Investment Planning (Professional Development Program) IMS Learning Resources Pvt Ltd.

E-Block, 6th Floor, NCL Bandra Premises, Bandra Kurla Complex, Bandra (E). Mumbai 400 051 Tel No: +91 22 66680005 Fax No: +91 22 66680006 Email: help.fp@imsindia.com Website:www.imsindia.com PDP Investment Planning 1

PREFACE Investment Planning is all about achieving desired rate of returns from investib le surplus and existing assets, matching ones time frame of goals, age and risk p rofile. Hence this forms the heart of comprehensive financial planning process. Investment planning begins with designing a suitable strategy identifying and se lecting various asset classes to grow existing assets and future investible surp lus. Sound investment strategy is based on comprehensive knowledge about various clas ses of assets, their unique characteristics and understanding of expected return s and associated risks with each class of asset. It is important to bear in mind that investment strategy will always be linked to ones risk profile. This program will guide you systematically in understanding the concepts require d for preparing a sound investment plan. PDP Investment Planning 3

Table of Contents Chapter - 1 Chapter - 2 Chapter - 3 Chapter - 4 Chapter - 5 Chapter - 6 Chapter - 7 Chapter - 8 Chapter - 9 Fundamentals of Investment Planning ................ .................................................... 8 Understanding Investment Risk ........................................................................... . 16 Measurement of Risk ....................................................... .................................... 27 Managing Risk in Investments ........... ................................................................... 40 Measuring Investment Returns ............................................................ ................. 54 Building an Investment Portfolio .......................... ................................................. 71 Small Saving Schemes ...... ................................................................................ .. 94 Fixed Income Instruments ................................................. ................................. 107 Life Insurance Products .................. .................................................................... 116 Chapter - 10 Mutual Funds ...................................................... ............................................... 126 Chapter - 11 Stock market in vestments ...................................................................... ............ 144 Chapter - 12 Derivatives ...................................... ................................................................... 160 Chapter - 13 Real Estate ............................................................... ......................................... 188 Chapter - 14 Investment strategies ............................................................................... .......... 197 Chapter - 15 Asset Allocation ................................... ............................................................... 205 Chapter - 16 Structuring Portfolio for Investors ........................................... ............................ 212 Chapter - 17 Regulation of Financial Planners . ....................................................................... 219 PDP Investment Planning 5

Chapter 1 PDP Investment Planning 7

Fundamentals of Investment Planning What is Investing? I nvestment refers to a commitment of funds to one or more assets that will be hel d over some future time period. It is important to understand the difference bet ween Savings and Investments. Anything not consumed today and saved for future u se can be considered as savings. Almost all of us save money. In fact we are a n ation of savers where the domestic savings is a high percentage of Gross Domesti c Product sometimes as high as 26-27%. It is important to channel these savings into productive investment avenues. Almost all individuals have wealth of some k ind, ranging from the value of their services in the workplace to tangible asset s to monetary assets.. For our purposes, investment will mean a measurable asset retained in order to increase ones personal wealth. A financial asset is one tha t generates income and contributes to accumulation and growth of wealth over a p eriod of time. The two elements in investments are generation of income on a per iodic basis and/or growth in value over a period of time. Investment scenario in India A pick-up in investment, reflecting the high business optimism, not only strengthened industrial performance but also reinforced the growth outlook itsel f. The rally in gross domestic capital formation (GDCF) that had commenced in 20 02-03 continued and as a proportion of GDP it reached a high of 30.1 per cent in 2004-05.1 The increasing trend in gross domestic savings, which provided most o f the resources for investment, as a proportion of GDP observed since 2001-02 co ntinued with the savings ratio rising from 26.5 per cent in 2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in 2004-05.2 India is a nation of s avers and the domestic savings is a very high percentage of GDP. That is extreme ly good. It is shocking to note that more than 45% of domestic savings is invest ed in bank deposits and only about 2/3% in equity and equity related investments . This clearly shows that while as a nation we are very good savers we are very poor investors because it is equally important for the savers to invest in avenu es that fetch decent returns after considering factors like inflation, taxation, etc. Bank deposits not only offer lower returns but they are hardly tax efficie nt and thus do not serve the cause of earning high post tax & net of inflation r eturns. In developed countries the proportion of savings being diverted to equit y and equity related instruments is in the region of 20-25% of GDP while around 20% of savings are parked in bank deposits. Some investors have failed to recogn ize the less obvious, but potentially more damaging, risk of diminished income f rom staying completely invested in low yielding fixed income securities or bank deposits. The financial planner should ensure that investors take a hard look at the fixed income components of their portfolios and rethink this strategy in th e context of more comprehensive, long-term objectives. Understanding where the c lients are coming from, the priorities in their life and the challenges they fac e in a rapidly changing investment horizon. Succeeding in career, planning child rens education, marriages and having more than enough for an enjoyable retirement are some of the objectives most people aim at. 1 Economic Survey 2005-2006 2 Economic Survey 2005-2006 Investment Planning PDP 8

The financial planner in India hence, has a very important role to play. The pla nners job in India is more challenging because of Indian mind set and the aversio n to risk. It will be part of his job to educate his clients on concepts of risk s and returns and their relationship. Why Invest? We all work for money. It is e qually important to ensure that money works for us. We should inculcate the habi t of reliance on a secondary source of income. We invest to improve our future w elfare. Funds to be invested come from assets already owned, borrowed money, and savings or foregone consumption. By foregoing consumption today and investing t he savings, we expect to enhance our future consumption possibilities. Anticipat ed future consumption may be by other family members, such as education funds fo r children or by ourselves, possibly in retirement when we are less able to work and produce for our daily needs. Regardless of why we invest we should all seek to manage our wealth effectively, obtaining the most from it. This includes pro tecting our assets from inflation, taxes and other factors. Investment fundament als Some of the fundamental rules of investments are: START EARLY INVEST REGULAR LY ENSURE HIGHER RETURNS ON YOUR INVESTMENTS The following table will demonstrat e the difference, very graphically: It is assumed that an investor invests Rs 1, 000/- p.m., at the end of each month, systematically, in different invest plans which yield 5%, 8%, 12% and 15% p.a. returns. Look at the big difference in the maturity values as the term gets longer and longer and as the returns are higher . Indian investors have always preferred fixed income securities where the returns are assured and have compromised on the returns. In general investors are risk averse and more so Indian investors. It is the job of the financial planner to a dvise the investors on the concept of focusing on higher returns for better stab ility and higher capital building over a longer period of time. The above table very clearly illustrates how a higher rate of return over longer period of time can make a world of difference to the capital at the end of the term. PDP Investment Planning 9

Example Mr. Sunil Joshi, a very conservative investor, has been religiously investing Rs . 5,000/- p.m. in a provident fund account which gives him interest at the rate of 8% p.a. compounded annually. Mr. Ashwin Shah, on the advise of his planner, h as been investing Rs. 5,000/- p.m. in equity linked investments which have given him around 15% p.a. return. Both start at the same age of 25 years and keep inv esting for 30 years. Mr. Sunil Joshi will have a capital amount of Rs. 74.50 lac s in his provident fund account while Mr. Ashwin Shah will have accumulated Rs. 3.46 crores which is about 5 times the retirement capital of Mr. Sunil Joshi. Th ese dramatic results have been possible because of the focus on the rate of retu rn. Mr. Sunil Joshi has done well by starting early and investing regularly but he has not focused on the rate of returns on his investments. While assured retu rns are important it is also important to focus on expected returns on investmen t, even at a risk. How Do We Invest? If we are making investment decisions today that will directly affect our future wealth, it would make sense that we utiliz e a plan to help guide our decisions. Surprisingly, the majority of people do no t have in place any type of formalized investment plan. Taking some time to put together a financial plan can reap tremendous benefits. First, lets define financ ial planning. Financial planning is the process of meeting ones life goals throug h the proper management of your finances. Life goals can include buying a home, saving for childs education or planning for retirement. Financial planning provid es direction and meaning to ones financial decisions. It allows one to understand how each financial decision affects other areas of finances. For example, buyin g a particular investment product might help you pay off your mortgage faster or it might delay your retirement significantly. By viewing each financial decisio n as part of a whole, one can consider its short and long-term effects on life g oals. One can also adapt more easily to life changes and feel more secure that g oals are on track. Common Mistakes in the planning process It may be helpful to be aware of some common mistakes people make when approaching investments: 1. 2. 3. 4. 5. 6. 7. 8. 9. Dont set measurable financial goals. Make a financial decis ion without understanding its effect on other financial issues. Confuse financia l planning with investing. Neglect to re-evaluate their financial plan periodica lly. Think that financial planning is only for the wealthy. Think that financial planning is for when they get older. Think that financial planning is the same as retirement planning. Wait until a money crisis to begin financial planning. E xpect unrealistic returns on investments. 10. Think that using a financial planner means losing control. 11. Believe that financial planning is primarily tax planning. These are some of the most common misconceptions about financial planning and it the perhaps one of the first jobs of the financial planner to clear these areas with the prospective client. The financial planner should explain the process of planning; the various steps invo lved and the ultimate objective of the exercise before hand and make the investo r comfortable about disclosing his personal information. 10 Investment Planning PDP

What Process Do We Use to Invest? Nobody plans to fail but many fail to plan. It is important for the investor to realize that planning is very important. The f inancial planner has to spend time in educating the investors about the common m istakes and how to come over them. He has to take the client through the systema tic process of financial planning outlined below. The financial planning process consists of six steps that help the investor/client take a big picture look at wh ere he is financially. Using these six steps, the investor can work out where he is now, what he may need in the future and what he must do to reach his goals. These six steps are: 1. Establishing and defining the client-planner relationshi p. The financial planner should clearly explain or document the services to be p rovided to you and define both his and the clients responsibilities. The planner should explain fully how he will be paid and by whom. The client and the planner should agree on how long the professional relationship should last and on how d ecisions will be made. 2. Gathering client data, including goals. The financial planner should ask for information about the clients financial situation. The cli ent and the planner should mutually define the personal and financial goals, und erstand the clients time frame for results and discuss, if relevant, how he feels about risk. The financial planner should gather all the necessary documents bef ore giving the client the advice he needs. 3. Analyzing and evaluating your fina ncial status. The financial planner should analyze the clients information to ass ess his current situation and determine what he must do to meet his goals. Depen ding on what services you have asked for, this could include analyzing your asse ts, liabilities and cash flow, current insurance coverage, investments or tax st rategies. 4. Developing and presenting financial planning recommendations and/or alternatives. The financial planner should offer financial planning recommendat ions that address clients goals, based on the information collected. The planner should go over the recommendations with the client to help him understand them a nd help the client make informed decisions. The planner should also listen to th e clients concerns and revise the recommendations as appropriate. 5. Implementing the financial planning recommendations. The client and the planner should agree on how the recommendations will be carried out. The planner may carry out the r ecommendations or serve as the coach, coordinating the whole process with the clie nt and other professionals such as attorneys or stockbrokers. 6. Monitoring the financial planning recommendations. The client and the planner should agree on w ho will monitor the progress towards achieving the goals. If the planner is in c harge of the process, he should report to the client periodically to review the situation and adjust the recommendations, if needed, along with life changes. Product selling Vs. Financial planning Financial planning is the process through which the planner helps his client to achieve his financial goals. The financial planner may also be an insurance advi sor and/or a mutual fund distributor. The planner may have a product bias becaus e of the commissions and brokerages and he may try to push PDP Investment Planning 11

these products rather than act in the best interest of his client. This is not o nly unethical and immoral but is also not a proper strategy for long term busine ss success for the planner. It is a well established fact that success in market ing any product or service is more dependant on motivating a client to buy the p roduct/service rather than resorting to aggressive selling tactics. The client w ould be better motivated to opt for your service as a planner if you take care o f his long term interest rather than your short term interest of brokerage/commi ssions. It is easier for you to achieve your goals if you help a large number of people achieve their goals. The financial planner plays a very important role i n designing an investment plan that would best suit his clients needs. He tries t o understand thoroughly the financial goals of his clients; he discusses the var ious investment options available and finally suggests to his client a financial plan that will serve the purpose of achieving the clients goals. This is a very comprehensive process which requires a thorough understanding of the financial p roducts; markets; economy and also an analysis of the clients risk profile; needs ; goals, etc. Thus financial planning is much superior to selling financial prod ucts/services; more comprehensive and more rewarding for the client and the plan ner in the long term. In India many investors have a low level of understanding of the concept of financial risk and hence have conventionally preferred fixed i ncome instruments to market related instruments with uncertain income flows. Thu s our investors have a very low risk tolerance. It is one of the most important tasks of the planner to educate his client on the concept of investment risk ; p repare the client mentally to accept volatility in the markets in the short term and explain how patience will be rewarded in the long term. Product selling doe s not involve these steps of educating and increasing the risk tolerance of the investor. Hence a planner will enjoy a long term advantage and better relationsh ip with his client compared to a product seller. Self-Help or Professional Help? Some investors may feel that they understand financial products better and can do the financial planning themselves rather than entrust the same to a professio nal financial planner. Investors may prefer some personal finance software packa ges, magazines or self-help books that can help them do their own financial plan ning. However, they may decide to seek help from a professional financial planne r if: n They need expertise that they dont possess in certain areas of finances. For example, a planner can help you evaluate the level of risk in your investmen t portfolio or adjust your retirement plan due to changing family circumstances. They may want to get a professional opinion about the financial plan they have developed for themselves. They may not have the time to spare to do their own fi nancial planning. Certain changes take place in the family or an immediate need or unexpected life event such as a birth, inheritance or major illness. An inves tor may feel that a professional adviser could help him improve on how he is cur rently managing his finances. n n n n n An investor may feel that he should improve his financial position but does not know where to start and how to go about it. Some of the common problems which ar e brought before the financial planner are listed below. The list is inclusive a nd there can a number of other areas as well. n How should I create and preserve personal wealth? 12 Investment Planning PDP

n n n n n n n How can I achieve a specific lifetime financial objective? How should I provide for my childrens education? I am receiving a distribution from my employer. What do I do? Do I have enough to retire? I just received a lump-sum inheritance. Wha t do I Do? When should I execute my stock options? How should I best leave wealt h to my heirs? Expectations from a financial planner 1. 2. 3. 4. He should believe that a sound financial plan is fundamental to achieving his clients goals and enhancing the q uality of life. He should also believe that money is not everything but having c ontrol and confidence about managing it can allow the client to concentrate on o ther things like family, career and future. He should recognize that the issues that brought the client to him are unique and he should try to take result orien ted approach to solving the clients concerns. He should adopt a personal, confide ntial and patient approach to help his client reach decisions on complex choices and alternatives in investments. PDP Investment Planning 13

Review Questions 1. Financial Planning is: a. Investing assets to receive the hi ghest rate of return possible b. Keeping taxes as low as possible c. Planning to retire with the maximum income possible d. A process of solving financial probl ems and reaching financial goals 2. The main reason people fail to plan is: a. T hey keep on postponing b. They are too old to plan c. They are too young to plan d. They lack the expertise to plan 3. Successful investing can be directly rela ted to I. Starting early II. Investing regularly III. Taking unduly high risks I V. Focusing on risk and return in different investment vehicles a. I & II only b . III only c. I, II and IV only d. All four Answers: 1. 2. 3. d a c 14 Investment Planning PDP

Chapter 2 PDP Investment Planning 15

Understanding Investment Risk Definitions and Concepts Understanding Risk I n the context of investments risk refers not only to the chance that a person may lose his capital but more importantly to the chance that the investor may not ge t the desired return on an investment vehicle. We invest in various investment p roducts which generally comprise: 1. Fixed Income Instruments and 2. Growth orie nted investments. In the case of Fixed Income Instruments with a definite coupon rate there is virtually no risk of not being able to get the desired returns but in the case of other instruments an investor goes with an expectation of a certa in amount of return and the term risk in this context refers to the probability of the investor not getting the desired/expected returns The notion of risk is an integral and primary concept in the understanding of investments. Risk can be de fined as the uncertainty of an outcome from an investment decision. In making an investment decision, an investor forms an exception regarding that decisions out come. Any departure form that expected outcome can be considered the risk of tha t decision. Thus, another way to consider risk is to consider the possibilities of unexpected outcomes. The outcome form an investment decision may unexpectedly increase or decrease the principal amount invested. While most people consider the decrease in value as the investment risk, we will observe that in measuring risk, both positive and negative unexpected outcomes must be considered. Before considering the issues regarding the measurement of risk let us begin by enumera ting the different types of risk that may exist for an investment. The issue of risk being incorporated in both positive and negative surprises can be explained with a simple example. Assume you are explaining the possible outcomes of an in vestment decision to a client where the client may receive a return of either 8% (poor outcome) or a 16% (good outcome). You also explain that the client may ex pect to receive a simple average of the two returns, or 12%, from the investment decision. Your client now states that she is averse to the 8% outcome and wants to know if the investment can yield 12% or better. That is, the client wishes t o remove the poor outcome altogether. Notice that if this were possible, then th e simple average of the new investment decision, or the expected outcome would n ow be 14% ((16%+12%)/2) and the new poor outcome would now be 12%. In other word s, risk, or the unexpected outcomes, cannot go away. It is only meaningful in th e context of an expected outcome and both positive and negative unexpected outco mes. There are many different ways in which the principal invested can be unexpe ctedly changed. We will now consider each of these types of risk. Risk Avoidance Investment planning is almost impossible without a thorough understanding of ri sk. There is a risk/return trade-off. That is, the greater risk accepted, the gr eater must be the potential return as reward for committing ones funds to an unce rtain outcome. Generally, as the level of risk rises, the rate of return should also rise, and vice versa. Before we discuss risk in detail, we should first exp lain that risk can be perceived, defined and handled in a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses 16 Investment Planning PDP

to completely avoid the activity the risk is associated with. An example would b e the risk of being injured while driving an automobile. By choosing not to driv e, a person could avoid that risk altogether. Obviously, life presents some risk s that cannot be avoided. One may view a risk in eating food that might be toxic . Complete avoidance, by refusing to eat at all, would create the inevitable out come of death, so in this case, avoidance is not a viable choice. In the investm ent world, avoidance of some risk is deemed to be possible through the act of in vesting in risk-free investments. Short-term maturity Government bonds are usually equated with a risk-free rate of return. In the Indian market place risk free retur ns are the returns available on Treasury Bills of a certain tenor; necessarily l ess than one year and about 90days or 180 days. Stock market risk, for example, can be completely avoided by choosing not to invest equities and equity related instruments. Risk Transfer Another way to handle risk is to transfer the risk. A n easy to understand example of risk transfer is the concept of insurance. If on e has the risk of becoming severely ill (and unfortunately we all do), then heal th insurance is advisable. An insurance company will allow you to transfer the r isk of large medical bills to them in exchange for a fee called an insurance pre mium. The company knows that statistically, if they collect enough premiums and have a large enough pool of insured persons, they can pay the costs of the minor ity who will require extensive medical treatment and have enough left over to re cord a profit. Risk transfer can also occur in investing. One may purchase a put option on a stock or on the market index which allows that person to put to or se ll to someone their stock or the index at a set price, regardless of how much lo wer the stock or the index may drop. There are many examples of risk transfer in the area of investing. The Risk Averse Investor Do investors dislike risk? In e conomics in general, and investments in particular, the standard assumption is t hat investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say that investors dislike risk, but more precisely, we should say that investors are risk averse. A risk-averse investor is one who will not assu me risk simply for its own sake and will not incur any given level of risk unles s there is an expectation of adequate compensation for having done so. Note care fully that it is not irrational to assume risk, even very large risk, as long as we expect to be compensated for it. In fact, investors cannot reasonably expect to earn larger returns without assuming larger risks. Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to in cur. Some investors choose to incur high levels of risk with the expectation of high levels of return. Other investors are unwilling to assume much risk, and th ey should not expect to earn large returns. We have said that investors would li ke to maximize their returns. Can we also say that investors, in general, will c hoose to minimize their risks? No! The reason is that there are costs to minimiz ing the risk, specifically a lower expected return. Lower the risk, lower the ret urn. Taken to its logical conclusion, the minimization of risk would result in ev eryone holding risk-free assets such as savings accounts and Treasury bills. Thu s, we need to think in terms of the expected return/risk trade-off that results from the direct relationship between the risk and the expected return of an inve stment. Influence of Time on Risk Investors need to think about the time period involved in their investment plans. The objectives being pursued may require a p olicy statement that speaks to specific planning horizons. In the case of an ind ividual investor this could be a year or two in anticipation of a down payment o n a home purchase or a lifetime, if planning for retirement. Generally speaking, the longer the time horizon the more risk can be incorporated into the financia l planning. PDP Investment Planning 17

Globally as well as in India it is well established on the basis of track record of performance that equities as a class of asset has outperformed other asset c lasses and delivered superior returns over longer periods of time. With these st atistics available why wouldnt everyone at all times be 100 percent invested in s tocks? The answer is, of course, that while over the long term stocks have outpe rformed, there have been many short term periods in which they have underperform ed, and in fact, have had negative returns. Exactly when short term periods of u nderperformance will occur is unknown and thus there is more risk in owning stoc ks if one has a short term horizon than if there exists a long term horizon. A f inancial planner has to take into account the time horizon while structuring inv estment portfolios and the general rule is that the younger a person is, the lon ger can be his time horizon and hence more exposure to equities this follows the rule that risk and returns go up with time. Time has a different effect when an alyzing the risk of owning fixed income securities, such as bonds. There is more risk associated with holding a bond long term than short term because of the un certainty of future inflation and interest rate levels. If one were to lock in a r ate of 8 percent for a bond that matured in one year, an upward move in inflatio n or interest rates would have a less adverse effect on the price of that bond t han a 8 percent bond that matured in thirty years. That is because the bond coul d be redeemed in one year and reinvested in a bond with a presumably higher inte rest rate. The thirty year bond, however, will continue to pay only 8 percent fo r the rest of its thirty year life. Types of Investment Risk Systematic versus Unsystematic Risk Modern investment analysis categorizes the t raditional sources of risk causing variability in returns into two general types : those that are pervasive in nature, such as market risk or interest rate risk, and those that are specific to a particular security issue, such as business or financial risk. Therefore, we must consider these two categories of total risk. The following discussion introduces these terms. Total risk can be divided into its two components, a general (market) component and a specific (issuer) compon ent. Then we have systematic risk and nonsystematic risk, which are additive: To tal risk = = = Systematic Risk An investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or non market part. Wha t is left is the non diversifiable portion or the market risk. Variability in a securitys total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk. Virtually all sec urities have some systematic risk, whether bonds or stocks, because systematic r isk directly encompasses interest rate, market and inflation risks. The investor cannot escape this part of the risk because no matter how well he or she divers ifies, the risk of the overall market cannot be avoided. If the stock market dec lines sharply, most stocks will be adversely affected; if it rises strongly, mos t stocks will appreciate in value. These movements occur regardless of what any single investor does. Clearly, market risk is critical to all investors. General risk + Specific risk Market risk + Issuer risk Systematic risk + Unsystematic r isk 18 Investment Planning PDP

Unsystematic Risk The variability in a securitys total returns not related to ove rall market variability is called the unsystematic (non market) risk. This risk is unique to a particular security and is associated with such factors as busine ss and financial risk as well as liquidity risk. Although all securities tend to have some nonsystematic risk, it is generally connected with common stocks. Rem ember the difference: Systematic (Market) Risk is attributable to broad macro fa ctors affecting all securities. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security. Market Risk A market is a place where goods and services are traded. Events occur within a market that similarly affect all the goods traded in that market. For example, when the Reserve Bank of India unexpe ctedly changes interest rates, most financial securities are affected similarly. Other examples of events that affect all securities are the possibilities of wa r, severe natural catastrophes, recessions, structural changes in the economy, t ax law changes, even changes in consumer preferences etc. When the unexpected ch ange in values is systematic to the whole market, that risk is termed as market or systematic risk. Reinvestment Risk In the context of bonds investors look at the current yield as well as Yield To Maturity (YTM) the return one would get if the security were held till the maturity and redeemed with the issuing institut ion. It is important to understand that YTM is a promised yield, because investo rs earn the indicated yield only if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at the calculated YTM (yield to maturity). It is important to reinvest the periodic payments, at the same rate as the YTM, to obtain the YTM yield on the security. In the context of long term bonds during the tenor of which the interest rates may fluctuate in any economy it is virtually difficult for the investor to invest periodic coupon payments a t YTM and hence the risk of not being able to get the desired return (YTM) and t his risk is referred to as reinvestment risk. Obviously, no trading can be done for a particular bond if the YTM is to be earned. The investor simply buys and h olds. What is not so obvious to many investors, however, is the reinvestment imp lications of the YTM measure. Because of the importance of the reinvestment rate , we consider it in more detail by analyzing the reinvestment risk. The YTM calc ulation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest on inter est over the life of the bond at the computed YTM rate. In effect, this calculat ion assumes that the reinvestment rate is the yield to maturity. If the investor spends the coupons, or reinvests them at a rate different from the assumed rein vestment rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that differs from the prom ised yield. This gives rise to reinvestment rate risk. This interest-on-interest concept significantly affects the potential total dollar return. The exact impa ct is a function of coupon and time to maturity, with reinvestment becoming more important as either coupon or time to maturity, or both, rises. Specifically: a . b. Holding everything else constant, the longer the maturity of a bond, the gr eater the reinvestment risk. Holding everything else constant, the higher the co upon rate, the greater the dependence of the total return from the bond on the r einvestment of the coupon payments. PDP Investment Planning 19

The notion of reinvestment rate risk is particularly easy to see in the retireme nt planning process. In assisting a client with a retirement plan, an assumed ra te of return is built into the retirement forecast as to estimate the annual con tributions the client will be required to make to the retirement plan. It is ass umed that the funds will build at that rate of return until the client retires. What we see in reality is varying rates of return throughout the life of the por tfolio. Some realized rates of return may be better than the forecast and some m ay be worse than the forecast. Either way, as the retirement plan grows, we will not see the steady, forecasted rate of return on the retirement portfolio. If t he rates of return are consistently lower than the original forecast, the client s will not have enough funds at retirement to meet their need. In this case, the reinvestment risk is the cause of the problem. Interest Rate Risk The variabili ty in a securitys return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inv ersely; that is, other things being equal, security prices move inversely to int erest rates. The reason for this movement is tied up with the valuation of secur ities. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. As interest rates change, bond prices cha nge in the opposite direction. As a financial planner, while considering investm ents in various fixed income securities it is desirable to explain the concepts of interest rate risk as well as reinvestment risk and build the same while stru cturing client portfolios. If the current scenario is such that the interest rat es may rise in the near future and may keep rising for some time to come, then m ay be more of short term debt instruments would find place in the portfolio and in a scenario where the interest rates have reached historic peaks and may fall in the future, then it would make sense to commit funds for long term and hence investors should be advised to get into long term bonds/annuities of insurance c ompanies, etc. to protect from these two risks that we have discussed. The value s of all financial and real assets are in some part dependent on the general lev els of interest rates in an economy. Therefore, any unexpected change in the gen eral level of interest rates will also unexpectedly affect the values of all suc h assets. Financial assets such as bonds are especially affected by such changes . As we shall see later, the values of bonds and all other fixed income securiti es are inversely related to interest rates, i.e. when interest rates increase, t hese values decrease and vice versa. Values of stocks are also affected by chang es in interest rates, though understanding the impact of interest rate changes o n stock values is less straightforward than for bonds. Real assets such as real estate are also tremendously impacted by changes in interest rates. When changes in interest rates are unexpected, the uncertain changes in asset values are sai d to arise form interest rate risk. The reader can appreciate why participants i n the financial markets so engrossed in pending activities of the Reserve Bank o f India which through its policy making decisions, has a considerable influence on interest rates. Purchasing Power Risk Inflation risk is also known as purchas ing power risk because the ability to purchase different quantities of goods and services is dependent upon the changing levels of prices of all items in an eco nomy. For example, assume a client wishes to invest a sum ofRs. 2,90,000 which i s expected to result in a certain outcome of Rs. 3,00,000. Now also consider tha t the client wishes to purchase a car, either today or one year from now and whi ch is valued today also at Rs. 2,90,000. Suppose the price of this car increases to Rs. 3,10,000 over the year. In this case, the investor would have been bette r off if she had bought the car instead of investing the amount. Thus the invest or has a choice in how the money may be used. If the money is invested then the client will need an additional Rs. 10,000 to purchase the car. In other words, t he inflation in the cars price has eroded the purchasing power of the invested su m. If we 20 Investment Planning

PDP

consider that the increase in the price of the car was unexpected, then we can c onsider the effect of the outcome as arising out of inflation risk. Inflation ri sk is especially important to investment decisions where the financial securitie s being utilized are interest rate sensitive. Such as bonds. A factor affecting all securities is the purchasing power risk also known as inflation risk. This i s the chance that the purchasing power of invested money may decline. With uncer tain inflation, the real (inflation-adjusted) return involves risk even if the n ominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because l enders demand additional inflation premiums to compensate for the loss of purcha sing power. Liquidity Risk Liquidity in the context of investment in securities is related to being able to sell and realize cash with the least possible loss in terms of time and money. Liquidity risk is the risk associated with the particul ar secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more the uncertainty about the time element and the price concession, the gr eater the liquidity risk. A Treasury bill has little or no liquidity risk, where as a small cap stock listed in a regional stock exchange may have substantial li quidity risk. Liquidity is concerned with the ability to convert the value of an asset into cash. Any event or condition that affects this ability is termed as liquidity risk. For example, an investor may wish to sell her holding in a stock . If the investor cannot find a buyer for the stock, then her position in that s tock cannot be liquidated. Hence, in this example, she faces liquidity risk. Ass ets differ from each other by liquidity risk. Securities offered by the governme nt (such as Treasury bills) are very liquid because there are many participants seeking to trade in these securities. Treasury bills can be sold almost instanta neously, and hence are considered to be highly liquid. At the other end of the s pectrum, stocks of very small and little known companies are considered to conta in high liquidity risk because they are thinly traded. When investors make purch ase decisions that may require to be quickly converted to cash, they will always seek securities which have low liquidity risk. For example, firms that temporar ily place excess cash in financial (marketable) securities in order to enhance y ields will seek highly liquid securities that do not increase the firms liquidity risk exposure. Regulation Risk Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Interest earned on Public Provident Fund accounts are to tally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a result of that special tax exemption on the interest as well as the invested am ount qualify for deduction from income u/s 80C the yield on PPF account is much higher than its current interest rate of 8%. The risk of a regulatory change tha t could adversely affect the stature of an investment is a real danger. A specia l committee has advised the Government of India to do away with various sections of The Income Tax Act which allow exclusions and deductions. If its recommendat ions are accepted by the Government then the attractiveness of this investment a venue will drop dramatically. Dividends on shares and equity mutual funds are ta x free in the hands of investors. These avenues become attractive because of the tax concessions (which are matters of legislation) and these can change. That i s one risk associated with investments which cannot be avoided. The best solutio n lies in periodic review of investment plans. Business Risk The risk of doing b usiness in a particular industry or environment is called business risk. For exa mple, some commodities like fertilizers and oil are highly price sensitive in th e Indian context and the Government PDP Investment Planning 21

policies of subsidies substantially affect the profitability of the companies en gaged in manufacturing/ marketing these products. The risk associated with the c hanges in a firms abilities to measure up to expectations is known as business ri sk or unsystematic risk. Business risk can be further segregated into operating risk and financial risk. The risk that a business may not be able to meet its fi xed operating costs, such as rent, management salaries, etc., is known as operat ing risk. The risk that the firm may not be able to meet its fixed financial obl igations, such as paying interest on its debt or lease payments, is known as fin ancial risk. Financial risk is also known as credit risk since lenders or credit ors of funds seek to assess the ability of the firm to meet its debt services ob ligations. International Risk International Risk can include both Country risk a nd Exchange Rate risk. Exchange Rate Risk All investors who invest international ly in todays increasingly global investment arena face the prospect of uncertaint y in the returns after they convert the foreign gains back to their own currency . Unlike the past when most Indian investors ignored international investing alt ernatives, investors today must recognize and understand exchange rate risk, whi ch can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. The market for potential assets in which to invest spans the entire globe. Investors are no t constrained to invest only in their home countries. However, when an investor purchases a security in a foreign country, it must be paid for in a foreign curr ency. At the time of the purchase, the value of the foreign security is derived form the current, or spot, exchange rate. The exchange rate that will prevail wh en the investor sells the security in the future cannot be predicted with any ce rtainty, and hence, the conversion value becomes uncertain. This uncertainty can be considered as exchange rate risk. We illustrate this risk by a simple exampl e. For example, a U.S. investor who buys an Indian stock denominated in Indian R upees must ultimately convert the returns from this stock back to dollars. If th e exchange rate has moved against the investor, losses from these exchange rate movements can partially or totally negate the original return earned. A stable r ather than a depreciating foreign currency (in this case Indian Rupee) is what t he investor would be looking for while deciding to invest in that country. The r eturns to an international investor is always the market returns + or the foreig n currency appreciation or depreciation in the intervening period. Obviously, th e investors who invest only in domestic markets do not face this risk, but in to days global environment where investors increasingly consider alternatives from o ther countries, this factor has become important. Currency risk affects internat ional mutual funds, global mutual funds, closed-end single country funds, Americ an Depository Receipts, foreign stocks, and foreign bonds. Country Risk Country risk, also referred to as political risk, is an important risk for investors tod ay. With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a countrys eco nomy need to be considered. More and more international investors are investing in the Indian market because of the political and economic stability of India in the last few years and the belief of continued stability on these fronts. Trans parent economic policies and political stability are key factors for attracting more foreign investments in India. Many firms operate in foreign political clima tes that are more volatile than those in the United States. 22 Investment Planning PDP

Firms can face the danger of the foreign operations being nationalized by the lo cal government or can experience imposed restriction of capital flows from the f oreign subsidiary to the parent. Danger from a violent overthrow of the politica l party in power can also have an effect on the rate of return investors receive on foreign investments. Many countries have also been unable to meet their fore ign debt obligations to banks and other foreign institutions which contain impor tant political and economic implications. The informed investor must have some f eel for the political/economic climate of the foreign country in which he or she invests. Political risk represents a potential deterrent to foreign investment. The best solution for the investor is to be sufficiently diversified around the world so that a political or economic development in one foreign country does n ot have a major impact on his or her portfolio. Am I Willing to Accept Higher Ri sk? Every investor needs to find his or her comfort level with risk and construc t an investment strategy, with the help of a financial planner, around that leve l. A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically. An investors comfort level with risk should pass the good nights sleep test, which means the investor sh ould not worry about the amount of risk in his portfolio so much as to lose slee p over it. There is no right or wrong amount of risk it is a very personal decisio n for each investor. However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster stri kes. If an investor is five years away from retirement, he probably would not wa nt to be taking extraordinary risks with his nest egg, because he will have litt le time left to recover from a significant loss. Of course, a too conservative a pproach may mean the investor will not achieve his financial goals. Conclusion I nvestors can control some of the risk in their portfolio through the proper mix of stocks and bonds. Most experts consider a portfolio more heavily weighted tow ard stocks riskier than a portfolio that favours bonds. PDP Investment Planning 23

Review Questions : 1. Which of the following statements concerning investment ri sk is (are) correct) I. It is the uncertainty that actual return will differ fro m the expected return. II. It is composed of two parts: systematic risk and unsy stematic risk. a. I only b. II only c. Both I and II d. Neither I nor II 2. Syst ematic risk has all the following components EXCEPT: a. Market risk b. Business risk c. Interest rate risk d. Purchasing power risk 3. All the following stateme nts concerning unsystematic risk are correct EXCEPT: a. It can not be reduced by diversification b. It is that portion of total risk that is unique to the parti cular firm c. It may be affected by changes in consumer preferences and the comp etence of the firms management d. Such risk may be independent of factors affecti ng other industries 4. Unsystematic risk is composed of which of the following: I. Business risk II. Market risk III. Financial risk a. I only b. I & II only c. I & III only d. I, II and III 5. All the following statements concerning system atic risk are correct EXCEPT: a. It is typically influenced by the same factors affecting the market prices of many other comparable investments b. It is typica lly affected by economic, political and sociological factors c. It is typically found to some extent in nearly all listed securities d. It can usually be substa ntially reduced by a carefully executed program of diversification 6. If Indian Rupee was Rs. 48 to a US$ in 2004 and Rs. 46.50 to a US$ in 2005, which of the f ollowing statements is true: a. Foreign Institutional Investors would not attrib ute any significance to this change in values b. FIIs will perceive the currency risk to be very high c. FIIs will perceive the currency risk to be low d. FIIs wil l shy away from Indian markets 24 Investment Planning PDP

7. Inflation is on the rise; interest rates may move up in the near future. An inve stor seeks your advice which of the two products would be good for him at this p oint in time. Government of India taxable bonds offering 8% p.a. return for 6 ye ars with no premature repayment option or AAA rated corporate Fixed Deposit for one year offering 8% p.a. interest. What would be your advice? a. Better let the investor decide because both are safe. b. He should prefer the 1 year FD c. He should prefer the 6 year GOI Bond d. He can choose either of them there is no di fference as the interest rate is the same Answers: 1. 2. 3. 4. 5. 6. 7. c b a c d c b PDP Investment Planning 25

Chapter 3 26 Investment Planning PDP

Measurement of Risk W n n e invest in various investment vehicles expecting some amount of return from the se avenues. The investment risk refers to the probability of actually not earnin g the desired or expected return and may be a lower or negative return. A partic ular investment is considered riskier if the chances of lower than expected retu rns or negative returns are higher. Standard deviation (si) measures total, or s tand-alone, risk. The larger the si, the lower the probability that actual retur ns will be close to the expected return. Standard Deviation When an investor goes in for an investment option, he may do so expecting to get a return of say 15% in one year. This is only a one-point estimate of the entir e range of possibilities. Given that an investor must deal with the uncertain fu ture, a number of possible returns can and will occur. In the case of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment wil l be made with 100 per cent certainty barring a financial collapse of the econom y. The probability of occurrence is 1.0, because no other outcome is possible. W ith the possibility of two or more outcomes, which is the norm for stock market investment, each possible likely outcome must be considered and a probability of its occurrence assessed. The result of considering these outcomes and their pro babilities together is a probability distribution consisting of the specificatio n of the likely returns that may occur and the probabilities associated with the se likely returns. Probabilities represent the likelihood of various outcomes an d are typically expressed as a decimal (sometimes fractions are used.) The sum o f the probabilities of all possible outcomes must be 1.0, because they must comp letely describe all the (perceived) likely occurrences. How are these probabilit ies and associated outcomes obtained? The probabilities are obtained on the basi s of past occurrences with suitable modifications for any changes expected in th e future. In the final analysis, investing for some future period involves uncer tainty and, therefore, subjective estimates. Investors and analysts should be at least somewhat familiar with the study of probability distributions. Since the return which an investor earns from investing is not known, it must be estimated . An investor may expect the TR (total return) on a particular security to be 10 per cent for the coming year, but in truth, this is only a point estimate. Probab ility distributions can be either discrete or continuous. With a discrete probab ility distribution, a probability is assigned to each possible outcome. With a c ontinuous probability distribution an infinite number of possible outcomes exist . The most familiar continuous distribution is the normal distribution depicted by the well-known bell-shaped curve often used in statistics. It is a two-parame ter distribution in which the mean and the variance fully describe it. To descri be the single most likely outcome from a particular probability distribution, it is necessary to calculate its expected value. The expected value is the average of all possible return outcomes, where each outcome is weighted by its respecti ve probability of occurrence. For investors, this can be described PDP Investment Planning 27

as the expected return. Expected Return In the case of a fixed income security l ike a Government of India Bond or a bank fixed deposit, normally the expected re turn is the same as the coupon rate or rate of interest. Hence there, are no unc ertainties about being able to get the expected return. In the case of investmen ts where the returns are market dependant, for example a stock, one will have to estimate the possible returns and the probability of getting the same, as given here below: In this case, the expected return is calculated as under: Expected return = Sum (returns*probability) = = = (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1) .004+. 016+.048+.032+.02 0.12 or 12% It is a normal distribution curve as pictorially depicted below: 28 Investment Planning PDP

Standard Deviation We have mentioned that its important for investors to be able to quantify and measure risk. To calculate the total risk associated with the ex pected return, the variance or standard deviation is used. This is a measure of the spread or dispersion in the probability distribution; that is, a measurement of the dispersion of a random variable around its mean. Without going into furt her details, just be aware that the larger this dispersion, the larger the varia nce or standard deviation. Since variance, volatility and risk can in this conte xt be used synonymously, remember that the larger the standard deviation, the mo re uncertain the outcome. Calculating Standard Deviation Lets use the same table that we did for calculating the expected returns and find out the standard devia tion of the same: Standard deviation is square root of variance. Variance = Sum of {Probabilities* (actual return expected return)2} Variance = Probability * (actual return expect ed return)2 So, based on the figures in the table we can work out the variance as under; Exp ected return already calculated to be 12% Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2 Standard deviation = Square root of variance = 4.3817 Lets quickly work out another example to underst and how to arrive at expected returns and calculate standard deviation. PDP Investment Planning 29

Expected return = [-6*.15+0*.2+6*.3+12*.2+18*15) = [-0.9+0+1.8+2.4+2.7] = 6% Sta ndard deviation can be worked out as follows: Variance = (21.6+7.2+0+7.2+21.6) = 57.6 Standard deviation = 7.5895 Calculating a standard deviation using probability distributions involves making subjective estimates of the probabilities and the likely returns. However, we cannot avoid such estimates because future returns are uncertain. The prices of securities ar e based on investors expectations about the future. The relevant standard deviati on in this situation is the ex ante (estimated before the event) standard deviat ion and not the ex post (calculated after the events/historic) based on realized returns. Although standard deviations based on realized returns are often used as proxies for projecting standard deviations, investors should be careful to re member that the past cannot always be extrapolated into the future without modif ications. Historic (ex post) standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviati on is the distinction between individual securities and portfolios. Standard dev iations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the futur e. Moving from well- diversified portfolios to individual securities, however, m akes historical calculations less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable. Somethin g very important to remember about standard deviation is that it is a measure of the total risk of an asset or a portfolio, including both systematic and unsyst ematic risk. It captures the total variability in the assets or portfolios retur n, whatever the sources of that variability. In summary, the standard deviation of return measures the total risk of one security or the total risk of a portfol io of securities. The 30 Investment Planning PDP

historical standard deviation can be calculated for individual securities or por tfolios of securities using total returns for some specified period of time. Thi s ex post value is useful in evaluating the total risk for a particular historic al period and in estimating the total risk that is expected to prevail over some future period. The standard deviation, combined with the normal distribution, c an provide some useful information about the dispersion or variation in returns. In a normal distribution, the probability that a particular outcome will be abo ve (or below) a specified value can be determined. With one standard deviation o n either side of the arithmetic mean of the distribution, 68.3 percent of the ou tcomes will be encompassed; that is, there is a 68.3 percent probability that th e actual outcome will be within one (plus or minus) standard deviation of the ar ithmetic mean. The probabilities are 95 and 99 percent that the actual outcome w ill be within two or three standard deviations, respectively, of the arithmetic mean. In a bell shaped normal distribution the probabilities for values lying within c ertain bands are as follows: 1 S.D. 2 S.D. 3 S.D. 68.3% 95.4% 99.7% What Standard Deviation Means Say a fund has a standard deviation of 4% and an a verage return of 10% per year. Most of the time (or, more precisely, 68% of the time), the funds future returns will range between 6% and 14% (or its 10% average plus or minus its 4% standard deviation). Almost all of the time (95% of the ti me), its returns will fall between 2% and 18%, or within two standard deviations i.e. [10-(2*4) or 10 + (2*4)] Limitations of Standard Deviation Using standard deviation as a measure of risk can have its drawbacks. For starters, its possible to own a fund with a low standard deviation and still lose money. In reality, t hats rare. Funds with modest standard deviations tend to lose less money over sho rt time frames than those with high standard deviations. PDP Investment Planning 31

