Study on Equity share trading & Mutual fund

A report submitted to IIMT, Greater Noida as a part fulfillment of full time

Postgraduate Diploma in Marketing Management.
Submitted to: Submitted by
Director Nilesh kumar
IIMT, ENR NO: MMR3049
Greater Noida Batch: 3rd (Marketing)
Ishan Institute of Management & Technology
1A, Knowledge Park 1, Greater Noida
E-mail: ishan_corporate@yahoo.com
Website-www.ishanfamily.com
Name- Nilesh kumar
Enr. No.- MMR-3049
TITLE- Study on Equity share trading & Mutual fund
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PREFACE
All students learn theoretical subjects in their classroom, but as we are the management
students, apart from theoretical studies we need to get a deeper insight into the practical
aspects of those theories by working as a part of organization during our summer
training. Training is a period in which a student can apply his theoretical knowledge in
practical field. Basically practical knowledge and theoretical knowledge have a very
broad difference.
So this training has high importance as to know how both the aspects are applied
together.
The study of management acquires most crucial position in the business administration.
In order to be successful, it is necessary to give priority to the management in an
organization. But it cant be denied that the study of management would be more
educational, materialistic and even more interesting, if it is to be paired with the work in
organization as an employee.
The training session helps to get details about the working process in the organization. It
has helped me to know about the organizational management and discipline, which has
its own importance. The training is going to be a life long experience.
Management in India is heading towards a better profession as compared to other
professions. The demand for professional managers is increasing day by day. To achieve
profession competence, manager ought to be fully occupied with theory and practical
exposure of management. A comprehensive understanding of the principle will increases
their decision-making ability and sharpens their tools for this purpose. During the
curriculum of management programmers a student has to attain a practical exposure of an
organization on live project in addition to theory he/she studies.
This report is about the practical training done at RELIGARE SECURITIES LTD.
during the curriculum of PGDM (MM) from IIMT, Noida (U.P.)
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CERTIFICATE
This is to certify that the project work done on Study on Equity share trading &
Mutual fund Submitted to Ishan Institute Of Management & Technology, Greater
Noida by Nilesh kumar in partial fulfillment of the requirement for the award of degree
of Post Graduation Diploma in Marketing Management in a bonafide work carried
out by him under my supervision and guidance. This work has not been submitted
anywhere else for my other degree/diploma. The original work was carried during 12-05-
2009 to 04-07-2009 in Religare securities Ltd. at Dhanbad Branch.
DATE: Name of the Guide:
Seal/Stamp of the Organization Mr. Shaket kapoor

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ACKNOWLEGEMENT
Acknowledgement is not mere formality but an expression of deep sense of
gratitude
Any work visible in the project report is not only the effort of the presenter, but there are
many others behind the camera as well and this report is not an exception to this. So in
the process of recognizing the efforts of those behind the scene, I would like to sincerely
thanks Religare securities ltd, our training guide Mr. Shaket kapoor (Equity manager)
and Mr. Pankaj kumar (branch manager) and Faculty Members of Ishan Institute of
Management & Technology, for sharing their valuable views and time thereby helping
me in completing this project report of mine.
Above all I would like to thank the Financial Management team of Religare securities ltd.
for continuously motivating me and guide me with their valuable suggestion thus helping
me in completing the project in a very productive manner.
Last but not least I would like to show my gracious thanks to my classmates for providing
me with any relative data they came across and also for providing me with many ideas to
make the project report of mine more innovative.
PGDMM, ENR No: MMR 3049
Session: 2008-10
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DECLARATION
I, Nilesh kumar student of PGDM (MM) 2
nd
Semester in Ishan Institute of
Management & Technology, ENR. NO. mmr3049, hereby declare that, this Project
Report under the title Study on Equity share trading & Mutual fund is the record
of my original work under the guidance of Mr. Shaket Kapoor (Equity Manager),
Dhanbad Branch. This report has never been submitted anywhere else for award of any
degree or diploma.
Place: Noida Nilesh kumar
Date:
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TABLE OF CONTENT
TOPIC PAGE NO.
COVER AND TITLE PAGE 1
INTRODUCTORY PAGES
(1) PREFACE 6-7
(2) CERTIFICATE 8-9
(3) ACKNOWLEDGEMENT 10-11
(4)DECLARATION 12-13
EXECUTIVE SUMMARY 17-18
INTRODUCTION 19-21
OBJECTIVES 22-23
METHODOLOGY
1. SOURCES OF DATA 25-26
2. METHODS OF DATA COLLECTION 26
3. INSTRUMENTS USED 27
LITERARURE REVIEW 28-29
COMPANY PROFILE
1. BACKGROUND 30-32
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2. PROMOTORS 33-35
3. PRODUCTS LINE 36-37
4. FEATURE OF PRODUCTS 38-41
5. MARKETING STRATEGIES 42-48
6. COMPETITORS 49-73
7. GOVERNMENT POLICIES 74-84
8. TAXATION POLICIES 85-87
9. MAJOR PROBLEM 88-96
10. ACHIEVEMENTS 97-99
11. SHARE MARKET POSITION 100-101
12. FUTURE PROSPECTS 102-103
ABOUT THE TOPIC
SECURITY ANALYSIS & PORTFOLIO MANAGEMENT & DESIGNING NEW
MARKET STRATEGY
REGARDING SECURITY ANALYSIS 105-120
DEFINITION OF PORTFOLIO MANAGEMENT 120-125
STEPS OF NEW MARKET STRATEGY 125-126
MONEY MARKET 126-128
FUTURES EXCHANGE 128-132
FOREIGN EXCHANGE MARKET 132-186
SEBI 187-189
ROLE OF SEBI 189
REGULATION OF STOCK EXCHANGE 190-193

CONCEPTUAL FRAMEWORK 194-244
RECOMMENDATION 245-246
CONCLUSION 247-249
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LEARNINGS DURING SUMMER TRAINING 250-251
BIBLIOGHAPHY 252-254
WORD OF THANKS
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EXECUTIVE SUMMARY
Being a PGDM (Marketing Management) student it was the great pleasure for me that I
was assigned the most relevant title, as regards Summer Training project, i.e. Study on
Equity share trading & Mutual fund
To execute the assigned task, I had to advise to the investors so that they could get
maximum profit attend phone calls of investors and with the help of them security
products is given to the prospects investors for the benefit of the investors. For the
purpose of attending the calls of investors we have to explain the each & every aspect
trading through Religare Securities Ltd. For fulfilling the formalities of attending calls of
investors & having products knowledge & suggest them to the investors, I have to gain
the knowledge of the operational part also.
Further, in operations I learned about the documentation & trading process of investment
& in this process we have to follow the guidelines given by the SEBI. In operations I also
Learned how the investment process makes superb.
Further, I also gained the practical knowledge about the Religare securities products, I
have analyzed the various products of Security market & finally I decide that investment
management is finally products of choice. I also learn investment in mutual fund is better
option during market declination rather than other part of securities.
The RELIGARE SECURITIES LTD. has its research division, from where the advisory
functions are provided and on the basis of which we forward the given tips to the clients
by explaining the fundamentals. The research team consists of well qualified and
experienced professionals in the field of fundamental & technical analysis for explaining
the fundamentals. I have to learn all about the STUDY ON EQUITY SHARE TRADING
& MUTUAL FUND In the given project I have gained the overall view of the Indian
security market.
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INTRODUCTION
This project comprises of how Security analysis work as a hedging tool in stock market.
As one of the prime avenues for investment that generates reasonable rate of return in
times of very low interest rate market, security market has come as a boon for the
investors to generate some income on their savings and idle funds.
The growth (the bull run of 2003-04) was an ideal case of how the bourses behave in
climate of optimism and the resultant effect on equities as a whole. Not only did the large
cap funds performed but also the Mid-cap and small cap. In these situations it became
extremely difficult for investor to select stocks that were to outperform the index. More
so because of the inherent growth that Services and Industries were putting up on the face
of buoyant economy.
In this backdrop, our study compares the various stocks (mainly Large Cap) that were
selected by the Top Performing Funds and the individual return they gave to arrive at the
returns from the Fund as a whole. Also, this leads us to the next important criteria of
identifying whether or not these returns were the best in their respective sectors, to
understand about the alternative
Opportunities that are present whenever an investment decision is taken
Thus in this regard the project will also aim to study the top four performing stock
amongst the major stocks on offer currently in the market. Comparison of their rate of
return and what was the reason for their outstanding performance will be dealt in detail
Also when was the scheme initiated and how often was the portfolio changed and its
impact on funds performance.
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A company might be fairly valued in the eyes of the investor, and yet its scrip value rises
in the future trading sessions on account of its being the market leader and the industry as
a whole on a path of accelerated growth. Thus it becomes important, from the point of
view of stocks to take into account a more holistic view and be certain of more than one
opportunity for each selection so made to give a superior performance over the
competition.

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OBJECTIVE
The objectives of the study as regards the summer training project are as follows:
To know the attitude & preference of the investors in the Indian stock market.
To know the advantage and disadvantage of equity market as well as mutual fund
segment.
To analyze the difference between future and capital market.
How far Indian capital market stands in the world financial system.
To gain the deep knowledge about equity market.
To study the basics of the Indian stock market.
To study the evolution, function, importance and legal frame work of the Indian
stock market.
To study the importance of stock indexes (NIFTY & SENSEX) and its impact on
the stock market and economy.
To study the structure of the equity department
Last but not the least to take the overall view of Indian financial market.

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METHODOLOGY
The methodology is an integral primary part of the project work. Every project has been
undertaken in and definite manner, which forms the validity of the report. The project
undertaken by me is also based on a definite method, which is usually found in most of
the research projects. The methodology in my project is based on the following manner in
a sequential order: -
A. Data Collection
1. Data Collection (types of data).
2. Source of data collection.
3. Methods of data collection.
A. Data Collection
The collection of data is a core part of every activities relating to marketing decisions.
The information derived from such data is closely analyzed, Interpreted and a conclusion
has been arrived on which other decisions are totally depends.
There are various sources from where data can be collected any there also most
appropriate methods in the application of which we can collect the data. In the
application of sources and methods the reliability and accuracy must be well judged prior
to collection. The whole study has been worked out depending on the data availed from.
Sources of data collection:
There are two sources on which data can be collected via primary source and secondary
source. The data which are prepared from the main proposed and researcher or owner it is
called primary source and the data collected from this source is called primary data.
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The data which is collected from the persons, private bodies, private research agencies
etc are called secondary source and the data collected is from both primary and secondary
type. The following are the data which have been collected from both the sources:-
Primary data: -
In the course of carrying out the project I have collected very few data from this source
but they are more needed in carrying out the project work. The following data has been
has been collected from this source like the Delhi & NCR market.
Secondary data: -
Most of the data in my project has been collected from the secondary source as the data is
only available to them and other parties I have found the most convenient source and
collected from them. The data collected from this source are the past records and it is
used to analyses.
The data, which have been collected from this source, are mentioned below:
Methods of data collection:
The method of data collection is as essential as the source of collection of data. The
methods of data collection establish a pattern, the application on which provides a well
fledged out data. A most appropriate method will produce data which are more accurate,
reliable and cheap and also will require less time and efforts in the collection. In the
carrying of my project I have used the following methods in collecting the data:-
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Personal Enquiry: - The data from the personal contacts collected by the use of the
method of personal enquiry. The customers located at different places in Delhi & NCR
was approached by me to obtain favorable and required data to add in to the part of my
project.
Personal Survey: -
The information regarding the Investors being kept has been collected through personal
survey. The application of the above mentioned methods have been instructed by the
guide. Infant, in some cases it has been beneficial on the part of the project to meet the
big investors. The most important part of the project under the data collection has been
the collecting the information from the various corporate sectors in Delhi & NCR.
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LITERATURE REVIEW
1. The Background
2. The promoters
3. The Company and its Product line
4. Features of the product
5. Marketing Strategies
6. Competitors
7. Govt. Policies
8. Taxation aspects
9. Major problems
10. Achievements
11. Share Market Positions
12. National & International Image
13. Future Prospects
14. Conclusion
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THE BACKGROUND
ABOUT RELIGARE SECURTIES LTD.

INTRODUCTION
Religare is present in more then 100 branches all over India and will cross more than 200
branches very soon.
Our branches are fully equipped with high bandwidth internet lines and high end
computers machines. There are efficient branch managers and dealers to give US tips of
highest quality and accuracy with support from our analysts.
Our branches give us the feel of doing business in Dhanbad field however, in a more
sophisticated manner. We get to work with more traders and learn more and also trade
more.
We are present in more than 150 locations across length and breadth
of the country and each location is manned by experienced professionals who are highly
motivated and are genuinely interested to serve the clients in the best possible manner.
Our equity research team consists of well qualified and experienced professionals in the
field of fundamental & technical analysis.
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BACKGROUND AND HISTORY
Late Dr. Parvinder Singh (ex CMD Ranbaxy) was a true leader -- practical and realist
and yet, talked the language of a visionary and an idealist. For it was his vision to start
integrated financial services driven by the relationship of trust and confidence. From here
Religare Securities Limited, a Ranbaxy Promoter Group Company started its operations.
To realise its vision, the Religare group has taken one
step ahead. Today, Religare provides various financial services which include broking
(stocks & commodities), depository participant services, portfolio management services,
advisory on mutual fund investments and many more.
Unlike a traditional broking firm, Religare group
works on the philosophy of being Financial Care Partner. We not only execute the
trades for our clients but also provide them critical and timely investment advice. The
growing list of financial institutions with which Religare is empanelled as an approved
broker is a reflection of the high level service standard maintained by the company.

Religare is proud of being a truly professional
financial service provider managed by a highly skilled team, who have proven track
record in their respective domains. Through its regional, zonal and branch offices,
Religare has the widest reach and is available to us across the length and breadth of the
country.
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THE PROMOTERS:
Late Dr. Parvinder Singh (ex CMD Ranbaxy) was a true leader -- practical and realist
and yet, talked the language of a visionary and an idealist. For it was his vision to start
integrated financial services driven by the relationship of trust and confidence. From here
Religare Securities Limited, a Ranbaxy Promoter Group Company started its operations.
To realise its vision, the Religare group has taken one step ahead. Today, Religare
provides various financial services which include broking (stocks & commodities),
depository participant services, portfolio management services, advisory on mutual fund
investments and many more.
Unlike a traditional broking firm, Religare group works on the philosophy of being
Financial Care Partner. Company not only executes the trades for their clients but also
provide them critical and timely investment advice. The growing list of financial
institutions with which Religare is empanelled as an approved broker is a reflection of the
high level service standard maintained by the company.
Religare is proud of being a truly professional financial service provider managed by a
highly skilled team, who have proven track record in their respective domains. Through
its regional, zonal and branch offices, Religare has the widest reach and is available to
you across the length and breadth of the country.
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MANAGEMENT PROFILE
Religare is led by individuals who are professional leaders and are committed to reface
the financial services industry in India.
Each of the individual works constantly towards Religares objective of Indias
first truly MNC in financial services.
Religare team is led by a very eminent Board of Directors who provide policy
guidance and work under the active leadership of its CEO & Managing Director and
support of its Central Guidance Team.
Board of Directors
Following is the list of Directors of Religare Securities Limited
Chairman Mr. Harpal Singh
Managing Director Mr. Sunil Godhwani
Director Mr. Vinay Kumar Kaul
Director Mr. Malvinder Mohan Singh
Director Mr. Shivinder Mohan Singh
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COMPANY AND ITS PRODUCT LINE:
EQUITY AND DERIVATIVES
COMMODITY
DEPOSITORY
PORTFOLIO MANAGEMENT SERVICES
INSTITUTIONAL BUSINESS
INVESTMENT BANKING
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FEATURES OF THE PRODUCTS AND SERVICES:
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EQUITY AND DERIVATIVES:
For the first time Religare brings investing community the power to be associated with
the elite dealing rooms and freedom to execute trade on their own. That is, we may trade
from our branches or trade on our own over the net and with that we get our expertise and
assistance.
It has been designed to provide world class experience and expertise to investors. R-
ALLY as the name suggests is the perfect partner for savvy investors. Clients opting for
this service would be provided services managed by a team of dedicated relationship
managers and experienced trade dealers. They would not only assist the client in
information dissemination but would also take care of all post trade requirements.
COMMODITY
Commodities as a word originated from the French word commdite meaning benefit,
profit. Rightly so! The kind of continuously growing turnover which commodities
market has seen is incredible, benefiting both producers and buyers. These amazing
results have transformed commodities as a most sought after asset class. And this has
caught attention of the whole world.
Commodities market is particularly significant to our country as India is essentially a
commodity based economy. Therefore, it should not be surprising to see that Indian
Commodities Market is also taking giant strides, growing at a scorching pace and is well
poised to occupy its rightful place in the world. This has provided the Indian investors
with new emerging investment opportunities in the arena of commodities.
Commodity Derivatives trading in India is now done through the electronic trading
platform of two popular exchanges NCDEX (National Commodity & Derivative
Exchange Limited) and MCX (Multi Commodity Exchange). The various commodities
being traded on the exchanges include precious metals, crude oil, agro-commodities
amongst others.
Religare Commodities Limited is a member of both the exchanges (MCX & NCDEX)
that allows you to trade in all the commodities traded at both the exchanges. At present,
trading in commodities is restricted to futures contracts only.
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PORTFOLLIO MANGEMENT SERVICES:
The main idea behind Portfolio Management Services is to manage our clients wealth
more efficiently, reduce risk by diversifying across assets, sectors and funds, and
maximizing returns. Expert Portfolio Managers find best of avenues to achieve optimum
returns at managed levels of risk.
This service could also be called as transparent collective investments. You get an
upper hand in many ways.
Advantage of Portfolio Management Services
Constant monitoring of portfolios asset mix to ensure effectively position to meet
long-term objectives. Our portfolio managers adjust the asset mix to reflect the current
economic climate and to benefit from opportunities.
Performance linked fees, constant disclosure of the portfolio on daily and monthly
basis.
It defines the customised risk and return.
Great flexibility of deploying and exposing the initial investment in the market.
High water mark level for profit sharing.
No transaction and custodian charges.
Diversification across asset classes and investment styles.
Investment objectives and goals presented clearly through a personalized profile.
Encourages a disciplined approach to investing over a longer time horizon
Company offer four different schemes to investors according to their varying tastes,
objectives and risk tolerance.
Each benefits from professional management that aims to provide you consistent returns
at a reduced level of risk.
TORTOISE
PANTHER
ELEPHANT
LEO
India has emerged as one of the fastest growing financial markets in the world and is a
preferred destination for investment among the global investor fraternity. Religare
Securities countrys premier financial services company will help you pick the best of
products. At Religare, we believe in partnership driven by ethical and dynamic process
for wealth creation.
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INSTITUTIONAL BUISINESS:
Religare has already started investing in Mutual Funds for its clients. We have sound and
in-depth knowledge on the subject, with people from the Mutual Fund industry on board.
A strong research work - not only on commodities / equities / international market- but
also on MUTUAL FUNDS, is the cutting edge which we boast of.
Mutual funds provide a form of investment that is both relatively safe and relatively
lucrative. Mutual funds offer investors the advantages of professional management of
invested money and diversification of that investment.
Our expertise lies in identifying top performing schemes, debt as well as equity, on a
daily basis and disseminating the information through our daily research reports and
Mutual Fund Roundup.
Gradually other products like insurance, fixed deposits, debentures, bonds etc will join in.
Religare is currently offering two special services to our esteemed investors in
commodities:
Retail Commodity Broking Our branches, spread all over India are well
positioned to cater to the growing needs of retail clients. Our research team provides
trading calls to our clients, enabling them to profit from the market movements.

Portfolio Advisory Services (COMPASS) - We have launched COMPASS, our
non-discretionary Commodity Portfolio Advisory Services, which allows investors to get
the benefit of our in-depth research services and generate better returns with minimal
risk. We also offer a special product called RALLY.
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MARKETING STRATEGY:
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POLICIES:
A- Basis of preparation
The financial statements have been prepared to comply with the mandatory Accounting
Standards issued by the Institute of Chartered Accountants of India (`ICAI') and the
relevant provisions of the Companies Act, 1956 (the `Act'). The financial statements have
been prepared under the historical cost convention on accrual basis. The accounting
policies have been consistently applied by the Company unless otherwise stated.
B- Fixed assets
Fixed assets are stated at cost less accumulated depreciation and impairment losses. Cost
comprises the purchase price and any attributable cost of bringing the asset to its working
condition for its intended use.
C- Intangibles
Patents, Trademarks and Designs
Costs relating to patents, trademarks and designs, which are acquired, are capitalized and
amortized on a straight-line basis over a period of 5 years.
Computer software
Pursuant to adoption of Accounting Standard 26 - Intangible Assets, issued by the ICAI,
software which is not an integral part of the related hardware is classified as an intangible
asset and is being amortised over a period of 6 years, being the estimated useful life.
Non-compete
Costs relating to payment of non compete compensation is capitalised and amortised on a
straight-line basis over the life of non-compete agreement.
D- Depreciation
Depreciation is provided on straight-line method at the rates and in the manner prescribed
in Schedule XIV of the Act.
Premium paid on perpetual leasehold land is charged to revenue on termination/renewal
of lease agreements.
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E- Leases
Operating lease payments are recognized as an expense in the Profit and Loss account on
a straight-line basis over the lease term.
F- Investments
Investments that are readily realisable and intended to be held for not more than a year
are classified as current investments. All other investments are classified as long-term
investments. Current investments are carried at lower of cost and fair value determined
on an individual investment basis. Long-term investments are carried at cost. However,
provision for diminution in value is made to recognise a decline other than temporary in
the value of the investments.
Profit/loss on sale of investments is computed with reference to their average cost.
G- Inventories
Inventories are valued as follows:
Raw materials, stores and spares and packing materials
Lower of cost and net realizable value. However, materials and other items held for use
in the production of inventories are not written down below cost if the finished products
in which they will be incorporated are expected to be sold at or above cost. Cost is
determined on a weighted average basis.
Finished goods
Lower of cost and net realizable value. Cost includes direct materials and labour and a
proportion of manufacturing overheads based on normal operating capacity. Cost of
finished goods includes excise duty.
Work-in-process
At cost upto estimated stage of process. Cost includes direct materials and labour and a
proportion of manufacturing overheads based on normal operating capacity.
Net realizable value is the estimated selling price in the ordinary course of business, less
estimated costs of completion and the estimated costs necessary to make the sale.
Where duty paid/indigenous materials are consumed, prior to duty-free import of
materials under the Advance License Scheme, in manufacture of products for export, the
estimated excess cost of such materials over that of duty free materials is carried forward
in the cost of raw materials and charged to revenue on consumption of such duty-free
materials.
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H- Revenue recognition
Revenue is recognized to the extent that it is probable that the economic benefits will
flow to the Company and the revenue can be reliably measured.
Sale of Goods:
Revenue from sale of goods is recognised when the significant risks and rewards of
ownership of the goods are transferred to the customer and is stated net of trade
discounts, excise duty, sales returns and sales tax.
Royalties, Technical Know-how and licensing income:
Revenue is recognised on an accrual basis in accordance with the terms of the relevant
agreement.
Interest:
Revenue is recognised on a time proportion basis taking into account the amount
outstanding and the rate applicable.
Dividends:
Revenue is recognised when the right to receive the income is established.
I- Research and development costs
Revenue expenditure incurred on research and development is charged to revenue in the
year it is incurred. Capital expenditure is included in the respective heads under fixed
assets.
J- Expenditure on regulatory approvals
Expenditure incurred for obtaining regulatory approvals and registration of products for
overseas markets and products acquisition is charged to revenue.
K- Employee stock option plan
The accounting value of stock options representing the excess of the market price over
the exercise price of the shares granted under "Employees Stock Option Scheme" of the
Company, is amortised on straight-line basis over the vesting period as "Deferred
employees compensation" in accordance with the SEBI (Employee Stock Option Scheme
and Employee Stock Purchase Scheme) Guidelines, 1999.
L- Foreign currency translation
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Foreign currency translations
(i) Initial Recognition
Foreign currency transactions are recorded in the reporting currency, by applying to the
foreign currency amount the exchange rate between the reporting currency and the
foreign currency at the date of the transaction.
(ii) Conversion
Foreign currency monetary items are reported using the closing rate. Non-monetary items
which are carried in terms of historical cost denominated in a foreign currency are
reported using the exchange rate at the date of the transaction; and investments in foreign
companies are recorded at the exchange rates prevailing on the date of making the
investments.
(iii) Exchange Differences
Exchange differences arising on the settlement of monetary items or on reporting
company's monetary items at rates different from those at which they were initially
recorded during the year, or reported in previous financial statements, are recognised as
income or as expenses in the year in which they arise, except for loans denominated in
foreign currencies utilized for acquisition of fixed assets where the exchange gains/losses
are adjusted to the cost of such assets.
(iv) Forward Exchange Contracts not intended for trading or speculation purposes
The premium or discount arising at the inception of forward exchange contracts is
amortised as expense or income over the life of the contract. Exchange differences on
such contracts are recognised in the profit and loss in the year in which the exchange
rates change. Any profit or loss arising on cancellation or renewal of forward exchange
contract is recognised as income or as expense for the year.
Representative offices
In translating the financial statements of representative offices for incorporation in
financial statements, the monetary assets and liabilities are translated at the closing rate;
non monetary assets and liabilities are translated at exchange rates prevailing at the dates
of the transactions and income and expense items are converted at the respective monthly
average rate.
M- Retirement benefits
Contributions in respect of provided fund, superannuation and gratuity are made to Trust
set up by the Company for the purpose and charged to profit and loss account.
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Provisions for liabilities in respect of gratuity, pension and leave encashment benefits are
made based on actuarial valuation made by an independent actuary as at the balance sheet
date.
N- Income taxes
Tax expenses comprises both current and deferred taxes.
The provision for current income tax is the aggregate of the balance provision for tax for
three months ended March 31, 2004 and the estimated provision based on the taxable
profit of remaining nine months up to December 31, 2004, the actual tax liability, for
which, will be determined on the basis of the results for the period April 1,2004 to March
31, 2005.
Deferred income taxes reflects the impact of current year timing differences between
taxable income and accounting income for the year and reversal of timing differences of
earlier years. Deferred tax is measured based on the tax rates and the tax laws enacted or
substantively enacted at the balance sheet date. Deferred tax assets are recognised only to
the extent that there is reasonable certainty that sufficient future taxable income will be
available against which such deferred tax assets can be realised.
O- Export benefits/incentives
Export entitlements under the Duty Entitlement Pass Book ("DEPB") Scheme are
recognised in the profit and loss account when the right to receive credit as per the terms
of the scheme is established in respect of the exports made.
Obligation/entitlements on account of Advance License Scheme for import of raw
materials are accounted for on purchase of raw materials and/or export sales.
P- Contingent liabilities
Depending on facts of each case and after due evaluation of relevant legal aspects, claims
against the Company not acknowledged as debts are disclosed as contingent liabilities. In
respect of statutory matters, contingent liabilities are disclosed only for those demand(s)
that are contested by the Company.
Q- Use of estimates
In preparing Company's financial statements in conformity with accounting principles
generally accepted in India, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosure of contingent
liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period; actual results could differ from those estimates.
R- Earnings per share
44
Basic earnings per share are calculated by dividing the net profit or loss for the period
attributable to equity shareholders by the weighted average number of equity shares
outstanding during the period. The weighted average number of equity shares outstanding
during the period is adjusted for events of bonus issue.
For the purpose of calculating diluted earnings per share, the net profit or loss for the
period attributable to equity shareholders and the weighted average number of shares
outstanding during the period are adjusted for the effects of all dilutive potential equity
shares.
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THE COMPETITORS:
46
SHARE KHAN
5 PAISA
KOTAK SECURITIES
INDIA BULLS
ICICI DIRECT
HDFC SECURITIES
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Share khan
Company Background
Share khan is the retail broking arm of SSKI Securities Pvt. Ltd. SSKI owns 56% in
share khan; balance ownership is HSBC, First Caryle, and Intel Pacific
Exists Into broking since 80 years
Focused on providing equity solutions to every segment
Largest ground network of 250 Branded Share shops in 123 Cities
Online trading account
Share khan provide two types of trading account:
1. Classic account (For beginners and medium investor)
2. Speed Trade (For heavy investor)
Classic Account:--
The CLASSIC ACCOUNT is a Share khan online trading account, through which We
can buy and sell shares through our website www.sharekhan.com in an instant.
Along with enabling access for us to trade online, the CLASSIC ACCOUNT also gives
us our Dial-n-Trade service. With this service, all you have to do is dial 1-600-22-7050 to
buy and sell shares using your phone.
Features of the CLASSIC ACCOUNT that enables us to invest effortlessly
Online trading account for investing in Equities and Derivatives via
sharekhan.com
Integration of: Online trading + Bank + Demat account
Instant cash transfer facility against purchase & sale of shares
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Reasonable transaction charges
Instant order and trade confirmation by e-mail
Streaming quotes
Personalized market watch
Pricing for Retail Customers
Speed Trade
Account Opening: Rs. 1000
Demat 1st Yr: Incl in Account Opening
Initial Margin: NIL
Min Margin Retainable: NIL
Brokerage:
Trading 0.10% each side + All Taxes
Delivery 0.50% each side + All Taxes
( Default brokerage but is Negotiable based on volume )
Account Access Charges
Monthly Rs 500, adjustable qtr against brokerage of Rs 1500/- for qtr (i.e. Client has to
pay Rs.500, if he is unable to generate the brokerage of Rs.500 per month)
No access charges for gold customers (Clients who is generating brokerage more than 1
lac per annum)
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Classic A/C
Account opening : 750 (lifetime)
Demat 1
st
year: free a/c opening
Initial margin : NIL
Minimum margin :NIL
Brokerage:
Trading 0.10% each side + All Taxes
Delivery 0.50% each side + All Taxes
( Negotiable based on volume
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52
5paisa
Company Background
Indiainfoline was founded in 1995 and was positioned as a research firm.
In 2000 e-broking was started under the brand name of 5 paisa.com.
Apart from offering online trading in stock market the company offers
Mutual funds online.
It also acts as a distributor of various financial services i.e. GOI securities, Company
Fixed Deposits, Insurance.
Limited ground network, present in 20 Cities
Online Account Types
Investor Terminal : Investors / Students
Trader Terminal : Day Traders / HNIs
PRICING FOR RETAIL CLIENTS
Investor Terminal
Account Opening : Rs 500
Demat 1st Yr : Rs 250
Initial Margin: Rs 2500(Compulsory)
Min Margin Retainable: Rs 100
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Brokerage:
Trading 0.10% each side + ST
Delivery 0.50% each side + ST
PRICING FOR HNI CLIENTS
Trader Terminal
Account Opening : Rs 500
Demat 1st Yr : Rs 250
Initial Margin : Rs 5000(Compulsory)
Min Margin Retainable : Rs 1000
Brokerage :
Trading 0.10% each side + ST
Delivery 0.50% each side + ST (Negotiable to 0.05% each side & 0.25%)
Account Access Charges
Monthly Rs 800, adjustable against Brokerage
Yearly Rs 8000, adjustable against brokerage

Deal Clinchers v/s 5 Paisa
Company Background
Not having a very positive image, relatively new in the broking arena, limited
network
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Downtime
Recent past 5 paisa Trader Terminal (T.T) is experiencing high frequency
downtime between 3 3:30 p.m. due to server load (as their T.T is feature heavy
compared to Speetrade charting)
Manual Accounting
The 5 paisa accounting system is manual, Online fund transfer through bank is not
credited instantly.
Limit is provided EOD for shares sold from DP, or call
Similarly limit released for shares sold under BTST is manual
Delay in receiving pay-out of clear funds from trading to Bank Account.
.
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Kotakstreet
Company Background
Kotakstreet is the retail arm of kotak securities. Kotak Securities limited is a joint venture
between Kotak Mahindra Bank and Goldman Sachs.
Online Account Types
Twin Advantage / Green Channel: 2 DPs, Limit against shares
Free Way: Flat Rs 999 Cover Charge p.m, 0.03% per transaction
High Trader: 6 Times Exposure Cash & Derivatives, Auto sq off 2:55
Cash Expressway: Spot payment, additional 0.5% charges
For Kotak Fast Lane / Keat Lite / Keat Desktop are trading interfaces. Keat Desktop with
advanced tools comes at a charge of Rs 500 p.m, Non refundable.
PRICING OF KOTAK
Account Opening: Rs 500
Demat: Rs 22.5 p.m
Initial Margin: Rs 5000(Compulsory)
Min Margin Retainable: Rs 1000
Brokerage Slab wise: Higher the volume, lower the brokerage. Even older customers (on
0.25% & 0.40%) have been moved to the slab wise structure wef 1/4/2004
Slab structure of Kotak
Delivery Vol p m Brokerage *
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< 1 lakhs 0.65%
1 lakhs - 5 lakhs 0.60% Square Vol off p m
< 10 lakhs 0.10% Both Sides
10lakhs - 25 lakhs 0.08% Both Sides
25lakhs 2 Cr 0.06% Both Sides
2 Cr - 5 Cr 0.05% Both Sides
> 5 Cr 0.04% Both Sides
Brokerage is inclusive of All Taxes
** Min Brokerage of Rs 0.01 per share
Derivatives Vol off p m Brokerage
< 2 Cr 0.07% Both Sides
2 Cr - 5.5 Cr 0.05% Both Sides
5.5 Cr - 10 Cr 0.04% Both Sides
> 10 Cr 0.03% Both Sides
Brokerage is inclusive of All Taxes
DP Charges Extra
Brokerage is inclusive of All Taxes
Min Brokerage of Rs 0.05 per share
Deal Clinchers v/s Kotakstreet
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Rigid Account Opening Terms
No Flexibility of A/c opening charges (Rs 500) + Compulsory margin Rs 5000/-
Account opening free with Rs 10,000 Margin OR competitor Contract Note.
No Customization of commercial Terms
No Flexibility in Leverage Dependent on Type of Account ( 4 to 6 times only)
No flexibility in Brokerage, driven by slab structure
Many Other Charges
Rs 22.5 p.m towards DP AMC charges
DP incoming charges extra, 0.02%
Rs 1,000 as retainable Margin to keep account active
Rs 25 per call after 20 calls for the month
Restricted Access to Terminal Like product
KEAT Desktop restricted distribution on payment of Rs 500, Non refundable.
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60
INDIABULLS
DP Account.
Paid Research Services
Access to an research even for an IB trading account holder is charged a min of Rs
500 a month Company Background
IndiaBulls is a retail financial services company present in 70 locations covering 62
cities. It offers a full range of financial services and Products ranging from Equities to
Insurance. 450 + Relationship Managers who act as personal financial advisors.
India bulls Financial Services Limited was incorporated on January 10, 2000 as
M/s Orbis InfoTech Private Limited at New Delhi under the Companies Act, 1956 with
Registration No. 55 - 103183. The name of Company was changed to M/s. India bulls
Financial Services Private Limited on March 16, 2001 due to change in the main objects
of the Company from InfoTech business to Investment & Financial Services business. It
became a Public Limited Company on February 27, 2004 and the name of Company was
changed to M/s. India bulls Financial Services Limited. The Company was promoted by
three engineers from IIT Delhi, and has attracted more than Rs.700 million as
investments from venture capital, private equity and institutional investors such as LNM
India Internet Ventures Ltd., Transatlantic Corporation Ltd., Farallon Capital Partners,
L.P., R R Capital Partners L.P., and Infinity Technology Trustee Pvt. Ltd. and has
developed significant relationships with large commercial banks such as Citibank, HDFC
Bank, Union Bank, ICICI Bank, ABN Amro Bank, Standard Chartered Bank, Lord
Krishna Bank and IL&FS. The Company and its subsidiaries have facilities from the
above mentioned banks and financial institutions aggregating to Rs. 1760 million. The
Company headquarters are co-located in Mumbai and Delhi, allowing it to access the two
most important regions for Indian financial markets, the Western region including
Mumbai, rest of Maharashtra and Gujarat; and the Northern region, including the
National Capital Territory of Delhi, nearby cities, parts of Haryana, Uttar Pradesh and
Punjab; and access the highly skilled and educated workforce in these cities. The
Marketing and Sales efforts are headquartered out of Mumbai, with a regional
headquarter in Delhi; and its back office, risk management, internal finances etc. are
headquartered out of Delhi, allowing The Company to scale these processes efficiently
for the nationwide network,
- Indiabulls Financial Services Ltd fixes an issue price of Rs 19 per share for its initial
public offering (IPO), which was oversubscribed 18.5 times.Indiabulls Financial Services
IPO closed on September 10, with an impressive response from all categories of
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investors. The book was finally subscribed 18.5 times with over 1.3 lakh bids. The
institutional portion was subscribed more than 12 times, the retail portion 25 times and
the non-institutional portion 24 times.
Online Account Type
Signature Account: Plain Vanilla Account with focus on Equity Analysis. The equity
analysis is a paid service even for A/c holders
Power Indiabulls: Account with sophisticated trading tools, low commissions and priority
access to R.M
Pricing of IB Accounts
Signature Account
Account Opening : Rs 250
Demat: Rs 200 if POA is signed, No AMC for this DP
Initial Margin: NIL
Brokerage: Negotiable
Power IndiaBulls
Account Opening: Rs 750
Demat: Rs 200 if POA is signed, No AMC (Annual maintenance charges) for this DP.
Initial Margin: NIL
Brokerage: Negotiable
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PAID Research
SCHEME FACILITY
WebBased-1-Month-500: View & Print on website
WebBased-1-Year-6000 View & Print on website
PrintReport-1-Month-750: View & Print on website + 10
Reports Delivered
PrintReport-1-Year-9000: View & Print on website + 10 Reports
Delivered
Deal Clinchers v/s IndiaBulls

