MBA-0000

Wealth Management

Block

2
INVESTMENT AVENUES

UNIT 5
Investment and Investment Products 05

UNIT 6
Alternative Investment Options 49

UNIT 7
Mutual Funds 64
Expert Committee
Dr. J. Mahender Reddy Prof. P. A. Kulkarni
Vice Chancellor Vice Chancellor
IFHE (Deemed University), Hyderabad Icfai University, Dehradun

Prof. Y. K. Bhushan Dr. O. P. Gupta

Vice Chancellor Vice Chancellor
Icfai University, Meghalaya Icfai University, Nagaland

Dr. Lata Chakravorty Prof. D. S. Rao

Director Director
IBS Bangalore IBS Hyderabad

Prof. P. Bala Bhaskaran Dr. Dhananjay Keskar

Director Director
IBS Ahmedabad IBS Pune

Prof. P. Ramnath
Director
IBS Chennai

Course Preparation Team

Shri T. S. Rama Krishna Rao Prof. Hilda Amalraj

Icfai University IBS Hyderabad

Dr. Y. G. Sivaram Prof. Bratati Ray

Icfai University IBS Kolkata

Ms. C. Padmavathi Dr. Vijaya Lakshmi S

Icfai University IBS Hyderabad

Ms. Sudha Dr. Vunyale Narender

Icfai University IBS Hyderabad

Ms. Sunitha Suresh Prof. Arup Chowdhury

Icfai University IBS Kolkata

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BLOCK 2 INVESTMENT AVENUES
This block discusses the basics of investing and also gives indepth analysis of all
investment products available for investment. It helps the learner to comprehend the
important features of these investment products. It specifically discusses mutual fund
investments in detail. Further, it also explains the risk analysis of investment products.
This block provides a clear understanding of all the investment products to the learner.

Unit 5 begins with the basics of investing. It explains the concept of risk and return with
numerical but quite practical examples. It also gives indepth explanation of all
investment products available for investment.

Unit 6 flows in the direction of Unit 5 and deals with alternative investment options. It
analyses these options with all the important features of the alternative investment
products, which include art objects, gold and silver, hedge funds, commodities and real
estate.

Unit 7 discusses mutual fund investments in detail. It clearly explains the advantages
and disadvantages of mutual fund investments. It also explains the different types of
mutual funds in addition to the entire structure of the mutual fund industry with special
reference to India. Besides, it also mentions the significance of systematic investment
planning.

3
UNIT 5 INVESTMENT AND
INVESTMENT PRODUCTS
Structure
5.1 Introduction
5.2 Objectives
5.3 Basics of Investing
5.4 Concept of Risk and Return
5.5 Fixed Income Securities
5.6 Variable Income Securities
5.7 Derivatives
5.8 Mutual Funds and Structured Products
5.9 Risk Analysis of Investment Products
5.10 Summary
5.11 Glossary
5.12 Suggested Readings/Reference Material
5.13 Suggested Answers
5.14 Terminal Questions

5.1 INTRODUCTION
Every individual earns and spends his/her income. For some earnings may be more than
consumption and for some it may be vice versa. These disparities lead to saving certain
amount from the current income for future consumption, which is one of the basic
motifs and essence of investment. Investing is the process of placing money in some
financial instruments or monetary assets to receive future benefits. Consider the
following example:
i. In order to settle down, a young couple buys a house for Rs.3 lakh in Bangalore.
ii. A wealthy farmer pays Rs.1 lakh for a piece of land in his village.
iii. A cricket fan bets Rs.100 on the ‘outcome’ of a test match in England.
iv. A government officer buys ‘units’ of Unit Trust of India worth Rs.l0,000.
v. A college professor buys, in anticipation of good return, 100 shares of Reliance
Industries Ltd. for Rs.40,000.
vi. A lady clerk deposits Rs.5,000 in a Post Office Savings Account.
vii. Based on the rumor that it would be a hot issue in the market in no distant future,
our friend John invests all his savings in the newly floated share issue of
Fraternity Electronics Ltd., – a company intending to manufacture audio and
video magnetic tapes to start with and cine sound tapes at a later stage.
The common feature of all these transactions is that something is sacrificed now for the
prospect of gaining something later. For example, the wealthy farmer in transaction (ii)
sacrifices Rs.1 lakh now with an intention to use it for farming and derives income from
the crop in the future. The lady clerk in transaction (vi) sacrifices Rs.5,000 now for the
prospect of getting a larger amount later due to interest earned on the savings account.
Thus, in a broader sense, all these seven transactions qualify as investments.
Wealth Management
5.2 OBJECTIVES
After going through the unit, you should be able to:
• Understand the basics of Investing;
• Familiarize with the concept of Risk and Return;
• Come to know about Fixed and Variable Income Securities;
• Analyze the features of Derivatives;
• Understand Mutual Funds and Structured Products; and,
• Determine the kinds of Risks associated with Investment Products.

5.3 BASICS OF INVESTING

Investment planning is something in a written form that specifies how capital has to be
invested for the purpose of achieving a specified goal. Investment planning starts with
setting an objective – financial goal that can be achieved within a particular period of
time; it is followed by deciding the amount of money to accumulate and for how long.
An important aspect of investment planning is the rate of return that can be earned on
the invested money. There are two ways of investment planning:
• Investing a lump sum amount one time and letting it grow over a period.
• Setting up a systematic plan and putting certain amount each year.
TYPES OF INVESTMENTS
There are different ways of making an investment. These different ways are referred to
as ‘Investment vehicles’. Each investment vehicle has negative and positive aspects.
The ultimate goal of any investment vehicle is to earn additional profit for the investor.
There are different types of investments such as fixed income securities or debt
securities, variable income securities, derivatives, mutual funds, and structured
products. Apart from these, there are also other alternative investment vehicles such as
art, gold, commodities, real estate, real estate mutual funds and charity.
INVESTMENT OBJECTIVES
Investment objectives play a major role in determining how conservative or aggressive
the investor is in making the investment decisions. Having adequate savings and
insurance to cover any emergencies that arise, there are certain objectives/goals for an
investment that an investor is to be aware of. Goals can be classified into various types
based on the way investors approach them. Investment goals vary from individual to
individual and at different stages of life for the same individual. The most frequent
investment objectives are – enhancing current income, saving for major expenses,
accumulating funds for retirement, and tax shelters.
Enhancing Current Income: The idea behind this objective is to invest into those
investments that enhance the current income. Investors need additional income due to
various reasons such as improving their educational qualification, meeting costly
medical expenses of family members etc. They generally tend to invest their funds in
safe and liquid investments to achieve these goals.
Major Expenditures: Investors want to save for some major expenditure such as
down payment for purchasing a home, planning for higher education of a child,
planning to set up a charitable institution after retirement, or achieving financial
independence a certain number of years down the line. The goals being long-term and
cannot be jeopardized with any other goals, the investors prefer to choose investments
that are less risky. It is also common to hold a reasonably diversified portfolio.
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 Investment and
Investment Products
Retirement: Apart from the above-mentioned objectives, the most important reason for
investing is to accumulate funds for retirement. Though the retirement age is a very
small period, still planning accurately to meet those needs is very important. Though
employees rely on employers and social security for retirement needs, they have to
supplement it with personal investing. The earlier one invests with the objective of
meeting retirement needs, the greater the opportunity to accumulate the needs.
Shelter from Taxes: Another objective of investment is to avoid paying taxes. Tax
treatment for all sources of incomes is not the same. If one tries to avoid paying taxes,
more funds would be available for reinvestment during the period.

Box: The Six Basic Principles of Successful Investing

You really don’t need to have a degree in finance to enjoy success in your investing
endeavors. Simple, basic knowledge is a powerful tool. The purpose in becoming
familiar with these fundamental investing concepts is to remove fears from your
decision-making process. Once you have a grasp of the way they operate, you’ll be
able to take a more active, informed role in the direction of your portfolio, and
ultimately your financial future.
Diversification: Simply, diversification means not putting all of your eggs in one
basket. If one investment bottoms out, you haven’t lost everything. Since stocks
respond differently to changes in the economy and the market place, a short-term
decline in one can be balanced by others in your portfolio, which are currently stable
or rising in value. The key, then, is not necessarily the number of assets that you
own, but the tendency of those holdings to not move in concert with each other.
Asset Class Investing: Each basic asset class – stocks, bonds, and cash investments – has
specific risk and return characteristics. Stocks can be grouped and evaluated
according to their capitalization and whether they perform as growth or value assets.
For instance, small capitalization (smallcap) companies are generally newer, faster
growing organizations that consequently carry higher risk than larger capitalization
(largecap) companies, which tend to be more established, well-known, and have
steadier streams of income and profits. Bonds are most commonly evaluated by their
length of maturity and quality of the borrower.
Asset Allocation: Asset allocation refers to the way investment funds are divided
among the three basic asset classes – stocks, bonds, and cash investments – in order
to increase the expected risk-adjusted returns. The goal is to combine percentages of
investments in different asset classes to maximize your portfolio’s growth for the
amount of risk that you’re willing to take in that area. Asset allocation can also be
applied to narrower segments of each of the basic classes. Stocks, for example, can
be further divided according to growth, value, small or large cap, domestic, or
foreign. As a broad group, stocks have the highest average total return over the long
run, but are usually the most volatile over a short period of time. Cash-equivalents
are the least volatile, but have the lowest return. Bond volatility falls between the
two.
Rebalancing: The purpose of rebalancing is to maintain the same percentages in the
various asset classes in order to preserve proper diversification during all market
conditions. Rebalancing is necessary because the inevitable up and down moves of
the market invariably change allocation percentages. For example, some short-term
gains might be forfeited by rebalancing your portfolio, but huge losses can also be
avoided.
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Wealth Management
Compounding: Compounding is the process of earning interest on money that is
invested, and reinvesting those earnings into the same investment. The concept is
that at the end of each year, interest is earned not only on your original principal,
but also on all of the previously accumulated interest as well; in other words,
earning interest on interest, which is a very powerful investment mechanism.
Time: Given enough time, investments which might otherwise seem of little
value can become quite attractive. The longer the period of time you hold an
investment, the closer the actual returns will approach the expected average. In
other words, short-term fluctuations will even out. Analyses have shown that the
trade-off between risk and reward is driven by time. With a long-term view,
you’re better able to make investment choices, which have a greater chance for
success.
Source: http://www.finweb.com/investing/the-6-basic-principles-of-successful-
investing.html
INVESTMENT CONSTRAINTS
An investor seeking fulfillment of one of the above goals operates under certain
constraints as given below:
• Liquidity
• Age
• Need for Regular Income
• Time Horizon
• Risk Tolerance
• Tax Liability.
INVESTOR CATEGORIZATION
For a successful investment policy, investment objectives and risk tolerance have to be a
blend of constraints and preferences of the investors. Each investor has his/her own set
of objectives and constraints. While most of these are known only in qualitative terms,
they will eventually lead to form quantitative objectives and constraints by the
investment manager, which, in turn, form the basis for the formulation of the optimal
portfolio. Let us discuss below the two categories of investors:
• ‘Institutional investors’ are the financial institutions or organizations, which
collect and invest money on a long-term basis on behalf of individuals or
corporates. They include pension funds, life insurance companies, general
insurance companies, investment trusts, and unit trusts. In India, the dominant
institutional investors are the Life Insurance Corporation of India, General
Insurance Corporation of India, Unit Trust of India, and other approved Mutual
Funds. In recent years, Foreign Institutional Investors (FIIs) have also been
active players in the Indian stock market. These institutional investors have
exerted an important influence on capital markets all over the world. They play
an important role in the management of corporations as they are entitled to
voting rights. They also engage in corporate governance activities. They have
freedom to buy/sell shares. They are more knowledgeable and better protect
themselves.
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 Investment and
Investment Products
• As against institutional investors, ‘Individual investors’ are those who purchase
small amounts of securities. They are also called retail/small investors. They
generally treat risk as ‘the possibility of losing money’ or sometimes even as
‘losing money’. Individual investors can be categorized based on their
psychological characteristics such as being an introvert or extrovert, aggressive
or conservative, confident or uncertain, etc.
Investment policies of the investors can be laid down based on what the investors think
is best for them while often, the investment policies of the institutions are determined to
a significant extent based on various legal requirements. For example, in India, the
government lays down the investment pattern of provident funds and also insurance
companies and the freedom available to portfolio managers while handling the
portfolios of these institutions is limited. Investment policies of the individuals
generally become complex as they are subject to taxes. Allocation of a significant
portion of the portfolio to tax-saving investments makes the job of a portfolio manager
much more difficult as the returns have to be brought up to the desired level with the
remaining funds. Most of the major investment institutions are, on the other hand,
exempt from tax.
INVESTING STYLES
Each investor has a unique style of investing. Investing style refers to the approach, the
mindset under which the investors frame their expectations and choose the means to
achieve those objectives. Investing style is determined by the amount and type of
resources, time constraints, risk tolerance level and alternative means. The three
different investing styles – conservative, moderate, and aggressive.
Conservative Investor: Conservative investors aim to maintain initial investment.
When they invest Rs.5,000 conservative investors make sure that they require the initial
investment back. Therefore, they invest in less risky investments like bonds and short-
term money market accounts. Conservative investors are uncomfortable with market
volatility; they protect their investment value from inflation effects and have basic
knowledge of investment. They prefer shorter time horizon.
Moderate Investor: Moderate investors increase the value of their portfolio, protecting
their assets from losses. They behave like conservative investors but put a portion of
their funds in risky investments. They put 50% of their funds in risky investments and
the remaining in conservative investments. They have a good understanding of
investment markets. They keep a diverse portfolio. They accept moderate risk and
prefer moderate to long-term time horizon.
Aggressive Investor: Aggressive investors concentrate on the investments that have
significant growth and realize greater returns. They invest more than 75% of their
investment in stocks and mutual funds. Aggressive investors have a good understanding
of financial markets. They are willing to take high risk with their investments. They
invest for long-term.
The challenge for investment management, therefore, lies in choosing the appropriate
investments that will meet the investment objectives of the investor subject to his
constraints. To take on this challenge, the investor needs to acquaint himself with
different types of investments that are available in the financial market.

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Wealth Management
Self-Assessment Questions – 1

a. List out the basic investment constraints

………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
b. What are the basic determinants of Investing Style?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

5.4 CONCEPT OF RISK AND RETURN

No investor is obliged to take any amount of risk on his or her investment. One may
invest one’s money in a government bond or a fixed bank deposit and receive fixed
interest. This interest may be called risk-free return (near risk-free) on investment. It
appeals to commonsense that one will invest in a risky venture only if one expects to
earn a return in excess of the risk-free return. Here, our main concern is to compute or
estimate return from an investor’s perspective on a particular investment.
SINGLE PERIOD RETURNS
Let us at the outset consider situations where we are concerned with only a single period
(say, one day, one week, one month or one year, etc.).
Consider the following illustration.
Illustration 1
Let us consider a share whose prices now (period 0 or P0), one year later
(period 1 or P1), two years later (period 2 or P2) etc., over a 10 year period are as
follows:
Period P0 P1 P2 P3 P4 P5 P6 P7 P8 P9 P10
Prices 100 110 108 130 154 145 160 170 193 220 264
We need to compute the return from the share in each of the periods.
Solution
If all the prices are cum-dividend (that is, prior to the payment of dividends), the single
period return to the investor in period 1 (r1), period 2 (r2), etc., could be expressed as
below:

P1 − P0 110 − 100
r1 = = = 10% … (1)
P0 100
Similarly,
P2 − P1 108 − 110
r2 = = = –2%
P1 110

P10 − P9 264 − 220

r10 = = = 20%
P9 220

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 Investment and
Investment Products
The computed single period percentage returns (rounded off to the nearest digit) have
been shown below:

Period P0 P1 P2 P3 P4 P5 P6 P7 P8 P9

Returns 10 –2 20 18 –6 10 6 13 14 20
As analysts or investors, we may want to know the average annual return (single period
return) over the period 0 to 10. This may be computed from above as follows:
1 n r + r + r + .... + r10
∑ ri = 1 2 3 = 10%. … (2)
n i =1 n
Where,
i is the subscript for the period.
Single period returns is nothing but the arithmetic average of the returns over the ten
year period. While this computation appears quite reasonable, and serves the purpose
in most cases, we run into trouble when the change in prices is rather erratic (See
Illustration 2).
MULTI-PERIOD RETURNS
Let us now consider returns when more than a single period is under consideration. In
this context we are concerned with computing the return per period, over a longer
period. For example, over a span of ten years, what has been the annual return on a
security? Consider the following illustration.

Illustration 2

Period P0 P1 P2

Prices 100 200 110

What is the per period return in this case? In other words, if P0, P1, and P2 represent
prices now, a year from now, and two years from now, what is the annual return over
the two year period in this example?
Solution
In this illustration, we have r1 = 100% and r2 = – 45%,
so that the average annual return = 27.5%.
However, it is obvious that an investor who bought the share for 100 in
period 0 and sold it for 110 in period 2, made a return of only 10% over the two
year period.
The single period return over the period 0 to 2 (r0,2) is arrived at as follows:

P2 − P0 110 − 100
r0,2 = = = 10% … (3)
P0 100
This return (r0,2) can be reduced to an equivalent per period return (r). One way of
computing the per period return is as follows:

P0 (1 + r)2 = P2, or r = ( P2 /P0 ) – 1 = 1.1 – 1 = 4.88% … (4)

Alternatively,

(1 + r)2 = 1 + r0,2, or r = (1 + r0,2 ) – 1 = 4.88%

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Wealth Management
Thus, r is the annual rate of return on a time adjusted basis.
One could also compute the annual rate of return without adjusting for time.
The unadjusted annual rate of return = r0,2 / n = 10 / 2 = 5%. ... (5)
Thus we see that in this example, the annual rate of return is about 5% per annum, so
that the average annual return of 27.5% as computed earlier has little meaning.
MULTIPLICATIVE RELATIONSHIPS OF RETURNS
In the context of computing multi-period returns, it may be useful to note the following
relationships:
r0,2 in illustration 2 above (from equation 3) may be expressed as:

P2 P P
1 + r0,2 = = 1 x 2 = (1 + r1) x (1 + r2)
P0 P0 P1

In general,
Pn P P P
1 + r0,n = = 1 x 2 ... x n ... (6)
P0 P0 P1 Pn − 1
Where,
r0,n is the return over the period 0 to n.
LOGARITHMIC RETURNS
Another important relationship results by taking the natural logarithm of the two sides
of equation (6) above:

ln(Pn/P0) = ln(P1/P0) + ln(P2 / P1) + ... + ln(Pn/Pn – 1) … (7)

or

ln(1 + r0,n) = ln(1 + r1) + ln(1 + r2) + ...... + ln(l + rn)

Where,

ln stands for logarithm with base e, that is, natural logarithm.