The bigger flaw with standard deviation is that it isnt intuitive. Certainly, a s tandard deviation of 7% is higher than a standard deviation of 5%, but these are absolute figures and one can not reach a conclusion as to whether these are hig h or low figures. Because a funds standard deviation is not a relative measure, w hich means its not compared to other funds or to a benchmark, it is not very usef ul to the investor without some context. Case Let us consider two stocks: stock X and stock Y whose returns and probability ar e given as follow: Stock X Expected return on stock X is sum of the last column which is 12% Stock Y Expected return on stock Y is the sum of the last column which is 12%. In this e xample, we find that the expected returns of both stocks are the same. If the ex pected returns on two stocks are the same, obviously one should prefer that stoc k where the risk is less. In other words, we shall go ahead and measure the stan dard deviation of both the stocks to find out which stock is more likely to give us the expected returns of 12%. 32 Investment Planning PDP

Variance which is the sum of the last column = 2.1 Standard deviation for stock X = 1.449 Lets work out for stock Y Variance of stock Y which is the sum of last column = 0.6 Standard deviation of stock Y = 0.77 Thus, after the calculation of total risk (standard deviation), i t is obvious that stock Y is more likely to deliver the expected returns of 12% compared to stock X. This case has been discussed basically to understand that w hile deciding on which stock to invest in, it is important to consider the expec ted return as well as the total risk of not getting the desired return stock wis e and reach decision accordingly. All the same, it may be pertinent to point out here that standard deviation is more seriously considered and is useful in port folio of stocks rather than individual stocks. We shall consider the portfolio s cenario in the subsequent topics. Beta Beta is a measure of the systematic risk of a security that cannot be avoided th rough diversification. Beta measures non-diversifiable risk. Beta shows the pric e of an individual stock which performs with changes in the market. In effect, t he more responsive the price of a stock to the changes in the market, the higher is its Beta. Beta is a relative measure of risk the risk of an individual stock relative to the market portfolio of all stocks. If the securitys returns move mo re (or less) than the markets returns as the latter changes, the securitys returns have more (or less) volatility (fluctuations in price) than those of the market . It is important to note that beta measures a securitys volatility, or fluctuati ons in price, relative to a benchmark, the market portfolio of all stocks. PDP Investment Planning 33

Securities with different slopes have different sensitivities to the returns of the market index. If the slope of this relationship for a particular security is a 45-degree angle, the beta is one (1). This means that for every one percent c hange in the markets return, on average, this securitys returns change one (1) per cent. The market portfolio has a beta of one (1). A security with a beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as marke t returns, both up and down. This would be considered an aggressive security bec ause when the overall market return rises or falls 10 per cent, this security, o n average, would rise or fall 15 per cent. Stocks having a beta of less than 1.0 would be considered a more conservative investment than the overall market. Bet as can be negative or positive. But generally, betas have been found to be posit ive which means that the direction of the movement of individual stock generally tends to be in line with the market: falling when the market is falling and ris ing when the market is rising. Beta is useful for comparing the relative systema tic risk of different stocks and, in practice, is used by investors to judge a s tocks risk. Stocks can be ranked by their betas. Because the variance of the mark et is a constant across all securities for a particular period, ranking stocks b y beta is the same as ranking them by their absolute systematic risk. Stocks wit h high betas are said to be high-risk securities. Given below are different scen ario showing how the portfolio return moves relative to market for Beta equal to 1, 0.5, and 2. 34 Investment Planning PDP

The beta of a security is a historical measure and it is arrived at by plotting the actual returns on the security over long periods of time with market returns as shown in the earlier charts. A line is drawn which depicts beta of the secur ity. To determine the beta of any security, youll need to know the returns of the security and those of the benchmark index you are using for the same period. Us ing a graph, plot market returns on the X-axis and the returns for the stock ove r the same period on the Y-axis. Upon plotting all of the monthly returns for th e selected time period (usually one year), we draw a bestfit line that comes the closest to all of the points. This line is called the regression line. Beta is the slope of this regression line. The steeper the slope, the more the systemati c risk, the shallower the slope, the less exposed the company is to the market f actor. In fact, the coefficient (Beta) quantifies PDP Investment Planning 35

the expected return for the stock, depending upon the actual return of the marke t. Calculating Beta Rs = a + BsRm Where, Rs = estimated return on the stock a = estimated return when the market return is zero Bs = measure of the stocks sensit ivity to the market index Rm = return on the market index Allowing for random er rors, some times beta is calculated as under: Rs = a + BsRm+ e Where, e is the ran dom error term embodying all of the factors that together make up the unsystemat ic return. If we want to compare the return on the security related to the risk free avenues, then the formula is: Rs = Rf + Bs (Rm - Rf) Where the concept of R f is the risk free return return that can be obtained by investing in risk free securities like treasury bills. Case For example, suppose you are considering a private equity investment in a compan y with a new job work. The process is inherently risky, i.e. the standard deviat ion of the project is 75% per year. The beta of the project is 0.5. The Rf = 5% and the E[Rm] = 14.5%. What is the required rate of return on the project? Theor y tells us that the answer does not depend upon the volatility associated with t he returns. Instead we use the beta of the project. E[Rjob] = 5% + (.5)(14.5% 5%) = 9.5% This is the required rate of return on the project. The answer would not change if the range of outcome next year broadened or narrowed. (beta) is th e only relevant piece of information now all that remains is to estimate it! 36 Investment Planning PDP

Review Questions: 1. Mr. Joshi has analysed a stock for a one-year holding perio d. The stock is currently quoting at Rs 100 and is paying no dividends. There is a 50-50 chance that the stock may quote Rs 100 or Rs 120 by year-end. What is t he expected return on the stock? a. 12% b. 10% c. 15% d. 20% 2. A stock is quoti ng at Rs. 100 and is paying no dividends. The possible year end price and the pr obabilities are given below: Year end price 110 115 120 125 130 a. 10% b. 15% c. 8% d. 20% 3. What is the standard deviation of the stock based on the figures i n question 2? a. 14.45 b. 5.79 c. 16.30 d. 33.60 4. Stocks A and B are not payin g any dividends. Stock A is quoting at Rs. 100 while B is quoting at Rs 50. Ther e is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 5050 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the y ear. Which stock will you buy considering the return and the risk? a. I shall bu y B because it is cheaper b. I will buy Stock B because the risk is less c. I wi ll buy Stock A because the risk is less d. The risk and the return in both are s ame; I shall buy any one 5. Compute the expected return for the stock when the r isk free return is 8% and the expected return from the market is 12% for a stock with Beta of 1.2. a. 15.6% b. 12.8% c. 16.4% d. 22.2% Probabiltiy 0.1 0.2 0.3 0 .2 0.1 What is the expected return on the stock? PDP Investment Planning 37

6. Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an aggressive investor would buy: a. Either A or B; because in a risin g market all stocks will rise b. Stock A because it may deliver superior returns compared to B c. Stock B because the risk will be less compared to A while the returns would be the same d. Stock B because it may deliver superior returns com pared to A Answers: 1. 2. 3. 4. 5. 6. b c b d - (while deciding you calculate the risk also besides the returns) b - use the formula Rs = Rf + Bs (Rf -Rm) b - higher beta means higher risk and also higher returns compared to market. 38 Investment Planning PDP

Chapter 4 PDP Investment Planning 39

Managing Risk in Investments isk is an integral part of investments. Risk in the context of investments not o nly refers to the chance of losing ones capital, but mainly to the chance/probabi lity of getting less than expected returns from an investment vehicle. Thus, ris k in investments can not be avoided but it can be managed to suit ones risk profi le and investment objectives. Risk in investments is categorized as systematic and un systematic risk; which are also called non diversifiable and diversifiable risk. Unsystematic risk can be reduced through diversification while systematic risk i s a market risk which can not be reduced through diversification. Investors can resort to different strategies to manage risk in investments. Lets look at some s trategies that investors can adopt to manage risk. R Diversification It is well established in investments that in order to be able to obtain require d returns, it is essential to reduce the risk and this can be achieved through d iversification. Diversification reduces the risk and can be achieved through div ersifying investments: n n n n Across different asset classes equity; debt; comm odities; precious metals; real estate and so on. Across different countries (geo graphies) India; USA; UK; Japan; Singapore; Australia; Middle East and so on. Ac ross different securities and so on Different stocks; bonds, etc. Across maturit ies short term; long term; for life; etc. Diversification across different asset classes n As financial planners, we shoul d ensure that the investments are diversified across different asset classes and that proper allocation among different assets is made as decided in the Asset A llocation Plan. It is important to decide the quantum of investments in risky as set classes like equity, real estate, etc. based on the age, risk appetite, etc. of the investor. Over dependence on a particular asset class can also be quite risky. For example, if an investor is highly risk averse and has little or no ex posure to equities, then he will find the going tough if the interest rates in t he economy were to fall. He will continue to earn less over a period of time and may even suffer loss on existing investing because of fall in bond prices. Henc e, exposure to equity should be considered in such cases. Similarly, a very high exposure to equity can prove very tricky because the stock market over a long p eriod of time may turn bearish and the investor may get very little return and c apital appreciation in this period. The chances of capital loss are also quite h igh in such cases. Equity is a long term asset class and should be accordingly p lanned while deciding the Asset Allocation Plan. n n Portfolio of Securities While investing in stocks, it is essential to invest in a number of stocks and not just a few to reduce the 40 Investment Planning PDP

risk. But the purpose of diversification will be achieved only if the stocks bel ong to different sectors and that some of the sectors are not related to each ot her. Let us look at the following example to understand the co-relationship betw een two securities in a portfolio: Suppose you live on an island where the entir e economy consists of only two companies: one sells umbrellas while the other se lls sunscreen lotion. If you invest your entire portfolio in the company that se lls umbrellas, youll have strong performance during the rainy season, but poor pe rformance when its sunny outside. The reverse occurs with the sunscreen company, the alternative investment: your portfolio will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are youd rather have c onstant, steady returns. The solution is to invest 50% in one company and 50% in the other. Since you have diversified your portfolio, you will get decent perfo rmance year round instead of, depending on the season, having either excellent o r terrible performance. It is a well established fact as borne out by the follow ing diagram that diversification across securities reduces the risk: Studies and mathematical models have shown that maintaining a well-diversified p ortfolio of 25 to 30 stocks will yield the most cost-effective amount of risk re duction. Investing in more securities will still yield further diversification b enefits, albeit at a drastically smaller rate. So, it is only sensible to hold a certain number of securities and monitor the same periodically rather than hold ing too many securities in a portfolio which will serve the purpose of diversifi cation in a very limited way. Further, diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated to domestic investments. For example, an economic downturn in the Indian econom y may not affect Japans economy in the same way. Therefore, having Japanese inves tments would allow an investor to have a small cushion of protection against los ses due to an Indian economic downturn. The following important conclusions can be drawn regarding diversification across securities: 1. 2. The number of securi ties should be limited to say 20 to 30 and not more. The securities should ideal ly belong to different industrial sectors, and if possible, even different geogr aphical regions. PDP Investment Planning 41

3. The co-relation of market movements may be built in selecting stocks in a portfo lio (oil marketing companies and automobiles; export oriented and import dependa nt companies; lending companies and borrowing companies, etc.). Returns on the portfolio In a portfolio containing a number of securities, the r eturns on the same will depend upon the return on individual securities as well as weightage of each of the security in the total portfolio. While deciding on t he securities to be invested in the weightage of each security, the portfolio is also decided at the point of investment. The weightage may change over a period of time with change in prices of underlying securities as well the portfolio va lue. The weights are calculated on the basis of initial investment value. We can express the same in the following formula for return on the portfolio: Where E (RP) is the expected return on the portfolio, Wi is the weight of securi ty i in the portfolio and, E(ri) is the expected return on security i Example Le t us consider a portfolio with two securities A and B with a weight of 60% assig ned to A and 40% to security B. If the following are the probabilities of return for individual securities A and B let us try and find out the probable return o n the portfolio: Expected return on security A = [ (0.15*25)+(0.2*15)+(0.3*0)+(0.2*-5)+(0.15*-10) ] = 3.75+3+0-1-1.5 = 4.25% Expected return on security B = [(0.15*30)+(0.2*20)+(0.3*5)+(0.2*0)+(0.15*-10) = 4.5+4+1.5+0-1.5 = 8.5% 42 Investment Planning PDP

Return on the portfolio = RAB = WA*RA+WB*RB = 0.6*4.25+0.4*8.5 = 2.55+3.40 = 5.95% Where, WA is the weight of A in the portfolio while WB is the weight of B in the portfolio.. Risk of the Portfolio - Measurement Risk on a portfolio is calculated by considering the standard deviation of indiv idual securities included in the portfolio as well as interactive risk among sec urities, measured by covariance. Variance of Portfolio Given a portfolio consisting of n securities, the variance of the portfolio can be written as: Portfolio Risk =Sum of individual securities risks + Sum of interaction among sec urities Where, sP2 is the variance of the portfolio. ri, j is the covariance bet ween securities i and j. sI is the standard deviation of security i. is the formula for calculating the standard deviation of a portfolio of two secu rities x and y where sXY is the standard deviation of the portfolio, w represent s the weight of securities x and y in the portfolio while COVxy is the covarianc e between securities x and y. Example Let us consider a portfolio with two secur ities X and Y with a weight of 60% assigned to X and 40% to security Y. If the f ollowing are the probabilities of return for individual securities X and Y, let us try and find out the standard deviation of the portfolio: PDP Investment Planning 43

The same can be done in 3 steps: firstly find out the standard deviation of indi vidual securities; secondly calculate the covariance between the two securities and thirdly the risk on the portfolio. Standard deviation of Securities X and Y Expected return on security X is = {0.1*30+0.2*20+0.5*10+0.2*(-10)+0.1*(-20)} = 8% Expected return on security Y is = {0.1*20+0.2*15+0.5*10+0.2*0+0.1*(-10)} = 9 % sX2 = Variance of security x = {[.1*(30-8)2]+[0.2*(20-8)2] + [0.5*(10-8)2]+[0. 2*(-10-8)2]+[0.1*(-20-8)2]} = 0.1*484 + 0.2*144 + 0.5*4 + 0.2*324 + 0.1*784 = 48 .4+28.8+2+64.8+78.4 = 222.4 Hence, standard deviation of security x is = square root of 222.4 = 14.91% Similarly, the variance of security y can be calculated a s under: = {[0.1*(20-9)2] + [0.2*(15-9)2] + [0.5*(10-9)2] + [0.2*(0-9)2] + [0.1* (-10-9)2} = 0.1*121+0.2*36+0.5*1+0.2*81+0.1*361 = 12.1+7.2+0.5+16.2+36.1 = 72.1 Standard deviation of security y is square root of 72.1 = 8.49% Covariance between securities X and Y The use of formula is illustrated by actua lly taking out the figures in the probability of returns on securities x and y C OVxy = 0.1*(30-8)(20-9)+ 0.2*(20-8)(15-9) + 0.5*(10-8)(10-9) + 0.2*(-10-8)(0-9) + 0.1 (-20-8)(-10-9) = 24.2+14.4+1+32.4+53.2 = 125.2 44 Investment Planning PDP

Portfolio Risk s2XY = (0.6)2*(14.91)2 + (0.4)2*(8.49)2 + (2*0.6*0.4*125.2) = (0.36*222.31) + (0.16*72.08) + (60.1) = 80.03+11.53+60.1 = 151.66 sXY = = squa re root of 151.66 12.31% Expected return on the portfolio Portfolio Risk and return in a two security scenario The calculations may look c omplicated but in many cases the correlation between the securities is given and hence, it is easier to work out the portfolio risk and the portfolio return. Le t us look at the following example to understand things better: Example 2 securi ty case

= 30% 0.15 + 70% 0.20 = 0.185 or 18.5% sP2 = wA2sA2 + wB2sB2 + 2 wAwBrA,BsAB = (0. 3)20.05 + (0.7)20.06 +2 0.30.70.50.2240.245 = 0.0454248 sP = Square root of 0.014524 0.213 or 21.3% Thus the portfolio risk is 21.3% while the expected return of th e portfolio is 18.5% Covariance and Correlation Coefficient The covariance and c orrelation coefficient measure the extent to which securities move together in t he PDP Investment Planning 45

market. For instance, suppose you own Stock A and B and both are high-tech stock s selling computer chips. Suppose that news breaks about Company A revealing a q uality assurance issue with their computer chips and the announcement of a major recall. Stock As price will probably decrease if the market had not expected suc h an announcement. Because Stock B is also in the computer chip industry, its st ock may very well decrease as well since investors will respond adversely to the overall market for computer chips. The measure of Stock Bs sensitivity to Stock As stock price could be measured over time to see the extent to which they move t ogether. We could use both the covariance and the correlation coefficient to tra ck the movements. Stock B could be measured relative to an overall stock market index as well in order to see how sensitive it is to that markets general movemen ts. The relationship between the movements of two securities or between a single security and general market movements are critical observations. As we shall se e in a later chapter, these observations and measures of co-movements provide th e underpinning in constructing efficient portfolios that contain many securities that move together in the same direction to each other (positive correlation) t end to do very well in good times and very poorly in bad times. The opposite is true too in that securities which are negatively correlated balance each other o ut in good time and in bad times as well. Covariance and correlation coefficient s are simple to calculate for two securities but become more complicated as the number of securities increases. That is why it is necessary to use computer prog rams to conduct such analysis. 1. Actually, rather than use the standard deviati on, we can also use its squared value, termed the variance to describe risk. Tha t is, we may use a2 (the standard deviation squared) to describe the risk in an individual security. Covariance Any two securities whose prices react to information similarly are said to have a positive covariance. Securities with a negative covariance have returns that v ary inversely, or that their prices move in opposite directions as reactions to the same information event. The covariance between two securities is calculated as follows: As you can see, the covariance of these two securities is 0.14. This means that these two securities tend to move in opposite directions. Without ca lculating the correlation coefficient, it is difficult to determine the extent t o which they move together. Since the covariance is calculated similar to the st andard deviation, we know that this is an absolute number. That is why it is nec essary to use the covariance to calculate the correlation coefficient. Correlati on Coefficient The correlation coefficient measures the strength of the relation ship between two securities and the coefficient is always a value between 1 and + 1. If the value is 1, it can be said that the returns of the securities are per fectly negatively correlated, meaning that the prices change equally but in oppo site directions, where direction implies increase and decrease. If they value is + 1, the two securities are perfectly positively correlated and that the securi ty prices change equally and in the same direction as well. If the correlation c oefficient equals zero, it means that the two securities do not move together in any meaningful way. 46 Investment Planning PDP

The calculation for correlation coefficient is as follows: Thus we can see that if correlation coefficient is 0.70, it means that these two securities exhibit a strong negative movement in opposite directions. In this ca se, barring other issues, these two securities may be suitable to put in a portf olio in order to project it from general stock market cycles. FIGURE 5:1 Correla tion Analysis Figure 5:1 demonstrates the concept of correlation. In Panel A, assets i and j a re perfectly correlated, with r ij equal to + 1. As i increases in value, so doe s j in exact proportion to i. Panel B, assets i and j exhibit a perfect negative correlation, with r if equal to 1. As i increases, j decreases in exact proport ion to i. Panel C demonstrates assets i and j having no correlation at all, with r ij equal to 0. Portfolio Effect An investor who is holding only investment i may consider adding investment j in the portfolio. If equal amounts are invested in each stock, the new portfolios Expected Return will be Kp. We define Kp as th e Expected Return of the portfolio: Kp = XiKi+XjKj The X values represent the we ights assigned by the investor to each component in the portfolio and are 50 per cent for both investments in this example. The i and j values were determined to be 10 percent. Thus we have: Kp = 0.5(10%) + 0.5(10%) = 5% + 5% = 10% What abou t the standard deviation ( p ) for the total portfolio? Assume standard deviation of i = 3.9% PDP Investment Planning 47

and j = 5.1%. If a weighted average were taken of the two investments, the new s tandard deviation would be 4.5 percent: s Xi + s Xj 0.5 (3.9%) + 0.5 (5.1%) = 1.95 % + 2.55% = 4.5% The interesting element is that the investor appears to be wors e off from the combined investment. His Expected Return remains at 10 percent, b ut his standard deviation has increased from 3.9 to 4.5 percent. It appears that he is adding risk rather than reducing it by expanding his portfolio and withou t any change in return. There is one fallacy in the analysis. The standard devia tion of a portfolio is not based on the simple weighted average of the individua l standard deviation (as the Expected Return is) rather, it considers significan t interaction between the investments. If one investment does well during a give n economic condition while the other does poorly and vice versa, there may be si gnificant risk reduction from combining the two, and the standard deviation for the portfolio may be less than the standard deviation for either investment (thi s is the reason we do not simply take the weighted average of the two). FIGURE 5 :2 Investment Outcomes under Different Conditions Note : In Figure 5:2 risk-reduction potential from combining the two investments under study. Investment i alone may produce outcomes anywhere from 5 to 15 perc ent, and investment j, from 6 to 20 percent. By combining the two, we narrow the range for investment (i, j) from 7.5 to 12.5 percent. Thus, we have reduced the risk while keeping the Expected Return constant at 10 percent. Coefficient of D etermination As we just saw, correlation and covariance are statistical measures that gauge the nature of the relationship between two random variables. Sometim es, the relationships between such variables may be one of dependence or causali ty. For example, when our income increases (decreases), our consumption of goods and services generally also increases (decreases). In this case, we can say tha t changes in consumption are caused (is dependent upon), to some extent, on chan ges in income. In this example, we can then classify consumption as the dependen t variable and income as the independent variable. A common 48 Investment Planning PDP

procedure to measure the extent of such a dependent relationship between two var iables is known as simple regression analysis. Regression analysis provides us w ith many statistical gauges of the relationship which help us better understand the scope and nature of the relationship. One such measure in a statistic known as the coefficient of determination, also known as R. This widely used statistica l measure (R), represents the proportion of variation in the dependent variable t hat has been explained or accounted for by the independent variable. In the abov e example of income and consumption, the R statistic form a simple regression ana lysis would tell us how many changes in consumption, are explained by changes in income. What is interesting to note is that the coefficient of determination, w hen observed as a result of simple regression analysis, is also the square of th e correlation coefficient, which was discussed previously. Since the correlation coefficient is commonly denoted by the symbol r, hence the R for the determination coefficient. Also note that since correlation has a value between l and + l, it s squared value must also necessarily be a value between o and l. Continuing fur ther, we consider the correlation value of l to represent a perfect negative rel ationship (each change in a variable being matched by an equal but directionally opposite change in the other) between two variables and a correlation value of + l to represent a perfect positive relationship (each change in a variable bein g matched by an equal, in both magnitude and direction, change in the other) bet ween two variables. Thus, the squared values in both these cases, or their R, wou ld equal l. We can say then that the value of R being equal to l implies that the independent variable fully explains all changes in the dependent variable. When the value of R is equal to zero, we can similarly say that there is absolutely n o dependent relationship between the two variables. In the case where multiple r egression analysis is being used, i. e. relationships between and among more tha n two variables, the R measure similarly interprets the depth of the relationship but is no more simply the squared correlation value. Risk Reduction through Pro duct Diversification It is important to have a dynamic asset allocation plan div ersified among different asset classes. Financial investment products comprise d irect equity; indirect equity through the mutual fund route; balanced fund which focuses on both debt and equity; debt corporate and government; fixed income in struments like small saving schemes; government bonds, fixed deposits bank and c orporate, etc. Risk on the total portfolio is reduced through investments among different products, in a pre-determined proportion, depending upon the risk prof ile of the investor and managed through periodic review of the proportion. Risk Reduction through Time Diversification When it comes to equity investments, it i s a well established fact, especially in respect of retail investors that they c annot time the market. It is the time one stays invested that would determine th e returns on equity investments over a period of time and not market timing. Man y investors tend to take higher exposure to equity at market highs and tend to r educe their exposure during market lows due to emotional swings. These investors invariably end up losing money. The best and time tested solution lies in syste matic investment and sticking to asset allocation plans. The quantum of funds al located to equities can be invested over a period of time through systematic inv estment plans. Almost all mutual funds offer SIPs where the people can invest in these funds on a monthly basis at predetermined dates and fixed amounts per mont h. Auto debit and ECS make it very convenient for investors to invest on a syste matic basis. Another very important strategy could be parking the available fund s in Floating Rate Debt funds and transferring fixed quantum of funds on a month ly basis through a Systematic Transfer Plan out of floaters through SIPs into equ ity funds. In this strategy, the funds may earn decent returns in floating rate funds with less interest-rate risk while the equity market timing-risk is reduce d through SIPs. PDP Investment Planning 49

Hedging Diversification reduces unsystematic risk in a portfolio. Unsystematic r efers to a specific individual corporate or country financial risk event. Theref ore, as the number of securities increase in a portfolio, the portfolios unsystem atic risk decreases. The remaining risk is called systematic or market risk. Sys tematic risk cannot be diversified out of a portfolio; however, systematic risk can be hedged. Consider a portfolio consisting of an indexation of the BSE Sense x. By holding positions in these 30 companies, a portfolio has reduced the unsys tematic risk. Now the dependence and exposure on the fortune or failure of each company is an approximation of a 1 in 30 chance. The portfolios remaining risk is viewed as systematic or market risk. This means that the portfolio value will s wing with the benchmark market. A manager can reduce this systematic risk by hed ging. To offset the systematic risk, a fund manager would establish a hedge. Thi s hedge would offset the value changes in the underlying portfolio position. Typ ically, this offset is accomplished with the futures, options, or other derivati ve markets. Example If the actual portfolio had a market value of Rs. 12 lacs an d the NSE Nifty was trading at 3,000, then four future contracts would be sold t o effectively offset the market risk. This is so because each futures contract r epresents the index level times a multiplier of Rs. 3,00,000 per contract at the Nifty level of 3000 (Each Nifty contract size is 100). By selling four (4) cont racts; i.e. 400 Nifties, the market value of Rs. 12,00,000/- of the portfolio is protected against a fall in Nifty. When the market falls by 5%, the portfolio w ill fall by 5% resulting in a loss of Rs. 60,000/- while the Nifty futures contr act will earn Rs. 60,000/- on 4 contracts because Nifty would have fallen from 3 000 to 2850. This is an example of fully hedging the portfolio through selling t he index futures. The same effect can be achieved by buying Index puts as well. The put option starts gaining when the market starts falling and in case the marke t rises, the loss on puts will be to the extent of premium paid only. In other w ords, puts can be used to limit the loss in case of a market rise with potential to earn unlimited profits in case of a market fall. The use of futures and opti ons as tools of hedging as well as leveraging portfolios has been explained in a separate topic. 50 Investment Planning PDP

Review Questions: 1. Given the following information, what is the expected retur n on the portfolio of two securities where both are held in equal weights? a. 15% b. 19% c. 16% d. 17% 2. What would be the standard deviation of the portf olio comprising of the two securities as per details given below? a. 4.14% b. 3.82% c. 14.13% d.1.78% 3. Diversification among different asset cla sses will reduce all risks. Is this statement true? a. Yes b. No; diversificatio n does not serve the purpose of risk reduction c. No; diversification reduces no n systematic risk only d. No; diversification reduces systematic risk only 4. He dging is a strategy adopted to reduce all risks. Is this true? a. Yes b. No; hed ging does not serve the purpose of risk reduction c. No; hedging reduces non sys tematic risk only d. No; hedging reduces systematic risk only 5. Hedging, agains t market loss, in a diversified stock portfolio can be achieved through which on e of the following strategies? a. By selling index futures b. By selling index p uts c. By buying specific stock futures d. By buying index futures PDP Investment Planning 51

6. Mr. Ashok Kulkarni, age 40 years, is a salaried person. He wants to invest Rs. 1 ,00,000/- in equities and seeks your advice about whether this is the right time to invest in equities and how to go about it. What would be your advice to him? a. Stay away from stock market because it is a risky place. b. This is not the right time to invest in stocks because the market is likely to fall. c. Invest t he funds in a floating rate debt fund and adopt SIP route to invest in mutual fu nds systematically on a monthly basis as retail investor cannot time the market. d. Buy shares of Infosys Technologies as the company is doing very well and has declared a bonus also. 7. Mr. A. G. Doshi has investments in stocks of 50 companies. He wants to invest so me more money in direct equities and requests you to advice him on how many more companies he should invest in so that he shall have a well diversified equity p ortfolio. What will be your advice to him? a. He should have at least another 50 more companies to be adequately diversified. b. He already has too many compani es. He should reduce the number to about 20/25 companies belonging to diverse in dustrial sectors. Any additional investment he wants to make, he should make in these companies. c. Diversification cannot be achieved through increasing the nu mber of companies in ones portfolio. d. He can continue to hold on to all and add more companies as per funds availability. 8. A small investor wants to participate in the equity market but does not have the expertise or the funds to have a well diversified equity portfolio. What will b e your advice to him? a. Equity is not the place for small investors as the risk s are very high. He should stay away. b. Since funds available are limited, he c an buy just one or two stocks of large companies and participate in the equity b oom. c. He should prefer a diversified equity mutual fund as this is where diver sification can be achieved even on a small capital. d. He should first get the e xpertise by undergoing training programs and then only venture into stock market . Answers: 1. c 2. a 3. c 4. d 5. a 6. c 7. b 8. c 52 Investment Planning PDP

Chapter 5 PDP Investment Planning 53

Measuring Investment Returns W e all make investments to get returns/rewards from the investment vehicles. Ther e are two types of returns viz. realized return and expected return. Realized return is what the term implies; it is ex post (after the fact) return, or return that was or could have been earned. Realized return has occurred and can be measured with the proper data. Expected return, on the other hand, is the estimated return from an asset that investors anticipate (expect) they will ear n over some future period. As an estimated return, it is subject to uncertainty and may or may not occur. The objective of investors is to maximize expected ret urns, although they are subject to constraints, primarily risk. Return is the mo tivating force in the investment process. It is the reward for undertaking the i nvestment. An assessment of return is the only rational way (after allowing for risk) for investors to compare alternative investments that differ in what they promise. The measurement of realized (historical) returns is necessary for inves tors to assess how well they have done or how well investment managers have done on their behalf. Furthermore, the historical return plays a large part in estim ating future, unknown returns. Return on a typical investment consists of two co mponents: 1. Yield: The basic component that usually comes to mind when discussi ng investing returns is the periodic cash flows (or income) on the investment, e ither interest or dividends. The distinguishing feature of these payments is tha t the issuer makes the payments in cash to the holder of the asset on a periodic basis. Yield measures relate these cash flows to a price for the security, such as the purchase price or the current market price. Capital gain (loss): The sec ond component is also important, particularly for stocks but also for long-term bonds and other fixed-income securities. This component is the appreciation (or depreciation) in the price of the asset, commonly called the capital gain (loss) . It is the difference between the purchase price and the price at which the ass et can be, or is, sold. 2. Total return Given the two components of a securitys return, we need to add them together (alg ebraically) to form the total return, which for any security is defined as: Tota l return = Yield + Price change where: the yield component can be nil or positiv e. the price change component can be nil, positive or negative. Measurement of T otal return Total return = {Cash payments received + Price change over the perio d}/purchase price of the asset The price change over the period = end price open price (can be negative) 54 Investment Planning PDP

Example The shares of Alpha were bought on Jan 1 for Rs. 50/-. During the year, Alpha paid a dividend of Rs. 2/- per share. At the end of the year, Alpha was so ld for Rs. 52/- What is the total return on Alpha? Returns = Dividend + price ch ange = 2 + (52-50) = 2+2 = 4 Total returns = returns/purchase price = 4/50 =0.08 = 8% This is a conceptual statement for the total return for any security. The important point here is that a securitys total return consists of the sum of two components, yield and price change. Investors returns from assets can come only f rom these two components - an income component (the yield) and/or a price change component, regardless of the asset. Current Yield It is a very simple measure o f returns on any security and it is obtained by the following formula: Annual In terest/price of the security Yield to Maturity (YTM) The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), which is define d as the promised compounded rate of return an investor will receive from a bond purchased at the current market price and held to maturity. It captures the cou pon income to be received on the bond as well as any capital gains and losses re alized by purchasing the bond for a price different from face value and holding to maturity. Similar to the Internal Rate of Return (IRR), in financial manageme nt, the yield to maturity is the periodic interest rate that equates the present value of the expected future cash flows (both coupons and maturity value) to be received on the bond to the initial investment in the bond, which is its curren t price. An investor would use the bonds coupon rate, price, par value, and term to maturity to determine the yield to maturity, or internal rate of return. For a bond selling at Rs. 1,000 and expected to be redeemed by the issuer at Rs. 1,0 00, the current yield and the yield to maturity are identical. However, the yiel d to maturity will differ from the current yield if the bond sells at a discount or a premium. Computation of YTM Where, P = Price of the security C = annual interest payments received r = rate of interest M = Maturity value (amount receivable on maturity) n = number of yea rs left for the security to mature The computation of YTM requires a trial and e rror procedure. The interest payments are payments of annuity over a period of t ime while the maturity value is the future value of the present price of the bon d and r the YTM has to be worked out substituting different values for r. PDP Investment Planning 55

Approximate Computation of YTM Instead of following the trial and error basis, o ne can find out the approximate value of YTM by using the formula: Where, YTM is the yield to maturity C = annual interest payment M = Maturity val ue of the bond P = Present price of the bond n = number of years to maturity Ari thmetic average returns A stock not paying dividends, quotes at Rs. 100 at the b eginning of the year. It quotes at Rs. 120; Rs. 132; Rs. 118.80 at the end of ye ar 1, 2, and 3 respectively. Lets find out how the arithmetic average return is c alculated over this period: Opening price Rs. 100 Year 1 : 20/100 = 20% Year 2 : (132-120)/120 = 10% Year 3 : (118.8-132)/132 = -10% Total returns over 3 years = 20% Arithmetic average return = 20/3 = 6.66% p.a. Using the same method, let u s calculate the arithmetic average returns based on the following figures: Openi ng price Rs. 100; Year 1 end price Rs. 200; Year 2 end price Rs. 100 What is the arithmetic average return for this stock? Year 1 returns 100% Year 2 returns -5 0% [(-100/200)*100] Total returns over 2 years 50% Arithmetic average returns 50 /2 = 25% This example brings out the limitations of Arithmetic Average Returns b ecause it is obvious that the returns on the stock can not be 25% when the openi ng price and price at the end of the second year are the same at Rs. 100/-. 56 Investment Planning PDP

Therefore, this measure of Arithmetic Average Returns is used for measuring futu re period returns rather than past returns. Geometric Average Returns The formul a for measuring Geometric Average Returns is: G = [(1+R1)(1+R2)(1+R3) (1+Rn)]1/n -1 Where, G is the Geometric Average Returns R1..Rn is the return over different periods from 1 to n Lets try to work out the geometric average return in the foll owing example: Opening price Rs. 100; Year 1 end price Rs. 200; Year 2 end price Rs. 100 R1 = 100% or 1 R2 = -50% or 0.5 G = square root of [(1+1)(1-.5) 1] = squ are root of [(2*0.5) 1] = 0 Types of Returns Investors use various methods by which they measure investment returns. We will discuss several type of returns; the nominal rate of return, the real rate of re turn, the real after tax rate of return, total return and risk adjusted return. We will briefly discuss each of these concepts. Nominal Rate of Return The nomin al rate of return is simply the return that one can earn on an investment. If fo r instance, you invest your money in a Certificate of Deposit that promises to p ay 7 percent per year, a Rs. 100 investment will yield Rs 107, one year later. I n this example, the nominal rate of return is 7 percent, the rate you can earn b efore considering the effects of inflation or taxes on your investments. Require d Rate of Return The required rate or return is a key concept in investment plan ning. However, it is also a difficulty and complex concept to understand for rea sons that require further discussion. Thus, it is worthwhile for us to spend som e time on this issue. When an investor assesses an investment opportunity, they may conduct much research and analysis to gauge the attractiveness of the invest ment. Ultimately, the investor will boil down the research and analysis to two f actors; the risk of the investment opportunity and the return the investor expec ts to earn on this investment. The rate of return that an investor expects to ea rn on a risk-free security (e.g. A Treasury Bill) is the return that an investor expects to earn on a security that is free of default risk. All other securitie s contain the possibility of defaulting on their obligations. Hence, an investor will require returns in addition to the risk free rate as compensation for assu ming the higher risk. We can think of this compensatory additional return as the securitys risk premium. Thus we may express the required rate of return as follo ws: PDP Investment Planning 57

Required rate of return = risk-free return + risk premium What the planner needs to comprehend is that in arriving at a required rate of return, the primary ass essment is the nature and extent of risk of an investment opportunity. The great er our understanding of the riskiness of a security, the more accurate our under standing of the risk premium we must receive, as compensation, in order to be in duced to invest in that particular security. For example, suppose an investor, o r planner, is considering an investment in two securities a small cap stock and a highly rated bond. The planner will understand that the bond contains lower de fault risk than the small Cap stock and will provide a greater assurance of an i ncome stream and a redemption value at maturity. On the other hand, the small ca p stocks price will most likely fluctuate greatly and a higher probability will e xist that the firm may well go bankrupt. Thus, from the planners or investors pers pective, the bond will be considered a much safer investment and the risk premiu m that the investor will require to invest in the bond will be much lower than w hat will be assessed for the stock. When these risk premiums are added to the ri sk free rate, the rate or return that the investor will require for the small ca p stock will be much higher than the bond. In summary, the required rate of retu rn may be considered as the gauge of the securitys riskiness. There are two other related return concepts that are also worth discussing briefly. Under various e conomic conditions, the performance of securities with varying characteristics w ill differ. For example, when the economy is in a recessionary stage, we expect most stocks to perform poorly, in terms of the returns they generate during this period. In this example, this rate would be the stocks expected rate. If the inv estors required rate for this stock was higher than the expected rate, then the i nvestor would not consider this investment, since the expected rate would not co mpensate the bearing of the risk of this particular security, as determined by t he required rate. Similarly, in an economic growth cycle, the expected rate may equal or exceed the required rate and the investment would be made. Thus, we obs erve that both the required rate and the expected rate are assessed and compared and which lead to the eventual trading decision. Finally, note that the assessm ent of both the required rate and the expected rate begin before the investment decision and they continue to exist during the tenure of that decision, i.e. As long as the security is held. Once the investor sells the security, then the rat e that was actually earned, or the realized rate, can be calculated. The realize d rate may well be, and usually is, different form both the expected rate and th e required rate. The Real Rate of Return The decision to invest is, in a sense, decision not to consume. Alternately, an investment decision is a decision that implies a postponement of current consumption. To understand this further, consi der this example; suppose you made a return of 12 percent in one year and 15 per cent the following year, did you truly do better in the second year? The answer to this question depends on what your earnings could buy at the end of each of t hose years, or the purchasing power of your earnings. If the general level of pr ices, or inflation was very mild in the first year and severe in the second, you r earnings would stretch further (purchase more) in the first year than in the s econd and hence you would have actually done better in the first year. Thus, the investment decision is related to the purchasing power of your earnings. This r elationship, in turn, allows us to describe the concept of the real rate of retu rn. Consider another simple example. Suppose you have Rs. 100 that you are seeki ng to manage for one year and that you have two choices of how to use this money . The first choice is to invest the money in a savings account where you will ea rn a nominal rate of return of 3 percent/year. Thus, in this choice, if you deci ded to invest, you would have Rs 103 at the end of the year. The second choice i s to buy a watch, which you have always wanted, and which too costs Rs. 100, tod ay. Had you decided to invest the money, then you would buy the watch one year f rom today. However, due to the general increase in the level of prices, or infla tion, 58 Investment Planning

PDP

you may find that at the end of the year, the price of the watch has increased t o Rs. 104. In this case, you cannot buy the watch. Further, not having bought th e watch before, you have also given up the enjoyment of possessing the watch for the entire year. Thus, at the beginning, if you feel that the price of the watc h will increase to a level that is higher than what you would earn from your inv estment, you would be prone to not invest and buy the watch. The only way you wo uld be inclined to invest instead would be if you were being provided with a nom inal rate that was greater than what you would expect the price to be in a years time. In the above example, you would invest only if the nominal rate was just g reater than 4%. Note that you would not be willing to invest if the nominal rate was just enough (equal to 4% in this example) to offset the cost increase. If t hat were so, you would rather buy the watch and get to enjoy it for the year. Th ere are two important observations that we can make form this example. First, th e decision to invest is always in competition with the decision to consume. That is, the decision to invest can be considered as a decision to postpone consumpt ion. Second, we will invest only when we expect not only to consume a similar pr oduct in the future but that we are also rewarded by a higher earning rate for p ostponing our consumption. If we are not offered this reward, we will always ten d to consume and not invest. In the above example, the rate we earn on the inves tment is the nominal rate, the rate at which the price of the product will rise is the inflation rate and the rate of the reward is the real rate of return. Thu s in the above example, if the savings (nominal) rate was 6 percent and the infl ation rate was 4 percent, the real rate of return would approximately be 2 perce nt. This approximate relationship can be expressed as follows: Nominal rate = re al rate + inflation rate The exact relationship is given by the following equati on: (1 + Nominal rate) = (1 + real rate) x (1 + inflation rate) or, The real rat e = [ (1 + Nominal rate)/ (1 + inflation rate) ] 1 Real After Tax Rate of Return Many of the returns that investors earn are not tax-free. Short-term capital gai ns are taxed at the investors marginal tax rate. Recall that short-term capital g ains are those gains that are held for less than one year in case of financial a ssets like equities, Debt etc. and three years in case of real assets like real estate, work of arts etc. Long-term capital gains are gains from increases in se curity prices where the security was held (owned) for one year, three years or l onger. Such gains are currently taxed at 20 percent with indexation or 10% flat without indexation for most individuals. In advising a client to sell a financia l instrument, the real after tax rate of return must be taken into consideration in order to relay a true picture of return to the client. Taxes are relevant to all of us, but those clients in high income tax brackets are particularly affec ted by after tax returns. The formula for the real after tax rate or return is: r = ( R) (1-t) I where r is the real after tax rate or return, R, is the nominal rate of interest, and t is the tax rate at which the investment will be taxed a nd I is the inflation rate for the period. In this formula, we took the rate of inflation into consideration because it reduces the purchasing power of our retu rns. If the nominal rate of interest on a security is yielding 9 percent, the in dividual s tax rate is 30 percent and the inflation rate is an equal to 4 percent , the real after tax rate of return is: R = (0.0 0.09) (1- 0.30) 0. 0.04 = 2.3 % PDP Investment Planning 59