POA for Clients DMAT
All shares held by client trading with India Bulls are moved to pool Account and
the same is shown as a reflection in client DP Account. Charges are Levied to move
shares from India bulls pool account to client
Margin Funding hoax
The interest on funding starts on leveraged delivery trades from T+1 day itself
@21% p.a. on a daily basis.
The role of Relationship Manager
Each RM is looked upon as a revenue generator and he gets a % on business
generated from client. This can lead to over leveraged (Interest) & high frequency
(Brokerage) trading, which may not be in the best interest of the client.
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ICICIDirect
Company Background
ICICI Web Trade Limited (IWTL) maintains ICICIdirect.com. IWTL is an Affiliate of
ICICI Bank Limited and the Website is owned by ICICI Bank Limited.
Account Types
ICICI Direct e-invest Account: Plain Vanilla Account with focus on 3 in 1 advantage.
Differentiated in services within the account
1. Cash on spot
2. MarginPlus
Premium trading interface of ICICIDirect Link is given to DBC partners and HNIs
Account Opening: Rs 750
Schemes: For short periods Rs 750 is refundable against brokerage generated in a qtr.
These schemes are introduced 3-4 times a year.
Demat: NIL, 1st year charges included in Account Opening Plus a facility to open
additional 4 DPs without 1st yr AMC
Initial Margin: Nil
Brokerage: All brokerage is inclusive of stamp duty and exclusive of other taxes.
Delivery Vol per qtr Brokerage
< 10 lakhs 0.75%
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10 lakhs - 25 lakhs 0.70%
25 lakhs -50 lakhs 0.55%
50 lakhs 1 Cr 0.45%
1 Cr 2 Cr 0.35%
2 Cr 5 Cr 0.30%
> 5 Cr 0.25%
Deal Clinchers v/s ICICIDirect
Poor online Interface
Slow website interface with no real-time quotes creates dissatisfaction among high
frequency traders.
Margin trading restriction
The margin trading system is available up to 2:45 p.m, with outstanding net positions
under margin segment automatically squared off at any time between 2:45 3:30 p.m.
Thus no control of square off price.
Morning Trades Issue
Being one of the websites with largest no of after hour orders which are pushed 1st thing
in the morning, creates a choking of orders to the exchange, causes delay of
confirmations for new order placed during the early morning trades.
Restriction of BTST
The sale of shares purchased is restricted to T+1 day and is not permitted on T+2 Day.
No leverage for Delivery trades
Delivery is restricted to the total money allocated into the trading account.
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No flexibility on leverage on Intra-day trades
The leverage of 4 times is available for intra- day trades.
Restriction of Bank Account
The choice of bank is restricted to ICICI Bank.
Higher Brokerage rates with slabs
The delivery brokerage is pegged at 0.75% and trading at 0.10% each side, this makes is
very unviable for customers dealing in large volumes. Although progressively the
delivery and trading brokerage reduce as volumes go up.
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HDFC Securities.com
Company Background:
HDFC Securities Ltd, is promoted by the HDFC Bank, HDFC and Chase. capital Capital
Partners and their associates. Pioneers in setting up Dial-a-share services with the largest
team of Tele-brokers.
Online Account Type:
HDFC Online Trading A/c: Plain Vanilla Account with focus on 3 in 1 advantage.
Pricing of HDFC Account:
Account Opening: Rs 750
Demat: NIL, 1st year charges included in Account Opening
Initial Margin: Rs 5000/- for non HDFC Bank customers (AQB)
Brokerage:
Trading 0.15%* each side + ST
Delivery 0.50%** each side + ST
* Rs 25 Min Brokerage per transaction
** Rs 8 Min Brokerage per transaction
Deal Clinchers v/s HDFC Securities
Poor online Interface
Apart from having no product to cater to Day-Traders, the hdfcsec.com website is
plagued with downtime. The same is currently being revamped.
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Lack of focus on Broking
The core business of HDFC is Housing Finance and that of HDFC Bank is Banking.
Broking as a business is a small part of the portfolio of financial services and hence the
commitment to resources is limited.
No Leverage
No leverage is available to clients even for Intra-Day trades, effectively all clients are on
cash and carry system.
No flexibility in commercial terms
The delivery brokerage is pegged at 0.5% and trading at 0.15% each side, this makes it
unviable for customers dealing in large volumes.
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Govt. Policies:
Process of conversion of securities into the demat form Securities specified as being
eligible for dematerialization by the depository in its bye laws and as under the SEBI
(Depositories and Participants) Regulations, 1996 (the Regulations) can be converted or
issued in a dematerialized form. The process of conversion of securities into a
dematerialized form or the issuance of the same in a dematerialized form can be
explained thus:
1. Firstly, the issuer company, whose securities are eligible for dematerialization, has to
enter into an agreement with a depository for dematerialization of securities already
issued, or proposed to be issued to the public or existing shareholders .
2. The investor is given an option to hold the securities in a dematerialized form and it is
his prerogative to exercise the option to hold the securities in that manner.
3.The depository enters into an agreement with the participants who are the agents of the
depository and co-functionaries in the process of dematerialization of securities.
4. Any person can then enter into an agreement, through the participant, with the
depository for availing the services provided by the depository.
5. Upon the entering into such agreement with the depository, the person has to surrender
the certificate pertaining to the securities sought to be dematerialized to the issuer. This
surrender is affected in the following manner
(i) The person (beneficial owner) who has entered into an agreement with the participant
for dematerialization of the securities has to inform the participant about the details of the
certificate of such securities.
(ii) The beneficial owner has to then surrender the said certificate to the participant.
(iii) The participant informs the depository about the particulars of the securities to be
dematerialized and the agreement entered into between him and the beneficial owner.
(iv) The participant then transfers the certificate pertaining to the said securities to the
issuer along with the details and particulars of the securities.
(v) These certificates are mutilated upon receipt by the issuer and substituted in the
records against the name of the depository, who is the registered owner of the said
securities. A certificate to this effect is sent to the depository and all stock exchanges
where the security is listed.
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(vi) Subsequent to this, the depository enters the name of the person who has surrendered
the certificate of security as the beneficial owner of the dematerialized securities.
(vii) The depository also enters the name of the participant through whom the process has
been carried out and sends an intimation of the same to the said participant.
6. Once the aforesaid process of dematerialization is carried out, the depository has the
responsibility to maintain all the records pertaining to the securities that have been
dematerialized.
Understanding risks associated with equities and learning how to manage them is the key
to achieving higher returns from equities. Remember, the most important features of a
fast car are the brakes and the steering wheel not the accelerator!
Registration of Stock Broker
A stock broker applies in the prescribed format for grant of a certificate through the stock
exchange or stock exchanges, as the case may be, of which he is admitted as a member
(Regulation 3). The stock exchange forwards the application form to SEBI as early as
possible as but not later than thirty days from the date of its receipt.
SEBI takes into account for considering the grant of a certificate all matters relating to
buying, selling, or dealing in securities and in particular the following, namely, whether
the stock broker:
(a) is eligible to be admitted as a member of a stock exchange,
(b) has the necessary infrastructure like adequate office space, equipment and man power
to effectively discharge his activities,
(c) has any past experience in the business of buying, selling or dealing in
securities,
(d) is subjected to disciplinary proceedings under the rules, regulations and bye laws of a
stock exchange with respect to his business as a stock-broker involving either himself or
any of his partners, directors or employees, and
(e) is a fit and proper person.
SEBI on being satisfied that the stock-broker is eligible, grants a certificate to the stock-
broker and sends intimation to that effect to the stock exchange or stock exchanges, as the
case may be. Where an application for grant of a certificate does not fulfill the
requirements, SEBI may reject the application after giving a reasonable opportunity of
being heard.
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Fees by stock brokers
Exchanges, as the case may be. Where an application for grant of a certificate does not
fulfill the requirements, SEBI may reject the application after giving a reasonable
opportunity of being heard.
Fees by stock brokers
Every applicant eligible for grant of a certificate shall pay such fees and in such manner
as specified in Schedule III. Provided that SEBI may on sufficient cause being shown
permit the stock-broker to pay such fees at any time before the expiry of six months from
the date for which such fees become due (Regulation 10). Where a stock-broker fails to
pay the fees, SEBI may suspend the registration 154 certificate, whereupon the stock-
broker shall cease to buy, sell or deal in securities as a stock- broker.
The broking house like Share khan has to follow certain norms, and rules to run
smoothly. These rules are guided by the name SEBI Rules. These norms are as under :
Role OF SEBI
The Securities and Exchange Board of India (SEBI) is the regulatory authority in India
established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for
establishment of Securities and Exchange Board of India (SEBI) with statutory powers
for (a) protecting the interests of investors in securities (b) promoting the development of
the securities market and (c) regulating the securities market. Its regulatory jurisdiction
extends over corporates in the issuance of capital and transfer of securities, in addition to
all intermediaries and persons associated with securities market. SEBI has been obligated
to perform the aforesaid functions by such measures as it thinks fit. In particular, it has
powers for:
Regulating the business in stock exchanges and any other securities markets.
Registering and regulating the working of stock brokers, subbrokers etc.
Promoting and regulating self-regulatory organizations
Prohibiting fraudulent and unfair trade practices
Calling for information from, undertaking inspection, conducting inquiries and audits of
the stock exchanges, intermediaries, self regulatory organizations, mutual funds and
other persons associated with the securities market.
Why have equity prices fallen in the past?
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Whenever governments have fallen; political instability. Inflation hitting double digits;
rupee falling; interest rate hikes (the knowledgeable tells that these are broad economic
parameters that affect all businesses). A lot of people tell that wars have spooked the
market increasing oil prices in global market etc (country and lives are at stake.).Scams!!
(Human greed knows no bounds).
Bad management interested in making a quick buck themselves Company s products
bombed (Bad luck, bad strategy or bad marketing?)Lakshmi Machine Works suffers as
textile mills are not doing well (a case of a specific sector going bad that wipes out even
the best of companies).
A chemical company s plant caught fire destroying it completely, A brilliant product but
the company s borrowings strangled the product before it saw the light of the day. If you
look at these reasons in detail, you realize that there are some factors that are within the
companys control or specific to the companys business (bad management, products
bombing, sector downslide, fire, borrowings?). The rest of the factors (politics,
macroeconomic issues and wars) affect the market in general.
OK, one seems to have got two watertight classifications for equity risk. One affects
specific companies and sectors. Textbooks have various names for it diversifiable risk,
unsystemic risk, business risk, company risk and so on. The other set of risk affects the
entire market. Undiversifiable risk, systemic risk, market risk.....
The amazing power of classification! Suddenly, our big list of risks looks manageable.
We just need to understand which basket they belong to! To get the classification right,
let us delve a little deeper into the two groups. We will take up the ways and means of
tackling these risks in our next session (lest we suffer from overload).
Company risk: a closer look
Though company risk is specific to the company, some risk factors that affect the
business are within the control of the company. Corporate India is replete with instances
of how a company could have controlled its future better.
Calling for information from, undertaking inspection, conducting inquiries and audits of
the stock exchanges, intermediaries, self regulatory organizations, mutual funds and
other persons associated with the securities market.
Real Values (the Ceasefire Company) ill-conceived foray into vacuumisers is an example
of strategy going haywire. There are hazar Indian promoters who have siphoned money
from their listed companys examples of bad management. Core Healthcare (earlier Core
Parenterals) is another classic example of a company that had the right product but, in its
urge to build mega plants, it borrowed beyond its means before creating a market the rest
is history (the company got into a debt trap, and the product became a commodity).
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All these risks can be avoided if proper homework is done to understand businesses and
make a future looking call on their businesses. Only stock-picking skills can see you
through this maze of risks. Now you know why good research analysts are so sought
after!
The other sets of risks that are business specific are beyond the control of the company.
What can Madras Cements do if the cement market suddenly slumps as there is too much
new capacity with no matching demand! What can TNPL do if demand for newsprint
falls as more and more people take to reading newspapers on the Internet! (Not now! But
it can happen 10 years down the line) What can Tisco do if Posco dumps a million tons of
steel in the country (not literally!)!
Of course there is something that these companies can do to rework their strategies, but it
is time consuming. And you know our stock markets! The prices will get hammered with
the first waft of bad news. In any case, if one were to diversify one?s holdings across
various sectors and companies, the risks can get minimised to a certain extent. Risk
diversification is another useful concept to understand, which we will take up next time.
Market risk
Company risk is still easy to contend with, but what do we do about market risks? Out of
the number of factors affecting markets, our experience tells us that market declines
under many of these factors are temporary and provide excellent buying opportunities for
the patient investor who thinks and buys good companies.
Market risk is a different animal altogether. Diversification does not help as all stocks get
affected by these factors. But fret not, the native ingenuity of mankind has found
solutions to this problem too, in the form of Futures & Options.
a] Basis of preparation
The financial statements have been prepared to comply with the mandatory Accounting
Standards issued by the Institute of Chartered Accountants of India (`ICAI') and the
relevant provisions of the Companies Act, 1956 (the `Act'). The financial statements have
been prepared under the historical cost convention on accrual basis. The accounting
policies have been consistently applied by the Company unless otherwise stated.
[b] Fixed assets
Fixed assets are stated at cost less accumulated depreciation and impairment losses. Cost
comprises the purchase price and any attributable cost of bringing the asset to its working
condition for its intended use.
[c] Intangibles
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Patents, Trademarks and Designs
Costs relating to patents, trademarks and designs, which are acquired, are capitalized and
amortized on a straight-line basis over a period of 5 years.
Computer software
Pursuant to adoption of Accounting Standard 26 - Intangible Assets, issued by the ICAI,
software which is not an integral part of the related hardware, is classified as an
intangible asset and is being amortised over a period of 6 years, being the estimated
useful life.
Non-compete
Costs relating to payment of non compete compensation is capitalised and amortised on a
straight-line basis over the life of non-compete agreement.
[d] Depreciation
Depreciation is provided on straight-line method at the rates and in the manner prescribed
in Schedule XIV of the Act.
Premium paid on perpetual leasehold land is charged to revenue on termination/renewal
of lease agreements.
[e] Leases
Operating lease payments are recognized as an expense in the Profit and Loss account on
a straight-line basis over the lease term.
[f] Investments
Investments that are readily realizable and intended to be held for not more than a year
are classified as current investments. All other investments are classified as long-term
investments. Current investments are carried at lower of cost and fair value determined
on an individual investment basis. Long-term investments are carried at cost. However,
provision for diminution in value is made to recognize a decline other than temporary in
the value of the investments.
Profit/loss on sale of investments is computed with reference to their average cost.
[g] Inventories
Inventories are valued as follows:
Raw materials, stores and spares and packing materials
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Lower of cost and net realizable value. However, materials and other items held for use
in the production of inventories are not written down below cost if the finished products
in which they will be incorporated are expected to be sold at or above cost. Cost is
determined on a weighted average basis.
Finished goods
Lower of cost and net realizable value. Cost includes direct materials and labour and a
proportion of manufacturing overheads based on normal operating capacity. Cost of
finished goods includes excise duty.
Work-in-process
At cost upto estimated stage of process. Cost includes direct materials and labour and a
proportion of manufacturing overheads based on normal operating capacity.
Net realizable value is the estimated selling price in the ordinary course of business, less
estimated costs of completion and the estimated costs necessary to make the sale.
Where duty paid/indigenous materials are consumed, prior to duty-free import of
materials under the Advance License Scheme, in manufacture of products for export, the
estimated excess cost of such materials over that of duty free materials is carried forward
in the cost of raw materials and charged to revenue on consumption of such duty-free
materials.
[h] Revenue recognition
Revenue is recognized to the extent that it is probable that the economic benefits will
flow to the Company and the revenue can be reliably measured.
Sale of Goods:
Revenue from sale of goods is recognised when the significant risks and rewards of
ownership of the goods are transferred to the customer and is stated net of trade
discounts, excise duty, sales returns and sales tax.
Royalties, Technical Know-how and Licensing income:
Revenue is recognised on an accrual basis in accordance with the terms of the relevant
agreement.
Interest:
Revenue is recognised on a time proportion basis taking into account the amount
outstanding and the rate applicable.
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Dividends:
Revenue is recognised when the right to receive the income is established.
[i] Research and development costs
Revenue expenditure incurred on research and development is charged to revenue in the
year it is incurred. Capital expenditure is included in the respective heads under fixed
assets.
[j] Expenditure on regulatory approvals
Expenditure incurred for obtaining regulatory approvals and registration of products for
overseas markets and products acquisition is charged to revenue.
[k] Employee stock option plan
The accounting value of stock options representing the excess of the market price over
the exercise price of the shares granted under "Employees Stock Option Scheme" of the
Company, is amortised on straight-line basis over the vesting period as "Deferred
employees compensation" in accordance with the SEBI (Employee Stock Option Scheme
and Employee Stock Purchase Scheme) Guidelines, 1999.
[1] Foreign currency translation
(i) Initial Recognition
Foreign currency transactions are recorded in the reporting currency, by applying to
translations
the foreign currency amount the exchange rate between the reporting currency and the
foreign currency at the date of the transaction.
(ii) Conversion
Foreign currency monetary items are reported using the closing rate. Non-monetary items
which are carried in terms of historical cost denominated in a foreign currency are
reported using the exchange rate at the date of the transaction; and investments in foreign
companies are recorded at the exchange rates prevailing on the date of making the
investments.
(iii) Exchange Differences
Exchange differences arising on the settlement of monetary items or on reporting
company's monetary items at rates different from those at which they were initially
79
recorded during the year, or reported in previous financial statements, are recognised as
income or as expenses in the year in which they arise, except for loans denominated in
foreign currencies utilized for acquisition of fixed assets where the exchange gains/losses
are adjusted to the cost of such assets.
(iv) Forward Exchange Contracts not intended for trading or speculation purposes
The premium or discount arising at the inception of forward exchange contracts is
amortised as expense or income over the life of the contract. Exchange differences on
such contracts are recognised in the profit and loss in the year in which the exchange
rates change. Any profit or loss arising on cancellation or renewal of forward exchange
contract is recognised as income or as expense for the year.
Representative offices
In translating the financial statements of representative offices for incorporation in
financial statements, the monetary assets and liabilities are translated at the closing rate;
non monetary assets and liabilities are translated at exchange rates prevailing at the dates
of the transactions and income and expense items are converted at the respective monthly
average rate.
[m] Retirement benefits
Contributions in respect of provided fund, superannuation and gratuity are made to Trust
set up by the Company for the purpose and charged to profit and loss account.
Provisions for liabilities in respect of gratuity, pension and leave encashment benefits are
made based on actuarial valuation made by an independent actuary as at the balance sheet
date. [n] Income taxes
Tax expenses comprise both current and deferred taxes.
The provision for current income tax is the aggregate of the balance provision for tax for
three months ended March 31, 2006 and the estimated provision based on the taxable
profit of remaining nine months up to December 31, 2007 the actual tax liability, for
which, will be determined on the basis of the results for the period April 1, 2007 to
March 31, 2008.
Deferred income taxes reflects the impact of current year timing differences between
taxable income and accounting income for the year and reversal of timing differences of
earlier years. Deferred tax is measured based on the tax rates and the tax laws enacted or
substantively enacted at the balance sheet date. Deferred tax assets are recognised only to
the extent that there is reasonable certainty that sufficient future taxable income will be
available against which such deferred tax assets can be realized.
[o] Export benefits/incentives
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Export entitlements under the Duty Entitlement Pass Book ("DEPB") Scheme are
recognised in the profit and loss account when the right to receive credit as per the terms
of the scheme is established in respect of the exports made.
Obligation/entitlements on account of Advance License Scheme for import of raw
materials are accounted for on purchase of raw materials and/or export sales.
[p] Contingent liabilities
Depending on facts of each case and after due evaluation of relevant legal aspects, claims
against the Company not acknowledged as debts are disclosed as contingent liabilities. In
respect of statutory matters, contingent liabilities are disclosed only for those demand(s)
that are contested by the Company.
[q] Use of estimates
In preparing Company's financial statements in conformity with accounting principles
generally accepted in India, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosure of contingent
liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period; actual results could differ from those estimates.
[r] Earnings per share
Basic earnings per share are calculated by dividing the net profit or loss for the period
attributable to equity shareholders by the weighted average number of equity shares
outstanding during the period. The weighted average numbers of equity
shares outstanding during the period are adjusted for events of bonus issue.
For the purpose of calculating diluted earnings per share, the net profit or loss for the
period attributable to equity shareholders and the weighted average number of shares
outstanding during the period are adjusted for the effects of all dilutive potential
equity shares.
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TAXATION ASPECTS
TAX IMPLICATIONS OF INVESTING IN INDIAN EQUITIES
Tax rates on investments gains are categorized as long term & short term capital gains.
Long term capital gains
Long Term investments that are held for more than 12 months are termed as long term
capital assets. Profit on sale of such assets is termed as long term capital gain (LTCG)
which as per the latest Budget notification will attract nil tax.
(b) Short term capital gains
Shares that are held for less than 12 months are classified as short term capital assets
which as per the latest Budget notification will attract 10% tax.
Mutual Fund Taxation in India
Taxation policies in India with respect to mutual funds have varied over the years. The
purpose, over all these years, in part, has been to encourage the growth of the industry.
Currently, a variety of tax laws apply to mutual funds. Investors should opt for that
option that minimizes their tax liability. If dividend income is tax-free (as is in the case
with dividends from equity funds), then dividend option or dividend reinvestment option
is a good bet. If capital gains are tax-free (as is the case currently with equity-oriented
funds) then choosing the growth option would probably be more viable. If both are tax-
exempt, the net returns will be identical from any option. Tax provisions applying to
fund investments and funds themselves in respect of various matters are listed below:
Capital Gains
Units of mutual fund schemes are treated as long-term capital assets if they are held for a
period more than 12 months. In this case the unit holder has the option to pay capital
gains tax at either 20 per cent (with indexation) or 10 per cent without indexation.
No Tax Deducted At Source (TDS) or Wealth Tax
Income from units
Any income received from units of the schemes of a mutual fund specified under section
23 (D) is exempt under section 10(33) of the Act. While section 10(23D) exempts income
of specified mutual funds from tax (which currently includes all mutual funds operating
in India), section 10(33) exempts income from funds in the hands of the unit holders.
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However, this does not mean that there is no tax at all on income distributions by mutual
funds.
Income Distribution Tax
As per prevailing tax laws income distributed by schemes other than open-end equity
schemes is subject to tax at 10 per cent (plus surcharge of 2 per cent). For this purpose
equity schemes have been defined to be those schemes that have more than 50 per cent of
their assets in the form of equity. Open-end equity schemes have been left out of the
purview of this distribution tax for a period of three years beginning from April 1999.
Section 80C
The investment in mutual funds designated as Equity Linked Saving Scheme (ELSS)
qualifies for rebate under section 80C. The maximum amount that can be invested in
these schemes is Rs.10,000, therefore the maximum tax benefit available works out to Rs
2000. Apart from ELSS schemes, the benefit of Section 80C is also available in select
schemes of some funds such as UTI ULIP, KP Pension Plan etc.
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85
MAJOR PROBLEMS:
Religare is a broking company and the main task of it is to make new clients who must be
ready to Invest and Trade in the securities market. There are many problems which is to
be faced by the company to get in a long run and maintain the reputed position attained
during the last years, the number of problems that the company has to face are :
Risk factor which become a hurdle for Investment in share market.
To Maintain the position achieved, along with maintaining a healthy competition.
How to reduce the Risk.
Risk of time.
Risk of time to purchase and sell.
What is the right Risk premium.
Risk offer healthy return
What is the second thing that strikes your mind when you hear the word 'equity' or
'stock'? (If 'risk' is the first thing that flashes across your mind, then you seem to have had
an overdose of emphasis on risk in our recent school write-ups. Maybe it is time for you
to learn more about how stocks offer great returns over the long run and the 'power of
compounding'.)
If 'risk' is the second thing to take the dais, you are ready to take the next few steps in
understanding this concept better. And just in case 'risk' was the last thing to chance upon
your mind, we suggest that you start right at the beginning of these series.
What is equity risk premium?
Last time we understood that though risk is the chance of loss, it is equally a matter of
choice. 'Equity risk premium' is the leveller that makes risky investment options
attractive. Now it is time to put a finger on 'equity risk premium'.
equity risk premium is forward looking.
If equity risk premium is forward looking and based on expectations, how do we know
that we have settled for the right 'risk premium? Or how do we know that the 'risk
premium' adequately compensates us in case the returns go against expectations?
A theoretically applicable method is to look at returns associated with all possible
situations. Then assign probabilities to these possibilities and get a fix on the 'expected'
return. In the end, the expected return needs to be compared with the risk-free return to
evaluate if the 'risk premium' is adequate enough.
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You have come a long way. We already have gone through issues such as the need to
invest. You also know when you are ready to invest. Now it is time to understand what
we must buy.
So what we now need to figure out is how to evaluate which equity to buy. I am afraid of
where all those fancy sounding valuation tools come in?
Investing in equities is akin to owning a business.
Lets now explore the full ramifications of this principle.
When you put your money in a bank deposit, you take a risk (albeit small, depending on
which bank). In return, you get paid a small interest.
The bank takes on a higher degree of risk and lends that money at a higher interest rate to
some businessman, or to a credit card holder who wants to buy a diamond ring for his
wife. The bank pays your interest out of the money he earns from the businessman. Or
the doting husband.
Whereas, when you buy shares in a company, We are not lending money to the company.
By providing capital for the company, which is represented by an equity share, you are
participating in the ownership of the company. Clearly, our risk is much greater in this
case. Because, in this case, we are entrusting the company with the job of managing risk
for you.
Relatively, the risk in lending to a bank is limited. For one, most of our neighborhood
banks are nationalized. So bank deposits are perceived to be backed by the government.
There is little soul searching to be done as to which bank to choose. Even in doing so, the
highest priority is accorded to a Nationalized Bank purely on the safety parameter.
Obviously, when you invest in equities, even this notional sense of security, of a
government standing guard over your money, isnt available to you.
What kind of business would we like to enter?
Lets look at this another way now. Lets assume we want to invest our money into a
business. How will we decide what kind of business to We have come a long way. We
have already been through issues such as the need to invest. We also know when We are
ready to invest. Now it is time to understand what we exactly buy when we buy equity.
So what we now need to figure out is how to evaluate which company to buy. But before
us get into the complexities of the various valuations tools we can use and how we
calculate them, we must table a fundamental principle:
Investing in equities is akin to owning a business.
Lets now explore the full ramifications of this principle.
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When We put our money in a bank deposit, our take a risk (albeit small, depending on
which bank). In return, we get paid a small interest.
The bank takes on a higher degree of risk and lends that money at a higher interest rate to
some businessman, or to a credit card holder who wants to buy a diamond ring for his
wife. The bank pays our interest out of the money he earns from the businessman. Or the
doting husband.
Whereas, when we buy shares in a company, we are not lending money to the company.
By providing capital for the company, which is represented by an equity share, we are
participating in the ownership of the company. Clearly, our risk is much greater in this
case. Because, in this case, we are entrusting the company with the job of managing risk
for us.
Relatively, the risk in lending to a bank is limited. For one, most of our neighborhood
banks are nationalised. So bank deposits are perceived to be backed by the government.
There is little soul searching to be done as to which bank to choose. Even in doing so, the
highest priority is accorded to a Nationalised Bank purely on the safety parameter.
Obviously, when we invest in equities, even this notional sense of security, of a
government standing guard over our money, isnt available to us.
The same concepts apply to stocks
Now, heres the punch line. Everything we discussed above doesnt apply only to running
a business. The same concepts apply, even if our just own shares in the company.
We all know of a document called an annual report. This document is the most basic
source for information available on the companys operations. In the annual reports, the
directors dwell, at times in length, explaining the nature of operations and the external
environment surrounding the business and how it affected the company during the year.
If we take the additional effort of finding out the positioning of the companys products
in the marketplace, it would give a fair idea of the companys reputation in the field it
operates. All this with the objective of figuring out how stable the companys operation
is.
The companys progress can be tracked periodically over close intervals of 3 months.
This is through quarterly financial statements, the publication of which has been made
mandatory by the regulatory authorities.
Next question is of management issues. The common question that pops up in this
context is: How do I externally control the business if I do not have a say in the
management?
Ok, lets assume that we are now running the business we chose. Can we, a single
individual, handle all functions of the company? For a while, maybe. But once growth
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sets in, it would be humanly impossible to manage all the functions of an economic
activity, viz. marketing, finance, procurement, etc. Thats when our business will need to
morph from outfit to organization status. Wherein the various functions are distributed
across individuals, and finally the same is translated into a unified activity.
Similarly, as a shareholder, we end up delegating authority to others to run the
organization us have a stake in. Imagine Mr. Narayana Murthy (Infosys), Mr. Dadiseth
(HLL) and Mr. Anji Reddy (Dr Reddys) reporting to us. Thats exactly how the cookie
crumbles. The company whose equity base we have participated in is answerable. To us,
as well as other shareholders of the company. Thus, while we as a joint owner have
delegated the operations of the company to the professional managers and the employees,
the management in turn is responsible to its shareholders. The management
communicates through the balance sheet and the AGM, where shareholders voice their
opinion on the performance of the company.
Infact, shareholders can actually participate in constructive criticism of the operation of
the company.
What we brought today was the first step in how to investigate and understand the
qualitative issues in a business. We will be taking up the statistical part of our adventure
into evaluating stocks in Valuing Equities.
During bearish times when the Sensex plumbs new depths and the entire market looks
like a discount sale, it is natural to doubt the basic assumption that investing in equities
really pays off.
TAMING THE RISK
We began by understanding the necessity to invest for growth, the necessity to beat
inflation and retire wealthy. Our adventure began the moment we discovered that equities
are lucrative.
We figured out that the most important criteria to qualify for the journey is to be debt-free
or, in simpler words, how much surplus we have after paying off all our obligations. We
also understood a very important concept. Building of equity investments depends on two
criteria:
Everybody cant take the same level of excitement (Risk Profile)
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Individual cash requirement (Liquidity Requirement) Then came the party pooper Risk.
The outside chance of losing instead of gaining. In our attempt to understand risk, we
classified risk into?
Controllable Risks (also called Company Risk or Diversifiable Risk)
Beyond Control Risks (also called Market Risk or Undiversifiable Risk?). We know that
risk will always exist. Let us learn to tame it. We use a clinch reinforce an age-old truth:
Dont put all our eggs in one basket! Spread it around so that if one basket were to drop,
only a few of our eggs break! Equally important is to decide: In which basket do I put my
eggs in. We will take this up in our next leg of preparation. Remember, we hope to make
soldiers out of you! Let us understand our monster better Equity Risk. Try answering this
question below. For the uninitiated, Long stands for a bought position in stock while
Short stands for a sold position in a stock that is not owned. More widespread the
selection of stocks, the better diversified and less risky a portfolio becomes. As the
number of stocks increase, risk reduces.
TIME FACTOR
We all know that 'company' and 'market' risks are the hazards that any equity
investor faces, right or Wrong. Risk has another dimension - that of time. Time
plays a role that is often not very obvious to us in the stock market.
How likely is it that we may trip and fall in the next one second? How likely is it
that we might trip and fall in the next half an hour? How likely is it that we might
trip and fall some time in the next five years?
Get the point? We can say with 100% certainty that we will not trip in the next one
second. we can also, perhaps with the same degree of certainty, say that we are unlikely
to trip and fall in the next half an hour. But the degree of certainty would definitely
reduce over a five-year time frame. And further still, over a 10-yearperiod.
That in other words, ladies and gentlemen, is the time element of risk.
Risk increases with time
Arguably, the time element of risk is very often part of company risk or market risk. But
the reason we would like to focus on this element separately is that this is an element of
risk that is not understood very well. Neither is it given the place of.
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This is particularly true of what we call 'growth' stocks. Stocks that you buy because we
think that they will grow phenomenally over the next few years. 'Growth' investing has
been the most popular and successful form of investing in recent years. Stocks from the
technology, media, and telecom and biotech sectors are prime.
These 'growth' stocks look expensive by conventional metrics - price-earning (P/E),
price-book (P/B) and economic value (EV). But even after the recent meltdown in the
past three months these stocks have handsomely rewarded investors who bought them 2-3
years ago. Despite, as we said, being overvalued based on conventional metrics
In the words of the legendary investor and thinker Benjamin Graham: 'The successful
purchase of growth stocks requires two rather obvious conditions - first, that their
prospect of growth be realized; and, second, that the market has not already pretty
Let us presume that the second condition (which continues to be debated to death) is not
true - the market has not already discounted these growth prospects. So then, the only
other condition that needs to be met is that the prospects of their growth need to be
realized.
This is not as simple as it seems
And the obvious numbers that we look at do not tell the whole story. 'Infosys ka EPS agle
saal 100 taka bad jayega' is the typical refrain that one gets to hear. Now we are no
slaves to conventional metrics and are willing to be completely open minded.
But is it okay to buy Infosys at a P/E of 180 only because it will grow at 100% in
FY2001? The answer is a resounding NO. If buying Infosys at this price is to be a
profitable proposition for us, then Infosys must grow at a scorching pace not just next
year but for many years beyond that.
The risk in owning Infosys comes from time. The risk is not whether it will grow at 100%
next year, but whether it can grow at a compounded annual growth return (CAGR) of 50-
60% over the next five years. Not an impossible task for a company with an impressive
track record.
But look at the size of the challenge. A 55% CAGR over the next five years means a
forecast of Rs2500cr profit in FY2005. That is more than what big daddy Reliance makes
by way of profits currently. At today's price (Rs7870) that would place Infosys at a
reasonable P/E of 20 times its FY2005 estimates. That is a P/E that many companies
(including Reliance) are not getting even on their FY2000 earnings currently.
But that is another issue altogether
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What is relevant to us as a buyer of Infosys shares is that the company cannot afford
to trip and fall anytime over the next five years. Now what degree of certainty would
Before we jump to any conclusions, it's not as impossible as it may seem (as our
analysts are at pains to point out). After all, this same company reported a profit of
just Rs13cr in FY1995. Would you have (in 1995) estimated that it would, in five
years, grow to report a profit of Rs285cr? A twenty-fold jump!
Our objective in highlighting Infosys is to underline the time element of risk. We are
aware of the risk and have chosen to take it because we have confidence in the
management of this company and believe that its strategy and business model will
enable the company to get there. Those who took this risk in 1995 have been amply
rewarded.
Many people would dismiss this entire concept of time element of risk on the premise
that if Infosys is going to double its profits this year, then so will its price and, hence,
they can dump the share within six months and make money. To them we suggest
that they consider the second condition listed by Benjamin Graham: '? That the
market has not already pretty well discounted these growth prospects.
Equity Risk Premium:
Risk is not always a bad thing
What is the second thing that strikes your mind when you hear the word 'equity' or
'stock'? (If 'risk' is the first thing that flashes across your mind, then you seem to have had
an overdose of emphasis on risk in our recent school write-ups. Maybe it is time for you
to learn more about how stocks offer great returns over the long run and the 'power of
compounding'.)
If 'risk' is the second thing to take the Dias, you are ready to take the next few steps in
92
understanding this concept better. And just in case 'risk' was the last thing to chance upon
your mind, we suggest that you start right at the beginning of these series.
What is equity risk premium?
Last time we understood that though risk is the chance of loss, it is equally a matter of
choice. 'Equity risk premium' is the leveller that makes risky investment options
attractive. Now it is time to put a finger on 'equity risk premium'.
A Risk Management Committee consisting of senior executives of the Company
identified several risks, and formulated counter measures, during the year. Such counter
measures were incorporated in the strategic planning process of the Company.
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ACHIEVEMENTS
An Impeccable track record across the globe in providing security and cover for us and
our future
We, at Religare Securities, realize that we seek an investor who we can trust our hard
earned money with Religare AG with over 33 years of experience in India and Ranbaxy ,
trusted for over 55 years in the Indian market, together are committed to offering us
financial solutions that provide all the security we need for ourselves and future.
Religare Securities brings to us several innovative products, the details of which we can
browse in this section.
Key Achievements in FY 2006-07 :
No.1 Pvt Security Firm FY 2006-07. Leading by Rs. 78 Cr.
No.1 Pvt Security Firm in Retail Business. Leading by Rs. 339 Cr.
Whopping growth of 216% for the FY 2006-07

Is backed by a network of 550 offices spanning the country
Accelerated Growth
Fiscal Year No of Clients Brokerage in FY
2001-2002 (6mths) 21,376 Rs 7 cr.
2002-2003 1,15,965 Rs 69 cr.
2003-2004 1,86,443 Rs 221 cr.
2004-2005 2,88,189 Rs 1002 cr.
2005-2006 7,81,685 Rs 3134 cr.
Assets under management Rs 3,324 cr.

