Investment Planning (Professional Development Program) IMS Learning Resources Pvt Ltd.

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PREFACE Investment Planning is all about achieving desired rate of returns from investib le surplus and existing assets, matching one’s time frame of goals, age and risk p rofile. Hence this forms the heart of comprehensive financial planning process. Investment planning begins with designing a suitable strategy identifying and se lecting various asset classes to grow existing assets and future investible surp lus. Sound investment strategy is based on comprehensive knowledge about various clas ses of assets, their unique characteristics and understanding of expected return s and associated risks with each class of asset. It is important to bear in mind that investment strategy will always be linked to one’s risk profile. This program will guide you systematically in understanding the concepts require d for preparing a sound investment plan. PDP Investment Planning 3

Table of Contents Chapter - 1 Chapter - 2 Chapter - 3 Chapter - 4 Chapter - 5 Chapter - 6 Chapter - 7 Chapter - 8 Chapter - 9 Fundamentals of Investment Planning ................ .................................................... 8 Understanding Investment Risk ........................................................................... . 16 Measurement of Risk ....................................................... .................................... 27 Managing Risk in Investments ........... ................................................................... 40 Measuring Investment Returns ............................................................ ................. 54 Building an Investment Portfolio .......................... ................................................. 71 Small Saving Schemes ...... ................................................................................ .. 94 Fixed Income Instruments ................................................. ................................. 107 Life Insurance Products .................. .................................................................... 116 Chapter - 10 Mutual Funds ...................................................... ............................................... 126 Chapter - 11 Stock market in vestments ...................................................................... ............ 144 Chapter - 12 Derivatives ...................................... ................................................................... 160 Chapter - 13 Real Estate ............................................................... ......................................... 188 Chapter - 14 Investment strategies ............................................................................... .......... 197 Chapter - 15 Asset Allocation ................................... ............................................................... 205 Chapter - 16 Structuring Portfolio for Investors ........................................... ............................ 212 Chapter - 17 Regulation of Financial Planners . ....................................................................... 219 PDP Investment Planning 5

Chapter 1 PDP Investment Planning 7

5 per cent in 2002-03 to 28. Almost all individuals have wealth of some k ind. risk of diminished income f rom staying completely invested in low yielding fixed income securities or bank deposits. This clearly shows that while as a nation we are very good savers we are very poor investors because it is equally important for the savers to invest in avenu es that fetch decent returns after considering factors like inflation. long-term objectives. It is shocking to note that more than 45% of domestic savings is invest ed in bank deposits and only about 2/3% in equity and equity related investments . It is important to understand the difference bet ween Savings and Investments. reflecting the high business optimism.1 per cent in 2004-05. ranging from the value of their services in the workplace to tangible asset s to monetary assets. taxation. A financial asset is one tha t generates income and contributes to accumulation and growth of wealth over a p eriod of time. The two elements in investments are generation of income on a per iodic basis and/or growth in value over a period of time. marriages and having more than enough for an enjoyable retirement are some of the objectives most people aim at. Understanding where the c lients are coming from. but potentially more damaging. Investment scenario in India A pick-up in investment. Some investors have failed to recogn ize the less obvious. which provided most o f the resources for investment. The financial planner should ensure that investors take a hard look at the fixed income components of their portfolios and rethink this strategy in th e context of more comprehensive. etc.1 The increasing trend in gross domestic savings.9 per cent in 2003-04 and further to 29. Bank deposits not only offer lower returns but they are hardly tax efficie nt and thus do not serve the cause of earning high post tax & net of inflation r eturns. as a proportion of GDP observed since 2001-02 co ntinued with the savings ratio rising from 26..2 India is a nation of s avers and the domestic savings is a very high percentage of GDP.Fundamentals of Investment Planning What is Investing? I nvestment refers to a commitment of funds to one or more assets that will be hel d over some future time period. It is important to channel these savings into productive investment avenues. Succeeding in career. In developed countries the proportion of savings being diverted to equit y and equity related instruments is in the region of 20-25% of GDP while around 20% of savings are parked in bank deposits. 1 Economic Survey 2005-2006 2 Economic Survey 2005-2006 Investment Planning PDP 8 . That is extreme ly good. The rally in gross domestic capital formation (GDCF) that had commenced in 20 02-03 continued and as a proportion of GDP it reached a high of 30. investment will mean a measurable asset retained in order to increase one’s personal wealth. the priorities in their life and the challenges they fac e in a rapidly changing investment horizon. not only strengthened industrial performance but also reinforced the growth outlook itsel f. planning child ren’s education. In fact we are a n ation of savers where the domestic savings is a high percentage of Gross Domesti c Product – sometimes as high as 26-27%. For our purposes.1 per cent in 2004-05. Anything not consumed today and saved for future u se can be considered as savings. Almost all of us save money.

000/. The pla nner’s job in India is more challenging because of Indian mind set and the aversio n to risk. It will be part of his job to educate his clients on concepts of risk s and returns and their relationship. at the end of each month.. Regardless of why we invest we should all seek to manage our wealth effectively. 12% and 15% p. Look at the big difference in the maturity values as the term gets longer and longer and as the returns are higher .The financial planner in India hence. possibly in retirement when we are less able to work and produce for our daily needs. Investment fundament als Some of the fundamental rules of investments are: START EARLY INVEST REGULAR LY ENSURE HIGHER RETURNS ON YOUR INVESTMENTS The following table will demonstrat e the difference. Anticipat ed future consumption may be by other family members. we expect to enhance our future consumption possibilities. borrowed money. obtaining the most from it. systematically.p. such as education funds fo r children or by ourselves. very graphically: It is assumed that an investor invests Rs 1. PDP Investment Planning 9 . in different invest plans which yield 5%.m. It is e qually important to ensure that money works for us.a. returns. and savings or foregone consumption. taxes and other factors. By foregoing consumption today and investing t he savings. has a very important role to play. Funds to be invested come from assets already owned. The above table very clearly illustrates how a higher rate of return over longer period of time can make a world of difference to the capital at the end of the term. Indian investors have always preferred fixed income securities where the returns are assured and have compromised on the returns. We should inculcate the habi t of reliance on a secondary source of income. Why Invest? We all work for money. It is the job of the financial planner to a dvise the investors on the concept of focusing on higher returns for better stab ility and higher capital building over a longer period of time. In general investors are risk averse and more so Indian investors. 8%. We invest to improve our future w elfare. This includes pro tecting our assets from inflation.

m. Wait until a money crisis to begin financial planning. These are some of the most common misconceptions about financial planning and it the perhaps one of the first jobs of the financial planner to clear these areas with the prospective client. one can consider its short and long-term effects on life g oals. Financial planning is the process of meeting one’s life goals throug h the proper management of your finances. 6. a very conservative investor. Th ese dramatic results have been possible because of the focus on the rate of retu rn. Common Mistakes in the planning process It may be helpful to be aware of some common mistakes people make when approaching investments: 1. Think that financial planning is the same as retirement planning. 3. Think that financial planning is only for the wealthy. h as been investing Rs.a. Life goals can include buying a home. on the advise of his planner. Don’t set measurable financial goals. the various steps invo lved and the ultimate objective of the exercise before hand and make the investo r comfortable about disclosing his personal information. 2. Sunil Joshi. Think that using a financial planner means losing control. 8. 11. it would make sense that we utiliz e a plan to help guide our decisions. 5. First. return. One can also adapt more easily to life changes and feel more secure that g oals are on track. While assured retu rns are important it is also important to focus on expected returns on investmen t. 4. 74. 3. Ashwin Shah will have accumulated Rs. 5. Sunil Joshi has done well by starting early and investing regularly but he has not focused on the rate of returns on his investments. Mr. Both start at the same age of 25 years and keep inv esting for 30 years. Sunil Joshi will have a capital amount of Rs.Example Mr. 10 Investment Planning PDP . the majority of people do no t have in place any type of formalized investment plan.a. even at a risk. saving for child’s education or planning for retirement.p. Sunil Joshi. 5. Ashwin Shah. in equity linked investments which have given him around 15% p.50 lac s in his provident fund account while Mr. has been religiously investing Rs . Financial planning provid es direction and meaning to one’s financial decisions. It allows one to understand how each financial decision affects other areas of finances. Taking some time to put together a financial plan can reap tremendous benefits.m.000/. Surprisingly. Mr. 9. 7. let’s define financ ial planning. The financial planner should explain the process of planning.000/. Think that financial planning is for when they get older. Neglect to re-evaluate their financial plan periodica lly. buyin g a particular investment product might help you pay off your mortgage faster or it might delay your retirement significantly. Confuse financia l planning with investing.p. E xpect unrealistic returns on investments. For example. How Do We Invest? If we are making investment decisions today that will directly affect our future wealth. in a provident fund account which gives him interest at the rate of 8% p. compounded annually. Make a financial decis ion without understanding its effect on other financial issues. Mr. 10.46 crores which is about 5 times the retirement capital of Mr. By viewing each financial decisio n as part of a whole. Believe that financial planning is primarily tax planning.

The planner may carry out the r ecommendations or serve as the “coach. The financial planner should offer financial planning recommendat ions that address client’s goals. he should report to the client periodically to review the situation and adjust the recommendations. It is important for the investor to realize that planning is very important.What Process Do We Use to Invest? Nobody plans to fail but many fail to plan. The planner should also listen to th e client’s concerns and revise the recommendations as appropriate. if relevant. The cli ent and the planner should mutually define the personal and financial goals. Financial planning Financial planning is the process through which the planner helps his client to achieve his financial goals. investments or tax st rategies. The financial planning process consists of six steps that help the investor/client take a “big picture” look at wh ere he is financially. These six steps are: 1. based on the information collected. The client and the planner should agree on w ho will monitor the progress towards achieving the goals. The planner may have a product bias becaus e of the commissions and brokerages and he may try to push PDP Investment Planning 11 . Using these six steps. Monitoring the financial planning recommendations. including goals. Analyzing and evaluating your fina ncial status. The financial planner should ask for information about the client’s financial situation. if needed. 3. Establishing and defining the client-planner relationshi p. The f inancial planner has to spend time in educating the investors about the common m istakes and how to come over them. The financial planner should analyze the client’s information to ass ess his current situation and determine what he must do to meet his goals. Depen ding on what services you have asked for. und erstand the client’s time frame for results and discuss. 2. the investor can work out where he is now. The client and the planner should agree on how long the professional relationship should last and on how d ecisions will be made. The financial planner should clearly explain or document the services to be p rovided to you and define both his and the client’s responsibilities. current insurance coverage.” coordinating the whole process with the clie nt and other professionals such as attorneys or stockbrokers. Implementing the financial planning recommendations. The planner should explain fully how he will be paid and by whom. Developing and presenting financial planning recommendations and/or alternatives. liabilities and cash flow. what he may need in the future and what he must do to reach his goals. 6. The planner should go over the recommendations with the client to help him understand them a nd help the client make informed decisions. this could include analyzing your asse ts. The client and the planner should agree on how the recommendations will be carried out. The financial planner may also be an insurance advi sor and/or a mutual fund distributor. Product selling Vs. along with life changes. Gathering client data. how he feels about risk. The financial planner should gather all the necessary documents bef ore giving the client the advice he needs. 5. He has to take the client through the systema tic process of financial planning outlined below. If the planner is in c harge of the process. 4.

magazines or self-help books that can help them do their own financial plan ning. This is not o nly unethical and immoral but is also not a proper strategy for long term busine ss success for the planner. Product selling doe s not involve these steps of educating and increasing the risk tolerance of the investor. The financial planner plays a very important role i n designing an investment plan that would best suit his client’s needs. The client w ould be better motivated to opt for your service as a planner if you take care o f his long term interest rather than your short term interest of brokerage/commi ssions. goals. An inves tor may feel that a professional adviser could help him improve on how he is cur rently managing his finances. etc. Thu s our investors have a very low risk tolerance. It is one of the most important tasks of the planner to educate his client on the concept of investment risk . a planner can help you evaluate the level of risk in your investmen t portfolio or adjust your retirement plan due to changing family circumstances. It is easier for you to achieve your goals if you help a large number of people achieve their goals.these products rather than act in the best interest of his client. Hence a planner will enjoy a long term advantage and better relationsh ip with his client compared to a product seller. more comprehensive and more rewarding for the client and the plan ner in the long term. p repare the client mentally to accept volatility in the markets in the short term and explain how patience will be rewarded in the long term. This is a very comprehensive process which requires a thorough understanding of the financial p roducts. Self-Help or Professional Help? Some investors may feel that they understand financial products better and can do the financial planning themselves rather than entrust the same to a professio nal financial planner. economy and also an analysis of the client’s risk profile. In India many investors have a low level of understanding of the concept of financial risk and hence have conventionally preferred fixed i ncome instruments to market related instruments with uncertain income flows. markets. They may want to get a professional opinion about the financial plan they have developed for themselves. However. they may decide to seek help from a professional financial planne r if: n They need expertise that they don’t possess in certain areas of finances. n n n n n An investor may feel that he should improve his financial position but does not know where to start and how to go about it. It is a well established fact that success in market ing any product or service is more dependant on motivating a client to buy the p roduct/service rather than resorting to aggressive selling tactics. Some of the common problems which ar e brought before the financial planner are listed below. n How should I create and preserve personal wealth? 12 Investment Planning PDP . For example. He tries t o understand thoroughly the financial goals of his clients. Thus financial planning is much superior to selling financial prod ucts/services. Certain changes take place in the family or an immediate need or unexpected life event such as a birth. Investors may prefer some personal finance software packa ges. needs . The list is inclusive a nd there can a number of other areas as well. They may not have the time to spare to do their own fi nancial planning. inheritance or major illness. he discusses the var ious investment options available and finally suggests to his client a financial plan that will serve the purpose of achieving the client’s goals.

PDP Investment Planning 13 . confide ntial and patient approach to help his client reach decisions on complex choices and alternatives in investments. 2. 3. He should adopt a personal. He should also believe that money is not everything but having c ontrol and confidence about managing it can allow the client to concentrate on o ther things like family.n n n n n n n How can I achieve a specific lifetime financial objective? How should I provide for my children’s education? I am receiving a distribution from my employer. 4. He should believe that a sound financial plan is fundamental to achieving his client’s goals and enhancing the q uality of life. What do I do? Do I have enough to retire? I just received a lump-sum inheritance. Wha t do I Do? When should I execute my stock options? How should I best leave wealt h to my heirs? Expectations from a financial planner 1. He should recognize that the issues that brought the client to him are unique and he should try to take result orien ted approach to solving the client’s concerns. career and future.

Successful investing can be directly rela ted to I.Review Questions 1. I. I & II only b . II and IV only d. The main reason people fail to plan is: a. d a c 14 Investment Planning PDP . III only c. Investing regularly III. A process of solving financial probl ems and reaching financial goals 2. Focusing on risk and return in different investment vehicles a. Keeping taxes as low as possible c. All four Answers: 1. Financial Planning is: a. They lack the expertise to plan 3. 3. Taking unduly high risks I V. Starting early II. T hey keep on postponing b. 2. Investing assets to receive the hi ghest rate of return possible b. They are too old to plan c. Planning to retire with the maximum income possible d. They are too young to plan d.

Chapter 2 PDP Investment Planning 15 .

While most people consider the decrease in value as the investment risk. Generally. cannot go away. the gr eater must be the potential return as reward for committing one’s funds to an unce rtain outcome. We will now consider each of these types of risk. That is. Your client now states that she is averse to the 8% outcome and wants to know if the investment can yield 12% or better. or the expected outcome would n ow be 14% ((16%+12%)/2) and the new poor outcome would now be 12%. the client wishes t o remove the poor outcome altogether. risk. There are many different ways in which the principal invested can be unexpe ctedly changed. In other word s. That is. Before we discuss risk in detail. another way to consider risk is to consider the possibilities of unexpected outcomes. Risk can be de fined as the uncertainty of an outcome from an investment decision. The issue of risk being incorporated in both positive and negative surprises can be explained with a simple example. In the case of Fixed Income Instruments with a definite coupon rate there is virtually no “risk” of not being able to get the desired returns but in the case of other instruments an investor goes with an expectation of a certa in amount of return and the term “risk” in this context refers to the probability of the investor not getting the desired/expected returns The notion of risk is an integral and primary concept in the understanding of investments. Notice that if this were possible. Fixed Income Instruments and 2. as the level of risk rises. Thus. the rate of return should also rise. One way to handle risk is to avoid it. The outcome form an investment decision may unexpectedly increase or decrease the principal amount invested. It is only meaningful in th e context of an expected outcome and both positive and negative unexpected outco mes. There is a risk/return trade-off. Risk avoidance occurs when one chooses 16 Investment Planning PDP . we should first exp lain that risk can be perceived. Risk Avoidance Investment planning is almost impossible without a thorough understanding of ri sk. We invest in various investment p roducts which generally comprise: 1. You also explain that the client may ex pect to receive a simple average of the two returns. Assume you are explaining the possible outcomes of an in vestment decision to a client where the client may receive a return of either 8% (poor outcome) or a 16% (good outcome). Growth orie nted investments. Before considering the issues regarding the measurement of risk let us begin by enumera ting the different types of risk that may exist for an investment. the greater risk accepted. In making an investment decision. an investor forms an exception regarding that decision’s out come. or 12%. from the investment decision. and vice versa. Any departure form that expected outcome can be considered the risk of tha t decision. defined and handled in a multitude of ways. we will observe that in measuring risk. both positive and negative unexpected outcomes must be considered. then th e simple average of the new investment decision.Understanding Investment Risk Definitions and Concepts Understanding Risk I n the context of investments “risk” refers not only to the chance that a person may lose his capital but more importantly to the chance that the investor may not ge t the desired return on an investment vehicle. or the unexpected outcomes.

if planning for retirement. so in this case. even very large risk. Rational investors prefer certainty to uncertainty. avoidance is not a viable choice. A n easy to understand example of risk transfer is the concept of insurance. PDP Investment Planning 17 . Complete avoidance. we should say that investors are risk averse. Taken to its logical conclusion. Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to in cur. but more precisely. can be completely avoided by choosing not to invest equities and equity related instruments. the standard assumption is t hat investors are rational. a person could avoid that risk altogether. we need to think in terms of the expected return/risk trade-off that results from the direct relationship between the risk and the expected return of an inve stment. Obviously. Stock market risk. would create the inevitable out come of death. Risk transfer can also occur in investing. for example. by refusing to eat at all. “Lower the risk. if they collect enough premiums and have a large enough pool of insured persons. Generally speaking. An example would b e the risk of being injured while driving an automobile. The Risk Averse Investor Do investors dislike risk? In e conomics in general. investors cannot reasonably expect to earn larger returns without assuming larger risks. The objectives being pursued may require a p olicy statement that speaks to specific planning horizons. An insurance company will allow you to transfer the r isk of large medical bills to them in exchange for a fee called an insurance pre mium. One may view a risk in eating food that might be toxic . We have said that investors would li ke to maximize their returns. the longer the time horizon the more risk can be incorporated into the financia l planning. the minimization of risk would result in ev eryone holding risk-free assets such as savings accounts and Treasury bills. regardless of how much lo wer the stock or the index may drop. Short-term maturity Government bonds are usually equated with a “risk-free” rate of return. specifically a lower expected return. In the Indian market place “risk free” retur ns are the returns available on Treasury Bills of a certain tenor. Other investors are unwilling to assume much risk. Note care fully that it is not irrational to assume risk. in general. A risk-averse investor is one who will not assu me risk simply for its own sake and will not incur any given level of risk unles s there is an expectation of adequate compensation for having done so. then heal th insurance is advisable. The company knows that statistically. In the investm ent world. they can pay the costs of the minor ity who will require extensive medical treatment and have enough left over to re cord a profit. lower the ret urn”. as long as we expect to be compensated for it. It is easy to say that investors dislike risk. life presents some risk s that cannot be avoided. avoidance of some risk is deemed to be possible through the act of in vesting in “risk-free” investments. If on e has the risk of becoming severely ill (and unfortunately we all do). There are many examples of risk transfer in the area of investing. will c hoose to minimize their risks? No! The reason is that there are costs to minimiz ing the risk. Thu s. In fact. By choosing not to driv e. and investments in particular. Some investors choose to incur high levels of risk with the expectation of high levels of completely avoid the activity the risk is associated with. and th ey should not expect to earn large returns. One may purchase a put option on a stock or on the market index which allows that person to “put to” or se ll to someone their stock or the index at a set price. Influence of Time on Risk Investors need to think about the time period involved in their investment plans. In the case of an ind ividual investor this could be a year or two in anticipation of a down payment o n a home purchase or a lifetime. necessarily l ess than one year and about 90days or 180 days. Can we also say that investors. Risk Transfer Another way to handle risk is to transfer the risk.

Then we have systematic risk and nonsystematic risk. market and inflation risks. Types of Investment Risk Systematic versus Unsystematic Risk Modern investment analysis categorizes the t raditional sources of risk causing variability in returns into two general types : those that are pervasive in nature. the diversifiable or non market part. The thirty year bond. that while over the long term stocks have outpe rformed. if it rises strongly. The investor cannot escape this part of the risk because no matter how well he or she divers ifies. Therefore. the lon ger can be his time horizon and hence more exposure to equities – this follows the rule that risk and returns go up with time. whether bonds or stocks. such as business or financial risk. A f inancial planner has to take into account the time horizon while structuring inv estment portfolios and the general rule is that the younger a person is. the risk of the overall market cannot be avoided. Wha t is left is the non diversifiable portion or the market risk. such as market risk or interest rate risk. If the stock market dec lines sharply. If one were to “lock in” a r ate of 8 percent for a bond that matured in one year. General risk + Specific risk Market risk + Issuer risk Systematic risk + Unsystematic r isk 18 Investment Planning PDP .Globally as well as in India it is well established on the basis of track record of performance that equities as a class of asset has outperformed other asset c lasses and delivered superior returns over longer periods of time. such as bonds. That is because the bond coul d be redeemed in one year and reinvested in a bond with a presumably higher inte rest rate. With these st atistics available why wouldn’t everyone at all times be 100 percent invested in s tocks? The answer is. there have been many short term periods in which they have underperform ed. Clearly. There is more risk associated with holding a bond long term than short term because of the un certainty of future inflation and interest rate levels. Virtually all sec urities have some systematic risk. we must consider these two categories of total risk. a general (market) component and a specific (issuer) compon ent. have had negative returns. will continue to pay only 8 percent fo r the rest of its thirty year life. market risk is critical to all investors. These movements occur regardless of what any single investor does. Exactly when short term periods of u nderperformance will occur is unknown and thus there is more risk in owning stoc ks if one has a short term horizon than if there exists a long term horizon. which are additive: To tal risk = = = Systematic Risk An investor can construct a diversified portfolio and eliminate part of the total risk. however. Variability in a security’s total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk. The following discussion introduces these terms. Time has a different effect when an alyzing the risk of owning fixed income securities. mos t stocks will appreciate in value. and in fact. Total risk can be divided into its two components. and those that are specific to a particular security issue. most stocks will be adversely affected. an upward move in inflatio n or interest rates would have a less adverse effect on the price of that bond t han a 8 percent bond that matured in thirty years. of course. because systematic r isk directly encompasses interest rate.

Rem ember the difference: Systematic (Market) Risk is attributable to broad macro fa ctors affecting all securities. The YTM calc ulation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond. because investo rs earn the indicated yield only if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at the calculated YTM (yield to maturity). In effect. structural changes in the economy. this calculat ion assumes that the reinvestment rate is the yield to maturity. or reinvests them at a rate different from the assumed rein vestment rate of 10 percent. thereby earning interest on inter est over the life of the bond at the computed YTM rate. to obtain the YTM yield on the security. Because of the importance of the reinvestment rate .Unsystematic Risk The variability in a security’s total returns not related to ove rall market variability is called the unsystematic (non market) risk. that risk is termed as market or systematic risk. recessions. This interest-on-interest concept significantly affects the potential total dollar return. at the same rate as the YTM. Events occur within a market that similarly affect all the goods traded in that market. PDP Investment Planning 19 . Other examples of events that affect all securities are the possibilities of wa r. And. This risk is unique to a particular security and is associated with such factors as busine ss and financial risk as well as liquidity risk. Specifically: a . In the context of long term bonds during the tenor of which the interest rates may fluctuate in any economy it is virtually difficult for the investor to invest periodic coupon payments a t YTM and hence the risk of not being able to get the desired return (YTM) and t his risk is referred to as reinvestment risk. Market Risk A market is a place where goods and services are traded. the gr eater the reinvestment risk. the higher the co upon rate. For example. we consider it in more detail by analyzing the reinvestment risk. Reinvestment Risk In the context of bonds investors look at the current yield as well as Yield To Maturity (YTM) – the return one would get if the security were held till the maturity and redeemed with the issuing institut ion. coupons almost always will be reinvested at rates higher or lower than the computed YTM. even changes in consumer preferences etc. If the investor spends the coupons. the greater the dependence of the total return from the bond on the r einvestment of the coupon payments. When the unexpected ch ange in values is systematic to the whole market. no trading can be done for a particular bond if the YTM is to be earned. b. It is important to understand that YTM is a promised yield. however. the longer the maturity of a bond. when the Reserve Bank of India unexpe ctedly changes interest rates. t ax law changes. The investor simply buys and h olds. The exact impa ct is a function of coupon and time to maturity. Holding everything else constant. or both. it is generally connected with common stocks. Holding everything else constant. in fact. severe natural catastrophes. Although all securities tend to have some nonsystematic risk. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security. rises. It is important to reinvest the periodic payments. resulting in a realized yield that differs from the prom ised yield. This gives rise to reinvestment rate risk. What is not so obvious to many investors. the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. is the reinvestment imp lications of the YTM measure. with reinvestment becoming more important as either coupon or time to maturity. most financial securities are affected similarly. Obviously.

000 which i s expected to result in a certain outcome of Rs. as the retirement plan grows. 2. Therefore.000. Some realized rates of return may be better than the forecast and some m ay be worse than the forecast. When changes in interest rates are unexpected. we will not see the steady.000 to purchase the car. As a financial planner. Values of stocks are also affected by chang es in interest rates. bond prices cha nge in the opposite direction. that is.The notion of reinvestment rate risk is particularly easy to see in the retireme nt planning process. an assumed ra te of return is built into the retirement forecast as to estimate the annual con tributions the client will be required to make to the retirement plan. Now also consider tha t the client wishes to purchase a car. Purchasing Power Risk Inflation risk is also known as purchas ing power risk because the ability to purchase different quantities of goods and services is dependent upon the changing levels of prices of all items in an eco nomy. to protect from these two risks that we have discussed. the client s will not have enough funds at retirement to meet their need. If we 20 Investment Planning . 2. If the current scenario is such that the interest rat es may rise in the near future and may keep rising for some time to come. has a considerable influence on interest rates. In this case. other things being equal. when interest rates increase.000. Real assets such as real estate are also tremendously impacted by changes in interest rates. any unexpected change in the gen eral level of interest rates will also unexpectedly affect the values of all suc h assets. Interest Rate Risk The variabili ty in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. then m ay be more of short term debt instruments would find place in the portfolio and in a scenario where the interest rates have reached historic peaks and may fall in the future. Either way. In other words.90. though understanding the impact of interest rate changes o n stock values is less straightforward than for bonds. the values of bonds and all other fixed income securiti es are inversely related to interest rates.10. As interest rates change.90. the reinvestment risk is the cause of the problem. then it would make sense to commit funds for long term and hence investors should be advised to get into long term bonds/annuities of insurance c ompanies. 3. It is ass umed that the funds will build at that rate of return until the client retires. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. the investor would have been bette r off if she had bought the car instead of investing the amount. Financial assets such as bonds are especially affected by such changes . 10. If t he rates of return are consistently lower than the original forecast. 3. while considering investm ents in various fixed income securities it is desirable to explain the concepts of interest rate risk as well as reinvestment risk and build the same while stru cturing client portfolios. assume a client wishes to invest a sum ofRs.000 over the year. either today or one year from now and whi ch is valued today also at Rs. The value s of all financial and real assets are in some part dependent on the general lev els of interest rates in an economy. What we see in reality is varying rates of return throughout the life of the por tfolio. t hese values decrease and vice versa. The reason for this movement is tied up with the valuation of secur ities. As we shall see later. Thus the invest or has a choice in how the money may be used. security prices move inversely to int erest rates.e. The reader can appreciate why participants i n the financial markets so engrossed in pending activities of the Reserve Bank o f India which through its policy making decisions. the uncertain changes in asset values are sai d to arise form interest rate risk. If the money is invested then the client will need an additional Rs. For example. i. forecasted rate of return on the retirement portfolio. Suppose the price of this car increases to Rs. etc.00. In this case. Such changes generally affect securities inv ersely. In assisting a client with a retirement plan. t he inflation in the car’s price has eroded the purchasing power of the invested su m.


If its recommendat ions are accepted by the Government then the attractiveness of this investment a venue will drop dramatically. A factor affecting all securities is the purchasing power risk also known as inflation risk. This risk is related to interest rate risk. Inflation ri sk is especially important to investment decisions where the financial securitie s being utilized are interest rate sensitive. Ass ets differ from each other by liquidity risk. An investment that can be bought or sold quickly and without significant price concession is considered liquid. If the investor cannot find a buyer for the stock. These avenues become attractive because of the tax concessions (which are matters of legislation) and these can change. a Treasury bond). stocks of very small and little known companies are considered to conta in high liquidity risk because they are thinly traded. because l enders demand additional inflation premiums to compensate for the loss of purcha sing power. With uncer tain inflation. the real (inflation-adjusted) return involves risk even if the n ominal return is safe (e. When investors make purch ase decisions that may require to be quickly converted to cash. Dividends on shares and equity mutual funds are ta x free in the hands of investors. A specia l committee has advised the Government of India to do away with various sections of The Income Tax Act which allow exclusions and deductions. The best solutio n lies in periodic review of investment plans. That i s one risk associated with investments which cannot be avoided. For example. Such as bonds. firms that temporar ily place excess cash in financial (marketable) securities in order to enhance y ields will seek highly liquid securities that do not increase the firm’s liquidity risk exposure. where as a small cap stock listed in a regional stock exchange may have substantial li quidity risk. This i s the chance that the purchasing power of invested money may decline. A Treasury bill has little or no liquidity risk. Business Risk The risk of doing b usiness in a particular industry or environment is called business risk. and hence are considered to be highly liquid.g. an investor may wish to sell her holding in a stock . they will always seek securities which have low liquidity risk.consider that the increase in the price of the car was unexpected. The risk of a regulatory change tha t could adversely affect the stature of an investment is a real danger. some commodities like fertilizers and oil are highly price sensitive in th e Indian context and the Government PDP Investment Planning 21 . Hence. For example. the gr eater the liquidity risk. since interest rates generally rise as inflation increases. As a result of that special tax exemption on the interest as well as the invested am ount qualify for deduction from income u/s 80C the yield on PPF account is much higher than its current interest rate of 8%. For exa mple. Any event or condition that affects this ability is termed as liquidity risk. Liquidity is concerned with the ability to convert the value of an asset into cash.. Liquidity Risk “Liquidity’ in the context of investment in securities is related to being able to sell and realize cash with the least possible loss in terms of time and money. Regulation Risk Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. she faces liquidity risk. The more the uncertainty about the time element and the price concession. Securities offered by the governme nt (such as Treasury bills) are very liquid because there are many participants seeking to trade in these securities. Treasury bills can be sold almost instanta neously. in this example. then we can c onsider the effect of the outcome as arising out of inflation risk. Interest earned on Public Provident Fund accounts are to tally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). At the other end of the s pectrum. then her position in that s tock cannot be liquidated. Liquidity risk is the risk associated with the particul ar secondary market in which a security trades.

stability and viability of a country’s eco nomy need to be considered.S. The risk that a business may not be able to meet its fi xed operating costs. when an investor purchases a security in a foreign country. The risk associated with the c hanges in a firm’s abilities to measure up to expectations is known as business ri sk or unsystematic risk. Exchange rate risk is sometimes called currency risk. and hence. the political. International Risk International Risk can include both Country risk a nd Exchange Rate risk. Exchange Rate Risk All investors who invest international ly in today’s increasingly global investment arena face the prospect of uncertaint y in the returns after they convert the foreign gains back to their own currency . or spot. The risk that the firm may not be able to meet its fixed financial obl igations. is an important risk for investors tod ay. At the time of the purchase. also referred to as political risk. Many firms operate in foreign political clima tes that are more volatile than those in the United States. the value of the foreign security is derived form the current. losses from these exchange rate movements can partially or totally negate the original return earned. global mutual funds. 22 Investment Planning PDP . is known as fin ancial risk. Americ an Depository Receipts. closed-end single country funds. investor who buys an Indian stock denominated in Indian R upees must ultimately convert the returns from this stock back to dollars. whi ch can be defined as the variability in returns on securities caused by currency fluctuations. However. The exchange rate that will prevail wh en the investor sells the security in the future cannot be predicted with any ce rtainty. is known as operat ing risk. Financial risk is also known as credit risk since lenders or credit ors of funds seek to assess the ability of the firm to meet its debt services ob ligations. the conversion value becomes uncertain. investors today must recognize and understand exchange rate risk. Business risk can be further segregated into operating risk and financial risk. The r eturns to an international investor is always the market returns + or – the foreig n currency appreciation or depreciation in the intervening period. such as paying interest on its debt or lease payments. th e investors who invest only in domestic markets do not face this risk. it must be paid for in a foreign curr ency. management salaries. We illustrate this risk by a simple exampl e. both directly and indirectly. exchange rate. Unlike the past when most Indian investors ignored international investing alt ernatives. etc. such as rent. Trans parent economic policies and political stability are key factors for attracting more foreign investments in India. If th e exchange rate has moved against the investor. More and more international investors are investing in the Indian market because of the political and economic stability of India in the last few years and the belief of continued stability on these fronts. A stable r ather than a depreciating foreign currency (in this case Indian Rupee) is what t he investor would be looking for while deciding to invest in that country. Obviously. a U. Currency risk affects internat ional mutual funds.policies of subsidies substantially affect the profitability of the companies en gaged in manufacturing/ marketing these products. and therefore economic.. but in to day’s global environment where investors increasingly consider alternatives from o ther countries. and foreign bonds. For example. this factor has become important. foreign stocks. Country Risk Country risk. With more investors investing internationally. The market for potential assets in which to invest spans the entire globe. This uncertainty can be considered as exchange rate risk. Investors are no t constrained to invest only in their home countries.

Conclusion I nvestors can control some of the risk in their portfolio through the proper mix of stocks and bonds. The informed investor must have some f eel for the political/economic climate of the foreign country in which he or she invests. young investors can afford higher risk than older investors can because young investors have more time to recover if disaster stri kes. Many countries have also been unable to meet their fore ign debt obligations to banks and other foreign institutions which contain impor tant political and economic implications. a too conservative a pproach may mean the investor will not achieve his financial goals. The best solution for the investor is to be sufficiently diversified around the world so that a political or economic development in one foreign country does n ot have a major impact on his or her portfolio. If an investor is five years away from retirement. An investor’s comfort level with risk should pass the “good night’s sleep” test. Danger from a violent overthrow of the politica l party in power can also have an effect on the rate of return investors receive on foreign investments. There is no “right or wrong” amount of risk – it is a very personal decisio n for each investor. with the help of a financial planner. Am I Willing to Accept Higher Ri sk? Every investor needs to find his or her comfort level with risk and construc t an investment strategy. around that leve l. A portfolio that carries a significant degree of risk may have the potential for outstanding returns. PDP Investment Planning 23 . because he will have litt le time left to recover from a significant loss. which means the investor sh ould not worry about the amount of risk in his portfolio so much as to lose slee p over it. Political risk represents a potential deterrent to foreign investment. he probably would not wa nt to be taking extraordinary risks with his nest egg. but it also may fail dramatically. Most experts consider a portfolio more heavily weighted tow ard stocks riskier than a portfolio that favours bonds. Of course.Firms can face the danger of the foreign operations being nationalized by the lo cal government or can experience imposed restriction of capital flows from the f oreign subsidiary to the parent. However.

It is typically influenced by the same factors affecting the market prices of many other comparable investments b. It can not be reduced by diversification b. Syst ematic risk has all the following components EXCEPT: a. Interest rate risk d. Unsystematic risk is composed of which of the following: I. FII’s wil l shy away from Indian markets 24 Investment Planning PDP . II. which of the f ollowing statements is true: a. I & II only c. If Indian Rupee was Rs. All the following stateme nts concerning unsystematic risk are correct EXCEPT: a. FII’s will perceive the currency risk to be very high c. 46. It is typica lly affected by economic. It is the uncertainty that actual return will differ fro m the expected return. Neither I nor II 2. Business risk c. 48 to a US$ in 2004 and Rs. Market risk III. I. It is that portion of total risk that is unique to the parti cular firm c. I only b. It may be affected by changes in consumer preferences and the comp etence of the firm’s management d. Market risk b. It can usually be substa ntially reduced by a carefully executed program of diversification 6. Which of the following statements concerning investment ri sk is (are) correct) I. It is composed of two parts: systematic risk and unsy stematic risk. Purchasing power risk 3. I only b. Both I and II d. II only c. Such risk may be independent of factors affecti ng other industries 4. All the following statements concerning system atic risk are correct EXCEPT: a. a. It is typically found to some extent in nearly all listed securities d. Foreign Institutional Investors would not attrib ute any significance to this change in values b. Financial risk a. political and sociological factors c. I & III only d. II and III 5.50 to a US$ in 2005. FII’s will perceive the currency risk to be low d.Review Questions : 1. Business risk II.

interest rates may move up in the near future. 7. He should prefer the 1 year FD c.a. Government of India taxable bonds offering 8% p.a. b. return for 6 ye ars with no premature repayment option or AAA rated corporate Fixed Deposit for one year offering 8% p. 2. 4. Inflation is on the rise. 5. 3. c b a c d c b PDP Investment Planning 25 . Better let the investor decide because both are safe.7. What would be your advice? a. interest. He should prefer the 6 year GOI Bond d. He can choose either of them – there is no di fference as the interest rate is the same Answers: 1. An inve stor seeks your advice which of the two products would be good for him at this p oint in time. 6.

Chapter 3 26 Investment Planning PDP .

he may do so expecting to get a return of say 15% in one year. this can be described PDP Investment Planning 27 . paying a fixed rate of interest. W ith the possibility of two or more outcomes.) The sum o f the probabilities of all possible outcomes must be 1. a probability is assigned to each possible outcome. a number of possible returns can and will occur. The probability of occurrence is 1. How are these probabilit ies and associated outcomes obtained? The probabilities are obtained on the basi s of past occurrences with suitable modifications for any changes expected in th e future. because no other outcome is possible. The larger the si. it must be estimated . therefore. Standard Deviation When an investor goes in for an investment option. It is a two-parame ter distribution in which the mean and the variance fully describe it. An investor may expect the TR (total return) on a particular security to be 10 per cent for the coming year.Measurement of Risk W n n e invest in various investment vehicles expecting some amount of return from the se avenues. The most familiar continuous distribution is the normal distribution depicted by the well-known bell-shaped curve often used in statistics. In the final analysis. A partic ular investment is considered riskier if the chances of lower than expected retu rns or negative returns are higher. For investors. Investors and analysts should be at least somewhat familiar with the study of probability distributions. it is necessary to calculate its expected value. or s tand-alone. With a discrete probab ility distribution. Given that an investor must deal with the uncertain fu ture. risk. which is the norm for stock market investment.0. The investment risk refers to the probability of actually not earnin g the desired or expected return and may be a lower or negative return. The expected value is the average of all possible return outcomes. investing for some future period involves uncer tainty and. each possible likely outcome must be considered and a probability of its occurrence assessed. of say 90 days. Since the return which an investor earns from investing is not known. Standard deviation (si) measures total. Probabilities represent the likelihood of various outcomes an d are typically expressed as a decimal (sometimes fractions are used. but in truth. this is only a “point estimate. subjective estimates. because they must comp letely describe all the (perceived) likely occurrences. With a c ontinuous probability distribution an infinite number of possible outcomes exist . This is only a one-point estimate of the entir e range of possibilities. To descri be the single most likely outcome from a particular probability distribution. The result of considering these outcomes and their pro babilities together is a probability distribution consisting of the specificatio n of the likely returns that may occur and the probabilities associated with the se likely returns.0. the lower the probability that actual retur ns will be close to the expected return.” Probab ility distributions can be either discrete or continuous. In the case of a Treasury bill. where each outcome is weighted by its respecti ve probability of occurrence. the interest payment wil l be made with 100 per cent certainty barring a financial collapse of the econom y.

1+0.02 0. the expected return is calculated as under: Expected return = Sum (returns*probability) = = = (0.04*0.048+. one will have to estimate the possible returns and the probability of getting the same.4+0.12 or 12% It is a normal distribution curve as pictorially depicted below: 28 Investment Planning PDP .2+0. are no unc ertainties about being able to get the expected return. 016+. Hence there.1) .08*0. normally the expected re turn is the same as the coupon rate or rate of interest.2* the expected return. as given here below: In this case. In the case of investmen ts where the returns are market dependant.12*0.16*0.2+0.004+. Expected Return In the case of a fixed income security l ike a Government of India Bond or a bank fixed deposit. for example a stock.

Standard Deviation We have mentioned that it’s important for investors to be able to quantify and measure risk. volatility and risk can in this conte xt be used synonymously. based on the figures in the table we can work out the variance as under. To calculate the total risk associated with the ex pected return.3817 Let’s quickly work out another example to underst and how to arrive at expected returns and calculate standard deviation. Exp ected return already calculated to be 12% Variance = sum of last column = (6. the variance or standard deviation is used.2+0+3. This is a measure of the spread or dispersion in the probability distribution. Since variance. just be aware that the larger this dispersion. Variance = Sum of {Probabilities* (actual return – expected return)2} Variance = Probability * (actual return – expect ed return)2 So. the mo re uncertain the outcome. Calculating Standard Deviation Let’s use the same table that we did for calculating the expected returns and find out the standard devia tion of the same: Standard deviation is square root of variance.4) = 19. a measurement of the dispersion of a random variable around its mean. remember that the larger the standard deviation.4+3.2 Standard deviation = Square root of variance = 4. PDP Investment Planning 29 . that is.2+6. the larger the varia nce or standard deviation. Without going into furt her details.

however. It captures the total variability in the assets or portfolios retur n. Moving from well. However.3+12*.6+7. The 30 Investment Planning PDP .2+6*.diversified portfolios are reasonably steady across time.15+0*. Somethin g very important to remember about standard deviation is that it is a measure of the total risk of an asset or a portfolio. Fortunately. One important point about the estimation of standard deviati on is the distinction between individual securities and portfolios.6 Standard deviation = 7.6) = 57.4+2. and therefore historical calculations may be fairly reliable in projecting the futur e.2+21. The relevant standard deviati on in this situation is the ex ante (estimated before the event) standard deviat ion and not the ex post (calculated after the events/historic) based on realized returns. and the standard deviations of well-diversified portfolios may be more stable. we cannot avoid such estimates because future returns are uncertain.5895 Calculating a standard deviation using probability distributions involves making subjective estimates of the probabilities and the likely returns.Expected return = [-6*. but they are subject to errors.2+0+7.2+18*15) = [-0. m akes historical calculations less reliable. whatever the sources of that variability.diversified portfolios to individual securities.7] = 6% Sta ndard deviation can be worked out as follows: Variance = (21. including both systematic and unsyst ematic risk. the number one rule of portfolio management is to diversify and hold a portfolio of securities. the standard deviation of return measures the total risk of one security or the total risk of a portfol io of securities.8+2. Standard dev iations for well.9+0+1. The prices of securities ar e based on investors’ expectations about the future. Although standard deviations based on realized returns are often used as proxies for projecting standard deviations. Historic (ex post) standard deviations may be convenient. In summary. investors should be careful to re member that the past cannot always be extrapolated into the future without modif ications.

For starters.D. that is. Almost all of the time (95% of the ti me).7% What Standard Deviation Means Say a fund has a standard deviation of 4% and an a verage return of 10% per year. 3 S. PDP Investment Planning 31       . Thi s ex post value is useful in evaluating the total risk for a particular historic al period and in estimating the total risk that is expected to prevail over some future period. 68. The probabilities are 95 and 99 percent that the actual outcome w ill be within two or three standard deviations. 68% of the time). In a bell shaped normal distribution the probabilities for values lying within c ertain bands are as follows: 1 S.D.historical standard deviation can be calculated for individual securities or por tfolios of securities using total returns for some specified period of time. its returns will fall between 2% and 18%. [10-(2*4) or 10 + (2*4)] Limitations of Standard Deviation Using standard deviation as a measure of risk can have its drawbacks.3% 95. In reality.3 percent probability that th e actual outcome will be within one (plus or minus) standard deviation of the ar ithmetic mean. of the arithmetic mean.D.4% 99. the probability that a particular outcome will be abo ve (or below) a specified value can be determined.3 percent of the ou tcomes will be encompassed. In a normal distribution. The standard deviation. the fund’s future returns will range between 6% and 14% (or its 10% average plus or minus its 4% standard deviation). it’s possible to own a fund with a low standard deviation and still lose money. t hat’s rare.e. or within two standard deviations i. c an provide some useful information about the dispersion or variation in returns. Funds with modest standard deviations tend to lose less money over sho rt time frames than those with high standard deviations. Most of the time (or. 68. combined with the normal distribution. respectively. there is a 68. more precisely. With one standard deviation o n either side of the arithmetic mean of the distribution. 2 S.

The bigger flaw with standard deviation is that it isn’t intuitive. Case Let us consider two stocks: stock X and stock Y whose returns and probability ar e given as follow: Stock X Expected return on stock X is sum of the last column which is 12% Stock Y Expected return on stock Y is the sum of the last column which is 12%. a s tandard deviation of 7% is higher than a standard deviation of 5%. we find that the expected returns of both stocks are the same. In other words. In this e xample. 32 Investment Planning PDP . but these are absolute figures and one can not reach a conclusion as to whether these are hig h or low figures. we shall go ahead and measure the stan dard deviation of both the stocks to find out which stock is more likely to give us the expected returns of 12%. it is not very usef ul to the investor without some context. w hich means it’s not compared to other funds or to a benchmark. Because a fund’s standard deviation is not a relative measure. If the ex pected returns on two stocks are the same. obviously one should prefer that stoc k where the risk is less. Certainly.

t he more responsive the price of a stock to the changes in the market. the security’s returns have more (or less) volatility (fluctuations in price) than those of the market . Beta Beta is a measure of the systematic risk of a security that cannot be avoided th rough diversification.6 Standard deviation of stock Y = 0. Beta measures non-diversifiable risk. If the security’s returns move mo re (or less) than the market’s returns as the latter changes. the market portfolio of all stocks. We shall consider the portfolio s cenario in the subsequent topics.77 Thus. Beta shows the pric e of an individual stock which performs with changes in the market. after the calculation of total risk (standard deviation). the higher is its Beta. i t is obvious that stock Y is more likely to deliver the expected returns of 12% compared to stock X.1 Standard deviation for stock X = 1. This case has been discussed basically to understand that w hile deciding on which stock to invest in.449 Let’s work out for stock Y Variance of stock Y which is the sum of last column = 0. it is important to consider the expec ted return as well as the total risk of not getting the desired return stock wis e and reach decision accordingly. PDP Investment Planning 33 . or fluctuati ons in price. In effect. relative to a benchmark. All the same.Variance which is the sum of the last column = 2. It is important to note that beta measures a security’s volatility. it may be pertinent to point out here that standard deviation is more seriously considered and is useful in port folio of stocks rather than individual stocks. Beta is a relative measure of risk – the risk of an individual stock relative to the market portfolio of all stocks.

Bet as can be negative or positive.5 times as volatile as marke t returns. this security. The market portfolio has a beta of one (1). A security with a beta of 1.0 would be considered a more conservative investment than the overall market. But generally. Stocks wit h high betas are said to be high-risk securities. 34 Investment Planning PDP . and 2. ranking stocks b y beta is the same as ranking them by their absolute systematic risk. Stocks having a beta of less than 1. o n average. in practice. 0. Because the variance of the mark et is a constant across all securities for a particular period.Securities with different slopes have different sensitivities to the returns of the market index. the beta is one (1).5. betas have been found to be posit ive which means that the direction of the movement of individual stock generally tends to be in line with the market: falling when the market is falling and ris ing when the market is rising. both up and down. This means that for every one percent c hange in the market’s return. Stocks can be ranked by their betas. This would be considered an aggressive security bec ause when the overall market return rises or falls 10 per cent. on average.5 indicates that. is used by investors to judge a s tock’s risk. security returns are 1. If the slope of this relationship for a particular security is a 45-degree angle. this security’s returns change one (1) per cent. would rise or fall 15 per cent. on average. Beta is useful for comparing the relative systema tic risk of different stocks and. Given below are different scen ario showing how the portfolio return moves relative to market for Beta equal to 1.