Note that by using logarithms, we are able to reduce a multiplicative relationship

(equation 6) into an additive one (equation 7). The additive relationship of the
logarithmic returns is much simpler to handle in arithmetic manipulations. For this
reason, logarithmic returns frequently find their way into security research.
Once r0,n (or Pn/P0, which is equal to 1 + r0,n) has been computed, the time adjusted
annual rate of return r is given by:
P0 (1 + r)n = Pn or r = n (Pn /P0 ) –1 ... (8)

alternatively,
(1 + r)n = 1 + r0,n or r = n (1 + r0,n ) – 1 ... (9)

ESTIMATION OF RETURN USING REGRESSION METHOD

We note that the computed value of annual rate of return (r) using equations
8 and 9 depends upon merely two observations; namely, the share price on period 0 and
that on period n. All the prices of the intermediate period (P1, P2, .... Pn – 1) are irrelevant
to the computation of r (since r0,n depends on only P0 and Pn – see equation (6). Clearly,

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Investment Products
the estimate of r can be further improved if all the price observations could be used in
the process of estimation. This can be done using a regression procedure with the
following specification:
ln(Pn) = ln(P0) + ln(1 + r) n + e
Where,
n is the time variable and e is the error term.
Through the regression procedure, the coefficient of n, ln(1 + r) is estimated, using the
data on share prices for the entire period under consideration. The annual rate of return r
is then computed from the estimate of ln(1 + r).
MEASURING HISTORICAL (EX-POST) RETURNS
To properly measure the return generated by an investment, one must account for both
the price change and the cash flow derived from the asset during the period the asset
was held. In other words, we can say that the return (the reward) from the investment
includes both current income and capital gains (or losses) brought about by the
appreciation (or depreciation) of the price of the security. The income and capital gains
are then expressed as a percentage of the initial investment. Hence, return usually
represents the total annual income and capital gain as a percentage of investment.
In bond investment, yield is the compounded rate of return on the purchase price of the
bond over its life. Simply stated, it is referred to as yield to maturity. Since yield to
maturity includes interest and capital gains or losses, it is also the return. The yield on a
common stock, however, assumes no maturity date. Therefore, the stock yield is simply
the price of the stock divided into the current dividend; there is no compounding of
returns. It is known as the current yield. When bond yields are compared with stock
yields, errors of judgment might be made, since the measures are different.
The return on a stock is calculated by including annual gains. If an investor receives
Rs.2 per share in dividends and earns Rs.3 per share per year in capital gains and
has an average investment of Rs.25, the return on the stock would be 20%.
Consider the following illustration.
ABC Ltd. XYZ Ltd.
Price as on 31-3-x1 (Rs.) 20.00 10.00
Price as on 31-3-x2 (Rs.) 15.00 15.00
Dividends for the year x1 – x2 1.00 1.00
Let,
r stand for the rate of return on investment,
P stand for the price, and
D stand for dividend.
The return from holding, the stock of ABC Ltd. and XYZ Ltd., for one year is
calculated as follows:

ABC Ltd. rx2 =

( Px 2
)
− Px1 + D x 2
Px1

(15 − 20) + 1 −5 + 1 −4
= = = = – 0.2 = –20%
20 20 20
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XYZ Ltd. rx2 =

( Px 2
)
− Px1 + D x 2
Px1

(15 − 10) + 1 5 +1 6
= = = = 0.6 = 60%
10 10 20
Thus, for stocks the return for a particular time period is equal to the sum of the price
change plus dividends received, divided by the price at the beginning of the time period.
For bonds, the holding-period return is equal to the price change plus interest received,
divided by the beginning price.
In general, for the ‘i’th asset and the ‘t’th time period:

rit =
( Pit − Pi,t −1 ) + Dit
Pi,t −1

The subscript notation used above might seem complex at first. However, it is really a
very useful method of keeping track of variables associated with different assets and
different time periods.
To compute the ex-post, or historical, average return for the ith stock, we use the
standard formula for computing arithmetic means.
1
ri = (ri1 + ri2 + ri3 + ri4 + .... + rin)
n
Where,
‘n’ equals the number of time periods.
This can be expressed as:
1 n
ri = ∑ rit
n t =1
Consider the following illustration. Data is given for PQR Ltd.

Year Annual Returns (%)

1 16.98

2 –11.36

3 7.64

4 21.12

5 –22.14

6 –30.01

7 37.68

8 28.27

9 1.76

10 13.93
The mean annual return of these returns would be
1 10
ri = ∑ rit
n t =1
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 Investment and
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1
= [16.98 – 11.36 + 7.64 + 21.1 – 22.14 – 30.01 + 37.68
10
+ 28.27 + 1.76 + 13.93]
1
= (63.87) = 6.387%.
10
Thus, calculating the arithmetic mean for historical returns is a relatively
straightforward process.
The majority of investors tend to emphasize the return they expect from a security. They
also tend to view both return and risk in subjective terms. Intuitive judgment is used to
make decisions about risk. The reasoning, for example, goes something like this:
Chrysler is more risky than General Motors, General Telephone is more risky than
AT&T and Polaroid is more risky than Eastman Kodak. And in India, Reliance is more
risky than Tisco.
Return also receives subjective and intuitive analysis. The usual statement about return
is something like, “The stock offers a dividend yield of 7% and has prospects for future
price appreciation”. The dividend yield, which is current price dividend into the current
rupees dividend is mentioned specifically, but little or no attempt is made to estimate in
a formal way the likely impact of capital gains or losses on the total return.
Measuring historical returns is, therefore, appropriate to develop a measure of return
that includes both dividends or interest and capital gains in the calculation. This
measure will then be applied to the calculation of historic or future expected returns.
The precise measure of return will make it easier to estimate and judge the magnitude of
returns of various securities. The return includes dividends and capital gains. The best
proxy for return is the future expected return. Thus, the basic equation for measuring
return for a yearly period or less is
(Pi − P0 ) + D i
P0

Where,
P0 = The rupees beginning price of the security.
Pi = The rupees end-of-period price.
Di = The rupees amount of dividends paid in period 1.
EXPECTED RETURN (EX-ANTE) OF A SECURITY
Frequently, in security analysis, we talk of expected return rather than historical return.
Let us now understand the meaning of the term “expected return” in the context of the
return on securities through an example.
Illustration 3
Investors’ assessment of return on a share of Xylene Corporation under three different
scenarios is as follows:
Scenario Chance Return (%)
1 0.25 36
2 0.50 26
3 0.25 12

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How investors make an overall assessment about the return on the share based on the
above anticipated returns under different scenarios?
Solution
As a first step in dealing with so many values, investors tend to ask the question, “What
return can we expect on an average?” This is known in statistics as the expected value
of the return and is nothing but the sum of each possible return multiplied by the chance
of its occurrence. The expected return E(x) in this case will be 25% (being 0.25 x 36 +
0.50 x 26 + 0.25 x 12).
Illustration 4
Consider the following illustration, where the expected value of the returns for a stock is
computed when probability of occurrence is given.
Conditional Return (%) (Xi) Probability of Occurrence (Pi) XiPi
–24 0.05 –1.20
–10 0.15 –1.50
0 0.15 0
12 0.20 2.40
18 0.20 3.60
22 0.15 3.30
30 0.10 3.00
9.60
n
Expected value of returns = E(x) = ∑ X i Pi = 9.60%
i =1

It is important to note that the sum of all the chances must add up to one.

We could generalize the above approach. If the return on a security is expected to be r1

with a chance of P1, r2 with a chance of P2, ..., and rn with a chance of Pn, then the
overall assessment of investors is based on the expected value of returns, which is
computed as follows:
Expected Return, Er = P1r1 + P2r2 + ... + Pnrn
EXPECTED RETURN OF A PORTFOLIO OF SECURITIES
The expected return on a portfolio of securities is nothing but the weighted average of
the return on individual securities in the portfolio. For a portfolio of two securities:
Expected portfolio return, Ep = W1E1 + W2E2
Where,
E1 is the expected return on security 1.
W1 is the proportion of money invested in security 1.
E2 is the expected return on security 2.
W2 is the proportion of money invested in security 2.
Similarly, the expected return of a portfolio of n assets, Ep is given by:
Ep = W1E1 + W2E2 + ... + WnEn, or
Ep = WiEi

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Where,
Wi is the proportion of investment in asset i,
Ei is the expected return on asset i, and
N is the total number of assets in the portfolio.
The above fact can be proved using the following illustration.
Stock Price as on 1.4.x 1 Price as on Yearly Rate of Return
(Rs.) 31.3.x 2 (Rs.) Dividend (%)
X 20 30 2 60.00
Y 30 40 3 43.33
Z 50 60 5 30.00
Portfolio of (X, Y, Z) 100 130 10 40.00
Rate of return is computed as:
(Pit − Pi,t − 1 ) + Dit
Eit = (for X, Y, Z)
Pi,t −1
(Ppt − Pp,t − 1 ) + D pt
Ept = (for portfolio)
Pp,t −1

(30 − 20) + 2
X = = 60%
20
(40 − 30) + 3
Y = = 43.33%
30
(60 − 50) + 5
Z = = 30%
50
(130 − 100) + 10
Portfolio = = 40.00%
100
The above portfolio return can also be computed as using the formula (for ex-post data):
Ept = ExtWx + EytWy + EztWz
Where,
Ept = Expected return on portfolio
Ex = Expected return on security X
Wx = Proportion of money invested in security X and so on.
20 30 50
= 60% x + 43.33% x + 30% x
100 100 100
= 12% + 13% + 15% = 40%
This confirms that portfolio returns are simply a weighted average of the returns
associated with the individual securities in the portfolio.
RISK
Suppose we are evaluating two shares M and N for investment. We have collected data
on the returns earned by investors on these shares in the last five years which are as
follows:
Share M 30% 28% 34% 32% 31%
Share N 26% 13% 48% 11% 57%

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If we have to choose only one of the two shares for investment, which share shall we
choose?
One approach would be to compute the average return for each share and choose the
one which has higher average return. If we do that we find that both the shares have an
average return of 31%. Can there be any other criterion for choice? Now, most investors
would regard Share N (or return on share N) to be riskier as its return fluctuates
substantially from year to year. They would, therefore, prefer share M to N. Thus,
investors appear to make their choices based on two considerations – expected return
and riskiness of returns.
WHAT IS RISKINESS OF RETURNS?
In the context of security analysis, we interpret risk essentially in terms of the variability
of security returns. The most common measures of riskiness of a security are the
standard deviation and variance of returns.
Standard Deviation and Variance of Returns
Standard deviation (commonly denoted as σ) of returns merely measures the extent of
deviation of returns from the average value of return. Precisely put, standard deviation
of returns is the square root of the average of squares of deviations of the observed
returns from their expected value of return.
The square of standard deviation is called variance (commonly denoted by σ2). Thus,
variance of security returns is the average value of the squares of deviations of the
observed returns from the expected value of return.
The variance is computed as follows:
Variance, σ2 = P1 (r1 – E)2 + P2 (r2 – E)2 + ... + Pn (rn – E)2
Where,
r1 … rn = Observed returns;
E = Expected rate of return; and
P1 .... Pn = Probability.
Since variance is the square of standard deviation, we have standard deviation,

σ= (Variance)
Illustration 5
Let us continue with the shares of Xylene Corporation mentioned in illustration 3. What
is our assessment about the risk of these shares?
Solution
Scenario Chance P Return Ex (P.rx) Deviation (Deviation)2 Chance (P) x
(%) rx (rx – Ex) (rx – Ex)2 (Deviation)2
1 0.25 36 9 11 121 30.25
2 0.50 26 13 1 1 0.50
3 0.25 12 3 –13 169 42.25
Ex = 25
Variance σ 2x = 73.00 (sum of the last column)

Standard deviation (σx = 8.54%)

Thus, the riskiness of a Xylene share as measured by standard deviation is 8.54%.

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The equations for quantifying the return, variance and standard deviation of individual
security returns for both ex-post and ex-ante data are summarized in the following table:
Historical (ex-post) Expected (ex-ante)
Arithmetic mean return Expected return
1 n n
ri = ∑ rit E(ri) = ∑ risPs
n t =1 s =1

Variance (Risk) Variance (Risk)

1 n n
σi2 = ∑ (r − r )2 σi2 = ∑ [ris − E(ri )]2 .Ps
n − 1 t =1 it i s =1

Standard deviation Standard deviation

1 n n
σi = ∑ (r − r )2 σi = ∑ [ris − E(ri )]2 .Ps
n − 1 t =1 it i s =1

Table 1
rit = Historical (ex-post) return generated by the ith stock in time period t.
ris = Expected (ex-ante) return for the ith stock assuming that S state of the
world occurs.
Ps = Probability that the S state of the world will occur.
Having discussed the concept of risk and return and volatility measures
on a particular investment. Let us, discuss in detail the various
components of financial planning like tax planning, insurance planning,
retirement and estate planning.

5.5 FIXED INCOME SECURITIES

Fixed income securities are bought and sold between two parties. They are also called
debt securities. They are issued by the government, government agencies, state
governments, corporate etc. They are paid for a fixed period of time. Investors benefit
by investing in these securities as they have fixed returns and attractive interest rates.
More importantly, they are free from tax and returns are easily predictable. Though
fixed securities offer numerous benefits, they are not free from risks. The important
risks associated with fixed income instruments are interest rate risk, reinvestment risk,
and default risk. An appropriate risk management strategy has to be developed to deal
with the risks arising from investing in debt. Depending on the investor’s risk appetite,
one can decide the portion of investment in these securities. Conservative investors have
70% of their portfolio in debt whereas aggressive investors have only 5-10%. They are
less risky and less volatile than equities and the returns from debt are less when
compared to equities. There is a sense of assurance for returns in debt though the
amount of returns is not as attractive as equities. Debt securities include money market
instruments, bonds, bank deposits, debentures and small saving schemes.
MONEY MARKET INSTRUMENTS
Money market is the market for the short-term borrowing and lending. Money market
instruments are normally used for investing for a period of one year or less. Companies
borrow money through the issue of long-term instruments in the primary market. The
secondary market refers to the place where such instruments are traded i.e., the stock
exchanges. As the secondary market is created for the securities raised in the primary
market, the depth of the secondary market depends upon the primary market. From the
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investor’s point of view, while he can obtain the instruments either or both by applying
for them in the primary market or purchasing them in the secondary market, the
liquidity for these instruments is created only in the secondary market. Hence, the
movements in both these markets are important for him. A brief discussion on various
money market instruments is given below.
Gilt-Edged Securities
Debt securities issued by the government and semi-government bodies are called gilt-
edged securities. They comprise the treasury bills and dated securities (also called bonds
or dated loans) issued by the central government, state governments and semi-government
bodies like port trusts and state electricity boards.
Treasury Bills
These short-term securities are issued by the RBI on behalf of the central government.
No interest is paid on these bills. Instead, they are sold at a discount. As the
government’s revenue collections are bunched and expenses are dispersed, these bills
enable it to manage the cash position in a better way. Treasury Bills, also known as
T-bills, enable the RBI to perform Open Market Operations (OMO), which indirectly
regulate money supply in the economy. Investors prefer treasury bills because of their
high liquidity, assured returns, no default risk, no capital depreciation, and eligibility for
statutory requirements. T-bills are issued either in the form of promissory note (or scrip)
or credited to the investor’s SGL account. For every class, a standardized format is
used. Treasury bills are issued for a minimum amount of Rs.25,000 and in multiples of
Rs.25,000 thereof. They are issued at a discount and redeemed at par.
Indian Government, at present, issues three types of T-bills through auction. They are:
91-day, 182-day, and 364-day T-bills. Presently, no treasury bills are issued by state
governments.
Ad hoc T-bills are issued in favor of the RBI when the Government needs cash.
They are neither issued nor available to the public. The RBI purchases these bills at
a discount and holds them in its Issue Department and in turn issues currency notes
against these bills to the government if required. These bills are renewed at
maturity.
Ad hoc T-bills are issued to serve two purposes; firstly, to replenish cash balances of the
central government; and secondly, to provide a medium of investment for temporary
surpluses to state governments, semi-government departments, and foreign central
banks.
Dated Securities
Dated securities are the securities where the date of maturity is specified. Generally,
central government and state governments issue these securities. RBI issues these
securities through auction and based on the response it decides the coupon or discount
rate. These are fixed interest-bearing securities. Based on requirement, sometimes these
securities are issued as zero-coupon instruments and floating rate securities. For retail
purpose, these instruments are issued in the physical form; however, mostly they are
issued in the form of entries in RBI’s Subsidiary General Ledger (SGL).
Central Government-Dated Securities
These securities of the central government have a maturity period longer than one year
and carry a fixed rate of interest. The coupon rate on the central government- dated
securities is higher than the discount rate on treasury bills as dated securities have
longer maturities.
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Semi-Government-Dated Securities
These are the promissory notes issued by institutions and corporations set up by the
central/state governments like NTPC, NMDC, HPCL, India Oil, Bharat Petroleum, to
mention a few.
BONDS
A bond is the basic form of fixed income security. It is issued by a borrower (borrowing
company) to the lender (the investor). It is a formal contract to repay the borrowed
amount with interest. The bondholder receives coupon payments at periodical intervals
say annually, quarterly or semi-annually and the redemption amount on the maturity
date. The borrower is required to repay the borrowed amount at fixed intervals.
For example, when an individual invests Rs.1,000 in a bond that pays interest at the
rate of 10% semi-annually, he/she can expect to receive Rs.50 semi-annually
(i.e., 10% x 100 x 0.50) and at maturity he/she will recover Rs.1,000, if the bond is
redeemed at par.
Risks Arising from Investing in Bonds
Bonds are generally less risky than equities. Primarily, bonds involve two types of risks
– default risk, and interest rate risk.
Default Risk: Default risk arises when the issuing company defaults on the interest or
principal obligations. In case the company goes bankrupt and is unable to repay its debt
fully, a part of the investment may be completely lost, and even the remaining part may
be paid after a long delay resulting in opportunity losses.
Interest Rate Risk: In certain cases, bonds may be sold before maturity. In some other
cases, the redemption value of the bond may be reinvested in other bonds. It is only in
some cases that the maturity of the bond exactly matches the investment horizon of the
investor. Even in such cases, the annual interest on the bond may have to be reinvested
unless it exactly matches the annual requirements of funds of the investor. In all these
cases, the yield-to-maturity of the bond does not represent the true return to the investor
over his holding period unless the interest rates remain unchanged throughout the
holding period. The holding period return is thus subject to interest rate risk.
Types of Bonds
Variations in investor demands and preferences have brought about new innovations
and new features in bonds. To have more clarity on the innovations and features in
bonds, let us discuss the different types of bonds.
Municipal Bonds: These bonds are also known as ‘Muni’. These are issued by states,
municipalities to finance their capital expenditures. Municipal bonds are exempted from
federal income tax. The municipal bond issuer receives cash at the time of issuance with
a promise to repay the investors the cash over a period of months say 10, 20 or longer.
Government Bonds: A bond issued by the national government of a country in its own
currency is termed a ‘government bond’. Government bonds are risk-free bonds issued
by the government and are free of credit risk. But, they are exposed to other types of
risks such as currency risk and inflation risk. These bonds are issued through agencies
that are part of the treasury department.
Treasury Bonds: These are marketable, fixed interest US government security bonds.
Interest is paid semi-annually at a fixed coupon rate. These bonds are normally issued
for longer maturity periods.
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Bank Bonds: Banks issue and sell bonds in the security market to finance their lending.
These bonds are referred to as bank bonds. The maturity period of these bonds generally
varies between three to eight years.
Corporate Bonds: These bonds are generally traded in the secondary market and the
price of the bonds depends on the interest rates prevailing at the time of trading.
Corporate bonds are debt securities issued by a corporation. Corporate bonds have a par
value and a definite term to maturity. The income from corporate bonds is taxable. A
company can issue bonds in a similar fashion it issues stocks. Depending on the
maturity period, bonds are classified as:
• Short-term corporate bonds: Up to 5 years.
• Intermediate-term corporate bonds: Up to 12 years.
• Long-term corporate bonds: Above 12 years.
Corporate bonds are exemplified by higher yields because there is a higher risk of
default. Sometimes, corporate bonds are considered highly rewarding fixed income
securities because of the risk the investor takes. At the same time, the company’s credit
quality is very important because the higher the quality the higher is the interest rate the
investor receives. The price will appreciate if the coupon rate is higher than the
prevailing rates. As such, bonds are quoted at a premium. Conversely, if the coupon rate
on the bond is less than the prevailing market rates, then the bonds are quoted at a
discount.
BANK DEPOSITS
The banking sector in India has undergone tremendous transformation since
independence and has almost achieved the global standards today. India, which has a
dominating presence of nationalized banks, is able to attract a number of foreign and
private banks. All the banks in India operate under the guidelines of the Reserve Bank
of India, which formulates the rules and regulations for the banks from time to time
keeping in view the changing economic and global conditions.
Against this backdrop, most individuals give top priority to save their money in the form
of bank deposits. Banks pay interest in the range of 7.5% to 9.0% per annum depending
on the tenure of the deposits. Indian banks provide different deposit schemes for different
consumers such as: domestic customers, corporates, Non-Resident Indians etc.
Investors who are not willing to take any risk or who have more financial
responsibilities or who are not ready to lose money for generating higher returns
generally keep their money in deposits with banks instead of investing in stocks, bonds
etc. Banks offer fixed rate of interest for the entire period. Bank deposits are the safest
and least risky instruments available for investors who look for moderate returns. They
are also called term deposits.
An important savings instrument banks offer is term deposits A feature of term
deposits is the deregulated interest rates. Banks are free to set their own rates depending
on the size of the deposit and the tenure. This interest will be paid on a quarterly
compounded basis. Apart from the annual compounding, if the interest is
compounded monthly/quarterly/half-yearly, the effective rate of interest for such
periods will be different from the nominal rate.