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Shareholder capital base of Rs 500 cr.
Religare Security accelerates rapid growth with additional capital infusion of Rs.
130 crores
Religare Securities Crosses 2 Million investment Mark & US $ 1 billion in
premiums
Religare Securities gears up for aggressive growth with additional capital infusion
of Rs. 70.8 crores (Total capital reaches Rs. 570 crores)
Religare Securities takes number one position - SEBI results September 2005
positions Religare Security at No 1
Religare Security goes all out on investment - Ties up with 5 cooperative banks.
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SHARE MARKET POSITION:
This is the share market position of Promoter Company of Religare that is Ranbaxy.
Religare has not issue any share in its own name. Religare has been issued shares of 1100
cr in September 2007.
From YearTo Year Class Of Share Authorized Capital
(Crores)
Issued Capital
(Crores)
Paid Up
Shares
(Nos)
2007 2007 Equity Share 299.00 1100 372442190
2006 2006 Equity Share 199.00 185.89 185890742
2005 2005 Equity Share 199.00 185.54 185543625
2004 2004 Equity Share 150.00 115.90 115895478
2003 2003 Equity Share 150.00 115.90 115895478
2002 2002 Equity Share 150.00 115.90 115895250
2001 2001 Equity Share 69.00 53.73 53726252
2000 2000 Equity Share 69.00 49.41 49414717
1999 1999 Equity Share 69.00 48.13 5000000
1998 1998 Equity Share 69.00 48.13 43132253
1997 1997 Equity Share 69.00 43.13 43132253
1996 1996 Equity Share 69.00 35.33 35330269
1995 1995 Equity Share 49.00 21.79 21793050
1994 1994 Equity Share 29.00 15.19 15189970
1993 1993 Equity Share 14.00 9.11 9113982
1990 1990 Equity Share 14.00 9.11 9113982
1989 1989 Equity Share 4.25 4.25 4250000
1987 1987 Equity Share 4.25 3.73 3729320
1986 1986 Equity Share 4.25 3.69 2439810
1984 1984 Equity Share 4.25 2.44 2436785
1983 1983 Equity Share 2.25 1.40 1400000
1979 1979 Equity Share 1.50 0.70 697525
1978 1978 Equity Share 1.50 0.70 697000
1976 1978 Equity Share 1.50 0.70 696050
1974 1976 Equity Share 1.50 0.70 700000
1973 1974 Equity Share 7.50 0.70 356470
1973 1974 Equity Share 7.50 0.70 343530
1969 1973 Equity Share 0.75 0.20 202076
1967 1969 Equity Share 0.75 0.16 161667
1966 1967 Equity Share 0.75 0.16 64661
1961 1966 Equity Share 1.00 0.33 32908
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FUTURE PROSPECTS
Religare securities, Indias leading security provided company, announced the promoting
minimum brokerage so that large number of investors should invest money easily. The
announcement highlighted the vision of investment for the Indian stock market, which is
based on the collective ability and strengths of all the shareholders.

"The unique strength of company announcement lies in
making the investment solutions and their benefits accessible to consumers across the
Indian stock market," said Sunil godhwani, chief executive officer & managing director
of religare security ltd..

"our focus is to offer products and services that are
useful, simple and convenient, and provide the financial security that people seek in
business and in life.," he added. Addressing newspersons, dr henning schulte-noelle,
chairman, board of management of religare said "we are confident that with the excellent
reputation of religare and the international experience of religare we will be able to offer
the highest standards to our customers. we are proud to join hands from new investors so
that all will be accessible with ",

he added. "we will ensure that all stakeholders will
benefit from the know-how transfer within the minimum brokerage rate", he said.
Security company religare security ltd. With a paid up capital of rs 110 crore, offers
technical excellence in all area of general and investors and risk management. the product
portfolio of the religare currently includes tariff and non-tariff products.
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101