Beta is the slope of this regression line. you’ll need to know the returns of the security and those of the benchmark index you are using for the same period.The beta of a security is a historical measure and it is arrived at by plotting the actual returns on the security over long periods of time with market returns as shown in the earlier charts. The steeper the slope. Us ing a graph. To determine the beta of any security. In fact. the less exposed the company is to the market f actor. we draw a bestfit line that comes the closest to all of the points. the coefficient (Beta) quantifies PDP Investment Planning 35 . A line is drawn which depicts beta of the secur ity. the shallower the slope. the more the systemati c risk. plot market returns on the X-axis and the returns for the stock ove r the same period on the Y-axis. Upon plotting all of the monthly returns for th e selected time period (usually one year). This line is called the regression line.

5%. What is the required rate of return on the project? Theor y tells us that the answer does not depend upon the volatility associated with t he returns. i.5. The process is inherently risky. If we want to compare the return on the security related to the risk free avenues. depending upon the actual return of the marke t. the standard deviat ion of the project is 75% per year.5)(14.the expected return for the stock.Rf) Where the concept of R f is the risk free return – return that can be obtained by investing in risk free securities like treasury bills. The answer would not change if the range of outcome next year broadened or narrowed. some times beta is calculated as under: Rs = a + BsRm+ e Where. ß (beta) is th e only relevant piece of information — now all that remains is to estimate it! 36 Investment Planning PDP . Rs = estimated return on the stock a = estimated return when the market return is zero Bs = measure of the stock’s sensit ivity to the market index Rm = return on the market index Allowing for random er rors. suppose you are considering a private equity investment in a compan y with a new job work. E[Rjob] = 5% + (.5% This is the required rate of return on the project.5% 5%) = 9. The beta of the project is 0. Instead we use the beta of the project.e. Calculating Beta Rs = a + BsRm Where. Case For example. “e” is the ran dom error term embodying all of the factors that together make up the unsystemat ic return. The Rf = 5% and the E[Rm] = 14. then the formula is: Rs = Rf + Bs (Rm .

1 0. I shall bu y B because it is cheaper b. 5. 100 and is paying no dividends. What is the standard deviation of the stock based on the figures i n question 2? a. Mr.Review Questions: 1.6% b. The possible year end price and the pr obabilities are given below: Year end price 110 115 120 125 130 a. Which stock will you buy considering the return and the risk? a. 10% b.2 0. 100 while B is quoting at Rs 50.60 4. 12% b. I shall buy any one 5.30 d.79 c. I wi ll buy Stock A because the risk is less d.45 b. 15% d.2% Probabiltiy 0. Joshi has analysed a stock for a one-year holding perio d. What is t he expected return on the stock? a. A stock is quoti ng at Rs. Stocks A and B are not payin g any dividends.3 0 . Stock A is quoting at Rs. 20% 3.4% d. 15. The stock is currently quoting at Rs 100 and is paying no dividends. 8% d. The risk and the return in both are s ame. 12. There is a 50-50 chance that the stock may quote Rs 100 or Rs 120 by year-end.8% c. 16. Ther e is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 5050 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the y ear. 16. 14. Compute the expected return for the stock when the r isk free return is 8% and the expected return from the market is 12% for a stock with Beta of 1. I will buy Stock B because the risk is less c.1 What is the expected return on the stock? PDP Investment Planning 37 .2. a. 20% 2. 22. 10% c. 15% c. 33.2 0.

higher beta means higher risk and also higher returns compared to market. Stock B because it may deliver superior returns com pared to A Answers: 1. Either A or B.(while deciding you calculate the risk also besides the returns) b . 4. 3. because in a risin g market all stocks will rise b. 38 Investment Planning PDP . Beta of stock A is 1. Stock A because it may deliver superior returns compared to B c. b c b d .use the formula Rs = Rf + Bs (Rf -Rm) b . 2. Stock B because the risk will be less compared to A while the returns would be the same d. 6.6.5 while that of stock B is 1. 5. If the market is expected to rise then an aggressive investor would buy: a.

Chapter 4 PDP Investment Planning 39 .

but mainly to the chance/probabi lity of getting less than expected returns from an investment vehicle. we shoul d ensure that the investments are diversified across different asset classes and that proper allocation among different assets is made as decided in the Asset A llocation Plan. etc. “Risk” in investments is categorized as “systematic” and “un systematic” risk. etc. precious metals. Middle East and so on. Henc e. then he will find the going tough if the interest rates in t he economy were to fall. The chances of capital loss are also quite h igh in such cases. based on the age. if an investor is highly risk averse and has little or no ex posure to equities. comm odities. R Diversification It is well established in investments that in order to be able to obtain require d returns. real estate and so on. Similarly. Equity is a long term asset class and should be accordingly p lanned while deciding the Asset Allocation Plan. Diversification reduces the risk and can be achieved through div ersifying investments: n n n n Across different asset classes – equity. Japan. Australia. He will continue to earn less over a period of time and may even suffer loss on existing investing because of fall in bond prices. real estate. Thus. long term. Singapore. Unsystematic risk can be reduced through diversification while systematic risk i s a market risk which can not be reduced through diversification. Diversification across different asset classes n As financial planners. Risk in the context of investments not o nly refers to the chance of losing one’s capital. Across different countries (geo graphies) – India. it is essential to invest in a number of stocks and not just a few to reduce the 40 Investment Planning PDP . for life. etc. Let’s look at some s trategies that investors can adopt to manage risk. debt. of the investor. For example. USA. a very high exposure to equity can prove very tricky because the stock market over a long p eriod of time may turn bearish and the investor may get very little return and c apital appreciation in this period. It is important to decide the quantum of investments in risky as set classes like equity.Managing Risk in Investments isk is an integral part of investments. bonds. Across maturit ies – short term. ris k in investments can not be avoided but it can be managed to suit one’s risk profi le and investment objectives. Ac ross different securities and so on – Different stocks. which are also called non diversifiable and diversifiable risk. it is essential to reduce the risk and this can be achieved through d iversification. n n Portfolio of Securities While investing in stocks. UK. Over dependence on a particular asset class can also be quite risky. risk appetite. etc. Investors can resort to different strategies to manage risk in investments. exposure to equity should be considered in such cases.

even different geogr aphical regions. The securities should ideal ly belong to different industrial sectors. The number of securi ties should be limited to say 20 to 30 and not more. diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated to domestic investments. The reverse occurs with the sunscreen company.risk. If you invest your entire portfolio in the company that se lls umbrellas. you’ll have strong performance during the rainy season. 2. For example. Since you have diversified your portfolio. but it will tank when the clouds roll in. you will get decent perfo rmance year round instead of. So. and if possible. the alternative investment: your portfolio will be high performance when the sun is out. depending on the season. steady returns. But the purpose of diversification will be achieved only if the stocks bel ong to different sectors and that some of the sectors are not related to each ot her. an economic downturn in the Indian econom y may not affect Japan’s economy in the same way. It is a well established fact as borne out by the follow ing diagram that diversification across securities reduces the risk: Studies and mathematical models have shown that maintaining a well-diversified p ortfolio of 25 to 30 stocks will yield the most cost-effective amount of risk re duction. albeit at a drastically smaller rate. Investing in more securities will still yield further diversification b enefits. it is only sensible to hold a certain number of securities and monitor the same periodically rather than hold ing too many securities in a portfolio which will serve the purpose of diversifi cation in a very limited way. PDP Investment Planning 41 . The solution is to invest 50% in one company and 50% in the other. The following important conclusions can be drawn regarding diversification across securities: 1. Therefore. having either excellent o r terrible performance. Let us look at the following example to understand the co-relationship betw een two securities in a portfolio: Suppose you live on an island where the entir e economy consists of only two companies: one sells umbrellas while the other se lls sunscreen lotion. Further. Chances are you’d rather have c onstant. but poor pe rformance when it’s sunny outside. having Japanese inves tments would allow an investor to have a small cushion of protection against los ses due to an Indian economic downturn.

etc.3. Wi is the weight of securi ty i in the portfolio and.5+4+1.25% Expected return on security B = [(0. The weightage may change over a period of time with change in prices of underlying securities as well the portfolio va lue.5 = 8. export oriented and import dependa nt companies.3*0)+(0.15*-10) ] = 3.5% 42 Investment Planning PDP . If the following are the probabilities of return for individual securities A and B let us try and find out the probable return o n the portfolio: Expected return on security A = [ (0.3*5)+(0.5 = 4.2*-5)+(0. the portfolio is also decided at the point of investment. While deciding on t he securities to be invested in the weightage of each security.2*0)+(0.75+3+0-1-1.15*-10) = 4. E(ri) is the expected return on security i Example Le t us consider a portfolio with two securities A and B with a weight of 60% assig ned to A and 40% to security B.). The weights are calculated on the basis of initial investment value.15*30)+(0. We can express the same in the following formula for return on the portfolio: Where E (RP) is the expected return on the portfolio.5+0-1.2*15)+(0. lending companies and borrowing companies. the r eturns on the same will depend upon the return on individual securities as well as weightage of each of the security in the total portfolio. The co-relation of market movements may be built in selecting stocks in a portfo lio (oil marketing companies and automobiles. Returns on the portfolio In a portfolio containing a number of securities.2*20)+(0.15*25)+(0.

Measurement Risk on a portfolio is calculated by considering the standard deviation of indiv idual securities included in the portfolio as well as interactive risk among sec urities.55+3. measured by covariance. Risk of the Portfolio .40 = 5. sP2 is the variance of the portfolio.95% Where.25+0. is the formula for calculating the standard deviation of a portfolio of two secu rities x and y where sXY is the standard deviation of the portfolio.Return on the portfolio = RAB = WA*RA+WB*RB = 0. If the f ollowing are the probabilities of return for individual securities X and Y.4*8.5 = 2. WA is the weight of A in the portfolio while WB is the weight of B in the portfolio. Variance of Portfolio Given a portfolio consisting of n securities. w represent s the weight of securities x and y in the portfolio while COVxy is the covarianc e between securities x and y. j is the covariance bet ween securities i and j. the variance of the portfolio can be written as: Portfolio Risk =Sum of individual securities’ risks + Sum of interaction among sec urities Where. sI is the standard deviation of security i.6*4. let us try and find out the standard deviation of the portfolio: PDP Investment Planning 43 .. Example Let us consider a portfolio with two secur ities X and Y with a weight of 60% assigned to X and 40% to security Y. ri.

1 Standard deviation of security y is square root of 72.1 = 72.1 (-20-8)(-10-9) = 24. standard deviation of security x is = square root of 222.2*(-10)+0. 2*(-10-8)2]+[0.1*(30-8)(20-9)+ 0.2*(15-9)2] + [0.2*(20-8)(15-9) + 0. secondly calculate the covariance between the two securities and thirdly the risk on the portfolio.5*10+0.2*20+0.2*(-10-8)(0-9) + 0.5*1+0.5*(10-8)(10-9) + 0.1*(30-8)2]+[0.2 44 Investment Planning PDP .The same can be done in 3 steps: firstly find out the standard deviation of indi vidual securities.4+1+32.5*10+0.2*0+0.1*30+0.4 = 14.5*4 + 0.2 = 125.4+28. Standard deviation of Securities X and Y Expected return on security X is = {0.4+53.1*484 + 0.2*81+0.49% Covariance between securities X and Y The use of formula is illustrated by actua lly taking out the figures in the probability of returns on securities x and y C OVxy = 0.1*(-20)} = 8% Expected return on security Y is = {0.1*(-10)} = 9 % sX2 = Variance of security x = {[.4 Hence.1*784 = 48 . the variance of security y can be calculated a s under: = {[0.5*(10-9)2] + [0.2*(20-8)2] + [0.1* (-10-9)2} = 0.1*361 = 12.1*121+0.8+2+64.2*144 + 0.2+14.4 = 222.1*(20-9)2] + [0.2*15+0.1*(-20-8)2]} = 0.1*20+0.5+16.1 = 8.2*(0-9)2] + [0.1+7.2+0.2+36.2*36+0.2*324 + 0.8+78.5*(10-8)2]+[0.91% Similarly.

014524 0.3% while the expected return of th e portfolio is 18.5´0.224´0.16*72.66 12.6)2*(14.66 sXY = = squa re root of 151. it is easier to work out the portfolio risk and the portfolio return.7´0.03+11.91)2 + (0.49)2 + (2*0.Portfolio Risk s2XY = (0.5% Covariance and Correlation Coefficient The covariance and c orrelation coefficient measure the extent to which securities move together in t he PDP Investment Planning 45 .213 or 21.05 + (0.31% Expected return on the portfolio Portfolio Risk and return in a two security scenario The calculations may look c omplicated but in many cases the correlation between the securities is given and hence.1 = 151. 3)2´0.06 +2 ´0.6*0.B´sA´B = (0.31) + (0.3´0.1) = 80.20 = 0.36*222.4)2*(8.4*125.5% sP2 = wA2sA2 + wB2sB2 + 2 wAwBrA.185 or 18.245 = 0.53+60.7)2´0. Le t us look at the following example to understand things better: Example 2 securi ty case = 30% ´ 0.08) + (60.3% Thus the portfolio risk is 21.2) = (0.0454248 sP = Square root of 0.15 + 70% ´ 0.

termed the variance to describe risk. Actually.14. For instance. If the value is –1. suppose you own Stock A and B and both are high-tech stock s selling computer chips. The measure of Stock B’s sensitivity to Stock A’s stock price could be measured over time to see the extent to which they move t ogether. We could use both the covariance and the correlation coefficient to tra ck the movements. where direction implies increase and decrease. Because Stock B is also in the computer chip industry. we may use a2 (the standard deviation squared) to describe the risk in an individual we know that this is an absolute number. Stock A’s price will probably decrease if the market had not expected suc h an announcement. That is why it is necessary to use computer prog rams to conduct such analysis. If the correlation c oefficient equals zero. Stock B could be measured relative to an overall stock market index as well in order to see how sensitive it is to that market’s general movemen ts. the two securities are perfectly positively correlated and that the securi ty prices change equally and in the same direction as well. Suppose that news breaks about Company A revealing a q uality assurance issue with their computer chips and the announcement of a major recall. The covariance between two securities is calculated as follows: As you can see. Since the covariance is calculated similar to the st andard deviation. it means that the two securities do not move together in any meaningful way. the covariance of these two securities is 0. Covariance and correlation coefficient s are simple to calculate for two securities but become more complicated as the number of securities increases. Tha t is. Correlati on Coefficient The correlation coefficient measures the strength of the relation ship between two securities and the coefficient is always a value between – 1 and + 1. That is why it is nec essary to use the covariance to calculate the correlation coefficient. Securities with a negative covariance have returns that v ary inversely. If they value is + 1. This means that these two securities tend to move in opposite directions. or that their prices move in opposite directions as reactions to the same information event. The opposite is true too in that securities which are negatively correlated balance each other o ut in good time and in bad times as well. rather than use the standard deviati on. Covariance Any two securities whose prices react to information similarly are said to have a positive covariance. we can also use its squared value. Without ca lculating the correlation coefficient. its st ock may very well decrease as well since investors will respond adversely to the overall market for computer chips. As we shall se e in a later chapter. these observations and measures of co-movements provide th e underpinning in constructing efficient portfolios that contain many securities that move together in the same direction to each other (positive correlation) t end to do very well in good times and very poorly in bad times. it is difficult to determine the extent t o which they move together. 46 Investment Planning PDP . 1. it can be said that the returns of the securities are per fectly negatively correlated. meaning that the prices change equally but in oppo site directions. The relationship between the movements of two securities or between a single security and general market movements are critical observations.

j decreases in exact proport ion to i. The i and j values were determined to be 10 percent. Portfolio Effect An investor who is holding only investment i may consider adding investment j in the portfolio. We define Kp as th e Expected Return of the portfolio: Kp = XiKi+XjKj The X values represent the we ights assigned by the investor to each component in the portfolio and are 50 per cent for both investments in this example. with r ij equal to 0. assets i and j a re perfectly correlated. with r ij equal to + 1. As i increases in value.9% PDP Investment Planning 47 . As i increases. these two securities may be suitable to put in a portf olio in order to project it from general stock market cycles. FIGURE 5:1 Correla tion Analysis Figure 5:1 demonstrates the concept of correlation. with r if equal to – 1.5(10%) = 5% + 5% = 10% What abou t the standard deviation (ó p ) for the total portfolio? Assume standard deviation of i = 3. In this ca se. the new portfolio’s Expected Return will be Kp. it means that these two securities exhibit a strong negative movement in opposite directions. If equal amounts are invested in each stock.5(10%) + 0. barring other issues. assets i and j exhibit a perfect negative correlation. so doe s j in exact proportion to i. Panel B.The calculation for correlation coefficient is as follows: Thus we can see that if correlation coefficient is –0. In Panel A.70. Panel C demonstrates assets i and j having no correlation at all. Thus we have: Kp = 0.

the relationships between such variables may be one of dependence or causali ty. A common 48 Investment Planning PDP . The standard devia tion of a portfolio is not based on the simple weighted average of the individua l standard deviation (as the Expected Return is) rather. there may be si gnificant risk reduction from combining the two. For example. There is one fallacy in the analysis. Investment i alone may produce outcomes anywhere from 5 to 15 perc ent.9 to 4. we narrow the range for investment (i.5% The interesting element is that the investor appears to be wors e off from the combined investment.5 to 12. we can then classify consumption as the dependen t variable and income as the independent variable.5 (3. If a weighted average were taken of the two investments. the new s tandard deviation would be 4.1%. and investment j. FIGURE 5 :2 Investment Outcomes under Different Conditions Note : In Figure 5:2 risk-reduction potential from combining the two investments under study. from 6 to 20 percent. when our income increases (decreases). to some extent. on chan ges in income.55% = 4.5 percent: s¡ Xi + s¡ Xj 0.and j = 5.9%) + 0. we can say tha t changes in consumption are caused (is dependent upon). By combining the two.1%) = 1. we have reduced the risk while keeping the Expected Return constant at 10 percent. In this example. and the standard deviation for the portfolio may be less than the standard deviation for either investment (thi s is the reason we do not simply take the weighted average of the two).5 percent. His Expected Return remains at 10 percent. In this case. Coefficient of D etermination As we just saw. b ut his standard deviation has increased from 3. If one investment does well during a give n economic condition while the other does poorly and vice versa.95 % + 2. our consumption of goods and services generally also increases (decreases). Thus. correlation and covariance are statistical measures that gauge the nature of the relationship between two random variables. j) from 7.5 (5. It appears that he is adding risk rather than reducing it by expanding his portfolio and withou t any change in return. Sometim es. it considers significan t interaction between the investments.5 percent.

wou ld equal l. Risk Reduction through Pro duct Diversification It is important to have a dynamic asset allocation plan div ersified among different asset classes. in both magnitude and direction. Risk on the total portfolio is reduced through investments among different products. which was discussed previously. it s squared value must also necessarily be a value between o and l. indirect equity through the mutual fund route. debt – corporate and government. Risk Reduction through Time Diversification When it comes to equity investments. Almost all mutual funds offer SIP’s where the people can invest in these funds on a monthly basis at predetermined dates and fixed amounts per mont h. represents the proportion of variation in the dependent variable t hat has been explained or accounted for by the independent variable. in a pre-determined proportion. In the abov e example of income and consumption. One such measure in a statistic known as the coefficient of determination. especially in respect of retail investors that they c annot time the market. In this strategy. We can say then that the value of R² being equal to l implies that the independent variable fully explains all changes in the dependent variable. the R² measure similarly interprets the depth of the relationship but is no more simply the squared correlation value. Since the correlation coefficient is commonly denoted by the symbol ‘r’. are explained by changes in income. we consider the correlation value of – l to represent a perfect negative rel ationship (each change in a variable being matched by an equal but directionally opposite change in the other) between two variables and a correlation value of + l to represent a perfect positive relationship (each change in a variable bein g matched by an equal. etc. or their R². w hen observed as a result of simple regression analysis. The best and time tested solution lies in syste matic investment and sticking to asset allocation plans. Also note that since correlation has a value between – l and + l. PDP Investment Planning 49 . The quantum of funds al located to equities can be invested over a period of time through systematic inv estment plans. These investors invariably end up losing money. the funds may earn decent returns in floating rate funds with less interest-rate risk while the equity market timing-risk is reduce d through SIP’s. Another very important strategy could be parking the available fund s in Floating Rate Debt funds and transferring fixed quantum of funds on a month ly basis through a Systematic Transfer Plan out of floaters through SIP’s into equ ity funds. relationships between and among more tha n two variables. Financial investment products comprise d irect equity. also known as R². fixed income in struments like small saving schemes. we can similarly say that there is absolutely n o dependent relationship between the two variables. balanced fund which focuses on both debt and equity. change in the other) bet ween two variables. This widely used statistica l measure (R²). Auto debit and ECS make it very convenient for investors to invest on a syste matic basis. the squared values in both these cases.procedure to measure the extent of such a dependent relationship between two var iables is known as simple regression analysis. the R² statistic form a simple regression ana lysis would tell us how many changes in consumption. What is interesting to note is that the coefficient of determination. It is the time one stays invested that would determine th e returns on equity investments over a period of time and not market timing. Man y investors tend to take higher exposure to equity at market highs and tend to r educe their exposure during market lows due to emotional swings. Thus. In the case where multiple r egression analysis is being used. is also the square of th e correlation coefficient. government bonds. When the value of R² is equal to zero. depending upon the risk prof ile of the investor and managed through periodic review of the proportion. Continuing fur ther. hence the R² for the determination coefficient. i. it i s a well established fact. Regression analysis provides us w ith many statistical gauges of the relationship which help us better understand the scope and nature of the relationship. e. fixed deposits – bank and c orporate.


To offset the systematic risk. The use of futures and opti ons as tools of hedging as well as leveraging portfolios has been explained in a separate topic. This is so because each futures contract r epresents the index level times a multiplier of Rs. a portfolio has reduced the unsys tematic risk. a fund manager would establish a hedge.00. By selling four (4) cont racts.000 per contract at the Nifty level of 3000 (Each Nifty contract size is 100). 50 Investment Planning PDP .while the Nifty futures contr act will earn Rs.000/. 60. Consider a portfolio consisting of an indexation of the BSE Sense x. Now the dependence and exposure on the fortune or failure of each company is an approximation of a 1 in 30 chance.Hedging Diversification reduces unsystematic risk in a portfolio. The “put” option starts gaining when the market starts falling and in case the marke t rises. The portfolio’s remaining risk is viewed as systematic or market risk. systematic risk can be hedged. however. or other derivati ve markets. Unsystematic r efers to a specific individual corporate or country financial risk event.e. A manager can reduce this systematic risk by hed ging. Thi s hedge would offset the value changes in the underlying portfolio position. When the market falls by 5%. By holding positions in these 30 companies. then four future contracts would be sold t o effectively offset the market risk. 12. 3.on 4 contracts because Nifty would have fallen from 3 000 to 2850.000. Example If the actual portfolio had a market value of Rs. the portfolio w ill fall by 5% resulting in a loss of Rs. Sys tematic risk cannot be diversified out of a portfolio. the portfolio’s unsystem atic risk decreases. The remaining risk is called systematic or market risk. In other w ords. 400 Nifties. This means that the portfolio value will s wing with the benchmark market. the loss on puts will be to the extent of premium paid only. Typ ically. this offset is accomplished with the futures.000/.00. Theref ore. The same effect can be achieved by buying Index puts as well. This is an example of fully hedging the portfolio through selling t he index futures. as the number of securities increase in a portfolio. 12 lacs an d the NSE Nifty was trading at 3. options. puts can be used to limit the loss in case of a market rise with potential to earn unlimited profits in case of a market fall.000/. i. 60. the market value of Rs.of the portfolio is protected against a fall in Nifty.

13% d. 16% d. Is this true? a. Is this statement true? a.14% b.1. Yes b. Hedging. No. hedging reduces non sys tematic risk only d.82% c.78% 3. 4.Review Questions: 1. No. diversificatio n does not serve the purpose of risk reduction c. No. hed ging does not serve the purpose of risk reduction c. hedging reduces systematic risk only 5. What would be the standard deviation of the portf olio comprising of the two securities as per details given below? a. No. By selling index p uts c. By selling index futures b. diversification reduces no n systematic risk only d. Diversification among different asset cla sses will reduce all risks. 14. By buying index futures PDP Investment Planning 51 . Yes b. No. agains t market loss. diversification reduces systematic risk only 4. He dging is a strategy adopted to reduce all risks. in a diversified stock portfolio can be achieved through which on e of the following strategies? a. 17% 2. 3. 19% c. 15% b. Given the following information. By buying specific stock futures d. No. what is the expected retur n on the portfolio of two securities where both are held in equal weights? a.

Invest t he funds in a floating rate debt fund and adopt SIP route to invest in mutual fu nds systematically on a monthly basis as retail investor cannot time the market. He should prefer a diversified equity mutual fund as this is where diver sification can be achieved even on a small capital. c 4. Mr. he should make in these companies. b. Stay away from stock market because it is a risky place. c. 7. Since funds available are limited. He wants to invest Rs. A. Mr. Diversification cannot be achieved through increasing the nu mber of companies in one’s portfolio. d 5. c. G. age 40 years. b. c. d. Equity is not the place for small investors as the risk s are very high. he c an buy just one or two stocks of large companies and participate in the equity b oom. d. Answers: 1. He should first get the e xpertise by undergoing training programs and then only venture into stock market . What will be your advice to him? a. 1 . Doshi has investments in stocks of 50 companies. 8.000/. He wants to invest so me more money in direct equities and requests you to advice him on how many more companies he should invest in so that he shall have a well diversified equity p ortfolio. He already has too many compani es. c 52 Investment Planning PDP . is a salaried person. He should have at least another 50 more companies to be adequately diversified. b. This is not the right time to invest in stocks because the market is likely to fall. A small investor wants to participate in the equity market but does not have the expertise or the funds to have a well diversified equity portfolio. What will b e your advice to him? a. c 2. b 8. What would be your advice to him? a.00. Buy shares of Infosys Technologies as the company is doing very well and has declared a bonus also. Ashok Kulkarni. c 7. He should stay away.6. equities and seeks your advice about whether this is the right time to invest in equities and how to go about it. a 3. He can continue to hold on to all and add more companies as per funds availability. Any additional investment he wants to make. He should reduce the number to about 20/25 companies belonging to diverse in dustrial sectors. a 6.

Chapter 5 PDP Investment Planning 53 .

which for any security is defined as: Tota l return = Yield + Price change where: the yield component can be nil or positiv e. particularly for stocks but also for long-term bonds and other fixed-income securities. Measurement of T otal return Total return = {Cash payments received + Price change over the perio d}/purchase price of the asset The price change over the period = end price – open price (can be negative) 54 Investment Planning PDP . Realized return has occurred and can be measured with the proper data. Realized return is what the term implies. Expected return. or is. Furthermore. primarily risk. the price change component can be nil. Yield: The basic component that usually comes to mind when discussi ng investing returns is the periodic cash flows (or income) on the investment. This component is the appreciation (or depreciation) in the price of the asset. realized return and expected return. Yield measures relate these cash flows to a price for the security. such as the purchase price or the current market price. It is the difference between the purchase price and the price at which the ass et can be. Ther e are two types of returns viz.Measuring Investment Returns W e all make investments to get returns/rewards from the investment vehicles. The distinguishing feature of these payments is tha t the issuer makes the payments in cash to the holder of the asset on a periodic basis. It is the reward for undertaking the i nvestment. although they are subject to constraints. we need to add them together (alg ebraically) to form the total return. As an estimated return. the historical return plays a large part in estim ating future. or return that was or could have been earned. is the estimated return from an asset that investors anticipate (expect) they will ear n over some future period. Capital gain (loss): The sec ond component is also important. 2. Total return Given the two components of a security’s return. commonly called the capital gain (loss) . e ither interest or dividends. Return is the mo tivating force in the investment process. positive or negative. unknown returns. it is subject to uncertainty and may or may not occur. An assessment of return is the only rational way (after allowing for risk) for investors to compare alternative investments that differ in what they promise. The objective of investors is to maximize expected ret urns. Return on a typical investment consists of two co mponents: 1. sold. The measurement of realized (historical) returns is necessary for inves tors to assess how well they have done or how well investment managers have done on their behalf. on the other hand. it is ex post (after the fact) return.

Similar to the Internal Rate of Return (IRR). and term to maturity to determine the yield to maturity. the current yield and the yield to maturity are identical. price. During the year. 50/-. Computation of YTM Where. Alpha paid a dividend of Rs. PDP Investment Planning 55 . the yiel d to maturity will differ from the current yield if the bond sells at a discount or a premium.0 00. The interest payments are payments of annuity over a period of t ime while the maturity value is the future value of the present price of the bon d and “r” the YTM has to be worked out substituting different values for r. 52/. in financial manageme nt.Example The shares of Alpha were bought on Jan 1 for Rs.000 and expected to be redeemed by the issuer at Rs. However.per share. yield and price change. which is its curren t price. P = Price of the security C = annual interest payments received r = rate of interest M = Maturity value (amount receivable on maturity) n = number of yea rs left for the security to mature The computation of YTM requires a trial and e rror procedure. regardless of the asset. The important point here is that a security’s total return consists of the sum of two components. the yield to maturity is the periodic interest rate that equates the present value of the expected future cash flows (both coupons and maturity value) to be received on the bond to the initial investment in the bond. which is define d as the promised compounded rate of return an investor will receive from a bond purchased at the current market price and held to maturity. 1. It captures the cou pon income to be received on the bond as well as any capital gains and losses re alized by purchasing the bond for a price different from face value and holding to maturity.What is the total return on Alpha? Returns = Dividend + price ch ange = 2 + (52-50) = 2+2 = 4 Total returns = returns/purchase price = 4/50 =0. An investor would use the bond’s coupon rate. or internal rate of return. At the end of the income component (the yield) and/or a price change component. Alpha was so ld for Rs. Current Yield It is a very simple measure o f returns on any security and it is obtained by the following formula: Annual In terest/price of the security Yield to Maturity (YTM) The rate of return on bonds most often quoted for investors is the yield to maturity (YTM). 2/. par value. 1. Investors’ returns from assets can come only f rom these two components .08 = 8% This is a conceptual statement for the total return for any security. For a bond selling at Rs.

80 at the end of ye ar 1. and 3 respectively. 132. 100 Year 1 : 20/100 = 20% Year 2 : (132-120)/120 = 10% Year 3 : (118. YTM is the yield to maturity C = annual interest payment M = Maturity val ue of the bond P = Present price of the bond n = number of years to maturity Ari thmetic average returns A stock not paying dividends. 100. Using the same method.66% p. quotes at Rs. 120. Rs. 56 Investment Planning PDP . Rs. 118.a. Let’s find out how the arithmetic average return is c alculated over this period: Opening price Rs. let u s calculate the arithmetic average returns based on the following figures: Openi ng price Rs. 2. 100 What is the arithmetic average return for this stock? Year 1 returns 100% Year 2 returns -5 0% [(-100/200)*100] Total returns over 2 years 50% Arithmetic average returns 50 /2 = 25% This example brings out the limitations of Arithmetic Average Returns b ecause it is obvious that the returns on the stock can not be 25% when the openi ng price and price at the end of the second year are the same at Rs. Year 1 end price Rs. It quotes at Rs. Year 2 end price Rs.8-132)/132 = -10% Total returns over 3 years = 20% Arithmetic average return = 20/3 = 6. o ne can find out the approximate value of YTM by using the formula: Where.Approximate Computation of YTM Instead of following the trial and error basis. 200. 100/-. 100 at the b eginning of the year.

g. If fo r instance. one year later. I n this example. this measure of Arithmetic Average Returns is used for measuring futu re period returns rather than past returns.5) – 1] = 0 Types of Returns Investors use various methods by which they measure investment returns. However. We will briefly discuss each of these concepts. it is worthwhile for us to spend som e time on this issue. A Treasury Bill) is the return that an investor expects to earn on a security that is free of default risk. We can think of this compensatory additional return as the security’s risk premium. Nominal Rate of Return The nomin al rate of return is simply the return that one can earn on an investment. the nominal rate of return. We will discuss several type of returns. Geometric Average Returns The formul a for measuring Geometric Average Returns is: G = [(1+R1)(1+R2)(1+R3) …(1+Rn)]1/n -1 Where. Thus we may express the required rate of return as follo ws: PDP Investment Planning 57 . the investor will boil down the research and analysis to two f actors.. total return and risk adjusted return. you invest your money in a Certificate of Deposit that promises to p ay 7 percent per year. the risk of the investment opportunity and the return the investor expec ts to earn on this investment. the real rate of re turn. the rate you can earn b efore considering the effects of inflation or taxes on your investments. the nominal rate of return is 7 percent. 100 investment will yield Rs 107. Year 1 end price Rs. an investor will require returns in addition to the risk free rate as compensation for assu ming the higher risk. Hence. the real after tax rate of return. 200.Rn is the return over different periods from 1 to n Let’s try to work out the geometric average return in the foll owing example: Opening price Rs.5 G = square root of [(1+1)(1-.Therefore. Thus. it is also a difficulty and complex concept to understand for rea sons that require further discussion. All other securitie s contain the possibility of defaulting on their obligations. G is the Geometric Average Returns R1…. a Rs. 100 R1 = 100% or 1 R2 = -50% or –0. 100. The rate of return that an investor expects to ea rn on a risk-free security (e. When an investor assesses an investment opportunity.5) – 1] = squ are root of [(2*0. they may conduct much research and analysis to gauge the attractiveness of the invest ment. Ultimately. Year 2 end price Rs. Require d Rate of Return The required rate or return is a key concept in investment plan ning.

then you would buy the watch one year f rom today. the investment decision is related to the purchasing power of your earnings. allows us to describe the concept of the real rate of retu rn. you r earnings would stretch further (purchase more) in the first year than in the s econd and hence you would have actually done better in the first year. Consider another simple example. For example. or infla tion. in a sense. can be calculated. Thus. or the realized rate. consi der this example.e. as compensation. Alternately. as determined by t he required rate. suppose an investor. the bond will be considered a much safer investment and the risk premiu m that the investor will require to invest in the bond will be much lower than w hat will be assessed for the stock. For example. the performance of securities with varying characteristics w ill differ. This r elationship. the required rate of retu rn may be considered as the gauge of the security’s riskiness. when the economy is in a recessionary stage. If the general level of pr ices. To understand this further. different form both the expected rate and th e required rate. we obs erve that both the required rate and the expected rate are assessed and compared and which lead to the eventual trading decision. Thus. As long as the security is held. Under various e conomic conditions. The first choice is to invest the money in a savings account where you will ea rn a nominal rate of return of 3 percent/year. The realize d rate may well be. Had you decided to invest the money. There are two other related return concepts that are also worth discussing briefly. in terms of the returns they generate during this period. then the i nvestor would not consider this investment. However. since the expected rate would not co mpensate the bearing of the risk of this particular security. the rate or return that the investor will require for the small ca p stock will be much higher than the bond. is considering an investment in two securities – a small cap stock and a highly rated bond. or the purchasing power of your earnings. Similarly. the small ca p stock’s price will most likely fluctuate greatly and a higher probability will e xist that the firm may well go bankrupt. if you deci ded to invest. the more accurate our under standing of the risk premium we must receive. On the other hand. Suppose you have Rs. decision not to consume. o r planner. the expected rate may equal or exceed the required rate and the investment would be made. an investment decision is a decision that implies a postponement of current consumption. When these risk premiums are added to the ri sk free rate. If the inv estor’s required rate for this stock was higher than the expected rate. in an economic growth cycle. we expect most stocks to perform poorly. The Real Rate of Return The decision to invest is. 100. and usually is. in turn. The great er our understanding of the riskiness of a security. In this example. in this choice. then the rat e that was actually earned. Thus. or inflation was very mild in the first year and severe in the second. tod ay.Required rate of return = risk-free return + risk premium What the planner needs to comprehend is that in arriving at a required rate of return. Finally. in order to be in duced to invest in that particular security. In summary. 100 that you are seeki ng to manage for one year and that you have two choices of how to use this money . and which too costs Rs. The planner will understand that the bond contains lower de fault risk than the small Cap stock and will provide a greater assurance of an i ncome stream and a redemption value at maturity. note that the assessm ent of both the required rate and the expected rate begin before the investment decision and they continue to exist during the tenure of that decision. you would have Rs 103 at the end of the year. the primary ass essment is the nature and extent of risk of an investment opportunity. which you have always wanted. Once the investor sells the security. suppose you made a return of 12 percent in one year and 15 per cent the following year. from the planner’s or investor’s pers pective. Thus. The second choice i s to buy a watch. due to the general increase in the level of prices. this rate would be the stock’s expected rate. i. 58 Investment Planning . did you truly do better in the second year? The answer to this question depends on what your earnings could buy at the end of each of t hose years.


Th ere are two important observations that we can make form this example. if you feel that the price of the watc h will increase to a level that is higher than what you would earn from your inv estment. we took the rate of inflation into consideration because it reduces the purchasing power of our retu rns. Taxes are relevant to all of us. In the above example. and three years in case of real assets like real estate. Debt etc. Second. you have also given up the enjoyment of possessing the watch for the entire year.04 = 2.30) – 0.3 % PDP Investment Planning 59 .0. If we are not offered this reward.09) (1. Thu s in the above example. three years or l onger. The real rat e = [ (1 + Nominal rate)/ (1 + inflation rate) ] –1 Real After Tax Rate of Return Many of the returns that investors earn are not tax-free. if the savings (nominal) rate was 6 percent and the infl ation rate was 4 percent. the rate we earn on the inves tment is the nominal rate. The only way you wo uld be inclined to invest instead would be if you were being provided with a nom inal rate that was greater than what you would expect the price to be in a year’s time. If the nominal rate of interest on a security is yielding 9 percent. In advising a client to sell a financia l instrument. Long-term capital gains are gains from increases in se curity prices where the security was held (owned) for one year. you would rather buy the watch and get to enjoy it for the year. but those clients in high income tax brackets are particularly affec ted by after tax returns. Short-term capital gai ns are taxed at the investor’s marginal tax rate. you would be prone to not invest and buy the watch. we will invest only when we expect not only to consume a similar pr oduct in the future but that we are also rewarded by a higher earning rate for p ostponing our consumption. you would invest only if the nominal rate was just g reater than 4%. Further. 0. not having bought th e watch before. work of arts etc. the in dividual ‘s tax rate is 30 percent and the inflation rate is an equal to 4 percent . the decision to invest can be considered as a decision to postpone consumpt ion. The formula for the real after tax rate or return is: r = ( R) (1-t) – I where r is the real after tax rate or return. you cannot buy the watch. If t hat were so. First. th e decision to invest is always in competition with the decision to consume.0 0. and t is the tax rate at which the investment will be taxed a nd I is the inflation rate for the may find that at the end of the year. is the nominal rate of interest. the real after tax rate of return is: R = (0. Recall that short-term capital g ains are those gains that are held for less than one year in case of financial a ssets like equities. 104. That is. the rate at which the price of the product will rise is the inflation rate and the rate of the reward is the real rate of return. Such gains are currently taxed at 20 percent with indexation or 10% flat without indexation for most individuals. Thus. Note that you would not be willing to invest if the nominal rate was just enough (equal to 4% in this example) to offset the cost increase. the real after tax rate of return must be taken into consideration in order to relay a true picture of return to the client. In the above example. the price of the watch has increased t o Rs. In this case. the real rate of return would approximately be 2 perce nt. In this formula. we will always ten d to consume and not invest. R. at the beginning. This approximate relationship can be expressed as follows: Nominal rate = re al rate + inflation rate The exact relationship is given by the following equati on: (1 + Nominal rate) = (1 + real rate) x (1 + inflation rate) or.

14% percent Measuring Inves tment Returns In order to begin to understand the various types of investment re turns and their uses. the risk premium may be 12. For example. total return over the four years is Rs. 20 Rs. For example. 20. 100 per share. 20. For common stock. If the risk-free rate were 8% percent.0 0 Rs. the investor’s required return may carry a 9 -10 percent risk premium in addition to the riskfree rate of return. the investor might h ave an overall required return of 17 to 18% percent on common stock. 100 / Rs. for bonds. For example. 20.00 each year. then the risk premium will change. Thus. when talking about stocks. that when we discussed stocks. Like the real of return and the inflation rate. 100 = 100% Risk Adjusted Return Risk premium is a percentage return that an investment must expect to ea rn in order for an investor to assume a given level of risk.00 Rs. we begin by considering a simple investment return for one time period. the ri sk premium is not stagnant but changes from time to time.00 Rs. the total return is equal to any dividends that the stock pays plus the capital gains or losses that the investor realizes on the sale of the stock. The same notion is true for mutual f unds whereby the fund earns dividends and/or interest as well as capital gains o r losses. If investors are very fearful abo ut the economic outlook.0 0 per share. supp ose an investor purchased Stock A for Rs. the risk premiu m may be 3 to 4% percent. 100 Thus.00 Rs. if the i ssuing company’s risk profile changes or if the macroeconomic outlook becomes more uncertain. 80. Over the next four year s. 20. Recall. At the end of the fourt h year the investor decided to sell his stock at market for a price of Rs. the 60 Investment Planning PDP . 20. n n n n n R eal rate 5% Anticipated inflation 5% Risk – free rate 8% Risk premium 9 – 10% Requir ed rate of return 19 – 20% Corporate bonds fall somewhere between short-term government obligations (genera lly no risk) and common stock in terms of risk. Total returns are expressed in whole currency terms. Stock A paid annual dividends of Rs. for a deposit at a bank or RBI Treasury bill. 120. for instance.00 Rs. Thus the gains are as follows: Year 1 Year 2 Year 3 Year 4 Total In come Capital Gain: Total Gain : Rs. The risk premium wi ll be different for each investment once all investment have different risk prof iles and different expected returns.Total Return The notion of total return centers on the total return that an inve stment yields. the risk premium approaches zero.

Keeping with the example above.4 1% PDP Investment Planning 61 . 125. we find that the holding period return from at the end of period 1 was 20 percent. The time weighted rate of return (Simple Airithmatic Rate of Return) is a formula which uses the holding period returns o f an investment and averages them in order to yield an average rate of return. 125 to purchase first share of stock. 150 to purchase second share of stock The cas h inflows for the receipt of dividends are as follows: T1 . suppose that in stead of selling the share of stock at the end of the year. During the year. 3 dividend T2 Rs. If this is the case. 160. we collect our second Rs 3 dividend. The return on the seco nd share of stock was 28-27+3/27 or 14. you also sell the stock for Rs150 as it has increased in market value. To calculate the average time weighted rate of return: Time Weighted Rate of Return = (20% + 14.Rs. The same notio n is true for mutual funds whereby the fund earns dividends and/or interest as w ell as capital gains or losses.95% This value is known as the interna l rate of return on the investment and is also known as the compounded annual gr owth rate of return on the investment. To . Using the numbers from our previous examples. Suppose you purchase stock X. the stock pays a dividend of Rs 3. 3 dividend plus Rs320 for selling each share of stock at Rs. and subsequently sell both shares of our stock for Rs160 each. we measure investment returns where there are seri es of cash inflows and outflows. however. Recall o ur formula for the Holding Period Return which is: HPR = P1 –P0 + Dividends/P0 The return on this investment is: (150-125+3) = 28 = 22 . we get R= 12. The cash outflows for the purchase of stock are as follows. where To is our initial cash outflow at Time zero Ti . At the end of t he year. Using the discounted cash flow approach. measur ing investment returns is a bit more difficult. at a price of Rs. we calculate the average return (r) over two year s as follows: Solving for return was equal to any dividends that the stock paid plus the capital gai ns or losses that the investor realized on the sale of the stock. It does not take cash inflows/outflows into consideration during any period. I t is unlike the CAGR of return in that it ignores the number of shares held in e ach period. At the end of the year. we decide to purchas e one more share of stock at the current market value of Rs 150.Rs.81 percent. With the basic concept of the ho lding period return.Rs.81%)/2 = 17.4 % 125 Time Weighted Returns versus Dollar Weighted Returns In reality we may want to c onsider investments over a period of time whereby we may have added to our inves tment positions or reduced our investment positions.

the description of different types of risk is followed by explanations of how ri sk may be Measured. The time weighted return discussed in the previous section is also an example of arithmetic average rate of return. or by th e investment risk. the dollar weighted return yielded less return than the time weighted rate of return. as in the real rate return. we calculate the geometric rate as foll ows: Rg = [(1 + 0. “How much was the return on your investment?” Before having read this chapter. as in the risk-free rate.2) X (1 + 0. Therefore. the astute student should recognize that the various return definitions exist because they are all meaningful to investors under diff erent investment circumstances and scenarios. s uch a question may have been interpreted as a simple question. t he dollar weighted rate of return is generally considered to be the superior mea sure of return for this reason. It will alway s be true that the geometric rate of return will yield a smaller number than the arithmetic rate of return. the effect of time or the means of averaging. This measure would thus be used by those wishing to know how investment returns fared within a particular portfolio or portfolio s. we studied the many different forms that investment returns may ta ke. Depending upon the individual investment resul ts either measurement could yield a result greater than the other. Using the same numbers from the previous example of calcu lating the time weighted rate of return. Because money managers cannot control the timing or the amount of money coming into their funds. time weighted returns are used in order to measure results. It is useful to u nderstand the nature and various types of risk since investors implicitly or exp licitly price this risk in arriving at required returns investments. Summary This chapter began with a descript ion of the different kinds of risk that accompany investments. Since investors are particularly interested in the tot al amount of return that a portfolio or security yields over a period of time.38% whereas the arithmetic rate of return is 17. The arithmetic and geometric weighted averages are examples of such returns. The equation for the geometric is as follows: Rg = [(1 + HPR year1) X (1 + HPR y ear2) X (1+HPR year)]¹/n – 1 Where Rg is the geometric rate of return and n. Time weighted retur ns are generally used in order to measure results of money managers in their man agement of particular funds. Armed with su ch knowledge.41%. Once we can identify the types of risk in an investment and understand how to measure such risk. Not any more. Returns may be classified by inflation. this method inc ludes the effect of compounding into consideration when calculating the return. Even though the simplici ty of the term is no more. the greater is th e disparity between the two averages. These differing applications were explained in the context of defining each of the terms of returns. stands for the nth period of investment. a financial planner cannot only explain investment outcomes to cli ents more clearly but also help clients identify the 62 Investment Planning PDP . we can then proceed to identify what kinds of returns we may require from investing in different kinds of investment produc ts. the lower the returns. Other return measures may incorpora te taxes. In general th e results from these two measures will be different however. Thus. Arithmetic versus Geometric Averages A separate set of measures arises from a veraging returns on investments. The arithmetic rate of return is a simple aver age of annual returns. The geometric rate of return considers cash flows generated during the security’s holding period to be reinvested at the security’s required rate of return.1481)]½ – 1 = 17.38% Notice that the geometric average return is 17.In this particular example. In general. In this chapter.

45/-. Therefore. If an investment is made in a taxable vehicle within a taxable acco unt. Ketan bought a share on Jan 1. discounting.023 or 2. 2003 for Rs.72% = -0. but what you keep that re ally counts. A better calculation is the promised y ield to call. Co mpounding vs. The company did not pay any d ividends. Post Tax Returns (Tax Adjusted Returns) As an investor.e. Compounding invo lves future value resulting from compound interest.111+1)*(. Problem Mr. one should really look at the net after tax return. for premium bonds selling above a certain level. What is Mr.11% = 0. ty pically after some deferred call period. Mukherjee’s post tax return on this investment? PDP Investment Planning 63 . The year end prices were as follows: 2003 = 50 2004 = 55 2005= 48 If h e sold the share on end 2005 for Rs. they must be discounted back to the present. The end of the deferred call period when a bond can first be calle d.3% Yield to Call Most co rporate bonds. are callable by the issuers. that is interest on intere st.111 R2 = (5/50)*100 = 10% = 0.127 Arithmetic Average returns = [11. Mr. After all.01+1)*(-0.misuse and abuse of these in the description of investment products. you learn very quickly that taxes can take a big bite out of you r investment returns. the yiel d-to-maturity calculation is unrealistic. what returns did he get on this investm ent? Solution R1 = (5/45)*100 = 11. Tables exist for both compounding and d iscounting.127+1) ]} -1 = {cube root of 1. Such Rupees are no t comparable because of the time value of money. and calculators and computers make these calculations simple. as is its complement.79665 Geometric Average returns = {cube root of [(0. Mukherjee h as an investment with an 8% taxable yield. Example Mr. Present value (discounting) is the value today of the Rupee to be received in the future.023-1 = .11+10-12.72]/3 = 2. because it produces the lowest measure of yield. In order to be comparable.1 R3 = (-7/55)*100 = -12. is an important concept. Discounting The concept of compounding. 48. it’s not what you make.0669} . This is particularly appropr iate for bonds selling at a premium (i. yield to call replaces yield to maturity.1 = 1.. Bond prices are calculated on the basis of the lowest yield me asure. Mukherjee pays tax at the rate of 30% on his income. high-coupon bonds with market prices above par value). as well as some government bonds. is often used for the yield-to-call calculation. For bonds likely to be called.

