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Investment
Money earned is partly spent and the rest is saved for meeting future expenses. Instead of keeping the resource(money) idle , it is used to earn a return in the future, this is called investment.
Why to invest?
To put forward in simple terms we invest in order to create wealth. While investing is relatively painless, its rewards are plentiful. To understand why investment is necessary, we need to realize what we lose when we just save and do not invest. That is because the value of the rupee decreases every year due to inflation. For example, if you ran a household within a budget of Rs.10000 in 2000, to run the same household today (assuming the same set of expenses) you would probably need Rs 15,000. This means Rs15,000 is added to your budget because of inflation. Thus we need to generate an additional Rs15,000 and that can be possible only by INVESTING your hard-earned money.
To sum up, we need to invest for the following reasons
  • To create wealth
  • Earn a return on idle resources
  • Make a provision for an uncertain future
  • Generate a specified sum of money for a specific goal in life
  • Meet the cost of inflation
When to start investing
The sooner one starts investing the better. Investing early would allow investments to grow more with time, whereby the concept of compounding increases your income, by accumulating the principal and the interest or dividend earned on it, year after year.
The three rules for all investors are
  • Invest early
  • Invest regularly
  • Invest for long term and not short term
How much money do I need to invest?
There is no statutory amount that an investor needs to invest inorder to generate adequate returns from his savings. The amount that you invest will eventually depend on factors such as:
  • Your risk profile
  • Your Time horizon
  • Savings made
Options available for investment
Physical assets like real estate, gold, commodities etc.
AND/OR
Financial assets like fixed deposits with banks, small savings instruments with post offices, insurance/provident/pension fund etc. or securities market related instruments like shares, bonds, debentures etc.
Twelve important steps to investing
  • 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
Interest
Interest is an amount charged to the borrower for the privilege of using the lender’s money. Interest is usually calculated as a percentage of the principal balance (the amount of money borrowed). The percentage rate may be fixed for the life of the loan, or it may be variable, depending on the terms of the loan.
Factors which determine the interest rates
  • Demand for money
  • Level of Government borrowings
  • Supply of money
  • Inflation rate
  • The Reserve Bank of India and the Government policies
Short term financial options available for investment
Savings bank account
is often the first banking product people use, which offers low interest (4%-5% p.a.), making them only marginally better than fixed deposits.
Money market or liquid funds
are a specialized form of mutual funds that invest in extremely short-term fixed income instruments and thereby provide easy liquidity. Money market funds are primarily oriented towards maximizing returns,protecting capital and usually yield better returns than savings accounts, but lower than bank fixed deposits.
Fixed deposits with banks
are also referred to as term deposits and minimum investment period for bank FDs is 30 days. Fixed Deposits with banks are for investors with low risk appetite, and may be considered for 6-12 months investment period as normally interest on less than 6 months bank FDs is likely to be lower than money market fund returns.
Long term financial options available for investment
Post office savings
Post Office Monthly Income Scheme is a low risk saving instrument, which can be availed through any post office. It provides an interest rate of 8% per annum, which is paid monthly. Minimum amount, which can be invested, is Rs. 1,000/- and additional investment in multiples of 1,000/-Maximum amount is Rs. 3,00,000/- (if Single) or Rs. 6,00,000/- (if held Jointly) during a year. It has a maturity period of 6 years. Premature withdrawal is permitted if deposit is more than one year old. A deduction of 5% is levied from the principal amount if withdrawn prematurely.
Public provident fund
A long term savings instrument with a maturity of 15 years and interest payable at 8% per annum compounded annually. A PPF account can be opened through a nationalized bank at anytime during the year and is open all through the year for depositing money. Tax benefits can be availed for the amount invested and interest accrued is tax-free. A withdrawal is permissible every year from the seventh financial year of the date of opening of the account and the amount of withdrawal will be limited to 50% of the balance at credit at the end of the 4th year.
Company fixed deposits
These are short-term (six months) to medium-term (three to five years) borrowings by companies at a fixed rate of interest which is payable monthly, quarterly, semiannually or annually. They can also be cumulative fixed deposits where the entire principal along with the interest is paid at the end of the loan period. The rate of interest varies between 6-9% per annum for company FDs. The interest received is after deduction of taxes.
Bonds
It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date, called the Maturity Date.
Mutual funds
These are funds operated by an investment company which raises money from the public and invests in a group of assets. It is a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints. Mutual fund units are issued and redeemed by the Fund Management Company based on the fund's net asset value (NAV), which is determined at the end of each trading session. NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are usually long term investment vehicle though there some categories of mutual funds, such as money market mutual funds which are short term instruments.
Need for capital
Companies require capital for the following purposes
  • Business Start up
  • Expansion
  • Investment in projects
  • Diversification
Sources of finance for companies
Own Capital – It is the money which the promoters or the owners of the company invest . This is internal source of financing the business.
AND/OR
External Sources- It is the money which is borrowed from the external sources like raising from banks or other financial institutions or through issue of financial instruments to the public like shares, debentures etc.
External sources for long term financing
  • Issue of Shares
  • Issue of Debentures
  • Company Fixed Deposits
  • Raising capital from Banks
  • Venture Capital
Equity / Stock
A share or stock is also known as an equity share as well. The equity share basically represents ownership in the company. When a company needs capital or money to operate, it generates the required funds by selling ownership in the company. Total equity capital of a company is divided into equal units of small denominations, each called a share. For example, in a company the total equity capital of Rs 3,00,00,000 is divided into 30,00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to have 30,00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights.
Why do companies need to issue shares to public?
Most companies are usually started privately by their promoter(s). Promoters’ capital ,borrowings from banks and financial institutions may not be sufficient for setting up or running the business over a long term. So companies invite the public to contribute towards the equity and issue shares to individual investors. A public issue is an offer to the public to subscribe to the share capital of a company. Once this is done, the company allots shares to the applicants as per the prescribed rules and regulations laid down by SEBI.
Different kinds of issues
Primarily, issues can be classified as a Public, Rights or Preferential issues (also known as private placements).
Initial public offering (IPO)
When an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuer’s securities.
A follow on public offering (further issue)
When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document.
Rights issue
When a listed company which proposes to issue fresh securities to its existing shareholders as on a record date. The rights are normally offered in a particular ratio to the number of securities held prior to the issue. This route is best suited for companies who would like to raise capital without diluting stake of its existing shareholders.
A preferential issue
An issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital. The issuer company has to comply with the Companies Act and the requirements contained in the Chapter pertaining to preferential allotment in SEBI guidelines.
Issue price
The price at which a company's shares are offered initially in the primary market is called as the Issue price. When they begin to be traded, the market price may be above or below the issue price.
Market capitalization
The market value of a quoted company, which is calculated by multiplying its current share price (market price) by the number of shares in issue is called as market capitalization. E.g. Company X has 100 million shares in issue. The current market price is Rs. 100. The market capitalization of company X is Rs. 10000 million.
Types of shares
Equity shares
An equity share, commonly referred to as ordinary share, represents the form of fractional ownership in a business venture.
Rights issue/ rights shares
The issue of new securities to existing shareholders at a ratio to those already held, at a price. For e.g. a 2:4 rights issue at Rs. 100, would entitle a shareholder to receive 2 shares for every 4 shares held at a price of Rs. 100/share.
Bonus shares
Shares issued by the companies to their shareholders free of cost based on the number of shares the shareholder owns.
Preference shares
Owners of these kind of shares are entitled to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the company’s creditors, bondholders/debenture holders.
Cumulative preference shares
A type of preference shares on which dividend accumulates if remained unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.
Cumulative convertible preference shares
A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company.
Equity investment
Why should one invest in equities?
Equities have the potential to increase in value over time. It also provides portfolio with the growth necessary to reach long term investment goals. Research studies have proved that the equities have outperformed most other forms of investments in the long term. Equities are considered the most challenging and the rewarding,when compared to other investment options. Research studies have proved that investments in some shares with a longer tenure of investment have yielded far superior returns than any other investment.
Average return on equities in India
Since 1990 till date, Indian stock market has returned about 17% to investors on an average in terms of increase in share prices or capital appreciation annually. Besides that on average stocks have paid 1.5% dividend annually. Dividend is a percentage of the face value of a share that a company returns to its shareholders from its annual profits. Compared to most other forms of investments, investing in equity shares offers the highest rate of return, if invested over a longer duration.
Factors that influence the price of a stock
Broadly there are two factors
  • Stock specific
  • Market specific
The stock-specific factor is related to people’s expectations about the company, its future earnings capacity, financial health and management, level of technology and marketing skills. The market specific factor is influenced by the investor’s sentiment towards the stock market as a whole. This factor depends on the environment rather than the performance of any particular company. Events favorable to an economy, political or regulatory environment like high economic growth, friendly budget, stable government etc. can fuel euphoria in the investors, resulting in a boom in the market. On the other hand, unfavorable events like war, economic crisis, communal riots, minority government etc. depress the market irrespective of certain companies performing well. However, the effect of market-specific factor is generally short-term. Despite ups and downs, price of a stock in the long run gets stabilized based on the stock specific factors.
Growth stock / value stock
Growth stocks
Growth Stocks are companies whose potential for growth in sales and earnings are excellent, are growing faster than other companies in the market or other stocks in the same industry. These companies usually pay little or no dividends and instead prefer to reinvest their profits in their business for further expansions.
Value stocks
Value stock companies are those which may have been beaten down in price because of some bad event, but still has assets to its name like buildings, real estate, inventories, subsidiaries, and so on. Many of these assets still have value, yet that value may not be reflected in the stock's price. Value investors look to buy stocks that are undervalued, and then hold those stocks until the rest of the market realizes the real value of the company's assets. The value investors tend to purchase a company's stock usually based on relationships between the current market price of the company and certain business fundamentals.
How can one acquire equity shares?
  • a. Primary market- IPO’s /private placements
  • b. Secondary market