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Unlike the current and savings accounts, term deposits do not facilitate transactions.
This non-transactional type of deposit can, however, be classified into various
categories depending on whether the entire amount is deposited at one time or over a
period of time, whether interest is compounded or withdrawn at regular intervals, etc.
Thus, term deposits can be in any one of the following forms:
• Fixed Deposit Scheme.
• Reinvestment Scheme.
• Cash Certificates.
• Recurring Deposit Scheme.
Fixed Deposit Scheme: In this scheme, a lump sum amount is deposited for a fixed
term during which the amount cannot be withdrawn. The interest is paid on a
monthly/quarterly/half-yearly/annual basis. This scheme provides liquidity to the
depositor as it can be withdrawn during these periods. By withdrawing the amount, the
depositor can actually earn a return (interest) on this interest amount. However, if the
monthly interest is withdrawn for reinvestment, the returns earned will be more than
those earned for a quarterly repayment.
Reinvestment Scheme: In a reinvestment scheme, a lump sum amount is accepted for a
fixed period and repaid with interest on maturity. Interest on deposit is reinvested at the
end of each quarter, and hence there will be an interest on the interest. The minimum
and maximum durations for such schemes are 6 and 120 months respectively. The
(minimum) period accepted differs from bank to bank. The depositor can withdraw the
interest, plus the principal at the end of the tenure.
Cash Certificates: Under this type of reinvestment deposit scheme, odd sums are
accepted for a fixed period to pay whole sums at the time of maturity. The interest on
deposits is reinvested quarterly and hence there will be interest on interest.
A deposit receipt, which gives the details of the deposit, will be issued to the depositor.
The minimum and maximum durations are same as the reinvestment scheme. The
amount that is deposited initially will be the issue price of the cash certificate and this
will be arrived at based on the maturity amount i.e., the face value of the cash certificate
and the tenure of the deposit, and the depositor would decide about these two. Based on
the tenure, the bank decides on the interest rate.
Recurring Deposit Scheme: In a Recurring Deposit (RD) scheme, a fixed sum will be
deposited every month for a fixed period. At the end of the period, the depositor will be
paid the total amount of deposit installments with interest. A passbook will be issued,
that will be updated to show the details of deposits. The minimum and maximum
deposit periods are 6 and 120 months respectively.
Term deposits are non-transactional in nature and cannot be withdrawn during the
tenure of the deposit. However, if the depositor plans to withdraw a part/full amount of
the deposit before the maturity date, then the bank may impose a penalty for the same.
Penalties will be imposed at the discretion of the banks. Apart from penalty, banks also
cut the interest rate on the deposit, if the difference between the withdrawal date and the
maturity date (called ‘closure before maturity’ in banking terminology) were significant.
For instance, if a two-year deposit, which has a deposit rate of 9 percent, is withdrawn
at the end of one year, then the applicable deposit rate for this deposit will be the one-
year deposit rate minus penalty for foreclosure or withdrawal. However, with product
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innovations taking place, banks are introducing flexible deposit schemes for fixed
deposits, wherein the entire FD will be broken into smaller denominations. This helps
the borrower to withdraw funds from the FD without the need to foreclose the entire
deposit. For instance, if a depositor has an FD for Rs.5,000, then the flexi deposit
scheme will issue five deposits of Rs.1,000 each. Thus, when the depositor needs funds
up to Rs.2,000, then only two deposits will have to be withdrawn prematurely.
Advantages of Bank Deposits
The deposits discussed above provide a lot of convenience and hassle-free banking to
the customers. Some of the advantages of opting for bank deposits are discussed below:
Safety: Bank deposits are assumed to be fairly safe because banks are supposedly
subject to the controls of the Reserve Bank of India with regard to several policy and
operational parameters. Moreover, bank deposits are considered safe because the
Deposit Insurance Scheme backs them. The Deposit Insurance and Credit Guarantee
Corporation guarantees safety of deposits in any scheduled bank; besides, it also
provides insurance to individual depositors who deposit up to Rs.1 lakh.
Interest: Different banks offer varying rates of interest on the deposits of varying
maturities. Careful planning and searching might earn a few percentage points of higher
interest. Normally, interest is compounded quarterly and therefore there is a higher
effective rate.
Liquidity: Loans of up to 75% of the deposit amount can be obtained from banks
against fixed deposit receipts. The interest charged is generally 2% more than the rate of
interest the deposit earns. Banks also allow premature withdrawal of fixed deposits
subject to certain conditions, including loss of interest.
Convenience: Apart from safety, return and liquidity, banks offer extraordinary
convenience to customers through their wide network of branches and ATMs. Thanks to
the massive branch expansion, there are quite a few bank branches in every urban
neighborhood. This is a great convenience, particularly for the retired and the aged.
DEBENTURES
Whenever a corporation or an institution is in need of money for its operations, it sells
bonds to people outside. It promises to pay back the money in full after a certain period
of time with interest. Debentures are the debt instruments issued by the governments
and large institutions for long period of time. They are freely negotiable debt
instruments. Like government securities, they have an issue price at which they are
originally issued, a coupon interest rate and a specified maturity date. They are not
backed by any collateral. They are backed by the reputation and creditworthiness of the
issuer. They have some similarities with bonds but differ by means of terms and
conditions.
Types of Debentures
Debentures can be classified into two or more categories along the following
dimensions: security, transferability, and convertibility.
Straight and Mortgage Debentures: Based on security dimension, debentures can be
classified as unsecured (or straight) debentures and secured (or mortgage) debentures.
Unsecured debentures have no charge on any specific asset(s) of the company while
secured debentures carry a fixed or floating charge on the assets of the company.
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Registered and Bearer Debentures: As per the dimension of transferability,
debentures can be classified as registered and unregistered debentures. Unregistered
debentures (or bearer debentures) are freely negotiable and can be transferred by a
simple endorsement. On the other hand, registered debentures can be transferred only by
executing a transferdeed and filing a copy of it with the company.
Convertible and Non-convertible Debentures: Debentures can also be classified into
convertible and non-convertible debentures depending upon whether they carry a
conversion feature or not. Convertible debentures are the ones that can be converted into
equity shares at the option of the debenture holders. Non-convertible debentures are
those that cannot be converted into equity and they earn high interest than convertible
debentures.
Small Saving Schemes
• Small savings schemes are intended to provide safe and attractive investment
options to the public and at the same time, mobilize resources for developmental
purposes. These schemes are promoted mainly by the National Savings
Organization (NSO), through publicity campaigns and through multi-media
advertisement campaigns. Apart from this, a large network of over 5 lakh small
savings agents working under different categories, like the Standardized Agency
System (SAS), Mahila Pradhan Kshetriya Bachat Yojana (MPKBY), Public
Provident Fund Agency Scheme, Payroll Savings Groups, and School Savings
Banks (Sanchayikas), also participate in promoting these schemes. The Extra
Departmental Branch Postmasters (EDBPMs) are responsible in mobilizing
savings, especially in rural and remote areas.
• The small savings schemes presently in operation have significant relevance,
especially for farmers, self-employed people, salaried people, and other fixed
income investors, like retired persons. In view of their importance, let us discuss
the features of these schemes in detail.
Features of Small Savings Schemes: The following salient features are common to the
various small savings schemes:
Government-backed: All these small savings schemes are operated either directly by
the government or by a government organization like the post offices or nationalized
banks, and are, therefore, very safe. The government, after all, can always be expected
to honor its commitments. Fairly streamlined procedures are in place for making
deposits and withdrawals of money, whether upon maturity or earlier. With these saving
schemes, individuals can rest assured about the safety of their investment, timely
payment of interest and repayment at maturity.
Suitable for Small Investors: As the minimum investment limits in some schemes
range from Rs.50 to Rs.500, even a person with very low monthly savings can
participate and thereby save and earn additional income. An added advantage is the fact
that since most of these schemes are operated through post offices and nationalized
banks, they are easily accessible to the small investors across the country.
Attractive Interest Rates: Returns on some schemes like Indira Vikas Patra, Kisan
Vikas Patra, etc., are somewhat higher than the interest on bank deposits or dividend
yield on units. Some schemes even offer a totally tax-free income, like the PPF (8%),
and Post Office Savings (Deposit) (3.5%), etc.
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Liquidity: Most of these schemes have a provision for premature withdrawal, which
increases the liquidity of your investment. Further, some banks extend loans against the
security of these saving certificates.
Duration: These schemes offer a wide choice in so far as the duration is concerned,
varying from one year to 15 years. It is easy, therefore, to find a saving scheme, which
meets your requirements in terms of time frame.
Tax Benefits: All small savings schemes are entitled to some tax benefits or the other,
like income tax, wealth tax, etc. The actual quantum of benefit varies from scheme to
scheme and limited to a few, on account of the changes introduced by the Finance Act
2005. These schemes are often advantageous to those in high tax brackets as they offer
various tax benefits.
Types of Small Saving Schemes:
• There are different types of small saving schemes that are discussed below,
which are mainly meant to small investors who are chiefly invested in safe
invests, who are averse to taking any risk and also those who are in high tax.
• Public Provident Fund: Public provident fund is the most popular and best
suited scheme for long-term investment. This scheme offers 8% return and a
maturity period of 15 years. Minimum amount to be invested is Rs.500 and
maximum of Rs.70,000. Depositing minimum amount every financial year is
compulsory. For effective tax savings, PPF is the best suitable fixed income
scheme. After maturity, this scheme provides an accumulated amount including
the principal and interest. The amount received on maturity is tax-free. Tax
benefits can be claimed under Sec. 88 of the Income Tax Act. For example, if an
investor invests Rs 60,000 in the first year, he earns an interest of Rs.4,800 on
the initial investment. Next year the interest will be calculated on the sum of
initial investment + first year’s interest + the amount invested in the second year.
The PPF account can be opened through post office or designated nationalized
banks.
• Employees Provident Fund: Employees provident fund is also one of the most
popular and tax savings schemes. This fund was established in 1952. It provides
benefits upon retirement, death or resignation. Under this fund, both the
employer and the employee contribute at the rate of 12% of their annual income.
Interest rate is fixed by the central government and is credited to the member’s
account. The member can withdraw full amount at the age of 55 years. He can
withdraw the amount even if he is not 55 years but is physically or mentally
disabled, terminated from service, taking employment abroad etc.
• National Saving Certificate (NSC): NSC is a post office saving scheme
backed by the government. The minimum amount of investment is Rs.500 and
there is no maximum limit. The rate of interest is 8%, which is compounded
half yearly. Individuals and minors with guardians can purchase National
Saving Certificates. NRIs/HUFs or companies, trusts, or any other institutions
are not eligible to purchase these. There is no possibility of withdrawing the
amount before maturity. It can be pledged as security against loan in a bank.
NSCs are transferable from one post office to another and from one person to
another. Encashment of certificates can be done through banks. Even duplicate
certificates are issued if the originals are destroyed, lost or stolen.
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• Kisan Vikas Patra (KVP): Kisan vikas patra is also one of the best schemes
available under small savings. Under this scheme, the investment will be
doubled but is not free from income tax. Investors opting for this scheme can
withdraw after 2.5 years of investment but cannot receive interest for that
particular period. The rate of interest is 8.25%. It can be invested by an
individual, by two or three individuals in joint names, by a guardian in the
name of the minor or any trust.
• Deposit Schemes for Retiring Employees of Government and Public Sector
Companies
• These accounts can be opened by retired/retiring employees of Public Sector
Undertakings, Institutions, Public Sector Companies and Corporations like
Public Sector Banks, Life Insurance Corporation of India, General Insurance
Corporation, etc. The account can be opened either individually or jointly with
his/her spouse. Nomination facility is available in respect of individual accounts.
• The account matures after 3 years, but it can be continued either wholly or a part
of it after maturity. The minimum amount that can be deposited is Rs.1,000 and
the maximum amount that can be deposited can be the maximum of the total
retirement benefits in multiples of Rs.1,000.
Total retirement benefits include:
i. Balance in the credit of an employee in any of the Government Provident Funds,
ii. Retirement/Superannuation gratuity,
iii. Commuted value of pension,
iv. Cash-equivalent of leave,
v. Savings element of Government insurance scheme payable to the employee on
retirement, and
vi. Arrears of retirement benefits as defined in (i) to (v) of the above.
Withdrawal of deposits in whole or in parts is permissible at any time after expiry of the
normal maturity period of 3 years. Premature withdrawals are permissible after
completion of one year and before completion of three years on reduced interest rate.
Interest is paid at the rate of 7% payable on half-yearly basis at any time after 30th June
and 31st December, every year. Interest accrued is fully tax-free. Amount deposited
under this scheme is free from wealth tax.

5.6 VARIABLE INCOME SECURITIES

Equity is defined as the ownership interest in the corporation in the form of stocks. It is
an important asset class in one’s portfolio. Equity returns can be in the form of
dividends or through increase in the price of shares. It is most risky as it is not
permanent and also discretionary when comes to payment of dividend. Shareholders
carry the reward and risk associated with ownership of enterprises.
Rewards associated with equities include dividends, cash dividends, capital gains, rights
issue, voting rights for stockholders, right to information etc. Like any other investment,
equity is also not free from risks. The common risks associated with equity include no
assurance of profit with certainty, uncertainty over allotment of shares of the company,
poor liquidity, and share prices may be highly volatile leading to capital loss.
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Different Types of Stocks
Like any other asset, even stock is divided into different types, which are given below:
Common Stock: Normally, stocks are referred as common stocks. Majority of the
stocks are referred to as common stock or shares that represent the ownership in the
company. The holders of stock have the right to claim a portion of profits. Common
stock has benefits like earning dividends and capital appreciation. However, if a
company goes bankrupt, the common shareholders will not receive money until the
creditors, debtors and the preferred shareholders are paid.
Preferred Stock: Also called preference capital or preference share, it represents some
degree of preference of ownership in the company. Investors are guaranteed a fixed
dividend. The most advantageous feature of preferred stock is that, in the event of
liquidation, the preferred shareholders are paid ahead of common shareholders. The
company has the option to purchase shares from the shareholders at any time.
A brief discussion on the stocks that are traded in the securities market is given below:
Income Stock: Income stocks are those stocks, which have an elongated and prolonged
record of paying high dividends. Usually, a company whose common stock is classified
as income stock is considered a stable and matured company. These companies
normally pay a high percentage of corporate earnings as dividends to common
shareholders. They are also more likely to be sensitive to interest rate fluctuations.
Income stocks are more common with those who need current cash flow from their
stock investments.
Growth Stock: Growth stocks are the stocks of those companies that have high growth
and are expected to experience higher growth in operations or earnings in future. They
are also called glamor stock. These growth rates are to a large extent higher than the
market average. These companies usually reinvest their earnings in capital projects
instead of distributing them as dividends to support their high growth rates. The price of
growth stock as well as the return on this stock tends to be higher than the income stock.
Value Stock: These are the stocks of companies, which are considered undervalued
because, they may be in an industry that is out of favor, or they may be experiencing
management turmoil or they may be restructuring their business operations. These
stocks tend to have lower price or earnings and price-to-book ratios than growth stocks
do. Therefore, their prices are cheap compared to the prices required to be paid for
growth stocks.
Cyclical Stock: These are the stocks of companies, whose earnings follow the business
cycle. Examples of cyclical industries are oil and other natural resources, steel, cement
and housing, etc. These are more risky than other stocks. They are subject to changes in
business cycles. The objective to invest in cyclical stocks is to purchase these stocks
during the economic upturn and sell them before the economic downturn.
Defensive Stock: The dividends of these stocks are constant and earnings are stable
irrespective of the market. These stocks remain stable during the various phases of
business cycle. These perform better during economic downturn and poorly during
expansion. Defensive stocks should not be confused with defense stocks. They are also
called non-cyclical stocks.
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Blue-chip Stock: Stocks of well established companies are called blue-chip stocks.
Their earnings are stable and even the liabilities are not widespread. Stocks of these
companies are financially stable with steady-dividend paying records during both good
and bad periods. These are usually the leaders within their industry. Many investors find
blue-chips attractive because they are of high-quality and have relative stability.
Advantages of Equity Investment

There are many advantages of investing in equity shares of well-managed and

successful companies. The most important of these are:
Capital Appreciation: Equity shares of good companies appreciate in value and thus
act as a partial hedge against inflation. Sometimes, the prices of such shares
appreciate in value faster than the rate of inflation. Consequently, the purchasing
power of an individual’s investment in such shares is generally protected to a great
extent.
Bonus Shares: Successful companies issue bonus shares from time to time subject to
the guidelines issued by the SEBI. Issue of bonus shares increases the paid-up capital of
a company. After bonus shares are issued, shareholders are entitled to dividends not
only on the original shares, but also on the bonus shares.
Annual Dividends: Profitable companies try to maintain a steady rate of dividends. In
fact, many of them also declare interim dividends. The higher the dividends paid, the
higher will be the confidence among the shareholders.
Rights Shares: They are the shares that are offered to the existing shareholders. The
shareholders who do not wish to subscribe for further shares can sell their rights at a
profit, if there is a good demand for them. When such a rights offer is made, the rights
coupons enjoy excellent premium. If an individual does not have money to participate in
the rights issue, he may renounce his rights at a premium and make a profit.
Voting Rights: As an owner of a company, an equity shareholder enjoys voting rights
in the general body meeting of the company. He can also appoint a proxy to vote on his
behalf. It is also the equity shareholders, who elect the company’s directors and
auditors, though in practice, this voting right does not mean much if you hold only a
few shares, except to the extent of enjoying the hospitality of the company once a year
at its general meeting.
Marketability of Equity Shares: Equity shares that are listed, actively quoted, and
traded on stock exchanges, can be bought or sold without difficulty. With
dematerialization and online trading, picking up shares in the Indian markets, and
buying and selling of shares of any listed company has become very easy.
Tax Benefits: There is no wealth tax on shares. Bonus shares are not subject to tax
when they are issued, but profits made through selling rights or bonus shares are
taxable. Shares held for more than 12 months are treated as long-term capital assets. If
one makes profits on the sale of shares held for more than 12 months, he/she has to pay
no tax. Short-term capital gains are treated as current income and are subject to tax at
normal progressive rates of income tax.

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Disadvantages of Investing in Equities

Though equity shares offer a number of advantages, there are some disadvantages
associated with investments in shares.
Changing Market Values: The market values of actively traded equity shares
seldom remain constant. They keep fluctuating; some moderately and some others
violently. At the same time, some shares do not move at all i.e., trading hardly takes
place in those shares. These fluctuations in market prices are likely to cause anxiety
and discomfort for an individual investor. Therefore, individuals trading in equity
shares need to have an in-depth understanding of the basics or the fundamentals of the
market and the company too.
No Guarantee of Profits: There is a guarantee that one will make profits or super
profits by investing in equities. It all depends on how one capitalizes on the timing of
the market; one can make profits, but with little certainty. A strategy that works out for
one investor may not work out for another. There are no hard and fast rules which can
be suggested for success in the stock market. Some investors may gain and many others
may lose. There is even a risk of complete loss of the capital invested. One has to be
prepared for this before investing in this market.
Uncertain Government Policies: Uncertain and changing policies of the
government cause considerable damage to the profitability of companies, which, in
turn, affect the shareholders. A change in the government, of course, leads to
considerable changes in policies. This is a major trigger for the stock markets to
fluctuate.
Oversubscription of New Issues: When you apply for a new issue, which a company
belonging to a reputed group offers, it is likely that the issue may be oversubscribed
several times. Several public issues, including premium issues, have been
oversubscribed more than 50 times. Even though allotment is done on a proportionate
basis, the successful applicants, out of the total applicants of a category are picked by a
draw of lots. There are also chances of not getting an allotment (though not as high as
the lottery draw system). Not getting an allotment will result in a loss of interest during
the intervening period of four weeks. There are often complaints of malpractices by
registrars and delays in refunds. To address this problem, the market regulator SEBI has
reduced the maximum time period for allotment to 30 days from the closure of the issue
in case of fixed price issue, and 15 days in case of book-building issue, failing which,
the issuing company is liable to pay interest @ 15% p.a.
Importance of Timing: Since timing is crucial, investors have to be alert while buying
or selling shares. If an individual happens to miss a good opportunity once, he may have
to wait for a long time for the next one. Therefore, perfect timing of the market plays a
crucial role in deciding profits.
Need for Constant Monitoring: Equity investment needs constant monitoring of
environmental factors such as economic conditions, industry’s prospects, company’s
performance etc.
Professional Guidance is Essential: Professional guidance may make some money in
the beginning through beginner’s luck. This often leads to aggressive buying of shares
at high prices and subsequent panic sales, often at` lowest prices.

