You are on page 1of 58

Basics of Financial Markets and Financial

GUIDE MANUAL
[Type the abstract of the document here. The
abstract is typically a short summary of the
contents of the document. Type the abstract of
the document here. The abstract is typically a
short summary of the contents of the
document.]
[Type the author name]

Guide Manual: Basics of Financial Markets and


Financial Planning
1.Financial Market is a place where the savings from various sources like households,
government, firms and corporates are mobilized towards those who need it. Alternatively
put, financial market is an intermediary which directs funds from the savers (lenders) to the
borrowers.
In other words, financial market is the place where assets like equities, bonds, currencies,
derivatives and stocks are traded.
Some of the salient features of financial market are:
Transparent pricing
Basic regulations on trading
Low transaction costs
Market determined prices of traded securities
2.Six key functions of Financial Market are :
Borrowing & Lending: Financial market transfers fund from one economic agent (saver/lender) to another
(borrower) for the purpose of either consumption or investment.
Determination of Prices: Prices of the new assets as well as the existing stocks of financial assets are set in
financial markets. Determination of prices is major function of financial market.
Assimilation and Co-ordination of Information: It gathers and co-ordinates information regarding the value
of financial assets and flow of funds in the economy.
Liquidity: The asset holders can sell or liquidate their assets in financial market.
Risk Sharing: It distributes the risk associated in any transaction among several participants in an
enterprise.
Efficiency: It reduces the cost of transaction and acquiring information. It help to increase efficiency in
financial market.
3.The principle participants in the financial market are as follows:
BANKS: Largest provider of funds to business houses and corporates through accepting deposits. Banks
are the major participant in the financial market.
INSURANCE COMPANIES: Issue contracts to individuals or firms with a promise to refund them in
future in case of any event and thereby invest these funds in debt, equities, properties, etc.
FINANCE COMPANIES: Engages in short to medium term financing for businesses by collecting funds by
issuing debentures and borrowing from general public.
MERCHANT BANKS: Funded by short term borrowings; lend mainly to corporations for foreign currency
and commercial bills financing.
COMPANIES: The surplus funds generated from business operations are majorly invested in money market
instruments, commercial bills and stocks of other companies.
MUTUAL FUNDS: Acquire funds mainly from the general public and invest them in money market,
commercial bills and shares. Mutual fund is also principle participant in financial market.
GOVERNMENT: Authorized dealers basically look after the demand-supply operations in financial
market. Also works to fill in the gap between the demand and supply of funds.
4.Major participants and players in financial markets
In the financial markets, there is a flow of funds from one group of parties (funds-surplus units) known as
investors to another group (funds-deficit units) which require funds. However, often these groups do not
have direct link. The link is provided by market intermediaries such as brokers, mutual funds, leasing and
finance companies, etc. In all, there is a very large number of players and participants in the financial
market. These can be grouped as follows :
The individuals: These are net savers and purchase the securities issued by corporates. Individuals provide
funds by subscribing to these security or by making other investments.
The Firms or corporates: The corporates are net borrowers. They require funds for different projects from
time to time. They offer different types of securities to suit the risk preferences of investors Sometimes, the
corporates invest excess funds, as individuals do. The funds raised by issue of securities are invested in real
assets like plant and machinery. The income generated by these real assets is distributed as interest or
dividends to the investors who own the securities.

Government: Government may borrow funds to take care of the budget deficit or as a measure of
controlling the liquidity, etc. Government may require funds for long terms (which are raised by issue of
Government loans) or for short-terms (for maintaining liquidity) in the money market. Government makes
initial investments in public sector enterprises by subscribing to the shares, however, these investments
(shares) may be sold to public through the process of disinvestments.
Regulators: Financial system is regulated by different government agencies. The relationships among
other participants, the trading mechanism and the overall flow of funds are managed, supervised and
controlled by these statutory agencies. In India, two basic agencies regulating the financial market are the
Reserve Bank of India (RBI ) and Securities and Exchange Board of India (SEBI). Reserve Bank of India,
being the Central Bank, has the primary responsibility of maintaining liquidity in the money market It
undertakes the sale and purchase of T-Bills on behalf of the Government of India. SEBI has a primary
responsibility of regulating and supervising the capital market. It has issued a number of Guidelines and
Rules for the control and supervision of capital market and investors protection. Besides, there is an array
of legislations and government departments also to regulate the operations in the financial system.
Market Intermediaries: There are a number of market intermediaries known as financial intermediaries or
merchant bankers, operating in financial system. These are also known as investment managers or
investment bankers. The objective of these intermediaries is to smoothen the process of investment and to
establish a link between the investors and the users of funds. Corporations and Governments do not market
their securities directly to the investors. Instead, they hire the services of the market intermediaries to
represent them to the investors. Investors, particularly small investors, find it difficult to make direct
investment. A small investor desiring to invest may not find a willing and desirable borrower. He may not
be able to diversify across borrowers to reduce risk. He may not be equipped to assess and monitor the
credit risk of borrowers. Market intermediaries help investors to select investments by providing
investment consultancy, market analysis and credit rating of investment instruments. In order to operate in
secondary market, the investors have to transact through share brokers. Mutual funds and investment
companies pool the funds(savings) of investors and invest the corpus in different investment alternatives.
5.Financial Markets can be categorized into six types:
1.Capital Markets: Stock markets and Bond markets
2.Commodity Markets
3.Money Markets
4.Derivatives Markets: Futures Markets
5.Insurance Markets
6.Foreign Exchange Markets
6. Capital market: Classification

The Primary market consists of issue of initial public offers wherein the issuer directly
allots the shares/debt to the investor.
In the Primary Capital Market, the public issue could be either equity i.e. equity shares or
debts like debentures, bonds etc.
In the secondary market, one investor sells to another investor through the stock
exchange.
Primary market provides opportunity to issuers of securities, Government as well as
corporates, to raise resources to meet their requirements of investment and/or discharge
some obligation. The issuers create and issue fresh securities in exchange of funds through
public issues and/or as private placement. They may issue the securities at face value, or at

a discount/ premium and these securities may take a variety of forms such as equity, debt or
some hybrid instrument. They may issue the securities in domestic market and/or
international market through ADR/GDR/ECB route.
Secondary market is the place for sale and purchase of existing securities. It enables an
investor to adjust his holdings of securities in response to changes in his assessment about
risk and return. It also enables him to sell securities for cash to meet his liquidity needs. It
essentially comprises of the stock exchanges which provide platform for trading of securities
and a host of intermediaries who assist in trading of securities and clearing and settlement
of trades. The securities are traded, cleared and settled as per prescribed regulatory
framework under the supervision of the Exchanges and SEBI.

7. Initial Public Offer(IPO)


The first sale of stock by a private company to the public. IPOs are often issued by smaller,
younger companies seeking the capital to expand, but can also be done by large privately
owned companies looking to become publicly traded.

Equity shares are instruments issued by companies to raise capital and it represents the title
to the ownership of a company. You become an owner of a company by subscribing to its
equity capital (whereby you will be allotted shares) or by buying its shares from its existing
owner(s).
The public issue can be kept open to public or on private placement basis.
In private placement, specified informed investors invest i.e. the general public or individual
investors are not allowed to invest. In such cases the issue is also not publicized.
Primary issue could be at par i.e. is sold at the face value of the share/debenture or it could
be at a premium or discount.
The primary issue is publicized by issue of an offer document called prospectus containing
the details of the issue and the past performance/future plans of the issuer. Public issues
are offered by public limited companies.
Profit is shared with the share holders in the form of Dividend annually.

TYPE OF EQUITY ISSUES

Types of Investors
a. Public issue
Securities are issued to the members of
the public, and anyone eligible to invest
can participate in the issue. This is
primarily retail issue of securities.

Resident individuals

Hindu undivided
family (HUF)

8. Debt Market:

Minors through
guardians

Securities are issued to a select set of


investors who can bid and purchase the
securities on offer. This is primarily a
wholesale issue of securities to
institutional investors by an unlisted
company.

Registered societies
and clubs

Non-resident Indians
Individual investors are further categorized based on the
(NRI)
amount invested as

c.Preferential issue

Persons of Indian
Retail, who invests less than Rs.2 lakhs in a
Origin (PIO)
single issue and

Qualified Foreign
Non-Institutional Buyers (NIBs), who invest
investors (QFI)
more than Rs. 2 lakhs in a single issue.

Banks

b. Private placement

A private placement of securities by a


listed company is called a preferential
issue. Securities are issued to an
identified set of investors, on
preferential terms, along with or
independent of a public issue. This may
include promoters, strategic investors,
employees and such specified
preferential groups.
d. Qualified Institutional Placement
(QIP)
A private placement of securities by a
listed company to a set of institutional
investors termed as qualified
institutional buyers is a QIP. Qualified
institutional buyers include institutions
such as mutual funds.
e. Rights and Bonus issues
Securities are issued to existing
investors as on a specific cut-off date,
enabling them to buy more securities at
a specific price (rights) or get an
allotment of additional shares without
any consideration (bonus).

The debt market in India can be


classified into Government
Securities market and
Corporate debt
Market.

The other categories of investors are classified


as institutional investors and are also known as
Financial institutions
qualified institutional buyers (QIBs)

Association of persons

Companies

Partnership firms

Trusts

Foreign institutional
investors (FIIs)

Limited Liability
Partnerships (LLP

The common instruments in


the debt market are:

Corporate Fully
Convertible Debentures(FCDs)/

Party Convertible
Debentures (PCDs)/

Non Convertible
Debentures (NCDs)/

PSU Bonds/Zero
Coupon Bonds/Deep Discount
Bonds

Gilt Edged Securities


etc.
9.Money Market

Money market deals with short-term money and financial


assets that are near substitutes for money. By short term it is meant generally a period less

than 12 months. Near substitute to money means any financial asset which can be
converted into cash quickly with minimum transaction cost.
What is traded in the Indian money market?

Treasury Bills

Call Money

Commercial Paper (CP)

Certificates of Deposit (CD)

Inter Bank Participation Certificates

Inter Bank Term Money

Major players:
Reserve Bank of India
Private banks
Public sector banks,
Development banks and other Non-Banking Financial Companies(NBFCs) such as Life
Insurance Corporation of India (LIC), Unit Trust of India (UTI), the International Finance
Corporation, mutual funds, FIIs, Provident Funds and Trusts.
Commercial Paper
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note.
Issuers: Highly rated corporate borrowers, primary dealers (PDs) and satellite
dealers (SDs) and all-India financial institutions (FIs).
Rating: All eligible participants should obtain the credit rating for issuing CP.
Minimum and maximum period of maturity:
Minimum of 7 days and a maximum of up to one year from the date of issue.
The maturity date of the CP should not go beyond the date up to which the credit
rating of the issuer is valid.
Denomination - Rs.5 lakh or multiples thereof.
Who can invest?
Individuals, banking companies, other corporate bodies (registered or incorporated in
India) and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional
Investors (FIIs) etc. can invest in CPs.
However, investment by FIIs would be within the limits set for them by Securities and
Exchange Board of India (SEBI) from time-to-time.
Certificate of Deposit (CD)
Certificate of Deposit (CD) is a negotiable money market instrument.
Issuers- (i) Scheduled commercial banks except Regional Rural Banks& Local Area
Banks (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI
to raise short-term resources within the umbrella limit fixed by RBI.
Minimum and maximum period of maturity- 7 days and not more than one year,
from the date of issue
Denomination - Rs.1 lakh or multiples thereof.
Who can invest?

Individuals, Corporations, Companies (including banks and PDs), Trusts, Funds,


Associations, etc.
10.Call/Notice Money Market/Term Money
The call/notice money market forms an important segment of the Indian Money Market.
Under call money market, funds are transacted on an overnight basis and under notice
money market, funds are transacted for a period between 2 days and 14 days.
The money market primarily facilitates lending and borrowing of funds between banks and
entities like Primary Dealers (PDs). Banks and PDs borrow and lend overnight or for the short
period to meet their short term mismatches in fund positions. This borrowing and lending is
on unsecured basis. Call Money is the borrowing or lending of funds for 1day. Where money
is borrowed or lend for period between 2 days and 14 days it is known as Notice Money and
Term Money refers to borrowing/lending of funds for period exceeding 14 days.
Interest rates in these markets are market determined i.e. by the demand and supply of
short term funds. In India, 80% demand comes from the public sector banks and rest 20%
comes from foreign and private sector banks. Then, around 80% of short term funds are
supplied by Financial Institutions such as IDBI and Insurance giants such as LIC. Rest 20% of
the short term funds come from the banks. Since banks work as both lenders and borrowers
in these markets, they are also known as Inter-Bank market.
The short term fund market in India is located only in big commercial centres such as
Mumbai, Delhi, Chennai and Kolkata. The intervention of RBI is prominent in the short term
funds money market in India.
Call Money / Notice Money market is most liquid money market and is indicator of the
day to day interest rates. If the call money rates fall, this means there is a rise in the
liquidity and vice versa.
11.Market Capitalisation = Current Stock Price x Number of Shares outstanding
Company XYZ has 10,000,000 shares outstanding and its current share price is Rs 8. Based
on the above formula, we can calculate that Company XYZ's market capitalisation is Rs 80
million, or 10,000,000 shares x Rs 8 per share.
It is common to consider the
top 50 stocks by market
capitalisation as large cap, the

12.PFRDA

The Pension Fund Regulatory & Development Authority Act was passed on 19th September,
2013 and the same was notified on 1st February, 2014. PFRDA is regulating NPS, subscribed
by employees of Govt. of India, State Governments and by employees of private
institutions/organizations & unorganized sectors. The PFRDA is ensuring the orderly growth
and development of pension market.
The Government of India had, in the year 1999, commissioned a national project titled
OASIS (an acronym for old age social & income security) to examine policy related to old

age income security in India. Based on the recommendations of the OASIS report,
Government of India introduced a new Defined Contribution Pension System for the new
entrants to Central/State Government service, except to Armed Forces, replacing the
existing system of Defined Benefit Pension System. On 23rd August, 2003, Interim Pension
Fund Regulatory & Development Authority (PFRDA) was established through a resolution by
the Government of India to promote, develop and regulate pension sector in India. The
contributory pension system was notified by the Government of India on 22nd December,
2003, now named the National Pension System (NPS) with effect from the 1st January, 2004.
The NPS was subsequently extended to all citizens of the country w.e.f. 1st May, 2009
including self employed professionals and others in the unorganized sector on a voluntary
basis.
13.RBI

Main Functions
a.Monetary Authority:Formulates, implements and monitors the monetary policy.
Objective: maintaining price stability and ensuring adequate flow of credit to productive
sectors.
b.Regulator and supervisor of the financial system:
Prescribes broad parameters of banking operations within which the country's banking and
financial system functions.
Objective: maintain public confidence in the system, protect depositors' interest and provide
cost-effective banking services to the public.
c.Manager of Foreign Exchange
Manages the Foreign Exchange Management Act, 1999.
Objective: to facilitate external trade and payment and promote orderly development and
maintenance of foreign exchange market in India.
d.Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for circulation.
Objective: to give the public adequate quantity of supplies of currency notes and coins and
in good quality.
e.Developmental role

Performs a wide range of promotional functions to support national objectives.