Allotment in case of IPO
  • Allotment of shares is made within 15 days of the closure of the issue.
  • An investor must see the prospectus of the company that he is applying in which gives the information about the company, the project for which it is raising funds and its future potential.
BID and ASK price
The ‘Bid’ is the buyer’s price. It is this price that needs to be known when the stock has to be sold. Bid is the rate/price at which there is a ready buyer for the stock, which seller intends to sell. The ‘Ask’ is the price that needs to be known when stock has to be bought i.e. it is the rate/ price at which there is seller ready to sell his stock.
Face value of a share
The nominal or stated amount assigned to a security by the issuer is known as the face value of a share.It is the original cost of the share shown on the certificate. It is also known as par value or nominal value.For an equity share, the face value is usually a very small amount (Rs.5 or Rs.10)
Market value of a share
It is the price at which the share is traded in the stock exchange.The face value doesn’t have much bearing on the price
Secondary market
Secondary market provides a platform for buying and selling of securities that have already been issued. Stock markets (national and regional) deal in secondary market. One can invest in shares, government securities,derivative products, units of Mutual Funds through secondary market.
Portfolio
A Portfolio is a combination of different investment assets mixed and matched for the purpose of achieving an investor's goal(s). Items that are considered a part of portfolio can include any asset owned from shares, debentures, bonds, mutual fund units to items such as gold, art and even real estate etc
Diversification
It is a risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance. Diversification is possibly the best way to reduce the risk in a portfolio.
Securities
As per Securities Contract (Regulation) Act (SCRA) 1956, securities are Instruments such as shares, bonds, scrips, stocks or other marketable securities of similar nature in or any company, body corporate, government securities, derivatives of securities, units of collective investment scheme, interest and rights in securities, security receipt or any other instruments so declared by the Central Government. The stock exchange where they are dealt with is called security market.
Security market
Security market is a place where buyers and sellers of securities can enter into transactions to buy and sell shares, bonds, debentures etc. It enables corporates, entrepreneurs to raise resources for their companies and business ventures through public issues. It enables to tansfers resources from those having idle ( investors) to others who have a need for them (corporates) most efficiently. Hence, it links savings to investments through various financial products, called securities
Regulators for security market
  • Department of Economic Affairs (DEA)
  • Department of Company Affairs (DCA)
  • Reserve Bank of India (RBI)
  • Securities and Exchange Board of India (SEBI)
Issue of securities
Securities can be issued at face value, premium or discount in domestic and/or international market
SEBI
It is a regulatory authority which is established under Sec 3 of SEBI Act, 1992.
SEBI has statuary powers for
  • Protecting the interests of investors in securities
  • Promoting the development of the securities market
  • Regulating the securities market
SEBI functions
  • Regulating the business in stock exchanges and any other securities market
  • Registering and regulating the working of stock brokers, sub-brokers etc
  • Promoting and regulating self regulatory organizations
  • Prohibiting fraudulent and unfair trade practices
  • Calling for information from, undertaking inspection, conducting inquiries and audit of stock exchanges, intermediaries, self regulatory organizations, mutual funds and other persons associated with the securities market
ISSUE of securities
It can be done at face value, premium or discount. The securities may be issued in domestic and/or international market
Stock exchange
Formed under Securities Contract (Regulation) Act , 1956. It is a body of individuals constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.
Stock exchanges
  • National Stock Exchange (NSE)
  • Bombay Stock Exchange (BSE)
  • The above are the national stock exchanges where most trading is done. Other than these, there are regional exchanges.
Trading in stock exchanges
The traditional method of trading used to take place through open outcry without use of information technology for immediate recording or matching of trades. This was time consuming and inefficient. This imposed limits on trading volumes and efficiency. In order to provide efficiency, liquidity, and transparency, NSE introduced a nation wide, online fully automated screen based trading system where a member can punch into the computer the quantities of a security and the price at which he would like to transact, and the transaction is executed as soon as a matching order from the counter party is found.
Investor access to IBT
Internet based trading enables an investor to buy/sell securities through internet which can be accessed from a computer at the investor’s residence or anywhere else where the client can access the internet. Investors need to get in touch with the NSE broker providing this service to avail of the internet based trading facility.
Demutualization of exchange
It refers to the legal structure of the exchange where ownership, management and trading rights are segregated from each other. So, it doesn’t lead to conflict of interest in decision making. In India, NSE and OTCEI ( over the counter exchange of India) are demutualised
Demat account
It is mandatory for an investor to have a demat account which is managed by a depository. Hence, an investor needs to choose a SEBI registered intermediary who can give guidance regarding the formalities required to be met with.
Opening a demat account
The investor has to approach a Depository Participant and fill up an account opening form with the support proof of identity and address.
  • Proof of Identity : Photograph and Signature of investor must be authenticated by investor's bank or by an existing demat account holder.
  • Alternatively, one can submit a copy of a valid Passport, Voters Id Card, Driving License or PAN card with photograph.
  • Proof of Address : A copy of ration card or passport or voter ID or PAN card or driving license or bank passbook as proof of address.
Contract note
Contract note is a confirmation of trades done on a particular day on behalf of the client by the trading member.It is the only proof that a client has with him of the transactions that have taken place. It imposes a legally enforceable relationship between the client and the trading member with respect to purchase/sale and settlement of trades.It also helps to settle disputes/claims between the investor and the trading member.The contract note should be received from the broker within 24 hours of the transaction.
Benefits of trading through a recognized stock exchange
  • An investor doesn’t get any protection if he trades outside a stock exchange.
  • Trading at the exchange offers investors the best prices prevailing at the time in the market, lack of any counter party risk which is assumed by the clearing corporation, access to investor grievance, protection up to a prescribed limit from the investor protection fund.
Entities in trading system
Trading members
  • Trading members are members of NSE they can either trade on their behalf or their clients.
  • The exchange assigns a trading member ID to each trading member.
  • Each trading member can have more than one user
  • The number of users is notified by NSE from time to time
  • Each user of the trading member is assigned an ID by the exchange
  • This ID is common for all users of a particular trading member
Clearing members
  • Clearing members are members of NSCCL
  • They carry out risk management activities and confirmation / enquiry of trades through the trading system
Professional clearing members
  • professional clearing member is one who is not a trading member
  • Typically banks and custodians become professional clearing members and clear and settle for their trading members
Participants
  • A participant is a client of a of a trading member like financial institutions
  • They may trade through multiple trading members but settle through a single clearing member
Order types and condition
The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories:
  • Time condition
  • Price condition
  • Other condition
Time condition
  • DAY ORDER: A day order as the name suggests is valid for the day on which it is entered. If the order is not executed during the day the system automatically cancels the order.
  • IMMEDIATE OR CANCEL (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system failing which the order is canceled from the system.
Price condition
Stop Loss The facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for a stop loss buy order the trigger is Rs. 1027 the limit price is Rs. 1030 and the market price is Rs. 1023 then the order is released into the system once the market price reaches or crosses Rs. 1027
Margins
Types of margins
  • Initial Margin The amount required to be collected in order to open a position.
  • Maintenance MarginThe minimum amount of money to be kept by a broker in order to keep a position open.
  • Premium Margin An addition to the initial margin a premium margin is charged. This is required to be paid by the buyer of an option till the premium settlement is complete.
Margin call
When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor then closes his position or provides additional margin to keep his position open
Depository
Two main depositories
  • National Securities Depository Ltd (NSDL)
  • Central Depository Services Ltd (CDSL)
NSDL
  • Estd August, 1996
  • Largest Depository in India
CDSL
  • Estd Feb, 1999
Depository participant
A Depository Participant (DP) is described as an agent of the depository. They are the intermediaries between the depository and the investors. The relationship between the DPs and the depository is governed by an agreement made between the two under the Depositories Act, 1996. Legally, a DP is an entity who is registered as such with SEBI under the provisions of the SEBI Act. As per the provisions of the SEBI Act, a DP can offer depository- related services only after obtaining a certificate of registration from SEBI
Capital market intermediaries
Merchant bankers
Mandated by SEBI to overlook Public Issues (as Lead Managers) and open offers in takeovers
  • Fewer banks are allowed because the 2 activities have major implications on the integrity of the markets
Underwriting of Shares and debentures
Other Services
  • Organizing and extending finance for investment projects
  • Assistance in financial management
  • Raising euro-dollar loans
  • Issue of foreign currency bonds
Stock broker
Stock brokers are intermediaries who are allowed to trade in securities of the stock exchange they are members of. They buy and sell on their own behalf as well as on the behalf of their clients and charge a commission while trading on behalf of their clients for every transaction that the customer makes. In addition they offer research tips and advise the client on when to buy and when to sell stocks in the market. They also intimate clients as to when new offers and NFO’s come in the market to enable them to trade better in the market.
Mutual fund
Mutual funds are financial intermediaries which collect savings from a large no. of small investors and then invest these funds in a diversified portfolio (ie a collection of different stocks) to minimize the risk and maximize returns for their participants.
Profitability ratios
(i)  Gross Profit Ratio   =
  Gross Profit
  ----------------
  Net Sales
(ii)  Net Profit Ratio      =
  Net Profit
  ----------------
  Net Sales
Some of the profitability ratios related to investments are:
(iii)  Return on Total Assets  =
  Net Income
  ----------------
  Average Total Assets
(iv)  Return on capital Employed  =
  Net Profit
  ----------------
  Capital Employed
( Here, Capital Employed = Fixed Assets + Current Assets – Current Liabilities)
Return on Shareholder’s Equity  =
  Net Income After Tax
  ----------------
  Average Total Shareholder’s Equity or Net worth
(Net Worth includes shareholder’s Equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e. ,only after claims of creditors and preference shareholders are fully met, the equity shareholders receive a distribution of profits or assets on liquidation. A measure of his well being is reflected by return on equity.
There are several other measures to calculate return on shareholder’s equity:
(i) Earnings Per Share (EPS):
EPS measures the profit available to the equity shareholders per share, that is, the amount that they can get on every share held. It is calculated by dividing the profits available the profits available to the shareholders by number of outstanding shares. The profits available to the ordinary shareholders are arrived at by net profits after taxes and preference dividend.
It indicates the value of equity in the market
  EPS  =
  Net Profit
  ----------------
  Number of Ordinary Shares Outstanding
(ii)  Price-earnings ratios  =  P/E Ratio  =
  Market Price Per Share
  ----------------
  EPS
(iii) Cash Earnings Per Share (CPS/CEPS):
(iii)  CPS/CEPS  =
  Net Profit – Preference Dividend + Depreciation
  ----------------
  Number of Equity Shares

