CHAPTER 1

INTRODUCTION

1.1 INTRODUCTION TO INVESTMENT

The money one earns is partly spent and the rest is saved for meeting future expenses,
instead of keeping savings idle one may like to use savings in order to get returns on it in the
future, this is called as investment. In an economic sense, an investment is the purchase of
goods that are not consumed today but are used in the future to create wealth. In finance, an
investment is a monetary asset purchased with the idea that the asset will provide income in
the future or appreciate and be sold at a higher price. Mere earning will not help one to secure
the future, so it becomes important to invest.
One of the important reasons why one needs to invest wisely is to meet the cost of
Inflation. Inflation is the rate at which the cost of living increases. The cost of living is simply
what it costs to buy the goods and services you need to live. Inflation causes money to lose
value because it will not buy the same amount of a good or a service in the future as it does
now or did in the past. The sooner one starts investing the better. By investing early one
allow one’s investments more time to grow, whereby the concept of compounding increases
one’s income, by accumulating the principal and the interest or dividend earned on it, year
after year.
The dictionary meaning of investment is to commit money in order to earn a financial
return or to make use of the money for future benefits or advantages. People commit money
to investments with expectations to increase their future wealth by investing money to spend
in future years. For example, if you invest Rs. 1000 today and earn 10% over the next year,
you will have Rs.1100 one year from today.
An investment can be described as perfect if it satisfies all the needs of all investors. So,
the starting point in searching for the perfect investment would be to examine investor needs.
If all those needs are met by the investment, then that investment can be termed the perfect
investment. Most investors and advisors spend a great deal of time understanding the merits
of the thousands of investments available in India. Little time, however, is spent
understanding the needs of the investor and ensuring that the most appropriate investments
are selected for him.
Before making any investment, one must ensure to:
 Obtain written documents explaining the investment
 Read and understand such documents
 Verify the legitimacy of the investment
 Find out the costs and benefits associated with the investment
 Assess the risk-return profile of the investment
 Know the liquidity and safety aspects of the investment
 Ascertain if it is appropriate for your specific goals
 Compare these details with other investment opportunities available
 Examine if it fits in with other investments you are considering or you have already made
 Deal only through an authorized intermediary
 Seek all clarifications about the intermediary and the investment
 Explore the options available to you if something were to go wrong, and then, if satisfied,
make the investment.

1.2 INVESTMENT NEEDS OF AN INVESTOR

Investing money is a stepping stone to manage spending habits and prepare for the future
expenses. Most people recognize the need to put their money away for events or
circumstances that may occur in future. People invest money to manage their personal
finances some of them invest to plan for retirement, while others invest to accumulate
wealth. Each one has a different need and each of them expect something from their
money in future.
By and large, most investors have eight common needs from their investments:
i. Security of original capital
ii. Wealth accumulation
iii. Tax Advantages
iv. Life cover
v. Income
1.3 TYPES OF INVESTMENT AVENUES

