and Exchange Board of India is the market regulator of the Indian
Capital Market.
c. Stock Exchanges have not taken any initiative for investors’ education and
awareness.
d. Investors’ grievances are not redressed by the companies themselves.
e. Regulation of stock market is a pre requisite to investors’ protection.
f. Securities and Exchange Board of India aims to provide for redressal of the
grievances of investors.
g. Ministry of Corporate Affairs has nothing to do with the investors’ protection.
h. SCORES is a web based centralized grievance redressal system of SEBI.
i. To cater to the needs of investors, NSE has established its Investor Services
Cell at various places in India.
j. It is important to make the investors aware about the general market
conditions and economic environment so that they can make an informed
investment decision.
k. NSE has established a Department of Investors Services (DIS) to redress
investors' grievances.
l. SEBI does not handle the complaints against various registered entities.
(Ans- a. F, b. T, c. F, d. F, e. T, f. T, g. F, h. T, i. T, j. T, k. F, l. F, )
15. Write short notes on-
a) Investor Protection
b) SCORES
c) Investor Education and Protection Fund
d) Uses of SEBI Investor Education and Protection Fund
e) IEPF Authority
f) Investor Awareness Program
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CHAPTER 2
UNFAIR TRADE PRACTICES AND INSIDER TRADING

 Introduction
 Unfair Trade Practices
 Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade
Practices Relating to Securities Market) Regulations, 2003
 Insider Trading
 Securities And Exchange Board Of India (Prohibition of Insider Trading)
Regulations, 2015
 Points to remember
2.1 Introduction
To protect the interests of the investors, SEBI has provided a list of the practices which
are considered as unfair trade practices. These unfair trade practices are prohibited by
SEBI. Insider trading is one of the most unethical practices is the capital market.
Therefore, SEBI prohibits insider trading. SEBI has introduced “Securities and Exchange
Board of India (Prohibition of Insider Trading) Regulations, 2015 to discourage insider
trading. The present chapter deals with the unfair trade practices, insider trading and the
SEBI regulations for unfair trade practices and insider trading.
2.2 Unfair trade practices
Unfair trade practices literally mean the practices or acts which are not fair or justifiable.
These acts are basically unethical. These include wrong means to earn profit in a business
like false advertisement, concealment of material information, etc. A large number of
practices are often considered as unfair in stock market as well. Securities and Exchange
Board of India strictly prohibits any manipulative, fraudulent and unfair trade practices.
SEBI has issued Securities and Exchange Board of India (Prohibition of Fraudulent and
Unfair Trade Practices Relating to Securities Market) Regulations, 2003.
2.3 Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair
Trade Practices Relating to Securities Market) Regulations, 20038
As per these regulations, fraud includes any act, expression, omission or concealment
committed by any person or his agent while dealing in securities in order to induce any
other persons to deal in securities, whether or not there is any wrongful gain or avoidance
of any loss. Fraud also includes the act of an issuer of securities giving out
misinformation that affects the market price of the security and-
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(1) A knowing misrepresentation of the truth or concealment of material fact in order
that another person may act to his detriment;
(2) A suggestion as to a fact which is not true by one who does not believe it to be true;
(3) An active concealment of a fact by a person having knowledge or belief of the fact;
(4) A promise made without any intention of performing it;
(5) A representation made in a reckless and careless manner whether it be true or false;
(6) Any such act or omission as any other law specifically declares to be fraudulent,
(7) Deceptive behaviour by a person depriving another of informed consent or full
participation,
(8) A false statement made without reasonable ground for believing it to be true.
(9) The act of an issuer of securities giving out misinformation that affects the market
price of the security, resulting in investors being effectively misled even though
they did not rely on the statement itself or anything derived from it other than the
market price.
Prohibition of certain dealings insecurities
Regulation 3 of the Securities and Exchange Board of India (Prohibition of Fraudulent
and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, prohibits
certain dealings in securities. As per the regulations, no person shall directly or
indirectly—
(a) Buy, sell or otherwise deal in securities in a fraudulent manner;
(b) Use or employ, in connection with issue, purchase or sale of any security listed or
proposed to be listed in a recognized stock exchange, any manipulative or deceptive
device or contrivance in contravention of the provisions of the Act or the rules or
the regulations made there under;
(c) Employ any device, scheme or artifice to defraud in connection with dealing in or
issue of securities which are listed or proposed to be listed on a recognized stock
exchange;
(d) Engage in any act, practice, course of business which operates or would operate as
fraud or deceit upon any person in connection with any dealing in or issue of