6% Conversely. the tax adjusted yield in the year of investment is 11. Arun Joshi? Tax adjusted yield is = Tax free return / (1-t) For deduc tion u/s 80C. The returns on the investment being taxable or tax free.3 = 0. Arun Joshi makes it a point to invest Rs.7 = 11. the return will be 8/(1-0. tax free interest.3 265% as calculated subsequently. the yield works out to 16.Return = 1 Tax = 0. on maturity/withdrawal and whether the same is taxable or not.4285% But this return is also tax free u/s 10 Hence. 70. let us assume that Mr.5% Case Mr.7 = 16.7 = 8% Taxable return = 1 = 8/0. 3.every year in his Public Provident Fund account.3) = 8/0.3265% Since PPF investment qualifies for tax deduction. He enjoys tax deduction u/s 80C on the amount deposited and he earns 8% p. additional yield calculation will follow Yield on P PF to Mr Arun Joshi = 11. if any.4285% The formul a can be given as: Taxable return = Tax free return / (1-t) Where “t” is the margina l rate at which the investor pays tax. Mukherjee gets 8% tax fre e returns and he is paying tax at 30%.3 Post tax return = 1-0.7 = 5. Deduction on amount invested and subsequent saving of income t ax. The capital gain or loss. The three important aspects of tax adjusted yie lds are: 1. Ta x free return = 10% Taxable return = 10 % /(1 .2) = 10/0. 2.5 % 0 .000/. What is his taxable yield on this investm ent? Tax free return = 0.4285% as c alculated above and since the return is not taxable. Let us try and find out what would be the yield to Mr.7 Taxable yield = 8% Post tax y ield = 8*0. What is the tax adjusted yield on PPF depos its to Mr.t ) = 10 % = 12 .8 = 12. He pays income tax at the rate of 30%. credited annually to his PPF account.7 = 11.4285/0.a.8 Alternatively: Tax free return / (1-t) = 10/(1-0. 64 Investment Planning PDP . Mukherjee on his 10% tax free bonds if he is paying tax at 20%.

we will get a l ess accurate return i. What is the real return on the stock? Real return = {(1+0. adding dividends an d capital gains and dividing the resulting figure by the purchase price. there are no capital gain/loss issues and hence mat urity value taxability is not an issue while calculating the yield. The return is measured the same as total return. Patel bought a share for Rs. To calculate inflation-adjusted returns. Real return = {(1 + Nominal return)/(1+ Infla tion rate)} – 1 Example The rate of return on a stock in a particular year was 19. Holding period returns = (120-110)/110 = .5 = 14% Holding Period Return A holding period return is the total return actually realized or expected from h olding a specific asset for a specified period of time (not necessarily one year ). we need to consider real returns. Calculate his hol ding period returns.09% PDP Investment Planning 65 . The rate of inflation during that year was 5. 120/-. Solution Abs olute returns Rs. if an in vestment produced a return of 5% in 182 days.5%. To capture this dimension.7373 or 73. It is important to note that this return measurement assumes the return could be duplicated over the full year. or in flation-adjusted returns.e. This calculation is sometimes simplified by subtracting rather than dividing .5-5. the annualized yield would be appr oximately 10%. For example.195)/(1+0. 5 %.055)} – 1 = 1. we divide 1 + nominal total return by 1 + the inflation rate as shown in the following equati on. producing a close approximation.0909 = 9. Problem Mr.In the case of PPF deposits. Patel bought a share for Rs. Calculate his annualized returns. 10/110 over 45 days Annualized returns = (10*365)/(110*45) = 0 .27% Me rely by subtracting inflation rate from the return on the stock.73% Real (Inflation-Adjusted) Return All of the returns discussed earlier are nominal returns. 19. which may or may not actually be achievable. Example Mr.1327 = 13.1327-1 = . They measure Rupee amounts or changes but say nothing about the purchasing power of these Rupees. 110 on 10th Jan 2006 and sold it after 45 days at Rs. Annualized R eturn An annualized return is a rate of return over a full calendar year on an i nvestment that is held for less than a full calendar year. No dividend was received by him in this period. or money returns. that is. 110 on 10th Jan 2006 and so ld it after 45 days at Rs. 120/-.

the benchmark portfolio must be a legitimate alternative that accura tely reflects the objectives of the portfolio owners. and Michael Jensen developed measure s of portfolio performance in the 1960s. a portfolio of small capitalization stoc ks should not be judged against that same benchmark. A 12% ret urn.Measures of Return Portfolio Performance Measurement We have been discussing returns on individual securities. An evaluation is imperative. one can only measure return in relation to th e risk taken. exac t. over the same timeframe. universally agreed upon methods of portfolio evaluation remain an el usive goal. Comparisons for such a widely diversified group can be quite difficult.William Sharpe. The framework for evaluating portfolio performance consists of measuring both the realized return and the differential risk of the portfolio used to compare a portfolio’s performan ce. by itself. precise. Benchmark Portfolios Evaluatio n of portfolio performance. Investing is always a two-dimensional process based on return and risk. It must be viewed in comparison to the performance.Portfolio of Securities . and both must be ev aluated if intelligent decisions are to be made. Although all investors prefer higher returns. is a fairly meaningless figure. Many observers now agree that multiple benchmarks can be more appropriate to use when evaluating portfolio returns. if we know nothing a bout the risk of an investment. The measurement process must involve relevant and obtainable alternative s. three researchers . An equity portfolio consis ting of BSE Sensex stocks should be evaluated relative to the BSE Sensex or othe r equity portfolios that could be constructed from the Index. Remember. that is. Even more diff icult to evaluate are equity funds that hold some midcap and small stocks while holding many BSE Sensex stocks. These two factors are opposite sides of the same coin. meaning that t hey incorporate both realized return and risk into the evaluation. If a bond portfolio manager’s objective is to invest in bonds rated A or higher. the bottom line of the investing process. and an important related issue is the ben chmark to be used in evaluating the performance of a portfolio. We must make relative c omparisons in performance measurement. we must evaluate performance on a risk-adjusted basis. On the other hand. To ev aluate portfolio performance properly. after adjusting fo r the risk involved. is an impo rtant aspect of interest to all investors and money managers. and recognize any constraints that the portfolio manager may face. These measure s are still used by mutual funds and money managers. The essence of p erformance evaluation in investments is to compare the returns obtained on some portfolio with the returns that could have been obtained from a comparable alter native. though it is unfortunate that some stud ies have indicated that most investors don’t have a good idea how well their portf olios are actually performing. Jack Treynor. If we are to assess performance carefully . These measures are often referred to as the composite (risk-adjusted) measures of portfolio performance. Therefore. there is little we can say about its performance . we must determine whether the returns are large enough given the risk involved. Risk-adjusted Returns Recognizing the necessity t o incorporate both return and risk into the analysis of portfolio return. Now let us measure portfolio returns. of alternative investments bearing a similar level of risk. it would be inappropriate to compare his or her performance with that of a junk bond manager. they are also risk averse. All investors should understand that even in today’s investment world of computers and databases. 66 Investment Planning PDP .

The Sharpe and Treynor measures can be used to ran k portfolio performance and indicate the relative positions of the portfolios be ing evaluated.Rf)*B] Rp= return on the portfolio Rf = risk free return Rm = Market return (Index return) B = Beta of the portfolio (Beta is the measure of m arket risk of the portfolio) PDP Investment Planning 67 . It calculated the difference between wha t the portfolio actually earned and what it was expected to earn given its level of systematic risk. Basically. the better the portfolio performan ce).Sharpe Ratio William Sharpe introduced a risk-adjusted measure of portfo lio per formance c alled the reward-to-variability ratio (RVAR). the return of an unmanaged portfol io with the same market risk. Jensen’s measure is an absolute measure of performance. Jensen’s Index Michael Jensen’s measure of portfolio performance w as differential return measure (Alpha). or below. implicitly assuming that portfolios are well di versified. it attempts to measure the constant return that the portfolio manager earned above. Sharpe used RVAR to: n n Measur e the excess return per unit of total risk (as measured by standard deviation). This measure uses a ben chmark based on the ex post capital market line.Rf SD Rp = Return of the portfolio Rf = Risk free return SD = Standard Deviation of Po rtfolio (total risk) Treynor Measure Jack Treynor presented a similar measure ca lled the reward-to volatility ratio (RVOL). distinguished between total risk and systematic risk. Treynor sought to relat e the return on a portfolio to its risk. Jensen’s inde x = Rp – [Rf + (Rm. RP . that is. He used as a benchmark th e ex post security market line. Rank portfolios by RVAR (the higher the RAVR. RVAR = RP .Rf Beta Beta is the measure of market risk of the portfolio. however. Like Sharpe. Treynor. he ignores any diversifiable risk.

74% c. 10.0 1% c.11% b.24% b.Review Questions: 1.70% d. What is geometric average returns for stock A given the details above? a. and Rs. 8% b.0 % 6. What is the YTM of the above bond (by using the method of computing the YTM approximately). 15. He did not get any dividend on the stock.62% 3.and sold it after a year for Rs. 11. A bought a stock X fo r Rs. 115/-.and the year end prices for the last 3 years were Rs . Mr.4% d. Rs. Mr.74% b. 12. 12. 95. 44.40% d.42% 5. 30% b.73% d .82% d. 8% c. 38.11% 2. 11. 950 with a face value of Rs. A? a.24% b.after 120 days. 102 and sold i t for Rs. 100/-? a.46% d. 13. 13. 2/. A bought stock X for Rs. 102/. What is the arithmetic average returns on stock A if the st ock was bought for Rs. 10. 1000/-? a. 11. 11.per share in the interim. 9. 13. What is the total return on stock X? a. 9% c. 11. 14. 25. 8. He also received a dividend of Rs. What i s the holding period return on stock X to Mr. 24% c.76% c. 85. 75/. What is the current yield of a bond bearing a coupon r ate of 8% payable annually and currently priced at Rs. 115/.48% 68 Investment Planning PDP . 12.12% 4. 10. if the bond will matur e after 2 years? a.

25 c. 10% 10. 6.75 d. A bought stock X for Rs.74% b. Vasudeo Mumbaikar? a. a.75 b. 2.73% d.76% c. his PPF account and saved income tax of Rs.7. 10.enjoyed by Mr.000/. 4. 11. Mr. What is the tax adjusted yield on PPF deposit of Rs. 10. Mr. 12.on maturity after 6 years which works out to a return of 8% p. 5. W Jones? a. 2. 16.48% 8. 8% b. 11.32% d.and sav ed income tax of Rs. He di d not get any dividend on the stock. 3. find out the S harpe Index: Return on the portfolio was 15% while risk free return was 8% and t he standard deviation of the portfolio was 4%. 5. 2. 3. Mr. Vasudeo Mumbaikar invested Rs. 10% 9. What is the tax adjusted yield on NSC pu rchased by Mr. a b c c c a b c d c PDP Investment Planning 69 .32% d. A? a. 1. He will get Rs. 102 and sold it for Rs.000/.43% c. 3.000/-.43% c. Given the following information about the returns on a portfolio. What is the annualized return earned by Mr. 8. 16. 38. 115/. Winston Jones purchased National Saving Certificate for Rs.a.000/. 44. He will get 8% p.000/-. 9. 10.010/. 8% b. 16. interest which is tax free on his PPF de posit.after 120 days.a. 7.75 Answers: 1. 10.

Chapter 6 70 Investment Planning PDP .

asset allocation is closely related to the age of an investor. This involves the so-called life-cycle theory of asset allocation. According to some studies. bills. for example. the investor’s risk tolerance. However. and other assets? Within each of the major asset classes. 2. Individual investors often consider the investment decision as consisting of tw o steps: Asset allocation Security selection The asset allocation decision refers to the allocation of portfolio assets to br oad asset markets. and the correlation coefficients may be quit e low. The rationa le behind this approach is that different asset classes offer various potential returns and various levels of risk. bonds. exchange-listed stocks versus over-the-counter stocks . what percentage of portfolio funds is to be invested in stocks. how much in bonds. According to some analyses. The asset allocation decision involves deciding the percentage of investible funds to be placed in s tocks. and so forth? Many knowledgeable market observers agree that the asset allocation decision may be the most important decision made by an investor. in other words. diversified portfolios will tend to produce similar returns over time. Correlation can help in making decisio ns concerning diversification among mutual fund categories.Building an Investment Portfolio W n n e now consider how investors go about selecting stocks to be held in portfolios. different asset classes are likely t o produce results that are quite dissimilar. Correlation determines the extent to which a variable moves in the same d irection as other variable. what percentage of portfolio funds goes to various types of bonds. The returns of a well-diversified po rtfolio within a given asset class are highly correlated with the returns of the asset class itself. money market assets. Each weig ht can range from zero percent to 100 percent. then we have to ask the following questions: 1. It is the most important investment decision made by investors because it is the basic determinant of the return and risk ta ken. Within an asset class. This is a result of holding a well-diversified portfolio. Therefore. It is statistically determined an d labeled as the correlation coefficient. Factors to consider in making the asset allocation decision include the i nvestor’s return requirements (current income versus future income). and cash equivalents. bonds. such as inflation. how much of the portfolio’s funds are to be inv ested in stocks. 3. which we know is the primary lesson of portfolio management. the asset allocation decision accounts for more than 90 per cent of the variance in quarterly returns for a typical large pension fund. What percen tage of portfolio funds is to be invested in each of the countries for which fin ancial markets are available to investors? Within each country. and the time horizon. This makes intuitive sense because the PDP Investment Planning 71 . and so forth. If it is possible to make investm ents globally. differences in asset all ocation will be the key factor over time causing differences in portfolio perfor mance. This is done in conjunction with the inves tment manager’s expectations about the capital markets and about individual assets .

portfolio construction involves the selection of securi ties to be included in the portfolio and the determination of portfolio funds (t he weights) to be placed in each security. is to determine which percentage of total investable assets should be allocated to each category deem ed appropriate. Unfortunately. the margin al risk reduction is small. As we add securities to the portfo lio. Th e first few stocks cause a large decrease in portfolio risk. Based on these actu al data. on average. Stated at its simplest. Diversification Diversification is the key to the management of po rtfolio risk because it allows investors to minimize risk without adversely affe cting return. Nevertheless. According to the life-cycle theory . in consultation with the financial planner. the risk is reduced dramatically – to th e extent of 33%. It is also established in the US through studies that by ad ding foreign securities to the portfolio. average portfolio risk can be reduced to approximately 19 per cent. from those who are starting out in their 20s. The next step. adding one more stock to the portfolio will continue to reduce the risk. 51 per cent of portfolio standard deviation is eliminated as we go from 1 to 10 securities. the benefits of random diversification do no t continue as we add more securities. the more likely it is that the sample mean will be 72 Investment Planning PDP . as individuals approach retirement. the larger the sample size. Random diversification refers to the act of randomly diversifying without regard to relevant investment characteristics such as expected return an d industry classification. For randomly selected portfolios. for example. Asset Classes Portfolio construction listing out the asset classes. An investor simply selects a relatively large number of securities randomly.needs and financial positions of workers in their 50s would differ. as discussed in the preceding section on asset allocation. although the amount of the reduction becomes smaller and smaller. they become more risk averse. According to the Law of Large Numbers. Risk Reduction in the Stock Portion of a Portfolio 1. Law of La rge Numbers One simple way of going about risk reduction is through increasing t he number of securities held. An efficient portfolio is one with the highest level of expected return for a gi ven level of risk. or the lowest risk for a given level of expected return. the total risk associated with the portfolio of stocks declines rapidly. where money can be investe d are: n n n n n Cash (or cash equivalents such as money market funds) Stocks Bo nds Real Estate (including Real Estate Investment Trusts) Foreign Securities Each investor must determine which of these major categories of investments is s uitable for him/her. As subsequent stocks are added. the exposu re to any particular source of risk becomes small. As we add securities to this portfolio. The Markowitz model provides the basi s for a scientific portfolio construction that results in efficient portfolios. Only then should individual securities be considered within each asset class.

Weighted co-movements between securities’ returns (i. We find that most stocks are positively correlated with each other. Harry Markowitz. Risk reduction in the case of independen t risk sources can be thought of as the insurance principle. however.e. His equation accounts for two factors: 1.. originated the basic portfolio m odel that underlies modern portfolio theory. Investors have known intuitively fo r many years that it is smart to diversify. Unfortunately. co nsidered the father of modern portfolio theory. 2. He showed quantitatively why. Risk cannot be eliminated because common sources of risk affect all firms.e. that is.. Combination of securities It is assumed that combination of two securities re sults in risk reduction. and how. th e movements in their returns are related. again weighted by the percentage of investible funds placed in each security). the covariance bet ween the securities’ returns. investors dealt l oosely with the concepts of return and risk. Markowitz developed an equation that calculates the risk of a portfolio as measured by th e variance or standard deviation. W eighted individual security risks (i. was the first to develop the concept of portfo lio diversification in a formal way. the assumption of statistically independent returns on stocks is unrealistic in the real world. Ma rkowitz sought to organize the existing thoughts and practices into a more forma l framework and to answer a basic question: Is the risk of a portfolio equal to the sum of the risks of the individual securities comprising it? Markowitz was t he first to develop a specific measure of portfolio risk and to derive the expec ted return and risk for a portfolio based on covariance relationships. that is. We are assuming here that rates of return on indiv idual securities are statistically independent such that any one security’s rate o f return is unaffected by another’s rate of return. the stock Y is riskier because the standard deviation is higher but t he expected return is also higher. port folio diversification works to reduce the risk of a portfolio to an investor. the variance of each individual securit y. weighted by the percentage of investible funds placed in each individual secu rity). not to “put all of your eggs in one basket. Before Markowitz. Most stocks have a significant level o f co-movement with the overall market of stocks. Is it possible to reduce the risk of a portfolio by add ing into it a security whose risk is higher than that of any of the investments held already? Let us consider the following example: Obviously.” Markowitz. 2. as measured by such indexes as the BSE Sensex or NSE Nifty. named for the idea that an insurance company reduces its risk by writing many policies against many independent sources of risk.close to the population expected value. We will have to analyze and find out whether it would be sensible for an investor who is already PDP Investment Planning 73 . Modern Portfolio Theory In the 1950’s.

then we will have ret urns of 0. stock X per forms well while stock Y does not perform well. Th e coefficient of correlation is another measure that would indicate the similari ty or dissimilarity in the behaviour of the two variables. In either case.80% If it is the other way round.holding Stock X to buy a riskier stock Y.25 The stocks X and Y are negatively correlated. and mul tiplied the two deviations together and taken the average of such deviations. If we can find two securities that are perfectly negatively correlated. that is.4*14 = 11. we will have a situation when th e return will be 0. add it in his portfolio to reduce the risk. Rxy = COVxy / (sx * s y) = -2/(2*4) = -2/8 = -0.6*11+0. we have got returns ver y close to the expected return with risk virtually being nil.6*10+0. 74 Investment Planning PDP . The exp ected return on the portfolio Rp would be 0. the returns will depend upon the interacti ve risk between / among those securities. A perfect correlation will be when Rxy = 1 and a perfect negative correlation will be when Rxy = -1.60% If we assume th at stock Y gives good returns when stock X performs badly. determined the variation of each from its expected value. when we have t wo or more securities in a portfolio. which means one stock will perform while the other may not and vice versa. using the example given above the covariance can be worked out as under: ½ [(9-10)(16-14 )+(11-10)(12-14)] = ½ [-2-2] = -2 We have taken two corresponding observations at the same time. In other words. then we can have a portfolio of two securities without any risk at all.4*16 = 11.6*9+0.40%. Covariance or interactive risk Where the probabilities are equal the formula can be expressed as: COVxy is arri ved out by using the formula given below: If it assumed that stock X gives a return of 9% while stock Y gives a return of 16% and stock X gives a return of 11% when stock Y gives a return of 12%. We have assumed a negative correlation between stock X and Stock Y.4*12 = 11. Whether buying stock Y and adding to one’s portfolio will amount to diversif ication? Let us find out by assuming that we shall build a portfolio of 2 securi ties with weightage of 60% for stock X and weightage of 40% for stock Y.

we have already calculat ed: COVxy = -2 Weights for stock x and stock y are 0.4)2*16+[2*. True diversification is about choosing correct securit ies that are negatively correlated rather than mere increase in number of securi ties. we can conclude that in order to achieve diversification we should choose stocks with negative or low covariance. the less ris ky the portfolio will be.06*. As more secu rities are added under the condition of perfect positive correlation.56-0. The purpose of diversification will not be served if we add securities that have positive co-relation or no co-relation at all. Where. by adding a security y with a higher risk to security x and constructing a portfolio. Port folio effect in a 2 security case We have seen that diversification reduces the risk.6 and 0.0096 = 3. When does Diversification pay? n Combining securities with perfect positive correlation with each other p rovides no reduction in portfolio risk. the lower the correlation of securities in a portfolio.related at all and the returns will be independent of each other. Var iance for stocks x and y have been given as 4 and 16. Thus. So portfolio variance will be: (0.4 respectively. While achieving risk reduction. In general. we have achiev ed risk reduction without compromising on the returns. these two stocks are absolutely not co . one should not compromise on the returns. There is no risk reduction. PDP Investment Planning 75 .99 Portfolio risk will be square root of variance which is less than 2. When Rxy = 0.04*(-2)] 1.Rxy lies between -1 and +1. sxy is the portfolio standard deviation wx = percentage of stock x in the total portfolio value wy = percentage of stock y in the total portfolio value s 2x = variance of stock x sy2 = variance of stock y COVxy = covariance of stock x and stock y In the case which we have been discussing.44+2. portfolio risk remains a weighted average. Thus. The risk of the resulting portfolio is s imply a weighted average of the individual risks of the securities.6)2*4+(0.

0 downward. secur ities typically have some positive correlation with each other. while the importan ce of the covariance relationships increases. By doing so. n n Markowitz’s theory shows us that the risk for a portfolio encompasses not only the individual security risk but also the co-variance between the securities. However. Portfolio risk will be reduced as the correlation c oefficient moves from +1. for example. The standard deviation of the portfolio will be directly affected by the correla tion between the two stocks. Rather. but they generally will be faced with positively correlated security r eturns. Because rupee cost averaging involves regular investments during periods of fluctuating prices. Thus. You invest a fixed amount of money at regular in tervals. Other things being equal. This strategy allows one to take away the guesswor k of trying to time the market. these extreme correlations are rare. He was the first to derive t he concept of an efficient portfolio. you should consider your financial ability to continue i nvesting when price levels are low. Investors can identify efficient portfolios by specifyi ng an expected portfolio return and minimizing the portfolio risk at this level of return. Markowitz’s approach to portfolio selection is that an investor should evaluate portfolios on the basis of their expected retu rns and risk as measured by the standard deviation. Combining two secur ities with perfect negative correlation with each other could eliminate risk alt ogether. this 76 Investment Planning PDP . Rupee Cost Averaging The systematic investment pla ns in mutual funds. the impo rtance of each individual security’s risk (variance) decreases. i nvestors wish to find securities with the least positive correlation possible. significant risk reduction can be achieved . although r isk can be reduced. they can specify a portfolio risk level they are willi ng to assume and maximize the expected return on the portfolio for this level of risk. In a portfolio of 500 securities. we must under stand that in the real world. along with consistent periodic new purchases of shares. you end u p buying fewer shares when the prices are high and more shares when the prices a re low. it usually cannot be eliminated.n Combining two securities with zero correlation (statistical independence) with e ach other reduces the risk of the portfolio. defined as one that has the smallest portf olio risk for a given level of expected return or the largest expected return fo r a given level of risk. One of Markowitz’s real contributions to port folio theory is his insight about the relative importance of the variances and c o-variances. 3. Finally. Alternatively. The co-variances between securities. they would like securities with negative correlation or low positive cor relation. If more securities with uncorrelate d returns are added to the portfolio. As the number of securities held in a portfolio increases. regardless of whether the market is high or low. crea tes risk reduction by creating a lower cost per share owned over time. portfolio risk cannot be eliminated in this case. The portfolio weights for each security. portfolio risk will consist almost entirely of the covariance risk between securities. Rational investors will seek efficient portfolios because these portfolio s are optimized on the two dimensions which are of most importance to investors: expected return and risk. This is k nown as rupee cost averaging. the contribution of each security’s own risk to the total portfolio r isk will be extremely small. and t hat three factors determine portfolio risk: n n n The variance of each security. I deally. However. This is the principle behind hedging strategies.


each investor’ s personal risk-return considerations or “utility” is i ntroduced into the construction. “the Effect of Diversification on Risk. Assume we have identified the following risk-return possibilities for ei ght different portfolios (there may also be many more. Although we have only diagr ammed eight possibilities. We have seen how the c ombination of two investments has allowed us to maintain our return of 10 percen t but reduce the portfolio standard deviation to 1. Next. See W H. These are time-tested investment philosophies t hat should go into building investment portfolios. we see an efficient set of portfolios would lie along the ACFH line in Figure 6:1. A shrewd portfolio manager may wish to consider a large number of portfolios. or portfolios. It is a f act that risk in investments can be reduced but can not be totally removed throu gh diversification. the efficient combinations are superim posed on the investor’s desired utilities. on the correlations between the individual securities.10.approach reduces the effects of market fluctuation on the average price you pay for your shares.C. say equities.or even 100-asset portfolios. we show the values in Figure 6:1. In diagramming our various risk-return points in the table on page 78. In 1990 Markowitz won the Nobel Prize in economics for thi s work. to arrive at one efficient combination. but we will restrict ours elves to this set for now). our example may be expanded to cover 5. or benefits. The incremental benefit from reduction of the portfolio s tandard deviation through adding securities appears to diminish fairly sharply w ith a portfolio of 10 securities and is quite small with a portfolio as large as 20. each with a different expected va lue and standard deviation. which are superior to other comb inations either from better returns and / of lower risk These superior or “efficie nt” combinations are then plotted to determine a “frontier” of all such efficient comb inations.. Wagner and S. We also saw in the preceding table that different coefficient correlations produce many different possibilities for portfolio standard deviations. an “optimal portfolio” for the stated investor.. and so we refer to them as Markow itz portfolio theory.8 percent. It is pertinent to have more securities in a particular asset class. it helps you maintain a regular investment plan. based on the expected values and standard deviations of the individual securities and more importantly. Finally. Additionally. Lau.” PDP Investment Planning 77 . In order to reduce risk associated with investments for getting a desired level of returns: n n n n n It is essential to be diversified across different asset c lasses. This line is called the effic ient frontier because the portfolios on the efficient frontier provide the best risk return trade-off. Modern portfolio theory begin s by combinations of securities. Though we have been discussing a two-asset portfolio case. The major tenets of portfolio theory that we are currently examining were develo ped by professor Harry Markowitz in the 1950s. Systematic investment – investments in selected securities at regular pre determin ed intervals will serve the purpose of “Rupee Cost Averaging” and take away the risk of investing at the wrong time. Co-relation among different securities chosen is more important than mere number of securities in one’s portfolio to achieve diversification. This line is efficient because the portfolios on t his line dominate all other attainable portfolios. A portfolio of 12 to 14 securities is generally thought to be of sufficient size to enjoy the majority of desirable portfolio effects.

To also demonstrate that we are getting minimum risk for a gi ven return level. whereas directly below point F.FIGURE 6:1 Diagram of Risk-Return Trade-Offs That is along this efficient frontier we can receive a maximum return for a give n level of risk or a minimum risk for a given level of return. we can examine point A in which we receive a 10 percent return for a 2.8 percent risk level. and portfolios below this line do not offer acceptable alternatives to points along the line. Along the efficient frontier. portfolio E provides a 13 percent return for the same 5 percent s tandard deviation. we are receiving a 14 percent return for a 5 percent risk level. Portfolios do not exist above the efficient frontier. we get 78 Investment Planning PDP . whereas to the right of point A. As an example of maximum retu rn for a given level of risk. consider point E.

Once computed. Measurement of Return in R elation to Risk In examining the performance of fund managers. PDP Investment Planning 79 . A classic study by john McDonald published in the journal of Financial and Quantitative Analysis indicates that mutual fund managers gener ally follow the objectives they initially set. Using be tas and portfolio standard deviations.the same 10 percent return from B. long-run adherence to risk objectives is advisable.3 mutual funds and compared these with the funds’ stated objec tives. The rate on RBI Treasury bills is often used to represent the risk-free rate of return in the financial markets (though other definitions are possible). a fund that earns 12 percent when the Tre asury bill rate is 6 percent has excess returns of 6 percent. Those with a growth objective had an average beta of 1. For example. Although we have shown but eigh t points (portfolios). Though the term excess returns has many defin itions the one most commonly used is total return on a portfolio (capital apprec iation plus dividends) minus the risk-free rate: Excess returns = Total portfoli o return – Risk-free rate Thus. For example. Anyone who aspires to maximize capital gains must. but a less desirable 3. Thus. the return measur e commonly used is excess returns. An incomeoriented fund should have a m inimum risk exposure. by nature.01. Other studies have continually reaffirmed the position established in this seminal study by McDonal d. Although it may be appropriate to shift the risk level in anticipation of changing market conditions (lower the beta at a perceived peak in the market) . Most lawsuits brought against money managers are not for inferior profit performance but for failure to adhere to stated risk obj ectives. the Treynor approach. exc ess returns are then compared with risk. absorb more risk.1 percent risk level. a combination of growth plus income. While short-run return performance can be greatly influenced by unp redictable changes in the economy. excess returns represent returns over and above wh at could be earned on a riskless asset. The objectives should be set with an eye towar d the capabilities of the money managers and the financial needs of the investor s. a nd the Jensen approach. we can connect the points between A and C by generating portfolio s that combine different percentages of portfolio A and portfolio C and so on be tween portfolios C and F and portfolios F and H. a fully developed efficient frontier may be based on a vi rtually unlimited number of observations as is presented in Figure 6:1. Adherence to objectives as measured by risk exposure is important in evaluati ng a fund manager because risk is one of the variables a money manager can direc tly control. the fund manager has almost total control in setting the risk level. we see that the risk absorption was caref ully tailored to the fund’s stated objectives. while the opposite was true of balanced and income-oriented funds. or simply income ( with many variations in between). One portfolio can consist of various proportions of two assets or two portfolios . The best way to measure adherence to these objectives is to evaluate the risk exposure the fund manager has accepted . Funds with aggressive capital gains and growth objectives had high betas and portfolio standard deviations..22. He can be held accountable for doing what was specified or promised in regard to risk. and so on all the way down to an average beta of 0. We look at three different approaches t o comparing excess returns to risk: the Sharpe approach. He measured the betas and standar d deviations for 12. Benchmar ks A first question to be posed to a professional money manager is: Have you fol lowed the basic objectives that were established? These objectives might call fo r maximum capital gains. funds with an objective of maximum capital gains had an aver age beta of 1.55 for income-oriented.

or beta Implicit in the Treynor approach is the assumption that portfolio ma nagers can diversify away unsystematic risk.9 0. and a market standard deviation of 12 percent.6% Sharpe measure = 18% = 18% 4 % = 0. and the portfolio beta is 0. Of course.22 This measure can be compared with other portfolios or with the market in general to assess performance.044. the risk-free rate is 6 percent.6% = 0 . 10% . 22.044 80 Investment Planning PDP .Sharpe Approach In the Sharpe approach. Treynor Approach The formula for the second appr oach for comparing excess returns with risk (developed by Treynor) is: Total por tfolio return – Risk-free rate Treynor measure = Portfolio beta The only differenc e between the Sharpe and Treynor approaches is in the denominator. Assume the re is a 9 percent total market return. while Treynor uses only the systematic ri sk.25 and repres ents an inferior performance.9 0.22: 10% . the risk-free rate is 6 percent. Treynor uses the portfolio beta.04 = 0. and only systematic risk remains.9. and the portfolio standard deviation is 18 percent the Sharpe measure is 0.25 or: 9% . Then the Sharpe measure for the overall market is 0. I f a portfolio has a total return of 10 percent.9 4% = 0. If the market return per unit of risk is greater than 0. on e can say that Sharpe uses total risk. While Sharpe uses the portfolio standard deviation. Thus. a portfolio measure above 0. the Treynor measure would be 0.22 is less than the market measure of 0.6% = 12% 12% 3 % = 0. a 6 percent risk-free rate.25 The portfolio measure of 0. then the portfolio manager has turned in an inferior performance.25 would re present a superior performance. the excess returns on a portfolio are co mpared with the portfolio standard deviation Total portfolio return – Risk-free ra te Sharpe measure = Portfolio standard deviation The portfolio manager is thus a ble to view excess returns per unit of risk If a portfolio has a return of 10 pe rcent.

FIGURE 6:2 Risk -Adjusted Portfolio Returns The expected portfolio excess returns should be equal to market excess returns. the risk-free rate is 6 percent. but the beta is less (0. 044 versus 0.This measure can be compared with other portfolios or with the market in general to determine whether there is a superior performance in terms of return per uni t of risk. as the market line.03 = 0. the market excess returns are 3 percent.0 1. If the market return (KM) is 9 percent and the risk-free rate (RF) is 6 percent.03: 9% . based on thei r portfolio beta. with a beta of 0. the excess returns will be 0. th ere is more return per unit of risk. Assume the total market return is 9 percent. PDP Investment Planning 81 . then the Treynor measure as a pplied to the market is 0. Jens en emphasizes using certain aspects of the capital asset pricing model to evalua te portfolio managers.030 This would imply the portfolio has turned in a superior return to the market (0. Jensen Approach In the third approach. A portfolio with a beta of 1 should ex pect to the market rate of excess returns (KM-RF). He compares their actual excess returns (total portfolio return – risk-free rate) with what should be required in the market. The required rate of excess returns in the market for a given beta is shown in Figure 6:2 given below.030) Not only is the portfolio return higher than the market return (10percent versus 9 percent). the exp ected excess returns on the market line are 0.0 0.6% = 1. If the beta is 0. the p ortfolio has a excess returns as shown in the following diagram.0) Clearly. equal to 3 percent. t he investor should expect to earn no more than the risk-free rate of return beca use there is no systematic risk. and the market beta (by definition) is 1. Thus. If the portfolio manager earns only the risk-fr ee rate of return.9 versus 1.0 3% = 1. With a portfolio beta of 1.

a positive alp ha indicates a superior performance. the adequacy of a portfolio man ager’s performance can be edged against the market line.5 perc ent along the market.5 indicated an excess return of 4.5. such planners consider market timing as an exercise in futility and instead.For example. Did he or she fall above or below the line? The vertical difference from a fund’s performance point to the market line can be viewed as a measure of performance. termed alpha or average differential return. Ad equacy of Performance Using the Jensen approach. while a negative alpha leads to the opposit e conclusion. Clearly. In other words. year in. The basic concept of indexing rests with the assumption that planners cannot outperform the performance of ma rket indexes such as the S&P 500 Index. the BSE Sensex 30. in most sense. the beta of 1. About as many funds under-performed (negative alpha below the line) as over performed (positiv e alpha above the line). the advisors who will outperform the market in any given year 82 Investment Planning PDP . Indexing-Buy and Hold Indexing-buy and hold is a concept which is. opposite to the concept of market timing. advise their clients to buy secu rities and funds which track broad market indexes. Although a few high-beta funds had an unusually strong performance on a risk adjusted basis. can they g enerate returns better than those available along the market line. indicates the difference between the return on t he fund and a point on the market line that corresponds to a beta equal to the f und.5%). Indexers also believe that over the long run the market will generally outperform at least 50% of all fund advisors. This value.5.9% to 4.6 percent (3. In the case of fund. and if the actual excess return was only 3. a portfolio with a beta of 1. Hence. which are the oretically available to anyone? FIGURE 6:3 Empirical Study of Risk.Adjusted Por tfolio Returns. Fur ther. The small dots represent performance of the funds.Systematic Risk and Return The upward-sloping line is the market line.. NSE 50 etc. there is no consistent pattern of superior performance. we t hus have a negative alpha of 0. planne rs who advocate indexing believe that future price changes or duration of change s cannot be predicted with any consistency. or anticipated level of performance based on risk. year out) basis.5 should provide excess returns of 4.9 percent.Other excess returns expectations are shown for betas ranging from 0 to 1.e. on a con sistent (i. Key questions for portfolio managers in general include the follow ing: Can they consistently perform at positive alpha levels? That is.

for childre n’s college education. etc. We will return to the description of how the selection is made easy. and as men tioned earlier. For example. an appropriate objective may be to maintain PDP Investment Planning 83 . as in the investment decision process. are as follows: 1. since the compositions of indexes do not change very frequently. The first three questions to addres s. Moreover. such planners consider the alternative of investing in securit ies or funds that closely track the performance of underlying market indexes as desirable. in saving for retire ment. the costs involved in an active style a lso increase due to the much higher costs of transactions. Moreover. the fund advisors who may outperform the market indexes over a future time perio d of time cannot be identified today with any certainty or reliability. These fees are paid because these funds managers consider their skills at investments to b e superior and hence. The new type of fund has appeared in the markets that also tracks indexes. Along with eac h of these reasons is an associated objective. There are many reasons to invest. This is because indexers believe the m arkets to be efficient and consistently picking winners near impossible. Mutual fu nds are most popular as securities that track the movement of market or securiti es indexes. market indexes are generally expected to outperform most activel y managed funds over longer time periods. Second. investment time-horizon and risk preferences and the macroeconomic conditions as reflected through the business cycle. the fund companies offer numerous index funds that cover generally most in dexing needs. These funds provide the appropriate vehicles for both investors and financ ial planners to buy and hold a basket of securities. 3. very lit tle trading and transaction costs are incurred in managing index tracking funds. Fu rther. Money Manager Selecti on and Monitoring To begin with. have become very popular tracking tools in this decade. known as “Exchange Traded Funds”or ETFs. broad and narro w marker indexes. that track financial market indexes. domestic and foreign market ind exes. they will “buy and hold “their positions. Since indexers may choose to trac k a wide variety of indexes such as large and small cap indexes. to buy a house or car. require higher fees.or two will in turn perform worse than the index in subsequent years. stock and bond market indexes. On the other hand. First. “active” managers continuously produce information about various securities that either indicates buying. Such planners also consider holding their investment positions for a longer time period. to build wealth. selli ng or holding various investment positions. funds that are actively managed charge high fees. Given th ese observations. the search process uses the same objectives use d in the investment decision process itself. Most large mutual fund companies. The companies that offer ETFs claim that ETFs are much eas ier to trade since they are structured like common stocks. passively investing through index tracking securities is considerably cheaper b ecause the costs of researching to find winning investments are not expended. The length of time over which a position is held depends primarily on the client particular s such as investment objective. What is the p rimary objective of the investment decision for which you need a money manager? What are the risk/return preferences of the clients? What is the investment time horizon? Understanding the answers to these three questions thoroughly will considerably ease the burden of planners in selecting suitable money managers. and the number of ETFs being offered in the market are inc reasing almost daily. but first let us evaluate each of these three questions in some detail. Examples of reasons include savings and investments for retirement. in the form of a single mut ual fund. offer index mutual funds for inves tors. 2. provide benefits in s hielding against capital gains taxes and are generally cheaper than index mutual funds. Indexes which follow a passive buy-and-hold strategy claim a number of b enefits in their approach over active approach to investments. and hence. Since such an approach requires freq uent alterations in portfolio structure.

Similarly. or discomfort. Being able to tie the objective (private or public edu cation. and most importantly. Simil arly. Many planners tend to jump first on assessing the past performances of money managers in selecting a . provisions may be for public or private colleges and may include the financing of an auto for a child as well . Consider the example of a parent who can afford to save a limited sum of money towards a child’s education. The point being made here is that the need and the objectives help us determin e certain aspects of the investments decision which in turn help us evaluate man agers. Thus. will be considera bly influenced by the style of the chosen manager. The styles that were affirmed when the investment objective was considered may either be reinforced or rejected by including the r isk preferences of clients. whatever the investment need be. Finally. the greater will be the need to find managers who pursue growth and aggressive growth styles. the level of comfort. Obviously. private colleges cost more and hence the future funding required f or a private college education would require a higher rate of growth than the ra te required for funding public college education. A growth style man ager would be desirable to grow money faster whereas a balanced fund manager may be considered for that same investment. in this example) allows us to narrow the manager selection criterion to only managers who practice/affirm a certain style of management. This required rate of return of 12% would imply that most of the savings be invested in equity or other high-yielding instruments. In this case. They help us eliminate many managers from the selecti on process and isolate others. the objective may differ from maintaining living stand ard to improving them. In the college funding e xample. It is a good idea to evaluate and match the risk preferenc es of the manager to those of the client. Once the manager is selected and the i nvestment process begins. the time horizon of the investment de cisions must also be included in the selection process. given some limited amount of funds and given a certain risk preference p rofile. Assume that the limited funds that a parent can save towards this objective will require the fund to grow at a 12% rate in order to be sufficient to meet th e funding need. Finally. if the objective were to fund the educa tion at a public college. The risk preference of the client would determine wha t styles of funds are chosen. An associated feature of such an investment would be a fairly significant amount of investmen t risk that the parent would be exposed to and which in turn would also imply th at there would be a higher probability of accumulating insufficient funds. The reader should note that t he application of the basics of the investment process serves as screens in the manager selection process. They help us narrow down the universe of managers to a level where the selection process is more manageable and where it is feasi ble to apply other subjective and objective criteria to further narrow the selec tion process. for the nee d to fund for retirement. in providing for children’s college education.and/or increase the standard of living that pre-existed before retirement. This inclusion reduces the universe of potential managers significantly. Another way to consider this is that if the planner can persuade a client to invest early. Given this limitation (or budget constraint) th e parent next has to consider the type of college (public or private) to fund fo r. the shorter the time available to accumulate the funds. matching the ma nager’s risk preference with that of client can considerably help the planner in m anaging the client relationships. an d vice versa. other selection criteria that ne ed to be used on a smaller subset of managers are discussed. There is another important aspect of including the r isk preferences of clients in selecting the fund manager. Continue with the example of funding for children’s educati on. The right choice of managers will ult imately lead to client satisfaction and retention. then the planner can h ave more flexibility in choosing managers. the choice of managers i n this case would be determined by the style of the managers. the risk preference of the client would become another input in the pro cess of manager selection. In th is case. the inclusion of the client’s basic i nputs in the selection process should generally lead to a much greater level of client satisfaction. One of the important v ariables that enters the process of manager selection is the risk perspective of the manager himself. In the following sections.

84 Investment Planning PDP .

There are several subjective and objective criteria that may be applied to further narrow the selection process. whether qualitative or quantitative or both? Has the manager ever violat ed or has not been in compliance with laws and regulations? Does the manager eng age in “window dressing” types of activities that are harmful to clients? What are t he answers to the above question for the investment team members that the manage r leads? How research oriented is the manager? As the reader can observe. at best. how often has he strayed from that style. Alternately. managers within that style can be scrutinized further. A nother way to consider the issue of consistency is that the manager’s activities a re as stable as the investment decision inputs of the clients. how often have they strayed from their paths? Does the manager use risk manage ment techniques that are consistent with the fund’s stated objectives? How often h ave the fund’s operating expenses exceeded both those stated and those that were e xpected? How often has the fund’s risk exceeded the stated or expected risk? How l ong has a manager served for a fund? Is the manager known to have managed funds of many different styles or have there been transitions within similar styles? I f the manager affirms a passive style. there are many questions that require to be evaluated in selecting a manager. In a sense. The following are examples of questions that need to be ass essed in determining the selection. managers who change their operating acti vities often are much more likely to under perform against their expectations. n n n n n n n n n n n n n Has the manager co nsistently selected securities that are compatible with the stated style? If not . However. the step that affirms a manager’s choice. Once the general fund style has been i dentified. it may be useful to categorize these questions along some common themes. trading activity. Happily. PDP Investment Planning 85 . The basic idea here is that neither should the manager’s attitudes and perceptions change on those scales. the better. fund expens e levels. The more consistent a manager has been tow ards her/his style. The relationship between past performance and manager selection has bee n widely studied. Perhaps the most important summation of these criteria is to understand how consistent a manager is and has been. In a sense. and vice versa? How consistently does the manager apply security selection tech niques. etc. manager perfo rmance should be the last screen in the selection process. such a categorization is possible. the selector is trying to assess two basic traits of a manag er. It is much more prudent to consider other facets of managers that reinforce the investment objectives. security selection techniques.manager. The main objec tive at this stage is to identify inconsistencies and incongruencies between the stated style of the managers and the styles that they have actually implemented in their practices. Results of these studies generally support the notion that usi ng past performance as the main criterion in the selection process is. In using the above criteria. The client’s retire ment objectives or their risk tolerances for those investment do not change on a weekly or monthly basis. a very poor indicator of future performance potential. risk preferences and timing horizon de cisions. there is a direct relationship between consistency and competency.