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5.7 DERIVATIVES
Derivatives are financial instruments that derive their value from the value of an
underlying asset. These underlying assets could be fundamental securities like stocks
and bonds, commodities and foreign exchange. Derivatives can be used to make profit
when the underlying moves as expected. Traders also use derivatives to hedge or
mitigate risks in the underlying by entering into a contract. Derivatives are classified on
the basis of how they are traded. They are exchange-traded derivatives and over-the-
counter or structured derivatives. The market participants, by entering into derivative
contracts rather than trading in the asset itself, enter into an agreement to exchange
money, assets or some other value at some future date based on the underlying asset.
Derivative instruments were primarily designed to avoid volatility risk in prices. The
most common types of derivatives are future contracts, forwards, swaps and options.
PARTICIPANTS IN DERIVATIVE MARKETS
In order to understand the significance of these markets, it will be necessary to know
about market participants. The participants can be banks, Financial Institutions (FIs),
corporates, brokers, individuals etc., and all these can be classified into three categories:
• Hedgers,
• Speculators, and
• Arbitrageurs.
Hedgers: A transaction in which an investor seeks to protect a position or anticipated
position in the spot market by using an opposite position in derivatives is known as a
hedge. A person who hedges is called a hedger. These are the people who are exposed
to risk due to their normal business operations and would like to eliminate or minimize
or reduce the risk. There are many financial vehicles to accomplish like forwards,
swaps, options etc. For example, an exporter whose receivable is denominated in US
dollars is exposed to the risk of adverse movements of US dollars.
Speculators: A person who buys and sells a contract in the hope of profiting from the
subsequent price movements is known as a speculator. These people voluntarily accept
what hedgers want to avoid. A speculator does not have any risk to hedge. He/she has a
view on the market and based on the forecast, the speculator would like to make gains
by taking long and short positions on the derivatives. They perform a valuable
economic function by feeding information and analysis into the derivatives markets. In
general, speculators can be the counterparties for hedgers.
Arbitrageurs: These are the third important participants in the derivative market.
Arbitrage means obtaining risk-free profits by simultaneously buying and selling
identical or similar instruments in different markets. For example, one could buy in the
cash market and simultaneously sell in the futures market. The person who does this
activity is called an arbitrageur. Arbitrageurs consistently keep track of the different
markets. Whenever there is a chance of getting profit without any risk they will take
position and make riskless profit. They perform a very valuable economic function by
keeping the derivatives’ price and current underlying assets’ price closely consistent.
Arbitrageurs are in the same class as speculators to the extent that they have no risk to
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hedge. However, they buy to make gains by identifying mispriced derivatives or
inefficiencies between the markets for derivative and the corresponding underlying assets.
While speculators help in enhancing liquidity, arbitrageurs help in price discovery
leading to market efficiency.
EXCHANGE-TRADED DERIVATIVES
They are standardized derivative contracts which are traded on a recognized exchange.
Examples of such derivatives are futures and options.
Futures: These are organized contracts traded on a recognized exchange and are liquid
in nature. They refer to the contract to buy or sell a specified commodity of quality at a
future date. Each contract under this is settled with the clearing corporation. There are
two types of future contracts. Commodity future is a future contract in a commodity and
financial future is a future contract in a treasury bond, treasury note etc. Futures contract
gives the holder the obligation but not the right to make or take delivery on the basis of
the contract.
Options: These are financial instruments wherein the holder is given the right but not
the obligation to buy or sell the option at a specific price on or before a specific date.
There are two types of options – call option and put option. Call option gives the buyer
the right to buy the underlying asset. Put option gives the buyer the right to sell the
underlying asset. The seller is required to buy/sell the asset at an agreed price. The
buyer may sometimes choose not to exercise the asset and let the agreement expire.
Majority of the options are of European or American style. European style includes
exercising the option only after its expiration. American style includes exercising the
option on or before its expiration.
Types of options apart from the above discussed call and put options, the other types of
options include the following:
Exchange Traded Options: They are also called listed options. They are a class of
exchange traded derivatives. They have standardized contracts and are settled through
clearing house. They include stock options, commodity options etc.
Currency Options: The inter-bank market participants i.e., banks, are the major
participants in the currency options market. It is a contract that grants the right to the
holder but not the obligations to buy or sell currency at a specified exchange rate during
a specified period of time. A currency call is similar to a call on a stock that gives the
holder the right to buy a fixed amount of foreign currency at a fixed exchange rate on or
before the option’s expiration date. A currency put gives the holder the right to sell a
fixed amount of foreign currency at a fixed exchange rate on or before the option’s
expiration date.
Currency options are identified by the five parameters viz., time to expiration, currency
pair, option type, strike and the face value.
Futures Options: In futures options, the underlying asset of an option is a futures
contract. These futures may be index futures, currency futures or interest rate futures. In
the United States, options on futures trade only on futures exchanges. Each futures
exchange trades options on its active futures contracts. Financial instruments account
for the majority of futures options. Options on foreign currency constitute the next
largest category. Options on energy and wood product futures and other agricultural
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commodities are traded relatively in fewer quantities. Futures options tend to be more
popular than options on the underlying assets, due to the cost advantage of delivering
the futures options instead of the asset as the contracts are exercised usually before the
expiry date. Transaction charges on future options are generally lower than those on the
current options.
Interest Rate Options: An interest rate option holder gets the right to buy or sell the
underlying cash instrument or the financial futures contract. The treasurer may use these
options to protect his position from rising interest rates or falling interest rates by
buying put options or call options respectively. These options are both exchange traded
and over-the-counter instruments.
Caps, Floors and Collars: Interest rate caps and interest rate floors are special types of
borrowing and lending options, which are meant for long-term hedging.
Interest Rate Caps (Caps): A cap is a series of interest rate options, which guarantees a
fixed rate payable on a borrowing over a specific time period at specific future dates. If
interest rates rise above the agreed cap rate then the seller pays the difference
between the cap rate and the interest rate to the purchaser. A cap is usually bought to
hedge against a rise in interest rates and yet is not a part of the loan agreement and may
be bought from a completely different bank/writer. In a cap, usually an upfront fee is to
be paid to the bank/writer. The cap guarantees that the rate charged on a loan at any
given point of time will never exceed the current existing rates or the cap rate.
Interest Rate Floors (Floors): A floor is an agreement where the seller agrees to
compensate the buyer if interest rates fall below the agreed upon floor rate. It is similar
to a cap, but ensures that if the interest rate falls below a certain agreed floor limit, the
floor limit interest rate will be paid.
Collars: A collar is a combination of a cap and a floor where you sell a floor at a lower
strike rate and buy a cap at a higher strike rate. Thus, they provide protection against a
rise in interest rates and some benefit from a fall in interest rates.
Over-the-Counter Options: A very popular type of options that companies or financial
institutions trade with each other, rather than on the stock exchanges.
These options seldom match the features of exchange-traded options. Bermudan and
Asian options are some Over-The-Counter options. The popularity of these options has
resulted in many exchanges offering Flex options, in which the terms agreed are
different from the usual ones in the exchange, in an effort to compete with the Over-
The-Counter options business.
Zero Cost Options: Zero cost options are types of long option positions financed by
the sale of other options. They can be divided into constituent options that have the
same strike price. Hedging is also possible by buying out-of-money puts and
simultaneously selling in-the-money calls. The main advantage of this type of options is
that it entails premium.
Exotic Options: Options, which are more complicated than the standard European or
American options, are referred to as exotic options. Most of them are traded in the
over-the-counter market and are designed by financial institutions to meet the specific
requirements of the clients. These are used in the marketplace either for yield

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enhancements or disaster insurances. Some of the different types of exotic options
include following:
i. Leaps: Leaps mean long-term equity anticipation securities. They are safer when
compared to traditional options, stock movements over longer periods are
comparatively easy to predict. Leaps allow investors to lock-in a fixed price for
the underlying security. They can be exercised at any time before expiration,
which is generally 36 months after purchase.
ii. Basket: Basket is an option whose underlying asset is a portfolio of
commodities, securities or currencies. Basket options are cash-settled. These are
popular to hedge foreign exchange risk. The value of basket option is regarded as
a single asset. These options are attractive due to their low cost; generally, an
option on a basket is cheaper than buying options on the individual components.
iii. Asian Options: These are the options whose pay-off depends on the average
price of the underlying asset during a pre-specified period of the life of the
option. Asian options are used to avoid manipulation of the prices of the options
on the underlying asset by the traders of the options, which might turn harmful to
the issuer of the underlying asset.
iv. Barrier Options: These are the options whose pay-off depends on whether the
underlying asset price reaches a certain level during a certain period of time.
There are numerous variations of barrier options. A barrier option may be a
knock-in or a knock-out option. A knock-in option is one that comes into
existence only when the underlying asset price reaches a certain barrier. A
knock-out option is one that ceases to exist when the underlying asset price
reaches a certain barrier. Barrier options are cheaper than plain vanilla options.
v. Bermudan Options: These are non-standard American options in which early
exercise is restricted to certain dates during the life of the option, but the exercise
price is always the same.
vi. Binary Options: These are the options, which have discontinuous pay-offs.
For instance, these options pay zero if stock price is below the strike price and
pay a fixed amount.
vii. Chooser Options: A chooser option is one in which the option holder has a
choice to make an option either a call or a put after a specified period of time.
These are also called as-you-like-it options. These are useful for hedging a future
event that has a high level of uncertainty in occurrence.
viii. Compound Options: These are the options on options. There are four main
types of compound options viz., a call on a call; a call on a put; a put on a call;
a put on a put. The pay-off in these options depends on the number of
installments used for exercising the call.
ix. Forward Start Options: These are the options paid for now but that will start at
a certain time in future. The exercise price is specified to be the current price at
the beginning of the option’s life. For a forward start option, there are three dates
to consider viz., the valuation date, the date the option life begins, and the expiry
date of the option.

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x. Flex Options: These are the options where the traders agree to non-standard
terms. These non-standard terms may involve strike prices or exercise dates.
These options were created by the stock exchanges, which dealt in options in
order to attract back the investors who were showing more interest towards
Over-The-Counter options.
xi. Look Back Options: The pay-offs from these options depend on the maximum
or minimum stock price reached during the life of the option. The investor can
buy the underlying asset at the lowest price achieved during the life of the
option. Similarly, if the investor holds a look back put option, s/he can sell the
underlying asset at the highest price achieved during the life of the option. The
investor buys a look back call option on a stock that is European.
xii. Rainbow Options: These are options involving two or more risky assets. For
example, there is an option called basket option whose pay-off depends on the
value of a portfolio of assets.
xiii. Exchange Options: These are the options to exchange one asset for another
under which in return for foregoing one asset, the investor can receive another
asset.
xiv. Homemade Artificial Options: Homemade artificial options is possible to
create patterns similar to options in order to produce the pay-off features of the
options market for other securities like treasury bills. This is a type of portfolio
insurance.
xv. Ratchet Options: A series of consecutive forward start options is called a
ratchet option. Originally, the strike price for a ratchet option is set; however, it
is reset to match the prevailing asset price on a set of predetermined dates.
Generally, the intrinsic value is locked-in when the strike price is reset. The
profit can be paid out at each reset date or it can be gathered until the last
maturity. Ratchet options are mainly popular during periods of high volatility,
because they facilitate the investor to lock-in returns periodically rather than risk
losing gains that have accumulated. These options allow the buyer to lock-in
gains on the underlying asset during set intervals over the lifetime of the option
by resetting the strike price annually or semi-annually. Ratchet options can be of
two types – regular ratchet options, and compound ratchet options. Regular
ratchet option refers to the simple ratchet explained till now. However, a
compound ratchet option refers to the standard ratchet option, increasing the
notional value without carrying forward each return gained at reset dates.
Generally, no payouts are made at each reset date and the total amount is given
only at the end.
xvi. Quanto Options: Quanto is short for quantizing-adjusting option. It is a
derivative denominated in one currency that settles in another. Generally, the
underlying and the strike price are in foreign currency and the derivative is paid
out in domestic currency. In order to protect the investor from fluctuations, the
investment is paid at a fixed exchange rate. This derivative can take the form of
either a future or an option. It is also called a cross currency derivative. This
situation arises when the investor is confident about the stock but uncertain about
the performance of the currency in which it is denominated.
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xvii. Option on Option: Option on option provides the investor with a put/call
written on the option. It gives the holder of the option a right to buy another
option. The price of an option on option will be low because the option value is
below the value of the underlying asset.
xviii. Margrabe Options: These options allow an investor to exchange the units of
one asset for the units of another asset at maturity.
xix. Exchange on an Exchange Option: Exchange on an exchange option provides
an investor to exchange the units of an asset for an exchange option on that asset
with a second asset.
OTC DERIVATIVES
These contracts are traded directly between two persons without any recognized
exchange. Swaps, forward contracts, exotic options are all traded using OTC
derivatives. The most common OTC derivative is a forward contract.
Forward Contract: Forward contract is a contract between two parties to buy or sell an
asset at a future time for certain price agreed today. Forward contracts like other
derivatives are used to hedge the risk. They offer flexibility in terms of designing price,
quantity, quality, delivery time and place. Default risk and credit risk are high in case of
forwards. The price agreed upon is called delivery price.
Futures contracts are a development over forward contracts. A futures contract can be
defined as an agreement to buy or sell a standard quantity of a specific instrument at a
predetermined future date and at a price agreed between the parties through open
bidding on the floor of an organized futures exchange. Every futures contract is a
forward contract but more standardized. A futures contract gives the obligation to the
holder to make or take delivery under the terms of the contract.
There are some basic differences between forwards and futures as illustrated below:
Particulars Financial Futures Market Forwards Market
Location Futures Exchange. No fixed location.
Size of Contract Fixed (Standard). Depends on the terms of
contract.
Maturity/ Fixed (Standard). Depends on the terms of
Payment Date contract.
Counterparty Clearing House. Known bank or client.
Market Place Central Exchange floor Over telephone with the
with the worldwide worldwide network.
network.
Valuation Marked-to-market No unique method of valuation.
everyday.
Variation Margins Daily. None.
Regulations Regulated by the Self-regulated.
in Trading exchanges concerned.
Credit Risk Almost non-existent Depends on the counterparty.
except in emerging
markets.

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Particulars Financial Futures Market Forwards Market
Settlement Through clearing house. Depends on the terms of
contract.
Liquidation Mostly by offsetting the Mostly settled by actual delivery.
positions, and very few Some by cancellation at a cost.
by delivery.
Transaction Costs Direct costs such as Direct costs are generally low,
commission, clearing indirect costs are high in the
charges, exchange fees form of high bid-ask spread.
are high; indirect costs,
bid-ask spreads are low.
Source: Academic Wing Research Team.
Table 2: OTC Derivatives
SWAPS CONTRACT
A contract between two parties in which the parties: (a) promise to make payments to
one another on scheduled dates in the future, and (b) use different criteria or formulas to
determine their respective payments. There are four classes of swaps: interest rate,
equity, currency and commodity. As forwards and futures are used to hedge risk, swaps
are used to lengthen or shorten maturities, raise or lower coupon rates.
INTEREST RATE SWAPS
An interest rate swap is defined as an agreement between two or more parties who agree
to exchange interest payments over a specific time period on agreed terms. The interest
rates agreed may be fixed or floating. If there is an exchange of interest obligations,
then it is termed a liability swap. If there is an exchange of interest income, then it is
called an asset swap.
The simple interest rate swaps are popularly called plain vanilla swaps. There are many
variants on the plain vanilla swaps. These swap variants are the major innovations in the
swap market and are tailored to suit the needs of different customers.
The basic swap techniques can be explained using plain vanilla swap concept. The plain
vanilla swaps are those swaps where fixed rate obligations are exchanged for floating
rate obligations over a specific period of time on a notional principal. They are also
called coupon swaps or generic swaps.

Figure: Swap Arrangement

A swap transaction can be routed through an intermediary like a bank.

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Other Types of Interest Rate Swaps
Apart from liability swap, asset swap and plain vanilla swap, the other types of Interest
Rate Swaps are discussed below:

Basis Swap: A swap in which a stream of floating interest rates is exchanged for
another stream of floating interest rates is known as basis swap. This swap is possible
when, both the floating interest rate streams are based on the same structure, but
different instruments. The two interest rate streams are calculated using the same index,
but with different tenor. The two interest rate streams are calculated using the same
index and the same tenor, but with one of the rates having margin.

Forward Swaps: Forward swaps are those swaps in which the commencement date is
set as a future date. Thus, it helps in locking the swap rates and using them later as and
when needed. Forward swaps are also known as deferred swaps (different from deferred
rate swaps) as the start date of the swap is delayed (deferred). This is attractive to those
users who do not need funds immediately but would like to benefit from the existing
rates of interest.

Deferred Rate Swaps: Deferred rate swap is different from a forward rate swap, in which
it allows the fixed rate payer to enter into a swap at any time up to a specified future date.
Thus, it works to the convenience of the fixed rate payer because the payment can be
deferred until a time when the rates are lower so that he ends up paying less than what
would have been paid, if paid at the rate on the commencement date. It is particularly
attractive to those users of funds who need funds immediately but do not consider the
current rates of interest very attractive and feel that the rates may fall in future.

Callable Swaps: A callable swap gives the holder, i.e., the fixed rate payer, the right to
terminate the swap at any time before its maturity. This right has a fee in terms of a
higher fixed rate at the commencement of the agreement than what would normally be
charged and which is calculated as a percentage of the swap’s notional principal.

Puttable Swaps: A puttable swap gives the seller of the swap (the floating rate payer)
the right to terminate the swap at any time before its maturity. If the interest rates rise,
the floating rate payer will terminate the swap. The option premium in this case will be
a higher floating rate charged at the beginning of the swap. Sometimes, a termination
fee is also charged which is calculated as a percentage of the swap’s notional principal.

Extendible Swaps: In an extendible swap, the fixed rate payer gets the right to extend
the swap maturity date. If the interest rates rise and are expected to rise further, then
such an extendible swap works to the advantage of the fixed rate payer since he is
required to pay less than the current rates. The premium charged for this right will be
a higher fixed rate than the prevailing rates at the beginning of the agreement.

Rate-Capped Swaps: An interest rate swap, which incorporates the cap feature, is
called a rate-capped swap. If a floating rate payer anticipates a rise in interest rates then
he can purchase a cap at a fee payable upfront to the fixed rate payer so that the floating
rate payable cannot exceed the capped rate. This gives more protection to the floating
rate payer. He can pay an upfront fee to the fixed rate payer. Another type of rate-
capped swap is the mini-max swap, which has both a floor and a ceiling rate to the
floating rate.
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Zero-Coupon Swaps: In a zero-coupon swap, the fixed rate payer makes a single fixed
payment at the maturity of the swap from the proceeds of the bond repayment. It is a
variation of the plain vanilla swap. The interest is calculated on a discount basis, while
the floating rate payer makes periodic payments.
Amortizing Swaps: If the interest rates are fairly stable then the floating payments are
also reduced over time. This swap is particularly useful if a swap is undertaken to
manage the risk arising from mortgage loans. Since the principal on a mortgage loan is
amortized over the life of the loan, an amortizing swap is particularly useful for
managing the associated interest rate risk.
Amortized Swaps: These swaps are the ones where the notional principal amount on
which interest is paid decreases according to a predetermined schedule mostly based on
a sinking fund. With a plain vanilla, the amount remains the same.
Accreting Swaps: The floating rate payments can be converted into fixed rate payments
through an accreting swap where the principal amount increases every time additional
loan is availed. It is the same as amortized swap, except that the notional principal
amount increases according to a predetermined schedule. Such a swap could be used by
a bank, which has agreed to lend increasing sums to its customers over time so that they
may fund projects.
Roller-Coaster Swaps: Roller-coaster swap is a combined feature of both amortized
swap and accreting swap, i.e., the notional principal increases and decreases during the
life of the transaction, going up and down according to a schedule agreed at the time of
the deal.
OPTIONS ON SWAPS
Options on swaps or swaptions can be written on any kind of swap and give the holder
the option to enter into swaps at a certain date in the future on the terms agreed at the
time of purchase of the swaption. They ensure that the interest paid on a swap in future
will not exceed a certain pre-decided level. Swaptions give a right and not an obligation
to the buyer to exercise his choice. Swaptions can be either American or European.
European swaptions are more popular and can be exercised only on maturity, while the
American swaptions can be exercised any time before maturity.
Swaptions can be either call swaptions or put swaptions.
Call Swaption: A call swaption gives its buyer the right to enter into a swap as a fixed
rate payer. The writer of the call swaptions will be a floating rate payer if the option is
exercised.
Put Swaption: Here, the buyer gets the right to enter into a swap as a floating rate
payer. The writer becomes the fixed rate payer when the option is exercised.
OTHER TYPES OF SWAPS
Having discussed the interest rate swap, the other three different types of swaps are
given below:
Commodity Swaps
In a commodity swap, the counterparties make payments based on the price of a fixed
amount of a certain commodity in which one party pays a fixed price for the good and
the other party pays a market rate over the swap period. The first commodity swap took
place in the Chase Manhattan Bank, New York, in 1986.
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In order to regularize the commodity swaps, the Commodity Futures Trade Commission
(CFTC) has come out with the following rules and regulations:

i. No commodity swap can be terminated by one of the parties, without the consent
of the other party.
ii. Parties should enter into contracts only for the commodities they deal.
iii. Only institutions and companies can indulge in commodity swaps. Individuals
are not allowed to do so.
iv. Mark-to-market process with variation margins is not allowed.
v. Collateral or margin loans are not permitted for commodity swaps.
Assume that you are a wheat farmer producing 400 tons of wheat every year. You are
not sure about the price of wheat for the next five years due to unpredictable nature of
government policies that fix the price every year. You can avoid the risk arising from
fluctuating nature of prices by using a swap where you receive a fixed price and pay a
floating rate to the counterparty. In this manner, you are assured to receive a fixed
amount every year for your commodity for the next five years.

