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profits. H o w e v e r , m o r e often t h a n not the transaction costs w i p e out whatever profits they m a y generate f r o m frequent t r a d i n g . Over-Diversification and Under-Diversification A n u m b e r of i n d i v i d u a l p o r t f o l i o s are either o v e r - d i v e r s i f i e d or u n d e r - d i v e r s i f i e d . M a n y i n d i v i d u a l s h a v e p o r t f o l i o s consisting of thirty to sixty, or even more, different stocks. M a n a g i n g s u c h portfolios is a n u n w i e l d y task. P e r h a p s as c o m m o n as o v e r - d i v e r s i f i c a t i o n is u n d e r - d i v e r s i f i c a t i o n . M a n y i n d i v i d u a l s d o not a p p a r e n t l y u n d e r s t a n d the p r i n c i p l e of d i v e r s i f i c a t i o n a n d its benefit i n terms of r i s k r e d u c t i o n . A n u m b e r of i n d i v i d u a l portfolios seem to be h i g h l y u n d e r d i v e r s i f i e d , c a r r y i n g a n a v o i d a b l e r i s k exposure. Wrong Attitude Towards Losses and Profits T y p i c a l l y , a n investor has a n a v e r s i o n to a d m i t h i s mistake a n d cut losses short. If the price falls, contrary to his expectation at the time of purchase, he s o m e h o w hopes that it w i l l r e b o u n d a n d he can break e v e n (he m a y e v e n b u y some m o r e shares at the l o w e r p r i c e i n a b i d to reduce h i s average price). S u r p r i s i n g l y , s u c h a belief persists e v e n w h e n the prospects l o o k d i s m a l a n d there m a y be a greater p o s s i b i l i t y of a further decline. T h i s perhaps arises out of a d i s i n c l i n a t i o n to a d m i t mistakes. The p a i n of regret a c c o m p a n y i n g the realisation of losses is sought to be p o s t p o n e d . A n d if the p r i c e recovers d u e to f a v o u r a b l e c o n d i t i o n s , there is a tendency to dispose of the share w h e n its price m o r e or less equals the o r i g i n a l purchase price, e v e n t h o u g h there m a y be a fair chance of further increases. The p s y c h o l o g i c a l relief e x p e r i e n c e d b y a n i n v e s t o r f r o m r e c o v e r i n g losses seems to m o t i v a t e s u c h b e h a v i o u r . P u t differently, the tendency is to let the losses r u n a n d cut profits short, rather than to cut the losses short a n d let the profits r u n .

1.7

QUALITIES FOR SUCCESSFUL INVESTING

The game of investment, as a n y other game, requires certain qualities a n d virtues o n the part of the investors, to be successful i n the l o n g r u n . W h a t are these qualities? W h i l e the lists prescribed b y v a r i o u s commentators tend to v a r y , the f o l l o w i n g qualities are f o u n d i n most of the lists. Contrary thinking Patience * Composure a F l e x i b i l i t y a n d openness Decisiveness Before w e d w e l l o n these qualities, one p o i n t needs to be e m p h a s i s e d . C u l t i v a t i n g these qualities d i s t i n c t l y i m p r o v e s the o d d s of s u p e r i o r p e r f o r m a n c e b u t does not guarantee it.

Overview

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Traits of the Great Masters In a fascinating b o o k , J o h n T r a i n s t u d i e d the strategies e m p l o y e d b y n i n e great masters. Based o n his analysis, he p r e p a r e d a list of traits c o m m o n a m o n g t h e m : 1. 2. 3. 4. 5. He He He He He is is is is is realistic intelligent to the p o i n t of genius utterly dedicated to h i s craft d i s c i p l i n e d a n d patient a loner

Source: J o h n T r a i n , The Money Masters, N e w Y o r k : H a r p e r & R o w P u b l i s h e r s , Inc., 1981. Contrary Thinking Investors t e n d to have a h e r d m e n t a l i t y a n d f o l l o w the c r o w d . T w o factors e x p l a i n this b e h a v i o u r . First, there is a n a t u r a l desire o n the part of h u m a n beings to be part of a g r o u p . Second, i n a c o m p l e x f i e l d l i k e investment, most p e o p l e d o not have e n o u g h confidence i n their o w n j u d g m e n t . T h i s i m p e l s t h e m to substitute others' o p i n i o n for their o w n . F o l l o w i n g the c r o w d b e h a v i o u r , h o w e v e r , often p r o d u c e s p o o r investment results. W h y ? If e v e r y o n e fancies a certain share, it s o o n becomes o v e r p r i c e d . T h a n k s to b a n d w a g o n p s y c h o l o g y , it is l i k e l y to r e m a i n b u l l i s h for a p e r i o d longer t h a n w h a t is r a t i o n a l l y justifiable. H o w e v e r , this cannot persist i n d e f i n i t e l y because sooner or later the market corrects itself. A n d w h e n that h a p p e n s the m a r k e t p r i c e falls, sometimes v e r y a b r u p t l y a n d s h a r p l y c a u s i n g w i d e s p r e a d losses. G i v e n the r i s k of i m i t a t i n g others a n d j o i n i n g the c r o w d , y o u m u s t cultivate the habit of c o n t r a r y t h i n k i n g . T h i s m a y be d i f f i c u l t to d o because it is so t e m p t i n g a n d convenient to f a l l i n line w i t h others. P e r h a p s the best w a y to resist s u c h a tendency is to recognise that i n v e s t m e n t requires a different m o d e of t h i n k i n g t h a n w h a t is a p p r o p r i a t e to e v e r y d a y l i v i n g . A s James G i p s o n s a i d : " B e i n g a joiner is fine w h e n it comes to team sports, fashionable clothes, a n d t r e n d y restaurants. W h e n it comes to i n v e s t i n g , h o w e v e r , the i n v e s t o r m u s t r e m a i n aloof a n d suppress social tendencies. W h e n it comes to m a k i n g m o n e y a n d k e e p i n g it, the majority is a l w a y s w r o n g . " The s u g g e s t i o n to cultivate ' c o n t r a r y t h i n k i n g ' s h o u l d not, of course, be l i t e r a l l y interpreted to m e a n that y o u s h o u l d a l w a y s go against the p r e v a i l i n g m a r k e t sentiment. If y o u d o so, y o u w i l l m i s s m a n y o p p o r t u n i t i e s presented b y the m a r k e t s w i n g s . A m o r e sensible interpretation of the c o n t r a r i a n p h i l o s o p h y is this: g o w i t h the m a r k e t d u r i n g i n c i p i e n t a n d intermediate phases of bullishness a n d bearishness b u t g o against the market w h e n it m o v e s t o w a r d s the extremes.
4

James Gipson, Winning the Investment Game, N e w York, M c G r a w - H i l l Book Company, 1986.

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H e r e are some suggestions to cultivate the contrary a p p r o a c h to investment: A v o i d stocks w h i c h h a v e a h i g h price-earnings ratio. A h i g h relative p r i c e earnings ratio reflects that the stock is v e r y p o p u l a r w i t h investors. Recognise that i n the w o r l d of investment, m a n y p e o p l e have the t e m p t a t i o n to p l a y the w r o n g game. Sell to the o p t i m i s t s a n d b u y f r o m the pessimists. W h i l e the f o r m e r h o p e that the future w i l l be m a r v e l l o u s , the latter fear that it w i l l be a w f u l . R e a l i t y often lies s o m e w h e r e i n b e t w e e n . So it is a g o o d investment p o l i c y to bet against the t w o extremes. M o r e specifically, remember the f o l l o w i n g rules w h i c h are h e l p f u l i n i m p l e m e n t i n g the contrary a p p r o a c h : D i s c i p l i n e y o u r b u y i n g a n d s e l l i n g b y s p e c i f y i n g the target prices at w h i c h y o u w i l l b u y a n d sell. D o n ' t t r y o v e r z e a l o u s l y to b u y w h e n the market is at its n a d i r or sell w h e n the m a r k e t at its p e a k (these c a n often be k n o w n o n l y w i t h the w i s d o m of h i n d s i g h t ) . R e m e m b e r the a d v i c e of B a r o n R o t h s c h i l d w h e n he s a i d that he w o u l d leave the 20 percent gains at the top as w e l l as at the b o t t o m for others as h i s interest w a s o n l y o n the 60 percent p r o f i t i n the m i d d l e . N e v e r l o o k back after a sale or purchase to ask w h e t h e r y o u s h o u l d have w a i t e d . It is pointless to w o n d e r w h e t h e r y o u c o u l d have b o u g h t a share for Rs.10 less or s o l d it for Rs.20 m o r e . W h a t is i m p o r t a n t is that y o u b u y at a price w h i c h w i l l ensure p r o f i t a n d sell at a price w h e r e y o u realise y o u r expected p r o f i t . Counterintuitive Trading Successful investors u s u a l l y trade i n a c o u n t e r i n t u i t i v e m a n n e r : they increase t u r n o v e r w h e n they are d o i n g w e l l , b u t p a t i e n t l y e n d u r e d i s a p p o i n t m e n t s . T h i s b e h a v i o u r is at variance w i t h h u m a n nature a n d the culture of most investment committees. If investments h a v e fared w e l l , it is h u m a n nature to c o m p l a c e n t l y adhere to the strategy that has s e r v e d w e l l . Yet, investments that have p e r f o r m e d w e l l i n the recent past, m a y n o longer be attractively p r i c e d to generate g o o d returns. C o n v e r s e l y , i f i n v e s t m e n t s h a v e p e r f o r m e d b a d l y , h u m a n instincts p r o m p t us to f i x the p r o b l e m b y c h a n g i n g the p o r t f o l i o . Yet, the p o r t f o l i o m a y n o w be attractively p r i c e d to generate better returns. Patience A s a v i r t u e , patience is strangely d i s t r i b u t e d a m o n g i n v e s t o r s . Y o u n g investors, w i t h a l l the time i n the w o r l d to reap the benefits of patient a n d d i l i g e n t i n v e s t i n g , seem to be the most i m p a t i e n t . T h e y l o o k for instantaneous results a n d often check prices o n a d a i l y basis. O l d investors, o n the other h a n d , d i s p l a y a h i g h degree of patience e v e n t h o u g h they have little chance of e n j o y i n g the fruits of patience. W h a t e v e r m a y be the t e m p e r a m e n t a l basis for the y o u n g to be impatient, i n the f i e l d of i n v e s t m e n t there are c o m p e l l i n g reasons for c u l t i v a t i n g patience. T h e game of investment requires patience a n d d i l i g e n c e . I n the short r u n , the factor of l u c k m a y be

Overview

21

i m p o r t a n t because of r a n d o m n e s s i n stock price b e h a v i o u r , w h i c h m a y be l i k e n e d to the B r o w n i a n m o t i o n i n p h y s i c s . In the l o n g r u n , h o w e v e r , i n v e s t o r p e r f o r m a n c e depends m a i n l y o n patience a n d diligence, because the r a n d o m m o v e m e n t s t e n d to e v e n out. Composure R u d y a r d K i p l i n g b e l i e v e d that a n i m p o r t a n t v i r t u e for b e c o m i n g a mature a d u l t is to keep y o u r h e a d w h e n a l l a r o u n d y o u are l o s i n g theirs. The a b i l i t y to m a i n t a i n c o m p o s u r e is also a v i r t u e r e q u i r e d to be a successful investor. C o n s c i o u s of this, as a n investor y o u s h o u l d try to (a) u n d e r s t a n d y o u r o w n i m p u l s e s a n d instincts t o w a r d s greed a n d fear; (b) s u r m o u n t these emotions that can w a r p y o u r j u d g m e n t ; a n d (c) capitalise o n the greed a n d fear of other investors. W h i l e the above advice s o u n d s s i m p l e , it is d i f f i c u l t to practice. G r e e d a n d fear are far m o r e p o w e r f u l forces than reason i n i n f l u e n c i n g investment decisions. R a r e l y d o y o u come across a n investor w h o is i m m u n e to these emotions that are so p e r v a s i v e i n the market place. G r e e d a n d fear t e n d to be i n s i d i o u s l y contagious. In y o u r attempt to overcome t h e m , y o u m a y f i n d the f o l l o w i n g suggestions h e l p f u l . M a i n t a i n a certain distance f r o m the m a r k e t place. Y o u r v u l n e r a b i l i t y to the contagious influences of greed a n d fear d i m i n i s h e s , if y o u r contact w i t h others caught i n the w h i r l p o o l of market p s y c h o l o g y decreases. R e l y m o r e o n h a r d n u m b e r s a n d less o n j u d g m e n t ( w h i c h is m o r e p r o n e to be i n f l u e n c e d b y the e m o t i o n s of g r e e d a n d fear). T h i s is the a d v i c e g i v e n b y Benjamin G r a h a m , w i d e l y r e g a r d e d as the father of security analysis. Flexibility and Openness N o t h i n g is m o r e certain t h a n change i n the w o r l d of investments. M a c r o e c o n o m i c c o n d i t i o n s change, n e w technologies a n d i n d u s t r i e s emerge, c o n s u m e r tastes a n d preferences shift, investment habits alter, a n d so o n . A l l these d e v e l o p m e n t s have a b e a r i n g o n i n d u s t r y a n d c o m p a n y prospects o n the one h a n d a n d investor expectations o n the other. Despite the i n e x o r a b i l i t y of change, most of us adjust to it p o o r l y . W e often base o u r expectations a s s u m i n g that the status q u o w i l l c o n t i n u e . A s J . M . K e y n e s s a i d : " T h e facts of the existing s i t u a t i o n enter, i n a sense d i s p r o p o r t i o n a t e l y into the f o r m a t i o n of o u r l o n g - t e r m expectations; o u r u s u a l practice b e i n g to take the existing situation a n d project it into a future m o d i f i e d o n l y to the extent that w e have more or less definite reasons for expecting a change." W e tend to c o m p o u n d the p r o b l e m further b y b e i n g over-protective of o u r j u d g m e n t , m a i n l y d u e to p s y c h o l o g i c a l reasons. T h i s leads to a failure to absorb a n d interpret n e w f o r m a t i o n w i t h a n o p e n m i n d . T h i s i n a b i l i t y to consider n e w evidence b l i n d s us to the f l a w s i n o u r o p e r a t i n g p r e m i s e s . A s A r t h u r Z e i k e l s a i d : " W e t e n d to d e v e l o p a 'defensive' interpretation of n e w d e v e l o p m e n t s , a n d this cripples o u r capacity to m a k e g o o d j u d g m e n t s about the f u t u r e . "
5

Arthur Zeikel, " O n the Threat of Change", Financial Analysts Journal, vol.31 No.6, Nov-Dec. 1975.

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Since a n o p e n m i n d , not b l o c k e d b y prejudices a n d biases, is c r u c i a l for success i n i n v e s t i n g , conscious a n d deliberate efforts s h o u l d be m a d e to re-examine o l d premises, assimilate n e w i n f o r m a t i o n , a n d cultivate m e n t a l f l e x i b i l i t y . B a r t o n M . Briggs p u t it this w a y : " F l e x i b i l i t y of t h i n k i n g a n d w i l l i n g n e s s to change is r e q u i r e d f o r the successful investor. I n the stock market, i n i n v e s t i n g , there is n o t h i n g permanent except change. The investment manager s h o u l d t r y to cultivate a m i x of healthy s k e p t i c i s m , o p e n - m i n d e d n e s s , a n d w i l l i n g n e s s to l i s t e n . " A s J o h n T r a i n says: " T h e i r temperament does not change, so they go o n repeating the same patterns, i n this as i n a l l matters. A n d the e x t r a o r d i n a r y t h i n g is that they have m o r e confidence, not less as they repeat the same mistakes, because they t h i n k they have l e a r n e d f r o m their p r e v i o u s m i s f o r t u n e s . " Decisiveness A n i n v e s t o r often has to act i n face of imperfect i n f o r m a t i o n a n d a m b i g u o u s signals. Investment decisions generally c a l l for r e a c h i n g conclusions o n the basis of inadequate premises. T o succeed i n the investment game, the investor s h o u l d be decisive. If he procrastinates, he m a y m i s s v a l u a b l e o p p o r t u n i t i e s ; if he d i l l y d a l l i e s , he m a y have to forego gains. Decisiveness does not m e a n rashness. Rather, it refers to a n a b i l i t y to q u i c k l y w e i g h a n d balance a v a r i e t y of factors (some w e l l u n d e r s t o o d a n d some n o t - s o - w e l l u n d e r s t o o d ) , f o r m a basic j u d g m e n t , a n d act p r o m p t l y . It reflects the a b i l i t y to take decisions, after d o i n g the necessary h o m e w o r k of course, w i t h o u t b e i n g o v e r w h e l m e d b y uncertainties characterising the investment s i t u a t i o n . The most successful investors t e n d to be those w h o are w i l l i n g to m a k e b o l d p o s i t i o n s consistent w i t h their c o n v i c t i o n s . V a c i l l a t i o n a n d half-hearted c o m m i t m e n t s often p r o d u c e l a c k l u s t r e investment results. 1.8 | PROVERBIAL INVESTMENT W I S D O M

a m w

The m a r k e t is a d i s c o u n t i n g m e c h a n i s m . A c y n i c k n o w s the price of e v e r y t h i n g a n d the v a l u e of n o t h i n g . M o n e y management is 10 percent i n s p i r a t i o n a n d 90 percent p e r s p i r a t i o n , T o err is h u m a n , to hedge d i v i n e . N o stock is i n h e r e n t l y g o o d or b a d , it is the price that makes it so. N o price is too h i g h for a b u l l or too l o w for a bear. E v e r y t i m e a trade is m a d e , s o m e b o d y is w r o n g . R i d e the w i n n e r s a n d sell the losers. B u y o n the r u m o u r , sell o n the n e w s . Y o u never u n d e r s t a n d a stock unless y o u are l o n g (or short). Be l o n g - t e r m b u t w a t c h the ticks. N e v e r t h r o w g o o d m o n e y after the b a d . T o achieve s u p e r i o r performance, y o u have to be different f r o m the majority. T w o things cause a stock to m o v e t h e expected a n d the unexpected.

Overview *

23

N o tree g r o w s to the s k y . A pie doesn't g r o w t h r o u g h its s l i c i n g . N e v e r confuse b r i l l i a n c e w i t h a b u l l market. Successful m o n e y managers have brains, nerve, a n d l u c k . A l l generalisations are false, i n c l u d i n g this one. The market makes m o u n t a i n s out of m o l e h i l l s . Investigate, t h e n invest. The m e m o r y of p e o p l e i n the stock market is p r o v e r b i a l l y short. O p e n - r n i n d e d n e s s a n d i n d e p e n d e n t t h i n k i n g w i l l p a y b i g d i v i d e n d s i n the stock market. The F r e n c h say that it is o n l y a step f r o m the s u b l i m e to the r i d i c u l o u s . So, too, it seems o n l y a step f r o m c o m m o n stock investment to c o m m o n stock s p e c u l a t i o n . The market is a p e n d u l u m that s w i n g s back a n d forth t h r o u g h the m e d i a n line of rationality. The o n l y w a y to beat the m a r k e t is to d i s c o v e r a n d e x p l o i t other i n v e s t o r s ' mistakes. N o m o n e y manager can p e r f o r m successfully i n a l l k i n d s of market. There is n o m a n , for a l l seasons. Better is one forethought t h a n t w o after. The greatest of a l l gifts is the p o w e r to estimate things at their true w o r t h . S h a l l o w m e n believe i n l u c k , w i s e a n d strong m e n i n cause a n d effect. A n economist's guess is l i k e l y to be as g o o d as anyone else's. I d o n ' t k n o w w h a t the seven w o n d e r s of the w o r l d are, b u t I k n o w the e i g h t h c o m p o u n d interest. I n the stock market, a g o o d n e r v o u s system is m o r e i m p o r t a n t t h a n a g o o d h e a d . T i m e is the f r i e n d of stocks; the e n e m y of b o n d s . P o r t f o l i o d i v e r s i f i c a t i o n makes u p for investor ignorance. B u l l s m a k e m o n e y . Bears m a k e m o n e y . P i g s get slaughtered. There are t w o times i n a m a n ' s life w h e n he s h o u l d n ' t speculate. W h e n he can't afford it a n d w h e n he can: M a r k T w a i n . M e n , it has been w e l l s a i d , t h i n k i n herds; it w i l l be seen that they go m a d i n h e r d s w h i l e they o n l y recover their senses s l o w l y a n d one b y one: C h a r l e s Mackay. October. T h i s is one of the p e c u l i a r l y dangerous m o n t h s to speculate i n stocks. The others are J u l y , January, September, A p r i l , N o v e m b e r , M a y , M a r c h , June, December, A u g u s t a n d F e b r u a r y : M a r k T w a i n . It requires a great d e a l of boldness a n d a great d e a l of c a u t i o n to m a k e a great fortune.

24 SUMMARY

Investment Analysis and Portfolio

Management

The t w o k e y aspects of a n y investment are time a n d risk. A s an investor y o u have a w i d e range of i n v e s t m e n t avenues available to y o u . For e v a l u a t i n g a n investment avenue, the f o l l o w i n g attributes are relevant: rate of return, risk, m a r k e t a b i l i t y , tax shelter, a n d convenience. F i n a n c i a l markets facilitate price d i s c o v e r y , p r o v i d e l i q u i d i t y , a n d reduce the cost of t r a n s a c t i n g . F i n a n c i a l markets c a n be classified b y the nature of c l a i m (debt market versus equity market), m a t u r i t y of c l a i m (money m a r k e t v e r s u s c a p i t a l market), seasoning of c l a i m (primary m a r k e t versus s e c o n d a r y m a r k e t ) , t i m i n g of d e l i v e r y (spot m a r k e t v e r s u s f o r w a r d m a r k e t ) , a n d o r g a n i s a t i o n a l structure (exchange -traded m a r k e t versus over-the -counter m a r k e t ) . P o r t f o l i o management m a y be b r o k e n d o w n into the f o l l o w i n g steps: (i) specification of investment objectives a n d constraints, (ii) choice of asset m i x , (iii) f o r m u l a t i o n of p o r t f o l i o strategy, (iv) selection of securities, (v) p o r t f o l i o execution, (vi) p o r t f o l i o revision. Investors p u r s u e f o u r b r o a d approaches: f u n d a m e n t a l a p p r o a c h , p s y c h o l o g i c a l a p p r o a c h , academic a p p r o a c h , a n d eclectic a p p r o a c h . Investors are p r o n e to v a r i o u s errors i n m a n a g i n g their investments. C o n t r a r y t h i n k i n g , patience, c o m p o s u r e , flexibility, a n d decisiveness are i m p o r t a n t qualities to succeed i n the game of i n v e s t i n g .

QUESTIONS
1. Describe briefly the wide array of investment avenues. 2. Discuss the attributes that one should consider while evaluating an investment. 3. How do the following investments compare in terms of return, risk, marketability, tax shelter, and convenience: equity shares, bank deposits, public provident fund, residential house, and gold. 4. What are the key differences between an investor and a speculator? 5. Briefly describe the functions of financial markets. 6. Present a summary classification of financial markets. 7. Discuss briefly the key steps involved in the portfolio management process. 8. Describe briefly the following approaches to investment decision making: fundamental approach, and eclectic approach. 9. Discuss the common errors in investment management. 10. What qualities are required for successful investing?

Overview APPENDIX IA

25

THREE APPROACHES TO SUCCEED AS AN INVESTOR


A s C h a r l e s E l l i s a r g u e d , it appears that there are three different w a y s of e a r n i n g s u p e r i o r risk-adjusted returns o n the stock m a r k e t . The first is p h y s i c a l l y d i f f i c u l t , the second is intellectually difficult, a n d the t h i r d is p s y c h o l o g i c a l l y d i f f i c u l t . Physically Difficult Approach M a n y investors seem to f o l l o w this approach, w i t t i n g l y or u n w i t t i n g l y . They l o o k at newspapers a n d financial periodicals to learn about n e w issues, they visit the offices of brokers to get advice a n d a p p l i c a t i o n forms, a n d they regularly a p p l y i n the p r i m a r y market. T h e y f o l l o w the b u d g e t announcements intently, they read C M I E reports to learn about the developments i n the economy a n d various i n d u s t r i a l sectors, they read the c o l u m n s i n technical analysis, a n d they attend seminars a n d conferences. I n a nutshell, they a p p l y themselves assiduously, diligently, a n d even d o g g e d l y . They operate o n the premise that if they can be a step ahead of others, they w i l l o u t p e r f o r m the market. The p h y s i c a l l y d i f f i c u l t a p p r o a c h seems to have w o r k e d reasonably w e l l for most of the investors i n I n d i a since the late 1970s to the late 2000s, for three p r i n c i p a l reasons: 1. T y p i c a l l y , issues i n the p r i m a r y market have been p r i c e d v e r y attractively. 2. The s e c o n d a r y m a r k e t , t h a n k s to l i m i t e d c o m p e t i t i o n t i l l a l m o s t 1991, w a s characterised b y n u m e r o u s inefficiencies that p r o v i d e d r e w a r d i n g o p p o r t u n i t i e s to the d i l i g e n t investor. 3. A n a d v a n c i n g p r i c e - e a r n i n g m u l t i p l e , i n general, b a i l e d out e v e n i n e p t investors. T h i n g s , h o w e v e r , have c h a n g e d f r o m late 2000s. The o p p o r t u n i t i e s for s u b s c r i b i n g to issues i n the p r i m a r y m a r k e t h a v e s u b s t a n t i a l l y d r i e d u p as c o m p a n i e s , quite u n d e r s t a n d a b l y , are p l a c i n g securities w i t h i n s t i t u t i o n a l investors at prices that are f a i r l y close to the p r e v a i l i n g m a r k e t prices. L i k e w i s e , the scope for e a r n i n g s u p e r i o r returns i n the s e c o n d a r y m a r k e t has d i m i n i s h e d as the degree of c o m p e t i t i o n a n d efficiency is increasing, thanks to emergence of h u n d r e d s of n e w i n s t i t u t i o n a l p l a y e r s ( m u t u a l f u n d s , f o r e i g n i n s t i t u t i o n a l investors, m e r c h a n t b a n k i n g o r g a n i s a t i o n s , corporate bodies) a n d m i l l i o n s of n e w i n d i v i d u a l investors. F i n a l l y , the prospects of a f l u c t u a t i n g price-earnings m u l t i p l e seem to be greater t h a n the prospects of a rise i n the price-earnings m u l t i p l e . Intellectually Difficult Approach The i n t e l l e c t u a l l y d i f f i c u l t a p p r o a c h to successful i n v e s t i n g calls for d e v e l o p i n g a p r o f o u n d u n d e r s t a n d i n g of the nature of investments a n d h a m m e r i n g out a strategy based o n s u p e r i o r i n s i g h t s . T h i s a p p r o a c h has been f o l l o w e d m a i n l y b y the h i g h l y talented investors w h o have a n exceptional ability, a rare perceptiveness, a n u n u s u a l s k i l l , or a t o u c h of c l a i r v o y a n c e . S u c h a gift has been d i s p l a y e d b y investors l i k e B e n j a m i n G r a h a m , J o h n M a y n a r d K e y n e s , J o h n T e m p l e t o n , G e o r g e Soros, W a r r e n Buffett, P h i l Fisher, Peter L y n c h , a n d others.

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Management

Benjamin G r a h a m , w i d e l y acclaimed as the father of m o d e r n security analysis, w a s a n exceptionally gifted quantitative n a v i g a t o r w h o r e l i e d o n h a r d f i n a n c i a l facts a n d r e l i g i o u s l y a p p l i e d the ' m a r g i n of safety' p r i n c i p l e . J o h n M a y n a r d K e y n e s , a r g u a b l y the most i n f l u e n t i a l economist of the 2 0 C e n t u r y , achieved considerable investment success o n the basis of h i s sharp insights into market p s y c h o l o g y . J o h n T e m p l e t o n h a d a n u n u s u a l feel for b a r g a i n stocks a n d achieved remarkable success w i t h the h e l p of b a r g a i n stock i n v e s t i n g . W a r r e n Buffett, the most successful stock market investor of o u r times, is the quintessential l o n g t e r m v a l u e investor. G e o r g e Soros, a p h e n o m e n a l l y successful speculator, d e v e l o p e d a n d a p p l i e d a special insight w h i c h he labels as the ' r e f l e x i v i t y ' p r i n c i p l e . P h i l Fisher, a p r o m i n e n t g r o w t h stock advocate, d i s p l a y e d a rare ability w i t h r e g a r d to i n v e s t i n g i n g r o w t h stocks. Peter L y n c h , perhaps the most w i d e l y r e a d investment g u r u i n recent years, has p e r f o r m e d exceptionally w e l l , thanks to a rare degree of openness a n d f l e x i b i l i t y i n his a p p r o a c h . The intellectually d i f f i c u l t a p p r o a c h calls for a special talent that is d i l i g e n t l y h o n e d a n d n u r t u r e d over time. O b v i o u s l y , it c a n be practised o n l y b y a select f e w a n d y o u s h o u l d have the objectivity to d i s c e r n w h e t h e r y o u c a n j o i n this elite c l u b . R e m e m b e r that m a n y investors unrealistically believe that they have a rare gift because the stock market p r o v i d e s a n exceptionally fertile e n v i r o n m e n t for self-deception. Participants i n this m a r k e t c a n easily l i v e i n a w o r l d of m a k e believe b y accepting c o n f i r m i n g evidence a n d rejecting c o n t r a d i c t o r y e v i d e n c e . A s D a v i d D r e m a n says: " U n d e r c o n d i t i o n s of anxiety a n d uncertainty, w i t h a vast interacting i n f o r m a t i o n g r i d , the market c a n become a giant R o r s c h a c h test, a l l o w i n g the investor to see a n y pattern he w i s h e s ... experts cannot o n l y analyse i n f o r m a t i o n i n c o r r e c t l y , they c a n also f i n d relationships that aren't therea p h e n o m e n o n c a l l e d i l l u s o r y c o r r e l a t i o n . "
th

Psychologically Difficult Approach The stock market is p e r i o d i c a l l y s w a y e d b y t w o basic h u m a n e m o t i o n s , v i z . g r e e d a n d fear. W h e n greed a n d e u p h o r i a sweep the market, prices rise to d i z z y heights. O n the other h a n d , w h e n fear a n d despair e n v e l o p the market, prices fall to a b y s m a l l y l o w levels. If y o u c a n s u r m o u n t these emotions w h i c h c a n w a r p y o u r j u d g m e n t , create distortions i n y o u r t h i n k i n g , a n d i n d u c e y o u to c o m m i t follies, y o u are l i k e l y to achieve s u p e r i o r investment results. The p s y c h o l o g i c a l l y d i f f i c u l t a p p r o a c h essentially calls for f i n d i n g w a y s a n d means of substantially o v e r c o m i n g fear a n d greed. Its operational guidelines are as f o l l o w s : D e v e l o p a n investment p o l i c y a n d adhere to it consistently D o not try to forecast stock prices R e l y m o r e o n h a r d n u m b e r s a n d less o n j u d g m e n t M a i n t a i n a certain distance f r o m the marketplace Face uncertainty w i t h e q u a n i m i t y

These g u i d e l i n e s l o o k s i m p l e , b u t they are p s y c h o l o g i c a l l y d i f f i c u l t to f o l l o w . Yet, for the b u l k of the investors this appears to be the o n l y sensible a p p r o a c h to i m p r o v e the o d d s of their investment performance. Y o u have to a s s i d u o u s l y a n d c o n s c i o u s l y cultivate certain qualities, discussed i n the p r e c e d i n g chapter, to f o l l o w this a p p r o a c h .

Chapter 2

Investment Alternatives
Choices Galore

After studying this chapter you should be able to * Describe the features of financial assets, both marketable and non-marketable. * Determine the suitability of mutual funds for your needs. Understand the key considerations that need to be borne in mind before buying a life insurance policy. U Know the pros and cons of investing in real assets.

b e w i l d e r i n g range of investment alternatives is available. T h e y f a l l i n t o t w o b r o a d categories, v i z . , f i n a n c i a l assets a n d real assets. Financial assets are p a p e r (or electronic) c l a i m s o n some issuer s u c h as the g o v e r n m e n t o r a corporate b o d y . T h e i m p o r t a n t f i n a n c i a l assets are e q u i t y shares, corporate debentures, g o v e r n m e n t securities, deposit w i t h banks, m u t u a l f u n d shares, insurance policies, a n d d e r i v a t i v e instruments. Real assets are represented b y tangible assets l i k e r e s i d e n t i a l house, c o m m e r c i a l p r o p e r t y , a g r i c u l t u r a l f a r m , g o l d , p r e c i o u s stones, a n d art objects. A s the e c o n o m y advances, the relative importance of f i n a n c i a l assets tends to increase. O f course, b y and large the t w o forms of investments are c o m p l e m e n t a r y a n d not c o m p e t i t i v e . For sensible i n v e s t i n g , y o u s h o u l d be f a m i l i a r w i t h the characteristics a n d features of v a r i o u s investment alternatives before y o u . This chapter describes v a r i o u s investment alternatives. Since the emphasis of this b o o k is o n f i n a n c i a l assets, t h e y w i l l be discussed i n greater d e t a i l . A l t h o u g h the d i s c u s s i o n i s f a i r l y u p to date, the r a p i d changes i n the w o r l d of investments leads to the creation of n e w investment alternatives. If y o u u n d e r s t a n d the basic characteristics of major investment alternatives c u r r e n t l y available, y o u w i l l have the b a c k g r o u n d to u n d e r s t a n d n e w alternatives as they appear.

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Management

2.1 | NON-MARKETABLE FINANCIAL ASSETS


A g o o d p o r t i o n of the f i n a n c i a l assets of i n d i v i d u a l investors is h e l d i n the f o r m of n o n marketable f i n a n c i a l assets l i k e b a n k deposits, post office deposits, c o m p a n y deposits, a n d p r o v i d e n t f u n d deposits. A d i s t i n g u i s h i n g feature of these assets is that t h e y represent p e r s o n a l transactions b e t w e e n the investor a n d the issuer. F o r e x a m p l e , w h e n y o u o p e n a savings b a n k account at a b a n k , y o u d e a l w i t h the b a n k p e r s o n a l l y . I n contrast, w h e n y o u b u y e q u i t y shares i n the stock market y o u d o not k n o w w h o the seller is a n d y o u d o not care. The i m p o r t a n t non-marketable f i n a n c i a l assets h e l d b y investors are b r i e f l y described b e l o w : Bank Deposits P e r h a p s the s i m p l e s t of i n v e s t m e n t avenues, b y o p e n i n g a b a n k account a n d d e p o s i t i n g m o n e y i n it one can m a k e a b a n k deposit. There are v a r i o u s k i n d s of b a n k accounts: current account, savings account, a n d f i x e d deposit account. W h i l e a deposit i n a current account does not earn a n y interest, deposits i n other k i n d s of b a n k accounts earn interest. The i m p o r t a n t features of b a n k deposits are as f o l l o w s : D e p o s i t s i n s c h e d u l e d b a n k s are v e r y safe because of the r e g u l a t i o n s of the Reserve B a n k of I n d i a a n d the guarantee p r o v i d e d b y the D e p o s i t Insurance C o r p o r a t i o n , w h i c h guarantees deposits u p t o Rs 100,000 per depositor of a b a n k . There is a c e i l i n g o n the interest rate p a y a b l e o n deposits i n the savings account. The interest rate o n f i x e d deposits varies w i t h the t e r m of the deposit. In general, it is l o w e r for f i x e d deposits of shorter t e r m a n d h i g h e r for f i x e d deposits of longer t e r m . * If the d e p o s i t p e r i o d is less t h a n 90 d a y s , the interest is p a i d o n m a t u r i t y ; otherwise it is generally p a i d quarterly. B a n k deposits enjoy exceptionally h i g h l i q u i d i t y . Banks n o w offer customers the facility of p r e m a t u r e w i t h d r a w a l s of a p o r t i o n or w h o l e of f i x e d deposits. S u c h w i t h d r a w a l s w o u l d earn interest rates c o r r e s p o n d i n g to the p e r i o d s for w h i c h they are d e p o s i t e d . L o a n s c a n be r a i s e d against b a n k deposits. a F o r s a v i n g s b a n k accounts, m o s t b a n k s calculate interest o n the m i n i m u m d e p o s i t b e t w e e n the 1 0 a n d the last date of the m o n t h . So the best w a y to m a x i m i s e returns o n y o u r savings account is to treat it l i k e a current account b e t w e e n the 1 a n d the 10 , a n d a f i x e d deposit for the rest of the m o n t h .
th st th

Post Office Savings Account A post office savings account is s i m i l a r to a savings b a n k account. Its salient features are as f o l l o w s : The interest rate is 3.5 percent per a n n u m . The interest is tax exempt. The a m o u n t of first d e p o s i t s h o u l d be at least R s . 20 for a n o r d i n a r y account a n d Rs. 250 for a c h e c k i n g account. The m a x i m u m balance that c a n be h e l d is R s . 50,000 for a single account a n d Rs. 100,000 for a joint account.

Investment Alternatives Post Office Time Deposits (POTDs) P O T D S have the f o l l o w i n g features:

29

S i m i l a r to f i x e d deposits of c o m m e r c i a l b a n k s ,

D e p o s i t s can be m a d e i n m u l t i p l i e s of R s . 50 w i t h o u t a n y l i m i t . The interest rates o n P O T D s are, i n general, s l i g h t l y h i g h e r t h a n those o n b a n k deposits. The interest is calculated h a l f - y e a r l y a n d p a i d a n n u a l l y . N o w i t h d r a w a l is p e r m i t t e d u p t o six m o n t h s . A f t e r six m o n t h s , w i t h d r a w a l s are p e r m i t t e d . H o w e v e r , o n w i t h d r a w a l s m a d e b e t w e e n six m o n t h s a n d one year, n o interest is p a y a b l e . O n w i t h d r a w a l s after one year, b u t before the t e r m of deposit, interest is p a i d for the p e r i o d the deposit has been h e l d , subject to a p e n a l d e d u c t i o n of 2 percent. m A P O T D account c a n be p l e d g e d . Deposits i n 10 years to 15 years Post Office C u m u l a t i v e T i m e D e p o s i t A c c o u n t c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . Monthly Income Scheme of the Post Office (MISPO) A p o p u l a r scheme of the post office, the M I S P O is meant to p r o v i d e regular m o n t h l y i n c o m e to the depositors. The salient features of this scheme are as f o l l o w s : The t e r m of the scheme is 6 years. The m i n i m u m a m o u n t of investment is R s . 1,000. The m a x i m u m investment c a n be R s . 300,000 i n a single account or R s . 600,000 i n a joint account. T h e interest rate is 8.0 percent per a n n u m , p a y a b l e m o n t h l y . A b o n u s of 10 percent is payable o n m a t u r i t y . There is n o tax d e d u c t i o n at source. There is a f a c i l i t y of p r e m a t u r e w i t h d r a w a l after one year, w i t h 5 percent d e d u c t i o n before 3 years. Kisan Vikas Patra (KVP) A scheme of the post office, the K i s a n V i k a s Patra has the f o l l o w i n g features: The m i n i m u m a m o u n t of investment is R s . 1,000. There is n o m a x i m u m l i m i t . The investment doubles i n 8 years a n d 7 m o n t h s . H e n c e the c o m p o u n d interest rate w o r k s out to 8.4 percent. There is n o tax d e d u c t i o n at source. m K V P s c a n be p l e d g e d as a collateral security for r a i s i n g loans. There is a w i t h d r a w a l facility after 2 Vi years. National Savings Certificate has the f o l l o w i n g features: Issued at the post offices, N a t i o n a l S a v i n g s Certificate

It comes i n d e n o m i n a t i o n s of R s . 100, R s . 500, R s . 1,000, R s . 5,000 a n d R s . 10,000. It has a t e r m of 6 years. O v e r this p e r i o d R s . 100 becomes R s . 160.1. H e n c e the c o m p o u n d rate of r e t u r n w o r k s out to 8.16 percent. The investment i n N S C c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C .

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There is n o tax d e d u c t i o n at source. It c a n be p l e d g e d as a collateral for r a i s i n g loans. Company Deposits M a n y companies, large a n d s m a l l , solicit f i x e d deposits f r o m the p u b l i c . F i x e d deposits m o b i l i s e d b y m a n u f a c t u r i n g c o m p a n i e s are r e g u l a t e d b y the C o m p a n y L a w B o a r d a n d f i x e d deposits m o b i l i s e d b y finance c o m p a n i e s (more precisely n o n - b a n k i n g finance companies) are regulated b y the Reserve B a n k of I n d i a . The k e y features of c o m p a n y deposits i n I n d i a are as f o l l o w s : F o r a m a n u f a c t u r i n g c o m p a n y the t e r m of deposits c a n be one to three years, whereas for a n o n - b a n k i n g finance c o m p a n y it can v a r y b e t w e e n 25 m o n t h s to five years. A m a n u f a c t u r i n g c o m p a n y c a n m o b i l i s e , b y w a y of f i x e d deposits, a n a m o u n t e q u a l to 25 percent of its w o r t h f r o m the p u b l i c a n d a n a d d i t i o n a l a m o u n t e q u a l to 10 percent of its w o r t h f r o m its shareholders. A n o n - b a n k i n g finance c o m p a n y , however, can mobilise a higher amount. The interest rates o n c o m p a n y deposits are h i g h e r t h a n those o n b a n k f i x e d deposits. C o m p a n y deposits have to be necessarily credit-rated. D e p o s i t o r s d o n ' t get a n y tax benefit o n c o m p a n y deposits. H o w e v e r n o i n c o m e tax is d e d u c t e d at source if the interest i n c o m e is u p t o R s . 5,000 i n a f i n a n c i a l year. C o m p a n i e s offer some incentives l i k e facility for p r e m a t u r e w i t h d r a w a l or free p e r s o n a l accident insurance cover to attract deposits. Employee Provident Fund Scheme A major vehicle of savings for salaried employees, the p r o v i d e n t f u n d scheme has the f o l l o w i n g features: m E a c h e m p l o y e e has a separate p r o v i d e n t f u n d account i n w h i c h b o t h the e m p l o y e r a n d e m p l o y e e are r e q u i r e d to contribute a certain m i n i m u m a m o u n t o n a m o n t h l y basis. The e m p l o y e e can choose to contribute a d d i t i o n a l a m o u n t s , subject to certain restrictions. a W h i l e the c o n t r i b u t i o n m a d e b y the e m p l o y e r is f u l l y tax exempt ( f r o m the p o i n t of v i e w of the e m p l o y e e ) , the c o n t r i b u t i o n s m a d e b y the e m p l o y e e c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . P r o v i d e n t f u n d c o n t r i b u t i o n s c u r r e n t l y e a r n a c o m p o u n d interest rate of 8.5 percent per a n n u m that is totally exempt f r o m taxes. The interest h o w e v e r is a c c u m u l a t e d i n the p r o v i d e n t f u n d account a n d n o t p a i d a n n u a l l y to the employee. The balance i n the p r o v i d e n t f u n d account is f u l l y e x e m p t f r o m w e a l t h tax. Further, it is not subject to attachment u n d e r a n y order or decree of a court. W i t h i n certain l i m i t s , the e m p l o y e e is eligible to take a l o a n against the p r o v i d e n t f u n d balance p e r t a i n i n g to h i s contributions o n l y .

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31

Public Provident Fund Scheme O n e of the m o s t attractive i n v e s t m e n t avenues available i n I n d i a , the P u b l i c P r o v i d e n t F u n d (PPF) scheme has the f o l l o w i n g f e a t u r e s : m I n d i v i d u a l s a n d H U F s c a n participate i n this scheme. A P P F account m a y be o p e n e d at a n y b r a n c h of the State B a n k of I n d i a or its subsidiaries or at specified branches of the other p u b l i c sector b a n k s . * T h o u g h the p e r i o d of a P P F account is stated to be 15 years, the n u m b e r of contributions has to be 16. T h i s is because the 15 year p e r i o d is calculated f r o m the f i n a n c i a l year f o l l o w i n g the date o n w h i c h the account is o p e n e d . T h u s , a P P F account matures o n the first d a y of the 1 7 year. The subscriber to a P P F account is r e q u i r e d to m a k e a m i n i m u m d e p o s i t of Rs. 100 per year. The m a x i m u m p e r m i s s i b l e deposit per year is Rs 70,000. Deposits i n a P P F account can be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . P P F deposits c u r r e n t l y earn a c o m p o u n d interest rate of 8.0 percent per a n n u m , w h i c h is totally exempt f r o m taxes. The interest, h o w e v e r , is a c c u m u l a t e d i n the P P F account a n d not p a i d a n n u a l l y to the subscriber. The balance i n a P P F account is f u l l y exempt f r o m w e a l t h tax. Further, it is not subject to attachment u n d e r a n y order or decree of a court. * The subscriber to a P P F account is e l i g i b l e to take a l o a n f r o m the t h i r d year to the s i x t h year after o p e n i n g the P P F account. T h e a m o u n t of l o a n cannot exceed 25 percent of the balance s t a n d i n g to the c r e d i t of the P P F account at the e n d of the s e c o n d p r e c e d i n g f i n a n c i a l y e a r . T h e i n t e r e s t p a y a b l e o n s u c h a l o a n is 1 p e r c e n t h i g h e r t h a n the P P F a c c o u n t i n t e r e s t r a t e . * T h e s u b s c r i b e r t o a P P F a c c o u n t c a n m a k e one w i t h d r a w a l e v e r y y e a r f r o m the s i x t h y e a r to the f i f t e e n t h y e a r . T h e a m o u n t of w i t h d r a w a l c a n n o t exceed 50 p e r c e n t of the b a l a n c e at the e n d of the f o u r t h p r e c e d i n g y e a r or the y e a r i m m e d i a t e l y p r e c e d i n g the year of w i t h d r a w a l , w h i c h e v e r is l o w e r , less the a m o u n t of l o a n , if a n y . T h e w i t h d r a w a l c a n be p u t to a n y use a n d is n o t r e q u i r e d to be r e f u n d e d . m O n m a t u r i t y , the c r e d i t balance i n a P P F account c a n be w i t h d r a w n . H o w e v e r , at the o p t i o n of the s u b s c r i b e r , the account c a n be c o n t i n u e d for three successive b l o c k p e r i o d s of f i v e years each, w i t h or w i t h o u t d e p o s i t s . D u r i n g the extensions the account h o l d e r c a n m a k e one w i t h d r a w a l p e r year, subject to the c o n d i t i o n that the total a m o u n t w i t h d r a w n d u r i n g a 5-year b l o c k does n o t exceed 60 percent of the balance to the c r e d i t of the account at the b e g i n n i n g .
th

2.2

MONEY MARKET INSTRUMENTS

Debt instruments, w h i c h h a v e a m a t u r i t y of less t h a n one year at the time of issue are c a l l e d m o n e y m a r k e t i n s t r u m e n t s . These i n s t r u m e n t s are h i g h l y l i q u i d a n d h a v e n e g l i g i b l e r i s k . The major m o n e y m a r k e t instruments are T r e a s u r y bills, certificates of deposit, c o m m e r c i a l p a p e r , a n d repos. The m o n e y m a r k e t is d o m i n a t e d b y the g o v e r n m e n t , f i n a n c i a l institutions, b a n k s , a n d corporates. I n d i v i d u a l investors scarcely

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participate i n the m o n e y m a r k e t d i r e c t l y . A brief d e s c r i p t i o n of m o n e y instruments is g i v e n b e l o w .

Treasury Bills. Treasury b i l l s are the most i m p o r t a n t m o n e y m a r k e t instrument. T h e y represent the obligations of the G o v e r n m e n t of I n d i a w h i c h have a p r i m a r y tenor l i k e 91 d a y s a n d 364 days. T h e y are s o l d o n a n a u c t i o n basis every w e e k i n certain m i n i m u m d e n o m i n a t i o n s b y the Reserve B a n k of I n d i a . T h e y d o not carry a n explicit interest rate (or c o u p o n rate). Instead, they are s o l d at a discount a n d r e d e e m e d at p a r . H e n c e the i m p l i c i t y i e l d of a T r e a s u r y b i l l is a f u n c t i o n of the size of the d i s c o u n t a n d the p e r i o d of maturity. T h o u g h the y i e l d o n T r e a s u r y b i l l s is s o m e w h a t l o w , they h a v e a p p e a l for the f o l l o w i n g reasons: T h e y can be transacted r e a d i l y a n d there is a v e r y active secondary m a r k e t for t h e m . Treasury b i l l s have n i l credit r i s k a n d negligible price r i s k (thanks to their short tenor). Certificates of Deposits Certificates of deposits (CDs) represent short t e r m deposits w h i c h are transferable f r o m one p a r t y to another. B a n k s a n d f i n a n c i a l institutions are the major issuers of C D s . T h e p r i n c i p a l investors i n C D s are b a n k s , f i n a n c i a l institutions, corporates, a n d m u t u a l f u n d s . C D s are i s s u e d i n bearer or registered f o r m . T h e y generally have a m a t u r i t y of 3 m o n t h s to 1 year. C D s carry a certain interest rate. C D s are a p o p u l a r f o r m of short-term investment for m u t u a l f u n d s a n d c o m p a n i e s for the f o l l o w i n g reasons: Banks are n o r m a l l y w i l l i n g to tailor the d e n o m i n a t i o n s a n d maturities to suit the needs of the investors. C D s are generally risk-free. C D s generally offer a h i g h e r rate of interest t h a n Treasury b i l l s or t e r m deposits. C D s are transferable. Commercial Paper C o m m e r c i a l p a p e r represents short-term u n s e c u r e d p r o m i s s o r y notes i s s u e d b y f i r m s that are generally c o n s i d e r e d to be f i n a n c i a l l y strong. C o m m e r c i a l paper u s u a l l y has a m a t u r i t y p e r i o d of 90 days to 180 days. It is s o l d at a d i s c o u n t a n d r e d e e m e d at p a r . H e n c e the i m p l i c i t rate is a f u n c t i o n of the size of d i s c o u n t a n d the p e r i o d of m a t u r i t y . Repos The t e r m " r e p o " is u s e d as a n a b b r e v i a t i o n for R e p u r c h a s e A g r e e m e n t or R e a d y F o r w a r d . A " r e p o " i n v o l v e s a simultaneous "sale a n d r e p u r c h a s e " agreement. A " r e p o " w o r k s as f o l l o w s . P a r t y A needs short-term f u n d s a n d P a r t y B w a n t s to m a k e a short-term investment. P a r t y A sells securities to P a r t y B at a certain price a n d s i m u l t a n e o u s l y agrees to repurchase the same after a specified time at a s l i g h t l y h i g h e r p r i c e . The difference b e t w e e n the sale p r i c e a n d the repurchase price represents the interest cost to P a r t y A a n d conversely the interest i n c o m e for P a r t y B.

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A "reverse r e p o " is the opposite of a " r e p o " i t i n v o l v e s an i n i t i a l purchase of a n asset f o l l o w e d b y a subsequent sale. It is a safe a n d convenient f o r m of short-term investment.

2.3

BONDS OR DEBENTURES

B o n d s or debentures represent l o n g - t e r m debt i n s t r u m e n t s . The issuer of a b o n d p r o m i s e s to p a y a s t i p u l a t e d stream of cash f l o w s . T h i s generally comprises of p e r i o d i c interest p a y m e n t s over the life of the i n s t r u m e n t a n d p r i n c i p a l p a y m e n t at the time of redemption(s). This section discusses the f o l l o w i n g instruments: G o v e r n m e n t securities, RBI savings b o n d s , private sector debentures, P S U bonds, a n d preference shares. Government Securities D e b t securities i s s u e d b y the central g o v e r n m e n t , state g o v e r n m e n t , a n d quasi-government agencies are referred to as g o v e r n m e n t securities or g i l t - e d g e d securities. Three types of instruments are i s s u e d . A n investment that resembles a c o m p a n y debenture. It carries the n a m e of the holder(s) a n d is registered w i t h the P u b l i c D e b t Office ( P D O ) . F o r transfer, it has to be l o d g e d w i t h the P D O a l o n g w i t h a d u l y c o m p l e t e d transfer d e e d . The P D O pays interest to the holders registered w i t h it o n the specified date of p a y m e n t . A p r o m i s s o r y note, issued to the o r i g i n a l h o l d e r , w h i c h contains a p r o m i s e b y the President of I n d i a (or the G o v e r n o r of State) to p a y as per a g i v e n schedule. It can be transferred to a b u y e r b y a n endorsement b y the seller. The current h o l d e r has to present the note to the g o v e r n m e n t T r e a s u r y (or a designated a u t h o r i s e d agency) to receive interest a n d other p a y m e n t s . A bearer security, w h e r e the interest a n d other p a y m e n t s are m a d e to the h o l d e r of the security. G o v e r n m e n t securities have maturities r a n g i n g f r o m 3-20 years a n d carry interest rates that u s u a l l y v a r y b e t w e e n 7 a n d 10 percent. E v e n t h o u g h these securities carry some tax advantages, they have t r a d i t i o n a l l y not a p p e a l e d to i n d i v i d u a l investors because of l o w rates of interest a n d l o n g m a t u r i t i e s a n d s o m e w h a t i l l i q u i d r e t a i l markets. T h e y are t y p i c a l l y h e l d b y banks, f i n a n c i a l institutions, insurance companies, a n d p r o v i d e n t f u n d s m a i n l y because of certain statutory c o m p u l s i o n s . Savings Bonds at
1

A p o p u l a r instrument, R B I Savings Bonds have the f o l l o w i n g features:

I n d i v i d u a l s , H U F s , a n d N R I s can invest i n these b o n d s . The m i n i m u m a m o u n t of investment is R s . 1,000. There is n o m a x i m u m l i m i t , The m a t u r i t y p e r i o d is 5 years f r o m the date of issue. There are t w o options: the c u m u l a t i v e o p t i o n a n d the n o n - c u m u l a t i v e o p t i o n .

Technically they are called Government of India Savings Bonds. Since they are issued by the Reserve Bank of India, they are popularly referred to as RBI Savings Bonds.

MM MM.