securities which are listed or proposed to be listed on a recognized stock exchange
in contravention of the provisions of the Act or the rules and the regulations made
there under.
Prohibition of manipulative, fraudulent and unfair trade practices
Regulation 4 of the Securities and Exchange Board of India (Prohibition of Fraudulent
and Unfair Trade Practices Relating to Securities Market) Regulations, 2003,
prohibits manipulative, fraudulent and unfair trade practices. As per this regulation-
(1) Without prejudice to the provisions of regulation 3, no person shall indulge in a
fraudulent or an unfair trade practice in securities.
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(2) Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if
it involves fraud and may include all or any of the following, namely :—
(a) indulging in an act which creates false or misleading appearance of trading in the
securities market;
(b) dealing in a security not intended to effect transfer of beneficial ownership but
intended to operate only as a device to inflate, depress or cause fluctuations in the
price of such security for wrongful gain or avoidance of loss;
(c) advancing or agreeing to advance any money to any person thereby inducing any
other person to offer to buy any security in any issue only with the intention of
securing the minimum subscription to such issue;
(d) paying, offering or agreeing to pay or offer, directly or indirectly, to any person any
money or money’s worth for inducing such person for dealing in any security with
the object of inflating, depressing, maintaining or causing fluctuation in the price of
such security;
(e) any act or omission amounting to manipulation of the price of a security;
(f) publishing or causing to publish or reporting or causing to report by a person
dealing in securities any information which is not true or which he does not believe
to be true prior to or in the course of dealing in securities;
(g) entering into a transaction in securities without intention of performing it or without
intention of change of ownership of such security;
(h) selling, dealing or pledging of stolen or counterfeit security whether in physical or
dematerialized form;
(i) an intermediary promising a certain price in respect of buying or selling of a
security to a client and waiting till a discrepancy arises in the price of such security
and retaining the difference in prices as profit for himself;
(j) an intermediary providing his clients with such information relating to a security as
cannot be verified by the clients before their dealing in such security;
(k) an advertisement that is misleading or that contains information in a distorted
manner and which may influence the decision of the investors;
(l) an intermediary reporting trading transactions to his clients entered into on their
behalf in an inflated manner in order to increase his commission and brokerage;
(m) an intermediary not disclosing to his client transactions entered into on his behalf
including taking an option position;
(n) circular transactions in respect of a security entered into between intermediaries in
order to increase commission to provide a false appearance of trading in such
security or to inflate, depress or cause fluctuations in the price of such security;
(o) encouraging the clients by an intermediary to deal in securities solely with the
object of enhancing his brokerage or commission;
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(p) an intermediary predating or otherwise falsifying records such as contract notes;
(q) an intermediary buying or selling securities in advance of a substantial client order
or whereby a futures or option position is taken about an impending transaction in
the same or related futures or options contract;
(r) planting false or misleading news which may induce sale or purchase of securities.
Power of the Board to order investigation
As per Regulation 5 of this act, where the Board (i.e., Securities and Exchange Board of
India), the Chairman, the member or the Executive Director (hereinafter referred to as
“appointing authority”) has reasonable ground to believe that—
(a) the transactions in securities are being dealt with in a manner detrimental to the
investors or the securities market in violation of these regulations;
(b) any intermediary or any person associated with the securities market has violated
any of the provisions of the Act or the rules or the regulations,
It may, at any time by order in writing, direct any officer not below the rank of Division
Chief (hereinafter referred to as the “Investigating Authority”) specified in the order to
investigate the affairs of such intermediary or persons associated with the securities
market or any other person and to report thereon to the Board in the manner provided in
section 11C of the Act.
Powers of Investigating Authority
As per regulation 6, without prejudice to the powers conferred under the Act, the
Investigating Authority shall have the following powers for the conduct of investigation,
namely:—
(1) To call for information or records from any person specified in section 11(2)(i) of
the Act;
(2) To undertake inspection of any book, or register, or other document or record of any
listed public company or a public company (not being intermediaries referred to in
section 12 of the Act) which intends to get its securities listed on any recognized
stock exchange where the Investigating Authority has reasonable grounds to believe
that such company has been conducting in violation of these regulations;