Regarding Security Analysis
Security Analysis stands for the proposition that a well-disciplined investor
Can determine a rough value for a company from all of its financial
Statements make purchases when the market inevitably under-prices some of them, earn
a satisfactory return, and never be in real danger of permanent loss.
Words related to Security
Stock
Stock typically takes the form of shares of common stock. As a unit of ownership,
common stock typically carries voting rights that can be exercised in corporate decisions.
Preferred stock differs from common stock in that it typically does not carry voting rights
but is legally entitled to receive a certain level of dividend payments before any dividends
can be issued to other shareholders. Convertible preferred stock is preferred stock that
includes an option for the holder to convert the preferred shares into a fixed number of
common shares, usually anytime after a predetermined date. Shares of such stock are
called "convertible preferred shares" (or "convertible preference shares" in the United
Kingdom).
Although there is a great deal of commonality between the stocks of different companies,
each new equity issue can have legal clauses attached to it that make it dynamically
different from the more general cases. Some shares of common stock may be issued
without the typical voting rights being included, for instance, or some shares may have
special rights unique to them and issued only to certain parties. Note that not all equity
shares are the same.
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Share
In financial markets, a share is a unit of account for various financial instruments
including stocks, mutual funds,& limited partnerships.
A share is one of a finite number of equal portions in the capital of a company, entitling
the owner to a proportion of distributed, non-reinvested profits known as dividends, and
to a portion of the value of the company in case of liquidation. Shares can be voting or
non-voting, meaning they either do or do not carry the right to vote on the board of
directors and corporate policy.
Stock market
A stock market, or (equity market), is a private or public market for the trading of
company stock and derivatives of company stock at an agreed price; these are securities
listed on a stock exchange as well as those only traded privately.
The expression "stock market" refers to the market that enables the trading of company
stocks collective shares, other securities, and derivatives. Bonds are still traditionally
traded in an informal, over-the-counter market known as the bond market. Commodities
are traded in commodities markets, and derivatives are traded in a variety of markets but,
like bonds, mostly 'over-the-counter.
The size of the worldwide "bond market" is estimated at $45 trillion. The size of the
stock market is estimated at about $51 trillion. The world derivatives market has been
estimated at about $480 trillion face or nominal value, 30 times the size of the U.S.
economyand 12 times the size of the entire world economy. It must be noted though
that the value of the derivatives market, because it is stated in terms of Notional amount
notional values, cannot be directly compared to a stock or a fixed income security, which
traditionally refers to an Actual cash value actual value. Many such relatively illiquid
securities are valued as mark to model marked to model, rather than an actual market
price.
The stocks are listed and traded on stock exchanges which are entities a corporation or
mutual organization specialized in the business of bringing buyers and sellers of stocks
and securities together. The stock market in the United States includes the trading of all
securities listed on the New York Stock Exchange|NYSE, the NASDAQ, the American
Stock Exchange|Amex, as well as on the many regional exchanges, e.g. OTC Bulletin
Board|OTCBB and Pink Sheets. European examples of stock exchanges include the Paris
Bourse now part of Euro next, the London Stock Exchange and the Deutsche Borse.
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Importance of stock market
The stock market is one of the most important sources for companies to raise money.
This allows businesses to be publicly traded, or raise additional capital for expansion by
selling shares of ownership of the company in a public market. The liquidity that an
exchange provides affords investors the ability to quickly and easily sell securities. This
is an attractive feature of investing in stocks, compared to other less liquid investments
such as real estate.
History has shown that the price of shares and other assets is an important part of the
dynamics of economic activity, and can influence or be an indicator of social mood.
Rising share prices, for instance, tend to be associated with increased business investment
and vice versa. Share prices also affect the wealth of households and their consumption.
Therefore, central banks tend to keep an eye on the control and behavior of the stock
market and, in general, on the smooth operation of financial system functions. Financial
stability is the raison d'tre of central banks.
Exchanges also act as the clearinghouse for each transaction, meaning that they collect
and deliver the shares, and guarantee payment to the seller of a security. This eliminates
the risk to an individual buyer or seller that the counterparty could default on the
transaction.
The smooth functioning of all these activities facilitates economic growth in that lower
costs and enterprise risks promote the production of goods and services as well as
employment. In this way the financial system contributes to increased prosperity.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a remarkable
transformation. One feature of this development is disintermediation. A portion of the
funds involved in saving and financing flows directly to the financial markets instead of
being routed via banks' traditional lending and deposit operations. The general public's
heightened interest in investing in the stock market, either directly or through mutual
funds, has been an important component of this process. Statistics show that in recent
decades shares have made up an increasingly large proportion of households' financial
assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid
assets with little risk made up almost 60 per cent of households' financial wealth,
compared to less than 20 per cent in the 2000s. The major part of this adjustment in
financial portfolios has gone directly to shares but a good deal now takes the form of
various kinds of institutional investment for groups of individuals, e.g., pension funds,
mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards
forms of saving with a higher risk has been accentuated by new rules for most funds and
insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be
found in other industrialized countries. In all developed economic systems, such as the
European Union, the United States, Japan and other developed nations, the trend has been
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the same: saving has moved away from traditional (government insured) bank deposits to
more risky securities of one sort or another.
The stock market, individual investors, and financial risk
Riskier long-term saving requires that an individual possess the ability to manage the
associated increased risks. Stock prices fluctuate widely, in marked contrast to the
stability of (government insured) bank deposits or bonds. This is something that could
affect not only the individual investor or household, but also the economy on a large
scale. The following deals with some of the risks of the financial sector in general and the
stock market in particular. This is certainly more important now that so many newcomers
have entered the stock market, or have acquired other 'risky' investments (such as
'investment' property, i.e., real estate and collectables).
Trading
Participants in the stock market range from small individual stock investors to large
hedge fund traders, who can be based anywhere. Their orders usually end up with a
professional at a stock exchange, who executes the order.
Some exchanges are physical locations where transactions are carried out on a trading
floor, by a method known as open outcry. This type of auction is used in stock exchanges
and commodity exchanges where traders may enter "verbal" bids and offers
simultaneously. The other type of exchange is a virtual kind, composed of a network of
computers where trades are made electronically via traders.
Actual trades are based on an auction market paradigm where a potential buyer bids a
specific price for a stock and a potential seller asks a specific price for the stock. (Buying
or selling at market means we will accept any ask price or bid price for the stock,
respectively.) When the bid and ask prices match, a sale takes place on a first come first
served basis if there are multiple bidders or askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities between buyers
and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-
time trading information on the listed securities, facilitating price discovery.
The New York Stock Exchange is a physical exchange, also referred to as a listed
exchange only stocks listed with the exchange may be traded. Orders enter by way of
exchange members and flow down to a specialist, who goes to the floor trading post to
trade stock. The specialist's job is to match buy and sell orders using open outcry. If a
spread exists, no trade immediately takes place--in this case the specialist should use
his/her own resources (money or stock) to close the difference after his/her judged time.
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Once a trade has been made the details are reported on the "tape" and sent back to the
brokerage firm, which then notifies the investor who placed the order. Although there is a
significant amount of human contact in this process, computers play an important role,
especially for so-called "program trading".
The NASDAQ is a virtual listed exchange, where all of the trading is done over a
computer network. The process is similar to the New York Stock Exchange. However,
buyers and sellers are electronically matched. One or more NASDAQ market makers will
always provide a bid and ask price at which they will always purchase or sell 'their' stock.
Mutual Fund
Mutual funds can give investors access to emerging markets.
A mutual fund is a professionally managed firm of collective investments that collects
money from many investors and puts it in stocks, bonds, short-term money market
instruments, and/or other securities. The fund manager, also known as portfolio manager,
trades the fund's underlying securities, realizing capital gains or losses and passing any
proceeds to the individual investors. Currently, the worldwide value of all mutual funds
totals more than $26 trillion.
Since 1940, there have been three basic types of mutual fund investment companies in
the United States. Similar funds also operate in Canada. However, in the rest of the
world, mutual fund is used as a generic term for various types of collective investment
vehicles, such as unit trusts, open-ended investment companies (OEICs), and unitized
insurance funds.
History
Massachusetts Investors Trust (now MFS Investment Management) was founded on
March 21, 1924, and, after one year, it had 200 shareholders and $392,000 in assets. The
entire industry, which included a few closed-end funds, represented less than $10 million
in 1924.
The stock market crash of 1929 hindered the growth of mutual funds. In response to the
stock market crash, Congress passed the Securities Act of 1933 and the Securities
Exchange Act of 1934. These laws require that a fund be registered with the Securities
and Exchange Commission (SEC) and provide prospective investors with a prospectus
that contains required disclosures about the fund, the securities themselves, and fund
manager. The SEC helped draft the Investment Company Act of 1940, which sets forth
the guidelines with which all SEC-registered funds today must comply.
With renewed confidence in the stock market, mutual funds began to blossom. By the end
of the 1960s, there were approximately 270 funds with $48 billion in assets. The first
retail index fund, First Index Investment Trust, was formed in 1976 and headed by John
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Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior
thesis at Princeton University
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. It is now called the Vanguard 500 Index Fund and is one
of the world's largest mutual funds, with more than $100 billion in assets.
A key factor in mutual-fund growth was the 1975 change in the Internal Revenue Code
allowing individuals to open individual retirement accounts (IRAs). Even people already
enrolled in corporate pension plans could contribute a limited amount (at the time, up to
$2,000 a year). Mutual funds are now popular in employer-sponsored "defined-
contribution" retirement plans such as (401(k)s) and 403(b)s as well as IRAs including
Roth IRAs.
As of October 2007, there are 8,015 mutual funds that belong to the Investment Company
Institute (ICI), a national association of investment companies in the United States, with
combined assets of $12.356 trillion.
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Usage
Since the Investment Company Act of 1940, a mutual fund is one of three basic types of
investment companies available in the United States.
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Mutual funds can invest in many kinds of securities. The most common are cash
instruments, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for
instance, can invest primarily in the shares of a particular industry, such as technology or
utilities. These are known as sector funds. Bond funds can vary according to risk (e.g.,
high-yield junk bonds or investment-grade corporate bonds), type of issuers (e.g.,
government agencies, corporations, or municipalities), or maturity of the bonds (short- or
long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic
funds), both U.S. and foreign securities (global funds), or primarily foreign securities
(international funds)..
Most mutual funds' investment portfolios are continually adjusted under the supervision
of a professional manager, who forecasts cash flows into and out of the fund by investors,
as well as the future performance of investments appropriate for the fund and chooses
those which he or she believes will most closely match the fund's stated investment
objective. A mutual fund is administered through a parent management company, which
may hire or fire fund managers.
Mutual funds are subject to a special set of regulatory, accounting, and tax rules. In the
U.S., unlike most other types of business entities, they are not taxed on their income as
long as they distribute 90% of it to their shareholders. Also, the type of income they earn
is often unchanged as it passes through to the shareholders. Mutual fund distributions of
tax-free municipal bond income are tax-free to the shareholder. Taxable distributions can
be either ordinary income or capital gains, depending on how the fund earned those
distributions. Net losses are not distributed or passed through to fund investors.
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Net asset value
The net asset value, or NAV, is the current market value of a fund's holdings, less the
fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is
determined daily, after the close of trading on some specified financial exchange, but
some funds update their NAV multiple times during the trading day. The public offering
price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at the POP and
redeem shares at the NAV, and so process orders only after the NAV is determined.
Closed-end funds (the shares of which are traded by investors) may trade at a higher or
lower price than their NAV; this is known as a premium or discount, respectively. If a
fund is divided into multiple classes of shares, each class will typically have its own
NAV, reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on any formal
exchange. These may be shares in very small or bankrupt companies; they may be
derivatives; or they may be private investments in unregistered financial instruments
(such as stock in a non-public company). In the absence of a public market for these
securities, it is the responsibility of the fund manager to form an estimate of their value
when computing the NAV. How much of a fund's assets may be invested in such
securities is stated in the fund's prospectus.
Turnover
Turnover is a measure of the fund's securities transactions, usually calculated over a
year's time, and usually expressed as a percentage of net asset value.
This value is usually calculated as the value of all transactions (buying, selling) divided
by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and
another one bought as one "turnover". Thus turnover measures the replacement of
holdings.
In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is
calculated based on the lesser of purchases or sales divided by the average size of the
portfolio (including cash).
Expenses and TER's
Mutual funds bear expenses similar to other companies. The fee structure of a mutual
fund can be divided into two or three main components: management fee,
nonmanagement expense, and 12b-1/non-12b-1 fees. All expenses are expressed as a
percentage of the average daily net assets of the fund.
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Management fees
The management fee for the fund is usually synonymous with the contractual investment
advisory fee charged for the management of a fund's investments. However, as many
fund companies include administrative fees in the advisory fee component, when
attempting to compare the total management expenses of different funds, it is helpful to
define management fee as equal to the contractual advisory fee + the contractual
administrator fee. This "levels the playing field" when comparing management fee
components across multiple funds.
Contractual advisory fees may be structured as "flat-rate" fees, i.e., a single fee charged
to the fund, regardless of the asset size of the fund. However, many funds have
contractual fees which include breakpoints, so that as the value of a fund's assets
increases, the advisory fee paid decreases. Another way in which the advisory fees
remain competitive is by structuring the fee so that it is based on the value of all of the
assets of a group or a complex of funds rather than those of a single fund.
Non-management expenses
Apart from the management fee, there are certain non-management expenses which most
funds must pay. Some of the more significant (in terms of amount) non-management
expenses are: transfer agent expenses (this is usually the person you get on the other end
of the phone line when you want to purchase/sell shares of a fund), custodian expense
(the fund's assets are kept in custody by a bank which charges a custody fee), legal/audit
expense, fund accounting expense, registration expense (the SEC charges a registration
fee when funds file registration statements with it), board of directors/trustees expense
(the disinterested members of the board who oversee the fund are usually paid a fee for
their time spent at meetings), and printing and postage expense (incurred when printing
and delivering shareholder reports).
12b-1/Non-12b-1 service fees
12b-1 service fees/shareholder servicing fees are contractual fees which a fund may
charge to cover the marketing expenses of the fund. Non-12b-1 service fees are
marketing/shareholder servicing fees which do not fall under SEC rule 12b-1. While
funds do not have to charge the full contractual 12b-1 fee, they often do. When investing
in a front-end load or no-load fund, the 12b-1 fees for the fund are usually .250% (or 25
basis points). The 12b-1 fees for back-end and level-load share classes are usually
between 50 and 75 basis points but may be as much as 100 basis points. While funds are
often marketed as "no-load" funds, this does not mean they do not charge a distribution
expense through a different mechanism. It is expected that a fund listed on an online
brokerage site will be paying for the "shelf-space" in a different manner even if not
directly through a 12b-1 fee.
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Investor fees and expenses
Fees and expenses borne by the investor vary based on the arrangement made with the
investor's broker. Sales loads (or contingent deferred sales loads (CDSL) are not included
in the fund's total expense ratio (TER) because they do not pass through the statement of
operations for the fund. Additionally, funds may charge early redemption fees to
discourage investors from swapping money into and out of the fund quickly, which may
force the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity
Diversified International Fund (FDIVX) charges a 1 percent fee on money removed from
the fund in less than 30 days.
Brokerage commissions
An additional expense which does not pass through the statement of operations and
cannot be controlled by the investor is brokerage commissions. Brokerage commissions
are incorporated into the price of the fund and are reported usually 3 months after the
fund's annual report in the statement of additional information. Brokerage commissions
are directly related to portfolio turnover (portfolio turnover refers to the number of times
the fund's assets are bought and sold over the course of a year). Usually the higher the
rate of the portfolio turnover, the higher the brokerage commissions. The advisors of
mutual fund companies are required to achieve "best execution" through brokerage
arrangements so that the commissions charged to the fund will not be excessive.
Types of mutual funds
Open-end fund
The term mutual fund is the common name for an open-end investment company. Being
open-ended means that, at the end of every day, the fund issues new shares to investors
and buys back shares from investors wishing to leave the fund.
Mutual funds may be legally structured as corporations or business trusts but in either
instance are classed as open-end investment companies by the SEC.
Other funds have a limited number of shares; these are either closed-end funds or unit
investment trusts, neither of which a mutual fund is.
Exchange-traded funds
A relatively recent innovation, the exchange-traded fund or ETF, is often structured as an
open-end investment company. ETFs combine characteristics of both mutual funds and
closed-end funds. ETFs are traded throughout the day on a stock exchange, just like
closed-end funds, but at prices generally approximating the ETF's net asset value. Most
ETFs are index funds and track stock market indexes. Shares are issued or redeemed by
institutional investors in large blocks (typically of 50,000). Most investors purchase and
sell shares through brokers in market transactions. Because the institutional investors
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normally purchase and redeem in in kind transactions, ETFs are more efficient than
traditional mutual funds (which are continuously issuing and redeeming securities and, to
effect such transactions, continually buying and selling securities and maintaining
liquidity positions) and therefore tend to have lower expenses.
Exchange-traded funds are also valuable for foreign investors who are often able to buy
and sell securities traded on a stock market, but who, for regulatory reasons, are limited
in their ability to participate in traditional U.S. mutual funds.
Equity funds
Equity funds, which consist mainly of stock investments, are the most common type of
mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the
United States. Often equity funds focus investments on particular strategies and certain
types of issuers.
Capitalization
Fund managers and other investment professionals have varying definitions of mid-cap,
and large-cap ranges. The following ranges are used by Russell Indexes:
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Russell Microcap Index - micro-cap ($54.8 - 539.5 million)
Russell 2000 Index - small-cap ($182.6 million - 1.8 billion)
Russell Midcap Index - mid-cap ($1.8 - 13.7 billion)
Russell 1000 Index - large-cap ($1.8 - 386.9 billion)
Growth vs. value
Another distinction is made between growth funds, which invest in stocks of companies
that have the potential for large capital gains, and value funds, which concentrate on
stocks that are undervalued. Value stocks have historically produced higher returns;
however, financial theory states this is compensation for their greater risk. Growth funds
tend not to pay regular dividends. Income funds tend to be more conservative
investments, with a focus on stocks that pay dividends. A balanced fund may use a
combination of strategies, typically including some level of investment in bonds, to stay
more conservative when it comes to risk, yet aim for some growth.
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Index fund and active management
An index fund maintains investments in companies that are part of major stock (or bond)
indices, such as the S&P 500, while an actively managed fund attempts to outperform a
relevant index through superior stock-picking techniques. The assets of an index fund are
managed to closely approximate the performance of a particular published index. Since
the composition of an index changes infrequently, an index fund manager makes fewer
trades, on average, than does an active fund manager. For this reason, index funds
generally have lower trading expenses than actively managed funds, and typically incur
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fewer short-term capital gains which must be passed on to shareholders. Additionally,
index funds do not incur expenses to pay for selection of individual stocks (proprietary
selection techniques, research, etc.) and deciding when to buy, hold or sell individual
holdings. Instead, a fairly simple computer model can identify whatever changes are
needed to bring the fund back into agreement with its target index.
Certain empirical evidence seems to illustrate that mutual funds do not beat the market
and actively managed mutual funds under-perform other broad-based portfolios with
similar characteristics. One study found that nearly 1,500 U.S. mutual funds under-
performed the market in approximately half of the years between 1962 and 1992.
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Moreover, funds that performed well in the past are not able to beat the market again in
the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman, 1989.
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Bond funds
Bond funds account for 18% of mutual fund assets.
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Types of bond funds include term
funds, which have a fixed set of time (short-, medium-, or long-term) before they mature.
Municipal bond funds generally have lower returns, but have tax advantages and lower
risk. High-yield bond funds invest in corporate bonds, including high-yield or junk
bonds. With the potential for high yield, these bonds also come with greater risk.
Money market funds
Money market funds hold 26% of mutual fund assets in the United States.
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Money
market funds entail the least risk, as well as lower rates of return. Unlike certificates of
deposit (CDs), money market shares are liquid and redeemable at any time. The interest
rate quoted by money market funds is known as the 7 Day SEC Yield.
Funds of funds
Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds
(i.e., they are funds comprised of other funds). The funds at the underlying level are
typically funds which an investor can invest in individually. A fund of funds will
typically charge a management fee which is smaller than that of a normal fund because it
is considered a fee charged for asset allocation services. The fees charged at the
underlying fund level do not pass through the statement of operations, but are usually
disclosed in the fund's annual report, prospectus, or statement of additional information.
The fund should be evaluated on the combination of the fund-level expenses and
underlying fund expenses, as these both reduce the return to the investor.
Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor),
although some invest in funds managed by other (unaffiliated) advisors. The cost
associated with investing in an unaffiliated underlying fund is most often higher than
investing in an affiliated underlying because of the investment management research
involved in investing in fund advised by a different advisor. Recently, FoFs have been
classified into those that are actively managed (in which the investment advisor
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reallocates frequently among the underlying funds in order to adjust to changing market
conditions) and those that are passively managed (the investment advisor allocates assets
on the basis of on an allocation model which is rebalanced on a regular basis).
The design of FoFs is structured in such a way as to provide a ready mix of mutual funds
for investors who are unable to or unwilling to determine their own asset allocation
model. Fund companies such as TIAA-CREF, American Century Investments, Vanguard,
and Fidelity have also entered this market to provide investors with these options and
take the "guess work" out of selecting funds. The allocation mixes usually vary by the
time the investor would like to retire: 2020, 2030, 2050, etc. The more distant the target
retirement date, the more aggressive the asset mix.
Hedge funds
Hedge funds in the United States are pooled investment funds with loose SEC regulation
and should not be confused with mutual funds. Some hedge fund managers are required
to register with SEC as investment advisers under the Investment Advisers Act.
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The
Act does not require an adviser to follow or avoid any particular investment strategies,
nor does it require or prohibit specific investments. Hedge funds typically charge a
management fee of 1% or more, plusperformance fee of 20% of the hedge funds
profits. There may be a "lock-up" period, during which an investor cannot cash in shares.
A variation of the hedge strategy is the 130-30 fund for individual investors.
Mutual funds vs. other investments
Mutual funds offer several advantages over investing in individual stocks. For example,
the transaction costs are divided among all the mutual fund shareholders, who also
benefit by having a third party (professional fund managers) apply expertise and dedicate
time to manage and research investment options. However, despite the professional
management, mutual funds are not immune to risks. They share the same risks associated
with the investments made. If the fund invests primarily in stocks, it is usually subject to
the same ups and downs and risks as the stock market.
Share classes
Many mutual funds offer more than one class of shares. For example, you may have seen
a fund that offers "Class A" and "Class B" shares. Each class will invest in the same pool
(or investment portfolio) of securities and will have the same investment objectives and
policies. But each class will have different shareholder services and/or distribution
arrangements with different fees and expenses. These differences are supposed to reflect
different costs involved in servicing investors in various classes; for example, one class
may be sold through brokers with a front-end load, and another class may be sold direct
to the public with no load but a "12b-1 fee" included in the class's expenses (sometimes
referred to as "Class C" shares). Still a third class might have a minimum investment of
$10,000,000 and be available only to financial institutions (a so-called "institutional"
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share class). In some cases, by aggregating regular investments made by many
individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase
"institutional" shares (and gain the benefit of their typically lower expense ratios) even
though no members of the plan would qualify individually.
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As a result, each class will
likely have different performance results.
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A multi-class structure offers investors the ability to select a fee and expense structure
that is most appropriate for their investment goals (including the length of time that they
expect to remain invested in the fund).
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Load and expenses
A front-end load or sales charge is a commission paid to a broker by a mutual fund when
shares are purchased, taken as a percentage of funds invested. The value of the
investment is reduced by the amount of the load. Some funds have a deferred sales charge
or back-end load. In this type of fund an investor pays no sales charge when purchasing
shares, but will pay a commission out of the proceeds when shares are redeemed
depending on how long they are held. Another derivative structure is a level-load fund, in
which no sales charge is paid when buying the fund, but a back-end load may be charged
if the shares purchased are sold within a year.
Load funds are sold through financial intermediaries such as brokers, financial planners,
and other types of registered representatives who charge a commission for their services.
Shares of front-end load funds are frequently eligible for breakpoints (i.e., a reduction in
the commission paid) based on a number of variables. These include other accounts in the
same fund family held by the investor or various family members, or committing to buy
more of the fund within a set period of time in return for a lower commission "today".
It is possible to buy many mutual funds without paying a sales charge. These are called
no-load funds. In addition to being available from the fund company itself, no-load funds
may be sold by some discount brokers for a flat transaction fee or even no fee at all. (This
does not necessarily mean that the broker is not compensated for the transaction; in such
cases, the fund may pay brokers' commissions out of "distribution and marketing"
expenses rather than a specific sales charge. The purchaser is therefore paying the fee
indirectly through the fund's expenses deducted from profits.)
No-load funds include both index funds and actively managed funds. The largest mutual
fund families selling no-load index funds are Vanguard and Fidelity, though there are a
number of smaller mutual fund families with no-load funds as well. Expense ratios in
some no-load index funds are less than 0.2% per year versus the typical actively managed
fund's expense ratio of about 1.5% per year. Load funds usually have even higher
expense ratios when the load is considered. The expense ratio is the anticipated annual
cost to the investor of holding shares of the fund. For example, on a $100,000 investment,
an expense ratio of 0.2% means $200 of annual expense, while a 1.5% expense ratio
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would result in $1,500 of annual expense. These expenses are before any sales
commissions paid to purchase the mutual fund.
Many fee-only financial advisors strongly suggest no-load funds such as index funds. If
the advisor is not of the fee-only type but is instead compensated by commissions, the
advisor may have a conflict of interest in selling high-commission load funds.
Corporate bond
A Corporate Bond is a bond issued by a corporation. The term is usually applied to
longer-term debt instruments, generally with a maturity date falling at least a year after
their issue date. (The term "commercial paper" is sometimes used for instruments with a
shorter maturity.)
Sometimes, the term "corporate bonds" is used to include all bonds except those issued
by governments in their own currencies. Strictly speaking, however, it only applies to
those issued by corporations. The bonds of local authorities and supranational
organizations do not fit in either category.
Corporate bonds are often listed on major exchanges (bonds there are called "listed"
bonds) and ECNs like MarketAxess, and the coupon (i.e. interest payment) is usually
taxable. Sometimes this coupon can be zero with a high redemption value. However,
despite being listed on exchanges, the vast majority of trading volume in corporate bonds
in most developed markets takes place in decentralized, dealer-based, over-the-counter
markets.
Some corporate bonds have an embedded call option that allows the issuer to redeem the
debt before its maturity date. Other bonds, known as convertible bonds, allow investors to
convert the bond into equity.
One can obtain an unfunded synthetic exposure to corporate bonds via credit default
swaps.
Types
Corporate debt falls into several broad categories:
secured debt vs. unsecured debt
senior debt vs. subordinated debt
Generally, the higher one's position in the company's capital structure, the stronger one's
claims to the company's assets in the event of a default.
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Risk analysis
Compared to government bonds, corporate bonds generally have a higher risk of default.
This risk depends, of course, upon the particular corporation issuing the bond, the current
market conditions and governments to which the bond issuer is being compared and the
rating of the company. Corporate bond holders are compensated for this risk by receiving
a higher yield than government bonds.
Consequently, this default risk can be quantified using spread analysis, which seeks to
determine the difference in yield between a given corporate bond and a risk-free treasury
bond of the same maturity. Common statistics used include Z-spread and option adjusted
spread (OAS).
External Resources
Corporate Bond Basics
Bond market
Fixed income Bond Debenture
Types of
bonds by
issuer
Government bond Sovereign bond Agency bond Municipal bond
Corporate bond (Senior debt, Subordinated debt) Emerging market debt
Types of
bonds by
payout
Fixed rate bond Floating rate note Inverse floating rate note Zero coupon
bond Inflation-indexed bond Commercial paper Accrual bond Auction
rate security High-yield debt Convertible bond Mortgage-backed
security Asset-backed security
Derivatives
Bond option Credit derivative Credit default swap Collateralized debt
obligation Collateralized mortgage obligation
Pricing
Bond valuation Par value Coupon Clean price Dirty price Accrued
interest Day count convention
Yield
analysis
Nominal yield Current yield Yield to maturity Yield curve Bond
duration Bond convexity
Credit and
spread
analysis
Credit analysis Credit risk Credit spread Yield spread Z-spread Option
adjusted spread
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Interest
rate
models
Short rate models Rendleman-Bartter Vasicek Ho-Lee Hull-White
Cox-Ingersoll-Ross Chen Heath-Jarrow-Morton Black-Derman-Toy
Brace-Gatarek-Musiela
Government Bonds
A government bond is a bond issued by a national government denominated in the
country's own currency. Bonds issued by national governments in foreign currencies are
normally referred to as sovereign bonds. Governments bonds are usually referred to as risk-
free bonds, because the government can raise taxes or simply print more money to
redeem the bond at maturity. Some counter examples do exist where a government has
defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"),
though this is very rare.
As an example, in the US, Treasury securities are denominated in US dollars and are the
safest US dollar investments. In this instance, the term risk-free means free of credit risk.
However, other risks still exist, such as currency risk for foreign investors (for example
non-US investors of US Treasury securities would have received lower returns in 2004
because the value of the US dollar declined against most other currencies). Secondly,
there is inflation risk, in that the principal repaid at maturity will have less purchasing
power than anticipated if the inflation outturn is higher than expected. Many governments
issue inflation-indexed bonds, which protect investors against inflation risk.
An example of somewhat risky bonds issued by a government can be given with
countries that have less than perfect capabilities of conducting financial policies. Such an
example is Bulgaria due to its being dependent on the world economy and economic
institutions much more than, say, the US. Some of this country's bonds were only given
an A-scale rating after 2004. As of February 2006, Standard & Poor's rates Bulgaria's
long-term debt denominated in domestic currency at BBB+. Moreover, this rating is the
result of almost a decade of constantly decreasing risk (and increasing ratings). It should
also be noted that this country's short-term debt is in fact currently rated A.
Definition of Portfolio Management
Portfolio
In finance, a portfolio is an appropriate mix of or collection of investments held by an
institution or a private individual. In building up an investment portfolio a financial
institution will typically conduct its own investment analysis, whilst a private individual
may make use of the services of a financial advisor or a financial institution which offers
portfolio management services. Holding a portfolio is part of an investment and risk-
limiting strategy called diversification. By owning several assets, certain types of risk (in
particular specific risk) can be reduced. The assets in the portfolio could include stocks,
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bonds, options, warrants, gold certificates, real estate, futures contracts, production
facilities, or any other item that is expected to retain its value.
Portfolio Management
Portfolio management involves deciding what assets to include in the portfolio, given the
goals of the portfolio owner and changing economic conditions. Selection involves
deciding what assets to purchase, how many to purchase, when to purchase them, and
what assets to divest. These decisions always involve some sort of performance
measurement, most typically expected return on the portfolio, and the risk associated with
this return (i.e. the standard deviation of the return). Typically the expected return from
portfolios of different asset bundles is compared.
Portfolio formation
Many strategies have been developed to form a portfolio.
equally-weighted portfolio
capitalization-weighted portfolio
price-weighted portfolio
optimal portfolio (for which the Sharpe ratio is highest)
Portfolio returns can be calculated either in absolute manner or in relative manner.
Absolute return calculation is very straight forward, where return is calculated by
considering total investment and total final value. Time duration and cash flow in
portfolio doesn't influence final return.
To calculate more accurate return of your investments we have to use complicated
statistical models like internal rate of return or Modified Internal Rate of Return. The
only problems with these models are that, they are very complicated and very difficult to
compute by pen and paper. You need to have a scientific calculator or some software.
Both of these models consider all cash flow (Money In/Money Out) and provide more
accurate returns than absolute return. Time is a major factor in these models.
The term asset management is often used to refer to the portfolio management of
collective investments, whilst the more generic fund management may refer to all forms
of institutional investment as well as investment management for private investors.
Investment managers who specialize in advisory or discretionary management on behalf
of (normally wealthy) private investors may often refer to their services as wealth
management or portfolio management often within the context of so-called "private
banking".
The provision of portfolio management services includes elements of financial analysis,
asset selection, stock selection, plan implementation and ongoing monitoring of
investments. Investment management is a large and important global industry in its own
right responsible for caretaking of trillions of dollars, euro, pounds and yen. Coming
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under the remit of financial services many of the world's largest companies are at least in
part investment managers and employ millions of staff and create billions in revenue.
Fund manager (or investment advisor in the U.S.) refers to both a firm that provides
investment management services and an individual(s) who directs "fund management"
decisions.
Investment managers and portfolio structures
At the heart of the investment management industry are the managers who invest and
divest client investments.
A certified company investment advisor should conduct an assessment of each client's
individual needs and risk profile. The advisor then recommends appropriate investments.
Asset allocation
The different asset classes and the exercise of allocating funds among these assets (and
among individual securities within each asset class) is what investment management
firms are paid for. Asset classes exhibit different market dynamics, and different
interaction effects; thus, the allocation of monies among asset classes will have a
significant effect on the performance of the fund. Some research suggested that allocation
among asset classes have more predictive power than the choice of individual holdings in
determining portfolio return. Arguably, the skill of a successful investment manager
resides in constructing the asset allocation, and separately the individual holdings, so as
to outperform certain benchmarks (e.g., the peer group of competing funds, bond and
stock indices).
Long-term returns
It is important to look at the evidence on the long-term returns to different assets, and to
holding period returns (the returns that accrue on average over different lengths of
investment). For example, over very long holding periods (eg. 10+ years) in most
countries, equities have generated higher returns than bonds, and bonds have generated
higher returns than cash. According to financial theory, this is because equities are riskier
(more volatile) than bonds which are themselves more risky than cash.
Diversification
Against the background of the asset allocation, fund managers consider the degree of
diversification that makes sense for a given client (given its risk preferences) and
construct a list of planned holdings accordingly. The list will indicate what percentage of
the fund should be invested in each particular stock or bond. The theory of portfolio
diversification was originated by Markowitz and effective diversification requires
management of the correlation between the asset returns and the liability returns, issues
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internal to the portfolio (individual holdings volatility), and cross-correlations between
the returns.
Investment styles
Investment Style selection depends upon risk appetite and return expectation. There are a
range of different styles of fund management that the institution can implement. For
example, growth, value, market neutral, small capitalization, indexed, etc. Each of these
approaches has its distinctive features, adherents and, in any particular financial
environment, distinctive risk characteristics. For example, there is evidence that growth
styles (buying rapidly growing earnings) are especially effective when the companies
able to generate such growth are scarce; conversely, when such growth is plentiful, then
there is evidence that value styles tend to outperform the indices particularly successfully.
Performance measurement
Fund performance is the acid test of fund management, and in the institutional context
accurate measurement is a necessity. For that purpose, institutions measure the
performance of each fund (and usually for internal purposes components of each fund)
under their management, and performance is also measured by external firms that
specialize in performance measurement. The leading performance measurement firms
(e.g. Frank Russell in the USA) compile aggregate industry data, e.g., showing how funds
in general performed against given indices and peer groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be made (as far as
the client is concerned) every quarter and would show a percentage change compared
with the prior quarter (e.g., +4.3% total return in US dollars). This figure would be
compared with other similar funds managed within the institution (for purposes of
monitoring internal controls), with performance data for peer group funds, and with
relevant indices (where available) or tailor-made performance benchmarks where
appropriate. The specialist performance measurement firms calculate quartile and decile
data and close attention would be paid to the (percentile) ranking of any fund.
Generally speaking, it is probably appropriate for an investment firm to persuade its
clients to assess performance over longer periods (e.g., 3 to 5 years) to smooth out very
short term fluctuations in performance and the influence of the business cycle. This can
be difficult however and, industry wide, there is a serious preoccupation with short-term
numbers and the effect on the relationship with clients (and resultant business risks for
the institutions).
An enduring problem is whether to measure before-tax or after-tax performance. After-
tax measurement represents the benefit to the investor, but investors' tax positions may
vary. Before-tax measurement can be misleading, especially in regimens that tax realised
capital gains (and not unrealised). It is thus possible that successful active managers
(measured before tax) may produce miserable after-tax results. One possible solution is to
report the after-tax position of some standard taxpayer.
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Absolute versus relative performance
In the USA and the UK, two of the world's most sophisticated fund management markets,
the tradition is for institutions to manage client money relative to benchmarks. For
example, an institution believes it has done well if it has generated a return of 5% when
the average manager (usually culled from amongst its peer class) generates a 4% return.to
do the same
Risk-adjusted performance measurement
Performance measurement should not be reduced to the evaluation of fund returns alone,
but must also integrate other fund elements that would be of interest to investors, such as
the measure of risk taken. Several other aspects are also part of performance
measurement: evaluating if managers have succeeded in reaching their objective, i.e. if
their return was sufficiently high to reward the risks taken; how they compare to their
peers; and finally whether the portfolio management results were due to luck or the
managers skill. The need to answer all these questions has led to the development of
more sophisticated performance measures, many of which originate in modern portfolio
theory.
Modern portfolio theory established the quantitative link that exists between portfolio
risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964)
highlighted the notion of rewarding risk and produced the first performance indicators, be
they risk-adjusted ratios (Sharpe ratio, information ratio) or differential returns compared
to benchmarks (alphas). The Sharpe ratio is the simplest and best known performance
measure. It measures the return of a portfolio in excess of the risk-free rate, compared to
the total risk of the portfolio. This measure is said to be absolute, as it does not refer to
any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile,
it does not allow the separation of the performance of the market in which the portfolio is
invested from that of the manager. The information ratio is a more general form of the
Sharpe ratio in which the risk-free asset is replaced by a benchmark portfolio. This
measure is relative, as it evaluates portfolio performance in reference to a benchmark,
making the result strongly dependent on this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the return of the
portfolio and that of a benchmark portfolio. This measure appears to be the only reliable
performance measure to evaluate active management. In fact, we have to distinguish
between normal returns, provided by the fair reward for portfolio exposure to different
risks, and obtained through passive management, from abnormal performance (or
outperformance) due to the managers skill, whether through market timing or stock
picking. The first component is related to allocation and style investment choices, which
may not be under the sole control of the manager, and depends on the economic context,
while the second component is an evaluation of the success of the managers decisions.
Only the latter, measured by alpha, allows the evaluation of the managers true
performance.
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Portfolio normal return may be evaluated using factor models. The first model, proposed
by Jensen (1968), relies on the CAPM and explains portfolio normal returns with the
market index as the only factor. It quickly becomes clear, however, that one factor is not
enough to explain the returns and that other factors have to be considered. Multi-factor
models were developed as an alternative to the CAPM, allowing a better description of
portfolio risks and an accurate evaluation of managers performance. For example, Fama
and French (1993) have highlighted two important factors that characterize a company's
risk in addition to market risk. These factors are the book-to-market ratio and the
company's size as measured by its market capitalization. Fama and French therefore
proposed a three-factor model to describe portfolio normal returns. Carhart (1997)
proposed to add momentum as a fourth factor to allow the persistence of the returns to be
taken into account. Also of interest for performance measurement is Sharpes (1992)
style analysis model, in which factors are style indices. This model allows a custom
benchmark for each portfolio to be developed, using the linear combination of style
indices that best replicate portfolio style allocation, and leads to an accurate evaluation of
portfolio.
Steps of New Market Strategy
1 our Present Situations
The financial planner clarifies the clients present situation by collecting and assessing all
relevant financial information, including:
net worth and cash flow statements, insurance policies, tax returns, investment portfolios,
pension plans, employee benefit statements etc. The planner will itemize all basic family
information - name, age, marital status, employment history, details of the childrens
birth dates and other qualitative data.
Essentially this step summarizes where the client is today. An individuals current
situation is a result of the cumulative effects of all of the financial decisions and
transactions that have occurred in the past up until the current time.
2 Identify Goals & Objectives
The financial planner helps identify both financial and personal goals and objectives as
well as clarify the clients financial and personal values and attitudes. These may include
providing for childrens education, supporting elderly parents or relieving immediate
financial pressures which would help maintain the clients current lifestyle and provide
for retirement. These considerations are important in determining the best financial
planning strategy. Any goals established should be:
Specific. Otherwise they are not goals, they are merely dreams. I require $500,000 by
my 65th birthday is an example of a specific goal. I want to be rich when I retire is a
dream, not a goal.
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Measurable. Financial goals are easily measurable since dollars and cents can be
counted.
Realistic and attainable. In order for a goal to be achieved, it must be within the realm
of reason. To accumulate $1 million by age 65, if one is currently age 64, and has no
savings may be attainable by winning a lottery however; this is unrealistic. Conversely,
for a 25-year-old to accumulate $1 million by age 65 through saving and investing is
probably both attainable and realistic.
Time bound. All goals should be time bound in order to track progress towards the
goals completion and to provide feedback. Corrections should be made in the action plan
therefore maximizing the probability of success.
3 Identify Problems
The financial planner identifies financial obstacles to achieving financial independence.
Problem areas can include too little or too much insurance coverage, or a high tax burden.
The clients cash flow may be inadequate, or the current investments may not be winning
the battle with changing economic times. These possible problem areas must be identified
before solutions can be found.
4 Design The Plan
The financial planner provides written recommendations and alternative solutions. The
length of the recommendations will vary with the complexity of ones individual
situation, but they should always be structured to meet the clients needs without undue
emphasis on purchasing certain investment products..
5 Implement The Plan
A financial plan is only helpful if the recommendations are put into action. Implementing
the right strategy will help to reach the desired goals and objectives. The financial
planner should assist in either actually executing the recommendations, or in coordinating
their execution with other knowledgeable professionals..
6 Periodic Review
The financial planner provides periodic review and revision of the plan to assure that the
goals are achieved. Your financial situation should be re-assessed at least once a year to
account for changes in life and current economic conditions..
Money Market
In finance, the money market is the global financial market for short-term borrowing and
lending. It provides short-term liquid funding for the global financial system. The money
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market is where short-term obligations such as Treasury bills, commercial paper and
bankers' acceptances are bought and sold.
The money market consists of financial institutions and dealers in money or credit who
wish to either borrow or lend. Participants borrow and lend for short periods of time,
typically up to thirteen months. Money market trades in short term financial instruments
commonly called "paper". This contrasts with the capital market for longer-term funding,
which is supplied by bonds and equity.
The core of the money market consists of banks borrowing and lending to each other,
using commercial paper, repurchase agreements and similar instruments. These
instruments are often benchmarked to the London Interbank Offered Rate (LIBOR).
Finance companies such as GMAC typically fund themselves by issuing large amounts of
asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets
into an ABCP conduit. Examples of eligible assets include auto loans, credit card
receivables, residential/commercial mortgage loans, mortgage backed securities and
similar financial assets. Certain large corporations with strong credit ratings, such as
General Electric, issue commercial paper on their own credit. Other large corporations
arrange for banks to issue commercial paper on their behalf via commercial paper lines.
In the United States, federal, state and local governments all issue paper to meet funding
needs. States and local governments issue municipal paper, while the US Treasury issues
Treasury bills to fund the US public debt.
Trading companies often purchase bankers' acceptances to be tendered for
payment to overseas suppliers.
Retail and Institutional Money Market Funds
Banks
Central Banks
Cash management programs
Arbitrage ABCP conduits, which seek to buy higher yielding paper, while
themselves selling cheaper paper.
Trading takes place between banks in the "money centers" (London, New York, and
Tokyo).
Common money market instruments
Bankers' acceptance - A draft issued by a bank that will be accepted for payment,
effectively the same as a cashier's check.
Certificate of deposit - A time deposit at a bank with a specific maturity date;
large-denomination certificates of deposits can be sold before maturity.
Repurchase agreements - Short-term loansnormally for less than two weeks and
frequently for one dayarranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
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Commercial paper - An unsecured promissory notes with a fixed maturity of one
to 270 days; usually sold at a discount from face value.
Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch
located outside the United States.
Federal Agency Short-Term Securities - (in the US). Short-term securities issued
by government sponsored enterprises such as the Farm Credit System, the Federal
Home Loan Banks and the Federal National Mortgage Association.
Federal funds - (in the US). Interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They are lent
for the federal funds rate.
Municipal notes - (in the US). Short-term notes issued by municipalities in
anticipation of tax receipts or other revenues.
Treasury bills - Short-term debt obligations of a national government that are
issued to mature in 3 to 12 months. For the U.S., see Treasury bills.
Money market mutual funds - Pooled short maturity, high quality investments
which buy money market securities on behalf of retail or institutional investors.
Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of
the exchange of currencies at a predetermined time in the future.
Futures Exchange
A futures exchange is a central financial exchange where people can trade standardized
futures contracts; that is, a contract to buy specific quantities of a commodity or financial
instrument at a specified price with delivery set at a specified time in the future.
Though the origins of futures trading can supposedly be traced to Ancient Greek or
Phoenician times,
[citation needed]
the first modern organized futures exchange began in 1710 at
the Dojima Rice Exchange in Osaka, Japan.
[1]
The United States followed in the early 1800s. Chicago is located at the base of the Great
Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a natural
center for transportation, distribution and trading of agricultural produce. Gluts and
shortages of these products caused chaotic fluctuations in price, and this led to the
development of a market enabling grain merchants, processors, and agriculture
companies to trade in "to arrive" or "cash forward" contracts to insulate them from the
risk of adverse price change and enable them to hedge.
Forward contracts were standard at the time. However, most forward contracts weren't
honored by both the buyer and the seller. For instance, if the buyer of a corn forward
contract made an agreement to buy corn, and at the time of delivery the price of corn
differed dramatically from the original contract price, either the buyer or the seller would
back out. Additionally, the forward contracts market was very illiquid and an exchange
was needed that would bring together a market to find potential buyers and sellers of a
commodity instead of making people bear the burden of finding a buyer or seller.
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In 1848, the Chicago Board of Trade (CBOT the world's first modern futures exchange)
was formed. Trading was originally in forward contracts; the first contract (on corn) was
written on March 13, 1851. In 1865, standardized futures contracts were introduced.
The Chicago Produce Exchange was established in 1874 and renamed the Chicago
Mercantile Exchange (CME) in 1898 and reorganised in the 1919. In 1972 the
International Monetary Market (IMM), a division of the CME, was formed to offer
futures contracts in foreign currencies: British pound, Canadian dollar, German mark,
Japanese yen, Mexican peso, and Swiss franc.
In 1881, a regional market was founded in Minneapolis, Minnesota and in 1883
introduced futures for the first time. Trading continuously since then, today the
Minneapolis Grain Exchange (MGEX) is the only exchange for hard red spring wheat
futures and options.
[2]
Later in the 1970s saw the development of the financial futures contracts, which allowed
trading in the future value of interest rates. These (in particular the 90-day Eurodollar
contract introduced in 1981) had an enormous impact on the development of the interest
rate swap market.
Today, the futures markets have far outgrown their agricultural origins. With the addition
of the New York Mercantile Exchange (NYMEX) the trading and hedging of financial
products using futures dwarfs the traditional commodity markets, and plays a major role
in the global financial system, trading over 1.5 trillion U.S. dollars per day in 2005.
The recent history of these exchanges (Aug 2006) finds the Chicago Exchange trading
more than 70% of its Futures contracts on its "Globex" trading platform and this trend is
rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million
contracts) every single day in "electronic trading" as opposed to open outcry trading of
Futures, Options and Derivatives.
In June of 2001, ICE (Intercontinental Exchange) acquired the International Petroleum
Exchange (IPE), now ICE Futures, which operated Europes leading open-outcry energy
futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange
(CCX) to host its electronic marketplace. In April of 2005, the entire ICE portfolio of
energy futures became fully electronic.
In 2006, the New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-
Paris Exchanges "Euronext" electronic exchange to form the first trans-continental
Futures and Options Exchange. These two developments as well as the sharp growth of
internet Futures trading platforms developed by a number of trading companies clearly
points to a race to total internet trading of Futures and Options in the coming years.
In terms of trading volume, the Bombay Stock Exchange of India in Mumbai is the
largest stock futures trading exchange in the world, followed by JSE Limited in Sandton,
Gauteng, South Africa.
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Nature of contracts
Exchange-traded contracts are standardized by the exchanges where they trade. The
contract details what asset is to be bought or sold, and how, when, where and in what
quantity it is to be delivered. The terms also specify the currency in which the contract
will trade, minimum tick value, and the last trading day and expiry or delivery month.
Standardized commodity futures contracts may also contain provisions for adjusting the
contracted price based on deviations from the "standard" commodity, for example, a
contract might specify delivery of heavier USDA Number 1 oats at par value but permit
delivery of Number 2 oats for a certain seller's penalty per bushel.
Before the market opens on the first day of trading a new futures contract, there is a
specification but no actual contracts exist. Futures contracts are not issued like other
securities, but are "created" whenever Open interest increases; that is, when one party
first buys (goes long) a contract from another party (who goes short). Contracts are also
"destroyed" in the opposite manner whenever Open interest decreases because traders
resell to reduce their long positions or rebuy to reduce their short positions.
Speculators on futures price fluctuations who do not intend to make or take ultimate
delivery must take care to "zero their positions" prior to the contract's expiry. After
expiry, each contract will be settled , either by physical delivery (typically for commodity
underlyings) or by a cash settlement (typically for financial underlyings). The contracts
ultimately are not between the original buyer and the original seller, but between the
holders at expiry and the exchange. Because a contract may pass through many hands
after it is created by its initial purchase and sale, or even be liquidated, settling parties do
not know with whom they have ultimately traded.
Compare this with other securities, in which there is a primary market when an issuer
issues the security, and a secondary market where the security is later traded
independently of the issuer. Legally, the security represents an obligation of the issuer
rather than the buyer and seller; even if the issuer buys back some securities, they still
exist. Only if they are legally cancelled can they disappear.
Standardization
The contracts traded on futures exchanges are always standardized. In principle, the
parameters to define a contract are endless (see for instance in futures contract). To make
sure liquidity is high, there is only a limited number of standardized contracts.
Derivatives Clearing
There is usually a division of responsibility between provision of trading facility and
settlement of those trades. While derivative exchanges like the CBOE and LIFFE take
responsibility for providing efficient, transparent and orderly trading environments,
settlement of the resulting trades are usually handled by Clearing Corporations, also
known as Clearing Houses that serve as central counterparties to trades done in the
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respective exchanges. For instance, the Options Clearing Corporation and the London
Clearing House respectively are the clearing corporations for CBOE and LIFFE. A well
known exception to this is the case of Chicago Mercantile Exchange, which clears trades
by itself.
Central Counterparty
Derivative contracts are leveraged positions whose value is volatile. They are usually
more volatile than their underlying asset. This can lead to situations where one party to a
trade loses a big sum of money and is unable to honor its settlement obligation. In a safe
trading environment, the parties to a trade need to be assured that their counterparty will
honor the trade, no matter how the market has moved. This requirement can lead to
messy arrangements like credit assessment, setting of trading limits and so on for each
counterparty, and take away most of the advantages of a centralised trading facility. To
prevent this, Clearing corporations interpose themselves as counterparties to every trade
and extend guarantee that the trade will be settled as originally intended. This action is
called Novation. As a result, trading firms take no risk on the actual counterparty to the
trade, but on the clearing corporation. The clearing corporation is able to take on this risk
by adopting an efficient margining process.
Margin and Mark-to-Market
Clearing houses charge two types of margins: the Initial Margin and the Mark-To-Market
margin (also referred to as Variation Margin).
The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the
clearing corporation to cover possible future loss in the positions (the set of positions held
is also called the portfolio) held by a firm. In the simplest case, this is the dollar figure
that answers a question of this nature: What is the likely loss that this firm may incur on
its portfolio with a 99% confidence and over a period of 2 days? The clause 'with a 99%
confidence' and 'over a period 2 days' is to be interpreted as that number such that the
actual portfolio loss over 2 days is expected to exceed the number only 1% of the time,
although how they know this is unknown. Several popular methods are used to compute
initial margins. They include the CME-owned SPAN (a grid simulation method used by
the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based
methodology used by the OCC), TIMS (earlier used by the OCC, and still being used by
a few other exchanges like the Bursa Malaysia.
The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to
offset losses (if any) that have already been incurred on the positions held by a firm. This
is computed as the difference between the cost of the position held and the current market
value of that position. If the resulting amount is a loss, the amount is collected from the
firm; else, the amount may be returned to the firm (the case with most clearing houses) or
kept in reserve depending on local practice. In either case, the positions are 'marked-to-
market' by setting their new cost to the market value used in computing this difference.
The positions held by the clients of the exchange are marked-to-market daily and the
128
MTM difference computation for the next day would use the new cost figure in its
calculation.
Clients hold a margin account with the exchange, and every day the swings in the value
of their positions is added to or deducted from their margin account. If the margin
account gets too low, they have to replenish it. In this way it is highly unlikely that the
client will not be able to fulfill his obligations arising from the contracts. As the clearing
house is the counterparty to all their trades, they only have to have one margin account.
This is in contrast with OTC derivatives, where issues such as margin accounts have to be
negotiated with all counterparties.
Regulators
Each exchange is normally regulated by a national governmental (or semi-governmental)
regulatory agency:
In Australia, this role is performed by the Australian Securities and Investments
Commission.
In the Chinese mainland, by the China Securities Regulatory Commission.
In Hong Kong, by the Securities and Futures Commission.
In India, by the Securities and Exchange Board of India.
In Pakistan, by the Securities and Exchange Commission of Pakistan.
In Singapore by the Monetary Authority of Singapore.
In the UK, futures exchanges are regulated by the Financial Services Authority.
In the USA, by the Commodity Futures Trading Commission.
In Malaysia, by the Securities Commission.
Foreign Exchange Market
The foreign exchange (currency or forex or FX) market exists wherever one currency is
traded for another. It is the largest financial market in the world, and includes trading
between large banks, central banks, currency speculators, multinational corporations,
governments, and other financial markets and institutions. The average daily trade in the
global forex and related markets currently is over US$ 3 trillion.
[1]
Market Size and liquidity
The foreign exchange market is unique because of
its trading volumes,
the extreme liquidity of the market,
the large number of, and variety of, traders in the market,
129
its geographical dispersion,
its long trading hours: 24 hours a day except on weekends (from
5pm EST on Sunday until 4pm EST Friday),
the variety of factors that affect exchange rates.
the low margins of profit compared with other markets of fixed
income (but profits can be high due to very large trading volumes)
the use of leverage
Foreign exchange market turnover, 1988 - 2007, measured in billions of USD.
As such, it has been referred to as the market closest to the ideal perfect competition,
notwithstanding market manipulation by central banks. According to the BIS,
[1]
average
daily turnover in traditional foreign exchange markets is estimated at $3.21 trillion. Daily
averages in April for different years, in billions of US dollars, are presented on the chart
below:
This $3.21 trillion in global foreign exchange market "traditional" turnover was broken
down as follows:
$1,005 billion in spot transactions
$362 billion in outright forwards
$1,714 billion in forex swaps
$129 billion estimated gaps in reporting
In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago
Mercantile Exchange and are actively traded relative to most other futures contracts.
Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the
total foreign exchange market volume, according to The Wall Street Journal Europe
(5/5/06, p. 20).
Average daily global turnover in traditional foreign exchange market transactions totaled
$2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London,
New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover,
including non-traditional foreign exchange derivatives and products traded on exchanges,
averaged around $2.9 trillion a day. This was more than ten times the size of the
combined daily turnover on all the worlds equity markets. Foreign exchange trading
increased by 38% between April 2005 and April 2006 and has more than doubled since
2001. This is largely due to the growing importance of foreign exchange as an asset class
and an increase in fund management assets, particularly of hedge funds and pension
funds. The diverse selection of execution venues such as internet trading platforms
offered by companies such as First Prudential Markets and Saxo Bank have made it
easier for retail traders to trade in the foreign exchange market.
[2]
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Because foreign exchange is an OTC market where brokers/dealers negotiate directly
with one another, there is no central exchange or clearing house. The biggest geographic
trading centre is the UK, primarily London, which according to IFSL estimates has
increased its share of global turnover in traditional transactions from 31.3% in April 2004
to 32.4% in April 2006. RPP
The ten most active traders account for almost 73% of trading volume, according to The
Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually
provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the
difference between the price at which a bank or market maker will sell ("ask", or "offer")
and the price at which a market-maker will buy ("bid") from a wholesale customer. This
spread is minimal for actively traded pairs of currencies, usually 03 pips. For example,
the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum
trading size for most deals is usually 100,000 units of currency, which is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up
the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes
or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no
more than 3 pips wide (i.e. 0.0003). Competition is greatly increased with larger
transactions, and pip spreads shrink on the major pairs to as little as 1 to 2 pips.
Market participants
Unlike a stock market, where all participants have access to the same prices, the forex
market is divided into levels of access. At the top is the inter-bank market, which is made
up of the largest investment banking firms. Within the inter-bank market, spreads, which
are the difference between the bid and ask prices, are razor sharp and usually unavailable,
and not known to players outside the inner circle. As you descend the levels of access, the
difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some
currencies such as the EUR). This is due to volume. If a trader can guarantee large
numbers of transactions for large amounts, they can demand a smaller difference between
the bid and ask price, which is referred to as a better spread. The levels of access that
make up the forex market are determined by the size of the line (the amount of money
with which they are trading). The top-tier inter-bank market accounts for 53% of all
transactions. After that there are usually smaller investment banks, followed by large
multi-national corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail forex market makers.
According to Galati and Melvin, Pension funds, insurance companies, mutual funds, and
other institutional investors have played an increasingly important role in financial
markets in general, and in FX markets in particular, since the early 2000s. (2004) In
addition, he notes, Hedge funds have grown markedly over the 20012004 period in
terms of both number and overall size Central banks also participate in the forex market
to align currencies to their economic needs.
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Banks
The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is conducted
by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today, however,
much of this business has moved on to more efficient electronic systems. The broker
squawk box lets traders listen in on ongoing interbank trading and is heard in most
trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial Companies
An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly
small amounts compared to those of banks or speculators, and their trades often have
little short term impact on market rates. Nevertheless, trammde flows are an important
factor in the long-term direction of a currency's exchange rate. Some multinational
companies can have an unpredictable impact when very large positions are covered due
to exposures that are not widely known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try
to control the money supply, inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Milton Friedman argued that the best
stabilization strategy would be for central banks to buy when the exchange rate is too
low, and to sell when the rate is too high that is, to trade for a profit based on their
more precise information. Nevertheless, the effectiveness of central bank "stabilizing
speculation" is doubtful because central banks do not go bankrupt if they make large
losses, like other traders would, and there is no convincing evidence that they do make a
profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize
a currency, but aggressive intervention might be used several times each year in countries
with a dirty float currency regime. Central banks do not always achieve their objectives.
The combined resources of the market can easily overwhelm any central bank.
[4]
Several
scenarios of this nature were seen in the 199293 ERM collapse, and in more recent
times in Southeast Asia.
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Hedge Funds
Hedge funds have gained a reputation for aggressive currency speculation since 1996.
They control billions of dollars of equity and may borrow billions more, and thus may
overwhelm intervention by central banks to support almost any currency, if the economic
fundamentals are in the hedge funds' favor.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of
customers such as pension funds and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager with an
international equity portfolio will need to buy and sell foreign currencies in the spot
market in order to pay for purchases of foreign equities. Since the forex transactions are
secondary to the actual investment decision, they are not seen as speculative or aimed at
profit-maximization.
Some investment management firms also have more speculative specialist currency overlay
operations, which manage clients' currency exposures with the aim of generating profits
as well as limiting risk. Whilst the number of this type of specialist firms is quite small,
many have a large value of assets under management (AUM), and hence can generate
large trades.
Retail forex brokers
There are two types of retail broker: brokers offering speculative trading. Retail forex
brokers or market makers handle a minute fraction of the total volume of the foreign
exchange market. According to CNN, one retail broker estimates retail volume at $2550
billion daily, which is about 2% of the whole market. Retail traders (individuals) are a
small fraction of this market and may only participate indirectly through brokers or
banks, and might be subject to forex scams.
Other
Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as Foreign
Exchange Brokers but are distinct from Forex Brokers as they do not offer speculative
trading but currency exchange with payments. i.e. there is usually a physical delivery of
currency to a bank account.
It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign
Exchange Companies. These companies' selling point is usually that they will offer better
exchange rates or cheaper payments than the customer's bank. These companies differ
from Money Transfer/Remittance Companies in that they generally offer higher-value
services.
Money Transfer/Remittance Companies perform high-volume low-value transfers
generally by economic migrants back to their home country. In 2007, the Aite Group
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estimated that there were $369 billion of remittances (an increase of 8% on the previous
year). The four largest markets (India, China, Mexico and the Philippines) receive $95
billion. The largest and best known provider is Western Union with 345,000 agents
globally.
Trading characteristics
There is no unified or centrally cleared market for the majority of FX trades, and there is
very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency
markets, there are rather a number of interconnected marketplaces, where different
currency instruments are traded. This implies that there is not a single dollar rate but
rather a number of different rates (prices), depending on what bank or market maker is
trading. In practice the rates are often very close, otherwise they could be exploited by
arbitrageurs instantaneously. A joint venture of the Chicago Mercantile Exchange and
Reuters, called FxMarketSpace opened in 2007 and aspires to the role of a central market
clearing mechanism.
The main trading centers are in London, New York, Tokyo, Hong Kong and Singapore,
but banks throughout the world participate. Currency trading happens continuously
throughout the day; as the Asian trading session ends, the European session begins,
followed by the North American session and then back to the Asian session, excluding
weekends.
There is little or no 'inside information' in the foreign exchange markets. Exchange rate
fluctuations are usually caused by actual monetary flows as well as by expectations of
changes in monetary flows caused by changes in GDP growth, inflation, interest rates,
budget and trade deficits or surpluses, large cross-border M&A deals and other
macroeconomic conditions. Major news is released publicly, often on scheduled dates, so
many people have access to the same news at the same time. However, the large banks
have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an
individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217
international three-letter code of the currency into which the price of one unit of XXX is
expressed (called base currency). For instance, EUR/USD is the price of the euro
expressed in US dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first
currency in the pair, the base currency, was the stronger currency at the creation of the
pair. The second currency, counter currency, was the weaker currency at the creation of
the pair.
The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes
positive currency correlation between XXX/YYY and XXX/ZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
EUR/USD: 28 %
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USD/JPY: 18 %
GBP/USD (also called sterling or cable): 14 %
and the US currency was involved in 88.7% of transactions, followed by the euro
(37.2%), the yen (20.3%), and the sterling (16.9%) (see table). Note that volume
percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.
Although trading in the euro has grown considerably since the currency's creation in
January 1999, the foreign exchange market is thus far still largely dollar-centered. For
instance, trading the euro versus a non-European currency ZZZ will usually involve two
trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an
established traded currency pair in the interbank spot market.
Factors affecting currency trading
Although exchange rates are affected by many factors, in the end, currency prices are a
result of supply and demand forces. The world's currency markets can be viewed as a
huge melting pot: in a large and ever-changing mix of current events, supply and demand
factors are constantly shifting, and the price of one currency in relation to another shifts
accordingly. No other market encompasses (and distills) as much of what is going on in
the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
economic factors, political conditions and market psychology.
Economic factors
These include economic policy, disseminated by government agencies and central banks,
economic conditions, generally revealed through economic reports, and other economic
indicators.
Economic policy comprises government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government's central bank influences the supply
and "cost" of money, which is reflected by the level of interest rates).
Economic conditions include:
Government budget deficits or surpluses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the
demand for goods and services, which in turn indicates demand for a country's currency
to conduct trade. Surpluses and deficits in trade of goods and services reflect the
135
competitiveness of a nation's economy. For example, trade deficits may have a negative
impact on a nation's currency.
Inflation levels and trends: Typically, a currency will lose value if there is a high level of
inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that particular currency. However, a
currency may sometimes strengthen when inflation rises because of expectations that the
central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health: Reports such as gross domestic product (GDP),
employment levels, retail sales, capacity utilization and others, detail the levels of a
country's economic growth and health. Generally, the more healthy and robust a country's
economy, the better its currency will perform, and the more demand for it there will be.
Political conditions
Internal, regional, and international political conditions and events can have a profound
effect on currency markets.
For instance, political upheaval and instability can have a negative impact on a nation's
economy. The rise of a political faction that is perceived to be fiscally responsible can
have the opposite effect. Also, events in one country in a region may spur positive or
negative interest in a neighboring country and, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a
variety of ways:
Flights to quality: Unsettling international events can lead to a "flight to quality," with
investors seeking a "safe haven". There will be a greater demand, thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts.
Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends.
"Buy the rumor, sell the fact:" This market truism can apply to many currency situations.
It is the tendency for the price of a currency to reflect the impact of a particular action
before it occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being "oversold" or
"overbought".
[9]
To buy the rumor or sell the fact can also be an example of the cognitive
bias known as anchoring, when investors focus too much on the relevance of outside
events to currency prices.
136
Economic numbers: While economic numbers can certainly reflect economic policy,
some reports and numbers take on a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate impact on short-term market
moves. "What to watch" can change over time. In recent years, for example, money
supply, employment, trade balance figures and inflation numbers have all taken turns in
the spotlight.
Technical trading considerations: As in other markets, the accumulated price movements
in a currency pair such as EUR/USD can form apparent patterns that traders may attempt
to use. Many traders study price charts in order to identify such patterns.
Algorithmic trading in forex
Electronic trading is growing in the FX market, and algorithmic trading is becoming
much more common. According to financial consultancy Celent estimates, by 2008 up to
25% of all trades by volume will be executed using algorithm, up from about 18% in
2005.
Financial instruments
A spot transaction is a two-day delivery transaction (except in the case of the Canadian
dollar, which settles the next day), as opposed to the futures contracts, which are usually
three months. This trade represents a direct exchange between two currencies, has the
shortest time frame, involves cash rather than a contract; and interest is not included in
the agreed-upon transaction. The data for this study come from the spot market. Spot has
the largest share by volume in FX transactions among all instruments.
Forward
One way to deal with the Forex risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A
buyer and seller agree on an exchange rate for any date in the future, and the transaction
occurs on that date, regardless of what the market rates are then. The duration of the trade
can be a few days, months or years.
Future
Foreign currency futures are forward transactions with standard contract sizes and
maturity dates for example, 500,000 British pounds for next November at an agreed
rate. Futures are standardized and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures contracts are usually
inclusive of any interest amounts.
137
Swap
The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through
an exchange.
Option
A foreign exchange option (commonly shortened to just FX option) is a derivative where
the owner has the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a specified date. The FX
options market is the deepest, largest and most liquid market for options of any kind in
the world.
Exchange Traded Fund
Exchange-traded funds (or ETFs) are Open Ended investment companies that can be
traded at any time throughout the course of the day. Typically, ETFs try to replicate a
stock market index such as the S&P 500 (e.g. SPY), but recently they are now replicating
investments in the currency markets with the ETF increasing in value when the US Dollar
weakness versus a specific currency, such as the Euro. Certain of these funds track the
price movements of world currencies versus the US Dollar, and increase in value directly
counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar
denominated investors and speculators.
Speculation
Controversy about currency speculators and their effect on currency devaluations and
national economies recurs regularly. Nevertheless, many economists (e.g. Milton
Friedman) have argued that speculators perform the important function of providing a
market for hedgers and transferring risk from those people who don't wish to bear it, to
those who do. Other economists (e.g. Joseph Stiglitz) however, may consider this
argument to be based more on politics and a free market philosophy than on economics.
[citation needed]
Large hedge funds and other well capitalized "position traders" are the main professional
speculators.
Currency speculation is considered a highly suspect activity in many countries. While
investment in traditional financial instruments like bonds or stocks often is considered to
contribute positively to economic growth by providing capital, currency speculation does
not; according to this view, it is simply gambling that often interferes with economic
policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to
raise interest rates for a few days to 500% per annum, and later to devalue the krona
[11]
.
Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of
138
this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros
and other speculators.
[12]
Gregory Millman reports on an opposing view, comparing speculators to "vigilantes"
who simply help "enforce" international agreements and anticipate the effects of basic
economic "laws" in order to profit.
In this view, countries may develop unsustainable financial bubbles or otherwise
mishandle their national economies, and forex speculators allegedly made the inevitable
collapse happen sooner. A relatively quick collapse might even be preferable to
continued economic mishandling. Mahathir Mohamad and other critics of speculation are
viewed as trying to deflect the blame from themselves for having caused the
unsustainable economic conditions. Given that Malaysia recovered quickly after
imposing currency controls directly against IMF advice, this view is open to doubt.
WE AND INVESMENT:
INVESTING IS NEVER AN EASY PROCESS. HOWEVER, A SOUND UNDERSTANDING OF SOME BASIC
CONCEPTS MAKES THE PROCESS OF INVESTING DECISION-MAKING MUCH MORE ENJOYABLE. THE
FOLLOWING STEPS CAN HELP YOU PATH TO BECOMING A SUCCESSFUL INVESTOR.
1. IDENTIFY OUR FINANCIAL NEEDS AND GOALS