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The interest rate is 8.0 percent per a n n u m , p a y a b l e h a l f - y e a r l y . U n d e r the c u m u l a t i v e o p t i o n R s . 1,000 becomes R s . 1,480 after 5 years. n The interest earned is taxable. The b o n d s are exempt f r o m w e a l t h tax w i t h o u t any limit. The b o n d s are i s s u e d i n the f o r m of B o n d L e d g e r A c c o u n t or i n the f o r m of P r o m i s s o r y N o t e s . B o n d L e d g e r A c c o u n t c a n be o p e n e d i n the n a m e of the investors at the r e c e i v i n g offices (designated offices of banks) a n d at the P u b l i c Debt Offices of R B I . B o n d s i n the f o r m of P r o m i s s o r y N o t e s are i s s u e d o n l y at R B I offices. The b o n d s are transferable. The B o n d L e d g e r A c c o u n t is transferable, w h o l l y or i n part, b y e x e c u t i o n of a p r e s c r i b e d transfer d e e d . P r o m i s s o r y N o t e s are transferable b y endorsement a n d d e l i v e r y . * N o m i n a t i o n facility is available. The b o n d s c a n be offered as security to banks for a v a i l i n g loans. Private Sector Debentures A k i n to p r o m i s s o r y notes, debentures are i n s t r u m e n t s meant for r a i s i n g l o n g t e r m debt. The o b l i g a t i o n of a c o m p a n y t o w a r d s its debenture holders is s i m i l a r to that of a b o r r o w e r w h o p r o m i s e s to p a y interest a n d p r i n c i p a l at specified times. The i m p o r t a n t features of debentures are as f o l l o w s : W h e n a debenture issue is s o l d to the i n v e s t i n g p u b l i c , a trustee is a p p o i n t e d t h r o u g h a d e e d . The trustee is u s u a l l y a b a n k or a financial institution. Entrusted w i t h the role of protecting the interest of debentureholders, the trustee is responsible for e n s u r i n g that the b o r r o w i n g f i r m fulfils its contractual obligations. * T y p i c a l l y , debentures are secured b y a charge o n the i m m o v a b l e properties, b o t h present a n d future, of the c o m p a n y b y w a y of a n equitable mortgage. * A l l debenture issues w i t h a m a t u r i t y p e r i o d of m o r e t h a n 18 m o n t h s m u s t be necessarily c r e d i t - r a t e d . F u r t h e r , for s u c h debenture issues, a D e b e n t u r e R e d e m p t i o n Reserve ( D R R ) has to be created. The c o m p a n y s h o u l d create a D R R e q u i v a l e n t to at least 50 percent of the a m o u n t of issue before r e d e m p t i o n commences. P r e v i o u s l y the c o u p o n rate (or interest rate) o n debentures w a s subject to c e i l i n g f i x e d b y the M i n i s t r y of Finance. N o s u c h c e i l i n g a p p l i e s n o w . A c o m p a n y is free to choose the c o u p o n rate. Further, the rate m a y be f i x e d or f l o a t i n g . I n the latter case it is p e r i o d i c a l l y d e t e r m i n e d i n relation to some b e n c h m a r k rate. E a r l i e r the average r e d e m p t i o n p e r i o d for n o n - c o n v e r t i b l e debentures w a s s u p p o s e d to be about seven years. N o w there is n o s u c h restriction. A c o m p a n y has f r e e d o m to choose the r e d e m p t i o n (maturity) p e r i o d . Debentures sometimes carry a ' c a l l ' feature w h i c h p r o v i d e s the i s s u i n g c o m p a n y w i t h a n o p t i o n to r e d e e m the debentures at a certain price before the m a t u r i t y date. Sometimes, the debentures m a y have a ' p u t ' feature w h i c h gives the h o l d e r the r i g h t to seek r e d e m p t i o n at specified times at p r e d e t e r m i n e d prices. Debentures m a y have a convertible clause w h i c h gives the debentureholder the o p t i o n to convert the debentures i n t o e q u i t y shares o n certain terms a n d conditions that are pre-specified.

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Public Sector Undertaking Bonds P u b l i c Sector U n d e r t a k i n g s (PSUs) issue debentures that are referred to as P S U b o n d s . There are t w o b r o a d varieties of P S U b o n d s : taxable b o n d s a n d tax free b o n d s . W h i l e P S U s are free to set the interest rates o n taxable b o n d s , they cannot offer m o r e t h a n a certain interest rate o n tax-free b o n d s w h i c h is f i x e d b y the M i n i s t r y of Finance. M o r e i m p o r t a n t , a P S U c a n issue tax-free b o n d s o n l y w i t h the p r i o r a p p r o v a l of the M i n i s t r y of Finance. In general, P S U b o n d s h a v e the f o l l o w i n g i n v e s t o r - f r i e n d l y features: (a) there is n o d e d u c t i o n of tax at source o n the interest p a i d o n these b o n d s , (b) they are transferable b y mere endorsement a n d d e l i v e r y , (c) there is n o stamp d u t y a p p l i c a b l e o n transfer, a n d (d) they are t r a d e d o n the stock exchanges. I n a d d i t i o n , some institutions are r e a d y to b u y a n d sell these b o n d s w i t h a s m a l l p r i c e difference. Preference Shares Preference shares represent a h y b r i d security that partakes some characteristics of e q u i t y shares a n d some attributes of debentures. T h e salient features of preference shares are as f o l l o w s : Preference shares carry a f i x e d rate of d i v i d e n d . Preference d i v i d e n d is p a y a b l e o n l y o u t of distributable p r o f i t s . H e n c e , w h e n there is i n a d e q u a c y of distributable profits, the question of p a y i n g preference d i v i d e n d does n o t arise. D i v i d e n d o n preference shares is generally c u m u l a t i v e . D i v i d e n d s k i p p e d i n one year has to be p a i d subsequently before e q u i t y d i v i d e n d c a n be p a i d . Preference shares are redeemable- the r e d e m p t i o n p e r i o d is u s u a l l y 7 to 12 years. C u r r e n t l y preference d i v i d e n d is tax-exempt.

2.4

= EQUITY SHARES

E q u i t y capital represents o w n e r s h i p capital. E q u i t y shareholders c o l l e c t i v e l y o w n the c o m p a n y . T h e y bear the r i s k a n d enjoy the r e w a r d s of o w n e r s h i p . O f a l l the f o r m s of securities, e q u i t y shares appear to be the most r o m a n t i c . W h i l e f i x e d i n c o m e investment avenues m a y be m o r e i m p o r t a n t to most of the investors, equity shares seem to capture their interest the most. T h e p o t e n t i a l r e w a r d s a n d penalties associated w i t h e q u i t y shares m a k e t h e m a n interesting, e v e n e x c i t i n g , p r o p o s i t i o n . N o w o n d e r , e q u i t y investment is a favourite topic of conversation i n parties a n d get-togethers. Terminology The a m o u n t of capital that a c o m p a n y c a n issue as p e r its m e m o r a n d u m represents the authorised capital. T h e a m o u n t offered b y the c o m p a n y to the investors is called the issued capital. That part of the i s s u e d capital that has been s u b s c r i b e d to b y the investors is called the subscribed capital; the actual a m o u n t p a i d is c a l l e d the paid-up capital. T y p i c a l l y , the i s s u e d , subscribed, a n d p a i d - u p capital are the same. The par value is stated i n the m e m o r a n d u m a n d w r i t t e n o n the share s c r i p . T h e p a r v a l u e of e q u i t y shares is generally R s . 10 or R e 1. Infrequently, one comes across p a r v a l u e s l i k e R s . 5, R s . 50, a n d R s . l,000.There is a p r o p o s a l to m a k e the p a r v a l u e u n i f o r m l y at Re 1. T h e issue p r i c e is the price at w h i c h the e q u i t y share is i s s u e d . W h e n the issue price exceeds the p a r v a l u e , the difference is referred to as the share p r e m i u m .

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N o t e that the issue price cannot be, as per l a w , l o w e r than the par v a l u e . The book value of a n e q u i t y share is e q u a l to: P a i d - u p equity capital + Reserves a n d surplus N u m b e r of outstanding equity shares Q u i t e n a t u r a l l y , the b o o k v a l u e of a n e q u i t y share tends to increase as the ratio of reserves a n d s u r p l u s to the p a i d - u p e q u i t y capital increases. The market value of a n equity share is the price at w h i c h it is t r a d e d i n the market. This price can be easily established for a c o m p a n y that is listed o n the stock market a n d actively t r a d e d . For a c o m p a n y that is listed o n the stock market b u t t r a d e d v e r y i n f r e q u e n t l y , it is d i f f i c u l t to obtain a reliable market quotation. F o r a c o m p a n y that is not l i s t e d o n the stock market, one can m e r e l y conjecture as to w h a t its market price w o u l d be if it were t r a d e d . Rights of Equity Shareholders the f o l l o w i n g rights: A s o w n e r s of the c o m p a n y , equity shareholders enjoy

E q u i t y shareholders have a r e s i d u a l c l a i m to the income of the f i r m . T h i s means that the p r o f i t after tax less preference d i v i d e n d belongs to e q u i t y shareholders. H o w e v e r , the b o a r d of directors has the prerogative to decide h o w it s h o u l d be s p l i t b e t w e e n d i v i d e n d s a n d r e t a i n e d earnings. D i v i d e n d s p r o v i d e current i n c o m e to e q u i t y shareholders a n d r e t a i n e d earnings t e n d to increase the intrinsic v a l u e of equity shares. N o t e that equity d i v i d e n d s are presently taxexempt i n the h a n d s of the recipient. The c o m p a n y p a y i n g the d i v i d e n d is r e q u i r e d to p a y the d i v i d e n d d i s t r i b u t i o n tax. E q u i t y shareholders elect the b o a r d of directors a n d have the right to vote o n every r e s o l u t i o n p l a c e d before the c o m p a n y . The b o a r d of directors, i n t u r n , a p p o i n t s the top management of the f i r m . H e n c e , e q u i t y shareholders, i n theory, exercise a n indirect control over the operations of the f i r m . In practice, h o w e v e r , e q u i t y shareholdersscattered, i l l - o r g a n i s e d , passive, a n d indifferent as they often are - f a i l to exercise their collective p o w e r effectively. E q u i t y shareholders enjoy the p r e - e m p t i v e right w h i c h enables t h e m to m a i n t a i n their p r o p o r t i o n a l o w n e r s h i p b y p u r c h a s i n g the a d d i t i o n a l equity shares i s s u e d b y the f i r m . The l a w requires companies to g i v e existing e q u i t y shareholders the first o p p o r t u n i t y to p u r c h a s e , o n a p r o rata basis, a d d i t i o n a l issue of e q u i t y c a p i t a l . F o r e x a m p l e , if y o u o w n 1,000 e q u i t y shares i n a c o m p a n y that has 1,000,000 o u t s t a n d i n g shares, y o u are entitled to subscribe to 200 shares if the c o m p a n y proposes to issue 200,000 a d d i t i o n a l shares. The equity shareholders of the c o m p a n y m a y , h o w e v e r , forfeit this right p a r t i a l l y or totally, to enable the c o m p a n y to m a k e a p u b l i c issue. A s i n the case of i n c o m e , e q u i t y shareholders have a r e s i d u a l c l a i m over the assets of the c o m p a n y i n the event of l i q u i d a t i o n . C l a i m s of a l l othersdebenture h o l d e r s , secured lenders, u n s e c u r e d lenders, preferred shareholders, a n d other creditorsare p r i o r to the c l a i m of e q u i t y shareholders.

Investment Alternatives Stock Market Classification shares as f o l l o w s : Blue-chip Shares Growth Shares

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In stock m a r k e t parlance, it is c u s t o m a r y to classify e q u i t y

Shares of large, well-established, a n d f i n a n c i a l l y s t r o n g companies w i t h a n i m p r e s s i v e r e c o r d of earnings a n d d i v i d e n d s . Shares of c o m p a n i e s that h a v e a f a i r l y entrenched p o s i t i o n i n a g r o w i n g m a r k e t a n d w h i c h enjoy a n above average rate of g r o w t h as w e l l as p r o f i t a b i l i t y . Shares of companies that h a v e f a i r l y stable operations, relatively l i m i t e d g r o w t h o p p o r t u n i t i e s , a n d h i g h d i v i d e n d p a y o u t ratios. Shares of c o m p a n i e s that have a p r o n o u n c e d c y c l i c a l i t y i n their operations. Shares of companies that are relatively unaffected b y the u p s a n d d o w n s i n general business c o n d i t i o n s . Shares that t e n d to fluctuate w i d e l y because there is a l o t of speculative t r a d i n g i n t h e m .

Income Shares Cyclical Shares Defensive Shares Speculative Shares

N o t e that the above classification is o n l y i n d i c a t i v e . It s h o u l d not be r e g a r d e d as r i g i d a n d straitjacketed. O f t e n y o u can't p i g e o n h o l e a share e x c l u s i v e l y i n a single category. I n fact, m a n y shares m a y fall i n t o t w o (or e v e n more) categories. Peter Lynch's Classification There are different w a y s of c l a s s i f y i n g shares. H e r e is Peter L y n c h ' s classification of companies (and, b y d e r i v a t i o n shares). Slow Growers Stalwarts Fast Growers Cyclicals Turnarounds L a r g e a n d a g e i n g c o m p a n i e s that are expected to g r o w s l i g h t l y faster t h a n the gross n a t i o n a l p r o d u c t . G i a n t companies that are faster t h a n s l o w g r o w e r s b u t are not agile climbers. S m a l l , aggressive n e w enterprises that g r o w at 10 to 25 percent a year. C o m p a n i e s w h o s e sales a n d p r o f i t rise a n d fall i n a regular, t h o u g h not completely predictable, f a s h i o n . C o m p a n i e s w h i c h are steeped i n a c c u m u l a t e d losses b u t w h i c h s h o w signs of recovery. T u r n a r o u n d c o m p a n i e s have the p o t e n t i a l to m a k e u p lost g r o u n d q u i c k l y . C o m p a n i e s that h a v e v a l u a b l e assets w h i c h h a v e been s o m e w h a t o v e r l o o k e d b y the stock market.

Asset Plays

Nature of Equity Shares Benjamin G r a h a m has described the nature of e q u i t y shares, referred to as c o m m o n stocks i n the U . S . , v e r y a p t l y : "Common stocks have one important investment characteristic and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the re-investment of undistributed earnings. However, most of the time

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common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble, i.e., to give way to hope, fear, and greed".

MUTUAL FUND SCHEMES

If y o u f i n d it d i f f i c u l t or c u m b e r s o m e to i n v e s t d i r e c t l y i n e q u i t y shares a n d debt instruments, y o u c a n invest i n these f i n a n c i a l assets i n d i r e c t l y t h r o u g h a m u t u a l f u n d . A m u t u a l f u n d represents a vehicle for collective investment. W h e n y o u participate i n a scheme of a m u t u a l f u n d , y o u become a p a r t - o w n e r of the investments h e l d u n d e r that scheme. T i l l 1986 the U n i t Trust of I n d i a w a s the o n l y m u t u a l f u n d i n I n d i a o f f e r i n g a s m a l l n u m b e r of schemes. A s the m u t u a l f u n d sector w a s liberalised, n e w entrants came into the f i e l d . A t present, there are about 30 m u t u a l f u n d s o f f e r i n g over 1000 schemes. In I n d i a , the f o l l o w i n g entities are i n v o l v e d i n a m u t u a l f u n d operation: the sponsor, the m u t u a l f u n d , the trustees, the asset management c o m p a n y ( A M C ) , the c u s t o d i a n , a n d the registrars a n d transfer agents. M u t u a l f u n d schemes invest i n three b r o a d categories of f i n a n c i a l assets, v i z . stocks, b o n d s , a n d cash. Stocks refer to e q u i t y a n d equity-related instruments. B o n d s are debt instruments that h a v e a m a t u r i t y of m o r e t h a n one year. C a s h represents b a n k deposits a n d debt instruments that have a m a t u r i t y of less than one year. D e p e n d i n g o n the asset m i x , m u t u a l f u n d schemes are classified into three b r o a d types, v i z . e q u i t y schemes, h y b r i d schemes, a n d debt schemes. E q u i t y schemes invest the b u l k of their c o r p u s , 85-95 percent or e v e n m o r e , i n stocks a n d the balance i n cash. H y b r i d schemes, also referred to as balanced schemes, invest i n a m i x of stocks a n d debt instruments. D e b t schemes invest i n b o n d s a n d cash. W i t h i n each of these b r o a d categories, there are several variants as s h o w n i n the a c c o m p a n y i n g b o x . Schemes Galore I. E q u i t y Schemes * * D i v e r s i f i e d e q u i t y schemes Index schemes Sectoral schemes Tax p l a n n i n g schemes

II. H y b r i d (Balanced) Schemes E q u i t y - o r i e n t e d schemes s? Debt-oriented schemes V a r i a b l e asset allocation schemes III. Debt Schemes a * m G i l t schemes M i x e d schemes F l o a t i n g rate debt schemes C a s h (liquid) schemes

Investment Alternatives

39

M u t u a l f u n d s i n I n d i a are c o m p r e h e n s i v e l y r e g u l a t e d u n d e r the S E B I ( M u t u a l F u n d s ) R e g u l a t i o n , 1996. Some of the i m p o r t a n t p r o v i s i o n s of this r e g u l a t i o n are as follows: A m u t u a l f u n d s h a l l be constituted i n the f o r m of a trust executed b y the sponsor i n f a v o u r of the trustees. T h e sponsor o r , if so a u t h o r i s e d b y the trust d e e d , the trustees s h a l l a p p o i n t a n asset management c o m p a n y ( A M C ) . The m u t u a l f u n d shall appoint a custodian. N o scheme s h a l l be l a u n c h e d b y the A M C unless it is a p p r o v e d b y the trustees a n d a c o p y of the offer d o c u m e n t has been f i l e d w i t h SEBI. T h e offer d o c u m e n t a n d advertisement materials s h a l l n o t be m i s l e a d i n g . N o guaranteed r e t u r n s h a l l be p r o v i d e d i n a scheme unless s u c h returns are f u l l y guaranteed b y the sponsor or the A M C . The m o n e y s collected u n d e r a n y m o n e y m a r k e t scheme of a m u t u a l f u n d s h a l l be invested o n l y i n m o n e y market instruments i n accordance w i t h directions i s s u e d b y the Reserve B a n k of I n d i a . T h e m u t u a l f u n d s h a l l n o t b o r r o w except to meet t e m p o r a r y l i q u i d i t y needs. T h e net asset v a l u e ( N A V ) a n d the sale a n d repurchase p r i c e of m u t u a l f u n d schemes m u s t be r e g u l a r l y p u b l i s h e d i n d a i l y n e w s p a p e r s . E v e r y A M C s h a l l keep a n d m a i n t a i n p r o p e r b o o k s of accounts, records, a n d d o c u m e n t s for each scheme. T h e investments of a m u t u a l f u n d are subject to several restrictions relating to e x p o s u r e to stocks of i n d i v i d u a l c o m p a n i e s , debt i n s t r u m e n t s of i n d i v i d u a l issuers, so o n a n d so f o r t h . Costs associated w i t h m u t u a l f u n d i n v e s t i n g s u c h as i n i t i a l expenses, loads (entry a n d exit), a n d a n n u a l r e c u r r i n g expenses are subject to certain ceilings. F o r most of the i n d i v i d u a l investors, m u t u a l f u n d s represent a n excellent vehicle for i n v e s t i n g i n d i r e c t l y i n stocks, b o n d s , a n d cash. H o w e v e r , there are some disadvantages as w e l l . T h e p r o s a n d cons of m u t u a l f u n d i n v e s t i n g are s u m m a r i s e d b e l o w . Pros Diversification Professional management Liquidity T a x advantages Comprehensive regulation Transparency Cons Expenses L a c k of t h r i l l

2.6

FINANCIAL DERIVATIVES

A d e r i v a t i v e is a n i n s t r u m e n t w h o s e v a l u e d e p e n d s o n the v a l u e of some u n d e r l y i n g asset. H e n c e , it m a y be v i e w e d as a side bet o n that asset. F r o m the p o i n t of v i e w of

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investors a n d p o r t f o l i o managers, futures a n d o p t i o n s are the t w o most i m p o r t a n t f i n a n c i a l d e r i v a t i v e s . T h e y are u s e d for h e d g i n g a n d s p e c u l a t i o n . T r a d i n g i n these derivatives has b e g u n i n I n d i a . Futures A futures contract is a n agreement b e t w e e n t w o parties to exchange a n asset for cash at a p r e d e t e r m i n e d future date for a price that is specified today. The p a r t y w h i c h agrees to purchase the asset is s a i d to have a long position a n d the p a r t y w h i c h agrees to sell the asset is s a i d to have a short position. The p a r t y h o l d i n g the l o n g p o s i t i o n benefits if the price increases, whereas the p a r t y h o l d i n g the short p o s i t i o n loses if the price increases a n d vice versa. T o illustrate this p o i n t , consider a futures contract b e t w e e n t w o parties, v i z . , A a n d B. A agrees to b u y 1000 shares of A c m e C h e m i c a l s at Rs. 100 f r o m B to be d e l i v e r e d 90 d a y s hence. A has a l o n g p o s i t i o n a n d B has a short p o s i t i o n . O n the 9 0 d a y , if the price of A c m e C h e m i c a l s h a p p e n s to be Rs. 105, A gains R s . 5,000 [1000 x (105 - 1 0 0 ) ] whereas B loses R s . 5000. O n the other h a n d , if the price of A c m e C h e m i c a l s o n the 9 0 d a y h a p p e n s to be R s . 95, A loses Rs. 5000 [1000 x (95 - 100)] whereas B gains Rs. 5000.
th th

Options A n o p t i o n gives its owner the right to b u y or sell a n u n d e r l y i n g asset (our focus here w i l l be o n equity shares) o n or before a g i v e n date at a predetermined price. N o t e that options represent a special k i n d of financial contract u n d e r w h i c h the o p t i o n holder enjoys the right (for w h i c h he pays a price), but has n o obligation, to d o something. There are t w o basic types of options: c a l l options a n d p u t options. A c a l l o p t i o n gives the o p t i o n h o l d e r the r i g h t to b u y a f i x e d n u m b e r of shares of a certain stock, at a g i v e n exercise price o n or before the e x p i r a t i o n date. T o enjoy this o p t i o n , the o p t i o n b u y e r (holder) p a y s a p r e m i u m to the o p t i o n w r i t e r (seller) w h i c h is n o n - r e f u n d a b l e . The w r i t e r (seller) of the c a l l o p t i o n is o b l i g e d to sell the shares at the specified price, if the b u y e r chooses to exercise the o p t i o n . A p u t o p t i o n gives the o p t i o n h o l d e r the right to sell a f i x e d n u m b e r of shares of a certain stock at a g i v e n exercise price o n or before the e x p i r a t i o n date. T o enjoy this right, the o p t i o n b u y e r (holder) p a y s a n o n - r e f u n d a b l e p r e m i u m to the o p t i o n seller (writer). The w r i t e r of the p u t o p t i o n is o b l i g e d to b u y the shares at the specified price, if the o p t i o n h o l d e r chooses to exercise the o p t i o n . 2.7 = LIFE I N S U R A N C E
2

The basic customer needs met b y life insurance policies are p r o t e c t i o n a n d savings. Policies that p r o v i d e protection benefits are d e s i g n e d to protect the p o l i c y h o l d e r (or h i s dependents) f r o m the f i n a n c i a l consequence of u n w e l c o m e events s u c h as death or l o n g - t e r m sickness/disability. Policies that are d e s i g n e d as savings contracts a l l o w the p o l i c y h o l d e r to b u i l d u p f u n d s to meet specific investment objectives s u c h as i n c o m e i n retirement or r e p a y m e n t of a l o a n . I n practice, m a n y p o l i c i e s p r o v i d e a m i x t u r e of savings a n d p r o t e c t i o n benefits.
2

This section has been contributed by Dr K. Sriram.

Investment Alternatives The c o m m o n types of insurance policies are: Endowment Assurance M o n e y Back P l a n Whole Life Assurance Unit Linked Plan Term Assurance Immediate A n n u i t y Deferred A n n u i t y Riders

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Endowment Assurance There are b a s i c a l l y t w o variants of this p o l i c y : (a) N o n P a r t i c i p a t i n g ( W i t h o u t Profit) E n d o w m e n t A s s u r a n c e , (b) P a r t i c i p a t i n g ( W i t h Profit) Endowment Assurance. Non-Participating Endowment Assurance T h i s p o l i c y offers a g u a r a n t e e d a m o u n t of m o n e y (the " s u m assured") at the m a t u r i t y date of the p o l i c y i n exchange for a single p r e m i u m at the start of the p o l i c y or a series of regular p r e m i u m s t h r o u g h o u t the t e r m of the p o l i c y . If the p o l i c y h o l d e r dies before the m a t u r i t y date then u s u a l l y the same s u m assured is p a i d o n death. O f course, the p o l i c y c o u l d be s t r u c t u r e d w i t h a s u m assured p a i d o n death, w h i c h is different f r o m that p a i d at m a t u r i t y . The p o l i c y h o l d e r m a y be a l l o w e d to surrender the p o l i c y before m a t u r i t y a n d receive a l u m p s u m (surrender v a l u e or cash value) at the t i m e , o n g u a r a n t e e d or n o n guaranteed terms. If the p o l i c y h o l d e r w i s h e s to keep the p o l i c y i n force w i t h o u t p a y i n g further p r e m i u m s , a r e d u c e d s u m assured (paid u p v a l u e or p a i d u p s u m assured) m a y be granted. There is u s u a l l y a p r o v i s i o n to take a l o a n u p to 90% of the surrender v a l u e . Participating Endowment Assurance The structure of this p o l i c y is s i m i l a r to that of the n o n - p a r t i c i p a t i n g p o l i c y except that the i n i t i a l s u m assured u n d e r the p o l i c y is expected to be e n h a n c e d b y p a y m e n t of bonuses ( d i s t r i b u t i o n of the p r o f i t s m a d e b y the insurance c o m p a n y ) to the p o l i c y h o l d e r . I n the I n d i a n context, bonuses u s u a l l y take the f o r m of a d d i t i o n s to the i n i t i a l s u m assured a n d become payable i n the event of the occurrence of the i n s u r e d event, i.e. s u r v i v a l u p to the m a t u r i t y date or earlier death. H o w e v e r , some life insurance companies p r o v i d e bonuses (dividends) as regular cash p a y m e n t s . I n this case, the p o l i c y h o l d e r m a y have the o p t i o n of u s i n g the cash b o n u s to offset the future p r e m i u m s p a y a b l e . Money Back Plan T h i s is a p o p u l a r savings c u m protection p o l i c y because it p r o v i d e s l u m p s u m at p e r i o d i c intervals. F o r example, g i v e n a n i n i t i a l s u m assured of Rs. 1000 a n d a t e r m of 20 years, the p o l i c y m a y p r o v i d e for part p a y m e n t of the s u m assured as follows: * II 2 0 % at the e n d of 5 years 20% at the e n d of 10 years 20% at the e n d of 15 years 40% at the e n d of 20 years

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T h i s p o l i c y is u s u a l l y sweetened b y p r o v i d i n g a guaranteed a d d i t i o n to the i n i t i a l s u m assured every year. T h e m o n e y b a c k p o l i c y illustrated above is a n o n - p a r t i c i p a t i n g p o l i c y . The p o l i c y can also be offered i n the " p a r t i c i p a t i n g " format i n w h i c h case the guaranteed a d d i t i o n s w i l l be replaced b y " b o n u s e s " . A s w i t h e n d o w m e n t assurance, a surrender v a l u e o n guaranteed or non-guaranteed terms m a y be p a i d if the p o l i c y h o l d e r chooses to w i t h d r a w f r o m p o l i c y . A l t e r n a t i v e l y the p o l i c y h o l d e r m a y have the o p t i o n of c o n v e r t i n g the p o l i c y i n t o a p a i d - u p p o l i c y . U s u a l l y there is n o l o a n facility attached to this p o l i c y . Whole Life Assurance T h i s p o l i c y p r o v i d e s a benefit o n the death of the p o l i c y h o l d e r w h e n e v e r that m i g h t occur. Basically it p r o v i d e s l o n g - t e r m f i n a n c i a l protection to the dependents. It is p a r t i c u l a r l y u s e f u l as a means of p r o t e c t i n g some of the expected w e a l t h transfer that a parent w o u l d be a i m i n g to m a k e to h i s or her c h i l d r e n w h e n he or she d i e d . W i t h o u t this p o l i c y , the w e a l t h transfer is l i k e l y to be v e r y s m a l l if the parent d i e d y o u n g . S u c h policies can also be a tax efficient w a y of transferring w e a l t h at a n y age d e p e n d i n g o n legislation (often r e d u c i n g the l i a b i l i t y to inheritance tax). There are b o t h n o n - p a r t i c i p a t i n g a n d p a r t i c i p a t i n g v e r s i o n s of this p o l i c y . N o n p a r t i c i p a t i n g policies offer a guaranteed s u m assured o n death. U n d e r p a r t i c i p a t i n g p o l i c i e s , the i n i t i a l g u a r a n t e e d s u m a s s u r e d m a y be increased b y b o n u s e s or cash r e f u n d s m a y be g i v e n . W i t h e n d o w m e n t assurance, a benefit m a y be p a i d if the p o l i c y h o l d e r chooses to w i t h d r a w f r o m the p o l i c y . S i m i l a r l y , there m a y be a " p a i d u p " p o l i c y o p t i o n . T h e p o l i c y h o l d e r m a y also h a v e the o p t i o n of t a k i n g a l o a n u p to say 90% of the surrender value. Unit Linked Plan A u n i t - l i n k e d p l a n is also a n i n v e s t m e n t - o r i e n t e d p r o d u c t . A s c o m p a r e d to other investment plans, the investment p o r t i o n of the u n i t l i n k e d p l a n functions l i k e a m u t u a l f u n d . It is invested i n a p o r t f o l i o of debt a n d e q u i t y instruments, i n c o n f o r m i t y w i t h the a n n o u n c e d investment p o l i c y . H e n c e , it g r o w s or erodes i n l i n e w i t h the performance of that p o r t f o l i o . O f course, t h r o u g h o u t the p e r i o d of investment, the p o l i c y h o l d e r enjoys a n insurance cover as s t i p u l a t e d . Term Assurance T h i s is a p u r e protection p o l i c y , w h i c h p r o v i d e s a benefit o n the death of the p o l i c y h o l d e r w i t h i n a s p e c i f i e d t e r m , say 5 years or 10 years or 20 years or w h a t e v e r . P r e m i u m s m a y be p a i d r e g u l a r l y over the t e r m of the p o l i c y (or some shorter p e r i o d ) o r as a single p r e m i u m at the outset. G e n e r a l l y , there is n o p a y m e n t if the p o l i c y h o l d e r s u r v i v e s to the e n d of the p o l i c y . H o w e v e r , there are t e r m assurance policies, w h i c h offer some p r o p o r t i o n of p r e m i u m s p a i d o n s u r v i v a l to the m a t u r i t y date of the p o l i c y . A p o p u l a r v a r i a n t of the t e r m assurance p o l i c y is the decreasing t e r m assurance p o l i c y u n d e r w h i c h the s u m assured decreases over the t e r m of the p o l i c y . T h i s type of p o l i c y can be u s e d to meet t w o s u c h specific needs. First, it c a n be u s e d to repay the balance o u t s t a n d i n g u n d e r a l o a n (like house mortgage) i n the event of death of the

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p o l i c y h o l d e r . S e c o n d l y , it c a n be u s e d to p r o v i d e a n i n c o m e for the f a m i l y of the deceased p o l i c y h o l d e r f r o m the time of death u p to the e n d of the p o l i c y term. T e r m assurance policies are t y p i c a l l y offered i n the n o n - p a r t i c i p a t i n g format. These policies are u s u a l l y structured w i t h n o " s u r r e n d e r v a l u e " a n d " p a i d u p " p o l i c y o p t i o n s . The m a i n attraction of a t e r m assurance p o l i c y is that it p r o v i d e s a death benefit at a l o w e r cost t h a n u n d e r a n e n d o w m e n t or w h o l e life p o l i c y for the same l e v e l of benefit. Immediate Annuity T h i s type of p o l i c y meets the p o l i c y h o l d e r ' s n e e d for a regular i n c o m e , for e x a m p l e , after his or her retirement. The p o l i c y can also be structured to p r o v i d e a n i n c o m e for a l i m i t e d p e r i o d , for e x a m p l e to p a y the s c h o o l fees of the i p o l i c y h o l d e r ' s c h i l d r e n . The r e g u l a r income is p u r c h a s e d b y p a y i n g a single p r e m i u m at the i n c e p t i o n of the p o l i c y . Strictly s p e a k i n g the regular i n c o m e ceases o n the death of the p o l i c y h o l d e r . There are h o w e v e r variants of this p o l i c y u n d e r w h i c h a (reduced) i n c o m e m a y be p a i d to the spouse (of the p o l i c y h o l d e r ) over his or her lifetime; or the single p r e m i u m m a y be r e t u r n e d to the dependents of the deceased p o l i c y h o l d e r . Immediate annuities c a n be offered either i n the n o n - p a r t i c i p a t i n g format or i n the p a r t i c i p a t i n g format. I n the case of a p a r t i c i p a t i n g a n n u i t y the i n c o m e p a i d to the p o l i c y h o l d e r is a guaranteed a m o u n t p l u s a b o n u s a d d e d b y the insurance c o m p a n y . U s u a l l y n o p a y m e n t is m a d e to the annuitant o n w i t h d r a w a l . P u t differently, there is n o surrender v a l u e o p t i o n associated w i t h this type of p o l i c y . Deferred Annuity The u s u a l structure of this p o l i c y is that the p o l i c y h o l d e r p a y s regular p r e m i u m s for a p e r i o d u p to the specified " v e s t i n g d a t e " . These p r e m i u m s b u y a m o u n t s of r e g u l a r i n c o m e , payable to the p o l i c y h o l d e r f r o m the v e s t i n g date. A single p r e m i u m at the start of the p o l i c y is a possible alternative to regular p r e m i u m s . A d e f e r r e d a n n u i t y enables the p o l i c y h o l d e r to b u i l d u p a p e n s i o n that becomes payable o n his or her retirement f r o m g a i n f u l e m p l o y m e n t . A t the v e s t i n g date of the a n n u i t y , the alternative of a l u m p s u m m a y be offered i n l i e u of p a r t or a l l of the p e n s i o n , thereby m e e t i n g a n y n e e d for a cash s u m at that p o i n t , for e x a m p l e to p a y o f f a housing loan. Riders R i d e r s are a d d - o n s to the life insurance policies described above. These a d d ons c a n be p u r c h a s e d w i t h the base p o l i c y o n p a y m e n t of a s m a l l a d d i t i o n a l p r e m i u m . The c o m m o n l y offered riders i n the I n d i a n context are: * A c c i d e n t a l D e a t h Benefit ( A D B ) R i d e r C r i t i c a l Illness (CI) R i d e r W a i v e r of P r e m i u m (WoP) R i d e r Term Rider A t the time of w r i t i n g , the tax breaks f r o m a p o l i c y h o l d e r ' s perspective are

Tax Breaks as f o l l o w s :

The p r e m i u m payable u n d e r a life insurance p o l i c y c a n be d e d u c t e d f r o m taxable i n c o m e u n d e r Section 80 C of the Income T a x A c t , 1961. I n the case of a n i n d i v i d u a l , the insurance p o l i c y c a n be o n the life of the i n d i v i d u a l or o n the life

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of the spouse of the i n d i v i d u a l or o n the life of a n y c h i l d of the i n d i v i d u a l . The d e d u c t i o n u n d e r Section 80 C is also available for p r e m i u m s p a y a b l e u n d e r a n o n - c o m m u t a b l e deferred a n n u i t y a n d for c o n t r i b u t i o n m a d e b y the i n d i v i d u a l to a n y n o t i f i e d p e n s i o n f u n d set u p b y a M u t u a l F u n d or b y the U T I . M The p r e m i u m p a i d b y a n i n d i v i d u a l u n d e r a n a n n u i t y p l a n of the L i f e Insurance C o r p o r a t i o n of I n d i a or of a n y other i n s u r e r (as a p p r o v e d b y the I R D A ) is d e d u c t i b l e f r o m the taxable i n c o m e of that i n d i v i d u a l subject to a m a x i m u m a m o u n t of Rs. 10,000 [Section 80 C C C of the Income Tax A c t ] . A n y s u m received u n d e r a life insurance p o l i c y , i n c l u d i n g the s u m allocated b y w a y of b o n u s o n s u c h p o l i c y is exempt f r o m tax u n d e r Section 10 (10D) of the Income Tax A c t . Considerations in Choosing a Policy choosing a policy. Bear i n m i n d the f o l l o w i n g considerations i n

R e v i e w y o u r o w n insurance needs a n d circumstances. C h o o s e the k i n d of p o l i c y that has benefits that m o s t closely fit y o u r needs. A life insurance agent or a f i n a n c i a l a d v i s o r can h e l p y o u i n this task. m Be sure that y o u c a n h a n d l e p r e m i u m p a y m e n t s . C a n y o u a f f o r d the i n i t i a l p r e m i u m ? If the p r e m i u m increases later a n d y o u still need insurance, can y o u still afford it? D o n ' t b u y life insurance unless y o u i n t e n d to stick w i t h y o u r p l a n . It m a y be v e r y costly if y o u q u i t d u r i n g the early years of the p o l i c y ' s t e r m . If y o u are t h i n k i n g of s u r r e n d e r i n g y o u r insurance p o l i c y or r e p l a c i n g it w i t h a n e w one, y o u s h o u l d c a r e f u l l y assess the surrender v a l u e a n d the rights a n d benefits of the n e w p o l i c y v i s - a - v i s the existing p o l i c y .

2.8

REAL ASSETS

U n l i k e f i n a n c i a l assets, real assets are tangible or p h y s i c a l i n nature. The major types of real assets are as f o l l o w s : A . R e a l Estate R e s i d e n t i a l house Commercial property U r b a n and semi-urban land Agricultural farm T i m e share i n a h o l i d a y resort B . Precious M e t a l s Gold Silver C . Precious Stones Diamonds Others

Chapter 3

Securities Market
The Battlefield
LEARNING OBJECTIVES!! After studying this chapter you should be able to 8 $ Discuss the different ways in which a company may raise equity capital in the primary market. * Explain the functioning of the stock market in India. * Describe the distinctive features of the National Stock Exchange and the Bombay Stock Exchange. * Read stock market quotations and describe the construction of stock market indices. * Explain the functioning of the government securities market, corporate debt market, and money market in India.

^he Sensex falls b y 360 p o i n t s i n a d a y of hectic t r a d i n g . The Reserve B a n k of I n d i a l o w e r s the r e p o rate b y 25 basis p o i n t s . The G o v e r n m e n t of I n d i a raises 4500 crore rupees b y i s s u i n g b o n d s w i t h a m a t u r i t y of 10 years. So o n a n d so forth. A l l these are examples of securities m a r k e t at w o r k . M o s t p e o p l e are a w a r e that this m a r k e t has a n i m p o r t a n t b e a r i n g o n m o d e r n life a n d g l i b l y speak of " D a l a i Street," the " g i l t - e d g e d m a r k e t , " a n d the " N i f t y " w i t h a s o m e w h a t v a g u e u n d e r s t a n d i n g of these terms. T h i s chapter explains h o w the securities m a r k e t w o r k s . The securities m a r k e t is the m a r k e t for e q u i t y , debt, a n d d e r i v a t i v e s . The debt market, i n t u r n , m a y be d i v i d e d into three parts, v i z . , the g o v e r n m e n t securities market, the corporate debt m a r k e t , a n d the m o n e y m a r k e t . The d e r i v a t i v e s m a r k e t , i n t u r n , m a y be d i v i d e d i n t o t w o parts, v i z . , the options m a r k e t a n d the futures m a r k e t . The structure of the securities m a r k e t is s h o w n i n E x h i b i t 3.1. Except the derivatives m a r k e t , each of the above markets has t w o components, v i z . , the p r i m a r y m a r k e t a n d the secondary m a r k e t . The m a r k e t w h e r e n e w securities are i s s u e d is c a l l e d the p r i m a r y m a r k e t a n d the m a r k e t w h e r e o u t s t a n d i n g securities are traded is called the secondary m a r k e t . T h i s chapter focuses o n the e q u i t y m a r k e t a n d the debt m a r k e t .

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Screen-based System I n the screen-based system, the t r a d i n g r i n g is replaced b y the c o m p u t e r screen a n d distant p a r t i c i p a n t s c a n trade w i t h each other t h r o u g h the c o m p u t e r n e t w o r k . A large n u m b e r of participants, g e o g r a p h i c a l l y separated, c a n trade s i m u l t a n e o u s l y at h i g h speeds. T h e screen-based t r a d i n g s y s t e m (a) enhances the i n f o r m a t i o n a l efficiency of the market as m o r e participants trade at a faster speed; (b) p e r m i t s the m a r k e t participants to get a f u l l v i e w of the market, w h i c h increases their confidence i n the m a r k e t ; a n d (c) establishes transparent a u d i t trails. W h i l e c o m p u t e r i s e d t r a d i n g is m o r e efficient, it d e c i d e d l y lacks the v i b r a n c y a n d v i t a l i t y of the t r a d i t i o n a l f l o o r t r a d i n g . T e c h n o l o g y seems to h a v e its o w n w a y of p u s h i n g c o l o u r f u l traditions a n d practices into o b l i v i o n .

Block Deals A b l o c k d e a l is a d e a l i n v o l v i n g a m i n i m u m q u a n t i t y of f i v e l a k h shares or a m i n i m u m v a l u e of R s . 5 crore. There is a separate w i n d o w for b l o c k deals o n B S E and N S E . These deals c a n take place o n l y b e t w e e n 9.55 a . m a n d 10.25 a . m . B l o c k deals i n v o l v e s i m u l t a n e o u s large scale b u y a n d sell transactions at a p r e d e t e r m i n e d p r i c e . T h i s is different f r o m the u s u a l price d i s c o v e r y m e c h a n i s m i n w h i c h a n u m b e r of b u y e r s a n d sellers compete against each other. T h e p u r p o s e of h a v i n g a separate w i n d o w a n d m e c h a n i s m for b l o c k deals is to check i n t r a - d a y v o l a t i l i t y a n d prevent d i s r u p t i o n of n o r m a l t r a d i n g . I n essence, b l o c k deals are negotiated transactions outside the exchange. H o w e v e r , they are g i v e n effect i n a p r e d e t e r m i n e d m a n n e r o n the exchange, p r i m a r i l y for r e p o r t i n g p u r p o s e s . T i l l 1994, t r a d i n g o n the stock m a r k e t i n I n d i a w a s based o n the o p e n outcry system. W i t h the establishment of the N a t i o n a l Stock Exchange i n 1994, I n d i a entered the era of screen-based t r a d i n g . W i t h i n a short s p a n of time, screen-based t r a d i n g has s u p p l a n t e d the o p e n o u t c r y system o n a l l the stock exchanges i n the c o u n t r y , thanks to SEBI's i n i t i a t i v e i n this respect. N o c o u n t r y has a c h i e v e d s u c h a t r a n s f o r m a t i o n so r a p i d l y . T h e k i n d of screen-based t r a d i n g s y s t e m a d o p t e d i n I n d i a is referred to as the o p e n electronic l i m i t order b o o k ( E L O B ) m a r k e t system. T h e k e y features of this s y s t e m are as f o l l o w s : Buyers a n d sellers place their orders o n the c o m p u t e r . These orders m a y be l i m i t orders or m a r k e t orders. A limit order pre-specifies the price l i m i t . F o r e x a m p l e , a l i m i t order to b u y at a price of R s . 90 means that the trader w a n t s to b u y at a price n o t greater t h a n R s . 90. L i k e w i s e , a l i m i t order to sell at a price of R s . 95 means that the trader w a n t s to s e l l at a p r i c e n o t less t h a n R s . 95. A market order is a n order to b u y or sell at the best p r e v a i l i n g p r i c e . A m a r k e t order to sell w i l l be executed at the highest b i d p r i c e whereas a m a r k e t o r d e r to b u y w i l l be executed as the lowest ask price.

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Investment Analysis and Portfolio Exhibit 3.1

Management

Structure of the Securities Market

Securities Market

Government Securities Market

3.1

PARTICIPANTS IN THE SECURITIES MARKET

The I n d i a n securities m a r k e t comprises of a n u m b e r of participants as described b e l o w : Regulators The k e y agencies that have a s i g n i f i c a n t r e g u l a t o r y i n f l u e n c e , direct or indirect, over the securities m a r k e t are c u r r e n t l y as f o l l o w s : The C o m p a n y L a w B o a r d ( C L B ) w h i c h is responsible for the a d m i n i s t r a t i o n of the C o m p a n i e s A c t , 1956. T h e Reserve B a n k of I n d i a (RBI) w h i c h is p r i m a r i l y responsible, inter alia, for the s u p e r v i s i o n of b a n k s , m o n e y market, a n d g o v e r n m e n t securities m a r k e t . The Securities a n d Exchange B o a r d of I n d i a (SEBI) w h i c h is responsible for the r e g u l a t i o n of the capital market, The D e p a r t m e n t of E c o n o m i c A f f a i r s ( D E A ) , a n a r m of the g o v e r n m e n t , w h i c h , inter alia, is concerned w i t h the o r d e r l y f u n c t i o n i n g of the f i n a n c i a l markets as a whole. The D e p a r t m e n t of C o m p a n y A f f a i r s ( D C A ) , a n a r m of the government, w h i c h is responsible for the a d m i n i s t r a t i o n of corporate b o d i e s .

a a

Stock Exchanges A stock exchange is a n i n s t i t u t i o n w h e r e securities that have a l r e a d y been i s s u e d are b o u g h t a n d s o l d . Presently there are 23 stock exchanges i n I n d i a , the most i m p o r t a n t ones b e i n g the N S E a n d B S E . Listed Securities Securities that are listed o n v a r i o u s stock exchanges a n d hence eligible for b e i n g t r a d e d there are c a l l e d l i s t e d securities. P r e s e n t l y about 10,000 securities are listed o n a l l the stock exchanges i n I n d i a p u t together.

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Depositories A d e p o s i t o r y is a n i n s t i t u t i o n w h i c h dematerialises p h y s i c a l certificates a n d effects transfer of o w n e r s h i p b y electronic b o o k entries. Presently there are t w o depositories i n I n d i a , v i z . , the N a t i o n a l Securities D e p o s i t o r y L i m i t e d ( N S D L ) a n d the C e n t r a l Securities D e p o s i t o r y L i m i t e d ( C S D L ) . Brokers B r o k e r s are registered m e m b e r s of the stock exchanges t h r o u g h w h o m investors transact. There are about 10,000 brokers i n I n d i a . Foreign Institutional Investors Institutional investors f r o m a b r o a d w h o are registered w i t h S E B I to operate i n the I n d i a n c a p i t a l m a r k e t are c a l l e d f o r e i g n i n s t i t u t i o n a l investors. There are about 600 of t h e m a n d they have e m e r g e d as a major force i n the I n d i a n market. Merchant Bankers F i r m s that specialise i n m a n a g i n g the issue of securities are c a l l e d merchant bankers. T h e y have to be registered w i t h S E B I . Primary Dealers A p p o i n t e d b y the R B I , p r i m a r y dealers serve as u n d e r w r i t e r s i n the p r i m a r y m a r k e t a n d as m a r k e t m a k e r s i n the s e c o n d a r y m a r k e t for g o v e r n m e n t securities. Mutual Funds A m u t u a l f u n d is a v e h i c l e f o r collective i n v e s t m e n t . It p o o l s a n d manages the f u n d s of investors. There are about 30 m u t u a l f u n d s i n I n d i a . Custodians A c u s t o d i a n looks after the investment back office of a m u t u a l f u n d . It receives a n d d e l i v e r s securities, collects i n c o m e , distributes d i v i d e n d s , a n d segregates the assets b e t w e e n schemes. Registrars A l s o k n o w n as a transfer agent, a registrar is e m p l o y e d b y a c o m p a n y or a m u t u a l f u n d to h a n d l e a l l investor-related services. Underwriters A n u n d e r w r i t e r agrees to subscribe to a g i v e n n u m b e r of shares (or a n y other security) i n the event the p u b l i c s u b s c r i p t i o n is inadequate. The u n d e r w r i t e r , i n essence, stands guarantee for p u b l i c s u b s c r i p t i o n . Bankers to an Issue The bankers to a n issue collect m o n e y o n behalf of the c o m p a n y f r o m the applicants. Debenture Trustees W h e n debentures are i s s u e d b y a c o m p a n y , a debenture trustee has to be a p p o i n t e d to ensure that the b o r r o w i n g f i r m fulfills its contractual obligations. Venture Capital Funds A venture c a p i t a l f u n d is a p o o l of capital w h i c h is essentially invested i n e q u i t y shares or e q u i t y - l i n k e d instruments of u n l i s t e d c o m p a n i e s . Credit Rating Agencies securities. A credit r a t i n g agency assigns ratings p r i m a r i l y to debt

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3.2

= PRIMARY EQUITY MARKET

A l t h o u g h the e q u i t y market i n I n d i a has been f u n c t i o n i n g since the late nineteenth century, the p r i m a r y e q u i t y market, also c a l l e d the n e w issues market, r e m a i n e d rather d u l l a n d inactive, b a r r i n g occasional b u t brief bursts of activity, t i l l 1991. I n 1992, the C o n t r o l of C a p i t a l Issues A c t w a s a b o l i s h e d a n d S E B I w a s e n t r u s t e d w i t h the r e s p o n s i b i l i t y of r e g u l a t i n g the p r i m a r y market. A series of initiatives taken b y SEBI, a l o n g w i t h a m o r e c o n d u c i v e e n v i r o n m e n t that e m e r g e d i n the w a k e of e c o n o m i c reforms, i m p a r t e d a s t r o n g f i l l i p to the p r i m a r y market. Some of the i m p o r t a n t changes i n t r o d u c e d b y SEBI are w o r t h m e n t i o n i n g . b Free Pricing C o m p a n i e s h a v e b e e n g i v e n f r e e d o m i n p r i c i n g their e q u i t y shares a n d d e t e r m i n i n g the interest rate structure o n their debt securities. a Disclosure and Investor Protection (DIP) Guidelines Issues of securities h a v e to c o n f o r m to f a i r l y elaborate disclosure requirements, so that investors can take m o r e i n f o r m e d decisions. D I P g u i d e l i n e s a n d their c o n t i n u a l i m p r o v e m e n t have m a d e I n d i a n d i s c l o s u r e r e q u i r e m e n t s c o m p a r a b l e to the best i n t e r n a t i o n a l practices. O f course, this has m a d e the offer d o c u m e n t quite v o l u m i n o u s . Efficient Delivery Mechanism SEBI has m a d e it m a n d a t o r y for a l l n e w I P O s to be i s s u e d o n l y i n the dematerialised f o r m . Further, the time lapse b e t w e e n the closure of a n issue a n d the l i s t i n g of shares has been c o m p r e s s e d . There are three w a y s i n w h i c h a c o m p a n y m a y raise equity capital i n the p r i m a r y market: s P u b l i c issue Rights issue Preferential allotment * Public Issue B y far the most i m p o r t a n t m e t h o d of i s s u i n g securities, a p u b l i c issue i n v o l v e s sale of securities to the p u b l i c at large. P u b l i c issues i n I n d i a are g o v e r n e d b y the p r o v i s i o n s of the C o m p a n i e s A c t , 1956, S E B I G u i d e l i n e s o n Investor P r o t e c t i o n , a n d the l i s t i n g agreement b e t w e e n the i s s u i n g c o m p a n y a n d the stock exchanges. T h e C o m p a n i e s A c t describes the p r o c e d u r e to be f o l l o w e d i n offering shares to the p u b l i c a n d the type of i n f o r m a t i o n to be d i s c l o s e d i n the prospectus a n d the SEBI g u i d e l i n e s i m p o s e certain conditions o n the issuers besides s p e c i f y i n g the a d d i t i o n a l i n f o r m a t i o n to be disclosed to the investors. The issue of securities to members of the p u b l i c i n v o l v e s a fairly elaborate process c o m p r i s i n g of the f o l l o w i n g steps: * A p p r o v a l of the b o a r d of directors A p p r o v a l of shareholders A p p o i n t m e n t of the l e a d manager D u e diligence b y the l e a d manager A p p o i n t m e n t of other intermediaries l i k e co-managers, a d v i s o r s , u n d e r w r i t e r s , bankers, brokers, a n d registrars

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P r e p a r a t i o n of the draft prospectus F i l i n g of the draft prospectus w i t h SEBI A p p l i c a t i o n for l i s t i n g i n stock exchanges F i l i n g of the p r o s p e c t u s (after i n c o r p o r a t i n g a n y m o d i f i c a t i o n s suggested b y SEBI) w i t h the Registrar of C o m p a n i e s P r o m o t i o n of the issue P r i n t i n g a n d d i s t r i b u t i o n of applications Statutory announcement C o l l e c t i o n of applications Processing of applications D e t e r m i n a t i o n of the l i a b i l i t y of u n d e r w r i t e r s F i n a l i s a t i o n of allotment G i v i n g of demat credit a n d r e f u n d orders L i s t i n g of the issue

The merchant b a n k e r h a n d l i n g a p u b l i c issue p l a y s a multifaceted role. The merchant b a n k e r advises the i s s u i n g c o m p a n y , p e r f o r m s d u e d i l i g e n c e o n the c o m p a n y , coordinates the w o r k of a l l agencies i n v o l v e d i n the issue, serves as a w a t c h d o g for statutory c o m p l i a n c e , a n d protects the interest of investors i n a f i d u c i a r y capacity.