Related Functions
f.Banker to the Government: performs merchant banking function for the central and the
state governments; also acts as their banker.
g.Banker to banks: maintains banking accounts of all scheduled banks.

14.SEBI

Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a
non-statutory body for regulating the securities market. It became an autonomous body in
1992 and more powers were given through an ordinance. Since then it regulates the market
through its independent powers.

Objectives of SEBI:
As an important entity in the market it works with following objectives:
1. It tries to develop the securities market.

2. Promotes Investors Interest.

3. Makes rules and regulations for the securities market.


Functions Of SEBI:
Find below SEBI's important functions:
1. Regulates Capital Market

2. Checks Trading of securities.

3. Checks the malpractices in securities market.

4. It enhances investor's knowledge on market by providing education.

5. It regulates the stockbrokers and sub-brokers.

6. To promote Research and Investigation


SEBI In India's Capital Market:
SEBI from time to time have adopted many rules and regulations for enhancing
the Indian capital market. The recent initiatives undertaken are as follows:
Sole Control on Brokers:

Under this rule every brokers and sub brokers have to get registration with SEBI
and any stock exchange in India.
For Underwriters:

For working as an underwriter an asset limit of 20 lakhs has been fixed.


For Share Prices

According to this law all Indian companies are free to determine their
respective share prices and premiums on the share prices.

For Mutual Funds

SEBI's introduction of SEBI (Mutual Funds) Regulation in 1993 is to have direct


control on all mutual funds of both public and private sector.

15. Stock exchanges


An Index is used to give information about the price movements of products in the financial,
commodities or any other markets. Financial indexes are constructed to measure price
movements of stocks, bonds, T-bills and other forms of investments. Stock market indexes
are meant to capture the overall behaviour of equity markets. A stock market index is
created by selecting a group of stocks that are representative of the whole market or a
specified sector or segment of the market. An Index is calculated with reference to a base
period and a base index value.
Stock exchanges are players in the Secondary Markets: Stock exchange is a platform
where buyers and sellers meet. (Market where existing securities can be exchanged).For
example:
Bombay Stock Exchange (BSE)
National Stock Exchange (NSE)
New York Stock Exchange (NYSE)
Stock market indexes are useful for a variety of reasons. Some of them are :
They provide a historical comparison of returns on money invested in the stock
market against other forms of investments such as gold or debt.
They can be used as a standard against which to compare the performance of an
equity fund.
In It is a lead indicator of the performance of the overall economy or a sector of the
economy
Stock indexes reflect highly up to date information
Modern financial applications such as Index Funds, Index Futures, Index Options play
an important role in financial investments and risk management
Stock Exchanges
Major stock exchange in India
Bombay Stock Exchange (BSE).
National Stock Exchange (NSE).
Major stock indices in India
BSE Sensex: a stock market index of 30 well-established and financially sound
companies listed on the BSE.
NSE Nifty: is an indicator of the 50 top major companies on the National Stock
Exchange (NSE).

ROLE OF NSE IN INDIAN SECURITIES


MARKET

15.NIFTY 50
The Nifty 50 is a well diversified 50 stock index
accounting for 13 sectors of the economy. It is used for
a variety of purposes such as benchmarking fund
portfolios, index based derivatives and index funds.
Nifty 50 is owned and managed by India Index Services
and Products Ltd. (IISL). IISL is India's first specialised
company focused upon the index as a core product.
The Nifty 50 Index represents about 66.17% of the free
float market capitalization of the stocks listed on NSE
as on March 31, 2015.
The total traded value of Nifty 50 index constituents for the last six months ending
March 2015 is approximately 46.22% of the traded value of all stocks on the NSE.
Impact cost of the Nifty 50 for a portfolio size of Rs.50 lakhs is 0.06% for the month
March 2015.
Nifty 50 is professionally maintained and is ideal for derivatives trading.

National Stock Exchange of India


Limited (NSE) was given recognition
as a stock exchange in April 1993.
NSE was set up with the objectives
of (a) establishing a nationwide
trading facility for all types of
securities, (b) ensuring equal access
to all investors all over the country
through an appropriate
communication network, (c)
providing a fair, efficient and
transparent securities market using
electronic trading system, (d)

10

16.Large cap stocks


The first category based on market capitalisation is that of 'large cap stocks'.
1.One can look at the BSE-Sensex or BSE-100 Index as a reference point for large
cap stocks. Market capitalisation for stocks in the BSE-100 Index, for instance,
ranges from Rs 200 bn to Rs 3,500 bn.
2.These are stocks of usually large and well-established companies that have a strong
market presence and are generally considered as safe investments.
3.One important fact about large caps is that information regarding these companies is
readily available in newspapers and magazines.
4.Most of the large cap companies have good disclosures and therefore there is no dearth of
information for an investor looking into them.
Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These
companies have been around in the industry long enough and have firmly established
themselves as leading players. Their stocks are publicly traded and have large market
capitalisations.
17.Mid cap stocks
1.Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those
that generally have a market capitalisation within the range of Rs 50 bn and Rs
200 bn.
2.These represent mid-sized companies that are relatively more risky than large cap as
investment options yet, they are not considered as risky as small cap companies. They rank
between the two extremes on all the important parameters like size, revenues, employee
and client base.
When one invests in mid caps for the long term, he may be investing in companies that
could become tomorrow's runaway success stories.
Generally speaking, mid cap stocks as an investment can bring you higher returns in 3 to 5
years as opposed to their big brother large cap stocks that can bring you moderate (yet
safer) returns during this timeframe.
18. Small cap stocks
Lying at the lowest end of market capitalisation, Small cap stocks are generally viewed
under the misconception of being hazardous or 'quick rich' stocks. However, both these
labels are untrue.
Small cap companies have smaller revenue and client bases, and usually include the startups or companies in the early stage of development.

11

Small cap stocks are potentially big gainers as they are yet to be discovered within the
sector and can show growth potential in large numbers once unfurled in the market.
A thorough research is required regarding the promoters' credentials, management strength
and track record, and long and short term growth plans of the company before investing.
Small caps can prove to be a very wise 'long term' investments especially if the chosen
companies are good businesses and are well-managed.

19.Debt Instruments (loan instruments)


A. CORPORATE DEBT
B. GOVERNMENT DEBT

12

A.CORPORATE DEBT
i) Debentures and ii) Bonds
i) Debentures are instrument issued by companies to raise debt capital. As an investor,
you lend you money to the company, in return for its promise to pay you interest at a fixed
rate (usually payable half yearly on specific dates) and to repay the loan amount on a
specified maturity date say after 5/7/10 years (redemption).Normally specific asset(s) of
the company are held (secured) in favour of debenture holders. This can be liquidated, if
the company is unable to pay the interest or principal amount. Unlike loans, you can buy or
sell these instruments in the market.
Types of debentures:
Non convertible debentures (NCD) Total amount is redeemed by the issuer
Partially convertible debentures (PCD) Part of it is redeemed and the remaining is
converted to equity shares as per the specified terms
Fully convertible debentures (FCD) Whole value is converted into equity at a
specified price

ii). Bonds are broadly similar to debentures.


Bonds are broadly similar to debentures .They are issued by companies, financial
institutions, municipalities or government companies and are normally not secured by any
assets of the company (unsecured).
Types of bonds
i)Regular Income Bonds provide a stable source of income at regular, pre-determined
intervals
ii)Tax-Saving Bonds offer tax exemption up to a specified amount of investment,
depending on the scheme and the Government notification. Examples are:
Infrastructure Bonds under Section 88 of the Income Tax Act, 1961
NABARD/ NHAI/REC Bonds under Section 54EC of the Income Tax Act, 1961
iii)RBI Tax Relief Bonds
iv)Fixed Rate Bonds These are bonds on which the coupon rate is fixed for the entire
life of the bond. Most Government bonds are issued as fixed rate bonds.
For example 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing
on April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly
payment being the half of the annual coupon of 8.24%) of the face value on October 22 and
April 22 of each year.
v)Floating Rate Bonds Floating Rate Bonds are securities which do not have a fixed
coupon rate. The coupon is re-set at pre-announced intervals (say, every six months or one
year) by adding a spread over a base rate. In the case of most floating rate bonds issued
by the Government of India so far,the base rate is the weighted average cut-off yield of the
last three 364- day Treasury Bill auctions preceding the coupon re-set date and the spread is
decided through the auction. Floating Rate Bonds were first issued in September 1995 in
India.
For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thus
maturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at
6.50% being the weighted average rate of implicit yield on 364-day Treasury Bills during the
preceding six auctions. In the bond auction, a cut-off spread (markup over the benchmark

13

rate) of 34 basis points (0.34%) was decided. Hence the coupon for the first six months was
fixed at 6.84%.
vi)Zero Coupon Bonds Zero coupon bonds are bonds with no coupon payments. Like
Treasury Bills, they are issued at a discount to the face value. The Government of India
issued such securities in the nineties, It has not issued zero coupon bond after that.
vii)Capital Indexed Bonds These are bonds, the principal of which is linked to an
accepted index of inflation with a view to protecting the holder from inflation. A capital
indexed bond, with the principal hedged against inflation, was issued in December 1997.
These bonds matured in 2002. The government is currently working on a fresh issuance of
Inflation Indexed Bonds wherein payment of both, the coupon and the principal on the
bonds, will be linked to an Inflation Index (Wholesale Price Index). In the proposed structure,
the principal will be indexed and the coupon will be calculated on the indexed principal. In
order to provide the holders protection against actual inflation, the final WPI will be used for
indexation.
viii)Bonds with Call/ Put Options Bonds can also be issued with features of optionality
wherein the issuer can have the option to buy-back (call option) or the investor can have the
option to sell the bond (put option) to the issuer during the currency of the bond.
6.72%GS2012 was issued on July 18, 2002 for a maturity of 10 years maturing on July 18,
2012. The optionality on the bond could be exercised after completion of five years tenure
from the date of issuance on any coupon date falling thereafter. The Government has the
right to buyback the bond (call option) at par value (equal to the face value) while the
investor has the right to sell the bond (put option) to the Government at par value at the
time of any of the half-yearly coupon dates starting from July 18, 2007
B. GOVERNMENT DEBT
Government Securities
A government security is a tradable instrument issued by the central government or the
state governments.
It acknowledges the governments debt obligation.
Government paper with tenor beyond one year is known as dated security.
At present, there are central government dated securities with a tenor up to 30 years
in the market.
Treasury Bills
1.Treasury bills or T-bills, which are money market instruments, are short term debt
instruments issued by the Government of India and are presently issued in three tenors,
namely, 91 day, 182 day and 364 day.
2.Treasury bills are zero coupon securities and pay no interest. They are issued at a discount
and redeemed at the face value at maturity.
3. For example, a 91 day Treasury bill of Rs.100/- (face value) may be issued at say Rs.
98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of
Rs.100/-.
4.The return to the investors is the difference between the maturity value or the face value
(that is Rs.100) and the issue price (for calculation of yield on Treasury Bills please see
answer to question no. 26).
5.The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills.
Payments for the T-bills purchased are made on the following Friday.
The 91 day T-bills are auctioned on every Wednesday. The Treasury bills of 182 days and 364
days tenure are auctioned on alternate Wednesdays. T-bills of of 364 days tenure are
auctioned on the Wednesday preceding the reporting Friday while 182 T-bills are auctioned
on the Wednesday prior to a non-reporting Fridays. The Reserve Bank releases an annual
calendar of T-bill issuances for a financial year in the last week of March of the previous
financial year. The Reserve Bank of India announces the issue details of T-bills through a
press release every week.
A Government security is a tradable instrument issued by the Central Government or the
State Governments. It acknowledges the Governments debt obligation. Such securities are

14

1.Short term (usually called treasury bills, with original maturities of less than one
year) or
2.Long term (usually called Government bonds or dated securities with original
maturity of one year or more).
In India, the Central Government issues both, treasury bills and bonds or dated securities
while the State Governments issue only bonds or dated securities, which are called the State
Development Loans (SDLs).
Government securities carry practically no risk of default and, hence, are called risk-free giltedged instruments.

Government of India also issues savings instruments (Savings Bonds, National Saving
Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds,
fertiliser bonds, power bonds, etc.).
They are, usually not fully tradable and are, therefore, not eligible to be SLR securities.
20.How is the yield of a Treasury Bill calculated?

Wherein;
P Purchase price
ILLUSTRATION:

22. Fixed income Instruments:


Fixed income securities, or bonds, include the debt obligations of governments,
agencies, municipalities and corporations.
The borrower (issuer) promises to pay the lender (investor) interest at a specified
rate over the life of the bond (maturities typically range from one to 30 years) and
repay face value at maturity.
Fixed income securities market:
They consist of:
Money market
Debt or bond market
Characteristics of Fixed Income Securities
Regular interest incomeInterest payments can be monthly, quarterly or semiannually, depending on the security type.