(3) To require any intermediary or any person associated with securities market in any
manner to furnish such information to, or produce such books, or registers, or other
documents, or record before him or any person authorized by him in this behalf as
he may consider necessary if the furnishing of such information or the production of
such books, or registers, or other documents, or record is relevant or necessary for
the purposes of the investigation;
(4) To keep in his custody any books, registers, other documents and record produced
under this regulation for a maximum period of one month which may be extended
upto a period of six months by the Board:
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(5) Provided that the Investigating Authority may call for any book, register, other
document or record if the same is needed again to examine orally and to record the
statement of the person concerned or any director, partner, member or employee of
such person and to take notes of such oral examination to be used as an evidence
against such person:
(6) to examine on oath any manager, managing director, officer or other employee of
any intermediary or any person associated with securities market in any manner in
relation to the affairs of his business and may administer an oath accordingly and
for that purpose may require any of those persons to appear before him personally.
2.4 Insider Trading
Insider trading is the act of taking benefit of the non-public information about a
company’s securities and trading those securities on the basis of that information which is
crucial for taking investment decisions. This act of insider trading is highly discouraged
by the SEBI as it results in the benefit of the person who is having the access of the
information and huge loss to other investors. SEBI emphasizes the promotion of fair
trading in the market for the benefit of investors. SEBI has come up with regulations for
prohibition of insider trading in 2015.
2.5 Securities And Exchange Board of India (Prohibition of Insider Trading)
Regulations, 20159
The objective of these Regulations is to prevent "insider trading" by prohibiting
dealing, communicating, counseling or procuring "unpublished price sensitive
information". Some of the important features of these regulations are as follows-
1. Important Definitions-
 “compliance officer” means any senior officer, designated so and reporting to the
board of directors or head of the organization in case board is not there, who is
financially literate and is capable of appreciating requirements for legal and
regulatory compliance under these regulations and who shall be responsible for
compliance of policies, procedures, maintenance of records, monitoring adherence
to the rules for the preservation of unpublished price sensitive information,
monitoring of trades and the implementation of the codes specified in these
regulations under the overall supervision of the board of directors of the listed
company or the head of an organization, as the case may be.
 "connected person" means-
i. any person who is or has during the six months prior to the concerned act been
associated with a company, directly or indirectly, in any capacity including by
reason of frequent communication with its officers or by being in any
contractual, fiduciary or employment relationship or by being a director,
officer or an employee of the company or holds any position including a
professional or business relationship between himself and the company
9
https://www.sebi.gov.in/legal/regulations/aug-2021/securities-and-exchange-board-of-india-prohibition-of-
insider-trading-regulations-2015-last-amended-on-august-05-2021-_41717.html
118
whether temporary or permanent, that allows such person, directly or
indirectly, access to unpublished price sensitive information or is reasonably
expected to allow such access.
ii. Without prejudice to the generality of the foregoing, the persons falling within
the following categories shall be deemed to be connected person sunless the
contrary is established,-
a) an immediate relative of connected persons specified in clause(i);or
b) a holding company or associate company or subsidiary company ; or
c) an intermediary as specified in section 12 of the Act or an employee or director
there of; or
d) an investment company, trustee company, asset management company or an
employee or director thereof; or
e) an official of a stock exchange or of clearing house or corporation; or
f) a member of board of trustees of a mutual fund or a member of the board of
directors of the asset management company of a mutual fund or is an employee
thereof; or
g) a member of the board of directors or an employee, of a public financial
institution as defined in section2 (72) of the Companies Act, 2013; or
h) an official or an employee of a self-regulatory organization recognized or
authorized by the Board; or
i) a banker of the company; or
j) a concern, firm, trust, Hindu undivided family, company or association of
persons wherein a director of a company or his immediate relative or banker of
the company, has more than ten per cent. of the holding or interest;
 "generally available information" means information that is accessible to the
public on a non-discriminatory basis;
 “Insider” means any person who is either a connected person or in possession of
or having access to unpublished price sensitive information;
 "unpublished price sensitive information" means any information, relating to a
company or its securities, directly or indirectly, that is not generally available