Equity Swaps
An equity swap means an exchange of dividends earned and capital gains made on a
portfolio, which is based on a stock index against periodic interest payments.
Equity swap is similar to an interest rate swap, in that it has a fixed period, a fixed rate
payer, and a floating rate payer.
Currency Swaps
A currency swap is a contract involving the exchange of interest payments on a loan in
one currency for fixed or floating interest payments on equivalent loan in a different
currency. Currency swaps may or may not involve initial exchange of principal. A plain
vanilla currency swap is a fixed-to-fixed currency swap in which each party pays a fixed
payment on the loan it takes.
Other types of currency swap include, fixed-to-floating, fixed-to-fixed, circus swap, and
exotic swap, which are given below:
Fixed-to-Floating Currency Swaps (Non-amortizing): As in a currency swap, the
parties exchange principal at the outset of the swap but one party pays a fixed rate of
interest on the foreign currency it receives and the other party pays a floating rate of
interest rate on the foreign currency it receives. It is a plain vanilla currency swap. At
the swap’s maturity, there is a re-exchange of principal amounts. Interest payments are
periodically exchanged during the life of the transaction.
Fixed-to-Fixed Currency Swaps (Non-amortizing): Fixed-to-fixed currency swap is
identical to the fixed-to-floating currency swaps except that instead of a fixed and a
floating rate of interest, both parties pay fixed rate of interest. Having a single
agreement or two agreements for swapping can do this.
Circus Swaps
Here two fixed-floating currency swaps are combined to form a fixed-to-fixed currency
swap which is also called a circus swap. Combining a currency swap and an interest rate
swap too can create it with floating rate or both having LIBOR-based pricing.

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Exotic Swaps
Like exotic options, exotic swaps are new products in the swap market. Some of the
exotic swaps are:
• Delayed Start Swap: Delayed start swap is a regular plain vanilla swap
exchanging cash flows in one index against cash flows in another index with the
exception that the start date of the swap is not immediate. These are used to
match the swap’s cash flows with their existing cash flows.
• Collapsible Swap: This swap is simply a combination of the plain vanilla swap
with a swaption on that swap. A swaption is an option on the swap. In this case,
the swaption gives us the right but not the obligation to enter into a swap with
the same terms except that we will be buying fixed rates and receiving floating
rates. The cash flows will offset and the swap will be deemed to be closed since
the swaption is with the same financial institution with which we have contracted
the swap.
• Indexed Principal Swap: Normally, interest rate swaps (and currency swaps,
etc.) involve a fixed notional amount. The indexed principal swap is a variant in
which the principal is not fixed for the life of the option but tied to the level of
interest rates. Consider an indexed principal swap in which one is obligated to
pay fixed rates and receive floating rates and in which the size of the principal
increases as interest rates decline. This kind of indexing means that a higher
principal reduces the risk of lower interest rates.
• The swap can be constructed by adding an option to the swap that pays a definite
amount of principal if interest rates fall below a pre-set level. Thus, when interest
rates decline, one need not worry about the value of the swap getting reduced
because the option on the swap offsets the swap’s reduced value in case the
interest rates fall.
• Asset Swap: Asset swap is an exchange of fixed and floating investments rather
than swapping of regular fixed and floating loan interest rates. Here, a fixed
investment such as bond with assured coupon payments is swapped for a floating
investment like index fund. These are used for many reasons but generally used
to transform and improve the character of an investor’s asset. In order to generate
the expected cash flows, an existing market instrument is combined with an
accompanying swap or series of swaps.
CREDIT DERIVATIVES
Credit derivatives are a financial instrument whose value is derived from the credit risk
on an underlying asset. Credit derivatives are bilateral contracts. Credit risk arises due
to default of the debtor. It is therefore essential for the investor to assess and mitigate
credit risk through efficient hedging strategies. Credit derivatives are divided into two
categories – funded, and unfunded credit derivatives.
UNFUNDED CREDIT DERIVATIVES
An unfunded credit derivative is a bilateral contract between two parties, where each
party makes payment. Unfunded credit derivatives are of two types: Credit Default
Swap (CDS), and Total Return Swap (TRS).
Credit Default Swap (CDS): Credit Default Swap is also known as default swap. It is
one of the most important innovations of credit derivatives market. 30% of the credit
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derivatives market is occupied by CDSs. It is a contract between the buyer and the
seller. CDSs can be used for speculation, arbitrage and hedging. The buyer of the credit
swap receives credit protection and the seller guarantees the creditworthiness of the
product. Buying the credit protection shortens the credit risk and selling the credit
protection lengthens the credit risk. Protection exists till specified maturity date. The
protection buyer makes payments to the protection seller till a credit event or maturity
whichever occurs first. This is referred to as premium leg. When the protection seller
makes payment to the buyer even if the credit event doesn’t occur before maturity, it is
referred to as protection leg.
Total Rate of Return Swap (TROR): Total rate of return swap is also called as total
return swap. It is a contract where one party pays another a set rate and the other party
makes payment based on the return of the assets. It transfers both credit and market risk
of an underlying asset.
FUNDED CREDIT DERIVATIVES
Under this the potential seller makes initial payments that settle any potential credit
events. The two different types of funded credit derivatives are Credit linked notes, and
Collateralized Debt Obligations (CDOs).
Credit Linked Notes: These are used by borrowers to hedge against credit risk and by
investors to increase their yield. It is defined as funded as the protection seller pays the
entire notional amount. CLNs are useful to those investors who are unable to trade in
derivatives securities due to regulatory or other impediments.
Collateralized Debt Obligations: These are asset backed securities issued by Special
Purpose Vehicles (SPV). Collateralized Debt Obligations are used by banks and
financial institutions to manage credit risk. This is a mechanism of converting illiquid
loans into marketable securities. These are classified into two types – collateralized
mortgage obligations and collateralized loan obligations.

Self-Assessment Questions – 2

a. Who are the participants in the Derivatives Market?

…………..…………………………………………………………………….

…………..…………………………………………………………………….

…………..…………………………………………………………………….

b. What do you mean by interest rate swap?

…………..…………………………………………………………………….

…………..…………………………………………………………………….

…………..…………………………………………………………………….

5.8 MUTUAL FUNDS AND STRUCTURED PRODUCTS

The concept of mutual funds is not new. Originating in the US and moving on to the
UK in the 1930s, this culture entered India only in the 1960s with the setting up of UTI
in 1963. Mutual Funds are financial intermediaries in the investment business. In a
mutual fund, the money collected is invested by the fund manager in stocks, bonds, and
other securities across companies. It issues units to the investor depending on the
amount of money invested. The investors are called unit holders. Unit holders receive
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interest/dividend and gain through capital appreciation. The main objective behind
setting up mutual funds is to provide an opportunity for lower income groups to acquire
property without much difficulty in the form of shares, to cater to the needs of
individual investors, whose means are small and to manage the investor’s portfolios in a
manner that provides regular income, growth, safety, liquidity and diversification.
Mutual funds became popular because they offer certain advantages like diversification,
investor’s expertise in managing personal investments, liquidity, convenience and
economies of scale. At the same time, they have certain disadvantages too like dilution,
fluctuating returns, evaluating funds and costs. A detailed description of mutual funds,
characteristics, types, advantages and disadvantages is given in the chapter titled
‘Mutual Funds’.
STRUCTURED PRODUCTS
Structured products are synthetic investment instruments specially created to meet
specific needs that cannot be met from the standardized financial instruments available
in the markets. Structured products can be used as an alternative to a direct investment
as part of the asset allocation process to reduce risk exposure of a portfolio or to utilize
the current market trend. They are issued by investment banks. They have fixed
maturity and have two components – risk element and capital protection.
Structured investments arose from the needs of companies, which want to issue debt
more cheaply. Traditionally, one of the ways to do this was to issue a convertible bond,
i.e., debt that under certain circumstances could be converted into equity. Interest in
these investments has been growing in recent years and high-net worth investors now
use structured products as a way of portfolio diversification. Structured products are
also available at the mass retail level – particularly in Europe, where national post
offices, and even supermarkets, sell investments on these to their customers.
The benefits of structured products include principal protection, enhanced returns, and
reduced volatility. Typical examples of structured products include the following:
• Flow through share limited partnerships.
• Funds of income trusts.
• Funds of hedge funds.
• High yield bond portfolios.
• Covered call writing.
• Split share corporations.

5.9 RISK ANALYSIS OF INVESTMENT PRODUCTS

Before proceeding to know how risk arises in investments, let us first understand the
two terms that are often used interchangeably – risk and uncertainty. Risk in financial
context is often used as a synonym of uncertainty. In the context of an investment, a
situation of certainty is one in which the return from the investment is known for sure.
Let us say, an individual invests in government securities and holds them to maturity.
The individual can be sure about the redemption of the amount invested on maturity and
payment of interest. Therefore, his rate of return is known for sure.
The term risk, in the context of investments, refers to the variability of the expected
returns. It is an attempt to quantify the probability of the actual return being different
from the expected return. Though, there is a subtle distinction between uncertainty and
risk, it is common to find the use of both the terms interchangeably.
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Depending on the nature of investment, the risk will vary. The types of risks associated
with various investment products are discussed below:
Capital Risk: Capital risk is a risk an investor faces that he/she may lose all or some
part of the initial investment. For example, if an investor invests Rs.10,000 in the stock
market he may face the risk of losing the capital.
Currency Risk: Currency risk is a risk that arises from change in the price of one
currency against another. Whenever investors have assets invested in another country,
they face the currency risk if their position is not hedged. Currency risk exists regardless
of whether you are investing domestically or abroad.
If you invest in your home country, and your home currency devalues, you have lost
money. Any and all stock market investments are subject to currency risk, regardless of
the nationality of the investor or the investment, and whether they are the same or
different. The only way to avoid currency risk is to invest in commodities, which hold
value independent of any monetary system.
For example, if you are a US investor and you have stocks in Canada, the return that
you will realize is affected by both the change in the price of the stocks and the change
of the Canadian dollar against the US dollar. Suppose that you realized a return in the
stocks of 15% but if the Canadian dollar depreciated 15% against the US dollar, you
would make a small loss.
Liquidity Risk: Liquidity risk refers to the uncertainty of the ability of an investor to
exit from an investment when he desires. The exit route primarily depends on the
secondary market where the securities are traded. Though the issuer may step into
provide liquidity in the form of buyback of shares, options on bonds, redemption of
securities, all such provisions have a time dimension, which is determined by the issuer.
However, the term liquidity refers to the ability of the investor to exit according to his
requirements. When an investor approaches the secondary market for liquidity, his
concerns are twofold: Time taken for liquidation and price realization. If the security is
illiquid, it may become necessary to sell at a price lower than the market price to reduce
the time taken for liquidation. Such discount/reduction in price is called price
concession. Hence, price concession on a security and liquidity is inversely related.
Financial Risk: Financial risk arises from the financing pattern of the investee
company. In other words, it is the variability of the returns from investments made in
the company that is brought about by the financing mix used by the company. If a
company uses only equity, its financial risk will be relatively less, as there are no
obligatory payments to be made. A company using debt will carry more risk, as the
obligatory payments on account of interest and repayment of principal have to be met
before any money is available for distribution to the equity investors. And, inability to
meet the obligations may result in compulsory liquidation. These factors create
variability in the profits of the firm and its share price.
Market Risk: Market risk is also called systematic risk. This risk arises when the value
of the investments declines over a period of time because of economic changes or due to
other events that have a large impact on the market. The four standard market risk
factors are – equity risk, interest rate risk, currency risk and commodity risk.

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Business Risk: Business risk can be easily understood in the context of an investment
in a business entity. This risk is the variability of returns introduced by the nature of
business of the entity invested in. Changes in the prices of raw materials and finished
goods, changes in supply and demand for raw materials and finished goods, changes in
wage rates, changes in fuel costs, changes in the economic lives of assets, changes in tax
laws, and changes in operating costs are some of the factors which cause business risk.
These factors have a direct impact on the profitability of the invested and these, in turn,
influence the share price and the dividend payment or the ability of the firm to repay its
debt with interest. The share price at the time of sale and the dividend payments or the
interest payments and redemption amount determine the return to an investor. If we
need to draw a parallel in the context of a consumer credit to an employee, it can be
related to job security, career prospects etc. In the context of a government bond, it may
mean the ability of the government to generate adequate revenues. However, this
becomes less relevant because of its ability to monetize a deficit.
Interest Rate Risk: The risk that the investment value may change due to change in the
interest rate. Interest rate risk affects the value of the bond more than the stock. Increase
in interest rates reduces the value of the bond.

5.10 SUMMARY
Investments are made with the objective of getting safe returns without speculating or
gambling.
Investments can be categorized into financial investments and real investments.
Financial investments can be further classified as security form of investments and non-
security form of investments.
An investor can choose from a wide array of investments. The security form of
investments includes stocks, bonds, and mutual funds, to name a few. The non-security
form of investments includes national savings certificates and real investments such as
gold, precious metals, real estate, etc.
There are other financial instruments called derivative instruments like forwards,
futures, swaps and options, which do not have any value on their own but derive their
value from the underlying asset.
Derivative instruments are usually used as hedge or speculative instruments.
Mutual funds are the most preferred instrument, especially among the people with
meager savings and those who do not have the time and necessary knowledge to
monitor the portfolio.

5.11 GLOSSARY
Time-weighted Return is a method of measuring the performance of a portfolio over a
specific period of time. Effectively, it is the return on the rupee invested in the portfolio
at the beginning of the measurement period.
Bond is an instrument of loan raised by the government or a company, against a
specified interest rate and a promised date of repayment. Debentures are bonds secured
by mortgage against company assets as distinguished from fixed deposits which are
unsecured.
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Gilt-edged Securities are usually government securities and bonds; a very safe asset to
hold, as the government is responsible for the payment of interest and refund.
Fixed Income Investments are investments such as fixed deposits, non-convertible
debentures, monthly income plans, or any other government bonds or certificates which
yield a fixed rate of interest. When the rate of inflation is low, these may provide a
steady and adequate return. With high inflation, both their capital value and yield value
are eroded.
Coupon is the interest payment on a bond or debenture.
Zero Interest Bonds/ Debentures are the new type of security permitted to be issued
by the companies. These bonds or debentures offer no interest payments and the same
will be either fully or partly convertible into equity shares of the company at the choice
of the bond/debenture holder or they will be redeemable debentures/bonds.
Yield is the return earned by the investor or shareholder on his investment.
Yield-to-Maturity is the return obtained on holding a bond to maturity. The yield-to-
maturity assumes that any coupon payments received before redemption can be
reinvested at this yield. This implies a flat yield curve and is hence not a realistic
assumption. The discount rate that equates the PV of the cash flow to its market value.
Structured Product is a pre-packaged investment strategy which is based on
derivatives.
Future is a term used to designate all contracts covering the purchase and sale of
physical commodities or financial instruments for future delivery on a commodity
exchange.
Derivative is a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes.
Option is an instrument that conveys the right but not the obligation in future
transactions on some underlined security, forward or future.
Swap is basically an exchange of payment streams between two counterparties based on
the underlying asset or liability which could be a currency or interest to maximize
revenues and minimize the finance costs.

5.12 SUGGESTED READINGS/REFERENCE MATERIAL

• Jonathan Reuvid, Handbook of Personal Wealth Management, Korgan Page Ltd,
2010
• Dun, and Bradstreet. Wealth Management. Mc Graw Hill, 2009.

5.13 SUGGESTED ANSWERS

Self-Assessment Questions – 1
a. Investment Constraints
• Liquidity
• Age
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Investment Products
• Need for Regular Income
• Time Horizon
• Risk Tolerance
• Tax Liability.
b. Investing style is basically determined by the amount and type of resources, time
constraints, risk tolerance level and alternative means.

Self-Assessment Questions – 2
a. Parties involved in the Derivatives Market-
1. Speculators: A speculator operating in Derivatives market is the one,
who buys or sells futures contracts of the commodities without any
countervailing transactions in the spot market with the intention of
making profit from the fluctuations in the prices. They can earn profit if
they can predict the market movement correctly. Thus speculators are
risk-taking investors, who trade with a higher-than-average risk to earn
higher-than-the average profit.
For ex. Mr. R. Shaha, a bullish speculator for Jute buys Sep .contract
@Rs.1600. per quintal with the expectation that it would move up to
Rs.1700 and he would make profit of Rs.100 per quintal .
Mr. T. Kothari, a bearish speculator for Jute sells Sep .contract
@Rs.1600 per quintal with the expectation that it would fall to Rs.1500
and he would make profit of Rs.100 per quintal by placing buy order for
the same
2 Hedgers: Hedgers are those participants in this market who want to
protect their businesses from adverse price changes, which could dent the
profitability of their businesses. They do so by taking an equal but
opposite position in the futures market.
3. Arbitragers: Arbitragers are those players, who attempt to profit from
price inefficiencies in the market. An arbitrager makes simultaneous
trades in two different market, which offset each other and gains risk free
profit Arbitragers lock in profit when they spot cash and carry arbitrage
opportunity; or reverse cash and carry arbitrage opportunity.
b. Interest Rate Swap: An interest rate swap is an agreement between two or
more parties who agree to exchange interest payments over a specific time period
on agreed terms.

5.14 TERMINAL QUESTIONS

A. Multiple Choice Questions
1. Conservative investors aim _____________.
a. To gain large amount of profit
b. To maintain initial investment
c. To gain high current yield
d. Only (a), (b) and (c) of the above
e. To gain large amount of trading income.

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2. Money market instruments have maturity period of ____________or less.
a. 3 years
b. 10 years
c. 5 years
d. 1 year
e. 7 years.
3. In futures market, the contract is _________.
a. Customized
b. Standardised
c. Based upon buyer’s requirement
d. Based upon seller’s requirement
e. Only (c) and (d) of the above.
4. _______________ is the real asset.
a. Equity share
b. Preference share
c. Gold
d. Debenture
e. FCCB.
5. Which of the following is not the derivative instrument?
a. Futures
b. Forward
c. Swap
d. Spot
e. Options.
B. Descriptive
1. Describe the basic investment style.
2. Write a short note on the concept of risk and return.
3. Differentiate between forward and futures market.
4. Enunciate different types of risks associated with various investment products.

These questions will help you to understand the unit better. These are for your
practice only.

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UNIT 6 ALTERNATIVE INVESTMENT
OPTIONS
Structure
6.1 Introduction
6.2 Objectives
6.3 Selection of Alternative Investments
6.3.1 Advantages of Alternative Investments
6.3.2 Disadvantages of Alternative Investments
6.3.3 Role of Alternative Assets in a Traditional Portfolio
6.4 Art Objects
6.5 Gold and Silver
6.6 Hedge Funds Investment
6.7 Commodities
6.8 Real Estate
6.8.1 Real Estate Investment Trust
6.8.2 Real Estate-Related Mutual Funds
6.9 Summary
6.10 Glossary
6.11 Suggested Readings/Reference Material
6.12 Suggested Answers
6.13 Terminal Questions

6.1 INTRODUCTION
Institutional investors have always aspired for a well-diversified portfolio. For this
reason, they focused their attention on traditional investment vehicles such as stocks,
bonds and money market instruments in the past. The umbrella of investments does not
contain only these popular investment instruments but includes other non-traditional
instruments also. In the last four to five decades, institutional investors ignored the
importance of these non-traditional instruments in reducing portfolio risk and boosting
returns. All such investments that do not fall in the traditional investment instruments
category can be named as alternative investments. In recent days, the investment pattern
shifted from traditional investment instruments to non-traditional investment
instruments or alternative investments. They started increasingly investing in traditional
alternative investments such as private equity and private debt and also in contemporary
alternative investments such as hedge funds and managed futures. A detailed discussion
on all kinds of possible alternative investments is out of the purview of this book.