Public Issues in the US In the U S , p u b l i c offerings of b o t h stocks a n d b o n d s are t y p i c a l l y m a r k e t e d b y i n v e s t m e n t bankers w h o p e r f o r m the role of u n d e r w r i t e r s . G e n e r a l l y , the l e a d i n v e s t m e n t b a n k e r f o r m s a n u n d e r w r i t i n g syndicate w i t h other i n v e s t m e n t bankers to share the r e s p o n s i b i l i t y for the issue. The k e y steps i n a p u b l i c offer are as f o l l o w s : a The f i r m engages investment bankers b y negotiation or competitive b i d d i n g . Investment bankers a d v i s e the f i r m o n the terms o n w h i c h it s h o u l d try to sell securities. * The f i r m files a p r e l i m i n a r y registration statement ( p r e l i m i n a r y prospectus) w i t h the S E C . It is also c a l l e d a red herring as it i n c l u d e s a statement p r i n t e d i n r e d stating that the c o m p a n y is not a t t e m p t i n g to s e l l the s e c u r i t y before S E C a p p r o v e s its registration statement. O n c e the S E C approves the registration statement, it becomes the prospectus a n d the p u b l i c offer price of the securities is a n n o u n c e d . The u n d e i w r i t i n g syndicate b u y s the securities f r o m the i s s u i n g f i r m at the p u b l i c offer price less a spread that serves as compensation for u n d e r w r i t i n g . (Alternatively, investment bankers d o not actually b u y the securities b u t o n l y agree to h e l p the f i r m sell the issue to the p u b l i c o n a best efforts basis.) The u n d e r w r i t i n g syndicate resells p u r c h a s e d securities at the offer p r i c e .

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A s a n investor, y o u s h o u l d be f a m i l i a r w i t h the f o l l o w i n g aspects of p u b l i c issues: 1. A c o m p a n y m a k i n g a p u b l i c issue i n f o r m s the p u b l i c about it t h r o u g h statutory announcements i n the n e w s p a p e r s , makes a p p l i c a t i o n forms available t h r o u g h stock brokers a n d others, a n d keeps the s u b s c r i p t i o n o p e n f o r a p e r i o d of three to ten d a y s . Investors can n o w d o w n l o a d the a p p l i c a t i o n f o r m s f r o m the websites of b r o k e r s o r other d i s t r i b u t o r s l i k e K a r v y C o n s u l t a n c y ( K a r v y . c o m N e w Issues) a n d C a p i t a l M a r k e t (capitalmarket.com / - I P O centre). 2. If the issue is over-subscribed, the pattern of allotment is d e c i d e d i n c o n s u l t a t i o n w i t h the stock exchange w h e r e the issue is p r o p o s e d to be l i s t e d . A f t e r the allotment p a t t e r n i s f i n a l i s e d , the c o m p a n y m a i l s the allotment a d v i c e / letter a l o n g w i t h r e f u n d order, i f any. T h i s is s u p p o s e d to be done w i t h i n few w e e k s of the closure of s u b s c r i p t i o n . 3. If the f u l l a m o u n t is not asked for at the time of allotment, the balance is called i n one or t w o calls later. The letter of allotment is exchangeable for share certificates (or debenture certificates, as the case m a y be), after it is d u l y s t a m p e d b y the bank w h e r e the balance p a y m e n t i s m a d e . O f course, if the allottee w a n t s , h e c a n sell the letter of allotment itself b y t r a n s m i t t i n g i t a l o n g w i t h a transfer d e e d . 4. If the allottee fails to p a y the c a l l m o n i e s as a n d w h e n called b y the c o m p a n y , the shares are liable to be forfeited. In s u c h a case, the allottee is not eligible for a n y r e f u n d of the a m o u n t s already p a i d . 5. W h e n a c o m p a n y issues n e w shares b y w a y of p u b l i c issues (or, for that matter, a rights issue o r a b o n u s issue), these shares m a y be entitled f o r d i v i d e n d o n l y f r o m the date of allotment. A s per a central g o v e r n m e n t directive, there is to be o n l y one q u o t a t i o n i n the stock exchanges f o r the existing shares of a c o m p a n y a n d n e w shares a r i s i n g out of the further issues m a d e b y the same c o m p a n y . The new shares, are, h o w e v e r , p e r m i t t e d to be t r a d e d a n d d e l i v e r e d pari passu w i t h the existing shares against the q u o t a t i o n subject to the d e d u c t i o n of the d i v i d e n d a m o u n t , if any, of the p r e v i o u s year. 6. P u b l i c issues m a y be m a d e at p r e d e t e r m i n e d prices (fixed p r i c e issues) o r at prices d e t e r m i n e d o n the basis of b i d s received f r o m potential investors (book b u i l t issues). I n I n d i a , h i s t o r i c a l l y p u b l i c issues have been f i x e d price issues. I n recent years, SEBI has a l l o w e d companies to m a k e b o o k b u i l t issues a n d this has been a v e r y significant d e v e l o p m e n t as almost a l l p u b l i c issues n o w are b o o k mm b u i l t issues. The m e c h a n i s m of b o o k b u i l d i n g w o r k s as f o l l o w s : T h e c o m p a n y announces the p u b l i c issue g i v i n g a n i n d i c a t i v e price b a n d w h i c h is d e t e r m i n e d i n consultation w i t h its l e a d merchant bankers. Investors interested i n the issue s u b m i t the b i d - c u m - a p p l i c a t i o n f o r m , m e n t i o n i n g their price a n d v o l u m e options to syndicate members, w h o are o n a n electronic l i n k e d p l a t f o r m across the c o u n t r y . T h e electronic p l a t f o r m s of BSE a n d N S E are u s e d f o r this p u r p o s e . W h e n a b i d i s s u b m i t t e d , i t is u p l o a d e d o n the N S E / B S E system. The status of the b o o k can be seen o n the b i d d i n g terminals b y investors. Investors c a n revise their b i d s any n u m b e r of time before the b i d d i n g p e r i o d closes.

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O n c e the b i d d i n g p e r i o d i s over, the l e a d manager ascertains the d e m a n d f u n c t i o n a n d decides the issue price a n d the pattern of a l l o c a t i o n i n c o n s u l tation w i t h the issuer. P r i c i n g is generally a i m e d at e n s u r i n g that there i s a healthy d e m a n d o v e r h a n g l e a d i n g to a p o s t - l i s t i n g price that is h i g h e r t h a n the issue p r i c e . The i d e a is to 'leave s o m e t h i n g o n the table' for the investors. A s far as the allotment is concerned, u n d e r the existing regulations a m i n i m u m of 25 percent h a s to be allotted to i n d i v i d u a l s b i d d i n g u p to 1000 shares, a m i n i m u m of 15 percent has to be allotted to corporates, H N I s ( H i g h N e t w o r t h I n d i v i d u a l s ) a n d i n d i v i d u a l investors b i d d i n g i n excess of 1000 shares, a n d a m a x i m u m of 60 percent m a y be allotted to Q I B s ( Q u a l i f i e d Institutional Buyers s u c h as FIIs, b a n k s , a n d so on). I n the event of overs u b s c r i p t i o n , allotment has to be d o n e o n a p r o p o r t i o n a t e basis. Indian Public Issue Market Has Arrived June 2007 m a r k e d a w a t e r s h e d i n the I n d i a n p u b l i c issue m a r k e t . D u r i n g this m o n t h c o m p a n i e s r a i s e d R s . 22,503 crore t h r o u g h i n i t i a l p u b l i c offerings a n d f o l l o w - o n p u b l i c offerings. I n d i a seems to have a r r i v e d i n the b i g league. T h i s is suggested b y the f o l l o w i n g : (a) W o r l d ' s l e a d i n g i n v e s t m e n t bankers l i k e M e r r i l l L y n c h , G o l d m a n Sachs, M o r g a n Stanley, a n d L e h m a n Brothers have entered I n d i a or are entering I n d i a i n a b i g w a y . (b) A p p e t i t e for g o o d q u a l i t y p a p e r is v e r y s t r o n g a n d h u g e m o b i l i s a t i o n s i n the p r i m a r y market have not dented the s e c o n d a r y m a r k e t , (c) I n recent years, the q u a l i t y of issuances has i m p r o v e d s i g n i f i c a n t l y , thanks to stringent e n t r y n o r m s of S E B I , better v e t t i n g b y S E B I , c o m p u l s o r y p a r t i c i p a t i o n of Q u a l i f i e d Institutional B u y e r s , a n d the i n v o l v e m e n t of t w o n a t i o n a l l e v e l exchanges, (d) I n 1990s, s m a l l a n d n u m e r o u s issues b y r e l a t i v e l y u n k n o w n promoters d o m i n a t e d the p r i m a r y m a r k e t . T o d a y the issues are larger a n d fewer a n d are offered b y established c o m p a n i e s .

IPO Grading by Credit Rating Agencies (CRAs) T r a d i t i o n a l l y , credit r a t i n g agencies ( C R A s ) f o c u s e d o n the r a t i n g of debt i n s t r u m e n t s . I n recent years, I P O g r a d i n g b y C R A s has b e g u n . T h e factors n o r m a l l y c o n s i d e r e d for s u c h g r a d i n g are business prospects of the c o m p a n y a n d the i n d u s t r y , f i n a n c i a l risks, m a n a g e r i a l competence, corporate governance, a n d accounting quality. It m u s t be e m p h a s i s e d that the p u r p o s e of I P O r a t i n g i s to assess the f u n d a m e n t a l strength of the c o m p a n y a n d not the investment attractiveness of the issue. The latter w o u l d d e p e n d o n f u n d a m e n t a l strength as w e l l as the issue p r i c e . A s the o l d investment adage goes: " N o stock i s i n h e r e n t l y g o o d or b a d , it is the price w h i c h m a k e s it s o . " Rights Issue A rights issue i n v o l v e s s e l l i n g securities i n the p r i m a r y market b y i s s u i n g rights to the existing shareholders. W h e n a c o m p a n y issues a d d i t i o n a l e q u i t y c a p i t a l , it has to be offered i n the first instance to the e x i s t i n g shareholders o n a pro rata basis. T h i s is

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r e q u i r e d u n d e r Section 81 of the C o m p a n i e s A c t 1956. The shareholders, h o w e v e r , m a y b y a special r e s o l u t i o n forfeit this right, p a r t i a l l y or f u l l y , to enable a c o m p a n y to issue a d d i t i o n a l capital to the general p u b l i c or to selected investors o n a preferential basis. Procedure for Rights Issue A c o m p a n y m a k i n g a rights issue sends a 'letter of offer' a l o n g w i t h a composite a p p l i c a t i o n f o r m consisting of f o u r f o r m s (A, B, C a n d D) to the shareholders. F o r m A is meant for the acceptance of the rights a n d a p p l i c a t i o n for a d d i t i o n a l shares. T h i s f o r m also s h o w s the n u m b e r of rights shares the shareholder is entitled to. It also has a c o l u m n t h r o u g h w h i c h a request for a d d i t i o n a l shares m a y be m a d e . F o r m B is to be u s e d if the shareholder w a n t s to renounce the rights i n f a v o u r of someone else. F o r m C is meant for a p p l i c a t i o n b y the renouncee i n w h o s e f a v o u r the rights have been r e n o u n c e d b y the o r i g i n a l allottee, t h r o u g h F o r m B. F o r m D is to be u s e d to m a k e a request for s p l i t f o r m s . The composite a p p l i c a t i o n f o r m m u s t be m a i l e d to the c o m p a n y w i t h i n a s t i p u l a t e d p e r i o d , w h i c h is u s u a l l y 30 days. Preferential Allotment A n issue of e q u i t y b y a listed c o m p a n y to selected investors at a price w h i c h m a y or m a y not be related to the p r e v a i l i n g m a r k e t price is referred to as preferential allotment i n the I n d i a n capital m a r k e t . S u c h a n issue can be m a d e o n l y w h e n the shareholders pass a special r e s o l u t i o n (a r e s o l u t i o n that is p a s s e d b y shareholders h a v i n g at least 75 percent of the v o t i n g rights). A preferential allotment is not related to a p u b l i c issue a n d it s h o u l d not be c o n f u s e d w i t h reservations that m a y be m a d e o n a preferential basis for certain categories of investors i n a p u b l i c issue. Preferential allotment i n I n d i a is g i v e n m a i n l y to p r o m o t e r s or f r i e n d l y investors to w a r d off the threat of takeover. T h i s is n o w a v e r y p o p u l a r means of r a i s i n g fresh e q u i t y capital because: (i) The cost a n d uncertainty associated w i t h the p u b l i c issue is h i g h , (ii) Sophisticated investors l i k e m u t u a l f u n d s a n d p r i v a t e e q u i t y investors are l i k e l y to p a y a h i g h e r price. The price at w h i c h a preferential allotment of shares is m a d e s h o u l d not be l o w e r t h a n the h i g h e r of the average of the w e e k l y h i g h a n d l o w of the c l o s i n g prices of the shares q u o t e d o n the stock exchange d u r i n g the six m o n t h s p e r i o d before the relevant date or d u r i n g the t w o w e e k s p e r i o d before the relevant date.

3.3

SECONDARY EQUITY MARKET (STOCK MARKET)

The o r i g i n of the stock market i n I n d i a goes back to the e n d of the eighteenth century w h e n l o n g - t e r m negotiable securities w e r e first i s s u e d . H o w e v e r , for a l l p r a c t i c a l p u r p o s e s , the real b e g i n n i n g o c c u r r e d i n the m i d d l e of the nineteenth c e n t u r y after the enactment of the C o m p a n i e s A c t i n 1850, w h i c h i n t r o d u c e d the feature of l i m i t e d l i a b i l i t y a n d generated investor interest i n corporate securities. A n i m p o r t a n t early event i n the d e v e l o p m e n t of the stock market i n I n d i a w a s the f o r m a t i o n of the N a t i v e Share a n d Stock B r o k e r s ' A s s o c i a t i o n at B o m b a y i n 1875, the p r e c u r s o r of the present d a y B o m b a y Stock E x c h a n g e . T h i s w a s f o l l o w e d b y the f o r m a t i o n of associations/ exchanges i n A h m e d a b a d (1894), C a l c u t t a (1908), a n d

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M a d r a s (1937). I n a d d i t i o n , a large n u m b e r of e p h e m e r a l exchanges e m e r g e d m a i n l y i n b u o y a n t p e r i o d s o n l y to recede i n t o o b l i v i o n d u r i n g d e p r e s s i n g times subsequently. In order to check s u c h aberrations a n d p r o m o t e a more o r d e r l y d e v e l o p m e n t of the stock m a r k e t , the central g o v e r n m e n t i n t r o d u c e d a l e g i s l a t i o n c a l l e d the Securities Contracts (Regulation) A c t , 1956. U n d e r this legislation, it is m a n d a t o r y o n the part of a stock exchange to seek g o v e r n m e n t a l r e c o g n i t i o n . A s of October 2007 there w e r e 23 stock exchanges r e c o g n i s e d b y the central g o v e r n m e n t . T h e y are located at A h m e d a b a d , Bangalore, B a r o d a , B h u b a n e s h w a r , C a l c u t t a , C h e n n a i (the M a d r a s Stock Exchange), C o c h i n , C o i m b a t o r e , D e l h i , G u w a h a t i , H y d e r a b a d , Indore, Jaipur, K a n p u r , L u d h i a n a , M a n g a l o r e , M u m b a i (The B o m b a y Stock Exchange), M u m b a i (the N a t i o n a l Stock E x c h a n g e or N S E ) , M u m b a i ( O T C E x c h a n g e of I n d i a ) , M u m b a i (the Interconnected Stock Exchange of India), Patna, P u n e , a n d Rajkot. The most i m p o r t a n t d e v e l o p m e n t i n the I n d i a n stock market w a s the establishment of the N a t i o n a l Stock Exchange (NSE) i n 1994. W i t h i n a short p e r i o d , it e m e r g e d as the largest stock exchange i n the c o u n t r y s u r g i n g ahead of the B o m b a y Stock Exchange (BSE) w h i c h w a s h i s t o r i c a l l y the d o m i n a n t stock exchange i n I n d i a . The N S E has cast its s h a d o w over most of the r e g i o n a l stock exchanges, j e o p a r d i s i n g their v e r y existence. I n a b i d to s u r v i v e , the r e g i o n a l stock exchanges h a v e set u p subsidiaries w h i c h i n t u r n have become i n s t i t u t i o n a l members of N S E as w e l l as B S E . F o r e x a m p l e , the Bangalore Stock Exchange has set u p a s u b s i d i a r y c a l l e d the B G S E F i n a n c i a l Services L i m i t e d w h i c h is a n i n s t i t u t i o n a l m e m b e r of N S E as w e l l as B S E . M e m b e r s of the Bangalore Stock Exchange can trade o n N S E as w e l l as B S E t h r o u g h the B G S E F i n a n c i a l Services L i m i t e d . A t present, N S E a n d B S E account for almost 100 percent of the total t u r n o v e r o n the I n d i a n stock m a r k e t , thanks to three factors: a d v e n t of a u t o m a t e d t r a d i n g a n d the n a t i o n w i d e reach of N S E a n d B S E ; i n t r o d u c t i o n of a c o m m o n r o l l i n g settlement system; a n d a b o l i t i o n of r e g i o n a l l i s t i n g requirement. Since the N a t i o n a l Stock Exchange a n d the B o m b a y Stock Exchange l o o m large over the I n d i a n stock market, it m a y be instructive to l e a r n about their distinctive features. The National Stock Exchange I n a u g u r a t e d i n 1994, the N a t i o n a l Stock Exchange seeks to (a) establish a n a t i o n - w i d e t r a d i n g facility for equities, debt, a n d h y b r i d s , (b) facilitate e q u a l access to investors across the c o u n t r y , (c) i m p a r t fairness, efficiency, a n d transparency to transactions i n securities, (d) shorten settlement cycle, a n d (e) meet i n t e r n a t i o n a l securities m a r k e t standards. T h e d i s t i n c t i v e features of N S E , as it functions c u r r e n t l y , are as f o l l o w s : The N S E is a ringless, n a t i o n a l , c o m p u t e r i s e d exchange. * The N S E has t w o segments: the C a p i t a l M a r k e t segment a n d the W h o l e s a l e D e b t M a r k e t segment. T h e C a p i t a l M a r k e t segment covers equities, c o n v e r t i b l e debentures, a n d retail trade i n n o n - c o n v e r t i b l e debentures. The W h o l e s a l e Debt M a r k e t segment is a m a r k e t for h i g h v a l u e transactions i n g o v e r n m e n t securities, P S U b o n d s , c o m m e r c i a l papers, a n d other debt instruments.

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The t r a d i n g members i n the C a p i t a l M a r k e t segment are connected to the central c o m p u t e r i n M u m b a i t h r o u g h a satellite l i n k - u p , u s i n g V S A T s ( V e r y S m a l l A p e r t u r e T e r m i n a l s ) . I n c i d e n t a l l y , N S E is the first exchange i n the w o r l d to e m p l o y the satellite t e c h n o l o g y . T h i s e n a b l e d N S E to achieve a n a t i o n - w i d e reach. The t r a d i n g m e m b e r s i n the W h o l e s a l e D e b t M a r k e t segment are l i n k e d t h r o u g h dedicated h i g h speed lines to the central c o m p u t e r at M u m b a i . The N S E has o p t e d for a n o r d e r - d r i v e n system. W h e n a n order is p l a c e d b y a t r a d i n g member, the computer automatically generates a u n i q u e order n u m b e r a n d the member can take a p r i n t of order confirmation slip containing this n u m b e r . W h e n a trade takes place, a trade c o n f i r m a t i o n s l i p is p r i n t e d at the t r a d i n g m e m b e r ' s w o r k station. It gives details l i k e q u a n t i t y , p r i c e , code n u m b e r of counterparty, a n d so o n . The i d e n t i t y of a t r a d i n g m e m b e r is not revealed to others w h e n he places a n order or w h e n h i s p e n d i n g orders are d i s p l a y e d . H e n c e , large orders can be p l a c e d o n the N S E . M e m b e r s are r e q u i r e d to d e l i v e r securities a n d cash b y a certain d a y . The p a y o u t d a y is the f o l l o w i n g d a y . A l l trades o n N S E are g u a r a n t e e d b y the N a t i o n a l Securities C l e a r i n g C o r p o r a t i o n ( N S C C ) . T h i s means that w h e n A b u y s f r o m B, N S C C becomes the counterparty to b o t h legs of the transaction. I n effect, N S C C becomes the seller to A a n d the b u y e r f r o m B. This eliminates counterparty r i s k .

The Bombay Stock Exchange Established i n 1875, the B o m b a y Stock Exchange (BSE) is one of the oldest o r g a n i s e d exchanges i n the w o r l d w i t h a l o n g , c o l o u r f u l , a n d chequered h i s t o r y . Its distinctive features are as f o l l o w s : The BSE switched f r o m the o p e n outcry system to the screen-based system i n 1995 w h i c h is called B O L T ( w h i c h is a n a c r o n y m for BSE O n L i n e T r a d i n g ) . It accelerated its computerisation p r o g r a m m e i n response to the threat f r o m the N S E . T o b e g i n w i t h , B O L T w a s a ' q u o t e - d r i v e n ' as w e l l as a n ' o r d e r - d r i v e n ' system, w i t h jobbers (specialists) f e e d i n g t w o - w a y quotes a n d brokers f e e d i n g b u y or sell o r d e r s T h i s h y b r i d s y s t e m reflected the h i s t o r i c a l practice of B S E w h e r e jobbers p l a y e d a n i m p o r t a n t role. A jobber is a b r o k e r w h o trades o n h i s o w n account a n d hence offers a t w o - w a y quote or a b i d - a s k quote. The bid p r i c e reflects the price at w h i c h the jobber is w i l l i n g to b u y a n d the ask price represents the price at w h i c h the jobber is w i l l i n g to sell. F r o m A u g u s t 13, 2001, h o w e v e r , B S E , l i k e N S E , became a c o m p l e t e l y o r d e r - d r i v e n market. I n O c t o b e r 1996 S E B I p e r m i t t e d B S E to extend its B O L T n e t w o r k o u t s i d e M u m b a i . I n 2002, s u b s i d i a r y c o m p a n i e s of 13 r e g i o n a l exchanges became m e m b e r s of B S E a n d t h r o u g h t h e m members of r e g i o n a l exchanges n o w serve as sub-brokers of B S E . T h i s has e x p a n d e d the reach of B S E considerably.

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T h e c o m p u t e r constantly tries to m a t c h m u t u a l l y c o m p a t i b l e o r d e r s . The m a t c h i n g is d o n e o n a price-time p r i o r i t y , i m p l y i n g that p r i c e is g i v e n preference over t i m e i n the process of m a t c h i n g . A b u y o r d e r at a h i g h e r l i m i t p r i c e is accorded precedence over a b u y order at a l o w e r l i m i t p r i c e . B y the same t o k e n , a sell order at a l o w e r l i m i t price is g i v e n p r i o r i t y over a sell order at a h i g h e r l i m i t p r i c e . B e t w e e n t w o l i m i t orders p l a c e d at the same price, the l i m i t o r d e r p l a c e d earlier is accorded p r i o r i t y over the l i m i t o r d e r p l a c e d later. The l i m i t order b o o k , i.e., the list of u n m a t c h e d l i m i t orders is d i s p l a y e d o n the screen. P u t differently, it is o p e n for i n s p e c t i o n to a l l traders.

Limit Order Book Because l i m i t orders m a y not be executed i m m e d i a t e l y o n s u b m i s s i o n , at a n y g i v e n time there are active l i m i t o r d e r s . A l i m i t o r d e r b o o k is the current set of active l i m i t orders, a r r a n g e d first b y price a n d t h e n b y t i m e . T h i s means that h i g h p r i c e d b u y o r d e r s a n d l o w - p r i c e d sell orders h a v e the highest p r i o r i t y . L i m i t orders w i t h the same l i m i t price are a r r a n g e d i n s u c h a w a y that orders s u b m i t t e d earlier are g i v e n p r i o r i t y over orders s u b m i t t e d later. G r a p h i c a l l y , the c u m u l a t i v e l i m i t order b o o k m a y l o o k as f o l l o w s .
Shares

.1
J
f

500 501 502 503

504 505 506 507 508 509 510 Limit Price

511 512

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Is the Screen Based Trading Always Advantageous? Is the screen based t r a d i n g a l w a y s advantageous? D o e s the g r o w i n g p o p u l a r i t y of screen based t r a d i n g suggest the eventual disappearance of intermediaries i n the s e c o n d a r y markets? T h i s m a y n o t h a p p e n because there is a f l i p side to the transparency associated w i t h screen b a s e d t r a d i n g . Since transparency a l l o w s everyone to get a better i d e a of b u y a n d sell orders, i n s t i t u t i o n a l investors w h o trade i n large quantities m a y suffer adverse p r i c e i m p a c t s . E v e n t h o u g h their trades are often n o t m o t i v a t e d b y p r i v a t e i n f o r m a t i o n , they m a y n o t be able to c o m m u n i c a t e their i n n o c u o u s n e s s to the m a r k e t . H e n c e they t e n d to suffer adverse p r i c e i m p a c t s . A large sell o r d e r , p r e s u m a b l y o r i g i n a t i n g f r o m a n i n s t i t u t i o n a l i n v e s t o r h a v i n g p r i v a t e i n f o r m a t i o n , depresses the p r i c e to the detriment of the i n s t i t u t i o n a l seller. L i k e w i s e a large b u y order f r o m a n i n s t i t u t i o n raises the price a n d hurts the b u y e r . S u c h adverse market impacts p r o d large-size traders to trade elsewhere. A s R a v i A n s h u m a n says: " N o w o n d e r , large-size traders s t i l l prefer specialised markets (e.g., the upstairs m a r k e t i n the N Y S E ) to screen based t r a d i n g systems. I n s t i t u t i o n a l investors (portfolio managers) m a y m o v e their trades back to a n i n t e r m e d i a t e d centralised marketplace that is less transparent." V . R a v i A n s h u m a n " I T a n d the c h a n g i n g Face of I n d i a n Stock E x c h a n g e s " E T I T , January - F e b r u a r y , 1999 Settlement

T r a d i t i o n a l l y , trades i n I n d i a were settled b y p h y s i c a l d e l i v e r y . This means that the securities h a d to p h y s i c a l l y m o v e f r o m the seller to the seller's broker, f r o m the seller's b r o k e r to the b u y e r ' s b r o k e r ( t h r o u g h the clearing house of the exchange o r d i r e c t l y ) , a n d f r o m the b u y e r ' s b r o k e r to the b u y e r . Further, the b u y e r h a d to l o d g e the securities w i t h the transfer agents of the c o m p a n y a n d the process of transfer took one to three m o n t h s . T h i s l e d to h i g h p a p e r w o r k cost a n d created b a d p a p e r risk. T o mitigate the costs a n d r i s k s associated w i t h p h y s i c a l d e l i v e r y , s e c u r i t y transactions i n d e v e l o p e d m a r k e t s are settled m a i n l y t h r o u g h electronic d e l i v e r y facilitated b y depositories. A d e p o s i t o r y is a n i n s t i t u t i o n w h i c h dematerialises p h y s i c a l certificates a n d effects transfer of o w n e r s h i p b y electronic b o o k entries. T o enable the creation of depositories to facilitate dematerialised t r a d i n g i n I n d i a , the central g o v e r n m e n t p r o m u l g a t e d the D e p o s i t o r y O r d i n a n c e , 1995 w h i c h w a s f o l l o w e d b y the Depositories A c t , 1996. T h e h i g h l i g h t s of the Depositories A c t are as follows: E v e r y d e p o s i t o r y w i l l be r e q u i r e d to be registered w i t h the Securities a n d Exchange B o a r d of I n d i a . Investors w i l l have the choice of c o n t i n u i n g w i t h the e x i s t i n g share certificates or opt for the d e p o s i t o r y m o d e . Investors o p t i n g to j o i n the d e p o s i t o r y m o d e are r e q u i r e d to register w i t h the agents of the depositories. These w i l l be c u s t o d i a l agencies l i k e banks, f i n a n c i a l institutions, a n d large brokerage f i r m s .

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W h i l e the d e p o s i t o r y w i l l be the registered o w n e r i n the register of the c o m p a n y , the investor w i l l enjoy the economic benefits as w e l l as the v o t i n g rights o n the share concerned. Shares i n the d e p o s i t o r y m o d e w i l l be f u n g i b l e . T h i s means that they w i l l cease to have distinctive n u m b e r s , i Investors h a v i n g entered the d e p o s i t o r y m o d e can leave the system a n d get share certificates f r o m the c o m p a n y as registered o w n e r s i n the b o o k s of the c o m p a n y . O w n e r s h i p changes i n the d e p o s i t o r y s y s t e m w i l l be m a d e a u t o m a t i c a l l y o n the basis of d e l i v e r y against p a y m e n t . F u r t h e r , there w i l l be n o s t a m p d u t y o n transfer of o w n e r s h i p , a A n y loss caused to the beneficial o w n e r s d u e to the negligence of the d e p o s i t o r y or the participant w i l l be i n d e m n i f i e d b y the d e p o s i t o r y . The N a t i o n a l Securities D e p o s i t o r y L i m i t e d ( N S D L ) , India's first d e p o s i t o r y , w a s set u p i n 1996. It w a s f o l l o w e d b y the C e n t r a l Securities Depositories L i m i t e d ( C S D L ) . B o t h the depositories, the N S D L i n particular, have r e c o r d e d a significant g r o w t h i n their operations. SEBI has m a d e dematerialised t r a d i n g c o m p u l s o r y for a l l the stock exchanges i n the c o u n t r y . T h i s means that if y o u w a n t to b u y or sell shares o n a n y exchange y o u h a v e to d o it o n l y i n the dematerialised f o r m . O f course, t w o parties c a n engage i n a n off-market spot transaction that can be settled t h r o u g h the d e l i v e r y of shares i n p h y s i c a l f o r m . There is a transfer d u t y of 0.50 percent o n p h y s i c a l transfer. Shift to Rolling Settlement T i l l recently share transactions i n I n d i a were settled o n the basis of a w e e k l y account p e r i o d . ( O n the B o m b a y Stock Exchange the account p e r i o d w a s M o n d a y to F r i d a y a n d o n the N a t i o n a l Stock Exchange the account p e r i o d w a s W e d n e s d a y to T u e s d a y ) . T h i s meant that purchases a n d sales d u r i n g a n account p e r i o d c o u l d be s q u a r e d u p a n d , at the e n d of the account p e r i o d , transactions c o u l d be settled o n a net basis. F o r e x a m p l e , if y o u b o u g h t 100 shares of Infosys o n B o m b a y Stock Exchange o n a M o n d a y at R s . 5,000 a share a n d s o l d 95 shares of Infosys at R s . 5050 o n the F r i d a y of that w e e k , y o u w e r e r e q u i r e d to take d e l i v e r y for o n l y 5 shares b y p a y i n g Rs. 20,250 (Purchase c o n s i d e r a t i o n of R s . 500,000Sale c o n s i d e r a t i o n of R s . 479,750) at the e n d of account p e r i o d . T h e w e e k l y settlement s y s t e m a l o n g w i t h the b a d l a s y s t e m of c a r r y i n g f o r w a r d transactions f r o m one account p e r i o d to the next, a c c o r d i n g to m a n y i n f o r m e d observers of the I n d i a n stock market, l e d to u n b r i d l e d speculative a c t i v i t y a n d p e r i o d i c m a r k e t crises. So, SEBI d e c i d e d to i n t r o d u c e r o l l i n g settlement i n a p h a s e d m a n n e r f r o m 2002. U n d e r the c o m p u l s o r y r o l l i n g system n o w i n v o g u e , e v e r y d a y represents a n e w settlement p e r i o d . P u t differently, the t r a d i n g cycle w h i c h w a s earlier one w e e k has been r e d u c e d to one d a y . T h i s means that y o u have to square a n o p e n p o s i t i o n the same d a y ; otherwise, y o u have to take or give d e l i v e r y , d e p e n d i n g o n y o u r p o s i t i o n . Presently, the settlement of a l l trades is o n a T + 2 basis a n d the settlement cycle is as follows:

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Settlement Cycle (T + 2) Day Activity For the Day T Trade T +1 Custodial confirmation & final obligation T +2 P a y - i n / P a y - o u t of f u n d s & securities T +3 A u c t i o n for shortages T +4 T +5 P a y - i h / P a y - o u t of f u n d s & securities for a u c t i o n Note: The table depicts a t y p i c a l settlement cycle for the T + 2 market segment. The days p r e s c r i b e d for the above activities m a y change i n case of factors l i k e h o l i d a y s , b a n k c l o s i n g , etc. Transaction Costs Transaction costs m a y be d i v i d e d i n t o three b r o a d h e a d i n g s : t r a d i n g costs, c l e a r i n g costs, a n d settlement costs. Trading Costs T r a d i n g costs consist of brokerage cost, m a r k e t i m p a c t cost, a n d securities transaction tax. Brokerage cost is the brokerage p a i d to the b r o k e r . D u e to heightened c o m p e t i t i o n i n stock b r o k i n g , brokerage cost has f a l l e n s i g n i f i c a n t l y . Market impact cost is the difference b e t w e e n the actual transaction p r i c e a n d the " i d e a l p r i c e " , the latter b e i n g d e f i n e d as the price at w h i c h the trade w i l l occur i f the market for the stock w e r e perfectly l i q u i d or i n f i n i t e l y deep. T o illustrate this, s u p p o s e that the best b u y a n d best sell price for a stock are R s . 49.50 a n d R s . 50.50 respectively at a g i v e n p o i n t of t i m e . If the market w e r e perfectly l i q u i d , the " i d e a l p r i c e " w o u l d be say Rs. 50. T h u s , a p e r s o n w h o w a n t s to b u y i m m e d i a t e l y has to p a y R s . 50.50, s u f f e r i n g a b u y - s i d e m a r k e t i m p a c t cost of R s . 0.50 or 1 percent. L i k e w i s e , a p e r s o n w h o w a n t s t o sell i m m e d i a t e l y w i l l get o n l y R s . 49.50, s u f f e r i n g a sell-side m a r k e t i m p a c t cost of R s . 0.50 o r 1 percent. T h a n k s to the d e e p e n i n g of the I n d i a n stock market, p a r t i c u l a r l y for the large a n d m e d i u m capitalisation stocks, the m a r k e t i m p a c t cost has come d o w n substantially. Securities transaction tax (STT) i s a l e v y o n securities transactions. C u r r e n t l y f o r d e l i v e r y based trades i n e q u i t y the l e v y is 0.25 percent a n d the same i s to be s p l i t e q u a l l y b e t w e e n the b u y e r a n d the seller. T h i s means that for a transaction w o r t h R s . 100, the b u y e r a n d seller have to p a y 12.5 paise each. F o r transactions o n w h i c h S T T i s p a i d the n e w tax treatment o n capital gains w i l l a p p l y . For n o n - d e l i v e r y based trades (day trades a n d arbitrage trades) i n equity the l e v y is o n l y 0.035 percent, a n d the same has to be s p l i t e v e n l y b e t w e e n the b u y e r a n d the seller. D a y traders a n d arbitrageurs can take c l a i m d e d u c t i o n of STT for c o m p u t i n g taxable project. Clearing Costs W h e n a negotiated trade takes place, the counterparty m a y default o r w h e n a trade takes place o n a n exchange, the exchange m a y d e f a u l t i n its p a y o u t . C l e a r i n g costs are costs experienced i n r e s o l v i n g s u c h defaults.

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H i s t o r i c a l l y , clearing costs i n I n d i a w e r e h i g h . T h a n k s to the establishment of the clearing c o r p o r a t i o n at N S E (a c l e a r i n g c o r p o r a t i o n becomes the legal counterparty to the net settlement obligations of each broker) a n d c l e a r i n g houses o n other exchanges, c l e a r i n g costs i n I n d i a have been v i r t u a l l y e l i m i n a t e d . Settlement Costs A trade is f i n a l l y c o n s u m m a t e d w h e n securities a n d f u n d s actually change h a n d s . Settlement costs are costs associated w i t h s u c h transfer. W i t h the a d v e n t of d e m a t e r i a l i s a t i o n , e l i m i n a t i o n of s t a m p d u t y o n d e m a t e r i a l i s e d trades, a n d i m p r o v e m e n t of b a n k i n g technology, settlement costs h a v e come d o w n substantially. T h a n k s to the i n t r o d u c t i o n of screen-based t r a d i n g a n d electronic d e l i v e r y , the stock m a r k e t has been v e r i t a b l y t r a n s f o r m e d . T h e i r c o m b i n e d effect has been to reduce the transaction costs i n India's stock market d r a m a t i c a l l y . A s of mid-1993, a c c o r d i n g to A j a y S h a h a n d S u s a n T h o m a s , the total transaction cost i n I n d i a n m a r k e t w a s 5.00 percent; presently it is a r o u n d 0.50 percent. The details are g i v e n b e l o w : Mid1993 Trading Brokerage cost M a r k e t i m p a c t cost Clearing Counterparty risk Settlement P a p e r w o r k cost Badpaper risk Total 3.75% 3.00% 0.75% Present 1.25% 0.75% 0.50% 5.00% (+ risk) Today 0.40% 0.25% 0.15% Absent 0.10% 0.10% 0.00% 0.50%

Role of the Clearing Corporation W h i l e the stock exchange p r o v i d e s the t r a d i n g p l a t f o r m , the c l e a r i n g c o r p o r a t i o n l o o k s after the post-trade activities s u c h as c l e a r i n g a l l trades, d e t e r m i n i n g the obligations of members, a r r a n g i n g for p a y - i n of funds/securities, a r r a n g i n g for p a y - o u t of funds/securities to members, guaranteeing settlement, a n d collecting a n d m a i n t a i n i n g m a r g i n s / c o l l a t e r a l / b a s e capital/other f u n d s . T h e c l e a r i n g c o r p o r a t i o n is connected to the exchange, the c l e a r i n g b a n k s , depositories, custodians, a n d members electronically.

3.5

BUYING AND SELLING SHARES

Procedure for Buying Shares


B u y i n g shares a n d debentures i n v o l v e s the f o l l o w i n g steps:

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Locating a Broker T y p i c a l l y , shares are b o u g h t t h r o u g h a stock b r o k e r , w h o i s a licensed m e m b e r of a recognised stock exchange. So, w h e n y o u w a n t to b u y shares, y o u s h o u l d locate a b r o k e r . A s k y o u r friends, w h o have experience, to r e c o m m e n d some names a n d meet the suggested brokers p e r s o n a l l y a n d m a k e a f i r s t - h a n d assessment. Basically, satisfy y o u r s e l f that the b r o k e r y o u select c a n render p r o m p t a n d efficient service a n d protect y o u r interest. For d o i n g business w i t h the broker, y o u have to submit a client registration f o r m as w e l l as a member-constituent f o r m (or a sub-broker client agreement form). The latter contains the terms a n d conditions relating to order/trade confirmation, brokerage charged b y a trading member/registered sub-broker, a n d delivery of securities a n d funds. Placement of Order A f t e r l o c a t i n g a suitable broker, place y o u r o r d e r to b u y . Y o u r order s h o u l d clearly specify the n a m e of the c o m p a n y a n d the type of securities (equity shares, preference shares, or debentures). N o t e that a l l transactions t h r o u g h a stock exchange are n o w settled t h r o u g h the depositories. So y o u m u s t have a demat account w i t h a n a u t h o r i s e d d e p o s i t o r y before y o u place a n order. Y o u c a n place a l i m i t order o r a market order. A l i m i t order specifies the quantity to be t r a d e d , the highest p r i c e (the l i m i t price) that the b u y e r is w i l l i n g to accept, a n d the length of time the order is v a l i d . A day order remains v a l i d o n l y for the d a y w h e n i t is p l a c e d . If the order is not executed o n that d a y , it a u t o m a t i c a l l y lapses. A week order is one w h i c h is v a l i d for a w e e k . A month order is a n order w h i c h i s v a l i d for one m o n t h . A n open order remains v a l i d i n effect u n t i l i t is executed o r cancelled. F o r example, y o u m a y s u b m i t a l i m i t order to b u y 100 shares of Reliance Industries u n t i l the close of the t r a d i n g o n a p a r t i c u l a r d a y at a price less t h a n or e q u a l to the l i m i t price of R s . 2500. W h e n y o u s u b m i t a l i m i t order, y o u r u n the r i s k of d e l a y e d execution as w e l l as the risk that the order w i l l not be executed. Those w h o place active l i m i t orders essentially s t a n d r e a d y to trade at the d i s c r e t i o n of the other m a r k e t p a r t i c i p a n t s . H e n c e they supply liquidity to the m a r k e t , just as a m a r k e t m a k e r ( w h o is r e a d y to b u y w h e n investors w a n t to sell a n d to sell w h e n investors w a n t to b u y ) does. W h e n y o u s u b m i t a m a r k e t order, y o u m e r e l y specify the quantity that y o u w a n t to b u y at the best available p r i c e . F o r example, y o u m a y s u b m i t a market order f o r 100 shares of Reliance Industries. A market order guarantees execution; h o w e v e r , the trade p r i c e is n o t k n o w n b e f o r e h a n d . Those w h o place m a r k e t orders essentially r e q u i r e l i q u i d i t y f r o m the m a r k e t . P u t differently, they demand liquidity f r o m the m a r k e t . Execution of Order O n r e c e i v i n g y o u r o r d e r , the b r o k e r w i l l feed the same o n h i s t e r m i n a l . O n c e the order is executed, the b r o k e r w i l l i n f o r m y o u a n d s e n d a 'contract note'. R e p r e s e n t i n g the d o c u m e n t a r y evidence of the transaction, the 'contract note' contains relevant details of the transactions. Preserve i t for tax a n d other p u r p o s e s . Y o u are expected to p a y f o r y o u r purchase w i t h i n a stipulated p e r i o d specified b y the b r o k e r . A f t e r y o u h a v e effected the p a y m e n t the b r o k e r w i l l transfer the shares electronically to y o u r d e p o s i t o r y participant account. Procedure for Selling

O n c e y o u have located a b r o k e r , the steps i n v o l v e d i n s e l l i n g shares are as f o l l o w s :

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Placement of Order Y o u have to place a 'sale o r d e r ' w i t h y o u r b r o k e r . Y o u m a y place a l i m i t order w h e r e i n y o u specify the m i n i m u m price acceptable to y o u ; or y o u m a y place a m a r k e t order, w h i c h means that y o u instruct y o u r b r o k e r to s e l l at the best available m a r k e t price. Before p l a c i n g the order, m a k e sure that the shares y o u w a n t to sell are to y o u r credit i n y o u r d e p o s i t o r y account. Execution of Order O n r e c e i v i n g y o u r 'sale o r d e r ' , y o u r b r o k e r w i l l feed the same i n his t e r m i n a l . O n c e the order is executed the b r o k e r w i l l i n f o r m y o u a n d send y o u a 'contract note', the d o c u m e n t a r y evidence of the transaction. Y o u w i l l then h a v e to issue a d e p o s i t o r y p a r t i c i p a n t cheque for the shares that y o u have s o l d i n f a v o u r of the b r o k e r . T h i s cheque transfers the shares f r o m y o u r d e p o s i t o r y account to the b r o k e r ' s d e p o s i t o r y account, just the w a y a b a n k cheque transfers m o n e y f r o m the p a y e r ' s account to the payee's account. Y o u w i l l receive p a y m e n t f r o m the b r o k e r i n a f e w days. Internet Trading F e b r u a r y 2000 w i t n e s s e d the i n t r o d u c t i o n of stock t r a d i n g o n the internet i n I n d i a . C u r r e n t l y , I C I C I W e b t r a d e , S h a r e k h a n , Kotakstreet, G e o g i t Securities, Investmart, a n d others offer internet t r a d i n g . T o d o internet t r a d i n g , y o u have to register yourself as a client w i t h the internet broker, apart f r o m h a v i n g a c o m p u t e r , a m o d e m , a n d a telephone connection. Y o u also have to keep a m i n i m u m deposit i n the b a n k account w i t h the internet b r o k e r w h i c h the b r o k e r c a n d i r e c t l y debit or credit. For e x a m p l e , for I C I C I W e b t r a d e , y o u s h o u l d o p e n a b a n k account as w e l l as a demat account w i t h I C I C I B a n k . Y o u can feel the N S E t e r m i n a l a n d B S E t e r m i n a l o n y o u r c o m p u t e r screen a n d y o u c a n k e y y o u r b u y a n d sell orders d i r e c t l y . W i t h i n the l i m i t s assigned b y y o u r internet b r o k e r , y o u r orders w i l l get l o g g e d d i r e c t l y o n the t r a d i n g p l a t f o r m . The l i n k e d 3 - i n - l account (savings b a n k account, d e p o s i t o r y account, a n d t r a d i n g account) p e r m i t s 24 x 7 i n v e s t i n g , security, instant order c o n f i r m a t i o n , easy transfer of f u n d s a n d securities, a n d transparency. I n a d d i t i o n , the 3 - i n - l account service p r o v i d e r offers f u n d a m e n t a l a n d technical i n f o r m a t i o n a n d market updates free of cost. Important Points to Remember

W h e n y o u ' b u y ' or ' s e l l ' shares (or debentures) of a c o m p a n y , bear i n m i n d the following points. 1. A s per the a m e n d e d g u i d e l i n e s for listing, a c o m p a n y is s u p p o s e d to: (a) C l o s e its transfer b o o k s o n l y once i n a year at the time of a n n u a l general m e e t i n g a n d to have r e c o r d dates for other p u r p o s e s l i k e b o n u s issues, rights issues, etc; (b) H a v e u n i f o r m dates of b o o k c l o s i n g a n d r e c o r d dates either o n 1 or 6 of a n y m o n t h a n d to g i v e to the exchange notice i n advance of at least 42 d a y s or of as m a n y d a y s as the exchange m a y f r o m time to time reasonably p r e scribe;
st th

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(c) A c c e p t registration for transfers that are l o d g e d w i t h the c o m p a n y u p to the date of closure of the transfer b o o k s (or, w h e n the transfer b o o k s are not closed, u p to the r e c o r d date) a n d defer, u n t i l the transfer b o o k s h a v e reo p e n e d , registration of a n y transfers w h i c h m a y be received after the closure of the transfer b o o k s ; a n d (d) Issue letters of allotment or letters of rights w i t h i n six w e e k s of the r e c o r d date or date of r e o p e n i n g of the transfer b o o k s , after their closure for the p u r p o s e of m a k i n g a b o n u s or rights issue. 2. O n the stock market, the shares become e x - d i v i d e n d (or ex-bonus or ex-rights as the case m a y be) several d a y s before the b o o k closure date (record date). The cutoff date for ' e x - d i v i d e n d ' transactions is n o r m a l l y f i x e d b y the stock exchange authorities. F o r e x a m p l e , i n a certain case, the share m a y become e x - d i v i d e n d o n say, A u g u s t 10. T h i s is i n d i c a t e d b y the a b b r e v i a t i o n ' x d ' affixed after the price of the share. S i m i l a r l y , ' x b ' stands for 'ex-bonus', ' c b ' for ' c u m - b o n u s ' , ' x r ' for 'exrights', a n d 'cr' for ' c u m - r i g h t s ' . 3. If y o u b u y the shares ' x d ' (or ' x b ' or 'xr') y o u are not entitled to d i v i d e n d (or b o n u s shares or rights) for w h i c h the b o o k s are about to be closed.

Architectural Deficiencies The I n d i a n m a r k e t is m o r e v o l a t i l e t h a n the U S market because of the f o l l o w i n g architectural deficiencies: Dominance of Single-Stock Futures A major architectural defect of the I n d i a n stock m a r k e t is the d o m i n a n c e of single stock futures. T r a d i n g v o l u m e i n s u c h futures is greater t h a n t w i c e that of cash segment. C u r i o u s l y , D r R . H . P a t i l , f o r m e r m a n a g i n g director of N S E , w h e r e single stock futures w e r e i n t r o d u c e d d u r i n g h i s tenure, is n o w a severe critic of this s y s t e m . I n a n article that a p p e a r e d i n the Economic and Political Weekly he states: " A l l the major futures exchanges of the w o r l d i n the U S or E u r o p e c o n s i d e r that i n d i v i d u a l stock futures are not o n l y h i g h l y unsafe b u t also that they d o not serve any justifiable p u r p o s e . Despite the o b v i o u s r i s k s that i n d i v i d u a l stock futures pose to the safety a n d i n t e g r i t y of the capital market of the c o u n t r y , they n o w have been i n t r o d u c e d i n a h u r r y i n o u r country." Unrestricted Day Trading D a y traders i n I n d i a are not r e q u i r e d to take a n d give d e l i v e r y . In the U S , for example, a p e r s o n w h o b u y s a n d sells o n the same d a y is first r e q u i r e d to p a y for the shares before he c a n s e l l t h e m . U n r e s t r i c t e d d a y t r a d i n g u n d o u b t e d l y has c o n t r i b u t e d to speculative excess a n d h i g h v o l a t i l i t y . Absence of Market Making M a r k e t m a k e r s (called specialists i n the U S ) s t a n d r e a d y to b u y a n d sell o n their account. T h e y contribute to o r d e r l y price b e h a v i o u r a n d ensure l i q u i d i t y , e v e n for m i d - c a p a n d small-cap shares. A b s e n c e of m a r k e t m a k i n g i n I n d i a contributes to v o l a t i l i t y to some extent.

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4. If y o u b u y the shares ' c d ' (or 'cb'or 'cr' as the case m a y be), y o u are entitled to the d i v i d e n d (or b o n u s shares or rights) for w h i c h the b o o k s are about to be closed. 5. Y o u can obtain i n f o r m a t i o n about b o o k closure dates f r o m y o u r b r o k e r or f r o m the stock exchange. F i n a n c i a l n e w s p a p e r s l i k e The Economic Times a n d The Financial Express a n d investment m a g a z i n e s l i k e Capital Market a n d Dalai Street Journal also p r o v i d e this i n f o r m a t i o n .

3.6

BUYING ON MARGIN AND SHORT SALE

Buying on Margin

Y o u can b u y shares o n m a r g i n . T h i s means that y o u p r o v i d e a p o r t i o n of the purchase v a l u e as m a r g i n a n d the rest is g i v e n b y the broker as a l o a n to y o u . F o r example, if y o u have a m a r g i n account w i t h kotaksecurities.com, y o u can get a l o a n u p t o 75 percent of the purchase v a l u e . So, if y o u r m a r g i n account has a balance of Rs. 25,000, y o u can b u y shares u p t o Rs. 100,000. The percentage margin is equal to: e q u i t y i n the account/market v a l u e of the shares. S u p p o s e y o u p a y a m a r g i n of R s . 10,000 a n d p u r c h a s e shares w o r t h R s . 25,000, b o r r o w i n g Rs. 15,000 f r o m the b r o k e r . T h e initial percentage margin is: E q u i t y i n the account R s . 10,000 = =40 percent V a l u e of the shares Rs. 25,000 A rise i n the v a l u e of the shares augments y o u r equity i n the account a n d a f a l l i n the v a l u e of shares d i m i n i s h e s y o u r equity i n the account. S u p p o s e the v a l u e of the shares falls to Rs. 20,000. Y o u r e q u i t y i n the account becomes Rs. 5,000 a n d the percentage margin becomes:
r

Rs. 5,000 = 25 percent Rs. 20,000 If the v a l u e of the shares falls b e l o w Rs. 15,000, y o u r e q u i t y i n the account w o u l d t u r n negative. T o g u a r d against s u c h a t h i n g , the b r o k e r prescribes a maintenance margin. S h o u l d the percentage m a r g i n fall b e l o w the maintenance m a r g i n , the b r o k e r w i l l issue a m a r g i n c a l l a s k i n g y o u to infuse m o r e cash i n the m a r g i n account. If y o u f a i l to d o so, the b r o k e r is entitled to sell securities f r o m the account to collect e n o u g h of the l o a n so that the percentage m a r g i n is restored to a n acceptable l e v e l . W h e n y o u b u y o n m a r g i n , y o u r u p s i d e potential as w e l l as the d o w n s i d e r i s k are m a g n i f i e d . T o see h o w , suppose y o u deposit Rs. 10,000 i n a m a r g i n account a n d b u y shares w o r t h R s . 40,000, b o r r o w i n g Rs. 30,000 f r o m the broker. If the shares appreciate b y 25 percent to R s . 50,000 y o u e a r n a 100 percent r e t u r n (Rs. 10,000/Rs. 10,000), i g n o r i n g the cost of b o r r o w i n g . If the shares f a l l b y 25 percent to R s . 30,000, y o u lose 100 percent, not c o u n t i n g the b o r r o w i n g cost.
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Short Sale

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A short sale is a sale of shares that one does not h a v e . A short seller expects the p r i c e of the shares to fall i n future so that he can square his p o s i t i o n at a p r o f i t . O f course, the p r i c e can rise, i n f l i c t i n g a loss o n the short seller. A short sale is a r r a n g e d b y the b r o k e r w h o b o r r o w s shares f r o m another customer or b r o k e r so that the short seller c a n effect d e l i v e r y . The short seller has to b u y back the shares i n future to replace the b o r r o w e d shares a n d also r e p a y a n y d i v i d e n d that m a y have b e e n p a i d o n the shares. T h u s the cash f l o w s associated w i t h the short sale of shares are as f o l l o w s : Time Action Cash flow 0 B o r r o w shares a n d sell t h e m + Initial price 1 B u y shares for replacement a n d p a y dividend - [ E n d i n g price + D i v i d e n d , if any]

Since a short sale entails risk, the b r o k e r insists o n a m a r g i n w h i c h m a y be 25 percent to 50 percent. S u p p o s e y o u w a n t to m a k e a short sale of 1000 shares of A l p h a C o m p a n y at R s . 100 a n d y o u r b r o k e r requires a m a r g i n of 40 percent. Y o u m u s t h a v e a balance of Rs. 40,000 i n y o u r account w i t h the b r o k e r to d o the short sale. T h e m a r g i n is meant to protect the b r o k e r , s h o u l d y o u start l o s i n g m o n e y o n y o u r account. S u p p o s e the shares of A l p h a fall to R s . 80, i n line w i t h y o u r expectation. Y o u b u y 1000 shares, square y o u r p o s i t i o n , a n d b o o k a p r o f i t of R s . 20,000. W h a t h a p p e n s if the p r i c e of A l p h a shares rises to R s . 1 2 0 , ' c o n t r a r y to y o u r expectation? I n this case, y o u r i n i t i a l m a r g i n or e q u i t y p o s i t i o n reduces f r o m R s . 40,000 to R s . 20,000. Initial m a r g i n (equity) R s . 40,000 Loss - R s . 20,000 C u r r e n t m a r g i n (equity) R s . 20,000

T h e b r o k e r w o u l d insist o n a certain m i n i m u m maintenance m a r g i n . S u p p o s e this is 25 percent. T h i s means that y o u r e q u i t y p o s i t i o n m u s t be at least e q u a l to 25 percent of the current value of the stock w h i c h has b e e n s o l d short. I n the present e x a m p l e it s h o u l d be R s . 30,000 (25 percent of R s . 120,000). Since y o u r e q u i t y p o s i t i o n is o n l y R s . 20,000 y o u have to post a n a d d i t i o n a l m a r g i n of R s . 10,000.