Derivatives

Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this rick, the concept of derivatives comes into the picture.
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified pric. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
In short, derivative is not an asset in itself but an agreement or a contract to transfer the real asset in future whenever exercised. The date and price of execution is mentioned in the contract as per agreement between the parties. There are varieties of derivatives available at present like futures, options and swaps; futures and options being the most common ones. They yield better returns with lower capital investment as compared to the amount that will be invested to buy the shares directly form the spot market.
It is governed by the Securities Contract Regulation Act or SCRA 1956.
Development of exchange – traded derivatives
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
The need for a derivatives market
The derivatives market performs a number of economic functions.
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse people in greater number
5. They increase savings and investment in the long run.
Holder: Holder is the buyer of derivative agreement. By buying an agreement, the buyer may agree to buy or sell the underlying asset.
Seller: One who sells the contract to holder.
Types of derivatives products
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 future contract is an agreement between two parties to buy or sell an asset a certain time in the future at a certain price. They are different from futures contract as they are standardized by the exchange .
Options
Options are of two types call and put. Call gives the buyer the right but not the obligation to buy a given quantity of the underlying asset at a future date at a pre determined price. Put give the seller the right but not an obligation to sell at a given price at a future date.
Warrants
Options generally have lives upto 1 year, majority of the options trade on the stock market have a maturity of up to 9 months. Longer traded options are called warrants and are generally traded over the counter.
Leaps
These are options having a maturity of up to 3 years.
Basket
Basket options are options on portfolios of underlying assets. The underlying asset is usually a basket of asset.
Swaps
swaps are private agreement between two parties to share cash flows in the future on the basis of a pre determined formula. The two commonly used swaps are:
1. Interest rate swaps: These entail only swapping the interest related cash flows between two parties.
2. Currency swaps: these entail swapping both the principal and the interest rate between the two parties with cash flows in one direction being in a different currency than those in the opposite direction.
Swaptions
Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
Table 1 The global derivatives industry : outstanding contracts, (in $ billion)
1995 1996 1997 1998 1999 2000
Exchange traded instruments 9283 10018 12403 139321352214302
Interest rate futures and options 8618925711221126431166912626
Currency futures and options 154171161815996
Stock index futures and options5115911021120817931580
Some OTC instruments 177132545329035803178820195199
Interest rate swaps and options165152389427211442595331658244
Currency swaps and options119715601824594847515532
Other instruments---301103013431423
Total26996354714143894249101723109501
Source: Bank for International Settlements
(OTC: Over The Counter traded instruments, discussed later.)
Factors driving the growth of financial derivatives
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets.
Table 2 Turnover in derivatives contracts traded on exchanges, (in US$ trillion)
1993 1994 1995 1996 1997 1998 1999 2000
Interest rate futures 177.3 271.9 266.4 253.6 247.8 296.6 - -
Interest rate futures and options 8618925711221126431166912626 - -
Currency futures and options 154171161815996 - -
Stock index futures and options5115911021120817931580 - -
Some OTC instruments 177132545329035803178820195199 - -
Interest rate swaps and options165152389427211442595331658244 - -
Currency swaps and options119715601824594847515532 - -
Other instruments---301103013431423 - -
Total26996354714143894249101723109501 - -
Basics of futures & options
What are futures and options?
  • A contract to make or take delivery of a product in the future, at a price set in the present
  • In formalized futures and options trading on exchanges, standardized agreements specify price, quantity, and month of delivery
  • Started in agriculture, but have expanded to a wide range of products
Futures
In futures contract the buyer and seller enter into an obligatory agreement to exercise the contract at maturity. It is not equity in a stock or commodity. It is a contract – a contract to make or take delivery of a product in the future, at a price set in the present.In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery.
Both the buyer and seller have the obligation to exercise the contract which means on maturity, seller will transfer the underlying securities and buyer will make the cash payment as per agreed price.
The buyer does not have to pay any amount for buying a futures contract because it is an enforceable agreement which will get settled on maturity date.
Example of future trading
A person bought a futures contract to buy security A at a price of Rs 500 on a specific future date. On the expiry date, the price went up to Rs 600. So the deal is good for buyer who will get the securities at Rs 100 lesser than the actual market price. On other side, it is devastating for the seller who is obliged to sell them at lower price which has been agreed upon.
Features
Future is again a contract to buy or sell an underlying of a certain qty at a certain future time at a certain price
  • Timings for trading in this product is 10.00 Am to 3.30 Pm
  • Futures can be bought in both Stock and Index.
  • In this only 3 month contracts are available (Near, Middle, Far)
  • It gives far more leverage than any product in other words you have more opportunities to earn money though immense loss cannot also be ignored
  • Like margin here also you need to keep some deposit/margin with us in order for to trade
  • Need to pay a small IM(initial margin) and keep a (MM) minimum margin
  • The contract expires on the last Thursday of every month means it wont be allowed for trading anymore from the expiry day onwards
Futures terminology
  • SPOT PRICE : The price at which an asset is traded in the spot market
  • FUTURES PRICE : The price at which a futures contract takes place in the futures market.
  • CONTRACT CYCLE: The period over which a contract trades. Contracts on NSE have a 1 month, 2 month and 3 month expiry cycles which expire on the last Thursday of the month. On the Friday following the last Thursday a new 3month expiry contract is issued.
  • EXPIRY DATE : The last date till which the contract can be executed beyond which the contract ceases to exist.
  • CONTRACT SIZE: The amount of assets that can be delivered under one contract.
  • BASIS:In the context of future basis can be defined as the difference between futures price and spot price.
  • INITIAL MARGIN: The amount that must be deposited into the margin account at the time when a futures contract is entered into is called initial margin.
  • MARKING TO MARKET: In the futures market at the end of each trading day the margin account is adjusted to see the days gain or loss depending on the futures closing price this is called marking to margin.
  • SQUARE OFF:Taking an opposite or close position of the initial position.
  • OPEN POSITIONS:The position is open and has not been squared off.
  • LIMIT:The purchasing power in each product. In other words how much you have allocated in that particular product for trading purpose.
  • LTP :It is the last traded price of the contract
  • MAINTAINENCE MARGIN:This is somewhat lower than the initial margin this is to ensure that the balance in the margin account never becomes negative. If the margin account falls below the maintenance margin then the investor receives a margin call and is expected to top up the A/c till the initial margin before the trading begins the next day.
Options
In options contract the buyer is given an option to decide whether or not he wants to exercise the contract at maturity.
Buyer of the contract has the option to exercise it anytime on or before expiry but seller has the obligation to exercise it. If buyer demands to buy the asset, seller will have to sell it.
Options are two types
  • CALL
  • PUT
Call option
It gives the buyer, the right to buy the asset at a strike price. A call option is an option to buy a stock at a specific price on or before a Certain date. The seller or writer however has the obligation to sell the asset if the buyer of the call option decides to exercise his option to buy.
Put Option
It gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Put options are options to sell a stock at a specific price on or before a certain date.The seller or writer however has the obligation to buy the asset if the buyer of the put Option decides to exercise his option to sell. These are like insurance policies. If you buy a new car and they auto insurance on the car, you pay a premium and are hence, protected if the asset is damaged in an accident. If this happens you use your policy to regain the value of the asset. So put options gains in value if the value of the asset decreases. With put option, you can insure a stock by fixing a selling price. If something happens which causes the asset price to fall and thus get damaged, you can exercise your option and sell it at its insured price level.
The buyer has to pay an amount called as Premium for acquiring an additional right of having an option to exercise the contract or not.
Example of option trading
A person bought a call option at a strike price of Rs 100. On maturity the price falls to Rs 80. He will not exercise the contract because he can buy the same asset from the market at Rs 80. However if price rises, he will exercise the contract. Similarly, a person bought a put option at a strike price of Rs 100. On maturity the price shoots up to Rs 150. He will not exercise the contract because he can sell the same asset in the market at Rs 150, rather than giving it to the seller at agreed upon price of Rs 100.
Options terminology
  • INDEX OPTION: Options which have index as the underlying.
  • STOCK OPTION: stock option are option on individual stocks. The contract gives the holder the right to buy or sell the stocks at a specified price.
  • BUYER OF AN OPTION: The buyer of the option is one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
  • WRITER OF AN OPTION: The writer of a call or put option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
  • CALL OPTION: This gives the holder the right to buy but not an obligation to buy a certain asset at a certain time at a certain price.
  • PUT OPTION: This gives the holder a right but not an obligation to sell at a fixed price at a future date.
  • OPTION PRICE/ PREMIUM: The price that the option buyer pays the option seller.
  • STRIKE PRICE: The price specified in the options contract is the strike price or the exercise price.
  • AMERICAN OPTIONS: Options that can be exercised any time up to the expiry date.
  • EUROPEAN OPTIONS: European options are options that can be exercised at the expiry date only.
  • ITM (In the Money) OPTION:An ITM option is one that would lead to positive cash flows to the holder if it were exercised immediately. A call option on the index is said to be ITM if Strike price < Spot price. A put option is said to be ITM if the Strike price > Spot price.
  • AT THE MONEY (ATM) OPTION: The option that would lead to zero cash flows if exercised immediately.
  • i.e. spot price = strike price
  • OUT OF MONEY (OTM) OPTION : An option that would lead to –ve cash flows if exercised immediately.
  • COST OF CARRY: The relationship between futures price and spot price can be summarized as what is known as cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on it.
Option payoffs
  • Payoff profile for buyer of a call option:
  • The profit or loss he makes depends on the spot price of the underlying. If upon expiration the spot price exceeds the strike price he makes a profit. If the strike price is more than the spot price he makes a loss to the amount of premium he has paid.
  • Payoff profile of a writer of the call option:
  • For selling an option the writer of the option charges a premium. If spot price exceeds the strike price the writer starts making losses whereas if the spot price is less than the strike price the option is not exercised and the writer gets a profit of the amount of premium.
  • Payoff profile of the buyer of put option :
  • If the spot price is below the strike price he makes a profit. If the spot price is more than the strike price he leaves his option unexercised and his loss is the amount of premium he has paid.
  • Payoff profile of a writer of put options:
  • By selling the option the writer of the option gets a premium. The profit or loss that the buyer makes depends on the spot price of the underlying. Whatever is the buyers loss is the sellers gain.
Why do futures and options markets exist?
  • Risk Transfer
  • Price Discovery
Professionals such as grain merchants, energy firms and portfolio managers use futures and options to reduce the risk to their business associated with volatile prices. For example, a flour miller might use a futures contract to set a price now for wheat that he knows he will need to purchase in the future, rather than face the chance that prices could be even higher when he buys the wheat. Similarly, a natural gas producer might use a futures contract to set a price now for gas he will sell in the future, locking in a profit rather than being exposed to the possibility of lower prices. These types of futures and options users are known as hedgers, and are in the market specifically to reduce risk.People who assume risk take it on in exchange for the opportunity for profit. Thus the futures and options markets serve the important function of risk transfer.
Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.
How does trading futures and options work?
Similar to stocks, gains and losses are the result of price changes
An added economic benefit of using futures and options markets for many investors is lowered transaction costs. Similar to stocks, gains and losses in futures trading are the result of price changes. If you have sold a futures contract, your trade will show a profit if prices fall. If you have bought, higher prices will produce a profit. To make a profit on a futures trade you can first buy low and then sell high, or reverse the order and sell high, then buy low.
  • Futures can be highly leveraged
  • Options risks differ depending on position
It is important to understand futures may be highly leveraged. This means that if the price moves in the direction you anticipated you could realize large profits in relation to your initial investment. Conversely, if prices move in the opposite direction of what you anticipated, you could realize large losses in relation to your initial investment.
Options on futures are different from futures themselves in that the most a buyer can lose is the cost of purchasing the option, known as the premium, along with transaction costs. An option seller, however, has unlimited risk.
  • A number of factors to consider including account type, trading style
  • Traded through a registered broker
Commodity Derivatives
Futures contracts in pepper, turmeric,gur(jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best effected using warehouse receipts(which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India(COFEI) has operated as system of warehouse receipts since 1998.
Exchange-traded vs.OTC(Over The Counter) derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the later. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded derivatives
  • The management of counter-party (credit) risk is decentralized and located within individual institutions,
  • There are no formal centralized limits on individual positions, leverage, or margining,
  • There are no formal rules for risk and burden-sharing,
  • There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants,and
  • 5. The OTC contracts are generally not regulated by a gegulatory authority and the exchange's self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
Paricipants in derivatives market
  • Hedgers :Face risk associated with the price of an asset.
  • Speculators :People who wish to bet on the future price movements.
  • Arbitrageurs :Take advantage of the price discrepancy between two markets.
Hedging
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks.
In financial markets,hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another. Technically, to hedge you would invest in two securities with negative correlations.
Hedging cannot help to escape the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. Hedging is a technique not to make money but to reduce potential loss. If the investment hedged against makes money, then the profit would be reduced but if the investment loses money and the hedge is successful, it will reduce the loss.
Speculation
Speculation usually involves making assumptions that a particular stock price is going to change.
  • Investors enter into a trade with the intention of ending it in the same settlement cycle;
  • When they use the existing mechanisms of lending and borrowing to carry-forward their obligations to subsequent settlements.
  • Having described it thus, it may be mentioned that speculation through borrowing and lending mechanisms is present in most markets.
Anything can lead to speculation. It can be based on some news or some global reaction. If a company reports consistent growth in net sales the stock price will be worth more and market reaction can drive it more. People may not know each and every product being sold but a close study of a company can give an estimate of where the companies sales are headed. The share value can increase or decrease on a given day due to thousands of reasons.
Why is it present?
Speculation exists because it enhances the functioning of the stock market. The market for stocks itself exists because different people have different views on the same stock. To explain, if all investors had the same view on every company, then everybody would want to buy at the same time or conversely, sell at the same time. The implication is that a market cannot exist because there is simply no one with a different view.
Unlike bank deposits, investing in stocks is, relatively, a risky business. There can be short, sharp fluctuations that result in big gains or losses. One way of looking at speculators is that they are a class of investors who are willing to take more risks on an average. And the thumb rule is that greater the variety (categories of investors), greater the likelihood of trades taking place.
Importance of volume in a market
The biggest advantage of speculation is that it increases the volume of the stocks traded. And volume is absolutely essential in creating a marketplace that functions smoothly.
Higher volume means that investors can enter and exit any moment. Equities are more actively traded than corporate debt in India, thus, providing investors with a handy investment avenue that yield cash at short notice.
Volume also plays an important role in price formation. If there arises a sudden huge sale in any market, the prices will crash. In a stock market that sees sporadic trades, orders for slightly bigger quantities will create huge swings in price. Thus, the price formation will be jerky.
On the other hand, when the market is liquid in terms of frequent trades taking place, the change in price is relatively smooth. Even if big orders come in, the depth in market results in relatively smooth changes taking place.
The downsides
The biggest fear with speculation is that it can accentuate sharp movements. By definition, speculators are the ones who are willing to take bigger risks and are also likely to be first to panic in case of adverse developments.
Arbitraging
"Arbitrage" trading is simply the trading of securities when the opportunity exists during the trading day, to take advantage of differences in value between the markets the trades are made within. Arbitrage trading takes place all day long on most days that the markets are active.
Arbritrage is legally allowed. In fact arbitrage is responsible for a large part of the daily volumes on the NSE & BSE exchanges. What mainly takes place in India is called Market Arbitrage. Market Arbitrage involves purchasing and selling the same security at the same time in different markets (BSE & NSE) to take advantage of a price difference between the two separate markets. In perfect securities markets there would never be any arbitrage traders or trades. Since the securities markets are not perfect when news or other information moves a security or index they can and often do become unequal in price temporally. If the markets were perfect all identical securities would trade at the same value or price on each market they were traded on.A market arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets.
Here is a simple example
Suppose you own 500 shares of RPL. One trading day you notice that RPL is trading at 150 on the BSE and 140 on the NSE. You sell your 600 shares on the BSE at 150 and simultaneously buy back the 600 shares on the NSE at 145.
You profit in this case is 500*10.00 = 5000.00 less brokerages if any.
One of the most popular Arbitrage trading opportunities is played with the S&P futures and the S&P 500 stocks. During most trading days these two will develop disparity in the pricing between the two of them. This happens when the price of the stocks which are mostly traded on the NYSE and NASDAQ markets either get ahead or behind the S&P Futures which are traded in the CME market. Lets say the stocks get ahead of the futures in price. Arbitrage traders will sell the stock and buy the futures. They end up with the same or closely related investment but have just made money by taking the difference in the prices from the two separate markets.