THE FIRST STEP IS TO GET A CLEAR UNDERSTANDING OF OUR OWN FINANCIAL NEEDS AND GOALS.
ASK YOURSELF THE QUESTION- WHEN DO I NEED MONEY AND FOR WHAT PURPOSE? LIST DOWN
YOUR FINANCIAL GOALS AND WHEN THEY WILL MATERIALIZE (DAUGHTERS HIGHER EDUCATION
AFTER 6 YEARS, PURCHASE OF A HOUSE AFTER 10 YEARS) AND HOW MUCH MONEY YOU WILL NEED
FOR THE SAME. THE ANSWER WILL HELP YOU ARRIVE AT THE TIME FRAME FOR YOU INVESTMENT-
SHORT TERM, MEDIUM TERM OR LONG TERM.
UNDERSTAND YOUR TOLERANCE TO RISK
Financial goals Amount required
Years' to
achieve your
goal
Investment
horizon
Retirement Rs. 25 lakhs 20 years long term
Daughter's higher education Rs. 2 lakhs 6 years long term
Buying a car son's Rs. 4 lakhs 2 years Medium term
Computer course Rs. 0.50 lakhs 6 months Short term 139
BEFORE MAKING AN INVESTMENT DECISION, IT IS IMPORTANT TO ASCERTAIN YOUR
FEELING ABOUT RISK. WILL WE BE COMFORTABLE WITH FLUCTUATIONS IN THE VALUE
OF OUR INVESTMENT? OR WOULD YOU PREFER TO SETTLE FOR LOWER RETURNS,
WITHOUT UPS AND DOWNS?
ESTIMATE YOUR REQUIRED RATE OF RETURN:
YOUR REQUIRED RATE OF RETURN DEPENDS ON OUR FINANCIAL GOALS AND THE TIME WE HAVE TO
ACHIEVE THEM, AS CAN BE SEEN FROM THE ILLUSTRATION BELOW:
IF OUR RETIREMENT GOAL AT 58YEARS IS RS. 20 LAKHS AND YOUR MONTHLY SAVINGS IS RS.
5000, OUR REQUIRED RATE OF RETURN DEPENDING ON OUR CURRENT AGE WOULD BE:
PRESENT AGE RETURNS
43 YEARS 9.5%
48 YEARS 21.2%
AS WE CAN SEE, THE LATER WE START, THE HIGHER WILL BE OUR REQUIRED RATE OF RETURN. IN
OTHER WORDS, AS OUR INVESTMENT HORIZON REDUCES, FOR THE SAME LEVEL OF SAVING, YOU
MAY NEED TO TAKE ON A HIGHER RISK. ALTERNATIVELY, IF WE WERE NOT WILLING TO TAKE A
HIGHER RISK, WE WOULD HAVE TO SAVE HIGHER AMOUNT EVERY MONTH- RS. 9800, ALMOST TWICE
THE ORIGINAL SAVING REQUIRED TO ACHIEVE OUR TARGET ACCUMULATION.
ONCE WE ARE COMFORTABLE WITH THESE BASICS, THE NEXT STEP IS TO UNDERSTAND OUR
INVESTMENT CHOICES, AND DRAW UP AN INVESTMENT PLAN RELEVANT TO OUR REQUIREMENT.
140
WHILE THE FOLLOWING SECTION PROVIDES US MORE DETAILS ON THESE CHOICES, WE WOULD URGE
US TO CONSULT OUR INVESTMENT ADVISOR TO UNDERSTAND THESE BETTER BEFORE INVESTING.
MEANING OF DERIVATIVES
Derivatives are a class of financial 'instruments' a set of things, of financial objects,
having a monetary value, and which can be bought and sold, just the same as company
stock, or a ton of coffee beans but are different because they derive their value from
some underlying financial entity, i.e., their worth depends on the worth of something else,
so there is a degree of abstraction involved. This can make the consequences of holding a
derivative hard to fathom, e.g., a derivative can increase in value when the value of the
underlying entity decreases but it is precisely this flexibility which makes derivatives
really useful.
The origin of derivatives trading goes back to commodity
traders who used futures to hedge themselves against disadvantageous price fluctuations
when bringing goods to market, i.e., they basically pre-arranged the buying or selling
prices of what they were producing. Doing this allows one to lock-in a level of profit,
thus making cash flow more predictable and so can help a great deal in financial
planning. Companies do this kind of thing a lot, e.g., to protect themselves against
currency movements, or oil price surges, or whatever even the weather.
This practice of reducing risk hedging is the good side of derivatives. Of course,
there is always the converse if you are laying off risk to someone else, why should
they want to take it on? Simple really, they believe that by assuming your risk, they can
make money they are speculating on the market. Speculating often gets a bad press but
is essential to the working of the markets; these only function properly if they are liquid,
i.e., it is possible to both buy and sell an entity; speculators provide this liquidity.
MEANING OF FUTURES:A future is a derivative that is used to transfer the price risk
of the underlying instrument from one party to another. A future is thus a contract
between two parties whereby the one party (the buyer) agrees to buy an underlying asset
from the other party to the contract on a specific future date, and at a price determined at
the close of the contract.
The underlying asset can be a financial asset such as a bond, a currency such as US
dollars, a commodity, etc. Because most futures are cash settled (which will be explained
141
later in the text), almost anything with a determinable value can be used as an underlying
asset to a futures contract.
A future is normally classified according to the underlying instrument. Where, for
instance, two parties agree to buy and sell a specific quantity of rice (of a certain quality)
at a certain price on a future date, the contract will be a commodity futures contract.
Where two parties agree to buy and sell bonds, this will be known as a financial futures
contract, and where two parties agree to buy and sell a certain amount of foreign
currency, this is a currency futures contract.
A futures contract is thus
an agreement between two parties
to buy and sell
a standardised type and quantity
of a specified underlying asset
with a certain quality
at a price determined at the closing of the contract
on a specified date
through a central exchange.
Futures contracts v. forward contracts
Futures contracts and forward contracts are similar in that they are both contracts to buy
and sell an underlying instrument at a predetermined price on a future date. Future
contracts between parties are closed with a futures exchange acting as intermediary, and
are standardised in terms of the type and quality of the underlying asset, the terms of the
contract and the delivery date, method of settlement and price determination.
Forward contracts, on the other hand, are closed between two parties independently from
an exchange (OTC), and the terms are structured to suit the specific needs of the two
parties.
The following is a comparison of some of the characteristics of forward contracts and
futures contracts:
The working and trading of a futures contract
In a futures contract, both parties have an obligation,
one to buy the underlying instrument
the other to sell the underlying instrument.
142
Both the buyer and the seller can make a profit or suffer a loss, due to the fact that the
contract price (at which the underlying instrument is bought and sold) is determined at
closing of the contract. If the market price at the delivery date is lower than the futures
contract price, the buyer suffers a loss because he could have bought the instrument in the
market at a lower price. He is now obliged, according to the contract, to buy the
underlying instrument at the higher price specified in the contract. the opposite applies
when the market value of the underlying instrument is above the futures contract price.
The buyer can now buy the underlying instrument at the lower contract price, and sell the
instrument immediately at the higher market price, thus making an immediate profit.
An example of the working of a futures contract
Mr Kriek is a farmer in Northern Natal, and one of his specialities is potatoes. Mr Kriek
has planted potatoes and he knows that they will be ready for sale and delivery in three
months' time. Due to the good rains during the season, Mr Kriek expects to harvest three
tons of potatoes. He also knows that the harvest countrywide will be a good one and is
worried that he won't be able to sell all his potatoes, or that he will be forced to sell them
at a discounted price and suffer a loss.
The Lion Food Company in Johannesburg produces potato chips. The company expects
an influx of tourists to South Africa due to a reduction in the currency and the sporting
events taking place during the summer. The company has budgeted a huge increase in
production in three months' time, and is scared that there will not be sufficient potatoes
available in the market, or that the demand would increase, thus pushing up prices.
Mr Kriek and the Lion Food Company close a contract whereby Mr Kriek undertakes to
supply the company with three tons of potatoes in three months' time. The Lion Food
company undertakes to buy three tons of potatoes from Mr Kriek at R1 000 per ton on
delivery of the potatoes. The market price of potatoes at the closing of the contract is
R950 per ton.
The effect of the contract and the market price
The market price of potatoes at the closing of the contract has no direct effect on the
contract except that it acts as a guideline to the determination of the contract price
(R1000).
At the date of delivery determined in the contract (called the close-out date), Mr Kriek
has an obligation to supply three tons of potatoes and the Lion Food Company has an
obligation to take delivery of the potatoes and pay Mr Kriek R3000 (R1 000 x 3).
143
If the market price of potatoes on the day of delivery (the close-out day of the contract) is
R1050, the effect for the two parties will be as follows:
If Mr Kriek did not close the contract, he could have sold his potatoes in the market at R1
050 (assuming the demand is high enough).
Settlement and delivery of a futures contract
Due to the fact that Mr Kriek lives in Northern Natal, and the Lion Food Company is in
Johannesburg, there are further costs and the risks of transporting the potatoes to
Johannesburg. Instead of physical delivery taking place, the parties agree to the
following:
Mr Kriek will sell his potatoes in the market at the market price (saving him the hassle of
delivery to Johannesburg), and will pay to (or receive from) the Lion Food Company the
difference between the market value and the contract price.
The Lion Food company will buy potatoes at the market in Johannesburg, and will
receive from Mr Kriek the difference between the market value and the contract price.
The effect for the two parties is as follows:
This process is called cash settlement and has the same effect as physical delivery. Most
of the futures in South Africa are cash settled.
A contract can thus be honoured by cash settlement, which would be the difference
between the market value on close-out date and the contract price. This would also be
the profit/loss to the buyer/seller. Because physical delivery does not take place, a
futures contract can be entered (as seen previously) on almost anything with a
determinable value, such as an index of prices.
Security measures of a futures contract
As seen in the above example, both the buyer and the seller can suffer a loss and be
obliged to pay to the other party the cash settlement amount. The risk is thus that the
party in a loss position cannot pay the amount owed to the other party at close-out of the
contract. To ensure that both parties can honour payments at close-out, they agree to put
an amount on deposit (in the case of futures, at an exchange) from which the settlement
can be made at close-out, if necessary. This initial security deposit, in the case of South
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African futures, is determined by the South African Futures Exchange (SAFEX), paid to
them by both parties at the closing of the contract, and is called an initial margin.
There is, however, the risk that the initial margin does not fully cover the loss suffered by
one party, because of an adverse movement in market prices. To cover this risk, the
futures contract further stipulates that the daily movement in market prices will be settled
between the two parties (through an exchange), as if the contract has expired (closed out)
every day. This process is called marking to market, which gives the effect of marking
(valuing) the futures contract to its market value at the end of each day.
The example used in 3.1 is used here, with the following detail relating to the contract:
Date of closure of contract: 1 February
Contract price
(called the strike price): R1 000 per ton
Size of each contract: 1 ton of potatoes
Amount of contracts: 3 (thus an agreement for 3 tons of potatoes)
Market price on 1 February: R950 per ton
Close-out date of contracts: 5 February
The following market values at the end of each day relates to these contracts:
2 February R 970
3 February R 930
4 February R1 010
5 February R1 050
The initial margin placed with SAFEX on 1 February is R500 per contract. The cash
flow effect of this contract would thus be as follows:
1 February:
Both parties would place an initial margin of R1 500 (R500 x 3) with the exchange. The
difference between the market price (R950) and the contract price (R1 000) must be
settled between the two parties as if the contract was closed out at the end of the day
(marking to market). The Lion Food Company thus pays Mr Kriek R150 ((R1 000 -
R950) x 3).
2 February:
The market price has now moved slightly in favour of the Lion Food Company compared
to the previous day. If the contract was closed out today, the loss to the Lion Food
Company would only have been R90 ((R1 000 - R970) x 3). Mr Kriek must thus pay
back R60 (R150 - R90) to the Lion Food Company. This payment is equal to the
movement in the market value times the amount of contracts ((R950 - R970) x 3) = 60.
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3 February:
The Lion Food Company pays Mr Kriek R120 ((R970 - R930) x 3).
4 February:
The farmer pays the Lion Food company R240 ((R930 - R1 010) x 3).
5 February:
This is the date of close-out. Two payments take place; the marking to market payment
as for the previous days, and the initial margins to be paid back by the exchange. The
marking to market payment will result in Mr Kriek paying R120 ((R1 010 - R1 050) x 3)
to the Lion Food Company.
Each party will also receive back R1 500 initial margin from the exchange.
After these payments have taken place, the contract will be closed out.
In practice, each party will receive a statement in the morning from SAFEX of the
previous days' movements in market values and the margins to be paid in or paid back
(see appendix 11 for an example). This statement has to be settled immediately with
SAFEX, who then receives money from one party and pays it over to the other party.
If we take the above scenario and work out the net cash flow of Mr Kriek, it will appear
as follows:
1 February Initial margin payment (R1 500)
Marking to market R 150
2 February Marking to market (R 60)
3 February Marking to market R 120
4 February Marking to market (R 240)
5 February Marking to market (R 120)
Initial margin received R1 500
Net cash flow (R 150)
The net cash flow for Mr Kriek is thus the same as if cash flow would have taken place
on close-out date only as in 6.3.3.
The same cash flow table can be drawn up for the Lion Food Company, from which it
can be seen that they would have made a profit of R150.
The following are examples of underlying instruments on which futures contracts are
available on SAFEX
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JSE ALS140 index
JSE GLDI index
JSE INDI index
R150 government bond
R153 government bond
Commodities such as maize and wheat.
Trading on SAFEX is totally electronic and on-line via the ATS system, and no telephone
conversations have to take place. Electronic funds transfer procedures are used for
settlement and no physical contracts are issued. A statement of positions and cash flows
is supplied daily to each member.
The gearing effect
Only a small initial margin is required relative to the value of the underlying instrument.
In the case where an investor invests in an all-share index futures contract, the initial
margin that has to be lodged with SAFEX is R3 250 (February 1996). The exposure of
one contract is equal to the index times R10. Thus, if the index is 6 400 (November
1997), the exposure of one contract is R64 000. Contracts are traded in multiples of 10
contracts. The investor investing in 10 contracts would thus pay an initial margin of R32
500, and have an exposure equal to a physical investment of R640 000 on the JSE in the
shares representing the all-share index.
The pricing of futures contracts
Theoretically, the trading price of a futures contract should be equal to the current market
value of the underlying instrument plus interest on this value for the period up to close-
out of the contract. For instance, there is a future available on 10 ounces of gold on 1
January and the following relates:
The market price of 10 ounces of gold on 1 January is R1 000.
The futures contract price on 10 ounces of gold, with a close-out of 31 December (thus
one year to settlement) is R1160.
The following would be applicable:
If the short-term borrowing rate was 15%, an arbitrageur (a trader who makes money out
of differences in separate markets) could borrow R1 000 at 15% for one year. He would
then buy the gold immediately at R1 000 and sell a futures contract at R1 160.
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On 31 December, he would deliver the gold (as seller in the futures contract) he has
bought and will receive R1 160 for the gold according to the futures contract. (Cash
settlement would result in the same situation, as can be seen in 6.3.3, assuming that he
can sell the gold in the market at market value.) He would then have to pay back his
loan, and in total he would have to pay back R1 150 (R1000 + 15% interest for a year).
Without taking risks, the arbitrageur would have made a profit of R10 on his transactions.
Theoretically, the value of a futures contract should thus be equal to the following:
FV = SP + (SP x i x d/365) (for simple interest as in above example)
Or
FV = SP(1 + 1)^(d/365) (for compound interest)
Where
FV = theoretical value of the futures contract expiring in d days
SP = current spot value of the underlying instrument
i = short-term borrowing rate
d = number of days left to close-out of the contract.
In the above example with a simple interest rate of 15% the theoretical value should be:
FV = 1000 + (1 000 x 15% x 365/365)
FV = R1150.
Where income is received on the underlying instrument, such as interest on a bond or
dividends on shares, the future value of the income stream must be subtracted from the
above calculation to arrive at the theoretical fair value. This is because the income
stream can be invested and applied to repay the interest on the amount loaned to purchase
the underlying instrument.
This calculation of the fair value of futures contracts is, however, a theoretical exercise to
determine, among other things, the possibility of arbitrage opportunities. The actual
market price is determined by supply and demand as is the case with other market
products. The differences in carrying costs are the main determinants that lead to
differences in fair values and market prices of futures.
The bid price by buyers and the offer price by sellers determine the final price at which
futures are bought and sold.
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MEANING OF OPTIONS
An option contract has an exceptional characteristic distinguishing it from any other
financial instrument - the holder or owner of an option has the right, but does not have an
obligation to buy or sell an underlying instrument at a predetermined price during a
specific period or at a specific time.
If a person buys a Mercedes, and his best friend wants to buy the car from him, the owner
can give his best friend the option to buy the car from him at the date when he wants to
sell the car, at a certain price.
There are two basic types of options:
An option to buy something, such as the example above. This is known as a call
option.
An option to sell something. This is called a put option.
The formal definition of a call option would be that it grants the buyer the right but does
not confer an obligation to purchase a certain quantity of the underlying asset at a
predetermined price. The price at which the purchase of the underlying asset will take
place if the option is exercised is called the strike price, and this is decided at the initial
closing of the option contract. The amount or-price paid for the option when the option is
bought, is called the option premium.
Likewise, a put option would grant the buyer the right but does not impose an obligation
to sell the underlying instrument at a predetermined price.
A further parameter of an option is the period that the holder has to exercise the option.
An American option can be exercised and settled at any time up to the expiry
date.
A European option can only be exercised using the market prices valid on expiry
date and is settled on or within a short time after the expiry date.
A call option can be illustrated as follows: A R1 million Eskom E168 American call
option contract costing R10 000 with an expiry date on the first Thursday of May 1997,
and a strike rate of 16,5%. From this strike rate the strike price for the bond (all-in price
at the strike rate) can be calculated. The following important characteristics can be
identified from this notation:
i) option type (American call),
ii) underlying instrument (E168),
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iii) option premium (R10 000),
iv) expiry date (first Thursday of May 1997),
v) contract size (R1 million),
vi) strike rate (16,5%) from which the strike price can be calculated (the all-in price of
the E168 bond at a yield of 16,5%).
MEANING OF CALL OPTION
A call option can be illustrated as follows: A R1 million Eskom E168 American call
option contract costing R10 000 with an expiry date on the first Thursday of May 1997,
and a strike rate of 16,5%. From this strike rate the strike price for the bond (all-in price
at the strike rate) can be calculated. The following important characteristics can be
identified from this notation:
A call option is a type of financial instrument known as a derivative. It is basically an
agreement between two parties to exchange ownership of a stock at an agreed upon price
within a certain time period. The exchange of the stock is optional and the owner of the
call option decides whether it takes place.
The agreed upon price of the exchange is called the strike price. The date on which the
agreement expires is the expiry date of the call option. The amount of money required to
purchase this call option is called the premium. If the exchange takes place, then one is
said to have exercised the call option.
Call option premiums are always quoted per stock, but sold in lots of 100 shares
minimum. Call options are always an agreement about being able to purchase the stock at
the agreed upon price. Call options come in both European style and American style.
European style call options are sold on European exchanges, while American style call
options are sold in North American exchanges. The difference is quite simple. European
options can only be exercised on the expiry day, while American style options can be
exercised at any time during the life of the call option.
Call options are frequently described by the relationship of the strike price to the stock
price. A call option for which the strike price is equal to the stock price is said to be an
"at the money" call option. If the strike price is above the stock price, the call option is
said to be an "out of the money" call option. Finally, if the strike price is less than the
stock price, the call option is said to be "in the money".
There are two investment styles when investing in call options. Conservative investors
sell an "out of the money" call option on a stock that is part of their portfolio to increase
the overall return on their portfolio. The intention is that the stock price will not increase
at such a rate that it becomes equal to or greater than the strike price. In this case, the
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investor gets to keep the premium and the stock, and the call option expires worthless.
The process will then be repeated.
The speculative call option investor will purchase "at the money" call options without
owning the underlying stock. The expectation is that the price of the call option will
increase as the price of the stock increases. Typically, if the stock price increases by one
US dollar (USD), the price of the call option will also increase by one USD. However,
since the call option may cost as little as one tenth of the stock, the rate of return on the
investment is much higher with the call option than it would be if the stock were
purchased.
For example, if the stock cost 10 USD, then the call option for this stock for a 10 USD
strike price could cost 1 USD. If the stock were to increase in price to 11 USD, the profit
with the stock purchase is 1 USD and equal to a 10% return; however, the call option
profit is also 1 USD, and since only 1 USD was invested, a 100% return is realized.
However, if the price were to drop to 9.50 USD, the call option would become worthless
and the entire 1 USD investment would be lost, while only 0.50 USD would be lost with
the stock purchase. With the leverage, a call option provides that gains are magnified, but
losses are as well. The stock owner would also receive any dividends paid out, while the
owner of a call option would not.
The holder of a call option has paid a premium at acquisition of the option and the option
gives him the right to buy an underlying instrument at a price determined in the option
contract (the strike price) from the writer of the option. the holder of the option will only
exercise the option if the current market price of the underlying instrument is higher than
the strike price, giving him the opportunity to buy the instrument at the lower strike price,
and sell the instrument at the higher market price. If the market price of the underlying
instrument is lower than the strike price, it means that the instrument can be bought
cheaper in the market than by exercising the option. The maximum loss for the holder of
an option is thus equal to the premium paid for the option. The break-even point for the
holder of an option is that point where the profit made on the underlying instrument is
equal to the option premium paid. If the market value of the underlying instrument rises
above the break-even point the holder starts making a profit on the option transaction,
and the writer of the option starts taking a loss. The holder of an option is said to be long
on a call option or to have a long position in a call option.
The following is a graph of the profit and loss profile of a long call option with a strike
price of A and a break-even price of B:
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From this graph it can be seen that if the market value of the underlying asset is below
price A, the holder of the option will not exercise the option, and the loss will be limited
to the premium paid. Between the market price A and B, the loss of the holder will be
the premium paid minus the profit on the underlying asset. Above market value B, the
holder starts making a profit, and this profit is in theory unlimited.
The writer of this call option has a different profit profile, opposite to that of the holder.
The maximum profit that the writer can make is equal to the premium that he received
when he wrote and sold the option. He will make this profit if the option is not exercised
by the holder (in the case where the market price of the underlying asset is less than the
strike price as can be seen from fig. 1). In the case where the market price of the
underlying asset is more than the strike price of the option, the holder will exercise the
option, and the writer will suffer a loss on the underlying asset. Where the loss on the
underlying asset is equal to the option premium received by the writer, the break-even
point (B in fig. 2) for the writer is found. If the market value of the underlying asset
increases above the break-even point, the writer starts making a loss, as depicted in fig.
2. The writer of a call option can also be said to be short of a call option previous to the
exercising or expiry of the option.

MEANING OF PUT OPTION
A put option is a type of financial instrument known as a derivative. It is basically an
agreement between parties to exchange ownership of a stock at an agreed upon price
within a certain time period. The exchange of the stock is optional and the owner of the
put option decides whether it takes place.
The agreed upon price of the exchange is called the strike price. The date on which the
put option expires is the expiry date. The amount of money required to purchase this put
option is called the premium. If the exchange takes place, then one is said to have
exercised the put option.
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Put option premiums are always quoted per stock, but sold in lots of 100 shares
minimum. Put options are always an agreement about being able to sell the stock at the
agreed upon price. Put options come in both European style and American style.
European style put options are sold on European exchanges, while American style put
options are sold in North American exchanges. The difference is quite simple. European
options can only be exercised on the expiry date, while American style options can be
exercised at any time during the life of the put option.
There are two investment styles when investing in put options. Conservative investors
purchase a put option on stock that is part of their portfolio as an insurance policy against
a large drop in the price of the stock. For example, if a conservative investor owns stock
in company XYZ and is concerned that the stock price may decline, but is unwilling to
sell the stock in XYZ, a put option can be purchased to insure that if XYZ stock were to
dramatically decline in price, the investor would be able to sell the stock at the strike
price of the put option. If XYZ stock is selling at 45 US dollars (USD), a put option could
be purchased with a strike price of 43 USD.
At any time during the life of the put option, the owner may sell XYZ stock for 43 USD
per share. This would only be done if the price of the XYZ share were to fall below 43
USD. The price of this put option will be dependant upon a number of variables but will
be much less then 43 USD, typically in the 1 to 2 USD range. This example assumes an
American style put option. Remember also that put options can only be purchased in lots
of 100 shares.
The speculative put option investor either purchases or sells put options without owning
the underlying stock. Selling a put option is also called "writing" a put option, and the
seller of the put option is said to be its writer. If a speculative investor thinks XZY stock
is going to increase in value, then the investor will be a writer or seller of put options.
When the stock price of XYZ company increases in value, the put options decrease in
value. If a speculative investor thinks XZY stock is going to decrease in value, then the
investor will be a buyer of put options. When the stock price of XYZ company decreases
in value, the put options increase in value.
The use of put options allows the speculative investor to dramatically increase the profit
earned compared to making purchases in the stock or company itself due to the leverage
that is built into the put option. For example, if the investor thinks XYZ stock currently
selling for 45 USD per share is likely to decline to 43 USD per share, a put option with a
45 USD strike could be purchased for close to 1 USD. If the price does in fact decline to
43 USD, the put option value will increase in value to 2 USD or possibly even more.
However, if the XYZ stock price does not decline as expected, then the investor will lose
the entire amount The holder of a put option has the right to sell an underlying instrument
to the writer of the option at a predetermined price, and for this right he pays a premium
on acquisition of the option. The holder of a put option will only exercise his option if
the market value of the underlying instrument is below the strike price of the option. If
this is the case, he can buy the underlying instrument in the market at the lower price, and
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sell the instrument to the writer of the option at the higher strike price of the option. If
the market value is above the strike price, the holder can sell the underlying instrument in
the market at a higher price, and will thus not exercise the option. In this case the holder
will suffer a loss equal to the premium paid. The profit profile for the holder of a put
option is shown in figure 3, where it can be seen that the break-even point (B) is the point
where the profit on the underlying instrument is equal to the premium paid (A). If the
market value of the underlying instrument decreases beyond B, the holder starts making a
profit on the option.
For the writer of a put option, the income profile is opposite to that of the holder. The
maximum profit to the writer is the premium that he received at the first sale of the
option. If the market value of the underlying asset decreases beyond the strike price of
the option, he will start making a loss on the underlying asset position until eventually
beyond break-even point B where he starts to make a loss in total on the option. The
writer is said to be short of a put option and his income profile is shown in Figure 4.
Parties and risks of option transactions
The party that transfers the risk and pays the premium for the option is the buyer and
holder of the option. The holder of an option can also sell this option to a new buyer,
who becomes the new holder of the option. The original seller of the option is called the
writer or grantor of the option and he stays liable to honour the option should the holder
exercise the option. The writer of a call option will receive the option premium at the
first sale. If the option is sold by a holder to a new buyer, a new premium will be
determined, which is paid by the buyer to the seller.
Because the writer of an option is bound to the contract until expiry, there is a credit risk
attached to the option. An option written by a large corporate company will have less
credit risk attached to it than an option written by an individual, because there is more
certainty that the corporate company will perform if the option is exercised. The option
with less credit risk will also trade more effectively in the secondary market. Options
traded through exchanges such as SAFEX are normally guaranteed by the exchange in
terms of settlement.
The price of an option (called the premium paid for an option) is split into two different
determinants:
Intrinsic value
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The intrinsic value of an option is the profit or loss that will be made on an option if the
option is exercised immediately (ignoring the premium). This is the difference between
the strike price of an option and the market value of the underlying asset. The intrinsic
value could be positive, negative or equal to 0. Because an option premium cannot be
negative, the effect of a negative intrinsic value on an option premium is limited to the
amount that will decrease the option premium to 0.
If the holder of an option will make a profit on the underlying position by exercising the
option immediately, the option is said to be in-the-money and the intrinsic value is
positive. This will be the case if:
the strike price is lower than the market value for a call option
the strike price is higher than the market value for a put option
If the holder of an option will suffer a loss on the underlying position by exercising the
option immediately (ignoring the option premium), the option is said to be out-of-the-
money and the intrinsic value is negative. This will be the case where
the strike price is higher than the market value for a call option
the strike price is lower than the market value for a put option.
If the strike price is equal to the market value of the underlying instrument, the option is
said to be at-the-money and the intrinsic value is 0.
The time value
The time value of an option combines the parameters of an option that determines the
possibility that the price of the underlying asset of the option will move so that the option
becomes more valuable. These parameters can be summarised as:
the quantity of the difference between the strike price
the market value of the underlying asset
the time left until expiry of the option
the short-term risk-free borrowing rate
the volatility of the underlying asset.
The calculation of the value of these parameters are quite complex, and historic events
and probabilities determine some parameters. The effect of these parameters will briefly
be discussed.
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The quantity of the difference between the strike price and the market value
If the market value of an underlying instrument is far from the strike price, the likelihood
of the option becoming at-the-money is less. A call option, for instance, where the
market value is far below the strike price, is said to be deep-out-of-the-money. The
probability of this option moving in-the-money or at-the-money is less than for a call
option where the strike price and the market value is close together (assuming the same
underlying instrument). The risk to the writer is more where the two prices are close
together, and this risk will be discounted in the price of the option.
The time left to expiry
The more time there is left to the expiry of the option contract, the more uncertainty there
is concerning the movement of the market value of the underlying asset. This increases
the risk, and the writer of the option has to be compensated for this risk (remember that
derivatives is about selling risks!). The time value of the option, however, does not
decrease over a straight line. During the last few days before expiry, the time value
decreases faster, as there is less uncertainty about the probable market value of the
underlying asset at expiry.
The short-term risk-free borrowing rate
The writer of a call option must buy the underlying instrument and carry (hold) this
instrument to expiry if he wants to hedge his risk in writing the option. To buy the
instrument it is assumed that he either borrows the money at the short-term risk-free
interest rate, or uses internal funds that will cost him the cost of capital from his
business. The writer must thus be compensated for the cost of carrying the asset, and this
cost will be incorporated in the price of the option.
The volatility of the underlying asset
The volatility of an asset is a measure of risk involved in an asset due to price
fluctuations of that asset. In general, the more the price of an asset is likely to fluctuate,
the more volatile the asset. Volatility can only be measured by using historic values.
Historic fluctuations of the price of an asset is thus used to determine a value for the
volatility to be used as a parameter in deciding the price of an option.
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The market as a whole can sometimes be more volatile than at other times. In times of
high volatility in the markets, options tend to be more expensive than in times of low
volatility.
Valuation models used
A few mathematical models were developed to calculate the value of options of which
the most popular are:
The Black-Scholes model, which gives a good valuation for European options on
commodities or assets which do not pay dividends or interest
The binomial model, which is more accurate with American options or options
where the underlying asset pays dividends or interest.
OTC and exchange trading of options and warrants
For a long time in South Africa, no formalised exchange existed where options could be
traded. Options were traded in the informal or OTC market between parties. This
resulted in non-standardised options being created and traded and consequently the
secondary market was not as active as is the case with standardised options.
Many options are still traded in the OTC market by telephone between dealers and
players in the market. Standardised options, however, exist such as options on long
bonds, which are quoted on computerised systems. The traders can see the bids and
offers on standardised options on the screen and still close the deal by telephone or
through an exchange for those options traded on exchanges.
The financial exchanges and the JSE attempted to standardise certain options on
instruments traded on the exchanges. Options are available on SAFEX on the futures
traded on SAFEX (options on futures) and on certain individual shares. The trading of
options on bond futures grew more than 300% in the first six months of 1997 compared
to the first six months of 1996. The first effort at establishing traded options on the JSE
was called the TOM (traded options market). This concept, however, did not succeed
and subsequently other systems and procedures have been put in place. Warrants are
now listed on the JSE and can be traded through the exchange.
Warrants are long-dated call or put options written by certain banks such as Standard
Bank. On the C1 Sasol warrant, for instance, ten warrants can be exchanged for one
ordinary Sasol share on 15 June 2000 at a price (strike price) of 7000c per share.
Options traded on exchanges differ in a few aspects from options traded OTC. Two of
the main differences are:
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Electronic trading normally takes place on an exchange. Trading is done by way
of computer terminals and systems, and does not need interaction by dealers on a
trading floor or by way of telephone. Bids and offers are entered into the
computer system, which automatically matches deals entered with the same
parameters.
Premiums are not paid (except on warrants), but option prices (premiums) are
revalued each day to the market value of the option. The difference between the
market value of the option on the previous day, and the market value on the
current day is settled by holders and writers of options every day. On the expiry
day (close-out) the value of the option is equal to the intrinsic value only (market
value minus strike price of the underlying instrument) as there is no time value
left.
The following is an example:
On 1 Jan. Mr A buys a call option at a premium of R10 000. He sells the call option on 4
Jan. for R11 000 in the secondary market. The market values at the end of the day on the
following dates are:
1 Jan. R10 500
2 Jan. R 9 000
3 Jan. R10 000 Option strategies
Options can be used to hedge certain risks attached to an open position, as previously
discussed. They can also be used to create a position similar to that of holding the
physical asset or being short in the physical asset. An advantage of using options to
create such positions is that the cash flow outlay of acquiring an option is mostly much
less than for buying or selling the physical asset (called the gearing effect). As an
example, when buying a call option, the risk profile is similar to a long position in the
underlying asset except that the loss is limited to the premium paid.
A combination of physical positions and options can also be used to create the desired
risk profiles. If a trader thinks that prices will go up but wants to limit his cash outflow
and risks:
He can buy a call option to gain from increasing prices. This will, however, result
in a cash outflow.
He then also sells a put option to gain from the cash inflow as well as gaining
from price increases. He now, though, has a double risk of losing money if prices
do not increase. To cancel the doubling effect of the short put option, and better
his cash flow even more;
He sells the instrument short. This means that he will have an extra cash inflow
from this short position although he might have to borrow scrip to settle the bear
sale.
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This strategy is called a bull spread (so called because the traders in instruments with the
expectation of prices going up are called bulls). Figure 5 shows the income profile of a
bull spread.
In the above example, the strike price of the call option was A and the strike price of the
put option was C with the break-even price for this strategy at B. If the market value of
the underlying asset is above B at the time the option is exercised, the trader taking this
position will make a profit on the bull spread. The profit is, however, limited to the
premium received for the put option.
Thus with combinations of options, physical instruments and other derivatives, the
desired income profiles can be created for different market situations
Options are amazingly flexible financial instruments. Options give opportunity to make
money provided you have a view, certain or fairly certain, on the market in terms of
direction of the price and the speed with which the price is rising or falling.
When you are very bullish, buy a call option. When you are verybullish on the market as
a whole, buy a call option on indices (Nifty/Sensex).
When you are very bullish on a particular stock, buy a call option on that stock. The more
bullish you are, the more out of the money (higher strike price) should be the option you
buy. No other position gives you as much leveraged advantage in a rising market with
limited downside.
Upside potential: The price of the option increases as the price of the underlying rises.
You can book profit by selling the same option at higher price whenever you think that
the underlying price has come to the level you expected. At expiration the break-even
underlying price is the strike price plus premium paid for buying the option.
Downside risk: your loss is limited to the premium you have paid. The maximum you can
lose is the premium, if the underlying price is below the strike price at expiry of the
option.
Time decay characteristic: options are wasting assets in the hands of a buyer. As time
passes, the value of the position erodes. If volatility increases, erosion slows down; if
volatility decreases, erosion hastens.
When you firmly believe that the underlying is not going to rise, sell a call option. When
you firmly believe that index (Nifty/Sensex) is not going to rise, sell a call option on
index. When you firmly believe that a particular stock is not going to rise, sell call option
on that stock. Sell out-of-the-money (higher strike price) options if you are only
somewhat convinced; sell at-the-money options if you are very confident that the
underlying would remain at the current level or fall.
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Upside potential: your profit is limited to the premium received. At expiration the break-
even is strike price plus premium. Maximum profit is realised if the underlying price is
below the strike price.
Downside risk: the price of the option increases as the underlying rises. You can cut your
losses by buying the same option if you think that your view is goingwrong. Losses keep
on increasing as the underlying rises and are virtually unlimited. Such a position must be
monitored closely.
Time decay characteristic: options are growing assets in the hands of a seller. Astime
passes, the value of position increases as the option loses its time value. Youget
maximum profit if the option is at the money.
When you are very bearish, buy a put option. When you are very bearish on the market as
a whole, buy put option on indices (Nifty/Sensex). When you are very bearish on a
particular stock, buy put option on that stock. The more bearish you are, the more out of
the money (lower strike price) should be the option you buy. No other position gives you
as much leveraged advantage in a falling market with limited downside.
Upside potential: the price of the option increases as the price of the underlying falls. You
can square up your position by selling the same option at a higher price whenever you
think that the underlying price has come to the level you expected. At expiration the
break-even underlying price is the strike price minus premium paid for buying the option.
Downside risk: your loss is limited to the premium you have paid. The maximum you can
lose is the premium, if the underlying price is above the strike price at expiry of the
option.
Time decay characteristic: options are wasting assets in the hands of a buyer. As time
passes, the value of the position erodes. If the volatility increases, erosion slows; if the
volatility decreases, erosion hastens.
When you firmly believe that the underlying is not going to fall, sell aput option. When
you firmly believe that index (Nifty/Sensex) is not going to fall,sell a put option on the
index. When you firmly believe that a particular stock is not going to fall, sell put option
on that stock. Sell out-of-the-money (lower strike price) options if you are only somewhat
convinced; sell at-the-money options if you are very confident that the underlying would
remain at the current level or rise.
Upside potential: your profit is limited to the premium received. At expiration the break-
even is strike price minus premium. Maximum profit is realised if the underlying price is
above the strike price.
Downside risk: the price of the option increases as the underlying falls. You can cut your
losses by buying the same option if you think that your view is going to be wrong. Losses
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keep on increasing as the underlying falls and are virtually unlimited. Such a position
must be monitored closely.
Time decay characteristic: options are growing assets in the hands of a seller. As time
passes, the value of the position increases as the option loses its time value. Maximum
profit is realised if the option is at the money.
When you think the underlying index or stock will go up somewhat or is at least more
likely to rise than fall, Bull Spread is the best strategy.
Strategy implementation: a call option is bought with a lower strike price and another
call option is sold with a higher strike price, producing a net initial debit. Or a put option
is bought with a lower strike price and another put sold with a higher strike price,
producing a net initial credit.
Upside potential: profit is limited.
Calls: difference between strikes minus initial debit.
Puts: net initial credit. Maximum profit if underlying price at expiry is above the higher
strike.
Downside risk: loss is limited.
Calls: net initial debit.
Puts: difference between strikes minus initial credit. Maximum loss if the underlying
price at expiry is below the lower strike.
Time decay characteristic: time value erosion is not too significant because of balanced
position.
When you think the underlying index or stock will go down somewhat or is at least more
likely to fall than rise, Bear Spread is the best strategy.
Strategy implementation: a call option is sold with a lower strike price and anothercall
option is bought with a higher strike price, producing a net initial credit or aput option is
sold with a lower strike price and another put bought with a higher strike, producing a net
initial debit.
Upside potential: profit is limited.
Calls: net initial credit.
Puts: difference between strikes minus initial debit. Maximum profit if the market is
below the lower strike at expiry.
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Downside risk: profit is limited.
Calls: difference between strikes minus initial credit.
Puts: net initial debit Maximum loss if the market is above the higher strike at expiry.
Time decay characteristic: time value erosion is not too significant because of balanced
position.
When you think the underlying index or stock will rise or fall sharply but are not sure of
the direction, Long Straddle is the best strategy.
Strategy implementation: buy a call and put option with the same strike price. Generally
at-the-money strike price is preferred.
Upside potential: the profit is unlimited if the underlying moves sharply in either
direction. Lower point of break-even is the strike price minus the premium paid for
buying both the options. Higher point of break-even is the strike price plus premium paid.
Downside risk: the loss is limited to the extent of premium paid. Maximum loss occurs if
the underlying price is exactly at the strike price level at expiry of the options.
Time decay characteristic: as both the long options are at the money, the rate of time
value erosion becomes very high as the options approach maturity. Such positions are
rarely held till expiry if the view is not realised.
When you think the underlying index or stock will rise or fall in a big way but are not
sure of the direction, Long Strangle is the best strategy.
Strategy implementation: buy out-of-the-money call and put options.
Upside potential: the profit is unlimited if the underlying moves substantially in either
direction. Lower point of break-even is the lower strike price minus premium paid for
buying both the options. Higher point of break-even is the higher strike price plus
premium paid.
Downside risk: this occurs if the underlying price is between the lower and higher strike
price at expiry of the options.
Time decay characteristic: time value erosion decreases the value of the position as time
passes. Such positions are rarely held till expiry if the view is not realised.
When you think the underlying index or stock will fluctuate in a narrow range and neither
rise nor fall, Short Straddle is the best strategy.
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Strategy implementation: sell a call and put option with the same strike price. Generally
at-the-money strike price is preferred.
Upside potential: the profit is limited to the extent of the premium received. Maximum
profit is realised if the underlying price is exactly at the strike price at expiry of the
options.
Downside risk: the loss is unlimited if the underlying moves sharply in either direction.
Lower break-even point is strike price minus premium received. Higher break-even point
is strike price plus the premium received. Such positions must be monitored closely. It is
prudent to square up the position at close of the expiry.
Time decay characteristic: as both short options are at the money, the position increases
in value as time passes because time value erosion becomes very high as the options
approach maturity.
When you think the underlying index or stock will fluctuate in a broader range, Short
Strangle is the best strategy.
Strategy implementation: sell out-of-the-money call and put options. Upside potential:
the profit is limited to the extent of the premium received. Maximum profit is realised if
the underlying price is between the lower and higher strike prices at expiry of the options.
Downside risk: the loss is unlimited if the underlying moves substantially in either
direction. Lower break-even point is lower strike price minus premium received. Higher
break-even point is higher strike price plus the premium received. Such positions must be
monitored closely.
Time decay characteristic: the position increases in value as time passes because the time
value of the options erodes.
These strategies are quite similar to Straddle. The only difference is that unlike straddle,
call and put options are not bought in equal numbers. In Strip strategy, the number of puts
bought or sold is double that of call options. In Strap, the number of calls bought or sold
is double that of put options. You buy strip when you expect sharp movement in the
prices of the underlying but are a little biased towards downward movement, so you buy
more put than call options. Likewise while buying strap you are little biased towards
upward movement, you buy more call than put options.
You sell strip when you expect the price to fluctuate in a narrow range but you also
believe that in case the price moves beyond the range, it would move upward, so you sell
more put than call options. Likewise while selling strap you are a little biased toward
downward movement of the underlying price in case it breaks the range.
When you believe that the underlying will fluctuate in a narrow range but are not very
sure of it moving sharply in either direction, Long Butterfly is the best strategy.
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Strategy implementation: buy one in-the-money call, sell two at-the-money calls and
buy one out-of-the-money call option. The same strategy can be implemented using put
options also. It is difficult to execute four transactions simultaneously. As such there is
execution risk involved.
Upside potential: the profit is limited to the extent of the difference between the lower
and middle strike prices minus initial debit.
Downside risk: the loss is limited to the extent of initial debit. Time decay characteristic:
time works against.
When you are not so sure that the underlying index or stock will rise or fall sharply and
are not certain about the direction, Short Butterfly is the best strategy.
Strategy implementation: sell one in-the-money call, buy two at-the-money calls and
sell one out-of-the-money call option. The same strategy can be implemented using put
options also. It is difficult to execute four transactions simultaneously. As such there is
execution risk involved.
Upside potential: the profit is limited to the extent of initial credit received.
Downside risk: the loss is limited to the extent of the difference between the lower and
middle strike prices minus initial credit received.
Time decay characteristic: time works in favor.
DERIVATIVE MARKET
INTRODUCTION
A derivative is a financial instrument which derives its value from some other financial
price. This other financial price is called the underlying. A wheat farmer may wish to
contract to sell his harvest at a future date to eliminate the risk of a change in prices by
that date. The price for such a contract would obviously depend upon the current spot
price of wheat. Such a transaction could take place on a wheat forward market. Here, the
wheat forward is the derivative and wheat on the spot market is the underlying. The
terms derivative contract, derivative product, or derivative are used
interchangeably.
The most important derivatives are futures and options.
SPOT TRANSACTION
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In a spot market, transactions are settled on the spot. Once a trade is agreed upon, the
settlement i.e. the actual exchange of money for goods takes place with the minimum
possible delay. When a person selects a shirt in a shop and agrees on a price, the
settlement (exchange of funds for goods) takes place immediately. That is a spot market.
Thats okay for shirts - but does it ever happen in fi-nance?
There are two realworld implementations of a spot market: rolling settlement and real-
time gross settlement (RTGS). With rolling settlement, trades are netted through one day,
and settled x working days later; this is called T + x rolling settlement. For example, with
T+5 rolling settlement, trades are netted through Monday, and the net open position as of
Monday evening is settled on the coming Monday. Similarly, trades are netted through
Tuesday, and settled on the coming Tuesday.
With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a
close approximation, and RTGS is a true spot market. The equity market in India today,
for the major part, is not a spot market. For example, the bulk of trading on NSE takes
place with netting from Wednesday to Tuesday, and then settlement takes place five days
later. This is not a spot market. The international standard in equity markets is T+3
rolling settlement.
FORWARD TRANSACTION
In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a
stated price and quantity. No money changes hands at the time the trade is agreed upon.
Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2001
at Rs.5,000/tola. Here, Rs.5,000/tola is the forward price of 31 Dec 2001 Gold.
The buyer L is said to be long and the seller S is said to be short. Once the contract has
been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2001, and take delivery
of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec
2001, and give 100 tolas of gold in exchange.
EXCHANGE TRADED DERIVATIVE
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Derivatives which trade on an exchange are called exchangetraded derivatives. Trades
on an exchange generally take place with anonymity. Trades at an exchange generally go
through the clearing corporation.
OTC DERIVATIVE
A derivative contract which is privately negotiated is called an OTC derivative. OTC
trades have no anonymity, and they generally do not go through a clearing corporation.
Every derivative product can either trade OTC (i.e., through private negotiation), or on an
exchange. In one specific case, the jargon demarcates this clearly: OTC futures contracts
are called forwards (or, exchangetraded forwards are called futures). In other cases,
there is no such distinguishing notation. There are exchangetraded options as opposed
to OTC options; but they are both called options.
Black market
Black market, the selling or buying of commodities at prices above the legal ceiling or
beyond the amount allotted to a customer in countries that have placed restrictions on
sales and prices. Such trading was common during World War II wherever the demand
and the means of payment exceeded the available supply.
Most of the warring countries attempted to equalize distribution
of scarce commodities by rationing and price fixing. In the United States black-market
transactions were carried on extensively in meat, sugar, tires, and gasoline. In Great
Britain, where clothing and liquor were rationed, these were popular black-market
commodities. In the United States, rationing terminated at the end of the war, but a black
market in automobiles and building materials continued while the scarcity lasted.
In the decades following World War II, as the countries of Eastern
Europe were trying to industrialize their economies, extensive black-market operations
developed because of a scarcity of consumer goods. Black marketing is also common in
exchange of foreign for domestic currency, typically in those countries that have set the
official exchange value of domestic currency too high in terms of the purchasing power
of foreign money. Black-market money activities also grow when holders of domestic
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currency are anxious to convert it into foreign currency through a fear that the former is
losing its purchasing power as a result of inflation.
Declinations: how they affect the stock market
Case study
The declination is in fashion nowadays. It is a necessary item of many security group
discussions. And most of the software that touches base in any way uses the declination
calculation at some point. In this small article, I would like to introduce the way of
conducting research on declinations using Market Trader and/or Timing Solution
software.
First of all, let me make some notes on declinations in general. Declinations are used by
anyone who takes the planetary movements into consideration. Our interest is in the
forecasting of stock market behavior. It is a common belief nowadays that stock market
behavior is strongly connected to mass psychology. There are many ways to work with
mass psychology phenomena. One of the possible ways is to consider the findings of old
astrology, so called astro indicators. There is a documented evidence of the usefulness of
such indicators (especially of those that can be calculated and are described and
confirmed by methods of modern astronomy and mathematics). There is no proven
theory yet that explains the mechanics of the relationship between the Universe and Man
(though there are some attempts to it). From this point of view, declinations are one of the
many factors that we might be willing to consider. Our task now is to realize to what
extent and how they are useful in market forecasting.
What are declinations? The declination is related with Equatorial Coordinates. Equatorial
coordinates describe a plane defined by the daily rotation of the Earth around its axis; it is
inclined to Ecliptic approximately at 23 degrees. This is a very important angle as it is a
reason of hot summers and cold winters on our planet. If this angle would be equal to
zero degrees, we would never have the summer and winter. All year around we would
experience the same temperature; to me, it is too boring. If this angle would be very big
(like 90 degrees for Uranus), we would have extremely hot North (especially around the
Pole) and extremely cold South.
The 23 degrees is the best angle, at least for those who like skiing in winter and
swimming in summer.
Now, the declination. The declination is nothing more than a parameter that shows how
far the planets and objects in the sky are located relative to the celestial Equator plane.
There is nothing mystic in calculating declinations, the modern astronomy and
mathematics do it well, and you can find the declination points info in ephemeris.
167
Current Indian Stock Market Scenario for NRIs in NSE & BSE Trading
The Indian Equity Markets remained subdued throughout the week with indices losing by
nearly 5% over the week (June 1st week). The selling pressure from FIIs& NRIs -
non resident Indians was seen in heavyweight stocks. At the same time some
consolidation was also seen in some selective stocks across the bombay and
national stock exchange indexes like the nifty and sensex.
The week started with the important support levels of 16000/4750 getting breached.
As mentioned in our previous equity report, the Indian markets saw massive sell-
off after this development. The indices reached near the next target support level of
4500. Though markets have fallen sharply there are no clear indication of
bottoming out and further downside cannot be ruled out. We feel the next important
support level is seen at 14700/4280. But before that big investors like person of
india origin and overseas citizen of india can start investing in small quantity in
selective stocks, they have to really time the market really well, and they need to
diversify their investments between mutual funds and stocks. The support for the
week is seen near 15100/4475 while the resistance for the week is seen near
16100/4800. In high volatility this band can stretch further to 14900/4400 and
16400/4850.
We advise our clients to invest in indian stock markets with caution and with a long
term view with a portfolio diversification view across various financial products
like: stocks, mutual funds, commodities and futures. Is correction in Indian Stock
Market over?
After making a high of 21000, the sensex has almost eroded most of the gains it made
during last year. Now the Indian stock markets are slowely recovering. But is it a sure
bull market again or is it just a pullback?
The approach of an investor in Indian stock market should be more stock specific than a
market wide approach..
The stocks which are giving good growth over years and which were available at low
valuations in terms of PE multiples, yield etc. have give substancial returns over last 1
year..
I recommend you to follow a similar approach this year and pick good stocks trading at
low valuations. An example for this may be a stock by name Shilp Gravures which is
available at Rs. 63 ( 16th May 2008). This is trading at a PE of less than 7 times. The
company is giving a good dividend of 21%. The company is growing nicely. Observe this
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stock.