Finally.g. Managerial implications of these two concepts ar e also discussed in the latter sections of the chapter. This in turn leads to the optimal solution. Monitoring the performance of the manager is akin to ensuring tha t the manager does not change any facet of his behavior once he has been selecte d. The portfolio outcomes in terms of risk and return are use d to assess the performance of portfolios both by comparisons with benchmarks an d comparisons with peer group performances. the mai n point being made here is that the consistency and stability of performance and in accord with expectations is a far more powerful tool in manager selection cr iteria than trying to find the superstars of yesterday. past performance i s not a reliable indicator of future performance. It should be fairly clea r to the reader that the selection criteria for a manager also define the monito ring criteria. Various mo ney manager selection and monitoring criteria were examined and a set of guideli nes were established for this very important task. Managers who rank high on both the scale s are appropriate for further consideration in the selection process. given the con siderations of consistency (competency) and ethics. As it turns out.The other important theme to assess is the ethical make-up of the manager. it is the consistent managers whose perform ances are most likely to satisfy the needs and objectives of their clients. a fter the universe of managers has been whittled down to a few. especially if the manager has stray ed from the stated and expected objectives and behavior. Similarly. two observations need to be. etc. In the same vein. how widely did the past ret urns vary and in comparison to their peers? In other words. The asset allocation decision is the most notable decision managers h ave to make in managing client portfolios. is actually not that daunting a task. trading. In ass essing past performance. Neither can be sacrificed at the expense of the other. expenses. how many times in the last 5 (or 10) years has the fund’s returns been close to 12 percent? Further. The most powerful concept in this optimization process is the benefits of diversification across different asset classes. chan ge often are also much more likely to engage in activities that are undesirable or even in violation of investment rules and regulations. Asset Allocation and Diversif ication This chapter presents two key investment concepts: Investment Policy Sta tements (IPS) and Asset Allocation. It is important to not e that the manager’s ethics is as important as his/her competency. The planner should note that in a longer framework of time. Each of these two concepts are explai ned in detail. Manag ers (and funds) whose styles. Mode rn portfolio theory is a method by which assets are selected to be included in a portfolio such that the expected portfolio outcome optimizes the individual’s uti lity. the past performa nce of managers should be assessed. the issue of past performanc e in predicting future performance. selection techniques. if a fund is expecte d to produce about 12 percent (e. the planner must note that the very act of selecting a manager is also a reward for the past consistency. Investment Policy Statem ent An Investment Policy Statement (IPS) serves as a plan that guides the invest or and the planner in long86 Investment Planning PDP . The former concept is an essential part of a ny investment plan in that an IPS lays the framework and objectives of how an in vestment plan will be managed. those that were expected a nd how different were they from their peers? Second. if the average return over the past returns has indeed been around 12 percent. hav e the individual (annual) returns been widely divergent from the expected 12 per cent. As the reader can see. why such a path is chosen and how it will serve t he client. As has been noted before. competency and the ethics of a manager. in this chapter. The performance of portfolios and th eir managers is one of the criteria used in selecting money managers. growth fund) per year. even though they average around 12 percent. a planner should not seek to replace a manager whose performan ce in a certain year has not been up to par. This benefit shows up primarily as both a reduction in risk and or an increase in return.


the IPS of an endowment fund is generally very different from that of a pension fund. Typically. endowment funds seek to produce a small stream of income to aug ment the operating budget of the organization and to grow the rest of the corpus at a very moderate rate. which in turn protect the interests of the plan beneficiaries. there will be occasions when an institutional investor may require the planner’s service and advice. Of course. Banks invest in order to meet short and long term obligations that it promise to pay depositors on specific savings deposits. institutional inves tors differ from individuals in the amount and size of the portfolios under mana gement. there are subcategories. IPS’s for pension funds are much more guided by r egulatory and compliance needs. each requires a clear investment policy statement in order to achieve longterm goals and investments objectives. whereas in the late career stage individual s seek to protect wealth more. Within the institutional category of investors. For example. Thus. Though financial planners w ill most often interact with individual investors. the donors may impose managerial clauses themse lves. Thus. etc. we can classify these typical investment ne eds at various life PDP Investment Planning 87 . Thus. To understand how these institutions differ in their investment need. It is important to note that the goal s of an individual will change over time as the client progresses through variou s stages of his/her life. the amounts of distribution to be made are generally known in advance. The inve stment goals that are generally associated with various stages of a client’s life are known as the client’s life-cycle needs.term financial and investment decisions. Generally the inves tment objectives of endowment funds are much more attuned to the needs of the no nprofit organization. such that the income may take the form of a perpetual stream. Thus. The primary goal of pension plan mangers is to ensure the availability of cash that requires to be distributed to plan benefic iaries every year. All types of investor s. Hence. Insurance companies invest in order to ensure suffic ient availabilities of future funds required to be distributed as payouts to pol icy holders. insurance companies. Both these institutions are simila r to pension funds in that their investment needs are dictated by those who lend them the investment funds. Examples of such sub-categories of institutional investors include mutual funds. Thus. Banks and insurance companies are other examples of institut ional entities that need investment policies. Investors may be categorized as being eit her institutional investors or individual investors. pension funds. determines to a large extent the choice of investment vehicles required to meet those distribution needs. An endowment fund is an accumulation of donations that is provided to a non-profit organization by its donors. are discussed in the fol lowing sections. Sometimes. consider the example between the needs of a defined benefit pe nsion plan and an endowment fund. endowment funds . this in turn. While investors may differ in type or f orm. Investment Policies For Individual Investors Life – Cycle Indentification Investment goals of the individual client naturally e merge from the financial planning process. pension plan management and policy is integrally involv ed in investments that match cash outflows with inflows. the obvious client for mo st financial advisors is the individual investor. Consider now the issues surrounding the management of investment assets for an endowment fund. Generally. In a pension plan. the investment objectives will also change over time as the client ages and succeeds at achieving previously set goals. the needs of various indivi duals at certain stages of life tend to be similar. Generally. early career in dividuals want to accumulate wealth. each of which differ in their investment needs. their needs and the appropriate investment policies. it is important for the planner to be able to understand the needs of both types of clients and articulate IPS’s for both types.


cycles. These classifications provide us with a tool to apply in the investment planning process. The first stage of an individual’s earning and career is conside red as the accumulation phase. This phase begins when an individual first become s gainfully employed and continues until the client is about 40 to 50 years of a ge. During this time period, investors are generally much more open to assuming greater investment risk to attain higher returns. Typically, such investors can shrug off losses on the assumption that they have sufficient time to earn and re coup their losses. Further, if the losses are in securities, they can understand that their investment time horizon permits them to wait out any temporary downt urn in the economy and business cycle since they are expected to be followed by growth cycles that will eventually increase their wealth. Further, individuals p rogressing through their careers also observe increased incomes and savings; the se savings augment the growth of their wealth. Essentially, individuals in this phase are the beneficiaries of the power of compounding in the value of their we alth. Common investment goals during this phase are the purchase of a house, sav ing for children’s education and accumulating funds for retirement. The next stage of the client life cycle is the conservation/protection phase. This stage begin s seamlessly with the trailing off of the accumulating phase and remains as the dominant phase until the first few years of retired life. During this stage, the client seeks to consolidate the assets that have been accumulated. Individual e arnings reach their peaks at this stage as does their savings. The aging of clie nts is reflected through their investments as they tend to lean toward a reducti on in undertaking risk and are content to receive lesser returns. Unlike the acc umulation phase, investors recognize the devastation that can be caused by signi ficant losses of wealth to their well being. Further, they understand that the t ime they have left before retirement may not be sufficient to undo losses that r esult from excessive risk taking. Thus, at this stage, loss aversion becomes the dominating trait of the investment life cycle. Common investment goals during t his time period are children’s education, savings for retirement and the beginning s of the need to gift to their beneficiaries, charities and well wishers. The la st stage is known as the preservation and gifting stage. This stage tends to beg in soon after retirement and continues through life expectancy. During this stag e, the investor is primarily concerned with preserving capital rather than enhan cing returns. The loss of earning power and the fixed expenses of retirement loo m large during the early parts of this stage. Thus the investments in this stage of life tend to be more conservative relative to the other life-cycle stages. T his is also the phase in which the client will most likely seek the planner’s assi stance in gifting income and property to desired beneficiaries. The ages mention ed in the above life-cycle discussion are only benchmarks. Similarly, particular goals will vary by client, life-cycle stage, and age. For instance, over the la st 100 years, the age at which individuals start families has considerably incre ased. This implies that the investment goal of saving for children’s education has shifted along the entire life cycle. Thus, the educational savings requirements can be part of the life-cycle phase where the client is primarily interested in conservation and protection as compared to the traditional notion that this obj ective is mostly encountered in the accumulation phase. Similarly, emerging heal thcare technologies are changing the needs of individuals in the latter stages. The growth of long-term care policies is a reflection of the impact of biotechno logy on the longevity of life. The concept of life cycles is important for plann ers to understand but care must be taken not to compartmentalize clients by age in order to impose life stage needs without considering the impact of the client s’s idiosyncratic or subjective attributes. Rather, careful discussion and analysi s based upon client goals will yield a more accurate measure in which stage or s tages the client resides. Life-cycle planning is thus relevant in the investment processes because it allows the planner to identify with the client through the various time horizons for each goal within the financial plan. Without time hor izons, an investment policy would not be whole. The client could be subject to t oo much risk and / or 88

Investment Planning PDP

insufficient funds for current consumption (too much savings), etc. The policy t hen, would not accurately articulate the goals within the plan and thus would su bject the achievement of goals to imminent failure. Investment Objectives Once t he goals, life cycle, and time horizons for the goals have been identified, the investment objectives become easier to identify. Investment objectives identify the goals of the portfolio in relation to the reasons for the individual’s financi al needs. Investment objectives can be further classified into four types curren t income, capital growth, total return, and preservation of capital. Current inc ome is a strategy whereby the main objective of the portfolio is to generate an immediate and ongoing flow of cash to the client. That is, the investor requires income generation from the principal balance of the portfolio via interest or d ividend payments. An investor who relies on the portfolio for income in this way needs the cash for living purposes. Thus the investments tend to be conservativ e in nature. Common investment securities are corporate bonds, government bonds, government mortgage backed securities preferred stocks and perhaps stable Blue Chip stocks that pay regular dividends. Capital growth is a strategy whereby the portfolio funds are invested over the long term with the objective of capital a ppreciation in mind. Because the objective is growth over the long term, the ris kiness of the portfolio tends to be higher. The most common securities for this type of approach are equities, particularly those in high growth companies or se ctors. However, it is always a good idea to diversify the portfolio holdings amo ng various sectors and industries. Further, stocks of very large companies that lead their industries (blue chip) in this case, can help to diversify the portfo lio while achieving some of the same growth objectives. Mutual funds, which inve st in various sectors or industries can also help to diversity a portfolio at a reasonable cost. The total return approach is a strategy that blends the current income and capital growth approaches. Thus, the investor wants the portfolio to grow over time, but wishes to have income generated from it right away as well. Obviously having two objectives from the same portfolio can be challenging to m anage, but it can be done if applied correctly. Thus, this strategy would use a blend of methods of the two strategies above. Those investors interested in pres entation of capital are most interested in ensuring that the amount of money inv ested in the portfolio does not decrease. Therefore, the investment choices are safe vehicles. Large returns are not important for these clients and types of in vestments are typically government bonds, certificates of deposit money markets (funds), and fixed annuities. Risk for Individual Investors Although we may have determined the goals and the investment objectives of our client, we cannot ser iously discuss the minute details of an investment policy without first assessin g the risk tolerance of the client. Without a meaningful assessment of client ri sk attitudes, the investment policy will be useless. Finance professionals often think of risk in terms of the standard deviation of returns and stock betas. In some cases, individual investors may understand these concepts but more often t han not, most investors do not fully understand these concepts. After all, that is why they seek out investment advisors for such expertise. Since the client ma y not understand the intricacies of integrating investor risk preferences in fin ancial applications, it is even more important for the advisor to determine the client’s risk preference before structuring appropriate portfolios. Many clients d escribe risk in terms of losing money so it may be a good starting point upon wh ich to discuss the notion of risk. This notion of loss can be seen from several perspectives, so it can be helpful if the client can articulate risk to the plan ner in one of these ways. Loss to some individuals occurs when the original valu e of the portfolio has decreased in either absolute terms or relative return per centages. For instance, PDP Investment Planning 89

suppose a client started with an initial investment of Rs. 2,50,000 and experien ced a Rs. 50,000 decrease in value due to a general downturn in the market. Some investors feel that they have lost Rs. 50,000 and consider it a total loss. Sim ilarly, they might say that they lost 20 percent of their portfolio. Other inves tors who are investing for the long term may not be concerned if the value of th e portfolio decreases for some period of time if they feel that the losses susta ined are short tem in nature. These types of investors often perceive a loss onl y when they sell assets from the portfolio and therefore have a realized loss. R isk to clients may also appears in the form of the types of securities that they know of. Therefore suggesting new types of securities to these clients may appe ar to the client as a type of risk that they do not wish to engage in. It is a c hallenge to the advisor to help the client understand why these types of investm ents are better for the client. In the end, the advisor may or may not be succes sful in persuading the client. Conversely, clients may have a notion of risk in areas where they have had previous investment losses. For instance, those who lo st money in stock market crashes trend to be averse to investing in stocks in th e future. It is up to the advisor to help clients understand why their investmen ts failed in the first instance and the measures that the planner can put into p lace to minimize those types of losses in the future. Some investors may mimic t he popular or in vogue. Such practices can result in undesirable outcomes and re sult in large losses. Thus when an advisor advocates some technique or security as appropriate for the client, the client may consider this to be risky and very poor advice. Risk is extremely difficult to define. The planner must initially spend a lot of time with the client to ascertain what risk means to that client. This can be accomplished through discussion with the client and is often done w ith questionnaires, which are used as complements to client/planner conversation s, Since each investor is subjectively and idiosyncratically different, risk wil l have a different meaning to each investor. When implementing an investment pol icy, it is valuable to incorporate the risk characteristics into the plan. This should be done in such a way so that the investor and the planner can quantify t he risk. Thus if certain events occur, such as a portfolio losing 10 percent of its value, the planner and investor will have identified, in advance, appropriat e actions for that particular event. With such preplanned and agreed upon action s, further risk to the portfolio value may be minimized. Other Topical Considerations for Individual Investment Policies Tax Considerations Incorporating the notion of before and after-tax investment r eturns in a portfolio is an important concept in portfolio planning. The after-t ax considerations must effectively integrate with other portions of the financia l plan so that taxes are minimized in years with high expected income. Recall th at taxes can be deferred (paid at a later date when assets are sold at a profit) , can be avoided or can be taxed at capital gains rates (investments held greate r than one year) rather than at ordinary rates. It is useful to spell out the ta x consequences in the investments policy. However, the advisor must discuss and incorporate into the plan the potentiality for changes in the tax law. Because l aws change, tax planning relative to portfolio management can be a very challeng ing aspect to the planner. When the client has a negative bias toward taxes or h as complicated transactions the sale and purchase of assets to and from the port folio. Tax considerations and goals should be spelled out in the investment poli cy to assist the planner and the client in quantifying tax consequences of decis ions. Measurement of Returns and Successes of the Planner The client and the pla nner should decide upon a method that measures the success of the advisor in pic king investments. The time weighted rate of return (or the holding period return ) is a method used 90 Investment Planning PDP

should be discussed in any plan in order to sustain the purchasing power of the client to the greatest extent possi ble. and the legal environment. whi ch affect the real rate of return on assets. he or she can integ rate those areas within the macroeconomic environment into the client’s plan. Other factors that should be taken into consideration are interest rates. unemployment. No matter what method is used. e conomic growth or decline as a whole or in specific industries. historical inflation rises. PDP Investment Planning 91 . This is so because a typical fund manager cannot co ntrol the amount of funds he or she has under management (in which case a geomet ric rate of return could be used). it should be s pelled out in the investment policy so that both the planner and the investor ha ve appropriate expectations regarding what performance measures are going to be used to judge the advisor. it is meant to give the advisor an appreciation of the areas that can affect th e investment policy. Macroeconomic Factors A good planner is always aware of macroeconomic factors that can ultimately affect investments. For instance. While this list is not exhaustive. These factors s hould be integrated into the plan.for fund manager evaluation. po litical stability. As the planner gets to know the client.

The returns of security B would increase 8% if the returns of security A increased 8% and the c orrelation coefficient for the returns of the two securities was +1. Which of the fo llowing statements concerning correlation coefficients is (are) correct? I. Both statements ar e correct c. d. The key to ef fective risk reduction through diversification is combining assets whose returns show negative. c. b. Is it possible to reduce the risk by adding a security with a higher risk to a security with a lower risk that is already held? a. I only b. II only d. c 4. None of the statement is correct 3. Standar d deviation of stock x = 2 and Standard deviation of stock y = 4 a. b 2. d. the total risk after the addition will be higher The new security will have no impact in reducing the risk Yes. a. provided both the securities are positively correlated to each other What is the portfolio standard deviation in the following case of two (2) securi ties which are held in equal weights? Covariance of two securities = -8. II. 1 2 4 0 “Rupee cost averaging” can be achieved through Systematic Investment Plan “Rupee cost averaging” helps in reducing risk I only Both II only None 5. Which of the following statements concerning diversificatio n is (are) correct? I. Both the statements are correct d. provided both the securities are negatively correlated Ye s. No. a 5. I only b . a. c. a. Which of the following statements is (are) correct? I. Studies suggest portfolios of 100 or more different commo n stocks are needed to substantially reduce unsystematic risk. Answers: 1. c.Review Questions: 1. b. II. low or no correlation over time. 4. None of the two statements is correct 2. b. d. II. A co rrelation coefficient of -1 for the returns of two securities would indicate tha t both of them should be carefully considered for inclusion in a portfolio since maximum risk reduction could be achieved by including both. b 92 Investment Planning PDP . c 3. II only c.

Chapter 7 PDP Investment Planning 93 .

6.2005.5.P. 5/-.O. 5. 3. Public Provident Fund (PPF) Who can invest? n n n An adult individual in his own name An adult on behalf of a minor for whom he is the guardian. Investment Planning PDP . 70. A PPF acc ount is in addition to Employee Provident Fund and GPF for government employees. Total num ber of credits per year is restricted to 12 Minimum investment each time is Rs.000/. How much can one invest? n n n n n 94 Minimum investment Rs. Any branch of the State Ban k of India and Selected branches of Nationalised a fina ncial year Can be invested in a lump sum or in convenient instalments. Any Selection Grade Post Office.Small Saving Schemes T 1. Public Provident Fund Pos t Office Monthly Income Scheme Post Office Time Deposit National Saving Certific ate Kisan Vikas Patra Government of India Taxable Savings Bond Senior Citizen Sa ving Scheme 1. n Where can one open a PPF account? One can open a PPF account in n n n n n Head P ost-Office. HUF’s can not open new accounts now. Non resident Indians are not allowed to invest in these schemes. n other words who contribute to EPF and GPF can also open PPF account. Let us look at the salient features of these schemes. Existing PPF accounts opened in the name of HUF shall contin ue till maturity and deposits can be made in the account as per rules. 7. 4. G.. hese are ideal investment vehicles for the small investor – the retail resident In dian investors. with eff ect from 13. 2. 500 in a financial year Maximum of Rs.

credited to the account. No l oan can be obtained after the end of 5th year. It is the date of deposit and not date of real ization that is considered for this purpose.000/.2001 – 1. Interest is calculated on monthly p roduct basis and credited to the account as on 31st March.1.2.1. – 1 2% 11% 9.5% 9% 8% Loan n n n The depositor can take a loan in the third financial year from the fi nancial year in which the account was all the acc ounts taken together.a. Interest n n n n n 8% p.2003 – 1. whichever is less.2000 to 28. Past interest rates were as und er: Upto 14. The entire balance can be withdrawn in full after the expiry of 15 years from the close of the financial year in which the account was opened.2 . within one year. PDP Investment Planning 95 .2.2001 to 28. as on 31st Marc h of each year.2002 to 28.per annum is for each account.3.2000 15. once a year. Withdrawals n n n A depositor is permitted to make one withdrawal every financia l year. The term of the ac count can be extended by 5 years at a time by making an application in a specifi ed form to the deposit office. Withdrawal is permitted from the 7th financial year Amount of withdrawal can not exceed 50% of the balance to his credit at the end of the fourth year i mmediately preceding the year of withdrawal or at the end of the preceding year. Tax benefits n The interest earned on PPF account (including interest during the extension period) is excluded from income tax under section 10(11). The interest rate can be changed by the Government of India at any time and the new rate will affect the balance lying in the account from that date. If an individual has his own account and accounts in the name of minors (where he is the guardian) th e total investment in a financial year can not exceed Rs 70. Deposits made on or before the 5th of the calendar month are eli gible for interest for the month.2002 – 1.000/.n n n The ceiling of Rs.3.3. An account can be extended any n umber of times. The loan shal l be repayable in 36 instalments and shall bear interest at the rate of 1%. Loan can be taken upto 25% of the amount standing at the end of the second preceding financial year.2003 onwards Term n n n n PPF is a 15 year account. 70. A HUF account where he is the karta is considered separate for this purpose.

Nomination n n PPF account is necessarily opened in a single name. A depositor can nominate more than one person and stipulate the percentage of sharing among the nominees.00. In other words an account can be transferred from Post O ffice to any bank branch or from any bank branch to any other branch of any othe r bank or to post office. 1. 3. 2. Post Office Monthly Income Scheme: Who can Invest? n n n An adult individual in his own (single account) An adult o n behalf of a minor for whom he is the guardian An adult individual jointly with other adult individuals (joint account) – the total number of account holders res tricted to 3 Where can one invest? n n n In all GPO’s In all selection grade Post Offices In se lect sub post offices How much can one invest? n n n n Minimum sin gle account (including all the deposits made earlier) Maximum Rs.000/.in joint account (including all the deposits made earlier) The maximum limit of Rs. 3.000/Maximum Rs. Nomination fa cility is available.n n The entire deposit in the account is exempt from Wealth Tax The annual contribut ion to the account is eligible for deduction u/s 80C Transferability n n A PPF account with one deposit office can be transferred to another deposit office.00.000/. 96 Investment Planning PDP .000/. A depositor may open a SB account with the same Post Office where he has dep osited his POMIS amount and give standing instructions for crediting the interes t amount directly to this SB account on a monthly applicable per individual and deposits in joint accounts are cons idered as having been made equally by all the depositors for the purpose of dete rmining the ceiling.00. Interest n n n 8% per annum payable monthly In select post offices ECS facility is available where the interest is credited every month directly to the saving b ank account of the depositor automatically through the Electronic Clearing Servi ce. 6.

presently Transferability n A deposit account can be transferred from one post office to a ny other post office at any time on the request of the depositor(s). Nomination n Nomination facility is available 3. Example: If a de positor withdraws Rs. the interest is taxable Tax is not deducted at source from the interest.a. 1.00. If withdrawn prematurely after 3 years the penalty is restricted to 1% of th e deposit amount – no deduction from interest already paid.n Past interest rates were as under: 14.1. Post office Time Deposit Who can Invest? n An adult individual in his own (single account) PDP Investment Planning 97 .000/. before 3 years a penalty of 2% of de posit amount is levied – no deduction from interest already paid. Tax benefits n n No tax benefit.2000 to 28. he will b e paid Rs.1.2.2003 – – – – 12% 11% 9.2.2002 From 1. Part withdrawals are n ot permitted – if required the depositor will have to withdraw the entire deposit amount. 98.5% 9% For deposit accounts opened up to Term n n 6 years The interest rate as above remains unchanged for the entire ter m of 6 years Withdrawals n n n No premature repayment is permitted within 1 year of deposit A fter 1 year but before completion of 3 years premature withdrawal of entire bala nce is permitted If withdrawn. n n Bonus on maturity n n n n A bonus of 10% of deposit amount is payable on maturit y (at the end of 6 years) This bonus has been discontinued from 13th February 20 06 No bonus is payable for deposit accounts opened after 13th February 2006 As p er the latest circular 5% Bonus will be payable on new deposit accounts made on or after 8th December 2007. prematurely.2000 From 15.000/-. which he has already received for the period for which the deposit was held by Post Offi ce.3. over and above the interest at the rate of 8% p.2.prematurely after 2 years of deposit.2001 to 28. 3.2001 From 1.2002 to 28.

200/No Maximum Limit . 4.Any amount can be invested Interest n n Interest is payable once a year Interest is compounded on a quarterly basis and hence the effective yield is slightly more than the interest rate indicated abov e Tax benefit n n As per the latest circular tax benefit is available u/s 80C of I ncome Tax Act from April 1.and thereafter in multiples of Rs. charitable trusts. An adult indivi dual jointly with another – on “Jointly or survivor” basis ( A type). co-oper ative societies and Government bodies are not permitted to invest in this scheme after 13th May 2005. presently. In respect of d eposits for 2 years to 5 years the interest payable shall be 2% less than the ra te applicable for the period for which the deposit has been held.n n n An adult on behalf of a minor for whom he is the guardian An adult individual jo intly with other adult individuals (joint account) – the total number of account h olders restricted to 3 Provident funds. 2007 on deposits made for period of 5 years or more. HUF’s are not allowed to purchase NSC’s from 13th May 2005 . An adult individ ual jointly with another – on “Either or survivor” basis ( B type). Tax is not deducted at source from the interest. institutions. 98 Investment Planning PDP . How much can one invest? n n Minimum Rs 200/. Withdrawals n n n No premature repayment before completion of 6 months. No inter est is payable if withdrawn after 6 months but before 12 months. Parents and guardi ans on behalf of a minor. National Saving Certificates (NSC) VIII Issue Who can purchase? n n n n n An adult individual in his own name.

Rs. Amount n n n Kisan Vikas Patras are available in denominations of Rs. 200/. 10.000 along with other specified investments/e xpenditure Accrued interest also qualifies for deduction u/s 80C -every year fro m the second year onwards till the year before the year of maturity 5. Rs.after the full term of 8 years & 7 mo nths Premature repayment n Not allowed within 2 ½ years of purchase in normal circumsta nces PDP Investment Planning 99 . 100 becomes Rs.Where can one invest? n Can be purchased from all post offices which are allowed to open Savings account. 5. Amount n n n National saving certificates are available in denominations of Rs. 1. 1. 50.000. Rs.000 and Rs. Rs.000. Rs. 500.000 and Rs. Rs 10. Kisan Vikas Patra Who can purchase? n n n n n An adult individual in his own name An adult individ ual jointly with another – on “Jointly or survivor” basis (A type) An adult individual jointly with another – on “Either or survivor” basis (B type) Parents and guardians o n behalf of a minor HUF’s. 100. 100 becomes Rs 160. 1.000.000 Can be purchased for any amou nt with out any ceiling Can be purchased for amounts in multiples of Rs 100 Maturity Value n Rs.00. 5. Rs.000 Can be purchased for any amoun t without any ceiling Can be purchased for amounts in multiples of Rs 100 Maturity Value n Rs. Trusts are not allowed to purchase KVP’s from 13th May 20 05 Where can one purchase Kisan Vikas Patra? n It can be purchased from all post of fices which are allowed to open Savings account.10 after the full term of 6 years Premature repayment n n Not allowed during the full term of 6 years In case of d eath of the investor premature payment is allowed to nominee at lower rates as p er rules Tax benefit n n Amount invested qualifies for deduction from income u/s 80C with in the over all ceiling of Rs. 100. 5 00.

Interest on KVP is taxable on accrual basis. 6.000/.000/.w ithout any upper limit 100 Investment Planning PDP . its subsidiaries and Nationalised Banks. 1. Government of India 8% Taxable Savings Bonds Who can purchase? n n n n n n An adult individual in his own name An adult indiv idual jointly with another – on “Jointly or survivor” basis An adult individual jointl y with another – on “Either or survivor” basis type) Parents and guardians on behalf o f a minor Hindu Undivided Family Charitable Institutions or a University {approv ed u/s 80G or 35(1)(ii)/(iii) of Income Tax Act From where can one purchase these bonds? n Bonds can be purchased from designate d branches of State Bank of India. HDFC Bank and Stock Holding Corporation of India Lt d. (SHCIL) Amount n The bonds can be purchased for any amount in multiples of Rs. UTI Bank. ICIC I Bank. IDBI Bank.n n In case of death of the investor premature payment is allowed to nominee at lowe r rates as per rules After 2 ½ years premature encashment is freely allowed and th e amounts payable for a certificate of Rs 1.denomination are as follows Tax benefit n n Tax is not deducted at source on maturity or otherwise – No TDS as of now.

000/Maximum permissible investment Rs.000/taking the total to Rs. payable half yearly i.000/Only one deposit ac count permitted in one calendar month for each depositor If both husband and wif e are eligible to invest then each of them can invest up to Rs. 1.becomes Rs.a. 31st January and 31st July eve ry year ECS facility is available – banks credit interest directly to bond holder’s account every 6 months through ECS Cumulative option is also available – in which case Rs.00.000/. 30 lacs.e.Term The full term of the bond is 6 years Interest n n n The bonds carry interes t at the rate of 8% p. 15. 1601/. 15. PDP Investment Planning 101 .00. 1. 2004 Who can invest? n n An individual who has attained the age of 60 years or above An adult individual who is above 55 years or more and who has retired – voluntaril y or otherwise (within one month from the date of receipt of retirement benefit and an amount not exceeding the retirement benefit within the overall ceiling of the account) The account can be opened singly or jointly with spouse (the spous e may be below 60 years of age) Joint account holder can not be anybody other th an spouse HUF’s and Non Residents are not allowed to invest n n n Where can one open this account? n The account can be opened in Select Post Offi ces and branches of banks which accept PPF deposits Amount n n n n Any number of accounts can be opened with each deposit in multipl es of Rs. Senior Citizen Savings the end of the term of 6 years Liquidity n n Premature encashment is not allowed These bonds are not transferab le and hence loans can not be availed against security of these bonds Tax Benefit n n Interest is taxable No Tax is deducted at source(TDS) presently 7.

Requirements n n n n n Joint photographs (both husband and wife in one photo) PA N Card or declaration in Form 60 Age proof for the first holder Retirement Proof along with proof of retirement benefits received for depositors above 55 years but not above 60 years Photograph of nominee(s) Term n n n n The full term of the account is 5 years which can be extended by 3 years on maturity Interest: 9% p. payable quarterly on 31st March/30th June/30 th September and 31st December Only non cumulative option is available ECS facil ity has been made available in many deposit branches and hence interest can be c redited directly to the depositor’s bank account Nomination n n n Nomination facility is available Joint nomination with percenta ge allocation is permitted Photograph and signature of the nominee(s) are also o btained and kept on the record of the deposit office Premature closure n Permitted only after one year from the date of deposit – in ca se of extreme emergencies premature closure within one year may be permitted on application to Ministry of Finance. Government of India In case of closure befor e 2 years but after 1 year an amount equivalent to 1.5% of the deposit amount is deducted as penalty – no deduction from interest already paid In case of closure after 2 years but before 5 years an amount equivalent to 15% of the deposit amou nt is deducted – no deduction from interest already paid In case of death of depos itor full amount is paid without any deduction n n n Transferability n A deposit account may be transferred from one deposit office/b ank to another in case of change of residence. by making an application in speci fied form along with the pass book Tax benefit n n Interest is taxable – no tax benefit Tax is deducted at source fro m the interest payable– senior citizens who are not assessed to Income tax can sub mit 15 H (if depositor is above 65 years of age) and form 15G (if not above 65 y ears of age) to avoid tax deduction at source from the interest Principal Amount can be considered towards the deductions u/s 80C n 102 Investment Planning PDP .a.

in a year 2. on maturity. if any. New PPF accou nt can not be opened in the name of a minor b. on the e xpiry of the full term of 15 years.000/. In respect of a Public Provident Fund account and a Hindu U ndivided Family which of these statements is true? a. How many times a PPF account. Any number of times 5. A bonus of 10% of deposit amount is payable on Post Office Monthly Income Scheme account. Interest on PPF ac count is payable for the month subject to the following condition getting fulfil led: a. An individual can deposit amo unt not exceeding Rs. Date of deposit should be on o r before 10th of the month.a. provided: a. 70. 70.Review Questions: 1. The deposit amount does not exceed the prescribed maximum limits in the scheme d. The deposit account was opened before 11th February 2006 b. Deposit should have been made on or before the 10th of the month and the cheque should have been realized by that date b. 70. on an applicati on being made by the depositor? a financial year d. will become applicab le 6. The deposit account is held in joint names c. The rate of interest will remain unchanged for the entire term of 1 5 years but at the time of extension. The amounts that can be deposited in a PPF account of a minor and that of the guardian together can not exceed Rs. It is paya ble on all accounts irrespective of number of depositors as well as when the dep osit was made PDP Investment Planning 103 . No deposits are allowed in the old PPF a ccounts of HUF d.000/. Only once a financial year in his account as well as the account in the name of the minor where he is the guardian 3. No new deposits are allowed to be made in the PPF accounts already held in the name of minors c. New account can not be ope ned b. The amount that can be deposited in a PPF account of a HUF and that of the karta together can not exceed Rs. date of realization can be later d. The in terest is taxable but not subjected to TDS c. can be extended for 5 years. Only thrice d. Which of the follo wing statements regarding interest is true? a. Yes new account can be opened c. The rate of interest can change at any time d. Interest rate on a PPF account is 8% p. Only twice c. date of realization can be later c. Deposit should have been made on or before 5th day of the month and the cheque should have been realized by that date 4. The interest is taxable b.000/. changed rate. Date of deposit should be on or before 5th day of the month. In respect of a PPF account and a Minor which of these statements is true? a.

Only one person can be nominated b. between the two of them b. If husband and wife both are above 60 years of age the maximum amount they can i nvest in Senior Citizen Savings Scheme is: a. Taxable and subj ect to TDS c. each person not exceeding Rs. 15 lacs 12.000/. Accrued interest on National Savings Certificates. Taxable but not subject to TDS c . The account can be held jointly with son or daughter b. totally. An individual above 55 years can invest within one month of receipt of retirement benefits 11. Which of the following statements is true regarding interest on Senior Citizen S avings Scheme? a. Which of the following statements is true in respect of nomination in Senior Cit izen Savings Scheme? a. Need not be shown as Income from other sources b. Should be shown as Incom e from other sources but the same is deductible u/s 80L of the Income Tax Act in all years except the year of maturity c. purchased in the previous yea rs a. Rs. i s true? a.00 . Only one of them can inve st and the total can not exceed Rs.00. 5. No ceiling on the amount of investment in this scheme d.00. Tax free b.00. Rs. None of the above joint accounts d. An individual below 60 years can not invest in this scheme at all d. It can be treated as capital gains and accounted for as such in the year of maturity 10. totally.per person 9. Taxable but not subject to TDS d. Tax free d. 3. Rate of interest can change at any time during the 5 year term 13. in all years except the year of maturity d.00/per person b. 30 lacs. No maximum limit c. 1. Rs. Joint nomination is permitted on successiv e nomination basis d. Interest on Post Office Monthly Income Scheme is a. Should be shown as Income from other s ources but can be claimed as deduction from income u/s 80C of the Income Tax Act . Joint nomination is permitted on proportional nomination b asis 104 Investment Planning PDP . 15 lacs. Which of the following statements. single account and Rs. in respect of Senior Citizen Saving Scheme.000/.000/. The account c an be held jointly but both the joint holders should above 60 years of age c.7. Taxable and subject to TDS b. 15 lacs c. In Post Office Time Deposit the maximum limit on investment is: a. Rs. Nomination is permit ted only in case of single account c. 6.

Not exceeding Rs. 2 lacs in a financial year b. 16. 13. 2 lacs c. Non Resident Indians d. a. 14. Not exceeding Rs. 15. Rs 6.00. Universities c. 5. a c c d c a c b c d b a d a c c PDP Investment Planning 105 . 3. True. 9. but the depositors have to specifically apply for the same c. 12.14. 7. Which out of the following persons are not allowed to invest in 8% GOI Taxable S avings Bonds? a.000/. 8. Not true. The maximum amount that an individual can deposit in 8% GOI taxable Savings Bond is. All the above Answers: 1. Charitable Institution approved u/s. 4. Available only for depositors in the age group of 55 to 60 15. 80G of the Income Tax Act b. No ceiling at all. 6. Cumulative interest option is available in Senior Citizen Savings Scheme. Available at the option of all the deposit ors jointly d. 2. only non cumulative option is available b. any amount can be deposited d. 10.if held join tly 16. a. 11.

Chapter 8 106 Investment Planning PDP .

Therefore.a.1% p. Repos are generally for a period of about 14 days or less though there is no such restriction on the maximum period for whic h a repo can be done. Commercial Paper (CP) C P’s are short term. the yield is around 5. The rate of interest will depend on over all short term money market rates as well as credit standing of the issuer company. currently. 4. In r epos the purchaser acquires the title to securities and he can enter into furthe r transactions on these securities. Individual investors can invest in Commercial Paper. These are issued at discounts to the face value and the ext ent of discount will determine the yield on the paper.9% to 6.Fixed Income Instruments Short Term Instruments – Money Market Instruments T he following are the short term instruments of less than 1 year maturity. whil e the yield on 364 days Treasury bill hovers around 6. Government Securities. The loan s have a maturity of 1 day to about 14 days and are repayable on demand at the o ption of either the lender or the borrower. The main holde rs of Treasury Bills are banks and primary dealers. In terms of liquidity this is slight ly lower than cash – in other words the liquidity is very high 2. which are required to hold g overnment securities as part of their liquidity requirements (SLR – The statutory liquidity ratio – banks are required to keep a certain percentage of their total d emand and time liabilities invested in government securities – Investments in Trea sury banks serve the purpose of meeting SLR requirements – currently SLR is 25%) O n 91 days Treasury Bills. These instruments are essentially institutional plays and retail investors don’t get to participate in this directly. 182 days and 364 days. Call Money Market This is basically an inter-bank market where the day-to-day surplus funds are made available/lent to banks that have a short fall. The difference in the prices i s the cost of borrowing to one party and income to the party lending the money. These transactions are secured and hence the counter party risk is highly reduce d. the interest rate is also lower compared to call money rates. Treasury Bil ls Treasury Bills are borrowings of Government of India for periods of less than 1 year and the normal tenors are 91 days. Government of India als o makes longer term borrowings to which banks subscribe.a.9% to about 7. The securities where th e term is 1 year or more are called Dated Securities. Banks are not permitted t o PDP Investment Planning 107 . Bank s subscribe to Treasury Bills through an auction process and Reserve Bank of Ind ia acts on behalf of Government of India in this regard. 1. usance promissory notes issued by large corporation s.40% p. Repos Repos or r epurchase agreements (ready forward) are transactions in which one party sells s ecurity to another party simultaneously agreeing to purchase it in future at a s pecified date and time for a predetermined price. unsecured. Treasury bills and PSU bonds are th e instruments used as collateral security for repo transactions. 3.

subject to norms laid by RBI from time to time. These are negotiable short term bearer deposits issued by banks. A pre-set index. The reference rate is fixed one or two days before the termination d ate. These are inter est bearing. The CP’s are regulated by Reserve Bank of India and companies can issue CP’s to meet their short term requirement of funds. A counter-party’s creditworthiness is an a ssessment of their ability to repay money lent to them over time. If a company h as a good credit rating. maturity dated obligations forming part of the time deposits of ban or underwrite CP’s issued by companies. 6. Fixed Inco me Instruments – Long Term This segment deals with securities and deposits that ha ve maturity periods one year or longer and where coupon/interest is paid periodi cally. as opposed to discounted prices in case of short term instruments. The minimum credit rating required for CP’s is P-2 of CRISIL or its equivalent of othe r credit rating agencies. The payments are calculated over a notional amount over a certain perio d of time and netted i. A swap is a combination of FRA’s. A company is eligible to issue CP only if its tangible net worth is more than Rs. 7. It is paid on the termin ation date. The period is 15 days to less than a year and the deno mination is Rs 5 lacs and its multiples. These vehicles are attractive for investors who seek regular income with relative safety. the en tity paying fixed and receiving floating is usually the less creditworthy of the two counterparties. they are more likely to be able to pay back a loan over time than a company with a poor credit rating. FRA’s are ove r-the-counter derivatives. lenders make sure that they are less exposed to this ris k.e only the differential is paid. By making it easier for less creditworthy agents to borrow in the short term than in the long term. Forward Rate Agreements (FRA) A Forward Rate Ag reement(FRA) is a forward contract in which one party pays a fixed interest rate . In the past when interest rates on bank deposits were regulated CD’s became ha ndy for banks to raise short term deposits even at rates lower than the regular fixed deposit interest rates. notional amount and set of dates of exchange determine each set of cash flows. Therefore. The most common type of interest rate swap is the exchange of fi xed rate flows for floating rate flows. discus sed earlier. 4 crores and if it has a sanctioned working capital limit from a bank or a financial institution. Some of the most popular avenues of fixed income instrume nts are as under: 108 Investment Planning PDP . The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entity’s relative advantage in raising funds in the shorter maturity buckets. Interest rate swaps (I RS) An Interest Rate Swap is the exchange of one set of cash flows for another. This effect is magnified with ti me. and receives a floating interest rate equal to a reference rate (the underlyin g rate). The payer of the fixe d interest rate is also known as the borrower or the buyer whilst the receiver o f the fixed interest rate is the lender or the seller. we would expect that in fixed-floating interest rate swaps. 5. dependent on the market convention for the particular currency. Certificates of Deposit (CD) Instrum ents very similar to CP’s but issued by banks are called Certificates of Deposit.

The convertible debenture s normally bear interest till the date of conversion and/or on the non-convertib le portion till redemption. banks. These b onds. The prices of these bonds fluctuate based on the prevailing interest rates. Companies in the past found it convenient to tap the capital mark et and PDP Investment Planning . These bonds are plain vanilla bonds of face value Rs 1000/. Public Sector Enterprises and local authorities.where on the coupon/interest is paid to the holders on half yearly basis. These bonds are quo ted as “8% GOI bonds 2014” which indicate the coupon rate and maturity of these bond s. such as. Corporate Bonds/Debentures Companies can borrow directly from the market through issue of securities. The non convertible debentures and the nonconvertible portion of partly convertible debentures are redeemed on maturity at par or with a premium. indirectly. t he nearness to payment of coupon and of course. are considered less risky compared to c orporate bonds/debentures but more risky compared to Government securities. These bonds are generally issued for periods ranging from 3 yea rs to 20 years. market factors of liquidity/ dem and/supply. subje ct to capital market regulations for meeting their capital requirements. Where the tenor of the debentures is 18 months or mo re credit rating for the debentures is mandatory. Th e term of the debentures will depend upon the need of the company. financial institutions. Because of the longer term. These a re typically “debentures” which are borrowings of the companies and these may be sec ured against a charge on the assets of the company or these may be unsecured. Banks. insurance companies. mutual funds. primar y dealers. only the large and informed investors. bigger size and illiquidity of these bonds these have not been attractive for retail investors. financial institutions. but supported by State/ Central Government issue securities similar to Central Gover nment Securities. etc. through the mutual fund route. The rate of interest will depend on market c onditions as well as creditworthiness of the company and the credit rating for t he debentures. Some mutual funds have launched GILT funds which invest only in Governme nt securities while Income Funds of mutual funds predominantly invest in fixed i ncome securities including Government securities. The investors bid either in terms of the rate of interest (coupon) for a new security or the price for an existing security being reissued. The Government of India issues securities in order to borrow money from the market. insurance companies and mutual funds su bscribe to these bonds through the auction process initiated by Reserve Bank of India. The investors have received excellent returns whi le the corporations could raise much needed capital funds for major projects. for developmental projects. etc genera lly participate in the auctions. Companies can issue Non Convertible Debentures which are pure fixed income instruments and al so partly convertible or fully convertible debentures. as they carry sovereign guarantee. through issue of tax fr ee bonds at attractive rates of interest. However. PSU Bonds Public Sector Undertaking. One way in which the secur ities are offered to investors is through auctions. The government notifies the date on which it will borrow a notified amount through an auction. It is also expected that Government of India will allow Municipal Corporations to raise funds from the market. investors c an participate in the government securities. Since the process of bidding is s omewhat technical. Normally the respective Government offers guarantee for paymen t of interest and repayment of principal amount of these PSU borrowings. Many State Government corporations have floated bonds in the past and have raised mo neys for infrastructure projects and the Indian retail investors have participat ed in the issues in a big way.GOI dated securities – Government Bonds GILT edged securities Government of India borrows for long term through these se curities.

109 .

1975 and notifications made there under f rom time to time The interest received by the depositor is taxable A company is liable to deduct tax at source where the interest per annum per depositor is lik ely to exceed Rs. Now that the rates of int erest have come down the debentures don’t continue to enjoy the same patronage fro m the retail investor. etc.p.a. Manufacturing Compan ies: n The public deposit mobilized by a company should not exceed 25% of Tangib le Net worth of the company (capital + free reserves) – this fixes the maximum amo unt a company can borrow from the public through fixed deposits route. Credit rating of fixed deposits is not mandatory Fixed deposits are unsecu red borrowings of the company n n n n n n n Non Banking Finance Companies: n n n n n n n Only NBFC’s which are registered with RBI can accept fixed deposits Credit rating of Fixed Deposits is mandatory An N BFC can accept fixed deposits only if credit rating is above Minimum rating fixe d by RBI from time to time These companies are allowed to raise much higher amou nts by way of fixed deposits in relation to their net worth To the investor Fixe d Deposits with NBFC’s offer a higher risk higher return investment option The int erest is taxable and subject to TDS Housing Finance Companies also accept fixed deposits and TDS is made only when the interest on deposits is likely to exceed Rs. The acceptance of deposits by Indian companies is su bject to the provisions of Section 58A and 58AA of the Companies Act.raise funds through issue of NCD’s and PCD’s and they preferred this route to long t erm borrowing from banks. 1975 (as amended). This limit may change as per provisions of Income Tax Act. 1956 and C ompanies (Acceptance of Deposits) Rules. 2. 5. 2.500/-. Corporate Deposits Companies are al lowed to borrow from the public through public deposits for meeting their medium term capital requirements. The maximum term of deposit cannot exceed a term of 3 years wh ile the minimum term is 6 months The company is free to fix the rate of interest payable on its fixed deposits within the overall limits laid down under the Com panies (Acceptance of Deposits) Rules. In respect of Government companies the limit is 35% of the c ompany’s net worth. These special instruments serve some pu rpose for the investors as well as the companies from the point of taxation as w ell as postponing interest liabilities. Companies have tapped the market with Zero Coupon Bonds as wel l Optional Fully Convertible Debentures. To the investor interest on debentures is taxable and als o subject to TDS. per depositor whereas in respect of other companies the limit i s Rs. The investors also preferred NCD’s because the debenture s were secured and the interest rates were quite high. A company can borrow from its share holders also and this amount should not exceed 10% of its net worth taking the total borrowings through public deposits to 35% of the company’s net worth.000/.500/110 Investment Planning PDP .

per annum per depositor p er branch the bank is required to deduct tax at source Bank deposits are highly flexible in their features and banks accept term deposits with extremely investo r friendly features Investment in a Bank Fixed Deposit with a 5 year lock-in per iod qualifies for deduction from income under sec 80C of Income Tax Act.000/.is available for say 98. by bank. The fixed income options like Money Market Mutual Funds and call deposits are found ideal by investors who want to park their money for short ter m. The better the credit rating of an instrument the lower could be the return on the same. especially the ones which are not rated. is not sub jected to tax deduction at source while Public Provident Fund.0 00/. Investors in relatively smaller banks and co-operat ive banks find this an important protection. If a 90day treasury bill of R. These deposits are perceived to be highly safe a nd liquid Interest rates tend to be lower compared to other fixed income avenues of comparable maturities Interest is taxable Interest is subject to TDS – where i nterest on term deposit is likely to exceed Rs 5. can be considered quite risky. Bank de posits can be insured against risk of default. on maturity. The liquidity. Invest ors some times prefer securities of shorter term as well as vehicles where the e xit is easier.186 th en the yield on the same would be worked as follows: Income earned is 1. Conv enience of handling is a parameter on which bank deposits score over many other avenues. Risk: This is a major factor.814 Tenor 90 days PDP Investment Planning 111 .186 = 1. Unsecured company fixed d eposits. attracts substantial investor interest because of tax benefits. n n n Valuation of fixed income securities: Money market securities The valuation of these securities is normally a function of the current interest rate prevailing in the market on short term debt instru ments. to the maximum limit of Rs.00. 1.00. Taxability and tax deduction at source are also important factors that determine flow of money to a particular avenue. A large net work of branches and ATM’s make banks very easy to handle. The risk of default is a factor which determine s where the investor would like to invest his savings.000 – 9 8.000/. This is the most popular investment vehicle for the retail investors in India because investors find bank s very convenient to deal with. with Deposit Insurance a nd Credit Guarantee Corporation of India Ltd. though taxable. though a longer t erm option.00.s 1. Features of fixed income securities n n The return or the yield which comprises of regular flow through coupon/inter est and capital appreciation or loss. if any. 8% GOI taxable savings bonds an d small saving schemes like Post Office Monthly Income Schemes have managed to a ttract huge funds flow because the interest on these.Bank deposits n n n n n n n n n Banks accept fixed deposits for short term as we ll long term offering specific fixed rate of interest.per depositor per bank.

The interest payments are payments of annuity over a period of time while the maturity value is the future value of the present Price of the bond a nd “r” the YTM has to be worked out substituting different values for r. The amount of interest and the timing of these payments w ill affect the price of a longer term security. The formula for calculating the yield is PV = FV/ [1+ (i*n/365) Where PV = pr esent value or the price of the bill/security FV = face value or the value recei vable on maturity n = number of days to maturity i = yield per annum In respect of fixed income securities which have less than 1 year left to maturity when all factors viz. The current yield which is nothing but the periodic pay ments received on the amount invested or in other words: the coupon divided by p urchase price.49% The yield is worked out fo r a year of 365 days from the discounting at which the treasury bill is availabl e. Howev er investors have found company fixed deposits as well as non convertible and co nvertible debentures easier to invest and have been investing in these vehicles. K isan Vikas Patra and direct borrowing by Government of India through 8% GOI Taxa ble Savings Bonds and Senior Citizen Savings Scheme. National Saving Scheme. Longer term securities In respect of longer term securities the time b etween receipts of interest income becomes a significant factor in its valuation . In market instruments there are no interest payments and the same is built in the price. Conclusion It may be pertinent to add here that small investors have little or no exposure to government securities and the money market instruments directly. 112 Investment Planning PDP .186*90) = 7.The yield therefore is (1814*365)/(98. FV and n are known and yield “i” can be calculated using the above formula. The other type of yield is YTM which is calculated as follows: where P = Price of the security C = annual interest payments received r = rate o f interest M = Maturity value – amount receivable on maturity n = number of years left for the security to mature The computation of YTM required a trial and erro r procedure. In respect of dated securities and bonds interest payments are made a t specified intervals. PV. There are two types of yields wh ich come into play here. Public Provident Fund. These schemes and their fea tures have been discussed in detail under the topic “Small Saving Schemes”. Some investo rs have been participating in these avenues through the mutual fund route. Besides the avenues discussed above fixed income instruments include Small savings schemes like Pos t Office Monthly Income Scheme. Public Sector bonds floated by many Government and Semi Government corporations have also received good response from the retail investors.

5. Interest on bank deposits is a.000/. If the yield on 90 days Treasury Bills is currently 6. at the o ption of the bank. If the market price of the bond.00.00 . 98. Tax free u/s 10 b. Taxable and subject to TDS where the interest is likely to exceed Rs. Rs. Taxable and subject to TDS wher e the interest is likely to exceed Rs. Remain steady d. Bank deposits. Deduction is available u/s 80L for individual investors c. per depositor per bank 4. Rs. Fall c. No such restrictions – the company m ay decide the quantum d. More than 8% 6. bearing coupon of 8%.900 d. A Manufacturing company can accept fixed deposits s ubject to the following conditions: a. 1.0 00/. 1. face value of the bond is Rs. 1.00.06. a. Not exceeding 20 times the net worth of t he company b.00.a. can be insured with DICGC and the maximum cover available per depositor is.Review Questions: 1.per branch of the bank c. is Rs.000/. Less than 8% c.p. 2.p. Equal to 8% b. Rise b. No insurance cover is available on bank deposits b. Not exceeding 5 times the net worth of the company. 5. R s. 985.327 c. Rs. per depositor per branch d.549 2. 5.100 b. Not exceeding 25% of its net worth from the public and not exceedi ng 10% of net worth from its share holders c.000/. Cant say d. a.000/. If the interest r ate in the economy rises then the prices of existing bonds will a. Rs. the market? a.per branch of the bank d. 96.per bank 3.000 and if there are two years to maturity then YTM would be: a. Rs. 93. The fall or rise will depend upon the coupon rate and the ma turity date of the bond PDP Investment Planning 113 . 1.9% wh at should be the price of the Treasury Bill of Rs 1.000/.