Commodity

A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is a physical substance, such as food, grains, and metals, which is interchangeable with another product of the same type, and which investors buy or sell, usually through futures contracts. The price of the commodity is subject to supply and demand. Risk is actually the reason exchange trading of the basic agricultural products began. Commodities are often substances that come out of the earth and maintain roughly a universal price. A commodity is fungible, that is, equivalent no matter who produces it.
In the broadest sense, a commodity is anything that has value, from watches to time to oranges. In a more specific market sense, however, a commodity is an item which is roughly the same market value across the board, with no difference based on quality.
The mainstream commodity market can be split into a number of different markets: precious metals, industrial metals, livestock, agricultural products, energy, and some commodities that don’t easily fall into a classification. Precious metals include gold, silver, platinum, and palladium. Industrial metals include aluminum, aluminum alloy, nickel, lead, zinc, tin, recycled steel, and copper. Livestock includes live cattle, feeder cattle, pork bellies, and lean hogs. Agricultural products include soybeans, soybean oil, soybean meal, wheat, cotton number two, sugar numbers eleven and fourteen, wheat, corn, oats, rice, cocoa, and coffee. Energy includes ethanol, heating oil, propane, natural gas, WTI crude oil, Brent crude oil, Gulf Coast gasoline, RBOB gasoline, and uranium. The commodity market also includes rubber, wool, polypropylene, polyethylene, and palm oil.
Commodity derivatives market
commodity derivatives trade contracts for which the underlying assets is a commodity like, wheat, soyabean, cotton etc or precious metal like Gold and Silver. The commodity derivatives differ from the financial derivatives mainly in the following two aspects: Firstly, due to the bulky nature of the Underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Secondly, in the case of commodities, the quality of the asset underlying a contract can vary largely.
Commodity market in India
India has a long history of future trading in commodities. In India, trading in Commodity future has been existence from the 19th Century with organised trading in Cotton, through the establishment at Bombay Cotton Association Ltd. in 1875. Over a period of time, other commodities were permitted to be traded in future exchanges. Spot trading in India occurs mostly in regional mandis and unorganized market, which are fragmented and isolated.
There were booming activities in this market at one time as many as 100 Unorganized exchanges were conducting forward trade in various commodities. The securities market was a poor competitor of this market as there were not many papers to be traded at that time.
However, many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying commodities. As a result, after independence, commodity option trading and cash settlement of commodity future were banned in 1952.
A further blow come in 1960’s when following several years of several droughts has forced many farmers to default on forward contact and even caused some suicides, forward trading was banned in many commodities considered primary or essential. Consequently, the commodities derivatives market dismantled and remained dormant for about four decades until the new millennium when the Govt. in a complete change in policy, started actively encouraging the commodity derivatives market.
The year 2003 marked the real turning point in the policy frame work for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets of the country is total GDP, commodities related and dependent industries constitute about roughly 50-60% which itself cannot be ignored.
Why are commodity derivatives required:
India is among the top 5 producer of the most of the commodities in addition to being a major consumer of bullion and energy products. Agriculture contributes more than 23% to be GDP of Indian economy. It employees around 57% of the labour force on a total of 185 million hectares of land. Agriculture sector is an important factor to achieving a GDP growth of 8.10. All this indicates that India can be promoted as a major centre for trading of commodity derivatives.
It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibilities of adverse price change in future creates risk for business. Derivatives are used to reduce or eliminate price risk arising from unforeseen price change. A derivatives is a financial contract whose price depends on, or is derived from the price of another assets.
Two important derivatives are future and options
1. Commodity Future Contract:

A future contract is an agreement for buying or selling a commodity for a predetermined delivery price at a specific future time. Futures are standardized contract that are traded on organized facture exchanges that ensure performance of the contract and remove the default risk. The commodity futures have existed since the Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together the major function of future market is toe transfer price risk from hedger to speculators. For example suppose a farmer who is expecting the crop of wheat to be ready in three months time, but is worried that the price of wheat may decline in this period, in order to minimize his risk, he can enter into a future contract to sell his crop in three months time at a price determined now.
Just take an another example. All we know that woolen garments demand picks up in winter season. A garment factory owner can by a factory contract of cotton to get the raw material for his products as predetermined price. This way both time is able to hedge their risk arising from a possible adverse change in the price of theirs commodity or raw material.


2. Commodity Option Contract:

Like futures, option are also financial instruments used for hedging and speculation. The commodity option holder has the right, but not the obligation to buy (or sell) a specified quantity of a commodity at specified price on or before a specified date. Option contract involve two parties – the seller of the option writes the option in favour of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options. A ‘call’ option gives the holder a right to buy a commodity at an agreed price, while a ‘put’ option gives the holder a right to sell a commodity at an agreed price on or before a specified date which is called expiry date.
The option holder will exercise the option only if it is beneficial to him, otherwise he will let the option lapse. Suppose a farmer buys a put option to sell 10 MT of wheat of Rs. 13000/- MT and pays a ‘premium’ of Rs. 500/- MT. If the price wheat decline, to say Rs. 1000/- MT before expiry, the farmer will the exercise his option and sell his wheat at the agreed price of Rs. 1300/- MT. However, if the market price of wheat increases by Rs. 1000/-MT, it will be better for the farmer to sell it directly in the open market at the spot price, rather than his option to sell at Rs. 13000/- MT.
Future and options trading therefore helps in hedging the price risk and also provide investment opportunity to speculators who are willing to assume risk for a possible return. Future trading and the ensuing discovery of price can help farmers to deciding which crops to grow.
Thus future and options market perform important functions that cannot be ignored in modern business environment. At the same time, it is true that too much speculative activity in essential commodities would destabilize the markets and therefore, these markets are normally regulated as per the law of the country. Commodity Options trading is not permitted in India till now.

Modern commodity exchange
To make up the loss of growth and development during the four decades of restrictive Govt. policies, FMC and the government encouraged setting up commodity exchanges using the most modern system and practices in the world. Some of the main regulatory measures imposed in the FMC include daily market to market system of margins, creation of trade guarantee fund, back office computerization for the existing single commodity exchanges , online trading for the new exchanges, demutualization for the new exchanges and one third representation of independent Directions the Board of existing Exchanges etc.
National Level Commodity Exchanges in India are:-
  • NMCE : National Multi Commodity Exchange of India.
  • NCDEX : National Commodity Derivatives Exchange Ltd.
  • MCX : Multi Commodity Exchange of India Ltd.
  • NSEL : National Stock Exchange Ltd.
NMCE : (National Multi Commodity Exchange of India Ltd
It is the first demutualised electronic commodity exchange of India granted the National exchange on Govt. of India and operational since 26th Nov, 2002. The Head Office of NMCE is located in Ahmadabad. There are various commodity trades on NMCE Platform including Agro and non-agro commodities.
NCDEX (National Commodity & Derivates Exchange Ltd
NCDEX is a public limited co. incorporated on April 2003 under the Companies Act 1956, It obtained its certificate for commencement of Business on May 9, 2003. It commenced its operational on Dec 15, 2003. NCDEX is located in Mumbai and currently facilitates trading in 57 commodity mainly in Agro product.
NSEL (National Spot Exchange Limited)
National Spot Exchange Limited (NSEL) is a National level Institutionalized, Electronic, Transparent Spot trading platform which commenced its live operations on 15th Oct, 2008. At present NSEL is operational in 13 states, providing delivery based spot trading of 26 commodities.
MCX Multi Commodity Exchange of India Ltd
Headquartered in Mumbai, the exchange started operation in Nov, 2003. MCX is a demutalised nation wide electronic commodity future exchange. Set up by Financial Technologies (India) Ltd. permanent recognition from government of India for facilitating online trading, clearing and settlement operations for future market across the country. MCX is well known for bullion and metal trading platform.
MCX offers futures trading in
MetalAluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long (Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin, Zinc
BULLIONGold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver
FIBERCotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn, Kapas
ENERGYBrent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil
SPICESCardamom, Jeera, Pepper, Red Chilli
PLANTATIONSArecanut, Cashew Kernel, Coffee (Robusta), Rubber
PULSESChana, Masur, Yellow Peas
PETROCHEMICALSHDPE, Polypropylene(PP), PVC
OIL & OIL SEEDSCastor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed, Crude Palm Oil, Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard Seed (Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame Seed, Soymeal, Soy Bean, Soy Seeds
CEREALSMaize
OTHERSGuargum, Guar Seed, Gurchaku, Mentha Oil, Potato (Agra), Potato (Tarkeshwar), Sugar M
Regulator of commodity exchanges:
FMCL (Forward Market commission) headquarted in Mumbai, is regulation authority which is overseen by the minister of consumer affairs, food and public distribution Govt. of India, It is a statutory body set up in 1953 under the forward contract (Regulation) Act 1952.
Needs for future trading in commodities:
Commodity futures, which terms an essential component of commodity exchanges, can be broadly classified into precious metals, agriculture, energy and other metals. Current future volumes are miniscule compared to underlying spot market volumes and thus have a tremendous potential in the near future. Future trading in commodities result in transparent and fair price discovery. It reflects videos and expectations of wider section of people related to a particular commodity. It provides effective platform for price risk management for all segment of players ranging from producers, trades and processors of a commodity. It aids in improving the cropping platform for farmers, thus mimizing the losses to the farmers. It also acts as a smart investment choice in providing hedging, trading and arbitrage opportunities to market players. Historically, pricing, in Commodities future has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option. Raw Materials form the most key element of industries. The significance of raw materials can further be strengthened by the fact that the increase in raw material cost means reduction in share prices. Industry in India a today runs the raw material price risk. Hence going forward the industry can hedge this risk by trading in commodities market.
Risk associated with commodities market:
No risk can be eliminated, but the same can be transferred to someone who can handle it better or to someone who has the appetite for risk. Commodity enterprises primarily face the following classes of risk. Namely: The price Risk, the quantity risk, the yield/output risk and the political risk, talking about the nationwide commodity exchanges, the risk of the counter party not fulfilling his obligations on due date or at any time therefore is the most common risk.
This risk is mitigated by collection of the following margins:-
  • Initial margins
  • Exposure margins
  • Mark to Market on daily positions.
  • Surveillance.
Key factors for success of commodities market:
The following are source of the key factors for the success of the commodities market:
  • How can one make the business grow
  • How many products are covered
  • How many people participate in the Platform.
Key factors for success of commodity exchanges:
Strategy, method of execution, background of promoters, credibility of the institution, transparency of platforms, scaleable technology, robustness of settlement structure, wider participation of Hedgers, speculators and arbitragers, acceptable clearing mechanism, financial soundness and capability, covering a wide range of commodity, reach of the organization and adding value to the ground.
Basic terminologies in commodities
Arbitrage: The simultaneous purchase and sale of similar commodities in different markets to take advantage of a perceived price discrepancy.
Basis: The difference between the current cash price and the futures price of the same commodity for a given contract month.
Bear Market: A period of declining market prices.
Bull Market: A period of rising market prices.
Broker: A company or individual that executes futures and options orders on behalf of financial and commercial institutions and/or the general public.
Call Option: An option that gives the buyer the right, but not the obligation, to purchase (go "long") the underlying futures contract at the strike price on or before the expiration date of the option.
Cash (Spot) Market: A place where people buy and sell the actual (cash) commodities, i.e., grain elevator, livestock market, etc.
Commission (Brokerage) Fee: A fee charged by a broker for executing a transaction.
Convergence: A term referring to cash and futures prices tending to come together as the futures contract nears expiration.
Cross-hedging: Hedging a commodity using a different but related futures contract when there is no futures contract for the cash commodity being hedged and the cash and futures markets follow similar price trends
Daily Trading Limit: The maximum price change set by the exchange each day for a contract.
Day Traders: Speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.
Delivery: The transfer of the cash commodity from the seller of a futures contract to the buyer of a futures contract.
Forward (Cash) Contract: A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer at a specific time in the future
Fundamental Analysis: A method of anticipating future price movement using supply and demand information.
Futures Contract: A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument sometime in the future. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price, which is determined on an exchange trading floor.
Hedger: An individual or company owning or planning to own a cash commodity - corn, soybeans, wheat, etc. and concerned that the costs of the commodity may change before they intend to either buy or sell it in the cash market. A hedger achieves protection against changing cash prices by purchasing (selling) futures contracts of the same or similar commodity and later offsetting that position by selling (purchasing) futures contracts of the same quantity and type as the initial transaction and at the same time as the cash transaction occurs.
Hedging: The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes.
Margin: Margin is the percentage amount required by the exchange from the trading member for carrying out trading activities in the particular contract. The member in turn collects the margin from the client entering into trade in that contract. Though the margin amount as a whole is more significant, it can be broken into 4 kinds of margin:
  • Initial Margin
  • Exposure Margin
  • Additional Margin
  • Special Margin
Initial Margin: The amount a futures market participant must deposit into his/her margin account at the time he/she places an order to buy or sell a futures contract.
In-the-Money Option: An option having intrinsic value. A call option is in-the-money if its strike price is below the current price of the underlying futures contract. A put option is in-the-money if its strike price is above the current price of the underlying futures contract.
Intrinsic Value: The difference between the strike price and the underlying futures price for an option that is in-the-money.
Liquidate: Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract.
Long: One who has bought futures contracts or plans to own a cash commodity.
Lot Size: There are generally 2 kind of lots associated with commodity futures
Trading lot
It is the lot size in which trading activities are carried out. It means that the minimum quantity in which trading would be conducted for any particular contract of a commodity. Eg. With lot size of Crude Oil being 100 barrels, any trader / investor would have to buy / sell a minimum of 100 barrels of crude oil on the trading platform. No fractions are allowed to trade on the exchanges and the trading is carried out in multiples of lot size only.
Delivery lot
It is the minimum size for conducting delivery in the particular commodity. It can differ from the trading lot but would be always in the multiples of the trading lot. It can’t be smaller than trading lot as the delivery would not be possible in that case. Generally, the delivery lot is decided on the basis of the standards of the delivery procedure carried out in spot markets.
Maintenance Margin: A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account.
Nearby (Delivery) Month: The futures contract month closest to expiration. Also referred to as spot month.
Open Interest: The total number of futures or options contracts of a given commodity that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each option transaction has a buyer and a seller, but for calculation of open interest only one side of the contract is counted.
Option: A contract that conveys the right, but not the obligation, to buy or sell a futures contract at a certain price for a specified time period. Only the seller (writer) of the option is obligated to perform.
Option Premium: The price of an option-the sum of money that the option buyer pays and the option seller receives for the rights granted by the option.
Out-of-the-Money Option: An option with no intrinsic value, i.e., a call whose strike price is above the current futures price or a put whose strike price is below the current futures price.
Purchasing Hedge (long hedge): Buying futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased.
Put Option: An option that gives the option buyer the right but not the obligation to sell (go short) the underlying futures contract at the strike price on or before the expiration date of the option.
Price Limit: Price Limit is put into the place by the Exchanges on directives from FMC, the regulatory body, to keep a check on extreme price movements within a single trading session.
A price limit is defined for each commodity in percentage terms which is calculated from the previous close of the contract. If the prices hit the circuit limit on either side, the trading is halted for 15 minutes, which is often termed as cooling period. Then the trading limit gets relaxed for another 50% of the initial limit specified and margin on the contract gets increased. The revised limit is the maximum price on the higher / lower side at which trading can take place.
Different commodities have different price limits. Same commodity might be having different price limits on different exchanges but different contracts of same commodity can’t have varying price limits (in percentage terms) on same exchange
Selling Hedge (short hedge): Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold.
Short Position: One who has sold futures contracts or plans to sell a cash commodity. Selling futures contracts or initiating a cash forward contract sale without offsetting a particular market position.
Speculator: A market participant who tries to profit from buying and selling futures and option contracts by anticipating future price movements. Speculators assume market price risk and add liquidity and capital to the futures markets. They do not hold equal and opposite cash market risks.
Spread: The price difference between two related markets or commodities. For example, the April-August live cattle spread.
Strike Price: The price at which the futures contract underlying a call or put option can be purchased (call) or sold (put). Also called exercise price.
Symbol: Exchange provides symbol to each commodity traded on its platform. These symbols are unique within the exchange.
Symbols on MCX are quite simple and easy to identify as the name is the symbol in most cases. Eg. Gold is written as 'GOLD', Silver as 'SILVER', Copper as 'COPPER' and Crude Oil as 'CRUDEOIL'
On the other hand, NCDEX has a different method of allotting symbols. Each symbol carries alphabets from the following:
  • Name of the commodity
  • Quality of the commodity
  • Delivery centre
Technical Analysis: Anticipating future price movements using historical prices, trading volume, open interest, and other trading data to study price patterns.
Time Value: The amount of money option buyers are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option's intrinsic value can be considered time value.
Tick Size: Tick size is the minimum price movement permissible for the particular contract. It means that the minimum price fluctuation (if any) in a commodity would be the tick size. Eg. Tick Size for Wheat at NCDEX is Rs. 0.20 which means that if the wheat is quoting at Rs. 850, then the next price on the higher side should be minimum Rs. 850.2. It cannot be Rs. 850.10.
Underlying Futures Contract: The specific futures contract that can be bought or sold by exercising an option.
Volatility: A measurement of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
Volume: The number of purchases or sales of a commodity futures contract made during a specified period of time, often the total transactions for one trading day.