15

Capital protection The borrower promises to repay the face value when the
securities mature, and some will pledge collateral to support interest and principal
payments.
DiversificationBonds can be an integral part of a diversified investment portfolio
that includes other asset classes such as stocks and alternative investments.
LiquidityLiquidity is a measure of how easily a security can be sold in a secondary
market, and fixed income securities can range from highly liquid to relatively illiquid.
Tax exemptionsInterest income from securities issued by government entities may be
fully or partially exempt from local, state or federal income taxes.

Mutual Funds
23. Mutual Funds
Mutual funds are a
1.Vehicle to mobilize moneys from (Pool of Money)
2.Investors,
3.To invest in different markets and securities,
4. In line with the investment objectives agreed upon,
investors.

16

between the mutual fund and the

Mutual funds collect money from many investors and invest this corpus in equity, debt or a
combination of both, in a professional and transparent manner. In return for your
investment, you receive units of mutual funds which entitle you to the benefit of the
collective return earned by the fund, after reduction of management fees.
Working of a Mutual Fund:

NEW FUND OFFER


When a scheme is first
made available for
investment, it is called a
New Fund Offer (NFO).
During the NFO, investors
may have the chance of
buying the units at their
face value. Post-NFO, when
they buy into a scheme,
they need to pay a price
that is linked to its NAV.

There are multiple entities involved in the activities of a mutual


fund business. All these entities are regulated by SEBI for their
eligibility in terms of experience and financial soundness, range
of responsibilities and accountability. A mutual fund is set up by a
sponsor, who is its promoter. Trustees are appointed to take care
of the interests of the investors in the various schemes launched
by the mutual fund. An asset management company (AMC) is
appointed to manage the activities related to launching a
scheme, marketing it, collecting funds, investing the funds
according to the schemes investment objectives and enabling
investor transactions. In this, they are assisted by other entities
such as banks, registrars to an issue and transfer agents, investor service centres (ISC),
brokers or members of stock exchanges, custodians, among others.
For example, the sponsor of the HDFC Mutual Fund is HDFC and Standard Life Investments
Ltd and the trustees are the HDFC Trustee Company Ltd. The AMC is HDFC Asset
Management Company Ltd.
MARK TO MARKET
The current value of the portfolio forms the base of the net assets of the scheme and therefore the NAV. It means that if the
portfolio was to be liquidated, then this would be the value that would be realised and distributed to the investors. Therefore the
portfolio has to reflect the current market price of the securities held. This process of valuing the portfolio on a daily basis at
current value is called marking to market. The price is taken from the market where the security is traded. If the security is not
traded or the price available is stale, then SEBI has laid down the method for valuing such securities.

24.Cllassification of Mutual Funds


1.Open-Ended Funds, Close-Ended Funds and Interval Funds
2.Actively Managed Funds and Passive Funds
3.Debt, Equity and Hybrid Funds
i)Debt Funds
a. Gilt funds
b.Diversified debt funds
c.Junk bond schemes
d.Fixed maturity plans

17

e.Floating rate funds


f.Liquid schemes
ii) Equity Funds
a.Diversified equity fund
b.Sector funds
c.Thematic funds
d.Equity Linked Savings Schemes (ELSS),
e.Equity Income / Dividend Yield
f.Arbitrage Funds
iii) Hybrid Funds

a.Monthly Income Plan

b.Capital Protected Schemes


4.Gold Funds
a.Gold Exchange Traded Fund,
b.Gold Sector Funds
5.Real Estate Funds
6.Commodity Funds
7.International Funds
8. Fund of Funds
9. Exchange Traded Funds
A mutual fund can also be classified based on the structure and/or investment
objective as under:
(A) By Structure

1.Open ended,2.Closed ended and 3.Interval


An Open-ended scheme allows investors to invest in additional units and redeem
investment continuously at current NAV. The scheme is for perpetuity unless the investors
decide to wind up the scheme.
The unit capital of the scheme is not fixed but changes with every investment or redemption
made by investors.
A Closed-ended scheme is for a fixed period or tenor. It offers units to investors only during
the new fund offer (NFO). The scheme is closed for transactions with investors after this. The
units allotted are redeemed by the fund at the prevalent NAV when the term is over and the
fund ceases to exist after this.
In the interim, if investors want to exit their investment they can do so by selling the units to
other investors on a stock exchange where they are mandatorily listed.
The unit capital of a closed end fund does not change over the life of the scheme since
transactions between investors on the stock exchange does not affect the fund.

Interval funds are a variant of closed end funds which become open-ended during
specified periods. During these periods investors can purchase and redeem units like in an
open-ended fund. The specified transaction periods are for a minimum period of two days
and there must be a minimum gap of 15 days between two transaction periods. Like closedended funds, these funds have to be listed on a stock exchange.
(B) By Investment Objective
1.Growth Schemes
Aim to provide capital appreciation over the medium to long term. These schemes normally
invest a majority of their funds in equities and are willing to bear short term decline in value
for possible future appreciation.
These schemes are NOT for investors seeking regular income or needing their money back
in the short term.

18

Ideal for:
Investors in their prime earning years.
Investors seeking growth over the long term.
2.Income Schemes
Aim to provide regular and steady income to investors. These schemes generally invest in
fixed income securities such as bonds and corporate debentures.
Capital appreciation in such schemes may be limited.
Ideal for:
Retired people and others with a need for capital stability and regular income.
Investors who need some income to supplement their earnings.
3.Balanced Schemes
Aim to provide both growth and income by periodically distributing a part of the income and
capital gains they earn. They invest in both shares and fixed income securities in the
proportion indicated in their offer documents. In a rising stock market, the NAV of these
schemes may not normally keep pace or fall equally when the market falls.
Ideal for:
Investors looking for a combination of income and moderate growth.
4.Money Market / Liquid Schemes
Aim to provide easy liquidity, preservation of capital and moderate income. These schemes
generally invest in safer, short term instruments such as treasury bills, certificates of
deposit, commercial paper and interbank call money. Returns on these schemes may
fluctuate, depending upon the interest rates prevailing in the market.
Ideal for:
Corporates and individual investors as a means to park their surplus funds for short
periods or awaiting a more favorable investment alternative.
5. Growth Fund
1.A diversified portfolio of stocks that has capital appreciation as its primary goal, with little
or no dividend payouts.
2.Portfolio companies would mainly consist of companies with above-average growth in
earnings that reinvest their earnings into expansion, acquisitions, and/or research and
development.
3.Most growth funds offer higher potential capital appreciation but usually at above-average
risk. Growth funds are more volatile than funds in the value and blend categories.
4.The companies in a growth fund portfolio are in an expansion phase and they are not
expected to pay dividends. Investing in growth funds requires a tolerance for risk and a
holding period with a time horizon of five to 10 years.
6. Equity and equity related funds
These would entail two types of funds:
An equity fund (invests in shares)
A balanced fund (invests in shares and fixed income instruments) that has more than
50% of its investments in shares.
If investor sells the units of such funds within a year of purchase, the profit on this sale is
called a short-term capital gain. Investor will be taxed 10% on short-term capital gain.
If investor make a profit by selling the units after a year, it is called long-term capital gain.
This is not taxed.
7.Debt Funds

19

Definition: Debt funds are mutual funds that invest in fixed income securities like bonds and
treasury bills. Gilt fund, monthly income plans (MIPs), short term plans (STPs), liquid funds,
and fixed maturity plans (FMPs) are some of the investment options in debt funds. Apart
from these categories, debt funds include various funds investing in short term, medium
term and long term bonds.
Description: Debt funds are preferred by individuals who are not willing to invest in a highly
volatile equity market. A debt fund provides a steady but low income relative to equity. It is
comparatively less volatile.
DEBT FUNDS
1.Gilt funds invest in only treasury
bills and government securities,
which do not have a credit risk (i.e.
the risk that the issuer of the
security defaults).
2.Diversified debt funds on the
other hand, invest in a mix of
government and non-government
debt securities.
3.Junk bond schemes or high
yield bond schemes invest in
companies that are of poor credit
quality. Such schemes operate on
Some
the premise that
the Important
attractive
returns offered
by the investee
Features
of Debt
companies makes
up for
losses
funds
or the
bond
arising out of a fewfunds:
companies
defaulting.
Funds which invest in
4.Fixed maturity plans are a kind
money
of debt fund
wheremarket
the investment
portfolio isinstruments
closely aligned to the
maturity
ofAlternate
the scheme.
forAMCs
money
tend
to structure
the scheme
around preparked
in savings
identified investments.
Further, like
bank account
close-ended schemes, they do

Can
provide
better
not accept moneys post-NFO.
returns
Thanks to post
thesetax
characteristics,
the
Highly
fund
manager
hasliquid
little ongoing role
in deciding
on the
investment
Debt
Funds
help bring
options. Such
a portfolio
stability
to your
construction gives more clarity to
investment portfolio
investors on the likely returns if
since they
arescheme
lower in
they stay invested
in the
risk asThis
compared
to
until its maturity.
helps them
Equity
Funds
compare the
returns
with
alternative
investments
like bank
They
are riskier
than
deposits. liquid funds
5.Floating
rate funds
These
wouldinvest
typically
largely in floating rate debt
invest
government
securities i.e. debtinsecurities
where
securities,
NCD,
CDs,
the interest
rate payable
by the
CPs bonds
and the
other
issuer changes
in line with
market. For
example,
a debt
fixed
income
security securities as well as
6.Liquid schemes
or Money
lend money
to large
Market Schemes are a variant of
organisations or
debt schemes that invest only in
corporates,
in moneys
return
debt securities
where the
of awithin
fixed91-days.
interestWidely
will be repaid
recognizedrate.
to be the lowest in risk
among
kinds of mutual
fund
all Investing
in debt
schemes mutual funds would be

ideal if youre looking


at a potentially higher
return than liquid
funds over a medium
term time horizon,
between 3 to 24
months.
FMPs CDs and CPs
with maturities
ranging from 1 month
to 3 years.

8.Income Funds
A type of mutual fund that emphasizes current income, either
on a monthly or quarterly basis, as opposed to capital
appreciation. Such funds hold a variety of government,
municipal and corporate debt obligations, preferred stock,
money market instruments, and dividend-paying stocks.
Share prices of income funds are not fixed; they tend to fall
when interest rates are rising and to increase when interest
rates are falling. Generally, the bonds included in the
portfolios of these funds are of investment grade. The other
securities are of sufficient credit quality to assure a
preservation of capital.
There are two popular high-risk funds that also focus mainly
on income: high-yield bond funds and bank loan funds. The
former invests primarily in corporate "junk" bonds and the
latter in floating-rate loans issued by banks or other financial
institutions.
9.Actively managed funds
Funds where the fund manager has the flexibility to choose
the investment portfolio, within the broad parameters of the
investment objective of the scheme. Since this increases the
role of the fund manager, the expenses for running the fund
turn out to be higher. Investors expect actively managed
funds to perform better than the market
10.Passive funds

20

Passive funds invest on the basis of a specified index, whose performance it seeks to track.
Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the
composition of the BSE Sensex. The proportion of each share in the schemes portfolio would
also be the same as the weightage assigned to the share in the computation of the BSE
Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are
not designed to perform better than the market. Such schemes are also called index
schemes.
11. Equity Funds
Diversified equity fund is a category of funds that invest in a diverse mix of securities
that cut across sectors.
Sector funds however invest in only a specific sector. For example, a banking sector fund
will invest in only shares of banking companies. Gold sector fund will invest in only shares of
gold-related companies.
Thematic funds invest in line with an investment theme. For example, an infrastructure
thematic fund might invest in shares of companies that are into infrastructure construction,
infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more
broad-based than a sector fund; but narrower than a diversified equity fund.
Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors.
However, the investor is expected to retain the Units for at least 3 years.
Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate
less, and therefore, dividend represents a larger proportion of the returns on those shares.
The NAV of such equity schemes are expected to fluctuate lesser than other categories of
equity schemes.
Arbitrage Funds take contrary positions in different markets / securities, such that the risk
is neutralized, but a return is earned. For instance, by buying a share in BSE, and
simultaneously selling the same share in the NSE at a higher price.
12.Types of Hybrid Funds
Monthly Income Plan seeks to declare a dividend every month. It therefore invests
largely in debt securities. However, a small percentage is invested in equity shares to
improve the schemes yield e.g. debt (80%) and equity (20%)..
Capital Protected Schemes are close -ended schemes, which are structured to
ensure that investors get their principal back, irrespective of what happens to the
market. This is ideally done by investing in Zero Coupon Government Securities
whose maturity is aligned to the schemes maturity. (Zero coupon securities are
securities that do not pay a regular interest, but accumulate the interest, and pay it
along with the principal when the security matures).
Hybrid funds:
Balanced funds
Monthly Income Plans: It seeks to declare a dividend every month though
not guaranteed. They invest mostly in debt (80%) and equity (20%).
Flexible Asset Allocation for fund manager
13. Gold Funds

These funds invest in gold and gold-related securities. They can be structured in
either of the following formats:
Gold Exchange Traded Fund, which is like an index fund that invests in gold. The
structure of exchange traded funds is discussed later in this unit. The NAV of such
funds moves in line with gold prices in the market.
Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold
mining and processing. Though gold prices influence these shares, the prices of these
shares are more closelylinked to the profitability and gold reserves of the companies.
Therefore, NAV of these funds do not closely mirror gold prices

14. Real Estate Funds

21

They take exposure to real estate. Such funds make it possible for small investors to take
exposure to real estate as an asset class. Although permitted by law, real estate mutual
funds are yet to hit the market in India.
15. Commodity Funds
Commodities, as an asset class, include:
food crops like wheat and chana
spices like pepper and turmeric
fibres like cotton
industrial metals like copper and aluminium
energy products like oil and natural gas
precious metals (bullion) like gold and silver
As with gold, such funds can be structured as Commodity ETF or Commodity Sector
Funds. In India, mutual fund schemes are not permitted to invest in commodities. Therefore,
the commodity funds in the market are in the nature of Commodity Sector Funds, i.e. funds
that invest in shares of companies that are into commodities. Like Gold Sector Funds,
Commodity Sector Funds too are a kind of equity fund.
16. Fund of Funds
Funds can be structured to invest in various other funds, whether in India or abroad. Such
funds are called fund of funds. These fund of funds pre-specify the mutual funds whose
schemes they will buy and / or the kind of schemes they will invest in. They are designed to
help investors get over the trouble of choosing between multiple schemes and their variants
in the market.
A fund of funds allows investors to achieve a broad diversification and an appropriate asset
allocation with investments in a variety of fund categories that are all wrapped up into one
fund. However, if the fund of funds carries an operating expense, investors are essentially
paying double for an expense that is already included in the expense figures of the
underlying funds.
17.Exchange Traded Funds
Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock
exchange.
A feature of open -ended funds, which allows investors to buy and sell units from the mutual
fund, is made available only to very large investors in an ETF.
27.Systematic Transactions
Mutual funds offer investors the facility to automate their investment and redemption
transactions to meet their needs from the investment. Systematic investment plans (SIP),
systematic withdrawal plans (SWP), systematic transfer plans (STP) and switches are some
of the facilities provided.
i.Systematic Investment Plans (SIP)
In a systematic investment plan, investors commit to invest a fixed sum of money at regular
intervals over a period of time in a mutual fund scheme.