3.7

STOCK MARKET QUOTATIONS AND INDICES

I n f o r m a t i o n o n stock m a r k e t a c t i v i t y is r e p o r t e d i n v a r i o u s m e d i a . It is c o v e r e d b y n e w s p a p e r s , business p e r i o d i c a l s , other p u b l i c a t i o n s , r a d i o , a n d t e l e v i s i o n . F o r most of the investors the coverage i n The Economic Times or The Financial Express is reasonably adequate.

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Investors are interested i n k n o w i n g w h a t is h a p p e n i n g to i n d i v i d u a l stocks a n d w h a t is h a p p e n i n g t o the market as a w h o l e . Let u s see h o w the i n f o r m a t i o n about these aspects is r e p o r t e d . Individual Stock Quotations The m a n n e r i n w h i c h d a i l y n e w s p a p e r s p r o v i d e i n f o r m a t i o n o n stock prices m a y be illustrated w i t h the h e l p of the f o l l o w i n g quotations for Bajaj A u t o for January 9, 2008 as g i v e n i n The Economic Times. N o t e that i t is a c o m b i n e d share q u o t a t i o n of the B S E a n d N S E . The BSE quotes are g i v e n first a n d the N S E quotes f o l l o w i n italics. Co., (Prev.CL), Open, High, Low, Close [Vol.,Val. Rs'OOOs, Trades] Bajaj Auto (932.65), 937, 948, 931, 932.85 [46436, 43591.29,1384] (932.80), 940, 949, 931, 933.20 [138630,130216.84, 4404]

P/E 12.7 12.7

MCap. 9438.6 9438.6

52-WkH/L 1200/692 1200/692

The first c o l u m n p r o v i d e s i n f o r m a t i o n o n p r i c e s , v o l u m e , v a l u e , a n d trade. T h e n u m b e r i n the brackets to the r i g h t of the c o m p a n y ' s name, w h i c h i n the case of Bajaj A u t o is R s . 932.65, represents the p r e v i o u s c l o s i n g q u o t a t i o n . T h e set of f o u r u n b r a c k e t e d prices after this represent the o p e n i n g price, the highest price, the lowest price, a n d the c l o s i n g price. F o r Bajaj A u t o these are R s . 937, R s . 948, R s . 931, a n d R s . 932.85 r e s p e c t i v e l y . A f t e r t h e stock p r i c e quotations, there i s a square bracket c o n t a i n i n g three n u m b e r s . The first n u m b e r , 46436, reflects the v o l u m e of shares t r a d e d ; the second n u m b e r , 43591.29, the v a l u e (Rs. i n '000) of shares t r a d e d ; the t h i r d n u m b e r , 1384, the n u m b e r of trades. The second c o l u m n reflects the d i l u t e d P / E , i.e., the ratio of the share's market p r i c e to the f u l l y d i l u t e d e a r n i n g s per share. F o r Bajaj A u t o i t i s 12.7. The t h i r d c o l u m n represents the market capitalisation (Rs. i n crores) of the c o m p a n y , w h i c h for Bajaj A u t o is R s . 9438.6 crore. F i n a l l y , the f o u r t h c o l u m n s h o w s the highest a n d l o w e s t prices d u r i n g the i m m e d i a t e l y p r e c e d i n g 52 weeks, after a d j u s t i n g for b o n u s a n d rights issues of e q u i t y shares, w h i c h are Rs. 1200 a n d Rs. 692. The i m p o r t a n t abbreviations u s e d i n stock exchange quotations are as f o l l o w s : c o n - convertible x d - ex (excluding) d i v i d e n d c d - c u m (with) d i v i d e n d xr - ex (excluding) r i g h t si - s m a l l lot The Types of Stock Market Indices Investors often ask the question: H o w is the m a r k e t d o i n g ? T h i s interest i n the b r o a d m a r k e t m o v e m e n t stems f r o m the general observation that prices of most of the stocks t e n d t o m o v e together, a fact that has a f a i r l y s t r o n g e m p i r i c a l u n d e r p i n n i n g . The

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general m o v e m e n t of the m a r k e t i s t y p i c a l l y m e a s u r e d b y indices r e p r e s e n t i n g the entire m a r k e t o r i m p o r t a n t segments thereof. M o s t of the stock m a r k e t indices u s e d i n practice are of three types: Price-weighted Index A p r i c e - w e i g h t e d i n d e x is a n i n d e x reflecting the s u m of the prices of the s a m p l e stocks o n a certain date i n r e l a t i o n to a base date. T h e p r i c e w e i g h t e d i n d e x assumes that the investor b u y s one share of each stock i n c l u d e d i n the index. Equal-weighted Index A n e q u a l - w e i g h t e d i n d e x is a n i n d e x reflecting the s i m p l e arithmetic average of the price relatives of the sample stocks o n a certain date i n relation to a base date. A n e q u a l - w e i g h t e d i n d e x assumes that the investor invests a n e q u a l a m o u n t of m o n e y i n each stock i n c l u d e d i n the i n d e x . Value-weighted Index A v a l u e - w e i g h t e d i n d e x i s a n i n d e x reflecting the aggregate market capitalisation of the sample stocks o n a certain date i n relation to a base date. A v a l u e - w e i g h t e d i n d e x assumes that the investor allocates m o n e y across v a r i o u s stocks i n c l u d e d i n the i n d e x i n such a w a y that the w e i g h t s assigned to v a r i o u s stocks are p r o p o r t i o n a l to their market capitalisation. T o illustrate the nature of these three types of indices, consider the data for a sample of f i v e stocks for t w o dates, the base date a n d d a y t, g i v e n i n E x h i b i t 3.2. A s s u m i n g that the base date i n d e x v a l u e is 100, the i n d e x values for d a y t for the different types of indices are as f o l l o w s : 314 x 100 = 140 225 915 E q u a l - w e i g h t e d i n d e x : x 100 = 183
6

P r i c e - w e i g h t e d index:

4550 Value-weighted index:


6

x 100 = 160 2850

Exhibit 3.2

Data for Constructing Stock Market Indices

Share

Price on Base Date (Rs)

Price on Day f

Price Relative

No. of Outstanding Shares (in mln) 4 10 20 5 15 50

Market Capitalisation on the Base date (Rs in mln) (1x4) 5 500 800 500 300 750 2850

Market Capitalisation on Day f (Rs in mln) (2x4) 6 700 1000 450 1200 1200 4550

1 A B C D E Sum 50 40 100 20 15 225

2 70 50 90 80 24 314

3 140 125 90 400 160 915

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T o illustrate the nature of different types of indices, w e expressed the current v a l u e i n relation to the v a l u e o n the base date. I n practice the i n d e x v a l u e for a particular d a y is calculated w i t h reference to the i n d e x v a l u e for the p r e v i o u s d a y . F o r example, the v a l u e - w e i g h t e d i n d e x for d a y t is calculated as f o l l o w s : , , , . Index v a l u e - Index v a l u e
T T t M

M a r k e t capitalisation M a r k e t capitalisation

Stock Market Indices in India A n u m b e r of stock m a r k e t indices are constructed i n I n d i a : Sensex, S & P C N X N i f t y Index, R B I Share Price Index, BSE-100 N a t e x , BSE-500, B S E D o l l e x , S & P C N X N i f t y Junior, a n d so o n . O u t of these, the most p o p u l a r indices are S & P C N X N i f t y Index a n d Sensex a n d so they w i l l be d i s c u s s e d i n some length. S&P CNX N ifty A r g u a b l y the most r i g o r o u s l y constructed stock m a r k e t i n d e x i n I n d i a , the Nifty reflects the p r i c e m o v e m e n t of 50 stocks selected o n the basis of m a r k e t cap and l i q u i d i t y (impact cost). T h e base date selected for Nifty is A p r i l 1, 1995. The base v a l u e of Nifty has been set at 1,000. Nifty is a v a l u e - w e i g h t e d i n d e x , i n w h i c h the w e i g h t s of constituents reflect the relative m a r k e t caps of the c o m p a n i e s that constitute the index. The m a n n e r i n w h i c h Nifty is r e p o r t e d i n Economic Times is s h o w n i n E x h i b i t 3.3of course, to save space o n l y a segment of w h a t is reported i n Economic Times is s h o w n i n this exhibit. Exhibit 3.3 Company NIFTY Reliance I n d ONGC Bharti Airtel Days close 4479.25 1972.90 832.60 858.30 NIFTY Mcap (Rs. cr.) 2322476 274926 178085 162832 Day's Weight 100 11.84 7.67 7.01 PE 20.27 23.7 11.0 35.0

% Change 0.10 0.76 -1.00 -1.29

Source: Economic Times, September 5,2007 Sensex P e r h a p s the m o s t w i d e l y f o l l o w e d stock m a r k e t i n d e x i n I n d i a , the B o m b a y Stock E x c h a n g e Sensitive Index, p o p u l a r l y c a l l e d the Sensex, reflects the m o v e m e n t of 30 s e n s i t i v e shares f r o m s p e c i f i e d a n d n o n - s p e c i f i e d g r o u p s . Sensex is a v a l u e w e i g h t e d i n d e x . The base date f o r Sensex is A p r i l 1, 1979, a l t h o u g h the Sensex came i n t o existence o n J a n u a r y 1, 1986 w h e n its v a l u e w a s c o m p u t e d at 598.53 (the base date v a l u e b e i n g 100).

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T i l l A u g u s t 31, 2003, Sensex w a s constructed o n the basis of f u l l market cap. F r o m September 1,2003, Sensex is b e i n g constructed o n the basis of free float market cap. Free float represents the n o n - p r o m o t e r , non-strategic s h a r e h o l d i n g . F o r e x a m p l e the free float of O N G C is not e v e n 15 percent because the rest is o w n e d b y the G o v e r n m e n t of I n d i a a n d p u b l i c sector c o m p a n i e s . T h i s change f r o m f u l l m a r k e t c a p to free float market cap w a s effected to c o n f o r m to the best g l o b a l practice. W i t h the g r o w i n g d o m i n a n c e of i n s t i t u t i o n a l investors interested i n h o l d i n g a b r o a d l y d i v e r s i f i e d p o r t f o l i o , the relevant criteria f o r j u d g i n g a n i n d e x are: C a n the i n d e x be u s e d as a b e n c h m a r k for p o r t f o l i o construction (investability)? C a n the i n d e x be u s e d as a b e n c h m a r k f o r c o m p a r i n g p e r f o r m a n c e i n terms of r e t u r n a n d r i s k (volatility)? I n terms of these criteria, a free float cap w e i g h t e d i n d e x is better t h a n a market cap w e i g h t e d i n d e x . Issues in Constructing the Index

The i m p o r t a n t issues i n constructing a stock market i n d e x are: A r e indices based o n samples reliable? W h a t is the tradeoff b e t w e e n d i v e r s i f i c a t i o n a n d l i q u i d i t y ? S h o u l d w e choose a v a l u e - w e i g h t e d i n d e x l i k e Sensex o r a n e q u a l - w e i g h t e d i n d e x l i k e the E c o n o m i c T i m e s Index of O r d i n a r y Share Prices? Reliability Indices based o n samples (even w h e n samples are as s m a l l as 30) are f a i r l y reliable because of the tendency of a l l stocks to m o v e together. W h e n the p u r p o s e of a n i n d e x is to represent the changes i n the v a l u e of stocks, one c a n have great confidence i n a s m a l l sample of large companies because relatively f e w companies account for a large p r o p o r t i o n of the v a l u e of a l l companies. Tradeoff D i v e r s i f y i n g the i n d e x reduces risk, b u t at a d i m i n i s h i n g rate. Increasing the sample size f r o m 10 stocks to 20 stocks reduces risk s h a r p l y , b u t g o i n g f r o m 50 stocks to 100 stocks b r i n g s o n l y a m a r g i n a l r e d u c t i o n i n r i s k . W h i l e the r i s k r e d u c t i o n benefit d i m i n i s h e s , a serious p r o b l e m arises if i l l i q u i d stocks have to be i n c l u d e d . Since prices of s u c h i l l i q u i d stocks are contaminated, they m a y w o r s e n the q u a l i t y of the i n d e x . H e n c e , c o n s t r u c t i n g a g o o d i n d e x i n v o l v e s a tradeoff b e t w e e n d i v e r s i f i c a t i o n a n d liquidity. Choice If the objective i s to indicate changes i n the aggregate v a l u e of a l l stocks, a v a l u e - w e i g h t e d i n d e x is a p p r o p r i a t e . O n the other h a n d , i f the p u r p o s e of the i n d e x is to reflect price m o v e m e n t s of t y p i c a l o r average stocks, a n e q u a l - w e i g h t e d i n d e x i s more appropriate.

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Stock Market Indices around the World T h e m o s t p o p u l a r stock m a r k e t i n d i c e s a r o u n d the w o r l d are the D o w Jones Industrial A v e r a g e , the S t a n d a r d & P o o r ' s C o m p o s i t e 500 Index, N i k k e i 225, a n d F T S E ( p r o n o u n c e d "footsie"). The D o w Jones I n d u s t r i a l A v e r a g e (DJIA) is based o n 30 large, " b l u e - c h i p " corporations i n the U S . It is a p r i c e - w e i g h t e d i n d e x . The S t a n d a r d & P o o r ' s C o m p o s i t e 500 ( S & P 500) stock i n d e x is a b r o a d based i n d e x of 500 U S stocks. It is a market v a l u e - w e i g h t e d i n d e x . The N i k k e i 225 is based o n the largest 225 stocks of T o k y o Stock E x c h a n g e . It is a p r i c e - w e i g h ted average. F T S E p u b l i s h e d b y the F i n a n c i a l T i m e s of L o n d o n i s b a s e d o n 100 large L o n d o n Stock Exchange stocks. It is a v a l u e - w e i g h t e d i n d e x .

3.8

SEBI AND FUTURE CHALLENGES

Before the establishment of the Securities a n d E x c h a n g e B o a r d of I n d i a (SEBI), the p r i n c i p a l legislations g o v e r n i n g the securities market i n I n d i a w e r e the C a p i t a l Issues C o n t r o l A c t , 1956 ( g o v e r n i n g the p r i m a r y market) a n d the Securities Contracts (Regulations) A c t , 1956 ( g o v e r n i n g the secondary market). The r e g u l a t o r y p o w e r s w e r e vested w i t h the C o n t r o l l e r of C a p i t a l Issues (for the p r i m a r y market) a n d the Stock E x c h a n g e D i v i s i o n (for the secondary market) i n the M i n i s t r y of Finance, G o v e r n m e n t of I n d i a . In 1989, SEBI w a s created b y a n a d m i n i s t r a t i v e fiat of the M i n i s t r y of Finance. Since then, SEBI has g r a d u a l l y been granted m o r e a n d m o r e p o w e r s . W i t h the repeal of the C a p i t a l Issues C o n t r o l A c t a n d the enactment of the SEBI A c t i n 1992, the r e g u l a t i o n of the p r i m a r y market has become the preserve of S E B I . Further, the M i n i s t r of Finance, G o v e r n m e n t of I n d i a , has transferred most of the p o w e r s u n d e r the Securities Contracts (Regulations) A c t , 1956 to SEBI. SEBI's p r i n c i p a l tasks are to: h Regulate the business i n stock exchanges a n d any other securities markets. Register a n d regulate the w o r k i n g of c a p i t a l m a r k e t i n t e r m e d i a r i e s (brokers, merchant bankers, p o r t f o l i o managers, a n d so on). Register a n d regulate the w o r k i n g of m u t u a l f u n d s . P r o m o t e a n d regulate self-regulatory organisations. P r o h i b i t f r a u d u l e n t a n d u n f a i r trade practices i n securities markets. P r o m o t e i n v e s t o r s ' e d u c a t i o n a n d t r a i n i n g of i n t e r m e d i a r i e s of securities markets. P r o h i b i t i n s i d e r t r a d i n g i n securities. Regulate substantial a c q u i s i t i o n of shares a n d takeovers of companies, a P e r f o r m s u c h other functions as m a y be p r e s c r i b e d .

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Management

SEBI has taken a n u m b e r of steps i n the last f e w years to r e f o r m the I n d i a n capital market. It has c o v e r e d the entire g a m u t of capital market activities t h r o u g h n e a r l y 30 legislations. The i m p o r t a n t initiatives are m e n t i o n e d b e l o w . Freedom in Designing and Pricing Instruments C o m p a n i e s n o w enjoy substantial f r e e d o m i n d e s i g n i n g the instruments of f i n a n c i n g as l o n g as they f u l l y disclose the character of the same. M o r e i m p o r t a n t , they enjoy considerable latitude i n p r i c i n g the same. Ban on Badla The f i n a n c i a l irregularities of 1992 h i g h l i g h t e d the deficiencies of the ' b a d l a ' system w h i c h p e r m i t t e d excessive l e v e r a g i n g . T o rectify the defects i n t r a d i n g practices, the ' b a d l a ' system has been b a n n e d . Screen-based Trading T h a n k s to the c o m p e t i t i o n p o s e d b y the N a t i o n a l Stock Exchange a n d the insistence or p r o d d i n g d o n e b y SEBI, a l l the exchanges have s w i t c h e d to screen-based t r a d i n g . Electronic Transfer The t r a d i t i o n a l m e t h o d of transfer b y endorsement o n security a n d registration b y issuer has been s u p p l a n t e d b y electronic transfer i n b o o k entry f o r m b y depositories. Risk Management A c o m p r e h e n s i v e r i s k m a n a g e m e n t s y s t e m that covers c a p i t a l a d e q u a c y , l i m i t s o n e x p o s u r e a n d t u r n o v e r , m a r g i n s b a s e d o n V A R (value at r i s k ) , client l e v e l gross m a r g i n i n g , a n d o n l i n e m o n i t o r i n g of positions has been i n t r o d u c e d . Rolling Settlement T h e t r a d i n g cycle, w h i c h w a s p r e v i o u s l y one w e e k , has b e e n r e d u c e d to one d a y a n d the system of r o l l i n g settlement has been i n t r o d u c e d . Corporate Governance Code A n e w code of corporate governance, b a s e d o n the r e c o m m e n d a t i o n s of the K u m a r a m a n g a l a m B i r l a C o m m i t t e e report, has been d e f i n e d . It has b e e r i o p e r a t i o n a l i s e d b y i n s e r t i n g a n e w clause (clause 49) i n the L i s t i n g Agreementa>-tne agreement that a listed c o m p a n y enters into w i t h the stock exchange w h e r e its securities are l i s t e d . Change in Management Structure Stock exchanges earlier w e r e b r o k e r d o m i n a t e d . SEBI n o w requires 50 percent n o n - b r o k e r directors. F u r t h e r , it has m a n d a t e d that a n o n - b r o k e r professional be a p p o i n t e d as the E x e c u t i v e D i r e c t o r . Registration and Regulation of Intermediaries C a p i t a l m a r k e t intermediaries s u c h as merchant b a n k e r s , u n d e r w r i t e r s , b a n k e r s to the issue, registrars, transfer agents, brokers, a n d sub-brokers are r e q u i r e d to be registered w i t h SEBI. Regulations for these intermediaries h a v e been p r e s c r i b e d . Redressal of Investor Grievances Investor grievances have been o n the rise. T h a n k s to the steps t a k e n b y S E B I the redressal ratio (the ratio of c o m p l a i n t s r e s o l v e d to c o m p l a i n t s received) has i m p r o v e d . Regulation of Mutual Funds M u t u a l f u n d s have been b r o u g h t u n d e r the p u r v i e w of SEBI a n d SEBI has issued the regulatory g u i d e l i n e s for this p u r p o s e .

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Regulation of Foreign Portfolio Investment T h e g o v e r n m e n t w e l c o m e s f o r e i g n p o r t f o l i o investment i n the I n d i a n capital market. SEBI has f o r m u l a t e d g u i d e l i n e s to p e r m i t this i n v e s t m e n t t h r o u g h b r o a d - b a s e d f u n d s (such as m u t u a l f u n d s , p e n s i o n f u n d s , a n d c o u n t r y funds) referred to as f o r e i g n i n s t i t u t i o n a l investors. Development of a Code for Takeover Takeovers are g a i n i n g i m p o r t a n c e i n I n d i a . S E B I has d e v e l o p e d a code for r e g u l a t i n g t h e m . Introduction of Equity Derivatives SEBI has a l l o w e d the i n t r o d u c t i o n of e q u i t y derivatives l i k e stock i n d e x futures, stock i n d e x options, i n d i v i d u a l stock options, a n d i n d i v i d u a l stock futures. > Integrated Market Surveillance System SEBI has l a u n c h e d a n I M S S f r o m December 2006. I M S S integrates data f r o m stock exchanges, depositories, a n d c l e a r i n g c o r p o r a t i o n s / h o u s e s a n d comes u p w i t h alerts, b a s e d o n certain p r e - s p e c i f i e d parameters. S u c h integration of data has been done for the first time i n a n y m a r k e t i n the w o r l d . T h a n k s to I M S S , officials of S E B I can detect c a p i t a l m a r k e t offences l i k e market d o m i n a t i o n a n d c o n t r o l , artificial r i g g i n g , a n d creation of false market. I M S S is meant to c u r b w a s h sales, m a t c h e d orders, s y n c h r o n i s e d t r a d i n g , front r u n n i n g , c o r n e r i n g of free float, p u m p i n g a n d d u m p i n g ( i n f l a t i n g share prices a n d t h e n u n l o a d i n g the same o n u n s u s p e c t i n g investors), a n d other forms of d e m a n d a n d s u p p l y manipulation.

Thrust of SEBI's Regulation

Primary Market
Access Instruments Pricing Disclosure norms R e s p o n s i b i l i t y of merchant bankers Method Restricted Multiplied Relaxed Tightened Enhanced Book building

Secondary Market
Trading Settlement m o d e Transaction costs Transparency Markets Globalisation R i s k management Exchange management Settlement p e r i o d Computerised Electronic Lowered Enhanced Integrated Encouraged Strengthened Improved Shortened

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W h i l e S E B I has d o n e a great d e a l , it has a l o n g w a y to go i n a c c o m p l i s h i n g its m i s s i o n . It has to address several challenges s u c h as the f o l l o w i n g : Preponderance of Speculative Trading and Skewed Distribution of Turnover There is a p r e p o n d e r a n c e of speculative t r a d i n g w h e r e the p r i m a r y m o t i v e is to d e r i v e benefit f r o m short-term fluctuations. O n l y a s m a l l fraction of trades results i n d e l i v e r y . E a r l i e r w h e n the account p e r i o d w a s one w e e k a n d the f a c i l i t y of b a d l a w a s a l l o w e d , n e a r l y 90 percent of the trades w e r e s q u a r e d u p w i t h i n the account p e r i o d or c a r r i e d f o r w a r d . A f t e r the i n t r o d u c t i o n of r o l l i n g settlement, i n t r a - d a y s q u a r i n g has become c o m m o n . A f t e r the b a n of b a d l a , i n d i v i d u a l stock futures, w h i c h are cash-settled, h a v e become very popular. A n a l l i e d p r o b l e m is that the d i s t r i b u t i o n of t r a d i n g is h i g h l y s k e w e d . A b o u t 10 scrips account for n e a r l y 80 percent of the t u r n o v e r o n the stock market. T h a n k s to s u c h s k e w e d d i s t r i b u t i o n of t r a d i n g , m o s t shares are t r a d e d i n f r e q u e n t l y a n d , hence, l a c k liquidity. L . C . G u p t a argues that the over-speculative character of the I n d i a n m a r k e t is evident f r o m the f o l l o w i n g : (i) There is a n extremely h i g h concentration of t r a d i n g i n a s m a l l n u m b e r of shares to the neglect of the r e m a i n i n g shares, (ii) The t r a d i n g v e l o c i t y is a b s u r d l y h i g h for 'speculative counters'the t r a d i n g v e l o c i t y of a share is d e f i n e d as: T o t a l t r a d i n g v o l u m e i n the share d u r i n g a year d i v i d e d b y its market capitalisation, (hi) H a r d l y 10 to 15 percent of the transactions are genuine investment transactions, the balance b e i n g speculative transactions. T o mitigate excessive s p e c u l a t i o n i n the cash m a r k e t a n d p r o m o t e l i q u i d i t y across the b o a r d , the f o l l o w i n g steps m a y be taken:
1

I n t r o d u c e m a r g i n t r a d i n g w h e r e i n investors p u t u p a certain a m o u n t for purchase of securities, the balance b e i n g lent b y brokerage f i r m s . E n c o u r a g e market m a k i n g b y jobbers P r o v i d e lines of credit to brokerage f i r m s . Market Abuses Insider t r a d i n g , market m a n i p u l a t i o n , a n d price r i g g i n g continue to i m p a i r the q u a l i t y of the m a r k e t . Insiders, w h o are p r i v y to price-sensitive i n f o r m a t i o n , m a y use s u c h i n f o r m a t i o n to their advantage. O f t e n , companies i s s u i n g securities i n the domestic m a r k e t or i n t e r n a t i o n a l c a p i t a l m a r k e t a r t i f i c i a l l y r i g u p prices. Cartels of p o w e r f u l b r o k e r s t e n d to p l a y m a n i p u l a t i v e games o n the market. It is v i r t u a l l y i m p o s s i b l e to e l i m i n a t e m a r k e t abuses because the i n g e n u i t y of m a n i p u l a t o r s manifests itself i n u n a n t i c i p a t e d w a y s . Nevertheless a v i g i l a n t r e g u l a t o r y b o d y , w e l l - m a n a g e d exchanges, a n d severe penalties can go a l o n g w a y i n m i t i g a t i n g m a r k e t abuses. T h o u g h some progress has been m a d e i n that d i r e c t i o n , a lot m o r e has to be d o n e .
1

L.C. Gupta, Stock Exchanges in India: Agenda for Reform New Delhi: Society for Capital Market Research & Development, 1992.

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MM

Improved Disclosure Standards D i s c l o s u r e standards i n I n d i a have i m p r o v e d s i g n i f i c a n t l y i n the last decade or so. The standards for w h a t , w h e n , a n d w h e r e of disclosure have been s p e c i f i e d i n the C o m p a n i e s A c t , D i s c l o s u r e a n d Investment P r o t e c t i o n G u i d e l i n e s ( D I P G ) , l i s t i n g agreement, takeover code, regulations r e l a t i n g to i n s i d e r t r a d i n g , a n d so o n . D i s c l o s u r e s relate to f i n a n c i a l p e r f o r m a n c e , s h a r e h o l d i n g p a t t e r n , i n s i d e r t r a d i n g , a c q u i s i t i o n s , related p a r t y transactions, a u d i t q u a l i f i c a t i o n s , share b u y b a c k s , corporate governance, d i r e c t o r r e m u n e r a t i o n , r i s k m a n a g e m e n t , u t i l i s a t i o n of issue proceeds, a n d so o n . Disclosures are m a d e t h r o u g h v a r i o u s d o c u m e n t s l i k e prospectuses, q u a r t e r l y statements, a n n u a l reports, a n d so o n , a n d are d i s s e m i n a t e d t h r o u g h v a r i o u s m e d i a , c o m p a n y websites, exchange websites, a n d E D I F A R (Electronic D a t a I n f o r m a t i o n F i l i n g a n d Retrieval) S y s t e m m a i n t a i n e d b y S E B I . T h a n k s to these i m p r o v e m e n t s , disclosure standards i n I n d i a are w o r l d class. I n their article ' W h a t W o r k s i n Securities L a w s , " L a P o r t a et. a l g i v e I n d i a 100 percent m a r k s o n disclosure.

3.9

STOCK MARKET ABROAD

It is i n s t r u c t i v e to h a v e a g l i m p s e i n t o the l e a d i n g stock markets a b r o a d . Stock Market in the US The t w o largest stock exchanges i n the U S , as w e l l as the w o r l d , are the N e w Y o r k Stock Exchange ( N Y S E ) a n d the N A S D A Q . New York Stock Exchange The w o r l d ' s biggest stock exchange i n terms of m a r k e t capitalisation, the N Y S E has f a i r l y stringent l i s t i n g requirements w h i c h seek to ensure that o n l y large, f i n a n c i a l l y s t r o n g c o m p a n i e s get l i s t e d . T r a d i n g o n the N Y S E takes place t h r o u g h a system of brokers a n d specialists. Brokers serve as a l i n k between the investors a n d the market. Specialists p l a y a d u a l role: (i) T h e y match b u y a n d sell orders w h e n p r e v a i l i n g prices p e r m i t t h e m to d o so. (ii) T h e y b u y a n d sell stocks o n their o w n account w h e n they cannot match customer orders. N A S D A Q N A S D A Q is a short f o r m for N a t i o n a l A s s o c i a t i o n of Securities Dealers A u t o m a t e d Q u o t a t i o n S y s t e m . W h i l e the m a r k e t capitalisation of N A S D A Q is less t h a n that of N Y S E , N A S D A Q is the biggest exchange of the w o r l d i n terms of t u r n o v e r . T h e success of N A S D A Q is m a i n l y d u e to investor interest i n t e c h n o l o g y stocks, a h i g h p r o p o r t i o n of w h i c h has b e e n l i s t e d o n this exchange. F o r e x a m p l e , t e c h n o l o g y h e a v y w e i g h t s l i k e C i s c o , Intel, a n d M i c r o s o f t have their l i s t i n g o n l y o n N A S D A Q . The l i g h t l i s t i n g requirements of N A S D A Q attracts y o u n g technology c o m p a n i e s a n d the low l i s t i n g costs at N A S D A Q keeps t h e m w i t h that exchange w h e n they h a v e g r o w n .

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N A S D A Q is a dealer m a r k e t w h i c h has substantial h u m a n i n v o l v e m e n t . M a r k e t m a k e r s p o s t the prices at w h i c h they are w i l l i n g to b u y a n d sell o n the screens of brokers, w h o i n t u r n choose a m o n g c o m p e t i n g market m a k e r s to h a n d l e the d e s i r e d trade. O v e r 500 market makers compete to m a k e markets i n over 5000 issues v i a a screenbased system of c o m p e t i n g quotes. N A S D A Q requires that a l l listed shares m u s t have at least t w o m a r k e t makers. The average n u m b e r of m a r k e t makers per stock is about 10 a n d some of the large capitalisation stocks have about 40 m a r k e t makers. Yet, there is a c r i t i c i s m that there is inadequate c o m p e t i t i o n a m o n g market makers, p a r t i c u l a r l y for s m a l l capitalisation stocks. Electronic Communications Networks L a r g e i n s t i t u t i o n a l investors m a y prefer to trade w i t h one another d i r e c t l y , rather t h a n s e n d a large o r d e r to the f l o o r of the exchange w h e r e they t e n d to suffer m a r k e t i m p a c t costs. O n e w a y to d o is t h r o u g h electronic c o m m u n i c a t i o n n e t w o r k s ( E C N s ) , w h i c h are electronic t r a d i n g systems that m a t c h b u y a n d sell orders at specified prices. In 1997, the Securities E x c h a n g e C o m m i s s i o n a l l o w e d t r a d i n g t h r o u g h E C N s . E C N s I n s t i n c t a n d I s l a n d E C N b e i n g the t w o most p r o m i n e n t E C N s h a v e c a p t u r e d n e a r l y 35-40 percent of the N a s d a q - l i s t e d stock v o l u m e a n d represent a n i m p o r t a n t source of c o m p e t i t i o n . Stock Market in the UK The stock m a r k e t i n the U K u n d e r w e n t a r a d i c a l r e f o r m i n 1986, referred to p o p u l a r l y as the ' b i g b a n g ' , w h i c h l e d to the a m a l g a m a t i o n of a l l the exchanges i n U K a n d Ireland into the 'International Stock Exchange of U K a n d I r e l a n d ' headquartered i n L o n d o n . T h i s has l e d to the emergence of a single electronic n a t i o n a l m a r k e t of U K a n d the closure of r e g i o n a l exchanges. Investors c a n access this market t h r o u g h local b r o k e r s or l o c a l branches of n a t i o n a l brokers. Equities are t r a d e d o n this market u s i n g the Stock Exchange A u t o m a t i c Q u o t a t i o n ( S E A Q ) System, a ' q u o t e - d r i v e n ' system or the Stock Exchange A u t o m a t i c E x e c u t i o n F a c i l i t y ( S E A F ) , a n ' o r d e r - d r i v e n ' system. U n d e r the 'quote d r i v e n ' m e c h a n i s m , market m a k e r s p r o v i d e t w o - w a y quotes v i a S E A Q . Based o n these quotes, m a r k e t participants contact the m a r k e t m a k e r s to negotiate a n d trade. U n d e r the ' o r d e r - d r i v e n ' m e c h a n i s m , clients give their orders to b r o k e r s w h i c h are f e d to the S A E F . These are a u t o m a t i c a l l y executed a c c o r d i n g to certain rules. I n f o r m e d observers believe that the ' b i g b a n g ' has v e r i t a b l y t r a n s f o r m e d the stock market i n the U K . It has l e d to significant i m p r o v e m e n t i n terms of t u r n o v e r , l i q u i d i t y , a m o u n t of capital r a i s e d , a n d l o w e r i n g of the b i d - a s k s p r e a d . V o l a t i l i t y , h o w e v e r , has not c h a n g e d . Stock Market in Japan The T o k y o Stock Exchange (TSE) is the d o m i n a n t stock exchange i n Japan, a c c o u n t i n g for about four-fifths of total t r a d i n g . The T S E d i v i d e s stocks i n t o t w o sections. T h e First Section consists of about 1200 m o s t actively t r a d e d stocks; the Second Section consists

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of about 400 less actively t r a d e d stocks. T r a d i n g i n the larger stocks of the First Section occurs o n the floor of the exchange. The r e m a i n i n g stocks i n the First Section a n d the Second Section are t r a d e d electronically. The T S E relies o n saitories w h o m a t c h orders b u t d o not trade o n their o w n account. A saitori maintains a p u b l i c l i m i t order b o o k , matches m a r k e t a n d l i m i t orders, a n d s l o w s d o w n p r i c e m o v e m e n t s w h e n s i m p l e m a t c h i n g of orders w o u l d result i n price changes greater t h a n w h a t is prescribed b y the exchange. Emerging Stock Markets

The t e r m e m e r g i n g stock m a r k e t s ( E S M s ) , as d e f i n e d b y the International iFinance C o r p o r a t i o n , refers to stock markets i n d e v e l o p i n g countries. E S M s r e c e i v e d p r o m i n e n c e i n the 1980s w h e n the f o r m e r socialistic economies a n d d e v e l o p i n g countries e m b r a c e d the m a r k e t b a s e d s y s t e m i n place of centralised p l a n n i n g a n d closed or i n w a r d - l o o k i n g system. E S M s m a y be classified into three g r o u p s : The first g r o u p represents markets i n A f r i c a ( K e n y a , Z i m b a b w e ) , Eastern E u r o p e ( H u n g a r y a n d P o l a n d ) , a n d former Soviet U n i o n (Belarus a n d U k r a i n e ) . These markets are i n the early stages of d e v e l o p m e n t a n d are characterised b y f e w q u o t e d c o m p a n i e s , l o w capitalisation, h i g h concentration, p o o r l i q u i d i t y , a n d high volatility. * The second g r o u p represents markets i n countries l i k e B r a z i l , I n d i a , P h i l i p p i n e s , P a k i s t a n , a n d C h i n a . These markets are f a i r l y d e v e l o p e d w i t h a large n u m b e r of l i s t e d c o m p a n i e s , g o o d l i q u i d i t y , a n d reasonable p a r t i c i p a t i o n b y f o r e i g n investors. The t h i r d g r o u p represents m o r e mature markets l i k e H o n g K o n g , K o r e a , a n d S i n g a p o r e . These m a r k e t s are c o m p a r a b l e to those i n the west i n terms of l i q u i d i t y , t r a d i n g activity, a n d equity risk p r e m i u m .

1 *10

SHOULD TRADING BE REGULATED?

M a n y i n f o r m e d observers of the capital m a r k e t have a r g u e d that there is a case for r e g u l a t i n g the v o l u m e of t r a d i n g i n the capital market to check excessive speculation. N o t a b l e a m o n g t h e m are J o h n M a y n a r d K e y n e s , James T o b i n , a n d W a r r e n Buffett. J o h n M a y n a r d K e y n e s , p e r h a p s the m o s t i n f l u e n t i a l economist of the t w e n t i e t h c e n t u r y , m a d e a fine d i s t i n c t i o n b e t w e e n ' i n d u s t r y ' a n d 'finance'. Industry refers to the activities i n v o l v e d i n p r o c u r i n g , m a n u f a c t u r i n g , a n d m a r k e t i n g goods a n d services; m o n e y f l o w s associated w i t h i n d u s t r y m a y be referred to as ' i n d u s t r i a l c i r c u l a t i o n ' . Finance refers to the business of h o l d i n g a n d e x c h a n g i n g titles to w e a l t h ; m o n e y f l o w s i n v o l v e d i n s u c h activities m a y be referred to as ' f i n a n c i a l c i r c u l a t i o n ' . J o h n M a y n a r d K e y n e s b e l i e v e d that a fair balance m u s t be m a i n t a i n e d b e t w e e n i n d u s t r i a l c i r c u l a t i o n a n d f i n a n c i a l c i r c u l a t i o n . If there is excessive ' f i n a n c i a l c i r c u l a t i o n ' o n account of u n d u e speculation it m a y l e a d to d i s t o r t i o n i n the e c o n o m y . E c h o i n g a s i m i l a r v i e w , James T o b i n , a N o b e l

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Laureate i n economics, p r o p o s e d some k i n d of tax o n f i n a n c i a l transactions i n o r d e r to keep m o n e y f l o w s w i t h i n reasonable b o u n d s . I n a s i m i l a r v e i n , W a r r e n Buffett, p e r h a p s the most successful investor of o u r times, suggested that each investor s h o u l d be g i v e n a c a r d c o n t a i n i n g a certain n u m b e r of holes to b e p u n c h e d a n d each t i m e the investor trades a hole s h o u l d be p u n c h e d . T h e i d e a is to i n d u c e c i r c u m s p e c t i o n i n t r a d i n g a n d check speculative tendencies. W h i l e the v i e w s of J o h n M a y n a r d K e y n e s , James T o b i n , a n d W a r r e n Buffett seem to m a k e sense, they have n o t b e e n i m p l e m e n t e d . W h y ? A p p a r e n t l y there are f o u r reasons. First, it curtails a person's f r e e d o m to engage i n a legitimate economic a c t i v i t y . Second, it m a y be a d m i n i s t r a t i v e l y i m p r a c t i c a l . T h i r d , a n d p e r h a p s m o s t i m p o r t a n t , i t m a y i m p a i r the efficiency of the process of p r i c e d i s c o v e r y i n f i n a n c i a l m a r k e t s . M a n y f i n a n c i a l economists believe that the p r i m a r y f u n c t i o n of f i n a n c i a l markets is to d i s c o v e r prices. T o p e r f o r m this f u n c t i o n the m a r k e t aggregates the i n f o r m a t i o n a n d j u d g m e n t of m i l l i o n s of p l a y e r s w h o participate i n the m a r k e t t h r o u g h their t r a d i n g activities. F o u r t h , a c e r t a i n a m o u n t of s p e c u l a t i o n a n d one does n o t k n o w h o w m u c h i s essential f o r l i q u i d i t y i n f i n a n c i a l markets. A l i q u i d m a r k e t i n d u c e s investors to save a n d invest w h i c h i n t u r n is necessary for e c o n o m i c g r o w t h . H e n c e speculation, e v e n t h o u g h it m a y appear unpalatable to m a n y , has to be p e r m i t t e d . P e r h a p s , it is a necessary e v i l . T h i s p o i n t w a s g r u d g i n g l y a d m i t t e d b y J . M . K e y n e s i n the f o l l o w i n g w o r d s : " T h e spectacle of m o d e r n i n v e s t m e n t m a r k e t s has sometimes m o v e d m e t o w a r d s the c o n c l u s i o n that to m a k e the p u r c h a s e of i n v e s t m e n t p e r m a n e n t a n d i n d i s s o l u b l e , l i k e m a r r i a g e , except b y reason of death o r other grave cause, m i g h t be a u s e f u l r e m e d y for o u r c o n t e m p o r a r y e v i l s . F o r this w o u l d force the investor to direct h i s m i n d to the l o n g - t e r m prospects a n d to those o n l y . B u t a little c o n s i d e r a t i o n of this expedient b r i n g s u s u p against a d i l e m m a a n d s h o w s u s h o w the l i q u i d i t y of investment markets often facilitates, t h o u g h it sometimes i m p e d e s , the cause of n e w investment.' Leo M e l a m e d , President a n d C h a i r m a n Emeritus, Chicago Mercantile Exchange offers a s t r o n g justification f o r s p e c u l a t i o n . H e says: "Finally, one cannot speak about efficiency of markets without mentioning the role of the speculator. All modern analysis leads to the conclusion that competitive speculation serves an all-important role in improving price efficiency. Speculation enhances market liquidity by creating higher levels of trading and a tighter bid-ask spread. The more trading and smaller the spread, the more market prices will migrate toward their true values. The more investors are confident that market prices reflect a high degree of accurate information, the more willing they are to commit capital with a smaller premium for uncertainty. Thus where speculation is high, the cost of capital will be lower, and the efficient allocation of capital among competing investments more likely. In other words, just as Adam Smith suggested a long time ago, by performing his speculative function, the speculator serves the overall economy".

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$Hft

GOVERNMENT SECURITIES MARKET

'

The g o v e r n m e n t securities (G-secs) m a r k e t is the largest segment of the l o n g - t e r m debt market i n I n d i a , a c c o u n t i n g for n e a r l y t w o - t h i r d s of the issues i n the p r i m a r y market a n d m o r e t h a n four-fifths of the t u r n o v e r i n the secondary market. F r o m 1990 o n w a r d s , the G-secs m a r k e t i n I n d i a has w i t n e s s e d significant developments s u c h as: I n t r o d u c t i o n of auction-based p r i c e d e t e r m i n a t i o n . m D e v e l o p m e n t of the RBI's y i e l d curve for m a r k i n g to market the G-secs p o r t f o l i o s of the b a n k s . I n t r o d u c t i o n of the system of p r i m a r y dealers. * I n t r o d u c t i o n of D V P (delivery versus payment) for settlement. Increase i n the n u m b e r of players i n the G-secs m a r k e t w i t h the facility for n o n competitive b i d d i n g i n auctions. Establishments of gilt-oriented m u t u a l f u n d s . Re-emergence of repos as a n i n s t r u m e n t of short-term l i q u i d i t y management. P h e n o m e n a l g r o w t h i n the v o l u m e of secondary m a r k e t transactions i n G-secs. * Emergence of self-regulating bodies s u c h as the P r i m a r y Dealers A s s o c i a t i o n of I n d i a ( P D A I ) a n d F i x e d Income a n d M o n e y M a r k e t Dealers A s s o c i a t i o n (FIMMDA). * Setting U p of the screen-based t r a d i n g system l i n k e d to the N e g o t i a t e d D e a l i n g System. Establishment of the C l e a r i n g C o r p o r a t i o n of I n d i a L i m i t e d ( C C I L ) .

Primary Issue
The issue of G-secs is regulated b y the Reserve B a n k of I n d i a u n d e r the P u b l i c D e b t A c t ( w h i c h is to be replaced b y the G o v e r n m e n t Securities A c t ) . G-secs are i s s u e d t h r o u g h a n a u c t i o n m e c h a n i s m . The Reserve B a n k of I n d i a (RBI), w h i c h essentially serves as the merchant banker to the central a n d state governments, announces the a u c t i o n of G-secs t h r o u g h a press n o t i f i c a t i o n a n d invites b i d s f r o m prospective investors l i k e banks, insurance companies, m u t u a l f u n d s , a n d so o n . The RBI opens the sealed b i d s at a n a p p o i n t e d time a n d makes allotment o n the basis of the cut -off p r i c e d e c i d e d b y it. T w o systems of treasury auctions are w i d e l y u s e d a l l over the w o r l d : (a) F r e n c h a u c t i o n (or variable p r i c e auction), (b) D u t c h a u c t i o n (or u n i f o r m p r i c e auction). In a F r e n c h a u c t i o n , successful b i d d e r s p a y the actual p r i c e (yield) they b i d for whereas i n a D u t c h a u c t i o n successful b i d d e r s p a y a u n i f o r m p r i c e w h i c h is u s u a l l y the cut off p r i c e (yield). G e n e r a l l y , the R B I f o l l o w s the F r e n c h a u c t i o n ; o c c a s i o n a l l y , it adopts the D u t c h a u c t i o n . C e r t a i n categories of prospective investors can s u b m i t n o n - c o m p e t i t i v e b i d s . Those w h o s u b m i t s u c h b i d s receive allotment (from a s m a l l p o r t i o n reserved for them) at the w e i g h t e d average price of a l l successful b i d s .

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Participants in the G-secs Market B a n k s are the largest h o l d e r s of G-secs. A b o u t onet h i r d of the net d e m a n d a n d time liabilities of the banks are i n v e s t e d i n G-secs m a i n l y to meet statutory l i q u i d i t y requirements a n d p a r t l y f o r investment p u r p o s e s . A p a r t f r o m b a n k s , insurance companies a n d p r o v i d e n t f u n d s have substantial h o l d i n g s of G secs - almost one-fifth of the o u t s t a n d i n g G-secs are h e l d b y these institutions. O t h e r investors i n G-secs i n c l u d e m u t u a l f u n d s , p r i m a r y a n d satellite dealers, a n d trusts. SGL Account The R B I p r o v i d e s the f a c i l i t y of S u b s i d i a r y G e n e r a l L e d g e r ( S G L ) account to large b a n k s a n d f i n a n c i a l institutions so that they can h o l d their investment i n G-secs a n d treasury b i l l s i n the electronic b o o k entry f o r m . These institutions c a n settle their trades i n securities t h r o u g h a D V P (delivery versus p a y m e n t ) m e c h a n i s m , w h i c h ensures a s i m u l t a n e o u s transfer of f u n d s a n d securities. Investors w h o d o not have access to the S G L account system c a n o p e n a constituent S G L account w i t h entities a u t h o r i s e d b y the R B I for this p u r p o s e . Primary Dealers I n t r o d u c e d i n 1995, p r i m a r y dealers are i m p o r t a n t intermediaries i n the G-secs m a r k e t . T h e y are a p p o i n t e d b y the R B I . Presently there are about 20 p r i m a r y dealers. T h e y serve as u n d e r w r i t e r s i n the p r i m a r y debt market, act as market m a k e r s i n the secondary debt market, a n d enable investors to access the S G L account. P r i m a r y dealers h a v e access to the c a l l market a n d repo m a r k e t for f u n d s . Secondary Market for G-secs

A s s o o n as they are i s s u e d , G-secs are d e e m e d to be listed a n d eligible for t r a d i n g . The N a t i o n a l Stock Exchange (NSE) has a W h o l e s a l e D e b t M a r k e t ( W D M ) segment w h i c h is a f u l l y automated screen based t r a d i n g system meant p r i m a r i l y for banks, institutions, dealers, a n d corporates w h o d o h i g h v a l u e transactions i n debt securities. L o n g - t e r m instruments s u c h as b o n d s a n d debentures as w e l l as short-term instruments s u c h as treasury b i l l s a n d c o m m e r c i a l p a p e r can be t r a d e d i n the W D M segment of N S E . H i s t o r i c a l l y , g o v e r n m e n t securities w e r e t r a d e d o n the stock exchanges. Later, the t r a d i n g s h i f t e d to a n over-the-counter m a r k e t i n w h i c h trades w e r e d o n e d i r e c t l y b e t w e e n the b u y e r a n d the seller, or, m o r e c o m m o n l y t h r o u g h b r o k e r s . Indeed, b r o k e r i n t e r m e d i a t e d t r a d i n g w a s the n o r m for m a n y years. H o w e v e r , b r o k e r - i n t e r m e d i a t e d t r a d i n g suffers f r o m certain weaknesses, (i) It g e n e r a l l y takes m o r e time to c o n c l u d e a d e a l , (ii) It lacks adequate transparency, (iii) It entails h i g h e r transaction costs because of larger b i d / o f f e r spreads a n d b r o k e r commission. NDS and Electronic Trading G i v e n the s h o r t c o m i n g s of b r o k e r - i n t e r m e d i a t e d t r a d i n g , there is a w o r l d w i d e t r e n d t o w a r d electronic t r a d i n g . I n I n d i a , the first step t o w a r d electronic t r a d i n g i n b o n d s w a s taken w h e n RBI's N e g o t i a t e d D e a l i n g System ( N D S ) w a s i n t r o d u c e d i n F e b r u a r y 2002. N D S w a s meant to be u s e d for b i d d i n g i n the p r i m a r y auctions of G-secs c o n d u c t e d b y R B I as w e l l as for t r a d i n g a n d r e p o r t i n g of secondary market transactions. H o w e v e r , i n the i n i t i a l years, d u e to some technical difficulties, N D S w a s u s e d m a i n l y for p l a c i n g b i d s i n the p r i m a r y market. A s far as the secondary m a r k e t w a s concerned, the role of N D S w a s l i m i t e d to b e i n g a r e p o r t i n g p l a t f o r m , w h i l e the t r a d i n g c o n t i n u e d to be b r o k e r - i n t e r m e d i a t e d .

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RBI, therefore, d e c i d e d to i n t r o d u c e a screen-based a n o n y m o u s o r d e r m a t c h i n g integrated w i t h N D S . T h i s s y s t e m , referred to b r i e f l y as N D S - O M , w a s i t i o n a l i s e d f r o m A u g u s t 1, 2005. Initially, o n l y b a n k s a n d p r i m a r y dealers c o u l d o n the N D S - O M . Subsequently, it has been g r a d u a l l y e x p a n d e d to cover other _yers l i k e insurance c o m p a n i e s a n d m u t u a l f u n d s . Presently, the trades d o n e b e t w e e n b a n k s a n d p r i m a r y dealers are settled t h r o u g h C l e a r i n g C o r p o r a t i o n of I n d i a L i m i t e d ( C C I L ) o t h e r trades have to be settled rately. T h a n k s to its speed, transparency, a n d l o w e r costs as w e l l as the facility of straight H i g h p r o c e s s i n g (STP) u s i n g the C C I L ' s c l e a r i n g a n d settlement system, N D S - O M b e e n g a i n i n g p o p u l a r i t y . A s a result, b r o k e r - i n t e r m e d i a t e d telephone-based transactions are l o s i n g their m a r k e t share.* D e l i v e r y versus Payment Trades i n the secondary m a r k e t are settled t h r o u g h a s y s t e m off " d e l i v e r y versus p a y m e n t " ( D V P ) : this i n v o l v e s a m o r e or less s i m u l t a n e o u s transfer off the security b y the seller to the b u y e r a n d p a y m e n t b y the b u y e r to the seller. A s far trades b e t w e e n C C I L ' s m e m b e r s (banks a n d p r i m a r y dealers) are c o n c e r n e d the settlement f u n c t i o n is p e r f o r m e d b y C C I L . C C I L settled trades account for almost 95 percent of the total trades. I n recent years secondary m a r k e t t r a d i n g has p i c k e d u p . H o w e v e r , the b u l k of the t r a d i n g occurs i n a s m a l l n u m b e r of G-Secs a n d Tbills. I n general, less t h a n half a d o z e n or so, out of m o r e t h a n h u n d r e d o u t s t a n d i n g g o v e r n m e n t securities, account for n e a r l y 80 percent of the t u r n o v e r . F u r t h e r , the p r i m a r y dealers are the most active p l a y e r s i n the secondary market.

Trading Volumes and Market Liquidity

Retail Participation R e t a i l investors can b u y G-secs f r o m a p r i m a r y dealer. I n d i v i d u a l s can n o w h o l d G-secs i n d e m a t f o r m , just the w a y they h o l d shares i n a d e m a t f o r m . If y o u w a n t to b u y G-secs contact a p r i m a r y dealer (like P N B G i l t s ) , c o n v e y y o u r requirement i n terms of a m o u n t a n d m a t u r i t y p e r i o d , a n d o b t a i n quotes for v a r i o u s G secs that m a t c h y o u r n e e d . S u p p o s e y o u w i s h to b u y G-secs that m a t u r e i n 2Q08. Some of the G-secs m a t u r i n g i n 2008 are 11.40% G O I 2 0 0 8 , 1 2 . 0 0 % G O I 2 0 0 8 , a n d 12.25% G O I 2008. G-secs are i d e n t i f i e d b y their c o u p o n rates a n d year of m a t u r i t y . If y o u i n f o r m the p r i m a r y dealer about the p a r t i c u l a r G-sec i n w h i c h y o u are interested, the p r i m a r y dealer w i l l give y o u a rate. O n c e y o u a n d the p r i m a r y dealer agree o n the rate, y o u have to f i l l u p a s i m p l e f o r m w h i c h gives y o u r demat account a n d issue a cheque. A f t e r y o u r cheque is realised, the p r i m a r y dealer w i l l issue instructions to transfer the G-secs f r o m h i s d e m a t account to y o u r d e m a t account. For G-secs the settlement a m o u n t i n c l u d e s t w o parts - the p r i n c i p a l a m o u n t a n d the interest for the b r o k e n p e r i o d . The b u y e r of a G-sec has to p a y interest for the p e r i o d the G-sec w a s h e l d b y the seller. T h i s is because interest o n G-secs is p a i d s e m i - a n n u a l l y b y R B I to the h o l d e r of the G-secs o n the interest p a y m e n t date. F o r G-secs the interest c a l c u l a t i o n is based o n 360 d a y s for a year a n d 30 d a y s for a m o n t h . T h u s , w h e n y o u b u y G-secs y o u h a v e to p a y the rate that has b e e n agreed u p o n p l u s the interest accrued for the b r o k e n p e r i o d .