Currency

Currency market basics: how the global currency markets work
The currency market is the largest and most liquid financial market in the world, but also one of the least known. Currencies like the U.S. dollar, the euro and the yen trade in the foreign exchange (FX) market 24 hours a day across national borders.
Overview of the global currency markets
Currency in its simplest form describes the money or official means of payment in a country or region. The best known currencies include the U.S. dollar, euro, yen, British pound and Swiss franc. A commonly used currency symbol exists for many currencies, for example $, £ or €. FX markets, however, use so called ISO codes, for example USD for U.S. dollar, GBP for the British pound and EUR for the euro.
Every day more than U.S. $3 trillion in currencies change hands in a highly professional interbank market, in which electronic trading platforms link currency traders from banks across the world directly. FX markets are effectively open 24 hours a day thanks to global cooperation among currency traders. At the end of each business day in Asia, traders pass their open currency positions on to their colleagues in Europe, who – at the end of their business day – pass their open positions on to American traders, who just begin their working day and pass positions on to Asia at the end of their business day. And there, the circle begins anew. This makes FX truly global and very liquid.
Around the turn of the century, trading volumes increased dramatically, as Chart 1 shows. The Bank for International Settlement (BIS) identified several factors responsible for the increase in currency trading at the time. First, higher volatility and clear trends in FX markets made currency a potentially attractive investment. Second, interest rate differentials between countries were prompting market participants to exploit these differentials with different strategies. The most famous of these strategies has become the Carry trade, which we will explain in more detail later. Third, the global search for yield was boosting interest in FX as an alternative to stocks and bonds.
Exchange rate
The exchange rate is a price - the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency.
A list of factors which determine currency value
What determines the value of a countries currency really comes down to supply and demand of that currency. If a particular country’s currency is in high demand by purchasers such as travelers, governments, and investors, it will increase the value of that country’s currency. The factors that follow may have a positive or negative effect on the demand for a particular currency.
1) Printing of currency
If a country prints an excessive amount of currency, more then what it normally would, this can decrease the value of the currency. A large amount of currency in circulation can lower the value of a currency. A small amount of currency in circulation can result in the value of the currency increasing.
2) Current state of the economy
If a country’s economy is not doing well, this can decrease the demand for that countries currency. Specifically, here we are talking about the degree of unemployment, degree of consumer spending, and extent of business expansion that is taking place in a country. High unemployment, decrease consumer spending, with a decrease in business expansion, means a poor economy and a decrease in currency value.
The potential for economic growth in a country should also be looked at. If the potential is strong, then it's currency value would expect to increase. Also, if a country produces products that other countries want to buy, it can increase the value of that country’s currency.
3) Prices of foreign goods
Prices of foreign goods is related to the economy. If a foreign company sells goods in a country which are cheaper then comparable products produced in that country, it can hurt the economy of that country. A poor economy results in a decrease in demand for that country’s currency, which lowers its value.
4) Political conditions of a country
A country which is known to have corrupt politicians, can result in a lowering of the value of its currency
5) How secretive is a country
A country which operates at a high level of secrecy, atleast as observed by those outside the country, can result in a lowering of the value of their currency.
6) National debt of a country
In a democratic society, national debt must be paid by the taxpayer. If taxes increase, this results in a lowering of the purchasing capability of society, which results in a deleterious effect on the economy. In this case, currency value will decrease.
7) Presidents popularity
If a president is popular, this can increase the demand for a currency. If the president’s popularity is dropping, due to unpopular government policies, this may result in a decrease in demand for a currency and a subsequent lowering of its value.
8) War and terrorists attacks
A terrorists attack can increase the probability of a war. A war or the strong potential for a war can decrease the demand for a currency, simply because a war drains the economy. Wars are expensive and must be paid by the taxpayer. So war lowers the value of a currency.
9) Government growth
Excess government growth can lower the value of a countries currency. Again, the taxpayer will need to pay for the new growth, which for the long run has a negative effect on the economy.
10) Tax cuts for the consumer
Tax cuts can stimulate the economy, as long as the consumer spends the extra money he or she may have. But also, tax cuts which are to large can result in high demand for products, which may raise prices, which can lead to inflation and the desire to purchase cheaper foreign products. But in general, tax cuts historically have been good for the economy, which can result in an increase demand for that countries currency.
11) Interest rates
A higher interest rate means a higher demand for a currency. Foreign investors in a currency prefer a higher interest. This increase in demand for a currency results in an increase in its value.
12) Housing market
If there is a slowing of a housing market, it means that the seller’s asking price will be less, resulting in less consumer spending. This has a negative effect on the economy. Again, poor economic conditions result in a lower demand for the currency, thereby lowering its value.
13) Positive or negative perception
How purchasers of a currency perceive the previous discussed parameters, can determine the degree of demand for a currency. Whether or not the perception is accurate is not as important as what the perception itself is. Perception is what determines if a currency purchaser decides to buy or sell a currency.
To conclude, the factors presented here are determinants of the degree of demand on a currency, and therefore its value. There are other factors such as manufacturing growth, degree of entrepreneurship in a country, employment growth, and even the weather and its effect on the agricultural industry, energy consumption, and local economies. These also can determine the demand for a currency. The factors listed here determine the perception that a potential buyer of currency may have. How a potential buyer of a currency looks at a particular country using these parameters, will determine the demand on the currency, and ultimately its value.
Economic variables which affect foreign exchange market
Interest rates, inflation, and GDP numbers are the main variables; however other economic indicators such as unemployment rate, bop, trade deficit, fiscal deficit, manufacturing indices, consumer prices and retail sales amongst others.
News and information regarding a country's economy can have a direct impact on the direction that the country's currency is heading in much the same way that current events and financial news affect stock prices, hence the importance of economic factors. The following eight economic factors will directly affect a currency's movements in the Forex market.
Interest rates, inflation, and GDP numbers are the main variables; however other economic indicators such as unemployment rate, bop, trade deficit, fiscal deficit, manufacturing indices, consumer prices and retail sales amongst others.
News and information regarding a country's economy can have a direct impact on the direction that the country's currency is heading in much the same way that current events and financial news affect stock prices, hence the importance of economic factors. The following eight economic factors will directly affect a currency's movements in the Forex market.

Factor 1 - employment data
Strong decreases in employment indicate a contracting economy, while strong increases are perceived indicators of a prosperous economy.

Factor 2 - interest rates
This is always a major focus in the forex market. Since the central banks mandate monetary policy and supply, they are the prime focus of investors and the various market participants.

Factor 3 – inflation
This is the measure of increases or decreases in pricing levels over a period of time. Due to the immense number of goods and services available in a country, usually a grouping of these goods and services are used to measure changes in the pricing. Increases in pricing indicate an increase in the inflation rate which in turn can devalue that country's currency.

Factor 4 - gross domestic product
is the measurement for goods and services that were finished over a period of time. The GDP is broken down into 4 categories:

  • Business spending
  • Government spending
  • Private consumption
  • Total net exports

Factor 5 - retail sales
The measurement of sales recorded by retailers over a period of time is a reflection of either increased or decreased consumer spending, depending on whether sales are up or down for the comparative period a year ago. This indicator gives market participants an idea as to how strong or weak the economy is.

Factor 6 - durable goods
Goods that have a lifespan of three or more years are considered durable goods and they are measured in quantities that are ordered, shipped, or unfilled over a period of time. These are also an indicator of economic spending or the lack of it.

Factor 7 - trade and capital flows
Currency values can be significantly impacted by monetary flows that result from certain interactions between countries. When imports exceed exports, there is a tendency for the currency value to decline. Increased investments in a country can lead to the opposite result.

Factor 8 - macroeconomic and geopolitical events
Elections, financial crises, monetary policy changes, and wars can influence the biggest changes in the Forex market. These events can either change and/or lead to reshaping of a country's economy.
Currency derivatives
Currency futures: A currency futures contract is an agreement between two parties to buy or sell a currency at a certain time in the future at a certain price. In India, one can trade in USDINR, EUROINR, GBPINR and JPYINR currency futures.