SIP Date

Investment Amount
(Rs) (A)

NAV(
B)

Units
Allotted(A/B)

10-Feb-14

2500

10.50

238.10

10-Mar-14

2500

11.70

213.68

22

10-Apr-14

2500

12.30

203.25

10-May-14

2500

12.10

206.61

10-Jun-14

2500

11.95

209.21

10-Jul-14

2500

10.25

243.90

Total

15000

1314.75

Average cost per


unit

11.41

ii.Systematic Withdrawal Plan (SWP)


Investors can structure a regular payout from the balance held in a mutual fund investment
by registering for a systematic withdrawal plan. An SWP enables recurring redemptions from
a scheme over a period of time at the applicable NAV on the date of each redemption. It is a
facility that provides a defined payout from a fund for investors who need it.
The SWP is redemption from a scheme. Exit loads will apply to each redemption transaction
and there will be tax implications for the investor on redemption in the form of capital gains.
iii.Systematic Transfer Plan (STP)
A systematic transfer plan combines redemption from one scheme and an investment to
another scheme of the same mutual fund. The scheme from which units are redeemed is
called the source scheme and the scheme into which investments are made is called the
target scheme.
iv.SWICH
A switch is a single transfer from one scheme or option of a scheme to another scheme, or
option of the same scheme.
The investor redeems units from scheme and simultaneously invests it in another scheme of
the same mutual fund in an inter-scheme switch.
In an intra-scheme switch, the investor redeems from one option of a scheme and invests in
another option of the same scheme.
In a switch, an investor can transfer all or a portion of the funds held in the investment. The
applicable NAV for the switch-out (redemption) from the source scheme or option and
switch-in (purchase) into the target scheme or option will depend upon the type of schemes.
Since there is a redemption that happens in a switch, exit loads and taxes will apply. The
investor will need to specify the source and target schemes and options and the amount to
be switched.
28.Small savings Instruments
The Indian government has instituted a number of small saving schemes to encourage
investors to save regularly. The main attraction of these schemes is the implicit guarantee of
the government, which is the borrower. These schemes are offered through the post office
and select banks.The saving schemes currently offered by the government are:
Public Provident Fund (PPF)
Senior Citizens Saving Scheme (SCSS)
National Savings Certificate (NSC)
Post Office Schemes and Deposits
29.Fixed Income Instruments
The Indian debt markets are largely wholesale markets dominated by institutional investors.
There is however a few retail products that are offered from time to time. Some bonds are
offered to retail investors but do not have a liquid secondary market. Therefore retail
investors do not participate in such bond issues or end up buying and holding the bonds to
maturity.

The following are bonds and deposits available to retail investors:

23

Government securities
Corporate bonds
Company deposits
30.Limitations of a Mutual Fund
i.Lack of portfolio customization:The unit-holder cannot influence what securities or
investments the scheme would buy.
ii.Choice overload :Over 800 mutual fund schemes offered by 38 mutual funds and multiple
options within those schemes.
iii.No control over costs
31.ULIP and MF
Description
Unit Linked Insurance Plans refer to
Unit Linked Insurance Plans offered by
insurance companies. These plans
allow investors to direct part of their
premiums into different types of funds
(equity, debt, money market, hybrid
etc.).

A mutual fund pools the money from


investors and uses it to invest in
various securities according to a prespecified investment objective.

Objective
Unit Linked Insurance Plans are long
term plans offering you a dual benefit
of insurance and investment.

Mutual funds are ideal investment tool


for the short to medium term.

Tax Benefit
All Unit Linked Plans offer tax benefits
under section 80C.

Only investments in tax saving funds


are eligible for section 80C benefits.

Switching options

Unit Linked Plans (ULIP) allows you to


switch your investment between the
funds linked to the plan. This enables
you to change the risk return.

No switching option is available. If you


are not satisfied with the performance
of the fund you can exit completely
from the same by paying exit charges,
if applicable.

Additional Benefits
Some of the Unit Linked Plans give you
an additional benefit or loyalty benefit
by issuing extra fund units.

There are no additional benefits issued


by mutual funds.

Liquidity
Unit Linked Plans have limited
liquidity. One needs to stay invested
for a minimum period of time as
specified in the policy before
redeeming the units.

You can easily sell mutual fund units


(except for ELSS and funds that have a
minimum lock-in period).

Charges

structure

Charges in a unit linked plan include


mortality charges for the life insurance
provided. In addition, premium
allocation charge, fund management
charge and administration charges are
applicable.

Mutual fund charges include an entry


load, the annual fund management
charge and an exit load, if applicable.

Benefit Snapshot

1. Dual benefit of investment and


insurance.
2. Suitable for the long term.
3. Option to switch between the
funds is permitted.
4. Offers tax benefits.

1. Investment
tool suitable for
short to medium
term.
2. Easy exit
possible.
3. Tax benefit
available only on
tax saving funds

24

Let us revise: Investment


Avenues
Financial forms of investment:

Fixed income securities,


Shares, Mutual funds etc.
Non-Financial forms of investments:

Real estate, precious metals,


commodities, art etc.
Security Form
A.
Money Market Securities

T-bills and dated


securities

Commercial
papers and
certificate of
deposit

Others
B.
Capital Market Securities

Equity shares

Preferences
shares

Debentures
Non-Security Form

Bank Deposit

Post Office
Deposit

Insurance
Schemes

Mutual Fund

Deposit Schemes
of NBFC
Exercise: Indicate the type of returns i.e.
yield/capital appreciation by mentioning
(Yes or No) ,
Risk(High/Low) and Liquidity (High/Low) in
the table given next to this box:

32. TAX IMPACT


The tax impact
Dividends from a mutual fund are not taxed.
When you sell the units of a mutual fund and make a
profit, it is known as capital gain.
Equity and equity related funds
An equity fund (invests in shares)
A balanced fund (invests in shares and fixed income instruments) that has more than
50% of its investments in shares.
If investor sells the units of such funds within a year of his purchase, the profit on this
sale is called a short-term capital gain. He will be taxed 10% on short-term capital
gain.
If he makes a profit by selling the units after a year, it is called long-term capital gain.
This is not taxed.
Debt funds
These are funds that invest in fixed income instruments (investments that give a
fixed return, like fixed deposits and bonds) and not in the stock market.
If investor sells the units of such a fund within a year of his purchase, the profit he
make is called is short-term capital gain. It will be added to his total income and he
will be taxed as per the tax bracket he now fall under.
If he makes a profit by selling these units after a year, it is called a long-term capital
gain.
In this case, indexation is taken into account (a type of computation that takes
inflation into account).
So the tax is the lower of these:
20% (of the long-term capital gain) + surcharge and cess levied by the
government after taking indexation into account.
10% (of the long-term capital gain) + surcharge and cess without taking indexation
into account.
Indexation is a technique to adjust income payments by means of a price index, in order to
maintain the purchasing power of the public after inflation, while indexation refers to the
unwinding of indexation.
The automatic adjustment of an economic variable, such as wages, taxes, or pension
benefits, to a cost-of-living index, so that the variable rises or falls in accordance with the
rate of inflation.

25

33. Real and Nominal Rates


1.Nominal Rate of interest is the interest that is visible in the market. Which is quoted by the
financial institutions.
2.Real rate is the rate that is effective rate after taking into account the impact of inflation
on the Nominal rate.
Correct Real rate=[(1+NR)/(1+IR)-1]*100
Nominal Rate

7%

12%

18%

22

Inflation Rate

4%

6%

8%

10%

Real Rate(By rule of Thumb)

12

12

Correct Real rate

2.88

5.66

9.26

10.91

34.RISK
Risk is defined as deviation of actual returns from expected return. Risk in
investment is categorized as Systematic and Unsystematic also called Non diversifiable and
Diversifiable risk. Unsystematic risk can be reduced through Diversification. Systematic risk
is a Market Risk which can not be reduced through Diversification.
Systematic risk or market risk refers to those risks that are applicable to the entire
financial market or a wide range of investments. These risks are also known as
undiversifiable risks, because they cannot be eliminated through diversification. Systematic
risk is caused due to factors that may affect the economy/markets as a whole, such as
changes in government policy, external factors, wars or natural calamities.
Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic
risks. Inflation risk affects all investments, though its highest impact is on fixed rate
instruments. All overseas investments are subject to exchange rate risk. Interest rate and
reinvestment risk impact all debt investments.
Unsystematic risk is the risk specific to individual securities or a small class of
investments. Hence it can be diversified away by including other assets in the portfolio.
Unsystematic risk is also known as diversifiable risk. Credit risk, business risk, and liquidity
risks are unsystematic risks.
Diversification can be achieved through:
Across different asset classes e.g. equity, debt, commodities, precious metals, real
estate.(Product Diversification)
Across different countries.
Across different securities e.g. Different Stocks, Different Bonds etc.
Across maturities e.g. short term, long term, for life etc.(Time Diversification).
Hedging: Systematic risk cannot be diversified out of portfolio. It can be Hedged. This is
done with the help of derivative products like futures, options, swaps.
What is risk appetite?
The amount and type of risk an individual is willing to take in order to meet his investment
objectives.
Risk appetite and Risk tolerance:

26

While risk appetite i.e risk an individual is willing to take differs from person to person, risk
tolerance is usually estimated keeping in mind the present financial circumstances and other
factors of the individual.
Factors that help to determine risk appetite are:
Age,Experience,Knowledge,Income ,Expenses
Risk Profiling is understanding the risk appetite of the Client.
Balancing the Risk: Spreading the investment among different asset classes
(Equity,Bond,G-Sec, Debentures, Gold,Real Estate)

35.Risk Return Trade off


The trade off which an investor faces between risk and return while considering investment
decisions is called the risk return trade off.
Definition: Higher risk is associated with greater probability of higher return and lower risk
with a greater probability of smaller return. This trade off which an investor faces between
risk and return while considering investment decisions is called the risk return trade off.
Description: For example, Rohan faces a risk return trade off while making his decision to
invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the
interest rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh
(currently the Deposit Insurance and Credit Guarantee Corporation in India provides
insurance up to Rs 1 lakh).
Case-1:
Earlier average/expected return was 20% whereas the risk(standard deviation) was 6. Now the risk reduces to 3 from 6 (i.e. decline
of 50% i.e. reduction of 3 for 6) whereas the return either remains as it is (i.e. 20% itself) Or reduces to 18% from 20% (i.e. decline
of 10% i.e. reduction of 2 for 20).Above is an example of Divercification
DIVERSIFIED FUND tries to increase the return either with no change in the level of risk or with lesser level of increase in risk in
comparison with the level of increase in return.

Case-2:
If the earlier average/expected return was 20% whereas the risk(standard deviation) was 6. Now due to diversified portfolio the
return increases to 30% from 20% (i.e. increase of 50% i.e. increase of 10 for 20) whereas the risk either remains as it is (i.e. 6 itself)
Or increases to 6.6 from 6 (i.e. increase of 10% i.e. increase of 0.60 for 6). Return Increased
50%
Risk increased
10%

Case-3:

36.ANNUITY

27

An annuity is a series of equal payments made at fixed intervals of time. For example a
Recurring Deposit account in a Bank accepting a monthly instalment of Rs.1000 for 5 years
at 10% interest.While the payments in an annuity can be made as frequently as every week,
in practice, ordinary annuity payments are made monthly, quarterly, semi-annually or
annually. The opposite of an ordinary annuity is an annuity due, where payments are made
at the beginning of each period.

Ordinary Annuity (Payment at the end of the investment period)


1.Future Value of Annuity
FVAn=AMT[(1+r)^n-1)/r]
2.Present Value of Annuity
PVAn=AMT [(1+r)^n1)/r*(1+r)^n]
Annuity Due (Payment at the beginning of the investment period)
OR =AMT [1-(1+r)^-n)/r]
1.Future Value of Annuity
FVADue=AMT[(1+r)^n-1)/r]*(1+r)
2.Present
Value of Annuity
PVADue=AMT [(1+r)^n3.Future Value Interest Factor
of Annuity
FVIFAn=[(1+r)^n-1)/r]
1)/r*(1+r)^n]*(1+r)
4.Present Value Interest Factor
of Annuity
PVIFAn=[(1+r)^nOR =AMT [1-(1+r)^-n)/r]*(1+r)
1)/r*(1+r)^n]
3.Future Value Interest Factor
FVIFADue=[(1+r)^n-1)/r]*(1+r)
4.Present Value Interest Factor
PVIFADue[(1+r)^n-1)/r*(1+r)^n]*(1+r)

In SIP, an investor commits to pay an annuity amount regularly. Here investor needs to invest the same
amount of money in a particular mutual fund at every stipulated time period.

37.What is Rule of 72?