which upon becoming generally available, is likely to materially affect the price
of the securities and shall, ordinarily including but not restricted to, information
relating to the following: –
i. financial results;
ii. dividends;
iii. change in capital structure;
iv. mergers, de-mergers, acquisitions, de-listings, disposals and expansion of
business and such other transactions;
v. changes in key managerial personnel.
2. Restrictions on communications and trading by corporate insiders
 Communication or procurement of unpublished price sensitive information
As per regulation 3, there is a prohibition on insider for communicating,
providing, or allowing access to any unpublished price sensitive information,
relating to a company or securities listed or proposed to be listed, to any person
119
including other insiders except where such communication is in furtherance of
legitimate purposes, performance of duties or discharge of legal obligations.
Further, it imposes restrictions on procurement of unpublished price sensitive
information by an insider, relating to a company or securities listed or proposed to
be listed.
However, an unpublished price sensitive information may be communicated, in
connection with a transaction that would-
i. entail an obligation to make an open offer under the takeover regulations
where the board of directors of the company is of informed opinion that
sharing of such information is in the best interests of the company;
ii. not attract the obligation to make an open offer under the takeover
regulations but where the board of directors of the listed company is of
informed opinion that sharing of such information is in the best interests of
the company and the information that constitute unpublished price
sensitive information is disseminated to be made generally available at
least two trading days prior to the proposed transaction being effected in
such form as the board of directors may determine to be adequate and fair
to cover all relevant and material facts.
The regulation also instructs the board of directors to require the parties to execute
agreements to contract confidentiality and non-disclosure obligations on the part of such
parties and such parties shall keep information so received confidential.
 Trading when in possession of unpublished price sensitive information
Regulation 4 prohibits insiders from trading in securities that are listed or
proposed to be listed on a stock exchange when in possession of unpublished
price sensitive information. However, there is an exemption to this regulation, i.e.,
i. If the transaction is an off-market inter-se transfer between who were in
possession of the same unpublished price sensitive information without
being in breach of regulation 3 and both parties had made a conscious and
informed trade decision.
ii. in the case of non-individual insiders: –
a.) the individuals who were in possession of such unpublished price
sensitive information were different from the individuals taking trading
decisions and such decision-making individuals were not in possession of
such unpublished price sensitive information when they took the decision
to trade; and
b.) appropriate and adequate arrangements were in place to ensure that
these regulations are not violated and no unpublished price sensitive
information was communicated by the individuals possessing the
information to the individuals taking trading decisions and there is no
evidence of such arrangements having been breached;
iii. the trades were pursuant to a trading plan set up in accordance with
regulation 5.
 Trading Plans
120
Regulation 5 entitles an insider to formulate a trading plan and present it to the
compliance officer for approval and public disclosure pursuant to which trades may be
carried out on his behalf in accordance with such plan.
Such trading plan shall:–
(i) not entail commencement of trading on behalf of the insider earlier than six months
from the public disclosure of the plan;
(ii) not entail trading for the period between the twentieth trading day prior to the last
day of any financial period for which results are required to be announced by the
issuer of the securities and the second trading day after the disclosure of such
financial results;
(iii) entail trading for a period of not less than twelve months;
(iv) not entail overlap of any period for which another trading plan is already in
existence;
(v) set out either the value of trades to be effected or the number of securities to be
traded along with the nature of the trade and the intervals at, or dates on which such
trades shall be effected; and
(vi) not entail trading in securities for market abuse.
The compliance officer shall review the trading plan to assess whether the plan would
have any potential for violation of these regulations and shall be entitled to seek such
express undertakings as may be necessary to enable such assessment and to approve and
monitor the implementation of the plan.
The trading plan once approved shall be irrevocable and the insider shall mandatorily
have to implement the plan, without being entitled to either deviate from it or to execute
any trade in the securities outside the scope of the trading plan.
Upon approval of the trading plan, the compliance officer shall notify the plan to the
stock exchanges on which the securities are listed.
3. Disclosures of trading by insiders
Regulations 6 deals with the general provisions regarding the disclosures. Some of the
important points to be noted are as follows-