Figure 1.1: Various investment alternatives

Figure 1.1 shows various investment alternatives which are explained below. One can
invest money in different types of Investment instruments. These instruments can be financial
or non-financial in nature. There are many factors that affect one’s choice of investment.
Millions of Indians buy fixed deposits, post office savings certificates, stocks, bonds or
mutual funds, purchase gold, silver, or make similar investments. They all have a reason for
investing their money. Some people want to supplement their retirement income when they
reach the age of 60, while others want to become millionaires before the age of 40. We will
look at various factors that affect our choice of an investment alternative, let us first
understand the basics of some of the popular investment avenues.
1.3.1 Non marketable Financial Assets: A good portion of financial assets is
represented by non-marketable financial assets. These can be classified into the following
broad categories:
 Bank Deposits: The simplest of investment avenues, by opening a bank account and
depositing money in it one can make a bank deposit. There are various kinds of bank
accounts: current account, savings account and fixed deposit account. The interest rate on
fixed deposits varies with the term of the deposit. In general, it is lower for fixed deposits
of shorter term and higher for fixed deposits of longer term. Bank deposits enjoy
exceptionally high liquidity.
 Post Office Savings Account: A post office savings account is similar to a savings bank
account. The interest rate is 6 percent per annum.
 Post Office Time Deposits (POTDs): Similar to fixed deposits of commercial banks,
POTD can be made in multiplies of 50 without any limit. The interest rates on POTDs
are, in general, slightly higher than those on bank deposits. The interest is calculated half-
yearly and paid annually.
 Monthly Income Scheme of the Post Office (MISPO): A popular scheme of the post
office, the MISPO is meant to provide regular monthly income to the depositors. The
term of the scheme is 6 years. The minimum amount of investment is 1,000. The
maximum investment can be 3, 00,000 in a single account or 6, 00,000 in a joint account.
The interest rate is 8.0 percent per annum, payable monthly. A bonus of 10 percent is
payable on maturity.
 Kisan Vikas Patra (KVP): A scheme of the post office, for which the minimum amount
of investment is 1,000. There is no maximum limit. The investment doubles in 8 years
and 7 months. Hence the compound interest rate works out to 8.4 percent. There is a
withdrawal facility after 2 ½ years.
 National Savings Certificate: Issued at the post offices, National Savings Certificate
comes in denominations of 100, 500, 1,000, 5,000 and 10,000. It has a term of 6 years.
Over this period Rs. 100 becomes Rs. 160.1. Hence the compound rate of return works
out to 8.16 percent.
 Company Deposits: Many companies, large and small, solicit fixed deposits from the
public. Fixed deposits mobilized by manufacturing companies are regulated by the
Company Law Board and fixed deposits mobilized by finance company (more precisely
non-banking finance companies) are regulated by the Reserve Bank of India. The interest
rates on company deposits are higher than those on bank fixed deposits, but so is risk.
 Employee Provident Fund Scheme : A major vehicle of savings for salaried employees,
where each employee has a separate provident fund account in which both the employer
and employee are required to contribute a certain minimum amount on a monthly basis.
 Public Provident Fund Scheme: One of the most attractive investment avenues
available in India. Individuals and HUFs can participate in this scheme. A PPF account
may be opened at any branch of State Bank of India or its subsidiaries or at specified
branches of the other public sector banks. The subscriber to a PPF account is required to
make a minimum deposit of 100 per year. The maximum permissible deposit per year is
70,000. PPF deposits currently earn a compound interest rate of 8.0 percent per annum,
which is totally exempt from taxes.

1.3.2 Bonds: Bonds are fixed income instruments which are issued for the purpose of
raising capital. Both private entities, such as companies, financial institutions, and the central
or state government and other government institutions use this instrument as a means of
garnering funds. Bonds issued by the Government carry the lowest level of risk but could
deliver fair returns. Many people invest in bonds with an objective of earning certain amount
of interest on their deposits and/or to save tax. Bonds are considered to be a less risky
investment option and are generally preferred by risk-averse investors. Bond prices are also
subject to market risk. Bonds may be classified into the following categories:
 Government securities: Debt securities issued by the central government state
government and quasi government agencies are referred as gilt edge securities. It has
maturities ranging from 3-20 years and carry interest rate that usually vary between 7 to
10 percent.
 Debentures of private sector companies: Debentures are viewed as a mixture of having
a shareholding and a fixed interest loan. Debenture holders are normally entitled to a
return equivalent to a fixed percentage of their initial investment. The security inherent
in debentures makes them a safer investment than shares.
 Preference shares: Investing in shares is safer and dividends are assured every year.
 Savings bonds