Currency options: Currency 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. Currently, currency options are available only for USDINR.
Major market participants
  • Hedgers
  • Speculators
  • Arbitrageurs
Various terminologies in currency market:
Spot price: The price at which a currency trades in the spot market. In the case of USD/INR, spot value is T + 2.

Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time.

Final settlement date: The last business day of the month will be termed the Value date/ Final Settlement date of each contract.

Expiry date: It is the date specified in the futures contract. All contracts expire on the last working day (excluding Saturdays) of the contract months. The last day for the trading of the contract shall be two working days prior to the final settlement date or value date.

Contract size: In the case of USD/INR it is USD 1000; EUR/INR it is EUR 1000; GBP/INR it is GBP 1000 and in case of JPY/INR it is JPY 100,000. ( Ref. RBI Circular: RBI/2009-10/290, dated 19th January, by which RBI has allowed trade in EUR/INR, JPY/INR and GBP/INR pairs.)

Basis: Basis can be defined as the futures price minus the spot price. In a normal market, basis will be positive. Futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures (in commodity markets) the storage cost plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset. For currency derivatives carry cost is the rate of interest.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price which is known as marking-to-market.
Advantages of currency futures
  • Transparency and efficient price discovery
  • Elimination of Counterparty credit risk
  • Access to all types of market participants
  • Transparent trading platform
  • Surveillance.
Contract specifications for currency futures
  
Symbol USDINR
Instrument Type FUTCUR
Unit of trading 1 (1 unit denotes 1000 USD)
Underlying USD
Quotation/Price Quote Rs. per USD
Tick size 0.25 paisa or INR 0.0025
Trading hours Monday to Friday
9:00 a.m. to 5:00 p.m.
Contract trading cycle 12 month trading cycle.
Last trading day Two working days prior to the last business day of the expiry month at 12 noon.
Final settlement day Last working day (excluding Saturdays) of the expiry month.The last working day will be the same as that for Interbank Settlements in Mumbai.
Base price Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.
Price operating range
Tenure upto 6 monthsTenure greater than 6 months
+/-3 % of base price      +/- 5% of base price
Position limits
ClientsTrading MembersBanks
Higher of 6% of total Higher of 15% of the total Higher of 15% of the
open interest or USD 10 million total open interest or total open interest or USD 100 million
Minimum initial margin 1.75% on first day & 1% thereafter.
Extreme loss margin 1% of MTM value of gross open position.
Calendar spreads Rs. 400/- for a spread of 1 month, Rs. 500/- for a spread of 2 months, Rs. 800/- for a spread of 3 months & Rs. 1000/- for a spread of 4 months or more USD
Settlement Daily settlement : T + 1
Final settlement : T + 2
Mode of settlement Cash settled in Indian Rupees
Daily settlement price (DSP) DSP shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time.
Final settlement price (FSP) RBI reference rate
Hedging
Currency hedge:
In equities, the act of holding a position in a stock denominated in a foreign currency while holding an equal but opposite position in the currency itself. This protects the investor from fluctuations in the value of a currency adversely affecting the stock holdings.

How hedging is useful for an importer:
The importers need to pay for the imports in terms of USD/EURO/GBP/JPY. The risk of importers is the appreciation of USD against INR. In this case they need to shell out more money in terms of INR for the same imports. The importer’s risk can be hedged using currency derivatives by taking LONG positions in the currency futures/options (call option long position) market.

Hedging exposure by an importer through currency derivatives:

Scenario 1: A chemical importer wants to import chemicals worth USD 1000 and places his import order on November 15, 2010, with the delivery being 2 months ahead. At the time when the contract is placed, in the spot market, one USD was worth say INR 45.10. But, suppose the Indian Rupee depreciates to INR 46.75 per USD at time of payment which is due in January 2011. So, the value of the payment for the importer goes up to INR 46,750 rather than INR 45,100. The hedging strategy for the importer, thus, would be:

Using currency futures:

Current Spot Rate (Nov 15 2010) 45.1000
Buy 1 lot USDINR Jan'11 Contract on 15th Nov '10 (1000 * 45.60) * 1 (Assuming the Jan '11 contract is trading at 45.6000 on 15th Nov '10)
Sell 1 lot USDINR Jan '11 Contracts in Jan '11 Profit/Loss (futures market) 46.7500 1000 * (46.75 – 45.60) * 1 = 1150
Purchases in spot market @ 46.75 Total 46.75 * 1000
cost of hedged transaction 1000 * 46.75 – 1150 = INR 45600
So, effectively the importer pays the November price of USDINR January futures which is 45.60.
Using currency options
Buy 1 lot USDINR Jan'11 Call option @ strike 45.25 on 15th Nov '10 by paying a premium of 0.70 per lot of 1000 USD. Therefore in total he pays a premium of INR 700 for the call option. In January 2011, since the spot price of USDINR is 46.75, the call option @ strike 45.25 is deep ITM (in-the-money) so the premium is increased to 1.50 per lot of USDINR. Thus, profit on hedge position is INR 800. So, he makes a total of INR 800 on his hedge. Effectively his cost of import decreases to INR 45950 (46750-800). How hedging is useful for an exporter: The exporters get their export receivables in terms of USD/EURO/GBP/JPY. The risk of exporters is the appreciation of INR against USD. In this case they get less in terms of INR for their exports. The exporter’s risk can be hedged using currency derivatives by taking SHORT positions in the currency futures/options market (put option long position). Hedging exposure by an exporter through currency derivatives:
Scenario 2: A textile exporter wants to export textile goods worth USD 1000 and gets his export order on November 15, 2010, with the delivery being 2 months ahead. At the time when the contract is placed, in the spot market, one USD was worth say INR 45.10. But, suppose the Indian Rupee appreciates to INR 44.25 per USD at the time of receipt of payments which is due in January 2011. So, the value of the receivables for the exporter decreases to INR 44,250 rather than INR 45,100. The hedging strategy for the exporter, thus, would be:

Using currency futures:
Current Spot Rate (Nov 15 2010) 45.1000
Sell 1 lot USDINR Jan'11 Contract on 15th Nov '10 (1000 * 45.60) * 1 (Assuming the Jan '11 contract is trading at 45.6000 on 15th Nov '10)
Buy 1 lot USDINR Jan '11 Contracts in Jan '11 Profit/Loss (futures market) 44.2500 1000 * (45.60 – 44.25) * 1 = 1350
Selling in spot market @ 44.25 Total cost of hedged transaction 44.25 * 1000 1000 * 44.25 + 1350 = INR 45600
So, effectively the exporter gets the November price of USDINR January futures which is 45.60.

Using currency options:
Buy 1 lot USDINR Jan'11 Put option @ strike 45.0 on 15th Nov '10 by paying a premium of 0.45 per lot of 1000 USD. Therefore in total he pays a premium of INR 450 for the put option.
In January 2011, since the spot price of USDINR is 44.25, the put option @ strike 45.0 is deep ITM (in-the-money) so the premium is increased to 0.75 per lot of USDINR. Thus, profit on hedge position is INR 300.
So, he makes a total of INR 300 on his hedge. Effectively his receivables of export increases to INR 44550 (44250+300).

Arbitrage:
Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relation between forward prices and futures prices differs, it gives rise to arbitrage opportunities. Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage

Profits through arbitrage:

Scenario 1: Assume the spot rate for USD/INR is quoted @ Rs. 45.20 and three months forward is quoted at 86 paisa premium to spot @ 46.06 while at the same time one month currency futures is trading @ INR 45.80.

An active arbitrager realizes that there is an arbitrage opportunity as the one month futures price is less than the one month forward price. He implements the arbitrage trade where he; Buys in futures @ 45.80 levels (3 months) Sells in forward @ 46.06 (3 months) with the same term period In the process, he makes a Net Gain of 46.06-45.80 = 0.26 i.e. Approx 26 Paisa arbitrage Profit per contract = INR 260 (0.26x1000)
The discrepancies in the prices between the two markets have given an opportunity to implement a lower risk arbitrage. As more and more market players will realize this opportunity, they may also implement the arbitrage strategy and in the process will enable market to come to a level of equilibrium.
Currency trading tools and techniques:
Technical analysis
To develop a strategy, traders use a variety of tools and techniques. Some traders perform Technical Analysis by using Currency Charts to study the market. This technique assumes that past market movements will help predict future activity. The effectiveness of Technical Analysis makes it a very popular trading technique.

Fundamental analysis
Other traders use Fundamental Analysis for their trading strategy. They follow the effect of economic, social and political events on currency prices. Reading specialized Forex News can help keep you in touch with the Forex community to find out how events might affect currency prices.

Practice and Familiarize
Every trader makes mistakes, so it's a good idea to familiarize oneself with a trading environment before investing money. To improve trading skills, a free demo trading account can be opened with a Forex company.

Know the risks
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for everyone. Before deciding to trade foreign exchange investment objectives, level of experience, and risk appetite should be carefully considered. Money that one can afford to lose should only be invested.

IPO

IPO or Initial Public Offer is a way for a company to raise money from investors for its future projects and get listed to Stock Exchange. It is the selling of securities to the public in the primary stock market. An Initial Public Offering (IPO) referred to simply as an "offering" or "flotation," is when a company (called the issuer) issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded.
Company raising money through IPO is also called as company ‘going public'. Initial Public Offerings (IPOs) represent the transition point of companies from a private status to a publicly held status. Thus, IPOs represent one of the most closely observed events in the stock market since they mark the inception of a new trading opportunity. Since every business starts as a small enterprise, the new player on the stock market issues only a few stocks, which results in a relatively small number of stockholders.
In an IPO the issuer may obtain the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), best offering price and time to bring it to market. From an investor point of view, IPO gives a chance to buy shares of a company, directly from the company at the price of their choice (In book build IPO's). Many a times there is a big difference between the price at which companies decides for its shares and the price on which investor are willing to buy share and that gives a good listing gain for shares allocated to the investor in IPO. An IPO can be a risky investment. For the individual investor it is tough to predict what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value. From a company prospective, IPO help them to identify their real value which is decided by millions of investor once their shares are listed in stock exchanges.
Reasons for listing
When a company lists its shares on a public exchange, it will almost invariably look to issue additional new shares in order at the same time. The money paid by investors for the newly-issued shares goes directly to the company. An IPO, therefore, allows a company to tap a wide pool of stock market investors to provide it with large volumes of capital for future growth. The company is never required to repay the capital, but instead the new shareholders have a right to future profits distributed by the company and the right to a capital distribution in case of a dissolution.
The existing shareholders will see their shareholdings diluted as a proportion of the company's shares. However, their capital investment will make their shareholdings more valuable in absolute terms. In addition, once a company is listed, it will be able to issue further shares via a rights issue, thereby again providing itself with capital for expansion without incurring any debt. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list.
Benefits of being a public company
  • Bolster and diversify equity base
  • Enable cheaper access to capital
  • If there were no uncertainties, there would be no need for insurance.
  • Exposure and prestige
  • Attract and retain the best management and employees
  • Facilitate acquisitions
  • Create multiple financing opportunities
Company registration
The first step a company should take in order to become publicly traded includes registration with the Securities and Exchange Commission (the SEC). After this a public offering is prepared, which should include a company's prospectus and other legal documents that are required by the SEC.
Every potential investor has the right to receive a company's prospectus. The latter represents a legal and accounting document, which explains in detail the situation in the company, including information about the senior staff, majority stockowners and the potential risks the company faces.
Life cycle of an IPO prospectus
Stage 1: draft offer document
"Draft Offer document" is prepared by Issuer Company and the Book Building Lead Manager of the public issue. This document is submitted to SEBI for review. After reviewing this document either SEBI ask lead managers to make changes to it or approve it to go ahead with IPO processing. It is usually a PDF file having information of an investor who needs to know about the public issue. It mainly contain information about the company, its business, management, risk involve in applying to this issue, company financials and the reason why company is raising money through IPO.
Stage 2: offer document
Once the ‘Draft Offer document' cleared by SEBI, it becomes "Offer Document". Offer Document is the modified version of ‘Draft Offer document' with SEBI suggestions. "Offer Document" is submitted to the registrar of the issue and stock exchanges where Issuer Company is willing to list.
Stage 3: red herring prospectus
Once "Offer Document" gets clearance from Stock Exchanges, Issuer Company add Issue size and price of the issue to the document and make it available to the public. The issue prospectus is now called "Red Herring Prospectus".
Issue
A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building.
Book Building is basically a process used in IPOs for efficient price discovery.It is a mechanism where,during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date.
Date of the issue
Once ‘Draft Prospectus' of an IPO is cleared by SEBI and approved by Stock Exchanges then it's up to company going public to finalize the date and duration of an IPO. Company consult with the Lead Managers, Registrar of the issue and Stock Exchanges before decides the date.
Life cycle of an IPO
Below is the detail process flow of a 100% Book Building Initial Public Offer IPO. This process flow is just for easy understanding for retail IPO investors. The steps provided below are most general steps involve in the life cycle of an IPO
1.Issuer company - IPO process initialization
  • Appoint lead manager as book runner
  • Appoint registrar of the issue
  • Appoint syndicate members
2.Lead manager's - pre issue role - part 1
  • Prepare draft offer prospectus document for IPO
  • File draft offer prospectus with SEBI
  • Road shows for the IPO
3.SEBI – prospectus review
  • SEBI review draft offer prospectus
  • Revert it back to Lead Manager if need clarification or changes (Step 2).
  • SEBI approve the draft offer prospectus, the draft offer prospectus is now become Offer Prospectus.
4.Lead manager - pre issue role - part 2
  • Submit the Offer Prospectus to Stock Exchanges, registrar of the issue and get it approved
  • Decide the issue date & issue price band with the help of Issuer Company
  • Modify Offer Prospectus with date and price band. Document is now called Red Herring Prospectus
  • Red Herring Prospectus & IPO Application Forms are printed and posted to syndicate members; through which they are distributed to investors
5.Investor – bidding for the public issue
  • Public Issue Open for investors bidding
  • Investors fill the application forms and place orders to the syndicate members
  • Syndicate members provide the bidding information to BSE/NSE electronically and bidding status gets updated on BSE/NSE websites
  • Syndicate members send all the physically filled forms and cheques to the registrar of the issue
  • Investor can revise the bidding by filling a form and submitting it to Syndicate member
  • Syndicate members keep updating stock exchange with the latest data.
  • Public Issue Closes for investors bidding
6.Lead manager – price fixing
  • Based on the bids received, lead managers evaluate the final issue price
  • Lead managers update the 'Red Herring Prospectus' with the final issue price and send it to SEBI and Stock Exchanges
7.Registrar - processing IPO applications
  • Registrar receives all application forms & cheques from Syndicate members
  • They feed applicant data & additional bidding information on computer systems.
  • Send the cheques for clearance.
  • Find all bogus application
  • Finalize the pattern for share allotment based on all valid bid received
  • Prepare 'Basis of Allotment'
  • Transfer shares in the demat account of investors
  • Refund the remaining money though ECS or Cheques
8.Lead manager – stock listing
Once all allocated shares are transferred in investors dp accounts, Lead Manager with the help of Stock Exchange decides Issue Listing Date
Finally share of the issuer company gets listed in Stock Market.
Difference between book building issue and fixed price issue
Initial Public Offering can be made through the fixed price method, book building method or a combination of both.
Difference between shares offered through book building and offer of shares through normal public issue (Source: BSE):
   