Can SENSEX Cross 20k again?
When I wrote the below article few months back, many were saying Indian markets
expensive. The SENSEX was at 15000 levels. Now SENSEX did 30% from those levels
and crossed 20000 for a short while and now trading around 8% lower from the peak at
18750 levels.
The PE for the SENSEX should be now around 23 times now ( I have not calculated the
exact value). The SENSEX stocks are bound to grow at least 25-30% cumulative for next
3 years (I here advance tax collection up by 40%). This will take the SENSEX EPS to
1600 1800 range.
Taking a low PE of 20, SENSEX should at least see 32000 mark. Taking a higher PE of
23 times on a higher growth and higher EPS target, SENSEX should see 41000 mark.
This target is for next 3 years.
Investors are recommended to stay invested.
Are Indian markets expensive?
The SENSEX ( The sensitive index of Bombay stock exchange) closed today at 15300
points (almost near 52 week high) up from 10149 (almost near 52 week low) a year back.
A whopping 50%. If you look at the dolex 30 52 week high of 3119 and 52 week low of
1729, dollarwise returns are almost unbelievable 80%.
Indian stock markets are in this dream run because of the effects of FII investments,
increasing corporate earnings and realisation of better valuations by Indian companies.
BHARTI TELEVENTURES gave 126%, HDFC gave 80%, ICICI BANK gave 96%,
LARSEN & TOUBRO gave 96%, STATE BANK OF INDIA gave 110%, RELIANCE
COMMUNICATIONS gave 108% returns during this period.
9 stocks gave negative returns versus 21 stocks which gave positive returns.
The PE Ratio of the sensex currently stands at 20.5 times. During september 2006 when
SENSEX was at around 12000 points the PE Ratio was at 20.75.
This means that the Indian markets are as attractive as it was in September 2006. I predict
a 35% returns on SENSEX in the coming 1 year.
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Tips for Indian stock investor
Indian Stocks market is showing strength from strength and is making steady gains over
last few years. SENSEX and NIFTY are less than 5% below the all time highs.
Advice on buying and selling of Indian stocks and indices. Indian stock market investing
made easy. Expert recommendations, mature tips, share market information at one place.
Portfolio advice for Indian stock markets.
Making money from Indian stock market was never so easy. But although markets are in
the upswing we find more and more people exiting citing losses in stocks. A close
analysis shows non understanding of financial markets as the main reason for this.
Stock price movement is just more than a simple graph. Fundamental analysis helps you
to identify potential winners which can be multibaggers. Technical analysis helps you
time the markets. If you are a long term investor, Fundamentals play a more important
tool. If you are a short term trader, Technical analysis, news, rumors play a more
important role.
Indian corporate earnings are showing strong growth in last 4-5 years which is well
reflected in Indian stock market.
Stock market trading without proper research is bound to make you loose all your
finance. We recommend studying charts, avoid keeping a close eye on quotes / prices,
day trading, penny stocks. Finding a good stockbroker, Stock Market Guide , stock exchange
like New York stock exchange, Toronto exchange, NSE etc. Stock picks should be purely
based on research on fundamentals and technical analysis. Consider future trading and
options. Mumbaibull.com presents a set of stocks to buy based on these principles.
Emphasising more on fundamental and a bit on technically.
Indian share market is one of the most volatile share markets in the world, that is why
SEBI is so strict and demanding in terms of compliance. This website is meant for
technical analysis only, as we dont follow news much, its only the quarterly results and
the normal news related to stocks like bonus and splits important for us, some news, like
recent SEBI declaring a scam done by prominent share brokers, this type of news comes
very rarely but if it comes then it is by chance and techncial analysis does not follow by
chance news.
Technical analysis follows mathetical methods like statistics and technical analysis
involves lot of stats, which is performed automatically by the softwares, like Metastock
Professional, supercharts, tradestation, Advanced Get, and so on.
I use Metastock Professional (my trading terminal also has analysis features, I use both.)
only for my technical analysis for stocks in NSE, and I get data using my own custom
made software called METQUOTES which sell for Rs5400/yearly license, using the
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software I download indian share market end of day prices using METQUOTES into my
hard drive which includes Cash market data, Futures and Indices data of NSE, it
automatically.
I then use my metastock professional and also run some reports in the METQUOTES
software, in the reports which are around 10 types of reports I find the best stocks for
next day trading and then I open their charts in metastock professional and then using my
technical analysis techniques I caluclate their resistance and support levels.
This is not all, using my broker's trading terminal I put all the alert levels on the share on
which I just did the analysis the next morning before market opens and only enter in the
market after 10:15am, any trigger which happens before 10:15am i dont follow it at all,
coz first 20minutes of the market are very volatile and I dont want to loose money in the
share market just because of volatility, as its very difficult to trade in the first 20minutes
of the market, which is basically a fluke for many.
After 10:15am if i get any alerts in my trading terminal then I open that share's intra-day
chart in my trading terminal software and see the stock pattern and make trade according
to that, most of the time I dont see the graph I just buy/sell the stock since my analysis in
the end-of-day stocks is pretty accurate and I always get some profits in a few minutes
and thats a small secret to do intra-day trading.(buy at breakouts and exit fast)
I take position in the share the moment it breaks on the upside its resistance or on the
downside once it breaks its support.This is one my favourite techniques and also I rely on
this method too to provide calls to my clients.
There are many other calculations and pattern analysis I do before entering into the stock,
there are some patterns which if you are able to site during the day, then you can enter in
it without any doubt and come out with money.(risk will always be there)
Our indian share market sometimes gets so choppy during the trading day that sometimes
we are not able to take position in the market or the share moves in both directions
touches the resistance and comes down and touches the support and moves up, so such a
market I always wait for a top or a bottom to form first, and then decide what to do, and i
always go with the index I make sure I dont go against the index.
The Mean Variance View of Risk
In the mean-variance world, variance is the only measure of risk. Investors given a choice
between tow investments with the same expected returns but different variances, will
always pick the one with the lower variance.
Estimating Mean and Variance
In theoretical models, the expected returns and variances are in terms of future
returns.
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In practice, the expected returns and variances are calculated using historical data
and are used as proxies for future returns.
Illustration 1: Calculation of expected returns/standard deviation using historical returns
GE The Home Depot
Year Price at Dividends Returns Price at Dividends Returns
end of year during year end of year during year
1989 $ 32.25 $ 8.13
1990 $ 28.66 $ 0.95 -8.19% $ 12.88 $ 0.04 58.82%
1991 $ 38.25 $ 1.00 36.95% $ 33.66 $ 0.05 161.79%
1992 $ 42.75 $ 1.00 14.38% $ 50.63 $ 0.07 50.60%
1993 $ 52.42 $ 1.00 24.96% $ 39.50 $ 0.11 -21.75%
1994 $ 51.00 $ 1.00 -0.80% $ 46.00 $ 0.15 16.84%
Average 13.46% 53.26%
Standard Deviation 18.42% 68.50%
While The Home Depot exhibited higher variance in returns, much of the
variance seems to come from the stock price going up dramatically between 1989
and 1992? Why is this upside considered risk?
Should risk not be defined purely in terms of "downside" potential (negative
returns)?
Variance of a Two-asset Portfolio

portfolio = w
A

A
+ (1 - w
A
)
B

2
portfolio
= w
A
2

2
A
+ (1 - w
A
)
2

2
B
+ 2 w
A
w
B

[

A

B
where
w
A
= Proportion of the portfolio in asset A
The last term in the variance formulation is sometimes written in terms of the covariance
in returns between the two assets, which is

AB
=
[

A

B
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The savings that accrue from diversification are a function of the correlation
coefficient.
Illustration 2: Extending the two-asset case - GE and The Home Depot
Step 1: Use historical data to estimate average returns and standard deviations in returns
for the two investments.
Stock Average Return (1990-94) Standard Deviation (1990-94)
General Electric 13.46% 18.42%
The Home Depot 53.26% 68.50%
Step 2: Estimate the correlation and covariance in returns between the two investments
using historical data.
Year
Returns on
GE(R
Ge
)
Returns on HD
(R
H
)
(R
GE
-
Avge(R
GE
))
2
(R
H
-
Avge(R
H
))
2

(R
GE
- Avge(R
GE
)
(R
H
-Avge(R
H
)
1990 -8.19% 58.82% 0.04686 0.00309 (0.01203)
1991 36.95% 161.79% 0.05518 1.17786 0.25494
1992 14.38% 50.60% 0.00008 0.00071 (0.00024)
1993 24.96% -21.75% 0.01322 0.56265 (0.08625)
1994 -0.80% 16.84% 0.02034 0.13265 0.05194
Total 0.13568 1.87696 0.20835
Variance in GE Returns = 0.13568/4 = 0.0339 Standard Deviation in GE Returns =
0.0339
0.5
= 0.1842
Variance in HD Returns = 1.87696/4 = 0.4692 Standard Deviation in HD Returns =
0.4692
0.5
= 0.6850
Covariance between GE and The Home Depot Returns = 0.20835/4 = 0.0521
Correlation between GE and The Home Depot Returns = GH = GH G H =
0.0521/(0.1842*0.6850) = 0.4129

Step 3: Compute the expected returns and variances of portfolios of the two securities
using the statistical parameters estimates above
Consider, for instance, a portfolio composed of 50% in GE and 50% in The Home Depot

Average Return of Portfolio = 0.5 (13.46%) + 0.5 (53.26%) =

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Variance of Portfolio = (0.5)2 + (0.5)2 + 2 (0.5) (0.5) 1518% jj j j j `
Standard Deviation of Portfolio = 38.96%
From Two Assets To Three Assets to n Assets
The variance of a portfolio of three assets can be written as a function of the variances of
each of the three assets, the portfolio weights on each and the correlations between pairs
of the assets. The variance can be written as follows -

p
2
= w
A
2

2
A
+ w
B
2

2
B
+ w
C
2

2
C
+ 2 w
A
w
B

AB

A

B
+ 2 w
A
w
C

AC

A

C
+ 2 w
B
w
C

BC

B

C
where
w
A
,w
B
,w
C
= Portfolio weights on assets

2
A
,
2
B
,
2
C
= Variances of assets A, B, and C

AB
,
AC
,
BC
= Correlation in returns between pairs of assets (A&B, A&C, B&C)
The Data Requirements
Number of covariance terms = n (n-1) /2
where n is the number of assets in the portfolio
Number of Covariance Terms as a function of the number of assets in portfolio
Number of
Assets
Number of covariance
terms
2 1
5 10
10 45
20 190
100 4950
1000 499500
Some Closing Thoughts on Risk
Most Investors do not measure their risk preferences in terms of standard deviation
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For other investors, risk has to be assessed by using
Scoring Systems (where investors are asked for information or questions to
answers which can be used to analyze how much risk an investor is willing to
take)
Risk categories (High; Average; Low)
Life cycle theories of investing
General Propositions:
As investors age, there will be a general increase in risk aversion, leading to greater
allocation to safer asset classes.
PORTFOLIO VALUE
The value of a portfolio constrains your choices at later stages.
This is because trading individual securities creates costs - brokerage costs, bid-
ask spreads and price impact
There is a critical mass value, below which it does not pay to actively manage a
portfolio - it is far better to invest in funds.
The larger a portfolio, the more choices become available in terms of assets - this
is largely because some components of trading costs - the brokerate costs and the
spread - may get smaller for larger portfolios.
If a portfolio becomes too large, it might start creating a price impact which might
cause trading costs to start increasing again.

Taxes do matter: Individuals should care about after-tax returns
Stock and Bond Returns: 1926-1989 - Before and After Taxes
Stocks Bonds
Market Returns $ 534.46 $ 17.30
After Transactions Cost $ 354.98 $ 11.47
After Income Taxes $ 161.55 $ 4.91
After Capital Gains Taxes $ 113.40 $ 4.87
After Inflation $ 16.10 $ 0.69
Transactions Costs: 0.5% a year; Income taxes: at 28%; Capital Gains at 28% every 20
years;
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CASH NEEDS & TIME FRAME
- What is a long time horizon?
- Determinants of time horizon
* Age
* Level of Income
* Stability of Income
* Cash Requirements
- Time Horizon and Asset Choice
Proposition: The cost of keeping funds in near-cash investments increases with the time
horizon of the investor.
THE IMPORTANCE OF ASSET ALLOCATION
The first step in all portfolio management is the asset allocation decision.
The asset allocation decision determines what proportions of the portfolio will be
invested in different asset classes.
Asset allocation can be passive,
o It can be based upon the mean-variance framework
o It can be based upon simpler rules of diversification or market value based
When asset allocation is determined by market views, it is active asset allocation.
Passive Asset Allocation: The Mean Variance View of Asset Allocation
Efficient Portfolios
Return Maximization Risk Minimization
Objective Function
Maximize Expected Return
Minimize return variance
Constraint
where,

j
= Investor's desired level of variance
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E(R) = Investor's desired expected returns
Markowitz Portfolios
The portfolios that emerge from this process are called Markowitz portfolios. These
portfolios are considered efficient, because they maximize expected returns given the
standard deviation, and the entire set of portfolios is referred to as the Efficient Frontier.
Graphically, these portfolios are shown on the expected return/standard deviation
dimensions
Application to Asset Allocation
If we have information on the expected returns and variances of different asset
classes and the covariances between asset classes, we can devise efficient
portfolios given any given level of risk.
For example, if the following is the information of 4 asset classes:
Asset Class Mean Standard deviation
U.S. stocks 12.50% 16.50%
U.S. bonds 6.50% 5.00%
Foreign Stocks 15.00% 26.00%
Real Estate 11.00% 12.50%
Correlation Matrix for Asset Classes
U.S. Stock U.S. Bonds Foreign Stocks Real Estate
U.S. Stocks 1.00 0.65 0.35 0.25
U.S. Bonds 1.00 0.15 -0.10
Foreign Stocks 1.00 0.05
Real Estate 1.00
Active Asset Allocation: The Market Timers
The objective is to create a portfolio to take advantage of 'forecasted' market movements,
up or down. Strategies could include:
* Shifting from (to) overvalued asset classes to (from) undervalued asset classes if you
expect the market to go up (down).
* Buying calls (puts) or buying (selling) futures on a market if you expect the market to
go up (down).
Assumption: we can forecast market movements
Advantage: If we can forecast market movements, the rewards are immense.
Disadvantage: If we err, the costs can be significant.
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SECURITY SELECTION
Once the asset allocation decision has been made, the portfolio manager has pick
the securities that go into the portfolio.
Again, the decision can be made on a passive basis or on active basis.
Active security selection can take several forms:
o it can be based upon fundamentals
o it can be based upon technical indicators
o it can be based upon information
Passive Security Selection: The Index Fund
Index funds are created by holding stocks in a wider index in proportion to their market
value. No attempt is made to trade on a frequent basis to catch market upswings or
downswings or select 'good' stocks.
Assumptions: Markets are efficient. Attempts to time the market and pick good stocks are
expensive and do not provide reasonable returns. Holding a well diversified portfolio
eliminates unsystematic risk.
Advantages: Transactions costs are minimal as is the cost of searching for information.
B. Markowitz Portfolio: A Markowitz efficient portfolio is created by searching through
all possible combinations of the universe of securities to find that combination that
maximizes expected return for any given level of risk.
Assumptions: The portfolio manager can identify the inputs (mean, variance, covariance)
to the model correctly and has enough computer capacity to run through the optimization
exercise.
Advantages: If historical data is used, the process is inexpensive and easily mechanised.
Disadvantages: The model is only as good as its inputs.
II. ACTIVE STRATEGIES
The objective is to use the skills of our security analysts to select stocks that will
outperform the market, and create a portfolio of these stocks. The security selection skills
can take on several forms.
(1) Technical Analysis, where charts reveal the direction of future price movements
(2) Fundamental Analysis, where public information is used to pick undervalued stocks
(3) Access to private information, which enables the analyst to pinpoint mis-valued
securities.
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Assumption: our stock selection skills help us make choices which, on average, beat the
market.
Inputs: The model will vary with the security selection model used.
Advantage: If there are systematic errors in market valuation andyour model can spot
these errors, the portfolio will outperform others in the market.
Disadvantage: If your security selection does not pay off, you have expended time and
resources to earn what another investor could have made with random selection.Security
Selection strategies vary widely and can lead to contradictory recommendations..
Technical investors can be
o momentum investors, who buy on strength and sell on weakness
o reversal investors, who do the exact opposite
Fundamental investors can be
o value investors, who buy low PE orlow PBV stocks which trade at less
than the value of assets in place
o growth investors, who buy high PE and high PBV stocks which trade at
less than the value of future growth
Information traders can believe
o that markets learn slowly and buy on good news and sell on bad news
o that markets overreact and do the exact opposite
The Trade offs on Trading
There are two components to trading and execution - the cost of execution
(trading) and the speed of execution.
Generally speaking, the tradeoff is between faster execution and lower costs.
For some active strategies (especially those based on information) speed is of the
essence.
Maximize: Speed of Execution
Subject to: Cost of execution < Excess returns from strategy
For other active strategies (such as long term value investing) the cost might be of
the essence.
Minimize: Cost of Execution
Subject to: Speed of execution < Specified time period.
The larger the fund, the more significant this trading cost/speed tradeoff becomes.
MEASURING PERFORMANCE
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* Who should measure performance?
Performance measurement has to be done either by the client or by an objective third
party on the basis of agreed upon criteria. It should not be done by the portfolio manager.
* How often should performance be measured?
The frequency of portfolio evaluation should be a function of both the time horizon of the
client and the investment philosophy of the portfolio manager. However, portfolio
measurement and reporting of value to clients should be done on a frequent basis.
* How should performance be measured?
I. Market Indices (No adjustment for risk): There are some who do not like models for
risk and return and prefer comparison to broad market indices (S&P 500, NYSE
composite, ..)
The limitation of this approach is that it does not explicitly control for risk. Thus, an
advantage is given to risky funds and money managers.
Tracking Error as a Measure of Risk
Tracking error measures the difference between a portfolios return and its benchmark
index. Thus portfolios that deliver higher returns than the benchmark
II. Against other portfolio managers
In some cases, portfolio managers are measured against other portfolio managers who
have similar objective functions. Thus, a growth fund manager may be measured against
all growth fund managers.
III. Risk-Adjusted Models
A. The CAPM: The capital asset pricing model provides a simple and intuitive measure
for measuring performance. It compares the actual returns made by a portfolio manager
with the returns he should have made, given both market performance during the period
and the beta of the portfolio created by the manager.
Abnormal Return = Actual Return - Expected Return
> 0: Outperformed
< 0: Underperformed
where,
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Actual Return = Returns on the portfolio (including dividends)
Expected Return = Riskfree rate at the start of the period + Beta of portfolio * (Actual
return on market during the period - Riskfree Rate)
This abnormal return is called Jensen's Alpha. It can also be computed by regressing the
returns on the portfolio against a market index, and then comparing the intercept to Rf (1-
Beta).
Variants: Define Rp to be the return on the portfolio and Rm to be the return on the
market.
Treynor Index = (Rp - Rf)/ Beta of the portfolio
> (Rm - Rf) : Outperformed
< (Rm - Rf) : Underperformed
Sharpe Index = (Rp - Rf)/ Variance of the portfolio
> (Rm - Rf)/sm : Outperformed
< (Rm - Rf)/sm : Underperformed
Information Ratio = Jensens alpha / Unsystematic Risk
> 0: Outperformed the market
< 0 : Underperformed
Tracking Error as a Measure of Risk
Tracking error measures the difference between a portfolio is return and its
benchmark index. Thus portfolios that deliver higher returns than the benchmark
but have higher tracking error are considered riskier.
Tracking error is a way of ensuring that a portfolio stays within the same risk
level as the benchmark index.
It is also a way in which the active in active money management can be
constrained.

Performance Attribtion
This analysis can be carried one step forward, and the overall performance of a money
manager can be decomposed into market timing and security selection components.
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If money managers are good market timers,
o they should hold high beta stocks, when the the return on the market > risk
free rate
o they should hold low beta stocks, when the return on the market < risk free
rate
Thus, the market timing capabilities of a money manager can be evaluated by
looking at the managers performance over time relative to the market. For
instance, consider the following funds
In some cases, better estimates of market timing can be obtained by fitting a quadratic
curve to actual returns.
where c is a measure of the market timing ability of a fund (money manager).
B. The APT: The arbitrage pricing theory defines the expected return in terms of
statistical factors (instead of just the market as in the CAPM). A beta is defined relative
to each factor.
C. Multi-Index Models: Multi-index models allow the performance evaluator to bring in
economic factors that may influence expected returns.
* Window Dressing and other Phenomena that cloud measurement
1. Marking up the merchandise (thinly traded stocks)
2. Tricking the technicians (stocks with breakout points)
3. Playing catch up (Buying hot stocks just before evaluation)
4. Dumping the losers just before evaluation
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THE SECURITIES & EXCHANGE BOARD OF INDIA [SEBI]
The great Indian Scam, which took place in the year 1991-92, credit for which goes to
one Mr. Harshad Mehta, a broker on the Bombay Stock Exchange, prompted the
Government of India to enact the Securities and Exchange Board of India Act, 1992. The
Indian Government in fact set up the SEBI in the year 1988. However, its power to
regulate the securities markets was limited until the SEBI Act, 1992 was enacted. Though
autonomous in principle, SEBI is not independent of the Central Government. Under the
SEBI Act, the SEBI's Board is set up, composition of which is:
A Chairman,
Two members from amongst the officials of the Ministries of the Central
Government dealing with finance and law,
One member from amongst the officials of the RBI, and
Two other members to be appointed by the Central Government who shall be
professionals and have experience or special knowledge relating to the securities
markets.
SEBI has its head office in Mumbai and its three regional offices in New Delhi, Calcutta
and Chennai. Each regional office is set up to carry out inter alia the duty of over seeing
the Stock Exchange and their brokers and attend to the complaints against them, to accept
offer documents of new issues of Rs.200 million or less and to accept applications for the
registration of Merchant Bankers in Categories II, III and IV. Currently SEBI consists of
the following departments:
The Primary Market Department,
The Secondary Market Department,
The Institutional Investors, the Mergers and Requisitions, Research and Public
Department (IIMARP Department),
The Legal Department and
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The Investigation Department
The registration of FII's is dealt with by the IIMARP Department.
Role of SEBI Regulatory Body
The Controller of Capital Issue (CCI) formed under the Capital Issues Control Act
controlled upto 1992, the capital primary market. During that period, the pricing of
capital issues was controlled by CCI. The premium on issue of equity shares issued
through the primary markets was done in accordance with the Capital Issues Control Act.
The CCI guidelines were abolished with the introduction of Securities & Exchange Board
of India (SEBI) formed under the SEBI Act, 1992 with the prime objective of protecting
the interests of investors in securities, promoting the development of, and regulating, the
securities market and for matters connected therewith or incidental thereto. The SEBI
Act came into force on 30th January 1992 and with its establishment, all public issues are
governed by the rules & regulations issued by SEBI. SEBI was formed to promote fair
dealing in issue of securities and to ensure that the capital markets function efficiently,
transparently and economically in the better interests of both the issuers and the investors.
The promoters should be able to raise funds at a relatively low cost. At the same time,
investors must be protected from unethical practices and their rights must be safeguarded
so that there is a steady flow of savings into the market. There must be proper regulation
and code of conduct and fair practice by intermediaries to make them competitive and
professional. Since, its formation, SEBI has been instrumental in bringing greater
transparency in capital issues. Under the umbrella of SEBI, companies issuing shares are
free to fix the premium provided adequate disclosure is made in the offer documents.
Focus being the greater investor protection, SEBI has become a vigilant watchdog.