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Y o u h a v e to f o l l o w a s i m i l a r p r o c e d u r e for s e l l i n g G-secs. G e t the rate f r o m the p r i m a r y dealer. O n c e y o u a n d the p r i m a r y dealer agree o n the rate, i n s t r u c t y o u r d e p o s i t o r y participant to transfer G-secs f r o m y o u r demat account to the demat account of the p r i m a r y dealer. A f t e r the G-secs are credited to the demat account of the p r i m a r y dealer, y o u w i l l receive p a y m e n t (for p r i n c i p a l a n d b r o k e n p e r i o d interest) b y cheque or d e m a n d draft. Bond Market Indices Just as stock market indices reflect the performance of the stock market, a b o n d market i n d e x measures the performance of the b o n d market. I-Sec, J.P. M o r g a n , C R I S I L , C C I L , a n d N S E are the major entities that p r o v i d e b o n d price indices i n I n d i a . I-Sec B O N D I N D E X (i-BEX) is p e r h a p s the most p o p u l a r b o n d market i n d e x i n I n d i a . There are t w o versions of i - B E X . Total return index T h i s tracks the total returns. It captures interest p a y m e n t (accrued a n d actual) a n d capital gains/losses. Principal return index T h i s i n d e x reflects m o v e m e n t of net prices i n the market, that is prices q u o t e d i n the market exclusive of accrued interest. A major p r o b l e m i n constructing a b o n d market i n d e x is that it is h a r d to get reliable, up-to-date prices of m a n y b o n d s as they trade i n f r e q u e n t l y . I n practice, it m a y be necessary to estimate some prices u s i n g b o n d v a l u a t i o n m o d e l s . These prices, c a l l e d m a t r i x prices, m a y be different f r o m true market prices.

3.12

CORPORATE DEBT MARKET

C o r p o r a t e debt market is the market for b o n d s issued b y f i n a n c i a l institutions, banks, p u b l i c sector u n d e r t a k i n g s (PSUs), a n d p r i v a t e sector c o m p a n i e s . U n l i k e the stock m a r k e t a n d the G-sec m a r k e t w h i c h have become v e r y m o d e r n a n d d y n a m i c , the corporate debt m a r k e t i n I n d i a has r e m a i n e d u n d e r d e v e l o p e d . H o p e f u l l y , w i t h the initiatives that are n o w u n d e r w a y , this market w i l l also become m o r e v i b r a n t a n d sophisticated. Primary Market The issuance of corporate debt securities is regulated b y S E B I . C h a p t e r X ( G u i d e l i n e s for Issue of D e b t Instruments) of SEBI G u i d e l i n e s for D i s c l o s u r e a n d Investment Protection, 2000 deals w i t h debt instruments. Debentures are offered to the p u b l i c or i s s u e d o n a rights basis or p r i v a t e l y p l a c e d . The mechanics for a p u b l i c issue of debentures are m u c h the same as that of a p u b l i c issue of e q u i t y . H o w e v e r , there are some differences: P u r e debt securities are t y p i c a l l y offered t h r o u g h the 100 percent r e t a i l route because the b o o k b u i l d i n g route is not a p p r o p r i a t e for t h e m . si Debt securities are generally secured against the assets of the i s s u i n g c o m p a n y and that security s h o u l d be created w i t h i n six m o n t h s of the close of the issue of debentures.

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A debt issue cannot be m a d e unless credit r a t i n g f r o m a credit r a t i n g agency i s obtained a n d d i s c l o s e d i n the offer d o c u m e n t . It is m a n d a t o r y to create a debenture r e d e m p t i o n reserve f o r e v e r y issue of debentures. It is necessary for a c o m p a n y to a p p o i n t one o r m o r e debenture trustees before a debenture issue. Presently, corporate debentures i n I n d i a are m o s t l y p l a c e d p r i v a t e l y . T h e p r i v a t e placement of a debenture issue is m a n a g e d b y a l e a d arranger, w h o is also the a d v i s o r a n d investment banker for the issue. B o o k b u i l d i n g m e c h a n i s m is c o m m o n l y e m p l o y e d . There is also a v i r t u a l b o o k b u i l d i n g p o r t a l called debtonnet, a joint venture of N S E a n d I L F S , t h r o u g h w h i c h investors c a n b i d f o r issues. W h i l e other investors c a n h o l d debentures i n p a p e r o r electronic f o r m , R B I requires that b a n k s , f i n a n c i a l institutions, p r i m a r y dealers, a n d s e c o n d a r y dealers m u s t h o l d debentures, p r i v a t e l y p l a c e d o r otherwise, o n l y i n demat f o r m . F r o m 1995 o n w a r d s p r i v a t e p l a c e m e n t of debentures t h r i v e d , t h a n k s to m i n i m a l r e g u l a t i o n . C o r p o r a t e s , f i n a n c i a l i n s t i t u t i o n s , i n f r a s t r u c t u r e c o m p a n i e s , a n d others d e p e n d e d c o n s i d e r a b l y o n p r i v a t e l y p l a c e d debentures w h i c h w e r e s u b s c r i b e d to m a i n l y b y m u t u a l f u n d s , b a n k s , i n s u r a n c e organisations, a n d p r o v i d e n t f u n d s . I n f o r m a t i o n a n d disclosures to be i n c l u d e d i n the p r i v a t e placement m e m o r a n d a w e r e not d e f i n e d , credit r a t i n g w a s n o t m a n d a t o r y , l i s t i n g w a s n o t c o m p u l s o r y , a n d b a n k s a n d f i n a n c i a l institutions c o u l d subscribe to these issues w i t h o u t too m a n y constraints. The r e g u l a t o r y f r a m e w o r k c h a n g e d s i g n i f i c a n t l y i n late 2003 w h e n SEBI a n d R B I tightened their regulations over the issuance of p r i v a t e l y p l a c e d debentures a n d the s u b s c r i p t i o n of the same b y b a n k s a n d f i n a n c i a l institutions. T h e k e y features of the n e w regulatory d i s p e n s a t i o n are: The disclosure requirements for p r i v a t e l y p l a c e d debentures are s i m i l a r to those of p u b l i c l y offered debentures. Debt securities s h a l l carry a credit r a t i n g of not less t h a n investment grade f r o m a credit r a t i n g agency registered w i t h SEBI. Debt securities s h a l l be i s s u e d a n d t r a d e d i n demat f o r m . D e b t securities s h a l l be c o m p u l s o r i l y l i s t e d . T h e t r a d i n g i n p r i v a t e l y p l a c e d debt s h a l l take place b e t w e e n Q I B s ( Q u a l i f i e d I n s t i t u t i o n a l Buyers) a n d H N I s ( H i g h N e t w o r t h I n d i v i d u a l s ) i n s t a n d a r d d e n o m i n a t i o n of R s . 10 l a k h . B a n k s s h o u l d n o t invest i n n o n - S L R securities of o r i g i n a l m a t u r i t y of less t h a n one year other t h a n c o m m e r c i a l p a p e r a n d certificates of deposits w h i c h are covered under RBI guidelines. Banks s h o u l d not invest i n u n r a t e d n o n - S L R securities. Shelf Registration I n I n d i a , SEBI a l l o w s p u b l i c sector banks, s c h e d u l e d c o m m e r c i a l banks, a n d p u b l i c f i n a n c i a l institutions the facility of shelf registration for debt securities. A b a n k o r i n s t i t u t i o n that wants to a v a i l of this facility has to file a shelf prospectus w i t h SEBI w h i c h discloses, inter alia, the aggregate a m o u n t p r o p o s e d to be r a i s e d over a

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p e r i o d of time. O n c e the shelf prospectus is f i l e d a n d a p p r o v e d b y SEBI, the b a n k or i n s t i t u t i o n c a n raise m o n e y i n stages, w i t h m i n i m a l p a p e r w o r k . Shelf r e g i s t r a t i o n p r o v i d e s flexibility to raise m o n e y as a n d w h e n it is convenient or attractive to d o so. Secondary Market

W h i l e the e q u i t y m a r k e t i n I n d i a has w i t n e s s e d reasonably h i g h t r a d i n g v o l u m e s a n d l i q u i d i t y , the secondary market for corporate debt instruments h i s t o r i c a l l y has been v e r y d u l l for several reasons: (a) Debt has been s u b s c r i b e d to b y investors w h o have t y p i c a l l y p u r s u e d a b u y a n d h o l d strategy, (b) D e b t instruments d o n o a p p e a l to the speculative traders w h o d o m i n a t e the secondary market. T h i n g s , h o w e v e r , are c h a n g i n g for the g o o d . The f o l l o w i n g d e v e l o p m e n t s suggest that t r a d i n g v o l u m e s i n corporate debt w o u l d rise i n future: (a) h i the last f e w years corporates h a v e r a i s e d s u b s t a n t i a l s u m s b y w a y of debt a n d this s h o u l d p r o v i d e s t i m u l u s to t r a d i n g i n secondary market, (b) B o m b a y Stock Exchange has p u t i n place a system to m a k e the s w i t c h o v e r f r o m the O T C (over-the counter) market to a n exchanget r a d e d m a r k e t for corporate b o n d s , (c) I n d i v i d u a l debt issues are increasing i n size a n d i n s t i t u t i o n a l investors, w h o are l i k e l y to be m o r e active i n t r a d i n g , are p a r t i c i p a t i n g h e a v i l y i n these issues. E v e r y effort s h o u l d be m a d e b y regulators, stock exchanges, a n d other concerned parties to realise the p o t e n t i a l of debt m a r k e t . Stamp d u t y o n transfer s h o u l d be s t a n d a r d i s e d across the c o u n t r y or s h o u l d be d o n e a w a y w i t h c o m p l e t e l y . Tax benefits m a y also be granted for investment i n corporate debt. Key Weaknesses of the Corporate Debt Market in India The corporate debt market i n I n d i a is characterised b y the f o l l o w i n g weaknesses: (a) The b u l k of corporate debt is i s s u e d t h r o u g h p r i v a t e placement, w h e r e the investor base is restricted to 49. A s a result, the secondary m a r k e t for corporate debt is v i r t u a l l y non-existent, (b) W h i l e n o stamp d u t y is p a y a b l e o n the issue o r transfer of g o v e r n m e n t securities, corporate b o n d s attract stamp d u t y f u r t h e r the d u t y varies w i d e l y f r o m state to state, (c) The v a l u a t i o n a n d p r i c i n g of corporate debt is opaque. In effect, there is n o y i e l d c u r v e that i n f o r m s the m a r k e t about the price at w h i c h corporate debt w i t h v a r y i n g ratings a n d different tenors s h o u l d trade at. (d) M e d i u m a n d l o w rated c o m p a n i e s have n o access to the corporate b o n d market.

3.13

MONEY MARKET

M o n e y m a r k e t is the market for short-term debt f u n d s . It comprises of the c a l l a n d notice m o n e y m a r k e t , r e p o m a r k e t , a n d the m a r k e t for debt i n s t r u m e n t s s u c h as treasury b i l l s that have a n o r i g i n a l m a t u r i t y of less t h a n one year. The m o n e y m a r k e t does not exist i n a specific p h y s i c a l location or f o l l o w a single set of rules or post a single set of prices. Rather, it represents a w e b of b o r r o w e r s a n d l e n d e r s , l i n k e d b y telephones a n d c o m p u t e r s , d e a l i n g w i t h s h o r t - t e r m debt f u n d s . B a n k s , f i n a n c i a l institutions, c o m p a n i e s , a n d governments are the k e y participants i n

Chapter

Risk and Return


Two Sides of the Investment Coin
LEARNING
- * *

OsjEcrms

After studying this chapter you should be able to Calculate the total return, return relative, and cumulative wealth index. Compute the arithmetic mean and geometric mean of a return series. Explain the rationale for using standard deviation as the principal measure of risk. Measure the expected (ex ante) return and risk of a security.

n v e s t m e n t decisions are i n f l u e n c e d b y v a r i o u s m o t i v e s . Some p e o p l e i n v e s t i n a business to acquire c o n t r o l a n d enjoy the prestige associated w i t h it. S o m e p e o p l e invest i n expensive yatchs a n d f a m o u s v i l l a s to d i s p l a y their w e a l t h . M o s t investors, h o w e v e r , are l a r g e l y g u i d e d b y the p e c u n i a r y m o t i v e of e a r n i n g a r e t u r n o n their investment. F o r e a r n i n g returns investors h a v e to almost i n v a r i a b l y bear some r i s k . In general, r i s k a n d r e t u r n g o h a n d i n h a n d . W h i l e investors l i k e returns they a b h o r r i s k . Investment decisions, therefore, i n v o l v e a tradeoff b e t w e e n r i s k a n d r e t u r n . Since r i s k a n d r e t u r n are central to investment decisions, w e m u s t clearly u n d e r s t a n d w h a t r i s k a n d r e t u r n are a n d h o w they s h o u l d be m e a s u r e d . 4.1 |

RETURN

R e t u r n is the p r i m a r y m o t i v a t i n g force that d r i v e s investment. It represents the r e w a r d for u n d e r t a k i n g investment. Since the game of i n v e s t i n g is about returns (after a l l o w i n g for r i s k ) , measurement of realised (historical) returns is necessary to assess h o w w e l l the investment manager has d o n e . I n a d d i t i o n , h i s t o r i c a l returns are often u s e d as a n i m p o r t a n t i n p u t i n estimating future (prospective) returns. The r e t u r n of a n investment consists of t w o components: Current Return The first c o m p o n e n t that often comes to m i n d w h e n one is t h i n k i n g about r e t u r n is the p e r i o d i c cash f l o w (income), s u c h as d i v i d e n d or interest, generated b y the investment. C u r r e n t r e t u r n is m e a s u r e d as the p e r i o d i c m c o m e i n r e l a t i o n to the

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Capital Return The second c o m p o n e n t of r e t u r n is reflected i n the p r i c e change c a l l e d the capital r e t u r n i t is s i m p l y the price a p p r e c i a t i o n (or depreciation) d i v i d e d b y the b e g i n n i n g p r i c e of the asset. F o r assets l i k e e q u i t y stocks, the c a p i t a l r e t u r n predominates. T h u s , the total r e t u r n for any security (or for that matter a n y asset) is d e f i n e d as: Total return = Current return + Capital return The current r e t u r n c a n be zero or p o s i t i v e , whereas the capital r e t u r n can be negative, zero, or p o s i t i v e .

4.2

= RISK

Y o u cannot talk about investment r e t u r n w i t h o u t t a l k i n g about risk because investment decisions i n v a r i a b l y i n v o l v e a trade-off b e t w e e n the t w o . R i s k refers to the p o s s i b i l i t y that the actual outcome of a n investment w i l l differ f r o m its expected o u t c o m e . M o r e specifically, m o s t investors are concerned about the actual o u t c o m e b e i n g less t h a n the expected o u t c o m e . The w i d e r the range of p o s s i b l e outcomes, the greater the r i s k . Sources of Risk R i s k emanates f r o m several sources. The three major ones are: business risk, interest rate risk, a n d market risk. W h i l e a detailed treatment of these sources of risETs w o v e n t h r o u g h o u t the b o o k , a brief d i s c u s s i o n is g i v e n here. Business Ris]<_ As a h o l d e r of corporate securities (equity shares or debentures), y o u are exposed to the r i s k of p o o r business performance. T h i s m a y be caused b y a v a r i e t y of factors l i k e h e i g h t e n e d c o m p e t i t i o n , emergence of n e w technologies, d e v e l o p m e n t of substitute p r o d u c t s , shifts i n c o n s u m e r preferences, inadequate s u p p l y of essential i n p u t s , changes i n g o v e r n m e n t a l policies, a n d so o n . O f t e n , of course, the p r i n c i p a l factor m a y be i n e p t a n d i n c o m p e t e n t management. The p o o r business p e r f o r m a n c e definitely affects the interest of e q u i t y shareholders, w h o have a r e s i d u a l c l a i m o n the i n c o m e a n d w e a l t h of the f i r m . It c a n also affect the interest of debenture h o l d e r s if the ability of the f i r m to meet its interest a n d p r i n c i p a l p a y m e n t o b l i g a t i o n is i m p a i r e d . I n s u c h a case, debenture h o l d e r s face the prospect of default r i s k . Interest Rate Risk The changes i n interest rate h a v e a b e a r i n g o n the w e l f a r e of i n v e s t o r s . ^ s ~ t h e T n t e r e s t rate goes u p , the m a r k e t , p r i c e s of e x i s t i n g f i x e d i n c o m e securities f a l l , a n d vice versa. This happens because the b u y e r of a f i x e d i n c o m e security" w o u l d not b u y it at its p a r v a l u e or face v a l u e if its f i x e d interest rate is l o w e r t h a n the p r e v a i l i n g interest rate o n a s i m i l a r security. F o r example, a debenture that has a face v a l u e of RsTOO a n d a f i x e d rate of 12 percent w i l l sell at a d i s c o u n t if the interest rate m o v e s u p f r o m , say, 12 percent to 14 percent. W h i l e the changes i n interest rate have a direct b e a r i n g o n the prices of f i x e d i n c o m e securities, they affect e q u i t y prices too, albeit s o m e w h a t i n d i r e c t l y . The changes i n the relative y i e l d s of debentures a n d e q u i t y shares influence e q u i t y prices.

Risk and Return

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Market Risk E v e n if the e a r n i n g p o w e r of the corporate sector a n d the interest rate structure r e m a i n m o r e or less u n c h a n g e d , prices of securities, e q u i t y shares i n particular, t e n d to fluctuate. W h i l e there can be several reasons for this f l u c t u a t i o n , a major cause appears to be the c h a n g i n g sentiment of the investors. There are p e r i o d s w h e n investors become b u l l i s h a n d their i n v e s t m e n t h o r i z o n s l e n g t h e n . Investor o p t i m i s m , w h i c h m a y b o r d e r o n e u p h o r i a d u r i n g s u c h p e r i o d s , d r i v e s share prices to great heights. T h e b u o y a n c y created i n the w a k e of this d e v e l o p m e n t is p e r v a s i v e , affecting almost a l l the shares. O n the other h a n d , w h e n a w a v e of p e s s i m i s m ( w h i c h often is a n exaggerated response to some u n f a v o u r a b l e p o l i t i c a l or e c o n o m i c development) sweeps the market, investors t u r n bearish a n d m y o p i c . Prices of almost a l l e q u i t y shares register decline as fear a n d uncertainty p e r v a d e the market. The market tends to m o v e i n cycles. A n J o h n T r a i n says " Y o u n e e d to get d e e p l y i n t o y o u r bones the sense that any market, a n d certainly^the stock market, m o v e s i n cycles, so that y o u w i l l i n f a l l i b l y get w o n d e r f u l bargains every f e w yearSj a n d h a v e a chance to "sell a g a i n at r i d i c u l o u s l y h i g h prices a f e w years later." The cycles are caused b y mass p s y c h o l o g y . A s John T r a i n explains: " T h e ebb a n d f l o w of mass e m o t i o n is quite regular: P a n i c is f o l l o w e d b y relief, a n d relief b y o p t i m i s m ; then comes e n t h u s i a s m , then e u p h o r i a a n d ra^turg,. Aeji^^Jbub^le^bjrrste, j i n d p u b l i c feeling slides off a g a i n into concern, des^eja.tipjuand f i n a l l y a n e w p a n i c . " O n e w o u l d expect large scale p a r t i c i p a t i o n of i n s t i t u t i o n s to d a m p e n the p r i c e fluctuations i n the m a r k e t . A f t e r a l l i n s t i t u t i o n a l investors have core p r o f e s s i o n a l expertise to d o f u n d a m e n t a l a n a l y s i s a n d greater f i n a n c i a l resources to act o n f u n d a m e n t a l analysis. H o w e v e r , n o t h i n g of this k i n d has h a p p e n e d . O n the contrary, price fluctuations seem to have become w i d e r after the a r r i v a l of i n s t i t u t i o n a l investors i n larger n u m b e r s . W h y ? Perhaps the institutions a n d their analysts have not d i s p l a y e d m o r e p r u d e n c e a n d r a t i o n a l i t y t h a n the general i n v e s t i n g p u b l i c a n d have s u c c u m b e d i n e q u a l measure to the t e m p t a t i o n to speculate. A s J o h n M a y n a r d K e y n e s h a d a r g u e d , factors that contribute to the v o l a t i l i t y of the m a r k e t are not l i k e l y to d i m i n i s h w h e n expert professionals s u p p o s e d l y possessing better j u d g m e n t a n d k n o w l e d g e compete i n the m a r k e t place. W h y ? A c c o r d i n g to K e y n e s , e v e n these p e o p l e are c o n c e r n e d w i t h speculation (the a c t i v i t y of forecasting the p s y c h o l o g y of the market) a n d not enterprise (the activity of forecasting the prospective y i e l d of assets over their w h o l e life). of Risk M o d e r n p o r t f o l i o theory l o o k s at r i s k f r o m a different perspective. It i total r i s k as f o l l o w s . T o t a l risk = U n i q u e r i s k + M a r k e t r i s k i unique r i s k of a security represents that p o r t i o n of its total risk w h i c h stems f r o m i c factors l i k e the d e v e l o p m e n t of a n e w p r o d u c t , a l a b o u r strikp, nr the ice of a j i e w cprryetitOT. feyertts of this nahiiy_ p r i m a r i l y affert; foej3gfjfir fine not a l T f i r m s i n general. H e n c e , the u n i q u e r i s k of a stock c a n be w a s h e d a w a y b y c o m b i n i n g it w i t h other stocks. In a d i v e r s i f i e d p o r t f o l i o , u n i q u e r i s k s of different stocks L l e n d to cancel each othera favourable d e v e l o p m e n t i n one f i r m m a y offset a n adverse

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h a p p e n i n g i n another a n d v i c e v e r s a . H e n c e , j i n i q u e r i s k is also referred to as diversifiablejrisk^j^n^jstemaHc r i s j ^ The market risk of a security represents that p o r t i o n of its r i s k w h i c h is attributable to e c o n o m y - w i d e factors l i k e the g r o w t h rate of G D P , the l e v e l of g o v e r n m e n t s p e n d i n g , m o n e y s u p p l y , interest rate structure, a n d i n f l a t i o n rate. Since these factors affect a l l f i r m s to a greater or k^serjdegree, investors cannot a v o i d the risk a r i s i n g f r o m themT* h o w e v e r d i v e r s i f i e d their p o r t f o l i o s m a y be. H e n c e , it is also referred to as systematic risk (as it affects a l l securities) or n o n - d i v e r s i f i a b l e r i s k

4.3

MEASURING HISTORICAL RETURN

The total r e t u r n o n a n investment for a g i v e n p e r i o d is: C a s h p a y m e n t received d u r i n g the p e r i o d


v

Price change over + the p e r i o d

/ T o t a l return =

Price of the investment at the b e g i n n i n g r u p e e cash p a y m e n t r e c e i v e d d u r i n g the price change over the p e r i o d is s i m p l y the the b e g i n n i n g p r i c e . T h i s can be p o s i t i v e or zero (ending price equals the b e g i n n i n g the b e g i n n i n g price).

A l l items are m e a s u r e d i n rupees. The p e r i o d m a y be p o s i t i v e or zero. The rupee difference b e t w e e n the e n d i n g p r i c e a n d (ending price exceeds the b e g i n n i n g price) price) or negative (ending price is less then In f o r m a l terms ^
C +

(4.1)

w h e r e R is the total r e t u r n over the p e r i o d , C is the cash p a y m e n t received d u r i n g the p e r i o d , P is the e n d i n g p r i c e of the investment, a n d P is the b e g i n n i n g price. T o illustrate, consider the f o l l o w i n g i n f o r m a t i o n for a n e q u i t y stock:
E B

P r i c e at the b e g i n n i n g of the year : Rs .60.00 D i v i d e n d p a i d at the e n d of the year : R s . 2.40 Price at the e n d of the year : Rs.69.00 The total r e t u r n o n this stock is calculated as f o l l o w s : 2.40+ (69.00-60.00) i '- = 0.19 or 19 percent 60.00 It is h e l p f u l to s p l i t the total r e t u r n i n t o t w o components, v i z . , current y i e l d a n d capital gains/loss y i e l d as f o l l o w s : Cash payment E n d i n g price - b e g i n n i n g price Beginning price B e g i n n i n g price
Current return Capital return

Risk and Return The total r e t u r n of 19 percent i n o u r e x a m p l e m a y be b r o k e n d o w n as f o l l o w s : 2.40 60.00 69.00 - 60.00 60.00 4 percent C u r r e n t return 15 percent C a p i t a l return

99

T h u s , the total r e t u r n concept is a l l - i n c l u s i v e (as it includes the current y i e l d as w e l l as the price change) a n d measures the total r e t u r n per rupee of o r i g i n a l investment. H e n c e it can be u s e d for c o m p a r i n g investment returns over a specified p e r i o d . Return Relative O f t e n it is necessary to measure returns i n a s l i g h t l y different m a n n e r . T h i s is p a r t i c u l a r l y true w h e n a c u m u l a t i v e w e a l t h i n d e x or a geometric m e a n has to be calculated, because i n s u c h calculations negative returns cannot be u s e d . The concept of return relative is u s e d i n s u c h cases. The return relative is d e f i n e d as: C + Pp U a e t u r n relative = P
B

(4.2)

P u t differently R e t u r n relative = 1 + T o t a l r e t u r n i n decimals In o u r e x a m p l e the r e t u r n relative is: 1 + 0.19 = 1.19 N o t e that even t h o u g h the total r e t u r n m a y b e j r e g j t i y e ^ jTegatiyg. A t w o r s t it is zero.

relative cannot be

Cumulative Wealth Index A r e t u r n measure l i k e total r e t u r n reflects changes i n the l e v e l of w e a l t h . For some purposes it is m o r e u s e f u l to measure the l e v e l of w e a l t h (or price) rather t h a n the change i n the l e v e l of w e a l t h . T o d o this, w e m u s t measure the c u m u l a t i v e effect of returns over t i m e , g i v e n some stated i n i t i a l a m o u n t , w h i c h is t y p i c a l l y one rupee. The c u m u l a t i v e w e a l t h i n d e x captures the c u m u l a t i v e effect of total returns. It is calculated as f o l l o w s : >yCWI
n n

= W I (1 + R ) (1+ R ) . . . (1+ R )
0 1 2 n 0

(4.3)

w h e r e CWI is the c u m u l a t i v e w e a l t h i n d e x at the e n d of n years, WI is the b e g i n n i n g i n d e x v a l u e w h i c h is t y p i c a l l y one rupee a n d R, is the total r e t u r n for year i (i = 1 , . . .n). T o illustrate, consider a stock w h i c h earns the f o l l o w i n g returns over a five year p e r i o d : R = 0.14, R = 0.12, R = -0.08, R = 0.25, a n d R = 0.02. The c u m u l a t i v e w e a l t h i n d e x at the e n d of the five year p e r i o d , a s s u m i n g a b e g i n n i n g i n d e x v a l u e of one rupee, is:
a 2 3 4 5

CWI = 1 (1.14) (1.12) (0.92) (1.25) (1.02) = 1.498


5

T h u s , one rupee i n v e s t e d at the b e g i n n i n g of year 1 w o u l d be w o r t h Re. 1.498 at the e n d of year 5. Y o u can use the values for the c u m u l a t i v e i n d e x to obtain the total r e t u r n for a g i v e n p e r i o d , u s i n g the f o l l o w i n g equation:

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w h e r e R i s the total r e t u r n for p e r i o d n a n d C W J is the c u m u l a t i v e w e a l t h i n d e x . Summary Statistics W h i l e total r e t u r n , r e t u r n relative, a n d w e a l t h i n d e x are u s e f u l measures of r e t u r n f o r a g i v e n p e r i o d of t i m e , i n investment analysis w e also n e e d statistics that s u m m a r i s e a series of total r e t u r n s . T h e t w o m o s t p o p u l a r s u m m a r y statistics are arithmetic m e a n a n d geometric m e a n . Arithmetic Mean T h e m o s t p o p u l a r s u m m a r y statistic i s the arithmetic m e a n . H e n c e the w o r d mean refers to the arithmetic m e a n , unless otherwise s p e c i f i e d . The arithmetic m e a n of a series of totaj returns is d e f i n e d as: n R = ^ (4.4) _ w h e r e R is the arithmetic m e a n , R, is the v a l u e of the total r e t u r n (i = 1 , . . . n) a n d n is the n u m b e r of total returns. T o illustrate, s u p p o s e the total returns f r o m stock A over a five year p e r i o d are as follows:
M

Year 1 2 3 4 5 The arithmetic m e a n for stock A i s

Total return (percentage) 19.0 14.0 22.0 -12.0 5.0

19 + 14 + 2 2 - 1 2 + 5 R =9.6 percent Geometric Mean W h e n y o u w a n t to k n o w the central tendency of a series of returns, the arithmetic m e a n is the a p p r o p r i a t e measure. It represents the t y p i c a l performance for a single p e r i o d . H o w e v e r , w h e n y o u w a n t to k n o w the average c o m p o u n d rate of g r o w t h that has actually o c c u r r e d over m u l t i p l e p e r i o d s , the arithmetic m e a n is n o t a p p r o p r i a t e . T h i s p o i n t m a y be i l l u s t r a t e d w i t h a s i m p l e e x a m p l e . C o n s i d e r a stock w h o s e p r i c e i s 100 at the e n d of the year 0. The p r i c e declines to 80 at the e n d of year 1 a n d recovers to 100 at the e n d of year 2. A s s u m i n g that there is n o d i v i d e n d p a y m e n t d u r i n g the t w o year p e r i o d , the a n n u a l returns a n d their arithmetic m e a n are as f o l l o w s : R e t u r n for year 1 = = 100
7

-0.20 o r - 2 0 percent
r

Risk and Return R e t u m f o r y e a ^ ^ Arithmetic mean return = - 2 0 + 25 -0.25or25percent =2.5 percent


n r

101

T h u s w e f i n d that t h o u g h the r e t u r n o v e r the t w o year p e r i o d is n i l , the arithmetic m e a n w o r k s o u t to 2.5 percent. So, this measure of average r e t u r n can be m i s l e a d i n g . I n a multi-period c O T i t o ^ t h e ^ e c ^ accurately the " t r u e " average return^ f h e g e o m e t r i c m e a n is d e f i n e d as f o l l o w s : v^GM = [(1+ RJ (1+ R ) . . . . ( l + R ) ] -1 (4.5) w h e r e GM is the geometric m e a n r e t u r n , R is the total r e t u r n for p e r i o d i (i =l,....,n), a n d n is the n u m b e r of time p e r i o d s . N o t i c e that the geometric m e a n is the n t h r o o t of the p r o d u c t r e s u l t i n g f r o m m u l t i p l y i n g a series of r e t u r n relatives m i n u s one. T o illustrate, consider the total r e t u r n a n d r e t u r n relative for stock A over a 5- year period:
2 n 1/n {

Year 1 2 3 4 5

Total return (%) 19 14 22 -12 5

Return relative 1.19 1.14 1.22 0.88 1.05

The geometric m e a n of the returns o v e r the 5 year p e r i o d is: GM = [(1.19) (1.14) (1.22) (0.88) ( 1 . 0 5 ) ] = 1.089 - 1 = 0.089 or 8.9 percent The geometric m e a n reflects the c o m p o u n d rate of g r o w t h over t i m e . I n the above i l l u s t r a t i o n stock A has generated a c o m p o u n d rate of r e t u r n of 8.9 percent over a p e r i o d of 5 years. T h i s means that a n investment of one rupee p r o d u c e s a c u m u l a t i v e e n d i n g w e a l t h of Rs.1.532 [1(1.089) ]. N o t i c e that the geometric m e a n is l o w e r t h a n the arithmetic m e a n [9.6 percent] . The geometric m e a n is a l w a y s less t h a n the arithmetic m e a n , except w h e n a l l the r e t u r n values b e i n g c o n s i d e r e d are e q u a l . The difference b e t w e e n the geometric m e a n a n d the arithmetic m e a n d e p e n d s o n the v a r i a b i l i t y of the d i s t r i b u t i o n . The greater the v a r i a b i l i t y , the greater the difference b e t w e e n the t w o means. The r e l a t i o n s h i p b e t w e e n the geometric m e a n a n d the arithmetic m e a n is a p p r o x i m a t e d b y the f o l l o w i n g f o r m u l a :
5 1/5

- 1

(1+ G e o m e t r i c m e a n )

~ (1+ A r i t h m e t i c m e a n ) - (Standard d e v i a t i o n )
2

In the above f o r m u l a , y o u w i l l f i n d a n e w t e r m v i z . , s t a n d a r d d e v i a t i o n , w h i c h is the most p o p u l a r measure of v a r i a b i l i t y . It is e x p l a i n e d i n the f o l l o w i n g section. Arithmetic Mean versus Geometric Mean I n the w o r l d of investments, the focus is m o s t l y o n k n o w i n g the central tendency of a series of returns. H e n c e arithmetic m e a n is

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c o m m o n l y e m p l o y e d . W h y s h o u l d , y o u m a y ask, the arithmetic m e a n be preferred to the geometric mean? T o a n s w e r this question, let us consider a n e x a m p l e . S u p p o s e the e q u i t y share of M o d e r n P h a r m a has a n expected r e t u r n of 15 percent i n each year w i t h a s t a n d a r d d e v i a t i o n of 30 percent. A s s u m e that there are t w o e q u a l l y possible outcomes each year, + 45 percent a n d -15 percent (that is, the m e a n p l u s or m i n u s one s t a n d a r d d e v i a t i o n ) . The arithmetic m e a n of these returns is 15 percent, (45-15)/2, whereas the geometric m e a n of these returns is 11.0 percent, [(1.45) ( 0 . 8 5 ) ] - 1. A n investment of one rupee i n the e q u i t y share of M o d e r n P h a r m a w o u l d g r o w over a t w o year p e r i o d as f o l l o w s :
1/2

End of year 1

End of year 2 2.10

Probability 0.25 0.50

1.23

~^

0.72

0.25

N o t i c e that the m e d i a n ( m i d d l e outcome) a n d m o d e (most c o m m o n outcome) are g i v e n b y the geometric m e a n (11.0 percent), w h i c h over a t w o - y e a r p e r i o d c o m p o u n d s to 23 percent ( l . l l = 1.23). The expected v a l u e of a l l possible outcomes, h o w e v e r , is e q u a l to:
2

(0.25 x 2.10) + (0.50 x 1.23) + (0.25 x 0.72) = 1.32 N o w 1.32 is e q u a l to (1.15) . T h i s means that the expected v a l u e of the t e r m i n a l w e a l t h is o b t a i n e d b y c o m p o u n d i n g u p the arithmetic m e a n , not the geometric m e a n . H e n c e the arithmetic m e a n is the a p p r o p r i a t e d i s c o u n t rate. Put differently, the arithmetic m e a n is the a p p r o p r i a t e m e a n because a n i n v e s t m e n t that has u n c e r t a i n returns w i l l h a v e a h i g h e r expected t e r m i n a l v a l u e t h a n a n investment that earns its c o m p o u n d or geometric m e a n w i t h certainty every year. I n the above e x a m p l e , c o m p o u n d i n g at the rate of 11 percent for t w o years p r o d u c e s a t e r m i n a l v a l u e of Rs.1.23, for a n i n v e s t m e n t of R e 1.00. B u t h o l d i n g the u n c e r t a i n investment w h i c h y i e l d s h i g h returns (45 percent per year for t w o years i n a r o w ) or m i d d l i n g returns (45 percent i n year 1 f o l l o w e d b y - 1 5 percent i n year 2 or vice versa) or l o w returns (-15 percent per year for t w o "years i n a r o w ) , y i e l d s a h i g h e r expected t e r m i n a l v a l u e , R e . 1.32. T h i s h a p p e n s because the gains f r o m higher-than-expected returns are greater t h a n the losses f r o m l o w e r - t h a n - e x p e c t e d r e t u r n s . A s R o g e r G . Ibbotson a n d R e x A . S i n q u e f i e l d p u t it:
2

"Therefore, in the investment markets, where returns are described by a probability distribution, the arithmetic mean is the measure that accounts for uncertainty, and is the appropriate one for estimating discount rates and the cost of capital."

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Real Returns T h e returns d i s c u s s e d so far are n o m i n a l returns, or m o n e y returns. T o convert n o m i n a l returns into real returns, a n adjustment has to be m a d e for the factor of i n f l a t i o n : _ , 1 + N o m i n a l return Real return = 1 1 + Inflation rate Example The total r e t u r n for a n e q u i t y stock d u r i n g a year w a s 18.5 percent. The rate of i n f l a t i o n d u r i n g that year w a s 5.5 percent. T h u s the real (inflation-adjusted) total return was: - 1 = 0.123 or 12.3 percent
K

1.055

Global Equity Returns A s t u d y t i t l e d Triumph of the Optimists: 101 Years of Global Investment Returns authored b y P. M a r s h and M . Staunton and published b y Princeton University Press i n 2002 f o u n d that i n the first half of the 2 0 century the arithmetic average a n n u a l real r e t u r n o n the w o r l d e q u i t y i n d e x w a s 5.1 percent, whereas it w a s 8.4 percent over the p e r i o d 1950 - 2002. W h a t e x p l a i n s larger e q u i t y returns i n the s e c o n d h a l f of the 2 0 c e n t u r y c o m p a r e d to the first half. P . M a r s h a n d M . S t a u n t o n attribute it to the f o l l o w i n g factors:
th t h

1. U n p r e c e d e n t e d g r o w t h i n p r o d u c t i v i t y a n d efficiency, thanks to r a p i d technological changes. 2. E n h a n c e m e n t i n the q u a l i t y of management a n d corporate governance. 3. R e d u c e d transaction a n d m o n i t o r i n g costs. 4. D e c l i n e i n i n f l a t i o n rates. 5. F a l l i n the r e q u i r e d rate of r e t u r n , t h a n k s to d i m i n i s h e d business a n d investment r i s k s .

4.4

MEASURING HISTORICAL RISK

R i s k refers to the p o s s i b i l i t y that the actual outcome of a n investment w i l l differ f r o m the expected o u t c o m e . P u t d i f f e r e n t l y , r i s k refers to v a r i a b i l i t y or d i s p e r s i o n . If a n asset's r e t u r n has n o v a r i a b i l i t y , it is riskless. S u p p o s e y o u are a n a l y s i n g the total r e t u r n of a n e q u i t y stock over a p e r i o d of t i m e . A p a r t f r o m k n o w i n g the m e a n r e t u r n , y o u w o u l d also l i k e to k n o w about the v a r i a b i l i t y i n returns. Variance and Standard Deviation The most c o m m o n l y u s e d measure of r i s k i n finance is variance or its square root the s t a n d a r d d e v i a t i o n . The variance a n d the s t a n d a r d d e v i a t i o n of a h i s t o r i c a l r e t u r n series are d e f i n e d as f o l l o w s :

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Z ( * - * f o ^
2

n-1
-

(4.6)

CT= V o ' (4.6a) w h e r e o is the variance of r e t u r n , cr i s t h e s t a n d a r d d e v i a t i o n of r e t u r n , R, is the r e t u r n f r o m the stock i n p e r i o d i (i =1,. . .., n), R is the arithmetic r e t u r n , a n d n is the n u m b e r of periods. T o illustrate, consider the returns f r o m a stock over a 6 year p e r i o d :
2

R j = 15%, R = 12%, R = 20%, R = -10%, R = 14%, a n d R = 9 %


2 3 4 5 6

The variance a n d s t a n d a r d d e v i a t i o n of returns are calculated b e l o w : Period 1 2 3 4 5 6 Return Ri 15 12 20 -10 14 9 Z R = 60


(

Deviation (R {

Square of deviation (Ri-R) 25 4 100 400 16 1 I(R,-R


2

R)

5 2 10 -20 4 -1

) = 536
2

R = 10
2>

a =

X(*-*)
n-1

= 107.2

a=

536 ^ 6-1

\l/2

= 10.4

L o o k i n g at the above calculations, w e f i n d that: T h e differences b e t w e e n the v a r i o u s v a l u e s a n d the m e a n v a l u e are s q u a r e d . T h i s means that values w h i c h are far a w a y f r o m the m e a n v a l u e h a v e a m u c h m o r e i m p a c t o n s t a n d a r d d e v i a t i o n t h a n values w h i c h are close to the m e a n v a l u e . T h e s t a n d a r d d e v i a t i o n is obtained as the square root of the average of s q u a r e d deviations. This means that the s t a n d a r d d e v i a t i o n a n d the m e a n are m e a s u r e d i n the same u n i t s a n d hence the t w o c a n be d i r e c t l y c o m p a r e d .

Note that *(*.-*)


2

is divided by n -1 not n. This is done technically to correct for the loss of one degree of freedom.

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Spreadsheet Application A spreadsheet l i k e E x c e l has m a n y h a n d y tools f o r calculation of v a r i o u s f i n a n c i a l functions. T o calculate s t a n d a r d d e v i a t i o n of the returns g i v e n i n the above table, proceed as f o l l o w s . O p e n a n E x c e l worksheet. It has r o w s n u m b e r e d 1,2,3,4 a n d c o l u m n s labeled A,B,C,D, T h e l o c a t i o n of a cell is specified b y the c o l u m n a n d r o w o n w h i c h it is located. F o r e x a m p l e , the v e r y first c e l l at the top left h a n d side of the s h e e t , w h i c h is at the intersection of c o l u m n labeled A a n d r o w n u m b e r e d 1, is designated as A l . T h e cell adjacent to it to the r i g h t is B l . T h e c e l l just b e l o w B l is B2 etc. K e y i n the g i v e n data v i z . p e r i o d a n d r e t u r n i n cells B l to G 2 . T o get the s t a n d a r d d e v i a t i o n i n c e l l G 4 , t y p e the f o r m u l a =STDEV(B2:G2) i n s i d e that c e l l a n d press enter. The b u i l t i n f u n c t i o n i n E x c e l a u t o m a t i c a l l y calculates the s t a n d a r d d e v i a t i o n a n d the v a l u e 10.45 appears i n the cell. A l t e r n a t i v e l y , y o u can first c l i c k o n the cell G 4 (also c a l l e d selecting G4), t y p e = a n d t h e n click o n the m e n u i t e m Insert. F r o m the d i a l o g u e b o x that opens, first select ' F u n c t i o n ' a n d out of the v a r i o u s functions, select the ' F i n a n c i a l ' f u n c t i o n S T D E V . A n a r g u m e n t b o x opens w h e r e i n , i n the space p r o v i d e d , k e y i n the data range B2 to G 2 b y t y p i n g B 2 : G 2 or b y just m o v i n g the cursor f r o m B2 to G 2 a n d click o n O K . If y o u w i s h to k n o w the m e a n of the returns, type = A V E R A G E ( B 2 : G 2 ) i n cell G 3 a n d press enter. The m e a n v a l u e automatically appears i n cell G 3 . A 1 2 3 4 Period Return (R,-) Mean Standard deviation B 1 15 C 2 12 D 3 20 E 4 (10) F 5 14 G 6 9 10.00 10.45

= A V E R A G E (B2:G2) = S T D E V (B2:G2)

Criticism of Variance (and Standard Deviation) as a Measure of Risk T h o u g h w i d e l y u s e d i n finance, there are t w o criticisms of the use of variance as a measure of r i s k : i l l V a r i a n c e considers a l l d e v i a t i o n s , negative as w e l l as p o s i t i v e . Investors, h o w e v e r , d o not v i e w p o s i t i v e deviations u n f a v o u r a b l y - i n fact, they w e l c o m e . it. H e n c e some researchers have a r g u e d that o n l y negative d e v i a t i o n s s h o u l d be considered while measuring risk.
<

M a r k o w i t z , the father of p o r t f o l i o theory, himself h a d recognised this limitation a n d suggested a measure of d o w n s i d e risk called semi-variance. Semi-variance is '. calculated the w a y variance is calculated, except that it considers o n l y negative - deviations. M a r k o w i t z , h o w e v e r , chose variance because a n a l y t i c a l l y it c a n be j .:. h a n d l e d easily. N o t e that, as l o n g as the returns are distributed s y m m e t r i c a l l y , variance is s i m p l y t w o times semi-variance a n d it does not m a k e any difference whether variance is u s e d or semi-variance is u s e d .

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2. W h e n the p r o b a b i l i t y d i s t r i b u t i o n is not s y m m e t r i c a l a r o u n d its expected v a l u e , v a r i a n c e alone does not suffice. I n a d d i t i o n to v a r i a n c e , the skewness of the d i s t r i b u t i o n s h o u l d also be u s e d . M a r k o w i t z does not consider skewness i n d e v e l o p i n g p o r t f o l i o theory. P r o p o n e n t s of the M a r k o w i t z m o d e l r e l y o n l y o n v a r i a n c e o n the g r o u n d s that the h i s t o r i c a l returns of stocks h a v e been approximately symmetrical. Rationale for Standard Deviation N o t w i t h s t a n d i n g the above c r i t i c i s m s , s t a n d a r d d e v i a t i o n is c o m m o n l y e m p l o y e d i n finance as a measure of risk. W h y ? The p r i n c i p a l reasons for u s i n g s t a n d a r d d e v i a t i o n appear to be as f o l l o w s : If a variable is n o r m a l l y d i s t r i b u t e d , its m e a n a n d s t a n d a r d d e v i a t i o n c o n t a i n a l l the i n f o r m a t i o n about its p r o b a b i l i t y d i s t r i b u t i o n . If the u t i l i t y of m o n e y is represented b y a q u a d r a t i c f u n c t i o n (a f u n c t i o n c o m m o n l y suggested to represent d i m i n i s h i n g m a r g i n a l u t i l i t y of wealth), t h e n the expected u t i l i t y is a f u n c t i o n of m e a n a n d standard d e v i a t i o n . S t a n d a r d d e v i a t i o n is a n a l y t i c a l l y m o r e easily tractable. Risk Aversion and Required Returns Y o u are l u c k y to be i n v i t e d b y the host of a television game s h o w . A f t e r the u s u a l i n t r o d u c t i o n , the host s h o w s t w o boxes to y o u . H e tells y o u that one b o x contains Rs.10,000 a n d the other b o x is e m p t y . H e does not tell y o u w h i c h one is w h i c h . The host asks y o u to o p e n a n y one of the t w o boxes a n d keep whatever y o u f i n d i n it. Y o u are not sure w h i c h b o x y o u s h o u l d o p e n . Sensing y o u r v a c i l l a t i o n , he says he w i l l offer y o u a certain Rs.3,000 if y o u forfeit the o p t i o n to o p e n a b o x . Y o u d o n ' t accept his offer. H e raises h i s offer to Rs.3,500. N o w y o u feel indifferent b e t w e e n a certain r e t u r n of Rs.3,500 a n d a r i s k y (uncertain) expected r e t u r n of Rs.5,000. T h i s means that a certain a m o u n t of Rs.3,500 p r o v i d e s y o u w i t h the same satisfaction as a r i s k y expected v a l u e of Rs.5,000. T h u s y o u r certainty equivalent (Rs.3,500) is less t h a n the r i s k y expected v a l u e (Rs.5,000). E m p i r i c a l evidence suggests that most i n d i v i d u a l s , if p l a c e d i n a s i m i l a r situation, w o u l d h a v e a certainty equivalent w h i c h is less t h a n the r i s k y expected v a l u e . The relationship of a person's certainty equivalent to the expected m o n e t a r y v a l u e of a r i s k y investment defines his attitude t o w a r d r i s k . If the certainty equivalent is less than the expected v a l u e , the p e r s o n is risk-averse; if the certainty equivalent is e q u a l to the expected v a l u e , the p e r s o n is risk-neutral; f i n a l l y , if the certainty equivalent is m o r e t h a n the expected v a l u e , the p e r s o n is risk-loving. In general, investors are risk-averse. T h i s means that r i s k y investments m u s t offer h i g h e r expected returns t h a n less r i s k y investments to i n d u c e p e o p l e to invest i n t h e m . Remember, h o w e v e r , that w e are t a l k i n g about expected returns; the actual r e t u r n o n a r i s k y investment m a y w e l l t u r n out to be less t h a n the actual r e t u r n o n a less r i s k y - investment. P u t differently, risk a n d r e t u r n go h a n d i n h a n d . T h i s i n d e e d is a well-established e m p i r i c a l fact, p a r t i c u l a r l y over l o n g p e r i o d s of t i m e . F o r e x a m p l e , the average a n n u a l rate of r e t u r n a n d a n n u a l s t a n d a r d deviations for T r e a s u r y b i l l s , b o n d s , a n d c o m m o n

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stocks i n the U S over a 75 year p e r i o d (1926-2000) as calculated b y Ibbotson Associates have been as s h o w n i n E x h i b i t 4 . 1 .
2

Exhibit 4.1

Return and Risk Performance of Different Categories of Financial Assets in the US Over 75 Years (1926 - 2000)

Portfolio Treasury bills Government bonds Corporate bonds Common stocks (S&P 500) Small-firm common stock

Average Annual Rate of Return (%) 3.9 5.7 6.0 13.0 17.3

Standard Deviation (%) 3.2 9.4 8.7 20.2 33.4

F r o m the above it is clear that: (a) Treasury bills, the least r i s k y of financial assets, earned the lowest average a n n u a l rate of return, (b) C o m m o n stocks, the most r i s k y of financial assets, earned the highest average a n n u a l rate of return, (d) B o n d s w h i c h o c c u p y a m i d d l i n g p o s i t i o n o n the risk d i m e n s i o n earned a m i d d l i n g average a n n u a l return. Risk Premiums Investors assume r i s k so that they are r e w a r d e d i n the f o r m of h i g h e r r e t u r n . H e n c e risk p r e m i u m m a y be d e f i n e d as the a d d i t i o n a l r e t u r n investors expect to get, or investors earned i n the past, for a s s u m i n g a d d i t i o n a l r i s k . R i s k p r e m i u m m a y be calculated b e t w e e n t w o classes of securities that differ i n their r i s k l e v e l . There are three w e l l k n o w n r i s k p r e m i u m s : Equity Risk Premium This is the difference b e t w e e n the r e t u r n o n e q u i t y stocks as a class a n d the risk-free rate represented c o m m o n l y b y the r e t u r n o n T r e a s u r y b i l l s . Bond Horizon Premium T h i s is the difference b e t w e e n the r e t u r n o n l o n g - t e r m g o v e r n m e n t b o n d s a n d the r e t u r n o n T r e a s u r y b i l l s . Bond Default Premium T h i s is the difference b e t w e e n the r e t u r n o n l o n g - t e r m corporate b o n d s ( w h i c h have some p r o b a b i l i t y of default) a n d the r e t u r n o n l o n g - t e r m g o v e r n m e n t b o n d s ( w h i c h are free f r o m default r i s k ) .

4.5

MEASURING EXPECTED (EX ANTE) RETURN AND RISK

So far w e l o o k e d at the h i s t o r i c a l (ex post facto) r e t u r n a n d r i s k . W e n o w discuss expected (ex ante) r e t u r n a n d r i s k . Probability Distribution W h e n y o u invest i n a stock y o u k n o w that the r e t u r n f r o m it can take v a r i o u s possible values. F o r example, it m a y be - 5 percent, or 15 percent, or 35

Source: Ibbotson Associates, Inc. 2001 Yearbook

The Time Value of Money Exhibit 5.1


Part A I 12% 10,000 12% 12% 10,000 PartB 12% 10,000 10,000 12% 10,000 12% 10,000 12% | 10,000 12% | 12% 10,000 | 10,000 12% | 10,000

117

Time Line

In E x h i b i t 5.1,0 refers to the present time. A cash f l o w that occurs at time 0 is a l r e a d y i n present v a l u e terms a n d hence does not require any adjustment for the time v a l u e of m o n e y . Y o u m u s t d i s t i n g u i s h b e t w e e n a period of time a n d a point in time. P e r i o d 1 w h i c h is the first year is the p o r t i o n of time l i n e b e t w e e n p o i n t 0 a n d p o i n t 1. T h e cash f l o w o c c u r r i n g at p o i n t 1 i s the cash f l o w that occurs at the e n d of p e r i o d 1. F i n a l l y , the discount rate, w h i c h is 12 percent i n o u r example, is specified for each p e r i o d o n the time l i n e a n d it m a y d i f f e r f r o m p e r i o d to p e r i o d . If the cash f l o w occurs at the b e g i n n i n g , rather t h a n the e n d , of each year, the time l i n e w o u l d be as s h o w n i n Part B of E x h i b i t 5.1. N o t e that a cash f l o w o c c u r r i n g at the e n d of year 1 is e q u i v a l e n t to a cash flow o c c u r i n g at the b e g i n n i n g of year 2. C a s h f l o w s c a n be p o s i t i v e or negative. A p o s i t i v e cash f l o w i s called a cash inflow; a negative cash f l o w , a cash outflow. The f o l l o w i n g n o t a t i o n w i l l be u s e d i n o u r d i s c u s s i o n : PV FV C A r g n
t

: : : : : : :

Present v a l u e F u t u r e v a l u e n years hence C a s h f l o w o c c u r r i n g at the e n d of year t A stream of constant p e r i o d i c cash f l o w s over a g i v e n time Interest rate or d i s c o u n t rate E x p e c t e d g r o w t h rate i n cash f l o w s N u m b e r of p e r i o d s over w h i c h the cash f l o w s occur.