Total Return The notion of total return centers on the total return that an inve stment yields. For example, when talking about stocks, the total return is equal to any dividends that the stock pays plus the capital gains or losses that the investor realizes on the sale of the stock. The same notion is true for mutual f unds whereby the fund earns dividends and/or interest as well as capital gains o r losses. Total returns are expressed in whole currency terms. For example, supp ose an investor purchased Stock A for Rs. 100 per share. Over the next four year s, Stock A paid annual dividends of Rs. 20.00 each year. At the end of the fourt h year the investor decided to sell his stock at market for a price of Rs. 120.0 0 per share. Thus the gains are as follows: Year 1 Year 2 Year 3 Year 4 Total In come Capital Gain: Total Gain : Rs. 20.00 Rs. 20.00 Rs. 20.00 Rs. 20.00 Rs. 80.0 0 Rs. 20 Rs. 100 Thus, total return over the four years is Rs. 100 / Rs. 100 = 100% Risk Adjusted Return Risk premium is a percentage return that an investment must expect to ea rn in order for an investor to assume a given level of risk. The risk premium wi ll be different for each investment once all investment have different risk prof iles and different expected returns. For example, for a deposit at a bank or RBI Treasury bill, the risk premium approaches zero. For common stock, the investors required return may carry a 9 -10 percent risk premium in addition to the riskfree rate of return. If the risk-free rate were 8% percent, the investor might h ave an overall required return of 17 to 18% percent on common stock. n n n n n R eal rate 5% Anticipated inflation 5% Risk free rate 8% Risk premium 9 10% Requir ed rate of return 19 20% Corporate bonds fall somewhere between short-term government obligations (genera lly no risk) and common stock in terms of risk. Thus, for bonds, the risk premiu m may be 3 to 4% percent. Like the real of return and the inflation rate, the ri sk premium is not stagnant but changes from time to time; for instance, if the i ssuing companys risk profile changes or if the macroeconomic outlook becomes more uncertain, then the risk premium will change. If investors are very fearful abo ut the economic outlook, the risk premium may be 12- 14% percent Measuring Inves tment Returns In order to begin to understand the various types of investment re turns and their uses, we begin by considering a simple investment return for one time period. Recall, that when we discussed stocks, the 60 Investment Planning PDP

total return was equal to any dividends that the stock paid plus the capital gai ns or losses that the investor realized on the sale of the stock. The same notio n is true for mutual funds whereby the fund earns dividends and/or interest as w ell as capital gains or losses. Suppose you purchase stock X, at a price of Rs. 125. During the year, the stock pays a dividend of Rs 3. At the end of the year, you also sell the stock for Rs150 as it has increased in market value. Recall o ur formula for the Holding Period Return which is: HPR = P1 P0 + Dividends/P0 The return on this investment is: (150-125+3) = 28 = 22 .4 % 125 Time Weighted Returns versus Dollar Weighted Returns In reality we may want to c onsider investments over a period of time whereby we may have added to our inves tment positions or reduced our investment positions. If this is the case, measur ing investment returns is a bit more difficult. With the basic concept of the ho lding period return, however, we measure investment returns where there are seri es of cash inflows and outflows. Keeping with the example above, suppose that in stead of selling the share of stock at the end of the year, we decide to purchas e one more share of stock at the current market value of Rs 150. At the end of t he year, we collect our second Rs 3 dividend, and subsequently sell both shares of our stock for Rs160 each. The cash outflows for the purchase of stock are as follows. To - Rs. 125 to purchase first share of stock, where To is our initial cash outflow at Time zero Ti - Rs. 150 to purchase second share of stock The cas h inflows for the receipt of dividends are as follows: T1 - Rs. 3 dividend T2 Rs. 3 dividend plus Rs320 for selling each share of stock at Rs. 160. Using the discounted cash flow approach, we calculate the average return (r) over two year s as follows: Solving for r, we get R= 12.95% This value is known as the interna l rate of return on the investment and is also known as the compounded annual gr owth rate of return on the investment. The time weighted rate of return (Simple Airithmatic Rate of Return) is a formula which uses the holding period returns o f an investment and averages them in order to yield an average rate of return. I t is unlike the CAGR of return in that it ignores the number of shares held in e ach period. It does not take cash inflows/outflows into consideration during any period. Using the numbers from our previous examples, we find that the holding period return from at the end of period 1 was 20 percent. The return on the seco nd share of stock was 28-27+3/27 or 14.81 percent. To calculate the average time weighted rate of return: Time Weighted Rate of Return = (20% + 14.81%)/2 = 17.4 1% PDP Investment Planning 61

In this particular example, the dollar weighted return yielded less return than the time weighted rate of return. Depending upon the individual investment resul ts either measurement could yield a result greater than the other. In general th e results from these two measures will be different however. Time weighted retur ns are generally used in order to measure results of money managers in their man agement of particular funds. Because money managers cannot control the timing or the amount of money coming into their funds, time weighted returns are used in order to measure results. Since investors are particularly interested in the tot al amount of return that a portfolio or security yields over a period of time, t he dollar weighted rate of return is generally considered to be the superior mea sure of return for this reason. This measure would thus be used by those wishing to know how investment returns fared within a particular portfolio or portfolio s. Arithmetic versus Geometric Averages A separate set of measures arises from a veraging returns on investments. The arithmetic and geometric weighted averages are examples of such returns. The time weighted return discussed in the previous section is also an example of arithmetic average rate of return. The geometric rate of return considers cash flows generated during the securitys holding period to be reinvested at the securitys required rate of return. Thus, this method inc ludes the effect of compounding into consideration when calculating the return. The equation for the geometric is as follows: Rg = [(1 + HPR year1) X (1 + HPR y ear2) X (1+HPR year)]/n 1 Where Rg is the geometric rate of return and n, stands for the nth period of investment. The arithmetic rate of return is a simple aver age of annual returns. Using the same numbers from the previous example of calcu lating the time weighted rate of return, we calculate the geometric rate as foll ows: Rg = [(1 + 0.2) X (1 + 0.1481)] 1 = 17.38% Notice that the geometric average return is 17.38% whereas the arithmetic rate of return is 17.41%. It will alway s be true that the geometric rate of return will yield a smaller number than the arithmetic rate of return. In general, the lower the returns, the greater is th e disparity between the two averages. Summary This chapter began with a descript ion of the different kinds of risk that accompany investments. It is useful to u nderstand the nature and various types of risk since investors implicitly or exp licitly price this risk in arriving at required returns investments. Therefore, the description of different types of risk is followed by explanations of how ri sk may be Measured. Once we can identify the types of risk in an investment and understand how to measure such risk, we can then proceed to identify what kinds of returns we may require from investing in different kinds of investment produc ts. How much was the return on your investment? Before having read this chapter, s uch a question may have been interpreted as a simple question. Not any more. In this chapter, we studied the many different forms that investment returns may ta ke. Returns may be classified by inflation, as in the real rate return, or by th e investment risk, as in the risk-free rate. Other return measures may incorpora te taxes, the effect of time or the means of averaging. Even though the simplici ty of the term is no more, the astute student should recognize that the various return definitions exist because they are all meaningful to investors under diff erent investment circumstances and scenarios. These differing applications were explained in the context of defining each of the terms of returns. Armed with su ch knowledge, a financial planner cannot only explain investment outcomes to cli ents more clearly but also help clients identify the 62 Investment Planning PDP

misuse and abuse of these in the description of investment products. Problem Mr. Ketan bought a share on Jan 1, 2003 for Rs. 45/-. The company did not pay any d ividends. The year end prices were as follows: 2003 = 50 2004 = 55 2005= 48 If h e sold the share on end 2005 for Rs. 48, what returns did he get on this investm ent? Solution R1 = (5/45)*100 = 11.11% = 0.111 R2 = (5/50)*100 = 10% = 0.1 R3 = (-7/55)*100 = -12.72% = -0.127 Arithmetic Average returns = [11.11+10-12.72]/3 = 2.79665 Geometric Average returns = {cube root of [(0.111+1)*(.01+1)*(-0.127+1) ]} -1 = {cube root of 1.0669} - 1 = 1.023-1 = .023 or 2.3% Yield to Call Most co rporate bonds, as well as some government bonds, are callable by the issuers, ty pically after some deferred call period. For bonds likely to be called, the yiel d-to-maturity calculation is unrealistic. A better calculation is the promised y ield to call. The end of the deferred call period when a bond can first be calle d, is often used for the yield-to-call calculation. This is particularly appropr iate for bonds selling at a premium (i.e., high-coupon bonds with market prices above par value). Bond prices are calculated on the basis of the lowest yield me asure. Therefore, for premium bonds selling above a certain level, yield to call replaces yield to maturity, because it produces the lowest measure of yield. Co mpounding vs. Discounting The concept of compounding, that is interest on intere st, is an important concept, as is its complement, discounting. Compounding invo lves future value resulting from compound interest. Present value (discounting) is the value today of the Rupee to be received in the future. Such Rupees are no t comparable because of the time value of money. In order to be comparable, they must be discounted back to the present. Tables exist for both compounding and d iscounting, and calculators and computers make these calculations simple. Post Tax Returns (Tax Adjusted Returns) As an investor, you learn very quickly that taxes can take a big bite out of you r investment returns. After all, its not what you make, but what you keep that re ally counts. If an investment is made in a taxable vehicle within a taxable acco unt, one should really look at the net after tax return. Example Mr. Mukherjee h as an investment with an 8% taxable yield. Mr. Mukherjee pays tax at the rate of 30% on his income. What is Mr. Mukherjees post tax return on this investment? PDP Investment Planning 63

Return = 1 Tax = 0.3 Post tax return = 1-0.3 = 0.7 Taxable yield = 8% Post tax y ield = 8*0.7 = 5.6% Conversely, let us assume that Mr. Mukherjee gets 8% tax fre e returns and he is paying tax at 30%. What is his taxable yield on this investm ent? Tax free return = 0.7 = 8% Taxable return = 1 = 8/0.7 = 11.4285% The formul a can be given as: Taxable return = Tax free return / (1-t) Where t is the margina l rate at which the investor pays tax. Let us try and find out what would be the yield to Mr. Mukherjee on his 10% tax free bonds if he is paying tax at 20%. Ta x free return = 10% Taxable return = 10 % /(1 - t ) = 10 % = 12 .5 % 0 .8 Alternatively: Tax free return / (1-t) = 10/(1-0.2) = 10/0.8 = 12.5% Case Mr. Arun Joshi makes it a point to invest Rs. 70,000/- every year in his Public Provident Fund account. He enjoys tax deduction u/s 80C on the amount deposited and he earns 8% p.a. tax free interest, credited annually to his PPF account. He pays income tax at the rate of 30%. What is the tax adjusted yield on PPF depos its to Mr. Arun Joshi? Tax adjusted yield is = Tax free return / (1-t) For deduc tion u/s 80C, the return will be 8/(1-0.3) = 8/0.7 = 11.4285% But this return is also tax free u/s 10 Hence, additional yield calculation will follow Yield on P PF to Mr Arun Joshi = 11.4285/0.7 = 16.3265% Since PPF investment qualifies for tax deduction, the tax adjusted yield in the year of investment is 11.4285% as c alculated above and since the return is not taxable, the yield works out to 16.3 265% as calculated subsequently. The three important aspects of tax adjusted yie lds are: 1. 2. 3. Deduction on amount invested and subsequent saving of income t ax. The returns on the investment being taxable or tax free. The capital gain or loss, if any, on maturity/withdrawal and whether the same is taxable or not. 64 Investment Planning PDP

In the case of PPF deposits, there are no capital gain/loss issues and hence mat urity value taxability is not an issue while calculating the yield. Annualized R eturn An annualized return is a rate of return over a full calendar year on an i nvestment that is held for less than a full calendar year. For example, if an in vestment produced a return of 5% in 182 days, the annualized yield would be appr oximately 10%. It is important to note that this return measurement assumes the return could be duplicated over the full year, which may or may not actually be achievable. Problem Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and so ld it after 45 days at Rs. 120/-. Calculate his annualized returns. Solution Abs olute returns Rs. 10/110 over 45 days Annualized returns = (10*365)/(110*45) = 0 .7373 or 73.73% Real (Inflation-Adjusted) Return All of the returns discussed earlier are nominal returns, or money returns. They measure Rupee amounts or changes but say nothing about the purchasing power of these Rupees. To capture this dimension, we need to consider real returns, or in flation-adjusted returns. To calculate inflation-adjusted returns, we divide 1 + nominal total return by 1 + the inflation rate as shown in the following equati on. This calculation is sometimes simplified by subtracting rather than dividing , producing a close approximation. Real return = {(1 + Nominal return)/(1+ Infla tion rate)} 1 Example The rate of return on a stock in a particular year was 19. 5 %. The rate of inflation during that year was 5.5%. What is the real return on the stock? Real return = {(1+0.195)/(1+0.055)} 1 = 1.1327-1 = .1327 = 13.27% Me rely by subtracting inflation rate from the return on the stock, we will get a l ess accurate return i.e. 19.5-5.5 = 14% Holding Period Return A holding period return is the total return actually realized or expected from h olding a specific asset for a specified period of time (not necessarily one year ). The return is measured the same as total return, that is, adding dividends an d capital gains and dividing the resulting figure by the purchase price. Example Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. No dividend was received by him in this period. Calculate his hol ding period returns. Holding period returns = (120-110)/110 = .0909 = 9.09% PDP Investment Planning 65

Portfolio of Securities - Measures of Return Portfolio Performance Measurement We have been discussing returns on individual securities. Now let us measure portfolio returns. Benchmark Portfolios Evaluatio n of portfolio performance, the bottom line of the investing process, is an impo rtant aspect of interest to all investors and money managers. The framework for evaluating portfolio performance consists of measuring both the realized return and the differential risk of the portfolio used to compare a portfolios performan ce, and recognize any constraints that the portfolio manager may face. A 12% ret urn, by itself, is a fairly meaningless figure. It must be viewed in comparison to the performance, over the same timeframe, of alternative investments bearing a similar level of risk. Remember, one can only measure return in relation to th e risk taken. Investing is always a two-dimensional process based on return and risk. These two factors are opposite sides of the same coin, and both must be ev aluated if intelligent decisions are to be made. Therefore, if we know nothing a bout the risk of an investment, there is little we can say about its performance . Although all investors prefer higher returns, they are also risk averse. To ev aluate portfolio performance properly, we must determine whether the returns are large enough given the risk involved. If we are to assess performance carefully , we must evaluate performance on a risk-adjusted basis. We must make relative c omparisons in performance measurement, and an important related issue is the ben chmark to be used in evaluating the performance of a portfolio. The essence of p erformance evaluation in investments is to compare the returns obtained on some portfolio with the returns that could have been obtained from a comparable alter native. The measurement process must involve relevant and obtainable alternative s; that is, the benchmark portfolio must be a legitimate alternative that accura tely reflects the objectives of the portfolio owners. An equity portfolio consis ting of BSE Sensex stocks should be evaluated relative to the BSE Sensex or othe r equity portfolios that could be constructed from the Index, after adjusting fo r the risk involved. On the other hand, a portfolio of small capitalization stoc ks should not be judged against that same benchmark. If a bond portfolio managers objective is to invest in bonds rated A or higher, it would be inappropriate to compare his or her performance with that of a junk bond manager. Even more diff icult to evaluate are equity funds that hold some midcap and small stocks while holding many BSE Sensex stocks. Comparisons for such a widely diversified group can be quite difficult. Many observers now agree that multiple benchmarks can be more appropriate to use when evaluating portfolio returns. All investors should understand that even in todays investment world of computers and databases, exac t, precise, universally agreed upon methods of portfolio evaluation remain an el usive goal. An evaluation is imperative, though it is unfortunate that some stud ies have indicated that most investors dont have a good idea how well their portf olios are actually performing. Risk-adjusted Returns Recognizing the necessity t o incorporate both return and risk into the analysis of portfolio return, three researchers - William Sharpe, Jack Treynor, and Michael Jensen developed measure s of portfolio performance in the 1960s. These measures are often referred to as the composite (risk-adjusted) measures of portfolio performance, meaning that t hey incorporate both realized return and risk into the evaluation. These measure s are still used by mutual funds and money managers. 66 Investment Planning PDP

Sharpe Ratio William Sharpe introduced a risk-adjusted measure of portfo lio per formance c alled the reward-to-variability ratio (RVAR). This measure uses a ben chmark based on the ex post capital market line. Sharpe used RVAR to: n n Measur e the excess return per unit of total risk (as measured by standard deviation). Rank portfolios by RVAR (the higher the RAVR, the better the portfolio performan ce). RVAR = RP - Rf SD Rp = Return of the portfolio Rf = Risk free return SD = Standard Deviation of Po rtfolio (total risk) Treynor Measure Jack Treynor presented a similar measure ca lled the reward-to volatility ratio (RVOL). Like Sharpe, Treynor sought to relat e the return on a portfolio to its risk. Treynor, however, distinguished between total risk and systematic risk, implicitly assuming that portfolios are well di versified; that is, he ignores any diversifiable risk. He used as a benchmark th e ex post security market line. RP - Rf Beta Beta is the measure of market risk of the portfolio. Jensens Index Michael Jensens measure of portfolio performance w as differential return measure (Alpha). It calculated the difference between wha t the portfolio actually earned and what it was expected to earn given its level of systematic risk. Basically, it attempts to measure the constant return that the portfolio manager earned above, or below, the return of an unmanaged portfol io with the same market risk. The Sharpe and Treynor measures can be used to ran k portfolio performance and indicate the relative positions of the portfolios be ing evaluated. Jensens measure is an absolute measure of performance. Jensens inde x = Rp [Rf + (Rm- Rf)*B] Rp= return on the portfolio Rf = risk free return Rm = Market return (Index return) B = Beta of the portfolio (Beta is the measure of m arket risk of the portfolio) PDP Investment Planning 67

Review Questions: 1. What is the arithmetic average returns on stock A if the st ock was bought for Rs. 75/- and the year end prices for the last 3 years were Rs . 85, Rs. 95, and Rs. 100/-? a. 10.11% b. 12. 24% c. 13.4% d. 11.11% 2. What is geometric average returns for stock A given the details above? a. 11.24% b. 10.0 1% c. 11.46% d. 13.62% 3. What is the current yield of a bond bearing a coupon r ate of 8% payable annually and currently priced at Rs. 950 with a face value of Rs. 1000/-? a. 8% b. 9% c. 13.40% d. 9.12% 4. What is the YTM of the above bond (by using the method of computing the YTM approximately), if the bond will matur e after 2 years? a. 11.24% b. 8% c. 10.82% d. 8.42% 5. Mr. A bought a stock X fo r Rs. 102/- and sold it after a year for Rs. 115/-. He also received a dividend of Rs. 2/- per share in the interim. What is the total return on stock X? a. 11. 30% b. 12.74% c. 14.70% d. 15.0 % 6. Mr. A bought stock X for Rs. 102 and sold i t for Rs. 115/- after 120 days. He did not get any dividend on the stock. What i s the holding period return on stock X to Mr. A? a. 12.74% b. 38.76% c. 44.73% d . 25.48% 68 Investment Planning PDP

7. Mr. A bought stock X for Rs. 102 and sold it for Rs. 115/- after 120 days. He di d not get any dividend on the stock. What is the annualized return earned by Mr. A? a. 12.74% b. 38.76% c. 44.73% d. 25.48% 8. Mr. Vasudeo Mumbaikar invested Rs. 10,000/- in his PPF account and saved income tax of Rs. 3,000/-. He will get 8% p.a. interest which is tax free on his PPF de posit. What is the tax adjusted yield on PPF deposit of Rs. 10,000/- enjoyed by Mr. Vasudeo Mumbaikar? a. 8% b. 11.43% c. 16.32% d. 10% 9. Mr. Winston Jones purchased National Saving Certificate for Rs. 10,000/- and sav ed income tax of Rs. 2,000/-. He will get Rs. 16,010/- on maturity after 6 years which works out to a return of 8% p.a. What is the tax adjusted yield on NSC pu rchased by Mr. W Jones? a. 8% b. 11.43% c. 16.32% d. 10% 10. Given the following information about the returns on a portfolio, find out the S harpe Index: Return on the portfolio was 15% while risk free return was 8% and t he standard deviation of the portfolio was 4%. a. 3.75 b. 2.25 c. 1.75 d. 5.75 Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. a b c c c a b c d c PDP Investment Planning 69

Chapter 6 70 Investment Planning PDP

Building an Investment Portfolio W n n e now consider how investors go about selecting stocks to be held in portfolios. Individual investors often consider the investment decision as consisting of tw o steps: Asset allocation Security selection The asset allocation decision refers to the allocation of portfolio assets to br oad asset markets; in other words, how much of the portfolios funds are to be inv ested in stocks, how much in bonds, money market assets, and so forth. Each weig ht can range from zero percent to 100 percent. If it is possible to make investm ents globally, then we have to ask the following questions: 1. 2. 3. What percen tage of portfolio funds is to be invested in each of the countries for which fin ancial markets are available to investors? Within each country, what percentage of portfolio funds is to be invested in stocks, bonds, bills, and other assets? Within each of the major asset classes, what percentage of portfolio funds goes to various types of bonds, exchange-listed stocks versus over-the-counter stocks , and so forth? Many knowledgeable market observers agree that the asset allocation decision may be the most important decision made by an investor. According to some studies, for example, the asset allocation decision accounts for more than 90 per cent of the variance in quarterly returns for a typical large pension fund. The rationa le behind this approach is that different asset classes offer various potential returns and various levels of risk, and the correlation coefficients may be quit e low. Correlation determines the extent to which a variable moves in the same d irection as other variable, such as inflation. It is statistically determined an d labeled as the correlation coefficient. Correlation can help in making decisio ns concerning diversification among mutual fund categories. The asset allocation decision involves deciding the percentage of investible funds to be placed in s tocks, bonds, and cash equivalents. It is the most important investment decision made by investors because it is the basic determinant of the return and risk ta ken. This is a result of holding a well-diversified portfolio, which we know is the primary lesson of portfolio management. The returns of a well-diversified po rtfolio within a given asset class are highly correlated with the returns of the asset class itself. Within an asset class, diversified portfolios will tend to produce similar returns over time. However, different asset classes are likely t o produce results that are quite dissimilar. Therefore, differences in asset all ocation will be the key factor over time causing differences in portfolio perfor mance. Factors to consider in making the asset allocation decision include the i nvestors return requirements (current income versus future income), the investors risk tolerance, and the time horizon. This is done in conjunction with the inves tment managers expectations about the capital markets and about individual assets . According to some analyses, asset allocation is closely related to the age of an investor. This involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the PDP Investment Planning 71

needs and financial positions of workers in their 50s would differ, on average, from those who are starting out in their 20s. According to the life-cycle theory , for example, as individuals approach retirement, they become more risk averse. Stated at its simplest, portfolio construction involves the selection of securi ties to be included in the portfolio and the determination of portfolio funds (t he weights) to be placed in each security. The Markowitz model provides the basi s for a scientific portfolio construction that results in efficient portfolios. An efficient portfolio is one with the highest level of expected return for a gi ven level of risk, or the lowest risk for a given level of expected return. Asset Classes Portfolio construction listing out the asset classes, where money can be investe d are: n n n n n Cash (or cash equivalents such as money market funds) Stocks Bo nds Real Estate (including Real Estate Investment Trusts) Foreign Securities Each investor must determine which of these major categories of investments is s uitable for him/her, in consultation with the financial planner. The next step, as discussed in the preceding section on asset allocation, is to determine which percentage of total investable assets should be allocated to each category deem ed appropriate. Only then should individual securities be considered within each asset class. Diversification Diversification is the key to the management of po rtfolio risk because it allows investors to minimize risk without adversely affe cting return. Random diversification refers to the act of randomly diversifying without regard to relevant investment characteristics such as expected return an d industry classification. An investor simply selects a relatively large number of securities randomly. For randomly selected portfolios, average portfolio risk can be reduced to approximately 19 per cent. As we add securities to the portfo lio, the total risk associated with the portfolio of stocks declines rapidly. Th e first few stocks cause a large decrease in portfolio risk. Based on these actu al data, 51 per cent of portfolio standard deviation is eliminated as we go from 1 to 10 securities. Unfortunately, the benefits of random diversification do no t continue as we add more securities. As subsequent stocks are added, the margin al risk reduction is small. Nevertheless, adding one more stock to the portfolio will continue to reduce the risk, although the amount of the reduction becomes smaller and smaller. It is also established in the US through studies that by ad ding foreign securities to the portfolio, the risk is reduced dramatically to th e extent of 33%. Risk Reduction in the Stock Portion of a Portfolio 1. Law of La rge Numbers One simple way of going about risk reduction is through increasing t he number of securities held. As we add securities to this portfolio, the exposu re to any particular source of risk becomes small. According to the Law of Large Numbers, the larger the sample size, the more likely it is that the sample mean will be 72 Investment Planning PDP

close to the population expected value. Risk reduction in the case of independen t risk sources can be thought of as the insurance principle, named for the idea that an insurance company reduces its risk by writing many policies against many independent sources of risk. We are assuming here that rates of return on indiv idual securities are statistically independent such that any one securitys rate o f return is unaffected by anothers rate of return. Unfortunately, the assumption of statistically independent returns on stocks is unrealistic in the real world. We find that most stocks are positively correlated with each other; that is, th e movements in their returns are related. Most stocks have a significant level o f co-movement with the overall market of stocks, as measured by such indexes as the BSE Sensex or NSE Nifty. Risk cannot be eliminated because common sources of risk affect all firms. Modern Portfolio Theory In the 1950s, Harry Markowitz, co nsidered the father of modern portfolio theory, originated the basic portfolio m odel that underlies modern portfolio theory. Before Markowitz, investors dealt l oosely with the concepts of return and risk. Investors have known intuitively fo r many years that it is smart to diversify, that is, not to put all of your eggs in one basket. Markowitz, however, was the first to develop the concept of portfo lio diversification in a formal way. He showed quantitatively why, and how, port folio diversification works to reduce the risk of a portfolio to an investor. Ma rkowitz sought to organize the existing thoughts and practices into a more forma l framework and to answer a basic question: Is the risk of a portfolio equal to the sum of the risks of the individual securities comprising it? Markowitz was t he first to develop a specific measure of portfolio risk and to derive the expec ted return and risk for a portfolio based on covariance relationships. Markowitz developed an equation that calculates the risk of a portfolio as measured by th e variance or standard deviation. His equation accounts for two factors: 1. 2. W eighted individual security risks (i.e., the variance of each individual securit y, weighted by the percentage of investible funds placed in each individual secu rity). Weighted co-movements between securities returns (i.e., the covariance bet ween the securities returns, again weighted by the percentage of investible funds placed in each security). 2. Combination of securities It is assumed that combination of two securities re sults in risk reduction. Is it possible to reduce the risk of a portfolio by add ing into it a security whose risk is higher than that of any of the investments held already? Let us consider the following example: Obviously, the stock Y is riskier because the standard deviation is higher but t he expected return is also higher. We will have to analyze and find out whether it would be sensible for an investor who is already PDP Investment Planning 73

holding Stock X to buy a riskier stock Y; add it in his portfolio to reduce the risk. Whether buying stock Y and adding to ones portfolio will amount to diversif ication? Let us find out by assuming that we shall build a portfolio of 2 securi ties with weightage of 60% for stock X and weightage of 40% for stock Y. The exp ected return on the portfolio Rp would be 0.6*10+0.4*14 = 11.60% If we assume th at stock Y gives good returns when stock X performs badly, then we will have ret urns of 0.6*9+0.4*16 = 11.80% If it is the other way round, that is, stock X per forms well while stock Y does not perform well, we will have a situation when th e return will be 0.6*11+0.4*12 = 11.40%. In either case, we have got returns ver y close to the expected return with risk virtually being nil. We have assumed a negative correlation between stock X and Stock Y. In other words, when we have t wo or more securities in a portfolio, the returns will depend upon the interacti ve risk between / among those securities. If we can find two securities that are perfectly negatively correlated, then we can have a portfolio of two securities without any risk at all. Covariance or interactive risk Where the probabilities are equal the formula can be expressed as: COVxy is arri ved out by using the formula given below: If it assumed that stock X gives a return of 9% while stock Y gives a return of 16% and stock X gives a return of 11% when stock Y gives a return of 12%, using the example given above the covariance can be worked out as under: [(9-10)(16-14 )+(11-10)(12-14)] = [-2-2] = -2 We have taken two corresponding observations at the same time, determined the variation of each from its expected value, and mul tiplied the two deviations together and taken the average of such deviations. Th e coefficient of correlation is another measure that would indicate the similari ty or dissimilarity in the behaviour of the two variables. Rxy = COVxy / (sx * s y) = -2/(2*4) = -2/8 = -0.25 The stocks X and Y are negatively correlated, which means one stock will perform while the other may not and vice versa. A perfect correlation will be when Rxy = 1 and a perfect negative correlation will be when Rxy = -1. 74 Investment Planning PDP

Rxy lies between -1 and +1. When Rxy = 0, these two stocks are absolutely not co - related at all and the returns will be independent of each other. Thus, we can conclude that in order to achieve diversification we should choose stocks with negative or low covariance. The purpose of diversification will not be served if we add securities that have positive co-relation or no co-relation at all. Port folio effect in a 2 security case We have seen that diversification reduces the risk. While achieving risk reduction, one should not compromise on the returns. In general, the lower the correlation of securities in a portfolio, the less ris ky the portfolio will be. True diversification is about choosing correct securit ies that are negatively correlated rather than mere increase in number of securi ties. Where, sxy is the portfolio standard deviation wx = percentage of stock x in the total portfolio value wy = percentage of stock y in the total portfolio value s 2x = variance of stock x sy2 = variance of stock y COVxy = covariance of stock x and stock y In the case which we have been discussing, we have already calculat ed: COVxy = -2 Weights for stock x and stock y are 0.6 and 0.4 respectively. Var iance for stocks x and y have been given as 4 and 16. So portfolio variance will be: (0.6)2*4+(0.4)2*16+[2*.06*.04*(-2)] 1.44+2.56-0.0096 = 3.99 Portfolio risk will be square root of variance which is less than 2. Thus, by adding a security y with a higher risk to security x and constructing a portfolio, we have achiev ed risk reduction without compromising on the returns. When does Diversification pay? n Combining securities with perfect positive correlation with each other p rovides no reduction in portfolio risk. The risk of the resulting portfolio is s imply a weighted average of the individual risks of the securities. As more secu rities are added under the condition of perfect positive correlation, portfolio risk remains a weighted average. There is no risk reduction. PDP Investment Planning 75

n Combining two securities with zero correlation (statistical independence) with e ach other reduces the risk of the portfolio. If more securities with uncorrelate d returns are added to the portfolio, significant risk reduction can be achieved . However, portfolio risk cannot be eliminated in this case. Combining two secur ities with perfect negative correlation with each other could eliminate risk alt ogether. This is the principle behind hedging strategies. Finally, we must under stand that in the real world, these extreme correlations are rare. Rather, secur ities typically have some positive correlation with each other. Thus, although r isk can be reduced, it usually cannot be eliminated. Other things being equal, i nvestors wish to find securities with the least positive correlation possible. I deally, they would like securities with negative correlation or low positive cor relation, but they generally will be faced with positively correlated security r eturns. n n Markowitzs theory shows us that the risk for a portfolio encompasses not only the individual security risk but also the co-variance between the securities, and t hat three factors determine portfolio risk: n n n The variance of each security. The co-variances between securities. The portfolio weights for each security. The standard deviation of the portfolio will be directly affected by the correla tion between the two stocks. Portfolio risk will be reduced as the correlation c oefficient moves from +1.0 downward. One of Markowitzs real contributions to port folio theory is his insight about the relative importance of the variances and c o-variances. As the number of securities held in a portfolio increases, the impo rtance of each individual securitys risk (variance) decreases, while the importan ce of the covariance relationships increases. In a portfolio of 500 securities, for example, the contribution of each securitys own risk to the total portfolio r isk will be extremely small; portfolio risk will consist almost entirely of the covariance risk between securities. Markowitzs approach to portfolio selection is that an investor should evaluate portfolios on the basis of their expected retu rns and risk as measured by the standard deviation. He was the first to derive t he concept of an efficient portfolio, defined as one that has the smallest portf olio risk for a given level of expected return or the largest expected return fo r a given level of risk. Investors can identify efficient portfolios by specifyi ng an expected portfolio return and minimizing the portfolio risk at this level of return. Alternatively, they can specify a portfolio risk level they are willi ng to assume and maximize the expected return on the portfolio for this level of risk. Rational investors will seek efficient portfolios because these portfolio s are optimized on the two dimensions which are of most importance to investors: expected return and risk. 3. Rupee Cost Averaging The systematic investment pla ns in mutual funds, along with consistent periodic new purchases of shares, crea tes risk reduction by creating a lower cost per share owned over time. This is k nown as rupee cost averaging. This strategy allows one to take away the guesswor k of trying to time the market. You invest a fixed amount of money at regular in tervals, regardless of whether the market is high or low. By doing so, you end u p buying fewer shares when the prices are high and more shares when the prices a re low. Because rupee cost averaging involves regular investments during periods of fluctuating prices, you should consider your financial ability to continue i nvesting when price levels are low. However, this 76 Investment Planning PDP

approach reduces the effects of market fluctuation on the average price you pay for your shares. Additionally, it helps you maintain a regular investment plan. In order to reduce risk associated with investments for getting a desired level of returns: n n n n n It is essential to be diversified across different asset c lasses. It is pertinent to have more securities in a particular asset class, say equities. Co-relation among different securities chosen is more important than mere number of securities in ones portfolio to achieve diversification. It is a f act that risk in investments can be reduced but can not be totally removed throu gh diversification. Systematic investment investments in selected securities at regular pre determin ed intervals will serve the purpose of Rupee Cost Averaging and take away the risk of investing at the wrong time. These are time-tested investment philosophies t hat should go into building investment portfolios. Modern portfolio theory begin s by combinations of securities, or portfolios, which are superior to other comb inations either from better returns and / of lower risk These superior or efficie nt combinations are then plotted to determine a frontier of all such efficient comb inations. Next, each investor s personal risk-return considerations or utility is i ntroduced into the construction. Finally, the efficient combinations are superim posed on the investors desired utilities, or benefits, to arrive at one efficient combination, an optimal portfolio for the stated investor. We have seen how the c ombination of two investments has allowed us to maintain our return of 10 percen t but reduce the portfolio standard deviation to 1.8 percent. We also saw in the preceding table that different coefficient correlations produce many different possibilities for portfolio standard deviations. A shrewd portfolio manager may wish to consider a large number of portfolios, each with a different expected va lue and standard deviation, based on the expected values and standard deviations of the individual securities and more importantly, on the correlations between the individual securities. Though we have been discussing a two-asset portfolio case, our example may be expanded to cover 5.,10.,or even 100-asset portfolios. The major tenets of portfolio theory that we are currently examining were develo ped by professor Harry Markowitz in the 1950s, and so we refer to them as Markow itz portfolio theory. In 1990 Markowitz won the Nobel Prize in economics for thi s work. Assume we have identified the following risk-return possibilities for ei ght different portfolios (there may also be many more, but we will restrict ours elves to this set for now). In diagramming our various risk-return points in the table on page 78, we show the values in Figure 6:1. Although we have only diagr ammed eight possibilities, we see an efficient set of portfolios would lie along the ACFH line in Figure 6:1. This line is efficient because the portfolios on t his line dominate all other attainable portfolios. This line is called the effic ient frontier because the portfolios on the efficient frontier provide the best risk return trade-off. The incremental benefit from reduction of the portfolio s tandard deviation through adding securities appears to diminish fairly sharply w ith a portfolio of 10 securities and is quite small with a portfolio as large as 20. A portfolio of 12 to 14 securities is generally thought to be of sufficient size to enjoy the majority of desirable portfolio effects. See W H. Wagner and S.C. Lau, the Effect of Diversification on Risk. PDP Investment Planning 77

FIGURE 6:1 Diagram of Risk-Return Trade-Offs That is along this efficient frontier we can receive a maximum return for a give n level of risk or a minimum risk for a given level of return. Portfolios do not exist above the efficient frontier, and portfolios below this line do not offer acceptable alternatives to points along the line. As an example of maximum retu rn for a given level of risk, consider point E. Along the efficient frontier, we are receiving a 14 percent return for a 5 percent risk level, whereas directly below point F, portfolio E provides a 13 percent return for the same 5 percent s tandard deviation. To also demonstrate that we are getting minimum risk for a gi ven return level, we can examine point A in which we receive a 10 percent return for a 2.8 percent risk level, whereas to the right of point A, we get 78 Investment Planning PDP

the same 10 percent return from B, but a less desirable 3.1 percent risk level. One portfolio can consist of various proportions of two assets or two portfolios . For example, we can connect the points between A and C by generating portfolio s that combine different percentages of portfolio A and portfolio C and so on be tween portfolios C and F and portfolios F and H. Although we have shown but eigh t points (portfolios), a fully developed efficient frontier may be based on a vi rtually unlimited number of observations as is presented in Figure 6:1. Benchmar ks A first question to be posed to a professional money manager is: Have you fol lowed the basic objectives that were established? These objectives might call fo r maximum capital gains, a combination of growth plus income, or simply income ( with many variations in between). The objectives should be set with an eye towar d the capabilities of the money managers and the financial needs of the investor s. The best way to measure adherence to these objectives is to evaluate the risk exposure the fund manager has accepted . Anyone who aspires to maximize capital gains must, by nature, absorb more risk. An incomeoriented fund should have a m inimum risk exposure. A classic study by john McDonald published in the journal of Financial and Quantitative Analysis indicates that mutual fund managers gener ally follow the objectives they initially set. He measured the betas and standar d deviations for 12.3 mutual funds and compared these with the funds stated objec tives. For example, funds with an objective of maximum capital gains had an aver age beta of 1.22. Those with a growth objective had an average beta of 1.01, and so on all the way down to an average beta of 0.55 for income-oriented. Using be tas and portfolio standard deviations, we see that the risk absorption was caref ully tailored to the funds stated objectives. Funds with aggressive capital gains and growth objectives had high betas and portfolio standard deviations., while the opposite was true of balanced and income-oriented funds. Other studies have continually reaffirmed the position established in this seminal study by McDonal d. Adherence to objectives as measured by risk exposure is important in evaluati ng a fund manager because risk is one of the variables a money manager can direc tly control. While short-run return performance can be greatly influenced by unp redictable changes in the economy, the fund manager has almost total control in setting the risk level. He can be held accountable for doing what was specified or promised in regard to risk. Most lawsuits brought against money managers are not for inferior profit performance but for failure to adhere to stated risk obj ectives. Although it may be appropriate to shift the risk level in anticipation of changing market conditions (lower the beta at a perceived peak in the market) , long-run adherence to risk objectives is advisable. Measurement of Return in R elation to Risk In examining the performance of fund managers, the return measur e commonly used is excess returns. Though the term excess returns has many defin itions the one most commonly used is total return on a portfolio (capital apprec iation plus dividends) minus the risk-free rate: Excess returns = Total portfoli o return Risk-free rate Thus, excess returns represent returns over and above wh at could be earned on a riskless asset. The rate on RBI Treasury bills is often used to represent the risk-free rate of return in the financial markets (though other definitions are possible). Thus, a fund that earns 12 percent when the Tre asury bill rate is 6 percent has excess returns of 6 percent. Once computed, exc ess returns are then compared with risk. We look at three different approaches t o comparing excess returns to risk: the Sharpe approach, the Treynor approach, a nd the Jensen approach. PDP Investment Planning 79

Sharpe Approach In the Sharpe approach, the excess returns on a portfolio are co mpared with the portfolio standard deviation Total portfolio return Risk-free ra te Sharpe measure = Portfolio standard deviation The portfolio manager is thus a ble to view excess returns per unit of risk If a portfolio has a return of 10 pe rcent, the risk-free rate is 6 percent, and the portfolio standard deviation is 18 percent the Sharpe measure is 0.22: 10% - 6% Sharpe measure = 18% = 18% 4 % = 0.22 This measure can be compared with other portfolios or with the market in general to assess performance. If the market return per unit of risk is greater than 0. 22, then the portfolio manager has turned in an inferior performance. Assume the re is a 9 percent total market return, a 6 percent risk-free rate, and a market standard deviation of 12 percent. Then the Sharpe measure for the overall market is 0.25 or: 9% - 6% = 12% 12% 3 % = 0.25 The portfolio measure of 0.22 is less than the market measure of 0.25 and repres ents an inferior performance. Of course, a portfolio measure above 0.25 would re present a superior performance. Treynor Approach The formula for the second appr oach for comparing excess returns with risk (developed by Treynor) is: Total por tfolio return Risk-free rate Treynor measure = Portfolio beta The only differenc e between the Sharpe and Treynor approaches is in the denominator. While Sharpe uses the portfolio standard deviation, Treynor uses the portfolio beta. Thus, on e can say that Sharpe uses total risk, while Treynor uses only the systematic ri sk, or beta Implicit in the Treynor approach is the assumption that portfolio ma nagers can diversify away unsystematic risk, and only systematic risk remains. I f a portfolio has a total return of 10 percent, the risk-free rate is 6 percent, and the portfolio beta is 0.9, the Treynor measure would be 0.044. 10% - 6% = 0 .9 0.9 4% = 0.9 0.04 = 0.044 80 Investment Planning PDP

This measure can be compared with other portfolios or with the market in general to determine whether there is a superior performance in terms of return per uni t of risk. Assume the total market return is 9 percent, the risk-free rate is 6 percent, and the market beta (by definition) is 1; then the Treynor measure as a pplied to the market is 0.03: 9% - 6% = 1.0 1.0 3% = 1.0 0.03 = 0.030 This would imply the portfolio has turned in a superior return to the market (0. 044 versus 0.030) Not only is the portfolio return higher than the market return (10percent versus 9 percent), but the beta is less (0.9 versus 1.0) Clearly, th ere is more return per unit of risk. Jensen Approach In the third approach, Jens en emphasizes using certain aspects of the capital asset pricing model to evalua te portfolio managers. He compares their actual excess returns (total portfolio return risk-free rate) with what should be required in the market, based on thei r portfolio beta. The required rate of excess returns in the market for a given beta is shown in Figure 6:2 given below, as the market line. If the beta is 0, t he investor should expect to earn no more than the risk-free rate of return beca use there is no systematic risk. If the portfolio manager earns only the risk-fr ee rate of return, the excess returns will be 0. Thus, with a beta of 0, the exp ected excess returns on the market line are 0. With a portfolio beta of 1, the p ortfolio has a excess returns as shown in the following diagram. FIGURE 6:2 Risk -Adjusted Portfolio Returns The expected portfolio excess returns should be equal to market excess returns. If the market return (KM) is 9 percent and the risk-free rate (RF) is 6 percent, the market excess returns are 3 percent. A portfolio with a beta of 1 should ex pect to the market rate of excess returns (KM-RF), equal to 3 percent. PDP Investment Planning 81