185
Regulation of stock exchanges
The stock market in India are regulated by the central government under the securities
contracts (regulation) Act, 1956 which provides the recognition of stock exchanges,
supervision and control of recognized stock exchanges, regulation of contracts in
securities, listing of securities, transfer of securities, and many other related functions.
The securities and exchange board of India Act, 1992,provides for the establishment of
the securities and exchange Board of India (SEBI) to protect investors interest in
securities and promote and regulate the securities market.
TAX IMPLICATIONS OF INVESTING IN INDIAN EQUITIES
Tax rates on investments gains are categorized as long term & short term capital gains.
(a) Long term capital gains
Long Term investments that are held for more than 12 months are termed as long
term capital assets. Profit on sale of such assets is termed as long term capital gain
(LTCG) which as per the latest Budget notification will attract nil tax.
(b) Short term capital gains
Shares that are held for less than 12 months are classified as short term capital
assets which as per the latest Budget notification will attract 10% tax.
WHAT IS FAIR VALUE OF SHARE?
We all like bargains but, but few investors attempt to estimate a company's worth before
buying a stock. Investing requires the same discipline one exerts when purchasing a
house, a car or even groceries, literally. The problem arises when investors don't
186
anticipate the amount of risk they are taking when purchasing stocks that trade at high
premiums to the intrinsic..
From a purely static point of view, the fair value of an equity share is a point of
indifference. A price level, below which we would buy the stock. Or a price level, above
which we would sell the stock. Real life, however, is more dynamic and as a stock
investor, we are dealing with moving targets. Where stock prices fluctuate madly, as
much as eight or 12 per cent every day. Thankfully, the fair value of a company does not
fluctuate with the price of its share. It is important to understand this before we proceed
with our equity investments.
How to determine fair value?
A simple method is to use the price-to-earning multiple, where the price of a company's
stock is divided by the earnings per share of a company. Which makes sense since growth
in earnings is a proxy for how well a company is performing within a given market
opportunity. However, as long-term investors we are interested in absolute value,
irrespective of how the stock market is currently pricing the company. Here, the P/E loses
relevance since it is will be continuously influenced by the demand or supply for a
company's stock on the numerator side.
Earnings per share, which represents the denominator side of the P/E, also may not help.
Since all earnings do not equal free cash flows. Most of it is ploughed back into the
company via capital expenditures. And as investors we are interested in the surplus cash
(though this term has many variations, it is loosely defined as the cash after providing for
recurring capital expenditures plus depreciation and taxes, the later being a non-cash
charge).
This dictum is codified in the discounted cash flow model. Which says, that the value of a
stock is equal only of the free cash flows it produces in the future, discounted back to the
present? When we discount future income, we essentially adjust for the fact that a rupee
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in hand today is more valuable than a rupee to be received in the future because today's
rupee can be invested elsewhere to generate a return. The DCF allows us to discount
incoming cash flows by a rate, which we believe equates the level of risk we are
assuming. This risk-adjusted value then is compared with the prevailing stock price to
check a company's investment worthiness. If a stock is said to be trading at fair value, it
simply means that the market is pricing it according to the value it represents. Otherwise,
it could either be bought or sold short. With minor modifications, the DCF can be used to
value a range of companies, from those growing faster than the economy to those
growing slower, or matching the pace of the economy.
Limitations
However, like all other valuation models, the DCF too has its limitations. For decades it
served analysts and investors well until faced with the prospect of valuing companies in
the so-called new economy businesses.
Not that the basic premises of the DCF are under question, but how does one account for
companies where revenues are growing at a rate, which have a high element of surprise.
And small changes in the amount of information available can bring about large changes
in stock prices. How does one come up with an appropriate discount rate, which reflects
the high level of technological risk for many such companies?
How does the DCF model build in for a boost in valuation that comes when a company is
taken over by another? Or when Infosys' seemingly expensively priced stock becomes a
relatively inexpensive form of currency acquisitions.
The inability to predict the fair value for these companies also causes their stock prices to
fluctuate beyond wildest imaginations. Limited free float also creates price distortions.
To stretch it a bit, using the words of John Burr Williams, who pioneered the concept of
DCF: "They (the stock market) had high hopes for the business, but no logical evaluation
of these hopes in terms of stock prices. The very fact that the company was one of the
188
hardest of all stocks to appraise was the reason it sold at extravagant prices, for
speculation ever feeds on mystery, as we have seen before."
Hence distinguish between 'price' and 'value'
In the end, instead of grasping on the appropriate valuation for these companies, investors
can caution themselves by thinking more carefully in terms of 'price' versus 'value'.
Price is not value. Price is what we pay. Value is what we get in return for owning a piece
of a company. When we shop for a consumer durable, we don't pay the list price without
being sure of the quality of the product and consistency of its expected performance.
Similar issues should matter more while investing--the qualimanagement, nature of the
company's business, the ability of the management to sustain growth and so on.
Alternatively, think about the return that we will need to compensate for the investment
risk given the quality of the management and the nature of business. If we cannot see a
company providing such a return over a longer term, do not invest.
When it comes to investing choosing a great company is only the starting point. In order
to make a good profit investors must buy the stocks of great companies at sensible prices.
189
190
EQUITY
Equity or stocks is a share in the ownership of a company. Stocks represent a claim on
the companys assets and earnings. As you acquire more stock, your ownership stake in
the company becomes greater.
BEING AN OWNER:

Holding a companys stock means that you are one of the many owners (share holders) of
a company, as such, you have a claim (albeit usually very small) to everything the
company owns. A stock is represented by a stock certificate. This is a piece of paper that
is a proof of your ownership.
Being a shareholder of a public company does not mean you have a say in the day-to-day
running of the business. Instead, one vote per share to elect the board of directors at
annual meetings is the extent to one has a say in the company.
The importance of being a shareholder is that one is entitled to a portion of the
companys profits and has a claim on assets. Profits are sometimes paid out in the form of
dividends. The more shares you own, the larger the portion of the profits you get. Your
claim on assets is only relevant if a company goes bankrupt. In case of liquidation, youll
receive whats left after all the creditors have been paid. Thus, the importance of stock
ownership is your claim on assets and earnings. Without this, the stock wouldnt be worth
the paper its printed on.
Another extremely important feature of stock is its limited liability, which means that, as
an owner of a stock, one is not personally liable if the company is not able to pay its
debts.

DEBT VERSUS EQUITY:
A company issues stocks, as at some point every company needs to raise money. To do
this, companies can either borrow it from somebody or raise it by selling part of the
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company, which is known as issuing stock. A company can borrow by taking a loan from
a bank or by issuing bonds. Both the methods are known as debt financing. On the
other hand, issuing stock is called equity financing. Later one is more advantageous for
a company as it does not require the company to pay back the money or make interest
payments along the way.
RISK:
It must be emphasized that there are no guarantees when it comes to individual stocks.
Some companies pay out dividends, but many others dont. And there is no obligation to
pay out dividends even for those firms that have traditionally given them.
Although risk might sound all negative, there is also a bright side. Taking on greater risk
demands a greater return on your investment. This is the reason why stocks have
historically outperformed other investments such as bonds or saving accounts. A great
proof of the power of owning equities is GENERAL ELECTRIC. One share bought in
1928 would be worth over $65,000 today.
TYPES OF STOCK:
There are two main types of stocks: common stock and preferred stock.
COMMON STOCK:
Common shares represent ownership in a company and a claim (dividends) on a portion
of profits. Investors get one vote per share to elect the board members, who oversee the
major decisions made by management. Over the long term, common stock, by means of
capital growth, yields higher returns than almost every other investment. This higher
return comes at a cost since common stocks entail the most risk.
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PREFERRED STOCK:
Preferred stock represents some degrees of ownership in a company but usually doesnt
come with the same voting rights. With preferred shares investors are usually guaranteed
a fixed dividend forever. Another advantage is that in the event of liquidation preferred
shareholders are paid off before the common shareholders.
STOCK BASICS:
THE BULLS
A bull market is when everything in the economy is great, people are finding jobs, GDP
is growing, and stocks are rising. Picking stocks during a bull market is easier because
everything is going up. Bull markets cannot last forever though, and sometimes they can
lead to dangerous situations if stocks become overvalued.
THE BEARS
A bear market is when the economy is bad, recession is looming, and stock prices are
falling. Bear markets make it tough for investors to pick profitable stocks. One solution to
this is to make money when stocks are falling using a technique called short selling.
Another strategy is to wait on the sidelines until you feel that the bear market is nearing
its end, only starting to buy in anticipation of a bull market.
IPOS / PUBLIC ISSUES
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An Initial Public Offer (IPO) is a means of collecting money from the public by a
company for the first time in the market to fund its projects. In return, the company gives
the share to the investors in the company.
In an IPO, the Lead managers decide the price of the issue. In a book-building offer, the
syndicate members decide the indicative price range and the investors decide the price of
the issue through a tender method.
A draft prospectus provides the information on the financials of the company, promoters,
background, tentative issue price etc. It is filed by the Lead Managers with the Securities
& Exchange Board of India (SEBI) to provide issue details. Overview of the draft
prospectus can be seen on www.sebi.gov.in (SEBIs web site). The final prospectus is
printed after obtaining the clearance from SEBI and the Registrar of Companies (ROC).
This differs from issue to issue. In a normal issue, the Lead managers decide the value
and this would be notified on the form. In a book building issue, a price range is declared
and the investors who quote higher value would be allotted. In Highlights page of any
IPO these issues are explained in detail.
For a public issue, you can know the status by calling the registrar (you will know about
the registrar on the Highlights Page of the issue) after 30 to 40 days from the closing date
of the issue. However, in a book building issue, you can know the status by calling the
registrar after 20 days from the closing date.
In a public issue, you will be getting refund or share certificates after 40-45 days from the
closing date of the issue. In a book building issue, you will be getting the
refund/certificates in 30-40 days from the closing date. The Share certificates will also be
mailed around the same time if you have got the allotment.
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DEPOSITORY SYSTEM
Technology has changed the face of the Indian stock markets in the post liberalization
era. Competition amongst the stock exchanges, increase in the number of players, and
changes in the trading system led to a tremendous increase in the volume of activity. The
traditional settlement and clearing system proved to be inadequate due to operational
inefficiencies. Hence, there emerged a need to replace this traditional system with a new
system called the Depository System.
DEPOSITORY
A depository can be compared to a bank. A depository holds securities (like shares,
debentures, bonds, Government Securities, units etc.) of investors in electronic form.
Besides holding securities, a depository also provides services related to transactions in
securities.
According to section 2(e) of the Depositories Act, 1996, Depository means a company
formed and registered under the companies Act, 1956 and which has been granted a
certificate of registration under section 12(1A) of the securities and exchanges board of
India Act, 1992.
A depository interfaces with the investors through its agents called Depository
Participants (DPs). If an investor wants to avail the services offered by the depository, the
investor has to open an account with a DP. This is similar to opening an account with any
branch of a bank in order to utilize the bank's services. Suggestions on how to select a DP
are given in Section IV.
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The benefits of participation in a depository are:
Immediate transfer of securities;
No stamp duty on transfer of securities;
Elimination of risks associated with physical certificates such as bad delivery ,
fake securities , etc.;
Reduction in paperwork involved in transfer of securities;
Reduction in transaction cost;
Nomination facility;
Change in address recorded with DP gets registered electronically with all
companies in which investor holds securities eliminating the need to correspond
with each of them separately;
Transmission of securities is done by DP eliminating correspondence with
companies;
Convenient method of consolidation of folios/accounts ;
Holding investments in equity, debt instruments and Government securities in a
single account;
Automatic credit into demat account, of shares, arising out of
split/consolidation/merger etc.

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In India we have two depositories: NSDL and CDSL.
NSDL offers following facilities: -
Dematerialization i.e., converting physical certificates to electronic form;
Facilitating repurchase / redemption of units of mutual funds;
Electronic settlement of trades in stock exchanges connected to NSDL;
Pledging/hypothecation of dematerialized securities against loan;
Electronic credit of securities allotted in public issues, rights issue;
Receipt of non-cash corporate benefits such as bonus, in electronic form;
Freezing of demat accounts, so that the debits from the account are not permitted;
Nomination facility for demat accounts;
Services related to change of address;
Effecting transmission of securities;
Instructions to your DP over Internet through SPEED-e facility. (Please check
with your DP for availing the facility);
Account monitoring facility over Internet for clearing members through SPEED-e
facility;
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Other facilities viz. holding debt instruments in the same account, availing stock
lending/borrowing facility, etc.

NSDL provides its services to investors through its agents called depository participants
(DPs). These agents are appointed by NSDL with the approval of SEBI. According to
SEBI regulations, amongst others, three categories of entities i.e. Banks, Financial
Institutions and Members of Stock Exchanges [brokers] registered with SEBI can become
DPs. You can get a list of DPs from NSDL's office or from our website at
www.nsdl.co.in.
One can select his DP to open a demat account just like one select a bank for opening a
savings account.
Some of the important factors for selection of a DP can be:
Convenience - Proximity to your office/residence, business hours.
Comfort - Reputation of the DP, past association with the
organization, whether the DP is in a position to give the
specific service you may need?
Cost - The service charges levied by DP and the service standards.
In order to obtain the complete list of DP locations and
their comparative charge structure, one may log on
to or else may write to NSDL for the same.

All the DPs are appointed subject to fulfillment of uniform requirements of SEBI
(Depositories and Participants) Regulations, 1996 and requirements of NSDL. However,
the type of services offered and the service standards may differ among various DPs. For
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example, a DP branch having direct connectivity with the main office having depository
set-up may be in a position to execute instructions faster.

One can approach any DP of his choice and fill up an account opening form. At the time
of opening an account, he has to sign an agreement with DP in a NSDL prescribed
standard agreement, which details him and his DPs rights and duties.
All investors have to submit following proof of identity and proof of address along with
the prescribed account opening form.
Proof of Identity: The signature and photograph must be authenticated
by an existing demat account holder with the same DP
or by his bank. Alternatively, one can submit a copy
of Passport, Voters Id Card, and Driving License or
PAN card with photograph.
Proof of Address: One can submit a copy of Passport, Voters Id
Card, Driving License or PAN card with
photograph, ration card or bank passbook as proof
of address.
Passport-size photograph: One must remember to take original
documents to the DP for verification. He
should remember to obtain a copy of
the agreement and schedule of charges for
your future reference.

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A person can open more than one account with the same DP. There is no restriction on
the number of accounts one can open with a DP. Just as one can have savings or current
accounts with more than one bank, one can open accounts with more than one DP.

The depository has not prescribed any minimum balance. One can have zero balance in
his account.

The demat account must be opened in the same ownership pattern in which the securities
are held in the physical form. e. g. if one share certificate is in one individual name and
another certificate is jointly held in one and his wife's name, two different accounts
would have to be opened.

In case if one has physical certificates with the same combination of names, but the
sequence of names is different. i.e. some certificates with husband as first holder and wife
as second holder and other set of certificates with wife as first holder and husband as the
second holder, he may open only one account with husband and wife as the account
holders and lodge the security certificates with different order of names for
dematerialization in the same account. He will fill-up an additional form called
Transposition cum Demat" form. This would help him to effect change in the order of
names as well as dematerialize the securities.

One can authorize any person to operate his account by executing a power of attorney
and submit it to the DP.

It is compulsory to give bank details while opening a DP account. the bank account
number will be mentioned on the interest or dividend warrants, to which is entitled, so
that such warrant cannot be encashed by any one else. Further, a DP cannot open the
account if bank account number is not given.

'Standing Instruction' given in the account opening form
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In a bank account, credit to the account is given only when a 'paying in' slip is submitted
together with cash/cheque. Similarly, in a depository account 'Receipt in' form has to be
submitted to receive securities in the account.
However, for the convenience of investors, facility of 'standing instruction' is given. If
you say 'Yes' for standing instruction, you need not submit 'Receipt in' slip everytime you
buy securities.
The demat account cannot be operated on "either or survivor" basis like the bank account.

Names of the accountholders for a depository account cannot be changed. If one wants to
change name or add / delete an accountholder, he need to open a new account in the
desired holding pattern (names) and transfer the securities to the newly opened account.
The old account may be closed.
In case the address is changed, one has to inform the new address to his DP(s). When DP
enters the new address in the depository computer system, it will be automatically
conveyed to all companies in which he holds shares.
One can submit account closure request to his DP in prescribed form. His DP will
transfer all his securities, as per his instruction, and close his demat account.
The charges for account closure and securities transfer due to account closing would be
as per the schedule of charges of ones DP, agreed by him at the time of account opening
or any subsequent changes therein.
NOMINATION
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Only individuals holding beneficiary accounts either singly or jointly can make
nomination. Non-individuals including society, trust, body corporate, partnership firm,
karta of Hindu Undivided Family, holder of power of attorney cannot nominate.
Nomination is permitted for accounts with joint holders. But, in case of death of any of
the joint holder(s), the securities will be transmitted to the surviving holder(s). Only in
the event of death of all the joint holders, the securities will be transmitted to the
nominee.

NRI can nominate directly. But, the power of attorney holder cannot nominate on behalf
of NRI.

A minor cannot nominate either directly or through its guardian. But he can be a
nominee. In such a case, the guardian will sign on behalf of the nominee and in addition
to the name and photograph of the nominee, the name, address and the photograph of the
guardian must be submitted to the DP.

Only an individual can be a nominee. A nominee shall not be a society, trust, body
corporate, partnership firm and karta of Hindu Undivided Family or a power of attorney
holder.

There can not be more than one nominee for one depository account.
Separate nomination can not be made for each security held in a depository account. It
can be made account wise and not security wise.

A NRI can be a nominee subject to the exchange control regulations in force from time
to time.

Procedure for nomination
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The nomination form duly filled-in should be submitted to the DP either at the time of
account opening or later. The account holder, nominee and two witnesses must sign this
form and the name, address and photograph of the nominee must be submitted. If
nomination was not made at the time of account opening, it can be made subsequently by
submitting the nomination form.
The nomination can be changed anytime by the account holder/s by simply filling up the
nomination form once again and submitting it to the DP.
TRANSMISSION

Transmission is the process by which securities of a deceased account holder are
transferred to the account of the surviving joint holder(s)/nominee/legal heirs of the
deceased account holder. Process of transmission in case of dematerialized holdings is
more convenient as the transmission formalities for all securities held in a demat account
can be completed by submitting documents to the DP whereas in case of physical
securities the surviving joint holder(s)/nominee/ legal heirs has to correspond
independently with each company in which shares are held.

Procedure for transmission of securities to the nominee in case of the death of the
sole account holder:
In case of the death of the sole holder, for the purpose of transmission of securities, the
nominee has to submit a duly filled-in transmission form, notarized copy of death
certificate and an affidavit in the prescribed format to the DP. After verifying these
documents and if found in order, the DP will transmit the securities to the account of the
nominee.

In case the sole account holder does not make nomination, the securities would be
transmitted to the account of legal heir(s), as may be determined by an order of the
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competent court. However in cases where the value of securities to be transmitted is less
than Rs. 1,00,000/- the DP may process the request based on submission of necessary
letter of indemnity, surety, affidavits and NOC documents.

Procedure for transmission in case of Joint Accounts
In the event of death of one of the joint holders the securities will be transmitted to the
surviving holder(s) on submission of Transmission Form and notarized copy of the death
certificate of the deceased joint holder to the DP. For transmission of securities, the
account of the surviving holder(s) must be in the same sequence in which the names
appear in the joint account to be closed.
DEMATERIALISATION

Dematerialization is the process by which physical certificates of an investor are
converted to an equivalent number of securities in electronic form and credited in the
investor's account with its DP. In order to dematerialize certificates; an investor will have
to first open an account with a DP and then request for the dematerialization of
certificates by filling up a dematerialization request form [DRF], which is available with
the DP and submitting the same along with the physical certificates. The investor has to
ensure that before the certificates are handed over to the DP for demat, they are defaced
by marking "Surrendered for Dematerialization" on the face of the certificates.

One cannot dematerialize any share certificate. Only those certificates that are already
registered in his name and are in the list of securities admitted for dematerialization at
NSDL. All the scrips included in S&P, CNX, NIFTY and BSE SENSEX have already
joined NSDL. This list has more than 4,300 companies and is steadily growing. One can
get an updated list of these companies from his DP or from NSDL's office or from NSDL
website at www.nsdl.co.in.
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Before defacing the share certificate, one must ensure that it is available for
dematerialization .He must therefore check with his Depository Participant (DP) whether
the ISIN (code number for the security in a depository system) has been activated and
made available for dematerialization by the depository. If yes, then he may deface the
share certificate. The certificates are defaced by marking "Surrendered for
Dematerialization" on the face of the certificate.

Dematerialization will normally take about 30 days.

If the process of dematerialization takes more than 30 days, one should contact his DP. If
he (DP) is unable to help him, then he may send his grievance to:
The Officer in Charge
Investor Grievance Cell
National Securities Depository Limited
4th Floor, Trade World
Kamala Mills Compound
Senapati Bapat Marg
Lower Parel, Mumbai - 400 013
Email: relations@nsdl.co.in

Difference between a Demat Share and a Physical Share
A demat share is held by the depository on behalf of the investor whereas a
physical share is held by the investor himself,
The holding and handling of a demat share is done electronically, whereas a
physical share is in the form of a paper,
The demat share can be converted into a physical share on request. This is
referred to as the rematerialization of share.
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The demat share does not have a folio number, distinctive number, or certificate
number like a physical share. Though there is no stamp duties on the transfer of
demat shares from one account to another. The depository participant charges a
transaction fee and levies asset holding charges.
There is, however no difference between demat share and physical shares as far as the
beneficial interests of ownership of securities are concerned. The owner is entitled to
exactly the same beneficial interests of ownership of securities are concerned. The owner
is entitled to exactly the same benefits of ownership of a security no matter in what form
it is maintained.
GOVERNMENT SECURITIES AND DEBT INSTRUMENTS
One dematerialize his debt instruments, mutual fund units, government securities also in
his demat account and hold all such investments in a single demat account.
REMATERIALISATION

Can ones electronic holdings be converted back into certificates?
If one wishes to get back his securities in physical form, he can, all he has to do is to
request his DP for dematerializations of the same. 'Dematerializations' is the term used
for converting electronic holdings back into certificates. Ones DP will forward his
request to NSDL, after verifying that he has the necessary balance. NSDL in turn will
intimate the registrar who will print the certificates and dispatch the same to him.

TRADING / SETTLEMENT

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The procedure for selling dematerialized securities
The procedure for selling dematerialized securities is very simple. After one has sold the
securities, he would instruct his DP to debit his account with the number of securities
sold by him and credit his broker's clearing account. This delivery instruction has to be
given to his DP using the delivery instruction slips given to him by his DP at the time of
opening the account.
Procedure for selling securities is given here below:
One sell securities in any of the stock exchanges linked to NSDL through a
broker;
One gives instruction to his DP to debit his account and credit the broker's
[clearing member pool] account;
Before the pay-in day, his broker gives instruction to its DP for delivery to
clearing corporation;
His broker receives payment from the stock exchange [clearing corporation];
One receives payment from the broker for the sale of securities.


To purchase dematerialized securities one may give a one-time standing instruction to his
DP. This standing instruction can be given at the time of account opening or later.
Alternatively, one may choose to give separate receipt instruction every time some
securities are to be received.
The transactions relating to purchase of securities are summarized below:
One purchase securities through a broker;
One makes payment to his broker who arranges payment to clearing corporation
on the pay-in day;
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His broker receives credit of securities in its clearing account (clearing member
pool account) on the pay-out day;
His broker gives instructions to its DP to debit clearing account and credit his
account;
One receives shares into his account. However, if standing instructions are not
given at the time of opening the account, one will have to give 'Receipt
Instructions' to his DP for receiving credit;
One should ensure that his broker transfers the securities from its clearing account
to his depository account, before the book closure. If the securities remain in the
clearing account of the broker, the company will give corporate benefits (dividend
or bonus) to the broker. In that case, one will have to collect the benefits from his
broker.
TRADING OF STOCKS:
Most stocks are traded on exchanges, which are places where buyers and sellers meet and
decide on a price. Some exchanges are physical locations where transactions are carried
out on a trading floor. The other type of exchange is virtual, composed of a network of
computers where trades are made electronically.
The purpose of a stock market is to facilitate the exchange of securities between buyers
and sellers, thus reducing the risks of investing.
There are two kinds of market: -
Primary markets:
Primary markets are those where securities are created.
Secondary markets:
In the secondary market, the previously issued securities are traded.
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Why do stock prices go up and down?
Fluctuations in a stocks price occur partly because companies make or lose money. But
that is not the only reason. There are many other factors not directly related to the
company or its sector. Interest rates, for instance. When interest rates on deposits or
bonds are high, stock prices generally go down. In such a situation, investors can make a
decent amount of money by keeping their money in banks or in bonds. Why should they
face the extra risks of the stock market? Money supply may also affect stock prices. If
there is more money floating around, some of it may flow into stocks, pushing up their
prices. Other factors that cause price fluctuations are the time of year, and publicity.
Some stocks are seasonal; they do well only during certain parts of the year and worse
during other parts. Publicity affects stock prices. If a newspaper story reports that Zee
Television has bought a stake in Asianet, odds are that the price of Zees stock will rise if
the market thinks its a good decision. Otherwise it will fall. The price of Asianet stocks
may also go up because investors may feel that it is now in better hands. Conversely, if
an article says that a company's president is a crook and has used the money raised to
build a palatial bungalow for him, and then it is a good bet that the price of that
companys stock will fall. Thus, many factors affect the price of a stock. The behavior of
the price movement of a stock is said to predict its future movement. The behavior is
analyzed by plotting on a graph the price movement against any standard index. This is
called technical analysis. It tells you when to buy a stock. Analysis of the fundamentals
of a company, on the other hand, tells you which stock to buy.
Ek-ka-do.
Stocks also go for splits. One fine day if the company whose 50 stocks you own and
having a current market price of Rs 40, declares a 2-for-1 split, you will now own 100
stocks of the company. The market will then halve the price, unless it has reasons to be
more bullish, to around Rs 20. Stock splits should not normally raise the value of your
stocks, since the prices fall to compensate for the larger number of shares held. The main
advantage of a stock split is that it improves liquidity. You can sell 50 shares and retain
the other 50. Usually companies go for stock splits when the stock's price zooms up to
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some phenomenal level and hence, becomes out of reach of many investors. Splits in
such cases make stocks affordable and usually lead to increased buying and, hence, also
increase liquidity. Naturally, it is expected that the stock's value will make an upward
ascent soon after the split and investors will stand to gain. We can also have a do-ka-ek.
Companies sometimes declare to retire their stocks in a certain proportion of their
outstanding stocks. Hence, a 1-for-2 reverse split would mean that any shareholder will
now own half the number of shares with the price of each being double as before the
reverse split. However, the total value of the holding will remain the same on the day of
the split. Reverse splits are currently not allowed in India though companies can buy back
their shares up to a certain percentage of the outstanding number of shares. Companies
usually go for reverse splits to boost up the stock's price, which might be performing
badly for a long time. A hiked price might invite more investors.

The important points to grasp about the trade on the stock are the
following:
At the most fundamental level, supply and demand in the market determine stock
price.
Price times the number of shares outstanding (market capitalization) is the value
of a company. Comparing just the share price of two companies is meaningless.
Theoretically earnings are what affect investors' valuation of a company, but there
are other indicators that investors use to predict stock price. Remember, it is
investors' sentiments, attitudes, and expectations that ultimately affect stock
prices.
There are many theories that try to explain the way stock prices move the way
they do. Unfortunately, there is no one theory that can explain everything.
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P/E RATIO:
P/E is short for the ratio of a company's share price to its per-share earnings. As the name
implies, to calculate the P/E you simply take the current stock price of a company and
divide by its earnings per share (EPS):
P/E Ratio = [Market Value per Share/Earnings per Share (EPS)]
Most of the time, the P/E is calculated using EPS from the last four quarters. This is also
known as the trailing P/E. However, occasionally the EPS figure comes from estimated
earnings expected over the next four quarters. This is known as the leading or projected
P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters
and estimates of the next two quarters.
There isn't a huge difference between these variations. But it is important to realize that,
in the first calculation, you are using actual historical data. The other two
calculations are based on analyst estimates that are not always perfect or precise.
Companies that aren't profitable, and consequently have a negative EPS, pose a challenge
when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say
there is a negative P/E, others give a P/E of 0, and while most just say the P/E doesn't
exist.
Historically, the average P/E ratio in the market has been around 15-25. This fluctuates
significantly depending on economic conditions at the time. The P/E can also vary widely
between different companies and industries.
Uses the P/E Ratio
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Theoretically, a stock's P/E tells us how much investor is willing to pay per rupee of
earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E
ratio of 20 suggests that investors in the stock are willing to pay Rs.20 for every Rs.1 of
earnings that the company generates. However, this is a far too simplistic way of viewing
the P/E because it fails to take into account the company's growth prospects.
Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the last four
quarters, the P/E is more than a measure of a company's past performance. It also takes
into account market expectations for the growth of a company. Remember, stock prices
reflect what investors think a company will be worth. Future growth is already accounted
for in the stock price. As a result, a better way of interpreting the P/E ratio is as a
reflection of the market's optimism concerning a company's growth prospects.
If a company has a P/E higher than the market or industry average, this means the market
is expecting big things over the next few months or years. A company with a high P/E
ratio will eventually have to live up to the high rating by substantially increasing its
earnings, or the stock price will need to drop.
A good example is Microsoft. Several years ago, when it was growing by leaps and
bounds, its P/E ratio was over 100. Today, Microsoft is one of the largest companies in
the world, so its revenues and earnings can't maintain the same growth as before. The
result is a current P/E ratio of 43 (at the time of writing, in June 2002). This reduction in
the P/E ratio is a common occurrence as high growth startups solidify their reputations
and turn into blue chips.
Cheap or Expensive?
The P/E ratio is a much better indicator of the value of a stock than the market price
alone. For example, all things being equal, an Rs.10 stock with a P/E of 75 is much more
"expensive" than an Rs.100 stock with a P/E of 20. That being said, there are limits to
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this form of analysis -- you can't just compare the P/Es of two different companies to
determine which a better value is.
It's difficult to determine whether a particular P/E is high or low without taking into
account two main factors:
Company growth rates:
How fast has the company been growing in the past, and are these rates expected to
increase or at least continue into the future? Something isn't right if a company has only
grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't
justify the P/E, then a stock might be overpriced. In this situation, all you have to do is
calculate the P/E using projected EPS.
Industry:
It is only useful to compare companies if they are in the same industry. For example,
utilities typically have low multiples because they are low growth, stable industries. In
contrast, the technology industry is characterized by phenomenal growth rates and
constant change. Comparing a tech to a utility is useless.

Problems with the P/E:
So far we've learned that, in the right circumstances, the P/E ratio can help us determine
whether a company is over or under-valued. But P/E analysis is only valid in certain
circumstances and it has its pitfalls. Some factors that can undermine the usefulness of
the P/E ratio include:
Accounting-
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Earnings are an accounting figure that includes non-cash items. Furthermore, the
guidelines for determining earnings are governed by accounting rules (GAAP) that
change over time and are different in each country. To complicate matters, EPS can be
twisted, prodded and squeezed into various numbers depending on how you do the books
(for more on this see our article:"The Different Types of EPS"). The result is that we
often don't know whether we are comparing the same figures, or apples to oranges.
Inflation-
In times of high inflation, inventory and depreciation costs tend to be understated because
the replacement costs of goods and equipment rises with the general level of prices. Thus,
P/E ratios tend to be lower during times of high inflation because the market sees
earnings as artificially distorted upwards. As with all ratios, it's more valuable to look at
the P/E over time in order to determine the trend. Inflation makes this difficult, as past
information is less useful today.
ROLE OF FII INVESTMENT IN INDIAN CAPITAL MARKET
India embarked on a programmed of economic reforms in the early 1990s to tie over its
balance of payment crisis and also as a step towards globalization. An important
milestone in the history of Indian economic reforms happened on September 14, 1992,
when the FIIs (Foreign Institutional Investors) were allowed to invest in all the securities
traded on the primary and secondary markets, including shares, debentures and warrants
issued by companies which were listed or were to be listed on the stock exchanges in
India and in the schemes floated by domestic mutual funds. Initially, the holding of a
single FII and of all FIIs, NRIs (Non-Resident Indians) and OCBs (Overseas Corporate
Bodies) in any company was subject to a limit of 5% and 24% of the companys total
issued capital respectively. In order to broad base the FII investment and to ensure that
such an investment would not become a camouflage for individual investment in the
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nature of FDI (Foreign Direct Investment), a condition was laid down that the funds
invested by FIIs had to have at least 50 participants with no one holding more than 5%.
Ever since this day, the regulations on FII investment have gone through enormous
changes and have become more liberal over time. From November 1996, FIIs were
allowed to make 100% investment in debt securities subject to specific approval from
SEBI as a separate category of FIIs or sub-accounts as 100% debt funds. Such
investments were, of course, subjected to the fund-specific ceiling prescribed by SEBI
and had to be within an overall ceiling of US $ 1.5 billion. The investments were,
however, restricted to the debt instruments of companies listed or to be listed on the stock
exchanges. In 1997, the aggregate limit on investment by all FIIs was allowed to be
raised from 24% to 30% by the Board of Directors of individual companies by passing a
resolution in their meeting and by a special resolution to that effect in the companys
General Body meeting. From the year 1998, the FII investments were also allowed in the
dated government securities, treasury bills and money market instruments. In 2000, the
foreign corporates and high net worth individuals were also allowed to invest as sub-
accounts of SEBI-registered FIIs. FIIs were also permitted to seek SEBI registration in
respect of sub-accounts. This was made more liberal to include the domestic portfolio
managers or domestic asset management companies. 40% became the ceiling on
aggregate FII portfolio investment in March 2000. This was subsequently raised to 49%
on March 8, 2001 and to the specific sectoral cap in September 2001. As a move towards
further liberalization, the Finance Minister announced in his budget speech on February
28, 2002 that, Foreign Institutional Investors (FIIs) can invest in a company under the
portfolio investment route beyond 24 per cent of the paid up capital of the company with
the approval of the general body of the shareholders by a special resolution. I propose
that now FII portfolio investments will not be subject to the sectoral limits for foreign
direct investment except in specified sectors. Guidelines in this regard will be issued
separately.
Accordingly, a committee was set up on March 13, 2002 to identify the sectors in which
FIIs portfolio investments will not be subject to the sectoral limits for FDI, under the
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chairmanship of Dr. Rakesh Mohan. Later, on December 27, 2002 the committee was
reconstituted and Dr. Ashok K.Lahiri became the chairman. The committee has come out
with recommendations in June 2004.The committee has proposed that, In general, FII
investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral
caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows
was exclusive of the FDI limit. The suggested measure will be in conformity with this
original stipulation. The committee also has recommended that the special procedure for
raising FII investments beyond 24 per cent up to the FDI limit in a company may be
dispensed with by amending the relevant regulations.
Meanwhile, the increase in investment ceiling for FIIs in debt funds from US $ 1 billion
to US $ 1.75 billion has been notified in 2004. The SEBI also has reduced the turnaround
time for processing of FII applications for registrations from 13 working days to 7
working days except in the case of banks and subsidiaries.
All these are indications for the countrys continuous efforts to mobilize more foreign
investment through portfolio investment by FIIs. The FII portfolio flows have also been
on the rise since September 1992.
One of the events that have gone into the history book of the Indian Economy during the
calendar year 2004 is the newer peaks of the stock markets. The year, before closing,
achieved an all time high of both Sensex and Nifty around 6602 and 2080 respectively.
While a lot of reasons could be cited as reasons for this stock markets rally, the role of
Foreign Institutional Investors (FIIs) can not be overlooked. In fact, the FIIs have been
playing a key role in the Indian financial markets since their entry into this country in the
early 1990s. Their importance has been growing over time as their net investment is on
the rise over time. The calendar year that just concluded has received an historic net
inflow from FIIs to the tune of US $ 9.187 billion which is around 28 per cent of the total
inflows the country has received till December 31, 2004. A huge portion of these inflows
has been received during the last six months of the year, July-December 2004. This
explosive portfolio flows by FIIs brings with them great advantages as they are engines
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of growth lowering the cost of capital in many emerging markets. They facilitate the flow
of capital to firms and countries that offer the best investment opportunities breaking the
geographical boundaries. They also bring with them the much wanted breadth and depth
into the capital markets of the emerging economies.
FIIs were first allowed to make portfolio investment in India on September 14, 1992,
initially with lots of restrictions. The regulations on them are liberalized over time and at
minimal now. The FIIs which made a modest beginning in 1993-94 at US $ 1638 million
stood at US $ 25754 million as of 2003-04. Because of the historical flows that the year
2004 witnessed, they are at US $ 32086.90 million as of December 31, 2004. This
increase in investment by FIIs is also accompanied by an increase in the number of
registered FIIs and sub accounts. There has been an addition of 195 sub accounts and 85
FIIs since the beginning of this financial year. The total number of registered FIIs is 637
as at the end of December 2004.
The size and robustness of the FIIs role in Indian capital markets can be better understood
by looking at the assets under their custody as compared to other institutions and
participants. As of November 2004, the total assets held by the FIIs stood at Rs.198243
crores as compared to Rs. 91084 crores with mutual funds and Rs.42855 with financial
institutions including banks.
In fact, the FIIs are the more predominant players in the equity market than the Mutual
funds. The total investment by the mutual funds in the Indian equity markets is just
Rs.1308 crores whereas, the same figure for the FIIs is Rs.39,959 crores as of 2003-04.
(RBI Annual Report, 2003-04) However, their roles in the debt markets are reversed with
mutual funds assuming a more important one than their counter part FIIs.
FIIs investment in Indian equity markets
The equity market capitalization in India has grown from Rs.7.25 trillion in March 2003
to Rs.13.77 trillion in March 2004. This equity market capitalization works out to US $
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310 billion. This has pushed Indian equity market into a significant one among those of
the emerging economies. The equity market capitalization is around 49 per cent of 2003-
04 GDP which places the equity market on par with the banking system in terms of
financial intermediation. (Economic Survey 2003-04).
However, given the fact that India is the second largest equity market in the world in
terms of the number of listed companies, and one of the important goals of our economic
and financial reforms is to obtain the deep and liquid stock market, we cannot possibly
satisfy ourselves with the current level of market capitalization. The two most prominent
Indian stock exchanges, NSE and BSE, rank third and fifth in the world evaluated by the
trading intensity as of 2003.
The impact cost, which is another important measure of the liquidity of the market has
drastically declined from 0.15 per cent in early 2002 to just 0.1 per cent as at the end of
2003-04.
Though all these gives us the satisfaction that we are in the right direction, we should also
not forget that this is a wide spread phenomenon across all the securities listed in the
stock markets. Many listed companies even today have a negligible liquidity. For
example, as of 2003-04, the top 50 companies listed in the NSE account for 79.47 per
cent of the turnover in the cash segment and this figure is 74.53 per cent for BSE, when
the total number of companies listed as of the same period in NSE and BSE stand at 818
and 5650 respectively.
The presence of FIIs can improve the liquidity in the market to a great extent by
providing the much wanted depth across many listed securities and make it broad based.
Broad basing the market by spreading the trading volumes across the various listed
securities is a prerequisite for insulating the market from reacting heavily to the specific
happenings of a few heavy weight companies.
LEVERAGE
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Suppose a user of a forward market adopts a position worth Rs.100. No money changes
hands at the time the deal is signed. In practice, a goodfaith deposit would be needed.
Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is
taken. In this case, we say there is leverage of 20 times. This example involves a
forward market. More generally, all derivatives involve leverage. Leverage makes
derivatives useful; leverage is also the source of a host of disasters, payments crises, and
systemic risk on financial
markets. Understanding and controlling leverage is equivalent to understanding and
controlling derivatives.
PROBLEM OF FORWARD MARKET
Forward markets tend to be afflicted by poor liquidity and from unreliability deriving
from counterparty risk (also called credit risk).
Why do forward markets have poor liquidity?
One basic problem of forward markets is that of too much flexibility and generality. The
forward market is like the real estate market in that any two consenting adults can form
customdesigned contracts against each other. This often makes them design terms of the
deal which are very convenient in that specific situation; this can make the contracts non-
tradeable since others might not find those specific terms useful. In addition, forward
markets are like the real estate market in that buyers and sellers find each other using
telephones. This is inefficient and timeconsuming. Every user faces the risk of not
trading at the best price available in the country. Forward markets often turn into small
clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by
users, i.e. it makes the forward market illiquid from the user perspective.
Why are forward markets afflicted by counterparty risk?
A forward contract is a bilateral relationship between two people. Each requires good
behaviour on the part of the other for the contract to perform as promised. Suppose L
agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on
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date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains
Rs.1,000/tola by living up to the terms of the contract.
When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more
than what could be obtained on the spot market at the same time. Hence, L is tempted to
declare bankruptcy and avoid performing as per the contract.
Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses
by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the
terms of the contract, which is Rs.1,000/tola worse than what could be obtained by
selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and
avoid performing as per the contract.
In either case, this leads to counterparty risk. When one of the two sides of the transaction
chooses to declare bankruptcy, the other suffers. Forward markets have one basic
property: the larger the time period over which the forward contract is open, the larger are
the potential price movements, and hence the larger is the counterparty risk.
How does counterparty risk affect liquidity?
A market where counterparty risk is present generally collapses into a small club of
participants, who have homogeneous credit risk, and who have formed social and cultural
methods for handling bankruptcies.
Club markets do not allow for free entry into intermediation. They support elevated
intermediation fees for club members, have fewer market participants, and result in
reduced liquidity.
Sometimes, regulators who are afraid of payments crises forcibly shut out large numbers
of participants from an OTC derivatives market. This automatically generates a club
17market, and yields a fraction of the liquidity which could come about if participation
could be enlarged.
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What is pricetime priority?
A market has pricetime priority if it gives a guarantee that every order will be matched
against the best available price in the country, and that if two orders are equal in price,
the one which came first will be matched first.
Forward markets, which involve dealers talking to each other on phone, do not have
pricetime priority. Floorbased trading with openoutcry does not have pricetime pri-
ority. Electronic exchanges with order matching, or markets with a monopoly market
maker, have pricetime priority.
On markets without pricetime priority, users suffer greater search costs, and there is a
greater risk of fraud.
What is a futures contract?
A futures contract is a forward contract which trades on an exchange.
How does the futures market solve the problems of for-ward markets?
Futures markets feature a series of innovations in how trading is organised: Futures
contracts trade at an exchange with pricetime priority. All buyers and sell-ers come to
one exchange. This reduces search costs and improves liquidity. This harnesses the gains
that are commonly obtained in going from a nontransparent club market (based on
telephones) to an anonymous, electronic exchange which is open to participation. The
anonymity of the exchange environment largely elimi-nates cartel formation.
Futures contracts are standardised all buyers or sellers are constrained to only choose
from a small list of tradeable contracts defined by the exchange. This avoids the
illiquidity that goes along with the unlimited customisation of forward contracts.
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A new credit enhancement institution, the clearing corporation, eliminates coun-terparty
risk on futures markets. The clearing corporation interposes itself into every transaction,
buying from the seller and selling to the buyer. This is called novation. This insulates
each from the credit risk of the other. In futures markets, unlike in forward markets,
increasing the time to expiration does not increase the counterparty risk.
Novation at the clearing corporation makes it possible to have safe trading between
strangers. This is what enables largescale participation into the futures market in
contrast with small clubs which trade by telephone and makes futures markets liquid.
What is cash settlement?
The forward or futures contracts discussed so far involved physical settlement. On 31
Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was
supposed to pay for it.
In practice, settlement involves high transactions costs. This is particularly the case for
products such as the equity index, or an interbank deposit, where effecting settlement is
extremely difficult or impossible.
In these cases, futures markets use cash settlement. Here, the terminal value of the
product is deemed to be equal to the price seen on the spot market. This is used to
determine cash transfers from the counterparties of the futures contract. The cash transfer
is treated as settlement.
Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec
2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is
actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a
loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty
applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the
clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000
to L. This is called cash settlement.
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Cash settlement was an important advance, which extended the reach of derivatives into
many products where physical settlement was unviable.
What determines the price of a futures product?
Supply and demand on the secondary market determines the futures price. On dates prior
to 31 Dec 2000, the Nifty futures expiring on 31 Dec 2000 trade at a price that purely
reflect supply and demand. There is a separate order book for each futures product which
generates its own price.
Economic arguments give us a clear idea about what the price of a futures should be. If
the secondary market prices deviate from these values, it would imply the presence of
arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is
nothing innate in the market which forces the theoretical prices to come about.