5.2

FUTURE VALUE OF A SINGLE AMOUNT

S u p p o s e y o u invest R s . 1,000 f o r three years i n a savings account that p a y s 10 percent interest p e r year. If y o u let y o u r interest i n c o m e be reinvested, y o u r investment w i l l g r o w as f o l l o w s : First year : P r i n c i p a l at the b e g i n n i n g Interest f o r the year (Rs. 1,000 x 0.10) 1,000 100

118
Second year

Investment Analysis and Portfolio P r i n c i p a l at the e n d : P r i n c i p a l at the b e g i n n i n g Interest for the year (Rs. 1,100 x 0.10) P r i n c i p a l at the e n d : P r i n c i p a l at the b e g i n n i n g Interest for the year (Rs. 1,210 x 0.10) P r i n c i p a l at the e n d

Management 1,100 1,100 110 1,210 1,210 121 1,331

T h i r d year

Formula The process of i n v e s t i n g m o n e y as w e l l as r e i n v e s t i n g the interest earned t h e r e o n is c a l l e d c o m p o u n d i n g . The f u t u r e v a l u e or c o m p o u n d e d v a l u e of a n investment after n years w h e n the interest rate is r percent is: FV = P V ( l + r )
:

(5.1)

In this e q u a t i o n (1+r)" is c a l l e d the future v a l u e interest factor or s i m p l y the f u t u r e v a l u e factor. T o solve future v a l u e p r o b l e m s y o u have to f i n d the f u t u r e v a l u e factors. Y o u can d o it i n different w a y s . I n the e x a m p l e g i v e n above, y o u c a n m u l t i p l y 1.10 b y itself three times or m o r e generally (1+r) b y itself n times. T h i s becomes tedious w h e n the p e r i o d of investment is l o n g . Fortunately, y o u have a n easy w a y to get the future v a l u e factor. M o s t calculators h a v e a k e y l a b e l l e d "y ". So a l l that y o u have to d o is to enter 1.10, press the k e y labelled y*, enter 3, a n d press the " = " k e y to obtain the answer. A l t e r n a t i v e l y , y o u can consult a future v a l u e interest factor (FVTF ) table. E x h i b i t 5.2 presents one s u c h table s h o w i n g the future v a l u e factors for certain combinations of periods a n d interest rates. A more comprehensive table is g i v e n i n A p p e n d i x A at the e n d of the b o o k . S u p p o s e y o u d e p o s i t R s . 1,000 t o d a y i n a b a n k w h i c h p a y s 10 percent interest c o m p o u n d e d a n n u a l l y , h o w m u c h w i l l the deposit g r o w to after 8 years a n d 12 years?
x r

Rs. 1,000 (1.10) = R s . 1,000 (2.144)


8

= Rs. 2,144 The future v a l u e , 12 years hence, w i l l be : Rs. 1,000 (1.10) = R s . 1,000 (3.138)
12

= R s . 3,138

The Time Value of Money Exhibit 5.2 n/r 2 4 6 8 10 12 6% 1.124 1.262 1.419 1.594 1.791 2.012

119

Value of FVIFrn for Various Combinations of r and n


8% 1.166 1.360 1.587 1.851 2.159 2.518 10% 1.210 1.464 1.772 2.144 2.594 3.138 12% 1.254 1.574 1.974 2.476 3.106 3.896 14% 1.300 1.689 2.195 2.853 3.707 4.817

W h i l e tables are easy to use they h a v e a l i m i t a t i o n as they c o n t a i n values o n l y for a s m a l l n u m b e r of interest rates. So often y o u m a y h a v e to use a calculator. Graphic View E x h i b i t 5.3 s h o w s g r a p h i c a l l y h o w one rupee w o u l d g r o w o v e r time for different interest rates. N a t u r a l l y the h i g h e r the interest rate, the faster the g r o w t h rate. We h a v e p l o t t e d the g r o w t h curves for three interest rates: 0 percent, 6 percent, a n d 12 percent. G r o w t h curves can be r e a d i l y p l o t t e d for other interest rates. Compound and Simple Interest So far w e a s s u m e d that m o n e y is i n v e s t e d at c o m p o u n d interest w h i c h m e a n s that each interest p a y m e n t is r e i n v e s t e d to e a r n further interest i n f u t u r e p e r i o d s . B y contrast, if n o interest is earned o n interest the investment earns o n l y s i m p l e interest. I n s u c h a case the investment g r o w s as f o l l o w s : F u t u r e v a l u e = Present v a l u e [ 1 + N u m b e r of years x Interest rate ]

Exhibit 5.3
Future Value

Graphic View of Simple and Compound Interest

Compound Interest

Simple Interest

Periods

F o r e x a m p l e , a n i n v e s t m e n t of R s . 1,000, i f i n v e s t e d at 12 percent s i m p l e interest rate w i l l i n 5 years t i m e become : 1,000 [1 + 5 x 0.12] = R s . 1,600 E x h i b i t 5.4 s h o w s h o w a n i n v e s t m e n t of R s . 1,000 g r o w s over time u n d e r s i m p l e interest as w e l l as c o m p o u n d interest w h e n the interest rate is 12 percent. F r o m this

120

Investment Analysis and Portfolio

Management

exhibit y o u c a n feel the p o w e r of c o m p o u n d interest. A s A l b e r t E i n s t e i n once r e m a r k e d : "I d o n ' t k n o w w h a t the seven w o n d e r s of the w o r l d are, b u t I k n o w the e i g h t h c o m p o u n d interest". Y o u m a y be w o n d e r i n g w h y y o u r ancestors d i d n o t d i s p l a y foresight. H o p e f u l l y , y o u w i l l s h o w concern for y o u r posterity. Exhibit 5.4 Value of Rs. 1000 Invested at 10 percent Simple and Compound Interest Compound Interest + = Interest
+ 100 + 146 + 236 + 612 + 10672 + 1,252,783

Year 1 5 10 20 50 100

Starting Balance 1000 1400 1900 2900 5900 10,900

Simple Interest Interest = Ending Balance + 1100 100 = + 1500 100 = + 2000 100 = + 3000 100 = + 6000 100 = + 100 = 11,000
+

Starting Balance 1000 1464 2358 6116 106,718 12,527,829

= = =
=

= =

Ending Balance 1100 1610 2594 6728 117,390 13,780,612

Doubling Period Investors c o m m o n l y ask the question: H o w l o n g w o u l d it take to d o u b l e the a m o u n t at a g i v e n rate of interest? T o answer this question w e m a y l o o k at the f u t u r e v a l u e interest factor table. L o o k i n g at E x h i b i t 5.2 w e f i n d that w h e n the interest rate is 12 percent it takes about 6 years to d o u b l e the a m o u n t , w h e n the interest rate is 6 percent it takes about 12 years to d o u b l e the a m o u n t , so o n a n d so forth. Is there a rule of t h u m b w h i c h dispenses w i t h the use of the future v a l u e interest factor table? Yes, there is one a n d it is c a l l e d the rule of 72. A c c o r d i n g to this r u l e of t h u m b , the d o u b l i n g p e r i o d is o b t a i n e d b y d i v i d i n g 72 b y the interest rate. F o r e x a m p l e , i f the interest rate is 8 percent, the d o u b l i n g p e r i o d is about 9 years (72/8). L i k e w i s e , if the interest rate is 4 percent the d o u b l i n g p e r i o d is about 18 years (72/4). T h o u g h s o m e w h a t c r u d e , it is a h a n d y a n d u s e f u l r u l e of t h u m b . If y o u are i n c l i n e d to d o a s l i g h t l y m o r e i n v o l v e d c a l c u l a t i o n , a m o r e accurate r u l e of t h u m b is the r u l e of 69. A c c o r d i n g to this r u l e of t h u m b , the d o u b l i n g p e r i o d is e q u a l to: 0.35
+

9 Interest Rate

A s a n i l l u s t r a t i o n of this rule of t h u m b , the d o u b l i n g p e r i o d is calculated f o r t w o interest rates, 10 percent a n d 15 percent. Interest Rate Doubling Period 69 0.35 + = 7.25 years 0.35 + = 4.95 15

10 percent 15 percent

The Time Value of Money

121

Finding the Growth Rate T h e f o r m u l a w e u s e d to calculate f u t u r e v a l u e is quite general a n d it can be a p p l i e d to answer other types of questions related to g r o w t h . S u p p o s e y o u r c o m p a n y c u r r e n t l y has 5,000 employees a n d this n u m b e r is expected to g r o w b y 5 percent per year. H o w m a n y employees w i l l y o u r c o m p a n y h a v e i n 10 years? The n u m b e r of employees 10 years hence w i l l be: 5,000 x (1.05)
10

= 5000 x 1.629 = 8,145

C o n s i d e r another e x a m p l e . P h o e n i x L i m i t e d h a d revenues of R s . 100 m i l l i o n i n 1990 w h i c h increased to R s . 1000 m i l l i o n i n 2000. W h a t w a s the c o m p o u n d g r o w t h rate i n revenues? The c o m p o u n d g r o w t h rate m a y be calculated as f o l l o w s : 100 (1+g) 10 (1+g)
10

1,000 1000
1 0

100 i/io
1 / 1 0

= 10

8 = 10

-1

= 1.26 - 1 = 0.26 or 26 percent Future Value in Real Terms So far w e calculated the future v a l u e figures i n n o m i n a l terms. T o convert a n o m i n a l f i g u r e i n t o a r e a l figure, y o u h a v e to adjust for the i n f l a t i o n factor. F o r e x a m p l e , if y o u earn a n o m i n a l rate of r e t u r n of 15 percent o n a n investment of R s . 100 for one year w h e n the i n f l a t i o n rate is 6 percent, y o u r investment g r o w s as follows: In N o m i n a l Terms 100 (1.15) = R s . 115 I n R e a l Terms 100 1.15 1.06 = R s . 108.49

h i general, the future v a l u e i n real terms is: Present v a l u e 1 + N o m i n a l rate 1 + Inflation rate

N o t e the f o l l o w i n g r e l a t i o n s h i p : 1 + R e a l rate = Put differently, R e a l rate = N o m i n a l rate - Inflation rate 1 + Inflation rate 1 + N o m i n a l rate 1 + Inflation rate

The Time Value of Money n l o g 1.12 = l o g 3.4 n x 0.0492 = 0.5315 n= 0.5315 0.0492 = 10.8 years

129

Y o u w i l l h a v e to w a i t f o r about 11 years. The spreadsheet i l l u s t r a t i o n of this p r o b l e m is as g i v e n b e l o w . A 1 2


3

B H o w long should you wait

Future cost (FV) 1,000,000 Period of waiting in years

A n n u a l saving (PMT) 50,000 = NPER(C3,B3-A3) ~ *

Interest rate (RATE) 12% 10.80

5.5

PRESENT VALUE OF AN ANNUITY

Suppose y o u expect to receive R s . 1,000 a n n u a l l y f o r 3 years, each receipt o c c u r r i n g at the e n d of the year. W h a t is the present v a l u e of this stream of benefits if the d i s c o u n t rate is 10 percent? T h e present v a l u e of this a n n u i t y is s i m p l y the s u m of the present values of a l l the i n f l o w s of this a n n u i t y : Rs. 1,000 1 1.10 + R s . 1,000 1 1.10 2 + Rs. 1,000 1 1.10

= R s . 1,000 x 0.9091 + R s . 1,000 x 0.8264 + R s . 1,000 x 0.7513 = R s . 2,486.8 The t i m e l i n e f o r this p r o b l e m is s h o w n i n E x h i b i t 5.10 Exhibit 5.10 Timeline

1,000 909.1826.4751.3Rs 2,486.8 Present value

1,000

1.000

130 Formula

Investment Analysis and Portfolio

Management

I n general terms the present v a l u e of a n a n n u i t y m a y be expressed as f o l l o w s : PVA = A (1 + r) A (1 + r )


2

A (1 + r)n-1

+ (1 + r ) "

= A

(1 + r)

(1 + r )
n

+ (l + r )

n _ 1

+ (1 + r)"
(5.6)
2

= A[{l-(l/l+r) }/r]

w h e r e PVA is the present v a l u e of a n a n n u i t y w h i c h has a d u r a t i o n of n p e r i o d s , A is the constant p e r i o d i c f l o w , a n d r is the d i s c o u n t rate. [{1- (1/1 + r) "}/r] is referred to as the present v a l u e interest factor for a n a n n u i t y (PVTFA ). It i s , as c a n be seen clearly, s i m p l y e q u a l to the p r o d u c t of the future v a l u e interest factor for a n a n n u i t y ( F V I F A , ) a n d the present v a l u e interest factor ( P V I F ). E x h i b i t 5.10 s h o w s the v a l u e of P V I F A , for several c o m b i n a t i o n s of r a n d n. A m o r e d e t a i l e d table of P V I F A values is f o u n d i n A p p e n d i x A at the e n d of this b o o k .
r n r n r

Exhibit 5 .10 n/r 2 4 6 8 10 12 6%

Value of PVIFA 8%

rn

for Different Combinations of r and n 10% 1.737 3.170 4.355 5.335 6.145 6.814 12% 1.690 3.037 4.111 4.968 5.650 6.194 14% 1.647 2.914 3.889 4.639 5.216 5.660

1.833 3.465 4.917 6.210 7.360 8.384

1.783 3.312 4.623 5.747 6.710 7.536

The formula for the present value of an annuity is derived as follows: PVA = A (1 + r )
_ 1

+ A (1 + r) ~ + ... + A (1 + r) ~"
2

(1)

Multiplying both the sides of (1) by (1 + r) gives: PVA (1 + r) = A + A (1 + r) Subtracting (1) from (2) yields : P V A r = A [1 - (1 + r ) = Dividing both the sides of (3) by r results in : PVA = A | [(1 + rf1] / r (1 + rf] = A [{1 - (1/1 + r)")/ r ] (4) A {[(1 + r) -1] / (1 + rf)
n _ 1

+ ... + A (1 + r) ~

n+1

(2) (3)

The Time Value of Money * Applications

131

The present v a l u e a n n u i t y f o r m u l a can be a p p l i e d i n a variety of contexts. Its i m p o r t a n t applications are discussed b e l o w . How Much Can You Borrow for a Car A f t e r r e v i e w i n g y o u r b u d g e t , y o u have d e t e r m i n e d that y o u c a n afford to p a y R s . 12,000 p e r m o n t h for 3 years t o w a r d a n e w car. Y o u call a finance c o m p a n y a n d learn that the g o i n g rate of interest o n car finance is 1.5 percent per m o n t h for 36 m o n t h s . H o w m u c h c a n y o u b o r r o w ? T o determine h o w m u c h y o u c a n b o r r o w , w e have to calculate the present v a l u e of R s . 12,000 p e r m o n t h for 36 months at 1.5 percent per m o n t h . Since the l o a n payments are a n o r d i n a r y a n n u i t y , the present v a l u e interest factor of a n n u i t y is: PVIFA =
r

1-1/(1+ r f r

(1-1/(1.015) .015

36

= 27.70

H e n c e the present v a l u e of 36 p a y m e n t s of Rs. 12,000 each is: Present v a l u e = R s . 12,000 x 27.70 = R s . 332,400 Y o u can, therefore, b o r r o w R s . 332,400 to b u y the car. A spreadsheet i l l u s t r a t i o n of this p r o b l e m is as g i v e n b e l o w . A 1 2 3 4 B H o w much can y o u borrow for a car Payment per month (PMT) 12,000 Loan amount N o . of months (NPER) 36 = PV(C3,B3,-A3) Interest rate (RATE) 1.50% 331,928 C

Period of Loan Amortisation Y o u w a n t to b o r r o w R s . 1,080,000 to b u y a flat. Y o u a p p r o a c h a h o u s i n g finance c o m p a n y w h i c h charges 12.5 percent interest. Y o u c a n p a y Rs. 180,000 p e r year t o w a r d l o a n amortisation. W h a t s h o u l d be the m a t u r i t y p e r i o d of the loan? The present v a l u e of a n n u i t y of Rs. 180,000 is set e q u a l to R s . 1,080,000. 180,000 x PVIFA = 1,080,000
r

180,000 x P V I F A 180,000

M = ? > T = n 5 %

= 1,080,000 = 1,080,000

1/(1.125)" 0.125

G i v e n this equality the v a l u e of n is calculated as f o l l o w s : 1-1/(1.125)" 0.125 1,080,000 180,000 = 6

132

Investment Analysis and Portfolio = 0.25 (1.125)" 1.125" = 4 n l o g 1.125 = l o g 4

Management

n x 0.0512 = 0.6021 0.6021 n = = 11.76 years 0.0512 Y o u c a n perhaps request for a m a t u r i t y of 12 years.
J

Determining the Loan Amortisation Schedule M o s t loans are r e p a i d i n e q u a l p e r i o d i c instalments ( m o n t h l y , quarterly, or a n n u a l l y ) , w h i c h cover interest as w e l l as p r i n c i p a l r e p a y m e n t . S u c h loans are referred to as amortised loans. F o r a n a m o r t i s e d l o a n w e w o u l d l i k e to k n o w (a) the p e r i o d i c instalment p a y m e n t a n d (b) the l o a n a m o r t i s a t i o n schedule s h o w i n g the break u p of the p e r i o d i c instalment p a y m e n t s between the interest c o m p o n e n t a n d the p r i n c i p a l r e p a y m e n t c o m p o n e n t . T o illustrate h o w these are calculated, let us l o o k at a n example. S u p p o s e a f i r m b o r r o w s R s . 1,000,000 at a n interest rate of 15 percent a n d the l o a n is to be r e p a i d i n 5 e q u a l instalments p a y a b l e at the e n d of each of the next 5 years. The a n n u a l installment p a y m e n t A is obtained b y s o l v i n g the f o l l o w i n g e q u a t i o n . L o a n amount = A x P V I F A _ 1,000,000 = A x 3.352 H e n c e A = 298,312 T h e a m o r t i s a t i o n schedule is s h o w n i n E x h i b i t 5.11. The interest c o m p o n e n t is the largest for year 1 a n d p r o g r e s s i v e l y declines as the o u t s t a n d i n g l o a n a m o u n t decreases. Exhibit 5.11 Year Beginning Amount (1) 1,000,000 851,688 681,129 485,986 259,422 Loan Amortisation Schedule
5< r

1 5 %

1 2 3 4 5

Annual Installment (2) 298,312 298,312 298,312 298,312 298,312

Interest (3) 150,000 127,753 ' 102,169 72,482 38,913

Principal Repayment (2)-(3) = (4) 148,312 170,559 196,143 225,564 259,399

Remaining Balance (1) - (4) = (5) 851,688 681,129 485,986 259,422 23*

* Due to rounding off error a small balance is shown.

The Time Value of Money The above schedule c a n be set u p u s i n g a spreadsheet, as u n d e r . B C D N o . of installments (in years) 5 E Annual installment amount (298,316) Principal repayment 148,316 170.563 196.148 225,570 259,406 F

133

r
r

Present value 1,000,000

Interest rate 15%

i3

Year 1

Beginning amount 1,000,000 851,684 681,121 484,973 259,403

Annual installment 298,316 298,316 298,316 298,316 298,316

Interest 150000 127753 102168 72746 38910

Remaining balance 851,684 681,121 484,973 259,403 (3)

5 6 '"7 8

2 3 4 5

T y p e 1,000,000,15%, a n d 5 i n B2, C 2 , a n d D 2 . U s e the f i n a n c i a l f u n c t i o n P M T to get the installment a m o u n t i n E 2 . T h i s means E 2 = P M T (B2, C 2 , D 2 ) . I n B4 type - B2 to get the b e g i n n i n g a m o u n t . T o get the installment a m o u n t i n C 4 type = - E 2 a n d press F4. A $ s i g n w i l l appear before E a n d 2($E$2). T h i s w i l l m a k e the v a l u e i n this cell absolute, that i s , constant t h r o u g h o u t . U s e the f o r m u l a = B4*$C$2 to get interest a m o u n t i n D 4 (note that C 2 here is m a d e absolute b y p r e s s i n g F4). F i l l i n the p r i n c i p a l r e p a y m e n t a m o u n t i n E4 u s i n g the f o r m u l a =C4-D4 a n d the r e m a i n i n g balance i n F4 u s i n g the f o r m u l a = B4-E4. C o p y this v a l u e to B5 b y t y p i n g =F4. N e x t , c l i c k o n C 4 . O b s e r v e that there is a t i n y b l a c k b o x at the l o w e r r i g h t corner of the c e l l . T h i s is c a l l e d a f i l l h a n d l e . P o i n t the cursor to the f i l l h a n d l e (it w i l l t u r n into a b l a c k cross) a n d d r a g it d o w n u p to C8. T h i s w i l l a u t o f i l the v a l u e i n C 4 (whether a n absolute v a l u e o r a f o r m u l a ) u p to C 8 . A u t o f i l the cell i n a l l c o l u m n s u s i n g f i l l h a n d l e b y d r a g g i n g d o w n the f o r m u l a f r o m the cell last f i l l e d i n . O n c e y o u f i n i s h this, correct values w i l l appear i n each c e l l . C o n c e p t u a l l y , the p e r i o d i c l o a n i n s t a l l m e n t is the v a l u e of A i n the f o l l o w i n g equation. P = A [ l - ( l / l + r)"]/r (5.6)

134
T h i s means,

Investment Analysis and Portfolio

Management

A =

Pxr [l-(l/l
+

rf]

(5.6a)

In the h o u s i n g finance i n d u s t r y , it is e q u i v a l e n t l y expressed as: A = Pxrx (l (l


+ +

r)"

r)"-l

(5.6b)

N o t e that the f o r m u l a i n E q (5.6b) is equivalent to the f o r m u l a i n E q (5.6a) because (l l - l / ( l + r) (i


+ r +

r)

)_i/(i

(l + r ) " - l

Determining the Periodic Withdrawal Y o u r father deposits R s . 300,000 o n retirement i n a b a n k w h i c h p a y s 10 percent a n n u a l interest. H o w m u c h c a n be w i t h d r a w n a n n u a l l y for a p e r i o d of 10 years? 1 A = R s . 300,000 x = R s . 300,000 x = R s . 48,819 A spreadsheet c a l c u l a t i o n of the above is as u n d e r . A 1 2 3 Initial deposit Interest rate Period i n years B (300,000) 10% 10 = PMT(B2,B3B1) C D E
PVIFA
1 0

/ o < 1 0

1 6.145

48,824

Finding the Interest Rate S u p p o s e someone offers y o u the f o l l o w i n g f i n a n c i a l contract: If y o u deposit R s . 10,000 w i t h h i m he p r o m i s e s to p a y R s . 2,500 a n n u a l l y for 6 years. W h a t interest rate d o y o u earn o n this deposit? T h e interest rate m a y be calculated i n t w o steps: Step 1 F i n d the P V I F A
r 6

for this contract b y d i v i d i n g R s . 10,000 b y R s . 2,500


r 6 = 6 R

PVIFA '
r

=4.000 Rs 2,500
S 1 0 0 0

Step 2 L o o k at the P V I F A table a n d r e a d the r o w c o r r e s p o n d i n g to 6 years u n t i l y o u f i n d a v a l u e close to 4.000. D o i n g so, y o u f i n d that

The Time Value of Money


PVIFA
1 2

135
M M

/ o 6

is 4.111 a n d P V I F A

1 4 < M

is 3.889

Since 4.000 lies i n the m i d d l e of these values the interest rate lies (approximately) i n the m i d d l e . So, the interest rate is 13 percent. Valuing an Infrequent Annuity R a g h a v a n w i l l receive a n a n n u i t y of R s . 50,000, payable once e v e r y t w o years. T h e p a y m e n t s w i l l stretch o u t over 30 years. T h e first p a y m e n t w i l l be received at the e n d of t w o years. If the a n n u a l interest rate is 8 percent, w h a t is the present v a l u e of the a n n u i t y ? The interest rate over a t w o - y e a r p e r i o d is: (1.08) x (1.08) - 1 = 0.1664 percent T h i s means that R s . 100 i n v e s t e d over t w o years w i l l y i e l d R s . 116.64. W e have to calculate the present v a l u e of a R s . 50,000 a n n u i t y over 15 p e r i o d s , w i t h an interest rate of 16.64 percent p e r p e r i o d . This w o r k s o u t to: Rs. 50,000 [{ 1 - (1/1.1664) }] / 0.1664 = R s . 270,620
15

Equating Present Value of Two Annuities R a v i w a n t s to save for the college e d u c a t i o n of h i s s o n , D e e p a k . R a v i estimates that the college e d u c a t i o n expenses w i l l be rupees one m i l l i o n p e r year f o r f o u r years w h e n h i s s o n reaches college after 16 years - the expenses w i l l be payable at the b e g i r m i n g of the years. H e expects the a n n u a l interest rate of 8 percent over the next t w o decades. H o w m u c h m o n e y s h o u l d he deposit i n the bank each year f o r the next 15 years (assume that the deposit is m a d e at the e n d of the year) to take care of h i s son's college e d u c a t i o n expenses? The time line for this p r o b l e m is as f o l l o w s : 0 1 2 15 16 17 18 19

I
Now

1
1 deposit
s t

r
2 deposit
n d

1
15 deposit
th

1
1 expense
s t

h
4 expense
t h

The present v a l u e of college education expenses as at the e n d of the 15th year: Rs. 1,000,000 x P V I F A (4 years, 8%) = R s . 1,000,000 x 3.312 = R s . 3,312,000 The a n n u a l deposit to be m a d e so that the future v a l u e of the deposits at the e n d of 15 years is R s . 3,312,000 is:
A

R s . 3,312,000

_ R s . 3,312,000 27.152

~ F V I F A (15 years, 8%) ~ = R s . 121,980 Present Value o f a Growing Annuity

A cash f l o w that g r o w s at a constant rate for a specified p e r i o d of time is a g r o w i n g a n n u i t y . T h e time l i n e of a g r o w i n g a n n u i t y is s h o w n b e l o w :

136

Investment Analysis and Portfolio A(\+g)


1

Management A(\
+ g

A(l+g)
1

i
n

The present v a l u e of a g r o w i n g a n n u i t y can be d e t e r m i n e d u s i n g the f o l l o w i n g formula:


2

fl+gr
(1 + r ) " (5.7)
3

P V of a G r o w i n g A n n u i t y = A (1+ g)

The above f o r m u l a can b e u s e d w h e n the g r o w t h rate is less t h a n the d i s c o u n t rate (g < r) as w e l l as w h e n the g r o w t h rate is m o r e t h a n the d i s c o u n t rate (g > r). H o w e v e r , it does not w o r k w h e n the g r o w t h rate is e q u a l to the discount rate (g = r) - i n this case, the present v a l u e is s i m p l y e q u a l ton A. F o r example, suppose y o u have the right to harvest a teak p l a n t a t i o n for the next 20 years over w h i c h y o u expect to get 100,000 cubic feet of teak per year. The current price per cubic feet of teak is Rs. 500, b u t it is expected to increase at a rate of 8 percent per year. The d i s c o u n t rate is 15 percent. The present v a l u e of the teak that y o u c a n harvest f r o m the teak forest can be d e t e r m i n e d as f o l l o w s :

The formula for the present value of a growing annuity (PVGA) is derived as follows: P V G A = - ^ + (1 + r) (1 + r) Multiplying both the sides of (1) by (1 + g)/(l
P V G A x

A ( 1+

+
2

- *gg
+

(1+r)"

(1)

+ r) gives :
n + l

(i4 (1 + r)

(1 + r)

(1 + r)

(1 + r)

n + l

(2)

Subtracting (2) from (1) yields: PVGA This simplifies to: (l + g f (1 + r)" (1+1) (1 + r)
=

A(l + g) (1+r)

A(l + g)' (l + r ) "

n + l
+1

(3)

P V G A = A (1 + g)

(4)

590
Exhibit 21.1

Investment Analysis and Portfolio

Management

Interrelationship Among Various Phases of Portfolio Management


Specification of investment objectives ant constraints

\
Choice of asset mix

\
Formulation of portfolio strategy Selection of securities

\
Portfolio execution

i
Portfolio revision

Portfolio evaluation

21.1

SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS

T h e first step i n the p o r t f o l i o m a n a g e m e n t process is to specify the investment p o l i c y w h i c h s u m m a r i s e s the objectives, constraints, a n d preferences of the i n v e s t o r . T h e investment p o l i c y m a y be expressed as f o l l o w s : * Objectives R e t u r n requirements R i s k tolerance C o n s t r a i n t s a n d Preferences w Liquidity Investment h o r i z o n Taxes Regulations U n i q u e circumstances Objectives T h e c o m m o n l y stated investment goals are: Income T o p r o v i d e a steady stream of i n c o m e t h r o u g h regular i n t e r e s t / d i v i d e n d payment. * Growth T o increase the v a l u e of the p r i n c i p a l a m o u n t t h r o u g h c a p i t a l appreciation. Stability T o protect the p r i n c i p a l a m o u n t i n v e s t e d f r o m the r i s k of loss. Since i n c o m e a n d g r o w t h represent t w o w a y s b y w h i c h r e t u r n is generated a n d stability i m p l i e s containment or e v e n e l i m i n a t i o n of risk, investment objectives m a y be

Portfolio Management Framework

591

expressed m o r e succinctly i n terms of r e t u r n a n d r i s k . A s a n investor, y o u w o u l d p r i m a r i l y be interested i n a h i g h e r r e t u r n (in the f o r m of i n c o m e a n d / o r c a p i t a l appreciation) a n d a l o w e r l e v e l of risk. H o w e v e r , r e t u r n a n d risk t y p i c a l l y go h a n d i n h a n d . So y o u have to o r d i n a r i l y bear a higher l e v e l of risk i n order to earn a h i g h e r r e t u r n . H o w m u c h risk y o u w o u l d be w i l l i n g to bear to seek a h i g h e r r e t u r n d e p e n d s o n y o u r risk d i s p o s i t i o n . Y o u r investment objective s h o u l d state y o u r preference for r e t u r n relative to y o u r distaste for risk. Y o u can specify y o u r investment objectives i n one of the f o l l o w i n g w a y s : M a x i m i s e the expected rate of return, subject to the risk exposure b e i n g h e l d w i t h i n a certain l i m i t (the risk tolerance level). M i n i m i s e the risk exposure, w i t h o u t sacrificing a certain expected rate of r e t u r n (the target rate of return). W h i c h of these t w o s h o u l d y o u adopt? M y r e c o m m e n d a t i o n is for y o u to start b y d e f i n i n g h o w m u c h r i s k y o u can bear or h o w m u c h y o u c a n a f f o r d to lose, rather t h a n s p e c i f y i n g h o w m u c h m o n e y y o u w a n t to m a k e . The r i s k y o u c a n bear d e p e n d s o n t w o k e y factors: (a) y o u r f i n a n c i a l s i t u a t i o n , a n d (b) y o u r t e m p e r a m e n t . T o assess y o u r f i n a n c i a l s i t u a t i o n , a n s w e r the f o l l o w i n g questions: W h a t is the p o s i t i o n of y o u r w e a l t h ? W h a t m a j o r expenses (house c o n s t r u c t i o n , m a r r i a g e , e d u c a t i o n , m e d i c a l treatment, etc.) can be a n t i c i p a t e d i n the near future? W h a t is y o u r e a r n i n g capacity? H o w m u c h m o n e y can y o u lose w i t h o u t s e r i o u s l y h u r t i n g y o u r s t a n d a r d of l i v i n g ? A c a r e f u l a n d realistic a p p r a i s a l of y o u r assets, expenses, a n d earnings is b a s i c to d e f i n i n g y o u r r i s k tolerance. A f t e r a p p r a i s i n g y o u r financial situation, assess y o u r temperamental tolerance for risk. E v e n t h o u g h y o u r financial situation m a y p e r m i t y o u to absorb losses easily, y o u m a y become extremely upset over s m a l l losses. O n the other h a n d , despite a not-sostrong financial p o s i t i o n , y o u m a y not be easily r u f f l e d b y losses. U n d e r s t a n d y o u r financial temperament as objectively as y o u can. Y o u r r i s k tolerance l e v e l is set b y either y o u r financial situation or y o u r financial temperament, w h i c h e v e r is l o w e r . O f course, y o u m u s t realise that y o u r r i s k tolerance cannot be or s h o u l d not be d e f i n e d too precisely a n d r i g o r o u s l y . F o r practical purposes, it suffices if y o u define it as l o w , m e d i u m , or h i g h . O n c e y o u have articulated y o u r r i s k tolerance realistically i n this f a s h i o n , it w i l l serve as a v a l u a b l e g u i d e i n y o u r investment selection. It w i l l p r o v i d e y o u w i t h a u s e f u l perspective a n d prevent y o u f r o m b e i n g a v i c t i m of the w a v e s a n d manias that tend to sweep the market f r o m t i m e to time. Risk Assessment F i n a n c i a l advisers, m u t u a l f u n d s , a n d b r o k e r a g e f i r m s h a v e d e v e l o p e d r i s k questionnaires to h e l p investors determine w h e t h e r t h e y are conservative, moderate, or aggressive. T y p i c a l l y , such risk q u e s t i o n a i r e s . h a v e 7 to 10 questions to guage a person's tendency to m a k e r i s k y or conservative choices i n certain

592

Investment Analysis and Portfolio

Management

h y p o t h e t i c a l situations. A l t h o u g h r i s k questionnaires are not precise, they are h e l p f u l i n g e t t i n g a r o u g h i d e a of a n investor's r i s k tolerance. A s p e c i m e n r i s k tolerance questionnaire is g i v e n i n E x h i b i t 21.2. W h i l e r i s k tolerance assessment is h e l p f u l , the real r i s k tolerance is often l o w e r t h a n expected. A s Robert D A r n o t t p u t it: " F e w investors h a v e the tolerance for loss or s h o r t f a l l that e v e n they t h i n k they h a v e . If they l o o k at h i s t o r i c a l e v i d e n c e for a p a r t i c u l a r investment strategy, a n d see a s o u n d h i s t o r y of p r o f i t interspersed w i t h brief p e r i o d s of d i s a p p o i n t m e n t , most investors w o u l d l i k e l y say, 'I c o u l d tolerate that d i s a p p o i n t m e n t ' . L i v i n g t h r o u g h d i s a p p o i n t m e n t is v e r y different f r o m l o o k i n g at it o n paper: M a n y investors d o not have as m u c h patience or r i s k tolerance as they believe they h a v e " . Constraints I n p u r s u i n g y o u r i n v e s t m e n t objective, w h i c h is s p e c i f i e d i n terms of r e t u r n requirement a n d r i s k tolerance, y o u s h o u l d bear i n m i n d the constraints a r i s i n g out of or relating to the f o l l o w i n g factors: Liquidity L i q u i d i t y refers to the speed w i t h w h i c h a n asset c a n be s o l d , w i t h o u t s u f f e r i n g a n y significant d i s c o u n t to its fair market price. F o r example, m o n e y market instruments are the most l i q u i d assets, whereas antiques are a m o n g the least l i q u i d . T a k i n g i n t o account y o u r cash requirements i n the foreseeable f u t u r e , y o u m u s t establish the m i n i m u m l e v e l of ' c a s h ' y o u w a n t i n y o u r i n v e s t m e n t p o r t f o l i o . Investment Horizon The i n v e s t m e n t h o r i z o n is the t i m e t i l l the i n v e s t m e n t or p a r t thereof is p l a n n e d to be l i q u i d a t e d to meet a specific n e e d . F o r example, the investment h o r i z o n m a y be ten years to f u n d a c h i l d ' s college e d u c a t i o n or t h i r t y years to meet retirement needs. The investment h o r i z o n has a n i m p o r t a n t b e a r i n g o n the choice of assets. Taxes W h a t matters f i n a l l y is the post-tax r e t u r n f r o m a n i n v e s t m e n t . Tax c o n s i d e r a t i o n s therefore h a v e a n i m p o r t a n t b e a r i n g o n i n v e s t m e n t decisions. So, c a r e f u l l y r e v i e w the tax shelters available to y o u a n d incorporate the same i n y o u r investment decisions. Regulations W h i l e i n d i v i d u a l investors are generally not constrained m u c h b y l a w , i n s t i t u t i o n a l investors have to c o n f o r m to v a r i o u s regulations. F o r e x a m p l e , m u t u a l f u n d s i n I n d i a are not a l l o w e d to h o l d m o r e t h a n 10 percent of the e q u i t y shares of a* public company. Unique Circumstances A l m o s t every investor faces u n i q u e circumstances. F o r example, a n i n d i v i d u a l m a y h a v e the r e s p o n s i b i l i t y of l o o k i n g after a g e i n g parents. O r , an e n d o w m e n t f u n d m a y be p r e c l u d e d f r o m i n v e s t i n g i n the securities of c o m p a n i e s m a k i n g alcoholic p r o d u c t s a n d tobacco p r o d u c t s .

Portfolio Management Exhibit 21.2

Framework

593

A Risk Tolerance Questionnaire

To assess your risk tolerance, seven questions are given below. Each question is followed by three possible answers. Circle the letter that corresponds to your answer. 1. Just six weeks after you invested in a stock, its price declines by 20 percent. If the fundamentals of the stock have not changed, what would you do? a. Sell b. Do nothing c. Buy more 2. Consider the previous question another way. Your stock dropped 20 percent, but it is part of a portfolio designed to meet investment goals with three different time horizons. (i) What would you do if your goal were five years away? a. Sell b. Do nothing c. Buy more (ii) What would you do if the goal were 15 years away? a. Sell b. Do nothing c. Buy more (iii) What would you do if the goal were 30 years away? a. Sell b. Do nothing c. Buy more 3. You have bought a stock as part of your retirement portfolio. Its price rises by 25 percent after one month. If the fundamentals of the stock have not changed, what would you do? a. Sell b. Do nothing c. Buy more 4. You are investing for retirement which is 15 years away. What would you do? a. Invest in a money market mutual fund or a guaranteed investment contract b. Invest in a balanced mutual fund that has a stock: bond mix of 50:50 c. Invest in an aggressive growth mutual fund 5. As a prize winner, you have been given some choice. Which one would you choose? a. Rs 50,000 in cash b. A 50 percent chance to get Rs 125,000 c. A 20 percent chance to get Rs 375,000 6. A good investment opportunity has come your way. To participate in it you have to borrow money. Would you take a loan? a. No b. Perhaps c. Yes 7. Your company, which is planning to go public after three years, is offering stock to its employees. Until it goes public, you can't sell your shares. Your investment, however, has the potential of multiplying 10 times when the company goes public. How much money would you invest? a. Nothing b. Three months' salary c. Six months'salary Your risk tolerance score is: Number of (a) answers x 1 + Number of (b) answers x 2 + Number of (c) answers x 3 If your score is ... You may be a ... 9-14 points Conservative investor 15-21 points Moderate investor 22-27 points Aggressive investor Adapted from a risk tolerance questionnaire developed by Dow Jones & Company Inc.

Portfolio Management

Framework

615

21.7

PERFORMANCE EVALUATION

The k e y d i m e n s i o n s of p o r t f o l i o performance e v a l u a t i o n are rate of r e t u r n a n d r i s k . T h i s section l o o k s at the measures of rate of r e t u r n , risk, a n d performance. Rate of Return The rate of r e t u r n f r o m a p o r t f o l i o for a g i v e n p e r i o d ( w h i c h m a y be d e f i n e d as a p e r i o d of one year) is m e a s u r e d as f o l l o w s : D i v i d e n d income + T e r m i n a l value - Initial v a l u e Initial v a l u e To * * illustrate the calculation of the rate of r e t u r n , let us l o o k at the f o l l o w i n g data: Initial market v a l u e of the p o r t f o l i o : Rs 100,000 D i v i d e n d a n d interest i n c o m e received t o w a r d the e n d of the year : Rs 10,000 T e r m i n a l m a r k e t v a l u e of the p o r t f o l i o : Rs 105,000 The rate of r e t u r n o n this p o r t f o l i o is s i m p l y : 10,000 + (105,000 -100,000) 100,000 = 0.15 or 15 percent

T o calculate the average rate of return, over a p e r i o d of several years, the f o l l o w i n g measures m a y be e m p l o y e d : (a) arithmetic average of a n n u a l rates of r e t u r n , (b) i n t e r n a l rate of r e t u r n (also referred to as the m o n e y - w e i g h t e d rate of return), a n d (c) geometric average of a n n u a l rates of r e t u r n (also referred to as the t i m e - w e i g h t e d rate of return). T h e c a l c u l a t i o n of these measures m a y be illustrated w i t h the h e l p of the data g i v e n i n E x h i b i t 21.10. T h e a r i t h m e t i c a v e r a g e of a n n u a l rates of r e t u r n i n the above case is: (15.0 + 0.0 + 36.8 + 26.7 + 15.7) / 5 = 18.8 percent The i n t e r n a l r a t e o f r e t u r n is d e f i n e d as the d i s c o u n t rate w h i c h b r i n g s about a n e q u a l i t y b e t w e e n the i n i t i a l i n v e s t m e n t a n d the present v a l u e of future benefits associated w i t h the investment. The internal rate of r e t u r n i n the above case is the v a l u e of r ( w h i c h w o r k s out to 17.65) i n the f o l l o w i n g equation: 100,000 = 10,000 (1 + r)
+

10,000 ( l + r)
2 +

10,000 (l + r)
3

12,000 (1 + r )
4

12,000+150,000 ~ (1 + r )
5

614

Investment Analysis and Portfolio

Management

p r i c e d investments, offering inferior returns; y o u m a y forego o p p o r t u n i t i e s of m a k i n g p r o m i s i n g investments. Y o u s h o u l d l e a r n h o w to w e i g h the o p p o r t u n i t y cost of n o n t r a d i n g against the e x p l i c i t costs of t r a d i n g . I n essence, p o r t f o l i o r e v i s i o n calls for d e v e l o p i n g a n a p p r o p r i a t e response to the t e n s i o n b e t w e e n the ' a p p a r e n t ' cost of t r a d i n g a n d the 'subtle' cost of i n a c t i o n .

Restoring the Target Proportions Since the strategic asset-mix d e c i s i o n (or p o l i c y asset-mix decision) is the most i m p o r t a n t d e c i s i o n i n p o r t f o l i o management, it is n o r m a l l y a s s u m e d that the investor w i l l p e r i o d i c a l l y (say, once a year) rebalance the p o r t f o l i o to restore the target p r o p o r t i o n . Suppose y o u r strategic asset m i x of 50:50 a n d y o u start w i t h a n investment of Rs. 100,000 i n stocks a n d Rs. 100,000 i n b o n d s . A f t e r one year the v a l u e s of the a n d b o n d s are say R s . 150,000 a n d R s . 110,000 r e s p e c t i v e l y . T o restore the target p r o p o r t i o n s , y o u must sell Rs. 20,000 of stocks a n d b u y Rs. 20,000 of b o n d s . D o i n g so m a y seem easy, b u t i n real life y o u require a lot of d i s c i p l i n e a n d patience because it i n v o l v e s d o i n g exactly the opposite of w h a t most others i n the investment w o r l d are d o i n g . A d i s c i p l i n e d restoration of target p r o p o r t i o n s is i n d e e d a n effective w a y of b e c o m i n g a " c o n t r a r i a n . " If y o u have stronger " c o n t r a r i a n " instincts, y o u can go a step further. Y o u can resort to d y n a m i c asset allocation. T h i s calls for increasing y o u r target allocation i n f a v o u r of the asset class that has u n d e r p e r f o r m e d . T o illustrate, suppose y o u r target allocation for stocks a n d b o n d s is 50:50 a n d y o u , to b e g i n w i t h , invest R s . 100,000 each i n stocks a n d b o n d s . A f t e r one year y o u f i n d that the values of the stock a n d the b o n d components are Rs. 80,000 a n d Rs. 110,000. Since stocks have u n d e r p e r f o r m e d b o n d s , y o u increase y o u r target a l l o c a t i o n to stocks f r o m 50 percent to say 55 percent a n d d i m i n i s h the target a l l o c a t i o n to b o n d s f r o m 50 percent to 45 percent. Y o u r p o r t f o l i o after rebalancing w i l l be as f o l l o w s : Before R e b a l a n c i n g After Rebalancing 80,000 104,500 110.000 85.500 190.000 190.000 N o t e that u n d e r d y n a m i c asset a l l o c a t i o n , changes i n target a l l o c a t i o n are d r i v e n p u r e l y b y m a r k e t v a l u a t i o n . F o r example, y o u m a y f o l l o w a s i m p l e r u l e l i k e increasing (decreasing) the target allocation to stocks b y 0.5 percent for every 1 percent f a l l (rise) i n its v a l u e . D y n a m i c asset allocation is i n essence a m o r e rigorous f o r m of rebalancing i n d e e d , it is " o v e r b a l a n c i n g " a n d it requires greater courage a n d d e t e r m i n a t i o n . A s W i l l i a m Bernstein p u t i n h i s i n s i g h t f u l b o o k The Intelligent Asset Allocator: " R e b a l a n c i n g requires nerve a n d d i s c i p l i n e ; o v e r b a l a n c i n g requires even m o r e of b o t h of these scarce c o m m o d i t i e s ; V e r y f e w investors, s m a l l or i n s t i t u t i o n a l can carry it off." H e a d d s " Y o u cannot p i l o t a m o d e r n jet fighter before m a s t e r i n g the trainer; l i k e w i s e , y o u s h o u l d not attempt d y n a m i c asset a l l o c a t i o n before mastering fixed asset a l l o c a t i o n . " Stocks Bonds

616

Investment Analysis and Portfolio Exhibit 21.10

Management

Rate of Return Data Rate of return

Year 0 1 2 3 4 5

Market value of the portfolio (Rs.) 100,000 105,000 95,000 120,000 140,000 150,000

Dividend and interest income (Rs.)

10,000 10,000 10,000 12,000 12,000

10,000+ (105,000-100,000) = 15% 100,000 10,000 + (95,000 - 105,000) = 0.0% 105,000 10,000+ (120,000-95,000) = 36.8% 95,000 12,000 + (140,000 - 120,000) = 26.7% 120,000 12,000 + (150,000 - 140,000) = 15.7% 140,000

The geometric m e a n of a n n u a l rates of r e t u r n is the n t h root of the p r o d u c t of n a n n u a l w e a l t h ratios (wealth ratio is s i m p l y 1 + a n n u a l rate of return) m i n u s 1. The geometric m e a n of a n n u a l rates of r e t u r n i n the above case is: [(1 + 0.15) (1 + 0.00) (1 + 0.368) (1 + 0.267) (1 + 0 . 1 5 7 ) ] = about 0.182 or 18.2 percent H o w u s e f u l or a p p r o p r i a t e are the above measures of rate of return? Let us examine t h e m one b y one. The arithmetic average of a n n u a l rates of r e t u r n is a p p e a l i n g because it is s i m p l e i n concept a n d a p p l i c a t i o n . H o w e v e r , it suffers f r o m a serious l i m i t a t i o n . T o u n d e r s t a n d this, consider a case w h e r e the m a r k e t v a l u e of a n investment of 100 m a d e at the e n d of year 0 declines to 80 at the e n d of year 1 a n d recovers to 100 at the e n d of year 2. A s s u m i n g that there is n o d i v i d e n d p a y m e n t d u r i n g the t w o year p e r i o d , the a n n u a l returns a n d their arithmetic average are as f o l l o w s : R e t u r n for year 1: = 100
7 n 175

- 1

- 20 percent
r

100-80 R e t u r n for year 2: = 25 percent A r i t h m e t i c average of a n n u a l returns: =2.5 percent

T h u s w e f i n d that a l t h o u g h the r e t u r n over the t w o year p e r i o d is n i l , the arithmetic average of a n n u a l returns w o r k s out to 2.5 percent. So this measure of r e t u r n c a n be m i s l e a d i n g . Despite this l i m i t a t i o n , thanks to its s i m p l i c i t y , it is the most c o m m o n l y u s e d measure of r e t u r n .

Portfolio Management

Framework

617

How u s e f u l is the i n t e r n a l rate of r e t u r n , also referred to as the m o n e y - w e i g h t e d r a t e o f r e t u r n ? T o a n s w e r this q u e s t i o n let u s l o o k at the i n t e r n a l rate of r e t u r n of t w o p o r t f o l i o s , A a n d B that experience different cash f l o w s as s h o w n i n E x h i b i t 21.11. Exhibit 21.11 Cash Flows of Portfolios A and B Period Rate of return earned Portfolio A 1. Beginning value before inflow or outflow 2. Inflow (outflow) 3. Amount invested 4. Ending value Portfolio B 1. Beginning value before inflow or outflow 2. Inflow (outflow) 3. Amount invested 4. Ending value 1 10% 10,000 2 30% 11,000 3 20% 14,300 4

17,160 (17,160)

10,000
11,000 10,000

11,000
14,300 11,000 (8,000) 3,000 3,900

14,300
17,160 3,900 3.900 4,680

4,680 (4,680)

10,000
11,000

In P o r t f o l i o A, a n i n i t i a l investment of 10,000 g r o w s to 17,160 at the e n d of year 3, w i t h n o intermediate cash f l o w s . H e n c e , its i n t e r n a l rate of r e t u r n is the v a l u e of r that satisfies the equation 1 0 , 0 0 0 = ^ (1 + r )

S o l v i n g this equation, w e get the v a l u e of r to be 19.72 percent. In P o r t f o l i o B, a n i n i t i a l investment of 10,000 results i n cash f l o w s of 8,000 a n d 4,680 at the e n d of years 1 a n d 3 respectively. H e n c e , its i n t e r n a l rate of r e t u r n is the v a l u e of r that satisfies the e q u a t i o n 10,000= 8 ^ (1 + r)
+

_ 0 . (1 + rf

4,680 (1 + rf

S o l v i n g this equation, w e get the v a l u e of r to be 15.27 percent. T h u s w e f i n d that t h o u g h the p e r i o d - b y - p e r i o d returns of b o t h the p o r t f o l i o s are i d e n t i c a l , the i n t e r n a l rate of r e t u r n (or the m o n e y - w e i g h t e d rate of return) for P o r t f o l i o A is greater than that for P o r t f o l i o B. T h i s is because the internal rate of r e t u r n suffers f r o m a l i m i t a t i o n i n that it is sensitive to the pattern of cash f l o w s over w h i c h p o r t f o l i o managers often h a v e n o c o n t r o l . N o t e that the i n t e r n a l rate of r e t u r n reflects investment p e r f o r m a n c e as w e l l as the effect of c o n t r i b u t i o n s a n d w i t h d r a w a l s . H e n c e it is not correct so say that investment performance alone accounted for 15.27 percent. Indeed, you cannot j u d g e the q u a l i t y o f i n v e s t m e n t p e r f o r m a n c e f r o m the i n t e r n a l rate of r e t u r n f i g u r e . The i n t e r n a l rate of r e t u r n , h o w e v e r , is u s e f u l i n m e a s u r i n g the t o t a l e x p e r i e n c e of a f u n d , reflecting investment performance as w e l l as cash f l o w s .

618

Investment Analysis and Portfolio Management

The geometric m e a n rate of r e t u r n (or the t i m e - w e i g h t e d rate of r e t u r n ) assigns e q u a l w e i g h t to the results a c h i e v e d i n each time p e r i o d a n d is i n d e p e n d e n t of pattern of cash f l o w s . H e n c e it is a superior measure. The geometric m e a n rate of re" for b o t h the portfolios s h o w n i n E x h i b i t 21.11 is: [(1.10) (1.30) (1.20)] Risk The risk of a p o r t f o l i o can be m e a s u r e d i n v a r i o u s w a y s . The t w o most c o m m o n l y i measures of r i s k are: v a r i a b i l i t y a n d beta. Variability T h e B a n k A d m i n i s t r a t i o n Institute of the U S r e c o m m e n d e d the use v a r i a b i l i t y (as m e a s u r e d b y the m e a n absolute d e v i a t i o n ) of the q u a r t e r l y rates r e t u r n of the p o r t f o l i o . Sharpe a n d others have also advocated the use of v a r i a b i l i t y ! H o w e v e r , their preferred measure of v a r i a b i l i t y is s t a n d a r d d e v i a t i o n .
7 1/2

- 1 = 0.1972 or 19.72 percent

Beta A measure of r i s k c o m m o n l y a d v o c a t e d is beta. The beta of a p o r t f o l i o c o m p u t e d the w a y the beta of a n i n d i v i d u a l security is c o m p u t e d . T o calculate the i of a p o r t f o l i o , regress the rate of r e t u r n of the p o r t f o l i o o n the rate of r e t u r n of a mark i n d e x . The slope of this regression line is the p o r t f o l i o beta. R e m e m b e r that is reflectf the systematic risk of the p o r t f o l i o . Performance Measures

F o r e v a l u a t i n g the performance of a p o r t f o l i o it is necessary to consider b o t h risk and r e t u r n . T h i s is w h a t the T r e y n o r measure, the Sharpe measure, the Jensen measure, and the M m e a s u r e t h e f o u r p o p u l a r l y e m p l o y e d p o r t f o l i o p e r f o r m a n c e m e a s u r e s precisely d o .
2

Treynor Measure A c c o r d i n g to Jack T r e y n o r , systematic risk or beta is the a p p r o p r i a t e measure of risk, as suggested b y the capital asset p r i c i n g m o d e l . The T r e y n o r meas of p o r t f o l i o performance relates the excess r e t u r n o n a p o r t f o l i o to the p o r t f o l i o beta. _ , Excess return on portfolio p T r e y n o r s measure = Beta of portfolio p A v e r a g e rate of return o n portfolio p A v e r a g e rate of return o n a risk-free investment Beta of portfolio p The n u m e r a t o r of the T r e y n o r measure is the risk p r e m i u m earned b y the p o r t f o l i o ; the d e n o m i n a t o r , the systematic risk (beta). H e n c e , the T r e y n o r measure reflects the excess r e t u r n earned per u n i t of r i s k . A s systematic risk is the measure of risk, the Treynor measure i m p l i c i t l y assumes that the p o r t f o l i o is w e l l d i v e r s i f i e d . The mean absolute deviation of a set of returns of simply: Z I d I In where I d I is the absolute deviation of a particular return from the arithmetic mean and n is the number of return observations.