When the number 72 has been divided by the interest (without /100) rate you assume to
earn then that number gives you with the approximate number of years it will take for your
investment to double. This is called rule of 72.
For example for an interest rate of 10% it takes 7.2 years to double your initial investment.
38. P/E (Price Earnings ratio)
P/E is short for the ratio of a company's share price to its per-share earnings. As the name
implies, to calculate the P/E, the current stock price of a company is divided by its earnings
per share (EPS):

P/E Ratio =

Market Value per Share


---------------------------------

Earnings per Share (EPS)


Most of the time, the P/E is calculated using EPS from the last four quarters. This is also
known as the trailing P/E. However, occasionally the EPS figure comes from estimated
earnings expected over the next four quarters. This is known as the leading or projected P/E.

28

A third variation that is also sometimes seen uses the EPS of the past two quarters and
estimates of the next two quarters.

39. NPV , IRR and Cost of Capital


Earnings per share (EPS) is
the portion of a companys
profit that is allocated to
each outstanding share of
common stock, serving as
an indicator of the
companys profitability. It is
often considered to be one
of the most important
variables in determining a
stocks value, and it
comprises the E part of
the P/E (price-earnings)
valuation ratio. EPS is
calculated as:

The net present value (NPV) is the difference between


the present value of the expected cash inflows and the
present value of the expected cash outflows.
If the present value of the expected cash outflows is
greater than the present value of the expected cash
inflows then NPV < 0.
If the present value of the expected cash outflows is
equal to the present value of the expected cash inflows
then NPV = 0.
If the present value of the expected cash outflows is
less than the present value of the expected cash
inflows then NPV > 0.

EPS = net income /


average outstanding
common shares
EPS = (net income
dividends on preferred
stock) / average
outstanding common
shares

and equity capital).

The IRR is defined as the discount rate that makes the


present value of the cash inflows equal to the present
value of the cash outflows in an investment analysis,
where all future cash flows are discounted to
determine their present values.
Application of IRR:
Comparison of cash flows
Comparison of financial products
Financial decision making
The cost of capital represents the minimum desired
rate of return (i.e., a weighted average cost of debt

Relationship between NPV,IRR and Cost of capital:

40.Ponzi scheme
A Ponzi scheme is a fraudulent investment operation where the operator, an individual or
organization, pays returns to its investors from new capital paid to the operators by new
investors, rather than from profit earned by the operator. Operators of Ponzi schemes

29

usually entice new investors by offering higher returns than other investments, in the form
of short-term returns that are either abnormally high or unusually consistent.
Ponzi schemes occasionally begin as legitimate businesses, until the business fails to
achieve the returns expected. The business becomes a Ponzi scheme if it then continues
under fraudulent terms.
41.Tax Planning:
a) Important Terms:
Assessment Year: The period of 12 months commencing on the first day of April every
year. All the income earned by persons during the previous year is assessed in the
assessment year and the taxes on the same are paid during the assessment year itself.
For instance, the period from April 1, 2011 to March 31, 2012 shall be the assessment year
for the income earned during previous year i.e. from April 1,2010 to March 31,2011.
Previous Year: It is defined as the financial year immediately preceding the Assessment
year. The previous year can also be understood as the year in which the income is earned by
a person.
Gross Total Income: Is the aggregate of income under all heads of income.
Taxable Income: Is the income arrived at, after allowing all deductions and exemptions.
PAN: Permanent Account Number - a ten digit number which helps the IT department to
identify any person liable to pay income tax.
TAN: tax deduction and collection account number a 10 digit alpha numeric number to be
obtained by all persons/entities who are entrusted with the task of collecting or deducting
tax.
TDS: Income tax shall be deducted while effecting payments like salary, interest,
contractors settlement, Consultants fee etc. and remitted to the Central Government
through an authorized bank.
Tax Structure:
Direct Tax(Paid by tax payer directly to
Government)

1.Income Tax
2.Wealth Tax
3.Gift Tax
4.Security Transaction Tax
5.Capital Gains Tax
Collected by :Central Board of Direct
Taxes

Indirect Tax(Paid to
the Government by a
third party and
collected from tax
payer)
1.Custom Duty
2.Excise Duty
3.Service Tax
4.Value Added Tax
Collected by: Central
Board of Excise and
Customs

Who is a person?
Under Section 2(31) Income Tax Act
1.Individual
4.Firm
2.HUF (Hindu Undivided
Family)

7.Any other
artificial person

5.Association of Persons
(Incorporated or Not)

30

3.Company

6.Local Authority

Who is a Resident Indian?


1.Basic Conditions: Assessee has been in India for a period of 182 days or more in the
previous year OR assessee has been in India for a period of at least 60 days in the previous
year and 365 days or more in 4 years immediately preceding the previous year
2.Additional conditions: Assessee has been resident in India at least 2 out of 10 years
immediately preceding the previous years AND assessee has been in India for a period of
730 days or more during the 7 years immediately preceding the previous year
3.Residential Status for Individuals is divided into three categories
Resident and Ordinarily Resident (R&OR)
Resident and Not Ordinarily Resident (R&NOR)
Non-Resident (NR)
4.Resident and Ordinarily Resident: a person who fulfils any of the basic conditions and
satisfies both the additional conditions
5.Non-resident: a person who fails to satisfy any of the basic conditions.

31

What is INCOME, Salary Income and allowances as per


Tax?
Income
Salary Income
1.Income from Salary
1.Wages
2.Income from House
2.Annuity/pension
Property
3.Income from Business
3.Retirement benefits
and Profession
4.Income from Capital
4.Other income in lieu of
Gains
salary
5.Income from other
5.Advance Salary
sources e.g. rental
income, interest income
etc.
6.Allowances

32

Section 2(24) of Income


Allowances
1.Rent
2.Childern Education
3.Entertainment
4.Transport
5.Medical

6.Dearness
7.Overtime
8.Special Allowance

b) Basic Exemptions in the Income Tax (2015-2016):


For Senior Citizens
For Men/Women
(Age 60 years or
below 60 years of
more but less than
age
80 years)

For Senior Citizens


(Age 80 years or
more)

Income
Level

Tax
Rate

Income Level

Tax
Rate

Income Level

Tax
Rate

Rs.
2,50,000

Nil

Upto Rs.
3,00,000

Nil

Upto Rs.
5,00,000

Nil

Rs.
2,50,001 Rs.
500,000

10%

Rs. 3,00,001 Rs. 500,000

10%

Rs. 5,00,001 Rs. 10,00,000

20%

Rs.
500,001 Rs.
10,00,000

20%

Rs. 500,001 Rs. 10,00,000

20%

Above Rs.
10,00,000

30%

Above Rs.
10,00,000

30%

Above Rs.
10,00,000

30%

Exemptions under Sec 80C:


Income
Life Insurance
Policies

Section
80C

Unit Linked
Insurance Plan
(ULIP)

Section
80C

Infrastructure
Bonds (NO
LONGER
AVAILABLE FOR
FRESH
INVESTMENT)

Section
80C

Contribution to
EPF / GPF /

Section
80C

Tax on Income
Varies from
Varies from year
scheme to
to year
scheme
Varies from
Varies from year
scheme to
to year
scheme
Varies from
issue to
issue. These
were around 8%
+ in Dec 2011.
These have lost
their charm as Taxable
Additional Tax
rebate of Rs
20,000 is NOT
given now from
FY 2012-13
onwards.
8.75% on EPF
Interest
for 2013-14
earned is tax

33

Maturity
Varies from scheme to
scheme
Varies from scheme to
scheme (15 to 20 years)

3 to 5 years

Till retirement (loans are


permitted only after 5

(announced in
August 2013)

Voluntary PF
Insurance
Policies

Section
80C

6 to 7% only

ULIPS

Section
80C

Market linked

free
Earnings are
tax free in
most of the
cases
Earnings are
tax free

years)

Locked till maturity


Partial withdrawal
allowed
15 years and
extendable.
Withdrawals allowed
after 7 years. Yield on
PPF will vary and will be
fixed at 25 basis point
above the 10 year
government bonds.
Withdrawal not
permitted before
maturity

8.70% for FY
2015-16

Interest
earned is tax
free

Section
80C

Market Linked

Interest
earned is tax
free

Section
80C

Not applicable

Not applicable Not applicable

Section
80C

Not applicable

Not applicable Not applicable

Section
80C

Varies from
bank to bank
Taxable
(around 7.50% 8.75%)

5 Years

Senior Citizens
Savings Scheme
Section
2004 (from
80C
financial year
2007-08)

9.30% for FY
2015-16

Taxable

As per the guidelines


issued in December
2011, there will be
spread of 100 basis
points above the 5 year
bonds yields for this
scheme.

Post Office Time


Deposit Account Section
(from financial
80C
2007-08)

8.50% for five


year Time
Deposit

Taxable

Public Provident Section


Fund (PPF)
80C

NPS
Tuition Fees
including
admission fees
or college fees
paid for full time
education of any
two children of
the assessee.
Repayment of
Housing Loan
(Principal)
Bank Tax Saving
Fixed Deposits
Schemes - 5
Years

d)Exemptions under Section 80CCC(1)

Under this section, the contributions by individuals towards "Pension" schemes of LIC
or any other Insurance company, is allowed as deduction of Rs.10,000/-. However, as
provided under section 80CCE, the aggregate deduction u/s 80C, and u/s 80CCC and

34

80CCD can not exceed Rs.1,50,000/-. Thus effectively, now these are covered under
the maximum limit of Rs.1,50,000/- under section 80C.
e) Deductions Under Section 80 D :

Basic Deduction under Section 80D, Mediclaim premium paid for Self, Spouse or
dependant children has now been raised to Rs 25,000 wef FY 2015-16.

The deduction for senior citizens is raised from Rs 20,000 to Rs 30,000. For
uninsured super senior citizens (more than 80 years old) medical expenditure
incurred up to Rs 30,000 shall be allowed as a deduction under section 80D.
However, total deduction for health insurance premium and medical expenses for
parents shall be limited to Rs 30,000.

f) Deductions Under Section 80 E :


i) Under this section, deduction is available for payment of interest on a loan taken
for higher education from any financial institution or an approved charitable institution.
The loan should be taken for either pursuing a full-time graduate or post-graduate course in
engineering, medicine or management, or a post-graduate course in applied science or pure
science.

g) Deductions Under Section 24B :


Under this section, interest on borrowed capital for the purpose of house purchase
or construction is deductible from taxable income upto Rs.2,00,000/- . (certain conditions
are to be fulfilled)
We have seen that the principal amount in the repayment of a home loan can be added to
the 80C limit of Rs1.5 lakh for tax savings. However, the interest component of home
loans is allowed as deduction under Section 24 B for up to Rs2 lakh in case of a self-occupied
house. In case the house is in the joint name of your spouse and you (joint loan), each one
can avail of Rs2 lakh interest component deduction. This limit is only for self-occupied
house. If you have property which is rented out, you can deduct the full interest paid on the
home loan. The rent on the property does become part of your income. If the rent is lesser
than the loan interest, it will lower your overall tax liability.
h) Deductions Under Section 10(10) (d) :
Section 10(10) (d) is one of the initiative taken by the government to promote the Insurance
Product, It says that the maturity benefit/death benefit/surrender value in an insurance
policy would be tax free in the hand of the recipient provided the sum assured should be
equal to 10 times of the first year annualised premium and should not be below than that
throughout the term of the policy.
For Example:

35

Suppose, you bought a single premium life insurance policy where you had paid an annual
premium of Rs 25000 and choose a sum assured of Rs 2.5 lakhs, then in this scenario your
policy would be eligible for Sec 10 (10)(d) of the Income Tax Act and will have tax-free
maturity benefit/death benefit/surrender value.
i)

TAX FREE INCOMES

Some of the incomes are completely exempted from income tax and that too without any
upper limit. The following incomes are tax free :(1) Interest on EPF / GPF / PPF
(2) Interest on GOI Tax Free Bonds / Tax Free Bonds issued with specific stipulation to this
effect
(3) Dividends on Shares and Mutual Funds. Dividend income from companies / Equity
Oriented Mutual funds is completely exempt in the hands of investors. Dividend is also tax
free in the hands of investors in case of debt-oriented Mutual Fund schemes. (However, the
Asset Management Company is liable to deduct 22.44% distribution tax in case of non
individuals / non HUF investors and 14.025% in case of individuals or HUF investors.)
(4) Capital receipts from Life Insurance policies i.e. sums received either on death of the
insured or on maturity of Life insurance plans. However, in case of life insurance policies
issued after March 31, 2004, exemption on maturity payment u/s 10(10D) is available only if
premium paid in any year does not exceed 20% of the sum asssured;
(5) Interest on Saving Bank accounts in banks upto Rs10,000/- per year (from FY 2012-13
onwards)
(6) Long term capial gains on sale of shares and equity mutual funds after 01/10/2004, if
security transaction is paid / imposed on such transactions.
j) Assessment Year 2016-17
a) Surcharge: The amount of income-tax shall be increased by a surcharge at the rate of
12% of such tax, where total income exceeds one crore rupees. However, the surcharge
shall be subject to marginal relief (where income exceeds one crore rupees, the total amount
payable as income-tax and surcharge shall not exceed total amount payable as income-tax
on total income of one crore rupees by more than the amount of income that exceeds one
crore rupees).
b) Education Cess: The amount of income-tax and the applicable surcharge, shall be further
increased by education cess calculated at the rate of two per cent of such income-tax and
surcharge.
c) Secondary and Higher Education Cess: The amount of income-tax and the applicable
surcharge, shall be further increased by secondary and higher education cess calculated at
the rate of one per cent of such income-tax and surcharge.
d) Rebate under Section 87A: The rebate is available to a resident individual if his total
income does not exceed Rs. 5,00,000. The amount of rebate shall be 100% of income-tax or
Rs. 2,000, whichever is less.
k) Case Study 1:
Calculate the income tax payable (Tax Liability) by Satish aged 36 years for the financial
year 2014-15(Assessment year 2015-16). Gross Annual Income for 2014-15 - Rs.9.5 lacs.
His investments are as under:

36

PPF.
Rs.55000.
NSC.
Rs.45000.
Life Insurance
Rs.20000.
ELSS
Rs.20000.
ULIP
Rs.15000.
His has taken medical insurance are as under:
Mediclaim (Self/Spouse)
Rs.20000.
Mediclaim (Parents-age 61Yrs)
Rs.25000.