Doesnt the clearing corporation adopt an enormous risk by giving out credit
guarantees to all brokerage firms?
Yes, it does.
If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing
corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally
obliged to either meet these obligations, or go bankrupt itself. There is no third
alternative. There is no committee that meets to decide whether the settlement fund can
be utilised; there are no escape clauses.
It is important to emphasise that when L buys from S, at a legal level, L has bought from
the clearing corporation and the clearing corporation has bought from S. Whether S lives
up to his obligations or not, the clearing corporation is the counterparty to L. There is no
escape clause which can be invoked by the clearing corporation if S defaults.
How does the clearing corporation assure it does not go bankrupt itself?
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The futures clearing corporation has to build a sophisticated risk containment system in
order to survive.
Two key elements of the risk containment system are the mark to market margin and
initial margin. These involve taking collateral from traders in such a way as to greatly
diminish the incentives for traders to default.
Electronic trading has generated a need for online, realtime risk monitoring. In India,
trading takes place swiftly and funds move through the banking system slowly. Hence the
only meaningful notion of initial margin is one that is paid upfront. This leads to the
notion of brokerage firms placing collateral, and obtaining limits upon the risk of their
position as a function of the amount of collateral with the clearing corporation.
Can we concretely sketch the operations of one futures market?
On 1 January, an exchange decides to trade three gold futures contracts with expiration
31 Jan, 28 Feb and 31 Mar respectively. The three futures contracts all trade at the same
time, with three distinct prices. Traders can buy/sell all three contracts as they please. All
through January, no settlement takes place. Positions are netted; i.e. if a person buys 100g
of 31 Jan gold and then (a few days later) sells off 100g of 31 Jan gold, his net position
drops to 0.
Trading for the January contract stops on 31 Jan. All net open positions on this contract,
as of the close of trading of 31 Jan, have to do settlement on 2 February (T+2 settlement).
A buy position (as of close of trading on 31 Jan) has to bring money on 2 Feb, and a sell
position (as of close of trading on 31 Jan) has to bring gold on 2 Feb. On 1 Feb, when
trading commences, the exchange announces the start of trading on a new contract, one
which expires on 30 Apr, thus ensuring that three contracts always trade at any one time.
Similarly, on 28 Feb, trading for the Feb contract stops. On 1 March, a new 31 May
contract is born. On 2 March, open positions of the Feb contract are settled.
Nifty options
The strike prices and expiration dates for traded options are selected by the exchange. For
example, NSE may choose to have three expiration months, and five strike prices
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(1200,1300,1400,1500,1600). There would be two types of options: put and call. This
gives a total of 30 distinct traded options (3 5 2), with 30 distinct order books and
prices.
A typical set of option prices is shown in Table 4.1. It illustrates the intruiging nature of
option prices.
When Nifty is at 1500, the right to buy Nifty at 1600 one month away is worth little
(Rs.13). The buyer of this option puts down Rs.13 when the option is purchased, and this
fee is nonrefundable. If Nifty turns out to be above 1600 after a month, this option will
prove to be valuable. If Nifty proves to be at 1602 after a month, the option will pay Rs.2.
Conversely when Nifty is at 1500, the right to sell Nifty at 1400 one month away isnt
worth much (Rs.8): this is the insurance premium for protecting yourself against a fall
in Nifty of worse than a hundred points.
However, when we increase the time to expiration of the option, there is a greater chance
that prices can move around, and these same options become worth more: e.g. the 25
right to sell Nifty at 1600 is worth Rs.25 when we consider a threemonth horizon (i.e.
insurance against a hundredpoint drop on a threemonth horizon).
Options v/s Futures
Options are different from futures in several interesting senses.
At a practical level, the option buyer faces an interesting situation. He pays for the option
in full at the time it is purchased. After this, he only has an upside. There is no possibility
of the options position generating any further losses to him (other than the funds already
paid for the option). This is different from a futures: which is free to enter into, but can
generate very large losses. This characteristic makes options attractive to many
occasional market participants, who cannot put in the time to closely monitor their futures
positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance
which reimburses the full extent to which Nifty drops below the strike price of the put
option. This is attractive to many people, and to mutual funds creating guaranteed return
products. The Nifty index fund industry will find it very useful to make a bundle of a
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Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which
gives the investor protection against extreme drops in Nifty.
Selling put options is selling insurance, so anyone who feels like earning revenues by
selling insurance can set himself up to do so on the index options market.
More generally, options offer nonlinear payoffs whereas futures only have linear
payoffs. By combining futures and options, a wide variety of innovative and useful
payoff structures can be created.
In general, both futures and options trade on all underlyings abroad. Indeed, the
international practice is to launch futures and options on a new underlying on the same
day.
Factors that determines the price of an option
Supply and demand on the secondary market drives the option price. On dates prior to 31
Dec 2000, the call option on Nifty expiring on 31 Dec 2000 with a strike of 1500 will
trade at a price that purely reflects supply and demand. There is a separate order book for
each option which generates its own price.
The values shown in Table 4.1 are derived from a theoretical model. If the secondary
market prices deviate from these values, it would imply the presence of arbitrage
opportunities, which (we might expect) would be swiftly exploited. But there is nothing
innate in the market which forces the prices in the table to come about.
Position of derivative in equity market
As mentioned in Question 3.9, trading on the spot market for equity has actually
always been a futures market with weekly or fortnightly settlement. These futures
markets feature the risks and difficulties of futures markets, without the gains in price
discovery and hedging services that come with a separation of the spot market from the
futures market.
Indias primary market has experience with derivatives of two kinds: convertible bonds
and warrants (a slight variant of call options). Since these warrants are listed and traded,
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options markets of a limited sort already exist. However, the trading on these instruments
is very limited.
A variety of interesting derivatives markets exist in the informal sector. These markets
trade contracts like bhav-bhav, teji-mandi, etc. For example, the bhav-bhav is a bundle of
one in-the-money call option and one in-the-money put option. These informal markets
stand outside the mainstream institutions of Indias financial system and enjoy limited
participation.
In 1995, NSE asked SEBI whether it could trade index futures. In 2000, SEBI gave
permissions to NSE and BSE to trade index futures. In addition, futures and options on
Nifty will also trade at the Singapore Monetary Exchange (SIMEX) from endAugust
2000.
Commodity derivatives
India produces a range of commodities that enjoy a high global rank in production. The
weighted rank of India in the global supply function pertinent to these commodities is
between two and three. The impact of the commodity sector on the total economy is
considerable.
A reforms program towards building commodity futures exchanges is being effected
under the aegis of the Forward Markets Commission (FMC), which is constituted under
the Ministry of Consumer Affairs and Public Distribution.
Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,
castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18
commodity exchanges located in various parts of the country. Futures trading in other
edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new
commodities, especially in edible oils, is expected to commence in the near future. The
sugar industry is exploring the merits of trading sugar futures contracts.
The policy initiatives and the modernisation programme include extensive training,
structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and
the thrust towards the establishment of a national commodity exchange. The Government
of India has constituted a committee to explore and evaluate issues pertinent to the
establishment and funding of the proposed national commodity exchange for the
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nationwide trading of commodity futures contracts, and the other institutions and
institutional processes such as warehousing and clearinghouses.
With commodity futures, delivery is best effected using warehouse receipts (which are
like dematerialised securities). Warehousing functions have enabled viable exchanges to
augment their strengths in contract design and trading. The viability of the national
commodity exchange is predicated on the reliability of the warehousing functions. The
programme for establishing a system of warehouse receipts is in progress. The Coffee
Futures Exchange India (COFEI) has operated a system of warehouse receipts since
1998.
How do futures trade?
In the cash market, the basic dynamic is that the issuer puts out paper, and people trade
this paper. In contrast, with futures (as with all derivatives), there is no issuer, and hence,
there is no fixed issue size. The net supply of all derivatives contracts is 0. For each
buyer, there is an equal and opposite seller. A contract is born when a buyer and a seller
meet on the market.
The total number of contracts that exist at a point is called open interest.
How would a seller deliver a market index?
On futures markets, open positions as of the expiration date are normally supposed to
turn into delivery by the seller and payment by the buyer.
It is not feasible to deliver the market index. Hence open positions are squared off in cash
on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date,
the last mark to market margin is calculated with respect to the spot Nifty instead of the
futures price.
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What products will be traded on NSEs market?
Three Nifty futures contracts will trade at any point in time, expiring in three near
months. The expiration date of each contract will be the last thursday of the month. For
example, in January 1996 we will see three tradeable objects at the same time: a Nifty
futures expiring on 25 January, a Nifty futures expiring on 29 February, and a Nifty
futures expiring on 28 March.
The three futures trade completely independently of each other. Each has a distinct price
and a distinct limit order book.
Hence, once this market trades, there would be four distinct prices that can be ob-served:
the Nifty spot, and three Nifty futures prices.
Market lot
The market lot is 200 nifties. A user will be able to buy 200 or 400 nifties, but not 300
nifties. If Nifty is at 1500, the smallest transaction will have a notional value of
Rs.300,000.
What kind of margins do we expect to see
The initial (upfront) margin on trading Nifty is likely to be around 7% to 8%. Thus, a
position of Rs.300,000 (around 200 nifties) will require upfront collateral of Rs.21,000
to Rs.24,000.
Nifty futures at SIMEX will probably involve a somewhat lower initial margin as
compared with Nifty futures at NSE. Since the BSE Sensex is more volatile than Nifty, a
higher initial margin will be required for trading it.
The daily marktomarket margin will be similar to that presently seen on the cash
market, with two key differences: As is presently the case, mark-to-market losses will
have to be paid in by the trader to NSCC. However, mark-to-market profits will be paid
out to traders by NSCC this is not presently done on the cash market.
Hedged futures positions will attract lower margin if a person has purchased 200
October nifties and sold 200 November nifties, he will attract much less than 7 8%
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margin. In the present cash market, all positions attract 15% initial (upfront) margin from
NSCC, regardless of the extent to which they are hedged.
Users of index futures
As with all derivatives, there are (a) speculators, (b) hedgers and (c) arbitrageurs.
Speculators would make forecasts about movements in Nifty or movements in futures
prices. Hedgers would take buy or sell positions on Nifty futures in offsetting equity
exposure that they have, which they consider undesirable. Arbitrageurs lend or borrow
money from the market, depending on whether rates of return are attractive.
What kind of liquidity is expected on index derivatives markets?
Impact cost on index derivatives markets is likely to be much smaller than that seen on
the spot index. One thumb rule which is commonly used internationally is that trans-
actions costs on trading index futures are around onetenth the cost of trading the spot
index. When this level of liquidity is attained, we will be able to trade Rs.1 million of
Nifty futures in a market impact cost of 0.01%. High liquidity is the essential appeal of
index derivatives. If trading on the spot market were cheap, then many portfolio
modifications would get done there itself. However, because transactions costs on the
cash market are high, using derivatives is an appealing alternative.
What determines the fair price of a derivative?
The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this
sense, arbitrage (and arbitrage alone) determines the fair price of a derivative: this is the
price at which there are no profitable arbitrage opportunities.
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What determines the fair price of an index futures product?
The pricing of index futures depends upon the spot index, the cost of carry, and expected
dividends. For simplicity, suppose no dividends are expected, suppose the spot Nifty is at
1000 and suppose the onemonth interest rate is 1.5%. Then the fair price of an index
futures contract that expires in a month is 1015.
What is basis?
The difference between the spot and the futures price is called the basis. When a Nifty
futures trades at 1015 and the spot Nifty is at 1000, the basis is said to be Rs.15 or
1.5%.
What is basis risk?
Basis risk is the risk that users of the futures market suffer, owing to unwanted
fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates,
and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations
reduce the usefulness of the futures market for hedgers and speculators.
What happens if the futures are trading at Rs.1025 instead of Rs.1015?
This is an error in the futures price of Rs.10. An arbitrageur can, in principle, capture the
mispricing of Rs.10 using a series of transactions. He would (a) buy the spot Nifty, (b)
sell the futures, and (c) hold till expiration. This strategy is equivalent to risklessly
lending money to the market at 2.5% per month. As long as a person can borrow at
1.5%/month, he would be turning a profit of 1% per month by doing this arbitrage,
without bearing any risk.
What happens if the futures are trading at Rs.1005 instead of Rs.1015?
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This is an error in the futures price of Rs.10. An arbitrageur can, in principle, capture the
mispricing of Rs.10 using a series of transactions. He would (a) sell the spot Nifty, (b)
buy the futures, and (c) hold till expiration. This is equivalent to borrowing money from
the market, using (Nifty) shares as collateral, at 0.5% per month. As long as a person can
lend at 1.5%/month, he would be turning a profit of 1% per month by doing this
arbitrage, without bearing any risk.
Are these pricing errors really captured by arbitrageurs?
In practice, arbitrageurs will suffer transactions costs in doing Nifty program trades. The
arbitrageur suffers one market impact cost in entering into a position on the Nifty spot,
and another market impact cost when exiting. As a thumb rule, transactions of a million
rupees suffer a oneway market impact cost of 0.1%, so the arbitrageur suffers a cost of
0.2% or so on the roundtrip. Hence, the actual return is lower than the apparent return by
a factor of 0.2 percentage points or so.
What kinds of arbitrage opportunities will be found in this fashion?
The international experience is that in the first six months of a new index futures market,
there are greater arbitrage opportunities that lie unexploited for relatively longer. After
that, the increasing size and sophistication of the arbitrageurs ensures that arbitrage
opportunities vanish very quickly. However, the international experience is that the
glaring arbitrage opportunities only go away when extremely large amounts of capital are
deployed into index arbitrage.
What kinds of interestrates are likely to show up on the index futures market will
they be like badla financing rates?
Arbitrage in the index futures market involves having the clearing corporation (NSCC) as
the legal counterparty on both legs of the transaction. Hence the credit risk involved here
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will be equal to the credit risk of NSCC. This is in contrast with the risks of badla
financing.

You say buying Nifty. How do you buy a market index?
A market index is just a portfolio of all the stocks in the index, where the weightage
given to each stock is proportional to its market capitalisation. Hence buying Nifty is
equivalent to buying all 50 stocks, in their correct proportions. To take one example,
suppose Reliance has a 7.14% weight in Nifty, suppose the price of Reliance is Rs.108
and we are buying Rs.1 million of Nifty. This means that we need to buy 661 shares of
Reliance.
Wont that be a lot of timeconsuming typing, placing 50 orders by hand?
These orders should not be placed by hand. In the time that it would take to place 50
orders, market prices would move, generating execution risk. A rapid placement of a
batch of orders is called program trading. NSEs NEAT software (which is used for
trading on the cash market) supports this capability. However, even though NSE is a fully
electronic market, the time taken in doing program trades is quite high (around two to
three minutes to do a Nifty program trade). This compares poorly against stock
exchanges elsewhere in the world.
Isnt program trading dangerous or somehow unhealthy?
Program trading replaces the tedium, errors, and delays of placing 50 orders by hand. If
program trading didnt exist, these orders would be placed manually. Its hard to see how
this automation can be dangerous.
What makes a good stock market index for use in an index futures and index
options market?
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Several issues play a role in terms of the choice of index. Diversification A stock market
index should be well-diversified, thus ensuring that hedgers or speculators are not
vulnerable to individual company- or industry-risk. This di-versification is reflected in
the Sharpe's Ratio of the index.
Liquidity of the index The index should be easy to trade on the cash market. This is partly
related to the choice of stocks in the index. High liquidity of index compo-nents implies
that the information in the index is less noisy.
Liquidity of the market Index traders have a strong incentive to trade on the market
which supplies the prices used in index calculations. This market should feature high
liquidity and be well designed in the sense of supplying operational conve-niences suited
to the needs of index traders. Operational issues The index should be regularly
maintained, with a steady evolution of securities in the index to keep pace with changes
in the economy. The calculations involved in the index should be accurate and reliable.
When a stock trades at mul-tiple venues, index computation should be done using prices
from the most liquid market.
How do we compare Nifty and the BSE Sensex from this perspective?
Nifty has a higher Sharpe's ratio. Nifty is a more liquid index. Nifty is calculated using
prices from the most liquid market (NSE). NSE has designed features of the trading
system to suit the needs of index traders. Nifty is better maintained. Nifty is used by three
index funds while the BSE Sensex is used by one.
Why does liquidity matter for a market index?
At one level a market index is used as a pure economic time-series. Liquidity affects this
application via the problem of non-trading. If some securities in an index fail to trade
today, then the level of the market index obtained reflects the valuation of the
macroecon-omy today (via securities which traded today), but is contaminated with the
valuation of the macroeconomy yesterday (via securities which traded yesterday). This is
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the problem of stale prices. By this reasoning, securities with a high trading intensity are
best-suited for inclusion into a market index.
As we go closer to applications of market indexes in the indexation industry (such as
index funds, or sector-level active management, or index derivatives), the market index is
not just an economic time-series, but a portfolio which is traded. The key difficulty faced
here is again liquidity, or the transactions costs faced in buying or selling the entire index
as a portfolio.
How can Nifty futures be used for interest rate trading?
The basis between the spot Nifty and the 1 month Nifty futures reflects the interest rate
over the coming month. If interest rates go up, the basis will widen. A buy position on the
futures and a sell on the spot Nifty stands to gain if interest rates go up, while being
immune to movements in Nifty. Similar positions can be used against the twomonth and
threemonth futures to take views on other spot interest rates on the yield curve. Similar
strategies can be applied for trading in forward interest rates, using the basis between the
onemonth and twomonth futures, the onemonth and threemonth futures, etc.
When does hedging go wrong?
Hedgers fear basis risk. Basis risk is about Nifty futures prices moving in a way which is
not linked to the Nifty spot.
An unhedged position suffers from price risk; the hedged position suffers from basis risk.
Of course, basis risk is generally much smaller than price risk, so that it is better to hedge
than not to hedge. However basis risk does detract from the usefulness of hedging using
derivatives.
What influences basis risk?
A well designed index, and a welldesigned cash market for equities, serves to minimise
basis risk. See Question 10.1.
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What do we know about Nifty and the BSE Sensex in their usefulness on hedging?
Nifty has higher hedging effectiveness for typical portfolios of all sizes. Nifty also
requires lower initial margin (since it is less volatile) and is likely to enjoy lower basis
risk (owing to the ease of arbitrage).

How do I lend money into the futures market?
Buy a million rupees of Nifty on the spot market. Pay for them, and take delivery.
When you make the payment, you are giving a loan.
Simultaneously, sell off a million rupees of Nifty futures.
Hold these positions till the futures expiration date.
On the futures expiration date, sell off the Nifty shares on the spot market. When you
get paid for these, you are getting your loan repaid.
When is this attractive?
This is worth doing when the interest rate obtained by lending into the futures market is
higher than that which can be obtained through alternative riskless lending avenues.
How do I borrow money from the futures market, using shares as collateral?
Sell a million rupees of Nifty on the spot market. Make delivery, and get paid. This is
your borrowed funds.
Simultaneously, buy a million rupees of Nifty futures.
Hold these positions till the futures expiration date.
On the futures expiration date, buy back the Nifty shares on the spot market. When you
pay for them, you are repaying your loan.
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When is this attractive?
This is worth doing when the interest rate obtained by borrowing from the futures market
is lower than that which can be obtained through alternative fully collateralised
borrowing avenues.
Is there a compact thumbrule through which I can visualise the interest rates
actually available in lending to the index futures market?
Suppose Nifty is at 1500 and a futures product which expires within 30 days is trading at
1520. At first, this looks like a return of Rs.20 on a base of Rs.1500 for a onemonth
holding period. However, you should subtract out the transactions costs that you will
suffer on doing two trades on the Nifty spot. Suppose we assume a transaction size of
Rs.1 million. In this case, its safe to assume transactions costs of roughly 0.1% (or
Rs.1.5) each.
Hence, you will actually get only 20 - 1.5 - 1.5 or Rs.17 on a base of Rs.1500. This is a
return of 1.13% for a onemonth holding period, or 14.48% annualised. Thinking in
terms of the actual transaction, you would lend Rs.1,000,000 into the market, and get
back Rs.1,011,333 after a month.
This thumbrule ignores the dividends obtained on the shares you hold for the month.
Dividend payments in India are highly bunched towards the yearend. At other times of
the year, its safe to ignore dividends in a thumbrule.
Exactly what is the timeperiod for which we calculate the interest cost?
Suppose we are on 12 June 2000 (a Monday) and we have purchased the spot, and sold
the near futures (which expires on 29 June 2000). We will only need to put up funds on
Tuesday, 20 June 2000. The shares are sold on the spot market on 29 June 2000
(Thursday). These turn into funds on 11 July 2000 (Tuesday). Hence, the overall period
for which funds are invested is from 20 June to 11 July, i.e. a holding period of 22 days.
Hence, the cost of carry should be applied for a 22 day holding period.
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Can it happen that a Nifty future is cheaper than the Nifty spot?
Suppose the Nifty spot is the same as the price of the three month futures, i.e. that the
basis is zero. This means that the futures market is willing to give you a loan (against a
Nifty portfolio as collateral) for a threemonth period at an interest rate of zero.
If the Nifty futures are cheaper than the Nifty spot, it means that the futures market
is willing to pay you if you borrow money.
Many people in India would be very happy to borrow (against a Nifty portfolio as
collateral) at a zero or negative interest rate. When they step into futures market to do so,
they will buy the futures and sell the spot. That will push futures prices away from these
weird states.
Nothing forbids these weird states (negative or zero basis). Its just that they are
extremely attractive arbitrage opportunities and are unlikely to lie around for long.
These transactions look exactly like a stock repo to me.
Index arbitrage is indeed an index repo, with one key difference. Repos normally
involve counterparty risk. In index arbitrage, you face nearzero risk with NSCC as the
counterparty.
Why these borrowing/lending activities are called arbitrage?
They involve a sequence of trades on the spot and on the index futures market. Yet, they
are completely riskless. The trader is simultaneously buying at the present and selling off
in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage
are the same. Since there is no risk involved, it is called arbitrage.
Are these transactions really riskless?
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These transactions are riskless insofar as the fluctuations of Nifty are concerned: no
matter whether Nifty goes up or down, they will yield the identical and predictable rate of
return. The rate of return you calculate at the outset is exactly what will come out at the
end.
However, they involve the credit risk of the clearing corporation. When you do arbitrage
on NSE, you are exposed to the risk that the National Securities Clearing Corporation
(NSCC) which is the legal counterparty to all your trades might be unable to meet its
obligations.
The required rate of return in lending to NSCC is the interest rate from the Government
of India yield curve, with a credit risk premium for NSCC added into it. If the 90day
interest rate on the GOI yield curve is 7%, and if you believe that NSCC requires a credit
risk premium of one percentage point, then the threemonth futures should involve an
interest rate of 8%.
Whats the probability that NSCC will default?
Internationally, clearing corporations calibrate their risk containment system so that
failures are expected to take place roughly once or twice in each fifty years.
The track record of futures clearing corporations internationally is impressive. In the 20th
century, we have seen just a handful of failures (e.g. Hong Kong in 1987).
NSCC has a short track record: it has been doing novation on the equity spot market
(which is actually a futures market) from 1996 onwards. In these five years, the equity
market has experienced high volatility, a high incidence of bankruptcies by NSE
brokerage firms, payments problems on other exchanges, etc. NSCC has successfully
shouldered the task of doing novation on Indias largest financial market (NSE). While
this suggests that NSCC may have fairly sound risk containment systems, we should be
cautious since it only has a track record of five years of doing novation.
What do we know about the risks of BSEs clearinghouse?
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BSE has no experience with novation. Today, equity trading at BSE takes place without
novation. BSE has experienced payments problems fairly recently.
What do we know about Nifty and the BSE Sensex on the question of arbitrage?
The market impact cost in trading the BSE Sensex is higher, for two reasons: index
construction and trading venue. Even if BSE Sensex trades were done on NSE, the
impact cost faced in trading the BSE Sensex is higher than that of Nifty. In addition,
arbitrageurs working on the BSE Sensex would be forced to trade at the less liquid
market, the BSE.
The BSE lacks a credit enhancement institution of the credibility of NSCC.
These problems imply that arbitrageurs working on the BSE Sensex will demand a higher
credit risk premium, and require larger pricing errors in order to compensate for the
larger transactions costs. Hence, the BSE Sensex futures are expected to show lower
market efficiency and greater basis risk.
How does one speculate using index futures?
There are several kinds of speculation that are possible forecasting movements of Nifty,
forecasting movements in Nifty futures prices, and forecasting interest rates.
What is involved in forecasting Nifty?
Nifty is a welldiversified portfolio of companies that make up 54% of the market
capitalisation of India. The diversification inside Nifty serves to cancel out influences
of individual companies or industries.
Hence Nifty, as a whole, reflects the overall prospects of Indias corporate sector and
Indias economy. Nifty moves with events that impact Indias economy. These include
politics, macroeconomic policy announcements, interest rates, money supply and
budgets, shocks from overseas, etc. Thomas & Shah (1999) offer some timeseries
econometrics applied to Nifty.
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RECOMMENDATIONS
On the basis of the study, as performance and achievements made by the responsibilities
assigned to me during my summer training tenure, I recommended the higher authorities
the following for their kind consideration:
As Religare has started to open the demate A/C, I have given the advice to the
authorities that the old clients normal trading & demat a/c should be converted
into the demate A/C. From this advice company can save the local conveyance
cost which is incurred to receive the delivery from the clients and also through
this settlements process will become easier.
In the company software i.e., ODIN the trading dealer is not able to see the scrip
vise client position and this is creating a lot of problems due to the reason that
whenever scrip prices increase or decreases the dealer want to buy or sell the
scripts of the clients for this dealer has to see the client wise position & not the
scrip wise position this will result in the lost of the precious time. On this I
recommended the systems dept to include the feature to see the scritp wise
position of the clients also.
The clearing and the settlement of the northern region is done on the centralized
basis & this is creating the a lot of problems i.e., to track the all the branches on
the telephonic line, this will result in delay in the settlement process, to short out
the queries of the clients branches has to call to the Delhi main branch where all
the settlement of the northern region are carried out,i.e., branches are dependent
on the H..O
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CONCLUSION
Investing is every bodys need. Every one wants to invest their savings for uncertain
future ahead. These hard earn savings should be properly and smartly invested so that the
principal is safe, returns are maximized and liquidity is available. With the globalization
of Indian financial market lot of avenues of investment has opened up. With the increase
in number of options now available, complexity too has increased. Proper knowledge can
help an investor to get maximum possible returns while minimizing his risk.
The project covers the various investment avenues provided by Religare and seeks to
analyze them with respect to return they generate and risk they have. The project cover
detailed information about making a investment in different investment. The key focus of
the project is to have better insight into investment in equities market and related
instrument like derivatives and portfolio management services (PMS) .The project has
also covered information about the investment options in debt market which have petty
low risk and assured but low returns.
The project in first stage has been able to cover the indepth study of direct investment in
equities market ie investment through holding the ownership of share of different
companies. The details regarding investment in fixed income options have also been
provided.
The next stage of project has covered the study of Derivatives and commodity. That has
been followed by the analysis of all of these options in different economic conditions in
terms of return they generate and degree of risk they have. Here study has been restricted
to only those investment options which are offered at Religare.
After studding the different investment avenues provided by the Religare I conclude that:
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For the risk awesser investors insurance products are the safest mode of the
earnings
For medium or less risk takers Mutual fund is the best option for investment as
there is the less risk in the mutual fund due to the reason that the portfolio is
managed by the professionals.
And for the higher risk taker in my view derivative segment is the best segment
for the investment. However it requires a lot of attention and market updation and
the good analytical review.
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ORGANISATIONAL LEARNINGS
It is very important in an organization to have clarity of roles and unity of command. I
observed that this feature was not focused upon in branch after an organizational
restructuring. Employee at the branch was not very clear about the reporting mechanisms,
the flow of command and formal authority. This had an negative effect on employee
moral irrespective of the leadership. Impact on entry level employee was the most, they
ended up being frustrated because unclear authority and command.
Generally organizations focus more on either marketing or finance in the organization
and make the Endeavour to make these functions as efficient as possible. But in the
process they dont have much focus on operations. I find operation at kotak securities
inefficient and wanting. They have serious complication on functioning and loss of
business to competitors. I believe that this function should also be provided be given
more attention and should be equipped with not only better technology but also more
efficient work force.

During my summers at Religare Securities, I was fortunate enough to experience two
different kind of leadership style. Not commenting on any one it , I just want to say that
they had major impact on the way the branch function, level of satisfaction of
employees , cost cutting, and most important of all revenue generated. So leadership is
one area where top management should be very careful and focused as they form
important part of any organizational success.
Technology plays a major role in organizational functioning.
Although it is an established fact that technology helps in smooth functioning of
organization. But I observed it myself at kotak securities. The BOS (back office support)
system is one of the major strength of kotak securities, it is one tool which keeps kotak
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ahead of its competitors by helping in better query handing , trouble shooting and having
a more satisfied customer.
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BIBLIOGRAPHY
BOOKS:
Bhalla .V.K, Investment Management: Security Analysis & Portfolio
Management, S.Chand publication, 2007, New Delhi. Depository & Index Pages
reffered from 102 -105 and 183-206.
NCFM, Security Market (Basic Module), 2007. Primary Market
Portfolio Management 2007. Role of AMC & Trustee in the Security market.
MAGAZINE & JOURNAL/ NEWSPAPER:
Kumar Dhirendra, ULIP Key Feature, Business world, 24 June, 2007, pages
reffered from 22-54.
Rao Ramesh, Portfolio Management Services, Mar2007, Pages reffered from 18-
34.
Mittal Ashok, Derivative Trading, Financial Express Annual magazine 2006,
pages reffered from 46-88.
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INTERNET
www.nseindia.com, Clearing & Settlement Of Equity & portfolio
June, 2007.
www.debtonnetindia.com, Retail debt market,

June, 2007.
www.moneycontrol.com, Basics, Future & Option, July, 2007.
www.Religare.in
www.yahoosearch.com
www.wikipedia.com
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WORD OF THANKS
I take the opportunity to pay hearty regards to Dr. D. K. Garg (chairman) and Mr. M. K.
Verma (dean) for lending me their kind support for completion of my project.
I thank all those who directly or indirectly supported me morally, financially and
through providing knowledge by which I could complete my research.
Last but not the least I am thankful to the management of Religare securities ltd.
And my guide Mr. Vipul Gupta (Sr. Relationship Manager) his guidance was a milestone
in completion of my project.
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