Portfolio Management

Framework

619

Sharpe Measure The Sharpe measure is s i m i l a r to the T r e y n o r measure except that it e m p l o y s s t a n d a r d d e v i a t i o n , not beta, as the measure of risk. T h u s , A v e r a g e rate of return Sharpe measure = o n portfolio p A v e r a g e rate of return o n a risk-free investment

Standard d e v i a t i o n of return of p o r t f o l i o p

H e n c e , the Sharpe measure reflects the excess r e t u r n earned o n a portfoUo per u n i t of its total risk (standard deviation). N o t e the f o l l o w i n g : (i) B o t h the measures, the T r e y n o r measure as w e l l as the Sharpe measure, postulate a linear relationship between risk a n d r e t u r n t h o u g h they e m p l o y different measures of risk, (ii) F o r a perfectly d i v e r s i f i e d p o r t f o l i o b o t h the measures g i v e i d e n t i c a l r a n k i n g s because i n s u c h cases the total r i s k a n d systematic risk are the same. Jensen Measure L i k e the T r e y n o r measure, the Jensen measure or Jensen's A l p h a is based o n the capital asset p r i c i n g m o d e l . It reflects the difference between the r e t u r n actually earned o n a p o r t f o l i o a n d the r e t u r n the p o r t f o l i o w a s s u p p o s e d to earn, g i v e n its beta as per the capital asset p r i c i n g m o d e l . T h u s , the Jensen measure is: Average return o n portfolio p f , , Risk-free return , ,. (Average return Risk Portfolio o n market - free beta portfolio return J) V

V F u n d e v a l u a t i o n services often place h e a v y reliance o n A l p h a because it is a riskadjusted measure. A positive A l p h a is considered g o o d a n d a negative A l p h a b a d . J o h n C . Bogle, h o w e v e r , is critical of s u c h emphasis o n A l p h a . H e argues: " B u t A l p h a s are v o l a t i l e a n d can s w i f t l y m o v e f r o m + to - . I n m y v i e w , A l p h a because of its unpredictable a n d b a c k w a r d - l o o k i n g nature is a c o u n t e r p r o d u c t i v e measure. I believe A l p h a is a f l a w e d measure of w h a t to expect f r o m a f u n d a n d s h o u l d g e n e r a l l y be i g n o r e d . " The essence of his a r g u m e n t is that the past performance of a n e q u i t y m u t u a l f u n d cannot p r e d i c t its future performance. The M Measure L e a h M o d i g l i a n i a n d F r a n c o M o d i g l i a n i , N o b e l Laureate i n E c o n o m i c s , p r o p o s e d a v a r i a n t of Sharpe measure w h i c h has been d u b b e d as the M measure (for M o d i g l i a n i - s q u a r e d ) . T h e M measure is d e f i n e d as
2 2 2

M where r* is the return o n a n " a d j u s t e d " portfoUo w h o s e volatility matches the volatiUty of the market index a n d r is the return o n the market index. The " a d j u s t e d " portfoUo (P*) is a " m a n a g e d " portfolio (P) m i x e d w i t h a p o s i t i o n i n Tbills i n s u c h a w a y that it (P*) has the volatility (defined as standard deviation) of the market index. T o iUustrate h o w the " a d j u s t e d " portfolio is constructed, let us consider the f o l l o w i n g data for a certain sample p e r i o d d u r i n g w h i c h the return o n T-biUs w a s 6%.
M

620

Investment Analysis and Portfolio Portfolio P ( A m a n a g e d portfolio) 30% 1.2 50%

Management Market Index 22% 1.0 30%

Average return Beta Standard deviation

Since the m a n a g e d p o r t f o l i o has 1.667 times the s t a n d a r d d e v i a t i o n of the m a r k e t i n d e x , the " a d j u s t e d " p o r t f o l i o w o u l d be invested 60 percent i n the m a n a g e d p o r t f o l i o a n d 40 percent i n T - b i l l s . H e n c e r*, the r e t u r n o n the " a d j u s t e d " portfoUo, is 20.4% [0J6* (30%) + 0.4 (6%)] a n d the M measure is: 20.4% - 22.00% = -1.6% The M measure, c o m p a r e d to the Sharpe measure, is easier to interpret as i t expressed as a rate of r e t u r n . H e n c e , it has g a i n e d i n p o p u l a r i t y .
2 2

Illustration T o illustrate the four measures of p o r t f o l i o performance, let u s l o o k at the returns o n the p o r t f o l i o s of three m u t u a l f u n d s , A, B, a n d C over a 9 year p e r i o d , a l o n g w i t h the r e t u r n o n a market i n d e x a n d the risk-free r e t u r n , g i v e n i n E x h i b i t 21.12. Exhibit 21.12 Period 1 2 3 4 5 6 7 8 9 Mean: R
p

Annua/ Returns for Three Mutual Funds and a Market Index Fund B -16 39.4 34.3 -6.9 3.2 28.9 24.1 0.0 23.4 14.5 19.7 0.92 FundC -33 30 18.2 -7.3 4.9 30.9 34.7 6.0 33.0 13.0 22.8 1.04 Return on market -26 36.9 23.6 -7.2 6.4 18.2 31.5 -4.8 20.4 11 20.5 1.00 Risk-free return 7.9 5.8 5.0 5.3 7.2 10.0 11.5 14.1 10.7 8.6

Fund A -38.7 39.6 11.1 12.7 20.9 35.5 57.6 -7.8 22.8 17.1 28.1 1.20

Standard deviation: cr Beta: p


p

G i v e n the data i n E x h i b i t 21.12 the performance of the three f u n d s A, B, a n d C is as s h o w n i n E x h i b i t 21.13. Performance Attribution A p a r t f r o m c a l c u l a t i n g risk-adjusted returns, practitioners also w a n t to ascertain the causes for s u p e r i o r or inferior investment performance. A c o m m o n l y f o l l o w e d m e t h o d of p e r f o r m a n c e a t t r i b u t i o n decomposes p o r t f o l i o performance into three components: (i) asset allocation choice across three b r o a d asset classes, v i z . , stocks, b o n d s , a n d m o n e y market instruments; (ii) sector choice w i t h i n each asset class; a n d (iii) security selection w i t h i n each sector.

Portfolio Management I

Framework

621

Performance Evaluation of the Three Funds

R R Treynor Measure: ~ FundA Fund B Fund C Market Index 17.1-8.6 1.20 7.1

14.5-8.6 = 4.9 0.92 13.0-8.6 = 4.8 1.04 110-8.6 1.0 = 2.4 Rp-Rf

Sharpe Measure: Fund A Fund B Fund C Market Index Jensen Measure: 17.1-[8.6+ 1.20 14.5-[8.6+ 0.92 13.0 -[8.6 +1.04 0 (By definition) Af Measure Fund A Fund B Fund C Market Index
2

17.1-8.6 28.1

0.302

14.5-8.6 = 0.299 19.7 13.0-8.6 = 0.193 22.8 110-8.6 20.5


p f

= 0.117 p (R -R )]
p M f

Fund A Fund B Fund C Market Index

R -[R + (2.4)] = 5.62 (2.4)] = 3.69 (2.4)] = 1.90

M =
2

r;-r

(0.730 x 17.1 + 0.270 x 8.6) - 11.000 = = 3.805 (1.041 x 14.5 - 0.041 x 8.6) - 11.000 = 3.742 (0.899 x 13.0 -0.101 x 8 . 6 ) - 11.000 = = 1.556 (1.000 x 1 1 . 0 - 0 ) - 11.000 = =0

The first step in performance performance called the bogey; it re by following acompletely passive asset classes in accordance with a the investor and holding an "index

attribution is to establish a benchmark level of f l e c t st h e r e t u r n s t h e p o r t f o l i o m a n a g e r w o u l d e a r n strategy. This means allocating funds across broad "neutral" allocation reflecting the risk tolerance of " portfoliowithin each asset class.

Chapter 22

Guidelines for Investment Decisions


What It All Comes To

After studying this chapter, you should be able to:

aiyLji

Explain the basic guidelines that all investors should follow. ii Discuss the guidelines that are specially relevant for aggressive equity investors. i S S "*1 * Discuss the guidelines that are specially relevant for conservative equity investors.", * * " ,

ou have c o v e r e d a vast terrain i n y o u r j o u r n e y t h r o u g h this b o o k . Y o u h a v e l e a r n t about the operations of the securities m a r k e t , the characteristics of v a r i o u s investment avenues available to y o u , the concept of time v a l u e of m o n e y , t h e b a s i c m o d e l s of security e v a l u a t i o n , the a p p r o a c h of f u n d a m e n t a l a n a l y s i s , the t o o l s o f technical analysis, the insights p r o v i d e d b y m o d e r n investment research, a n d t h e w a y s of r e s o l v i n g the k e y issues relating to the process of p o r t f o l i o management. I t i s t i m e now to translate the k n o w l e d g e , insights, a n d perspectives g a i n e d so far i n t o specific g u i d e l i n e s for investment d e c i s i o n m a k i n g .

32.1

BASIC GUIDELINES: THE TEN COMMANDMENTS

j|

There are ten c o m m a n d m e n t s of i n v e s t i n g w h i c h s h o u l d serve as basic g u i d e l i n e s for all investors. T h e y are as f o l l o w s . I. . I I I J K Start s a v i n g early a n d save r e g u l a r l y . M a i n t a i n a n adequate cash reserve a n d a n a p p r o p r i a t e insurance cover. A c c o r d top p r i o r i t y to a residential house. M a t c h y o u r s t o c k - b o n d m i x to y o u r investment situation. Select stocks a n d b o n d s (fixed i n c o m e instruments) j u d i c i o u s l y . A v a i l of tax shelters. D i v e r s i f y adequately.

640

Investment Analysis and Portfolio P e r i o d i c a l l y r e v i e w a n d revise y o u r p o r t f o l i o . Check your irrationality. M a x i m i s e y o u r lifetime f i n a n c i a l success.

Management

Start Saving Early and Save Regularly M a n y y o u n g p e o p l e , despite e a r n i n g w e l l , d o not seem to p a y m u c h attention to savings a n d investments. T h e y perhaps believe that they h a v e a l o n g p r o d u c t i v e career ahead of t h e m a n d they n e e d not w o r r y about b u i l d i n g a nest egg at a n e a r l y age. T h e y p r o b a b l y d o not f u l l y realise the benefit of g r o w t h o v e r t i m e . T o tap this benefit y o u s h o u l d start i n v e s t i n g e a r l y a n d i n v e s t r e g u l a r l y o v e r a l o n g p e r i o d . The m a g i c of c o m p o u n d i n g w o r k s w o n d e r s over t i m e . E x h i b i t 22.1 s h o w s the p a y o f f s f r o m l o n g term investing.
Exhibit 22.1 Payoffs from Long-Term Investing

Amount Invested per Year 10000 10000 10000 10000

Number of Years 10 20 30 40

8%

10%

12%

15%

18%

144,870 457,620 1,132,830 2.590,560

159,370 572,750 1,644,940 4,425,900

175,490 720,520 2,413,300 7,670,900

203,040 1,024,400 4, 347,500 17,791,000

235,210 1,466,300 7,909,500 41,632,000

The i m p o r t a n c e of s t a r t i n g the s a v i n g p r o g r a m m e e a r l y c a n be c o n v e y e d e m p h a t i c a l l y b y l o o k i n g at the f o l l o w i n g table w h i c h s h o w s the a m o u n t that a person has to save o n a m o n t h l y basis to accumulate Rs.10,000,000 a s s u m i n g that the a n n u a l rate of r e t u r n is 10 percent a n d the investments are m a d e over p e r i o d s that range f r o m 5 to 30 years. N o . of years M o n t h l y savings r e q u i r e d 30 4400 20 13100 10 48400 5 128100 A s J o h n C . Bogle p u t it: " T h e slope of the f i n a n c i a l m o u n t a i n y o u have to c l i m b gets steeper a n d steeper as time goes o n , f r o m a g r a d u a l a n d manageable slope if y o u have 30 years to invest to a n e a r - i n s u r m o u n t a b l e precipice if the s u m m i t m u s t be reached i n just f i v e y e a r s . " Retirement Planning A f i n a n c i a l l y secure a n d comfortable retirement is a top p r i o r i t y for every investor. T o achieve this g o a l , the investor m u s t save e n o u g h d u r i n g the preretirement p e r i o d so that he enjoys a certain l e v e l of real i n c o m e d u r i n g the retirement p e r i o d a n d bequeath a certain w e a l t h for his heirs. H o w m u c h s h o u l d that savings be? The m a n n e r i n w h i c h it is d e t e r m i n e d m a y be i l l u s t r a t e d w i t h a n e x a m p l e .

Guidelines for Investment Decisions

641

A m a n S h a r m a is 45 years o l d a n d h i s a n n u a l i n c o m e for the just c o n c l u d e d year w a s Rs. 500,000. H e expects h i s i n c o m e to increase b y 12 percent per year t i l l he retires at the age of 60. In h i s post-retirement p e r i o d , w h i c h he expects to be 15 years, A m a n S h a r m a w o u l d l i k e h i s a n n u a l i n c o m e f r o m h i s f i n a n c i a l investments t o b e 4 0 percent o f h i s salary i n c o m e i n h i s last w o r k i n g year. Further, he w o u l d l i k e the same to be protected i n real terms. A m a n S h a r m a o w n s a house a n d has R s . 1,000,000 of f i n a n c i a l assets. H e w a n t s t o bequeath the house a n d R s . 12,000,000 to h i s s o n w h e n he dies. The current f i n a n c i a l assets a n d the future savings of A m a n S h a r m a w o u l d e a r n a n o m i n a l rate of r e t u r n of 10 percent. The expected i n f l a t i o n rate for the next 30 years is l i k e l y to be 5 percent. W h a t p r o p o r t i o n of h i s salary i n c o m e s h o u l d A m a n S h a r m a save t i l l h e retires so that h e c a n meet his post-retirement f i n a n c i a l goals? T h i s q u e s t i o n m a y be a n s w e r e d i n three steps as f o l l o w s : Step 1: Estimate the annual income required in the post-retirement period The present a n n u a l i n c o m e of Rs. 500,000 w i l l g r o w to Rs. 500,000 (1.12) = R s . 2,736,783. F o r t y percent of the same w o r k s out to Rs. 1,094,713.
15

Step 2: Figure out the corpus required at the time of retirement The c o r p u s r e q u i r e d at the t i m e of retirement w i l l be: Present v a l u e of the i n c o m e r e q u i r e d i n the post-retirement p e r i o d

+
Present v a l u e of f i n a n c i a l assets to be bequeathed. T h e present v a l u e of the i n c o m e r e q u i r e d i n the post-retirement p e r i o d is: P V I F A x A n n u a l income required P V I F A ; . o x 1,094,713
r 76 /o
15

1-

(1.0476) .0476

15

x 1,094,713

= Rs. 11,549,346

N o t e that for c a l c u l a t i n g the P V I F A w e h a v e u s e d the real rate of interest (1.10/1.05 - 1 = 0.0476 or 4.76 percent) because the a n n u a l i n c o m e r e q u i r e d has to be protected i n real terms. The present v a l u e of the f i n a n c i a l assets of Rs. 12 m i l l i o n to be bequeathed, e v a l u a t e d at the time of retirement is:
PVIF
1 0 % 1 5

x Rs. 12,000,000

0.239 x R s . 12,CK)0,000 = R s . 2,868,000

So, the total c o r p u s r e q u i r e d o n retirement is:


Rs. 11,549,346 + R s . 2,868,000

642

Investment Analysis and Portfolio = R s . 14,417,346

Management

Step 3: Estimate the proportion of salary to be saved The current f i n a n c i a l assets of R s . 1,000,000 w i l l g r o w to R s . 1,000,000 (1.10) = R s . 1,000,000 x 4.177 = R s . 4,177,000 So, the savings d u r i n g the next 15 years s h o u l d c u m u l a t e to
15

Rs. 14,417,346 - 4,177,000 = R s . 10,240,346 Since A m a n S h a r m a w i l l save a f i x e d p r o p o r t i o n (p) of h i s salary, w h i c h i n t u r n w i l l g r o w at the rate of 12 percent p e r year f o r the next 15 years f r o m the current l e v e l of R s . 500,000, the s a v i n g s s t r e a m w i l l be a g r o w i n g a n n u i t y . T h e v a l u e of this g r o w i n g a n n u i t y at the e n d of 15 years w i l l be: 1px 500,000 (1.12) (1.12) (1.10)
15

15

0.10-0.12

(1.10)

15

= p x 36,294,736 T h i s s h o u l d be e q u a l to R s . 10,240,346 So, p=


r

10,240,346 36,294,736

= 0.282 o r 28.2 percent


r

Maintain an Adequate Cash Reserve and an Appropriate Insurance Cover

L i f e is u n c e r t a i n a n d almost everyone experiences unexpected f i n a n c i a l needs. Y o u m a y lose y o u r job just w h e n y o u r s o n has met w i t h a n accident. T o cope w i t h the catastrophes of life, y o u n e e d a n adequate cash reserve a n d a n a p p r o p r i a t e insurance cover. Cash Reserve Some p e o p l e believe that cash is a n i d l e asset a n d s i t t i n g o n a cash balance means f o r e g o i n g attractive investments. Y e t everyone needs a reserve of safe a n d l i q u i d assets to meet a n u n e x p e c t e d m e d i c a l expense o r t i d e o v e r a p e r i o d o f u n e m p l o y m e n t . T h e a m o u n t of this reserve m a y be 3 to 6 m o n t h s of y o u r m o n t h l y expenses. h i w h a t f o r m s h o u l d y o u m a i n t a i n this reserve? T h e most convenient f o r m s are fixed deposits ( w h i c h c a n be p r e m a t u r e l y encashed) w i t h banks a n d m o n e y market m u t u a l f u n d schemes. * Insurance Cover A s a protection against v a r i o u s risks, most p e o p l e n e e d insuranceInter a l i a , y o u n e e d auto i n s u r a n c e , h o m e i n s u r a n c e , h e a l t h i n s u r a n c e , d i s a b i l i t y insurance, a n d life insurance to f i n a n c i a l l y protect y o u r s e l f (or y o u r f a m i l y ) against d i e consequences of accidents, illness, d i s a b i l i t y , a n d death. '

Guidelines for Investment Decisions

643

Y o u c a n take a t h i r d p a r t y auto insurance cover ( w h i c h is m i n i m a l l y r e q u i r e d b y l a w ) or a c o m p r e h e n s i v e auto insurance cover, d e p e n d i n g o n the l e v e l of p r o t e c t i o n y o u w a n t . Y o u can insure y o u r h o m e a n d its valuables u p t o a d e s i r e d l i m i t . Y o u can b u y health insurance of the k i n d that gives y o u comfort. Y o u can take a n a p p r o p r i a t e life insurance cover for p r o t e c t i n g y o u r dependents. The Need and Type of Life Insurance The p r i m a r y p u r p o s e of life i n s u r a n c e is to p r o v i d e f i n a n c i a l p r o t e c t i o n to the d e p e n d e n t s , s h o u l d the i n s u r e d d i e w i t h o u t a c c u m u l a t i n g w e a l t h . H e n c e , the need for life insurance is a f u n c t i o n of (a) the f i n a n c i a l r e q u i r e m e n t s of the d e p e n d e n t s , a n d (b) a v a i l a b l e resources elsewhere. I g n o r i n g i n h e r i t e d w e a l t h , the n e e d for life insurance varies over one's life cycle as f o l l o w s : Phase Financial requirement of dependents None High Modest Small Available resources elsewhere Negligible Meagre to modest Substantial Substantial Need for insurance Absent High Diminished Absent

Young adulthood (0-25) Family formation and development (25-50) Pre-retirement (50-60) Retirement

F r o m the f o r e g o i n g , it is clear that the n e e d for insurance is h i g h i n the age bracket of 25 to 50 years. W h e n y o u r n e e d for insurance d i m i n i s h e s , y o u s h o u l d c o n s i d e r i n g surrendering your policy. T h e p r i m a r y p u r p o s e of i n s u r a n c e is p r o t e c t i o n , not a c c u m u l a t i o n of w e a l t h . So choose a n insurance p o l i c y w h i c h p r o v i d e s o n l y insurance a n d not insurance a l o n g w i t h a savings p l a n . If the insurance p o l i c y carries ' l i v i n g benefits', i.e., it p r o v i d e s m o n e t a r y benefits to the assured w h i l e he is a l i v e , it i m p l i e s that it combines insurance w i t h savings. S u c h a p o l i c y earns a modest tax-free r e t u r n o n the savings p o r t i o n . Y o u can p e r h a p s earn a h i g h e r r e t u r n if y o u invest o n y o u r o w n . H e n c e , y o u m a y be better off w i t h a t e r m assurance p o l i c y rather than the m o r e p o p u l a r e n d o w m e n t assurance p o l i c y . H o w e v e r , if y o u f i n d that the latter p o l i c y d i s c i p l i n e s y o u to save m o r e , enables y o u to get the k i n d of insurance cover y o u are l o o k i n g for, s i m p l i f i e s y o u r investment d e c i s i o n m a k i n g , saves y o u f r o m the chores of investment management, a n d prevents y o u f r o m s q u a n d e r i n g y o u r savings, y o u m a y consider it f a v o u r a b l y . T e r m policies have not been v e r y p o p u l a r i n I n d i a for v a r i o u s reasons. First, most i n d i v i d u a l s cannot reconcile to the idea of not getting a n y t h i n g back w h e n the p o l i c y matures for a l l the p r e m i u m s t h e y p l j y ? Second, insurance agents d o not h a v e m u c h i n c e n t i v e to s e l l s u c h p o l i c i e s because they c a r r y l o w e r p r e m i a a n d c o n s e q u e n t l y generate l o w e r c o m m i s s i o n s . F o r example, a p e r s o n w h o is about 30 years o l d c a n get a coverage of R s . 1 m i l l i o n for 20 to 25 years b y p a y i n g a p r e m i u m of R s . 3300 to R s . 3500 per year.

644

Investment Analysis and Portfolio

Management

Accord Priority to a Residential House A residential house represents a n attractive investment p r o p o s i t i o n for the f o l l o w i n g reasons: The rate of r e t u r n , c o n s i s t i n g of rental i n c o m e (or rental saving) a n d c a p i t a l a p p r e c i a t i o n , is attractive (capital a p p r e c i a t i o n often d o m i n a t e s the rental income). * The r i s k exposure is l i m i t e d . B a r r i n g a f e w b a d years, p r o p e r t y values i n India have been m o v i n g u p w a r d s . H e n c e , investment i n a residential house does not have m u c h d o w n s i d e r i s k associated w i t h it. * A residential house p r o v i d e s significant tax shelter i n the l o n g r u n . F o r w e a l t h tax p u r p o s e s , the v a l u e of a residential house is r e c k o n e d at its h i s t o r i c a l cost a n d not the current market v a l u e . L o a n s are available f r o m v a r i o u s quarters for b u y i n g / c o n s t r u c t i n g a residential h o u s e . F u r t h e r , interest o n loans t a k e n for b u y i n g / c o n s t r u c t i n g a r e s i d e n t i a l house is tax-deductible w i t h i n certain l i m i t s . * E v e n t h o u g h there m a y be i n i t i a l hassles w h e n a residential house is b o u g h t / constructed, i n the l o n g r u n it requires v e r y little m o n i t o r i n g . O w n e r s h i p of a r e s i d e n t i a l house p r o v i d e s p s y c h i c satisfaction w h i c h other f o r m s of investment m a y not offer. G i v e n the above advantages, y o u r first p r i o r i t y as a n investor s h o u l d be to b u y a residential site i n a n area w h e r e y o u p l a n to settle d o w n a n d , thereafter, construct a house as s o o n as y o u r resources p o s i t i o n p e r m i t s y o u to d o so. If y o u are not l i k e l y to l i v e i n that place i n the foreseeable future, the construction of the house c a n be deferred. It m a y be n o t e d that the rate of r e t u r n earned o n a w i s e l y chosen p o r t f o l i o of f i n a n c i a l investments c a n cover the escalation i n construction cost, b u t not p e r h a p s the escalation i n l a n d cost. H e n c e , y o u s h o u l d acquire the l a n d as early as possible, preferably t h r o u g h some h o u s i n g cooperative society, a n d u n d e r t a k e c o n s t r u c t i o n at a n a p p r o p r i a t e time. If the cost of a n i n d e p e n d e n t house is b e y o n d y o u r means, choose the alternative of b u y i n g a flat. I n m e t r o p o l i t a n areas, g i v e n the exorbitant l a n d prices, this m a y be the o n l y o p t i o n available to y o u . A d d i t i o n a l R e a l Estate A s p e o p l e b e c o m e m o r e affluent they have resources to b u y a d d i t i o n a l real estate l i k e a second house or c o m m e r c i a l p r o p e r t y or u r b a n l a n d or farmland. If y o u r resources p e r m i t , y o u s h o u l d l o o k at b u y i n g a d d i t i o n a l r e a l estate. R e a l estate earns excellent returns overtime a n d is p e r c e i v e d to be less r i s k y t h a n stocks - to some extent this m a y be because y o u d o n ' t see a d a i l y q u o t a t i o n for real estate as y o u see for stocks.

Guidelines for Investment Decisions Match Your Stock-bond Mix to Your Investment Situation

645

A f t e r y o u h a v e p r o v i d e d for y o u r p r i o r i t y needs (cash reserve, insurance cover, a n d residential house), y o u r most i m p o r t a n t d e c i s i o n is concerned w i t h the s t o c k - b o n d m i x . W h a t p r o p o r t i o n of y o u r assets s h o u l d y o u allocate to stocks? to bonds? Y o u r s t o c k - b o n d m i x d e p e n d o n three factors, i n the m a i n : Investment Horizon: y o u r investments. Risk Capacity: T h i s is the p e r i o d over w h i c h y o u w i l l b u i l d u p a n d h o l d

T h i s is y o u r f i n a n c i a l capacity to w i t h s t a n d investment losses.

Risk Tolerance: T h i s is y o u r w i l l i n g n e s s or e m o t i o n a l a b i l i t y to accept volatile returns The k e y g u i d e l i n e s relevant for the s t o c k - b o n d m i x are as f o l l o w s : , JL. O t h e r things b e i n g e q u a l , if y o u r investment h o r i z o n is longer, y o u r p o r t f o l i o s h o u l d be t i l t e d i n f a v o u r of stocks rather t h a n b o n d s a n d if y o u r investment h o r i z o n is shorter, y o u r p o r t f o l i o s h o u l d be tilted i n f a v o u r of b o n d s rather t h a n stocks. 2. O t h e r things b e i n g e q u a l , if y o u h a v e a greater capacity for r i s k , y o u r p o r t f o l i o s h o u l d be tilted i n f a v o u r of stocks rather t h a n b o n d s a n d if y o u have a lesser capacity for r i s k y o u r p o r t f o l i o s h o u l d be t i l t e d i n f a v o u r of b o n d s rather t h a n stocks. jjp O t h e r things b e i n g e q u a l , if y o u h a v e a greater tolerance for r i s k , y o u r p o r t f o l i o s h o u l d be tilted i n f a v o u r of stocks rather t h a n b o n d s a n d if y o u have a lesser tolerance for risk, y o u r p o r t f o l i o s h o u l d be tilted i n f a v o u r of b o n d s rather t h a n stocks. Risk-Return Preference Over Investor Life Cycle d i v i d e d into f o u r stages as f o l l o w s : The investor life cycle is t y p i c a l l y

Stage I: Early Career A t the b e g i n n i n g of h i s career, a n i n d i v i d u a l ' s net w o r t h is s m a l l it m a y e v e n be negative if he has taken e d u c a t i o n a l loans w h i c h have not been r e p a i d . H o w e v e r , h i s i n c o m e exceeds h i s expenses. M o r e i m p o r t a n t , he expects a larger future i n c o m e over a n extended p e r i o d of time as his career advances. G i v e n h i s l o n g - t e r m investment h o r i z o n , he is w i l l i n g to accept h i g h e r r i s k i n a n t i c i p a t i o n of h i g h e r returns. Stage II: Mid Career B y the t i m e the i n d i v i d u a l reaches this stage he w o u l d h a v e a c c u m u l a t e d some w e a l t h . A w e l l p r e p a r e d i n d i v i d u a l w o u l d h a v e a satisfactory insurance cover, a tangible investment i n a h o m e , a n d a reasonable base of f i n a n c i a l assets. The investment h o r i z o n is still l o n g (one is 15 to 20 years a w a y f r o m retirement) a n d hence h i g h - r e t u r n h i g h - r i s k investments still m a k e sense. Yet, d u r i n g this stage, p r e s e r v a t i o n of c a p i t a l acquires some i m p o r t a n c e a n d the i n d i v i d u a l m a y w a n t to moderate his r i s k exposure i n some w a y s . Stage III: Late Career The i n d i v i d u a l has v i r t u a l l y n o debt or mortgage o n h i s h o m e a n d has a reasonably s o l i d base of other assets as w e l l . Further, h i s savings l e v e l is h i g h , thanks to a n e x p a n d e d i n c o m e a n d a d i m i n u t i o n of expenses. N e v e r t h e l e s s , a

646

Investment Analysis and Portfolio

Management

s i g n i f i c a n t l y r e d u c e d i n v e s t m e n t h o r i z o n (5-10 years) i n d u c e s c o n s e r v a t i s m . P r e s e r v a t i o n of c a p i t a l becomes a n i m p o r t a n t c o n c e r n a n d , hence, r i s k e x p o s u r e is reduced. Stage IV: Retirement A t this stage, i n v e s t m e n t becomes the p r i n c i p a l source of sustenance. E v e n t h o u g h his investment i n c o m e m a y be comfortable, the vagaries of i n f l a t i o n a n d the u n p r e d i c t a b l e m e d i c a l expenses i n d u c e a great d e a l of conservatism. T h i s means that preservation of capital m a y become the o v e r - r i d i n g concern a n d , hence, risk is m i t i g a t e d further. E x h i b i t 22.2 s h o w s g r a p h i c a l l y the r i s k - r e t u r n preferences of a t y p i c a l i n d i v i d u a l over his life cycle. Exhibit 22.2
Return

Risk-Return Preferences Over Investor Life Cycle

Early Career Mid Career " ^ ^ ^ Retirement Late Career

Risk

The d i m i n i s h i n g r i s k appetite of a n i n d i v i d u a l as he advances i n age has a n i m p o r t a n t i m p l i c a t i o n for his investment p o l i c y (asset a l l o c a t i o n p o l i c y ) : A s one g r o w s o l d e r , the p r o p o r t i o n of b o n d s m u s t increase a n d the p r o p o r t i o n of stocks m u s t decrease. A c o n v e n t i o n a l r u l e of t h u m b says that the percentage invested i n b o n d s m u s t c o r r e s p o n d to the age of the i n d i v i d u a l . T h u s , a 30 year o l d p e r s o n m u s t invest 30 percent of his p o r t f o l i o i n b o n d s a n d a 70 year o l d m u s t invest 70 percent. Investment Horizon Versus Living Horizon The general r e c o m m e n d a t i o n that a p e r s o n s h o u l d g r a d u a l l y tilt h i s p o r t f o l i o i n f a v o u r of b o n d s as he advances i n age i m p l i c i t l y assumes that a person's i n v e s t m e n t h o r i z o n . i s m o r e or less the same as h i s living h o r i z o n . T h i s m a y often not be true because for most p e o p l e the investment h o r i z o n m a y be longer, i n d e e d m u c h longer, t h a n their l i v i n g h o r i z o n . F o r example, if y o u are 45 years o l d a n d h a v e a 10-year-old s o n , y o u r investment h o r i z o n is not just another 30 years (your future life expectancy), b u t close to 70 years that y o u r s o n m a y l i v e . E v e n if y o u are 70 years o l d , y o u r investment h o r i z o n m a y be 70 years if y o u have y o u n g g r a n d c h i l d r e n that y o u care for or a, charitable cause that y o u w a n t to contribute to.

Guidelines for Investment Decisions

647

A s C h a r l e s E l l i s p u t it, " M o s t i n v e s t o r s ' actual t i m e h o r i z o n s for investments are quite long20 years, 30 years, a n d often 50 years or morebecause the investments they pass o n to others w i l l continue to be active w e l l past the p e r i o d of their o w n l i v e s " . So E l l i s argues that y o u s h o u l d not change y o u r investments just because y o u have retired or reached a certain age. A s he says, " M a i n t a i n the strategy y o u have set for y o u r s e l f if y o u c a n a f f o r d to d o i t " . Select Stocks and Bonds (Fixed Income Instruments) judiciously A f t e r y o u have chosen the s t o c k - b o n d m i x a p p r o p r i a t e to y o u r investment situation, y o u h a v e to select stocks a n d b o n d s . Stock Selection Investors d i s p l a y w i d e l y different approaches to e q u i t y selection. A t one e n d of the s p e c t r u m , y o u h a v e aggressive investors c o n s t a n t l y s e a r c h i n g for u n d e r v a l u e d stocks a n d at the other e n d of the s p e c t r u m y o u have v e r y conservative investors w h o participate i n i n d e x schemes. h i general, y o u w o u l d d o w e l l i f y o u go l a r g e l y b y f u n d a m e n t a l s , w i t h o u t l o s i n g sight of technicals. This g u i d e l i n e a l o n g w i t h the g u i d e l i n e s specifically applicable to aggressive a n d conservative investors w i l l be discussed at some length i n the f o l l o w i n g sections. Bond Selection The most p o p u l a r f o r m s of f i x e d i n c o m e avenues (referred to v e r y b r o a d l y as ' b o n d s ' for o u r discussion) are: 1. 2. 3. 4. 5. 6. j|Jj| 8. 10 P r o v i d e n t f u n d deposits F i x e d deposits w i t h b a n k s a n d post offices F i x e d deposits w i t h c o m p a n i e s Income-oriented a n d g r o w t h - o r i e n t e d debt schemes Corporate bonds R B I savings b o n d s N a t i o n a l Savings Certificates C o n v e r t i b l e debentures K i s a n V i k a s Patras Debt-oriented U n i t L i n k e d Pension Plans
1

The relative attractiveness of v a r i o u s f i x e d i n c o m e avenues d e p e n d s m a i n l y o n t w o factors: (a) need for tax shelter; a n d (b) preference for current i n c o m e versus capital appreciation. The f o l l o w i n g m a t r i x w i l l b r o a d l y g u i d e y o u i n selecting f i x e d i n c o m e avenues based o n these t w o considerations. W h i l e the m a t r i x p r o v i d e s b r o a d g u i d e l i n e s , here are some specific suggestions:

Since the investor has the option of retaining the convertible debenture as a straight debt instrument, it is viewed here as a fixed income instrument.

648

Investment Analysis and Portfolio Preferred Form of Return Current income

Management

Capital appreciation Provident f u n d schemes

T X s h e 1 t e r s 0 u 8 h t

Post office savings bank account Tax-free bonds Y e s

Income-oriented debt schemes

Growth-oriented debt schemes

N o

* Fixed deposits w i t h banks and companies N o n convertible debentures

K i s a n Vikas Patras * Convertible debentures

If y o u are seeking to reduce y o u r tax l i a b i l i t y i n the l o n g r u n , deposit as l i b e r a l l y as y o u can i n a recognised p r o v i d e n t f u n d scheme a n d / or p u b l i c p r o v i d e n t f u n d scheme. Investment i n p r o v i d e n t f u n d schemes offer several advantages: (a) i n i t i a l tax advantage; (b) c o n t i n u i n g tax advantage; (c) f a c i l i t y for p a r t i a l w i t h d r a w a l s ; (d) satisfactory rate of r e t u r n ; a n d (e) i m m u n i t y f r o m attachment o f a court decree. G i v e n these advantages, it is a b o o n to the b u l k of the investors. H a r d l y any other f o r m of investment offers s u c h attraction. H e n c e , it s h o u l d be accorded a v e r y h i g h p r i o r i t y i n y o u r scheme of investments. G i v e preference to i n c o m e - o r i e n t e d debt schemes a n d tax-free b o n d s if y o u are l o o k i n g for a tax-sheltered current i n c o m e . T h e y offer attractive post-tax rates of r e t u r n c o m p a r e d to other f i x e d income avenues. JJ| Invest i n g o o d convertible debentures. D u e to some p e c u l i a r reasons, convertible debentures, i n general, s e l l for a p r i c e l o w e r t h a n the m a r k e t v a l u e of the u n d e r l y i n g e q u i t y . Yet, t i l l the c o n v e r s i o n takes place, the interest i n c o m e o n t h e m is h i g h e r t h a n the d i v i d e n d i n c o m e p r o v i d e d b y the u n d e r l y i n g e q u i t y . G i v e n this a n o m a l y of the I n d i a n stock market, it makes sense to b u y convertible debentures. C o n s i d e r i n v e s t m e n t i n n o n - c o n v e r t i b l e debentures, K i s a n V i k a s Patras, a n d corporate f i x e d deposit schemes u n d e r t w o b r o a d circumstances: W h e n y o u r taxable i n c o m e is less t h a n R s . 150,000; a n d * W h e n y o u have exhausted the l i m i t s for v a r i o u s tax-sheltered investments. W h i l e e v a l u a t i n g non-convertible debentures l o o k at the f o l l o w i n g factors: Y i e l d to m a t u r i t y Credit rating Maturity period * B u y - b a c k facility

Guidelines for Investment Decisions 6. L o o k at the f o l l o w i n g factors before m a k i n g a f i x e d deposit w i t h a c o m p a n y . Reserves a n d s u r p l u s i n r e l a t i o n to p a i d u p share capital a Track r e c o r d of earnings a n d d i v i d e n d s * R e p u t a t i o n of management """ * Credit rating Avail of Tax Shelters W h i l e p l a n n i n g y o u r investments bear i n m i n d the f o l l o w i n g :

649

* U n d e r Section 80C the f o l l o w i n g investments, inter alia, can be d e d u c t e d before c o m p u t i n g the taxable i n c o m e : c o n t r i b u t i o n s to statutory or r e c o g n i s e d p r o v i d e n t f u n d , c o n t r i b u t i o n to p u b l i c p r o v i d e n t f u n d , life insurance p r e m i u m s , s u b s c r i p t i o n to N a t i o n a l S a v i n g s Certificates, c o n t r i b u t i o n to u n i t - l i n k e d insurance p l a n , a n d c o n t r i b u t i o n to a n y n o t i f i e d e q u i t y - l i n k e d savings scheme of a m u t u a l f u n d . U n d e r Section 80 C C C , contributions to certain p e n s i o n f u n d s can be d e d u c t e d before c o m p u t i n g the taxable i n c o m e . The m a x i m u m permissible d e d u c t i o n u n d e r Sections 80C a n d 8 0 C C C is Rs. 100,000. a C a p i t a l gains (losses) are d i v i d e d i n t o t w o categories: (i) l o n g - t e r m capital gains (losses), a n d (ii) short-term c a p i t a l gains (losses). L o n g - t e r m capital gains (losses) arise f r o m the sale of e q u i t y shares a n d other securities that are h e l d for m o r e t h a n 12 m o n t h s (for a l l other capital assets the p e r i o d of h o l d i n g is 36 months); short-term capital gains (losses) arise f o r m the sale of e q u i t y shares a n d other securities that are h e l d for less t h a n 12 m o n t h s (for a l l other capital assets the p e r i o d of h o l d i n g is 36 months). * L o n g - t e r m capital gains (losses) are calculated as f o l l o w s : Sale Indexed cost of Indexed cost of consideration acquisition improvement Expenditure incurred i n connection w i t h transfer L o n g - t e r m capital gains f r o m e q u i t y shares are tax-exempt, whereas short-term capital gains are taxable at the rate of 15 percent. If the taxable i n c o m e e x c l u d i n g the capital gains is less t h a n Rs. 150,000, then n o tax is p a y a b l e o n so m u c h of the l o n g - t e r m c a p i t a l gains as is e q u a l to the aforesaid shortfall. Y o u m u s t p l a n to a v a i l of the tax shelters available to y o u . Some suggestions i n this regard are offered b e l o w : * D e p o s i t l i b e r a l l y or invest i n (a) a recognised p r o v i d e n t f u n d scheme a n d / o r the P P F scheme, a n d (b) life insurance p o l i c y to reduce y o u r tax l i a b i l i t y . a A u g m e n t y o u r tax-exempt current i n c o m e b y i n v e s t i n g i n e q u i t y shares, m u t u a l f u n d schemes, a n d so o n . O r d i n a r i l y , p l a n to h o l d y o u r e q u i t y shares a n d other securities for at least one year to get the benefit of tax e x e m p t i o n .

650

Investment Analysis and Portfolio

Management

A v o i d / r e d u c e l o n g - t e r m c a p i t a l gains b y i n v e s t i n g i n s p e c i f i e d securities, specified assets, a n d residential house as s t i p u l a t e d u n d e r Sections 5 4 E C , 5 4 E D , a n d 54F of the Income Tax A c t . Diversify Adequately Y o u r investment strategy s h o u l d be to d i v e r s i f y y o u r h o l d i n g s w i t h i n a n investment class a n d to h o l d different classes of assets (cash, b o n d s , stocks, a n d real estate) i n y o u r portfolio. O f t e n i n d i v i d u a l i n v e s t o r p o r t f o l i o s are not d i v e r s i f i e d p r o p e r l y . T h e y are either u n d e r - d i v e r s i f i e d or o v e r - d i v e r s i f i e d . I have seen a n u m b e r of i n d i v i d u a l portfolios d o m i n a t e d b y just 1 or 2 stocks w h i c h m a y account for 60 to 80 percent of portfoUo v a l u e . C l e a r l y s u c h p o r t f o l i o s are u n d e r - d i v e r s i f i e d a n d e x p o s e d to unnecessary unsystematic r i s k . I have also seen i n d i v i d u a l p o r t f o l i o s w h i c h are o v e r - d i v e r s i f i e d , h a v i n g 30 to 60 different shares. T h i s m a y be m a i n l y d u e to the f o l l o w i n g reasons: (a) The n u m b e r of shares received at the time of p u b l i c issue is often s m a l l . A s a result, investors t e n d to have a large n u m b e r of different shares i n s m a l l quantities, (b) Investors perhaps feel p s y c h o l o g i c a l l y secure w i t h a large n u m b e r of different shares i n their p o r t f o l i o , (c) There is reluctance o n the part of investors to sell shares. Y o u m u s t , h o w e v e r , realise that d i v e r s i f i c a t i o n b e y o n d a certain p o i n t does not b r i n g a n y a p p r e c i a b l e g a i n i n terms of r i s k r e d u c t i o n , w h i c h is u s u a l l y the p r i n c i p a l m o t i v a t i o n for d i v e r s i f i c a t i o n . E m p i r i c a l studies have p r o v i d e d reasonably conclusive evidence i n s u p p o r t of the hypothesis that the b u l k of the benefit f r o m d i v e r s i f i c a t i o n , i n the f o r m of r i s k r e d u c t i o n , can be a c h i e v e d b y f o r m i n g a p o r t f o l i o of about 10 stocks; thereafter, the gains f r o m d i v e r s i f i c a t i o n t e n d to be n e g l i g i b l e . In v i e w of this r e l a t i o n s h i p , y o u s h o u l d n o r m a l l y p l a n to have 10-12 stocks i n y o u r p o r t f o l i o . If y o u have fewer stocks i n y o u r p o r t f o l i o , y o u m a y be unnecessarily exposed to r i s k w h i c h c a n be easily d i v e r s i f i e d a w a y . The 10 to 12 stocks h e l d b y y o u s h o u l d s p a n at least 4 different i n d u s t r i e s w i t h n o single i n d u s t r y a c c o u n t i n g for m o r e than, say, 40 percent of y o u r e q u i t y investment. If y o u have m o r e stocks i n y o u r p o r t f o l i o , transaction a n d m o n i t o r i n g costs t e n d to increase, w i t h o u t a n y w o r t h w h i l e r e d u c t i o n i n r i s k . M o r e i m p o r t a n t , a n o v e r l y d i v e r s i f i e d p o r t f o l i o d i l u t e s focus w h i c h i n t u r n is l i k e l y to i m p a i r the q u a l i t y of investment m a n a g e m e n t . If y o u h a v e 10 stocks i n y o u r p o r t f o l i o , y o u are l i k e l y to be circumspect i n y o u r d e c i s i o n m a k i n g a n d attentive i n y o u r m o n i t o r i n g , because each stock accounts for, o n average, 10 percent of y o u r p o r t f o l i o v a l u e . O n the other h a n d , if y o u h a v e 50 stocks i n y o u r p o r t f o l i o , y o u are l i k e l y to be c u r s o r y i n y o u r d e c i s i o n m a k i n g a n d negligent i n y o u r m o n i t o r i n g , because each stock accounts for, o n average, just 2 percent of y o u r p o r t f o l i o v a l u e . Y o u h a v e to track c o m p a n y actions ( d i v i d e n d , rights, a n d b o n u s announcements), c o m p a n y n e w s , share prices, p e r i o d i c results, i n d u s t r y trends, a n d so o n , so that y o u c a n time y o u r decisions w e l l . E v e n a f u l l time investor cannot track m o r e t h a n 50 stocks. U n f o r t u n a t e l y , investors forget w h a t they a l r e a d y h a v e - a n d y e a r n for n e w investment o p p o r t u n i t i e s . T h i s h a p p e n s m o r e so i n a b u l l market, w h e n t h e y d o n ' t w a n t to m i s s the next ' h o t ' t h i n g a n d keep a d d i n g to their p r o b l e m s .
v

Guidelines for Investment Decisions

651

* Periodically Review and Revise the Portfolio O f t e n investors d o not r e v i e w a n d revise their p o r t f o l i o s r e g u l a r l y . T h i s m a y be d u e to a v a r i e t y of reasons: a L a c k of time a n d i n c l i n a t i o n to undertake p e r i o d i c r e v i e w a n d r e v i s i o n . S t i c k y p o r t f o l i o habits ( m a n y investors have a reluctance to s e l l securities because they are l i k e n e d to g o l d or real estate to be l i q u i d a t e d o n l y d u r i n g a time of f i n a n c i a l distress). A n inadequate a p p r e c i a t i o n of the benefits of p e r i o d i c r e v i e w a n d r e v i s i o n . Since the w o r l d of investments is h i g h l y d y n a m i c a n d r a p i d l y c h a n g i n g , it behooves u p o n every investor to p e r i o d i c a l l y r e v i e w his p o r t f o l i o a n d revise it i n the l i g h t of c h a n g e d circumstances. O v e r time, several changes are l i k e l y to take place: Relative market values of v a r i o u s securities i n the p o r t f o l i o tend to change. * N e w i n f o r m a t i o n m a y alter the r i s k - r e t u r n prospects of v a r i o u s securities. F u n d s m a y be m a d e available for p o r t f o l i o investment; or f u n d s m a y be r e q u i r e d f r o m the p o r t f o l i o . Investor d i s p o s i t i o n t o w a r d r i s k m a y itself change, albeit v e r y g r a d u a l l y . In order to cope w i t h these changes, p e r i o d i c r e v i e w a n d r e v i s i o n is r e q u i r e d to: M a i n t a i n adequate d i v e r s i f i c a t i o n w h e n relative values of v a r i o u s securities i n the p o r t f o l i o change. Incorporate n e w i n f o r m a t i o n relevant for r i s k - r e t u r n assessment. E x p a n d or contract the size of p o r t f o l i o to absorb f u n d s or w i t h d r a w f u n d s . Reflect changes i n investor risk d i s p o s i t i o n . * E n s u r e that the target asset-mix is m a i n t a i n e d . H o w often s h o u l d the exercise of p o r t f o l i o r e v i e w a n d r e v i s i o n be undertaken? A s this exercise entails m o n i t o r i n g costs, transaction costs, a n d taxes, its p e r i o d i c i t y s h o u l d be so f i x e d that its benefits are m a x i m i s e d i n relation to its costs. This means that (a) if the investment e n v i r o n m e n t is v o l a t i l e , r e v i e w s h o u l d be m o r e frequent, (b) i f a n active a p p r o a c h is f o l l o w e d , r e v i e w s h o u l d be m o r e frequent, a n d (c) if the size of the p o r t f o l i o is large, r e v i e w s h o u l d be m o r e frequent. If y o u are a t y p i c a l i n d i v i d u a l investor w h o is relatively passive i n his a p p r o a c h a n d w h o does not have a large p o r t f o l i o , y o u w i l l f i n d a r e v i e w p e r i o d of six m o n t h s alright. It y o u d o it m o r e often y o u m a y s u c c u m b to the t e m p t a t i o n of frequently s w i t c h i n g y o u r c o m m i t m e n t s i n a s o m e w h a t aimless f a s h i o n . G u a r d y o u r s e l f against this danger. R e m e m b e r w h a t P h i l Caret, a d i s t i n g u i s h e d investor, said: " T h e trader w h o is a l w a y s l o o k i n g for action i n the market w i l l u s u a l l y j u m p f r o m one stock to another d u r i n g the course of a b u l l m o v e m e n t o n l y to f i n d at the e n d that he has m a d e less m o n e y t h a n he w o u l d have m a d e b y p u t t i n g his m o n e y i n ten or a d o z e n carefully chosen issues at the beginning and holding them."

652

Investment Analysis and Portfolio

Management

A major p u r p o s e of p e r i o d i c r e v i e w is to i d e n t i f y securities for disinvestment. If a security is o v e r p r i c e d i n relation to its intrinsic v a l u e (the purchase price is irrelevant), it s h o u l d be s o l d so that the proceeds can be invested elsewhere. D i s i n v e s t m e n t , of course, is often a b h o r r e d b y investors w h o f i n d it easy to invest b u t d i f f i c u l t to disinvest. Yet, to succeed i n the investment game y o u m u s t not o n l y k n o w w h e n to invest b u t also w h e n to disinvest. There is a time to b u y as w e l l as a time to sell. So shuffle y o u r p o r t f o l i o , if necessary, o n the basis of y o u r r e v i e w s . M o s t investors r e v i e w their portfolios s u p e r f i c i a l l y . T h e y scan their p o r t f o l i o a n d m e r e l y take note of paper profits a n d losses. T o d o w e l l i n the game of i n v e s t i n g , y o u s h o u l d , h o w e v e r , go further a n d re-evaluate each cornmitment i n a detached fashion. T h o u g h it is d i f f i c u l t p s y c h o l o g i c a l l y , y o u m u s t m a k e a d e t e r m i n e d effort to d o this. Suppose y o u have 500 shares of A l p h a C o m p a n y stock w h i c h is s e l l i n g currently at Rs 120. A s k y o u r s e l f a s i m p l e question: "If I have Rs 60,000 of cash t o d a y a n d I w a n t to b u y some stock, w o u l d I choose the shares of A l p h a C o m p a n y i n preference to other options available to m e ? " If the answer is strongly i n the negative, y o u s h o u l d sell y o u r h o l d i n g of A l p h a C o m p a n y . R e m e m b e r that y o u r purchase price, w h e t h e r it w a s Rs 50 or Rs 150, s h o u l d not matter. Y o u r o r i g i n a l cost is irrelevant. O n e s h o u l d take a cue f r o m m a n y o u t s t a n d i n g investors w h o keep a systematic record of their investment decisions. M a i n t a i n a notebook w i t h a page for every security i n y o u r p o r t f o l i o . W r i t e d o w n w h y y o u have b o u g h t a n d later w h y y o u h a v e s o l d . P e r i o d i c a l l y r e v i e w y o u r c o m p l e t e d transactions to u n d e r s t a n d the p s y c h o l o g i c a l reasons, if a n y , for y o u r mistakes. In a b u l l market b o o k profits, e v e n if y o u believe that the b u l l r u n has some steam left i n it. O f f l o a d y o u r h o l d i n g s i n installments. Be contented w i t h the profits y o u realise. D o n ' t w a i t g r e e d i l y to sell w h e n the market reaches its peak. It is l i k e c h a s i n g a c h i m e r a . If y o u d o n ' t c o n t a i n y o u r avarice, y o u r p a p e r p r o f i t s m a y evaporate as the m a r k e t declines. Investors often have m o r e d i f f i c u l t y i n d e c i d i n g w h e n to sell than w h e n to b u y . A d i s c i p l i n e d a p p r o a c h to s e l l i n g m a y h e l p t h e m to overcome this d i f f i c u l t y . T h e y s h o u l d r e l i g i o u s l y f o l l o w rules l i k e the f o l l o w i n g . a Sell w h e n the price falls b e l o w a y 10 percent of their purchase price (this means that they f o l l o w a stop loss order rule of 10 percent). Sell w h e n a certain p r o f i t target, say 50 percent or 100 percent has been a c h i e v e d . * S e l l w h e n the r e v i e w suggests that the p r i c e exceeds the i n t r i n s i c v a l u e d e t e r m i n e d b y whatever a p p r o a c h the investor f o l l o w s . A practical p r o b l e m i n s w i t c h i n g f r o m one security (whether it is a stock or a b o n d ) to another (whether it is a stock or a b o n d ) is related to taxes. Let us l o o k at a n example to u n d e r s t a n d the issues i n v o l v e d . Suppose Suneel Shah has b o u g h t 1,000 equity shares of A L i m i t e d for Rs 25,000 six months ago. The current market price of these shares is Rs 50,000. Suneel Shah believes that these shares are somewhat o v e r p r i c e d a n d considers the scope for a p p r e c i a t i o n over the next one year to be s o m e w h a t modest. H e expects the price per share to be Rs 55 a year hence. H e is c o n s i d e r i n g the p o s s i b i l i t y of selling these shares n o w a n d i n v e s t i n g the post-tax sales proceeds i n the shares of c o m p a n y B

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which he expects to appreciate by 20 percent over a one year period. What will be the expected post-tax amount in Suneel Shah's hands a year hence under the following options? " v Option 1: Hold the shares of A and sell them for Rs 55,000 a year hence. Option 2: Sell the shares of A now, invest the post-tax proceeds in the shares of B, and sell the shares of B a year hence. For evaluating the two options, we will ignore dividends for the sake of simplicity: Option 1: Hold the shares of A 1. Expected market value of shares one year hence 2. Post-tax realisation 1. 2. 3. 4. 5. 6. 7. Current sales realisation Purchase cost (six months ago) Short-term capital gains Tax on short-term capital gains Post tax realisation Current investment in the shares of B Expected market value of shares of B one year hence (Rs 46,250 x 1.20) 8. Post-tax realisation : Rs 55,000 : Rs 55,000 : Rs 50,000 : Rs 25,000 : Rs 25,000 : Rs 3,750 : Rs 46,250 : Rs 46,250 : Rs 55,500 : Rs 55,500

Option 2: Switch from the shares of A to the shares ofB

Formula Plan as a Tool for Revision Emotion and poor judgment play a significant role in the lack of investment success. Formula plans have been developed to help investors overcome such human failings. A formula plan essentially prescribes the proportions of your wealth you should hold in stock and bond components. A commonly used and recommended formula plan is the constant ratio formula plan. If you use such a plan you will: (a) Decide in advance the proportions of your wealth you will keep in stocks and bonds respectively; (b) Periodically evaluate what the actual proportions are (it may be noted that changes in market values tend to change the proportions); and (c) Effect whatever switches are necessary to restore the predetermined proportions. To illustrate, suppose you have Rs 100,000 to invest as on 1.1.20X0 and you decide to invest equally in stocks and bonds. You review the market values of stocks and bonds in your portfolio every six months and effect whatever switch is required to ensure that the stock and bond components remain equal in value. Exhibit 22.3 shows the market values of these components at three review dates, viz. 1.7.20X0,1.1.20X1, and 1.7.20X1 and the switches to be made in conformity with your constant ratio formula plan.