Features Fixed price process Book building process
Pricing Price at which the securities are offered/allotted is known in advance to the investor. Price at which securities will be offered/allotted is not known in advance to the investor. Only an indicative price range is known.
Demand Demand for the securities offered is known only after the closure of the issue. Demand for the securities offered can be known everyday as the book is built.
Payment Payment if made at the time of subscription wherein refund is given after allocation. Payment only after allocation
Difference between floor price and cut-off price for a book building issue
Company coming up with Book Building Public Issue decide a price band for the issue. The price band usually contains an upper level and a lower level. Floor Price is the minimum price (lower level) at which bids can be made for an IPO. Investors can bid for the Book Build IPO at any price in the price band decided by the company. In Book Build process retail investors have an addition option to choose "Cut-Off" price for bidding. Cut-off price means the investor is ready to pay whatever price is decided by the company at the end of the book building process. Retail investor has to pay the highest price while placing the bid at Cut-Off price.
Role of registrar of an IPO
Registrar of a public issue is a prime body in processing IPO's. They are independent financial institution registered with SEBI and stock exchanges. They are appointed by the company going public. Responsibility of a registrar for an IPO is mainly involves processing of IPO applications, allocate shares to applicants based on SEBI guidelines, process refunds through ECS or cheque and transfer allocated shares to investors Demat accounts.
Categories of investors in an IPO
Investors can apply for shares in an IPO in 4 different categories-
1.Retail Individual Investor (RII)
In retail individual investor category, investors can not apply for more then Rs one lakh (Rs 1,00,000) in an IPO. Retail Individual investors have an allocation of 35% of shares of the total issue size in Book Build IPO's. NRI's who apply with less then Rs 1,00,000 /- are also considered as RII category.
2.High Networth Individual (HNI)
If retail investor applies more then Rs 1,00,000 /- of shares in an IPO, they are considered as HNI.
3.Non-institutional bidders
Individual investors, NRI's, companies, trusts etc who bid for more then Rs 1 lakhs are known as Non-institutional bidders. They need not to register with SEBI like RII's. Non-institutional bidders have an allocation of 15% of shares of the total issue size in Book Build IPO's.
4.Qualified Institutional Bidders (QIB's)
Financial Institutions, Banks, FII's and Mutual Funds who are registered with SEBI are called QIB's. They usually apply in very high quantities. QIBs are mostly representatives of small investors who invest through mutual funds, ULIP schemes of insurance companies and pension schemes. QIB's have an allocation of 50% of shares of the total issue size in Book Build IPO's.
Risks involved in an IPO
  • Stock list at lower then issue price
  • Issue oversubscribed heavily and investor doesn't get allotment
  • Any mishandling in processing refund could delay in getting the money back for shares not allocated
Tips to choose right IPO for investment
  • The issue size has to be big, the bigger the issue, the higher is the capability of the promoters
  • Money begets more money, so if they have raised more money, be sure, they will be able to earn more
  • A higher promoters stake is a must, instills a sense of responsibility
  • A background check on the promoters capabilities
  • Size of projects in the pipeline, will indicate the scalability of the company
  • Last but not the least, in big companies, look for long term wealth creation and not speculative gains