6.2 OBJECTIVES
After going through the unit, you should be able to:
• Categorize Alternative Investments;
• Elaborate different forms of real assets;
Wealth Management
• Analyze real assets such as Art objects, Commodities, Real Estate,
Gold and Silver etc.; and,
• Understand important aspects of Hedge Funds Investment.

6.3 SELECTION OF ALTERNATIVE INVESTMENTS

The alternative investment vehicles market is really large and it is almost impossible for
any investor to allocate his funds in every type of alternative investment. A considerate
and careful approach is essential while selecting an appropriate alternative investment
vehicle. It is difficult to give a precise definition for alternative investments. William P.
Miller II defines alternative investment strategies as “Private, non-traditional, illiquid
investments involving real estate, commodities, currencies or hedge funds etc.”
For convenience, alternative assets can be divided into two categories based on
their liquidity and volatility. The selection of the proper alternative asset should be
based on the different needs of the various investors. The most important determinant in
deciding the proper alternative investment is to understand the nature and risks
associated with that investment. First, the size of the alternative investment and its
diversification impact should be decided. Second, the risk involved in the investment
should be assessed. Generally, the risk associated with alternative investments is
relatively higher than traditional investments.
The selection of an alternative investment depends on the characteristics of the
investors, their experience and future expectations. Although risk return trade-off is the
primary concern of any alternative investor, there are some secondary and extremely
important factors concerning liquidity, tax considerations, legal issues, benchmarking,
leverage performance and experience, volatility, people, investment process fees,
correlation, timing, and risk management, that need to be considered. A comprehensive
analysis of potential alternative investment vehicles is required to understand their risk
and return level.
Apart from the mentioned above instruments, leveraged buyouts, venture capital,
mezzanine financing, distressed securities, international private equity, oil and gas
programs, economically targeted investments and timberlands or farmland can also be
included in the alternative investment category.
i. Leverage Buyout Funds: Such deals use huge amount of debt to acquire
existing companies. Generally, these companies are reorganized by selling off
some divisions to pay the debt, or other divisions are consolidated or sometimes
units are altered to improve the efficiency. These rearrangements are made so
that the debt financier can be benefited from the increased value of the
restructured equity.
ii. Venture Capital: Venture capital involves investing in new companies, which
may range from a new start-up to a fully developed business. These are generally
equity investments and the investor makes this investment to benefit from the
higher value of the invested equity. As opposed to buyouts, venture capital deals
are of a smaller size and generally involve only non-controlling minority interest
in the company.
iii. Mezzanine Financing: Mezzanine financing investment vehicle requires
investment in subordinated debt of privately owned companies. The debt
provider wishes to participate in the expected high equity value and he can do
this by exercising conversion of rights, warrants and options assigned to him.
iv. International Private Equity: International private equity investment vehicle
requires investment in firms, which are established outside the domestic country.
Such investment will suit investors who require diversification benefits and are
interested in taking some amount of international risk.
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v. Oil and Gas Programs: Oil and gas programs investment demands investment
in newly found oil exploration and gas reserves. It may include investments in
already existing and proven oil and gas reserves too.
vi. Timberland: Such investment vehicle requires investment in timberland and
various other forms of timber.
vii. Targeted Investments: These investment vehicles have a unique targeted factor.
This targeted factor is generally related to geographical, economic or social
issues. Sometimes these instruments are called ‘ETIs’ (Economically Targeted
Investments) and may also include investment in minority-owned businesses and
state-financed housing.
viii. Managed Futures: An approach to fund management that uses positions in
government securities, future contracts and options on future contracts in a
portfolio. Some managers specialize in physical commodity futures, but most of
them use a variety of financial and non-financial instruments.
ix. Hedge Funds: Funds that use hedging practices by purchasing stocks on margin,
selling short, or trading in options in an effort to maximize profits at the lowest
risk.
x. Distressed-Companies Investing: This refers to the purchase of debt of
companies that face financial distress, bankruptcy, or are in the reorganization
process. This implies buying debt at a discount in the hope that the company will
recover again.

6.3.1 Advantages of Alternative Investments

Alternative investments have the following advantages:
a. Alternative investments enjoy the benefits of diversification. Inclusion of
alternative assets in a traditional portfolio results in reducing the risk of the
portfolio and thereby improving its stability.
b. Alternative investments are very flexible and they can be tailored to meet the
requirements of investors and are also capable of producing the desired specific
risk/return trade-offs for different classes of investors.
c. Alternative investments provide an opportunity to access certain markets and
asset classes.

6.3.2 Disadvantages of Alternative Investments

A major problem associated with alternative investments is most of the investors will
find it difficult to integrate the alternative assets into their portfolio consisting of
traditional assets. Other important factors that should be considered include lack of
liquidity, high transaction costs, regulatory constraints attached to the alternative assets,
fees, taxes, infrequent valuation of investments etc. A detailed description of some of
the available alternative investments is provided below.

6.3.3 Role of Alternative Assets in a Traditional Portfolio

Inclusion of the alternative assets in traditional portfolios is primarily a function of the
correlation of traditional assets like stock, bond and other instruments. This is because
the amount of correlation decides the risk diversification in the traditional portfolios.
Broadly speaking, the decision to add alternative assets to an existing traditional
portfolio depends on relative mean return and standard deviations of the investment
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vehicles and the existing portfolios. Correlation between hedge funds and traditional
asset classes is low, which shows that it is possible to derive higher returns and lower
risks, using a combination of different asset classes.
Interestingly, these correlations between alternative assets and traditional assets differ in
various markets. This is a very important factor that any alternative investor should take
into account while incorporating alternative assets in a traditional portfolio. Needless to
say, inclusion of alternative assets in the traditional portfolio gives an extra protection
cover and additional opportunity to earn a good return in unfavorable circumstances.

Self-Assessment Questions – 1

a. What is Mezzanine Financing?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

b. What do you mean by Targeted Investments?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

6.4 ART OBJECTS

Objects which possess aesthetic appeal because their production requires skill, taste,
creativity, talent and imagination may be referred to as art objects. According to this
definition, paintings, sculptures, etchings, wooden icons and so on may be regarded as
art objects. Art objects as an investment avenue are considered profitable but risky. An
art object becomes a public good when it is a part of the museum. Awareness of art
objects has increased in the last few years. Art being a scarce product and
irreproducible, it has a low correlation with other asset classes. The number of buyers of
art objects has also grown over the years. The art market is illiquid, opaque and
unregulated. Even the transaction costs are too high. The two commonly bought art
objects are paintings and antiques.
There are certain risks associated with investing in art – subjective quality and
valuation, no regulation, no liquidity, high transaction costs, long-term investment
horizon, no intrinsic value, and no proper accounting standards. Based on the
investment objectives, buyers of art objects can be categorized into different segments.
• Some buyers focus on color and aesthetics. They prefer pleasant portraits.
• Buyers who are aware and experimental in their choice. They choose works of
better-known artists.
• Another segment of buyers go by big names and trophy art is most preferred and
money is no issue for such buyers.
• Another segment of buyers indulge in expensive hobby of collecting art. Such
buyers should have finance in good shape.
• Buyers, who go through catalogs, check prices to ensure that they have made a
sound financial investment.

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Box 1: Art Mart Regains Lost Ground, Prices Creep Up
The doubling of the sensex, may have started to influence the art market. From being
in a state of being complete limbo, prices are picking up again, according to art
circles. “The art market is generally based on perception. When the general economy
and markets are up, people want to invest in alternative assets and art falls in that
category, together with gold, jewellery and property. While art is aesthetic, it also
enjoys an investable component,” Dinesh Vazirani, director of leading auctioneer
Saffronart, told ET.
“In the past six months, the improvement in the economy and the growth in the stock
market have definitely helped the art market. With the economy doing well, people
are much more confident about investing in art. And, this is happening both in
auctions as well as galleries. The art market has changed. It is seeing an upswing.
Earlier, it was completely stagnant. Across the board, art prices have gone up by 15-
20%,” said Vazirani. Added Dr Prakash Kejariwal, director, Chitrakoot Art Gallery,
“The boom in the share market had brought about a simultaneous upsurge in the art
market. In the same breath, when the stock market collapsed with the recession, the art
market entirely slowed down. Nothing seemed to be moving. With the market
bouncing back almost 100%, a trend of bottom picking has also begun in the art
market. People who had burnt their fingers are careful about their purchases and are
selectively buying old and modern masters like the progressives and artists parallel to
the progressives with real worth. Artists who were artificially boosted during the
boom, just like shares, are being avoided.”
“Art traders and investors, who see art as an investable asset, are generally absent till
now, which has left largely seasoned collectors and art lovers. Art for drawing rooms
and public spaces is also being bought. While the improving stock market may have
had a trickle-down effect on the art market which is showing signs of bouncing back,
one would imagine that a sustained growth in the market would start having a deeper
effect on the art market,” Dr Kejariwal said.
“Basically, the sentiment in the art market is changing to positive now. Inquiries have
started coming in again. This is because of the liquidity which have been released in
the market because of the stock market rise,” Vikram Bachhawat, director, Aakriti
Art Gallery, said.
“It looks like prices have bottomed out at this level, and masters like MF Husain, SH
Raza, Bikash Bhattacharjee, Ganesh Pyne, FN Souza and Satish Gujral are in good
demand. Hyped artists during the boom are not finding any takers. Collectors are
more sensible now than ever before and have become choosy. They look at the
history of the artists before opening their wallet,” he observed.
Source: http://economictimes.indiatimes.com/personal-finance/art/Art-mart-
regains-lost-ground-prices-creep-up/articleshow/5221085.cms
In accordance with the interests of different buyer’s segments, purchasers need to
follow certain guidelines.
• Price that an investor is ready to spend on a particular art has to be decided
before and he has to stick to it.
• Time of sale is also crucial. Like other investments, art does not produce regular
income for the investor.
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• It is important to decide what type of art is to be purchased. Just purchasing any
art will not always result in a profitable investment.
• Proper research on the artists, art collectors, galleries and works should be
carried on.
• Reputation of the artist is also important while valuing the work of any art.
• Reputation of the galleries or auctioneers is also very important.
• Art should be considered a long-term investment as it is not possible to sell a
specific art work in a short period of time.
• Condition and framing of the work is to be thoroughly inspected.
PAINTINGS
Paintings appear to be the most popular among objects of art. In the last decade or so,
interest in paintings has grown considerably, thanks to the substantial appreciation in
the market value of paintings of Hussain, Raza, Menon, and others.
The prospective investor with an inclination to buy paintings should bear in mind the
following guidelines:
a. Put Bets More on Fledging Painters: The works of established painters may be
too expensive and beyond the reach of small investors. More importantly, the
expected appreciation in their value may not be considerable. Hence, it makes
more sense to buy good quality paintings done by fledging painters – the
potential Hussains of tomorrow. True, when one bets on an ‘emerging’ painter,
he is taking some risk. Often, the potential rewards justify such risk.
b. Develop a Sense for the Quality of Painting: Even if the investor does not have
the skills of a connoisseur, he can judge the basic qualities of painting by looking
at attributes like spontaneity, maturity of strokes, balance of color, and
originality. Over a period of time, one can refine his sensibility, provided he has
a basic aesthetic sense.
ANTIQUES
An object of historical interest may be regarded as an antique. Antiques have always
been a solid/illiquid investment. They offer double opportunity for investors as they act
as investments and at the same time they are used for home decoration. They are
referred to as lifestyle investments. Antiques include coins, manuscripts, sculptures,
paintings and various other objects. Investors should have appreciation for antiques to
use them for diversifying a portfolio. If one is interested in investing in an antique,
he/she should bear in mind the following:
a. The owner of an antique is required to register it with the Archeological Society
of India. If the registering authority is satisfied about the authenticity of the
antique, it issues a ‘Certificate of Registration’.
b. Whenever an antique is sold, the registering authority has to be informed and the
ownership must be transferred.
c. Export of antiques, in general, is banned. In exceptional cases, it is allowed only
at the instance of the Director General of the Archeological Society of India.
d. The government has the right to acquire an antique if it is felt that the same must
be kept in a museum for the general good.
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e. Antiques can be purchased from places such as Chor Bazar (Mumbai), Mullick
Market (Kolkata), and Burma Bazar (Chennai). However, it may not be easy to
get good bargains at these places. To buy antiques at bargain prices, the investor
has to actively look for them in smaller towns and villages.
f. There is a flourishing market for ‘fake’ antiques. These are the objects which are
chemically treated to give an ‘antique’ look, though they are not genuine.
g. Antiques tend to appreciate in value over time, but in a very unpredictable
manner.
h. Antiques seem to make sense only for those who have patience to wait and who
derive psychological satisfaction from owning objects of historical interest. One
may even argue that, since very few investors have the ability to assess the value
of antiques, investments in these may largely be left to connoisseurs.
BULLION-LURE OF GOLD
Precious metals that have a high market demand and market value and are available in
bulk are called bullion. They are traded in commodity markets. Gold and silver are
favorite avenues of investment for the Indian investors because:
• They provide a hedge against inflation.
• Have sentimental and social values attached to them.
• They have ornamental value and medicinal uses.

6.5 GOLD AND SILVER

Gold is one of the most valuable assets in any economy. It has both financial and
sentimental value in India. It is the long-term store of value, is highly liquid and is the
asset of last resort. It is easy to buy or sell anytime anywhere. It is a ‘safe haven’ asset.
In times of war or international crises, gold price tends to appreciate. The right time to
purchase gold is when one understands what it is and what role it plays in one’s
portfolio.
Investors generally buy gold for two reasons – to financially gain from increasing gold
prices and to use it for hedging against economic, political, and social crises. Although
the price of gold is always on the rise and it fetches higher resale value, in India, it is
retained for the social status associated with it and the feeling of security it gives.
HOW DO PEOPLE HOLD GOLD
Gold can be held in the form of bars, coins, jewellery, gold certificates issued by a
banker, gold derivatives (futures and options) and gold Exchange Traded Funds (ETFs).
Central banks and international monetary organizations like the International Monetary
Fund (IMF) purchase gold. Whenever exchanged, gold can get back the buyer the rate
on that particular day. However, derivatives like options and futures can be used to
hedge the risk of an increase in the price of gold. The buyer of a gold future or option
can take the physical delivery after the expiration of the contract or offset his respective
position. The nuances of these derivative instruments are already explained in the earlier
chapters. Similarly, ETFs allow investors to invest small amounts in gold funds
periodically so that at the end of a certain period or at maturity, they can take delivery or
get considerable amount of gold or can take an equivalent amount of money.

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Gold has a number of uses owing to some of its unique properties like:
a. Gold’s high resistance to corrosion, its malleability, ductility, high electrical
conductivity and its ability to adhere firmly to other metals. There are a number
of industries – electronic components to porcelain – that use gold.

b. Gold can be used as a shield against radiation from the sun and also to focus
light energy. Therefore, it is used in building spacecrafts and satellites. Industrial
and medical lasers use gold-coated reflectors to focus light energy. It has become
a vital tool for medical research and is even used in the direct treatment of
arthritis and other intractable diseases.
c. It has long-proven ability to retain value, and to appreciate in value.
d. Various sports authorities purchase gold to present gold medals, which are
deemed to be very prestigious.
FACTORS INFLUENCING GOLD PRICES
Today, like all investments and commodities, the price of gold is ultimately driven by
supply and demand. Some of the factors affecting gold prices are:
Cultural Differences and Sentiments: In countries like India and China, gold is
bought more as a part of tradition rather than with an investment objective. During
certain festivals, such as Dassera and Deepawali and during marriage seasons the
demand for gold increases and this is obviously a major reason for increase in the price
of gold during such times.
Inflation: When inflation rises, the purchasing power of people decreases. Therefore,
during times of inflation, people would prefer to purchase liquid, tangible assets that are
valued for some other purpose. Since gold is in no way related to any specific
government policies, it is not affected by inflation. So, it acts as a hedge against
inflation.
Low or Negative Real Interest Rates: Gold has a long history of being an inflation-proof
investment. Inflation and interest rates are inversely related. When inflation rises, interest
rates are relatively low and so investors show less interest to invest in interest-bearing
instruments. Hence, they tend to buy gold to protect their capital.
War, Invasion, Looting, Crisis: In times of national crisis, people fear that their assets
may be seized and the currency may become worthless. They see gold as a solid asset,
which will always buy food or transportation. Thus, in times of great uncertainty,
particularly when war is feared, the demand for gold rises.

Box 2: Investing in Precious Metals

Apart from gold and silver, there are other precious metals like platinum, diamonds
and other metals, which have great advantage and are very compact and convenient
stores of wealth. Platinum is more precious than gold and accordingly the price of
platinum changes along with its availability, but it normally costs about twice as
much as gold. Precious metals can be solid investment choice and are stable in times
of global uncertainty. If investors can opt for a suitable mix of all these precious
metals in their portfolio, it can lead to a well-diversified investment portfolio.

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Today, more and more investors are getting attracted toward these precious metals
as they feel the need for safety as well as the best hedge against inflation, easy and
almost instantly conversion into cash, which is not the case with property. Even in
the case of stocks, when investors wish to sell, it would well be that the prices are at
a low ebb. And in the case of mutual funds and insurance schemes, investors can
convert them to cash only as per rules and regulations by the company, not instantly
although. However, investment in precious metals requires certain precautionary
measures. First, the investor must opt for precious metals investments in the form of
either bullion, precious metals’ mutual funds, stocks and shares in mining
companies, or metals and gold futures. Amongst these, the safest is purchasing and
storing precious metal bars or coins. However, when compared with stocks and
bonds, the drawback of precious metals is that they increase in value only when the
price per ounce goes up, whereas investors in stock market can receive other
incentives, like dividends, bonus shares, etc.
Source: Mr. N. J. Yasaswy. Personal Investment and Taxation. 15th edition. New Delhi:
Vision Books Private Limited, 2006. Pg. No. 211.
SILVER

Silver is another precious metal that has a number of applications. It is currently about
1/50th the price of gold. Over the last 100 years, the price of silver and the gold/silver
price ratio have fluctuated greatly due to competing industrial and store of value
demands. Silver was earlier used as a form of currency. Silver coins were in circulation
in many countries including India. Today, it is being used in jewelry and silverware.
Silver is also used in medals, denoting second place. Many high-end musical
instruments are made with silver, which is supposed to give a higher tone quality.
Like gold, silver can be held in the form of bars, coins, jewelry, silver certificates issued
by a banker and silver derivatives. Silver in any form also provides a very high liquidity
to the buyer. Thus, whenever exchanged or sold, the seller of silver or gold gets the
price that is prevailing on that particular day.

6.6 HEDGE FUNDS INVESTMENT

Hedge funds investment is open to limited wealthy investors to undertake wide range of
investments and trading activities. It is a private investment vehicle that aggregates
investments of several participants. Hedge funds as the name suggests offset losses that
may arise in principal markets. Investors invest by hedging their investments using a
variety of strategies. It is growing extraordinarily from 300 funds to 9000 funds. They
have become highly visible managing around US$1.3 trillion. Hedge funds are not risk-
free. They sometimes underperform on equity portfolio in bull markets. At the same
time hedge funds have limited public transparency and high minimum investment. This
investment provides benefits of diversification due to their low correlation. The other
benefits of hedge funds include the following:
• Hedge funds provide diversification benefits.
• Hedge funds reduce volatility and risk.
• Hedge funds provide market efficiency and enhance liquidity.
• Hedge funds preserve capital and earn attractive returns irrespective of the
market conditions.
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• Hedge funds play an important role where various risks are distributed across a
variety of financial instruments.
• Hedge fund managers are highly specialized and trade only in their area of
expertise. They receive both performance fee and management fee. They charge
fees in the range of 2 percent and 20 percent.
• Management fee normally ranges from one percent to four percent. The standard
figure of management fee is 2% of the fund’s net asset value.
• Performance fee is charged at 20% of the profit. It is also known as incentive fee.
The profit derived contains both realized and unrealized profit.
STRATEGIES OF HEDGE FUNDS
While hedge funds play a crucial role in a portfolio, they include a range of strategies
and market benefits. The alternative strategies that are used include long/short equity,
market-neutral, event-driven, convertible arbitrage; short selling, fixed income
arbitrage, managed futures, global macro and equity trading.