Other excess returns expectations are shown for betas ranging from 0 to 1.5.For example, a portfolio with a beta of 1.5 should provide excess returns of 4.5. Ad equacy of Performance Using the Jensen approach, the adequacy of a portfolio man agers performance can be edged against the market line. Did he or she fall above or below the line? The vertical difference from a funds performance point to the market line can be viewed as a measure of performance. This value, termed alpha or average differential return, indicates the difference between the return on t he fund and a point on the market line that corresponds to a beta equal to the f und. In the case of fund, the beta of 1.5 indicated an excess return of 4.5 perc ent along the market, and if the actual excess return was only 3.9 percent, we t hus have a negative alpha of 0.6 percent (3.9% to 4.5%). Clearly, a positive alp ha indicates a superior performance, while a negative alpha leads to the opposit e conclusion. Key questions for portfolio managers in general include the follow ing: Can they consistently perform at positive alpha levels? That is, can they g enerate returns better than those available along the market line, which are the oretically available to anyone? FIGURE 6:3 Empirical Study of Risk- Adjusted Por tfolio Returns- Systematic Risk and Return The upward-sloping line is the market line, or anticipated level of performance based on risk. The small dots represent performance of the funds. About as many funds under-performed (negative alpha below the line) as over performed (positiv e alpha above the line). Although a few high-beta funds had an unusually strong performance on a risk adjusted basis, there is no consistent pattern of superior performance. Indexing-Buy and Hold Indexing-buy and hold is a concept which is, in most sense, opposite to the concept of market timing. In other words, planne rs who advocate indexing believe that future price changes or duration of change s cannot be predicted with any consistency. Hence, such planners consider market timing as an exercise in futility and instead, advise their clients to buy secu rities and funds which track broad market indexes. The basic concept of indexing rests with the assumption that planners cannot outperform the performance of ma rket indexes such as the S&P 500 Index, the BSE Sensex 30, NSE 50 etc., on a con sistent (i.e. year in, year out) basis. Indexers also believe that over the long run the market will generally outperform at least 50% of all fund advisors. Fur ther, the advisors who will outperform the market in any given year 82 Investment Planning PDP

or two will in turn perform worse than the index in subsequent years. Moreover, the fund advisors who may outperform the market indexes over a future time perio d of time cannot be identified today with any certainty or reliability. Given th ese observations, such planners consider the alternative of investing in securit ies or funds that closely track the performance of underlying market indexes as desirable. Such planners also consider holding their investment positions for a longer time period, and hence, they will buy and hold their positions. The length of time over which a position is held depends primarily on the client particular s such as investment objective, investment time-horizon and risk preferences and the macroeconomic conditions as reflected through the business cycle. Mutual fu nds are most popular as securities that track the movement of market or securiti es indexes. Most large mutual fund companies, offer index mutual funds for inves tors. These funds provide the appropriate vehicles for both investors and financ ial planners to buy and hold a basket of securities, in the form of a single mut ual fund, that track financial market indexes. Since indexers may choose to trac k a wide variety of indexes such as large and small cap indexes, broad and narro w marker indexes, stock and bond market indexes, domestic and foreign market ind exes, the fund companies offer numerous index funds that cover generally most in dexing needs. The new type of fund has appeared in the markets that also tracks indexes, known as Exchange Traded Fundsor ETFs, have become very popular tracking tools in this decade, and the number of ETFs being offered in the market are inc reasing almost daily. The companies that offer ETFs claim that ETFs are much eas ier to trade since they are structured like common stocks, provide benefits in s hielding against capital gains taxes and are generally cheaper than index mutual funds. Indexes which follow a passive buy-and-hold strategy claim a number of b enefits in their approach over active approach to investments. First, and as men tioned earlier, market indexes are generally expected to outperform most activel y managed funds over longer time periods. This is because indexers believe the m arkets to be efficient and consistently picking winners near impossible. Second, passively investing through index tracking securities is considerably cheaper b ecause the costs of researching to find winning investments are not expended. Fu rther, since the compositions of indexes do not change very frequently, very lit tle trading and transaction costs are incurred in managing index tracking funds. On the other hand, funds that are actively managed charge high fees. These fees are paid because these funds managers consider their skills at investments to b e superior and hence, require higher fees. Moreover, active managers continuously produce information about various securities that either indicates buying, selli ng or holding various investment positions. Since such an approach requires freq uent alterations in portfolio structure, the costs involved in an active style a lso increase due to the much higher costs of transactions. Money Manager Selecti on and Monitoring To begin with, the search process uses the same objectives use d in the investment decision process itself. The first three questions to addres s, as in the investment decision process, are as follows: 1. 2. 3. What is the p rimary objective of the investment decision for which you need a money manager? What are the risk/return preferences of the clients? What is the investment time horizon? Understanding the answers to these three questions thoroughly will considerably ease the burden of planners in selecting suitable money managers. We will return to the description of how the selection is made easy, but first let us evaluate each of these three questions in some detail. There are many reasons to invest. Examples of reasons include savings and investments for retirement, for childre ns college education, to buy a house or car, to build wealth, etc. Along with eac h of these reasons is an associated objective. For example, in saving for retire ment, an appropriate objective may be to maintain PDP Investment Planning 83

and/or increase the standard of living that pre-existed before retirement. Simil arly, in providing for childrens college education, provisions may be for public or private colleges and may include the financing of an auto for a child as well . The point being made here is that the need and the objectives help us determin e certain aspects of the investments decision which in turn help us evaluate man agers. Consider the example of a parent who can afford to save a limited sum of money towards a childs education. Given this limitation (or budget constraint) th e parent next has to consider the type of college (public or private) to fund fo r. Obviously, private colleges cost more and hence the future funding required f or a private college education would require a higher rate of growth than the ra te required for funding public college education. Thus, the choice of managers i n this case would be determined by the style of the managers. A growth style man ager would be desirable to grow money faster whereas a balanced fund manager may be considered for that same investment, if the objective were to fund the educa tion at a public college. Being able to tie the objective (private or public edu cation, in this example) allows us to narrow the manager selection criterion to only managers who practice/affirm a certain style of management. This inclusion reduces the universe of potential managers significantly. Similarly, for the nee d to fund for retirement, the objective may differ from maintaining living stand ard to improving them. Continue with the example of funding for childrens educati on. Assume that the limited funds that a parent can save towards this objective will require the fund to grow at a 12% rate in order to be sufficient to meet th e funding need. This required rate of return of 12% would imply that most of the savings be invested in equity or other high-yielding instruments. An associated feature of such an investment would be a fairly significant amount of investmen t risk that the parent would be exposed to and which in turn would also imply th at there would be a higher probability of accumulating insufficient funds. In th is case, the risk preference of the client would become another input in the pro cess of manager selection. The risk preference of the client would determine wha t styles of funds are chosen. The styles that were affirmed when the investment objective was considered may either be reinforced or rejected by including the r isk preferences of clients. There is another important aspect of including the r isk preferences of clients in selecting the fund manager. One of the important v ariables that enters the process of manager selection is the risk perspective of the manager himself. It is a good idea to evaluate and match the risk preferenc es of the manager to those of the client. Once the manager is selected and the i nvestment process begins, the level of comfort, or discomfort, will be considera bly influenced by the style of the chosen manager. In this case, matching the ma nagers risk preference with that of client can considerably help the planner in m anaging the client relationships. Finally, the time horizon of the investment de cisions must also be included in the selection process. In the college funding e xample, given some limited amount of funds and given a certain risk preference p rofile, the shorter the time available to accumulate the funds, the greater will be the need to find managers who pursue growth and aggressive growth styles, an d vice versa. Another way to consider this is that if the planner can persuade a client to invest early, whatever the investment need be, then the planner can h ave more flexibility in choosing managers. The right choice of managers will ult imately lead to client satisfaction and retention. The reader should note that t he application of the basics of the investment process serves as screens in the manager selection process. They help us eliminate many managers from the selecti on process and isolate others. They help us narrow down the universe of managers to a level where the selection process is more manageable and where it is feasi ble to apply other subjective and objective criteria to further narrow the selec tion process. Finally, and most importantly, the inclusion of the clients basic i nputs in the selection process should generally lead to a much greater level of client satisfaction. In the following sections, other selection criteria that ne ed to be used on a smaller subset of managers are discussed. Many planners tend to jump first on assessing the past performances of money managers in selecting a

84 Investment Planning PDP

manager. The relationship between past performance and manager selection has bee n widely studied. Results of these studies generally support the notion that usi ng past performance as the main criterion in the selection process is, at best, a very poor indicator of future performance potential. In a sense, manager perfo rmance should be the last screen in the selection process, the step that affirms a managers choice. It is much more prudent to consider other facets of managers that reinforce the investment objectives, risk preferences and timing horizon de cisions. There are several subjective and objective criteria that may be applied to further narrow the selection process. Once the general fund style has been i dentified, managers within that style can be scrutinized further. The main objec tive at this stage is to identify inconsistencies and incongruencies between the stated style of the managers and the styles that they have actually implemented in their practices. The following are examples of questions that need to be ass essed in determining the selection. n n n n n n n n n n n n n Has the manager co nsistently selected securities that are compatible with the stated style? If not , how often have they strayed from their paths? Does the manager use risk manage ment techniques that are consistent with the funds stated objectives? How often h ave the funds operating expenses exceeded both those stated and those that were e xpected? How often has the funds risk exceeded the stated or expected risk? How l ong has a manager served for a fund? Is the manager known to have managed funds of many different styles or have there been transitions within similar styles? I f the manager affirms a passive style, how often has he strayed from that style, and vice versa? How consistently does the manager apply security selection tech niques, whether qualitative or quantitative or both? Has the manager ever violat ed or has not been in compliance with laws and regulations? Does the manager eng age in window dressing types of activities that are harmful to clients? What are t he answers to the above question for the investment team members that the manage r leads? How research oriented is the manager? As the reader can observe, there are many questions that require to be evaluated in selecting a manager. However, it may be useful to categorize these questions along some common themes. Happily, such a categorization is possible. In using the above criteria, the selector is trying to assess two basic traits of a manag er. Perhaps the most important summation of these criteria is to understand how consistent a manager is and has been. The more consistent a manager has been tow ards her/his style, trading activity, security selection techniques, fund expens e levels, etc. the better. Alternately, managers who change their operating acti vities often are much more likely to under perform against their expectations. A nother way to consider the issue of consistency is that the managers activities a re as stable as the investment decision inputs of the clients. The clients retire ment objectives or their risk tolerances for those investment do not change on a weekly or monthly basis. The basic idea here is that neither should the managers attitudes and perceptions change on those scales. In a sense, there is a direct relationship between consistency and competency. PDP Investment Planning 85

The other important theme to assess is the ethical make-up of the manager. Manag ers (and funds) whose styles, trading, expenses, selection techniques, etc, chan ge often are also much more likely to engage in activities that are undesirable or even in violation of investment rules and regulations. It is important to not e that the managers ethics is as important as his/her competency. Neither can be sacrificed at the expense of the other. Managers who rank high on both the scale s are appropriate for further consideration in the selection process. Finally, a fter the universe of managers has been whittled down to a few, the past performa nce of managers should be assessed. As has been noted before, past performance i s not a reliable indicator of future performance. As it turns out, given the con siderations of consistency (competency) and ethics, the issue of past performanc e in predicting future performance, is actually not that daunting a task. In ass essing past performance, two observations need to be, those that were expected a nd how different were they from their peers? Second, how widely did the past ret urns vary and in comparison to their peers? In other words, if a fund is expecte d to produce about 12 percent (e.g. growth fund) per year, how many times in the last 5 (or 10) years has the funds returns been close to 12 percent? Further, if the average return over the past returns has indeed been around 12 percent, hav e the individual (annual) returns been widely divergent from the expected 12 per cent, even though they average around 12 percent. As the reader can see, the mai n point being made here is that the consistency and stability of performance and in accord with expectations is a far more powerful tool in manager selection cr iteria than trying to find the superstars of yesterday. It should be fairly clea r to the reader that the selection criteria for a manager also define the monito ring criteria. Monitoring the performance of the manager is akin to ensuring tha t the manager does not change any facet of his behavior once he has been selecte d. Similarly, the planner must note that the very act of selecting a manager is also a reward for the past consistency, competency and the ethics of a manager. In the same vein, a planner should not seek to replace a manager whose performan ce in a certain year has not been up to par, especially if the manager has stray ed from the stated and expected objectives and behavior. The planner should note that in a longer framework of time, it is the consistent managers whose perform ances are most likely to satisfy the needs and objectives of their clients. Mode rn portfolio theory is a method by which assets are selected to be included in a portfolio such that the expected portfolio outcome optimizes the individuals uti lity. The most powerful concept in this optimization process is the benefits of diversification across different asset classes. This benefit shows up primarily as both a reduction in risk and or an increase in return. This in turn leads to the optimal solution. The portfolio outcomes in terms of risk and return are use d to assess the performance of portfolios both by comparisons with benchmarks an d comparisons with peer group performances. The performance of portfolios and th eir managers is one of the criteria used in selecting money managers. Various mo ney manager selection and monitoring criteria were examined and a set of guideli nes were established for this very important task. Asset Allocation and Diversif ication This chapter presents two key investment concepts: Investment Policy Sta tements (IPS) and Asset Allocation. The former concept is an essential part of a ny investment plan in that an IPS lays the framework and objectives of how an in vestment plan will be managed, why such a path is chosen and how it will serve t he client. The asset allocation decision is the most notable decision managers h ave to make in managing client portfolios. Each of these two concepts are explai ned in detail, in this chapter. Managerial implications of these two concepts ar e also discussed in the latter sections of the chapter. Investment Policy Statem ent An Investment Policy Statement (IPS) serves as a plan that guides the invest or and the planner in long86 Investment Planning PDP

term financial and investment decisions. While investors may differ in type or f orm, each requires a clear investment policy statement in order to achieve longterm goals and investments objectives. Investors may be categorized as being eit her institutional investors or individual investors. Though financial planners w ill most often interact with individual investors, there will be occasions when an institutional investor may require the planners service and advice. Hence, it is important for the planner to be able to understand the needs of both types of clients and articulate IPSs for both types. Of course, the obvious client for mo st financial advisors is the individual investor. Generally, institutional inves tors differ from individuals in the amount and size of the portfolios under mana gement. Within the institutional category of investors, there are subcategories, each of which differ in their investment needs. Examples of such sub-categories of institutional investors include mutual funds, pension funds, endowment funds , insurance companies, etc. To understand how these institutions differ in their investment need, consider the example between the needs of a defined benefit pe nsion plan and an endowment fund. The primary goal of pension plan mangers is to ensure the availability of cash that requires to be distributed to plan benefic iaries every year. Thus, pension plan management and policy is integrally involv ed in investments that match cash outflows with inflows. In a pension plan, the amounts of distribution to be made are generally known in advance; this in turn, determines to a large extent the choice of investment vehicles required to meet those distribution needs. Thus, IPSs for pension funds are much more guided by r egulatory and compliance needs, which in turn protect the interests of the plan beneficiaries. Consider now the issues surrounding the management of investment assets for an endowment fund. An endowment fund is an accumulation of donations that is provided to a non-profit organization by its donors. Generally the inves tment objectives of endowment funds are much more attuned to the needs of the no nprofit organization, Sometimes, the donors may impose managerial clauses themse lves. Typically, endowment funds seek to produce a small stream of income to aug ment the operating budget of the organization and to grow the rest of the corpus at a very moderate rate, such that the income may take the form of a perpetual stream. Thus, the IPS of an endowment fund is generally very different from that of a pension fund. Banks and insurance companies are other examples of institut ional entities that need investment policies. Both these institutions are simila r to pension funds in that their investment needs are dictated by those who lend them the investment funds. Insurance companies invest in order to ensure suffic ient availabilities of future funds required to be distributed as payouts to pol icy holders. Banks invest in order to meet short and long term obligations that it promise to pay depositors on specific savings deposits. All types of investor s, their needs and the appropriate investment policies, are discussed in the fol lowing sections. Investment Policies For Individual Investors Life Cycle Indentification Investment goals of the individual client naturally e merge from the financial planning process. It is important to note that the goal s of an individual will change over time as the client progresses through variou s stages of his/her life. Thus, the investment objectives will also change over time as the client ages and succeeds at achieving previously set goals. The inve stment goals that are generally associated with various stages of a clients life are known as the clients life-cycle needs. Generally, the needs of various indivi duals at certain stages of life tend to be similar. For example, early career in dividuals want to accumulate wealth, whereas in the late career stage individual s seek to protect wealth more. Thus, we can classify these typical investment ne eds at various life PDP Investment Planning 87

cycles. These classifications provide us with a tool to apply in the investment planning process. The first stage of an individuals earning and career is conside red as the accumulation phase. This phase begins when an individual first become s gainfully employed and continues until the client is about 40 to 50 years of a ge. During this time period, investors are generally much more open to assuming greater investment risk to attain higher returns. Typically, such investors can shrug off losses on the assumption that they have sufficient time to earn and re coup their losses. Further, if the losses are in securities, they can understand that their investment time horizon permits them to wait out any temporary downt urn in the economy and business cycle since they are expected to be followed by growth cycles that will eventually increase their wealth. Further, individuals p rogressing through their careers also observe increased incomes and savings; the se savings augment the growth of their wealth. Essentially, individuals in this phase are the beneficiaries of the power of compounding in the value of their we alth. Common investment goals during this phase are the purchase of a house, sav ing for childrens education and accumulating funds for retirement. The next stage of the client life cycle is the conservation/protection phase. This stage begin s seamlessly with the trailing off of the accumulating phase and remains as the dominant phase until the first few years of retired life. During this stage, the client seeks to consolidate the assets that have been accumulated. Individual e arnings reach their peaks at this stage as does their savings. The aging of clie nts is reflected through their investments as they tend to lean toward a reducti on in undertaking risk and are content to receive lesser returns. Unlike the acc umulation phase, investors recognize the devastation that can be caused by signi ficant losses of wealth to their well being. Further, they understand that the t ime they have left before retirement may not be sufficient to undo losses that r esult from excessive risk taking. Thus, at this stage, loss aversion becomes the dominating trait of the investment life cycle. Common investment goals during t his time period are childrens education, savings for retirement and the beginning s of the need to gift to their beneficiaries, charities and well wishers. The la st stage is known as the preservation and gifting stage. This stage tends to beg in soon after retirement and continues through life expectancy. During this stag e, the investor is primarily concerned with preserving capital rather than enhan cing returns. The loss of earning power and the fixed expenses of retirement loo m large during the early parts of this stage. Thus the investments in this stage of life tend to be more conservative relative to the other life-cycle stages. T his is also the phase in which the client will most likely seek the planners assi stance in gifting income and property to desired beneficiaries. The ages mention ed in the above life-cycle discussion are only benchmarks. Similarly, particular goals will vary by client, life-cycle stage, and age. For instance, over the la st 100 years, the age at which individuals start families has considerably incre ased. This implies that the investment goal of saving for childrens education has shifted along the entire life cycle. Thus, the educational savings requirements can be part of the life-cycle phase where the client is primarily interested in conservation and protection as compared to the traditional notion that this obj ective is mostly encountered in the accumulation phase. Similarly, emerging heal thcare technologies are changing the needs of individuals in the latter stages. The growth of long-term care policies is a reflection of the impact of biotechno logy on the longevity of life. The concept of life cycles is important for plann ers to understand but care must be taken not to compartmentalize clients by age in order to impose life stage needs without considering the impact of the client ss idiosyncratic or subjective attributes. Rather, careful discussion and analysi s based upon client goals will yield a more accurate measure in which stage or s tages the client resides. Life-cycle planning is thus relevant in the investment processes because it allows the planner to identify with the client through the various time horizons for each goal within the financial plan. Without time hor izons, an investment policy would not be whole. The client could be subject to t oo much risk and / or 88

Investment Planning PDP

insufficient funds for current consumption (too much savings), etc. The policy t hen, would not accurately articulate the goals within the plan and thus would su bject the achievement of goals to imminent failure. Investment Objectives Once t he goals, life cycle, and time horizons for the goals have been identified, the investment objectives become easier to identify. Investment objectives identify the goals of the portfolio in relation to the reasons for the individuals financi al needs. Investment objectives can be further classified into four types curren t income, capital growth, total return, and preservation of capital. Current inc ome is a strategy whereby the main objective of the portfolio is to generate an immediate and ongoing flow of cash to the client. That is, the investor requires income generation from the principal balance of the portfolio via interest or d ividend payments. An investor who relies on the portfolio for income in this way needs the cash for living purposes. Thus the investments tend to be conservativ e in nature. Common investment securities are corporate bonds, government bonds, government mortgage backed securities preferred stocks and perhaps stable Blue Chip stocks that pay regular dividends. Capital growth is a strategy whereby the portfolio funds are invested over the long term with the objective of capital a ppreciation in mind. Because the objective is growth over the long term, the ris kiness of the portfolio tends to be higher. The most common securities for this type of approach are equities, particularly those in high growth companies or se ctors. However, it is always a good idea to diversify the portfolio holdings amo ng various sectors and industries. Further, stocks of very large companies that lead their industries (blue chip) in this case, can help to diversify the portfo lio while achieving some of the same growth objectives. Mutual funds, which inve st in various sectors or industries can also help to diversity a portfolio at a reasonable cost. The total return approach is a strategy that blends the current income and capital growth approaches. Thus, the investor wants the portfolio to grow over time, but wishes to have income generated from it right away as well. Obviously having two objectives from the same portfolio can be challenging to m anage, but it can be done if applied correctly. Thus, this strategy would use a blend of methods of the two strategies above. Those investors interested in pres entation of capital are most interested in ensuring that the amount of money inv ested in the portfolio does not decrease. Therefore, the investment choices are safe vehicles. Large returns are not important for these clients and types of in vestments are typically government bonds, certificates of deposit money markets (funds), and fixed annuities. Risk for Individual Investors Although we may have determined the goals and the investment objectives of our client, we cannot ser iously discuss the minute details of an investment policy without first assessin g the risk tolerance of the client. Without a meaningful assessment of client ri sk attitudes, the investment policy will be useless. Finance professionals often think of risk in terms of the standard deviation of returns and stock betas. In some cases, individual investors may understand these concepts but more often t han not, most investors do not fully understand these concepts. After all, that is why they seek out investment advisors for such expertise. Since the client ma y not understand the intricacies of integrating investor risk preferences in fin ancial applications, it is even more important for the advisor to determine the clients risk preference before structuring appropriate portfolios. Many clients d escribe risk in terms of losing money so it may be a good starting point upon wh ich to discuss the notion of risk. This notion of loss can be seen from several perspectives, so it can be helpful if the client can articulate risk to the plan ner in one of these ways. Loss to some individuals occurs when the original valu e of the portfolio has decreased in either absolute terms or relative return per centages. For instance, PDP Investment Planning 89

suppose a client started with an initial investment of Rs. 2,50,000 and experien ced a Rs. 50,000 decrease in value due to a general downturn in the market. Some investors feel that they have lost Rs. 50,000 and consider it a total loss. Sim ilarly, they might say that they lost 20 percent of their portfolio. Other inves tors who are investing for the long term may not be concerned if the value of th e portfolio decreases for some period of time if they feel that the losses susta ined are short tem in nature. These types of investors often perceive a loss onl y when they sell assets from the portfolio and therefore have a realized loss. R isk to clients may also appears in the form of the types of securities that they know of. Therefore suggesting new types of securities to these clients may appe ar to the client as a type of risk that they do not wish to engage in. It is a c hallenge to the advisor to help the client understand why these types of investm ents are better for the client. In the end, the advisor may or may not be succes sful in persuading the client. Conversely, clients may have a notion of risk in areas where they have had previous investment losses. For instance, those who lo st money in stock market crashes trend to be averse to investing in stocks in th e future. It is up to the advisor to help clients understand why their investmen ts failed in the first instance and the measures that the planner can put into p lace to minimize those types of losses in the future. Some investors may mimic t he popular or in vogue. Such practices can result in undesirable outcomes and re sult in large losses. Thus when an advisor advocates some technique or security as appropriate for the client, the client may consider this to be risky and very poor advice. Risk is extremely difficult to define. The planner must initially spend a lot of time with the client to ascertain what risk means to that client. This can be accomplished through discussion with the client and is often done w ith questionnaires, which are used as complements to client/planner conversation s, Since each investor is subjectively and idiosyncratically different, risk wil l have a different meaning to each investor. When implementing an investment pol icy, it is valuable to incorporate the risk characteristics into the plan. This should be done in such a way so that the investor and the planner can quantify t he risk. Thus if certain events occur, such as a portfolio losing 10 percent of its value, the planner and investor will have identified, in advance, appropriat e actions for that particular event. With such preplanned and agreed upon action s, further risk to the portfolio value may be minimized. Other Topical Considerations for Individual Investment Policies Tax Considerations Incorporating the notion of before and after-tax investment r eturns in a portfolio is an important concept in portfolio planning. The after-t ax considerations must effectively integrate with other portions of the financia l plan so that taxes are minimized in years with high expected income. Recall th at taxes can be deferred (paid at a later date when assets are sold at a profit) , can be avoided or can be taxed at capital gains rates (investments held greate r than one year) rather than at ordinary rates. It is useful to spell out the ta x consequences in the investments policy. However, the advisor must discuss and incorporate into the plan the potentiality for changes in the tax law. Because l aws change, tax planning relative to portfolio management can be a very challeng ing aspect to the planner. When the client has a negative bias toward taxes or h as complicated transactions the sale and purchase of assets to and from the port folio. Tax considerations and goals should be spelled out in the investment poli cy to assist the planner and the client in quantifying tax consequences of decis ions. Measurement of Returns and Successes of the Planner The client and the pla nner should decide upon a method that measures the success of the advisor in pic king investments. The time weighted rate of return (or the holding period return ) is a method used 90 Investment Planning PDP

for fund manager evaluation. This is so because a typical fund manager cannot co ntrol the amount of funds he or she has under management (in which case a geomet ric rate of return could be used). No matter what method is used, it should be s pelled out in the investment policy so that both the planner and the investor ha ve appropriate expectations regarding what performance measures are going to be used to judge the advisor. Macroeconomic Factors A good planner is always aware of macroeconomic factors that can ultimately affect investments. These factors s hould be integrated into the plan. For instance, historical inflation rises, whi ch affect the real rate of return on assets, should be discussed in any plan in order to sustain the purchasing power of the client to the greatest extent possi ble. Other factors that should be taken into consideration are interest rates, e conomic growth or decline as a whole or in specific industries, unemployment, po litical stability, and the legal environment. While this list is not exhaustive, it is meant to give the advisor an appreciation of the areas that can affect th e investment policy. As the planner gets to know the client, he or she can integ rate those areas within the macroeconomic environment into the clients plan. PDP Investment Planning 91

Review Questions: 1. Which of the following statements concerning diversificatio n is (are) correct? I. Studies suggest portfolios of 100 or more different commo n stocks are needed to substantially reduce unsystematic risk. II. The key to ef fective risk reduction through diversification is combining assets whose returns show negative, low or no correlation over time. a. I only b. Both statements ar e correct c. II only d. None of the two statements is correct 2. Which of the fo llowing statements concerning correlation coefficients is (are) correct? I. A co rrelation coefficient of -1 for the returns of two securities would indicate tha t both of them should be carefully considered for inclusion in a portfolio since maximum risk reduction could be achieved by including both. II. The returns of security B would increase 8% if the returns of security A increased 8% and the c orrelation coefficient for the returns of the two securities was +1. a. I only b . II only c. Both the statements are correct d. None of the statement is correct 3. Is it possible to reduce the risk by adding a security with a higher risk to a security with a lower risk that is already held? a. b. c. d. 4. No, the total risk after the addition will be higher The new security will have no impact in reducing the risk Yes, provided both the securities are negatively correlated Ye s, provided both the securities are positively correlated to each other What is the portfolio standard deviation in the following case of two (2) securi ties which are held in equal weights? Covariance of two securities = -8; Standar d deviation of stock x = 2 and Standard deviation of stock y = 4 a. b. c. d. 1 2 4 0 Rupee cost averaging can be achieved through Systematic Investment Plan Rupee cost averaging helps in reducing risk I only Both II only None 5. Which of the following statements is (are) correct? I. II. a. b. c. d. Answers: 1. b 2. c 3. c 4. a 5. b 92 Investment Planning PDP

Chapter 7 PDP Investment Planning 93

Small Saving Schemes T 1. 2. 3. 4. 5. 6. 7. hese are ideal investment vehicles for the small investor the retail resident In dian investors. Non resident Indians are not allowed to invest in these schemes. Let us look at the salient features of these schemes. Public Provident Fund Pos t Office Monthly Income Scheme Post Office Time Deposit National Saving Certific ate Kisan Vikas Patra Government of India Taxable Savings Bond Senior Citizen Sa ving Scheme 1. Public Provident Fund (PPF) Who can invest? n n n An adult individual in his own name An adult on behalf of a minor for whom he is the guardian. HUFs can not open new accounts now; with eff ect from 13.5.2005. Existing PPF accounts opened in the name of HUF shall contin ue till maturity and deposits can be made in the account as per rules. A PPF acc ount is in addition to Employee Provident Fund and GPF for government employees. n other words who contribute to EPF and GPF can also open PPF account. n Where can one open a PPF account? One can open a PPF account in n n n n n Head P ost-Office, G.P.O., Any Selection Grade Post Office, Any branch of the State Ban k of India and Selected branches of Nationalised Banks. How much can one invest? n n n n n 94 Minimum investment Rs. 500 in a financial year Maximum of Rs. 70,000/- in a fina ncial year Can be invested in a lump sum or in convenient instalments. Total num ber of credits per year is restricted to 12 Minimum investment each time is Rs. 5/-. Investment Planning PDP

n n n The ceiling of Rs. 70,000/- per annum is for each account. If an individual has his own account and accounts in the name of minors (where he is the guardian) th e total investment in a financial year can not exceed Rs 70,000/- in all the acc ounts taken together. A HUF account where he is the karta is considered separate for this purpose. Interest n n n n n 8% p.a. credited to the account, once a year, as on 31st Marc h of each year. Deposits made on or before the 5th of the calendar month are eli gible for interest for the month. It is the date of deposit and not date of real ization that is considered for this purpose. Interest is calculated on monthly p roduct basis and credited to the account as on 31st March. The interest rate can be changed by the Government of India at any time and the new rate will affect the balance lying in the account from that date. Past interest rates were as und er: Upto 14.1.2000 15.1.2000 to 28.2.2001 1.3.2001 to 28.2.2002 1.3.2002 to 28.2 .2003 1.3.2003 onwards Term n n n n PPF is a 15 year account. The term of the ac count can be extended by 5 years at a time by making an application in a specifi ed form to the deposit office; within one year. An account can be extended any n umber of times. The entire balance can be withdrawn in full after the expiry of 15 years from the close of the financial year in which the account was opened. 1 2% 11% 9.5% 9% 8% Loan n n n The depositor can take a loan in the third financial year from the fi nancial year in which the account was opened. Loan can be taken upto 25% of the amount standing at the end of the second preceding financial year. The loan shal l be repayable in 36 instalments and shall bear interest at the rate of 1%. No l oan can be obtained after the end of 5th year. Withdrawals n n n A depositor is permitted to make one withdrawal every financia l year. Withdrawal is permitted from the 7th financial year Amount of withdrawal can not exceed 50% of the balance to his credit at the end of the fourth year i mmediately preceding the year of withdrawal or at the end of the preceding year, whichever is less. Tax benefits n The interest earned on PPF account (including interest during the extension period) is excluded from income tax under section 10(11). PDP Investment Planning 95

n n The entire deposit in the account is exempt from Wealth Tax The annual contribut ion to the account is eligible for deduction u/s 80C Transferability n n A PPF account with one deposit office can be transferred to another deposit office. In other words an account can be transferred from Post O ffice to any bank branch or from any bank branch to any other branch of any othe r bank or to post office. Nomination n n PPF account is necessarily opened in a single name. Nomination fa cility is available. A depositor can nominate more than one person and stipulate the percentage of sharing among the nominees. 2. Post Office Monthly Income Scheme: Who can Invest? n n n An adult individual in his own (single account) An adult o n behalf of a minor for whom he is the guardian An adult individual jointly with other adult individuals (joint account) the total number of account holders res tricted to 3 Where can one invest? n n n In all GPOs In all selection grade Post Offices In se lect sub post offices How much can one invest? n n n n Minimum Rs. 1,000/Maximum Rs. 3,00,000/- in sin gle account (including all the deposits made earlier) Maximum Rs. 6,00,000/- in joint account (including all the deposits made earlier) The maximum limit of Rs. 3,00,000/- is applicable per individual and deposits in joint accounts are cons idered as having been made equally by all the depositors for the purpose of dete rmining the ceiling. Interest n n n 8% per annum payable monthly In select post offices ECS facility is available where the interest is credited every month directly to the saving b ank account of the depositor automatically through the Electronic Clearing Servi ce. A depositor may open a SB account with the same Post Office where he has dep osited his POMIS amount and give standing instructions for crediting the interes t amount directly to this SB account on a monthly basis. 96 Investment Planning PDP

n Past interest rates were as under: 14.1.2000 From 15.1.2000 to 28.2.2001 From 1. 3.2001 to 28.2.2002 From 1.3.2002 to 28.2.2003 12% 11% 9.5% 9% For deposit accounts opened up to Term n n 6 years The interest rate as above remains unchanged for the entire ter m of 6 years Withdrawals n n n No premature repayment is permitted within 1 year of deposit A fter 1 year but before completion of 3 years premature withdrawal of entire bala nce is permitted If withdrawn, prematurely, before 3 years a penalty of 2% of de posit amount is levied no deduction from interest already paid; Example: If a de positor withdraws Rs. 1,00,000/- prematurely after 2 years of deposit, he will b e paid Rs. 98,000/-, over and above the interest at the rate of 8% p.a. which he has already received for the period for which the deposit was held by Post Offi ce. If withdrawn prematurely after 3 years the penalty is restricted to 1% of th e deposit amount no deduction from interest already paid. Part withdrawals are n ot permitted if required the depositor will have to withdraw the entire deposit amount. n n Bonus on maturity n n n n A bonus of 10% of deposit amount is payable on maturit y (at the end of 6 years) This bonus has been discontinued from 13th February 20 06 No bonus is payable for deposit accounts opened after 13th February 2006 As p er the latest circular 5% Bonus will be payable on new deposit accounts made on or after 8th December 2007. Tax benefits n n No tax benefit; the interest is taxable Tax is not deducted at source from the interest, presently Transferability n A deposit account can be transferred from one post office to a ny other post office at any time on the request of the depositor(s). Nomination n Nomination facility is available 3. Post office Time Deposit Who can Invest? n An adult individual in his own (single account) PDP Investment Planning 97

n n n An adult on behalf of a minor for whom he is the guardian An adult individual jo intly with other adult individuals (joint account) the total number of account h olders restricted to 3 Provident funds, charitable trusts, institutions, co-oper ative societies and Government bodies are not permitted to invest in this scheme after 13th May 2005. How much can one invest? n n Minimum Rs 200/- and thereafter in multiples of Rs. 200/No Maximum Limit - Any amount can be invested Interest n n Interest is payable once a year Interest is compounded on a quarterly basis and hence the effective yield is slightly more than the interest rate indicated abov e Tax benefit n n As per the latest circular tax benefit is available u/s 80C of I ncome Tax Act from April 1, 2007 on deposits made for period of 5 years or more. Tax is not deducted at source from the interest, presently. Withdrawals n n n No premature repayment before completion of 6 months. No inter est is payable if withdrawn after 6 months but before 12 months. In respect of d eposits for 2 years to 5 years the interest payable shall be 2% less than the ra te applicable for the period for which the deposit has been held. 4. National Saving Certificates (NSC) VIII Issue Who can purchase? n n n n n An adult individual in his own name. An adult indivi dual jointly with another on Jointly or survivor basis ( A type). An adult individ ual jointly with another on Either or survivor basis ( B type). Parents and guardi ans on behalf of a minor. HUFs are not allowed to purchase NSCs from 13th May 2005 . 98 Investment Planning PDP

Where can one invest? n Can be purchased from all post offices which are allowed to open Savings account. Amount n n n National saving certificates are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs. 5,000 and Rs. 10,000 Can be purchased for any amoun t without any ceiling Can be purchased for amounts in multiples of Rs 100 Maturity Value n Rs. 100 becomes Rs 160.10 after the full term of 6 years Premature repayment n n Not allowed during the full term of 6 years In case of d eath of the investor premature payment is allowed to nominee at lower rates as p er rules Tax benefit n n Amount invested qualifies for deduction from income u/s 80C with in the over all ceiling of Rs. 1,00,000 along with other specified investments/e xpenditure Accrued interest also qualifies for deduction u/s 80C -every year fro m the second year onwards till the year before the year of maturity 5. Kisan Vikas Patra Who can purchase? n n n n n An adult individual in his own name An adult individ ual jointly with another on Jointly or survivor basis (A type) An adult individual jointly with another on Either or survivor basis (B type) Parents and guardians o n behalf of a minor HUFs, Trusts are not allowed to purchase KVPs from 13th May 20 05 Where can one purchase Kisan Vikas Patra? n It can be purchased from all post of fices which are allowed to open Savings account. Amount n n n Kisan Vikas Patras are available in denominations of Rs. 100, Rs. 5 00, Rs. 1,000, Rs. 5,000, Rs 10,000 and Rs. 50,000 Can be purchased for any amou nt with out any ceiling Can be purchased for amounts in multiples of Rs 100 Maturity Value n Rs. 100 becomes Rs. 200/- after the full term of 8 years & 7 mo nths Premature repayment n Not allowed within 2 years of purchase in normal circumsta nces PDP Investment Planning 99

n n In case of death of the investor premature payment is allowed to nominee at lowe r rates as per rules After 2 years premature encashment is freely allowed and th e amounts payable for a certificate of Rs 1,000/- denomination are as follows Tax benefit n n Tax is not deducted at source on maturity or otherwise No TDS as of now. Interest on KVP is taxable on accrual basis. 6. Government of India 8% Taxable Savings Bonds Who can purchase? n n n n n n An adult individual in his own name An adult indiv idual jointly with another on Jointly or survivor basis An adult individual jointl y with another on Either or survivor basis type) Parents and guardians on behalf o f a minor Hindu Undivided Family Charitable Institutions or a University {approv ed u/s 80G or 35(1)(ii)/(iii) of Income Tax Act From where can one purchase these bonds? n Bonds can be purchased from designate d branches of State Bank of India; its subsidiaries and Nationalised Banks; ICIC I Bank; IDBI Bank; UTI Bank; HDFC Bank and Stock Holding Corporation of India Lt d. (SHCIL) Amount n The bonds can be purchased for any amount in multiples of Rs. 1,000/- w ithout any upper limit 100 Investment Planning PDP

Term The full term of the bond is 6 years Interest n n n The bonds carry interes t at the rate of 8% p.a. payable half yearly i.e. 31st January and 31st July eve ry year ECS facility is available banks credit interest directly to bond holders account every 6 months through ECS Cumulative option is also available in which case Rs. 1,000/- becomes Rs. 1601/- at the end of the term of 6 years Liquidity n n Premature encashment is not allowed These bonds are not transferab le and hence loans can not be availed against security of these bonds Tax Benefit n n Interest is taxable No Tax is deducted at source(TDS) presently 7. Senior Citizen Savings Scheme, 2004 Who can invest? n n An individual who has attained the age of 60 years or above An adult individual who is above 55 years or more and who has retired voluntaril y or otherwise (within one month from the date of receipt of retirement benefit and an amount not exceeding the retirement benefit within the overall ceiling of the account) The account can be opened singly or jointly with spouse (the spous e may be below 60 years of age) Joint account holder can not be anybody other th an spouse HUFs and Non Residents are not allowed to invest n n n Where can one open this account? n The account can be opened in Select Post Offi ces and branches of banks which accept PPF deposits Amount n n n n Any number of accounts can be opened with each deposit in multipl es of Rs. 1,000/Maximum permissible investment Rs. 15,00,000/Only one deposit ac count permitted in one calendar month for each depositor If both husband and wif e are eligible to invest then each of them can invest up to Rs. 15,00,000/taking the total to Rs. 30 lacs. PDP Investment Planning 101

Requirements n n n n n Joint photographs (both husband and wife in one photo) PA N Card or declaration in Form 60 Age proof for the first holder Retirement Proof along with proof of retirement benefits received for depositors above 55 years but not above 60 years Photograph of nominee(s) Term n n n n The full term of the account is 5 years which can be extended by 3 years on maturity Interest: 9% p.a. payable quarterly on 31st March/30th June/30 th September and 31st December Only non cumulative option is available ECS facil ity has been made available in many deposit branches and hence interest can be c redited directly to the depositors bank account Nomination n n n Nomination facility is available Joint nomination with percenta ge allocation is permitted Photograph and signature of the nominee(s) are also o btained and kept on the record of the deposit office Premature closure n Permitted only after one year from the date of deposit in ca se of extreme emergencies premature closure within one year may be permitted on application to Ministry of Finance, Government of India In case of closure befor e 2 years but after 1 year an amount equivalent to 1.5% of the deposit amount is deducted as penalty no deduction from interest already paid In case of closure after 2 years but before 5 years an amount equivalent to 15% of the deposit amou nt is deducted no deduction from interest already paid In case of death of depos itor full amount is paid without any deduction n n n Transferability n A deposit account may be transferred from one deposit office/b ank to another in case of change of residence, by making an application in speci fied form along with the pass book Tax benefit n n Interest is taxable no tax benefit Tax is deducted at source fro m the interest payable senior citizens who are not assessed to Income tax can sub mit 15 H (if depositor is above 65 years of age) and form 15G (if not above 65 y ears of age) to avoid tax deduction at source from the interest Principal Amount can be considered towards the deductions u/s 80C n 102 Investment Planning PDP

Review Questions: 1. In respect of a Public Provident Fund account and a Hindu U ndivided Family which of these statements is true? a. New account can not be ope ned b. Yes new account can be opened c. No deposits are allowed in the old PPF a ccounts of HUF d. The amount that can be deposited in a PPF account of a HUF and that of the karta together can not exceed Rs. 70,000/- in a year 2. In respect of a PPF account and a Minor which of these statements is true? a. New PPF accou nt can not be opened in the name of a minor b. No new deposits are allowed to be made in the PPF accounts already held in the name of minors c. The amounts that can be deposited in a PPF account of a minor and that of the guardian together can not exceed Rs. 70,000/- in a financial year d. An individual can deposit amo unt not exceeding Rs. 70,000/- in a financial year in his account as well as the account in the name of the minor where he is the guardian 3. Interest on PPF ac count is payable for the month subject to the following condition getting fulfil led: a. Deposit should have been made on or before the 10th of the month and the cheque should have been realized by that date b. Date of deposit should be on o r before 10th of the month; date of realization can be later c. Date of deposit should be on or before 5th day of the month; date of realization can be later d. Deposit should have been made on or before 5th day of the month and the cheque should have been realized by that date 4. How many times a PPF account, on the e xpiry of the full term of 15 years, can be extended for 5 years, on an applicati on being made by the depositor? a. Only once b. Only twice c. Only thrice d. Any number of times 5. Interest rate on a PPF account is 8% p.a. Which of the follo wing statements regarding interest is true? a. The interest is taxable b. The in terest is taxable but not subjected to TDS c. The rate of interest can change at any time d. The rate of interest will remain unchanged for the entire term of 1 5 years but at the time of extension, changed rate, if any, will become applicab le 6. A bonus of 10% of deposit amount is payable on Post Office Monthly Income Scheme account, on maturity, provided: a. The deposit account was opened before 11th February 2006 b. The deposit account is held in joint names c. The deposit amount does not exceed the prescribed maximum limits in the scheme d. It is paya ble on all accounts irrespective of number of depositors as well as when the dep osit was made PDP Investment Planning 103

7. Interest on Post Office Monthly Income Scheme is a. Tax free b. Taxable and subj ect to TDS c. Taxable but not subject to TDS d. None of the above 8. In Post Office Time Deposit the maximum limit on investment is: a. Rs. 1,00,00/per person b. No maximum limit c. Rs. 3,00,000/- in single account and Rs. 6,00 ,000/- in joint accounts d. Rs. 5,00,000/- per person 9. Accrued interest on National Savings Certificates, purchased in the previous yea rs a. Need not be shown as Income from other sources b. Should be shown as Incom e from other sources but the same is deductible u/s 80L of the Income Tax Act in all years except the year of maturity c. Should be shown as Income from other s ources but can be claimed as deduction from income u/s 80C of the Income Tax Act , in all years except the year of maturity d. It can be treated as capital gains and accounted for as such in the year of maturity 10. Which of the following statements, in respect of Senior Citizen Saving Scheme, i s true? a. The account can be held jointly with son or daughter b. The account c an be held jointly but both the joint holders should above 60 years of age c. An individual below 60 years can not invest in this scheme at all d. An individual above 55 years can invest within one month of receipt of retirement benefits 11. If husband and wife both are above 60 years of age the maximum amount they can i nvest in Senior Citizen Savings Scheme is: a. Rs. 15 lacs, totally, between the two of them b. Rs. 30 lacs, totally; each person not exceeding Rs. 15 lacs c. No ceiling on the amount of investment in this scheme d. Only one of them can inve st and the total can not exceed Rs. 15 lacs 12. Which of the following statements is true regarding interest on Senior Citizen S avings Scheme? a. Taxable and subject to TDS b. Taxable but not subject to TDS c . Tax free d. Rate of interest can change at any time during the 5 year term 13. Which of the following statements is true in respect of nomination in Senior Cit izen Savings Scheme? a. Only one person can be nominated b. Nomination is permit ted only in case of single account c. Joint nomination is permitted on successiv e nomination basis d. Joint nomination is permitted on proportional nomination b asis 104 Investment Planning PDP