Step 1:Annual Income Rs.9.5 lacs.


Step 2
Exemptions Under
Amount actually
invested
80C : PPF
55000
NSC
45000
Life Insurance
20000
ELSS
20000
ULIP
15000
Sub-Total
155000
Sec 80D - Health
20000 (self & family)
Insurance
25000 (parents)
Total eligible
exemptions

Eligible Amount as per


exemptions

150000
20000
25000
195000

Step 3:
Total Income:
Rs. 9, 50,000
Less Eligible Exemptions (i.e. 1.5 Lakh+15K+20K): Rs. 1, 95,000
Taxable Income:
Rs. 7, 55,000
Step 4

Taxable Income Tax Rate


Tax Payable
Up to 2.50 lakhs
250000
A tax rebate of Rs 2,000
Nil
from tax calculated will
250001 to 5 lakhs
250000
be available for people
25000
having an annual income
500001 to 7.55 lakhs
255000
upto Rs 5 lakh.
51000
However, this benefit of
Total
765000
Rs2,000 tax credit will
76000
not be available if you

Add 3% Education Cess on Tax Payablecross the income range


76000x3/100
2280
of Rs 5 lakh. Thus we

can say that tax payable


Total Provisional Income Tax Payable
in 10% slab will be
78280
maximum Rs23,000
(taking into account Rs
2000 tax credit), but for
people who fall in income
range of Rs5 lakh and
above, the tax will be
Rs25,000 + 20% tax on
income above Rs 5 lakh;
The education cess to
continue at 3 percent.

42.Financial Planning

37

Nil
10%
20%

A process that enables better management of the personal financial situation of a


household. It works primarily through the identification of key goals and putting in place an
action plan to realign the finances to meet those goals.
A holistic approach that considers the existing financial position, evaluates the future needs,
puts a process to fund the needs and reviews the progress.
43. Need For Financial Advisory Services
The primary task of the financial adviser is to link the large range of financial products and
services to the specific needs and situations of the client. Not every product may be suitable
to every client; nor would a client be able to identify how to choose and use products and
services from a very large range. A financial advisor, who possesses the expertise to
understand the dynamics of the products on the one hand and the needs of the client on the
other, is best suited to enable using such products and services in the interest of the client.
The following are the primary reasons why financial advisers are needed:
1.Personal financial management requires time and attention to recognize income and
expense patterns, estimates of future goals, management of assets and liabilities, and
review of the finances of the household. Many clients may not find time from their
professional tasks to focus on these key issues.
2.Estimating financial goals, finding suitable products and arriving at suitable allocations to
various assets require specific expertise and skills which may not be available in most
households.
Selecting the right investment products, choosing the right service providers and managers,
selecting insurance products, evaluating borrowing options and such other financial
decisions may require extensive research. A professional adviser with capabilities to
compare, evaluate and analyse various products enables making efficient choices from
competing products.
Asset allocation is a technical approach to managing money that requires evaluating asset
classes and products for their risk and return features, aligning them to the investors
financial goals, monitoring the current and expected performance of asset classes and
modifying the weights to each asset in the investors portfolio periodically to reflect this.
Advisers with technical expertise enable professional management of assets.
Financial planning is a dynamic process that requires consistent attention to changing
market and product performances, dynamic changes in the needs and status of the client
and the ability to tune the process to these changes. It needs full-time professional attention
and the efficiencies of a disciplined and systematic process.
44. Elements of Financial advisory and planning services
The following are elements of financial advisory and planning services:
1.Personal financial analysis: An adviser assesses the financial position of a household by
bringing together its income, expenses, assets and liabilities.
2.Debt counselling: Financial advisers help households plan their liabilities efficiently. It is
common for households to borrow in order to fund their homes, cars and durables.
3. Insurance Planning: Several unexpected expenses that can cause an imbalance in the
income and expenses of a household can be managed with insurance. Insurance is a risk

38

transfer mechanism where a small premium payment can result in payments from the
insurance company to tide over risks from unexpected events.
4.Investment Planning and Asset Allocation: A crucial component in financial planning and
advisory is the funding of financial goals of a household. Investment planning involves
estimating the ability of the household to save, and choosing the right assets in which such
saving should be invested.
5.Tax Planning: Income is subject to tax and the amount a household can save, the return
they earn on their investment and therefore the corpus they are able to build for their future
goals, are all impacted by the tax regime they fall under.
6.Estate Planning: Wealth is passed on across generations. This process of inter-generational
transfer not only involves legal aspects with respect to entitlements under personal law, but
also documentation and processes that will enable a smooth transition of wealth in a taxefficient way.
45.Financial Planning Delivery Process
Financial planning requires financial advisors to follow a process that enables acquiring client
data and working with the client to arrive at appropriate financial decisions and plans, within
the context of the defined relationship between the planner and the client. The following is
the six-step process that is used in the practice of financial planning.
1.Establish and define the client-planner relationship: The planning process begins when the
client engages a financial planner and describes the scope of work to be done and the terms
on which it would be done.
2.Gather client data, including goals: The future needs of a client require clear definition in
terms of how much money will be needed and when. This is the process of defining a
financial goal.
3.Analyse and evaluate financial status: The current financial position of a client needs to be
understood to make an assessment of income, expenses, assets and liabilities. The ability to
save for a goal and choose appropriate investment vehicles depends on the current financial
status.
4.Develop and present financial planning recommendations: The planner makes an
assessment of what is already there, and what is needed in the future and recommends a
plan of action. This may include augmenting income, controlling expenses, reallocating
assets, managing liabilities and following a saving and investment plan for the future.
5.Implement the financial planning recommendations: This involves executing the plan and
completing the necessary procedure and paperwork for implementing the decisions taken
with the client.
6.Monitor the financial planning recommendations: The financial situation of a client can
change over time and the performance of the chosen investments may require review. A
planner monitors the plan to ensure it remains aligned to the
Case Study on Goal
goals and is working as planned and makes revisions as may
Value
be required.
The current cost of a
college admission may
46. Goal Value
be Rs. two lakhs. But
The goal value that is relevant to a financial plan is not the
after 5 years, the cost
current cost of the goal but the amount of money required for
would typically be higher.
the goal at the time when it has to be met. The current cost of
This increase in the cost
the goal has to be converted to the value in future.
of goods and services is
The amount of money required is a function of
called inflation. While
Current value of the goal or expense
saving for a goal,
Time period after which the goal will be achieved
therefore, it is important
Rate of inflation at which the cost of the expense is
to estimate the future
expected to go up
value of the goal
because that is the
amount that has to be
47. Risk Profiling of a Client
accumulated.
The future value of a
goal = Current Value x
39
(1+ Rate of Inflation) ^
(Years to Goal)
Rs.200000 x (1+10%) ^
5= Rs.322102.

Risk Profiling of a Client is Clients' financial risk tolerance . Risk tolerance is the
assumed level of risk that a client is willing to accept.

Financial risk tolerance can be split into two parts:


1.Risk capacity: the ability to take risk
This relates to their financial circumstances and their investment goals. Generally
speaking, a client with a higher level of wealth and income (relative to any liabilities
they have) and a longer investment term will be able to take more risk, giving them a
higher risk capacity.
2.Risk attitude: the willingness to take risk
Risk attitude has more to do with the individual's psychology than with their financial
circumstances. Some clients will find the prospect of volatility in their investments
and the chance of losses distressing to think about. Others will be more relaxed about
those issues.
Risk tolerance is typically measured using questionnaires that estimate the ability and
willingness to take risks. The responses of investors are converted into a score that may
classify them under categories that characterize their risk preferences.
Consider the following classification:
Conservative Investors
Do not like to take risk with their investments. Typically new to risky instruments.
Prefer to keep their money in the bank or in safe income yielding instruments.
May be willing to invest a small portion in risky assets if it is likely to be better for the
longer term.
Moderate Investors
May have some experience of investment, including investing in risky assets such as
equities
Understand that they have to take investment risk in order to meet their long-term
goals are likely to be willing to take risk with a part of their available assets.
Aggressive Investors
Are experienced investors, who have used a range of investment products in the
past, and who may take an active approach to
managing their investments?
Portfolio Construction

Willing to take on investment risk and understand that


An individual creates a
this is crucial to generating long term return.
portfolio of investments to
meet their various goals.
Willing to take risk with a significant portion of their
The investments selected
assets.
have to balance the
The risk preferences of the investor are taken into
required return with an
account while constructing an investment portfolio.
appropriate level of risk.
Assets and investments
differ on their features of
risk, return, liquidity and
others.
An investor will have
multiple, differing
requirements from their
portfolio depending upon
the goals they are saving
for.
They may need growth for
long-term goals, liquidity for
immediate needs and
regular payouts to meet
recurring expense.
No one investment can
meet all the requirements
for growth, liquidity, regular
income, capital protection
and adequate return.
The investor will have to
create a portfolio of
securities that has exposure
to different assets which will
cater to these diverse
needs.

48. Portfolio Construction


Portfolio Construction is Asset Allocation Linked to
Financial Goals
When a need can be expressed in terms of the sum of money
required and the time frame in which it would be needed, we
call it a financial goal.
When a financial goal is set, its monetary value and the future
date on which the money will be required is first defined. This
goal definition indicates the amount of investment value that
needs to be generated on a future date. It is normal to include

40

Case Study: Income


Replacement Method
Siddhartha earns Rs.8
lakhs p.a. He is 28 years
old and would like to
retire at age 55.
Calculate the insurance
he needs as per the
income replacement
method if we assume
that his income would
have gone up each year
by 5% and investment
would have earned a
return of 8%.
The amount of insurance
required is that sum of
money which if invested
today at a return of 8%
would replace the
income that Siddhartha
would have earned each
year, taking into
consideration the annual
increment.
The amount required has
to take into account two
rates that work here: the
rate at which the income
is expected to rise each
year and the rate of
return which the corpus
will earn during the given
period. The rate used in
the calculation will be
adjusted to reflect the
effect of both these rates
on the corpus required.
Then the PV function can
be used to calculate the
present value of the
corpus required. This will
be the amount of
insurance taken.
Calculate the adjusted
rate to be used in the
calculation of the
corpus.
((1+Invest
ment
rate)/
(1+Increm
ent rate))1 is the
formula to
be used
Investmen
t rate
given is
8% and
increment
rate is 5%.
The
adjusted
rate

assumptions for expected inflation rate while defining a future


goal. Then the return that the portfolio should generate to
achieve the targeted sum can be ascertained, after
understanding how much the investor can save for the goal.
49. Life Insurance Needs Analysis or Human Life Value
Assessment
1.This is the value that insurance needs to compensate for if
there is a loss to the life, or disability which results in a
reduction in the ability to generate income.
2.HLV is the present value of the expected income over the
working life of the individual that is available for the
dependents.
Human Life Value is the amount of insurance required after
considering the future value.
1.Income Replacement Method
2. Need Based Approach
1.Income Replacement Method
Human life value (HLV) is calculated as the present value of
the persons future earnings. This is a method of calculating
the amount of life insurance a family will need based on the
income that they would have to forego if the insured were to
pass away today. It is usually calculated by taking into
account a number of factors including but not limited to the
Insured Individuals :
1.Age, 2.Gender, 3.Planned Retirement Age, 4.Occupation,
5.Annual Wage, 6.Employment Benefits, as well as the
7.Personal and Financial Information of the Spouse and/ or
Dependent Children.
Information Required :
The information required to calculate HLV based on this
method is as follows:
1.The number of years the individual is likely to earn
(Retirement age less present age) .Average annual earnings
during the earning years.
2.Amount of personal expenses like taxes, personal costs,
insurance premium which is deducted from annual income.
3.The rate at which the income is expected to grow over the
earning years .The rate of return expected to be earned on
the corpus.

2.Need Based Approach


This is a method of calculating the human life value, and
therefore the amount of life insurance required by an
individual or family, based on the amount required to cover
their needs and goals in the event of the demise of the
earning member. These include things living expenses,

41

Case Study: Need based


approach
Anil currently has a
monthly income of Rs.
1,50,000. He pays an
insurance premium of Rs.
25,000 per month and an
EMI of Rs. 32,000 on a
loan of Rs. 40 lakhs that
he has taken for this
house. His personal
expenses are Rs. 10,000.
He wants to provide
insurance protection for
his wife who is currently
49 years old and is
expected to live till 80. If
the expected inflation is
6% and return on
investment is 8%, what
is the insurance cover he
should take? His current
insurance cover is for
Rs.1 Cr and he has other
investments amounting
to Rs.50 lakhs. His house
is worth about Rs.50
lakhs.
Calculate the current
value of the income
required to be provided.
Total income- (Portion of
income used by Anil for
personal needs+ EMI
payments+ Insurance
Premium)
= Rs. 1,50,000- (Rs.
10,000 + Rs. 32,000 +
Rs. 25,000)
= Rs. 1,50,000 - Rs.
67,000 = Rs. 83,000 per
month
=Rs. 9,96,000 per
annum
Calculate the applicable
rate after adjusting for
inflation and investment
return
Inflation rate =6%,
Investment rate= 8%,
Adjusted rate= ((1+8%)/
(1+6%))-1= 1.87%
Rate is the adjusted rate
of 1.87%
PV=PMT[{(1+r)^n1}/r(1+r)^n]
PV=9,96000X[{(1+1.87/
100)^311}/1.87/100X(1+1.87/10
0)^31]
(1+1.87/100)^31-1 =

mortgage expenses, rent, debt and loans, medical expenses,


college, child care, schooling and maintenance costs,
emergency funds.
The need based approach considers what is already available
in the form of investments, assets, and dues such as EPF,
gratuity that will contribute to the corpus. Insurance will be
taken for the remaining value.
Information Required
Sample Questions
The needs and goals that have
asked by Insurance
to be met and their current
Companies in India to
value.
calculate HLV
Inflation rate applicable.
The current value of the
1.How much annual
available investments.
income your
The rate at which the
dependants need if
investments are expected to
you die today?
grow.
2.How much annual
income does your
family get from other
sources (other than
your earnings)?
3.What is your
expected inflation
rate? (%):
4.What is your
expected return on
investemnt? (%):
50. Retirement Planning
5.For how many years
do you want to
provide this income
for your family?
(years):5
6.If you have any
outstanding loans in
your name which your
family would have to
repay , give the
amount?
7.What is the present
value of all your
investments?
8.How much insurance
do you already have
(give sum assured
amount)?