Self-Assessment Questions – 2

a. What are the basic features of Hedge Fund?

…………..……………………………………………………………………

…………..……………………………………………………………………

…………..……………………………………………………………………

b. What would you call as antique? Is investment into antiques liquid?

…………..……………………………………………………………………

…………..……………………………………………………………………

…………..……………………………………………………………………

6.7 COMMODITIES
Commodities are tangible goods that can be used for various purposes. They include
goods like agricultural food products, energy sources and mineral ores. Commodities
are traded through a mutual agreement between the buyer and the seller to exchange a
commodity at a given price. Commodity contracts are highly standardized except for the
price and are influenced by demand and supply forces. Commodity contracts are
generally in the form of futures and options.
Ways of investing in commodities:
• Previously direct investment in commodities was regarded as a minor part of an
investor’s asset allocation.
• Indirect investment through equity/debt of companies using commodities and
through commodity futures or exchange-traded funds is regarded as a means of
obtaining claims on commodity investment.
• Benefits of investing in commodities:
• Price volatility is less compared to stocks, bonds and other investments.

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• Factors influencing commodities are few and easier to understand and interpret
fraught.
• Risks of investing in commodities:
• Though return in commodities is good, it follows a roller coaster ride,
• Success in commodity investment is dependent on selecting the right commodity,
• Commodities react to various supply and demand factors,
• Commodities are inflation-sensitive, and
• Estimating the price accurately is one of the biggest challenges for wealth
managers.

6.8 REAL ESTATE

Real estate investment is investment of funds in immovable properties. Real estate
includes land and house properties. The main aim of real estate investors is to generate
more income by way of rental/lease or capital appreciation. It is unpredictable in nature.
A large number of people invest in real estate for hedging against the inflation rates.
Real estate forms an important part of asset class. It has become an important part of the
portfolios of High Net-Worth Individuals. The different types of real estate are
residential property, commercial property, suburban property, and agricultural property.
Residential Property
Residential property includes both independent houses and flats. These form an
important part of the portfolio for bulk of the investors. It is an attractive investment due
to the following reasons – (i) satisfactory total return, (ii) provides psychological
satisfaction, (iii) loans are available from banks and financial institutions, and (iv)
interest on loans is tax-deductible.
Due to the above formidable advantages, a residential property represents the most
important part of the portfolio for most of the investors. But there are certain factors that
affect the value of real estate – business cycle, inflation and interest rates, demographics
and legal environment.
Commercial Property
Investors who are wealthy prefer to invest in commercial property rather than in
residential. The demand for such property lies in the form of regular rental income
which can be increased or revised. Investors also enjoy the benefit of capital
appreciation. Commercial property can be in the form of offices, shopping complexes,
warehouses etc.
Suburban Property
Buying properties in metropolitan cities is very expensive to moderate investors.
Investors therefore prefer to buy residential properties in suburban areas with affordable
prices. It helps them by way of capital appreciation and at the same time gives them self
satisfaction of having an investment and an opportunity of moving themselves to very
quieter and non polluted locations.
Agricultural Property
Agricultural property is also one of the most attractive investment destinations. Some of
the benefits attached to agricultural property are – the income arrived from agricultural
property is not taxable; loans are given at concessional rates; and, land used for
agriculture is exempt from wealth tax. One of the demerits associated with investing in
agricultural property is restrictive laws concerning ownership. Also, investments in
agricultural property bring not so great profits.

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6.8.1 Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a trust that collects funds from investors
and/or operates income-producing real estate such as apartments, shopping centers,
offices, hotels and warehouses. In most cases, REITs own and operate the real-estate
property. REITs have been in existence since 1960. REITs are constrained by the
limited permission to operate or manage real estate. The Tax Reform Act of 1986
reduced the potential in generating tax shelter opportunities for real estate investors.
Also, it permitted REITs not only to operate but also to manage commercial properties.
Some REITs also finance real estate. The shares of many REITs are being traded on
major stock exchanges. To qualify as an REIT, a company must distribute at least 90%
of its taxable income to its shareholders annually. A company that qualifies as an REIT
is permitted to deduct dividends paid to its shareholders from its corporate taxable
income. As a result, most REITs remit at least 100% of their taxable income to their
shareholders and therefore owe no corporate tax. However, in India, REITs are yet to be
allowed.
In India, SEBI will soon outline framework for REITs. Sometime in April 2008, SEBI
had prepared norms for real estate mutual fund. But, the launch of real estate mutual
fund was delayed due to market meltdown. Incidentally, REITs is a trust that uses the
pooled capital of many investors to purchase and manage real estate assets and/or
mortgage loans. REITs are traded on major stock exchanges like normal stocks.
According to Mr Bhave, SEBI chairman the main hindrance for introducing REIT like
products in India is lack of transparency in the real estate market, variable stamp duties
in different states and absence of uniform price of land and properties across India. The
main aim of this framework is bring uniformity in stamp duties across states,
transparency in different investment avenues, new guidelines on portfolio management
schemes for the client to get exact asset portfolio through depository participants.
The REIT industry offers a choice to investors. REITs are classified as equity, mortgage
or hybrids. Equity REITs own and operate income-producing real estate; these are
primarily real estate operating companies engaged in a wide range of real estate
activities, including leasing, property development and tenant services. One major
distinction between REITs and other real estate companies is that an REIT must acquire
and develop its properties primarily to operate them as part of its own portfolio rather
than resell them once they are developed. Mortgage REITs lend money directly to real
estate owners and operators or extend credit indirectly through the acquisition of loans
or mortgage-backed securities.
REITs invest in a variety of property types: shopping centers, apartments, warehouses,
office buildings, hotels, and others. Most REITs specialize in one property type only,
such as shopping malls, self-storage facilities or factory outlet stores. Healthcare REITs
specialize in healthcare facilities, nursing homes and assisted living centers.
Some of the benefits associated with REITs as an investment option are exemption from
corporate tax, provides fairly regular income, gains exposure to commercial property,
and highly liquid.
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6.8.2 Real Estate-Related Mutual Funds
Real Estate Mutual Funds (REMF) are mutual funds used for investing in real estate.
The idea of REMFs is not new in India. A proposal was put forth almost a decade ago
for introducing these funds. But at that time, the authorities were doubtful as they
believed that such funds being speculative in nature, if permitted, will lead to an
increase in speculative trading that may not be beneficial for the economy. The
Securities and Exchange Board of India (SEBI), and Association of Mutual Funds in
India (AMFI) have set up a committee to advise on the introduction of REMF in India;
the committee has submitted its report and now, trading in these funds is allowed. SEBI
approved the guidelines for dealing in REMFs on June 26, 2006. Every REMF shall be
a close-ended fund. It should be listed on a recognized stock exchange. Real estate
assets held by REMF scheme should be kept in safe custody with a custodian of mutual
fund. All financial transactions of the REMF are routed through banking channels.
Every REMF shall invest at least 35% of net assets of the scheme directly in real estate
needs. REMF should invest 75% of their net assets in real estate assets, mortgage-
backed securities, and equity shares or debentures.
Almost all the funds invested some portion of their equity investments in the stocks of
real estate companies. At the end of September, mutual funds had invested Rs.1,564
crore in real estate stocks, about 1% of their total Assets Under Management (AUM).
With the crunch of stock market in 2008 and major liquidity crunch in the economy,
realty developed majorily affected as they launched number of new projects with
borrowed funds. Between April and July 08 the demand for commercial as well as
residential real estate declined. There were no new sales coming up. This resulted in
mutual funds offloading whole chunks of realty stocks from their portfolios.
However with economic growth picking up pace and equity markets rising, fund houses
are again moving towards this high-growth, highrisk business. Reliance Mutual Fund
probably has a contrarian view as it is the only fund that has been continuously selling
real estate stocks since May this year. Its investments in the sector stood at Rs.10 crore
in April ’09. It jumped 23 times in just about a month to Rs.230 crore, and it was at
Rs.129 crore at the end of Sept ’09. It is not only the bigger players like DLF, Unitech,
and HDIL that are preferred for investments. Middle rung companies like Phoenix
Mills, Mahindra Lifespaces and Anant Raj Industries have also found favor with a lot of
fund managers in the last 5-6 months. The fact that demand returned and developers
were able to sell a lot of residential units shows that normalcy is coming back. If
developers do not embark on price increases, it is likely that the sector could sustain this
momentum and mutual funds could become more confident of increasing their exposure
to the sector.

6.9 SUMMARY
Alternative investments are investment options that are outside the realm of traditional
investments.
The most important determinant in deciding the alternative investments is to understand
the nature and the risks involved in that investment.
There are various alternative investments available such as art objects, gold, hedge
funds, commodities, real estate, REIT and charity.
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Art market is illiquid, opaque and unregulated. Even the transaction costs are too high.
The two commonly bought art objects are paintings and antiques.
Gold is one of the most valuable assets in any economy. It has both a financial and
sentimental value in India. It has the long-term store of value, is highly liquid, and is the
asset of last resort.
Commodities are traded through a mutual agreement between the buyer and the seller to
exchange a commodity at a given price. Commodity contracts are highly standardized
except for the price and are influenced by the demand and supply forces.
There are different types of real estate – commercial property, semi urban land,
agricultural land and residential property.
REIT is a company that owns and operates income-producing real estates such as
apartments, shopping complexes, office premises, hotels and warehouses.

6.10 GLOSSARY
An Alternative Investment is regarded as an investment product other than traditional
investments such as stocks, bonds, money markets. Alternative investments include
commodities, financial derivatives, private equity, real estate etc.
Real Assets are land, houses, gems, gold etc., which appreciate in value faster than
equity shares, although their acquisition is difficult due to the large size of investment,
storage cost and insurance.

6.11 SUGGESTED READINGS/REFERENCE MATERIAL

• Jonathan Reuvid, Handbook of Personal Wealth Management, Korgan Page Ltd,
2010
• Dun, and Bradstreet. Wealth Management. Mc Graw Hill, 2009.

6.12 SUGGESTED ANSWERS

Self-Assessment Questions – 1
a. Mezzanine financing is a hybrid of debt and equity financing which is typically
used to finance the expansion of existing companies. It is basically debt capital
that gives the lender the rights to convert to an ownership or equity interest in the
company if the loan is not paid back fully in time.
b. Targeted investment vehicles have a unique targeted factor. This targeted factor
is generally related to geographical, economic or social issues

Self-Assessment Questions – 2
a. Following are the basic features of Hedge fund Investment
1. It is open to a limited range of investors
2. It undertakes a wider range of investment and trading activities in
addition to traditional long-only investment funds, and
3. In general, pays a performance fee to its investment manager.
b. An object of historical interest may be regarded as an antique. Antiques have
always been an illiquid investment.

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 Alternative Investment Options
6.13 TERMINAL QUESTIONS
A. Multiple Choice Questions
1. Hedge funds investment is open to ____________.
a. All retail investors
b. Limited wealthy investors
c. Sovereign funds
d. All investors
e. Conservative investors.
2. Venture capital involves investing in _______________.
a. New companies
b. Old companies
c. Well established companies
d. All companies
e. Multi national companies.
3. International private equity investment vehicle specifically makes investment in
________.
a. Firms established outside the domestic country
b. Firms established in the domestic country
c. Firms established in one of the states of the domestic country
d. Multinational companies in the domestic country
e. Domestic sick units having multinational presence.
4. Oil and gas programs invest in ______________.
a. Newly found oil exploration and gas reserves
b. Newly formed oil and Gas sector companies
c. Multinational oil and gas sector companies
d. Sick companies in oil and gas sector
e. Government owned oil and gas sector companies.
5. Timberland investment vehicle invests in _______________.
a. Gold
b. Silver
c. Real Estate
d. Equity
e. Timberland and various other forms of timber.
B. Descriptive
1. What are the alternative investment avenues?
2. List out the factors influencing the price of Gold.
3. What are the risk factors involved in investment into Commodities?
4. Discuss the functioning of REITs.
These questions will help you to understand the unit better. These are for your
practice only.

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UNIT 7 MUTUAL FUNDS
Structure
7.1 Introduction
7.2 Objectives
7.3 Advantages of Mutual Funds
7.4 Disadvantages of Mutual Funds
7.5 Types of Mutual Funds
7.6 Structure of Mutual Funds in India
7.7 Regulators of Mutual Funds in India
7.8 Who can Invest in Mutual Funds in India
7.9 Risks Associated with Mutual Funds
7.10 Systematic Investment Planning
7.11 Summary
7.12 Glossary
7.13 Suggested Readings/Reference Material
7.12 Suggested Answers
7.13 Terminal Questions

7.1 INTRODUCTION
A mutual fund is an investment scheme that brings together money from a number of
investors and invests the same in different financial instruments such as stocks, bonds
etc., based on certain investment objectives. A significant feature of a mutual fund is
that the contributors and the beneficiaries of the fund are the same class of people,
namely the investors. Here, the term ‘Mutual’ refers to the investor’s contribution to the
pool and investor’s benefits from the pool. The income earned through these
investments and the capital appreciated and realized by the scheme is shared by the unit
holders in proportion to the number of units owned by them. The main objective of
mutual funds is to invest the funds as per the investor’s choice.
Usually, investment professionals or fund managers manage mutual funds for which
they even earn a fee. An investor receives a certificate of share or unit within a period of
six weeks from the subscription closing date. The volume of units changes with change
in the portfolio’s value. Value of one unit of an investment is the net asset value.
Investors are entitled to receive information on the net asset value of the scheme at
regular intervals. On observing the past trends, certain factors are considered essential
for the growth of the mutual fund industry like investor base, returns on market and
investment avenues. Regular track of mutual funds is possible by way of Net Asset
Value (NAV), annual reports, half yearly reports, financial reports etc.
Some of the advantages and disadvantages of mutual funds are discussed below.

7.2 OBJECTIVES
After going through the unit, you should be able to:
• Assess the advantages and disadvantages of Mutual Funds;
• Understand types of Mutual Funds;
• Have an idea of the structure of Mutual Funds in India;
 Mutual Funds
• Recognize the regulatory aspects of Mutual Funds in India;
• Analyze risks Associated with Mutual Funds; and,
• Learn the details of Systematic Investment Planning.

7.3 ADVANTAGES OF MUTUAL FUNDS

The following are the advantages of investing in mutual funds:
Small Amounts: Investing in mutual funds is not restricted to investors who have large
funds. Even small investors with small amounts can enjoy the benefits of investing in
mutual funds. For example, an investor who has low savings can invest an amount of
Rs.500 in mutual funds every month.
Diversification: Diversification reduces the risk as all investment avenues don’t move
in one direction at the same time at the same proportion. If the equity market is going
down, the debt market may move up. Therefore, holding a portfolio that is diversified
across investment avenues is a wise way to manage risk. It also enables investors to
evaluate the portfolio continuously and manage risks more efficiently.
Professional Management: Mutual funds are managed by fund managers who trade
pooled money by investing them in stocks, bonds etc. Most of the investors don’t have
time or expertise in managing their investments. They therefore prefer to rely on
investment advisers. The fund manager should have good knowledge and access to
market information, bounded by rules issued by regulatory agencies. The adviser should
be able to decide and help investors in investing funds in such instruments that give
maximum return to the investors with moderate or less risk.
Reduction of Transaction Costs: Since mutual funds involve large transactions, the
transaction costs are comparatively lower. Mutual funds provide the investors the
advantage of economies of scale thereby reducing the transaction costs.
Liquidity: Most of the funds sold today are open-ended. That is, investors can sell their
existing units or buy new units, at any point of time, at prices that are related to the
NAV of the fund on the date of the transaction. This enables investors to enjoy a high-
level of liquidity on their investments. Since investors continuously enter and exit
funds, funds are actually able to provide liquidity to investors, even if the underlying
markets, in which the portfolio is invested, may not have the liquidity that the investor
seeks. For example, the debt markets are wholesale markets, where minimum trade lots
are Rs.25,000 onwards. However, investors in debt funds can invest as little as Rs.500,
and withdraw the same at NAV-related prices, at any time.
Convenience and Flexibility: Mutual funds offer various services that help in easy
investment. Investors can buy or sell shares at any time, in any way either through mail,
internet, or telephone. There is also an option of systematical investment or withdrawal
of funds according to one’s needs and convenience.
Choice and Tax Benefits: With the developing mutual fund industry, a number of
schemes are available to the investors. Investors now have a choice of selecting schemes
based on their funds, expected returns, time period and so on. At the same time
investing in mutual funds provides investors tax benefits. Dividends received are also
tax-free.

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7.4 DISADVANTAGES OF MUTUAL FUNDS
The following are some of the disadvantages of investing through mutual funds:
No Guaranteed Returns: Mutual funds are like any other investments that do not
generate any guaranteed returns. Unlike other fixed income securities, mutual funds
experience depreciating returns.
No Control Over Costs: Mutual funds usually have different kinds of fees that reduce
the overall pay out. The fees may be of two types (i) shareholders’ fees that are in the
form of redemption and load fees and are paid by the shareholders, and (ii) annual fund
operating fee that is charged as an annual percentage usually ranging between 1 – 3%.
These fees are charged to the investors irrespective of the performance of the mutual
fund. Since investors do not directly monitor the fund’s operations they cannot control
the costs effectively.
Evaluating Funds: Another disadvantage faced by the investors is in terms of evaluating
the funds. Unlike other funds, mutual funds sales growth, earning per share etc., are not
given. The performance of the fund is based on the Net Asset Value of the fund.

7.5 TYPES OF MUTUAL FUNDS

Mutual funds are classified on the basis of the maturity period and investment objective.
FUNDS ACCORDING TO MATURITY PERIOD
Mutual funds classified based on their maturity period include open-ended fund, close-
ended fund, and interval fund which are discussed below:
Open-ended Fund/ Scheme : An open-ended fund or scheme is one that is available
for subscription and repurchase on a continuous basis. These schemes do not have a
fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value
(NAV) related prices which are declared on a daily basis. The key feature of open-end
schemes is liquidity.
Close-ended Fund/ Scheme : A close-ended fund or scheme has a stipulated maturity
period e.g. 5-7 years. The fund is open for subscription only during a specified period at
the time of launch of the scheme. Investors can invest in the scheme at the time of the
initial fund offer and thereafter they can buy or sell the units of the scheme on the stock
exchanges where the units are listed. In order to provide an exit route to the investors,
some close-ended funds give an option of selling back the units to the mutual fund
through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at
least one of the two exit routes is provided to the investor i.e. either repurchase facility
or through listing on stock exchanges. These mutual funds schemes disclose NAV
generally on weekly basis.
Interval Fund: These funds fall between open-ended and close-ended funds. They offer
benefit of flexibility and ensure that investors have liquidity of capital at regular
intervals. Investors can repurchase or sell based on the NAV. They do allow investors to
make purchases once the initial offer period is over but they will not be available for
purchase and sale everyday. Companies that launched interval funds in India are Birla
sun life, prudential ICICI and ABN-Amro.
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 Mutual Funds
FUNDS ACCORDING TO INVESTMENT OBJECTIVE
According to investment objectives, funds are classified into growth fund, income fund,
balanced fund, money market fund, gilt fund. index fund, exchange traded fund. These
funds are discussed below:
Growth Fund: Growth fund is also known as equity scheme. Under this scheme, funds
are collected from various investors and invested into stocks of both listed and unlisted
companies. The main aim of this fund is capital appreciation. Growth funds are useful
for aggressive investors who can bear huge risks and are having long- and medium-term
outlook. The investors investing in growth funds earn high returns. Examples of growth
funds are Franklin India Prima Fund, Reliance Growth and Prudential ICICI Power
Fund.
Income Fund: The main aim of this fund is to provide regular and fixed income to
investors by way of investment in fixed income securities. These are also called as Debt
funds. These are less risky and are not affected by fluctuations in the equity market. The
NAVs are related to interest rates. When the interest rate increases, the NAV falls and
when interest rate decreases, NAV goes up. Some of the examples of income fund are
Sundaram Bond Saver, PNB Debt Fund and HDFC Income Fund etc.
Balanced Fund: The aim of balanced funds is to provide both income and growth by
investing in both equities and fixed income securities. They are also called as hybrid
funds. They are affected by the variations in the stock market. They are suitable for
conservative investors who take some risk and seek for both income and capital
appreciation. Examples of balanced funds are LIC Dhanaraksha 89, Templetion India
Pension Plan etc.
Money Market Fund: These are also known as liquid funds. These provide liquidity,
capital preservation and moderate income. Money market funds are suitable for
investors who have short-term outlook. They invest in short-term investments such as
treasury bills, certificate of deposits and commercial paper. Fluctuations on returns are
less in these funds compared to others. There are two types of money market funds –
institutional and retail. Examples of money market funds are BoB Liquid Fund,
Reliance Liquid Fund and Treasury Plan etc.
Gilt Fund: Gilt funds invest in medium and long-term government securities. They are
originated in Britain. These have no default risk. NAVs of these schemes fluctuate due
to change in interest rates and other economic factors.
Index Fund: Index funds are designed to replicate the performance of stock market
index. They are passively managed funds. The transaction fee is less. They have low
cost of management. They are appropriate for conservative long-term investors with
moderate risk. Examples of index funds are UTI Master Index Fund, Franklin India
Index Tax Fund etc.
Exchange Traded Fund: Exchange traded funds are investment vehicles traded on the
stock exchange. Exchange Traded Funds (ETFs) are innovative products that are
available in the USA since 1993. About 60% of trading in American Stock Exchanges
takes place in ETFs. ETFs give investors opportunity to buy or sell an entire portfolio,
in a single security. They also offer hedging and arbitrage opportunities. They safeguard
the interests of long-term investors. Unlike other mutual funds, ETFs are not sold or
redeemed at NAV. ETFs enjoy the benefits of diversification, low cost and
transparency. There are different types of ETFs – Index ETFs, Commodity ETFs, Bond
ETFs, Currency ETFs, Actively Managed ETFs, Hedge Fund ETFs, and Leveraged
ETFs. They also offer hedging and arbitrage opportunities.