14. Cumulative interest option is available in Senior Citizen Savings Scheme. a. Not true; only non cumulative option is available b. True; but the depositors have to specifically apply for the same c. Available at the option of all the deposit ors jointly d. Available only for depositors in the age group of 55 to 60 15. The maximum amount that an individual can deposit in 8% GOI taxable Savings Bond is; a. Not exceeding Rs. 2 lacs in a financial year b. Not exceeding Rs. 2 lacs c. No ceiling at all; any amount can be deposited d. Rs 6,00,000/- if held join tly 16. Which out of the following persons are not allowed to invest in 8% GOI Taxable S avings Bonds? a. Charitable Institution approved u/s. 80G of the Income Tax Act b. Universities c. Non Resident Indians d. All the above Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. a c c d c a c b c d b a d a c c PDP Investment Planning 105

Chapter 8 106 Investment Planning PDP

Fixed Income Instruments Short Term Instruments Money Market Instruments T he following are the short term instruments of less than 1 year maturity. These instruments are essentially institutional plays and retail investors dont get to participate in this directly. 1. Call Money Market This is basically an inter-bank market where the day-to-day surplus funds are made available/lent to banks that have a short fall. The loan s have a maturity of 1 day to about 14 days and are repayable on demand at the o ption of either the lender or the borrower. In terms of liquidity this is slight ly lower than cash in other words the liquidity is very high 2. Repos Repos or r epurchase agreements (ready forward) are transactions in which one party sells s ecurity to another party simultaneously agreeing to purchase it in future at a s pecified date and time for a predetermined price. The difference in the prices i s the cost of borrowing to one party and income to the party lending the money. These transactions are secured and hence the counter party risk is highly reduce d. Therefore, the interest rate is also lower compared to call money rates. In r epos the purchaser acquires the title to securities and he can enter into furthe r transactions on these securities. Repos are generally for a period of about 14 days or less though there is no such restriction on the maximum period for whic h a repo can be done. Government Securities, Treasury bills and PSU bonds are th e instruments used as collateral security for repo transactions. 3. Treasury Bil ls Treasury Bills are borrowings of Government of India for periods of less than 1 year and the normal tenors are 91 days, 182 days and 364 days. The main holde rs of Treasury Bills are banks and primary dealers, which are required to hold g overnment securities as part of their liquidity requirements (SLR The statutory liquidity ratio banks are required to keep a certain percentage of their total d emand and time liabilities invested in government securities Investments in Trea sury banks serve the purpose of meeting SLR requirements currently SLR is 25%) O n 91 days Treasury Bills, currently, the yield is around 5.9% to 6.40% p.a. whil e the yield on 364 days Treasury bill hovers around 6.9% to about 7.1% p.a. Bank s subscribe to Treasury Bills through an auction process and Reserve Bank of Ind ia acts on behalf of Government of India in this regard. Government of India als o makes longer term borrowings to which banks subscribe. The securities where th e term is 1 year or more are called Dated Securities. 4. Commercial Paper (CP) C Ps are short term, unsecured, usance promissory notes issued by large corporation s. The rate of interest will depend on over all short term money market rates as well as credit standing of the issuer company. Individual investors can invest in Commercial Paper. These are issued at discounts to the face value and the ext ent of discount will determine the yield on the paper. Banks are not permitted t o PDP Investment Planning 107

co-accept or underwrite CPs issued by companies. The CPs are regulated by Reserve Bank of India and companies can issue CPs to meet their short term requirement of funds, subject to norms laid by RBI from time to time. A company is eligible to issue CP only if its tangible net worth is more than Rs. 4 crores and if it has a sanctioned working capital limit from a bank or a financial institution. The minimum credit rating required for CPs is P-2 of CRISIL or its equivalent of othe r credit rating agencies. The period is 15 days to less than a year and the deno mination is Rs 5 lacs and its multiples. 5. Certificates of Deposit (CD) Instrum ents very similar to CPs but issued by banks are called Certificates of Deposit. These are negotiable short term bearer deposits issued by banks. These are inter est bearing, maturity dated obligations forming part of the time deposits of ban ks. In the past when interest rates on bank deposits were regulated CDs became ha ndy for banks to raise short term deposits even at rates lower than the regular fixed deposit interest rates. 6. Forward Rate Agreements (FRA) A Forward Rate Ag reement(FRA) is a forward contract in which one party pays a fixed interest rate , and receives a floating interest rate equal to a reference rate (the underlyin g rate). The payments are calculated over a notional amount over a certain perio d of time and netted i.e only the differential is paid. It is paid on the termin ation date. The reference rate is fixed one or two days before the termination d ate, dependent on the market convention for the particular currency. FRAs are ove r-the-counter derivatives. A swap is a combination of FRAs. The payer of the fixe d interest rate is also known as the borrower or the buyer whilst the receiver o f the fixed interest rate is the lender or the seller. 7. Interest rate swaps (I RS) An Interest Rate Swap is the exchange of one set of cash flows for another. A pre-set index, notional amount and set of dates of exchange determine each set of cash flows. The most common type of interest rate swap is the exchange of fi xed rate flows for floating rate flows. A counter-partys creditworthiness is an a ssessment of their ability to repay money lent to them over time. If a company h as a good credit rating, they are more likely to be able to pay back a loan over time than a company with a poor credit rating. This effect is magnified with ti me. By making it easier for less creditworthy agents to borrow in the short term than in the long term, lenders make sure that they are less exposed to this ris k. Therefore, we would expect that in fixed-floating interest rate swaps, the en tity paying fixed and receiving floating is usually the less creditworthy of the two counterparties. The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entitys relative advantage in raising funds in the shorter maturity buckets. Fixed Inco me Instruments Long Term This segment deals with securities and deposits that ha ve maturity periods one year or longer and where coupon/interest is paid periodi cally, as opposed to discounted prices in case of short term instruments, discus sed earlier. These vehicles are attractive for investors who seek regular income with relative safety. Some of the most popular avenues of fixed income instrume nts are as under: 108 Investment Planning PDP

GOI dated securities Government Bonds GILT edged securities Government of India borrows for long term through these se curities. Banks, financial institutions, insurance companies and mutual funds su bscribe to these bonds through the auction process initiated by Reserve Bank of India. These bonds are plain vanilla bonds of face value Rs 1000/- where on the coupon/interest is paid to the holders on half yearly basis. These bonds are quo ted as 8% GOI bonds 2014 which indicate the coupon rate and maturity of these bond s. The prices of these bonds fluctuate based on the prevailing interest rates, t he nearness to payment of coupon and of course, market factors of liquidity/ dem and/supply, etc. These bonds are generally issued for periods ranging from 3 yea rs to 20 years. Because of the longer term, bigger size and illiquidity of these bonds these have not been attractive for retail investors. However, investors c an participate in the government securities, indirectly, through the mutual fund route. Some mutual funds have launched GILT funds which invest only in Governme nt securities while Income Funds of mutual funds predominantly invest in fixed i ncome securities including Government securities. The Government of India issues securities in order to borrow money from the market. One way in which the secur ities are offered to investors is through auctions. The government notifies the date on which it will borrow a notified amount through an auction. The investors bid either in terms of the rate of interest (coupon) for a new security or the price for an existing security being reissued. Since the process of bidding is s omewhat technical, only the large and informed investors, such as, banks, primar y dealers, financial institutions, mutual funds, insurance companies, etc genera lly participate in the auctions. PSU Bonds Public Sector Undertaking, Public Sector Enterprises and local authorities, but supported by State/ Central Government issue securities similar to Central Gover nment Securities. Normally the respective Government offers guarantee for paymen t of interest and repayment of principal amount of these PSU borrowings. These b onds, as they carry sovereign guarantee, are considered less risky compared to c orporate bonds/debentures but more risky compared to Government securities. Many State Government corporations have floated bonds in the past and have raised mo neys for infrastructure projects and the Indian retail investors have participat ed in the issues in a big way. The investors have received excellent returns whi le the corporations could raise much needed capital funds for major projects. It is also expected that Government of India will allow Municipal Corporations to raise funds from the market, for developmental projects, through issue of tax fr ee bonds at attractive rates of interest. Corporate Bonds/Debentures Companies can borrow directly from the market through issue of securities, subje ct to capital market regulations for meeting their capital requirements. These a re typically debentures which are borrowings of the companies and these may be sec ured against a charge on the assets of the company or these may be unsecured. Th e term of the debentures will depend upon the need of the company. Companies can issue Non Convertible Debentures which are pure fixed income instruments and al so partly convertible or fully convertible debentures. The convertible debenture s normally bear interest till the date of conversion and/or on the non-convertib le portion till redemption. Where the tenor of the debentures is 18 months or mo re credit rating for the debentures is mandatory. The non convertible debentures and the nonconvertible portion of partly convertible debentures are redeemed on maturity at par or with a premium. The rate of interest will depend on market c onditions as well as creditworthiness of the company and the credit rating for t he debentures. Companies in the past found it convenient to tap the capital mark et and PDP Investment Planning

109

raise funds through issue of NCDs and PCDs and they preferred this route to long t erm borrowing from banks. The investors also preferred NCDs because the debenture s were secured and the interest rates were quite high. Now that the rates of int erest have come down the debentures dont continue to enjoy the same patronage fro m the retail investor. To the investor interest on debentures is taxable and als o subject to TDS. Companies have tapped the market with Zero Coupon Bonds as wel l Optional Fully Convertible Debentures. These special instruments serve some pu rpose for the investors as well as the companies from the point of taxation as w ell as postponing interest liabilities, etc. Corporate Deposits Companies are al lowed to borrow from the public through public deposits for meeting their medium term capital requirements. The acceptance of deposits by Indian companies is su bject to the provisions of Section 58A and 58AA of the Companies Act, 1956 and C ompanies (Acceptance of Deposits) Rules, 1975 (as amended). Manufacturing Compan ies: n The public deposit mobilized by a company should not exceed 25% of Tangib le Net worth of the company (capital + free reserves) this fixes the maximum amo unt a company can borrow from the public through fixed deposits route. A company can borrow from its share holders also and this amount should not exceed 10% of its net worth taking the total borrowings through public deposits to 35% of the companys net worth. In respect of Government companies the limit is 35% of the c ompanys net worth. The maximum term of deposit cannot exceed a term of 3 years wh ile the minimum term is 6 months The company is free to fix the rate of interest payable on its fixed deposits within the overall limits laid down under the Com panies (Acceptance of Deposits) Rules, 1975 and notifications made there under f rom time to time The interest received by the depositor is taxable A company is liable to deduct tax at source where the interest per annum per depositor is lik ely to exceed Rs. 2,500/-. This limit may change as per provisions of Income Tax Act. Credit rating of fixed deposits is not mandatory Fixed deposits are unsecu red borrowings of the company n n n n n n n Non Banking Finance Companies: n n n n n n n Only NBFCs which are registered with RBI can accept fixed deposits Credit rating of Fixed Deposits is mandatory An N BFC can accept fixed deposits only if credit rating is above Minimum rating fixe d by RBI from time to time These companies are allowed to raise much higher amou nts by way of fixed deposits in relation to their net worth To the investor Fixe d Deposits with NBFCs offer a higher risk higher return investment option The int erest is taxable and subject to TDS Housing Finance Companies also accept fixed deposits and TDS is made only when the interest on deposits is likely to exceed Rs. 5,000/- p,a, per depositor whereas in respect of other companies the limit i s Rs. 2,500/110 Investment Planning PDP

Bank deposits n n n n n n n n n Banks accept fixed deposits for short term as we ll long term offering specific fixed rate of interest. This is the most popular investment vehicle for the retail investors in India because investors find bank s very convenient to deal with. These deposits are perceived to be highly safe a nd liquid Interest rates tend to be lower compared to other fixed income avenues of comparable maturities Interest is taxable Interest is subject to TDS where i nterest on term deposit is likely to exceed Rs 5,000/- per annum per depositor p er branch the bank is required to deduct tax at source Bank deposits are highly flexible in their features and banks accept term deposits with extremely investo r friendly features Investment in a Bank Fixed Deposit with a 5 year lock-in per iod qualifies for deduction from income under sec 80C of Income Tax Act. Bank de posits can be insured against risk of default, by bank, with Deposit Insurance a nd Credit Guarantee Corporation of India Ltd. to the maximum limit of Rs. 1,00,0 00/- per depositor per bank. Investors in relatively smaller banks and co-operat ive banks find this an important protection. Features of fixed income securities n n The return or the yield which comprises of regular flow through coupon/inter est and capital appreciation or loss, if any, on maturity. The liquidity. Invest ors some times prefer securities of shorter term as well as vehicles where the e xit is easier. The fixed income options like Money Market Mutual Funds and call deposits are found ideal by investors who want to park their money for short ter m. Risk: This is a major factor. The risk of default is a factor which determine s where the investor would like to invest his savings. Unsecured company fixed d eposits, especially the ones which are not rated, can be considered quite risky. The better the credit rating of an instrument the lower could be the return on the same. Taxability and tax deduction at source are also important factors that determine flow of money to a particular avenue. 8% GOI taxable savings bonds an d small saving schemes like Post Office Monthly Income Schemes have managed to a ttract huge funds flow because the interest on these, though taxable, is not sub jected to tax deduction at source while Public Provident Fund, though a longer t erm option, attracts substantial investor interest because of tax benefits. Conv enience of handling is a parameter on which bank deposits score over many other avenues. A large net work of branches and ATMs make banks very easy to handle. n n n Valuation of fixed income securities: Money market securities The valuation of these securities is normally a function of the current interest rate prevailing in the market on short term debt instru ments. If a 90day treasury bill of R.s 1,00,000/- is available for say 98,186 th en the yield on the same would be worked as follows: Income earned is 1,00,000 9 8,186 = 1,814 Tenor 90 days PDP Investment Planning 111

The yield therefore is (1814*365)/(98,186*90) = 7.49% The yield is worked out fo r a year of 365 days from the discounting at which the treasury bill is availabl e. The formula for calculating the yield is PV = FV/ [1+ (i*n/365) Where PV = pr esent value or the price of the bill/security FV = face value or the value recei vable on maturity n = number of days to maturity i = yield per annum In respect of fixed income securities which have less than 1 year left to maturity when all factors viz. PV, FV and n are known and yield i can be calculated using the above formula. Longer term securities In respect of longer term securities the time b etween receipts of interest income becomes a significant factor in its valuation . In market instruments there are no interest payments and the same is built in the price. In respect of dated securities and bonds interest payments are made a t specified intervals. The amount of interest and the timing of these payments w ill affect the price of a longer term security. There are two types of yields wh ich come into play here. The current yield which is nothing but the periodic pay ments received on the amount invested or in other words: the coupon divided by p urchase price. The other type of yield is YTM which is calculated as follows: where P = Price of the security C = annual interest payments received r = rate o f interest M = Maturity value amount receivable on maturity n = number of years left for the security to mature The computation of YTM required a trial and erro r procedure. The interest payments are payments of annuity over a period of time while the maturity value is the future value of the present Price of the bond a nd r the YTM has to be worked out substituting different values for r. Conclusion It may be pertinent to add here that small investors have little or no exposure to government securities and the money market instruments directly. Some investo rs have been participating in these avenues through the mutual fund route. Howev er investors have found company fixed deposits as well as non convertible and co nvertible debentures easier to invest and have been investing in these vehicles. Public Sector bonds floated by many Government and Semi Government corporations have also received good response from the retail investors. Besides the avenues discussed above fixed income instruments include Small savings schemes like Pos t Office Monthly Income Scheme, Public Provident Fund, National Saving Scheme, K isan Vikas Patra and direct borrowing by Government of India through 8% GOI Taxa ble Savings Bonds and Senior Citizen Savings Scheme. These schemes and their fea tures have been discussed in detail under the topic Small Saving Schemes. 112 Investment Planning PDP

Review Questions: 1. If the yield on 90 days Treasury Bills is currently 6.9% wh at should be the price of the Treasury Bill of Rs 1,00,000/- in the market? a. R s. 93,100 b. Rs. 98,327 c. Rs. 1,06,900 d. Rs. 96,549 2. Bank deposits, at the o ption of the bank, can be insured with DICGC and the maximum cover available per depositor is; a. No insurance cover is available on bank deposits b. Rs. 2,00,0 00/- per branch of the bank c. Rs. 1,00,000/- per branch of the bank d. Rs. 1,00 ,000/- per bank 3. Interest on bank deposits is a. Tax free u/s 10 b. Deduction is available u/s 80L for individual investors c. Taxable and subject to TDS wher e the interest is likely to exceed Rs. 5,000/- p.a. per depositor per branch d. Taxable and subject to TDS where the interest is likely to exceed Rs. 5.000/- p. a. per depositor per bank 4. A Manufacturing company can accept fixed deposits s ubject to the following conditions: a. Not exceeding 20 times the net worth of t he company b. Not exceeding 25% of its net worth from the public and not exceedi ng 10% of net worth from its share holders c. No such restrictions the company m ay decide the quantum d. Not exceeding 5 times the net worth of the company. 5. If the market price of the bond, bearing coupon of 8%, is Rs. 985, face value of the bond is Rs. 1,000 and if there are two years to maturity then YTM would be: a. Equal to 8% b. Less than 8% c. Cant say d. More than 8% 6. If the interest r ate in the economy rises then the prices of existing bonds will a. Rise b. Fall c. Remain steady d. The fall or rise will depend upon the coupon rate and the ma turity date of the bond PDP Investment Planning 113

7. Commercial Papers (CP) are: a. Long term instruments issued by banks b. Long ter m instruments issued by companies c. Short term instruments issued by eligible c ompanies d. Short term instrument which can be issued by any company 8. Interest on short term money market instruments: a. Is paid periodically by the issuer b. It is discounted in the price c. It is paid by the issuer, as agreed b etween the issuer and the investor, but subject to Tax Deduction at source d. Is paid on a quarterly basis 9. How frequently is interest on Government securities (Dated Securities) paid? a. Once a year b. Half yearly c. Quarterly d. On maturity 10. It is expected that interest rates may rise in the near future. Which of the fol lowing instruments would you choose? a. One year bank FD offering 8% p.a. b. 5 y ear Bank FD offering 8.5% c. 6 year GOI bonds offering 8% p.a. d. Keep money loc ked in long term securities Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. b d c b d b c b b 10. a 114 Investment Planning PDP

Chapter 9 PDP Investment Planning 115

Life Insurance Products ife insurance is a misunderstood concept in India. Basically Life Insurance Plan s should provide insurance cover to protect the dependants of the Life Assured. But conventionally Life Insurance policies have been sold as investment products where the Life Assured gets a lump sum at the end of a fixed term or periodic r eturns on a regular basis during the term. The emphasis has been more on the inv estment aspects than on life cover. The private players in Life Insurance sector in India they have brought in newer concepts like adding riders to life insuran ce policies but they also continue to sell insurance plans with more emphasis on the investment features. Let us look at some of the standard policies offered b y Life Insurance Companies. L Endowment Policy n n n An endowment policy covers risk for a specified period, at the end of whic h the sum assured is paid back to the policyholder, along with the bonus accumul ated during the term of the policy. The method of bonus payment is called revers ionary bonus. The quantum of bonus is not assured and it is based on the investm ent out come of Life insurance companies. It is insurance-cum-investment product where the emphasis is more on investment because life cover for a given premium is less compared to a whole life policy with more focus on maturity benefit com pared to death benefit. Endowment life insurance pays the sum assured in the pol icy either at the insureds death or at a certain age or after a number of years o f premium payment. Ideally this policy is used by investors who would like to ha ve a certain amount of capital at the end of a fixed term and protect the end ca pital through life insurance of the saver. This has been the most popular life i nsurance plan of LIC of India before the private players entered life insurance sector and popularized Unit Linked Insurance Plans n n n Whole Life Insurance Policy n n n n n n A whole life policy runs as long as the policyholder is alive. As ri sk is covered for the entire life of the policyholder, therefore, such policies are known as whole life policies. A simple whole life policy requires the insure r to pay regular premiums throughout the life. Whole Life plans with limited pay ment options are also available where the insured is required to pay premium for a specific term after which premium payment will stop but life cover will conti nue In a whole life policy, the insured amount and the bonus is payable only to the nominee of the beneficiary upon the death of the policyholder. There is no s urvival benefit as the policyholder is not entitled to any money during his / he r own lifetime. 116 Investment Planning PDP

Term Life Insurance Policy n n n n n n Term life insurance policy covers risk only during the selected term period. The sum assured becomes payable only on death of the policy holder and not on end of the term as in an endowment plan The term life insurance policy of fers maximum life insurance cover for a given premium payment as this is pure li fe insurance without any investment built in Term life policies are primarily de signed to meet the needs of those people who are initially unable to pay the lar ger premium required for a whole life or an endowment assurance policy. No surre nder, loan or paid-up values are granted under term life policies because reserv es are not accumulated. If the premium is not paid within the grace period, the policy lapses without acquiring any paid-up value. Money Back Policy n n n Money back policy provides for periodic payments of partial survival benef its during the term of the policy, as long as the policyholder is alive. They di ffer from endowment policy in the sense that in endowment policy survival benefi ts are payable only at the end of the endowment period. An important feature of money back policies is that in the event of death at any time within the policy term, the death claim comprises full sum assured without deducting any of the su rvival benefit amounts, which may have already been paid as money-back component s. The bonus is also calculated on the full sum assured This is an insurance pla n with emphasis on investments and periodic return. A segment of investor popula tion finds the periodic receipts from Life Insurance Company attractive and henc e prefers this plan. n n Joint Life Insurance Policy n n n n n n These plans are ideal for a married couple especially when both are bread winners or business partners. Joint life insurance policies are similar to endowment policies offering maturity benefits as well as death benefits. In cas e of death of one of the persons the sum assured becomes payable. The sum assure d is paid again on death of the surviving policy holder or on policy maturity. T he premiums payable cease on the first death or on the expiry of the selected te rm, whichever is earlier. If one or both the lives survive to the maturity date, the sum assured as well as the vested bonuses are payable on the maturity date. Group Insurance n n Group insurance offers life insurance protection under group policies to var ious groups such as employers-employees, professionals, co-operatives, weaker se ctions of society, etc. It also provides insurance coverage for people in certai n approved occupations at the lowest possible premium cost. Investment Planning 117 PDP

n n n n Group insurance plans have low premiums. Such plans are particularly beneficial to those for whom other regular policies are a costlier proposition. Companies w ith a large workforce have preferred to provide life insurance to their less sop histicated employees/workers through Group Insurance Plans. Group insurance plan s extend cover to large segments of the population including those who cannot af ford individual insurance. A number of group insurance schemes have been designe d for various groups. Loan Cover Term Assurance Policy n n n n n Loan cover term assurance policy is an insurance policy, which covers a home loan. In the event of unfortunate death of the policy holder, before the full repayment of the housing loan, the amount outstanding in the housing loan i s paid in full. The cover on such a policy keeps reducing with the passage of ti me as individuals keep paying their EMIs (equated monthly instalments) regularly , which reduces the loan amount. This plan provides a lump sum in case of death of the life assured during the term of the plan. The lump sum will be a decreasi ng percentage of the initial sum assured as per the policy schedule. Since this is a non-participating (without profits) pure risk cover plan, no benefits are p ayable on survival to the end of the term of the policy. Term Assurance Plans n n n n n n Under this plan, in case of death of the policy holder during the po licy term, the sum assured will be paid to the beneficiary. There are no maturit y benefits. Hence on survival, the policy will terminate. The life insured will need to pay the regular annual premium for the term chosen. These are typically low cost bare insurance plans with no investment frills For a little additional cost some companies offer Term assurance plans with return of premium and here o n survival till maturity all the premiums paid will be returned Some term assura nce plans provide extended life cover rider where after the end of term, insuran ce up to certain percentage of sum assured, continues for a specified term , say 5 years, without payment of any premium Insurance companies tend to place a num ber of restrictions on term plans like: 1. 2. 3. Maximum life cover; say Rs 50 l acs Maximum term say 25 years Maximum age at maturity say 55 years and so on ... n Unit Linked Insurance Plans n n ULIPs are market-linked insurance plans with a life cover thrown in. The sai d insurance cover is lower than most plain-vanilla plans (like endowment plans) as a sizable portion of the premium goes towards investments in market-linked in struments like stocks, corporate bonds and government securities. On death sum a ssured together with market related returns on the investments is paid in other words the death benefit could be more than sum assured Investment Planning PDP n 118

n n Generally, the choice of extent of life cover is left to the insured/policy hold er The choice of investment plans is also left to the policy holder with an opti on to switch between different investment plans, a number of times, during the e ntire term of the plan. For example an investor may choose the aggressive or equ ity plan at his young age and later on switch to conservative or protective or d ebt plan at a later age. ULIP provides multiple benefits to the consumer. The be nefits besides life protection include: 1. 2. 3. 4. 5. 6. Investment and Savings Flexibility Adjustable Life Cover Investment Options Transparency Options to ta ke additional cover against n Death due to accident n Disability n Critical Illn ess n Surgeries n n n n ULIPs have managed to outsell plain vanilla plans by quite a margin. For some pr ivate insurance companies, they account for up to 70% of new business generated. ULIPs by their very nature are long term investment vehicles because of costs i nvolved as well as the nature of underlying investments especially equities. Inv estors while choosing ULIPs should very carefully study the loads charged by Lif e Insurance Companies because past performance shown by these companies is essen tially on the net investment portion of the premium paid by the policy holder. S o if the charges are high naturally the lump sum receivable at the end of the te rm will also be affected substantially. The policy holders should pay premium co ntinuously for a minimum period of 3 years. The insurance cover will continue ev en if the policy holder fails to pay the annual premium after a minimum period o f at least 3 years. The policy becomes paid up after 3 years and upon surrender the market value becomes payable. n How Unit Linked Insurance Plans work? Lets assume that Mr. Vikas Joshi, aged 30 y ears, is prepared to pay life insurance premium of Rs 20,000/- per annum. In a U LIP he can choose the extent of life cover he wants and where he wants his fund to be invested. Let us also assume that Mr. Joshi presently opts for the Aggress ive plan where his entire amount will be invested in equities and he chooses lif e cover of Rs. 2,00,000/-. From the premium paid by Mr. Joshi expenses under the following heads will be deducted. n n n n n Sales and marketing expenses Admini stration expenses Underwriting expense Mortality charges Fund management expenes The quantum of mortality charges will depend upon extent of life cover opted whi le the fund management PDP Investment Planning 119

expenses will also depend upon the investment option exercised the cost could be low for a debt fund and higher for an equity fund. In some cases out of Rs. 20, 000/- paid by Mr. Joshi expenses will account for nearly Rs. 5,000/- in the firs t year or first two years and only the balance amount of Rs. 15,000/- will be in vested as per his option. The quantum of administration, selling and marketing e xpenses go down dramatically from the third year onwards but in the initial 2 ye ars they tend to be quite high and this can alter the returns on the ULIP substa ntially. It is very important for Mr. Joshi to study the fine print regarding ex penses thoroughly before choosing a specific Plan. Mr. Joshi should also realize that he will get better returns only if he invests for a long period for the fo llowing important reasons: n n n Expenses, as a percentage of premium, tend to g o down dramatically over longer period time Equity as an asset class will perfor m better over longer period of time In the short term equity may perform erratic ally and may not deliver superior returns Where ULIPs invest? Each investment fund is composed of units. All the units in a fund are identical. You can choose from the following funds: Liquid fund The L iquid fund invests 100% in bank deposits and high quality short-term money marke t instruments. The fund is designed to be cash secure and has a very low level o f risk; however unit prices may occasionally go down due to the use of short-ter m money market instruments. The returns on the funds also tend to be lower. Secu re Managed /Protector Fund The Secure Managed fund invests 100% in Government Se curities and Bonds issued by companies or other bodies with a high credit standi ng, however a small amount of working capital may be invested in cash to facilit ate the day-to-day running of the fund. This fund has a low level of risk but un it prices may still go up or down. The risk that this fund may face is the inter est rate risk. If after investment the interest rates rise that may lead to a fa ll in unit prices temporarily. Hybrid Fund / Moderate fund / Defensive Managed 1 5% to 30% of the Defensive Managed fund will be invested in high quality Indian equities. The remainder will be invested in Government Securities and Bonds issu ed by companies or other bodies with a high credit standing. In addition, a smal l amount of working capital may be invested in cash to facilitate the day-to-day running of the fund. The fund has a moderate level of risk with the opportunity to earn higher returns in the long term from some equity investment. Unit price s may go up or down. Balanced Fund 30% to 60% of the Balanced Managed fund will be invested in high quality Indian equities. The remainder will be invested in G overnment Securities and Bonds issued by companies or other bodies with a high c redit standing. In addition a small amount of working capital may be invested in cash to facilitate the day-to-day running of the fund. The fund has a higher le vel of risk with the opportunity to earn higher returns in the long term from th e higher proportion it invests in equities. 120 Investment Planning PDP

Growth fund / Aggressive Fund The Growth fund invests 80% to 100% in high qualit y Indian equities. In addition a small amount of working capital may be invested in cash to facilitate the day-to-day running of the fund. The fund has a higher level of risk with the opportunity to earn higher returns in the long term from the investment in equities. n n The past performance of any of the funds is not necessarily an indication of future performance. There are no investment guaran tees on the returns of unit linked funds. Who can opt for ULIPs? n n n Individuals who are already adequately insured Indi viduals who are well informed regarding the market and are in a position to take a call on the performance of equity and or debt markets over a period of time I nvestors who are prepared to take more risk for better returns compared to pure endowment plans Insurance plans for childs future Life insurance plans help in servicing various needs in an individuals financial planning exercise. One such need happens to be planning for his childrens future. Childrens insurance plans help in addressing many of these needs. While individu als might have a financial plan for themselves in place, it is equally important that they secure the financial future of their children. For example, suppose a n individual wants to plan for his sons education. A child plan will serve in ach ieving this goal. An illustration will help understand this better. n n n n A pa rent saves regularly every year or every month for a fixed term The plan offers to pay lump sum amounts every year which could be spent on childs education on th e child reaching a certain age There are plans that pay a single lump sum on the child attaining a certain age typically planned to provide for marriage expense s The most important insurance feature in a child care plan is that in the event of unfortunate death of premium paying parent further premium payments are waiv ed (at the option of the policy holder while entering the plan) and the lump sum s are paid as planned so that the childs education expenses are met Some plans al so offer a rider called Accidental Disability Guardian Benefit rider where the f uture premiums are waived in case the parent is disabled because of an accident It is the life insurance of the parent that is important and not that of the chi ld because the child should not face financial problems on death of the parent many people tend to insure the child to secure the childs feature. The returns o n some products are market linked and not assured and therefore it is important to understand cost factors, track record of performance and other features befor e choosing a plan n n n Pension Plans n n n A pension plan is a retirement plan An investor can start planning for ret irement from an early age or look at the options close to retirement Ideally, in vestments should start from an early age through regular instalments on yearly b asis PDP Investment Planning 121

n n n Lump sum single premium payment is also allowed for investors, past a particular minimum age limit minimum age limit for starting of pension in many cases it ha ppens to be 40 years The pension payments can start immediately or after a time lag Immediate annuity or deferred annuity In case of deferred annuities, at the end of the term of deferment the pensioner can exercise an option of getting som e lump sum and pension on the balance amount or pension on the full amount part payment of capital is allowed The pension payments are at guaranteed rates for e ntire life of the pensioner or for a fixed term of say 10/15/20 years Some pensi on plans provide for paying increased rates of pension over a period of time ide al hedge against inflation The pension payments can be monthly, quarterly, half yearly or yearly at the option of the pensioner. The pension payments can contin ue to spouse on the death of the pensioner, at the same rates or reduced rates, as prescribed by Life Insurance companies this option can be exercised by pensio ner The capital sum may be returned to the nominee on the death of the pensioner (return of purchase price) or forfeited the rate of return on annuity plans wil l depend on which option the pensioner exercises the rate of returns are lower w hen the pensioner wants return of purchase price In case of immediate pension th e quantum of pension depends on the age, at entry, of the pensioner the higher t he age at entry the higher the amount of pension Pension plans typically offer n o life insurance cover but some plans do have term assurance rider for deferred pension plans, at an additional cost The most important factor that should be co nsidered while choosing a pension plan is that it provides protection from inter est rate risk insurance companies guarantee a specific return for the entire lif e of the pensioner where as in other avenues like fixed deposits/small savings, etc. the interest rates may go down disrupting the budget of the pensioner these plans cover the risk of living too long n n n n n n n n 122 Investment Planning PDP

Review Questions: 1. In a Whole life plan with limited payments, the sum assured becomes payable: a. At the end of premium paying term b. Only on death of the p olicy holder c. At the end of the premium term or on death of the policy holder which ever is earlier d. The sum assured is not payable at all if the policy hol der survives the premium paying term 2. In an Endowment Assurance Plan the sum a ssured becomes payable: a. Only at the end of the term of the policy b. On death of the policy holder or at the end of the term of the policy which ever is earl ier c. Only on death of the policy holder d. No sum is payable if policy holder survives the full term 3. In a Term Assurance Plan the sum assured becomes payab le: a. Only at the end of the term of the policy b. On death of the policy holde r or at the end of the term of the policy which ever is earlier c. Only if the p olicy holder dies after the end of the term d. Only if the policy holder dies be fore the end of the term for which he has been insured 4. The best way to take c are of a childs future through insurance plans is to a. Insure the life of the ch ild for maximum possible amount b. Life insurance plans can not protect the chil ds future at all c. Invest in a child care plan with premium waiver benefit, wher e upon death of the parent further premium need not be paid but the child will g et all benefits of the policy d. Invest in a child care plan but not opt for pre mium waiver rider because that involves additional cost 5. Unit Linked Insurance Plans are most suited under which of the following conditions? a. Ideal for und er insured persons b. Suitable for persons who are adequately insured and are pr epared to take some risks for better returns c. Suitable for investors with shor t term objective d. Suitable for people looking for maximizing insurance cover o n minimum premium payments 6. Unit Linked Insurance Plans are basically: a. Shor t term and Low cost insurance plans b. Low cost investment plans with no risk c. Market related plans with emphasis on investments d. Market related plans with emphasis on insurance 7. In respect of Unit Linked Insurance Plans which of the following statements is true? a. The returns are assured b. No risk investment p lans c. The return shown by way of past performance is on the entire amount of p remium paid by the policy holder d. Only a certain percentage of premium is inve sted in securities and a good amount, is deducted for various expenses, especial ly in the first few years PDP Investment Planning 123

8. A young and aggressive investor, who is already adequately insured, should choos e which of the following options in a ULIP plan? a. Aggressive/Growth plan which predominantly invests in equities b. A conservative or protector plan which pre dominantly invests in bonds and government securities c. The choice is immateria l as all funds tend to perform equally well over longer periods of time d. A hig her insurance cover with lower risk investment option ; say liquid fund/bond fun d 9. An investor who wants to invest in immediate pension plan seeks your advice on w hat option to choose. He is 50 years of age and he expects to live for another 3 0 years at least. Which one of the following options is suitable to him? a. Guar anteed pension for 5 years - offering 7% p.a. b. Guaranteed pension for 20 years - offering 6.5% p.a. c. Guaranteed pension for life and there after to his spou se -offering 7% p.a. d. He should be advised to invest in a mutual fund rather t han pension plan of a life insurance company Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. b b d c b c d a c 124 Investment Planning PDP

Chapter 10 PDP Investment Planning 125

Mutual Funds A Mutual fund is a collective investment vehicle where the resources of a number o f unit holders are pooled and invested as per objectives disclosed in the offer document. A mutual fund is set up as a trust which supervises the function of An Asset Management Company (AMC) which manages the investments collected in the m utual fund schemes. A mutual fund investor enjoys the following advantages 1. Professional management The funds are invested by professional fund managemen t team that analyses the performance and prospects of companies and selects suit able investments in line with the objectives of the schemes. 2. Diversification It is impossible for a small investor to diversify across different investment v ehicles as well as over a large number of companies. He invariably runs the risk of non diversification on his investments because of low capital. The mutual fu nd provides him the best option where on a small capital invested the unit holde r gets a diversified portfolio. 3. Regulated operation The mutual fund administr ation and fund management are subject to stringent regulations by Self Regulator y Organisation voluntarily set up mutual funds viz. Association of Mutual Funds of India (AMFI) and also by Securities and Exchange Board of India (SEBI). Thus the interest of the investors is kept protected. 4. Higher returns As these fund s are well managed and well diversified they tend to perform better than the mar ket over a longer period of time; there is potential for the unit holders to get better returns compared to fixed income avenues over a longer period of time. 5 . Transparency The NAVs of open ended funds are disclosed on a daily basis while the portfolio is disclosed on a monthly basis ensuring transparency to the inves tors. 6. Liquidity Open ended funds can be redeemed at any time; there is no loc k-in period; provides excellent liquidity; the redemptions are also very fast an d investors in equity funds tend to get money back 7. Tax Benefits Mutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The unit holders also enjoy certain tax benefits on the income earned; the capit al gains made and on amount invested in certain types of funds. 126 Investment Planning PDP

8. Flexibility Mutual funds offer a lot of flexibility where the investments can be lump sum investments or Systematic investment Plans on a monthly/quarterly b asis with very small amounts of investments. Withdrawal can be also full or part or on a systematic basis. What is the history of Mutual Funds in India and role of SEBI in mutual funds industry? Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sec tor banks and institutions to set up mutual funds. In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of SEBI are to protect the interest of investors in securities and to promote the development of and regulation of the securities market. As far as mutual funds are concerned , SEBI formulates policies and regulates the mutual funds to protect the interes t of the investors. SEBI notified regulations for the mutual funds in 1993. Ther eafter, mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been ame nded thereafter from time to time. SEBI has also issued guidelines to the mutual funds from time to time to protect the interests of investors. All mutual funds whether promoted by public sector or private sector entities including those pr omoted by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory requirements for these mutual funds and all are su bject to monitoring and inspections by SEBI. The risks associated with the schem es launched by the mutual funds sponsored by these entities are of similar type. How is a mutual fund set up? A mutual fund is set up in the form of a trust, wh ich has sponsor, trustees, an asset management company (AMC) and a custodian. Th e trust is established by a sponsor or more than one sponsor who is like promote r of a company. The trustees of the mutual fund hold its property for the benefi t of the unit holders. Asset Management Company (AMC) approved by SEBI manages t he funds by making investments in various types of securities. Custodian, who is registered with SEBI, holds the securities of various schemes of the fund in it s custody. The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of SEBI Regulat ions by the mutual fund. SEBI Regulations require that at least two thirds of th e directors of trustee company or board of trustees must be independent i.e. the y should not be associated with the sponsors. Also, 50% of the directors of AMC must be independent. All mutual funds are required to be registered with SEBI be fore they launch any scheme. What is Net Asset Value (NAV) of a scheme? The perf ormance of a particular scheme of a mutual fund is denoted by Net Asset Value (N AV). Mutual funds invest the money collected from the investors in securities ma rkets. In simple words, Net Asset Value is the market value of the securities he ld by the scheme. Since market value of securities changes every day, NAV of a s cheme also varies on day to day basis. The NAV per unit is the market value of s ecurities of a scheme divided by the total number of units of the scheme on any particular date. For example, if the market value of securities of a mutual fund scheme is Rs 300 lakhs and the mutual fund has issued 10 lakhs units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.30. NAV is requir ed to be disclosed by the mutual funds on a regular basis - daily or weekly - de pending on the type of scheme. PDP Investment Planning 127

Different types of mutual fund schemes Schemes according to Maturity Period A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period. Openended Fund/ Scheme An open-ended fund or scheme is one that is available for sub scription and repurchase on a continuous basis. These schemes do not have a fixe d maturity period. Investors can conveniently buy and sell units at Net Asset Va lue (NAV) related prices which are declared on a daily basis. The key feature of openend schemes is liquidity. Close-ended Fund/ Scheme A close-ended fund or sc heme has a stipulated maturity period e.g. 3- 5 years. The fund is open for subs cription only during a specified period at the time of launch of the scheme. Inv estors can invest in the scheme at the time of the initial public issue and ther eafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund th rough periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either rep urchase facility or through listing on stock exchanges. These mutual funds schem es disclose NAV generally on weekly basis. The market prices in respect of liste d close ended funds tend to be at a discount to NAV. Similarly when mutual funds offer limited repurchase on a periodic basis at intervals they charge a hefty e xit load especially in the first few years since inception the loads tend to get smaller as more time elapses. Thus the liquidity in close ended fund comes with a cost higher than open ended funds. Schemes according to expenses Load funds a nd no load funds: Funds which collect charges at the time of entry or exit or bo th from the investors are known as load funds. Funds which do not collect any of these charges at all are called No load funds - Issue expenses; distribution and marketing expenses are borne by AMCs or sponsors. However AMCs are allowed to char ge higher management fees in respect of no load funds compared to load funds. Lo ad charged at the time of purchase is called entry load while load charged at th e time of redemption is called exit load. Mutual funds want investors to invest for longer terms with them. Hence some times they charge a Contingent Deferred S ales Charge (CDSC) which will be charged only if the investor exits the fund bef ore a certain period of time say 6 months; this motivates the investors to stay invested in the fund for at least that period of time. SEBI has stipulated the m aximum load that can be charged by mutual funds and how the same can be levied. Initial expenses should not exceed 6% of initial resources raised/funds mobilize d under the scheme. In respect of a New Fund Offer (NFO) launch of a new mutual fund scheme the offer document which is also called KIM (Key information memoran dum) should contain all details regarding expenses. If the fund charges entry lo ad of say 2.25% then the initial investors in the fund will be sold units of Fac e Value Rs 10.00 at a price of Rs 10.225 and in respect of existing fund the loa d will be charged at specified rates on closing NAV for the day. Schemes accordi ng to Investment Objective A scheme can also be classified as growth scheme, inc ome scheme, or balanced scheme considering its investment objective. Such scheme s may be open-ended or close-ended schemes as described 128 Investment Planning PDP

earlier. Such schemes may be classified mainly as follows: Growth / Equity Orien ted Scheme The aim of growth funds is to provide capital appreciation over the m edium to long- term. Such schemes normally invest a major part of their corpus i n equities. Such funds have comparatively high risks. Growth schemes are good fo r investors having a long-term outlook seeking appreciation over a period of tim e. Income / Debt Oriented Scheme The aim of income funds is to provide regular a nd steady income to investors. Such schemes generally invest in fixed income sec urities such as bonds, corporate debentures, Government securities and money mar ket instruments. Such funds are less risky compared to equity schemes. These fun ds are not affected because of fluctuations in equity markets. However, opportun ities of capital appreciation are also limited in such funds. The NAVs of such f unds are affected because of change in interest rates in the country. If the int erest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuation s. Balanced Fund The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in t he proportion indicated in their offer documents. These are appropriate for inve stors looking for moderate growth. They generally invest 40-60% in equity and de bt instruments. These funds are also affected because of fluctuations in share p rices in the stock markets. However, NAVs of such funds are likely to be less vo latile compared to pure equity funds. Money Market or Liquid Fund These funds ar e also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-ter m instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for cor porate and individual investors as a means to park their surplus funds for short periods. Gilt Fund These funds invest exclusively in government securities. Gov ernment securities have no default risk. NAVs of these schemes also fluctuate du e to change in interest rates and other economic factors as is the case with inc ome or debt oriented schemes. Index Funds Index Funds are equity funds and they replicate the portfolio of a particular index such as the BSE Sensex, S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as tracking error in technical terms. These funds are also cal led passive funds as not much fund management skills are involved and these funds are expected to perform in line with the market. The expenses of fund management tend to be lower in index funds and these funds are suitable to investors who a re happy with market returns. Exchange Traded Funds (ETF) ETFs are traded like st ocks and thus offer more flexibility than conventional mutual funds. Investors c an purchase or sell ETFs at real time prices as against day end NAVs in case of op en ended mutual PDP Investment Planning 129

funds. ETFs provide investors an opportunity to take advantage of intra day swing s in the market and can be used to hedge their long positions in the equity mark et. ETfs are cheaper than even Index funds but in the Indian market place this co ncept has not picked up. NIFTY Bees and UTI SUNDER are two listed ETFs. These are traded on very low volumes with a high spread between bid and offer prices high er spread increases the cost and decreases the attractiveness of the ETF. Sector al Funds A mutual fund house may feel that a particular industrial sector may pe rform better than other sectors and that this sector offers tremendous growth op portunities over a period of time compared to other sectors. They may launch a s ector specific fund and the funds mobilized in this scheme would be invested in equities of companies of that sector. For example a Pharma fund will invest in e quities of pharmaceutical companies only and not in other industrial sectors. Th ese are high risk funds and the returns can also be higher. Thematic Funds A fun d house may feel that some sectors as a theme may outperform other securities be cause of government policies, consumer preferences, over all market conditions, etc. The fund house may launch a thematic fund and invest the funds collected on ly in companies which are connected with the specific theme. For example An infr astructure fund is not a sectoral fund as it will not fund only in one sector bu t invest in companies which are involved in infrastructure cement, steel; engine ering; construction, telecommunication, etc. These are slightly less risky compa red to sectoral funds but more risk in comparison with diversified equity funds. Funds classified on the lines of market caps like Small Cap Fund; Mid Cap Fund or Large Cap funds can also be considered as thematic where the theme is market c apitalization. Offshore funds Indian mutual funds have been permitted to invest o verseas. Some mutual fund houses have already launched schemes which seek to inv est a certain percentage of their corpus in foreign companies which are listed a nd traded outside India. These funds are unique in that they offer diversificati on across geographies, for the first time, to Indian investors. Commodity Funds These funds make investments in different commodities directly or through commod ities futures contracts and also invest shares of companies dealing in commoditi es. Typically they must invest in one commodity or a diversified set of commodit ies A gold fund invests only in gold whereas a metal fund may invest in precious metals and base metals like gold, silver, platinum, copper, nickel, zinc, etc. These funds serve the purpose of diversification across asset classes as direct investments by retail investors in commodities is virtually impossible due to va rious physical constraints. Real Estate Funds These funds invest in properties d irectly or indirectly by lending to real estate developers or buying shares of r eal estate and/or housing finance companies which are expected to benefit from r eal estate boom. Mutual funds in India are all set real estate funds as the norm s have been cleared recently by SEBI. Retail investors can take advantage of rea l estate boom through this indirect investment in real estate even on a lower ca pital. Tax Saving Funds Equity linked Saving Schemes of mutual funds with a lock in period of 3 years come with a tax benefit also. Investments in these schemes qualify for deduction u/s 80C of the Income Tax Act within the 130 Investment Planning PDP

overall ceiling of Rs. 1,00,000/-. Many fund houses have launched ELSS and these funds have rewarded the investors handsomely. These schemes tend to get open en ded after the initial lock in period of 3 years for the investors. Approved pens ion plans of mutual funds also enjoy tax benefit u/s 80C of the Income Tax Act. Pension funds designed by UTI mutual fund called Retirement benefit plan and that of Templeton Investments called Templeton India Pension Plan are basically balance d funds where the investors tend to save income tax at the time of investment th ese plans are suitable to long term investors who would like to take moderate ri sk as against high risk in ELSS tax saving plans. The lock in period is 3 years but mutual funds have fixed age limits for entry as well for getting pension as these plans are retirement plans in nature. Expenses charged by mutual funds Mut ual fund investors in India tend to assess a funds performance based only on the NAV basis. The first and last question on their minds is what returns has the fun d given? Rarely, if ever, do they ask questions like how much is the fund charging me? What goes into the expenses? Is it possible for the fund house to lower the expenses? The returns to the investor can sometimes change substantially through lower expenses charged by the AMCs especially in debt funds or under-performing equity markets. Mutual funds charge 3 kinds of expenses to the funds: 1. 2. 3. Initial issue expenses Investment management and advisory fees charged by AMC Re curring expenses marketing and selling expenses, audit fees, custodial charges, Trustee fees, etc. Initial issue expenses were allowed to the extent of 6% of funds mobilized and t hese expenses were allowed to be charged to the fund over a period of 5 years. T hese expenses were being charged over a period of time and are typically borne b y investors who stay invested and not by some initial investors who might have r edeemed and exited the fund in a short span of time. This provision had the effe ct of penalizing long term investors and was proving beneficial to short term in vestors. It has been recently amended by SEBI now open ended funds can not charg e issue expenses to the fund separately over a period of time and the initial ex penses will be part of the recurring expenses permitted to be incurred by them a s well as entry load, if any. However close ended funds can charge initial issue expenses as per prescribed maximum limit of 6% and amortize the same over the t erm of the plan and charge the same to the investors exiting the funds as entry load before the end of the term for which the fund will remain close ended. Inve stment management charges Fund management expenses for equity funds PDP Investment Planning 131