42

The amount of
insurance you need to
buy (Human Life
Value)

Retirement planning involves


making an estimate of the
expenses in retirement and the
income required to meet it,
calculating the corpus required
to generate the income,
assessing the current financial
situation to determine the
savings that can be made for
retirement and identifying the
products in which the savings
made will be invested so that
required corpus is created and
the products in which the
corpus will be invested to
generate the required income
in retirement.

There are two distinct stages in retirement: the accumulation stage and the distribution
stage. The accumulation stage is the stage at which the saving and investment for the
retirement corpus is made. Ideally, the retirement savings should start as early as possible
so that smaller contributions made can also contribute to the corpus significantly with the
benefit of compounding.
Retirement planning involves the following steps:
Compute the retirement corpus required based on the estimation of expenses in
retirement or income at retirement.
Determine the periodic savings required to accumulate the retirement corpus.
Analyse the current financial situation to determine the savings possible.
Set in place a long-term savings plan based on the expected income Identify the
investment products in which the savings will be invested.
Monitor the performance of the investment and the growth of the retirement corpus
periodically.
Review the adequacy of the retirement corpus whenever there is a change in
personal situation that has an impact on income or expenses.
Make mid-course corrections, if required.
Rebalance the portfolio to reflect the current stage in the retirement plan.

There are different methods used to estimate the amount of income required in retirement.
1. The Income Replacement method and the
2. Expense Protection Method
Income Replacement Method
The income replacement ratio is the percentage of the income just before retirement that
will be required by an individual to maintain the same standard of living in retirement. While
estimating this ratio, the current income has to be adjusted for a few heads of expenses that
may no longer be relevant in retirement. At the same time, there may be a larger outlay on
other heads of expense such as medical and healthcare. Some people may like to have a
higher discretionary income for travel or entertainment. Some of the expenses that have to
be reduced from the income include:
1.The portion of the income that is being used towards paying taxes.
2.The mandatory deduction from income being made, such as provident fund The
portion of income going to savings for goals.
3.Employment related expenses, such as those related to transportation.
The steps for estimating the income required in retirement under this method are:
1.Calculate the current income
2.Estimate the rate at which the income is expected to grow over the years to retirement
3.Calculate the years to retirement
4.Calculate the income at the time of retirement as Current value x(1+ rate of
growth)^(Years to retirement)
5.Apply the income replacement ratio to this income to arrive at the income required in
retirement.
Case Study: Income Replacement Method

Pradeep has a current annual income of Rs. 10,00,000. He is 30 years of age and expects to retire at
the age of 55. He also expects his income to grow at a rate of 10% and estimates that he will require
an income replacement of 75%. What is the income required by Pradeep in retirement?

43

Current Annual Income (Rs.)

1000000

Age

30

Retirement age

55

Years to Retirement

25

Annual Rate of Growth in Income


Income at the time of Retirement

10%
10834706

Income Replacement Ratio

75%

Annual Income required in Retirement 8126029

55-30

1000000*(1+10%)^25

10834706*75%

Expense Protection Method


In the expense protection method, the focus is on identifying and estimating the expenses
likely to be incurred in the retirement years and providing for it. Typically, the expenses
required by the person in retirement is taken as a percentage of the expenses of that person
just before retirement the assumption being that ones post retirement expenses will not
include certain expenses such as transport, home loan EMI. On the other hand the expenses
incurred on other heads such as health, is likely to be higher.
Expense Protection is a slightly cumbersome method due to the detailed listing out of
expenses incurred for the things / services required post-retirement. Estimating this wrongly
may make the determination of retirement corpus inaccurate. The process involves
preparing a list of pre and post-retirement expenses, and arriving at the total expense list.
The expense so calculated has to be adjusted for inflation over the period of time left to
retirement to arrive at the expense in retirement.
Case Study: Expense Protection Method
Pradeep has a monthly expense of Rs. 50,000 of which 60% is for household expenses. He is
30 years old and expects to retire at the age of 55. He expects to incur additional expenses
of Rs. 10,000 pm at current prices for discretionary expenses in retirement. If inflation is
seen at 6%, what is the expense that has to be met by retirement income?
Formula
Current monthly expense (Rs.)

50000

Proportion of household
expenses

60%

44

Current household expenses


(Rs.)

30000

Additional discretionary
expense in retirement

10000

Total retirement expenses at


current prices

40000

Time to retirement (years)

25

60% of Rs.50000

Retirement age(55)
Current
age(30)

Expected rate of inflation

6%

Expense at the time of


retirement (Rs.)

178600 40000 x (1+6%)^25

Determining the Retirement Corpus


The next step in retirement planning is to calculate the corpus that will generate the income
required in retirement. The variables in this calculation are
The periodic income required
The expected rate of inflation
The rate of return expected to be generated by the corpus
The period of retirement, i.e. the period for which income has to be provided by the
corpus.

Case Study
Rani requires a monthly income of Rs.35000 by todays value for her retirement 25 years
away at the age of 60. She expects to live up to 80 years. What is the retirement corpus
required if the banks deposit into which she will invest her retirement savings is likely to
yield 8% and the rate of inflation is 6%?
There are two stages to calculating the retirement corpus: in first step the income required
to meet expenses at retirement should be calculated and in the next step the corpus that
will generate this income has to be computed.

Step 1: Calculation of income at retirement


Income required at current value

Rs.35,000

Time to retirement (Years)

25
45

Expected inflation

6%

Income required at retirement (Rs)

150215

35000 x (1+6%)^25

Step 2: Calculation of retirement corpus


Formula
Income required at retirement (Rs.) 150215
Retirement Period

20

(80-60)

Rate of return on corpus

8%

Inflation rate

6%

Inflation adjusted rate of return

1.89%

{((1+8%)/(1+6%))-1}X100

The retirement corpus can be calculated using the PV formula .


The corpus required to generate a monthly income of Rs. 1,50,215 for 20 years is Rs.
3,00,48,832.
PV=AMT{(1+r)^n-1/r(1+r)^n}
In the previous example, what is the monthly saving that Rani must make to create the retirement corpus if she
expects
a return of 12% per annum on her investments?
The amount of monthly savings required can be calculated using the PMT function is excel. The inputs required are:

Rate (return on investment expected)

: 12%/12

period in months available to create the corpus


: 300 months (25 x
12) which is the period between now and retirement date)
Future Value (retirement corpus required)

: Rs. 30,048,832

Type (0 for investment at end of year and 1 for


beginning)
:1

46

The monthly savings required is Rs. 15,835. If this sum is invested at an annual rate of 12%
for 25 years, then the savings will compound to a value of Rs. 30,048,832, which is the
retirement corpus required.
What will be the effect if Rani had 30 years to save for the same amount? The amount of
monthly savings will come down to Rs. 8512 since there is a longer period over which Rani
can make contributions, and the money can be invested and grow to the corpus required.
51. Derivatives
A derivative refers to a financial product whose value is derived from another. A derivative is
always created with reference to the other product, also called the underlying.
A derivative is a risk management tool used commonly in transactions where there is risk
due to an unknown future value.
For example, a buyer of gold faces the risk that gold prices may not be stable. When one
needs to buy gold on a day far into the future, the price may be higher than today. The
fluctuating price of gold represents risk. Gold represents the underlying asset in this case.
A derivative market deals with the financial value of such risky outcomes. A derivative
product can be structured to enable a pay-off and make good some or all of the losses if gold
prices go up as feared.
Derivatives are typically used for three purposes: hedging, speculation and arbitrage.
a. Hedging
When an investor has an open position in the underlying, he can use the derivative markets
to protect that position from the risks of future price movements.

b. Speculation
A speculative trade in a derivative is not supported by an underlying position in cash, but
simply implements a view on the future prices of the underlying, at a lower cost.
c.Arbitrage
If the price of the underlying is Rs.100 and the futures price is Rs.110, anyone can buy in the
cash market and sell in the futures market and make the riskless profit of Rs.10. This is
called arbitrage.
Arbitrageurs are specialist traders who evaluate whether the Rs.10 difference in price is
higher than the cost of borrowing. If yes, they would exploit the difference by borrowing and
buying in the cash market, and selling in the futures market at the same time (simultaneous
trades in both markets). If they settle both trades on the expiry date, they will make the gain
of Rs.10 less the interest cost, irrespective of the settlement price on the contract expiry
date, as long as both legs settle at the same price.
52.FUTURES

47

A futures is a contract for buying or selling a specific underlying, on a future date, at a price
specified today, and entered into through a formal mechanism on an exchange. The
terms of the contract (such as order size, contract date, delivery value and expiry date) are
specified by the exchange.
Example:
FUTIDX NIFTY 26 Feb 2014 is a futures contract on the Nifty index that expires on
26th February 2014.
The value is 6235, which means a buyer or seller agrees to buy or sell Nifty for a
delivery value of 6235 on a future date.
It is available to trade from the date it is introduced by the exchange to its expiry
date on 26th February 2014.
On expiry, the settlement price at which this future contract will be settled may be
higher or lower than 6235. If it is higher, any investor who had bought the future
contract at a price of 6235 would have made profits and a seller at that price would
have made losses. If the settlement price is lower, then the situation is reversed for
the buyer and seller.
53.OPTIONS
Options are derivative contracts, which splice up the rights and obligations in a futures
contract. The buyer of an option has the right to buy (in case of call) or sell (in case of
put) an underling on a specific date, at a specific price, on a future date. The seller of an
option has the obligation to sell (in case of call) or buy (in case of put) an underlying on
a specific date, at a specific price, on a future date. An option is a derivative contract that
enables buyers and sellers to pick up just that portion of the right or obligation, on a future
date.
54. Absolute Return
The absolute return on an investment is computed as:
((End Value Beginning Value)/Beginning Value) x 100
OR
(Return on Investment/Original Investment) x 100
The rate of return is converted into percent terms by multiplying by 100.

Example:
There are two investment opportunities as under:
Period of
Investment

Beginning Value

End Value

Investment A

one year

23000

28000

Investment B

Three years

2500

3100

Which one of the above investment is better?


Absolute Return on Investment A: (28000-23000)/23000 = 21.74%
Absolute Return on Investment B: (3100-2500)/2500 = 24.0%

48

Investment A has a higher amount of return in terms of rupees, but earns a lower rate of
return as compared to investment B.
55. Annualized return
Annualized return is a standardized measure of return on investments in which the return is
computed as percent per annum (% p.a.).
It is calculated as:
(End value - Beginning value)/Beginning value) x 100 x (1/ holding period of investment in
years)
Measuring returns as percent per annum is the accepted way to measure investment return.
In the example given in section 54, the annualized return on the two investments is
computed as:
Annualized return = ( (30 lakh-20 lakhs)/20 lakhs) x100 x(1/1)= 50%
Annualized return = ( (30 lakh-20 lakhs)/20 lakhs) x100 x(1/3)= 16.3%
As expected, investment B has a much lower annualized return, because the same absolute
return is earned over a longer holding period.
56.TOTAL RETURN
The returns from an investment can be in different forms such as interest income
(debentures, bank deposits), dividend (mutual funds, equity shares) and profits on sale
(capital gain on selling a house).
An investment could provide more than one type of return.
For example, equity shares can give dividend income, as well as profits on sale. A
house property can yield rentals, and also capital gains on sale. A complete measure of
return should take all benefits from an investment into consideration.
Total return can be positive as well as negative. The sign of total return depends on its
components and whether they are positive or negative.

Example-1
consider an equity share
of face value Rs.10,
which yields a dividend
of 30%. The share is
purchased for Rs. 200,
but sold for Rs.190 after
one year.
In this example the loss
component is greater
than the positive
dividend earned so the
total return becomes
negative.
1.Loss on Sale: Rs.200Rs.190=Rs.10.00
2.Income as dividend
Rs.3 (30% of face value
of Rs.10)
3.Net Loss is Rs.7.00

Example-2
An investor bought a
house for Rs.10 lakh. He
earned a monthly rental
income of Rs.3000 for 2
years. He then sold off
the house for Rs.12 lakh.
What is his total return?
Rental Income = Rs.3000
x 24 = Rs.72000
Profit from selling after 2
years = Rs.12 lakhs Rs.10 lakhs =
Rs.200000
Total return =
200,000+72000 =
Rs.272000 on an
investment of
Rs.10,00,000
The rate of return
49 per
cent p.a.=
(272000/10,00,000) x
(1/2) x 100 = 13.6%

57. HOLDING PERIOD


RETURN
Holding period return is the
return earned on an investment
during a specific period when it
was bought and held by the
investor. Such return
computations use the portfolio
value at two chosen points. A
simple formula for holding
period return is:
HPR = Cash Inflows during the
period + Capital gains during
the period
Beginning Value of investment

OR
HPR = Cash inflows + (Ending value Beginning value)
Beginning value of investment

58. TAX ADJUSTED RETURN


Tax-adjusted return is the return earned after taxes have been paid by the investor. Since
taxes actually reduce the money in the hands for an investor, it is necessary to adjust for
them to get a realistic view of returns earned. Tax adjusted returns are lower than nominal
returns because tax payments lower the nominal value of returns.
Suppose an investor earns an interest of 10% on an investment of Rs.1000. If this interest is
taxed at 20%, then we calculate tax adjusted return as follows:
Nominal interest rate = 10%
Interest received = 10% of 1000 = 100
Tax payable = 20% of 100 = 20
Net interest received= 100- 20 = 80
Post tax return = 80/1000 = 8%
In general, post tax or tax adjusted return TR = NR * (1-tax rate)
TR: tax adjusted return
NR: nominal return
Example
An investment earns a return of
11% p.a., but the income is
taxable in the hands of the
investor. The investors
marginal tax rate is 30%. What
is his after tax rate of return?
In this investment, 30% of the
income will be paid as tax, and
only 70% will be available to
the investor.