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Wealth Management
Leveraged Fund: The main objective of this fund is to increase the value of the
portfolio and benefit the holders of the unit by gains exceeding the cost of borrowed
funds.
ULIPs Mutual Funds
Investment Determined by the investor and Minimum investment amounts
amounts can be modified as well. are determined by the fund
house.
Expenses No upper limits, expenses Upper limits for expenses
determined by the insurance chargeable to investors have
company. been set by the regulator.
Portfolio disclosure Not mandatory Quarterly disclosures are
mandatory.
Modifying asset Generally permitted for free or Entry/exit loads have to be
allocation at a nominal cost. borne by the investor
Tax benefits Section 80C benefits are Section 80C benefits are
available on all ULIP available only on investments
investments. in tax-saving funds.
Source: http://www.rediff.com/money/2005/oct/15perfin.htm
Table 1: Comparative Analysis of ULIP and Mutual Funds

Self-Assessment Questions – 1

a. Differentiate between open ended and close ended schemes of Mutual Fund.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
b. Where do Gilt funds invest in ?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

7.6 STRUCTURE OF MUTUAL FUNDS IN INDIA

In India, a Mutual Fund is constituted as a Trust registered under the Indian Trusts Act,
and is initiated by a Sponsor. The Sponsor is the person who acts alone or in association
with another corporate to establish a Mutual Fund. The Sponsor then appoints an AMC to
manage the investment, marketing, accounting and other functions pertaining to the Fund.
In India, SEBI regulations determine the structure of a Mutual Fund. These regulations
require a Fund to be set-up in the form of a Trust under the Indian Trusts Act, 1882. In
the Indian context, the Trust structure was approved as it would provide ‘an arm’s
length relationship,’ ‘fiduciary relationship,’ ‘greater protection to investors,’ and
enable effective regulation of Mutual Funds.
Further, a Mutual Fund needs to be constituted as 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. 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 money 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.
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 Mutual Funds
Later, an amendment was effected to the Securities and Exchange Board of India
(Mutual Funds) Regulations, 1996, according to which a Mutual Fund should be
registered as a Trust and not as a company or any other form of organization; also, the
Trust Deed should be registered under the Registration Act.
Since Mutual Funds receive money from the public for investments, investors’ rights
and interests are to be protected. If Mutual Fund promoters and Fund Managers are
given a free hand, chances of investors’ interests being ignored are very much there. A
fund promoter may prefer to invest in companies he is associated with and thereby may
ignore Internal Control and Risk Management Systems. In order to safeguard the
interest of investors and to protect them, regulations stipulate that a Mutual Fund should
be structured in such a way as to ensure clear differentiation between the promoters and
managers of a Fund.
A Mutual Fund in India constitutes:
• Sponsor
• Board of Trustees
• Asset Management Company (AMC)
• Custodian
• Registrar and Transfer Agents
• Distributors.

Source: www.pruicici.com
Figure: Structure of a Mutual Fund in India

7.7 REGULATORS OF MUTUAL FUNDS IN INDIA

Regulators protect the investors with stipulated laws to regulate the business conduct of
Mutual Funds. The two main regulators of Mutual Funds in India are SEBI and AMFI.

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Wealth Management
SEBI – THE PRINCIPAL REGULATOR OF MUTUAL FUNDS
A more comprehensive and revised Mutual Fund Regulations substituted the 1993 SEBI
(Mutual Fund) Regulations in 1996. The SEBI (Mutual Fund) Regulations, 1996 issued
guidelines on –
i. Registration of Mutual Funds.
ii. Constitution and Management of Mutual Fund and Operation of Trustees.
iii. Constitution and Management of Asset Management Company and Custodian.
iv. Monitoring the schemes launched by Mutual Funds.
The apex regulator of capital markets is not only responsible for registration and
authorization of Mutual Fund schemes but also for inspection of the registered Mutual
Funds and remedial actions against any irregularities.
Apart from these, SEBI (Mutual Fund) Regulations, 1996 issued standard guidelines on
internal management procedures, investment valuation norms and accounting policies
and standards that the Mutual Fund houses have to follow. SEBI regulations lay down
the procedures for calculation and declaration of Net Asset Value of Mutual Fund
schemes. The regulations also lay down the code for advertisements.
The regulator has laid down guidelines for winding up the schemes and protecting the
investors against any regulatory infraction or default by a Fund. The apex regulator has
also powers to amend the Mutual Fund regulations – whenever situations warrant – in
the form of guidelines and circulars that shall be binding on the Sponsor, Mutual Fund
Trustees, Asset Management Companies and the Custodians.
SEBI revised a list of code of conduct for intermediaries of mutual funds in 2002,
revised in 2008. These code of conduct are now revised by AMFI which are discussed
in Annexure I at the end of this chapter.
ASSOCIATION OF MUTUAL FUNDS IN INDIA (AMFI)
AMFI is established on the lines of the Investment Company Institute (ICI), the national
association of US investment companies.
AMFI was incorporated on August 22, 1995 as a non-profit organization with an
objective to:
i. Promote best business practices and code of conduct in all areas of operation of
Mutual Fund Industry.
ii. Maintain high professional and ethical standards in the Mutual Fund Industry.
iii. Interact with the Securities and Exchange Board of India (SEBI) and to represent
to SEBI on all matters concerning the Mutual Fund Industry.
iv. Make a representation to the Government, RBI and other regulatory bodies in
matters relating to the Mutual Fund Industry.
v. Develop a well-trained agent distributors network for the Mutual Fund Industry.
vi. Promote nationwide investor awareness program to make the investors
understand the concept and working of Mutual Funds.
vii. Disseminate information on Mutual Fund Industry and to undertake studies and
research directly and/or in association with other bodies.
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 Mutual Funds
AMFI has also set up the Committee on Valuation of Mutual Funds, Committee on Best
Practices, Committee on RBI Related Matters, and Committee on Registration of AMFI
Certified Distributors for reviewing and evolving standards in the Mutual Fund
Industry.
Though technically not an SRO, AMFI, right from its inception, has performed self-
regulatory functions like giving clarification on payment of brokerage to intermediaries,
training the Mutual Fund distributors, and educating the investors.

Self-Assessment Questions – 2

a. What is Mutual Fund?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
b. Mention the entities involved in Mutual Fund operation
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

7.8 WHO CAN INVEST IN MUTUAL FUNDS IN INDIA

Before marketing the Mutual Funds through their distribution channels, distributors
need to identify the category of investors allowed to invest in any particular scheme of a
Fund. The Offer Document specifies the category of investors eligible to invest.
Investors can be generally grouped as follows:
Institutional Investors: These include banks, insurance companies, provident funds,
non-banking firms and overseas corporate bodies. These Institutional Investors tend to
invest in large amounts directly in the fund house.
Individual Investors: These include High Net-Worth Investors (HNI) and retail investors.
These investors have different investment objectives and require advice and help in investing in
the Fund. With different load rates applicable to High Net-Worth Investors compared to retail
investors, distributors marketing the Funds need to identify the category of the investors who
suit best to deal with.

7.9 RISKS ASSOCIATED WITH MUTUAL FUNDS

Risk is the outcome of uncertainty. Any investment including mutual funds involves
investment risk. Investment objective of a fund and its holdings determine the risk
associated with a fund. In context to mutual funds, risk is defined as the fluctuations in
the net asset value of a fund. Any individual investing in mutual funds has to keep in
mind that longer the investment time horizon, less affected by short-term volatility. The
shorter the investor’s investment time horizon, more affected by volatility and risk. It is
therefore suggested that investor has to take into consideration his/her goals, time
horizon and risk tolerance level while choosing a fund. Some of the risk management
strategies of Mutual Funds are given in Annexure II.
The risks involved in any other portfolio are also involved in mutual funds. The
different types of risks associated with various types of funds are discussed below:
Call Risk: The falling interest rates will cause a bond issuer to redeem – or call – its
high-yielding bonds before the maturity date.
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Wealth Management
Country Risk: Risk associated with investing in a foreign country. It includes political
risk, economic risk and sovereign risk. It reduces the return expected on the investment.
The possibility that political events (a war, national elections), financial problems (rising
inflation, government default), or natural disasters (an earthquake, a poor harvest) will
weaken a country’s economy and cause investments in that country to decline.
Credit Risk: Credit risk is the risk that arises as a result of the counterparty’s inability
to repay interest and principal in a timely manner. It is also known as default risk.
Currency Risk: Currency risk is the risk that arises due to change in the price of one
currency against another. It arises irrespective of where one is investing i.e. home or
foreign country. The possibility that returns could get reduced for Americans investing
in foreign securities because of a rise in the value of the US dollar against foreign
currencies. Also called exchange-rate risk.
Income Risk: The possibility that a funds income fluctuates due to changing interest
rates.
Industry Risk: The possibility that the price of a group of stocks in a single industry
will decline due to developments in that industry.
Inflation Risk: The possibility of reduction in the value of assets or income due to
unexpected changes in the inflation rates.
Interest Rate Risk: The possibility of a reduction in the value of a security, due to
increasing interest rates.
Management Risk: The possibility that an actively managed Mutual Fund’s
Investment Advisor will fail to execute the Fund’s investment strategy effectively
resulting in the failure of stated objectives.
Market Risk: The value of investments decline due to change in market factors. It is
also called as systematic risk.
Principal Risk: The possibility that an investment will go down in value, or ‘lose
money,’ from the original or invested amount.

7.10 SYSTEMATIC INVESTMENT PLANNING

Successful investing starts with early investment and investing regularly. Investing a
fixed sum at regular intervals in a mutual fund scheme is known as systematic
investment. It is similar to regular savings schemes like recurring deposits. For example,
investing an amount of Rs.2,000 on first of every month and earning more than
Rs.24,000 at the end of a year. SIPs are time-tested investment avenues and thus make it
easy to invest even for small investors. The investor has the choice of deciding the
amount and also the scheme.
In systematic investment planning, an individual can buy more units when the prices are
down and fewer units when the prices are high. It is useful for beginners who want to
invest as low as Rs.500 on a monthly/quarterly basis. This proves to be lighter on the
wallet vis-à-vis lump sum investments. There are two options for payment – Electronic
Clearance System and Post Dated Cheques. Under ECS, the amount to be invested in
the fund is directly deducted from the investors account as per his instructions. In the
second option, post dated cheques are given which can be cashed on the given date.
An SIP also ensures averaging of rupee cost by spreading out investments over regular
intervals. Averaging of rupee cost which is usually termed as ‘Rupee-cost averaging’ is
an investment strategy that combines simplicity, risk reduction, and affordability. It is
an ideal way to spread the purchases and avoid paying too much. A big advantage of
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 Mutual Funds
rupee-cost averaging is that it takes the guesswork out of deciding when to buy. It does
not burden the investor with timing of his investments and over a period of time, it helps
him diversify his investments.

Date Amount Invested (Rs.) NAV (Rs./Unit) Units Allotted

Jan-08 500.00 10.0 50.0
Feb-08 500.00 13.0 38.5
Mar-08 500.00 10.5 47.6
Apr-08 500.00 9.5 52.6
May-08 500.00 8.0 62.5
Total 2,500.00 251.2
Table : Investing Systematically
Under rupee-cost averaging, an investor typically buys more of equities or an equity-
linked instrument like a mutual fund unit when prices are low. On the other hand, he
will buy fewer equities/mutual fund units when prices are high. This is a good discipline
as it forces the investor to commit cash at market lows, when other investors around
him are wary and exiting the market. Investors may even be pleased when prices fall
because the fixed rupee investments would now fetch more units.
In our example we have taken an investor who avails of rupee-cost averaging through
the Systematic Investment Plan (SIP) offered by most fund houses. At a higher NAV (in
Feb 2008), the investor purchased fewer units. Conversely, at a lower NAV (May
2008), the investor bought a large number of units. The investor can really ride the
downslide in the NAV by increasing his SIP investment. For instance, if an investor had
doubled his investment (to Rs.1,000) in May, his cumulative investments would have
jumped to 313.7 units (from 251.2 units).
Rupee-cost averaging works better if the investor can increase his SIP investments
during a downturn in the markets. That’s when he can take advantage of rock bottom
prices, which will further reduce the average cost and enhance returns. When
establishing a program, the investor needs to consider the frequency of his SIP
investments – monthly, quarterly, semi-annually, or any regular interval. More frequent
intervals increase the investor’s chances of buying units when prices are especially low.
ADVANTAGES OF SIP
The advantages of investing in a systematic investment planning are as follows:
• In an SIP market, volatility works in favor of investors i.e., investors purchase
more units when the NAV is low and vice versa. Investments are made regularly,
which makes discipline in investor’s savings that in turn leads to wealth
accumulation.
• Investing in mutual funds avoids the question of where and SIP overcomes the
problem of when to invest. Makes market timing irrelevant.
• Most of the investors have no time to and efforts or expertise in investing in
equities, thus mutual funds offer an attractive alternative through SIP.
• The general tendency of investors is to buy more units when markets are down
and NAV is low and fewer units when markets are up and NAV is high. SIPs
help in investing even when markets are low thus lowering the average cost.
• Even with small amounts of investment, SIPs help the investors in enjoying the
benefits of diversification.
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7.11 SUMMARY
Mutual funds exercise little control over price and, except through direct sales, little
over people.
Usually, mutual funds are managed by investment professionals or fund managers for
which they earn fees.
Investor base, returns on market, and investment avenues are factors essential for growth
of mutual funds.
The Reserve Bank of India (RBI) is responsible for regulation of a certain well-defined
segment of the capital market.
AMFI is established on the lines of the Investment Company Institute (ICI), the national
association of US investment companies. AMFI has set up the Committee on Valuation
of Mutual Funds, Committee on Best Practices, Committee on RBI Related Matters, and
Committee on Registration of AMFI Certified Distributors for Reviewing and Evolving
Standards in the Mutual Fund Industry.
The two different categories of investors suitable for investing in mutual funds in India
are individual and institutional investors.
Risks associated with different kinds of funds include credit risk, currency risk, income
risk, industry risk, inflation risk, management risk, market risk, and principal risk.
Investing a fixed sum at regular intervals in a mutual scheme is known as systematic
investment. It is similar to regular savings, schemes like recurring deposits.

7.12 GLOSSARY
Mutual Fund Custodian is a trust company, bank or similar financial institution
responsible for holding and safeguarding the securities owned within a mutual fund. It
may also act as the mutual fund’s transfer agent, maintaining records of shareholder
transactions and balances.
Net Asset Value or NAV is a term used by mutual funds, master shares and other
investment trusts to indicate the net tangible asset value of each share on a particular
date. It can also mean the total market price of all the shares held by a mutual fund less
any liabilities, divided by the total number of outstanding shares on a particular date.
With every change in share prices, the NAV of mutual funds changes.
Income Fund is a mutual fund with investments mostly in debentures, bonds and high
dividend shares. This type of fund attracts investors interested in income rather than
growth of their investment.
A Growth Fund is a mutual fund that invests only in securities which have scope for
good capital growth, rather than current income.

7.13 SUGGESTED READINGS/REFERENCE MATERIAL

• John c Bogle. Common Sense on Mutual Funds. John Wiley & Sons, 2010
• Indian Institute of Banking and Finance. Introduction to Financial Planning.
Taxmann Publications Pvt Ltd., 2007.

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7.14 SUGGESTED ANSWERS
Self-Assessment Questions – 1
a. 1. An open-ended fund or scheme is available for subscription and
repurchase on a continuous basis where as close ended fund is open for
subscription only during a specified period at the time of launch of the
scheme. Investors can invest in the scheme at the time of the initial fund
offer.
2. Open ended schemes do not have a fixed maturity period. A close-ended
fund or scheme has a stipulated maturity period e.g. 5-7 years.
3. In open ended scheme, Investors can conveniently buy and sell units at
Net Asset Value (NAV) related prices which are declared on a daily basis.
In close ended schemes, Investors can invest in the scheme at the time of
the initial public issue and thereafter they can buy or sell the units of the
scheme on the stock exchanges where the units are listed. In order to
provide an exit route to the investors, some close-ended funds give an
option of selling back the units to the mutual fund through periodic
repurchase at NAV related prices.
4. In open ended schemes, the NAV is declared on regular basis. In close
ended schemes, the NAV is declared periodically.
b. Gilt funds basically invest in medium and long-term government securities.

Self-Assessment Questions – 2
a. A mutual fund is an investment scheme that brings together money from a
number of investors and invests the same in different financial instruments such
as stocks, bonds etc., based on certain investment objectives.
b. A Mutual Fund in India constitutes:
• Sponsor
• Board of Trustees
• Asset Management Company (AMC)
• Custodian
• Registrar and Transfer Agents
• Distributors.

7.15 TERMINAL QUESTIONS

A. Multiple Choice Questions
1. Mutual Funds invest in ________________.
a. Only equities
b. Only debt instruments
c. Only gold
d. Only bank fixed deposits
e. Different financial instruments based on the objective of the scheme.

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2. Under rupee-cost averaging, an investor typically buys ________________.
a. More of equities or an equity-linked instrument like a mutual fund unit
when prices are low
b. Less of equities or an equity-linked instrument like a mutual fund unit
when prices are low
c. More of equities or an equity-linked instrument like a mutual fund unit
when prices are high
d. Bonds
e. Gold.
3. Growth funds invest major proportion of their fund in _______________.
a. Equities
b. Debts
c. Gold
d. Fixed Deposits
e. Only (a), (b) and (c) of the above.
4. Which one of the following is not an advantage of the systematic investment
plan?
a. Makes market timing irrelevant.
b. Light on the wallet.
c. Compound returns.
d. Helps you to maintain present situation.
e. Lower the average cost.
5. Money market fund basically invests in _________.
a. Short term debt securities
b. Long term debt securities
c. 10 year zero coupon bonds
d. Long term government securities
e. Gold.
B. Descriptive
1. What are the advantages and disadvantages of mutual fund investment?
2. What are the different types of mutual fund schemes based on their investment
objectives?
3. Elaborate the risk associated with mutual fund investment.

These questions will help you to understand the unit better. These are for your
practice only.

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NOTES

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NOTES

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Block Unit Unit Title

Nos.

I FUNDAMENTALS OF WEALTH MANAGEMENT

1. Introduction to Wealth Management

2. Understanding the Wealth Management Process

3. Client Profiling

4. Personal Financial Planning

II INVESTMENT AVENUES

5. Investment and Investment Products

6. Alternative Investment Options

7. Mutual Funds

III INVESTMENT MANAGEMENT

8. Asset Allocation

9. Portfolio Management and Performance

Measurement of Portfolios

IV MARKETING ASPECTS OF WEALTH

MANAGEMENT

10. Marketing of Financial Products

11. Behavioral Skills for Wealth Management

13. Understanding Investor Psychology