How frequently is interest on Government securities (Dated Securities) paid? a.a. 2. Is paid periodically by the issuer b. It is discounted in the price c. 5 y ear Bank FD offering 8. a 114 Investment Planning PDP . 7. Short term instruments issued by eligible c ompanies d. Commercial Papers (CP) are: a. Quarterly d. b d c b d b c b b 10. Long ter m instruments issued by companies c. Keep money loc ked in long term securities Answers: 1. 3. 5.7. 9. b. On maturity 10. 4. 8. Which of the fol lowing instruments would you choose? a. but subject to Tax Deduction at source d. d. Half yearly c. as agreed b etween the issuer and the investor. It is paid by the issuer. Is paid on a quarterly basis 9.5% c. It is expected that interest rates may rise in the near future. Once a year b. Interest on short term money market instruments: a. 6. 6 year GOI bonds offering 8% p. Long term instruments issued by banks b. Short term instrument which can be issued by any company 8. One year bank FD offering 8% p.a.

Chapter 9 PDP Investment Planning 115 .

There is no s urvival benefit as the policyholder is not entitled to any money during his / he r own lifetime. This has been the most popular life i nsurance plan of LIC of India before the private players entered life insurance sector and popularized Unit Linked Insurance Plans n n n Whole Life Insurance Policy n n n n n n A whole life policy runs as long as the policyholder is alive. 116 Investment Planning PDP . But conventionally Life Insurance policies have been sold as investment products where the Life Assured gets a lump sum at the end of a fixed term or periodic r eturns on a regular basis during the term. Basically Life Insurance Plan s should provide insurance cover to protect the dependants of the Life Assured. Let us look at some of the standard policies offered b y Life Insurance Companies. such policies are known as whole life policies. The method of bonus payment is called revers ionary bonus. therefore. Endowment life insurance pays the sum assured in the pol icy either at the insured’s death or at a certain age or after a number of years o f premium payment. A simple whole life policy requires the insure r to pay regular premiums throughout the life. at the end of whic h the sum assured is paid back to the policyholder. the insured amount and the bonus is payable only to the nominee of the beneficiary upon the death of the policyholder. The private players in Life Insurance sector in India they have brought in newer concepts like adding riders to life insuran ce policies but they also continue to sell insurance plans with more emphasis on the investment features. The emphasis has been more on the inv estment aspects than on life cover.Life Insurance Products ife insurance is a misunderstood concept in India. As ri sk is covered for the entire life of the policyholder. along with the bonus accumul ated during the term of the policy. It is insurance-cum-investment product where the emphasis is more on investment because life cover for a given premium is less compared to a whole life policy with more focus on maturity benefit com pared to death benefit. Ideally this policy is used by investors who would like to ha ve a certain amount of capital at the end of a fixed term and protect the end ca pital through life insurance of the saver. Whole Life plans with limited pay ment options are also available where the insured is required to pay premium for a specific term after which premium payment will stop but life cover will conti nue In a whole life policy. L Endowment Policy n n n An endowment policy covers risk for a specified period. The quantum of bonus is not assured and it is based on the investm ent out come of Life insurance companies.

professionals. They di ffer from endowment policy in the sense that in endowment policy survival benefi ts are payable only at the end of the endowment period. In cas e of death of one of the persons the sum assured becomes payable. etc. Group Insurance n n Group insurance offers life insurance protection under group policies to var ious groups such as employers-employees. the death claim comprises full sum assured without deducting any of the su rvival benefit amounts. Joint life insurance policies are similar to endowment policies offering maturity benefits as well as death benefits. No surre nder. An important feature of money back policies is that in the event of death at any time within the policy term. as long as the policyholder is alive. The sum assured becomes payable only on death of the policy holder and not on end of the term as in an endowment plan The term life insurance policy of fers maximum life insurance cover for a given premium payment as this is pure li fe insurance without any investment built in Term life policies are primarily de signed to meet the needs of those people who are initially unable to pay the lar ger premium required for a whole life or an endowment assurance policy. T he premiums payable cease on the first death or on the expiry of the selected te rm. It also provides insurance coverage for people in certai n approved occupations at the lowest possible premium cost. A segment of investor popula tion finds the periodic receipts from Life Insurance Company attractive and henc e prefers this plan. Money Back Policy n n n Money back policy provides for periodic payments of partial survival benef its during the term of the policy. loan or paid-up values are granted under term life policies because reserv es are not accumulated. co-operatives. If the premium is not paid within the grace period. the sum assured as well as the vested bonuses are payable on the maturity date. weaker se ctions of society. the policy lapses without acquiring any paid-up value. Investment Planning 117 PDP . The bonus is also calculated on the full sum assured This is an insurance pla n with emphasis on investments and periodic return. which may have already been paid as money-back component s. If one or both the lives survive to the maturity date. whichever is earlier. The sum assure d is paid again on death of the surviving policy holder or on policy maturity. n n Joint Life Insurance Policy n n n n n n These plans are ideal for a married couple especially when both are bread winners or business partners.Term Life Insurance Policy n n n n n n Term life insurance policy covers risk only during the selected term period.

say 5 years. continues for a specified term . On death sum a ssured together with market related returns on the investments is paid – in other words the death benefit could be more than sum assured Investment Planning PDP n 118 . The life insured will need to pay the regular annual premium for the term chosen. insuran ce up to certain percentage of sum assured. which covers a home loan. without payment of any premium Insurance companies tend to place a num ber of restrictions on term plans like: 1. the sum assured will be paid to the beneficiary. which reduces the loan amount. These are typically low cost bare insurance plans with no investment frills For a little additional cost some companies offer Term assurance plans with return of premium and here o n survival till maturity all the premiums paid will be returned Some term assura nce plans provide extended life cover rider where after the end of term. A number of group insurance schemes have been designe d for various groups. The cover on such a policy keeps reducing with the passage of ti me as individuals keep paying their EMIs (equated monthly instalments) regularly . n Unit Linked Insurance Plans n n ULIPs are market-linked insurance plans with a life cover thrown in. There are no maturit y benefits. The sai d insurance cover is lower than most plain-vanilla plans (like endowment plans) as a sizable portion of the premium goes towards investments in market-linked in struments like stocks. 3. Such plans are particularly beneficial to those for whom other regular policies are a costlier proposition.. Companies w ith a large workforce have preferred to provide life insurance to their less sop histicated employees/workers through Group Insurance Plans. Term Assurance Plans n n n n n n Under this plan. Since this is a non-participating (without profits) pure risk cover plan. corporate bonds and government securities. The lump sum will be a decreasi ng percentage of the initial sum assured as per the policy schedule. Maximum life cover. say Rs 50 l acs Maximum term – say 25 years Maximum age at maturity – say 55 years and so on . Loan Cover Term Assurance Policy n n n n n Loan cover term assurance policy is an insurance policy. in case of death of the policy holder during the po licy term.. Hence on survival. the policy will terminate. This plan provides a lump sum in case of death of the life assured during the term of the plan. the amount outstanding in the housing loan i s paid in full. 2. In the event of unfortunate death of the policy holder. no benefits are p ayable on survival to the end of the term of the policy. before the full repayment of the housing loan.n n n n Group insurance plans have low premiums. Group insurance plan s extend cover to large segments of the population including those who cannot af ford individual insurance.

3. For some pr ivate insurance companies.000/. during the e ntire term of the plan. Let us also assume that Mr. Vikas Joshi. n How Unit Linked Insurance Plans work? Let’s assume that Mr. From the premium paid by Mr. S o if the charges are high naturally the lump sum receivable at the end of the te rm will also be affected substantially. For example an investor may choose the aggressive or equ ity plan at his young age and later on switch to conservative or protective or d ebt plan at a later age. is prepared to pay life insurance premium of Rs 20. The policy holders should pay premium co ntinuously for a minimum period of 3 years.per annum. The be nefits besides life protection include: 1. 4. The insurance cover will continue ev en if the policy holder fails to pay the annual premium after a minimum period o f at least 3 years. 2.00. aged 30 y ears. 5. they account for up to 70% of new business generated. a number of times. n n n n n Sales and marketing expenses Admini stration expenses Underwriting expense Mortality charges Fund management expenes The quantum of mortality charges will depend upon extent of life cover opted whi le the fund management PDP Investment Planning 119 .000/-. 2. Joshi presently opts for the Aggress ive plan where his entire amount will be invested in equities and he chooses lif e cover of Rs. ULIPs by their very nature are long term investment vehicles because of costs i nvolved as well as the nature of underlying investments especially equities. The policy becomes paid up after 3 years and upon surrender the market value becomes payable. 6. Joshi expenses under the following heads will be deducted.n n Generally. Inv estors while choosing ULIPs should very carefully study the loads charged by Lif e Insurance Companies because past performance shown by these companies is essen tially on the net investment portion of the premium paid by the policy holder. In a U LIP he can choose the extent of life cover he wants and where he wants his fund to be invested. the choice of extent of life cover is left to the insured/policy hold er The choice of investment plans is also left to the policy holder with an opti on to switch between different investment plans. Investment and Savings Flexibility Adjustable Life Cover Investment Options Transparency Options to ta ke additional cover against n Death due to accident n Disability n Critical Illn ess n Surgeries n n n n ULIPs have managed to outsell plain vanilla plans by quite a margin. ULIP provides multiple benefits to the consumer.

All the units in a fund are identical. If after investment the interest rates rise that may lead to a fa ll in unit prices temporarily. 120 Investment Planning PDP . The remainder will be invested in G overnment Securities and Bonds issued by companies or other bodies with a high c redit standing.000/. The quantum of administration. Balanced Fund 30% to 60% of the Balanced Managed fund will be invested in high quality Indian equities. The fund has a higher le vel of risk with the opportunity to earn higher returns in the long term from th e higher proportion it invests in equities.will be in vested as per his option. tend to g o down dramatically over longer period time Equity as an asset class will perfor m better over longer period of time In the short term equity may perform erratic ally and may not deliver superior returns Where ULIPs invest? Each investment fund is composed of units. The risk that this fund may face is the inter est rate risk. as a percentage of the firs t year or first two years and only the balance amount of Rs.paid by Mr.000/. This fund has a low level of risk but un it prices may still go up or down. Mr. You can choose from the following funds: Liquid fund The L iquid fund invests 100% in bank deposits and high quality short-term money marke t instruments. Joshi expenses will account for nearly Rs. however unit prices may occasionally go down due to the use of short-ter m money market instruments. 20. The fund is designed to be cash secure and has a very low level o f risk. In addition. Hybrid Fund / Moderate fund / Defensive Managed 1 5% to 30% of the Defensive Managed fund will be invested in high quality Indian equities. however a small amount of working capital may be invested in cash to facilit ate the day-to-day running of the fund. The fund has a moderate level of risk with the opportunity to earn higher returns in the long term from some equity investment. The remainder will be invested in Government Securities and Bonds issu ed by companies or other bodies with a high credit standing. It is very important for Mr. selling and marketing e xpenses go down dramatically from the third year onwards but in the initial 2 ye ars they tend to be quite high and this can alter the returns on the ULIP substa ntially. Unit price s may go up or down. In some cases out of Rs. 000/. Secu re Managed /Protector Fund The Secure Managed fund invests 100% in Government Se curities and Bonds issued by companies or other bodies with a high credit standi ng. Joshi should also realize that he will get better returns only if he invests for a long period for the fo llowing important reasons: n n n Expenses. The returns on the funds also tend to be lower. Joshi to study the fine print regarding ex penses thoroughly before choosing a specific Plan. In addition a small amount of working capital may be invested in cash to facilitate the day-to-day running of the fund. a smal l amount of working capital may be invested in cash to facilitate the day-to-day running of the fund.expenses will also depend upon the investment option exercised – the cost could be low for a debt fund and higher for an equity fund. 15. 5.

n n The past performance of any of the funds is not necessarily an indication of future performance. One such need happens to be planning for his children’s future. track record of performance and other features befor e choosing a plan n n n Pension Plans n n n A pension plan is a retirement plan An investor can start planning for ret irement from an early age or look at the options close to retirement Ideally. While individu als might have a financial plan for themselves in place. Who can opt for ULIPs? n n n Individuals who are already adequately insured Indi viduals who are well informed regarding the market and are in a position to take a call on the performance of equity and or debt markets over a period of time I nvestors who are prepared to take more risk for better returns compared to pure endowment plans Insurance plans for child’s future Life insurance plans help in servicing various needs in an individual’s financial planning exercise. Children’s insurance plans help in addressing many of these needs. suppose a n individual wants to plan for his son’s education. For example. The returns o n some products are market linked and not assured and therefore it is important to understand cost factors. A child plan will serve in ach ieving this goal. In addition a small amount of working capital may be invested in cash to facilitate the day-to-day running of the fund. in vestments should start from an early age through regular instalments on yearly b asis PDP Investment Planning 121 . The fund has a higher level of risk with the opportunity to earn higher returns in the long term from the investment in equities. An illustration will help understand this better. There are no investment guaran tees on the returns of unit linked funds. it is equally important that they secure the financial future of their children.Growth fund / Aggressive Fund The Growth fund invests 80% to 100% in high qualit y Indian equities. n n n n A pa rent saves regularly every year or every month for a fixed term The plan offers to pay lump sum amounts every year which could be spent on child’s education on th e child reaching a certain age There are plans that pay a single lump sum on the child attaining a certain age – typically planned to provide for marriage expense s The most important insurance feature in a child care plan is that in the event of unfortunate death of premium paying parent further premium payments are waiv ed (at the option of the policy holder while entering the plan) and the lump sum s are paid as planned so that the child’s education expenses are met Some plans al so offer a rider called Accidental Disability Guardian Benefit rider where the f uture premiums are waived in case the parent is disabled because of an accident It is the life insurance of the parent that is important and not that of the chi ld because the child should not face financial problems on death of the parent many people tend to insure the child to secure the child’s feature.

at the end of the term of deferment the pensioner can exercise an option of getting som e lump sum and pension on the balance amount or pension on the full amount – part payment of capital is allowed The pension payments are at guaranteed rates for e ntire life of the pensioner or for a fixed term of say 10/15/20 years Some pensi on plans provide for paying increased rates of pension over a period of time – ide al hedge against inflation The pension payments can be monthly. at entry. The pension payments can contin ue to spouse on the death of the pensioner. quarterly. past a particular minimum age limit – minimum age limit for starting of pension – in many cases it ha ppens to be 40 years The pension payments can start immediately or after a time lag – Immediate annuity or deferred annuity In case of deferred annuities. the interest rates may go down disrupting the budget of the pensioner – these plans “cover the risk of living too long” n n n n n n n n 122 Investment Planning PDP . at the same rates or reduced rates. at an additional cost The most important factor that should be co nsidered while choosing a pension plan is that it provides protection from inter est rate risk – insurance companies guarantee a specific return for the entire lif e of the pensioner where as in other avenues like fixed deposits/small savings. half yearly or yearly – at the option of the pensioner. as prescribed by Life Insurance companies – this option can be exercised by pensio ner The capital sum may be returned to the nominee on the death of the pensioner (return of purchase price) or forfeited – the rate of return on annuity plans wil l depend on which option the pensioner exercises – the rate of returns are lower w hen the pensioner wants return of purchase price In case of immediate pension – th e quantum of pension depends on the age. etc.n n n Lump sum single premium payment is also allowed for investors. of the pensioner – the higher t he age at entry the higher the amount of pension Pension plans typically offer n o life insurance cover but some plans do have term assurance rider for deferred pension plans.

In a Whole life plan with limited payments. Market related plans with emphasis on investments d. wher e upon death of the parent further premium need not be paid but the child will g et all benefits of the policy d. The return shown by way of past performance is on the entire amount of p remium paid by the policy holder d. Insure the life of the ch ild for maximum possible amount b. Only at the end of the term of the policy b. Only a certain percentage of premium is inve sted in securities and a good amount. At the end of the premium term or on death of the policy holder which ever is earlier d. Shor t term and Low cost insurance plans b. Market related plans with emphasis on insurance 7. In respect of Unit Linked Insurance Plans which of the following statements is true? a. Unit Linked Insurance Plans are basically: a. Unit Linked Insurance Plans are most suited under which of the following conditions? a. Invest in a child care plan but not opt for pre mium waiver rider because that involves additional cost 5. On death of the policy holde r or at the end of the term of the policy which ever is earlier c. Only on death of the p olicy holder c. In an Endowment Assurance Plan the sum a ssured becomes payable: a. Ideal for und er insured persons b. especial ly in the first few years PDP Investment Planning 123 . Only if the policy holder dies be fore the end of the term for which he has been insured 4. Suitable for persons who are adequately insured and are pr epared to take some risks for better returns c. Invest in a child care plan with premium waiver benefit. Suitable for people looking for maximizing insurance cover o n minimum premium payments 6. Only on death of the policy holder d. the sum assured becomes payable: a. Only at the end of the term of the policy b. The returns are assured b. Only if the p olicy holder dies after the end of the term d. No risk investment p lans c.Review Questions: 1. is deducted for various expenses. Suitable for investors with shor t term objective d. The best way to take c are of a child’s future through insurance plans is to a. No sum is payable if policy holder survives the full term 3. On death of the policy holder or at the end of the term of the policy which ever is earl ier c. The sum assured is not payable at all if the policy hol der survives the premium paying term 2. Low cost investment plans with no risk c. Life insurance plans can not protect the chil d’s future at all c. In a Term Assurance Plan the sum assured becomes payab le: a. At the end of premium paying term b.

d.a. b b d c b c d a c 124 Investment Planning PDP . A conservative or protector plan which pre dominantly invests in bonds and government securities c. 7. 9. say liquid fund/bond fun d 9.a. The choice is immateria l as all funds tend to perform equally well over longer periods of time d. 8. 5. Guaranteed pension for life and there after to his spou se -offering 7% p.8. 4. A young and aggressive investor.offering 7% p. 2.a. Aggressive/Growth plan which predominantly invests in equities b. He should be advised to invest in a mutual fund rather t han pension plan of a life insurance company Answers: 1. b. Guaranteed pension for 20 years .5% p. c. 3. A hig her insurance cover with lower risk investment option . 6. He is 50 years of age and he expects to live for another 3 0 years at least. Guar anteed pension for 5 years . Which one of the following options is suitable to him? a. An investor who wants to invest in immediate pension plan seeks your advice on w hat option to choose. should choos e which of the following options in a ULIP plan? a.offering 6. who is already adequately insured.

Chapter 10 PDP Investment Planning 125 .

The mutual fu nd provides him the best option where on a small capital invested the unit holde r gets a diversified portfolio. Diversification It is impossible for a small investor to diversify across different investment v ehicles as well as over a large number of companies. the redemptions are also very fast an d investors in equity funds tend to get money back 7. there is potential for the unit holders to get better returns compared to fixed income avenues over a longer period of time. 4. He invariably runs the risk of non diversification on his investments because of low capital. Tax Benefits Mutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The unit holders also enjoy certain tax benefits on the income earned. 3. 2. 6. there is no loc k-in period. 126 Investment Planning PDP . Liquidity Open ended funds can be redeemed at any time. Transparency The NAV’s of open ended funds are disclosed on a daily basis while the portfolio is disclosed on a monthly basis ensuring transparency to the inves tors. A mutual fund is set up as a trust which supervises the function of An Asset Management Company (AMC) which manages the investments collected in the m utual fund schemes. Higher returns As these fund s are well managed and well diversified they tend to perform better than the mar ket over a longer period of time.Mutual Funds A Mutual fund is a collective investment vehicle where the resources of a number o f unit holders are pooled and invested as per objectives disclosed in the offer document. the capit al gains made and on amount invested in certain types of funds. Professional management The funds are invested by professional fund managemen t team that analyses the performance and prospects of companies and selects suit able investments in line with the objectives of the schemes. Thus the interest of the investors is kept protected. Regulated operation The mutual fund administr ation and fund management are subject to stringent regulations by Self Regulator y Organisation voluntarily set up mutual funds – viz. Association of Mutual Funds of India (AMFI) and also by Securities and Exchange Board of India (SEBI). A mutual fund investor enjoys the following advantages 1. 5 . provides excellent liquidity.

daily or weekly . They monitor the performance and compliance of SEBI Regulat ions by the mutual fund. Securities and exchange Board of India (SEBI) Act was passed. The risks associated with the schem es launched by the mutual funds sponsored by these entities are of similar type. How is a mutual fund set up? A mutual fund is set up in the form of a trust. There is no distinction in regulatory requirements for these mutual funds and all are su bject to monitoring and inspections by SEBI. The trustees of the mutual fund hold its property for the benefi t of the unit holders. SEBI formulates policies and regulates the mutual funds to protect the interes t of the investors. the y should not be associated with the sponsors. For example. All mutual funds are required to be registered with SEBI be fore they launch any scheme. if the market value of securities of a mutual fund scheme is Rs 300 lakhs and the mutual fund has issued 10 lakhs units of Rs. SEBI has also issued guidelines to the mutual funds from time to time to protect the interests of investors. In simple words. Since market value of securities changes every day. The NAV per unit is the market value of s ecurities of a scheme divided by the total number of units of the scheme on any particular date. wh ich has sponsor. What is Net Asset Value (NAV) of a scheme? The perf ormance of a particular scheme of a mutual fund is denoted by Net Asset Value (N AV). who is registered with SEBI. trustees. Government allowed public sec tor banks and institutions to set up mutual funds. Flexibility Mutual funds offer a lot of flexibility where the investments can be lump sum investments or Systematic investment Plans on a monthly/quarterly b asis with very small amounts of investments. SEBI Regulations require that at least two thirds of th e directors of trustee company or board of trustees must be independent i. The objectives of SEBI are – to protect the interest of investors in securities and to promote the development of and regulation of the securities market. holds the securities of various schemes of the fund in it s custody. What is the history of Mutual Funds in India and role of SEBI in mutual funds industry? Unit Trust of India was the first mutual fund set up in India in the year 1963.e. then the NAV per unit of the fund is Rs. SEBI notified regulations for the mutual funds in 1993.30. In early 1990s. NAV of a s cheme also varies on day to day basis. Also. Th e trust is established by a sponsor or more than one sponsor who is like promote r of a company. All mutual funds whether promoted by public sector or private sector entities including those pr omoted by foreign entities are governed by the same set of Regulations. NAV is requir ed to be disclosed by the mutual funds on a regular basis . 50% of the directors of AMC must be independent. PDP Investment Planning 127 . Ther eafter. Withdrawal can be also full or part or on a systematic basis. Net Asset Value is the market value of the securities he ld by the scheme. In the year 1992. Asset Management Company (AMC) approved by SEBI manages t he funds by making investments in various types of pending on the type of scheme. an asset management company (AMC) and a custodian. Mutual funds invest the money collected from the investors in securities ma rkets. 10 each to the investors. The regulations were fully revised in 1996 and have been ame nded thereafter from time to time. As far as mutual funds are concerned . The trustees are vested with the general power of superintendence and direction over AMC. Custodian.8. mutual funds sponsored by private sector entities were allowed to enter the capital market.

or balanced scheme considering its investment objective. Inv estors can invest in the scheme at the time of the initial public issue and ther eafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. this motivates the investors to stay invested in the fund for at least that period of time. The fund is open for subs cription only during a specified period at the time of launch of the scheme. Openended Fund/ Scheme An open-ended fund or scheme is one that is available for sub scription and repurchase on a continuous basis. These mutual funds schem es disclose NAV generally on weekly basis.Different types of mutual fund schemes Schemes according to Maturity Period A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period. Schemes according to expenses Load funds a nd no load funds: Funds which collect charges at the time of entry or exit or bo th from the investors are known as load funds. These schemes do not have a fixe d maturity period. Thus the liquidity in close ended fund comes with a cost higher than open ended funds. Investors can conveniently buy and sell units at Net Asset Va lue (NAV) related prices which are declared on a daily basis. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i. SEBI has stipulated the m aximum load that can be charged by mutual funds and how the same can be levied. Such scheme s may be open-ended or close-ended schemes as described 128 Investment Planning PDP . 3.g. The key feature of openend schemes is liquidity. However AMC’s are allowed to char ge higher management fees in respect of no load funds compared to load funds. Similarly when mutual funds offer limited repurchase on a periodic basis at intervals they charge a hefty e xit load especially in the first few years since inception – the loads tend to get smaller as more time elapses. If the fund charges entry lo ad of say 2. Lo ad charged at the time of purchase is called entry load while load charged at th e time of redemption is called exit load. some close-ended funds give an option of selling back the units to the mutual fund th rough periodic repurchase at NAV related prices. The market prices in respect of liste d close ended funds tend to be at a discount to NAV.Issue expenses. Mutual funds want investors to invest for longer terms with them. inc ome scheme. Close-ended Fund/ Scheme A close-ended fund or sc heme has a stipulated maturity period e.25% then the initial investors in the fund will be sold units of Fac e Value Rs 10. In order to provide an exit route to the investors.225 and in respect of existing fund the loa d will be charged at specified rates on closing NAV for the day. In respect of a New Fund Offer (NFO) – launch of a new mutual fund scheme – the offer document which is also called KIM (Key information memoran dum) should contain all details regarding expenses. Initial expenses should not exceed 6% of initial resources raised/funds mobilize d under the scheme. Funds which do not collect any of these charges at all are called “No load funds” . Hence some times they charge a Contingent Deferred S ales Charge (CDSC) which will be charged only if the investor exits the fund bef ore a certain period of time – say 6 months. distribution and marketing expenses are borne by AMC’s or sponsors. Schemes accordi ng to Investment Objective A scheme can also be classified as growth scheme.00 at a price of Rs 10.5 years. either rep urchase facility or through listing on stock exchanges.e.

These funds are also cal led “passive funds” as not much fund management skills are involved and these funds are expected to perform in line with the market. These funds are also affected because of fluctuations in share p rices in the stock markets. Index Funds Index Funds are equity funds and they replicate the portfolio of a particular index such as the BSE Sensex.earlier. Growth schemes are good fo r investors having a long-term outlook seeking appreciation over a period of tim e. Gov ernment securities have no default risk. S&P NSE 50 index (Nifty). However. Government securities and money mar ket instruments. opportun ities of capital appreciation are also limited in such funds. These are appropriate for inve stors looking for moderate growth. corporate debentures. NAVs of such funds are likely to increase in the short run and vice versa. Such funds are less risky compared to equity schemes. These funds are appropriate for cor porate and individual investors as a means to park their surplus funds for short periods. commercial paper and inter-bank call money. NAVs of such funds are likely to be less vo latile compared to pure equity funds. government securities. Such schemes may be classified mainly as follows: Growth / Equity Orien ted Scheme The aim of growth funds is to provide capital appreciation over the m edium to long. Money Market or Liquid Fund These funds ar e also income funds and their aim is to provide easy liquidity. Exchange Traded Funds (ETF) ETF’s are traded like st ocks and thus offer more flexibility than conventional mutual funds. etc.term. though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. Such schemes normally invest a major part of their corpus i n equities. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index. The NAVs of such f unds are affected because of change in interest rates in the country. Income / Debt Oriented Scheme The aim of income funds is to provide regular a nd steady income to investors. certificates of deposit. These schemes invest exclusively in safer short-ter m instruments such as treasury bills. Such funds have comparatively high risks. Balanced Fund The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in t he proportion indicated in their offer documents. etc These schemes invest in the securities in the same weightage comprising an index. The expenses of fund management tend to be lower in index funds and these funds are suitable to investors who a re happy with market returns. Such schemes generally invest in fixed income sec urities such as bonds. Investors c an purchase or sell ETF’s at real time prices as against day end NAV’s in case of op en ended mutual PDP Investment Planning 129 . However. However. They generally invest 40-60% in equity and de bt instruments. long term investors may not bother about these fluctuation s. If the int erest rates fall. Gilt Fund These funds invest exclusively in government securities. Returns on these schemes fluctuate much less compared to other funds. NAVs of these schemes also fluctuate du e to change in interest rates and other economic factors as is the case with inc ome or debt oriented schemes. These fun ds are not affected because of fluctuations in equity markets. preservation of capital and moderate income.

These funds serve the purpose of diversification across asset classes as direct investments by retail investors in commodities is virtually impossible due to va rious physical constraints. Some mutual fund houses have already launched schemes which seek to inv est a certain percentage of their corpus in foreign companies which are listed a nd traded outside India. NIFTY Bees and UTI SUNDER are two listed ETF’s. etc. Real Estate Funds These funds invest in properties d irectly or indirectly by lending to real estate developers or buying shares of r eal estate and/or housing finance companies which are expected to benefit from r eal estate boom. They may launch a s ector specific fund and the funds mobilized in this scheme would be invested in equities of companies of that sector. Th ese are high risk funds and the returns can also be higher. Investments in these schemes qualify for deduction u/s 80C of the Income Tax Act within the 130 Investment Planning PDP . platinum. Thematic Funds A fun d house may feel that some sectors as a theme may outperform other securities be cause of government policies. etc. Retail investors can take advantage of rea l estate boom through this indirect investment in real estate even on a lower ca pital. For example An infr astructure fund is not a sectoral fund as it will not fund only in one sector bu t invest in companies which are involved in infrastructure – cement. silver. copper. For example a Pharma fund will invest in e quities of pharmaceutical companies only and not in other industrial sectors. ETF’s provide investors an opportunity to take advantage of intra day swing s in the market and can be used to hedge their long positions in the equity mark et. Offshore funds Indian mutual funds have been permitted to invest o verseas. Tax Saving Funds Equity linked Saving Schemes of mutual funds with a lock in period of 3 years come with a tax benefit also. consumer preferences. to Indian investors.funds. These are slightly less risky compa red to sectoral funds but more risk in comparison with diversified equity funds. telecommunication. These funds are unique in that they offer diversificati on across geographies. These are traded on very low volumes with a high spread between bid and offer prices – high er spread increases the cost and decreases the attractiveness of the ETF. Funds classified on the lines of market caps like Small Cap Fund. Sector al Funds A mutual fund house may feel that a particular industrial sector may pe rform better than other sectors and that this sector offers tremendous growth op portunities over a period of time compared to other sectors. ETf’s are cheaper than even Index funds but in the Indian market place this co ncept has not picked up. Commodity Funds These funds make investments in different commodities directly or through commod ities futures contracts and also invest shares of companies dealing in commoditi es. etc. for the first time. Mid Cap Fund or Large Cap funds can also be considered as thematic where the theme is “market c apitalization”. Typically they must invest in one commodity or a diversified set of commodit ies – A gold fund invests only in gold whereas a metal fund may invest in precious metals and base metals like gold. engine ering. construction. The fund house may launch a thematic fund and invest the funds collected on ly in companies which are connected with the specific theme. nickel. over all market conditions. steel. zinc. Mutual funds in India are all set real estate funds as the norm s have been cleared recently by SEBI.

if any. Inve stment management charges Fund management expenses for equity funds PDP Investment Planning 131 . It has been recently amended by SEBI – now open ended funds can not charg e issue expenses to the fund separately over a period of time and the initial ex penses will be part of the recurring expenses permitted to be incurred by them a s well as entry load. However close ended funds can charge initial issue expenses as per prescribed maximum limit of 6% and amortize the same over the t erm of the plan and charge the same to the investors exiting the funds as entry load before the end of the term for which the fund will remain close ended. These schemes tend to get open en ded after the initial lock in period of 3 years for the investors. Pension funds designed by UTI mutual fund called “Retirement benefit plan” and that of Templeton Investments called ‘Templeton India Pension Plan” are basically balance d funds where the investors tend to save income tax at the time of investment – th ese plans are suitable to long term investors who would like to take moderate ri sk as against high risk in ELSS tax saving plans. do they ask questions like ‘how much is the fund charging me? What goes into the expenses? Is it possible for the fund house to lower the expenses?’ The returns to the investor can sometimes change substantially through lower expenses charged by the AMCs especially in debt funds or under-performing equity markets. Expenses charged by mutual funds Mut ual fund investors in India tend to assess a fund’s performance based only on the NAV basis. The first and last question on their minds is ‘what returns has the fun d given?’ Rarely. T hese expenses were being charged over a period of time and are typically borne b y investors who stay invested and not by some initial investors who might have r edeemed and exited the fund in a short span of time.overall ceiling of Rs. Approved pens ion plans of mutual funds also enjoy tax benefit u/s 80C of the Income Tax Act. if ever. 2. custodial charges. Initial issue expenses Investment management and advisory fees charged by AMC Re curring expenses marketing and selling expenses.000/-. 1. Mutual funds charge 3 kinds of expenses to the funds: 1. This provision had the effe ct of penalizing long term investors and was proving beneficial to short term in vestors. audit fees. etc. 3. Initial issue expenses were allowed to the extent of 6% of funds mobilized and t hese expenses were allowed to be charged to the fund over a period of 5 years.00. The lock in period is 3 years but mutual funds have fixed age limits for entry as well for getting pension – as these plans are retirement plans in nature. Many fund houses have launched ELSS and these funds have rewarded the investors handsomely. Trustee fees.

Such a security will be valued “in good faith” on the basis of appropriate valuation method. equity funds. which shall be period ically evaluated by the trustees and reported by Auditors as fair and reasonable . Tota l expenses that can be charged to the funds are subject to the following ceiling s: Total expenses permitted on equity funds Average weekly Net Assets Valuation of mutual funds Mutual funds are required to declare their NAV’s on dail y/weekly basis. The reported NAV is a function of valuation of underlying securi ties and therefore it is relevant to know how a mutual fund should value their s ecurities. 132 Investment Planning PDP . Debt instruments and Government securities are valued on a Yield to maturity b asis with adequate discounts for illiquidity. Taxation of mutual funds Income earned by mutual funds is tax free u/s 10 (23D) of the Income Tax Act. Valuation of non-traded securities: Wher e a security is not traded on any stock exchange for 60 days or more prior to va luation date. at current yield basis. Previously this limit was 50%. in respect of a given secu rity. if any. etc. Many Money market instruments are valued at cost plus accrual basis and so me instruments. If it is not traded on a given date the value of the previous day is used. where 65% or more of the total corpus has been invested in eq uities. Valua tion of traded securities: The closing price on the stock exchange where it is m ainly traded is taken for valuation purpose. deri vative funds. Taxation of investors Equity Oriented funds Equity oriented funds are growth funds. SEBI has issued guidelines regarding valuations of assets held.Fund management expenses for “No Load’ equity funds The percentage is computed on weekly average net assets managed by the AMC. it is treated as “Non Traded security”. of medium term.

DDT – dividend distribution tax is payabl e on the amount of dividend to be distributed – the rate of taxation depends on th e identity of the investor and class of assets held under fund management. It may be noted that DDT impac ts the return to the investor indirectly because DDT is paid out of the funds th ereby affecting NAV of the fund. Taxation on equity oriented funds of different enti ties: STCG indicates Short Term Capital gains made on selling the equity-oriented fund within one year of purchase LTCG – Long Term Capital Gains made on selling the eq uity oriented fund after having held it for one year or more from the date of pu rchase. where the mutual f und has been sold after a holding period of 1 year or more – 10% tax is payable wi thout indexation or 20% with indexation. But these funds also face interest rate risk especially at a time when the PDP Investment Planning 133 . The mutual fund is also not required to pay an y Dividend Distribution Tax. LTCG* – Long Term Capital Gain. This is applicable to all equity oriented funds including close ended fu nds DDT – Dividend Distribution Tax payable by the mutual fund Other than equity o riented funds Where STCG – indicates short term capital gain wherein the mutual fund has been so ld within one year of purchase.Dividends distributed by these funds are tax free in the hands of the investor u /s 10 (35) of the Income Tax Act. Double Indexation Benefit Double indexation ben efit in respect of debt funds and fixed maturity plans: Investors who are risk a verse prefer debt funds. Divid ends of Non equity funds are also tax free in the hands of investor but dividend distribution tax is payable by the mutual funds.

000/Thus the taxable short term capital gains is 11000 -11025 = -25 resulting in a nominal loss. They invested in funds that declared a very high percentage of dividends. The indexed cost of acquisition works out to 10000*1. Thus. 2.1025/1 = Rs 11. these investors received tax free dividends from mutual funds and suffered notional short term capital loss because ex dividend NAV’s used to be substantially lower compared to cum dividend NAV’s at which the units were purchased.earned by him will be treated as Short Term Capital Gain and the tax payable is 20% of the taxable capital gains after applying inflation index.6%. However in an FMP Rs. Example Mr. They used to purchase these units cum divid end and sell them at ex dividend NAV’s almost immediately with very little market risk involvement.00 0/-.has given capital appreciation of Rs.00 per unit on 14th March 2006 and he sells the units on 15th March 2006 at a price of Rs. Hence investors pr efer to lock in their funds in debt funds which are fixed maturity plans where t he mutual funds invest the corpus in debts that shall mature at a fixed time in future. What is the short term capital loss incurred by Mr Patel for income tax pu rpose? Mr. Short term loss on Dividend Stripping Investors used to resort to tax planning t hrough dividend stripping in equity funds. Further indexation be nefits are also available on these plans and hence the rate of taxation is also lower.025/The maturity value is Rs. If the investor is in the 30% tax bracket even when he earns 8% p.after 15 months. The yield on these bonds/govern ment securities are typically Held to Maturity (HTM) yields and hence there is n o risk of capital loss on account of interest rate fluctuations. 10. he will get Rs.20.000/. 1.a. If he invests Rs.and if the return expecte d FMP is about 8% p.10 25. 10. The investors a re sure of the return that can be expected from these FMP’s.000/. 11.a. which we shall assume to be 1. In the given example Rs. the inflation index for FY 2006-2007 will be 1. 1 2.000/. 1. Devesh Patel buys 1000 units of a fund for Rs. Example: n n n n n n n n n An investor invests in a 15 month FMP in March 2005 maturing in May 2006.000/. Assu ming inflation rate of 5% p. he receives dividend of Rs.interest rates are not stable and showing signs of moving up. 1 0. Short term capital loss will be allowed only if the investor had bought the units at least 3 months before record date for dividend or sold the units at le ast 9 months after the record date for dividend purpose. Hence tax payable on this investment i s NIL. The investor in this FMP has earned 8% virtually tax free because of inde xation benefits.50 cum dividend on 10th March 2006. If transactions of purc hase and sale of mutual funds have been done within the period specified above r esulting in capital loss then the same will be treated as dividend stripping and actual loss. in excess of dividend amount only will be allowed as short term capital loss.a. if any. 11. But now with amendment in the Income Tax act in respect of allowing c apital loss on mutual funds these planning methods have become virtually impossi ble. on fixed income instrument s his tax adjusted yield will be only 5. The Inflation index f or FY 2004 -2005 is applicable for purchase. Patel has not bought 3 months prior to record date for dividend nor h as he sold 9 months after the record 134 Investment Planning PDP . say 18 months or 24 months or 36 months.

An investor in an open ended fund can redeem his holdings partly or fully at any time witho ut giving any notice to the mutual fund and the redemptions in most equity funds take place on T+2 basis while in respect of debt funds it is even better at T+1 basis in most cases. T is the day when redemption request is received before fi xed hours. 2300 Rs. Wealth Tax: Ownership of un its of mutual funds is not wealth as per definitions of Wealth Tax Act and hence mutual funds are not chargeable to wealth tax. 1 2500 Rs. are pro mptly attended to by Registrars who are appointed by Mutual funds for providing these services. which is extremely good from a liquidity point of vie w. They can contact mutual funds through e mail for various investment related services. Monthly fact sheets. redemption cheques. 2300 PDP Investment Planning 135 . Tra nsparency: SEBI has made many mandatory provisions that shall ensure that the in terest of the small investors in mutual fund is protected. 300 and not Rs. In general. for dividend. are some examples of transparency efforts . the redemptions received before a stipulated time are made in a matter of hours – here the time is the ess ence. 2000 Rs. de tailed annual account statements. arising f rom such transactions shall be ignored and the amount of such loss shall be deem ed to be the cost of acquisition of the bonus units. Telephonic access: Almost all mutual funds have provided toll free n umbers or customer help desk telephone numbers in major cities to help the inves tors with their queries relating to their mutual fund investments. Rs. Disclosure of daily N AV’s in open ended funds. if any. within a period of 3 months prior t o the record date for distribution of bonus units and sells or transfers any of the originally acquired units within a period of nine months after such record d ate. Sale Value Purchase value Loss Dividend receive d Permitted short term capital loss Short term loss on bonus stripping If a pers on acquires units of UTI or any mutual fund. Hence short term capital loss will be limited to actual loss as per calculations given below. the service standards set by the mutual fund industry in India are quite high and the investors have little to complain about. through the internet. Forms for fresh investments are collected through the collection centres and designated banks and sent to centralized processing offices of the Registrars. In respect of liquid funds. weekly NAV’s of close ended funds. money market funds. The additional number of working days for actual payment of redemptio n is just 2 in many cases. while retaining all or any of the bonus units. Service standards of mutual fund s Matters of dispatch of statement of accounts. etc. etc. then loss. online. Redemptions: Liquidity is a very great attraction in mutual funds. Internet acce ss: Mutual funds provide investors with PIN (Personal identification Number) and enable them to watch their investments. 10200 Rs.

2. are essentially long term in nature. a fixed amount is tra nsferred. 5 years a nd so on. Under ARP these dividends are automatically invested in units at ex dividend NAV’s and here the nu mber of units keeps on increasing. The financial planner would be in the best position to advise the investor on which option to choose.Types of Investment plans Automatic Reinvestment Plans (ARP): Mutual funds generally offer Growth Plans an d Dividend Plans in their schemes. strategies. This serve s the advantage of SIP while the lump sum enjoys market related returns. The ability to out perform the market and deliver superior returns The ability to eliminate unsystematic risk through diversification. A financial planner has a very important role in helping the investor select the funds. The options are so many in number that they tend to confuse the retail investor. Investors who might have made lump sum investments at market peaks may feel l et down by the mutual funds – It is also our experience that mutual fund collectio ns in equity funds are the highest around market peaks. say on a monthly basis on their investment s. etc. taxation. and opt for SWP. etc. The retail investors can not time the market. In the short term the equity funds may yield negative returns as wel l. Under Dividend Pay out option the investor ge ts cash payment of dividend. Under Dividend Plan an investor may opt for D ividend Pay Out or Dividend Reinvestment. In growth plan no dividend distributio n is made and the NAV keeps on growing. These people tend to invest in a lump sum. mainly in income funds or floating rate funds. most suitable to him. In Dividend plan the fund may choose to declare a dividend after the NAV has appreciated substantially. plans. meeting the investment objectives. Mutual funds offer a variety of products to suit almost every conceivable need of the i nvestor. Systematic Withdrawal Plans (SWP): Many investors need periodic income. Performance of mutual funds Measurement Investors are very keen on fund performance and the alert ones keep watching the fund performance very frequently – even on a daily basis. especially equity funds. etc. Each fund i s evaluated and compared with the performance of the market and other funds in t he market. These investors prefer to park the lump sum amounts in a debt fund/floa ting rate funds and opt for STP where on a periodic basis. The performance of a fund manager is generally evaluated on two count s: 1. 136 Investment Planning PDP . on a specified date from Debt fund to a chosen equity fund. 1 year. in the short term. Systematic Transfer Plans (STP): These plans are suitable for investors who would like to invest large sums in equity funds but who do not want to time the markets. In SWP they specify the amount and the period icity of payments – part of the unit holdings are redeemed automatically at prevai ling NAV’s and paid to the investor as systematic withdrawal – subject to a minimum balance to be maintained by the investor. Thus SIP’s serve the purpose of “Rupee Cost Averaging’ strategy in investmen ts and investors get much better returns without the heart burn of falling marke ts. from the point o f risk profile. These are convenient for retired perso ns. Further most investors receive their incomes on a monthly b asis and would be more comfortable investing on a monthly basis rather than lump sums at intervals. etc. Systematic Investment Plan (S IP): Mutual fund investments. To meet all these needs mutual funds offer SIP’s where the inv estors can invest in select funds on systematic basis (monthly or quarterly) on pre determined dates for a pre determined period say 6 months. achieving financial goals. In order to encourage SIP’s funds were not charging any loa ds when investors opted for this route but now most funds treat SIP’s on par with lump sum investments regarding expenses.

5%. Bose works out to 46. it is assumed that units have been bought at Rs.000/10. 10+0.Rf SD Rp – Return of the po rtfolio Rf – Risk free return SD – Standard Deviation of Portfolio (total risk) Trey nor Index RP .an d loads have been ignored in this calculation of performance.with a load of a new fund offer at a unit price of Rs .25 No of unit s allotted to him in NFO will be Rs. Hence NAV’s of growth plans are considered for the purpose of measuring performance.Rf Beta PDP Investment Planning 137 .15 – 10.15 Gains made by Mr Bose = 14634. three year s. 10. Risk adjusted perf ormance measurement Many magazines and internet sites rank funds on the basis of performance over a given period of time.25 = 975. Bose will be calculated as follows: Uni t price paid by Mr.000/.Change in NAV is the most common performance measure used by investors. 10/.61*15 = 14634. It may be worthwhile to recall some very important performance measures here. Sharpe Index RP . 10. Example Let us assume t hat Mr.634.34% due to the entry load.000 = 4. Sometimes dividend distribution is ad ded to the difference in NAV’s to measure the performance. since inception etc. 10.15 assuming no exit load and no dividend pay out during the one year peri od Even though the NAV has gained 50% in one year the actual returns to Mr. A useful comparison can be achieved only when risk adjusted returns are calculated. We have dealt with measuring ri sk adjusted returns in earlier topics.25 (entry load) = Rs. After one year he finds that the NAV has gone up to Rs 15/-. The total returns earned by Mr. Bose will be Rs. These performances are absolute perfor mances and the risks taken by fund managers are not taken into consideration in this evaluation and comparison. Two funds may show same returns but their risk c haracteristics could be dramatically different and these funds may perform very differently when the market goes up or down. However the limitation here is that this formula does not take into considerations the d ividends distributed during the period. 10/. Bose had invested Rs.61 If he sells after one year he will get 975. Please remember that when funds anno unce on a periodic basis the returns earned over one year. two years.

Beta is the measure of market risk of the portfolio Jensen’s index = Rp –[Rf Rf)*B] Rp – return on the portfolio Rf – risk free return Rm – Market return turn) B – Beta of the portfolio Example Let us try to compare two funds with ollowing information on returns and the risk. Expense ratio mus t be evaluated from the point of fund size. particularly debt funds . This ratio i s a useful measure for evaluating income oriented funds.[8%+(12-8)*1] = 2% Fund B = 18% -[8%+ (12-8)*1.5] = 4% Other performance measures Expense ratio: The exp ense ratio is an indicator of the fund’s cost effectiveness and efficiency. It is the ratio of total expenses to average net assets of the fund.6 Fund B = (18-8)/18 = 10/18 = 0. It is important to note that brokerage and co mmissions on the fund’s transactions are not included in the expenses figure of th e fund while computing the expense ratio. Naturally higher expense ratio will affect fund performance adversely. average account size and portfolio c omposition – equity or debt. 138 Investment Planning PDP .5 = 6.66 Market = (12-8)/1 = 4 Jensen’s index Fund A = 14% . Sharpe Index Fund A = (14-8)/10 = 0.555 Market = (12-8)/8 = 4/8 = 0. Funds with small corpus will have a higher expense ra tio compared to a fund with a large corpus. This ratio is used in conjunction with ratios like total return and expense ra tios. given that risk free return is + (Rm(Index re the f 8%.5 Treynor Index Fund A = (14-8)/1 = 6 Fund B = (18-8)/1. Income Ratio: Income ratio is defined as fund’s net investment income divided by net assets for the period.

Based on these factors and his evaluation of performance of funds he should suggest a por tfolio of funds that will add value.Benchmarking relative to market Index Funds: An investor expects an index fund t o perform in line with the market and he does not expect the fund to out perform the bench mark index. Hence. risk appetite. through strategic asset allocati on. 2 years . over time. say 1 year. when a close-ended scheme is amortizing such expenses over a period. if an investor som ehow exits PDP Investment Planning 139 . Their number is increasing day by day. For example a Pha rma fund should perform in line with Pharmaceutical Index. etc Then he should arrive at an optima l mix of asset classes that would best meet the investment objectives. performance of money market funds is usually bench marke d against the treasury bill of matching period. 3 years or 5 years and invest in top perform ing funds in that category. Ideal bench marking would depen d up on the composition of debt instruments in the debt – for example A GSec Fund of GILT fund should be benchmarked to returns on Government Securities rather th an bank fixed deposits. Debt Funds: Generally investors have used inte rest rates on term deposits with banks as bench mark for assessing the returns o n debt funds for a matching maturity. There is a tendency to rank funds on the basis of their past performance over a given pe riod of time. Choosing the right mutual fund There are a large nu mber of mutual funds. The offer d ocument generally spells out the relevant market index they will be bench markin g their performance to. track record of performance. investment objectives of the funds and risk profile also whil e comparing different funds. While disclosing performance on a periodic basis fund ho uses give out the fund performance as well as that of the relevant bench mark in dex and this facilitates easy comparison. Benchmarking relative to other s imilar mutual funds While choosing investors have preferred to invest funds that have performed better in relation to other funds in the same category. The financial plann er should have clear idea of relative merits of various funds in terms of risk. Money Market Funds: These funds have invested in short t erm instruments. It is easier to evalu ate performance because many sector indices are available facilitating easy comp arison. returns. However the debt funds comprise of corpora te debt securities and/or government securities. It is important to keep track of the nature of under lying investments. The lower the tracking error. etc. the better the performance of the fund in replicating the underlying market index. return expectations. The real skill of a financial planner is in first arriving at a good mix of investment options and then selecting the best funds that would deliver the desi red results. Active Equity Funds: Most equity funds are actively managed. He should have a good idea of the inv estment objectives of his client taking into consideration factors like time hor izon. Sectoral funds: A sector s pecific fund is expected to perform in line with sector index. Latest changes in mutual fund industry Only close-ended schemes wil l be allowed to charge initial issue expenses from investors. Even here. It becomes easier for the investor to find out the extent of under performance or out performance of the specific fund in relation to bench mark index. Any difference between fund returns and the market return s is tracking error.