 Every public disclosure shall be made in such form as may be specified.
 The disclosures to be made by any person shall include those relating to trading by
such person’s immediate relatives, and by any other person for whom such person
takes trading decisions.
 The disclosures of trading in securities shall also include trading in derivatives of
securities and the traded value of the derivatives shall be taken into account.
 The disclosures made shall be maintained by the company in specified form for a
minimum period of five years.
Regulation 7 deals with disclosures by specific persons. The important points of this
regulation are as follows-
 Initial Disclosures- Every person on appointment as a key managerial personnel or
a director of the company or upon becoming a promoter or member of the promoter
group shall disclose his holding of securities of the company as on the date of
121
appointment or becoming a promoter, to the company within seven days of such
appointment or becoming a promoter.
 Continual Disclosures-
a) Every promoter, member of the promoter group, designated person and director
of every company shall disclose to the company the number of such securities
acquired or disposed of within two trading days of such transaction if the value
of the securities traded, whether in one transaction or a series of transactions
over any calendar quarter, aggregates to a traded value in excess of ten lakh
rupees or such other value as may be specified;
b) Every company shall notify the particulars of such trading to the stock
exchange on which the securities are listed within two trading days of receipt
of the disclosure or from becoming aware of such information.
 Disclosures by other connected persons- Any company whose securities are listed
on a stock exchange may, at its discretion require any other connected person or
class of connected persons to make disclosures of holdings and trading in securities
of the company in such form and at such frequency as may be determined by the
company in order to monitor compliance with these regulations.
4. Code of fair disclosure and conduct
 Code of fair disclosure-Regulation 8 requires that-
a) The board of directors of every company, whose securities are listed on a
stock exchange, shall formulate and publish on its official website, a code of
practices and procedures for fair disclosure of unpublished price sensitive
information that it would follow in order to adhere to each of the principles set
out in Schedule A to these regulations, without diluting the provisions of these
regulations in any manner.
b) Every such code of practices and procedures for fair disclosure of unpublished
price sensitive information and every amendment thereto shall be promptly
intimated to the stock exchanges where the securities are listed.
 Code of conduct- Regulation 9 requires that-
a) The board of directors of every listed company and the board of directors or
head(s) of the organisation of every intermediary shall ensure that the chief
executive officer or managing director shall formulate a code of conduct with
their approval to regulate, monitor and report trading by its designated persons
and immediate relatives of designated persons towards achieving compliance
with these regulations.
b) The board of directors or head(s) of the organisation, of every other person
who is required to handle unpublished price sensitive information in the
course of business operations shall formulate a code of conduct to regulate,
monitor and report trading by their designated persons and immediate relative
of designated persons towards achieving compliance with these regulations,
adopting the minimum standards set out in Schedule C to these regulations,
without diluting the provisions of these regulations in any manner.
c) Every listed company, intermediaryand other persons formulating a code of
conduct shall identify and designate a compliance officer to administer the
code of conduct and other requirements under these regulations.
122
 Institutional Mechanism for Prevention of Insider trading
Regulation 9A deals with Institutional Mechanism for Prevention of Insider trading. It
has following important features-
(1) The Chief Executive Officer, Managing Director or such other analogous person of
a listed company, intermediary or fiduciary shall put in place adequate and effective
system of internal controls to ensure compliance with the requirements given in
these regulations to prevent insider trading.
(2) The internal controls shall include the following:
(a) all employees who have access to unpublished price sensitive information are
identified as designated person;
(b) all the unpublished price sensitive information shall be identified and its
confidentiality shall be maintained as per the requirements of these
regulations;
(c) adequate restrictions shall be placed on communication or procurement of
unpublished price sensitive information as required by these regulations;
(d) lists of all employees and other persons with whom unpublished price
sensitive information is shared shall be maintained and confidentiality
agreements shall be signed or notice shall be served to all such employees and
persons;
(e) all other relevant requirements specified under these regulations shall be
complied with;
(f) periodic process review to evaluate effectiveness of such internal controls.
(3) The board of directors of every listed company and the board of directors or head(s)
of the organisation of intermediaries and fiduciaries shall ensure that the Chief