Fund management expenses for No Load equity funds The percentage is computed on weekly average net assets managed by the AMC. Tota l expenses that can be charged to the funds are subject to the following ceiling s: Total expenses permitted on equity funds Average weekly Net Assets Valuation of mutual funds Mutual funds are required to declare their NAVs on dail y/weekly basis. The reported NAV is a function of valuation of underlying securi ties and therefore it is relevant to know how a mutual fund should value their s ecurities. SEBI has issued guidelines regarding valuations of assets held. Valua tion of traded securities: The closing price on the stock exchange where it is m ainly traded is taken for valuation purpose. If it is not traded on a given date the value of the previous day is used. Valuation of non-traded securities: Wher e a security is not traded on any stock exchange for 60 days or more prior to va luation date, it is treated as Non Traded security. Such a security will be valued in good faith on the basis of appropriate valuation method, which shall be period ically evaluated by the trustees and reported by Auditors as fair and reasonable . Debt instruments and Government securities are valued on a Yield to maturity b asis with adequate discounts for illiquidity, if any, in respect of a given secu rity. Many Money market instruments are valued at cost plus accrual basis and so me instruments, of medium term, at current yield basis. Taxation of mutual funds Income earned by mutual funds is tax free u/s 10 (23D) of the Income Tax Act. Taxation of investors Equity Oriented funds Equity oriented funds are growth funds, equity funds; deri vative funds, etc. where 65% or more of the total corpus has been invested in eq uities. Previously this limit was 50%. 132 Investment Planning PDP

Dividends distributed by these funds are tax free in the hands of the investor u /s 10 (35) of the Income Tax Act. The mutual fund is also not required to pay an y Dividend Distribution Tax. Taxation on equity oriented funds of different enti ties: STCG indicates Short Term Capital gains made on selling the equity-oriented fund within one year of purchase LTCG Long Term Capital Gains made on selling the eq uity oriented fund after having held it for one year or more from the date of pu rchase. This is applicable to all equity oriented funds including close ended fu nds DDT Dividend Distribution Tax payable by the mutual fund Other than equity o riented funds Where STCG indicates short term capital gain wherein the mutual fund has been so ld within one year of purchase. LTCG* Long Term Capital Gain, where the mutual f und has been sold after a holding period of 1 year or more 10% tax is payable wi thout indexation or 20% with indexation. DDT dividend distribution tax is payabl e on the amount of dividend to be distributed the rate of taxation depends on th e identity of the investor and class of assets held under fund management. Divid ends of Non equity funds are also tax free in the hands of investor but dividend distribution tax is payable by the mutual funds. It may be noted that DDT impac ts the return to the investor indirectly because DDT is paid out of the funds th ereby affecting NAV of the fund. Double Indexation Benefit Double indexation ben efit in respect of debt funds and fixed maturity plans: Investors who are risk a verse prefer debt funds. But these funds also face interest rate risk especially at a time when the PDP Investment Planning 133

interest rates are not stable and showing signs of moving up. Hence investors pr efer to lock in their funds in debt funds which are fixed maturity plans where t he mutual funds invest the corpus in debts that shall mature at a fixed time in future, say 18 months or 24 months or 36 months. The yield on these bonds/govern ment securities are typically Held to Maturity (HTM) yields and hence there is n o risk of capital loss on account of interest rate fluctuations. The investors a re sure of the return that can be expected from these FMPs. Further indexation be nefits are also available on these plans and hence the rate of taxation is also lower. Example: n n n n n n n n n An investor invests in a 15 month FMP in March 2005 maturing in May 2006. If he invests Rs. 10,000/- and if the return expecte d FMP is about 8% p.a. he will get Rs. 11,000/- after 15 months. If the investor is in the 30% tax bracket even when he earns 8% p.a. on fixed income instrument s his tax adjusted yield will be only 5.6%. However in an FMP Rs. 1,000/- earned by him will be treated as Short Term Capital Gain and the tax payable is 20% of the taxable capital gains after applying inflation index. The Inflation index f or FY 2004 -2005 is applicable for purchase; which we shall assume to be 1. Assu ming inflation rate of 5% p.a. the inflation index for FY 2006-2007 will be 1.10 25. In the given example Rs. 10,000/- has given capital appreciation of Rs. 1,00 0/-. The indexed cost of acquisition works out to 10000*1.1025/1 = Rs 11,025/The maturity value is Rs. 11,000/Thus the taxable short term capital gains is 11000 -11025 = -25 resulting in a nominal loss. Hence tax payable on this investment i s NIL. The investor in this FMP has earned 8% virtually tax free because of inde xation benefits. Short term loss on Dividend Stripping Investors used to resort to tax planning t hrough dividend stripping in equity funds. They invested in funds that declared a very high percentage of dividends. They used to purchase these units cum divid end and sell them at ex dividend NAVs almost immediately with very little market risk involvement. Thus, these investors received tax free dividends from mutual funds and suffered notional short term capital loss because ex dividend NAVs used to be substantially lower compared to cum dividend NAVs at which the units were purchased. But now with amendment in the Income Tax act in respect of allowing c apital loss on mutual funds these planning methods have become virtually impossi ble. Short term capital loss will be allowed only if the investor had bought the units at least 3 months before record date for dividend or sold the units at le ast 9 months after the record date for dividend purpose. If transactions of purc hase and sale of mutual funds have been done within the period specified above r esulting in capital loss then the same will be treated as dividend stripping and actual loss, if any, in excess of dividend amount only will be allowed as short term capital loss. Example Mr. Devesh Patel buys 1000 units of a fund for Rs. 1 2.50 cum dividend on 10th March 2006; he receives dividend of Rs. 2.00 per unit on 14th March 2006 and he sells the units on 15th March 2006 at a price of Rs. 1 0.20. What is the short term capital loss incurred by Mr Patel for income tax pu rpose? Mr. Patel has not bought 3 months prior to record date for dividend nor h as he sold 9 months after the record 134 Investment Planning PDP

date for dividend. Hence short term capital loss will be limited to actual loss as per calculations given below; Sale Value Purchase value Loss Dividend receive d Permitted short term capital loss Short term loss on bonus stripping If a pers on acquires units of UTI or any mutual fund, within a period of 3 months prior t o the record date for distribution of bonus units and sells or transfers any of the originally acquired units within a period of nine months after such record d ate, while retaining all or any of the bonus units, then loss, if any, arising f rom such transactions shall be ignored and the amount of such loss shall be deem ed to be the cost of acquisition of the bonus units. Wealth Tax: Ownership of un its of mutual funds is not wealth as per definitions of Wealth Tax Act and hence mutual funds are not chargeable to wealth tax. Service standards of mutual fund s Matters of dispatch of statement of accounts, redemption cheques, etc. are pro mptly attended to by Registrars who are appointed by Mutual funds for providing these services. Forms for fresh investments are collected through the collection centres and designated banks and sent to centralized processing offices of the Registrars. Telephonic access: Almost all mutual funds have provided toll free n umbers or customer help desk telephone numbers in major cities to help the inves tors with their queries relating to their mutual fund investments. Internet acce ss: Mutual funds provide investors with PIN (Personal identification Number) and enable them to watch their investments, online, through the internet. They can contact mutual funds through e mail for various investment related services. Tra nsparency: SEBI has made many mandatory provisions that shall ensure that the in terest of the small investors in mutual fund is protected. Disclosure of daily N AVs in open ended funds; weekly NAVs of close ended funds; Monthly fact sheets; de tailed annual account statements; etc. are some examples of transparency efforts . Redemptions: Liquidity is a very great attraction in mutual funds. An investor in an open ended fund can redeem his holdings partly or fully at any time witho ut giving any notice to the mutual fund and the redemptions in most equity funds take place on T+2 basis while in respect of debt funds it is even better at T+1 basis in most cases. T is the day when redemption request is received before fi xed hours. The additional number of working days for actual payment of redemptio n is just 2 in many cases, which is extremely good from a liquidity point of vie w. In respect of liquid funds; money market funds, etc. the redemptions received before a stipulated time are made in a matter of hours here the time is the ess ence. In general, the service standards set by the mutual fund industry in India are quite high and the investors have little to complain about. Rs. 10200 Rs. 1 2500 Rs. 2300 Rs. 2000 Rs. 300 and not Rs. 2300 PDP Investment Planning 135

Types of Investment plans Automatic Reinvestment Plans (ARP): Mutual funds generally offer Growth Plans an d Dividend Plans in their schemes. Under Dividend Plan an investor may opt for D ividend Pay Out or Dividend Reinvestment. In growth plan no dividend distributio n is made and the NAV keeps on growing. In Dividend plan the fund may choose to declare a dividend after the NAV has appreciated substantially. Under ARP these dividends are automatically invested in units at ex dividend NAVs and here the nu mber of units keeps on increasing. Under Dividend Pay out option the investor ge ts cash payment of dividend. The financial planner would be in the best position to advise the investor on which option to choose. Systematic Investment Plan (S IP): Mutual fund investments, especially equity funds, are essentially long term in nature. In the short term the equity funds may yield negative returns as wel l. Investors who might have made lump sum investments at market peaks may feel l et down by the mutual funds It is also our experience that mutual fund collectio ns in equity funds are the highest around market peaks. The retail investors can not time the market. Further most investors receive their incomes on a monthly b asis and would be more comfortable investing on a monthly basis rather than lump sums at intervals. To meet all these needs mutual funds offer SIPs where the inv estors can invest in select funds on systematic basis (monthly or quarterly) on pre determined dates for a pre determined period say 6 months; 1 year; 5 years a nd so on. Thus SIPs serve the purpose of Rupee Cost Averaging strategy in investmen ts and investors get much better returns without the heart burn of falling marke ts, in the short term. In order to encourage SIPs funds were not charging any loa ds when investors opted for this route but now most funds treat SIPs on par with lump sum investments regarding expenses, etc. Systematic Withdrawal Plans (SWP): Many investors need periodic income; say on a monthly basis on their investment s. These people tend to invest in a lump sum, mainly in income funds or floating rate funds, etc. and opt for SWP. In SWP they specify the amount and the period icity of payments part of the unit holdings are redeemed automatically at prevai ling NAVs and paid to the investor as systematic withdrawal subject to a minimum balance to be maintained by the investor. These are convenient for retired perso ns. Systematic Transfer Plans (STP): These plans are suitable for investors who would like to invest large sums in equity funds but who do not want to time the markets. These investors prefer to park the lump sum amounts in a debt fund/floa ting rate funds and opt for STP where on a periodic basis, a fixed amount is tra nsferred, on a specified date from Debt fund to a chosen equity fund. This serve s the advantage of SIP while the lump sum enjoys market related returns. Mutual funds offer a variety of products to suit almost every conceivable need of the i nvestor. The options are so many in number that they tend to confuse the retail investor. A financial planner has a very important role in helping the investor select the funds, plans, strategies, etc. most suitable to him, from the point o f risk profile, taxation, meeting the investment objectives, achieving financial goals, etc. Performance of mutual funds Measurement Investors are very keen on fund performance and the alert ones keep watching the fund performance very frequently even on a daily basis. Each fund i s evaluated and compared with the performance of the market and other funds in t he market. The performance of a fund manager is generally evaluated on two count s: 1. 2. The ability to out perform the market and deliver superior returns The ability to eliminate unsystematic risk through diversification. 136 Investment Planning PDP

Change in NAV is the most common performance measure used by investors. However the limitation here is that this formula does not take into considerations the d ividends distributed during the period. Hence NAVs of growth plans are considered for the purpose of measuring performance. Sometimes dividend distribution is ad ded to the difference in NAVs to measure the performance. Example Let us assume t hat Mr. Bose had invested Rs. 10,000/- in a new fund offer at a unit price of Rs . 10/- with a load of 2.5%. After one year he finds that the NAV has gone up to Rs 15/-. The total returns earned by Mr. Bose will be calculated as follows: Uni t price paid by Mr. Bose will be Rs. 10+0.25 (entry load) = Rs. 10.25 No of unit s allotted to him in NFO will be Rs. 10,000/10.25 = 975.61 If he sells after one year he will get 975.61*15 = 14634.15 Gains made by Mr Bose = 14634.15 10,000 = 4,634.15 assuming no exit load and no dividend pay out during the one year peri od Even though the NAV has gained 50% in one year the actual returns to Mr. Bose works out to 46.34% due to the entry load. Please remember that when funds anno unce on a periodic basis the returns earned over one year; two years; three year s; since inception etc. it is assumed that units have been bought at Rs. 10/- an d loads have been ignored in this calculation of performance. Risk adjusted perf ormance measurement Many magazines and internet sites rank funds on the basis of performance over a given period of time. These performances are absolute perfor mances and the risks taken by fund managers are not taken into consideration in this evaluation and comparison. Two funds may show same returns but their risk c haracteristics could be dramatically different and these funds may perform very differently when the market goes up or down. A useful comparison can be achieved only when risk adjusted returns are calculated. We have dealt with measuring ri sk adjusted returns in earlier topics. It may be worthwhile to recall some very important performance measures here. Sharpe Index RP - Rf SD Rp Return of the po rtfolio Rf Risk free return SD Standard Deviation of Portfolio (total risk) Trey nor Index RP - Rf Beta PDP Investment Planning 137

Beta is the measure of market risk of the portfolio Jensens index = Rp [Rf Rf)*B] Rp return on the portfolio Rf risk free return Rm Market return turn) B Beta of the portfolio Example Let us try to compare two funds with ollowing information on returns and the risk; given that risk free return is

+ (Rm(Index re the f 8%.

Sharpe Index Fund A = (14-8)/10 = 0.6 Fund B = (18-8)/18 = 10/18 = 0.555 Market = (12-8)/8 = 4/8 = 0.5 Treynor Index Fund A = (14-8)/1 = 6 Fund B = (18-8)/1.5 = 6.66 Market = (12-8)/1 = 4 Jensens index Fund A = 14% - [8%+(12-8)*1] = 2% Fund B = 18% -[8%+ (12-8)*1.5] = 4% Other performance measures Expense ratio: The exp ense ratio is an indicator of the funds cost effectiveness and efficiency. It is the ratio of total expenses to average net assets of the fund. Expense ratio mus t be evaluated from the point of fund size, average account size and portfolio c omposition equity or debt. Funds with small corpus will have a higher expense ra tio compared to a fund with a large corpus. Naturally higher expense ratio will affect fund performance adversely. It is important to note that brokerage and co mmissions on the funds transactions are not included in the expenses figure of th e fund while computing the expense ratio. Income Ratio: Income ratio is defined as funds net investment income divided by net assets for the period. This ratio i s a useful measure for evaluating income oriented funds, particularly debt funds . This ratio is used in conjunction with ratios like total return and expense ra tios. 138 Investment Planning PDP

Benchmarking relative to market Index Funds: An investor expects an index fund t o perform in line with the market and he does not expect the fund to out perform the bench mark index. Any difference between fund returns and the market return s is tracking error. The lower the tracking error, the better the performance of the fund in replicating the underlying market index. Sectoral funds: A sector s pecific fund is expected to perform in line with sector index. For example a Pha rma fund should perform in line with Pharmaceutical Index. It is easier to evalu ate performance because many sector indices are available facilitating easy comp arison. Active Equity Funds: Most equity funds are actively managed. The offer d ocument generally spells out the relevant market index they will be bench markin g their performance to. While disclosing performance on a periodic basis fund ho uses give out the fund performance as well as that of the relevant bench mark in dex and this facilitates easy comparison. It becomes easier for the investor to find out the extent of under performance or out performance of the specific fund in relation to bench mark index. Debt Funds: Generally investors have used inte rest rates on term deposits with banks as bench mark for assessing the returns o n debt funds for a matching maturity. However the debt funds comprise of corpora te debt securities and/or government securities. Ideal bench marking would depen d up on the composition of debt instruments in the debt for example A GSec Fund of GILT fund should be benchmarked to returns on Government Securities rather th an bank fixed deposits. Money Market Funds: These funds have invested in short t erm instruments. Hence, performance of money market funds is usually bench marke d against the treasury bill of matching period. Benchmarking relative to other s imilar mutual funds While choosing investors have preferred to invest funds that have performed better in relation to other funds in the same category. There is a tendency to rank funds on the basis of their past performance over a given pe riod of time; say 1 year; 2 years ; 3 years or 5 years and invest in top perform ing funds in that category. It is important to keep track of the nature of under lying investments; investment objectives of the funds and risk profile also whil e comparing different funds. Choosing the right mutual fund There are a large nu mber of mutual funds. Their number is increasing day by day. The financial plann er should have clear idea of relative merits of various funds in terms of risk, returns, track record of performance, etc. He should have a good idea of the inv estment objectives of his client taking into consideration factors like time hor izon, risk appetite, return expectations, etc Then he should arrive at an optima l mix of asset classes that would best meet the investment objectives. Based on these factors and his evaluation of performance of funds he should suggest a por tfolio of funds that will add value, over time, through strategic asset allocati on. The real skill of a financial planner is in first arriving at a good mix of investment options and then selecting the best funds that would deliver the desi red results. Latest changes in mutual fund industry Only close-ended schemes wil l be allowed to charge initial issue expenses from investors. Even here, when a close-ended scheme is amortizing such expenses over a period, if an investor som ehow exits PDP Investment Planning 139

the scheme before such amortization is complete, the remaining part of the expen ses attributable to him must be recovered from him; which is done through gradua lly reducing exit loads. This is a positive move and will prevent the likelihood of shifting the burden of expenses from one investor to another. Till now, open -ended schemes were also allowed to amortize the expenses and if a significant p art of the investors of an NFO redeemed their units, this had the potential to i ncrease the burden of the initial issue expenses upon the remaining investors tr emendously. But with the new regulation, that will no longer be the case and the expenses will be rightfully borne by the person who is supposed to pay them. In another amendment, SEBI has standardized the process of declaring and distribut ing dividends. Among other guidelines related to the communication of dividend d istribution, SEBI has stated that the notice of dividend should be issued by the AMC within one day of the decision by the trustees to distribute the dividend. Further, the record date for such dividend should be 5 days from the issuance of the notice. Before the issuance of notice, no communication indicating the prob able date of the dividend declaration should be made. It has been observed over years that New fund offers manage to collect substantial subscription during the NFO period while existing funds with very good track record do not manage to co llect additional investments at the same rate, Hence fund houses have developed tendencies to come out with NFOs to boost the Assets Under Management (AUM). SEBI has stipulated that a mutual fund may come out with NFOs only if the new fund ha s something new to offer to the investors and the investment objectives are uniq ue and different from the funds already managed by the fund house. SEBI has plac ed the responsibilities on Trustees of mutual fund that they should declare that the NFO is new in terms of its investment objective and does not in any way rep licate the existing funds of the mutual fund. Mutual fund industry has recorded tremendous growth over the last few years. It is expected to maintain the growth rate in future. A look at the following figures will prove the popularity of mu tual funds in India. Investors seem to prefer mutual funds compared to other investment vehicles that is obvious from the fact that total assets under management of mutual funds hav years. Investors are willing to tak e gone up by a whopping 225% over a period 3 e more risk for the sake of higher returns as evidenced from the fact that equit y funds account for 31% of total AUM of mutual funds as on 31st July 2006 compar ed to just 11.21% in April 2003. 140 Investment Planning PDP

Review Questions: 1. How many units will be allotted to Mr. Chaturvedi if he inv ests Rs. 1 lakh in a New Fund offer of an equity fund, which charges entry load of 2.25%? a. 10,000 units b. 9779.951 units c. 9756.098 units d. 9779 units 2. T he risk measure used for calculating Treynor Index is: a. Alpha b. Variance c. B eta d. Standard Deviation 3. Which of the following is a self regulatory organiz ation in mutual fund industry? a. SEBI b. AMFI c. RBI d. Company Law Board 4. Wh ich one among following funds can be considered riskier than the others? a. Debt Funds b. Index Fund c. Diversified equity fund d. Sector specific equity fund 5 . Which one of the following statements is not true about mutual funds? a. Mutua l fund can lend securities b. Mutual fund can trade in derivatives c. Mutual fun d can invest in foreign equities d. Mutual fund can lend money to unit holders 6 . While seeking SEBI approval for new funds which of the following is required t o give a declaration that the new fund is unique in its investment objectives? a . Directors of Asset Management Company b. Directors of Sponsor Company c. Regis trars d. Trustees 7. Initial issue expenses, not exceeding 6% of funds collected , can be amortized in the subsequent years, in the following cases only: a. Clos e ended funds b. Open ended equity funds c. Open ended debt funds d. Exchange Tr aded Funds. PDP Investment Planning 141

8. In respect of index funds the difference between fund performance and the market performance is called: a. Under performance of the fund b. Out performance of t he fund c. Tracking error d. Superior returns over market returns 9. Which of the following is the best measure of a fund performance? a. NAV related performance over the period b. Risk adjusted performance c. Absolute returns in comparison with bank deposits d. Absolute returns in comparison with risk free returns 10. In respect of a No load fund which one of the statements is not true? a. Asset man agement, custodial, registrar and administrative and selling expenses are not ch arged to the fund b. Asset management and other recurring expenses are charged t o the fund c. No load funds are permitted to charge higher fund management expense s compared to Load funds d. No load refers to the entry load at the time of NFO th e units are allotted at par to the NFO unit holders Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. b c b d d d a c b a 142 Investment Planning PDP

Chapter 11 PDP Investment Planning 143

Stock market investments O ne of the most important asset classes is equity shares. In a clients portfolio t he equity investments direct and indirect form an essential component. We have d iscussed indirect equity investments through the mutual fund route. We shall now deal with direct investments in shares. An investor has the choice between prim ary and secondary markets to invest in stocks. Primary market Certain eligible companies may tap the capital market for their capital requirem ents. Eligibility criteria have been laid down by SEBI the capital market regula tor, and discussed in this chapter elsewhere. The eligible companies who need fu nds approach SEBI registered Merchant Bankers for tapping the capital market. Th e merchant bankers advise the company on matters of regulation, compliance with statues, marketing, pricing, timing and other issues which are of vital importan ce. Where the issue size is large companies prefer to appoint more than one merc hant banker for this purpose with specific functions. As per the advice of the m erchant banker a company may choose to issue shares with fixed price or a price band where the price will be discovered in a book building process. The company may be entering the capital market for the first time where upon its shares are to be listed on the stock exchanges such an issue is called Initial Public Offer ing (IPO). An existing listed company may come out with a subsequent issue to ra ise capital and such an issue is called Follow on Public Offering (FPO) Fixed pri ce issues: These are issues where a company enters the capital market and invite s subscription from the public to its issue of equity capital at a fixed price a t par or at a premium. Fixed price issues was the norm until some years ago, esp ecially before the book building concept was introduced in India but now we find more and more companies adopting the book building route to raise capital. Book building issues: Here the companies announce a price band for the issue and the investors can exercise their options in the application and bid for the same at whatever price they are prepared to pay for the issue but within the price band . The price band essentially consist of two prices the floor price and the cap p rice. The difference between the two cannot be more than 20%. In case of an FPO the listed company can announce the price band just a day before the issue opens for subscription while in the case of IPOs the price bands are mentioned in the application form itself. The bid lots are also decided by the issuer. Essentiall y a person applying for a book building offer of shares shall bid in multiples o f prescribed lot sizes and within the price band. The bidder can make three bids in the prescribed application form and can also revise or withdraw his bid befo re the close of the offer. Here the investor has the freedom to decide the price at which he shall be interested, of course within a band. Individuals in single or joint names, HUFs, Body Corporate, Banks and Financial Institutions, Mutual f unds, Non Resident Indians, Insurance Companies, Venture capital funds and other s can apply for the issues. In order to present a level playing field for the sm all investors SEBI has stipulated that a certain minimum percentage of the issue d shares should be reserved for allotment to Retail Individual Investors in case o f over subscription of the issue. The reservation for retail individual investor s is 35% of the net public offer and in the event of the issue getting oversubsc ribed it should be ensured that at least 35% of the shares are allotted to retai l individual investors. Retail individual investor means an 144 Investment Planning PDP

investor who applies or bids for securities of or for a value of not more than R s.1,00,000 The allocation for non institutional investors, who are not retail in vestors, the reservation is 15% and the reservation for qualified institutional bidders (QIB) the reservation is 50%. Subscription list for public issues shall be kept open for at least 3 working days and not more than 10 working days. In c ase of Book built issues, the minimum and maximum period for which bidding will be open is 37 working days extendable by 3 days in case of a revision in the pric e band. The public issue made by an infrastructure company may be kept open for a maximum period of 21 working days. Rights issues shall be kept open for at lea st 30 days and not more than 60 days rights issues are issues of companies to rais e further capital but only existing share holders of the company are entitled to apply for the same; the rights can be renounced by an existing share holder, in which case the renouncee gets the right to apply for the shares. The retail inv estor can tender his bids at the specified centres where his bids will be accept ed and registered in the book. Many broking houses have provided facilities for applying to an IPO/FPO through the internet; applications can be made online als o. One of the important advantages is, book building is a transparent process an d while the book is open it is easy for the potential investor to know the detai ls of bids already received; the prices at which the bids have been made; extent of subscription in relation to the issue size (over subscription or under subsc ription levels) etc. Many times the extent of subscription already received and the quantum of institutional participation influence investor decisions. After t he book is closed the price of the issue is discovered. If the issue is over sub scribed, at the cap price, then it is up to the company (in consultation with th e Book Running Lead Manager) to decide the price at which shares would be allott ed. Many times it is done at the cap price but some times it is even done at pri ces lower than the cap price. The shares can be allotted at discounts in relatio n to the discovered price for the retail individual investors some public sector companies which came out with issues offered shares to retail individual invest ors at discount to the discovered price. Even if a person has bid at prices high er than discovered price the person will be allotted at discovered price only an d not at the highest bid price. In case of fixed price issues, the investor is i ntimated about the allotment/refund within 30 days of the closure of the issue. In case of book built issues, the basis of allotment is finalized by the Book Ru nning lead Managers within 2 weeks from the date of closure of the issue. The re gistrar then ensures that the demat credit or refund as applicable is completed within 15 days of the closure of the issue. The listing on the stock exchanges i s done within 7 days from the finalization of the issue. Banks offer to lend to the investor in select IPOs in which case the investor pays only the margin money , of about 40%, while the bank pays the balance and puts in the application thus leveraging is possible while applying to IPO/ FPOs with attendant risks and cost s. Some investors traditionally have preferred to invest in stocks through the I PO/FPO route only. These investors believe that this process is less risky. It i s a well established fact that IPOs are more risky because the availability of in formation to the investing public compared to existing listed companies is much lower in IPOs. Decisions based purely on information provided in the offer docume nt (the prospectus) can prove to be tricky when the pricing is free. It is less risky to invest in an existing listed company because price history and performa nce history can be studied, in detail, whereas that does not happen to be the ca se in IPOs. It is also true that issuers price the issue in such a way that they l eave something on the table for the IPO investors. But it is not the case all the time. Hence investors should study the offer documents carefully; understand th e pricing and the future potential of the company very well before deciding to a pply in a public issue of shares. PDP Investment Planning 145

Secondary market Client registration An investor can invest in shares through the secondary marke t. He can invest in a stock which is already listed in one of the stock exchange s. In India there are 23 stock exchanges but only two of them are most important viz. National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE). Invest ors who would like to buy or sell shares directly from the market will have to r egister themselves as clients with brokers or sub brokers. Brokers are members o f stock exchanges while sub brokers work under a specific broker both should be SEBI registered Stock market intermediaries. It is mandatory for the market part icipant to get the full details of the client in a format prescribed by SEBI cal led KYC Know Your Client. Personal information of the client is obtained in this specified format and proof of the supplied information like residence proof, pe rsonal identity proof, Income Tax PAN details, demat account and bank account de tails, etc. are taken along with duly filled KYC form. Then the client and broke r enter into an agreement in the format prescribed by SEBI for this purpose. The reafter the client is registered with the market participant and allotted a uniq ue client ID. Now the client can trade on the stock exchange through the broker/ sub broker. Trading There are basically two trading mechanisms adopted by stock exchanges the world over to provide liquidity to investors. The two mechanisms a re: n n Quote Driven Mechanism of Trading & Order Driven Mechanism of Trading Quote Driven Mechanism is adopted by less liquid and emerging stock exchanges wh ere trading requires some stock brokers to provide two-way quotes. These liquidi ty providers, who trade on their own account, are called market makers or specia lists or jobbers (in India). This is a less efficient mechanism because the pric e spread between bid and offer tends to be high thanks to lower liquidity and le ss competition. This mechanism is generally adopted in stock exchanges where tra ding is done on the floor of the exchange on a face to face basis. In India this was the mechanism adopted by BSE for more than a century before moving over to the more efficient Order Driven Mechanism of trading in line with newer National Stock Exchange. In India, now on both NSE and BSE we follow the Order Driven Me chanism of trading where the trader places his order through his brokers trading terminal. The trader is also allowed to trade on the internet and he can place h is orders on a particular stock exchange through the internet by special trading facilities provided by the stock broker. The order placed by the registered cli ent is accepted first by the broker - the acceptance is subject to the order mee ting certain requirements in terms of trading limits set for the client (based o n the margin lying with the broker), etc. Then the order goes into the trading s ystem of the stock exchange and gets stacked on a time price priority basis. It is mandatory that the order entered in the system is clearly identifiable to the specific client through the usage of unique client ID. The order will get execu ted if the price condition, if any, specified by the trader, is met. Types of orders Market order the trader decides to buy or sell a particular scrip at the current market price; he can place a market price order; such orders get executed insta ntly at prices close to the last traded price but it is difficult to estimate th e price at which the order will be executed, as the price keeps changing very fa st with time. 146 Investment Planning PDP

Limit Order The trader would place a buy order at a price lower than the last tr aded price or a sale order at a price higher than the last traded price for a pa rticular stock. Stop Loss Order This type of order enables the trader to limit h is loss or protect his profits. This order enters the system on a trade being ex ecuted at a particular price, called trigger price. The trigger price should be higher than current market price for buying orders and lower than market price f or selling orders. Technical traders and day traders use Stop Loss Order facilit y more frequently. Disclosed Quantity There is a facility in the trading system that while placing an order for sale or purchase the quantity disclosed in the t rading system could be lower than the actual size of the order the maximum possi ble reduction in this type of stipulation is 90% - In other words, if somebody w ants to buy 1000 shares of a scrip he can use DQ facility and specify that quant ity that should be shown in the system but the specified quantity in this case s hould be 100 shares or more - which is 10% or more of the actual order size. All the orders placed in the system are day orders valid for the day and all pendin g orders get automatically cancelled at the end of the day. An order once placed in the system can be modified or cancelled any time before execution. Modificat ion in factors like quantity, price, etc. are permitted but client code modifica tions are not allowed an order with a wrong client code will have to be cancelle d. Risk management Brokers are required to have Base Minimum Capital (BMC) with the respective stock exchanges. Brokers also bring in additional capital over an d above the BMC in the form of cash, bank fixed deposits and/or securities. The brokers are set intra day trading limits, called Gross Exposure (GE) based on th e total margin money lying with the stock exchanges. The extent of trading a bro ker can do is a function of his capital thus restricting over trading and over e xposures as the first containment measure. Similarly, the net exposure of any br oker, at any point in time is also limited to a certain times his capital. The b rokers also take margin money from active clients along the same principles of r estricting exposures beyond certain times the margin thus controlling the specul ation and reducing the risk. SEBI has laid down mandatory rules for brokers to c ollect margins from clients who trade in volumes beyond some minimum limits curr ently collection of client margins is compulsory if a client at any point in tim e has net outstanding positions in excess of Rs 5 lacs (unless the same is to re sult in delivery) and the margin should be at least 10% of net outstanding posit ion. Stock exchanges also collect VaR and M2M margins on the outstanding positio ns VaR value at risk and M2M mark to market margins. The extent of margins may v ary and generally tends to increase as the market gets more and more volatile. P ay in and pay out, settlements, etc. Both NSE and BSE follow rolling settlement system as against fixed period settlements which were followed earlier. Each days obligations are settled independently and not clubbed with any other days positi ons to arrive at settlements net obligations for each broker. It is a matter of c ompliance of SEBI regulation that a broker issues confirmation of days trades to a client in a specified format. This contract note should carry the trade detail s like Order Number, Trade Number, Trade Time, Scrip Name, whether bought or sol d, the quantity, Market rate, brokerage, net rate along with all details of the client, his code number, address, PAN number, settlements details, etc. It is al so mandatory that the broker should issue contract note to the client within 24 hours of the end of day of trade and should obtain clients confirmation on the du plicate copy. Brokers may send contracts by post or through courier but should m aintain proof that the same were dispatched within the stipulated PDP Investment Planning 147

time. Electronic mailing of contracts shall also serve the purpose but the same also should be done within the time limit of 24 hours. Brokers collect the payme nts from clients who might have bought shares (pay in obligations) and credit th e same in Brokers account exclusive marked for client transactions. Brokers use t he funds in the clients accounts to meet Pay in obligations to the stock exchang e through another account called Clearing Account. The funds pay in is done befo re specified hours on T+2 basis that is within two working days, before stipulat ed hours, after trading day (T). Similarly securities pay in for shares sold by clients is also required to be made before a specified time on T+2 basis through the pool account of the broker maintained for meeting clearing obligations. Thu s funds pay in and securities pay in take place on T+2 basis but in the early pa rt of the day. Pay out of funds and securities are made on T+2 basis and the fun ds and securities are credited to brokers accounts at the later half of 2nd worki ng day after the trade day. It may be worthwhile to know that a broker is requir ed to make payments to a client who might have sold shares within 48 hours of pa y out day in other words the trade takes place on trade day (T), broker receives payments/deliveries 2 days later (T+2) and client should receive payments/deliv eries within 48 hours of T+2. It is important for a stock market investor to kno w his duties to the brokers like placing order specifically, keeping cash margin s with brokers while trading beyond certain limits, making payments/delivering s ecurities with in the prescribed time limit and also his rights to receive contr acts, payments/securities within the SEBI stipulated time frame. We may add here that each stock exchange has provided means by which a client can verify the tr ade on the same day from the web site of the stock exchange concerned. www.bsein dia.com and www.nseindia.com. A broker can not charge brokerage in excess of 2.5 % of the market price of stock bought or sold. A broker may charge all other cha rges over and above the brokerage. These charges include Service Tax on brokerag e which is currently 12.36% (including education cess of 3%), Regulatory charges , Stamp duty & Securities Transaction Tax. STT is currently 0.125% of turn over on delivery based trades; 0.025% of turn over of all non delivery trades in the cash segment and 0.017% of turn over of all non delivery trades in the derivativ es segment. Corporate benefits Companies declare book closure or record dates fo r determining eligibility for corporate benefits like dividend, bonus, rights en titlements, stock splits, etc. On the stock exchanges the stocks remain cum divi dend, cum bonus or cum rights up to a certain date and all investors who buy the particular stock on or before this specific date will be entitled to that corpo rate benefit. The next day onwards the stock starts quoting ex dividend, ex bonu s or ex rights meaning investors who buy after these dates will not get the resp ective corporate benefit; alternatively if a share holder of the company sells t he stock cum benefit he wont be entitled to it but if sells ex benefit he shall g et the benefit. The stock for some time on the exchanges may trade on no delivery basis all trades entered during the no delivery period are clubbed and settled, on a particular day, after the end of no delivery period. In other words, the pa y in and pay out of funds and securities in respect of this particular stock whi ch is trading on a no delivery basis is delayed to the extent of no delivery per iod and settled together, at a later date. Types of securities Equity shares the most common form of securities ; (the conventional stock or co mmon stock or 148 Investment Planning PDP

ordinary share) is the equity share issued by a company and the investors in equ ity shares are owners of the company to the extent of their share holding. These share holders are entitled to dividend and other benefits declared by the compa ny and are also entitled to vote. Companies may issue shares without voting righ ts also. Normally the shares traded are fully paid up but in certain cases partl y paid shares are also listed and traded on the stock exchanges. Convertible deb entures: A company may choose to issue debentures which could be converted partl y or fully into equity shares at a later date. These securities are also listed and traded on the stock exchanges. Warrants are essentially issued to share hold ers and the holder of the warrant will be able to exercise his right to purchase shares of the company at a future date. Till the prescribed date for exercising the rights to additional shares these warrants are also traded on the stock exc hanges. Preference shares can also be issued by a company. This is a not a popul ar instrument with the stock market investors because this is essentially a fixe d income instrument with no scope for capital appreciation. Bonus Shares: Compan ies reward the share holder by issuing bonus shares. Bonus shares are free share s distributed by the company to its share holders, as on a given date, in a prop ortion which is decided by the board and approved by the share holders and subje ct to certain limits, as prescribed by SEBI in this regard. A 1:1 bonus implies that a share holder having 100 shares will get another 100 shares free of cost ; similarly a 2:3 bonus implies that a share holder having 3 shares will get 2 bo nus shares. As a point of valuation a bonus per se does not add value to share h olders because the price of the stock adjusts for the bonus shares after the sam e are issued. However, a bonus declaration is a signal, to the market, from the company management that they are very confident about their future performance a nd that they will be able to service the expanded capital. In the market place i t is common to find that companies that reward the share holders with frequent b onuses get better valuations compared to similar but conservative companies. Rig hts Shares Issue of additional shares to existing share holders to raise capital is called Rights Issue. The difference is that compared to bonus shares which a re issued free here the share holder has to pay a price for getting additional s hares the price could be market related and may be at a discount to the market p rice of the stock. If the company issues rights shares to raise money for expans ion/modernization/new acquisitions, etc then that is considered quite positive. It may be worth while to understand how the market price gets adjusted for right s issues when trading on cum right and ex right basis. Example Lets assume the cu m rights price to be Rs. 200 Rights in the ratio of 1:2 at a price of Rs. 110 Th e ex rights price will be calculated as under: 1:2 means one share will be offer ed on two shares already held Two shares cum rights will cost 2*200 = 400 ; no o f cum right shares 2 One rights share will cost = 110 ; no of right shares 1 Tot al cost =510; no of ex right shares 3 The price per share ex rights = 510/3 = 17 0/Thus the stock will start quoting at an ex right price of Rs 170 if it closed at cum right price of Rs. 200/on the above terms. PDP Investment Planning 149

Stock splits: Normally the nominal value or the face value of a share is Rs. 10/ - but a company may choose to have the face value as Rs. 5 or Rs. 4 or Rs. 2 or even Re 1. Companies with low floating stock and/or companies whose shares are h ighly priced and not traded in huge volumes on the stock exchange may consider r educing the face value and increasing the number of shares. The stock splits doe s not necessarily result in value addition to the investor but all the same it i mproves the liquidity and invariably leads to better prices on the market place. If a share holder is holding 100 shares of a company FV Rs 10/- and the company announces a stock split of 5:1; then the number of stocks held by the investor will rise 5 fold to 500 while the face value will come down to Rs. 2/- and the m arket price will come down ex split to one fifth of cum split price. This is con sidered an investor friendly move and such companies command better valuations o n the market. Valuation of shares It is very important to understand how the sha res are valued on the stock exchanges. Investors would like to buy under-valued st ocks and sell over-valued stocks held by them. It is easier said than done. To lab el a stock at a price as under-valued or over-valued requires an understanding o f valuation of shares. Many methods are followed for valuing shares. Let us look at a few of them. Dividend discount model One of the widely followed valuation models is the dividend discount model. According to this model the present value of the share will be equal to the present value of the dividend and the expecte d sale price of the stock. Let us begin with the case where the investor expects to hold the equity share for one year. The price of the equity share will be; Where, P0 = current price of the equity share D1 = dividend expected a year henc e P1 = price of the share expected a year hence r = rate of the return required on the equity share the underlying assumptions are the dividend of D1 will be pa id at the end of the year and the share can be sold after one year at a price P1 Example If an investor expects to receive a dividend of 2.50 per share and year end price to be Rs. 150 and needs a return of 15% p.a. on his share investment at what price should he buy this share? here D1 = 2.5; P1 is 150 and r = 0.15 then P0 = [2.5(1+0.15)]+ [150(1+0.15)] = ( 1.5/1.15) + (150/1.15) = 2.173 +130.43 = 132.60 150 Investment Planning PDP