Mutual Funds

What are mutual funds?
Mutual fund is a managed group of owned securities of several corporations. It is a body corporate that pools the savings of a number of investors and invests the same in a variety of different financial instruments. Using a mutual fund is one way to invest in the stock or bond market without buying individual stocks or bonds. Income earned through these investments and the capital appreciations realized are shared by its unit holders. They are operated by an investment company which raises money from the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of objectives. It is a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints.
These corporations receive dividends on the shares that they hold and realize capital gains or losses on their securities traded. Investors purchase shares in the mutual fund as if it was an individual security. After paying operating costs, the earnings (dividends, capital gains or loses) of the mutual fund are distributed to the investors, in proportion to the amount of money invested. Investors hope that a loss on one holding will be made up by a gain on another. Mutual fund shares are able to collectively gain the advantage by diversifying their investments.
The units of mutual funds are also tradable securities. Mutual fund units are issued and redeemed by the Fund Management Company based on the fund's net asset value (NAV) which is declared periodically by the issuer of the fund. NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Buying and selling into funds is done on the basis of NAV-related prices. Mutual Funds are usually long term investment vehicle.
Each mutual fund will have a pre-defined objective, so you can choose a fund that is aggressive, conservative, a fund that invests only in stocks or only in bonds; or a fund that can invest in a multitude of things depending on what the fund's management committee thinks would be bes
  • Mutual funds are financial intermediaries
  • They collect savings from a large no. of small investors
  • They then invest these funds in a diversified portfolio
  • The investment in a diversified portfolio allows the minimisation of risk
Thus they minimize risk and maximise returns for their participants
History of mutual funds
The modern mutual fund was first introduced in Belgium in 1822. This form of investment soon spread to Great Britain and France. Mutual funds became popular in the United States in the 1920s and continue to be popular since the 1930s, especially open-end mutual funds. Mutual funds experienced a period of tremendous growth after World War II, especially in the 1980s and 1990s.
Role of RTA and exchanges in mutual funds
Registrar & Transfer Agent
Mutual fund (MF) houses have to maintain meticulous records of every transaction made by each of their investors. Registrar and Transfer agents (R&T agents) help them do this
Keeping records
Every mutual fund house has a large number of investors and it is essential to maintain records of all transactions made by each investor. Registrar and Transfer agent (R&T agent) is a body that maintains these records on behalf of the fund house. There are two main R&T agents in India—Computer Age Management Services (Cams) and Karvy. Few MFs, such as Franklin Templeton MF, have their own in-house R&T agents.
How an R&T agent works
Function
An R&T agent acts as a third-party on behalf of a fund house and has a vital role to play. It has a wide network through which it helps investors with their transactions, for example, getting the forms of various fund houses, transacting with fund houses or providing account statements. An R&T agent also provides technology-based services like online transaction or account statement facilities. It acts as single-window system for investors.
An R&T agent also helps investors with information on various corporate actions like details on new fund offers, dividend distributions or even maturity dates of investments. This information is also available with the fund houses, but an R&T Agent is a one-stop shop for all the information. Investors can get information about his various investments into different schemes of different fund house at a single place.
Importance
An R&T agent helps MF investors in submitting forms. This is very useful, especially for those investors who want to invest in many MFs. As per the Securities and Exchange Board of India’s (Sebi) rules, there is a cut-off time by when the investment has to be made for that day. So, if an investor has to make multiple investments, he can use an R&T agent’s single window system instead of rushing to different fund houses to submit applications.
R & T agents also help MFs reduce costs. Since they are present across the country, they also double as branches for their affiliated MFs as point-of-sale terminals.
Trading mutual funds on stock exchanges – what the investor needs to know
SEBI has recently allowed registered stockbrokers to transact mutual fund units on behalf of their clients through the stock exchange mechanism. The market regulator has now allowed mutual funds to be traded on stock exchanges so that more investors can access them and have a basket of various categories of securities to get assured of maximum returns. When the systems are in place there are a few points the investor has to consider while investing in mutual funds through Stock Exchanges (NSE and BSE)
  • Existing mutual fund investors who intend to buy more units will also benefit as this system will allow them to keep track of all investments under a single statement
  • Investors can hold units of mutual fund schemes in dematerialised form. Buying and selling will become more efficient and transparent , particularly if investors choose to transact through a demat account
  • Though cost seems to be a factor for those who do not have a demat account, the impact will be minimal for those who already are demat account holders
  • End users can use the convenience of their neighboring broker’s office for their mutual fund transactions
  • In reduces the clutter of paperwork and speedy execution
Mutual fund prospectus
The prospectus is a legal document that includes information about the mutual fund, terms of the offer, the issuer, and its objectives. The information in the prospectus is usually lengthy, packed with tables and graphs, and written in technical and legal language. This document is provided to help you make an informed investment decision before you invest in a mutual fund.
Following key sections have to be taken into consideration before investing in a Mutual fund:
Investment objective
A short statement of the fund's investment objectives. Some funds intend to achieve short-term growth while others might focus on long-term stability.
Investment strategy
Exactly how the fund plans to accomplish the objectives. This section describes the types of assets that the fund purchases.
Fees and expenses
Although mutual funds aim to make money for their investors, their ultimate goal, just like any other business, is to make money for themselves. In order to do so, funds charge their shareholders a variety of fees and expenses, all of which must be documented in the prospectus. A table at the front of every prospectus contains a breakdown of the different fees and expenses, along with a hypothetical projection of how the fees would impact a $10,000 investment over a 10-year period. This enables you to compare fees and expenses across mutual funds.
Risks
The level of risk that the fund takes and the risks that are associated with the specific investments made by the fund are one of the most important sections in the prospectus.
Performance
Information about the fund's performance over the last 10 years is included. Investors should be aware that past performance is not necessarily an indicator of future results. As important is how well the fund has traditionally performed compared to an index, such as the S&P 500. A fund's performance is also related to the fund's volatility, dividend payments, and turnover.
Management
The names the managers and some additional information about their experience and qualifications is reported. It can be helpful to know whether or not they have managed other funds in the past and their success or failure in order to get a sense of their past strategies and results.
Statement of additional information
Mutual funds split their prospectuses into two parts -- the "prospectus" (described above) and the Statement of Additional Information (SAI). In 1983, the Securities and Exchange Commission required mutual funds to supply much more detailed information about the fund. These are included in the SAI. For legal purposes it is assumed that you have read it. If you don't receive the SAI with the prospectus, you should request one. It provides great detail about the fund's board of directors, any limitations on the fund's investments, and the fees and expenses that are mentioned in the prospectus.
Professional management of mutual funds
Mutual funds use professional managers to make the decisions regarding which companies' securities should be bought and sold. The managers of the mutual fund decide how the pooled funds will be invested. Investment opportunities are abundant and complex. Fund managers are expected to know what is available, the risks and gains possible, the cost of acquiring and selling the investments, and the laws and regulations in the industry. The ability of the managers to select profitable investments and to sell those likely to decline in value is a key factor for the mutual fund to earn money for the investors.
Mutual fund annual report
Every year mutual funds send each investor an Annual Report. The Annual Report includes a list of the fund's financial statements, a list of the fund's securities, and explanations from the fund's management as to why the fund performed as it did for the previous year.
(a) On the basis of objective
Equity funds/ growth funds
Funds that invest in equity stocks from firms with higher low Price to Earning (P/E) Ratio which usually pay small dividends are called equity funds. The investor is looking for capital gains rather than income. They carry the principal objective of capital appreciation of the investment over the medium to long-term. In growth funds, the dividend accrued, if any, is reinvested in the fund for the capital appreciation of investments made by the investor.
Different types of mutual funds
  • Diversified funds
  • Sector specific funds
  • Index based funds.
Diversified funds
These funds invest in companies spread across sectors. These funds are generally meant for risk-averse investors who want a diversified portfolio across sectors.
Sector funds
These funds invest primarily in equity shares of companies in a particular business sector or industry. They are targeted at investors who are bullish or fancy the prospects of a particular sector.
Index funds
The money collected from the investors is invested only in the stocks,which represent the indices like S&P CNX Nifty or CNX Midcap 200.The objective of such funds is to give a return equivalent to the market returns.
Tax saving funds
These funds offer tax benefits to investors under the Income Tax Act. They aim to minimize tax bills, such as keeping turnover levels low or shying away from companies that provide dividends, which are regular payouts in cash or stock that are taxable in the year that they are received. These funds still shoot for solid returns; they just want less of them showing up on the tax returns.
Debt/Income funds
These funds invest predominantly in high-rated fixed-income-bearing instruments. The investor is looking for income which usually come from dividends or interest. These stocks are from firms which pay relative high dividends. This fund may include bonds which pay high dividends. They are best suited for the medium to long-term investors who are averse to risk and seek capital preservation. They provide a regular income to the investor.
Liquid funds/money market funds
These funds invest exclusively in certain kinds of highly liquid short-term instruments like money market. Investment period could be as short as a day. They provide easy liquidity.
Gilt funds
These funds invest in Central and State Government securities. Since they are Government backed bonds they give a secured return and also ensure safety of the principal amount. They are best suited for the medium to long-term investors who are averse to risk.
Balanced funds
The investor may wish to balance his risk between various sectors such as asset size, income or growth. A balanced fund invests equally in fixed income and equity in order to earn a minimum return to the investors. They provide a steady return and reduce the volatility of the fund. They are ideal for medium to long-term investors who are willing to take moderate risks.
b) On the basis of flexibility
Open-ended funds
Investors are allowed to enter and exit the fund even after the fund has closed. These funds do not have a fixed date of redemption. Generally they are open for subscription and redemption throughout the year. Their prices are linked to the daily net asset value (NAV).
Close-ended funds
These funds are open initially for entry during the Initial Public Offering (IPO) and thereafter closed for entry as well as exit. Once the fund closes investment can be withdrawn only at the end of the time period of the MF. These funds have a fixed date of redemption. One of the characteristics of the close-ended schemes is that they are generally traded at a discount to NAV; but the discount narrows as maturity nears. The units of these funds are listed on stock exchanges, are tradable.
Advantages of investing in mutual funds:
  • Invest on-line in all mutual funds without the hassles of filling application forms or any signatures or proof of identity for investing.
  • Portfolio Diversification : Mutual funds help to reap the benefit of returns by a portfolio spread across a wide spectrum of companies
  • Professional management and research to select quality securities
  • Spreading Risk: Mutual fund will spread its risk by investing a number of sound stocks or bonds. A fund normally invests in companies across a wide range of industries, so the risk is diversified.
  • Transparency: Provides complete portfolio disclosure of the investments made by various schemes and also the proportion invested in each asset type.
  • Choice: Offer the investor a wide variety of schemes to choose from. An investor can pick up a scheme depending upon his risk/ return profile.
  • Regulations: Registered with SEBI and function within the provisions of strict regulation designed to protect the interests of the investor
  • No manual processes involved. Bank funds are automatically debited or credited while simultaneously crediting or debiting the unit holdings.
  • Control over your investments with online order confirmations and order status tracking.
  • Online updation of MF portfolio with current NAV to check the performance of investments.
Disadvantages of mutual funds
  • No control over costs, customized solutions
  • Managing a portfolio of funds
  • The investor must rely on the integrity of the professional fund manager
  • Fund management fees may be unreasonable for the services rendered
  • The fund manager may not pass transaction savings to the investor
  • The fund manager is not liable for poor judgment when the investor's fund loses value
  • There may be too many transactions in the fund resulting in higher fee/cost to the investor - This is sometimes call "Churn and Earn"
  • Prospectus and Annual report are hard to understand
  • Investor may feel a lost of control of his investment dollars
  • There may be restrictions on when and how an investor sells/redeems his mutual fund shares
  • Market risk: If the overall stock or bond markets fall on account of overall
  • Economic factors: the value of stock or bond holdings in the fund's portfolio can drop, thereby impacting the fund performance
  • Non-market risk: Bad news about an individual company can pull down its stock price, which can negatively affect fund holdings
  • Interest rate risk: When the interest rates rise, bond prices fall and this decline in underlying securities affects the fund negatively
  • Credit risk: When the funds invest in corporate bonds, they run the risk of the corporate defaulting on their interest and principal payment obligations
Transactions in mutual funds
  • Purchase / Redemption: Purchase simply means buying mutual fund scheme units
  • Switch: To suit your changing needs ,transfer of cash between different schemes is possible. You can switch your cash online from one scheme to another in the same fund family without any hassles.
  • Systematic Investment plans (SIP): SIP allows to invest a certain sum of money over a period of time periodically by just filling in the investment amount, the period of investment, the frequency of investing.
  • Rupee Cost Averaging Adv.
  • Small Amount of Investment.
  • Disciplined Investing.
Advantages of an SIP
  • Rupee Cost Averaging Adv.
  • Small Amounts of Investment
  • Disciplined Investing
Mutual fund expenses
Mutual fund fees
In order to cover their expenses mutual funds charge fees to the investors. Although these fees are only a few percentage points a year and seem like a minor expense, they create a serious drain on the performance over a period of years.
Some fees to consider are:
Redemption fees
A mutual fund may charge fees when the investor sells shares back to the mutual fund.
Contingent deferred sales charge
A mutual fund may charge sales charges that are reduced at certain time intervals. For example, the fund may charge 6% of the sale price the first year after the shares are bought. Each year thereafter the fee would be reduced by 1% until no fee would be charged. This is an incentive for investors to leave their money in the fund.
Management fees
Mutual funds may charge fees to cover expenses such as advertising, brokers' costs and toll-free telephone lines. These are 12b-1 fees, regulated by law.
Transfer fees
A fee is charged each time the investor transfers money within the company.
Distribution of capital gains and dividends
After paying operating costs, the earnings and losses of the mutual fund are distributed to the investors in proportion to the amount of money invested. An investor may chose to receive dividends as cash, or he can reinvest them into the fund. Many funds will automatically reinvest dividends with the investor authorization.
Mutual fund taxation
The mutual fund manager must send the investor a tax information statement so the investor can declare taxes. The investor must account for all capital gains or loses and dividends even if the dividends and capital gains are reinvested into the mutual fund. When mutual funds shares are sold/redeemed the mutual fund manager should aid the investor in determining the purchase bases for the shares sold/redeemed.
Tips for investing in a mutual fund
Do’s
  • Draw down your investment objective. There are various schemes suitable for different needs. This will explain the mandate and scope of investment. Whether the fund is equity or debt oriented, whether the fund will be multi-, large, mid- or small-cap specific, the level of diversification, the option to the fund manager to invest overseas and other such issues.
  • Once you have decided on a plan or a couple of them, collect as much information as possible on them from different sources offering them through funds' prospectus and advisors
  • Pick out companies consistently performing above average. Mutual funds industry indices are helpful in comparing different funds as well as different plans offered by them
  • Get a clear picture of fees & associated cost, taxes (for non-tax free funds) for all your short listed funds and how they affect your returns. Best mutual funds have lower cost out go.
  • Best mutual funds maximize returns and minimize risks. A number called as Sharpe Ratio explains whether a fund is risk free based on its expected returns compared against a risk free money market fund.
  • Invest in funds that have the advantage of low minimum initial investments for building asset bases over a long period with small regular investments.
Don’ts
  • Don't go by the past performance alone
  • Don't go by blindly by hearsay about the reputations of a fund. There are various rating agencies which index the mutual funds regularly based on multiple factors
  • Don't invest huge sums of money in a single fund or all the money in one go. Spread out your investments rationally.
  • Don't chase a mutual fund because it is performing great in a bull run in the stock market. Once the market stagnates or the trend reverses these funds might crash.
  • Don't compare a mutual fund across the category. While choosing a best one compare funds from the same category regardless of the promoting companies.

Insurance

What is insurance?
Insurance is the only way to protect the economic value of assets and life. It is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance. A policyholder is the person or entity buying the insurance policy. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.
What is an asset?
Tangible Intangible
Home Earning Power
Car Training
Jewellery Experience
Computer Skills
Business
Collections
Why should you have insurance?
  • Assets can be destroyed by fire, flood, earth quake, etc. Insurance protects the assets.
  • Insurance covers the risk. A risk is the possibility of loss or damage, that may or may not happen. General insurance covers such contingencies that may happen.
  • If there were no uncertainties, there would be no need for insurance.
  • Life of a person is an income generating asset. In case of untimely death of the person, the family is protected by life insurance cover. For the post-retirement period, life insurance helps to ensures a lump sum payment or a regular income.
How will insurance help?
  • Insurance takes care of the unexpected
  • Family is protected from the loss of earnings in case of a crisis/calamity. Insurance takes the financial burden off.
  • The best way to save regularly- at the best rates.
  • Tax free payout on maturity acts as a ‘nest-egg’ for retirement.
  • Loans possible on certain life insurance policies.
  • Tax saving benefits under section 88 of I.T. Act.
  • After only a single premium, you are covered for the full benefit.
  • As a “locked-in savings”, Life Insurance gives you the highest returns.
  • Life Insurance policy can act as collateral when taking a loan.
  • For only a small sum each year, the Insurance company takes the risk.
What kinds of risks are covered under general insurance?
Fire Buildings, machinery,furniture,fittings, stocks, etc. Loss of net profit also covered.
Marine Large cargo/passenger vessels. Cargo handling also covered.
Burglary Stocks,cash,jewellery.
Fidelity Breach of trust by employees.
Personal Accident Accident to human lives.
Medical Medical expenses incurred during illness/hospitalization.
General insurance ~ additional products
  • Shopkeeper Insurance
  • Flood Insurance
  • Travel Insurance
  • Baggage Insurance
  • Engineering Insurance
  • Household Goods Insurance
  • Earthquake Insurance
Insurance for rural markets
  • Crop Insurance
  • Cattle Insurance
  • Pump Insurance
  • Lift Irrigation Insurance
  • Horticulture/Plantation Insurance
Life insurance covers
Family Financial protection on death of an earning member.
Children Savings for education/marriage/start-in life.
Old Age Retirement income.
Special Needs Medical treatment/Loss of income due to disability(accidents/illness).
Life insurance
Life Policy Has two components
1. Risk Cover- Benefit payable in the event of death
2. Savings- Benefit payable on maturity
Term policy Only risk cover for a specific period.
Endowment policy Survival benefit( for a specified period)
Insurance- an asset everyone should have
Our life is uncertain
  • The only certainty is death- everyone dies
  • The question is when?
Our assets are open to risks of all types
  • Natural & Man made.
So, insurance is needed to think ahead & be prepared financially
  • For old age.
  • For sudden death.
  • For assets & business.
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