Executive Officer or the Managing Director or such other analogous person ensures
compliance with regulation 9 and sub-regulations (1) and (2) of this regulation.
(4) The Audit Committee of a listed company or other analogous body for intermediary
or fiduciary shall review compliance with the provisions of these regulations at least
once in a financial year and shall verify that the systems for internal control are
adequate and are operating effectively.
(5) Every listed company shall formulate written policies and procedures for inquiry in
case of leak of unpublished price sensitive information or suspected leak of
unpublished price sensitive information, which shall be approved by board of
directors of the company and accordingly initiate appropriate inquiries on becoming
aware of leak of unpublished price sensitive information or suspected leak of
unpublished price sensitive information and inform the Board promptly of such
leaks, inquiries and results of such inquiries.
(6) The listed company shall have a whistle-blower policy and make employees aware
of such policy to enable employees to report instances of leak of unpublished price
sensitive information.
(7) If an inquiry has been initiated by a listed company in case of leak of unpublished
price sensitive information or suspected leak of unpublished price sensitive
123
information, the relevant intermediaries and fiduciaries shall co-operate with the
listed
company in connection with such inquiry conducted by listed company.
 Unfair trade practices literally mean the practices or acts which are not fair or
justifiable. These include wrong means to earn profit in a business like false
advertisement, concealment of material information, etc.
 A large number of practices are often considered as unfair in stock market as well.
Securities and Exchange Board of India strictly prohibits any manipulative,
fraudulent and unfair trade practices.
 Fraud includes any act, expression, omission or concealment committed by any
person or his agent while dealing in securities in order to induce any other persons
to deal in securities, whether or not there is any wrongful gain or avoidance of any
loss.
 The SEBI has the power to order investigation in case the transactions in securities
are being dealt with in a manner detrimental to the investors or the securities market
in violation of these regulations.
 Insider trading is the act of taking benefit of the non-public information about a
company’s securities and trading those securities on the basis of that information
which is crucial for taking investment decisions.
 SEBI emphasizes the promotion of fair trading in the market for the benefit of
investors.
 SEBI has come up with regulations for prohibition of insider trading in 2015.
 The objective of these Regulations is to prevent "insider trading" by prohibiting
dealing, communicating, counseling or procuring "unpublished price sensitive
information".
 "generally available information" means information that is accessible to the public
on a non-discriminatory basis.
 “Insider” means any person who is either a connected person or in possession of or
having access to unpublished price sensitive information.
 According to Regulation 3, there is a prohibition on insider for communicating,
providing, or allowing access to any unpublished price sensitive information,
relating to a company or securities listed or proposed to be listed, to any person
including other insiders.
 Regulation 4 prohibits insiders from trading in securities that are listed or proposed
to be listed on a stock exchange when in possession of unpublished price sensitive
information.
 Regulation 5 entitles an insider to formulate a trading plan and present it to the
compliance officer for approval and public disclosure pursuant to which trades may
be carried out on his behalf in accordance with such plan.
 Every public disclosure shall be made in such form as may be specified. The
disclosures to be made by any person shall include those relating to trading by such
person’s immediate relatives, and by any other person for whom such person takes
trading decisions.
124
 Every person on appointment as a keymanagerial personnel or a director of the
company or upon becoming a promoter or member of the promoter group shall
disclose his holding of securities of the company.
 The board of directors of every company, whose securities are listed on a stock
exchange, shall formulate and publish on its official website, a code of practices and
procedures for fair disclosure of unpublished price sensitive information that it
would follow in order to adhere to each of the principles.
 Regulation 9A deals with Institutional Mechanism for Prevention of Insider trading.
1. What do you mean by Insider Trading? Who is an insider as per SEBI guidelines?
(B.Com. (H) DU, 2009)
2. Define the terms ‘unpublished price sensitive information’ and ‘connected person’
as per SEBI Regulations on Insider Trading?
3. What are the disclosure requirements as per SEBI Regulations on Insider Trading?
4. What are the restrictions imposed by SEBI on communications and trading by
corporate insiders?
5. Write a short note on the following-
a) Institutional Mechanism for Prevention of Insider trading
b) Code of fair disclosure and conduct
c) Trading Plans
d) Connected Person
e) Compliance Officer
f) Trading when in possession of unpublished price sensitive information
g) Unfair trade practices
h) Power of the Board to investigate
i) Power of investigation officer
125