We have considered for a single period of one year; we can extend the same to mu lti periods where the present value of each years dividend will be discounted at the required rate of return and so will be the sale price at the end of the peri od. Stock prices and dividends have a tendency to grow over a period of time; we can factor in these growth rates in our calculation of share value: If the curr ent price, P0, becomes P0 (1+g) a year hence, for g the rate of growth, we get: Simplifying the above equation we get: The steps in simplification are: Example The dividend paid out by a company has been growing at the rate of 10% p .a. over the last few years. The next years dividend is expected to be Rs. 2/- pe r share. The expected return is 16%. At what price should we buy the stock? We may add here that D1 is the expected dividend for the next year; given the cu rrent years dividend one can work out the next years expected dividend by applying the rate of growth of dividends as follows: D1 = D0*(1+g) Example If a company has been currently paying dividend at the rate of Rs. 2/- per share and if the g rowth rate is PDP Investment Planning 151

10% and expected return is 15% what should be present price of the share? D1 = D 0*g = 2*(1.10) = 2.20 However, this constant growth model is rarely used in the market place for valui ng the stocks mainly because it is very difficult to estimate the growth rate an d that too in perpetuity. Earnings Multiplier Approach Another and more popular approach to stock valuation is the earnings multiplier approach. Price to earnin gs ratio is calculated as follows: P/E ratio = Market Price /EPS Where EPS is = Profit After Tax/No. of shares Market Price/PE ratio is the P/E multiple for the stock. P0 = E1 * (P0/E1) Where P0 is the estimated price E1 is the estimated EP S & P0/E1 is the reasonable P/E ratio The P/E ratio can be worked out as follows on the basis of dividend discounting model: where b is the plough back ratio or the proportion of retained profits out of to tal profits, r the required rate of return and g the growth rate, (1-b) is the d ividend pay out ratio. Thus the P/E multiple of a stock price is directly propor tional to the dividends distributed by the company. Another factor that influenc es the P/E ratio is the interest rate. The required rate of return on securities including stock as the interest rates rise. When the interest rate rises securi ty prices will fall. The relation between interest rates and P/E ratios is inver se. Riskier stocks have lower P/E multiples. Riskier a stock the higher the retu rns expectations and hence lower the P/E ratio. This is typically true in the ma rket place of mid cap and small cap stocks; these are high risk stocks and tend to trade at lower P/E multiples compared to large cap stocks because the return expectations from mid cap and small cap stocks are higher. P/E multiplier is a v ery common tool used for value purposes and we can summarise how the price proje ctions are done for stock valuations, as follows: 1. Estimate the EPS for the cu rrent financial year based on companys past track record, statements regarding fu ture out look, orders on hand, market price trends for the product, reported pro fits for the completed quarters, etc. This is a very highly skilled job and many researchers keep on estimating and revising, on a periodic basis because of the numerous elements involved. 152 Investment Planning PDP

2. 3. 4. 5. Find out the growth rate of earnings based on track record and other factors lis ted above Find out the average P/E ratio of other comparable companies in the in dustry Find out the historic P/E ratio at which this stock has been quoting Arri ve at a reasonable multiple for this stock based on the industry average and thi s stocks own P/E in the past; one of the thumb rules for a reasonable P/E ratio i s the growth rate of EPS, worked out in step 2 above if the EPS grows at 20% p.a . a P/E ratio of 20 is reasonable Multiply the P/E multiple arrived in step 5 by earnings estimated in step 1 to arrive at the projected price for the stock at the end of the year. n An investor can reach his decision on buying/holding/sell ing the stock based on the following factors: n Current market price n Required return 6. n Estimated market price at the year end, as worked out above If the estimated m arket price is greater than or equal to (Current market price*required return) t hen it is worth buying the stock ; but if it is estimated to be less then buying can be avoided. The valuations are much more complex than as listed above becau se the crucial factors of earnings projections and the multiples are influenced by various events some of which could be emotional rather than rational. Other Valuation Techniques Investors use other valuation techniques, based on fundamental analysis concepts . Three that are fairly often referred to are price to book value, price/sales r atio and economic value added. Price to book value is calculated as the ratio of price to stockholders equity as measured on the balance sheet. It is sometimes u sed to value companies, particularly financial companies. Banks have often been evaluated using this ratio because the assets of banks have book values and mark et values that are similar. If the value of this ratio is 1.0, the market price is equal to the accounting (book) value. It is also used in merger and acquisiti on analysis. The price/sales ratio is a valuation technique that has received in creased attention recently. This ratio is calculated as a companys total market v alue (price times number of shares) divided by it sales, In effect, it indicates what the market is willing to pay for a firms revenues. The newest technique for evaluating stocks is to calculate the economic value added, or EVA. In effect, EVA is the difference between operating profits and a companys true cost of capit al for both debt and equity and reflects an emphasis on return on capital. If th is difference is positive, the company has added value. Some studies have shown that stock price is more responsive to changes to EVA than to changes in earning s, the traditional variable of importance; some mutual funds are now using EVA a nalysis as the primary tool for selecting stocks for the fund to hold. One recom mendation for investors interested in this approach is to search for companies w ith a return of capital in excess of twenty percent because this will in all lik elihood exceed the cost of capital, and, therefore, the company is adding value. Fundamental Analysis Fundamental analysis is based on the premise that any secu rity (and the market as a whole) has an intrinsic value, or the true value as es timated by an investor. This value is a function of the firms underlying variable s, which combine to produce an expected return and an accompanying risk. By asse ssing these fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined. PDP Investment Planning 153

This estimated intrinsic value can then be compared to the current market price of the security. Similar to the decision rules used for bonds, decision rules ar e employed for common stocks when fundamental analysis is used to calculate intr insic value. In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates made by investors. An investor whose i ntrinsic value estimate differs from the market price is, in effect, differing w ith the market consensus as to the estimate of either expected return or risk, o r both. Investors who can perform good fundamental analysis and spot discrepanci es should be able to profit by acting, before the market consensus reflects the correct information. Fundamental analysis is based on the premise that any secur ity (and the market as a whole) has an intrinsic value, or the true value as est imated by an investor. This value is a function of the firms underlying variables , which combine to produce an expected return and an accompanying risk. By asses sing these fundamental determinants of the value of a security, an estimate of i ts intrinsic value can be determined. This estimated intrinsic value can then be compared to the current market price of the security. Similar to the decision r ules used for bonds, decision rules are employed for common stocks when fundamen tal analysis is used to calculate intrinsic value. In equilibrium, the current m arket price of a security reflects the average of the intrinsic value estimates made by investors. An investor whose intrinsic value estimate differs from the m arket price is, in effect, differing with the market consensus as to the estimat e of either expected return or risk, or both. Investors who can perform good fun damental analysis and spot discrepancies should be able to profit by acting, bef ore the market consensus reflects the correct information. Under either of the t wo fundamental approaches, an investor will have to work with individual company data. Does this mean that the investor should plunge into a study of company da ta first and then consider other factors such as the industry within which a par ticular company operates or the state of the economy, or should the reverse proc edure be followed? In fact, each of these approaches is used by investors and se curity analysts when doing fundamental analysis. These approaches are referred t o as the topdown approach and the bottom-up approach. With the bottom-up approach, in estors focus directly on a companys basics, or fundamentals. Analysis of such inf ormation as the companys products, its competitive position, and its financial st atus leads to an estimate of the companys earnings potential, and, ultimately, it s value in the market. Considerable time and effort are required to produce the type of detailed financial analysis needed to understand even relatively small c ompanies. The emphasis in this approach is on finding companies with good long-t erm growth prospects, and making accurate earnings estimates. To organize this e ffort, bottom-up fundamental research is often broken into two categories, growt h investing and value investing. Growth stocks carry investor expectations of ab ove-average future growth in earnings and aboveaverage valuations as a result of high price/ earnings ratios. Investors expect these stocks to perform well in t he future, and they are willing to pay high multiples for this expected growth. Value stocks, on the other hand, feature cheap assets and strong balance sheets. Value investing can be traced back to the value-investing principles laid out b y the well-known Benjamin Graham, who wrote a famous book on security analysis t hat has been the foundation for many subsequent security analysts. Growth stocks and value stocks tend to be in vogue over different periods, and the advocates of each camp prosper and suffer accordingly. In many cases bottom-up investing d oes not attempt to make a clear distinction between growth and value. Many compa nies feature strong earnings prospects and a strong financial base or asset valu e, 154 Investment Planning PDP

and therefore have characteristics associated with both categories. The top-down approach is the opposite to the bottom-up approach. Investors begin with the ec onomy and the overall market, considering such important factors as interest rat es and inflation. They next consider likely industry prospects, or sectors of th e economy that are likely to do particularly well (or particularly poorly). Fina lly, having decided that macro factors are favourable to investing, and having d etermined which parts of the overall economy are likely to perform well, individ ual companies are analyzed. There is no right answer to which of these two approac hes to follow. However, fundamental analysis can be overwhelming in its detail, and an investor should decide which approach seems more reasonable and try to de velop a consistent method of action. Technical analysis Technical analysis can b e defined as the use of specific market-generated data for the analysis of both aggregate stock prices (market indices or industry averages) and individual stoc ks. The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of inv estors toward a variety of economic, monetary, political and psychological force s. The art of technical analysis - for it is an art - is to identify trend chang es at an early stage and to maintain an investment posture until the weight of t he evidence indicates that the trend is reversed. Technical analysis is sometime s called market or internal analysis, because it utilizes the record of the mark et itself to attempt to assess the demand for, and supply of, shares of a stock or the entire market. Thus, technical analysts believe that the market itself is its own best source of data. Technicians believe that the process by which pric es adjust to new information is one of a gradual adjustment toward a new (equili brium) price. As the stock adjusts from its old equilibrium level to its new lev el, the price tends to move in a trend. The central concern is not why the chang e is taking place, but rather the very fact that it is taking place at all. Tech nical analysts believe that stock prices show identifiable trends that can be ex ploited by investors. They seek to identify changes in the direction of a stock and take a position in the stock to take advantage of the trend. The following p oints summarize technical analysis: Technical analysis is based on published mar ket data and focuses on internal factors by analyzing movements in the aggregate market, industry average, or stock. In contrast, fundamental analysis focuses o n economic and political factors, which are external to the market itself. The f ocus of technical analysis is identifying changes in the direction of stock pric es which tend to move in trends as the stock price adjusts to a new equilibrium level. These trends can be analyzed, and changes in trends detected, by studying the action of price movements and trading volume across time. The emphasis is o n likely price changes. Technicians attempt to assess the overall situation conc erning stocks by analyzing breadth indicators, market sentiment, and momentum. T echnical analysis includes the use of graphs (charts) and technical trading rule s and indicators. Price and volume are the primary tools of the pure technical a nalyst, and the chart is the most important mechanism for displaying this inform ation. Technicians believe that the forces of supply and demand result in partic ular patterns of price behavior, the most important of which is the trend or ove rall direction in price. Using a chart, the technician hopes to identify trends and patterns in stock prices that provide trading signals. PDP Investment Planning 155

Volume data are used to gauge the general condition in the market and to help as sess its trend. The evidence seems to suggest that rising (falling,) stock price s are usually associated with rising, (falling) volume. If stock prices rose but volume activity did not keep pace, technicians would be skeptical about the upw ard trend. An upward surge on contracting volume would be particularly suspect. A downside movement from some pattern or holding point, accompanied by heavy vol ume, would be taken as a bearish sign. Taxation Income derived from equity shares comprises dividends and capital appreciation. Dividends of Indian companies are tax free in the hands of share holders. The co mpanies declaring dividends are required to pay Dividend Distribution Tax at rat es prescribed from time to time; currently 12.5% + Surcharge of 5%. DDT is an in direct tax on the dividend income of the share holders. Capital gains on shares can be classified as Short Term Capital Gains and Long Term Capital Gains. In re spect of securities listed and traded on the stock exchanges the holding period is 12 months for determining whether the security is a long term capital asset o r otherwise. Day trading: A trader may buy and sell the shares on the same day w ithout receiving or giving delivery of shares. These transactions are considered speculative in nature. The income earned is taxed at the rate applicable say 30 % if the annual income is in excess of Rs. 2,50,000/STCG: If a stock has been so ld within 12 months of purchase the difference between selling and buying prices will be short term capital gain. STCG is taxed at the rate of 10% & @ 15% w.e.f . from financial year 2008-09 in respect of securities which are traded on the e xchanges and where Securities Transaction Tax has been levied on the transaction s. LTCG : Long term capital gains are tax exempt u/s 10(38), where the asset sol d is a long term capital asset, held for more than 12 months, and sold on a stoc k exchange where STT has been levied on the transaction. 156 Investment Planning PDP

Review Questions: 1. A company paid dividend of Rs 2.50 per share which is expec ted to grow at the rate of 8% p.a. If the expected rate of return is 12% what sh ould be current price of the stock according to the dividend discounting model? a. 67.50 b. 62.50 c. 70.25 d. 65.00 2. A Stop loss order is generally used for a. protecting profits b. limiting losses c. technical reasons of support and/or res istance d. all the three above 3. While trading on screen based trading systems which one of the following statements about orders is not true? a. Orders pending at the end of the trading day are automatically cancelled b. Orders once placed in the system can not be modified or cancelled c. Once an order is placed it is not possible to modify the client code d. The quantity that would be disclosed i n the system can be shown to be less than the true quantity of the order 4. The present mechanism of trading used in NSE and BSE is a. Quote driven mechanism of trading b. Order driven mechanism of trading c. Institution oriented mechanism of trading d. Jobber oriented mechanism of trading 5. A stock is quoting at Rs 1 00/- cum rights. What will be the price ex rights if the company offers rights s hares in the ratio 1:2 at a price of Rs 70/ (assuming the market price is steady )? a. 100 b. 90 c. 80 d. 70 6. A company fixes record date for bonus and stock s plit simultaneously. If the bonus is in the ratio of 1:2 and the stocks to be sp lit from FV of Rs 10 to Rs 2 and if the cum bonus and cum split price was Rs 900 what should be the ex bonus and ex stock split price? a.100 b. 110 c. 120 d. 30 0 PDP Investment Planning 157

7. An investor received 10 bonus shares of an infotech company on 10th March 2005. The cost of acquisition is NIL being bonus shares. He sold the bonus shares thro ugh a member of NSE, on 10th May 2006, for a price of Rs. 3200 each. What will b e capital gains tax payable by the investor on the sale? a. Rs. 3200 + education cess b. Rs. 6400 + education cess c. The rate of taxation will depend upon the tax slab at which the investor is being taxed on his total income d. NIL this is LTCG and hence no tax is payable 8. A company is growing at an average rate of 20% on the top and bottom lines. The current market price is Rs. 225 while the EPS for the last year was Rs. 12. Is i t advisable to buy the stock if the required return is 18%? a. The stock may quo te at Rs. 240 after one year and hence do no buy b. The stock may quote at Rs. 2 88 at a P/E of 20 on the next years EPS given that the growth rate is 20% hence b uy c. It can not be predicted the risks seem to be high do not buy d. There is n o certainty that the growth rate will be maintained the required return is very high do not buy 9. Interest rate has the following effect on share valuation: a. As the interest ri ses the stock prices will rise b. Interest rate rise or fall has no impact on st ock prices c. Stock market has nothing to do with interest rates d. As the inter est rate rises the stock prices tend to fall 10. Which one of the following statements regarding market capitalization and P/E mu ltiples is true? a. As Mid cap stocks are riskier the P/E multiple tends to be h igher as compared to large cap stocks b. As mid cap stocks are riskier the P/E m ultiple tends to be lower as compared to large cap stocks c. As mid cap stocks a re less risky their P/E multiples tend to be lower as compared to large cap stoc ks d. As mid cap stocks are less risky their P/E multiples tend to be higher as compared to large cap stocks 11. The spread between floor price and cap price in respect of book built IPOs should not exceed a. 20% b. 15% c. 10% d. No such limit Answers: 1. 7. 158 a d 2. 8. d b 3. 9. b d 4. b

5. b 6. c 10. b Investment Planning 11. a PDP

Chapter 12 PDP Investment Planning 159

Derivatives erivatives have become very important in the field of investments. They are very important financial instruments for risk management as they allow risks to be s eparated and traded. Derivatives are used to shift risk and act as a form of ins urance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asse t. This means that risks in trading derivatives may change depending on what hap pens to the underlying asset. A derivative is a product whose value is derived f rom the value of an underlying asset, index or reference rate. The underlying as set can be equity, forex, commodity or any other asset. For example, if the sett lement price of a derivative is based on the stock price of a stock for e.g. Tat a Steel which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly. We will try and understand n n n What are derivati ves? Why have derivatives at all? How are derivatives traded and used? D A derivative security can be defined as a security whose value depends on the va lues of other underlying variables. Very often, the variables underlying the der ivative securities are the prices of traded securities. Let us take an example o f a simple derivative contract: n n n n Mr. Kulkarni buys a futures contract, of 100 shares lot size He will make a profit of Rs. 1000 if the price of Tata Stee l rises by Rs. 10 If the price is unchanged Mr. Kulkarni will receive nothing. I f the stock price of Tata Steel falls by Rs. 9 he will lose Rs. 900. As we can see, the above contract depends upon the price of the Tata Steel scrip in the cash market referred to, in market parlance, as the spot price the price of the security in the futures segment could be different from cash market but it moves in line with the cash market price. Similarly, futures trading is done on Sensex futures and Nifty futures. The underlying securities in this case are the BSE Sensex and NSE Nifty. Derivatives and futures are basically of 3 types: n n n Forwards and Futures Options Swaps 160 Investment Planning PDP

Forward contract A forward contract is the simplest mode of a derivative transac tion. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. Example Mr. Kulkarni wants to buy a car, which costs Rs. 2,00,0 00 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of cars will rise 3 months from now. So in order to protect himself from the rise in prices Mr. Kulkarni enters into a contract with the car dealer that 3 months from now he will buy the car for Rs. 2,00,000. Wha t Mr. Kulkarni is doing is that he is locking the current price of a car for a f orward contract. The forward contract is settled at maturity. The dealer will de liver the car to Mr. Kulkarni at the end of three months and Mr. Kulkarni in tur n will pay Rs. 2,00,000/- to the car dealer on delivery. Example Mr Patel is an importer who has to make a payment for his consignment in six months time. In or der to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six mon ths from now at a decided rate. As he is entering into a contract on a future da te it is a forward contract and the underlying security is the foreign currency. The difference between a share and derivative is that shares/securities is an a sset while derivative instrument is a contract. To understand the use and functi oning of the index derivatives markets, it is necessary to understand the underl ying index. A stock index represents the change in value of a set of stocks, whi ch constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivativ e instruments such as index futures. The Sensex and Nifty In India the most popu lar indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30 st ocks comprising the index which are selected based on market capitalization, ind ustry representation, trading frequency etc. It represents 30 large well-establi shed and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Th en there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex. While the BSE Sensex was the first stock m arket index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of sha res of 50 companies with each having a market capitalization of more than Rs 500 crore. Futures and stock indices For understanding of stock index futures a tho rough knowledge of the composition of indexes is essential. Choosing the right i ndex is important in choosing the right contract for speculation or hedging. Sin ce for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedg ed and the characteristics of the index. Choosing and understanding the right in dex is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally g reater than spot stock indexes. PDP Investment Planning 161

Every time an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising. Retail investors will find the index derivatives useful due to the high correla tion of the index with their portfolio/stock and low cost associated with using index futures for hedging. Understanding index futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the f uture at a certain price. Index futures are all futures contracts where the unde rlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole. Index futures permits speculation and if a trader antici pates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. We have index fu tures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months dura tion contracts are available at all times. Each contract expires on the last Thu rsday of the expiry month and simultaneously from the next day onwards a new con tract is introduced for trading. Example Futures contracts in Nifty in August 20 06 The settlement day is the last Thursday of the month or the previous working day if last Thursday happens to be a holiday. The permitted lot size is 100 or mult iples thereof for the Nifty. That is if you buy one Nifty contract, the total de al value will be 100*3400 (Nifty futures price) = Rs. 3,40,000 Hedging We have seen how one can take a view on the market with the help of index future s. The other benefit of trading in index futures is to hedge your portfolio agai nst the risk of trading. In order to understand how one can protect his portfoli o from value erosion let us take an example. Stocks carry two types of risk comp any specific and market risk. Company specific risk can be reduced through diver sification while market risk is reduced through hedging. Beta is the measure of market risk. Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock pri ces for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index i ncreases by 10%, the value of the portfolio increases 11%. The strategy of hedgi ng is resorted to with the objective of reducing portfolio beta to zero and redu cing the market risk. Hedging involves protecting an existing equity portfolio f rom future adverse price movements in the stock market. In order to hedge the po rtfolio, a market player needs to take an equal and opposite 162 Investment Planning PDP

position in the futures market to the one held in the cash market. Every portfol io has a hidden exposure to the index, which is denoted by the beta. Assuming yo u have a portfolio of Rs. 20 lacs, which has a beta of 1.2, you can factor a com plete hedge by selling Rs. 24 lacs of S&P CNX Nifty futures. Steps in hedging 1. 2. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1. Short sell the index in such a quantum that t he gain on a unit decrease in the index would offset the losses on the rest of h is portfolio. This is achieved by multiplying the relative volatility of the por tfolio by the market value of his holdings. Therefore in the above scenario we have to short sell 1.2 * 20 lacs = 24 lacs wo rth of Nifty. Now let us study the impact on the overall gain/loss that accrues: As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that ari se out of improvement in the overall sentiment. Then why does one invest in equi ties if all the gains will be offset by losses in futures market. The idea is th at everyone expects his portfolio to outperform the market. Irrespective of whet her the market goes up or not, his portfolio value would increase. The same meth odology can be applied to a single stock by deriving the beta of the scrip and t aking a reverse position in the futures market. Thus, we have seen how one can u se hedging in the futures market to offset losses in the cash market. Speculation Speculators are those who do not have any position on which they enter in future s and options market. They only have a particular view on the market, stock, com modity etc. In short, speculators put their money at risk in the hope of profiti ng from an anticipated price change. They consider various factors such as deman d supply, market positions, open interests, economic fundamentals and other data to take their positions. Example Kirit is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Nifty Futures. On Sept 1, 2006 he buys 100 Nifty futures @ 3400 on expectations that the index will rise in futur e. On Sept 16,2006 Nifty rises to 3460 and at that time he sells Nifty futures a nd squares his position. Selling Price : 3460*100 = Rs. 3,46,000 Less: Purchase Cost: 3400*100 = Rs. 3,40,000 Net Gain PDP Rs. 6,000 Investment Planning 163

Kirit has made a profit of Rs. 6,000 by taking a call on the future value of the Nifty. However, if Nifty had fallen he would have made a loss. Similarly, if Ki rit had a bearish view on the market he could have sold Nifty futures and bought the same back after the expected market fall and made a profit from a falling m arket. Arbitrage An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are a lways in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and se lling at the higher priced market. In index futures arbitrage is possible betwee n the spot market and the futures market (NSE has provided a special software fo r buying all 50 Nifty stocks in the spot market) n n n n Take the case of the NS E Nifty. Assume that Nifty is at 3400 and 3 months Nifty futures is at 3500. The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. If there is a difference then arbitrage opportunity exist s. If we assume 8% interest rate then Nifty three months futures should be quoting at Rs. 3468 but is actually quoting at Rs. 3500; which is higher than the correc t price thus providing an arbitrageur an opportunity he will sell 3 months futur es at 3500 and buy spot at 3400 and should make Rs 32 per Nifty because of the d ifference between the actual price and the correct price:. These kind of imperfec tions continue to exist in the markets but one has to be alert to the opportunit ies as they tend to get exhausted very fast. Pricing of Index Futures The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market. The cost of carry model The costof-carry model where the price of the contract is defined as: F=S+C where: F Fut ures price S Spot price C Holding costs or carry costs If F < S+C or F > S+C, ar bitrage opportunities would exist i.e. whenever the futures price moves away fro m the fair value, there would be chances for arbitrage. If Nifty is quoting at R s. 3400 and the 3 months futures of Nifty is Rs 3500 then one can purchase Nifty at Rs. 3400 in spot by borrowing @ 8% annum for 3 months and sell Nifty futures for 3 months at Rs. 3500. 164 Investment Planning PDP

Here F=3400+68=3468 and is less than prevailing futures price and hence there ar e chances of arbitrage. Sale Cost =3400 + 68 Arbitrage profit = 3500 = 3468 = 32 However, one has to remember that the components of holding cost vary with contr acts on different assets. Futures pricing in case of dividend yield We have seen how we have to consider the cost of finance to arrive at the futures index valu e. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns. Example Suppose a stock portfolio has a v alue of Rs. 100 and has an annual dividend yield of 3% which is earned throughou t the year and finance rate =12% the fair value of the stock index portfolio aft er one year will be F= Rs. 100 + Rs. 100 * (0.12 0.03) Futures price = Rs. 109 I f the actual futures price of one-year contract is Rs. 112. An arbitrageur can b uy the stock at Rs. 100, borrowing the fund at the rate of 12% and simultaneousl y sell futures at Rs. 112. At the end of the year, the arbitrageur would collect Rs. 3 for dividends, deliver the stock portfolio at Rs 112 and repay the loan o f Rs. 100 and interest of Rs. 12. The net profit would be Rs. 112 + Rs. 3 - Rs. 100 - Rs. 12 = Rs. 3 Thus, we can arrive at the fair value in the case of divide nd yield. Trading strategies Speculation We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these in stances. Taking a view of the market If you are bullish on the market buy index futures If you are bearish on the market sell index futures Example Bullish On A ugust 13, 2006, X feels that the market will rise so he buys 100 Nifties with an e xpiry date of August 31 at an index price of 3350 costing Rs. 3,33,500 (100*3350 ). On August 21 the Nifty futures have risen to 3362 so he squares off his posit ion at 3362 PDP Investment Planning 165

X makes a profit of Rs. 1200 (100*12) Bearish On August 13, 2006, X feels that the m arket will fall so he sells 100 Nifties with an expiry date of August 31 at an i ndex price of 3350 costing Rs. 3,33,500 (100*3350). On August 21 the Nifty futur es have fallen to 3312 so he squares off his position at 3312. X makes a profit of Rs. (100*38) = Rs. 3,800/In the above cases X has profited from speculation i.e . he has wagered in the hope of profiting from an anticipated price change. Marg ins The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is d one on an intra-day basis. Daily margining is of two types: 1. Initial margins 2. Mark-to-market profit/loss The computation of initial margin on the futures m arket is done using the concept of Value-at-Risk (VaR). The initial margin amoun t is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing cor poration) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front. The daily settlement pr ocess called mark-to-market provides for collection of losses that have already oc curred (historic losses) whereas initial margin seeks to safeguard against poten tial losses on outstanding positions. The mark-to-market settlement is done in c ash. Let us take a hypothetical trading activity of a client of a NSE futures di vision to demonstrate the margins payments that would occur. n n A client purcha ses 100 units of FUTIDX NIFTY 31 Aug 2006 at Rs. 3400. The initial margin payabl e as calculated by VaR is 15%. Total long position = Rs. 3,40,000 (100*3400) Initial margin (15%) = Rs. 51,000 Assuming that the contract will close on Day + 3 the mark-to-market position wil l look as follows: Nifty closed on Day 1 at 3450 Nifty closed on Day 2 at 3350 N ifty was sold on Day 3 at 3425 Position on Day 1 Close Price 3450*100 = 3,45,000 Market to market profit = 50*100 = 5,000 Day end margin on open position = 3450 00*.15 = 51750 Additional margin = 51750 -51000 = 750 166 Investment Planning PDP

Receivable by client = 5000 750 = 4250 New position on Day 2 Value of new positi on = 3350*100= 3,35,000 Margin = 50,250 Margin at end of day1 = 51750 Mark to ma rket loss = 345000 335000 = 10,000 Amount payable by client = 10000-1500 {less m argin payable [51750-50250]} = 8500 Net position on Day 3 Profit on sale 342500 335000 = 7500 Release of margin = 50,250 Amount receivable by client = 7500+5025 0 = 57,750 Net profit on the whole deal: Initial margin out go = -51,000 End of day 1 = 4,250 End of day 2 = -8,500 End of day3 = 57,750 Net profit = (-51000+42 50-8500+57750) = 2,500 Which is 100*(3425-3400) = the lot size*(difference betwe en sale and purchase price of the index) Settlements All trades in the futures m arket are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures wil l be the daily settlement price and the position will be carried to the next day at the settlement price. The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction i s squared up. The initial buyer liquidates his long position by selling identica l futures contract. In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference betwe en the contract value and closing index value is paid. Options The markets are v olatile and huge amount of money can be made or lost in very little time. Deriva tive products are structured precisely for this reason to curtail the risk expos ure of an investor. Index futures and stock options are instruments that enable an investor to hedge his portfolio or open positions in the market. Option contr acts allow an investor to run his profits while restricting his downside risk. A part from risk containment, options can be used for speculation and investors ca n create a wide range of potential profit scenarios. What are options? Some peop le remain puzzled by options. The truth is that most people have been using opti ons for some time, because options are built into everything from mortgages to i nsurance. PDP Investment Planning 167

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or befo re a specific date. Option, as the word suggests, is a choice given to the investo r to either honour the contract; or if he so chooses to walk away from the contr act. To begin, there are two kinds of options: Call Options and Put Options. A C all Option is an option to buy a stock at a specific price on or before a certai n date. In this way, Call options are like security deposits. If, for example, y ou wanted to rent a certain property, and left a security deposit for it, the mo ney would be used to insure that you could, in fact, rent that property at the p rice agreed upon when you returned. If you never returned, you would give up you r security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. I f you decide not to use the option to buy the stock, and you are not obligated t o, your only cost is the option premium. Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are l ike insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the car is damaged in an acc ident. If this happens, you can use your policy to regain the insured value of t he car. In this way, the put option gains in value as the value of the underlyin g instrument decreases. If all goes well and the insurance is not needed, the in surance company keeps your premium in return for taking on the risk. With a Put Option, you can insure a stock by fixing a selling price. If something happens whi ch causes the stock price to fall, and thus, damages your asset, you can exercise your option and sell it at its insured price level. If the price of your stock goe s up, and there is no damage, then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed op tions, to allow investors ways to manage risk. Technically, an option is a contr act between two parties. The buyer receives a privilege for which he pays a prem ium. The seller accepts an obligation for which he receives a fee. Example Now l et us see how one can profit from buying an option. Mr. Shah feels that the mark et will go up. He is bullish on Nifty but he does not want to lose money if he i s turned wrong and if the market goes down. n n n n n n He buys an Options Contr act September 2006 Nifty for a strike price of 3450 paying a premium of Rs. 50. In about 15 days time Nifty goes up and therefore he sells the option for Rs. 75 making a profit of Rs. 25 per Nifty. The contract size being 100 he will make a profit of Rs. 25*100 = Rs. 2,500/-. If he had not sold and if the Nifty had gon e up further he would have made even more profits. If the Nifty were to fall his maximum loss would have been restricted to Rs. 50*100 = Rs. 5,000/the premium p aid by him for having bought the call option. Thus, you can see that the profit potential in a call option is unlimited while the loss is limited to the actual premium paid. 168 Investment Planning PDP

Call Options-Long & Short Positions When you expect prices to rise, then you tak e a long position by buying calls. You are bullish. When you expect prices to fa ll, then you take a short position by selling calls. You are bearish. Put Option s A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. Example: Mr. Dutt purchases one contract of Infoysys Technologies Sep 2006 1800 Put Premium Rs. 50 (contract size 100 shares) This contract allows Sam to sell 100 shares Infosys T echnologies at Rs. 1800 per share at any time between the current date and the e xpiry of Sep 2006 series. To have this privilege, Sam pays a premium of Rs. 5,00 0 (Rs. 50 a share for 100 shares). He will make a profit if the share price of I nfosys Technologies falls during this period. He has the potential to make high profits as there is a potential for the stock price to fall by any amount but in case the price of the share goes up; he will suffer a loss but the loss will be limited to Rs. 5,000/- premium paid by him for purchasing the right to sell (bu y a put option) The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell. Put Options-Long & Short Positions When you e xpect prices to fall, then you take a long position by buying Puts. You are bear ish. When you expect prices to rise, then you take a short position by selling P uts. You are bullish. The following table will summarise the actions to be taken depending upon your view on the stock price: Summary PDP Investment Planning 169

Option styles Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. Th e styles have geographical names, which have nothing to do with the location whe re a contract is agreed! The styles are: European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument onl y on the expiry date. This means that the option cannot be exercised early. Sett lement is based on a particular strike price at expiration. Currently, in India only index options are European in nature. Example: Mr. Dutt purchases 1 NIFTY S EP 2006 3450 Call Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract i s cash settled. American: These options give the holder the right, but not the o bligation, to buy or sell the underlying instrument on or before the expiry date . This means that the option can be exercised early. Settlement is based on a pa rticular strike price at expiration. Options in stocks that have been recently l aunched in the Indian market are American Options while the options on the Index a re European Options. Example: Mr Patel purchases 1 TATA STEEL SEP 06 - 520 Call Pre mium 20 Here Mr. Patel can close the contract any time from the current date til l the expiration date, which is the last Thursday of September. American style o ptions tend to be more expensive than European style because they offer greater flexibility to the buyer. Option Class & Series Generally, for each underlying, there are a number of options available: For this reason, we have the terms class and series. An option class refers to all options of the same type (call or put) and style (American or European) that also have the same underlying. Example: All N ifty call options are referred to as one class. An option series refers to all o ptions that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price. Example: ACC SEP 2006 900 ref ers to one series and trades take place at different premiums Concepts Important Terms Strike price: The Strike Price denotes the price at which the bu yer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 3,410, the strike prices available will be 3,370; 3,390; 3,410; 3,430; 3,450. The strike price is also called Exerc ise Price. This price is fixed by the exchange for the entire duration of the op tion depending on the movement of the underlying stock or index in the cash mark et. In-the-money: A Call Option is said to be In-the-Money if the strike price is less than the market price of 170 Investment Planning PDP

the underlying stock. A Put Option is In-The-Money when the strike price is grea ter than the market price. Example: Ram purchases 1 ACC SEP 900 Call Premium 50 I n the above example, the option is in-the-money, till the market price of ACC is r uling above the strike price of Rs. 900, which is the price at which Ram would l ike to buy 100 shares anytime before the expiry of Sep 2006 series. Similary, if Ram had purchased a Put at the same strike price, the option would have been inthemoney, if the market price of ACC was lower than Rs. 900 per share. Out-of-the -Money: A Call Option is said to be Out-of-the-Money if the strike price is greate r than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price. At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being At-the-Mon ey or Near-the-Money. If the index is currently at 3,410, the strike prices avail able will be 3,370; 3,390; 3,410; 3,430; 3,450. The strike prices for a call opt ion that are greater than the underlying (Nifty or Sensex) are said to be out-of the-money in this case 3430 and 3450 considering that the underlying is at 3410. Similarly in-the-money strike prices will be 3,370 and 3,390, which are lower t han the underlying of 3,410 while the strike price of 3410 is at the money. At the se prices one can take either a positive or negative view on the markets i.e. bo th call and put options will be available. Therefore, for a single series 10 opt ions (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in. Cov ered Call Option Covered option helps the writer to minimize his loss. In a cove red call option, the writer of the call option takes a corresponding long positi on in the stock in the cash market; this will cover his loss in his option posit ion if there is a sharp increase in price of the stock. Further, he is able to b ring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected). Example: Mr. Rajan belie ves that HLL has hit rock bottom at the level of Rs. 232 and it will move in a n arrow range. He can take a long position in HLL shares and at the same time writ e a call option with a strike price of 235 and collect a premium of Rs. 5 per sh are. This will bring down the effective cost of HLL shares to 227 (232-5). If th e price stays below 235 till expiry, the call option will not be exercised and t he writer will keep the Rs.5 he collected as premium. If the price goes above 23 5 and the Option is exercised, the writer can deliver the shares acquired in the cash market. Covered Put Option Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will increase by the premium amount (if the option i s not exercised at maturity). Here again, the investor is not in a position to t ake advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the und erlying asset, the option will be exercised and the investor will be left only w ith the premium amount. The loss in the option exercised will be equal to the ga in in the short position of the asset. Pricing of options Options are used as ri sk management tools and the valuation or pricing of the instruments is a careful PDP Investment Planning 171

balance of market factors. There are four major factors affecting the Option pre mium: n n n n Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying And two less important factors: n n Short-Term Interest Rates Dividends The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value o f the option when the underlying position is marked-to-market. For a call option : Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less t han the price of the underlying asset for the call to have an intrinsic value gr eater than 0. For a put option, the strike price must be greater than the underl ying asset price for it to have intrinsic value. Price of underlying The premium is affected by the price movements in the underlying instrument. For Call optio ns (the right to buy the underlying at a fixed strike price) as the underlying p rice rises so does its premium. As the underlying price falls so does the premiu m. For Put options as the underlying price rises, the premium falls; as the unde rlying price falls the premium rises. The following chart summarises the above f or Calls and Puts. The Time Value of an Option Generally, the longer the time remaining until an op tions expiration, the higher its premium will be. This is because the longer an o ptions lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an opti ons price remaining the 172 Investment Planning PDP

same, the time value portion of an options premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally w orth only its intrinsic value. Volatility Volatility is the tendency of the underlying securitys market price to fluctuate either up or down. It reflects a price changes magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under -lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. Higher volatility = Higher premium Lower volatility = Lower premium Interest rates In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may become important. All other factors being equal as interest rates rise, premium costs fall and vice ve rsa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either wa y the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premiu m costs fall. Why should the buyer be compensated? Because the option writer rec eiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall premiums rise. This time it is the writer who needs to be compensated. PDP Investment Planning 173

The options premium is determined by the three factors mentioned earlier intrins ic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows: n n n n Delta Gamma Vega Rho Delta Delta is the measure of an options sensitivity to changes in the price of t he underlying asset. Therefore, it is the degree to which an option price will m ove given a change in the underlying stock or index price, all else being equal. Change in option premium Delta = Change in underlying price For example, an elta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index. Example A trader is considering buying a Call option on a futures contrac t, which has a price of Rs. 20. The premium for the Call option with a strike pr ice of Rs. 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs. 21 a rise of Re 1 then th e premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.8 0 + 0.50 = Rs. 1.30. Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or c heap. An at-the-money call would have a delta of 0.5 and a deeply inthe-money ca ll would have a delta close to 1. While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stoc k price are inversely related. This is because if you buy a put your view is bea rish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The p ut delta equals the call delta minus 1. It may be noted that if delta of your po sition is positive, you desire the underlying asset to rise in price. On the con trary, if delta is negative, you want the underlying assets price to fall. 174 Investment Planning PDP

Uses: The knowledge of delta is of vital importance for option traders because t his parameter is heavily used in margining and risk management strategies. The d elta is often called the hedge ratio. e.g. if you have a portfolio of n shares of a stock then n divided by the delta gives you the number of calls you would need t o be short (i.e. need to write) to create a riskless hedge i.e. a portfolio whic h would be worth the same whether the stock price rose by a very small amount or fell by a very small amount. In such a delta neutral portfolio any gain in the va lue of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa. Note that as the de lta changes with the stock price and time to expiration, the number of shares wo uld need to be continually adjusted to maintain the hedge. Gamma This is the rat e at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument. Gamma = Change in option delta erlying price For example, if a Call option has a delta of 0.50 and a gamma of 0 .05, then a rise of 1 in the underlying means the delta will move to 0.55 for a p rice rise and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a car its acceleration in moving from a standstill, up to its cruis ing speed, and braking back to a standstill. Gamma is greatest for an ATM (at-th e-money) option (cruising) and falls to zero as an option moves deeply ITM (in-t he-money ) and OTM (out-of-the-money) (standstill). Theta It is a measure of an options sensitivity to time decay. Theta is the change in option price given a on eday decrease in time to expiration. It is a measure of time decay (or time shru nk). Theta is generally used to gain an idea of how time decay is affecting your portfolio. Theta = Change in an option premium Change in time to expiry Th tive for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases. Assume a n option has a premium of 3 and a theta of 0.06. After one day it will decline t o 2.94, the second day to 2.88 and so on. Naturally other factors, such as chang es in value of the underlying stock will alter the premium. Theta is only concer ned with the time value. Unfortunately, we cannot predict with accuracy the chan ges in stock markets value, but we can measure exactly the time remaining until ex piration. Vega This is a measure of the sensitivity of an option price to change s in market volatility. It is the change of an option premium for a given change typically 1% in the underlying volatility. Change in an option premium Vega = tility PDP Investment Planning 175