21% in April 2003. no communication indicating the prob able date of the dividend declaration should be made. SEBI has plac ed the responsibilities on Trustees of mutual fund that they should declare that the NFO is new in terms of its investment objective and does not in any way rep licate the existing funds of the mutual fund. But with the new regulation. Before the issuance of notice. Investors seem to prefer mutual funds compared to other investment vehicles – that is obvious from the fact that total assets under management of mutual funds hav years. 140 Investment Planning PDP ¡ . In another amendment. open -ended schemes were also allowed to amortize the expenses and if a significant p art of the investors of an NFO redeemed their units. SEBI has stipulated that a mutual fund may come out with NFO’s only if the new fund ha s something new to offer to the investors and the investment objectives are uniq ue and different from the funds already managed by the fund house.the scheme before such amortization is complete. It is expected to maintain the growth rate in future. SEBI has stated that the notice of dividend should be issued by the AMC within one day of the decision by the trustees to distribute the dividend. A look at the following figures will prove the popularity of mu tual funds in India. Mutual fund industry has recorded tremendous growth over the last few years. that will no longer be the case and the expenses will be rightfully borne by the person who is supposed to pay them. It has been observed over years that New fund offers manage to collect substantial subscription during the NFO period while existing funds with very good track record do not manage to co llect additional investments at the same rate. the remaining part of the expen ses attributable to him must be recovered from him. Among other guidelines related to the communication of dividend d istribution. which is done through gradua lly reducing exit loads. Hence fund houses have developed tendencies to come out with NFO’s to boost the Assets Under Management (AUM). Investors are willing to tak e gone up by a whopping 225% over a period 3 e more risk for the sake of higher returns as evidenced from the fact that equit y funds account for 31% of total AUM of mutual funds as on 31st July 2006 compar ed to just 11. this had the potential to i ncrease the burden of the initial issue expenses upon the remaining investors tr emendously. SEBI has standardized the process of declaring and distribut ing dividends. This is a positive move and will prevent the likelihood of shifting the burden of expenses from one investor to another. Till now. the record date for such dividend should be 5 days from the issuance of the notice. Further.

Mutual fun d can invest in foreign equities d. Variance c. 9779. not exceeding 6% of funds collected . 10. Open ended equity funds c.098 units d. Exchange Tr aded Funds. Mutual fund can lend money to unit holders 6 . 1 lakh in a New Fund offer of an equity fund. SEBI b. Debt Funds b.000 units b. Index Fund c. Wh ich one among following funds can be considered riskier than the others? a. Mutual fund can trade in derivatives c.Review Questions: 1. 9779 units 2. AMFI c. T he risk measure used for calculating Treynor Index is: a. Open ended debt funds d.951 units c. Directors of Sponsor Company c. Chaturvedi if he inv ests Rs. 9756. which charges entry load of 2. Standard Deviation 3. in the following cases only: a. While seeking SEBI approval for new funds which of the following is required t o give a declaration that the new fund is unique in its investment objectives? a . Trustees 7. Company Law Board 4. PDP Investment Planning 141 .25%? a. Sector specific equity fund 5 . RBI d. Which of the following is a self regulatory organiz ation in mutual fund industry? a. Mutua l fund can lend securities b. Initial issue expenses. Which one of the following statements is not true about mutual funds? a. Regis trars d. Clos e ended funds b. Diversified equity fund d. Alpha b. B eta d. Directors of Asset Management Company b. How many units will be allotted to Mr. can be amortized in the subsequent years.

Absolute returns in comparison with bank deposits d. Asset man agement. 7. 10. b c b d d d a c b a 142 Investment Planning PDP . 6. In respect of a “No load fund” which one of the statements is not true? a. In respect of index funds the difference between fund performance and the market performance is called: a. Tracking error d.8. 2. Absolute returns in comparison with risk free returns 10. 5. Risk adjusted performance c. Under performance of the fund b. Which of the following is the best measure of a fund performance? a. 3. “No load” funds are permitted to charge higher fund management expense s compared to “Load funds” d. Out performance of t he fund c. 4. custodial. Superior returns over market returns 9. NAV related performance over the period b. 9. No load refers to the entry load at the time of NFO – th e units are allotted at par to the NFO unit holders Answers: 1. registrar and administrative and selling expenses are not ch arged to the fund b. 8. Asset management and other recurring expenses are charged t o the fund c.

Chapter 11 PDP Investment Planning 143 .

The price band essentially consist of two prices the floor price and the cap p rice. ‘Retail individual investor’ means an 144 Investment Planning PDP . esp ecially before the book building concept was introduced in India but now we find more and more companies adopting the book building route to raise capital. and discussed in this chapter elsewhere. The bidder can make three bids in the prescribed application form and can also revise or withdraw his bid befo re the close of the offer. Where the issue size is large companies prefer to appoint more than one merc hant banker for this purpose – with specific functions. An existing listed company may come out with a subsequent issue to ra ise capital and such an issue is called “Follow on Public Offering (FPO) Fixed pri ce issues: These are issues where a company enters the capital market and invite s subscription from the public to its issue of equity capital at a fixed price – a t par or at a premium. In order to present a level playing field for the sm all investors SEBI has stipulated that a certain minimum percentage of the issue d shares should be reserved for allotment to “Retail Individual Investors” in case o f over subscription of the issue. Eligibility criteria have been laid down by SEBI – the capital market regula tor. The company may be entering the capital market for the first time where upon its shares are to be listed on the stock exchanges – such an issue is called Initial Public Offer ing (IPO). Mutual f unds. Body Corporate. timing and other issues which are of vital importan ce. Book building issues: Here the companies announce a price band for the issue and the investors can exercise their options in the application and bid for the same at whatever price they are prepared to pay for the issue – but within the price band . Banks and Financial Institutions. of course within a band. compliance with statues. The difference between the two cannot be more than 20%. pricing. marketing. As per the advice of the m erchant banker a company may choose to issue shares with fixed price or a price band where the price will be discovered in a book building process. HUF’s. Primary market Certain eligible companies may tap the capital market for their capital requirem ents. Fixed price issues was the norm until some years ago. The eligible companies who need fu nds approach SEBI registered Merchant Bankers for tapping the capital market. In a client’s portfolio t he equity investments – direct and indirect form an essential component. Insurance Companies. Individuals in single or joint names. Non Resident Indians. Th e merchant bankers advise the company on matters of regulation.Stock market investments O ne of the most important asset classes is equity shares. In case of an FPO the listed company can announce the price band just a day before the issue opens for subscription while in the case of IPO’s the price bands are mentioned in the application form itself. We have d iscussed indirect equity investments through the mutual fund route. The reservation for retail individual investor s is 35% of the net public offer and in the event of the issue getting oversubsc ribed it should be ensured that at least 35% of the shares are allotted to retai l individual investors. Essentiall y a person applying for a book building offer of shares shall bid in multiples o f prescribed lot sizes and within the price band. An investor has the choice between prim ary and secondary markets to invest in stocks. Venture capital funds and other s can apply for the issues. The bid lots are also decided by the issuer. We shall now deal with direct investments in shares. Here the investor has the freedom to decide the price at which he shall be interested.

It is also true that issuers price the issue in such a way that they “l eave something on the table” for the IPO investors.00. After t he book is closed the price of the issue is discovered. But it is not the case all the time. Decisions based purely on information provided in the offer docume nt (the prospectus) can prove to be tricky when the pricing is free. the rights can be renounced by an existing share holder. Many broking houses have provided facilities for applying to an IPO/FPO through the internet. Hence investors should study the offer documents carefully. extent of subscription in relation to the issue size (over subscription or under subsc ription levels) etc. Rights issues shall be kept open for at lea st 30 days and not more than 60 days – “rights” issues are issues of companies to rais e further capital but only existing share holders of the company are entitled to apply for the same. Even if a person has bid at prices high er than discovered price the person will be allotted at discovered price only an d not at the highest bid price. The shares can be allotted at discounts in relatio n to the discovered price for the retail individual investors – some public sector companies which came out with issues offered shares to retail individual invest ors at discount to the discovered price.1. at the cap price. In case of book built issues. in which case the renouncee gets the right to apply for the shares. the reservation is 15% and the reservation for qualified institutional bidders (QIB) the reservation is 50%. In c ase of Book built issues. Subscription list for public issues shall be kept open for at least 3 working days and not more than 10 working days. The re gistrar then ensures that the demat credit or refund as applicable is completed within 15 days of the closure of the issue. These investors believe that this process is less risky. In case of fixed price issues. the minimum and maximum period for which bidding will be open is 3–7 working days extendable by 3 days in case of a revision in the pric e band. applications can be made online als o. book building is a transparent process an d while the book is open it is easy for the potential investor to know the detai ls of bids already received. whereas that does not happen to be the ca se in IPO’s. the investor is i ntimated about the allotment/refund within 30 days of the closure of the issue. The listing on the stock exchanges i s done within 7 days from the finalization of the issue. the prices at which the bids have been made. of about 40%. Many times the extent of subscription already received and the quantum of institutional participation influence investor decisions. The public issue made by an infrastructure company may be kept open for a maximum period of 21 working days. in detail. The retail inv estor can tender his bids at the specified centres where his bids will be accept ed and registered in the book. while the bank pays the balance and puts in the application – thus leveraging is possible while applying to IPO/ FPO’s with attendant risks and cost s. Some investors traditionally have preferred to invest in stocks through the I PO/FPO route only.investor who applies or bids for securities of or for a value of not more than R s. PDP Investment Planning 145 . Banks offer to lend to the investor in select IPO’s in which case the investor pays only the margin money . Many times it is done at the cap price but some times it is even done at pri ces lower than the cap price. One of the important advantages is. then it is up to the company (in consultation with th e Book Running Lead Manager) to decide the price at which shares would be allott ed. who are not retail in vestors. If the issue is over sub scribed. It is less risky to invest in an existing listed company because price history and performa nce history can be studied. It i s a well established fact that IPO’s are more risky because the availability of in formation to the investing public compared to existing listed companies is much lower in IPO’s. the basis of allotment is finalized by the Book Ru nning lead Managers within 2 weeks from the date of closure of the issue. understand th e pricing and the future potential of the company very well before deciding to a pply in a public issue of shares.000 The allocation for non institutional investors.


Secondary market Client registration An investor can invest in shares through the secondary marke t. He can invest in a stock which is already listed in one of the stock exchange s. In India there are 23 stock exchanges but only two of them are most important viz. National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE). Invest ors who would like to buy or sell shares directly from the market will have to r egister themselves as clients with brokers or sub brokers. Brokers are members o f stock exchanges while sub brokers work under a specific broker – both should be SEBI registered Stock market intermediaries. It is mandatory for the market part icipant to get the full details of the client in a format prescribed by SEBI cal led KYC – Know Your Client. Personal information of the client is obtained in this specified format and proof of the supplied information like residence proof, pe rsonal identity proof, Income Tax PAN details, demat account and bank account de tails, etc. are taken along with duly filled KYC form. Then the client and broke r enter into an agreement – in the format prescribed by SEBI for this purpose. The reafter the client is registered with the market participant and allotted a uniq ue client ID. Now the client can trade on the stock exchange through the broker/ sub broker. Trading There are basically two trading mechanisms adopted by stock exchanges the world over to provide liquidity to investors. The two mechanisms a re: n n Quote Driven Mechanism of Trading & Order Driven Mechanism of Trading Quote Driven Mechanism is adopted by less liquid and emerging stock exchanges wh ere trading requires some stock brokers to provide two-way quotes. These liquidi ty providers, who trade on their own account, are called market makers or specia lists or jobbers (in India). This is a less efficient mechanism because the pric e spread between bid and offer tends to be high thanks to lower liquidity and le ss competition. This mechanism is generally adopted in stock exchanges where tra ding is done on the floor of the exchange on a face to face basis. In India this was the mechanism adopted by BSE for more than a century before moving over to the more efficient Order Driven Mechanism of trading in line with newer National Stock Exchange. In India, now on both NSE and BSE we follow the Order Driven Me chanism of trading where the trader places his order through his broker’s trading terminal. The trader is also allowed to trade on the internet and he can place h is orders on a particular stock exchange through the internet by special trading facilities provided by the stock broker. The order placed by the registered cli ent is accepted first by the broker - the acceptance is subject to the order mee ting certain requirements in terms of trading limits set for the client (based o n the margin lying with the broker), etc. Then the order goes into the trading s ystem of the stock exchange and gets stacked on a time price priority basis. It is mandatory that the order entered in the system is clearly identifiable to the specific client through the usage of unique client ID. The order will get execu ted if the price condition, if any, specified by the trader, is met. Types of orders Market order – the trader decides to buy or sell a particular scrip at the current market price; he can place a market price order; such orders get executed insta ntly at prices close to the last traded price – but it is difficult to estimate th e price at which the order will be executed, as the price keeps changing very fa st with time. 146 Investment Planning PDP

Limit Order – The trader would place a buy order at a price lower than the last tr aded price or a sale order at a price higher than the last traded price for a pa rticular stock. Stop Loss Order – This type of order enables the trader to limit h is loss or protect his profits. This order enters the system on a trade being ex ecuted at a particular price, called trigger price. The trigger price should be higher than current market price for buying orders and lower than market price f or selling orders. Technical traders and day traders use Stop Loss Order facilit y more frequently. Disclosed Quantity – There is a facility in the trading system that while placing an order for sale or purchase the quantity disclosed in the t rading system could be lower than the actual size of the order – the maximum possi ble reduction in this type of stipulation is 90% - In other words, if somebody w ants to buy 1000 shares of a scrip he can use DQ facility and specify that quant ity that should be shown in the system – but the specified quantity in this case s hould be 100 shares or more - which is 10% or more of the actual order size. All the orders placed in the system are day orders – valid for the day and all pendin g orders get automatically cancelled at the end of the day. An order once placed in the system can be modified or cancelled any time before execution. Modificat ion in factors like quantity, price, etc. are permitted but client code modifica tions are not allowed – an order with a wrong client code will have to be cancelle d. Risk management Brokers are required to have Base Minimum Capital (BMC) with the respective stock exchanges. Brokers also bring in additional capital over an d above the BMC in the form of cash, bank fixed deposits and/or securities. The brokers are set intra day trading limits, called Gross Exposure (GE) based on th e total margin money lying with the stock exchanges. The extent of trading a bro ker can do is a function of his capital – thus restricting over trading and over e xposures – as the first containment measure. Similarly, the net exposure of any br oker, at any point in time is also limited to a certain times his capital. The b rokers also take margin money from active clients along the same principles of r estricting exposures beyond certain times the margin thus controlling the specul ation and reducing the risk. SEBI has laid down mandatory rules for brokers to c ollect margins from clients who trade in volumes beyond some minimum limits – curr ently collection of client margins is compulsory if a client at any point in tim e has net outstanding positions in excess of Rs 5 lacs (unless the same is to re sult in delivery) and the margin should be at least 10% of net outstanding posit ion. Stock exchanges also collect VaR and M2M margins on the outstanding positio ns – VaR – value at risk and M2M – mark to market margins. The extent of margins may v ary and generally tends to increase as the market gets more and more volatile. P ay in and pay out, settlements, etc. Both NSE and BSE follow rolling settlement system as against fixed period settlements which were followed earlier. Each day’s obligations are settled independently and not clubbed with any other day’s positi ons to arrive at settlement’s net obligations for each broker. It is a matter of c ompliance of SEBI regulation that a broker issues confirmation of day’s trades to a client in a specified format. This contract note should carry the trade detail s like Order Number, Trade Number, Trade Time, Scrip Name, whether bought or sol d, the quantity, Market rate, brokerage, net rate along with all details of the client, his code number, address, PAN number, settlements details, etc. It is al so mandatory that the broker should issue contract note to the client within 24 hours of the end of day of trade and should obtain client’s confirmation on the du plicate copy. Brokers may send contracts by post or through courier but should m aintain proof that the same were dispatched within the stipulated PDP Investment Planning 147

time. Electronic mailing of contracts shall also serve the purpose but the same also should be done within the time limit of 24 hours. Brokers collect the payme nts from clients who might have bought shares (pay in obligations) and credit th e same in Brokers’ account exclusive marked for client transactions. Brokers use t he funds in the clients accounts to meet Pay in obligations to the stock exchang e through another account called Clearing Account. The funds pay in is done befo re specified hours on T+2 basis – that is within two working days, before stipulat ed hours, after trading day (T). Similarly securities pay in for shares sold by clients is also required to be made before a specified time on T+2 basis – through the pool account of the broker maintained for meeting clearing obligations. Thu s funds pay in and securities pay in take place on T+2 basis but in the early pa rt of the day. Pay out of funds and securities are made on T+2 basis and the fun ds and securities are credited to brokers’ accounts at the later half of 2nd worki ng day after the trade day. It may be worthwhile to know that a broker is requir ed to make payments to a client who might have sold shares within 48 hours of pa y out day – in other words the trade takes place on trade day (T), broker receives payments/deliveries 2 days later (T+2) and client should receive payments/deliv eries within 48 hours of T+2. It is important for a stock market investor to kno w his duties to the brokers like placing order specifically, keeping cash margin s with brokers while trading beyond certain limits, making payments/delivering s ecurities with in the prescribed time limit and also his rights to receive contr acts, payments/securities within the SEBI stipulated time frame. We may add here that each stock exchange has provided means by which a client can verify the tr ade on the same day from the web site of the stock exchange concerned. www.bsein and A broker can not charge brokerage in excess of 2.5 % of the market price of stock bought or sold. A broker may charge all other cha rges over and above the brokerage. These charges include Service Tax on brokerag e which is currently 12.36% (including education cess of 3%), Regulatory charges , Stamp duty & Securities Transaction Tax. STT is currently 0.125% of turn over on delivery based trades; 0.025% of turn over of all non delivery trades in the cash segment and 0.017% of turn over of all non delivery trades in the derivativ es segment. Corporate benefits Companies declare book closure or record dates fo r determining eligibility for corporate benefits like dividend, bonus, rights en titlements, stock splits, etc. On the stock exchanges the stocks remain cum divi dend, cum bonus or cum rights up to a certain date and all investors who buy the particular stock on or before this specific date will be entitled to that corpo rate benefit. The next day onwards the stock starts quoting ex dividend, ex bonu s or ex rights – meaning investors who buy after these dates will not get the resp ective corporate benefit; alternatively if a share holder of the company sells t he stock cum benefit he won’t be entitled to it but if sells ex benefit he shall g et the benefit. The stock for some time on the exchanges may trade on “no delivery” basis – all trades entered during the no delivery period are clubbed and settled, on a particular day, after the end of no delivery period. In other words, the pa y in and pay out of funds and securities in respect of this particular stock whi ch is trading on a no delivery basis is delayed to the extent of no delivery per iod and settled together, at a later date. Types of securities Equity shares – the most common form of securities ; (the conventional stock or co mmon stock or 148 Investment Planning PDP

ordinary share) is the equity share issued by a company and the investors in equ ity shares are owners of the company to the extent of their share holding. These share holders are entitled to dividend and other benefits declared by the compa ny and are also entitled to vote. Companies may issue shares without voting righ ts also. Normally the shares traded are fully paid up but in certain cases partl y paid shares are also listed and traded on the stock exchanges. Convertible deb entures: A company may choose to issue debentures which could be converted partl y or fully into equity shares at a later date. These securities are also listed and traded on the stock exchanges. Warrants are essentially issued to share hold ers and the holder of the warrant will be able to exercise his right to purchase shares of the company at a future date. Till the prescribed date for exercising the rights to additional shares these warrants are also traded on the stock exc hanges. Preference shares can also be issued by a company. This is a not a popul ar instrument with the stock market investors because this is essentially a fixe d income instrument with no scope for capital appreciation. Bonus Shares: Compan ies reward the share holder by issuing bonus shares. Bonus shares are free share s distributed by the company to its share holders, as on a given date, in a prop ortion which is decided by the board and approved by the share holders and subje ct to certain limits, as prescribed by SEBI in this regard. A 1:1 bonus implies that a share holder having 100 shares will get another 100 shares free of cost ; similarly a 2:3 bonus implies that a share holder having 3 shares will get 2 bo nus shares. As a point of valuation a bonus per se does not add value to share h olders because the price of the stock adjusts for the bonus shares after the sam e are issued. However, a bonus declaration is a signal, to the market, from the company management that they are very confident about their future performance a nd that they will be able to service the expanded capital. In the market place i t is common to find that companies that reward the share holders with frequent b onuses get better valuations compared to similar but conservative companies. Rig hts Shares – Issue of additional shares to existing share holders to raise capital is called Rights Issue. The difference is that compared to bonus shares which a re issued free here the share holder has to pay a price for getting additional s hares – the price could be market related and may be at a discount to the market p rice of the stock. If the company issues rights shares to raise money for expans ion/modernization/new acquisitions, etc then that is considered quite positive. It may be worth while to understand how the market price gets adjusted for right s issues when trading on cum right and ex right basis. Example Let’s assume the cu m rights price to be Rs. 200 Rights in the ratio of 1:2 at a price of Rs. 110 Th e ex rights price will be calculated as under: 1:2 means one share will be offer ed on two shares already held Two shares cum rights will cost 2*200 = 400 ; no o f cum right shares 2 One rights share will cost = 110 ; no of right shares 1 Tot al cost =510; no of ex right shares 3 The price per share ex rights = 510/3 = 17 0/Thus the stock will start quoting at an ex right price of Rs 170 if it closed at cum right price of Rs. 200/on the above terms. PDP Investment Planning 149

This is con sidered an investor friendly move and such companies command better valuations o n the market.15)]+ [150(1+0. Investors would like to buy “under-valued” st ocks and sell ‘over-valued’ stocks held by them.a. 4 or Rs.Stock splits: Normally the nominal value or the face value of a share is Rs. 5 or Rs. 10/ .and the company announces a stock split of 5:1.but a company may choose to have the face value as Rs.15 then P0 = [2.15) + (150/1. 150 and needs a return of 15% p. Companies with low floating stock and/or companies whose shares are h ighly priced and not traded in huge volumes on the stock exchange may consider r educing the face value and increasing the number of shares.and the m arket price will come down ex split to one fifth of cum split price.15) = 2. P0 = current price of the equity share D1 = dividend expected a year henc e P1 = price of the share expected a year hence r = rate of the return required on the equity share the underlying assumptions are the dividend of D1 will be pa id at the end of the year and the share can be sold after one year at a price P1 Example If an investor expects to receive a dividend of 2. Let us look at a few of them. on his share investment at what price should he buy this share? here D1 = 2. Dividend discount model One of the widely followed valuation models is the dividend discount model. Many methods are followed for valuing shares.5.5(1+0. The stock splits doe s not necessarily result in value addition to the investor but all the same it i mproves the liquidity and invariably leads to better prices on the market place. Let us begin with the case where the investor expects to hold the equity share for one year. Valuation of shares It is very important to understand how the sha res are valued on the stock exchanges. Where.60 150 Investment Planning PDP .173 +130. The price of the equity share will be. To lab el a stock at a price as under-valued or over-valued requires an understanding o f valuation of shares. P1 is 150 and r = 0. 2 or even Re 1.43 = 132. 2/. then the number of stocks held by the investor will rise 5 fold to 500 while the face value will come down to Rs.5/1. It is easier said than done. According to this model the present value of the share will be equal to the present value of the dividend and the expecte d sale price of the stock.50 per share and year end price to be Rs. If a share holder is holding 100 shares of a company – FV Rs 10/.15)] = ( 1.

over the last few years. P0. At what price should we buy the stock? We may add here that D1 is the expected dividend for the next year. becomes P0 (1+g) a year hence.per share and if the g rowth rate is PDP Investment Planning 151 . we can factor in these growth rates in our calculation of share value: If the curr ent price. we can extend the same to mu lti periods where the present value of each year’s dividend will be discounted at the required rate of return and so will be the sale price at the end of the peri od.a. given the cu rrent year’s dividend one can work out the next year’s expected dividend by applying the rate of growth of dividends as follows: D1 = D0*(1+g) Example If a company has been currently paying dividend at the rate of Rs. 2/. 2/. for g the rate of growth.We have considered for a single period of one year. Stock prices and dividends have a tendency to grow over a period of r share. The expected return is 16%. The next year’s dividend is expected to be Rs. we get: Simplifying the above equation we get: The steps in simplification are: Example The dividend paid out by a company has been growing at the rate of 10% p .

The required rate of return on securities including stock as the interest rates rise. market price trends for the product. (1-b) is the d ividend pay out ratio. orders on hand.10) = 2. Riskier stocks have lower P/E multiples.20 However. This is typically true in the ma rket place of mid cap and small cap stocks. statements regarding fu ture out look. The relation between interest rates and P/E ratios is inver se. Thus the P/E multiple of a stock price is directly propor tional to the dividends distributed by the company. Another factor that influenc es the P/E ratio is the interest rate. these are high risk stocks and tend to trade at lower P/E multiples compared to large cap stocks because the return expectations from mid cap and small cap stocks are higher. P0 = E1 * (P0/E1) Where P0 is the estimated price E1 is the estimated EP S & P0/E1 is the reasonable P/E ratio The P/E ratio can be worked out as follows on the basis of dividend discounting model: where b is the plough back ratio or the proportion of retained profits out of to tal profits.10% and expected return is 15% what should be present price of the share? D1 = D 0*g = 2*(1. Estimate the EPS for the cu rrent financial year based on company’s past track record. r the required rate of return and g the growth rate. 152 Investment Planning PDP . this constant growth model is rarely used in the market place for valui ng the stocks mainly because it is very difficult to estimate the growth rate an d that too in perpetuity. on a periodic basis because of the numerous elements involved. P/E multiplier is a v ery common tool used for value purposes and we can summarise how the price proje ctions are done for stock valuations. Riskier a stock the higher the retu rns expectations and hence lower the P/E ratio. This is a very highly skilled job and many researchers keep on estimating and revising. Price to earnin gs ratio is calculated as follows: P/E ratio = Market Price /EPS Where EPS is = Profit After Tax/No. as follows: 1. etc. Earnings Multiplier Approach Another and more popular approach to stock valuation is the earnings multiplier approach. of shares Market Price/PE ratio is the P/E multiple for the stock. reported pro fits for the completed quarters. When the interest rate rises securi ty prices will fall.

an estimate of its intrinsic value can be determined. In effect. Banks have often been evaluated using this ratio because the assets of banks have book values and mark et values that are similar. or EVA. the company is adding value. The price/sales ratio is a valuation technique that has received in creased attention recently. By asse ssing these fundamental determinants of the value of a security. 4. It is also used in merger and acquisiti on analysis. 5. particularly financial companies. based on fundamental analysis concepts . Other Valuation Techniques Investors use other valuation techniques. the market price is equal to the accounting (book) value.a . EVA is the difference between operating profits and a company’s true cost of capit al for both debt and equity and reflects an emphasis on return on capital. 3. One recom mendation for investors interested in this approach is to search for companies w ith a return of capital in excess of twenty percent because this will in all lik elihood exceed the cost of capital. a P/E ratio of 20 is reasonable Multiply the P/E multiple arrived in step 5 by earnings estimated in step 1 to arrive at the projected price for the stock at the end of the year. the company has added value. Find out the growth rate of earnings – based on track record and other factors lis ted above Find out the average P/E ratio of other comparable companies in the in dustry Find out the historic P/E ratio at which this stock has been quoting Arri ve at a reasonable multiple for this stock based on the industry average and thi s stock’s own P/E in the past. which combine to produce an expected return and an accompanying risk. n An investor can reach his decision on buying/holding/sell ing the stock based on the following factors: n Current market price n Required return 6. price/sales r atio and economic value added. worked out in step 2 above – if the EPS grows at 20% p. the traditional variable of importance.2. The newest technique for evaluating stocks is to calculate the economic value added. some mutual funds are now using EVA a nalysis as the primary tool for selecting stocks for the fund to hold. therefore. It is sometimes u sed to value companies. If th is difference is positive. The valuations are much more complex than as listed above becau se the crucial factors of earnings projections and the multiples are influenced by various events some of which could be emotional rather than rational. one of the thumb rules for a reasonable P/E ratio i s the growth rate of EPS. as worked out above If the estimated m arket price is greater than or equal to (Current market price*required return) t hen it is worth buying the stock . Some studies have shown that stock price is more responsive to changes to EVA than to changes in earning s. and. If the value of this ratio is 1.0. n Estimated market price at the year end. but if it is estimated to be less then buying can be avoided. or the true value as es timated by an investor. Three that are fairly often referred to are price to book value. In effect. Price to book value is calculated as the ratio of price to stockholders’ equity as measured on the balance sheet. it indicates what the market is willing to pay for a firm’s revenues. PDP Investment Planning 153 . This value is a function of the firm’s underlying variable s. This ratio is calculated as a company’s total market v alue (price times number of shares) divided by it sales. Fundamental Analysis Fundamental analysis is based on the premise that any secu rity (and the market as a whole) has an intrinsic value.

Considerable time and effort are required to produce the type of detailed financial analysis needed to understand even relatively small c ompanies. In many cases bottom-up investing d oes not attempt to make a clear distinction between growth and value. By asses sing these fundamental determinants of the value of a security. Similar to the decision r ules used for bonds. To organize this e ffort. This estimated intrinsic value can then be compared to the current market price of the security. the current m arket price of a security reflects the average of the intrinsic value estimates made by investors. In equilibrium. Investors who can perform good fun damental analysis and spot discrepancies should be able to profit by acting. Growth stocks and value stocks tend to be in vogue over different periods. In equilibrium. o r both. or both. An investor whose intrinsic value estimate differs from the m arket price is. decision rules ar e employed for common stocks when fundamental analysis is used to calculate intr insic value. in effect. Value stocks. feature cheap assets and strong balance sheets. Value investing can be traced back to the value-investing principles laid out b y the well-known Benjamin Graham. Fundamental analysis is based on the premise that any secur ity (and the market as a whole) has an intrinsic value. With the “bottom-up” approach. or fundamentals.This estimated intrinsic value can then be compared to the current market price of the security. in effect. or should the reverse proc edure be followed? In fact. the current market price of a security reflects the average of the intrinsic value estimates made by investors. on the other hand. Analysis of such inf ormation as the company’s products. An investor whose i ntrinsic value estimate differs from the market price is. decision rules are employed for common stocks when fundamen tal analysis is used to calculate intrinsic value. differing w ith the market consensus as to the estimate of either expected return or risk. Many compa nies feature strong earnings prospects and a strong financial base or asset valu e. Under either of the t wo fundamental approaches. and. differing with the market consensus as to the estimat e of either expected return or risk. ultimately. and the advocates of each camp prosper and suffer accordingly. Does this mean that the investor should plunge into a study of company da ta first and then consider other factors such as the industry within which a par ticular company operates or the state of the economy. This value is a function of the firm’s underlying variables . who wrote a famous book on security analysis t hat has been the foundation for many subsequent security analysts. Similar to the decision rules used for bonds. each of these approaches is used by investors and se curity analysts when doing fundamental analysis. it s value in the market. Investors expect these stocks to perform well in t he future. in estors focus directly on a company’s basics. bef ore the market consensus reflects the correct information. These approaches are referred t o as the “topdown” approach and the “bottom-up” approach. growt h investing and value investing. 154 Investment Planning PDP . or the true value as est imated by an investor. an investor will have to work with individual company data. its competitive position. which combine to produce an expected return and an accompanying risk. before the market consensus reflects the correct information. bottom-up fundamental research is often broken into two categories. and its financial st atus leads to an estimate of the company’s earnings potential. The emphasis in this approach is on finding companies with good long-t erm growth prospects. and they are willing to pay high multiples for this expected growth. and making accurate earnings estimates. an estimate of i ts intrinsic value can be determined. Investors who can perform good fundamental analysis and spot discrepanci es should be able to profit by acting. Growth stocks carry investor expectations of ab ove-average future growth in earnings and aboveaverage valuations as a result of high price/ earnings ratios.

The following p oints summarize technical analysis: Technical analysis is based on published mar ket data and focuses on internal factors by analyzing movements in the aggregate market. individ ual companies are analyzed. They next consider likely industry prospects. Tech nical analysts believe that stock prices show identifiable trends that can be ex ploited by investors.for it is an art . shares of a stock or the entire market. As the stock adjusts from its old equilibrium level to its new lev el. There is no “right” answer to which of these two approac hes to follow. the price tends to move in a trend. considering such important factors as interest rat es and inflation. and having d etermined which parts of the overall economy are likely to perform well. monetary. technical analysts believe that the market itself is its own best source of data. The top-down approach is the opposite to the bottom-up approach. and momentum. In contrast.and therefore have characteristics associated with both categories. The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of inv estors toward a variety of economic. Fina lly. Technicians believe that the forces of supply and demand result in partic ular patterns of price behavior. Technicians attempt to assess the overall situation conc erning stocks by analyzing breadth to identify trend chang es at an early stage and to maintain an investment posture until the weight of t he evidence indicates that the trend is reversed. Thus. political and psychological force s. industry average. because it utilizes the record of the mark et itself to attempt to assess the demand for. and an investor should decide which approach seems more reasonable and try to de velop a consistent method of action. Technical analysis is sometime s called market or internal analysis. The central concern is not why the chang e is taking place. The f ocus of technical analysis is identifying changes in the direction of stock pric es which tend to move in trends as the stock price adjusts to a new equilibrium level. fundamental analysis can be overwhelming in its detail. The emphasis is o n likely price changes. or stock. Using a chart. and changes in trends detected. market sentiment. They seek to identify changes in the direction of a stock and take a position in the stock to take advantage of the trend. and supply of. These trends can be analyzed. having decided that macro factors are favourable to investing. T echnical analysis includes the use of graphs (charts) and technical trading rule s and indicators. The art of technical analysis . However. which are external to the market itself. and the chart is the most important mechanism for displaying this inform ation. the technician hopes to identify trends and patterns in stock prices that provide trading signals. Technical analysis Technical analysis can b e defined as the use of specific market-generated data for the analysis of both aggregate stock prices (market indices or industry averages) and individual stoc ks. but rather the very fact that it is taking place at all. or sectors of th e economy that are likely to do particularly well (or particularly poorly). Technicians believe that the process by which pric es adjust to new information is one of a gradual adjustment toward a new (equili brium) price. fundamental analysis focuses o n economic and political factors. the most important of which is the trend or ove rall direction in price. PDP Investment Planning 155 . Price and volume are the primary tools of the pure technical a nalyst. by studying the action of price movements and trading volume across time. Investors begin with the ec onomy and the overall market.

In re spect of securities listed and traded on the stock exchanges the holding period is 12 months for determining whether the security is a long term capital asset o r otherwise. The evidence seems to suggest that rising (falling. would be taken as a bearish sign. currently 12. from financial year 2008-09 in respect of securities which are traded on the e xchanges and where Securities Transaction Tax has been levied on the transaction s.Volume data are used to gauge the general condition in the market and to help as sess its trend. LTCG : Long term capital gains are tax exempt u/s 10(38). The income earned is taxed at the rate applicable – say 30 % if the annual income is in excess of Rs.50. 156 Investment Planning PDP . 2. A downside movement from some pattern or holding point. Capital gains on shares can be classified as Short Term Capital Gains and Long Term Capital Gains. held for more than 12 months. If stock prices rose but volume activity did not keep pace.) stock price s are usually associated with rising.f . technicians would be skeptical about the upw ard trend. DDT is an in direct tax on the dividend income of the share holders. accompanied by heavy vol ume. Dividends of Indian companies are tax free in the hands of share holders. STCG is taxed at the rate of 10% & @ 15% w. Taxation Income derived from equity shares comprises dividends and capital appreciation.000/STCG: If a stock has been so ld within 12 months of purchase the difference between selling and buying prices will be short term capital gain. where the asset sol d is a long term capital asset. The co mpanies declaring dividends are required to pay Dividend Distribution Tax at rat es prescribed from time to time.e. An upward surge on contracting volume would be particularly suspect. (falling) volume. and sold on a stoc k exchange where STT has been levied on the transaction.5% + Surcharge of 5%. Day trading: A trader may buy and sell the shares on the same day w ithout receiving or giving delivery of shares. These transactions are considered speculative in nature.

Quote driven mechanism of trading b.cum rights.00 2. 62. Jobber oriented mechanism of trading 5.25 d. Orders pending at the end of the trading day are automatically cancelled b. 30 0 PDP Investment Planning 157 . A “Stop loss order” is generally used for a. A company paid dividend of Rs 2. The quantity that would be disclosed i n the system can be shown to be less than the true quantity of the order 4. 120 d. 65. Once an order is placed it is not possible to modify the client code d. protecting profits b. A company fixes record date for bonus and stock s plit simultaneously. technical reasons of support and/or res istance d. 80 d. Order driven mechanism of trading c. What will be the price ex rights if the company offers rights s hares in the ratio 1:2 at a price of Rs 70/ (assuming the market price is steady )? a. 67. all the three above 3.50 b.50 per share which is expec ted to grow at the rate of 8% p. 70. Orders once placed in the system can not be modified or cancelled c. Institution oriented mechanism of trading d.50 c.a. While trading on screen based trading systems which one of the following statements about “orders” is not true? a.100 b.Review Questions: 1. limiting losses c. If the bonus is in the ratio of 1:2 and the stocks to be sp lit from FV of Rs 10 to Rs 2 and if the cum bonus and cum split price was Rs 900 what should be the ex bonus and ex stock split price? a. The present mechanism of trading used in NSE and BSE is a. 70 6. If the expected rate of return is 12% what sh ould be current price of the stock according to the dividend discounting model? a. A stock is quoting at Rs 1 00/. 110 c. 90 c. 100 b.

Rs. 10% d. b d 4. 20% b. Interest rate has the following effect on share valuation: a. An investor received 10 bonus shares of an infotech company on 10th March 2005.7. The current market price is Rs. d b 3. No such limit Answers: 1. The stock may quo te at Rs. There is n o certainty that the growth rate will be maintained – the required return is very high – do not buy 9. 225 while the EPS for the last year was Rs. 3200 + education cess b. Which one of the following statements regarding market capitalization and P/E mu ltiples is true? a. 15% c. for a price of Rs. Is i t advisable to buy the stock if the required return is 18%? a. NIL – this is LTCG and hence no tax is payable 8. 158 a d 2. The rate of taxation will depend upon the tax slab at which the investor is being taxed on his total income d. A company is growing at an average rate of 20% on the top and bottom lines. Interest rate rise or fall has no impact on st ock prices c. 12. As mid cap stocks are riskier the P/E m ultiple tends to be lower as compared to large cap stocks c. Stock market has nothing to do with interest rates d. As Mid cap stocks are riskier the P/E multiple tends to be h igher as compared to large cap stocks b. 7. As the inter est rate rises the stock prices tend to fall 10. 240 after one year and hence do no buy b. on 10th May 2006. What will b e capital gains tax payable by the investor on the sale? a. As mid cap stocks a re less risky their P/E multiples tend to be lower as compared to large cap stoc ks d. b . 2 88 at a P/E of 20 on the next year’s EPS – given that the growth rate is 20% – hence b uy c. 8. The spread between floor price and cap price in respect of book built IPO’s should not exceed a. 6400 + education cess c. The stock may quote at Rs. Rs. 3200 each. As the interest ri ses the stock prices will rise b. As mid cap stocks are less risky their P/E multiples tend to be higher as compared to large cap stocks 11. The cost of acquisition is NIL being bonus shares. He sold the bonus shares thro ugh a member of NSE. It can not be predicted – the risks seem to be high – do not buy d. 9.

c 10. b Investment Planning 11. a PDP .5. b 6.

Chapter 12 PDP Investment Planning 159 .

I f the stock price of Tata Steel falls by Rs. Very often. For example. A derivative is a product whose value is derived f rom the value of an underlying asset. Let us take an example o f a simple derivative contract: n n n n Mr. Kulkarni buys a futures contract. the variables underlying the der ivative securities are the prices of traded securities. as the spot price – the price of the security in the futures segment could be different from cash market but it moves in line with the cash market price.g. Kulkarni will receive nothing.Derivatives erivatives have become very important in the field of investments. As we can see. of 100 shares lot size He will make a profit of Rs. futures trading is done on Sensex futures and Nifty futures. Similarly. It is also important to remember that derivatives are derived from an underlying asse t. Tat a Steel which frequently changes on a daily basis. if the sett lement price of a derivative is based on the stock price of a stock for e. Derivatives are used to shift risk and act as a form of ins urance. then the derivative risks are also changing on a daily basis. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. This means that risks in trading derivatives may change depending on what hap pens to the underlying asset. forex. 10 If the price is unchanged Mr. Derivatives and futures are basically of 3 types: n n n Forwards and Futures Options Swaps 160 Investment Planning PDP . 900. in market parlance. index or reference rate. We will try and understand n n n What are derivati ves? Why have derivatives at all? How are derivatives traded and used? D A derivative security can be defined as a security whose value depends on the va lues of other underlying variables. the above contract depends upon the price of the Tata Steel scrip in the cash market – referred to. The underlying securities in this case are the BSE Sensex and NSE Nifty. 9 he will lose Rs. 1000 if the price of Tata Stee l rises by Rs. commodity or any other asset. They are very important financial instruments for risk management as they allow risks to be s eparated and traded. The underlying as set can be equity. This means that derivative risks and positions must be monitored constantly.

Wha t Mr. Example Mr Patel is an importer who has to make a payment for his consignment in six months time. A stock index represents the change in value of a set of stocks. Kulkarni at the end of three months and Mr. He can only buy it 3 months hence. He. It represents 30 large well-establi shed and financially sound companies. which costs Rs. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six mon ths from now at a decided rate. No cash is exchanged when the contract is entered the car dealer on delivery. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. Sin ce for speculation. the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedg ed and the characteristics of the index. So in order to protect himself from the rise in prices Mr. 2.000/. trading in index futures has only commenced on the BSE Sensex. However. PDP Investment Planning 161 . he is not sure what the Re/$ rate will be then. Choosing and understanding the right in dex is important as the movement of stock index futures is quite similar to that of the underlying stock index. Kulkarni is doing is that he is locking the current price of a car for a f orward contract. it is necessary to understand the underl ying index. Volatility of the futures indexes is generally g reater than spot stock indexes. trading frequency etc.00. It represents 14 major industry groups. To understand the use and functi oning of the index derivatives markets. In or der to meet his payment obligation he has to buy dollars six months from today. however. Futures and stock indices For understanding of stock index futures a tho rough knowledge of the composition of indexes is essential. The Sensex represents a broad spectrum of companies in a variety of industries. whi ch constitute the index. As he is entering into a contract on a future da te it is a forward contract and the underlying security is the foreign currency. Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3.000. Example Mr. Kulkarni enters into a contract with the car dealer that 3 months from now he will buy the car for Rs. fears that prices of cars will rise 3 months from now. The Nifty index consists of sha res of 50 companies with each having a market capitalization of more than Rs 500 crore.0 00 but he has no cash to buy it outright. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivativ e instruments such as index futures.Forward contract A forward contract is the simplest mode of a derivative transac tion. The BSE Sensex has 30 st ocks comprising the index which are selected based on market capitalization. 1995. The forward contract is settled at maturity. Kulkarni wants to buy a car. ind ustry representation.00. The difference between a share and derivative is that shares/securities is an a sset while derivative instrument is a contract. The Sensex and Nifty In India the most popu lar indices have been the BSE Sensex and S&P CNX Nifty. Kulkarni in tur n will pay Rs. 2. 2. The dealer will de liver the car to Mr. Choosing the right i ndex is important in choosing the right contract for speculation or hedging. Th en there is a BSE national index and BSE 200. While the BSE Sensex was the first stock m arket index in the country. However.00.

Every time an investor takes a long or short position on a stock. Beta measures the relationship between movement of the index to the movement of the stock. the beta would be 1. The strategy of hedgi ng is resorted to with the objective of reducing portfolio beta to zero and redu cing the market risk.1. The beta measures the percentage impact on the stock pri ces for 1% change in the index. When the index i ncreases by 10%.40. the value of the portfolio increases 11%. We have index fu tures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months dura tion contracts are available at all times. The other benefit of trading in index futures is to hedge your portfolio agai nst the risk of trading. Example Futures contracts in Nifty in August 20 06 The settlement day is the last Thursday of the month or the previous working day if last Thursday happens to be a holiday. Index futures are all futures contracts where the unde rlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole. Stocks carry two types of risk – comp any specific and market risk.000 Hedging We have seen how one can take a view on the market with the help of index future s. Hedging involves protecting an existing equity portfolio f rom future adverse price movements in the stock market. Each contract expires on the last Thu rsday of the expiry month and simultaneously from the next day onwards a new con tract is introduced for trading. In order to hedge the po rtfolio. Beta is the measure of market risk. Index futures permits speculation and if a trader antici pates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. Company specific risk can be reduced through diver sification while market risk is reduced through hedging. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising. That is if you buy one Nifty contract. he also has an hidden exposure to the Nifty or Sensex. In order to understand how one can protect his portfoli o from value erosion let us take an example. 3. a market player needs to take an equal and opposite 162 Investment Planning PDP . the total de al value will be 100*3400 (Nifty futures price) = Rs. for a portfolio whose value goes down by 11% when the index goes down by 10%. The permitted lot size is 100 or mult iples thereof for the Nifty. Understanding index futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the f uture at a certain price. Retail investors will find the index derivatives useful due to the high correla tion of the index with their portfolio/stock and low cost associated with using index futures for hedging. Therefore.

2006 he buys 100 Nifty futures @ 3400 on expectations that the index will rise in futur e.position in the futures market to the one held in the cash market. we have seen how one can u se hedging in the futures market to offset losses in the cash market. market positions.2 * 20 lacs = 24 lacs wo rth of Nifty.46. one has to forego any gains that ari se out of improvement in the overall sentiment. that portfolio is completely insulated from any losses arising out of a fall in market sentiment. Every portfol io has a hidden exposure to the index. his portfolio value would increase. 3. Now let us study the impact on the overall gain/loss that accrues: As we see. Speculation Speculators are those who do not have any position on which they enter in future s and options market. you can factor a com plete hedge by selling Rs. The same meth odology can be applied to a single stock by deriving the beta of the scrip and t aking a reverse position in the futures market. Then why does one invest in equi ties if all the gains will be offset by losses in futures market. So instead of buying different stocks he buys Nifty Futures. com modity etc.40. Short sell the index in such a quantum that t he gain on a unit decrease in the index would offset the losses on the rest of h is portfolio. which is denoted by the beta. which has a beta of 1. it is safe to assume that it is 1.000 Investment Planning 163 . speculators put their money at risk in the hope of profiti ng from an anticipated price change. 2. But as a cost. They only have a particular view on the market. Therefore in the above scenario we have to short sell 1. Determine the beta of the portfolio. Assuming yo u have a portfolio of Rs. he fancies his chances in predicting the market trend. 6. On Sept 1. The idea is th at everyone expects his portfolio to outperform the market.2. Thus. stock. open interests. They consider various factors such as deman d supply. Steps in hedging 1. If the beta of any stock is not known.000 Net Gain PDP Rs. 3. 20 lacs. This is achieved by multiplying the relative volatility of the por tfolio by the market value of his holdings. Example Kirit is a trader but has no time to track and analyze stocks.2006 Nifty rises to 3460 and at that time he sells Nifty futures a nd squares his position. In short. However. economic fundamentals and other data to take their positions. On Sept 16.000 Less: Purchase Cost: 3400*100 = Rs. Selling Price : 3460*100 = Rs. Irrespective of whet her the market goes up or not. 24 lacs of S&P CNX Nifty futures.