59.RISK ADJUSTED RETURN

The relationship between the risk and return from an


investment is a direct one implying that the investor who
invests in a high risk investment will expect to be
compensated by higher returns. Risk adjusted return
relates the return from an investment to the risk taken to
generate it. A high risk adjusted return indicates that the investment was able to generate a
higher return for a unit of risk taken.
60. Practice Questions:

Questions on Investment Planning


1.Financial Planning is:
A.Investing in assets to receive the highest return possible
B.Keeping Taxes as low as possible
C.Planning to retire with maximum income possible
D.A process of solving financial problems and reaching financial goals.
2.Financial Planning is necessary:
A.To achieve financial goals
B.To retire successfully
C.Only for people with lot of money
D.If there is financial crisis in the family
3.Investment Planning is a process by which:
A. Risk is totally avoided
B.Huge risk is taken to achieve financial goals
C.Risk return tradeoff is studied and incorporated in plans to achieve goals
D.None of the above

50

4.Market risk can be reduced by diversification:


A.True
B.False
5.Bond prices will rise:
A. If interest rate falls
B. If interest rate rises
C. If interest remains static
D.No impact of interest rates on Bonds prices

6.In case of treasury bills the interest rate is paid:


A. Quarterly
B. Half yearly
C. Yearly
D. Issued at a discount
7.In case of dated securities of GOI the interest rate is paid:
A. Quarterly
B. Half yearly
C. Daily
D. Issued at a discount
8.Diversification can be achieved by all the following methods except:
A. Investing in different securities
B. Investing in different maturities
C. Investing in various asset classes
D. Purchasing Futures of Index.

9.The shares of Alpha were bought on Jan 1 ,2003 for Rs.45.The year end prices were as under:
2003
Rs.50
2004
Rs.55
2005
Rs.48
What is the total return percentage.
A. 4.36%
B. 2.22%
C. 7%
D. 8.42%
10.What is the yield of a Bond bearing a coupan rate of 8% payable annually and currently priced at Rs.950 with a
face value of Rs.1000?
A. 4.36%
B. 2.22%
C. 8.42%
D. 8.42%
11.Interest rate has following relation with share valuation:
A. Directly proportional to the stock price rise
B. Inversely proportional to the stock price rise
C. No Impact
D. None of the above
12.In respect of investing in Index Funds, which one of the following statement is true?
A. Suitable to investors who seek returns much in excess of market returns.
B. Aggressive investment strategy
C. Active investment strategy
D. Suitable to investors who expect index returns on the investment.
13.A retired couple should ideally prefer which of the following asset allocation plan?
Equity
Debt
cash
A.
60%
35%
5%
B.
50%
40%
10%

51

C.
D.

80%
20%

20%
70%

Nil
10%

14.A young man of 25 years,who has just joined an IT company as a programmer should prefer which kind of
investment planning.
A. Systematic Investment plans that take care of capital growth and life insurance
B. All money in life insurance plans
C. He should not invest now as he is too young. Should enjoy life.
D. Make lump sum investment in index funds.
15.Mutual fund distributors are regulated by:
A. AMFI
B. RBI
C. FPSB
D. IRDA
16.As a financial planner, if you expect the interest rate to rise, you should recommend:
A. Long Term bonds to clients
B. Government Securities
C. Short Term instruments
D. Stock Market

17.If the expected return of two stocks are the same then the investor should prefer that stock where the
A. Risk is higher
B. Risk is lower
C. Risk is same
D. No Risk involved

18. Mr. Samant has invested in 10% GOI Tax Free Relief Bonds.If he is paying income tax at the rate of 30%,the tax
effective yield on these bonds to Mr.Samant would work out to:
A. 10%
B. 12.5%
C. 14.28%
D. 16.23%
19.The rate of return on a stock in a particular year was 19.5%.The rate of inflation during that year was 5%.What is
the real raturn on the stock?
A. 14.5%
B. 13.33%
C. 15.8%
D. 16.2%
Hint: Real rate =[{(1+nominal rate/100)/(1+Inflation Rate/100)}-1] *100
20.

A. Rs.75
B. Rs.100
C. Rs.50
D. Rs.120
Hint: 3/(1+.12)^1+3.24/(1+.12)^2+{3.50+94.48/(1+.12)^3}
21.Which of the following strategies is not related to Managing Risk:
A. Avoiding Risk
B. Transferring Risk
C. Controlling Risk
D. Accepting Risk
E. Dividing Risk

52

22. The premium paid is used to purchase units in investment assets chosen by the policyholder after deducting
for all the charges and premium for risk cover under policy.
Identify the investment option which matches above style of payments:
1.Mutual Fund
2.Equity
3.Commodity
4.ULIP
23.In a whole life plan with limited payments,the sum assured becomes payable :
1.At the end of premium paying term
2.Only on death of the policy holder
3.At the end of the premium term or on the death whichever is earlier
4.The sum assured is not payable at all if the policy holder survives the premium paying term.
24. In an Endowment Insurance Plan ,the sum assured becomes payable :
1.At the end of premium paying term
2.Only on death of the policy holder
3.At the end of the term of the policy or on the death whichever is earlier
4.The sum assured is not payable at all if the policy holder survives the premium paying term.
26.Unit linked insurance plans are basically:
A.Short term and low cost Insurance plans
B.Low cost investment plan with no risk.
C.Market related plans with emphasis on investment
D.Market related plans with emphasis on insurance
27.An investor who wants to invest in immediate pension plan seeks your advice on what option to choose.He is 50
years of age and he expects to live for another 30 years at least.Which of the following option is best for him?
A.Guaranteed pension for 5 years offering 7% p.a.
B. Guaranteed pension for 25 years offering 6.5% p.a.
C.Guaranteed pension for life and thereafter to his spouse offering 7% p.a.
D.Invest in Mutual Fund rather than pension offering min 10% offering.
28.Which of the following funds is suitable for an investor who is happy with the equity market returns:
A.Balanced Fund
B.Money Market Fund
C.Gilt Fund
D.Index Fund
29.A Pharma Fund can be categorized as:
A.Thematic Fund
B.Offshore Fund
C.Real Estate Fund
D.Sectoral Fund
30.NAV minus Repurchase Price is
A. Sale Price
B. Exit Load
C. Entry Load
D. Redeem Price

ANS:1.D,2.A,3.C,4.True,5.A,6.D,7.B,8.D,9.B,9.B,10.C,11.B,12.D,13.D,14.A,15.A,16.C,17.B,18.C ,19.B,20.A,21.E
22.4,23.2,24.3,25.C,26.C,27.D,28.D,29.D,30.B,
61.Problems on future value
1.
2.
3.
4.

Mr. A deposits Rs. 50000 for 6 years with a finance company which pays interest of 15% p.a. Compute the
future value.
115655
Mrs.B invests Rs. 37,000 for 2 years at 10.5% per annum compounded annually. Calculate the redemption
value.
45177.9
Mr.B invests Rs. 44,000 in FD for 2 years at 3% per annum compounded quarterly. Calculate the maturity value
of the FD.
46,710
Mr.X deposits Rs. 94,000 for 3 years at 4.25% per annum compounded semi-annually. Calculate the maturity
value.
106640

53

5.
6.
7.

Mr. Prasad lends Rs. 125000 to Mr. Yaswanth for 3 years at the rate of 18% p.a. Compute the amount payable
by Mr. Ramrasad after 3 years.
205379
Mr. ABC deposits Rs. 10000, Rs.20000, Rs.30000, Rs.20000 and Rs.15000 respectively in the year 1, 2, 3, 4 and
5 respectively. His deposit earns an interest of 12% p.a. Calculate the amount he gets after 5 years.
118865
Mr. XYZ is a Lawyer and deposits his savings every year in a deposit which gives him an interest of 10% p.a.
Calculate the Future value if he deposits the money yearly as below. 284014.5

Year
Cash Flow
1
45000
2
30000
3
20000
4
50000
5
63000
8. Six annual payments of Rs. 5000 are made into a deposit account that pays 14% interest per year. What is the
future value of this annuity at the end of 6 years?
42,677.6
9. Mr. Pradeep deposits Rs. 10000 every year for 4 years and deposit earns an interest of 10% p.a. Determine how
much money he will have at the end of 4 years.
46,410
10. Ms. Smitha deposits Rs. 8000 each year for 6 years and the deposit earns a compound interest @ 14% p.a.,
how much amount will she receive after 6 years?
68,284
62.Problems on present value
1.
2.
3.
4.
5.

What is the present value of Rs.800 to be received at the end of 8 years, assuming an annual interest rate
of 8 percent? 432
Mr. Venkatesh wants to have Rs. 20,00,000 lakhs after 6 years for his daughters marriage. How much he
has to deposit today if the rate of interest is 14% p.a. 9,11,200
Mr. Lakshman is expecting Rs. 8,00,000 as retirement benefit after 5 years from now. How much loan he
can take so today if the interest rate is 11% p.a. 474800
Find the present value of 1,000 to be received at the end of 2 years at a 12% nominal annual interest rate
compounded quarterly. 789.4
What is the present value of the following cash stream
Year
0
1
2
3
4

Assume a discount rate of 10%.

Cash Flow
5000
6000
8000
9000
8000

26,629.14

6.

An investor wants to have Rs.10000, Rs.15000, Rs.8000, Rs.11000 and Rs.4000 respectively 1,2,3,4 and 5
years. Find out the amount he has to deposit today if discount rate is 10%?
37,494.96
7. A person wants to get Rs. 20,000 for the next 5 years. If his investment earns an interest 12%p.a., how
much he has to deposit today?
72096
8. A Company borrows Rs.500000 at an interest rate of 15% and the loan is to be repaid in 5 equal
installments payable at the end of each of the next 5 years. What shall be the size of installment?
1676100
9. You buy a house for Rs.5 lakh and immediately make cash payment of Rs.1 lakh. You finance the balance
amount at 12% for 6 years with equal annual installments. How much are the annual installment?
1644560
10. A 10,000 car loan has payments of 361.52 due at the end of each month for three years. What is the
nominal interest rate? 18%
63.Questions on CAGR

Example: An Face
investor
QUESTION
Date of
purchased mutual
fund units
at
No.
Value
Purchase
an NAV of Rs.11. After 450
days, she redeemed it at
Rs.13.50. What is her

NAV at
purchase

54

Date of
Sale

NAV at Sale Date

1.

Rs.10

15.01.2015

Rs.250.00

28.02.20
16

Rs.280.00

2.

Rs.10

10.04.2015

Rs.9.00

20.05.20
16

Rs.11.50

3.

Rs.10

12.03.2014

Rs.6.00

22.11.20
16

Rs.25.00

4.

Rs.100

01.01.2015

Rs.120.00

28.02.20
17

Rs.189.00

64.

Calculate Actual Return and Tax Adjusted Return:

Question
No.

Investmen
t

Rate of Intt on
Investment

Tax Bracket
Of the
Invstor

Period of
Investment

1.

Rs.1,00,00
0

8%

30%

2 years

2.

Rs.2,00,00
0

12%

20%

3 years

3.

Rs.3,00,00
0

10%

50%

4 years

4.

Rs.1,00,00
0

9%

30%

5 years

65.Multiple Choice Questions on Financial Planning (Involving Calculations):


1.Raj bought an equity share whose face value is Rs.10 for Rs.250 and earned 50% dividend
in year 1, 60% dividend in year 2, and sold it off after three years for Rs.300. What is the
return on his investment?
a.8.13%
b.61%
c.11%
d.10.13%
2.An investor bought a shop for Rs.10 lakh. He earned a monthly rental income of Rs.3000
for 2 years. He then sold off the shop for Rs.12 lakh. What is his total return?
a.13.6%
b.6.13%
c.61.10%
d.20.13%
3. Nominal rate of return is 10% and inflation rate is 5%.What is the Real Rate of Return?
a.4.76%
b.4.13%

55

c.4.10%
d.4.53%
Hint:{(1+NR/1+IR)-1}*100
4. An investment earns a return of 11% p.a., but the income is taxable in the hands of the
investor. The investors marginal tax rate is 30%. What is his after tax rate of return?
a.7.70%
b.7.13%
c.7.10%
d.7.53%
5.An investor is considering a tax-free bond that pays 8% p.a. and a taxable bank deposit
that pays 9% p.a. The tax bracket of the investor is 20%.What is the nominal return on Tax
Free Bond?
a.10.00%
b.7.02%
c.8.12%
d.15.53%

6. Which of the following amount is the maturity amount of an investment of Rs.25000 for
25 years in a Bank Fixed Deposit @10% p.a.?
a.Rs.2,70,868
b.Rs.87,500
c.Rs.1,70,868
d.Rs.1,87,500
7. Which of the following amount is the maturity amount of an SIP of Rs.2500 per month for
25 years in Mutual Fund @10% p.a.?
a. Rs.33,17,083
b.Rs.87,33,500
c.Rs.11,70,868
d.Rs.31,87,500
8. Which of the following factor is the PVIF for 25 years at an interest rate of 10% p.a.?
a. Rs.9.0770
b.Rs.8.0980
c.Rs.11.9807
d.Rs.3.9879
9. Which of the following factor is the FVIF (Annuity)for 25 years at an interest rate of 10%
p.a.?
a. Rs.98.347
b.Rs.80.980
c.Rs.119.807
d.Rs.39.879
10.Mrs. Kapoor has been accumulating mutual funds over the past two years.
She decides to sell her holdings on January 31, 2014, on which date the value of her
investments is as shown below.
What is the annualized rate of return on her investments?
Purchase Date
Dec 10, 2011
May 15, 2012

Purchase Cost (Rs.)


10000
15000

Market Value on Jan 31, 2014 (Rs.)


13000
16000

56

57

You might also like