Fundamentals of Investment: Discipline Specific Elective (DSE-3) Discipline Specific Elective (DSE-4)

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B.Com.(Hons.)/B.Com. (Prog.

Discipline Specific Elective (DSE-3)

SCHOOL OF OPEN LEARNING

SCHOOL OF OPEN LEARNING

1. Structure of the Chapter

Figure 11- Process of Portfolio Management

Covariance between the returns of A and B is -10.

1.5 Solved Illustrations

If a portfolio of 30% of X and 70% of Y is formed, find the-

2. Structure of the Chapter

• Setting the portfolio opportunity set (or

• Constructing indifference curves of the investor

• Selecting the Optimal Portfolio

Figure 11- Steps in Portfolio Selection

Figure 2- Portfolio opportunity set in case of N securities

Figure 3- Indifference curves of a risk averse investor

Figure 4- Selection of Optimal portfolio

Figure 5- Capital Market Line

Portfolio Expected Return Total Risk (S.D.)

Portfolio Given Expected Expected return as per Efficient or not

1. All the investors aim to maximize economic utilities.

2. The investors are ration a land risk-averse.

6. There are no taxes and transaction costs.

7. Securities are perfectly divisible.

8. Investors have homogeneous expectations about the price movements.

9. Free flow of information i.e., all information is available simultaneously to all

Figure 7- Security Market Line

Security Beta Actual Return (%)

Security Beta Actual Return as per SML Underpriced/Overpriced

Security Actual Return Beta Standard Deviation

Security Actual Beta Return as per SML Underpriced/Overpriced

Security Actual Beta Return as per SML Underpriced/Overpriced

3. Structure of the Chapter

Exhibit 33.1: Working of Mutual Funds

3.3 Mutual Fund Schemes

Objectives of Location of Special

Open-ended Growth Funds Load Domestic Index Schemes

Interval Balanced Tax Saving

Exhibit 33.2: Mutual Funds Schemes

3. On the basis of Load-

3.4 Systematic Investment Plan

An investor can invest a pre-determined fixed amount in a scheme every month or

3.5 Systematic Withdrawal Plan (SWP)

3.6 Systematic Transfer Plan (STP)

3.7 Net Asset Value (NAV)

NAV = (Value of Assets-Value of Liabilities)/number of units outstanding

Where, the number of units outstanding = 40,00,000/8 = 5,00,000

So, NAV = (45,60,000-1,60,000)/5,00,000

3.10 Solved Illustrations

Opening NAV per unit Rs. 22

Ascertain the expense ratio. (B.Com. (H), DU, 2018)

3.12 Review Questions

Cash Balance 400000

Opening NAV Rs. 104 crores

Ascertain the expense ratio. (B.Com. (H), DU, 2019)

Cash and Bank Balance Rs. 7,50,000

4. Structure of the Chapter

Mutual Fund Actual Return (%) Beta Standard Deviation (%)

Mutual Return Standard Sharpe Ratio Rank Remarks

Mutual Return Beta Treynor’s Rank Remarks

Mutual Return Beta CAPM Return α Rank Remarks

Mutual Fund Actual Return (%) Beta Standard Deviation