1.3.3 Mutual funds: A mutual fund allows a group of people to pool their money
together and have it professionally managed, in keeping with a predetermined investment
objective. This investment avenue is popular because of its cost-efficiency, risk-
diversification, professional management and sound regulation. There are three broad types
of mutual fund schemes classified on basis of investment objective:
 Equity schemes: The aim of growth funds is to provide capital appreciation over the
medium to long- term. Such schemes normally invest a major part of their corpus in
equities. Such funds have comparatively high risks. These schemes provide different
options to the investors like dividend option, capital appreciation, etc. and the investors
may choose an option depending on their preferences. Growth schemes are good for
investors having a long-term outlook seeking appreciation over a period of time.
 Debt schemes: The aim of income funds is to provide regular and steady income to
investors. Such schemes generally invest in fixed income securities such as bonds,
corporate debentures, Government securities and money market instruments. Such funds
are less risky compared to equity schemes. These funds are not affected because of
fluctuations in equity markets. However, opportunities of capital appreciation are also
limited in such funds. The NAVs of such funds are affected because of change in interest
rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in
the short run and vice versa. However, long term investors may not bother about these
fluctuations.
 Balanced schemes: The aim of balanced funds is to provide both growth and regular
income as such schemes invest both in equities and fixed income securities in the
proportion indicated in their offer documents. These are appropriate for investors looking
for moderate growth. They generally invest 40-60% in equity and debt instruments. These
funds are also affected because of fluctuations in share prices in the stock markets.
However, NAVs of such funds are likely to be less volatile compared to pure equity
funds.
1.3.4 Real Estate: Residential real estate is more than just an investment. There are more
ways than ever before to profit from real estate investment. Real estate is a great investment
option. It can generate an ongoing income source. It can also rise in value overtime and prove
a good investment in the cash value of the home or land. Many advisors warn against
borrowing money to purchase investments. The best way to do this is to save up and pay cash
for the home. One should be able to afford the payments on the property when the property is
vacant, otherwise the property may end up being a burden instead of helping to build wealth.
1.3.5 Equity Shares: Equities are a type of security that represents the ownership in a
company. Equities are traded (bought and sold) in stock markets. Alternatively, they can be
purchased via the Initial Public Offering (IPO) route, i.e. directly from the company.
Investing in equities is a good long-term investment option as the returns on equities over a
long time horizon are generally higher than most other investment avenues. However, along
with the possibility of greater returns comes greater risk.

1.3.6 Money market instruments: The money market is the market in which short term
funds are borrowed and lent. These instruments can be broadly classified as:
 Treasury Bills: These are the lowest risk category instruments for the short term. RBI
issues treasury bills [T-bills] at a prefixed day and for a fixed amount. There are 4 types
of treasury bills: 14-day T-bill, 91-day T-bill, 182-day T-bill and 364-day T-bill.
 Certificates of Deposits: After treasury bills, the next lowest risk category investment
option is certificate of deposit (CD) issued by banks and financial Institution (FI). A CD
is a negotiable promissory note, secure and short term, of up to a year, in nature.
Although RBI allows CDs up to one-year maturity, the maturity most quoted in the
market is for 90 days.
 Commercial Papers: Commercial papers are negotiable short-term unsecured
promissory notes with fixed maturities, issued by well-rated organizations. These are
generally sold on discount basis. Organizations can issue CPs either directly or through
banks or merchant banks. These instruments are normally issued for
30/45/60/90/120/180/270/364 days.
 Commercial Bills: Bills of exchange are negotiable instruments drawn by the seller or
drawer of the goods on the buyer or drawee of the good for the value of the goods
delivered. These are called as trade bills and when they are accepted by commercial
banks they are called as commercial bills. If the bill is payable at a future date and the
seller needs money during the currency of the bill then the seller may approach the bank
for discounting the bill.

1.3.7 Life insurance policies: Insurance is a form of risk management that is primarily used
to hedge the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk
of a loss, from one entity to another, in exchange for a premium. An insurer is a company that
sells insurance; insured or the policyholder is a person or entity buying the insurance. The
insurance rate is a factor that is used to determine the amount which is to be charged for a
certain amount of insurance coverage, and is called the premium. It can be classified as:
 Money-back Insurance: Money-back Insurance schemes are used as investment avenues
as they offer partial cash-back at certain intervals. This money can be utilized for
children’s education, marriage, etc.
 Endowment Insurance: These are term policies. Investors have to pay the premiums for
a particular term, and at maturity the accrued bonus and other benefits are returned to the
policyholder if he survives at maturity.

1.3.8 Bullion Market: Precious metals like gold and silver had been a safe haven for Indian
investors since ages. Besides jewellery these metals are used for investment purposes also.
Since last 1 year, both Gold and Silver have highly appreciated in value both in the domestic
as well as the international markets. In addition to its attributes as a store of value, the case
for investing in gold revolves around the role it can play as a portfolio diversifier.

1.3.9 Financial Derivatives: Derivatives are contracts and can be used as an underlying
asset. Various types of Derivatives are:
 Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.
 Futures: A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange traded contracts
 Options: Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before
a given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
 Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. E.g. Currency swaps, interest swaps.