654

Investment Analysis and Portfolio Exhibit 22.3

Management

Illustration of a Constant Ratio Formula Plan

Market value of stocks

Market value of bonds

Switch from stocks bonds

Switch from bonds to stocks

1.1.20X0 1.7.20X0 1.7.20X0 (After revision) 1.1.20X1 1.1.20X1 (After revision) 1.7.20X1 1.7.20X1 (After revision)

50,000 70,000 61,000 50,000 56,000 65,000 60,000

50,000 52,000 61,000 62,000 56,000 55,000 60,000

9,000

6,000

5,000

In the above i l l u s t r a t i o n , the p r o p o r t i o n s of stocks a n d b o n d s w e r e kept constant at 0.5 each. H e n c e , it w a s referred to as a constant ratio f o r m u l a p l a n . If y o u feel that y o u m a y l i k e to v a r y these p r o p o r t i o n s to reflect y o u r j u d g m e n t about market prospects, y o u m a y f o l l o w a v a r i a b l e ratio f o r m u l a p l a n . S u c h a p l a n p r o v i d e s scope for c h a n g i n g the p r o p o r t i o n s of stocks a n d b o n d s i n y o u r p o r t f o l i o . F o r example, if y o u assess that the o u t l o o k for stocks is bright, y o u m a y raise the p r o p o r t i o n of stocks to 0.75. O n the other h a n d , if y o u t h i n k that the o u t l o o k f o r stocks is d i s m a l , y o u m a y l o w e r the p r o p o r t i o n of stocks to 0.25. C l e a r l y , a v a r i a b l e ratio f o r m u l a p l a n is s u p e r i o r to a constant ratio f o r m u l a p l a n if y o u r j u d g m e n t about market o u t l o o k is s o u n d ; otherwise it is inferior. H e n c e , the practical g u i d e l i n e is: " S h o u l d y o u possess s u p e r i o r forecasting ability f o l l o w a variable ratio f o r m u l a p l a n ; otherwise f o l l o w a constant ratio f o r m u l a plan." F o r m u l a p l a n s i n d u c e c a u t i o n i n b u l l i s h markets a n d i n s t i l l courage d u r i n g bearish markets. If y o u adhere to a f o r m u l a p l a n r e l i g i o u s l y , y o u w i l l protect yourself f r o m b e i n g s w a y e d b y the w a v e s of o p t i m i s m a n d p e s s i m i s m w h i c h sweep the m a r k e t p e r i o d i c a l l y . H e n c e , y o u m a y , i n general, o u t p e r f o r m the market. H o w e v e r , remember that they are m o r e h e l p f u l w h e n prices fluctuate w i d e l y a n d generally trendless conditions prevail. * Check Your Irrationality A s h u m a n beings w e are e n d o w e d w i t h certain characteristics of m i n d a n d b e h a v i o u r that lead to imperfect decisions a n d e v e n d r e a d f u l l y serious mistakes. O f t e n w e are not r a t i o n a l a n d w e d o not act i n o u r o w n best interests. F o r example: * W e ignore the "base rate" i n preference to the "case rate." W e overreact to g o o d n e w s as w e l l as b a d n e w s . W e are impatient.

Guidelines for Investment Decisions * We We We We We t e n d to be o v e r o p t i m i s t i c a n d not realistic. are p r o u d a n d u n w i l l i n g to a d m i t o u r mistakes. are susceptible to hot tip i n v e s t i n g . n a i v e l y believe i n f o o l p r o o f schemes. easily s u c c u m b to h e r d m e n t a l i t y .

655

That is w h y to succeed as a n investor, y o u m u s t first k n o w yourself. Y o u r intellectual capabilities a n d y o u r e m o t i o n a l capabilities w i l l l a r g e l y determine y o u r investment success. Y o u r intellectual capabilities i n c l u d e y o u r a b i l i t y to analyse f i n a n c i a l statements, y o u r m e m o r y a n d recall p o w e r , y o u r capacity to master a n d manage k n o w l e d g e , y o u r flair for d e v e l o p i n g insights a n d u n d e r s t a n d i n g f r o m a m o r p h o u s data a n d i n f o r m a t i o n , a n d so o n . Y o u r e m o t i o n a l capabilities i n c l u d e y o u r a b i l i t y to m a i n t a i n c o m p o s u r e i n a chaotic e n v i r o n m e n t a n d y o u r capacity to deal r a t i o n a l l y w i t h v o l a t i l i t y a n d d i s r u p t i o n s that y o u face e v e r y d a y . Maximise Your Lifetime Financial Success There are five stages or d i m e n s i o n s of y o u r lifetime f i n a n c i a l success: a g Earning Saving Investing Contributing Estate p l a n n i n g

Y o u s h o u l d strive to m a x i m i s e achievement i n each of these areas, w i t h i n the set of o p p o r t u n i t i e s available to y o u , w h i l e enjoying a f u l l a n d b a l a n c e d life. If y o u have resources i n excess of w h a t y o u w i s h to transfer to y o u r f a m i l y a n d others y o u care about, y o u have r e w a r d i n g o p p o r t u n i t i e s to contribute to w o r t h w h i l e causes. Y o u m a y f i n d great f u l f i l l m e n t i n c o n v e r t i n g y o u r f i n a n c i a l resources ( w h i c h represent the stored values of y o u r h a r d w o r k , skills, a n d g o o d fortune) into actions that advance causes that y o u t r u l y care about. H e r e are some possibilities: a P r o v i d e scholarship to y o u n g c h i l d r e n w h o are e c o n o m i c a l l y d e p r i v e d . S u p p o r t hospitals a n d shelter homes that h e l p the needy a n d i n d i g e n t . C o n t r i b u t e to organisations engaged i n scientific or m e d i c a l research. Espouse institutions that w o r k for e n v i r o n m e n t a l protection.

In a d d i t i o n to c o n t r i b u t i n g m o n e y , y o u s h o u l d also c o m m i t y o u r time, talents, a n d energy to i n i t i a t i v e s a n d e n d e a v o u r s that y o u believe i n . It c a n be p r o f o u n d l y r e w a r d i n g to see h o w real, l i v i n g p e o p l e a n d i n s t i t u t i o n s benefit f r o m y o u r active p a r t i c i p a t i o n a n d i n v o l v e m e n t . A s C h a r l e s E l l i s p u t it: " A s w i t h other areas of i n v e s t i n g , it's w i s e to p l a n a h e a d , to be conservative ( w i t h i n l i m i t s ) , a n d to m a k e p r o d u c t i v e use of time b y b e g i n n i n g early a n d s u s t a i n i n g y o u r c o m m i t m e n t s over as l o n g a p e r i o d as y o u can p r o v i d e y o u r s e l f . "

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The t r a d i n g members i n the C a p i t a l M a r k e t segment are connected to the central c o m p u t e r i n M u m b a i t h r o u g h a satellite l i n k - u p , u s i n g V S A T s ( V e r y S m a l l A p e r t u r e T e r m i n a l s ) . I n c i d e n t a l l y , N S E is the first exchange i n the w o r l d to e m p l o y the satellite t e c h n o l o g y . T h i s e n a b l e d N S E to achieve a n a t i o n - w i d e reach. The t r a d i n g members i n the W h o l e s a l e D e b t M a r k e t segment are l i n k e d t h r o u g h dedicated h i g h speed lines to the central c o m p u t e r at M u m b a i . The N S E has o p t e d for an o r d e r - d r i v e n system. W h e n an order is p l a c e d b y a t r a d i n g member, the computer automatically generates a u n i q u e order n u m b e r a n d the member can take a p r i n t of order confirmation slip containing this n u m b e r . W h e n a trade takes place, a trade c o n f i r m a t i o n s l i p is p r i n t e d at the t r a d i n g m e m b e r ' s w o r k station. It gives details l i k e q u a n t i t y , p r i c e , code n u m b e r of counterparty, a n d so o n . ft The i d e n t i t y of a t r a d i n g m e m b e r is not revealed to others w h e n he places a n o r d e r or w h e n h i s p e n d i n g o r d e r s are d i s p l a y e d . H e n c e , large orders c a n be p l a c e d o n the N S E . M e m b e r s are r e q u i r e d to d e l i v e r securities a n d cash b y a certain d a y . The p a y o u t d a y is the f o l l o w i n g d a y . A l l trades o n N S E are guaranteed b y the N a t i o n a l Securities C l e a r i n g C o r p o r a t i o n ( N S C C ) . T h i s means that w h e n A b u y s f r o m B, N S C C becomes the counterparty to b o t h legs of the transaction. In effect, N S C C becomes the seller to A a n d the b u y e r f r o m B. T h i s eliminates counterparty r i s k . The Bombay Stock Exchange Established i n 1875, the B o m b a y Stock Exchange (BSE) is one of the oldest o r g a n i s e d exchanges i n the w o r l d w i t h a l o n g , c o l o u r f u l , a n d chequered h i s t o r y . Its d i s t i n c t i v e features are as f o l l o w s : The BSE s w i t c h e d f r o m the o p e n outcry system to the screen-based system i n 1995 w h i c h is called B O L T ( w h i c h is a n a c r o n y m for BSE O n L i n e T r a d i n g ) . It accelerated its computerisation p r o g r a m m e i n response to the threat f r o m the N S E . IB T o b e g i n w i t h , B O L T w a s a ' q u o t e - d r i v e n ' as w e l l as a n ' o r d e r - d r i v e n ' system, w i t h jobbers (specialists) f e e d i n g t w o - w a y quotes a n d brokers f e e d i n g b u y or sell orders T h i s h y b r i d s y s t e m reflected the h i s t o r i c a l practice of B S E w h e r e jobbers p l a y e d a n i m p o r t a n t role. A jobber is a b r o k e r w h o trades o n his o w n account a n d hence offers a t w o - w a y quote or a b i d - a s k quote. T h e b i d p r i c e reflects the price at w h i c h the jobber is w i l l i n g to b u y a n d the ask price represents the p r i c e at w h i c h the jobber is w i l l i n g to sell. F r o m A u g u s t 13, 2001, h o w e v e r , B S E , l i k e N S E , became a c o m p l e t e l y o r d e r - d r i v e n market. I n October 1996 SEBI p e r m i t t e d B S E to extend its B O L T n e t w o r k outside M u m b a i . I n 2002, s u b s i d i a r y c o m p a n i e s of 13 r e g i o n a l exchanges became members of B S E a n d t h r o u g h t h e m members of r e g i o n a l exchanges n o w serve as sub-brokers of B S E . This has e x p a n d e d the reach of B S E c o n s i d e r a b l y .

Securities Market

57

Demutualisation K e e n c o m p e t i t i o n a m o n g stock exchanges a l l over the w o r l d has been r e s h a p i n g their o r g a n i s a t i o n . T i l l e a r l y 1990s almost a l l stock exchanges w e r e m u t u a l ventures, o w n e d cooperatively b y m e m b e r s w h o enjoyed t r a d i n g p r i v i l e g e s . I n general, the o w n e r s (members) d i d not have m u c h incentive to m o d e r n i s e the exchanges, as m o r e efficient t r a d i n g c o u l d d i m i n i s h their p r o f i t s . F r o m 1993 o n w a r d s , h o w e v e r , a n u m b e r of smaller exchanges resorted to d e m u t u a l i s a t i o n . T h e y t r a n s f o r m e d themselves into p r o f i t - m a k i n g companies, a n d issued shares to outsiders. W i t h shareholders e x p e c t i n g p r o f i t s , the stock exchanges have a stronger incentive to offer n e w p r o d u c t s a n d services, increase t r a d i n g v o l u m e s , a n d reduce costs. The i d e a of d e m u t u a l i s a t i o n w a s g r a d u a l l y accepted b y bigger exchanges l i k e the L o n d o n Stock Exchange, N A S D A Q , T o k y o Stock Exchange, a n d the N e w Y o r k Stock Exchange. The p h e n o m e n a l success of the N a t i o n a l Stock Exchange, w h i c h w a s started ab initio as a profit-oriented c o m p a n y p r o m o t e d b y i n s t i t u t i o n a l investors, p r o v i d e d the s t i m u l u s for d e m u t u a l i s a t i o n of stock exchanges i n I n d i a . Indeed, SEBI has n o w m a n d a t e d that a l l the stock exchanges i n I n d i a s h o u l d be d e m u t u a l i s e d .

3.4

T R A D I N G A N D SETTLEMENT

Trading

E a c h stock exchange has certain listed securities a n d p e r m i t t e d securities w h i c h are t r a d e d o n it. M e m b e r s of the exchange alone are entitled to the t r a d i n g p r i v i l e g e s . Investors interested i n b u y i n g or s e l l i n g securities s h o u l d place their orders w i t h the m e m b e r s (also called brokers) of the exchange. There are t w o w a y s of o r g a n i s i n g the t r a d i n g activity: the o p e n o u t c r y system a n d the screen-based system. Open Outcry System A s the n o m e n c l a t u r e suggests, u n d e r the o p e n o u t c r y system, traders shout a n d resort to signals o n the t r a d i n g floor of the exchange w h i c h consists of several ' n o t i o n a l ' t r a d i n g posts for different securities. A m e m b e r (or his representative) w i s h i n g to b u y or sell a certain security reaches the t r a d i n g post w h e r e the security is traded. H e r e , he comes i n contact w i t h others interested i n transacting i n that security. Buyers m a k e their b i d s a n d sellers m a k e their offers a n d bargains are closed at m u t u a l l y agreed-upon prices. I n stocks w h e r e j o b b i n g is done, the jobber plays a n important role. H e stands ready to b u y or sell o n his account. H e quotes his b i d (buying) a n d ask (selling) prices. H e p r o v i d e s some stability a n d continuity to the market.

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Investment Analysis and Portfolio

Management

The t r a d i n g members i n the C a p i t a l M a r k e t segment are connected to the central c o m p u t e r i n M u m b a i t h r o u g h a satellite l i n k - u p , u s i n g V S A T s ( V e r y S m a l l A p e r t u r e T e r m i n a l s ) . I n c i d e n t a l l y , N S E is the first exchange i n the w o r l d to e m p l o y the satellite t e c h n o l o g y . T h i s e n a b l e d N S E to achieve a n a t i o n - w i d e reach. The t r a d i n g members i n the W h o l e s a l e D e b t M a r k e t segment are l i n k e d t h r o u g h dedicated h i g h speed lines to the central c o m p u t e r at M u m b a i . The N S E has o p t e d for an o r d e r - d r i v e n system. W h e n an order is p l a c e d b y a t r a d i n g member, the computer automatically generates a u n i q u e order n u m b e r a n d the member can take a p r i n t of order confirmation slip containing this n u m b e r . W h e n a trade takes place, a trade c o n f i r m a t i o n s l i p is p r i n t e d at the t r a d i n g m e m b e r ' s w o r k station. It gives details l i k e q u a n t i t y , p r i c e , code n u m b e r of counterparty, a n d so o n . m The i d e n t i t y of a t r a d i n g m e m b e r is not revealed to others w h e n he places a n o r d e r or w h e n h i s p e n d i n g o r d e r s are d i s p l a y e d . H e n c e , large orders c a n be p l a c e d o n the N S E . M e m b e r s are r e q u i r e d to d e l i v e r securities a n d cash b y a certain d a y . The p a y o u t d a y is the f o l l o w i n g d a y . A l l trades o n N S E are guaranteed b y the N a t i o n a l Securities C l e a r i n g C o r p o r a t i o n ( N S C C ) . T h i s means that w h e n A b u y s f r o m B, N S C C becomes the counterparty to b o t h legs of the transaction. In effect, N S C C becomes the seller to A a n d the b u y e r f r o m B. T h i s eliminates counterparty r i s k . The Bombay Stock Exchange Established i n 1875, the B o m b a y Stock Exchange (BSE) is one of the oldest o r g a n i s e d exchanges i n the w o r l d w i t h a l o n g , c o l o u r f u l , a n d chequered h i s t o r y . Its d i s t i n c t i v e features are as f o l l o w s : The BSE s w i t c h e d f r o m the o p e n outcry system to the screen-based system i n 1995 w h i c h is called B O L T ( w h i c h is a n a c r o n y m for BSE O n L i n e T r a d i n g ) . It accelerated its computerisation p r o g r a m m e i n response to the threat f r o m the N S E . IB T o b e g i n w i t h , B O L T w a s a ' q u o t e - d r i v e n ' as w e l l as a n ' o r d e r - d r i v e n ' system, w i t h jobbers (specialists) f e e d i n g t w o - w a y quotes a n d brokers f e e d i n g b u y or sell orders T h i s h y b r i d s y s t e m reflected the h i s t o r i c a l practice of B S E w h e r e jobbers p l a y e d a n i m p o r t a n t role. A jobber is a b r o k e r w h o trades o n his o w n account a n d hence offers a t w o - w a y quote or a b i d - a s k quote. T h e b i d p r i c e reflects the price at w h i c h the jobber is w i l l i n g to b u y a n d the ask price represents the p r i c e at w h i c h the jobber is w i l l i n g to sell. F r o m A u g u s t 13, 2001, h o w e v e r , B S E , l i k e N S E , became a c o m p l e t e l y o r d e r - d r i v e n market. I n October 1996 SEBI p e r m i t t e d B S E to extend its B O L T n e t w o r k outside M u m b a i . I n 2002, s u b s i d i a r y c o m p a n i e s of 13 r e g i o n a l exchanges became members of B S E a n d t h r o u g h t h e m members of r e g i o n a l exchanges n o w serve as sub-brokers of B S E . This has e x p a n d e d the reach of B S E c o n s i d e r a b l y .

Securities Market

57

Demutualisation K e e n c o m p e t i t i o n a m o n g stock exchanges a l l over the w o r l d has been r e s h a p i n g their o r g a n i s a t i o n . T i l l e a r l y 1990s almost a l l stock exchanges w e r e m u t u a l ventures, o w n e d cooperatively b y m e m b e r s w h o enjoyed t r a d i n g p r i v i l e g e s . I n general, the o w n e r s (members) d i d not have m u c h incentive to m o d e r n i s e the exchanges, as m o r e efficient t r a d i n g c o u l d d i m i n i s h their p r o f i t s . F r o m 1993 o n w a r d s , h o w e v e r , a n u m b e r of smaller exchanges resorted to d e m u t u a l i s a t i o n . T h e y t r a n s f o r m e d themselves into p r o f i t - m a k i n g companies, a n d issued shares to outsiders. W i t h shareholders e x p e c t i n g p r o f i t s , the stock exchanges have a stronger incentive to offer n e w p r o d u c t s a n d services, increase t r a d i n g v o l u m e s , a n d reduce costs. The i d e a of d e m u t u a l i s a t i o n w a s g r a d u a l l y accepted b y bigger exchanges l i k e the L o n d o n Stock Exchange, N A S D A Q , T o k y o Stock Exchange, a n d the N e w Y o r k Stock Exchange. The p h e n o m e n a l success of the N a t i o n a l Stock Exchange, w h i c h w a s started ab initio as a profit-oriented c o m p a n y p r o m o t e d b y i n s t i t u t i o n a l investors, p r o v i d e d the s t i m u l u s for d e m u t u a l i s a t i o n of stock exchanges i n I n d i a . Indeed, SEBI has n o w m a n d a t e d that a l l the stock exchanges i n I n d i a s h o u l d be d e m u t u a l i s e d .

3.4

T R A D I N G A N D SETTLEMENT

Trading

E a c h stock exchange has certain listed securities a n d p e r m i t t e d securities w h i c h are t r a d e d o n it. M e m b e r s of the exchange alone are entitled to the t r a d i n g p r i v i l e g e s . Investors interested i n b u y i n g or s e l l i n g securities s h o u l d place their orders w i t h the m e m b e r s (also called brokers) of the exchange. There are t w o w a y s of o r g a n i s i n g the t r a d i n g activity: the o p e n o u t c r y system a n d the screen-based system. Open Outcry System A s the n o m e n c l a t u r e suggests, u n d e r the o p e n o u t c r y system, traders shout a n d resort to signals o n the t r a d i n g floor of the exchange w h i c h consists of several ' n o t i o n a l ' t r a d i n g posts for different securities. A m e m b e r (or his representative) w i s h i n g to b u y or sell a certain security reaches the t r a d i n g post w h e r e the security is traded. H e r e , he comes i n contact w i t h others interested i n transacting i n that security. Buyers m a k e their b i d s a n d sellers m a k e their offers a n d bargains are closed at m u t u a l l y agreed-upon prices. I n stocks w h e r e j o b b i n g is done, the jobber plays a n important role. H e stands ready to b u y or sell o n his account. H e quotes his b i d (buying) a n d ask (selling) prices. H e p r o v i d e s some stability a n d continuity to the market.

Overview

1.2

INVESTMENT ALTERNATIVES A N D THEIR EVALUATION

* -*

Investment Alternatives
A s a n i n v e s t o r y o u h a v e a w i d e a r r a y of i n v e s t m e n t avenues a v a i l a b l e to y o u . S a c r i f i c i n g some r i g o u r , they m a y be classified as s h o w n i n E x h i b i t 1.1

^ ^ i ^ n i b f t l .1

Investment Alternatives

Investment Avenues NonmarketaWe Financial Assets

Equity Shares

Bonds
>

Money Market Instruments

Mutual Fund Schemes Real Estate

- %^,m

Life Insurance Policies Precious Objects Financial Derivatives

Non-marketable Financial Assets A g o o d p o r t i o n of f i n a n c i a l assets is represented b y n o n - m a r k e t a b l e f i n a n c i a l assets. T h e y c a n be c l a s s i f i e d i n t o the f o l l o w i n g b r o a d categories: * B a n k deposits Post office deposits C o m p a n y deposits P r o v i d e n t f u n d deposits

Equity Shares E q u i t y shares represent o w n e r s h i p c a p i t a l . A s a n e q u i t y shareholder, y o u have a n o w n e r s h i p stake i n the c o m p a n y . T h i s essentially means that y o u have a r e s i d u a l interest i n i n c o m e a n d w e a l t h . P e r h a p s the m o s t r o m a n t i c a m o n g v a r i o u s i n v e s t m e n t avenues, e q u i t y shares are classified into the f o l l o w i n g b r o a d categories b y stock m a r k e t analysts: B l u e c h i p shares G r o w t h shares

Investment Analysis

and Portfolio

Management

Income shares C y c l i c a l shares Speculative shares Traders, Speculators, and Investors W e m a y classify stock market participants into three b r o a d categories: traders, speculators, a n d investors. Traders have a v e r y short time h o r i z o n . T h e y square off their positions w i t h i n a d a y or w i t h i n a w e e k or w i t h i n a m o n t h t h e i r time h o r i z o n rarely exceeds a m o n t h . T h e y u s u a l l y w o r k o n m a r g i n i n the derivatives markets (futures a n d o p t i o n s markets) a n d hence their p o s i t i o n s are h i g h l y leveraged. M o s t of the traders rely o n technical analysis. Speculators h a v e a time h o r i z o n that m a y e x t e n d u p t o six m o n t h s . S a m u e l N e l s o n , i n his classic b o o k , The ABC of Stock Speculation, d e f i n e d speculation as " a venture based o n c a l c u l a t i o n . " H e distinguishes s p e c u l a t i o n f r o m g a m b l i n g b y s a y i n g that the latter is not based o n calculation. Investors h a v e a longer time h o r i z o n , t y p i c a l l y s p a n n i n g at least t w o years, often m u c h longer. G e n e r a l l y , investors d o not resort to m a r g i n t r a d i n g a n d take fewer r i s k s c o m p a r e d to traders or speculators. Investors, i n general, r e l y o n f u n d a m e n t a l analysis. C l e a r l y the f o r m u l a for i n v e s t i n g is different f r o m that u s e d for t r a d i n g a n d speculating. A s M a r t i n J. P r i n g p u t it: " T h e techniques practiced b y traders a n d speculators are as different f r o m i n v e s t o r s ' techniques as sprinter's t r a i n i n g is different f r o m that of a m a r a t h o n r u n n e r . B o t h n e e d to be d i s c i p l i n e d a n d fit, b u t each has a different r e g i m e n . " Bonds B o n d s or debentures represent l o n g - t e r m debt i n s t r u m e n t s . The issuer of a b o n d promises to p a y a stipulated stream of cash f l o w . B o n d s m a y be classified into the f o l l o w i n g categories:

G o v e r n m e n t securities Savings b o n d s G o v e r n m e n t agency securities P S U bonds Debentures of p r i v a t e sector companies Preference shares Money Market Instruments Debt instruments w h i c h have a m a t u r i t y of less t h a n one year at the time of issue are called m o n e y market instruments. The i m p o r t a n t m o n e y market instruments are:
1

Preference shares are hybrid securities which partake features of bonds and equity shares. For the sake of simplicity, we include them under bonds.

Overview * Treasury bills * C o m m e r c i a l paper Certificates of deposit

Mutual Funds Instead of d i r e c t l y b u y i n g e q u i t y shares a n d / o r f i x e d i n c o m e instruments, y o u c a n participate i n v a r i o u s schemes floated b y m u t u a l f u n d s w h i c h , i n t u r n , invest i n e q u i t y shares a n d f i x e d i n c o m e securities. There are three b r o a d types of m u t u a l f u n d schemes: E q u i t y schemes D e b t schemes Balanced schemes Life Insurance I n a b r o a d sense, life i n s u r a n c e m a y be v i e w e d as a n i n v e s t m e n t . Insurance p r e m i u m s represent the sacrifice a n d the assured s u m , the benefit. The i m p o r t a n t types of insurance policies i n I n d i a are:
2

E n d o w m e n t assurance p o l i c y M o n e y back p o l i c y W h o l e life p o l i c y T e r m assurance p o l i c y

Real Estate F o r the b u l k of the investors the most i m p o r t a n t asset i n their p o r t f o l i o is a residential house. I n a d d i t i o n to a residential house, the m o r e affluent investors are l i k e l y to be interested i n the f o l l o w i n g types of real estate: * Agricultural land Semi-urban land Commercial property A resort h o m e A second house

Precious Objects Precious objects are items that are generally s m a l l i n size b u t h i g h l y v a l u a b l e i n m o n e t a r y terms. The i m p o r t a n t precious objects are: G o l d a n d silver Precious stones A r t objects Financial Derivatives A f i n a n c i a l d e r i v a t i v e is a n i n s t r u m e n t w h o s e v a l u e is d e r i v e d f r o m the v a l u e of a n u n d e r l y i n g asset. It m a y be v i e w e d as a side bet o n the asset. The most i m p o r t a n t f i n a n c i a l derivatives f r o m the p o i n t of v i e w of investors are: Options Futures

Life insurance policies are also non-marketable financial assets. Given their distinctive character we have treated them as a separate category.

10

Investment Analysis and Portfolio

Management

Convenience C o n v e n i e n c e b r o a d l y refers to the ease w i t h w h i c h the investment c a n be m a d e a n d l o o k e d after. P u t d i f f e r e n t l y , the questions that w e ask to j u d g e convenience are: (a) c a n the investment be m a d e r e a d i l y ? a n d (b) c a n the investment be l o o k e d after easily? The degree of convenience associated w i t h investments varies w i d e l y . A t one e n d of the s p e c t r u m is the deposit i n a savings b a n k account that c a n be m a d e r e a d i l y a n d that does not r e q u i r e a n y m a i n t e n a n c e effort. A t the other e n d of the s p e c t r u m is the purchase of a p r o p e r t y that m a y i n v o l v e a lot of p r o c e d u r a l a n d legal hassles at the time o f a c q u i s i t i o n a n d a great d e a l of maintenance effort subsequently. How Do the Various Alternatives Compare?

H o w d o v a r i o u s i n v e s t m e n t avenues l i k e e q u i t y shares, f i x e d i n c o m e securities, deposits, real assets, a n d so o n compare? A s u m m a r y e v a l u a t i o n of these investment avenues i n terms of k e y i n v e s t m e n t attributes is g i v e n i n E x h i b i t 1.2. It m u s t be e m p h a s i s e d that w i t h i n each investment category i n d i v i d u a l assets m a y d i s p l a y some variations.

1.3

FINANCIAL MARKETS

A financial market is a market for creation a n d exchange of financial assets. If y o u b u y or sell financial assets, y o u w i l l participate i n financial markets i n some w a y or the other. Functions of Financial Markets F n a n c i a l markets p l a y a p i v o t a l role i n a l l o c a t i n g resources i n a n e c o n o m y b y p e r f o r m i n g three i m p o r t a n t functions: .'1; F i n a n c i a l m a r k e t s facilitate price discovery. The c o n t i n u a l i n t e r a c t i o n a m o n g . n u m e r o u s b u y e r s a n d sellers w h o t h r o n g f i n a n c i a l markets helps i n establishing the prices of f i n a n c i a l assets. W e l l - o r g a n i s e d f i n a n c i a l m a r k e t s seem to be r e m a r k a b l y efficient i n price d i s c o v e r y . That is w h y f i n a n c i a l economists say: "If y o u w a n t to k n o w w h a t the v a l u e of a f i n a n c i a l asset is, s i m p l y l o o k at its price i n the f i n a n c i a l m a r k e t " . F i n a n c i a l markets provide liquidity to f i n a n c i a l assets. Investors can r e a d i l y sell their f i n a n c i a l assets t h r o u g h the m e c h a n i s m of f i n a n c i a l markets. I n the absence of f i n a n c i a l markets w h i c h p r o v i d e s u c h l i q u i d i t y , the m o t i v a t i o n of investors to h o l d f i n a n c i a l assets w i l l be c o n s i d e r a b l y d i m i n i s h e d . T h a n k s to n e g o t i a b i l i t y and transferability of securities t h r o u g h the f i n a n c a i l markets, it is possible f o r c o m p a n i e s (and other entities) to raise l o n g - t e r m f u n d s f r o m investors w i t h jjjjj short- t e r m a n d m e d i u m - t e r m h o r i z o n s . W h i l e one i n v e s t o r is substituted b y another w h e n a security is transacted, the c o m p a n y is a s s u r e d of l o n g - t e r m U l l a v a U a b i l i t y of f u n d s .
;

fjlj

Overview

11

Exhibit 1.2

Summary Evaluation of Various Investment A venues Risk Marketability/ Liquidity Fairly high Average Tax shelter Convenience

Equity Shares Nonconvertible Debentures Equity Schemes Debt Schemes Bank Deposits Public Provident Fund Life Insurance Policies Residential House Gold and Silver

Return Current yield Capital appreciation Low High High Negligible

High Low

High Nil

High High

Low Moderate Moderate Nil

High Low Nil Moderate

High Low Negligible Nil

High High High Average

High No tax on dividends Low Section 80 C benefit Section 80 C benefit High Nil

Very high Very high Very high Very high

Nil

Moderate

Nil

Average

Very High

Moderate Nil

Moderate Moderate

Negligible Average

Low High

Fair Average

3. F i n a n c i a l markets c o n s i d e r a b l y reduce the cost of transacting. The t w o major costs associated w i t h transacting are search costs a n d i n f o r m a t i o n costs. Search costs c o m p r i s e e x p l i c i t costs s u c h as the expenses i n c u r r e d o n a d v e r t i s i n g w h e n one w a n t s to b u y or sell a n asset a n d i m p l i c i t costs s u c h as the effort a n d time one has to p u t i n to locate a customer. Information costs refer to costs i n c u r r e d i n e v a l u a t i n g the investment merits of f i n a n c i a l assets. Classification of Financial Markets There are different w a y s of c l a s s i f y i n g f i n a n c i a l markets. O n e w a y is to classify f i n a n c i a l markets b y the type of f i n a n c i a l c l a i m . The debt market is the f i n a n c i a l market for f i x e d claims (debt instruments) a n d the equity market is the f i n a n c i a l m a r k e t for r e s i d u a l claims (equity instruments). A second w a y is to classify f i n a n c i a l markets b y the m a t u r i t y of claims. The m a r k e t for short-term f i n a n c i a l claims is referred to as the money market a n d the m a r k e t for l o n g - t e r m f i n a n c i a l c l a i m s is c a l l e d the capital market. T r a d i t i o n a l l y , the cut off b e t w e e n short-term a n d l o n g - t e r m f i n a n c i a l claims has b e e n one year - t h o u g h this d i v i d i n g l i n e is arbitrary, it is w i d e l y accepted. Since short-term f i n a n c i a l c l a i m s are almost i n v a r i a b l y debt c l a i m s , the m o n e y m a r k e t is the m a r k e t for s h o r t - t e r m debt i n s t s r u m e n t s . T h e c a p i t a l m a r k e t is the m a r k e t for l o n g - t e r m debt i n s t r u m e n t s a n d equity instruments.

12
A

Investment Analysis and Portfolio

Management

t h i r d w a y to classify f i n a n c i a l markets is based o n w h e t h e r the c l a i m s represent new issues or o u t s t a n d i n g issues. The market w h e r e issuers sell n e w claims is referred to as the p r i m a r y m a r k e t a n d the market w h e r e investors trade o u t s t a n d i n g securities is c a l l e d the s e c o n d a r y m a r k e t . A f o u r t h w a y to classify f i n a n c i a l markets is b y the t i m i n g of d e l i v e r y . A cash or s p o t m a r k e t is one w h e r e the d e l i v e r y occurs i m m e d i a t e l y a n d a f o r w a r d or f u t u r e s m a r k e t is one w h e r e the d e l i v e r y occurs at a p r e - d e t e r m i n e d time i n f u t u r e . A fifth w a y to classify f i n a n c i a l m a r k e t s is b y the nature of its o r g a n i s a t i o n a l structure. A n e x c h a n g e - t r a d e d m a r k e t is characterised b y a centralised organisation w i t h s t a n d a r d i s e d procedures. A n o v e r - t h e c o u n t e r m a r k e t is a decentralised market w i t h c u s t o m i s e d p r o c e d u r e s . E x h i b i t 1.3 presents a s u m m a r y of the classification of f i n a n c i a l markets. Globalisation of Financial Markets There is a trend t o w a r d the integration of f i n a n c i a l markets t h r o u g h o u t the w o r l d i n t o a g l o b a l or international f i n a n c i a l market. T h a n k s to g l o b a l i s a t i o n of f i n a n c i a l markets, issuers a n d investors i n a n y c o u n t r y n e e d not confine themselves to their domestic f i n a n c i a l markets. F o r e x a m p l e , I n d i a n c o m p a n i e s c a n raise m o n e y b y i s s u i n g e q u i t y a n d debt i n i n t e r n a t i o n a l m a r k e t s ; l i k e w i s e I n d i a n investors c a n invest i n outside markets. O f course, s u c h p a r t i c i p a t i o n is regulated a n d l i m i t e d i n some w a y s . G l o b a l i s a t i o n of f i n a n c i a l m a r k e t s is d r i v e n b y three forces, i n the m a i n : (a) d e r e g u l a t i o n or l i b e r a l i s a t i o n of f i n a n c i a l markets i n different parts of the w o r l d , (b) technological advances i n c o m p u t i n g , c o m m u n i c a t i o n , a n d m a r k e t structures, a n d (c) g r o w i n g i n s t i t u i o n a l i s a t i o n of f i n a n c i a l markets. Indeed, these factors are interrelated. Exhibit 1.3 Classification of Financial Markets
Debt Market Nature of Claim Equity Market Money Market Maturity of Claim Capital Market Seasoning of Claim Primary Market Secondary Market Cash or Spot Market Timing of Delivery Forward or Futures Market Exchange Traded Market Organisational structure Over-the-Counter Market

Competitive Character of Financial Markets F i n a n c i a l markets are characterised b y a h i g h degree of c o m p e t i t i o n . T h o u s a n d s of intelligent, k n o w l e d g e a b l e , a n d d e t e r m i n e d

Overview

13

analysts constantly h u n t for the best b u y s . G i v e n s u c h intense c o m p e t i t i o n , it w o u l d be d i f f i c u l t to f i n d "free l u n c h e s " or o b v i o u s bargains. The no-free-lunch p r o p o s i t i o n has two important implications. There is a trade-off b e t w e e n r i s k a n d r e t u r n . If y o u w a n t to earn h i g h e r expected r e t u r n , y o u w i l l have to bear h i g h e r investment r i s k . F i n a n c i a l markets assimilate a l l relevant i n f o r m a t i o n about securities f a i r l y q u i c k l y a n d efficiently. A s a result, securities are generally p r i c e d f a i r l y .

1.4

PORTFOLIO MANAGEMENT PROCESS

Investment management (or p o r t f o l i o management) is a c o m p l e x activity w h i c h m a y be b r o k e n d o w n into the f o l l o w i n g steps: 1. S p e c i f i c a t i o n of I n v e s t m e n t O b j e c t i v e s a n d C o n s t r a i n t s The t y p i c a l objectives s o u g h t b y investors are current i n c o m e , c a p i t a l a p p r e c i a t i o n , a n d safety of p r i n c i p a l . The relative i m p o r t a n c e of these objectives s h o u l d be specified. Further, the constraints a r i s i n g f r o m l i q u i d i t y , time h o r i z o n , tax, a n d special circumstances m u s t be i d e n t i f i e d . 2. C h o i c e of the A s s e t M i x The most i m p o r t a n t d e c i s i o n i n p o r t f o l i o management is the asset m i x d e c i s i o n . V e r y b r o a d l y , this is concerned w i t h the p r o p o r t i o n s of 'stocks' (equity shares a n d units/shares of equity-oriented m u t u a l funds) a n d ' b o n d s ' (fixed i n c o m e i n v e s t m e n t vehicles i n general) i n the p o r t f o l i o . The a p p r o p r i a t e ' s t o c k - b o n d ' m i x d e p e n d s m a i n l y o n the r i s k tolerance a n d investment h o r i z o n of the investor. 3. F o r m u l a t i o n of P o r t f o l i o Strategy O n c e a certain asset m i x is chosen, a n a p p r o p r i a t e p o r t f o l i o strategy has to be h a m m e r e d out. T w o b r o a d choices are available: a n active p o r t f o l i o strategy or a passive p o r t f o l i o strategy. A n active p o r t f o l i o strategy strives to earn s u p e r i o r risk-adjusted returns b y resorting to m a r k e t t i m i n g , or sector rotation, or security selection, or some c o m b i n a t i o n of these. A passive p o r t f o l i o strategy, o n the other h a n d , i n v o l v e s h o l d i n g a b r o a d l y d i v e r s i f i e d p o r t f o l i o a n d m a i n t a i n i n g a p r e - d e t e r m i n e d l e v e l of r i s k exposure. 4 S e l e c t i o n of S e c u r i t i e s G e n e r a l l y , investors p u r s u e a n active stance w i t h respect to security selection. F o r stock selection, investors c o m m o n l y go b y f u n d a m e n t a l analysis a n d / o r technical analysis. The factors that are c o n s i d e r e d i n selecting b o n d s (or f i x e d i n c o m e instruments) are y i e l d to m a t u r i t y , credit rating, t e r m to m a t u r i t y , tax shelter, a n d l i q u i d i t y . 5. P o r t f o l i o E x e c u t i o n T h i s is the phase of p o r t f o l i o m a n a g e m e n t w h i c h is c o n c e r n e d w i t h i m p l e m e n t i n g the p o r t f o l i o p l a n b y b u y i n g a n d / or s e l l i n g specified securities i n g i v e n a m o u n t s . T h o u g h often glossed over i n p o r t f o l i o management discussions, this is a n i m p o r t a n t practical step that has a b e a r i n g o n investment results.

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6. P o r t f o l i o R e v i s i o n The v a l u e of a p o r t f o l i o as w e l l as its c o m p o s i t i o n t h e relative p r o p o r t i o n s of stock a n d b o n d c o m p o n e n t s m a y change as prices of stocks a n d b o n d s fluctuate. O f course, the f l u c t u a t i o n i n stock prices is often the d o m i n a n t factor u n d e r l y i n g this change. In response to such changes, p e r i o d i c r e b a l a n c i n g of the p o r t f o l i o is r e q u i r e d . T h i s p r i m a r i l y i n v o l v e s a shift f r o m stocks to b o n d s or vice versa. In a d d i t i o n , it m a y call for sector rotation as w e l l as security switches. 7. P e r f o r m a n c e E v a l u a t i o n T h e performance of a p o r t f o l i o s h o u l d be evaluated p e r i o d i c a l l y . The k e y d i m e n s i o n s of p o r t f o l i o performance e v a l u a t i o n are risk a n d r e t u r n a n d the k e y issue is whether the p o r t f o l i o r e t u r n is commensurate w i t h its risk exposure. S u c h a r e v i e w m a y p r o v i d e u s e f u l feedback to i m p r o v e _ the q u a l i t y of the p o r t f o l i o management process o n a c o n t i n u i n g basis.

1.5

APPROACHES TO INVESTMENT DECISION MAKING


approaches

The stock m a r k e t is t h r o n g e d b y investors p u r s u i n g diverse investment w h i c h m a y be s u b s u m e d u n d e r four b r o a d approaches: Fundamental approach Psychological approach Academic approach Eclectic a p p r o a c h

Fundamental Approach T h e basic tenets of the f u n d a m e n t a l a p p r o a c h , w h i c h is perhaps most c o m m o n l y advocated b y investment professionals, are as f o l l o w s : There is a n i n t r i n s i c v a l u e of a security a n d this d e p e n d s u p o n u n d e r l y i n g economic (fundamental) factors. T h e i n t r i n s i c v a l u e c a n be established b y a p e n e t r a t i n g analysis of the f u n d a m e n t a l factors r e l a t i n g to the c o m p a n y , i n d u s t r y , a n d economy. A t a n y g i v e n p o i n t of time, there are some securities for w h i c h the p r e v a i l i n g market price w i l l differ f r o m the intrinsic v a l u e . Sooner or later, of course, the market price w i l l fall i n line w i t h the intrinsic v a l u e . S u p e r i o r returns c a n be earned b y b u y i n g u n d e r - v a l u e d securities (securities w h o s e i n t r i n s i c v a l u e s exceed the m a r k e t prices) a n d s e l l i n g o v e r - v a l u e d securities (securities w h o s e intrinsic values are less t h a n the market prices). Psychological Approach T h e p s y c h o l o g i c a l a p p r o a c h is based o n the p r e m i s e that stock prices are g u i d e d b y e m o t i o n , rather than reason. Stock prices are b e l i e v e d to be i n f l u e n c e d b y the p s y c h o l o g i c a l m o o d of the investors. W h e n greed a n d e u p h o r i a sweep the m a r k e t , prices rise to d i z z y heights. O n the other h a n d , w h e n fear a n d despair envelop the market, prices f a l l to a b y s m a l l y l o w levels. J . M . K e y n e s described
3 3

J.M.Keynes, The General Theory of Employment, Interest and Money, N e w York, Harcourt Brace & World, 1936.

Overview

15

this p h e n o m e n o n i n eloquent terms: " A c o n v e n t i o n a l v a l u a t i o n w h i c h is established as the outcome of the mass p s y c h o l o g y of a large n u m b e r of ignorant i n d i v i d u a l s is liable to change v i o l e n t l y as the result of a s u d d e n f l u c t u a t i o n of o p i n i o n d u e to factors w h i c h d o not r e a l l y m a k e m u c h difference to the prospective y i e l d . " Since p s y c h i c v a l u e s appear to be m o r e i m p o r t a n t t h a n i n t r i n s i c v a l u e s , the p s y c h o l o g i c a l a p p r o a c h suggests that it is m o r e profitable to analyse h o w investors tend to behave as the m a r k e t is s w e p t b y w a v e s of o p t i m i s m a n d p e s s i m i s m w h i c h seem to alternate. T h e p s y c h o l o g i c a l . a p p r o a c h has b e e n d e s c r i b e d v i v i d l y as the 'castles-in-the-air' theory b y B u r t o n C M a l k i e l . Those w h o subscribe to the p s y c h o l o g i c a l a p p r o a c h or the 'castles-in-the-air' theory generally use some f o r m of technical analysis w h i c h is c o n c e r n e d w i t h a s t u d y of i n t e r n a l m a r k e t data, w i t h a v i e w to d e v e l o p i n g t r a d i n g rules a i m e d at p r o f i t - m a k i n g . The basic premise of technical analysis is that there are certain persistent a n d r e c u r r i n g patterns of p r i c e m o v e m e n t s w h i c h c a n be d i s c e r n e d b y a n a l y s i n g m a r k e t d a t a . T e c h n i c a l analysts use a v a r i e t y of tools l i k e bar chart, p o i n t a n d figure chart, m o v i n g average analysis, b r e a d t h of market analysis, a n d so o n . Academic Approach O v e r the last five decades or so, the academic c o m m u n i t y has s t u d i e d v a r i o u s aspects of the capital market, p a r t i c u l a r l y i n the a d v a n c e d countries, w i t h the h e l p of f a i r l y sophisticated methods of i n v e s t i g a t i o n . W h i l e there are m a n y u n r e s o l v e d issues a n d controversies s t e m m i n g f r o m studies p o i n t i n g i n different directions, there appears to be substantial s u p p o r t for the f o l l o w i n g tenets. Stock markets are reasonably efficient i n reacting q u i c k l y a n d r a t i o n a l l y to the f l o w of i n f o r m a t i o n . H e n c e , stock prices reflect intrinsic v a l u e f a i r l y w e l l . P u t differently M a r k e t price = Intrinsic v a l u e * Stock price b e h a v i o u r corresponds to a r a n d o m w a l k . T h i s means that successive p r i c e changes are i n d e p e n d e n t . A s a result, past p r i c e b e h a v i o u r cannot be u s e d to predict future price b e h a v i o u r . I n the capital market, there is a p o s i t i v e relationship between r i s k a n d r e t u r n . M o r e specifically, the expected r e t u r n f r o m a security is l i n e a r l y related to its systematic r i s k (also referred to as its m a r k e t r i s k or n o n - d i v e r s i f i a b l e risk). Eclectic Approach The eclectic a p p r o a c h d r a w s o n a l l the three different approaches d i s c u s s e d above. The basic premises of the eclectic a p p r o a c h are as f o l l o w s : F u n d a m e n t a l analysis is h e l p f u l i n establishing basic standards a n d b e n c h m a r k s . H o w e v e r , since there are uncertainties associated w i t h f u n d a m e n t a l analysis, e x c l u s i v e reliance o n f u n d a m e n t a l analysis s h o u l d be a v o i d e d . E q u a l l y i m p o r t a n t , excessive refinement a n d c o m p l e x i t y i n f u n d a m e n t a l analysis m u s t be v i e w e d w i t h c a u t i o n . T e c h n i c a l analysis is u s e f u l i n b r o a d l y g a u g i n g the p r e v a i l i n g m o o d of investors a n d the relative strengths of s u p p l y a n d d e m a n d forces. H o w e v e r , since the

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m o o d of i n v e s t o r s c a n v a r y u n p r e d i c t a b l y excessive reliance o n technical i n d i c a t o r s c a n be h a z a r d o u s . M o r e i m p o r t a n t , c o m p l i c a t e d technical systems s h o u l d o r d i n a r i l y be r e g a r d e d as suspect because they often represent figments of i m a g i n a t i o n rather than tools of p r o v e n usefulness. The market is neither as w e l l - o r d e r e d as the academic a p p r o a c h suggests, n o r as speculative as the p s y c h o l o g i c a l a p p r o a c h indicates. W h i l e it is characterised b y some inefficiencies a n d imperfections, it seems to react reasonably efficiently a n d r a t i o n a l l y to the f l o w of i n f o r m a t i o n . L i k e w i s e , despite m a n y instances of m i s p r i c e d securities, there appears to be a f a i r l y strong correlation between r i s k and return. The operational i m p l i c a t i o n s of the eclectic a p p r o a c h are as f o l l o w s : C o n d u c t f u n d a m e n t a l analysis to establish certain v a l u e 'anchors'. D o technical analysis to assess the state of the market p s y c h o l o g y . C o m b i n e f u n d a m e n t a l a n d technical analyses to determine w h i c h securities are w o r t h b u y i n g , w o r t h h o l d i n g , a n d w o r t h d i s p o s i n g off. Respect market prices a n d d o not s h o w excessive z e a l i n 'beating the m a r k e t ' . A c c e p t the fact that the search for a h i g h e r l e v e l of r e t u r n often necessitates the a s s u m p t i o n of a h i g h e r l e v e l of r i s k .

1.6

COMMON ERRORS IN INVESTMENT MANAGEMENT

Investors appear to be p r o n e to the f o l l o w i n g errors i n m a n a g i n g their investments. Inadequate c o m p r e h e n s i o n of r e t u r n a n d r i s k V a g u e l y f o r m u l a t e d investment p o l i c y N a i v e extrapolation of the past C u r s o r y decision m a k i n g U n t i m e l y entries a n d exits H i g h costs Over-diversification and under-diversification W r o n g attitude t o w a r d losses a n d profits Inadequate Comprehension of Return and Risk W h a t returns c a n one expect f r o m different investments? W h a t are the risks associated w i t h these investments? A n s w e r s to these questions are c r u c i a l before y o u invest. Yet investors often have n e b u l o u s ideas about r i s k a n d r e t u r n . M a n y investors h a v e unrealistic a n d exaggerated expectations f r o m investments, i n p a r t i c u l a r f r o m e q u i t y shares a n d convertible debentures. O n e often comes across investors w h o say that they h o p e to earn a r e t u r n of 25 to 30 percent per year w i t h v i r t u a l l y n o r i s k exposure or e v e n d o u b l e their investment i n a year or so. T h e y h a v e a p p a r e n t l y been m i s l e d b y one or m o r e of the f o l l o w i n g : (a) t a l l a n d unjustified claims m a d e b y people w i t h vested interests; (b) exceptional p e r f o r m a n c e of some p o r t f o l i o they h a v e seen or m a n a g e d , w h i c h m a y be attributable m o s t l y to fortuitous factors; a n d (c) p r o m i s e s m a d e b y tipsters, operators, a n d others. In most of the cases, s u c h expectations reflect investor naivete a n d g u l l i b i l i t y .

Overview

17

B y setting unrealistic goals, investors m a y d o precisely the things that g i v e p o o r results. T h e y m a y c h u r n their p o r t f o l i o s too frequently; they m a y b u y d u b i o u s 'stories' f r o m D a l a i Street; they m a y p a y h u g e p r e m i u m s for speculative, fashionable stocks; they m a y d i s c a r d s o u n d companies because of t e m p o r a r y stagnation i n earnings; they m a y t r y to outguess short-term m a r k e t s w i n g s . Vaguely Formulated Investment Policy O f t e n investors d o not clearly s p e l l out their risk d i s p o s i t i o n a n d investment p o l i c y . T h i s tends to create c o n f u s i o n a n d i m p a i r s the q u a l i t y of investment decisions. I r o n i c a l l y , conservative investors t u r n aggressive w h e n the b u l l market is near its peak i n the h o p e of r e a p i n g a b o n a n z a ; l i k e w i s e , i n the w a k e of sharp losses i n f l i c t e d b y a bear market, aggressive investors t u r n u n d u l y cautious a n d o v e r l o o k o p p o r t u n i t i e s before t h e m . Ragnar D . Naess p u t it this w a y : " T h e fear of l o s i n g capital w h e n prices are l o w a n d d e c l i n i n g , a n d the greed for m o r e c a p i t a l gains w h e n prices are r i s i n g , are p r o b a b l y , m o r e than a n y other factors, responsible for p o o r p e r f o r m a n c e . " If y o u k n o w w h a t y o u r r i s k attitude is a n d w h y y o u are i n v e s t i n g , y o u w i l l l e a r n h o w to i n v e s t w e l l . A w e l l a r t i c u l a t e d i n v e s t m e n t p o l i c y , a d h e r e d to consistently over a p e r i o d of time, saves a great d e a l of d i s a p p o i n t m e n t . Naive Extrapolation of Past Investors generally believe i n a s i m p l e extrapolation of past trends a n d events a n d d o not effectively incorporate changes i n t o expectations. A s A r t h u r Z e i k e l says: " P e o p l e generally, a n d investors p a r t i c u l a r l y , fail to appreciate the w o r k i n g of c o u n t e r v a i l i n g forces; change a n d m o m e n t u m are l a r g e l y m i s u n d e r s t o o d concepts. M o s t investors t e n d to c l i n g to the course to w h i c h they are c u r r e n t l y c o m m i t t e d , especially at t u r n i n g p o i n t s . " The apparent comfort p r o v i d e d b y extrapolating too far, h o w e v e r , is dangerous. A s Peter Berntsein says: " M o m e n t u m causes things to r u n further a n d longer t h a n w e anticipate. The v e r y f a m i l i a r i t y of a force i n m o t i o n reduces o u r a b i l i t y to see w h e n it is l o s i n g its m o m e n t u m . Indeed, that is w h y extrapolating the present into the future so frequently turns out to be the genesis of a n e m b a r r a s s i n g forecast." Cursory Decision Making Investment d e c i s i o n m a k i n g is characterised b y a great d e a l of cursoriness. Investors t e n d to: * Base their d e c i s i o n s o n t i p s a n d fads, rather t h a n o n t h o u g h t f u l , q u a n t i f i e d assessment of business. C a v a l i e r l y b r u s h aside v a r i o u s k i n d s of investment r i s k (market r i s k , business risk, a n d interest rate risk) as greed o v e r p o w e r s t h e m . U n c r i t i c a l l y f o l l o w others because of the t e m p t a t i o n to r i d e the b a n d w a g o n or lack of confidence i n their o w n j u d g m e n t . Untimely Entries and Exit Investors t e n d to f o l l o w a n i r r a t i o n a l start-and-stop a p p r o a c h to the market characterised b y u n t i m e l y entries (after a market advance has l o n g been u n d e r w a y ) a n d exits (after a l o n g p e r i o d of stagnation a n d decline). High Costs Investors trade excessively a n d s p e n d a lot o n investment management. A g o o d p r o p o r t i o n of investors i n d u l g e i n d a y t r a d i n g i n the h o p e of m a k i n g q u i c k