164 Investment Planning PDP .000 by taking a call on the future value of the Nifty. If Nifty is quoting at R s. 6. Pricing of Index Futures The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.Kirit has made a profit of Rs. buying in one market and simultaneously selling in other market gives riskless profit. 3468 but is actually quoting at Rs. if Nifty had fallen he would have made a loss. The cost of carry model The costof-carry model where the price of the contract is defined as: F=S+C where: F Fut ures price S Spot price C Holding costs or carry costs If F < S+C or F > S+C. 3400 and the 3 months futures of Nifty is Rs 3500 then one can purchase Nifty at Rs. which is higher than the correc t price thus providing an arbitrageur an opportunity – he will sell 3 months futur es at 3500 and buy spot at 3400 and should make Rs 32 per Nifty because of the d ifference between the actual price and the “correct price:. Similarly. In index futures arbitrage is possible betwee n the spot market and the futures market (NSE has provided a special software fo r buying all 50 Nifty stocks in the spot market) n n n n Take the case of the NS E Nifty. Arbitrageurs are a lways in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and se lling at the higher priced market. When markets are imperfect. Assume that Nifty is at 3400 and 3 month’s Nifty futures is at 3500. If there is a difference then arbitrage opportunity exist s. If we assume 8% interest rate then Nifty three months futures should be quoting at Rs. 3500. Arbitrage An arbitrageur is basically risk averse. there would be chances for arbitrage. whenever the futures price moves away fro m the fair value. 3500.e. ar bitrage opportunities would exist i. These kind of imperfec tions continue to exist in the markets but one has to be alert to the opportunit ies as they tend to get exhausted very fast. if Ki rit had a bearish view on the market he could have sold Nifty futures and bought the same back after the expected market fall and made a profit from a falling m arket. The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. He enters into those contracts were he can earn riskless profits. 3400 in spot by borrowing @ 8% annum for 3 months and sell Nifty futures for 3 months at Rs. However.

12. borrowing the fund at the rate of 12% and simultaneousl y sell futures at Rs.33.Rs.03) Futures price = Rs. In this module we will see one can trade in index futures and use forward contracts in each of these in stances.500 (100*3350 ). 3. 12 = Rs. In the case of equity futures. An arbitrageur can b uy the stock at Rs. 2006. 100. Taking a view of the market If you are bullish on the market buy index futures If you are bearish on the market sell index futures Example Bullish On A ugust 13.12 – 0. the cost of finance has to be adjusted for benefits of dividends and interest income. On August 21 the Nifty futures have risen to 3362 so he squares off his posit ion at 3362 PDP Investment Planning 165 .Here F=3400+68=3468 and is less than prevailing futures price and hence there ar e chances of arbitrage. ‘X’ feels that the market will rise so he buys 100 Nifties with an e xpiry date of August 31 at an index price of 3350 costing Rs. However. 112 + Rs. 109 I f the actual futures price of one-year contract is Rs. At the end of the year. Trading strategies Speculation We have seen earlier that trading in index futures helps in taking a view of the market. 3 for dividends. the arbitrageur would collect Rs. 112. the holding cost is the cost of financing minus the dividend returns. Example Suppose a stock portfolio has a v alue of Rs. 100 and interest of Rs. deliver the stock portfolio at Rs 112 and repay the loan o f Rs. one has to remember that the components of holding cost vary with contr acts on different assets. 3 Thus. 100 and has an annual dividend yield of 3% which is earned throughou t the year and finance rate =12% the fair value of the stock index portfolio aft er one year will be F= Rs.Rs. 100 + Rs. Futures pricing in case of dividend yield We have seen how we have to consider the cost of finance to arrive at the futures index valu e. we can arrive at the fair value in the case of divide nd yield. hedging. 100 * (0. Sale Cost =3400 + 68 Arbitrage profit = 3500 = 3468 = 32 However. 112. 100 . speculation and arbitrage. 3 . The net profit would be Rs.

1200 (100*12) Bearish On August 13.e .500 (100*3350).000 Market to market profit = 50*100 = 5.45. 3. 2006. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing cor poration) due to potential changes in the underlying asset market price.40. Initial margin amount computed using VaR is collected up-front. The mark-to-market settlement is done in c ash. Initial margins 2. n n A client purcha ses 100 units of FUTIDX NIFTY 31 Aug 2006 at Rs.15 = 51750 Additional margin = 51750 -51000 = 750 166 Investment Planning PDP . 51. The actual margining happens on a daily basis while online position monitoring is d one on an intra-day basis. 3. The initial margin payabl e as calculated by VaR is 15%. The initial margin amoun t is large enough to cover a one-day loss that can be encountered on 99% of the days.000 (100*3400) Initial margin (15%) = Rs.800/In the above cases ‘X’ has profited from speculation i. ‘X’ feels that the m arket will fall so he sells 100 Nifties with an expiry date of August 31 at an i ndex price of 3350 costing Rs.000 Day end margin on open position = 3450 00*.000 Assuming that the contract will close on Day + 3 the mark-to-market position wil l look as follows: Nifty closed on Day 1 at 3450 Nifty closed on Day 2 at 3350 N ifty was sold on Day 3 at 3425 Position on Day 1 Close Price 3450*100 = 3. Daily margining is of two types: 1. he has wagered in the hope of profiting from an anticipated price change. Marg ins The margining system is based on the JR Verma Committee recommendations. Let us take a hypothetical trading activity of a client of a NSE futures di vision to demonstrate the margins payments that would occur. On August 21 the Nifty futur es have fallen to 3312 so he squares off his position at 3312. 3. X makes a profit of Rs.‘X’ makes a profit of Rs. (100*38) = Rs.33. Mark-to-market profit/loss The computation of initial margin on the futures m arket is done using the concept of Value-at-Risk (VaR). Total long position = Rs. The daily settlement pr ocess called “mark-to-market” provides for collection of losses that have already oc curred (historic losses) whereas initial margin seeks to safeguard against poten tial losses on outstanding positions. 3400.

250 End of day 2 = -8. options can be used for speculation and investors ca n create a wide range of potential profit scenarios. In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference betwe en the contract value and closing index value is paid.500 Which is 100*(3425-3400) = the lot size*(difference betwe en sale and purchase price of the index) Settlements All trades in the futures m arket are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market.750 Net profit on the whole deal: Initial margin out go = -51.500 End of day3 = 57. PDP Investment Planning 167 .Receivable by client = 5000 – 750 = 4250 New position on Day 2 Value of new positi on = 3350*100= 3. The initial buyer liquidates his long position by selling identica l futures contract.000 Amount payable by client = 10000-1500 {less m argin payable [51750-50250]} = 8500 Net position on Day 3 Profit on sale 342500 – 335000 = 7500 Release of margin = 50.750 Net profit = (-51000+42 50-8500+57750) = 2. Index futures and stock options are instruments that enable an investor to hedge his portfolio or open positions in the market.250 Margin at end of day1 = 51750 Mark to ma rket loss = 345000 – 335000 = 10.35.000 End of day 1 = 4. What are options? Some peop le remain puzzled by options. The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction i s squared up. The truth is that most people have been using opti ons for some time. Deriva tive products are structured precisely for this reason — to curtail the risk expos ure of an investor.250 Amount receivable by client = 7500+5025 0 = 57. because options are built into everything from mortgages to i nsurance. A part from risk containment.000 Margin = 50. Option contr acts allow an investor to run his profits while restricting his downside risk. Options The markets are v olatile and huge amount of money can be made or lost in very little time. The closing price of the index futures wil l be the daily settlement price and the position will be carried to the next day at the settlement price.

hence. the mo ney would be used to insure that you could.000/the premium p aid by him for having bought the call option. I f you decide not to use the option to buy the stock. If the price of your stock goe s up. and you are not obligated t o. If something happens whi ch causes the stock price to fall. In this way. 25*100 = Rs. once again. When you buy a Call option. the in surance company keeps your premium in return for taking on the risk. is a choice given to the investo r to either honour the contract. rent that property at the p rice agreed upon when you returned. If all goes well and the insurance is not needed. in fact. 50. n n n n n n He buys an Options Contr act September 2006 Nifty for a strike price of 3450 paying a premium of Rs. and then buy auto insurance on the car. 75 making a profit of Rs. The buyer receives a privilege for which he pays a prem ium. Thus. and. there are two kinds of options: Call Options and Put Options. If. the price you pay for it. “damages” your asset. you can exercise your option and sell it at its “insured” price level. your only cost is the premium. secures your right to buy that certain stock at a specified price called the strike price. or if he so chooses to walk away from the contr act. In this way. you would give up you r security deposit.” then you do not need to use the insurance. To begin. He is bullish on Nifty but he does not want to lose money if he i s turned wrong and if the market goes down. This is the primary function of listed op tions. your only cost is the option premium. ‘Option’. Mr. you can use your policy to regain the insured value of t he car. an option is a contr act between two parties. 5.An option is a contract. With a Put Option. and thus. as the word suggests. Technically. 50*100 = Rs. The seller accepts an obligation for which he receives a fee. Put options are l ike insurance policies If you buy a new car. and there is no “damage. A C all Option is an option to buy a stock at a specific price on or before a certai n date. but not the obligation to buy or sell shares of the underlying security at a specific price on or befo re a specific date. If you never returned. If he had not sold and if the Nifty had gon e up further he would have made even more profits. Put Options are options to sell a stock at a specific price on or before a certain date. the put option gains in value as the value of the underlyin g instrument decreases. Shah feels that the mark et will go up. called the option premium. you can “insure” a stock by fixing a selling price. The contract size being 100 he will make a profit of Rs. Call options are like security deposits. 25 per Nifty. protected if the car is damaged in an acc ident. you can see that the profit potential in a call option is unlimited while the loss is limited to the actual premium paid. 168 Investment Planning PDP . y ou wanted to rent a certain property. for example.500/-. and left a security deposit for it. you pay a premium and are. If this happens. If the Nifty were to fall his maximum loss would have been restricted to Rs. to allow investors ways to manage risk. which gives the buyer the right. but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises. In about 15 days time Nifty goes up and therefore he sells the option for Rs. Example Now l et us see how one can profit from buying an option. 2. In this way.

The following table will summarise the actions to be taken depending upon your view on the stock price: Summary PDP Investment Planning 169 . Sam pays a premium of Rs. To have this privilege.00 0 (Rs.Call Options-Long & Short Positions When you expect prices to rise. Put Options-Long & Short Positions When you e xpect prices to fall. then you take a short position by selling calls. You are bear ish. He has the potential to make high profits as there is a potential for the stock price to fall by any amount but in case the price of the share goes up. 5. 50 a share for 100 shares). then you tak e a long position by buying calls.premium paid by him for purchasing the right to sell (bu y a put option) The buyer of a put has purchased a right to sell. Put Option s A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. 50 (contract size 100 shares) This contract allows Sam to sell 100 shares Infosys T echnologies at Rs. Example: Mr. then you take a long position by buying Puts. You are bullish. You are bullish. Dutt purchases one contract of Infoysys Technologies Sep 2006 1800 Put —Premium Rs. He will make a profit if the share price of I nfosys Technologies falls during this period. The owner of a put option has the right to sell. When you expect prices to rise. When you expect prices to fa ll.000/. 1800 per share at any time between the current date and the e xpiry of Sep 2006 series. he will suffer a loss but the loss will be limited to Rs. You are bearish. 5. then you take a short position by selling P uts.

Example: ACC SEP 2006 900 ref ers to one series and trades take place at different premiums Concepts Important Terms Strike price: The Strike Price denotes the price at which the bu yer of the option has a right to purchase or sell the underlying.Option styles Settlement of options is based on the expiry date. An option “class” refers to all options of the same type (call or put) and style (American or European) that also have the same underlying. there are three basic styles of options you will encounter which affect settlement.410. Five different strike prices will be available at any point of time. we have the terms “class” and “series”. the same expiration date and the same exercise price. 3. If the index is currently at 3. This means that the option cannot be exercised early. Currently. American: These options give the holder the right. the strike prices available will be 3. An option series refers to all o ptions that are identical: they are the same type. 3. Since there are no shares for the underlying. 3. Options in stocks that have been recently l aunched in the Indian market are “American Options” while the options on the Index a re “European Options”. to buy or sell the underlying instrument onl y on the expiry date. The strike price is also called Exerc ise Price. which is the last Thursday of September. The exchange will settle the contract on the last Thursday of August. 3. Dutt purchases 1 NIFTY S EP 2006 3450 Call — Premium 20. to buy or sell the underlying instrument on or before the expiry date . for each underlying. This price is fixed by the exchange for the entire duration of the op tion depending on the movement of the underlying stock or index in the cash mark et. Settlement is based on a pa rticular strike price at expiration. Th e styles have geographical names. the contract i s cash settled. In-the-money: A Call Option is said to be “In-the-Money” if the strike price is less than the market price of 170 Investment Planning PDP . Example: Mr. have the same underlying. in India only index options are European in nature.370.390. American style o ptions tend to be more expensive than European style because they offer greater flexibility to the buyer. which have nothing to do with the location whe re a contract is agreed! The styles are: European: These options give the holder the right. but not the o bligation. Patel can close the contract any time from the current date til l the expiration date. The strike price interval will be of 20.410.520 Call —Pre mium 20 Here Mr. Example: All N ifty call options are referred to as one class. This means that the option can be exercised early. there are a number of options available: For this reason.430. Option Class & Series Generally. but not the obligation. Example: Mr Patel purchases 1 TATA STEEL SEP 06 . Sett lement is based on a particular strike price at expiration. However.450.

the strike prices avail able will be 3.5 he collected as premium. The strike prices for a call opt ion that are greater than the underlying (Nifty or Sensex) are said to be out-of the-money in this case 3430 and 3450 considering that the underlying is at 3410. he is able to b ring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected). 900. A Put Option is In-The-Money when the strike price is grea ter than the market price. the option will be exercised and the investor will be left only w ith the premium amount. A Put option is Out-Of-Money if the strike price is less than the market price. Here again. the option would have been “inthemoney”. Further. He can take a long position in HLL shares and at the same time writ e a call option with a strike price of 235 and collect a premium of Rs. this will cover his loss in his option posit ion if there is a sharp increase in price of the stock. At the se prices one can take either a positive or negative view on the markets i. Example: Ram purchases 1 ACC SEP 900 Call —Premium 50 I n the above example. Example: Mr. 900 per share. which is the price at which Ram would l ike to buy 100 shares anytime before the expiry of Sep 2006 series. Covered Put Option Similarly. Rajan belie ves that HLL has hit rock bottom at the level of Rs. Similary. the writer of the call option takes a corresponding long positi on in the stock in the cash market. for a single series 10 opt ions (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in.410 while the strike price of 3410 is ‘at the money’. which are lower t han the underlying of 3. 232 and it will move in a n arrow range. Cov ered Call Option Covered option helps the writer to minimize his loss. This will bring down the effective cost of HLL shares to 227 (232-5). If there is a sharp decline in the price of the und erlying asset.370 and 3. Pricing of options Options are used as ri sk management tools and the valuation or pricing of the instruments is a careful PDP Investment Planning 171 . bo th call and put options will be available.the underlying stock. if the market price of ACC was lower than Rs. The loss in the option exercised will be equal to the ga in in the short position of the asset.410.390. 3.370. the option is “in-the-money”.410. 3. If the price goes above 23 5 and the Option is exercised. In a cove red call option. the call option will not be exercised and t he writer will keep the Rs. the investor is not in a position to t ake advantage of any sharp increase in the price of the asset as the underlying asset has already been sold.430. the writer can deliver the shares acquired in the cash market. 3. a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). 3.450.e. Therefore. if Ram had purchased a Put at the same strike price. till the market price of ACC is r uling above the strike price of Rs. Out-of-the -Money: A Call Option is said to be “Out-of-the-Money” if the strike price is greate r than the market price of the stock.390. Similarly in-the-money strike prices will be 3. The effective selling price will increase by the premium amount (if the option i s not exercised at maturity). If th e price stays below 235 till expiry. 5 per sh are. At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being “At-the-Mon ey” or Near-the-Money. If the index is currently at 3.

greater is the possibility that the underlying share price might move so as to make the option in-the-money. The Time Value of an Option Generally. Price of underlying The premium is affected by the price movements in the underlying instrument. All other factors affecting an opti on’s price remaining the 172 Investment Planning PDP .Spot Price The intrinsic value of an option must be positive or zero. or the immediate exercise value o f the option when the underlying position is marked-to-market. For a call option : Intrinsic Value = Spot Price . It cannot be negative. This is because the longer an o ption’s lifetime. the strike price must be greater than the underl ying asset price for it to have intrinsic value. For a put option. the higher its premium will be. the premium falls. the strike price must be less t han the price of the underlying asset for the call to have an intrinsic value gr eater than 0. For Call optio ns (the right to buy the underlying at a fixed strike price) as the underlying p rice rises so does its premium.Strike Price For a put option: Intrinsic Value = Strike Price . For a call option. the longer the time remaining until an op tion’s expiration. The following chart summarises the above f or Calls and Puts. There are four major factors affecting the Option pre mium: n n n n Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying And two less important factors: n n Short-Term Interest Rates Dividends The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money.balance of market factors. For Put options as the underlying price rises. as the unde rlying price falls the premium rises. As the underlying price falls so does the premiu m.

same, the time value portion of an option’s premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally w orth only its intrinsic value. Volatility Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under -lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. Higher volatility = Higher premium Lower volatility = Lower premium Interest rates In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may become important. All other factors being equal as interest rates rise, premium costs fall and vice ve rsa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either wa y the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premiu m costs fall. Why should the buyer be compensated? Because the option writer rec eiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated. PDP Investment Planning 173

The options premium is determined by the three factors mentioned earlier – intrins ic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows: n n n n Delta Gamma Vega Rho Delta Delta is the measure of an option’s sensitivity to changes in the price of t he underlying asset. Therefore, it is the degree to which an option price will m ove given a change in the underlying stock or index price, all else being equal. Change in option premium Delta = ————————————— Change in underlying price For example, an elta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index. Example A trader is considering buying a Call option on a futures contrac t, which has a price of Rs. 20. The premium for the Call option with a strike pr ice of Rs. 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs. 21 – a rise of Re 1 – then th e premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.8 0 + 0.50 = Rs. 1.30. Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or c heap. An at-the-money call would have a delta of 0.5 and a deeply inthe-money ca ll would have a delta close to 1. While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stoc k price are inversely related. This is because if you buy a put your view is bea rish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The p ut delta equals the call delta minus 1. It may be noted that if delta of your po sition is positive, you desire the underlying asset to rise in price. On the con trary, if delta is negative, you want the underlying asset’s price to fall. 174 Investment Planning PDP

Uses: The knowledge of delta is of vital importance for option traders because t his parameter is heavily used in margining and risk management strategies. The d elta is often called the hedge ratio. e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls you would need t o be short (i.e. need to write) to create a riskless hedge – i.e. a portfolio whic h would be worth the same whether the stock price rose by a very small amount or fell by a very small amount. In such a “delta neutral” portfolio any gain in the va lue of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa. Note that as the de lta changes with the stock price and time to expiration, the number of shares wo uld need to be continually adjusted to maintain the hedge. Gamma This is the rat e at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument. Gamma = Change in option delta ———————————— erlying price For example, if a Call option has a delta of 0.50 and a gamma of 0 .05, then a rise of 1 in the underlying means the delta will move to 0.55 for a p rice rise and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a car – its acceleration – in moving from a standstill, up to its cruis ing speed, and braking back to a standstill. Gamma is greatest for an ATM (at-th e-money) option (cruising) and falls to zero as an option moves deeply ITM (in-t he-money ) and OTM (out-of-the-money) (standstill). Theta It is a measure of an option’s sensitivity to time decay. Theta is the change in option price given a on eday decrease in time to expiration. It is a measure of time decay (or time shru nk). Theta is generally used to gain an idea of how time decay is affecting your portfolio. Theta = Change in an option premium ——————————————— Change in time to expiry Th tive for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases. Assume a n option has a premium of 3 and a theta of 0.06. After one day it will decline t o 2.94, the second day to 2.88 and so on. Naturally other factors, such as chang es in value of the underlying stock will alter the premium. Theta is only concer ned with the time value. Unfortunately, we cannot predict with accuracy the chan ge’s in stock market’s value, but we can measure exactly the time remaining until ex piration. Vega This is a measure of the sensitivity of an option price to change s in market volatility. It is the change of an option premium for a given change – typically 1% – in the underlying volatility. Change in an option premium Vega = ———————— tility PDP Investment Planning 175


Example: If stock X has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the vol atility factor increased by 1% to 31%. As the stock becomes more volatile the ch anges in premium will increase in the same proportion. Vega measures the sensiti vity of the premium to these changes in volatility. What practical use is the ve ga to a trader? If a trader maintains a delta neutral position, then it is possi ble to trade options purely in terms of volatility – the trader is not exposed to changes in underlying prices. Rho The change in option price given a one percent age point change in the risk-free interest rate. Rho measures the change in an o ption’s price per unit increase –typically 1% – in the cost of funding the underlying. Change in an option premium Rho = ——————————————————— Change in cost of funding underlying re are various option pricing models which traders use to arrive at the right va lue of the option. Some of the most popular models have been enumerated below. T he Binomial Pricing Model The binomial model is an options pricing model which w as developed by William Sharpe in 1978. Today, one finds a large variety of pric ing models which differ according to their hypotheses or the underlying instrume nts upon which they are based (stock options, currency options, options on inter est rates). The binomial model breaks down the time to expiration into potential ly a very large number of time intervals, or steps. A tree of stock prices is in itially produced working forward from the present to expiration. At each step it is assumed that the stock price will move up or down by an amount calculated us ing volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices. The tree represents all the possi ble paths that the stock price could take during the life of the option. At the end of the tree – i.e. at expiration of the option — all the terminal option prices for each of the final possible stock prices are known as they simply equal their intrinsic values. Next the option prices at each step of the tree are calculate d working back from expiration to the present. The option prices at each step ar e used to derive the option prices at the next step of the tree using risk neutr al valuation based on the probabilities of the stock prices moving up or down, t he risk free rate and the time interval of each step. Any adjustments to stock p rices (at an ex-dividend date) or option prices (as a result of early exercise o f American options) are worked into the calculations at the required point in ti me. At the top of the tree you are left with one option price. Advantage: The bi g advantage the binomial model has over the Black-Scholes model is that it can b e used to accurately price American options. This is because, with the binomial model it’s possible to check at every point in an option’s life (ie at every step of the binomial tree) for the possibility of early exercise (eg where, due to a di vidend, or a put being deeply in the money the option price at that point is les s than its intrinsic value). Where an early exercise point is found it is assume d that the option holder would elect to exercise and 176 Investment Planning PDP

The lognormal distributio n allows for a stock price distribution of between zero and infinity (ie no nega tive prices) and has an upward bias (representing the fact that a stock price ca n only drop 100 per cent but can rise by more than 100 per cent). Thus. volatility .the option price can be adjusted to equal the intrinsic value at that point. The Black-Scholes model is used to calculate a theoreti cal call price (ignoring dividends paid during the life of the option) using the five key determinants of an option’s price: stock price.XertN(d2 ) Where: The variables are: S = stock price X = strike price t = time remaining until exp iration. ln = natural logarithm N(x) = stand ard normal cumulative distribution function e = the exponential function Lognorm al distribution: The model is based on a lognormal distribution of stock prices. distribution. and short-term (risk free) interest rate. It is one of the most popular options pricing models. as opposed to a normal. The intention of this section is to introduce you to the basic premises upon which t his pricing model rests. it does not rely on calculation by iteration. Limitation: As mentioned before the main disadvantage of the binomial model is its relatively s low speed. time to expiration. expressed as a percent of a year r = current continuously compounded ri sk-free interest rate v = annual volatility of stock price (the standard deviati on of the short-term returns over one year). The original for mula for calculating the theoretical option price (OP) is as follows: OP = SN(d1 ) . The Black & Scholes Model The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is noted for its relative simplicity and its fast mode of calculatio n: unlike the binomial model. or bell-shaped. The important implication is that the price of an option is com pletely independent of the expected growth of the underlying asset. Thi s then flows into the calculations higher up the tree and so on. Risk-neutral v aluation: The expected rate of return of the stock (ie the expected rate of grow th of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the BlackScholes model (or any other model for op tion valuation). It’s great for half a dozen calculations at a time but even with today’s fastest PCs it’s not a practical solution for the calculation of thousands of pric es in a few seconds which is what’s required for the production of the animated ch arts. while any two PDP Investment Planning 177 . strike price.

He will be exposed to potentially large losses if the market m oves against his position and declines. The investor breaks even when the market price equals the exercise price plus the premium. Because a short put position holder has an obligation to purch ase if exercised. the investor loses money on the transaction . lower is the return. the potential l oss is unlimited. The key concept underlying the valuation of all derivatives — the fact that price of an op tion is independent of the risk preferences of investors — is called risk-neutral valuation. investors with long put positions will let their options expire worthless. If you expect the market price of the underlying asset to rise. the h igher price you will be forced to pay in order to buy back the option at a later date. profit potential is limited. always agree on the fair price of the option on that underlying asset. It does not consider the steps along the way where there could be the possibility of early exercise of an American option. A Put writer profits wh en the price of the underlying asset increases and the option expires worthless. An increase in volatility will inc rease the value of your put and decrease your return. At any price less than t he exercise price minus the premium. The exception to this is an A merican call on a non-dividend paying asset. Puts in a Bullish Strategy An investor with a bullish market outlo ok can also go short on a Put option. Basically. The break-even point occurs when the mar ket price equals the exercise price: minus the premium. In this case the call is always wor th the same as its European equivalent as there is never any advantage in exerci sing early. given agreement to the assumptions of volatility and the risk free rate. However. which enable it to handle both discrete and continuous dividends accurately. despite these adaptations the Blac k-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price a t one point in time — at expiration. but there are a number of widely us ed adaptations to the original formula. t hen you would rather have the right to purchase at a specified price and sell la ter at a higher price than have the obligation to deliver later at a higher pric e. an investor anticipating a bull market could write Put options. As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercise d at expiration) this is a significant limitation. Bull Market Strategies Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. his option is profitable.investors may strongly disagree on the rate of return they expect on a stock the y will. Limitation: Dividends are ignored in the basic Black-Scholes formula. If the market price increases and puts become o ut-ofthe-money. As an option writer. Advantage: The main advantage of the Black-Scholes model is speed — it lets you calculate a very large number of option prices in a very short time. However. At higher prices. The maximum profit is limited to the premium received. By writing Puts. 178 Investment Planning PDP . It means that all derivatives can be valued by assuming that the retu rn from their underlying assets is the risk free rate.

100 and you buy a September call option with a strike price of Rs. an investor can lose the net premium paid.Higher strike premium = 14 . both will be exercised and the maximum profit will be realised. The combination of these two options will result in a bought spread. the first position established in the spread is the l ong lower strike price call option with unlimited profit potential. Based on the above figures the maximum profit. 90 and pay a premium of Rs. To put on a bull spread. To “buy a call spread” is to purchase a c all with a lower exercise price and to write a call with a higher exercise price .90 . The “Bull Call Spread” allows the investor to participate to a limited extent in a bull market. He re you are buying a lower strike price option and selling a higher strike price option. while a t the same time limiting risk exposure. At the most. Now let us look at the fundamental reason for this position. At the most. the ma rket price must be as great as the lower exercise price plus the net premium. The cost of Putting on this position will be the difference between the premium paid for the low strike cal l and the premium received for the high strike call. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call. At the same time you sell another September call option on the same scrip with a strike price of Rs. 14. To recover the premium. the trader need s to buy the lower strike call and sell the higher strike call.Net premium paid = 110 . maximum loss and breakeven point of this spread would be as follows: Maximum profit = Higher strike price .Bullish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call o ptions but with different exercise prices. receiving a net premium for the position. 110 and receive a premium of Rs 4. At the same time to reduce the cost of puchase of the long position a short position at a hi gher call strike price is established. Th e investor’s potential loss is limited. While this not only reduces the outflow i n terms of premium but his profit potential as well as risk is limited. An example of a Bullish call spread Let’s assume that the cash price of a scrip is R s. here the trader buys a call with a higher exercise price and writes a cal l with a lower exercise price. When both calls are in-the-money. The investor breaks even wh en the market price equals the lower exercise price plus the net premium.4 = 10 Breakeven Price = Lower strike price + N et premium paid = 90 + 10 = 100 PDP Investment Planning 179 . the investor can lose is the net premium. The investor delivers on his short call and rec eives a higher price than he is paid for receiving delivery on his long call. The trader pays a net premium for the position. To “sell a call spread” is the opp osite. An inve stor with a bullish market outlook should buy a call spread. This would result in a net outflow of Rs 10 at the time of establishing the spread. The investor’s profit potenti al is limited.10 = 10 Maximum Loss = Lower strike premiu m .Lower strike price . Since t his is a bullish strategy.

because they could pu rchase the underlying asset at the lower market price. the trader breaks even. Bear Market Strategies Puts in a Bearish Strategy When you purchase a put you are long and want the mar ket to fall. higher the profits. An investo r’s profit potential is practically unlimited. When the market price equals the exercise price plus the premium. he will be expose d to potentially large losses if the market rises against his position. To “buy a put spread” is to purchase a put with a higher exercise pr ice and to write a put with a lower exercise price. To “sel l a put spread” is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price. the trader has the right to choose whether to sell t he underlying asset at the exercise price. An investor with a bullish market outlook should sell a Put spread. receiving a net premium for the position. the trader is losing money. The higher the fall in price of the underlying asset. For this an in vestor needs to write a call option. receivi ng a net premium for the position. Calls in a Bearish Strategy Another optio n for a bearish investor is to go short on a call with the intent to purchase it back in the future. long call holder s will let their outof-the-money options expire worthless. Here the loss potential is unlimited because a shor t call position holder has an obligation to sell if exercised. By purchasing put options. 180 Investment Planning PDP . It will increase in value if th e market falls. Bearish Put Spread Strategies A vertical put spread is the simultaneous purchase and sale of identical put options but with different e xercise prices. The trader pays a net premiu m for the position. The inve stor breaks even when the market price equals the exercise price: plus the premi um. Th e “vertical bull put spread” allows the investor to participate to a limited extent in a bull market. this choice is p referable to being obligated to buy the underlying at a price higher. If the market price falls. The trader pays a net premium for the position. To “sell a put spread” is the opposite. The investor’s profit poten tial is limited because the trader’s maximum profit is limited to the premium rece ived for writing the option. In a falling market. By selling a call. To “buy a p ut spread” is to purchase a Put with a higher exercise price and to write a Put wi th a lower exercise price. The trader buys a put wi th a lower exercise price and writes a put with a higher exercise price.Bullish Put Spread Strategies A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. An investor with a bearish market outlook shall buy put options. you have a net short position and needs to be bought back before expiration and cancel out your position. At any price greater than the exercise price plus the premium. while at the same time limiting risk exposure. A put option is a bearish position.

Though the trader has reduced the cost of taking a bearish position. A t rader need not be PDP Investment Planning 181 . the maximu m loss will equal high exercise price minus low exercise price minus net premium . 100. You buy a September put option on a scrip with a strike price of Rs . When th e market price falls to the lower exercise price. maximum loss and brea keven point of this spread would be as follows: Maximum profit = Higher strike p rice option . The investor’s profit potential is limited. the options will o ffset one another.10 = 100 Bearish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call o ptions but with different exercise prices. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread. 5. At any price greater than the high exercise price. This position h as huge profit potential on downside. To put on a bear call spread you sell the lower strike call and buy the higher strike call. receiving a net premium for the position. The resulting posi tion is a mildly bearish position with limited risk and limited profit profile.Lower strike price option .10 = 10 Maximum loss = Net premium paid = 15 . both outof-the-money options w ill expire worthless. As long as there is significant movement upwards or downwards. Here the investor’s potential loss is limited. Volatile Market Strategies Straddles in a Volatile Market Outlook Volatile market trading strategies are ap propriate when the trader believes the market will move but does not have an opi nion on the direction of movement of the market.90 . the market price does not have to fall as low as the lower exercise price to breakeven.An example of a bearish put spread. The trader pays a net premium for the position.Net premium paid = 110 .5 = 10 Breakeven Price = Higher strike pr ice . If the market rises. To “buy a call spread” is to purchase a c all with a lower exercise price and to write a call with a higher exercise price . Lets assume that the cash price of the scrip is Rs. The maximum profit. 110 at a premium of Rs. The strategy becomes profitable as the market price decli nes. The investor breaks even when the market price equals the lower exercise price plus the net premium. if the trader may recover a part of the pr emium paid by him by writing a lower strike price put option. To “sell a call spread” is the opp osite: the trader buys a call with a higher exercise price and writes a call wit h a lower exercise price. he has also capped the profit portential as well.Net premium paid = 110 . Since the trader is receiving a net premium. 15 and sell a September put option with a strike price of Rs. 90 at a premium of Rs. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price. these strategies offer profit opportunities. In this bearish position the put is taken as l ong on a higher strike price put with the outgo of some premium.

which is exercise price minus the premiums paid . both the call and the put are out-of-the-money. viewing a market as volatile. Advantages of option trading Risk management: Put options allow investors hold ing shares to hedge against a possible fall in their value. and for the put. 1. Here the loss potential is also very minimal because. One is for the call. but different exercise prices. and letting the other expire worthless. A “strangle purchase” allows the trader to profit from either a bull or bear market. Th is gives the call 182 Investment Planning PDP . the trader can profit from an upor downward movement by exercising the appropriate option. bear market.) While the investor’s potential loss is limited. the put. A trader. If the market is volatile. and the other for the put. in a bear market. exercise the call. when the market price equals the low exercise price minus the premium paid . To “buy a straddle” is to purchase a call and a put with the same exercise price and expiration date. the more the options are out-of-the-money. viewing a market as volatile. the lesser the premiums. ex cept that the call and the put have different exercise prices. Here the investor’s profit potential is unlimited. The trader’s profit poten tial is unlimited. the p ut). two breakeven points. 2. Time to de cide: By taking a call option the purchase price for the shares is locked in. (Bull market. Should the price of the underlying remain stable. If the market is volatile. which breakevens when t he market price equal the high exercise price plus the premium paid. the trader can profit from an upor downward movement by exercising the appropria te option while letting the other option expire worthless. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated. Here the trader has two long pos itions and thus. two b reakeven points. should buy option straddles. Because the options are typically out-of-the-money. This can be consider ed similar to taking out insurance against a fall in the share price. the most he will lose is the premium he paid for the options. exercis e the call. which is exercise price plus the premiums paid. the market must move to a g reater degree than a straddle purchase to be profitable. To “sell a s trangle” is to write a call and a put with the same expiration date. To “sell a straddle” is the opposite: the trader sells a call and a put with the same exercise price and exp iration date. A “straddle p urchase” allows the trader to profit from either a bull market or from a bear mark et. n A straddle is the simultaneous purchase (or sale) of two identical options. should buy strangles. In this case the trader has long two positions and thus. but different exercise prices. To “buy a strangle” is to purchase a call an d a put with the same expiration date. Strangles in a Volatile Market Outlook A strangle is similar to a straddle. the most the trader would lose is the premium he paid for the opt ions. one a call and the other a put. The investor’s potential loss is limited.bullish or bearish. One for the call. Usually. He must simply be of the opinion that the market is volatile . A trader. (In a bull market.

If expecting a fall. Likewise the taker of a put option has time to decide whe ther or not to sell the shares. as there is no stamp duty pay able unless and until options are exercised. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the sha re. However. Income generation: Shareholders can earn extra income over and above dividen ds by writing call options against their shares. PDP Investment Planning 183 . Trading options has a lower cost than shares. there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price. leverage usually involves more risks than a direct investment in the underlying shares. investors can create a wide range of potential profit scenarios. Either way the holder can sell the option prior to expiry to take a profit or limit a l oss. they may decide to buy put options. By writing an option they recei ve the option premium upfront. If an investor expects the market to rise. To find out more about options strategies read the module on trading strategies. Leverage: Leverage provides the pot ential to make a higher return from a smaller initial outlay than investing dire ctly. Speculation: The ease of trading in and out of a n option position makes it possible to trade options with no intention of ever e xercising them. Strategies: By combining different op tions. While they get to keep the option premium. they may decide to bu y call options.option holder until the Expiry Day to decide whether or not to exercise the opti on and buy the shares.

300 c. Rs. buy b. 240. Loss of Rs. Rs. Ashwin Mehta made in this transaction? a. 19 b. 600 0 b. A put option gives the ———————— the right but not the obligation to —————— the underlying asset ice: a. 4 d. A function of the v olatility of the index d.On expiry date Nifty closed at 3430. The stock exchange 2. owner. sell 6. Seller c. Unlimited c. The time value of the option is: a.Review Questions: 1. seller. A stock curr ently sells at Rs. 3434 d. How much profit/loss Mr. 3452 184 Investment Planning PDP . owner. 3000 d. Profit of Rs. Buyer b. None of the above 3. Limited b.0 00/-. 3. 3424 c. 15 5. what should be the fair price of One month Nifty futures contract? a. The potential r eturns on a futures contract are: a. Both d.000/. If spot Nift y is 3400 and the interest rate is 12% p. 5 c. The put option to sell the stock at Rs.40. Rs. Rs. Profit of Rs. He paid a margin of Rs. sell c. seller. buy d. 51. 3412 b. In an options contract the option lies with which one of th e following: a. 6000 4. On 13th August 2006 Mr. Profit of Rs. Ashwin Me hta bought a Aug Nifty futures contract of 100 Nifties which cost him Rs. 255 costs Rs 19.a.

061 d. The “T” that i s used in Black. 0. 27 b. 20. Short Nifty Rs. Only on expi ry c. By buying the September fut ures and selling October futures b. Only on expiry c. Expiry date for September 2006 contracts is 27. 20 lacs d. None of the above 9. A speculator thinks that India Cements is going to rise sharply. An American Option can be exercised : a. India Cements has a beta of 1. 20 lacs. 1 b. In the first week of September you observe that the spread between the September and October of Siemens futures has narrowed down to Rs. By both d. At any given time the F&O segment of NSE provides trading facility for ——— Nifty futur es contracts: a. 3 c. 20 lacs 8.074 c. He has a long p osition on the cash market in India Cements to the extent of Rs. Both at a ny time and on expiry d. Short Nifty Rs. At any time till expiry b. Long Nifty Rs. Which of the following positions on Index futures giv es him a complete hedge? a. 26 lacs c. By selling the September futures and buying the October futures c.3. An European Option can exercised : a. None of the above 11. On 1st September 2006 a call option of Nifty with a strike price of Rs 3400 is a vailable for trading. 9 PDP Investment Planning 185 . 0. How can you profit from this observation? a. Long Nifty Rs. 26 lacs b.Sholes formula should be: a.7. It is not used in India d. At any time b. 2 d. None of the above 12. None of th e above 10.10 as against the usual Rs.

buying a call a nd selling a call c. buying two calls Answers: 1. 10. 40 a call. . 76 per call and call at Rs. profit of 4.400 14. net : a.13. the pay off.800 b. buying a call and buying a put b. 2. 6. If Nifty closes at 3460 of costs from this bull spread will be loss of 2. profit of 2. buying two puts d. loss of 4. 9. 8. Each market lot o on the expiration date. 11.400 d. 5. 14. 13. 4. A bull spread is created by a. An investor buys two market lots of Sep sells two market lots of Sep 3400 Nifty f Nifty is 100. a b c c d c b b b a b b a b 186 Investment Planning PDP 3400 Nifty calls at Rs. 3. 12. 7.800 c.

Chapter 13 PDP Investment Planning 187 .

policies. mandatory registration. financiers and tenants are quite complex and require legal interpretation and construction. not only increase the cost of transactions but inv olve physical presence of the buyers and sellers for executing the transfer docu ments. This aspect of real estate brings in not only additional costs but the choice of right legal consultant. That also essentially means that this asset class would some time become the most importa nt (heavily weighted) in value terms in one’s portfolio. physical inconvenience and heavy costs make real estate i nvestments that much less attractive. 5. The real estate then becomes essentially a long t erm investment option where liquidity is a very big problem. “Buyers beware” is the most applicable jargon and can prove quit e tricky in real estate deals. etc.000/where as in the case of dire ct investment in real estate the amounts required will be much higher. Government controls.Real Estate L et’s look at real estate as an investment vehicle where the income earning capacit y and capital appreciation over time become more important than occupation for s elf use. Legal complexities The legal contracts bet ween property owners. Real estate h oldings involve a lot of legislation on who can own. etc. Characteristics of real estate investments Higher capital requirement It is possible for an investor to participate in debt or equity through small investments. Illiquidity Real estate is difficult to acquire and more dif ficult to sell because of absence of organized markets as in the case of bonds a nd equities That makes it a tall task for the investor to search for real estate worth investing. The heavy capital cost ke eps a large number of small investors away and that also contributes in reducing the number of investors who participate in real estate. 188 Investment Planning PDP . Numerous cases have come up where titles have been challenged many decades after deals on the properties have been entered in to. Documentati on involving payment of stamp duties. time and money are spent in finding investment options – same is the case at the time of sale. at arbitrary rates fixed by Stamp offices. Many of these are Stat e legislations and hence require specialist advice on these matters. With the judiciary taking a long time to settle matters of title in properti es the laws in respect to real estate are cumbersome and can easily put off enth usiastic investors. etc. say Rs. Indirect investments in real estate through Mutual fund realty funds have cleared the legal requirement s and are set to be launched in India where after retail participation in realty may become easier. Title and legal pro blems The property laws are not investor friendly. Buying property involves not just selection of a good property with scope for income and or appreciation but also with a good marketable title. In other words.

Income stream – where the property can be rented out – property rentals have been going up because of l arge scale employment generation in urban centres where people from smaller plac es move in to rental accommodation as ownership is beyond them at least in the i nitial years of employment. If an investor is able to analyze carefully take professional advice and legal h elp and invests for long term the scope for appreciation is quite high and this vehicle can yield handsome returns not only in PDP . etc. Tax shelter – the income earned on rented properties is subject to some deduction. Because of the very nature of immovable properties the market is also highly localized where local factors play a very vital role. Being able to retain possession. It involves considerable cost of maintenance. the tax on capital gains made on real estate can be saved tot ally through planning. There is a need for a national and structure market to emerge in order to attract large scale investments – but becau se of typical state laws it may become difficult in India to have a very dynamic and liquid real estate market. 6. e tc . Advantages of real estate 1. can be a challenging management task where many times “possession is c onsidered ownership” and the onus then falls on the owner to prove his title – in le gal battles for possession that can stretch to decades. 5. 2. Scope for capital appreciation – the longer one holds on to properties. Sense of pride – It gives a sense of pride to the individual that he stays in a house owned by him and this can not be measured in monetary terms. Inefficient market Real estates don’t have a market place as equities or bonds have. taxes – municipal a nd other charges. These tax advantages make real estate an attractive proposition for high net worth in di vi du al s. c orpo ra te s. etc. Numerous tax advantages exist in the case of agricultural land – agricultura l income being exempt from Income tax even though it may have a nominal impact o f taxation in the lower income tax bracket while capital gains on sale of agricu ltural land is fully exempt. Se lf occupation – house properties are bought more for self occupation than for reas ons of investment – at the point of self occupation these are not investments – but at the time of retirement people may shift to smaller cities in which case the o wnership houses in bigger cities can be sold at substantially higher prices and this shall provide retirement capital as well. 4. especially in case of va cant lands.Management burden Buying real estate is a complex process but holding on to it i s also not easy. The market is not pro perly structured. 3. have also been rising. higher the capital appreciation – demand for houses has been on the rise thanks to increasing income levels and lower cost of housing loans and the input costs like steel. A national market has not developed in real estate because of physical limitations as they exist today – in other words a person in New Delhi may find real estate in Bangalo re a very attractive proposition but it will be physically impossible for him to participate in this investment opportunity. a housing loan gives the investor tax advantages – which we shall consider in greater details later. it has been observed. cement. Sometimes people may shift from s maller homes to bigger ones or from one locality to another when their older hom es fetch them handsome prices compared to purchase costs thus making them a very good investment. Sense of security – properties are considered less vol atile compared to paper securities like bonds or shares – falling prices are quite rare – capital loss may not be incurred – obviously these are perceptions and may n ot be right.

Investment Planning 189 .

These legal issues are complex and an investment in agricultural land. which we have discussed under the “characteristics of real estate investments”. For example lands can be bought and regis tered only in the name of farmers – i. to launch realty funds. In order to attract retail investors the market players have found many ways. This means t hat holding costs in respect of high value house properties can go up astronomic ally making it uneconomical to hold them as long term investments. Time Share Some companies have floated novel schemes where an investor c an own properties for a part of the year. Some of them are listed below: Realty funds Mutual funds have now been permitted by SEBI. Real estates essentially involve h igh capital outlay. not withstanding the tax advantages. c ommon lighting. illiquidity. Disadvantages of real estate Legal issues There are a large number of legal issues involved in investing in r eal estate. water. you can buy agricultural land only if you already own agricultural land in that state. Many of the legislations are State legislations and hence a good und erstanding of local laws is essential. High cost of mainte nance Urban house property owners are required to pay maintenance charges to co operative housing societies for common facilities – like lifts. These costs have also risen substantially over time. Popular tenancy laws exist in many states where the tiller becomes the owner of the agri cultural land.e. You own it on a right to use concept. etc. etc. The returns you get on this is essentially c ost free holidays without hassles of maintaining the properties. These are essential costs of maintenance and these costs ar e rising at alarming rates.percentage terms but in quantitative terms as well because of inherent high valu e investment involved. water supply. Municipal and other levies An owner of land or house property is required to pay the local authority certain taxes on a regular basis. 190 Investment Planning PDP . Besides usage based charges local bodies charge property tax and there are proposals that these tax es could become “ad valorem” that is on value – in other words if a house property is of high value then it may attract very high municipal property tax. say for enjoying holidays for a few da ys in a year. In other words thr ough the mutual funds route it has now become possible for a small investor to p articipate in the property market and reap the benefits of the same in an indire ct way. There is rotational ownership with maintenance and other matters b eing managed by the company itself. can be considered only if an investor has a thorough understanding of these complex legal issues. If one holds house properties for just capital appre ciation and not for self use or renting out then the costs become all the more h eavy and can impact the over all returns on this property investment. that are provided by the local bodies. There are num erous other disadvantages such as higher investment quantum. shares and bonds of hous ing finance companies and real estate and property companies. etc. the regulator. Land ceiling laws are applicable i n certain states which makes buying a large piece of land highly risky. absence of uniform laws. These are essentially charges for t he services such as drainage. security. These funds c ollect corpus from retail investors and large investors – pool the funds and inves t directly in properties – residential and or commercial. lack o f organized market.

Because major em ployment opportunities generally exist in major cities these shuttle cities also develop over a period of time providing appreciation and income to the investor s in these smaller cities/towns. Proximity to employment opportun ities: Shuttle cities near major cities have developed into good centres because of nearness to mega cities. play grounds. railway station. PDP Investment Planning 191 . parks. work place.Lease back arrangements Some builders sell house properties to investors and the y assure a minimum guaranteed lease rental on these properties. p roviding huge employment opportunities. etc. are important considerations. etc. etc. The builders normally assur e through this process a fixed rental income per month for a fixed period of tim e. hospital s. from the gross income and finally capitalize the net income for the market yield on the property. drainage. are important factors while buying house property. Investors who cannot afford property investments in mega cities tend to invest in these suburbs or shuttle cities. hospitals. Th e parameters of valuation are complex and the valuations are many times highly s ubjective. Considerations f or value 1. gardens. These concepts have become very popular especially in tourist centres like Go a. Values of properties in cities like Bangalore h ave gone up because IT sector companies have moved into the city in a big way. Location – accessibility to public conveyance (nearness to local railw ay station in the case of Mumbai city) – nearness to schools. The price for a property is arrived at mutually by the buyer and the seller while the value could be different. The investor mak es a lump sum investment and buys a house property and in return the builder arr anges to rent out the property at a fixed rent ensuring that the investor gets a minimum assured return on the property.5% of property values. clean surroundings. temples. are important consi derations. Infrastructure: Easy accessibility through goo d road. etc. etc. shopping centres.. quality of oth er facilities provided. insurance. 4. Example Let’s presume that rent fetched is generally around 8. Environment – the general environment is a lso considered while making investment decision – whether the area is growing in i mportance or static or declining. Many housing complexes try to provide most of these facilities like s chools. This helps the investor in arriving at an investment decision because he knows the possible returns on the property and he is saved the trouble of hunting for an occupant. amenities provided. Capitalization approach It is important to find out based on a market researc h what kind of yields are obtainable on comparable properties. The quality of construction. 2. inside the complex to ma ke it an attractive investment at a good price. bus stand. 3. 5. They tend to be very close to each ot her if both the buyer and seller are making informed decisions. etc. Secondly it is re quired to work out the net income derived from the property by deducting expense s like repairs. Traditional approaches to valuation a. water and power supply. Valuation of real estate It is important to have a clear idea of valuati on of a property both at the time of purchase as well as at the time of sale.

Rentals also tend to fluctuate and normally go up over a period of time.are incurred every year on insurance.400/He will get desired retur n of 12% p. 25. et c.000/Taxability of real estate investments Taxability of income n n Rental income is taxable.a. Discounted cash flow method If the property was bought earlier and has be en earning regular income on a year on year basis we have to work out the presen t value of cash flows using our standard formula used in annuity calculations. In case of joint owner ship of house property deductions of interest amounts as loss on self occupied p roperty as well deduction u/s 80C are allowed for each one in the same proportio n. If we are given the present price.20. It is difficult to predict the future prices while a r easonable estimation of possible rental income can be made. n n The permitted deductions are: 30% of rent as a standard deduction Interest pa id on borrowed capital – the limit of Rs.000/.000/.72 = 273356.p. what price he should pay for the property? PV = [25000/( applicable for self occupi ed properties where the rental income is NIL.085 = Rs. 2.for an yield of 8. 235/b.12)3] = 22321.000/. 4. on a rent of Rs.a. 20. we get the capital value of the property: 2.84 + 231316.000.88.000/.400/. expected price at which the property will be sold after a few years and the quantum of rental income on a yearly basis then we can work out the return o n this investment the same way as we calculate the YTM of bonds. 2.. 3.73. 42 +19929. 2. 3. 25.42 +(25000/1. 20. then the net annual rental income from the property would amount to 12*20000 -20000 = 220000/Capitalising net income of Rs.2544)+(325000/1.p.p. Example An inve stor wants to purchase a property which will fetch him a net rental income of Rs .p.a.405) =22321.00. for the next 3 years if he purchase s the property now for Rs. steadily for the next 3 years at the end of which he will be abl e to sell the property for Rs. Certain deductions are permit ted from the income in computing taxable income on house property.000/.00. Municipal taxes actually paid Repayment of principal amount of housing loan is entitled to be deducted from in come u/s 80C up to a maximum limit of Rs. 3.000/. 1.20.m. 25. repairs. V alue of the property is the present values of all cash flows to be received by o wning the property as well as expected cash flow on sale of the property after a definite period of time.00.a.If rental income of say Rs. 2. 1. 192 Investment Planning PDP .5% a s follows. In other words increased tax benefit and each of the joint holders can enjoy tax advantages.000/. is earned on a property and expenses t o the tune of say Rs.12)] +[ 25000/(1. 1.1 2)2]+ [(25000+300000)/(1.50.98 say Rs.000/0.sells it after 3 years for Rs.73. If the investor wants a return of 12% p .

if constructed. advertisement on sale Expenses like society transfer charges Cost of acquisition Cost of improvement Long Term capital gains = Sale consideration (sale price)* n n n n Expenses like brokerage. should be within 3 years after sale If the cost of the new house is lower than net sale consideration then the diff erence will be taxable as LTCG If the assessee sells the new house within three years of its purchase then this becomes STCG and the cost of acquisition will be taken as NIL (if the cost of new house is lower than LTCG made on old house) PDP Investment Planning 193 . as per approved valuer. etc on sale Expenses like society transfer charges Indexed cos t of acquisition# Indexed cost of improvement *Sale consideration shall be the actual sale price as mentioned in the sale deed or value adopted by stamp duty valuation authority whichever is higher. STCG is added to incom e under the head “Income from other sources” and taxed at the rate applicable to the tax payer. Rate of Tax 1. LTCG is taxed at 20% after arriving at the figure of taxable LTCG as shown above Saving tax on LTCG It is possible to save tax payable on LTCG and the provisions have been laid down below: Sec 54 – Sell a house property and buy or construct an other house property n n n n n n n n Applicable for individuals and HUF The sold house need not be a self occupied house property The sold house need not be the only house property The sold house should have been held for more than 36 month s from purchase New house should be purchased within one year before sale or two years after sale New house.Taxability of capital gains It is defined that if a piece of land or house prope rty had been held for a minimum period of 36 months before selling then it is lo ng term capital gains and if sold with in 36 months the gains on sale shall be t reated as Short Term Capital Gains. shall be taken as the cost of purchase. In case of properties bought/acq uired/inherited before 1st April 1981 the market value. advt. # Index ed cost of acquisition is arrived at by multiplying the actual cost with the inf lation index (as published from time to time) for the year of sale and dividing by the inflation index in the year of purchase. 2. Short term capital gains = Sale consideratio n (sale price) * n n n n Expenses like brokerage.

If part of the p roceeds are invested in such bonds proportionate deduction from LTCG will be all owed The investment in bonds u/s 54EC should be made within 6 months of sale The lock in period for the bonds will be minimum of 3 years The interest on the bon ds is taxable The rate of interest is decided by the PSU companies – it is current ly around 5 -5. If the tax payer sells the new house with in 3 years of pur chase the conditions as spelt out earlier u/s 54E will become applicable. Sec 54 EC – sel l any long term asset and invest in infrastructure bonds . 194 Investment Planning PDP .n n In the previous explanation if the cost of new house was equal to or more than L TCG on old house the cost of new house will be computed as actual cost – LTCG on t he old house It may take some time to purchase or construct a new house – the amou nt of LTCG will have to kept in a special account designated as “Capital Gains Acc ount” with a specified bank before filing returns for the Previous year in which t he old house was sold – the funds in the account can be utilized for buying the ne w house. etc. An assessee might hav e made LTCG on sale of any long term capital asset like house. Sec 54 B – sell agricultural land and buy agricultural land -deals with sale of ag ricultural land. It may take some time to purchase or construct a new house – the amount of LTCG will hav e to be kept in a special account designated as “Capital Gains Account” with a speci fied bank before filing returns for the Previous year in which the old asset was sold – the funds in the account can be utilized only for buying the new house pro perty.a. and/or National Highway Au thority of India. LTCG on sale can be saved by buying another agricultural land a s per same terms and conditions listed above for a house property. If the cost of th e new house property is less than LTCG made on the old asset then a proportional deduction will be available under this section and balance tax will have to be paid as tax on LTCG. n n n n n Sec 54 F – sell any long term asset and buy a house property n n n n n n n n The t ax payer should be individual or HUF The LT asset sold should not be a house pro perty The new residential house should be purchased with in one year prior to sa le or two year after the sale of the old asset or The new house should be constr ucted with in 3 years from the sale of the old asset The deduction is applicable to an assessee even if he is already owning a house property. then the tax on LTCG can be saved fully. land. n If the entire sale proceeds are invested in bonds of Government companies like Rural Electrification Corporation Ltd.5% p. gold and jeweller y. Ltd.

50. Husband and wife have together bought a new house and have availed of ho using loan from a bank. he should invest within what period of sale to avail benefit u/s 54EC of IT Act? a. Rs. Wankhede is planning to sell his house and buy a bigger new house.000/. If the total amount of interest paid by them on the home loan for self occupied hou se property during a financial year has been Rs. 2. Both can get deduction – but the deduction will be Rs. 6 months b. 12 months c.000/c. Both can get deductio n – but the deduction will be restricted to Rs. c a a b PDP Investment Planning 195 . Rs.000/3. 4. 5.00.000/.000/What price should he pay for this house property now? a. 1.000/.12.Review Questions: 1.000/b. 1. An investor is considering a purchase of house property which shall fetch him a rental income of Rs.32. Mr.50 lacs but not both b.each Answers: 1. 1. 3.000/d. 3. Within two years prior to sale or 2 years after sale 2 . Rs. 4. With in 1 year after sale b.87. 3. 2. They have contributed 50% each to cost of the house. 2 y ears 4. 3 years d. Either one of them can g et a deduction not exceeding Rs. Within 3 years after sale c.each c.20.what deduction will each one get from income as ‘Loss under house property”? a. 15.m. Rs. When should he buy a new house with reference to sale of his old hou se in order to avail of full benefit of Sec 54 of the Income Tax Act? a.p. 1.6 6. The investor is looking for 10% returns and he is confident that he can sell the property after 3 years for Rs.40. 4. Only the first holder on the loan will get a deduction and it will be restricted to Rs.000/.00 0/d. If an individual who has made LTCG want s to save the tax on the same fully. Within one year prior to sale or 2 years after sale d.50.

Chapter 14 196 Investment Planning PDP .

Investment strategies Passive strategy S ome investors perceive that the securities markets, particularly the equity mark ets, are efficient. There is a belief that the stock market is a barometer of th e economy and that the market perfectly reflects the strengths and weaknesses of the economy over long term while in the short term there can be temporary aberr ations (and over reactions of optimism and pessimism). In an efficient market, t he prices of securities do not depart for any length of time from the justified economic values that investors calculate for them. Economic values for securitie s are determined by investor expectations about earnings, risks, and so on, as i nvestors grapple with the uncertain future. If the market price of a security do es depart from its estimated economic value, investors act to bring the two valu es together. Thus, as new information arrives in an efficient marketplace, causi ng a revision in the estimated economic value of a security, its price adjusts t o this information quickly and, on balance, correctly. In other words, securitie s are efficiently priced on a continuous basis and the long term investors who a re holding on to securities need not resort to any action of buying and selling but continue to hold. These investors believe that it is not worth their efforts in terms of time and cost to trade on the temporary aberrations but hold on to qualitative securities that shall perform in line with the market over a period of time. That is, after acting on information to trade securities and subtractin g all costs (transaction costs and taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy. If the market is economica lly efficient, securities could depart somewhat from their economic (justified) values, but it would not pay investors to take advantage of these small discrepa ncies. A natural outcome of this belief in efficient markets is to employ some t ype of passive strategy in owning and managing common stocks. If the market is t otally efficient, no active strategy should be able to beat the market on a risk -adjusted basis. The Efficient Market Hypothesis has implications for fundamenta l analysis and technical analysis, both of which are active strategies for selec ting common stocks. Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction co sts and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investo rs act as if the market is efficient and accept the consensus estimates of retur n and risk, accepting current market price as the best estimate of a security’s va lue. In adopting the passive strategy the investor will simply follow a buy-andhold strategy for whatever portfolio of stocks is owned. Alternatively, a very e ffective way to employ a passive strategy with common stocks is to invest in an indexed portfolio. We will consider each of these strategies in turn. Buy And Ho ld Strategy A buy-and-hold strategy means exactly that - an investor buys stocks and basically holds them until some future time in order to meet some objective . The emphasis is on avoiding transaction costs, additional search costs, and so forth., The investor believes that such a strategy will, over some period of ti me, produce results as good as alternatives that require active management where by some securities are deemed not satisfactory, sold, and replaced with other se curities. These alternatives incur transaction PDP Investment Planning 197

costs and involve inevitable mistakes. Notice that a buy-and-hold strategy is ap plicable to the investor’s portfolio, whatever its composition. It may be large or small, and it may emphasize various types of stocks. Also note that an importan t initial selection must be made to implement the strategy. The investor must de cide initially to buy certain stocks and not to buy certain other stocks. Note t hat the investor will, in fact, have to perform certain functions while the buyand-hold strategy is in existence. For example, any income generated by the port folio may be reinvested in other securities. Alternatively, a few stocks may do so well that they dominate the total market value of the portfolio and reduce it s diversification. If the portfolio changes in such a way that it is no longer c ompatible with the investor’s risk tolerance, adjustments may be required. The poi nt is simply that even under such a strategy investors must still take certain a ctions. In other words a passive strategy also requires some action on the part of the investors – much less frequently compared to active strategies. An interest ing variant of this strategy is to buy-and-hold the 10 highest dividend-yielding stocks among the BSE Sensex at the beginning of the year, hold for a year, and replace any stocks if necessary at the beginning of the next year with the newes t highest-yielding stocks in the BSE Sensex. This strategy does not require stoc k selection since it is based only on using the easily calculated dividend yield for 30 identified stocks, and making substitutions when necessary. Index Funds Some investors prefer indirect investment to direct investment in equities. For this class of investors the best passive strategy could be buying into an Index Fund. In an Index fund the fund manager pools the resources of a number of inves tors and invests in stocks that comprise the index in the same weightage as in t he Index. These funds are designed to duplicate as precisely as possible the per formance of some market index. A stock-index fund may consist of all the stocks in a well-known market average such as the NSE Nifty. No attempt is made to fore cast market movements and act accordingly, or to select under-or overvalued secu rities. Expenses are kept to a minimum, including research costs (security analy sis), portfolio managers’ fees, and brokerage commissions. Index funds can be run efficiently by a small staff. Surprisingly, at times the passive index funds hav e been found to perform better than some most actively managed funds – mainly beca use the active funds might have under performed the market during that period of time. These are open ended funds where the loads are the least and the returns in line with the market index which they propose to replicate. Active strategy I nvestors, who do not accept the Efficient Market Hypothesis and those who believ e that it is possible to out perform the market consistently over a period of ti me through active management of stocks selected, pursue active investment strate gies. These investors believe that they can identify undervalued securities and that lags exist in the market’s adjustment of these securities’ prices to new (bette r) information. These investors generate more search costs (both in time and mon ey) and more transaction costs, but they believe that the marginal benefit outwe ighs the marginal costs incurred. Investors adopt two pronged strategies to perf orm better than the market – proper stock selection and timing the entry and exit points. Stock Selection Most investment techniques involve an active approach to investing. In the area of common stocks the use of valuation models to value an d select stocks indicates that investors are analyzing and valuing stocks in an attempt to improve their performance relative to some benchmark such as a market index. 198 Investment Planning PDP

They assume or expect the benefits to be greater than the costs. Pursuit of an a ctive strategy assumes that investors possess some advantage relative to other m arket participants. Such advantages could include superior analytical or judgmen t skills, superior information, or the ability or willingness to do what other i nvestors, particularly institutions, are unable to do. Individual investors enjo y certain advantages over institutional investors: n n n They can invest in smal l cap stocks They need not have highly diversified portfolio They have go short on the market For example, many large institutional investors cannot take positions in very sm all companies, leaving this field for individual investors. Furthermore, individ uals are not required to own diversified portfolios and are typically not prohib ited from short sales or margin trading as are some institutions. Most investors still favour an active approach to common stock selection and management, despi te the accumulating evidence from efficient market studies and the published per formance results of institutional investors. The reason for this is obvious - th e potential rewards are very large, and many investors feel confident that they can achieve such awards even if other investors cannot. The most traditional and popular form of active stock strategies is the selection of individual stocks i dentified as offering superior return-risk characteristics. Such stocks typicall y are selected using fundamental security analysis or technical analysis and som etimes a combination of the two. Many investors have always believed, and contin ue to believe despite evidence to the contrary from the Efficient Market Hypothe sis, that they possess the requisite skill, patience, and ability to identify un dervalued stocks. We know that a key feature of the investments environment is t he uncertainty that always surrounds investing decisions. Most stock pickers rec ognize the pervasiveness of this uncertainty and protect themselves accordingly by diversifying. Therefore, the standard assumption of rational, intelligent inv estors who select stocks to buy and sell is that such selections will be part of a diversified portfolio. How important is stock selection in the overall invest ment process? Most active investors, individuals or institutions, are, to variou s degrees, stock selectors. The majority of investment advice and investment adv isory services are geared to the selection of stocks thought to be attractive ca ndidates at the time. Stocks are, of course, selected by both individual investo rs and institutional investors. Rather than do their own security analysis, indi vidual investors may choose to rely on the recommendations of the professionals. Many brokerage houses employ research personnel and put up research reports on various companies. One of the most important responsibilities of an analyst is t o forecast earnings per share for particular companies because of the widely per ceived linkage between expected earnings and stock returns. Earnings are critica l in determining stock prices, and what matters is expected earnings). Therefore , the primary emphasis in fundamental security analysis is on expected earnings, and analysts spend much of their time forecasting earnings. Studies indicate th at current expectations of earnings, as represented by the average of the analys ts’ forecasts, are incorporated into current stock prices. An active strategy that is similar to stock selection is group or sector rotation. This strategy involv es shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better, and avoid or de-emphasize tho se sectors that are expected to do relatively worse. PDP Investment Planning 199

Investors employing this strategy are betting that particular sectors will repea t their price performance relative to the current phase of the business and cred it cycle. Timing The Market n Market timers attempt to earn excess returns by va rying the percentage of portfolio assets in equity securities. One has only to o bserve a chart of stock prices over time to appreciate the profit potential of b eing in the stock market at the right times and being out of the stock market at bad times. When equities are expected to do well, timers shift from cash equiva lents such as money market funds to common stocks. When equities are expected to do poorly, the opposite occurs. Alternatively, timers could increase the Betas of their portfolios when the market is expected to rise and carry most stocks up , or decrease the Betas of their portfolio when the market is expected to go dow n. One important factor affecting the success of a market timing strategy is the amount of brokerage commissions and taxes paid with such a strategy as opposed to those paid with a buy-and-hold strategy. Like many issues in the investing ar ena, the subject of market timing is controversial. Evidence indicates it is dif ficult for investors to regularly time the market efficiently enough to provide excess return on a risk-adjusted basis. n n n n n On a pure timing basis, only a small percent of the stock timing strategies trac ked over the most recent five-and eight-year periods outperformed a buy-and-hold approach. Much of the empirical evidence on market timing comes from studies of mutual funds. A basic issue is whether fund managers increase the beta of their portfolios when they anticipate a rising market and reduce the beta when they a nticipate a declining market. Several studies found no evidence that funds were able to time market changes and change their risk level in response. n Considera ble research now suggests that the biggest risk of market timing is the investor s will not be in the market at critical times, thereby significantly reducing th eir overall returns. Investors who miss only a few key months may suffer signifi cantly. If anybody thinks that market timing as a strategy suitable for the aver age individual investor he is wrong and the market has proved this time and agai n all over the world. It has been proved without doubt that security market retu rns will depend more on the “time” than “timing” . Leveraging Aggressive investors adopt the bank financing route to invest in stock s a certain number of times their o wn capital through the process of buying stocks and pledging with bank, raising money on the stocks and buying more stocks. Thus, on a given capital, thanks to bank borrowing against stocks they are able to build a portfolio much higher in value but at a cost, namely the interest cost. These investors are highly aggres sive and are always under pressure that the stocks selected by them should perfo rm and deliver returns superior to the rate of interest payable on the borrowal accounts – banks lend against securities at a much higher rate of interest compare d to priority lending or prime lending rates. This route of bank borrowing is us ed by many investors in India when they apply to new issues of shares, through t he book building route of Initial Public Offerings (IPO) or Follow up Public Off erings (FPO) of existing listed companies. These investors while applying for th e IPO essentially put in the margin money alone; which is around 40% of the appl ication money and thus manage to increase the number of shares for which they co uld apply with a given capital, thereby increasing the chances of 200 Investment Planning PDP


If the need is short term then it may not be wis e to park the funds in equity and equity related instruments as the risk associa ted with this avenue is especially higher in the short term. The potential to earn returns as the market goes up or down increases becau se of leveraging. after a certain period of time – post retirement needs and so on … The investment strategy involved in meeting this type of time related fund requi rements would depend upon the time span after which the requirement will arise: a. 3. It has b een proved without doubt. Some investors use the futures mar ket route to leverage on the available capital. 4. 2. Buying a bigger house in about 5 years Regular income flows every year after a term to m eet education expenses of the children Lump sum requirement after a few years to meet marriage expenses of children especially the daughter Regular flow of inco me. in any case. on a monthly basis.allotment of shares. The success lies in developing the right stra tegy that would suit the investor’s risk profile and his financial goals. say. These cos ts are incurred. At the same time sin ce this is a high risk avenue the returns also tend to be higher and hence capit al building PDP Investment Planning 201 . In a later topic we shall discuss in detail about the types of asset al location models and how we go about implementing the same. fo r meeting education and/or marriage expenses of children over the next 5 to 10 y ears then an investor can invest in Balanced funds or specific child care funds of mutual funds or specific children plans of life insurance companies. A trader in the futures segment of the market. not withstanding whether these investors are allot ted any shares in the public offering or not. We have essent ially discussed the two types of strategies namely the passive strategy and acti ve strategy followed in investing. Some of these time horizon related needs could be: 1. It is a well established fact that equities have delivered superi or returns compared to other asset classes over longer period of time – while in t he short term the returns can be erratic and even negative. Short term – say requirement within 3/5 years Long term – not less than 5 year s The investment vehicle will be decided upon whether the need is expected to aris e over short term or long term. The equi ty or equity related instruments would be ideal for building capital over long p eriod of time. that success in investing is about fol lowing a disciplined approach with clearly spelt out goals and the manner of ach ieving the same. One of the time tested strategies for success in investing is a n “Asset Allocation Plan” decided well in advance before making the investments and sticking to same and acting on it periodically in consultation with a financial advisor. the world over. b. This is a high risk high return game – not suitable for average market investors but only for those with very high risk appetite. Maturity Selection In vestors make investments to meet specific demand on funds over a certain period of time. If the need is medium. when he takes a position is not required to pay the full market v alue of this position but only a certain percentage. Thus in the futures segment the trader gains a market exposure which is much higher than his available capi tal. A debt fund or a fi xed income instrument is preferred in such cases. These investors shall benefit only if they get substantial allotment and only if the shares list at prices much higher than the issue price because they incur interest costs on the money financed by the banks.

Many times it is the time based requirement of funds th at determines where the money is invested. Thus one can conclude th at the strategy of investments can not only be classified as Passive and Active but also based on the Time Horizon of the investible funds and the requirements for the funds over time. so that a certain amount of pension becom es payable on retirement.becomes that much easier. by the salaried class of investors. 202 Investment Planning PDP . There are specific deferred annuity plans of life insu rance companies where investments are made on a systematic basis while in servic e. These are essentially long term low risk low return ki nd of plans most suited for the conservative investors.

d c a 4. Aggressive investors 3. Trading in stock futures in the derivatives segment of the mark et would amount to which one of the following strategies? a. Active strategy of investments b. “Rupee Cost Aver aging” strategy 4. I nvestors who want their shares to out perform the market c. It is easy for the small investor to ti me the market and maximize the gains b. It is a very aggressive investment strategy c. “Rupee Cost Averaging” 5. It is suitable to investors who seek returns muc h in excess of market returns.Review Questions: 1. Answers: 1. Investors who believ e that market is an efficient place and that over long period this strategy pays d. floating rate debt fun d b. Which one of the following statem ents is true regarding market timing? a. Investors who want short term returns b. “Market Timing” is the most important factor for success in investment decisions for small investors c. Passive c . “Buy and hold” is a strategy suitable for which o f the following type of investors? a. He is not very keen on high returns on this investment. It is the “time” more th an the “timing” that has benefited the investors – investors stand to benefit if they are prepared to invest for longer term rather trying to time the market d. It is an active investment strategy d. 3. b. Adopting the bank financing route for applying to IP O’s would amount to which of the following? a. It is suitable to investors who expect m arket returns on the investment 2. Keep the money liquid in a saving bank account because returns over this period can be quite uncertain. “Timing” is the key for long term investors 6. In respect of investing in “Index funds” which one of the follo wing statements is not true? a. Low risk low return strategy d. Low Risk low return d. P assive strategy of investments c. 5. 6. A. Direct investment in select stocks from th e market d. 2. A sector specific equity fund c. a c a PDP Investment Planning 203 . An investor plans to invest some capital t o meet a requirement that is most likely to crop up within the next one or two y ears. Active b. Which out of the f ollowing could be the most suitable option for him? a.

Chapter 15 204 Investment Planning PDP .

especially in the short term. PDP Investment Planning 205 . In equities the range of returns as well as the potential for capital loss is the greatest. It is also well established that over the long term equitie s. While equity may be riskier asset class it also has the potential to earn superior ret urns over long term. age. It has been a well established fact that Asset allocation has been pri marily responsible for portfolio performance more than even stock selection and timing issues. Asset allocation is the key to portfolio returns and hence it is of paramount importance. To the analyst it is the chance that the invest ment vehicle may not deliver the required or expected returns and thus not fulfi ll the financial goals. asset allocation is closely related to the age of an investor. It is also well established through research over long p eriods that equity as an asset class. A ccording to some analyses. which we know is the primary lesson of portfolio manag ement. In other words t he returns on a stock portfolio will depend on the market returns to a great ext ent – no stock is expected to give phenomenal returns when the market returns are low or negative. for example. from those who are starting out in their 20 s. the investor’s ris k tolerance. is the most volatile of asset classes. as individuals approach reti rement they become more risk averse and hence they should allocate fewer amounts in percentage terms to equity and equity related instruments in their portfolio . It is the most important investment decision made by investors because it is the basic determinant of the return and risk taken. According to the life-cycle theory. This involves the so-called life-cycle theory of asset allocation. The asset allocation decision involves deciding the per centage of investable funds to be placed in stocks. Hence equities will find a place in every body’s portfo lio but the extent could vary depending on the risk profile. Within an asset class diversified portfolios will tend to produ ce similar returns over time. differences in asset allocati on will be the key factor. To the common investor risk means the probability that he may lose his capital o r suffer loss on the investment. etc. causing differences in portfolio performan ce. cash and even foreign investments … to a limited extent available to Resident Indian inves tors now. on average. However. Thi s makes intuitive sense because the needs and financial positions of workers in their 50s should differ. international as well as domestic. time frame. Asset class risk Risk in the context of investments has different meanings for different people. There are different asset classes like equities. need for highe r returns. Therefore. different asset classes are likely to pro duce results that are quite dissimilar. Thus asset allocation serves the purpose of diversification among differe nt asset classes and diversification among different securities within an asset class.Asset Allocation T he important decision that an investor is required to take is on Asset Allocatio n. The returns of a well-diversified portfolio within a given asset class ar e highly correlated with the returns of the asset class itself. have delivered returns much higher than other cl asses of financial assets. and the time horizon. bonds and cash equivalents. bonds. real estate. This is a result of holding a w elldiversified portfolio. This is done in conjunction with the investme nt manager’s expectations about the capital markets and about individual assets. over time. foreign as well as domestic. Factors to consider in making the asset allocation decision include the inve stor’s return requirements (current income versus future income).

All the same a balance is maint ained and it is ensured that each asset class in the model is maintained within the permitted range for that asset class A range for each asset class is fixed a nd short term movements/switches are made within the range to take advantage of market movements. A right allocation among different classes of assets shall ensure that investors’ investment objectives are met. n n Let’s look at both types of Asset Allocation models in a tabular form to understan d the essential differences: Thus you will find that while the asset classes are the same the difference lies in the manner of allocation among assets – fixed allocation in SAA while a ranged allocation in TAA. Strategic Asset Allocation n n n n n It is essentially a long t erm investment plan It is the structuring the individual asset classes within a portfolio to meet long term investment objectives. in this process. Let’s look at TAA allocations at different equity market level s: 206 Investment Planning PDP . T he asset allocation of a portfolio is changed. Tactical Asset Allocation n n n TAA is a dynamic portfolio technique that seeks to take advantage of the short term movements and opportunities in the market. It works on the underlying principle that in the short term the s ecurities market may not be properly valued resulting in under valuation and ove r valuations – it is possible to take advantage of these aberrations through switc hes between asset classes and within securities. No switches between securitie s or asset classes is normally done in the short term Defined exposures are made to different assets providing for some minor adjustments within the asset class without shifting the focus of the portfolio.Types of asset allocation The two models of asset allocation are Strategic Asset Allocation and Tactical A sset Allocation. on a short term basis to take advantage of perceived differences in the values of various asset class changes.

on paper. The taxation issues also need to be considered. investments will be there in all asset classes but t he percentage will vary depending upon the market condition and the out look for the market over the short term but the variation will be within the fixed limit s set for each asset class. TAA essentially de als with timing issues. till the same is revised based on the changed requireme nts. advancing age. We have looked at an example of stock market valuati ons affecting allocation to equities similarly interest rate out look and curren t interest rates will influence investment in fixed income securities.Thus. where the returns are uncertai n and market related. time factors. As the interest rates start falling bonds will fet ch capital appreciation while yields will fall and the weightage will gradually shift from bond to equity. Th is is a tough call and very few specialists have done it consistently over long periods of time. return expectations. at any point in time. a ge. etc. say equities is essentially a function of risk appetite. Thus one needs to work out whether TAA as compared to SAA has given superior returns after taking into account all the efforts in terms of time and money that has been put in. Advise the clients to essentially adopt a disciplined approach to investment through SAA rather than TAA The proportion of allocation to risk instruments. But TAA involves rese arch inputs which are very vital and also entails frequent transactions. SAA as being necessarily long term is better on the following counts: n n n n n No great issues of skills of timing the market decisions Does not test th e competency of the portfolio managers/advisor to the extent required under TAA Costs are lower Taxation will be lower Chances of success are better as compared to TAA where wrong decisions and costs can prove to be very costly. Both th ese come at substantial cost to the investor. If the in terest levels in the economy hover around very high levels it is only natural th at the fixed income portion would be close to the upper band of allocation which in the given example is 60%. etc. We may conclude the discussions on suitable asset allocation models as under: n n Some aggressive clients may be inclined towards TAA as the model. It is very vital to be able to time entries and exits in bonds as well as equities consistently to be able to outperform the markets. The “flexible asset allocation” is not necessarily an aggressive investment planning. looks superior – but the financial planner should make the short comings of TAA clear to the client. Comparison between SAA a nd TAA TAA can be expected to deliver superior on returns. “Flexible allocation” is som ething similar to TAA where the range is fixed for different asset classes and p eriodic switching between asset classes is done. This helps the alert investor to make use of some PDP Investment Planning 207 . sudden changes in the economy. Obviously while TAA strategy has the potential to ear n higher returns it also calls for a very good understanding of the movements bo nds/securities market and the equity market and also swift decisions of moving f unds from one asset class to the other and moving back. Fixed and flexible allocation “Fixed a llocation” is sticking to an allocation proportion among asset classes and followi ng the same religiously. Many short term transactions would result in short gains which are essentially taxed at higher rates.

Certainly. semi-permane nt. One after the other the financial goal s get completed. not an Investment Strategy. as the investor gets older and older. but that has nothing to do with the purpose of Fixed Income Securities nor is it in any way related to the reasons for having an asset allocation plan in the first place. 208 Investment Planning PDP . over a period of time. Bond prices dip to adjust to the current yields of the market. T here can be some internal family developments also that may make portfolio rebal ancing necessary. A portfolio is built to meet certain financial objectives. These economic factors are external factors that will have to be taken into account as their long term impact on the portfolios will be severe and hence suitable rebalancing will have to be done.. marriage of children. not all objectives are met at the same time. Redu cing equity exposure of the portfolio may become necessary and moving from long term debt swiftly into short term or from fixed rate long term debt funds to flo ating rate and short term debts could also become necessary. As these objectives are fulfilled the return requirements may come down and it may be necessary to switch to less aggressive asset allocation plan – reducing the exposure to equitie s and increasing the exposure to debt may be made. . An Asset Allocation Formula is a long-range. Asset Allocation is an Investment Pla nning Tool. the movement of a person’s assets from a falling bond market to a rising stock market or vice versa is about as far away from the principles of asset al location as one can get! n n n n Investors should arrive upon the most suitable Asset Allocation Plan Investors should not focus exclusively on “market value”. some economic developments may necessitate an urgent review. protracted interest rate movements are expected then a rebalancing will become absolutely essential – in a rising interest rate sc enario the corporate profitabilites will suffer and consequently the stock price s will fall. buying a new car. then portfolio rebalancing will become necessary again. One of the most important factors that will have a big influence on the performance of the portfolio is the interest rate (which generally moves with in flation). etc. should be monitor ed on a periodic basis. The frequency of review could be once in 6 months or eve n once a year – a higher frequency is generally not necessary for a long term inve stment plan but sometimes. that a rebalancing strategy can increase expected return is incorrect but on the contrary rebalancing costs definitely reduces expected ret urns. a 40% asset allocation to Fixed Income may soften th e fall in the portfolio bottom line during a stock market downturn. Thereafter the portfolio of investments comprising of debt. So me of the common objectives are buying a bigger home. planning decision that has absolutely nothing to do with market timing or “hed ging” of any kind. then securitie s are chosen for investments and the investment process is completed. Inve stors should not dwell upon comparisons of one’s own unique portfolio with Market Averages Investors should not expect “performance” during specific time intervals as this investment plan is expected to perform over a long period of time Portfolio rebalancing Once an asset allocation plan is finalized. It should simultaneously b e remembered these are turn around situations and these happen over long term. It is an established fact t hat the proposition. If economic slow do wn is seen. Investment Strategies are used to sele ct and to manage the securities that are “allocated” to either the Equity or Debt/fi xed income securities. through falling growth rates. equity. Whenever large scale. educatio n of children. S imilarly.. retirement capital etc.opportunities that come periodically in the market due to random developments wh ich simply cannot be predicted in advance.

When the portfolios are monitored it could be observed that the prop ortion among different asset classes has changed substantially. fortunes of compan ies also fluctuate. and particularly. While a Buy and Hold strategy is fine it makes sense to observe cr ucial economic factors that may specifically affect some of the securities held and it would be prudent at time to switch out of these securities and move into others. Monitoring an d revision of portfolios It is the financial planners’ function to monitor clients’ portfolios. say 5% which means that if the Equity proportion has moved above the fixed proportion of 40% by 5% or more . etc. Debt 55% and Cash 5% but on monitor ing if it was found to have changed to Equity 50% Debt 45% and Cash 5% then it a mounts to higher exposure to equity than originally planned. This situation migh t have arisen mainly because of rising stock market and the appreciation of stoc ks held in the portfolio.Probably the best rule of thumb on rebalancing is to look at the overall stock/b ond ratio quarterly. strength of domestic currency. an d examine individual equity asset classes once a year. Thus monito ring helps in maintaining a balanced portfolio all the time but also ensures pro fit booking when the markets are high and buying when the market prices fall sub stantially. PDP Investment Planning 209 . For example if t he original Asset allocation was Equity 40%. It could be. A lower i nterest rate on loans may not be good news for banks and financial institutions but good news for consumer durables. then a rebalancing would be done by selling excess equity and moving to debt o r cash to maintain the Asset allocation proportions decided earlier. generally in line with the over all economy but some times o n their own as well. While deciding on an asset allocation plan a formula i s generally discussed and agreed upon. While implementing the investment plan certain securities were bought based on their and the over a ll economic fundamentals. Rebalance only whe n asset classes. since it is the primary determinant of expected returns. A portfolio revision may become necessary because of government po licy changes. For example a strong domestic currency may not be good for export oriented companies but will benefit import dependant companies. budget and fiscal deficits. gets out of balance f ar enough to produce a significant expected difference in returns. the equity/fixed ratio. automobiles and housing sector as the same spurs demand. The formula could vary from investor to investor but it is essential so that portfolios are properly monitored to deliver the desired returns over t he long term. This formula for revision essentially hin ges on defining “substantial shift in emphasis of a particular asset class” or even a particular security in an asset class. or so. These factors may change over time. infla tion and interest rates. economic factors of growth rate.

Increase the potential to earn higher returns c. Taxation will be lower because short term transactions a re generally not done 2. Look at the equity/debt ratio every quarter and individual stock o nce a year d. 4. c a d a c 210 Investment Planning PDP . The proportion of each asset class is fixed in advance c. Which one of the following could be th e rule of thumb for portfolio rebalancing? a. Increase the costs without necessarily contributing to increased returns b. Keep on removing and adding securities on a half ye arly basis c. Which of the following statements is not true of Strategic Asset Allocation? a. 2. The transaction costs are very high because of frequent switches d. The transaction cost s are very high because of frequent switches d. 3. Which of the following statement is not true of Tactica l Asset Allocation? a. Requires exceptional skills of ti ming which nobody in fact can claim to possess c. It is a long term investment plan b. Taxation will be higher because of short term transactions 3. F requent portfolio rebalancing will cause which one of the following? a. The more frequently it is done the better Answers: 1. Strategic Asset Allocation has a better success rate – as proved in a majority of cases d. The risks are high and the chances of success are low b. What should be your advise to such an investor? a. Will ensure that inve stment objectives are achieved quickly 5. It is a conservative. Keep switching between debt and eq uity on a quarterly basis b. All of the above 4. 5. Decrease the costs d. long term investment plan b. An investor is very keen on adopting Tactical Asse t Allocation plan. The pr oportion of each asset class is set in a range of values c.Review Questions: 1.

Chapter 16 PDP Investment Planning 211 .

so that it becomes easier to identify the objectives. age. have a data sheet format where the colum ns/questions of personal information are already provided and it is easier for t he client to fill the same. basically comprises of the following components: n Personal information – name. i ntentions. required/expected returns on investments. Investment objectiv es – buying a luxury car. attitude. e mai l ID. If a 212 Investment Planning PDP . occupation of all family members. Thus before the pers onal meeting the financial planner has a good idea of the background of the clie nt. etc. The ultimate objective of underst anding a whole lot of investment avenues available. children’s marriage. Information from clients. life insurance. bigger apartment. etc. address. The client may be encouraged to fill the same and send through e mail. ages. The financial planners. The ultimate financial plan will revolve aro und the risk profile of the client and the required return. Many clients may prefer the ultra conservative route – while there is nothing with that approach. mutual funds. in order to avoid time delays and to facilitate more meaningful discussions. on matters of risk and return. Risk profile. some time s. informal talk with the client. is best gathered through a personal. However. retirement planning. It is essential to obtain information in respect of the same because while constructing the financial plan restructuring of existing portfolio is eq ually important. children’s education. It may become necessary to educate the investors primarily. before the meeting. etc. the client in such circumstanc e should be made to realize the kind of compromise he is making on returns and w hether he can afford to make such compromises. This advance collection of information and that too in a specified format sa ves a lot of time which other wise is lost during the meeting with the client. it may be a good idea to obtain personal information and details o f existing investments (the first two out of the parameters listed above in adva nce). normally. house pro perty. It may be more useful if both – husband and wife. It is necessary to collect information from the client about his financi al background. etc. etc. is to empower the financial planner so that he can understand t he client’s needs and suggest an investment plan that shall be able to achieve the investment goals of the investors. The data collection format may also be made availabl e online or mailed electronically to the client. I nformation on the other two parameters namely the objectives/goals and risk prof ile. expected returns on investme nts. (in case of married clients). All clients generally have some existing investments in shares. fixed income products. telephone number. time horizon. the risks involved. n n n Information is collected in a manner that is suitable for the investor and the p lanner. etc. investment objectives. etc. and such other information that are matters of record and which shall be h elpful in assessing general needs Information on their existing investments and levels of income and taxation for each member of the family. holidays especially abroad. therefore. names of other family m embers. how to measure the risk and returns on different investmen t products. the retu rns that be expected. are present during the discussions .Structuring Portfolio for Investors Identification of client needs A financial planner can go about his job after understanding his client’s needs thor oughly. tax saving instruments.

timid. The equity oriented assets whether direct investment in eq uities or indirect investments in equities through the mutual funds do not assur e any returns.client is inclined to take a higher risk the same may be advised and accordingly incorporated by the financial planner in the investment plan provided in the op inion of the planner it is necessary to do so for getting the desired return. humble. However the indirec t investments in debts through the mutual fund route do not offer any fixed rate of structuring client portfolios After having assessed th e clients needs. taxability. the returns are market oriented and these act as ideal hedge agai nst inflation. We have studied in detail about various financial products available in our market . These investments are relatively safer with lower rate of return and market oriented PDP Investment Planning 213 . Some economic factors that point towards risk profile of the client are: n n Liq uidity – a high concern for liquidity will imply a more conservative approach. This again is a very conservative approac h. n n n Asset allocation plan. Hence. background.from the point of risk. return. equity shall form an integral part of any portfolio – th e proportion will vary according to the profile of the investor. Income flow should be close to the required level and anything received in ex cess of requirement needs to be deployed for productive purposes to earn higher returns Inflation – a lower concern for inflation will mean more exposure to debt/ income oriented investments and less to growth. the next step is deciding on an A sset Allocation plan that shall best serve the client’s needs. Basically financial assets are equity orient ed and debt oriented. corporate debentures and fixed deposits carry fixed rates of int erest and as such there are no uncertainties about the same. Th e planner may advise a more conservative approach if high returns are not requir ed. Hence due care and lot of thoughts should go into preparing the same. Taxation – a high concern for taxa tion will mean higher exposure to growth and equity oriented instruments where t he incidence of taxation is lower compared to deb/income oriented instruments. The ultimate success of the financial planning p rocess that helps the investor to meet his financial objectives depends to a lar ge extent on the right Asset Allocation Plan. practical. But in general the extent of ris k that a client may be prepared to take is a function of the following factors: n n n n Age Socio economic status Background – academic and work place General nat ure – aggressive. Quantum of risk is subjective and it is bound to be different for different client profiles. Equity. Inc ome – many investors would prefer to have an income flow on all their investments and too preferably guaranteed returns. In case the client is not inclined towards riskier investments and if higher returns are required to meet the financial goals then the financial planner sho uld explain the consequences of a very conservative approach and the need for ta king risk in a certain proportion. etc. Based on the client’s background information which we have obtained though data sheet and meetings we should prepare an Asset Allocation Pl an specifically for the client. We have also studied about the two types of A sset Allocation plans. etc. as an asset class has delivered superior returns over lon g periods of time. small s avings schemes. modest. Debt oriented a re fixed income instruments and many of these assets like bank deposits. risk profile etc. V olatility – some clients are very concerned about loss of capital – that would mean that even a stock portfolio should contain more defensive and large cap stocks – l ower on risk and return.

While consid ering these assets in evaluating portfolio risk and return it has to be borne in mind that these assets are risky and the returns are not assured – hence resemble equities rather than debts. etc. Here are some thoughts how Asset Allocation Plans a re made. r egular income and inflation are their concerns Conservative approach – Asset alloc ation can be as under: Example 2 n n n n n n n Mature couple with grown children: Age around 45 years C hildren undergoing education Capital growth at a moderate rate and some income f low are their requirements Around this age the income level is quite high. are not financial a ssets and hence not considered in structuring An Asset Allocation Plan but many people do resort to investments in these classes of assets as well. the c apacity to invest is high Commencement of some retirement planning is also essen tial Moderate risk – The asset allocation suggested can be as under: 214 Investment Planning PDP . Real estate/property/commodity/bullion. etc.securities like Government Securities. for different classes of investors: Example 1 n n n n n n Old couple Ag e around 60 years Retired Children financially independent Preserving capital. face interest rate risk over time. corporate bonds.

for investment. Based on his assessment. on the higher side Expens es high because of small children Reasonably aggressive portfolio with emphasis on growth – asset allocation suggested is : Example 4 n n n n n n Young single professional Age around 20/25 years Can affor d to take risk No liabilities built up Need to save on a systematic basis High r isk portfolio desirable – Asset allocation may be as under: The actual portfolios Once the asset allocation is finalized then the next step is selecting the right products under each asset class. The financial planner sh ould be fully informed about the various financial products. suitability to the client and such other feature s that are relevant. mutual funds. research and the asset allocation plan. as decided. track record of performance.Example 3 n n n n n n Young couple with small children Age around 30 years Incom e flow reasonable Outgo on account of home loans. the planner shall recommend to the client a list of securities – bonds. the risk. After finalizing the list of securities or the actual investment plan the planner shall forward the same to PDP Investment Planning 215 . shares. etc. the retur n. etc.

If necessary some changes may be made in the suggested portfolio within the broad Asset Allocation Plan al ready finalized. performan ce of companies. A review can be more frequent. making the investments. interest rates. as per the asset allocation plan. This will necessitate some selling of equity shares and moving funds to debts to bring down the proportion of equities to the desired level. Th e portfolio has been created with certain objectives. performance of the economy. etc. All issues of related risks and expe cted returns also should be discussed in the meeting. A proper monitoring and review system is as critical to the success of the investment plan as selec ting the right securities and going ahead with the right mix of assets. The portfolio is then finalized and the plan is put into action through purchase of securities. say on ce in 3 months could be a good suggestion to the client. Thus a rebalancing becomes necessary in a constant pr oportion asset allocation model. The meeting will serve the purpose of clearing such doubts and making the clien t understand the reasons for the selection. etc. The client and the planner while implementing the financial plan can lay down certain parameter s for review – generally time based and at times event based. While mo nitoring performance of the funds is considered carefully. Funds and stocks have been selected on the basis of certain criteria. Gradual changes in some of the se economic fundamental factors will drive portfolio restructuring decisions. The percentage of assets w ithin the asset class – for example the percentage of equity in the portfolio may undergo changes because of changes in the values of these assets with the market movements. This exercise will enable the investors to take into consideration the developments in the capital market and various economic factors such as inflation.the client for his perusal. 216 Investment Planning PDP . Rebalancing may be required to adjust the marke t risks in a portfolio or because of maturity selection as well. It is desirable to meet after the plan is sent to th e client and discuss with the client the rationale for the selection of securiti es and the structure of the portfolio. A review is to ensure that thes e funds/stocks are performing in line with the expectations. say once in 3 months if active strategies are being employed otherwis e a periodic review of debts say once a year and stocks and equity funds. Monitoring and rev iew This is a very important step in the investment process. The client may have some doubts and conce rns on certain issues or in respect of some products that have been recommended. For example when the stock market goes up the values of equities wil l go up and consequently the proportion of equities in the total portfolio will also go up.

Systematic investment plans that take care of capital growth and life insurance b. c a a PDP Investment Planning 217 . 35% debt and 5% cash b. 60% equity. 60% debt and 10% cash 2. of 25 years. 2. 50% equity. A young man. A retired couple should ideally prefer which of the followi ng asset allocation plans? a. 3. Understanding the clients’ needs and preparing an as set allocation plan that shall best meet the client’s financial objectives b. Should invest all his mon thly savings in Life insurance plans c. Constant restructuring and rebalancing of clients’ por tfolios resulting in frequent selling and buying of securities d. 30% equity. 20% debt d. A financial planner should concentrate on which of the following? a. 80% equity. Dist ributing financial products to his clients to meet his targets with mutual funds and insurance companies c. Mak e lump sum investments in index funds 3.Review Questions: 1. 40 % debt and 10% cash c. None of the ab ove Answers: 1. He should leave the job of investments t o his father and concentrate on his own job – he is too young to understand d. who has just joined an IT company as a programmer should prefer which kind of investment planning? a.

Chapter 17 218 Investment Planning PDP .

The mutual funds are regulated by SEBI. One of the most important conditions is client registration. informed investment advisors who will be accountable to SEBI and the investors. however SEBI is considering regulation of investment advisor and a process of registration so that the investors get proper advice from qual ified. If a distribu tor employs marketing people/counter staff to market mutual funds it is required that each one of them has passed a specific examination conducted by NSE. SEBI has clearly spelt out the terms of operations of stock brokers and sub brok ers. Thus mutual fund distribu tors are regulated and AMFI ensures that distributors are informed about mutual fund functioning. Insurance advisor s are registered and subject to the regulations of Insurance Regulatory Developm ent Authority of India (IRDA). A Certified Financial Planner voluntarily submits himself to a code of conduct laid down by the parent body “Financial Planning Standards Boar d. SEBI has stipu lated that all brokers/sub brokers should obtain information from clients in a s pecified format along with documentary evidence in support of client personal in formation – called Know Your Client (KYC) norms. and that the distributors do not resort t o undesirable practices to push the sales of mutual fund products. Some of the products are small saving instruments. insurance linked products. etc. etc. The client’s dealings on the stock exchanges throug h the broker will be allowed only after compliance with the above. The financial planners may be selling financial products and pro viding financial services. A mutual f und distributor is required to be registered with Association of Mutual Funds of India (AMFI). Stock brokers and sub brokers are required to be registered with SEBI. India” and vows to abide by the ethics while practicing as a Certified Financia l Planner. on this behalf. A mutual fund distributor is required to qualify for an examinati on conducted by National Stock Exchange on mutual funds before being registered with AMFI. These agents are appointed by respective state governments on behalf of the Government of India and are subject to terms and conditions lai d by Ministry of Finance. One of the most important purposes of the regulation of market player s in insurance. SEBI has laid down a number of conditions in the interest of investor protection and the brok ers have to comply with the same. trained. Government of India. stocks. mutual funds. Then the broker is required to en ter into an agreement with the client in a specified format and allot a unique c lient ID number to the client. their products. IRDA has laid down the conditions under which an advisor will perform. IRDA is also the supreme authority in respect of insurance companies as well. The distributor is also required to give an undertaking on a yearly basis to each mutual fund with whom he is registered that he is abiding by the code of conduct set by AMFI.Regulation of Financial Planners T he profession of financial planning does not require any licence nor is it regul ated in India. PDP Investment Planning 219 . A mut ual fund distributor can be inspected by AMFI to ensure that he complies with al l the regulations and code of conduct. S tock markets are regulated by stock exchanges in the first place and ultimately by SEBI. government bonds. Now. mu tual funds. Small savings mobilizations are done through s mall savings agents. The AMFI registered mutual fund distributor is required to abide by t he code of conduct stipulated by AMFI.

stock markets. You will observe that the fin ancial services profession is evolving. etc. 220 Investment Planning PDP . In future it will be a much better regul ated place where the advisors will essentially be well informed players who valu e professional ethics the most. is that the investor should get informed advice and quality service. It is stipulated by all the regulators that each distributor/advisor/br oker should have investor service departments and investor grievance redressal m echanisms in place in their respective workplaces.