Example: If stock X has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the vol atility factor increased by 1% to 31%. As the stock becomes more volatile the ch anges in premium will increase in the same proportion. Vega measures the sensiti vity of the premium to these changes in volatility. What practical use is the ve ga to a trader? If a trader maintains a delta neutral position, then it is possi ble to trade options purely in terms of volatility the trader is not exposed to changes in underlying prices. Rho The change in option price given a one percent age point change in the risk-free interest rate. Rho measures the change in an o ptions price per unit increase typically 1% in the cost of funding the underlying. Change in an option premium Rho = Change in cost of funding underlying re are various option pricing models which traders use to arrive at the right va lue of the option. Some of the most popular models have been enumerated below. T he Binomial Pricing Model The binomial model is an options pricing model which w as developed by William Sharpe in 1978. Today, one finds a large variety of pric ing models which differ according to their hypotheses or the underlying instrume nts upon which they are based (stock options, currency options, options on inter est rates). The binomial model breaks down the time to expiration into potential ly a very large number of time intervals, or steps. A tree of stock prices is in itially produced working forward from the present to expiration. At each step it is assumed that the stock price will move up or down by an amount calculated us ing volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices. The tree represents all the possi ble paths that the stock price could take during the life of the option. At the end of the tree i.e. at expiration of the option all the terminal option prices for each of the final possible stock prices are known as they simply equal their intrinsic values. Next the option prices at each step of the tree are calculate d working back from expiration to the present. The option prices at each step ar e used to derive the option prices at the next step of the tree using risk neutr al valuation based on the probabilities of the stock prices moving up or down, t he risk free rate and the time interval of each step. Any adjustments to stock p rices (at an ex-dividend date) or option prices (as a result of early exercise o f American options) are worked into the calculations at the required point in ti me. At the top of the tree you are left with one option price. Advantage: The bi g advantage the binomial model has over the Black-Scholes model is that it can b e used to accurately price American options. This is because, with the binomial model its possible to check at every point in an options life (ie at every step of the binomial tree) for the possibility of early exercise (eg where, due to a di vidend, or a put being deeply in the money the option price at that point is les s than its intrinsic value). Where an early exercise point is found it is assume d that the option holder would elect to exercise and 176 Investment Planning PDP

the option price can be adjusted to equal the intrinsic value at that point. Thi s then flows into the calculations higher up the tree and so on. Limitation: As mentioned before the main disadvantage of the binomial model is its relatively s low speed. Its great for half a dozen calculations at a time but even with todays fastest PCs its not a practical solution for the calculation of thousands of pric es in a few seconds which is whats required for the production of the animated ch arts. The Black & Scholes Model The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculatio n: unlike the binomial model, it does not rely on calculation by iteration. The intention of this section is to introduce you to the basic premises upon which t his pricing model rests. The Black-Scholes model is used to calculate a theoreti cal call price (ignoring dividends paid during the life of the option) using the five key determinants of an options price: stock price, strike price, volatility , time to expiration, and short-term (risk free) interest rate. The original for mula for calculating the theoretical option price (OP) is as follows: OP = SN(d1 ) - XertN(d2 ) Where: The variables are: S = stock price X = strike price t = time remaining until exp iration, expressed as a percent of a year r = current continuously compounded ri sk-free interest rate v = annual volatility of stock price (the standard deviati on of the short-term returns over one year). ln = natural logarithm N(x) = stand ard normal cumulative distribution function e = the exponential function Lognorm al distribution: The model is based on a lognormal distribution of stock prices, as opposed to a normal, or bell-shaped, distribution. The lognormal distributio n allows for a stock price distribution of between zero and infinity (ie no nega tive prices) and has an upward bias (representing the fact that a stock price ca n only drop 100 per cent but can rise by more than 100 per cent). Risk-neutral v aluation: The expected rate of return of the stock (ie the expected rate of grow th of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the BlackScholes model (or any other model for op tion valuation). The important implication is that the price of an option is com pletely independent of the expected growth of the underlying asset. Thus, while any two PDP Investment Planning 177

investors may strongly disagree on the rate of return they expect on a stock the y will, given agreement to the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that underlying asset. The key concept underlying the valuation of all derivatives the fact that price of an op tion is independent of the risk preferences of investors is called risk-neutral valuation. It means that all derivatives can be valued by assuming that the retu rn from their underlying assets is the risk free rate. Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely us ed adaptations to the original formula, which enable it to handle both discrete and continuous dividends accurately. However, despite these adaptations the Blac k-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price a t one point in time at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option. As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercise d at expiration) this is a significant limitation. The exception to this is an A merican call on a non-dividend paying asset. In this case the call is always wor th the same as its European equivalent as there is never any advantage in exerci sing early. Advantage: The main advantage of the Black-Scholes model is speed it lets you calculate a very large number of option prices in a very short time. Bull Market Strategies Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, t hen you would rather have the right to purchase at a specified price and sell la ter at a higher price than have the obligation to deliver later at a higher pric e. The investor breaks even when the market price equals the exercise price plus the premium. Puts in a Bullish Strategy An investor with a bullish market outlo ok can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become o ut-ofthe-money, investors with long put positions will let their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits wh en the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential l oss is unlimited. Because a short put position holder has an obligation to purch ase if exercised. He will be exposed to potentially large losses if the market m oves against his position and declines. The break-even point occurs when the mar ket price equals the exercise price: minus the premium. At any price less than t he exercise price minus the premium, the investor loses money on the transaction . At higher prices, his option is profitable. An increase in volatility will inc rease the value of your put and decrease your return. As an option writer, the h igher price you will be forced to pay in order to buy back the option at a later date, lower is the return. 178 Investment Planning PDP

Bullish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call o ptions but with different exercise prices. To buy a call spread is to purchase a c all with a lower exercise price and to write a call with a higher exercise price . The trader pays a net premium for the position. To sell a call spread is the opp osite, here the trader buys a call with a higher exercise price and writes a cal l with a lower exercise price, receiving a net premium for the position. An inve stor with a bullish market outlook should buy a call spread. The Bull Call Spread allows the investor to participate to a limited extent in a bull market, while a t the same time limiting risk exposure. To put on a bull spread, the trader need s to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike cal l and the premium received for the high strike call. The investors profit potenti al is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and rec eives a higher price than he is paid for receiving delivery on his long call. Th e investors potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call. The investor breaks even wh en the market price equals the lower exercise price plus the net premium. At the most, an investor can lose the net premium paid. To recover the premium, the ma rket price must be as great as the lower exercise price plus the net premium. An example of a Bullish call spread Lets assume that the cash price of a scrip is R s. 100 and you buy a September call option with a strike price of Rs. 90 and pay a premium of Rs. 14. At the same time you sell another September call option on the same scrip with a strike price of Rs. 110 and receive a premium of Rs 4. He re you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread. Now let us look at the fundamental reason for this position. Since t his is a bullish strategy, the first position established in the spread is the l ong lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a hi gher call strike price is established. While this not only reduces the outflow i n terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows: Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10 Maximum Loss = Lower strike premiu m - Higher strike premium = 14 - 4 = 10 Breakeven Price = Lower strike price + N et premium paid = 90 + 10 = 100 PDP Investment Planning 179

Bullish Put Spread Strategies A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To buy a p ut spread is to purchase a Put with a higher exercise price and to write a Put wi th a lower exercise price. The trader pays a net premium for the position. To sel l a put spread is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position. An investor with a bullish market outlook should sell a Put spread. Th e vertical bull put spread allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure. Bear Market Strategies Puts in a Bearish Strategy When you purchase a put you are long and want the mar ket to fall. A put option is a bearish position. It will increase in value if th e market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell t he underlying asset at the exercise price. In a falling market, this choice is p referable to being obligated to buy the underlying at a price higher. An investo rs profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits. Calls in a Bearish Strategy Another optio n for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position. For this an in vestor needs to write a call option. If the market price falls, long call holder s will let their outof-the-money options expire worthless, because they could pu rchase the underlying asset at the lower market price. The investors profit poten tial is limited because the traders maximum profit is limited to the premium rece ived for writing the option. Here the loss potential is unlimited because a shor t call position holder has an obligation to sell if exercised, he will be expose d to potentially large losses if the market rises against his position. The inve stor breaks even when the market price equals the exercise price: plus the premi um. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even. Bearish Put Spread Strategies A vertical put spread is the simultaneous purchase and sale of identical put options but with different e xercise prices. To buy a put spread is to purchase a put with a higher exercise pr ice and to write a put with a lower exercise price. The trader pays a net premiu m for the position. To sell a put spread is the opposite. The trader buys a put wi th a lower exercise price and writes a put with a higher exercise price, receivi ng a net premium for the position. 180 Investment Planning PDP

An example of a bearish put spread. Lets assume that the cash price of the scrip is Rs. 100. You buy a September put option on a scrip with a strike price of Rs . 110 at a premium of Rs. 15 and sell a September put option with a strike price of Rs. 90 at a premium of Rs. 5. In this bearish position the put is taken as l ong on a higher strike price put with the outgo of some premium. This position h as huge profit potential on downside, if the trader may recover a part of the pr emium paid by him by writing a lower strike price put option. The resulting posi tion is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss and brea keven point of this spread would be as follows: Maximum profit = Higher strike p rice option - Lower strike price option - Net premium paid = 110 - 90 - 10 = 10 Maximum loss = Net premium paid = 15 - 5 = 10 Breakeven Price = Higher strike pr ice - Net premium paid = 110 - 10 = 100 Bearish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call o ptions but with different exercise prices. To buy a call spread is to purchase a c all with a lower exercise price and to write a call with a higher exercise price . The trader pays a net premium for the position. To sell a call spread is the opp osite: the trader buys a call with a higher exercise price and writes a call wit h a lower exercise price, receiving a net premium for the position. To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread. The investors profit potential is limited. When th e market price falls to the lower exercise price, both outof-the-money options w ill expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price. Here the investors potential loss is limited. If the market rises, the options will o ffset one another. At any price greater than the high exercise price, the maximu m loss will equal high exercise price minus low exercise price minus net premium . The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price decli nes. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven. Volatile Market Strategies Straddles in a Volatile Market Outlook Volatile market trading strategies are ap propriate when the trader believes the market will move but does not have an opi nion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A t rader need not be PDP Investment Planning 181

bullish or bearish. He must simply be of the opinion that the market is volatile . n A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put. 1. 2. To buy a straddle is to purchase a call and a put with the same exercise price and expiration date. To sell a straddle is the opposite: the trader sells a call and a put with the same exercise price and exp iration date. A trader, viewing a market as volatile, should buy option straddles. A straddle p urchase allows the trader to profit from either a bull market or from a bear mark et. Here the investors profit potential is unlimited. If the market is volatile, the trader can profit from an upor downward movement by exercising the appropria te option while letting the other option expire worthless. (Bull market, exercis e the call; bear market, the put.) While the investors potential loss is limited. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the options. In this case the trader has long two positions and thus, two b reakeven points. One is for the call, which is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the premiums paid . Strangles in a Volatile Market Outlook A strangle is similar to a straddle, ex cept that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money. To buy a strangle is to purchase a call an d a put with the same expiration date, but different exercise prices. To sell a s trangle is to write a call and a put with the same expiration date, but different exercise prices. A trader, viewing a market as volatile, should buy strangles. A strangle purchase allows the trader to profit from either a bull or bear market. Because the options are typically out-of-the-money, the market must move to a g reater degree than a straddle purchase to be profitable. The traders profit poten tial is unlimited. If the market is volatile, the trader can profit from an upor downward movement by exercising the appropriate option, and letting the other expire worthless. (In a bull market, exercise the call; in a bear market, the p ut). The investors potential loss is limited. Should the price of the underlying remain stable, the most the trader would lose is the premium he paid for the opt ions. Here the loss potential is also very minimal because, the more the options are out-of-the-money, the lesser the premiums. Here the trader has two long pos itions and thus, two breakeven points. One for the call, which breakevens when t he market price equal the high exercise price plus the premium paid, and for the put, when the market price equals the low exercise price minus the premium paid . Advantages of option trading Risk management: Put options allow investors hold ing shares to hedge against a possible fall in their value. This can be consider ed similar to taking out insurance against a fall in the share price. Time to de cide: By taking a call option the purchase price for the shares is locked in. Th is gives the call 182 Investment Planning PDP

option holder until the Expiry Day to decide whether or not to exercise the opti on and buy the shares. Likewise the taker of a put option has time to decide whe ther or not to sell the shares. Speculation: The ease of trading in and out of a n option position makes it possible to trade options with no intention of ever e xercising them. If an investor expects the market to rise, they may decide to bu y call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a l oss. Trading options has a lower cost than shares, as there is no stamp duty pay able unless and until options are exercised. Leverage: Leverage provides the pot ential to make a higher return from a smaller initial outlay than investing dire ctly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the sha re. Income generation: Shareholders can earn extra income over and above dividen ds by writing call options against their shares. By writing an option they recei ve the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price. Strategies: By combining different op tions, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies. PDP Investment Planning 183

Review Questions: 1. In an options contract the option lies with which one of th e following: a. Buyer b. Seller c. Both d. The stock exchange 2. The potential r eturns on a futures contract are: a. Limited b. Unlimited c. A function of the v olatility of the index d. None of the above 3. On 13th August 2006 Mr. Ashwin Me hta bought a Aug Nifty futures contract of 100 Nifties which cost him Rs. 3,40,0 00/-. He paid a margin of Rs. 51,000/- On expiry date Nifty closed at 3430. How much profit/loss Mr. Ashwin Mehta made in this transaction? a. Profit of Rs. 600 0 b. Profit of Rs. 300 c. Profit of Rs. 3000 d. Loss of Rs. 6000 4. A stock curr ently sells at Rs. 240. The put option to sell the stock at Rs. 255 costs Rs 19. The time value of the option is: a. Rs. 19 b. Rs. 5 c. Rs. 4 d. Rs. 15 5. A put option gives the the right but not the obligation to the underlying asset ice: a. seller, buy b. seller, sell c. owner, buy d. owner, sell 6. If spot Nift y is 3400 and the interest rate is 12% p.a. what should be the fair price of One month Nifty futures contract? a. 3412 b. 3424 c. 3434 d. 3452 184 Investment Planning PDP

7. A speculator thinks that India Cements is going to rise sharply. He has a long p osition on the cash market in India Cements to the extent of Rs. 20 lacs. India Cements has a beta of 1.3. Which of the following positions on Index futures giv es him a complete hedge? a. Long Nifty Rs. 26 lacs b. Short Nifty Rs. 26 lacs c. Long Nifty Rs. 20 lacs d. Short Nifty Rs. 20 lacs 8. In the first week of September you observe that the spread between the September and October of Siemens futures has narrowed down to Rs.10 as against the usual Rs. 20. How can you profit from this observation? a. By buying the September fut ures and selling October futures b. By selling the September futures and buying the October futures c. By both d. None of the above 9. On 1st September 2006 a call option of Nifty with a strike price of Rs 3400 is a vailable for trading. Expiry date for September 2006 contracts is 27. The T that i s used in Black- Sholes formula should be: a. 27 b. 0.074 c. 0.061 d. None of th e above 10. An American Option can be exercised : a. At any time till expiry b. Only on expi ry c. It is not used in India d. None of the above 11. An European Option can exercised : a. At any time b. Only on expiry c. Both at a ny time and on expiry d. None of the above 12. At any given time the F&O segment of NSE provides trading facility for Nifty futur es contracts: a. 1 b. 3 c. 2 d. 9 PDP Investment Planning 185

13. An investor buys two market lots of Sep sells two market lots of Sep 3400 Nifty f Nifty is 100. If Nifty closes at 3460 of costs from this bull spread will be loss of 2,400 d. profit of 2,400 14. A bull spread is created by a. buying a call and buying a put b. buying a call a nd selling a call c. buying two puts d. buying two calls Answers: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. a b c c d c b b b a b b a b 186 Investment Planning PDP 3400 Nifty calls at Rs. 76 per call and call at Rs. 40 a call. Each market lot o on the expiration date, the pay off, net : a. profit of 4,800 b. loss of 4,800 c.

Chapter 13 PDP Investment Planning 187

Real Estate L ets look at real estate as an investment vehicle where the income earning capacit y and capital appreciation over time become more important than occupation for s elf use. Characteristics of real estate investments Higher capital requirement It is possible for an investor to participate in debt or equity through small investments; say Rs. 5,000/where as in the case of dire ct investment in real estate the amounts required will be much higher. That also essentially means that this asset class would some time become the most importa nt (heavily weighted) in value terms in ones portfolio. The heavy capital cost ke eps a large number of small investors away and that also contributes in reducing the number of investors who participate in real estate. Indirect investments in real estate through Mutual fund realty funds have cleared the legal requirement s and are set to be launched in India where after retail participation in realty may become easier. Illiquidity Real estate is difficult to acquire and more dif ficult to sell because of absence of organized markets as in the case of bonds a nd equities That makes it a tall task for the investor to search for real estate worth investing; time and money are spent in finding investment options same is the case at the time of sale. The real estate then becomes essentially a long t erm investment option where liquidity is a very big problem. Title and legal pro blems The property laws are not investor friendly. Buying property involves not just selection of a good property with scope for income and or appreciation but also with a good marketable title. Numerous cases have come up where titles have been challenged many decades after deals on the properties have been entered in to. With the judiciary taking a long time to settle matters of title in properti es the laws in respect to real estate are cumbersome and can easily put off enth usiastic investors. Buyers beware is the most applicable jargon and can prove quit e tricky in real estate deals. Government controls; policies, etc. Real estate h oldings involve a lot of legislation on who can own; etc. Many of these are Stat e legislations and hence require specialist advice on these matters. Documentati on involving payment of stamp duties, at arbitrary rates fixed by Stamp offices, mandatory registration, etc. not only increase the cost of transactions but inv olve physical presence of the buyers and sellers for executing the transfer docu ments. In other words, physical inconvenience and heavy costs make real estate i nvestments that much less attractive. Legal complexities The legal contracts bet ween property owners, financiers and tenants are quite complex and require legal interpretation and construction. This aspect of real estate brings in not only additional costs but the choice of right legal consultant. 188 Investment Planning PDP

Management burden Buying real estate is a complex process but holding on to it i s also not easy. It involves considerable cost of maintenance; taxes municipal a nd other charges, etc. Being able to retain possession, especially in case of va cant lands, can be a challenging management task where many times possession is c onsidered ownership and the onus then falls on the owner to prove his title in le gal battles for possession that can stretch to decades. Inefficient market Real estates dont have a market place as equities or bonds have. The market is not pro perly structured. Because of the very nature of immovable properties the market is also highly localized where local factors play a very vital role. A national market has not developed in real estate because of physical limitations as they exist today in other words a person in New Delhi may find real estate in Bangalo re a very attractive proposition but it will be physically impossible for him to participate in this investment opportunity. There is a need for a national and structure market to emerge in order to attract large scale investments but becau se of typical state laws it may become difficult in India to have a very dynamic and liquid real estate market. Advantages of real estate 1. Scope for capital appreciation the longer one holds on to properties, it has been observed, higher the capital appreciation demand for houses has been on the rise thanks to increasing income levels and lower cost of housing loans and the input costs like steel, cement, etc. have also been rising. Income stream where the property can be rented out property rentals have been going up because of l arge scale employment generation in urban centres where people from smaller plac es move in to rental accommodation as ownership is beyond them at least in the i nitial years of employment. Sense of security properties are considered less vol atile compared to paper securities like bonds or shares falling prices are quite rare capital loss may not be incurred obviously these are perceptions and may n ot be right. Sense of pride It gives a sense of pride to the individual that he stays in a house owned by him and this can not be measured in monetary terms. Se lf occupation house properties are bought more for self occupation than for reas ons of investment at the point of self occupation these are not investments but at the time of retirement people may shift to smaller cities in which case the o wnership houses in bigger cities can be sold at substantially higher prices and this shall provide retirement capital as well. Sometimes people may shift from s maller homes to bigger ones or from one locality to another when their older hom es fetch them handsome prices compared to purchase costs thus making them a very good investment. Tax shelter the income earned on rented properties is subject to some deduction; the tax on capital gains made on real estate can be saved tot ally through planning; a housing loan gives the investor tax advantages which we shall consider in greater details later. These tax advantages make real estate an attractive proposition for high net worth in di vi du al s, c orpo ra te s, e tc . Numerous tax advantages exist in the case of agricultural land agricultura l income being exempt from Income tax even though it may have a nominal impact o f taxation in the lower income tax bracket while capital gains on sale of agricu ltural land is fully exempt. 2. 3. 4. 5. 6. If an investor is able to analyze carefully take professional advice and legal h elp and invests for long term the scope for appreciation is quite high and this vehicle can yield handsome returns not only in PDP

Investment Planning 189

percentage terms but in quantitative terms as well because of inherent high valu e investment involved. Disadvantages of real estate Legal issues There are a large number of legal issues involved in investing in r eal estate. Many of the legislations are State legislations and hence a good und erstanding of local laws is essential. For example lands can be bought and regis tered only in the name of farmers i.e. you can buy agricultural land only if you already own agricultural land in that state. Land ceiling laws are applicable i n certain states which makes buying a large piece of land highly risky. Popular tenancy laws exist in many states where the tiller becomes the owner of the agri cultural land. These legal issues are complex and an investment in agricultural land, not withstanding the tax advantages, can be considered only if an investor has a thorough understanding of these complex legal issues. High cost of mainte nance Urban house property owners are required to pay maintenance charges to co operative housing societies for common facilities like lifts, security, water, c ommon lighting, etc. These are essential costs of maintenance and these costs ar e rising at alarming rates. If one holds house properties for just capital appre ciation and not for self use or renting out then the costs become all the more h eavy and can impact the over all returns on this property investment. Municipal and other levies An owner of land or house property is required to pay the local authority certain taxes on a regular basis. These are essentially charges for t he services such as drainage, water supply, etc. that are provided by the local bodies. These costs have also risen substantially over time. Besides usage based charges local bodies charge property tax and there are proposals that these tax es could become ad valorem that is on value in other words if a house property is of high value then it may attract very high municipal property tax. This means t hat holding costs in respect of high value house properties can go up astronomic ally making it uneconomical to hold them as long term investments. There are num erous other disadvantages such as higher investment quantum, illiquidity, lack o f organized market, absence of uniform laws, etc. which we have discussed under the characteristics of real estate investments. Real estates essentially involve h igh capital outlay. In order to attract retail investors the market players have found many ways. Some of them are listed below: Realty funds Mutual funds have now been permitted by SEBI, the regulator, to launch realty funds. These funds c ollect corpus from retail investors and large investors pool the funds and inves t directly in properties residential and or commercial; shares and bonds of hous ing finance companies and real estate and property companies. In other words thr ough the mutual funds route it has now become possible for a small investor to p articipate in the property market and reap the benefits of the same in an indire ct way. Time Share Some companies have floated novel schemes where an investor c an own properties for a part of the year; say for enjoying holidays for a few da ys in a year. There is rotational ownership with maintenance and other matters b eing managed by the company itself. The returns you get on this is essentially c ost free holidays without hassles of maintaining the properties. You own it on a right to use concept. 190 Investment Planning PDP

Lease back arrangements Some builders sell house properties to investors and the y assure a minimum guaranteed lease rental on these properties. The investor mak es a lump sum investment and buys a house property and in return the builder arr anges to rent out the property at a fixed rent ensuring that the investor gets a minimum assured return on the property. This helps the investor in arriving at an investment decision because he knows the possible returns on the property and he is saved the trouble of hunting for an occupant. The builders normally assur e through this process a fixed rental income per month for a fixed period of tim e. These concepts have become very popular especially in tourist centres like Go a, etc. Valuation of real estate It is important to have a clear idea of valuati on of a property both at the time of purchase as well as at the time of sale. Th e parameters of valuation are complex and the valuations are many times highly s ubjective. The price for a property is arrived at mutually by the buyer and the seller while the value could be different. They tend to be very close to each ot her if both the buyer and seller are making informed decisions. Considerations f or value 1. Location accessibility to public conveyance (nearness to local railw ay station in the case of Mumbai city) nearness to schools, work place, hospital s, temples, bus stand, railway station, gardens, parks, etc. are important consi derations. Many housing complexes try to provide most of these facilities like s chools, shopping centres, play grounds, hospitals, etc. inside the complex to ma ke it an attractive investment at a good price. Proximity to employment opportun ities: Shuttle cities near major cities have developed into good centres because of nearness to mega cities. Investors who cannot afford property investments in mega cities tend to invest in these suburbs or shuttle cities. Because major em ployment opportunities generally exist in major cities these shuttle cities also develop over a period of time providing appreciation and income to the investor s in these smaller cities/towns. Values of properties in cities like Bangalore h ave gone up because IT sector companies have moved into the city in a big way, p roviding huge employment opportunities. Environment the general environment is a lso considered while making investment decision whether the area is growing in i mportance or static or declining. Infrastructure: Easy accessibility through goo d road, drainage, water and power supply, clean surroundings, etc. are important considerations. The quality of construction, amenities provided, quality of oth er facilities provided.. etc. are important factors while buying house property. 2. 3. 4. 5. Traditional approaches to valuation a. Capitalization approach It is important to find out based on a market researc h what kind of yields are obtainable on comparable properties. Secondly it is re quired to work out the net income derived from the property by deducting expense s like repairs, insurance, etc. from the gross income and finally capitalize the net income for the market yield on the property. Example Lets presume that rent fetched is generally around 8.5% of property values. PDP Investment Planning 191

If rental income of say Rs. 20,000/- p.m. is earned on a property and expenses t o the tune of say Rs. 20,000/- are incurred every year on insurance, repairs, et c. then the net annual rental income from the property would amount to 12*20000 -20000 = 220000/Capitalising net income of Rs. 2,20,000/- for an yield of 8.5% a s follows, we get the capital value of the property: 2,20,000/0.085 = Rs. 25,88, 235/b. Discounted cash flow method If the property was bought earlier and has be en earning regular income on a year on year basis we have to work out the presen t value of cash flows using our standard formula used in annuity calculations. V alue of the property is the present values of all cash flows to be received by o wning the property as well as expected cash flow on sale of the property after a definite period of time. It is difficult to predict the future prices while a r easonable estimation of possible rental income can be made. Rentals also tend to fluctuate and normally go up over a period of time. If we are given the present price, expected price at which the property will be sold after a few years and the quantum of rental income on a yearly basis then we can work out the return o n this investment the same way as we calculate the YTM of bonds. Example An inve stor wants to purchase a property which will fetch him a net rental income of Rs . 25,000/- p.a. steadily for the next 3 years at the end of which he will be abl e to sell the property for Rs. 3,00,000. If the investor wants a return of 12% p .a. what price he should pay for the property? PV = [25000/(1.12)] +[ 25000/(1.1 2)2]+ [(25000+300000)/(1.12)3] = 22321.42 +(25000/1.2544)+(325000/1.405) =22321. 42 +19929..84 + 231316.72 = 273356.98 say Rs. 2,73,400/He will get desired retur n of 12% p.a. on a rent of Rs. 25,000/- p.a. for the next 3 years if he purchase s the property now for Rs. 2,73,400/- sells it after 3 years for Rs. 3,00,000/Taxability of real estate investments Taxability of income n n Rental income is taxable. Certain deductions are permit ted from the income in computing taxable income on house property. 1. 2. 3. 4. n n The permitted deductions are: 30% of rent as a standard deduction Interest pa id on borrowed capital the limit of Rs. 1,50,000/- is applicable for self occupi ed properties where the rental income is NIL. Municipal taxes actually paid Repayment of principal amount of housing loan is entitled to be deducted from in come u/s 80C up to a maximum limit of Rs. 1,00,000/- p.a. In case of joint owner ship of house property deductions of interest amounts as loss on self occupied p roperty as well deduction u/s 80C are allowed for each one in the same proportio n. In other words increased tax benefit and each of the joint holders can enjoy tax advantages. 192 Investment Planning PDP

Taxability of capital gains It is defined that if a piece of land or house prope rty had been held for a minimum period of 36 months before selling then it is lo ng term capital gains and if sold with in 36 months the gains on sale shall be t reated as Short Term Capital Gains. Short term capital gains = Sale consideratio n (sale price) * n n n n Expenses like brokerage, advertisement on sale Expenses like society transfer charges Cost of acquisition Cost of improvement Long Term capital gains = Sale consideration (sale price)* n n n n Expenses like brokerage, advt, etc on sale Expenses like society transfer charges Indexed cos t of acquisition# Indexed cost of improvement *Sale consideration shall be the actual sale price as mentioned in the sale deed or value adopted by stamp duty valuation authority whichever is higher. # Index ed cost of acquisition is arrived at by multiplying the actual cost with the inf lation index (as published from time to time) for the year of sale and dividing by the inflation index in the year of purchase. In case of properties bought/acq uired/inherited before 1st April 1981 the market value, as per approved valuer, shall be taken as the cost of purchase. Rate of Tax 1. 2. STCG is added to incom e under the head Income from other sources and taxed at the rate applicable to the tax payer. LTCG is taxed at 20% after arriving at the figure of taxable LTCG as shown above Saving tax on LTCG It is possible to save tax payable on LTCG and the provisions have been laid down below: Sec 54 Sell a house property and buy or construct an other house property n n n n n n n n Applicable for individuals and HUF The sold house need not be a self occupied house property The sold house need not be the only house property The sold house should have been held for more than 36 month s from purchase New house should be purchased within one year before sale or two years after sale New house, if constructed, should be within 3 years after sale If the cost of the new house is lower than net sale consideration then the diff erence will be taxable as LTCG If the assessee sells the new house within three years of its purchase then this becomes STCG and the cost of acquisition will be taken as NIL (if the cost of new house is lower than LTCG made on old house) PDP Investment Planning 193

n n In the previous explanation if the cost of new house was equal to or more than L TCG on old house the cost of new house will be computed as actual cost LTCG on t he old house It may take some time to purchase or construct a new house the amou nt of LTCG will have to kept in a special account designated as Capital Gains Acc ount with a specified bank before filing returns for the Previous year in which t he old house was sold the funds in the account can be utilized for buying the ne w house. Sec 54 B sell agricultural land and buy agricultural land -deals with sale of ag ricultural land, LTCG on sale can be saved by buying another agricultural land a s per same terms and conditions listed above for a house property. Sec 54 EC sel l any long term asset and invest in infrastructure bonds . An assessee might hav e made LTCG on sale of any long term capital asset like house, gold and jeweller y, land, etc. n If the entire sale proceeds are invested in bonds of Government companies like Rural Electrification Corporation Ltd. and/or National Highway Au thority of India, Ltd. then the tax on LTCG can be saved fully. If part of the p roceeds are invested in such bonds proportionate deduction from LTCG will be all owed The investment in bonds u/s 54EC should be made within 6 months of sale The lock in period for the bonds will be minimum of 3 years The interest on the bon ds is taxable The rate of interest is decided by the PSU companies it is current ly around 5 -5.5% p.a. n n n n n Sec 54 F sell any long term asset and buy a house property n n n n n n n n The t ax payer should be individual or HUF The LT asset sold should not be a house pro perty The new residential house should be purchased with in one year prior to sa le or two year after the sale of the old asset or The new house should be constr ucted with in 3 years from the sale of the old asset The deduction is applicable to an assessee even if he is already owning a house property. If the cost of th e new house property is less than LTCG made on the old asset then a proportional deduction will be available under this section and balance tax will have to be paid as tax on LTCG. If the tax payer sells the new house with in 3 years of pur chase the conditions as spelt out earlier u/s 54E will become applicable. It may take some time to purchase or construct a new house the amount of LTCG will hav e to be kept in a special account designated as Capital Gains Account with a speci fied bank before filing returns for the Previous year in which the old asset was sold the funds in the account can be utilized only for buying the new house pro perty. 194 Investment Planning PDP

Review Questions: 1. Mr. Wankhede is planning to sell his house and buy a bigger new house. When should he buy a new house with reference to sale of his old hou se in order to avail of full benefit of Sec 54 of the Income Tax Act? a. With in 1 year after sale b. Within 3 years after sale c. Within one year prior to sale or 2 years after sale d. Within two years prior to sale or 2 years after sale 2 . An investor is considering a purchase of house property which shall fetch him a rental income of Rs. 15,000/- p.m. The investor is looking for 10% returns and he is confident that he can sell the property after 3 years for Rs. 5,00,000/What price should he pay for this house property now? a. Rs. 4,12,000/b. Rs. 3,6 6,000/c. Rs. 3,87,000/d. Rs. 4,32,000/3. If an individual who has made LTCG want s to save the tax on the same fully, he should invest within what period of sale to avail benefit u/s 54EC of IT Act? a. 6 months b. 12 months c. 3 years d. 2 y ears 4. Husband and wife have together bought a new house and have availed of ho using loan from a bank. They have contributed 50% each to cost of the house. If the total amount of interest paid by them on the home loan for self occupied hou se property during a financial year has been Rs. 2,40,000/- what deduction will each one get from income as Loss under house property? a. Either one of them can g et a deduction not exceeding Rs. 1.50 lacs but not both b. Both can get deductio n but the deduction will be restricted to Rs. 1,20,000/- each c. Only the first holder on the loan will get a deduction and it will be restricted to Rs. 1,50,00 0/d. Both can get deduction but the deduction will be Rs. 1,50,000/- each Answers: 1. 2. 3. 4. c a a b PDP Investment Planning 195

Chapter 14 196 Investment Planning PDP

Investment strategies Passive strategy S ome investors perceive that the securities markets, particularly the equity mark ets, are efficient. There is a belief that the stock market is a barometer of th e economy and that the market perfectly reflects the strengths and weaknesses of the economy over long term while in the short term there can be temporary aberr ations (and over reactions of optimism and pessimism). In an efficient market, t he prices of securities do not depart for any length of time from the justified economic values that investors calculate for them. Economic values for securitie s are determined by investor expectations about earnings, risks, and so on, as i nvestors grapple with the uncertain future. If the market price of a security do es depart from its estimated economic value, investors act to bring the two valu es together. Thus, as new information arrives in an efficient marketplace, causi ng a revision in the estimated economic value of a security, its price adjusts t o this information quickly and, on balance, correctly. In other words, securitie s are efficiently priced on a continuous basis and the long term investors who a re holding on to securities need not resort to any action of buying and selling but continue to hold. These investors believe that it is not worth their efforts in terms of time and cost to trade on the temporary aberrations but hold on to qualitative securities that shall perform in line with the market over a period of time. That is, after acting on information to trade securities and subtractin g all costs (transaction costs and taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy. If the market is economica lly efficient, securities could depart somewhat from their economic (justified) values, but it would not pay investors to take advantage of these small discrepa ncies. A natural outcome of this belief in efficient markets is to employ some t ype of passive strategy in owning and managing common stocks. If the market is t otally efficient, no active strategy should be able to beat the market on a risk -adjusted basis. The Efficient Market Hypothesis has implications for fundamenta l analysis and technical analysis, both of which are active strategies for selec ting common stocks. Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction co sts and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investo rs act as if the market is efficient and accept the consensus estimates of retur n and risk, accepting current market price as the best estimate of a securitys va lue. In adopting the passive strategy the investor will simply follow a buy-andhold strategy for whatever portfolio of stocks is owned. Alternatively, a very e ffective way to employ a passive strategy with common stocks is to invest in an indexed portfolio. We will consider each of these strategies in turn. Buy And Ho ld Strategy A buy-and-hold strategy means exactly that - an investor buys stocks and basically holds them until some future time in order to meet some objective . The emphasis is on avoiding transaction costs, additional search costs, and so forth., The investor believes that such a strategy will, over some period of ti me, produce results as good as alternatives that require active management where by some securities are deemed not satisfactory, sold, and replaced with other se curities. These alternatives incur transaction PDP Investment Planning 197

costs and involve inevitable mistakes. Notice that a buy-and-hold strategy is ap plicable to the investors portfolio, whatever its composition. It may be large or small, and it may emphasize various types of stocks. Also note that an importan t initial selection must be made to implement the strategy. The investor must de cide initially to buy certain stocks and not to buy certain other stocks. Note t hat the investor will, in fact, have to perform certain functions while the buyand-hold strategy is in existence. For example, any income generated by the port folio may be reinvested in other securities. Alternatively, a few stocks may do so well that they dominate the total market value of the portfolio and reduce it s diversification. If the portfolio changes in such a way that it is no longer c ompatible with the investors risk tolerance, adjustments may be required. The poi nt is simply that even under such a strategy investors must still take certain a ctions. In other words a passive strategy also requires some action on the part of the investors much less frequently compared to active strategies. An interest ing variant of this strategy is to buy-and-hold the 10 highest dividend-yielding stocks among the BSE Sensex at the beginning of the year, hold for a year, and replace any stocks if necessary at the beginning of the next year with the newes t highest-yielding stocks in the BSE Sensex. This strategy does not require stoc k selection since it is based only on using the easily calculated dividend yield for 30 identified stocks, and making substitutions when necessary. Index Funds Some investors prefer indirect investment to direct investment in equities. For this class of investors the best passive strategy could be buying into an Index Fund. In an Index fund the fund manager pools the resources of a number of inves tors and invests in stocks that comprise the index in the same weightage as in t he Index. These funds are designed to duplicate as precisely as possible the per formance of some market index. A stock-index fund may consist of all the stocks in a well-known market average such as the NSE Nifty. No attempt is made to fore cast market movements and act accordingly, or to select under-or overvalued secu rities. Expenses are kept to a minimum, including research costs (security analy sis), portfolio managers fees, and brokerage commissions. Index funds can be run efficiently by a small staff. Surprisingly, at times the passive index funds hav e been found to perform better than some most actively managed funds mainly beca use the active funds might have under performed the market during that period of time. These are open ended funds where the loads are the least and the returns in line with the market index which they propose to replicate. Active strategy I nvestors, who do not accept the Efficient Market Hypothesis and those who believ e that it is possible to out perform the market consistently over a period of ti me through active management of stocks selected, pursue active investment strate gies. These investors believe that they can identify undervalued securities and that lags exist in the markets adjustment of these securities prices to new (bette r) information. These investors generate more search costs (both in time and mon ey) and more transaction costs, but they believe that the marginal benefit outwe ighs the marginal costs incurred. Investors adopt two pronged strategies to perf orm better than the market proper stock selection and timing the entry and exit points. Stock Selection Most investment techniques involve an active approach to investing. In the area of common stocks the use of valuation models to value an d select stocks indicates that investors are analyzing and valuing stocks in an attempt to improve their performance relative to some benchmark such as a market index. 198 Investment Planning PDP

They assume or expect the benefits to be greater than the costs. Pursuit of an a ctive strategy assumes that investors possess some advantage relative to other m arket participants. Such advantages could include superior analytical or judgmen t skills, superior information, or the ability or willingness to do what other i nvestors, particularly institutions, are unable to do. Individual investors enjo y certain advantages over institutional investors: n n n They can invest in smal l cap stocks They need not have highly diversified portfolio They have go short on the market For example, many large institutional investors cannot take positions in very sm all companies, leaving this field for individual investors. Furthermore, individ uals are not required to own diversified portfolios and are typically not prohib ited from short sales or margin trading as are some institutions. Most investors still favour an active approach to common stock selection and management, despi te the accumulating evidence from efficient market studies and the published per formance results of institutional investors. The reason for this is obvious - th e potential rewards are very large, and many investors feel confident that they can achieve such awards even if other investors cannot. The most traditional and popular form of active stock strategies is the selection of individual stocks i dentified as offering superior return-risk characteristics. Such stocks typicall y are selected using fundamental security analysis or technical analysis and som etimes a combination of the two. Many investors have always believed, and contin ue to believe despite evidence to the contrary from the Efficient Market Hypothe sis, that they possess the requisite skill, patience, and ability to identify un dervalued stocks. We know that a key feature of the investments environment is t he uncertainty that always surrounds investing decisions. Most stock pickers rec ognize the pervasiveness of this uncertainty and protect themselves accordingly by diversifying. Therefore, the standard assumption of rational, intelligent inv estors who select stocks to buy and sell is that such selections will be part of a diversified portfolio. How important is stock selection in the overall invest ment process? Most active investors, individuals or institutions, are, to variou s degrees, stock selectors. The majority of investment advice and investment adv isory services are geared to the selection of stocks thought to be attractive ca ndidates at the time. Stocks are, of course, selected by both individual investo rs and institutional investors. Rather than do their own security analysis, indi vidual investors may choose to rely on the recommendations of the professionals. Many brokerage houses employ research personnel and put up research reports on various companies. One of the most important responsibilities of an analyst is t o forecast earnings per share for particular companies because of the widely per ceived linkage between expected earnings and stock returns. Earnings are critica l in determining stock prices, and what matters is expected earnings). Therefore , the primary emphasis in fundamental security analysis is on expected earnings, and analysts spend much of their time forecasting earnings. Studies indicate th at current expectations of earnings, as represented by the average of the analys ts forecasts, are incorporated into current stock prices. An active strategy that is similar to stock selection is group or sector rotation. This strategy involv es shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better, and avoid or de-emphasize tho se sectors that are expected to do relatively worse. PDP Investment Planning 199

Investors employing this strategy are betting that particular sectors will repea t their price performance relative to the current phase of the business and cred it cycle. Timing The Market n Market timers attempt to earn excess returns by va rying the percentage of portfolio assets in equity securities. One has only to o bserve a chart of stock prices over time to appreciate the profit potential of b eing in the stock market at the right times and being out of the stock market at bad times. When equities are expected to do well, timers shift from cash equiva lents such as money market funds to common stocks. When equities are expected to do poorly, the opposite occurs. Alternatively, timers could increase the Betas of their portfolios when the market is expected to rise and carry most stocks up , or decrease the Betas of their portfolio when the market is expected to go dow n. One important factor affecting the success of a market timing strategy is the amount of brokerage commissions and taxes paid with such a strategy as opposed to those paid with a buy-and-hold strategy. Like many issues in the investing ar ena, the subject of market timing is controversial. Evidence indicates it is dif ficult for investors to regularly time the market efficiently enough to provide excess return on a risk-adjusted basis. n n n n n On a pure timing basis, only a small percent of the stock timing strategies trac ked over the most recent five-and eight-year periods outperformed a buy-and-hold approach. Much of the empirical evidence on market timing comes from studies of mutual funds. A basic issue is whether fund managers increase the beta of their portfolios when they anticipate a rising market and reduce the beta when they a nticipate a declining market. Several studies found no evidence that funds were able to time market changes and change their risk level in response. n Considera ble research now suggests that the biggest risk of market timing is the investor s will not be in the market at critical times, thereby significantly reducing th eir overall returns. Investors who miss only a few key months may suffer signifi cantly. If anybody thinks that market timing as a strategy suitable for the aver age individual investor he is wrong and the market has proved this time and agai n all over the world. It has been proved without doubt that security market retu rns will depend more on the time than timing . Leveraging Aggressive investors adopt the bank financing route to invest in stock s a certain number of times their o wn capital through the process of buying stocks and pledging with bank, raising money on the stocks and buying more stocks. Thus, on a given capital, thanks to bank borrowing against stocks they are able to build a portfolio much higher in value but at a cost, namely the interest cost. These investors are highly aggres sive and are always under pressure that the stocks selected by them should perfo rm and deliver returns superior to the rate of interest payable on the borrowal accounts banks lend against securities at a much higher rate of interest compare d to priority lending or prime lending rates. This route of bank borrowing is us ed by many investors in India when they apply to new issues of shares, through t he book building route of Initial Public Offerings (IPO) or Follow up Public Off erings (FPO) of existing listed companies. These investors while applying for th e IPO essentially put in the margin money alone; which is around 40% of the appl ication money and thus manage to increase the number of shares for which they co uld apply with a given capital, thereby increasing the chances of 200 Investment Planning PDP

allotment of shares. These investors shall benefit only if they get substantial allotment and only if the shares list at prices much higher than the issue price because they incur interest costs on the money financed by the banks. These cos ts are incurred, in any case, not withstanding whether these investors are allot ted any shares in the public offering or not. Some investors use the futures mar ket route to leverage on the available capital. A trader in the futures segment of the market, when he takes a position is not required to pay the full market v alue of this position but only a certain percentage. Thus in the futures segment the trader gains a market exposure which is much higher than his available capi tal. The potential to earn returns as the market goes up or down increases becau se of leveraging. This is a high risk high return game not suitable for average market investors but only for those with very high risk appetite. We have essent ially discussed the two types of strategies namely the passive strategy and acti ve strategy followed in investing. The success lies in developing the right stra tegy that would suit the investors risk profile and his financial goals. It has b een proved without doubt, the world over, that success in investing is about fol lowing a disciplined approach with clearly spelt out goals and the manner of ach ieving the same. One of the time tested strategies for success in investing is a n Asset Allocation Plan decided well in advance before making the investments and sticking to same and acting on it periodically in consultation with a financial advisor. In a later topic we shall discuss in detail about the types of asset al location models and how we go about implementing the same. Maturity Selection In vestors make investments to meet specific demand on funds over a certain period of time. Some of these time horizon related needs could be: 1. 2. 3. 4. Buying a bigger house in about 5 years Regular income flows every year after a term to m eet education expenses of the children Lump sum requirement after a few years to meet marriage expenses of children especially the daughter Regular flow of inco me, on a monthly basis, after a certain period of time post retirement needs and so on The investment strategy involved in meeting this type of time related fund requi rements would depend upon the time span after which the requirement will arise: a. b. Short term say requirement within 3/5 years Long term not less than 5 year s The investment vehicle will be decided upon whether the need is expected to aris e over short term or long term. If the need is short term then it may not be wis e to park the funds in equity and equity related instruments as the risk associa ted with this avenue is especially higher in the short term. A debt fund or a fi xed income instrument is preferred in such cases. If the need is medium, say, fo r meeting education and/or marriage expenses of children over the next 5 to 10 y ears then an investor can invest in Balanced funds or specific child care funds of mutual funds or specific children plans of life insurance companies. The equi ty or equity related instruments would be ideal for building capital over long p eriod of time. It is a well established fact that equities have delivered superi or returns compared to other asset classes over longer period of time while in t he short term the returns can be erratic and even negative. At the same time sin ce this is a high risk avenue the returns also tend to be higher and hence capit al building PDP Investment Planning 201

becomes that much easier. There are specific deferred annuity plans of life insu rance companies where investments are made on a systematic basis while in servic e, by the salaried class of investors, so that a certain amount of pension becom es payable on retirement. These are essentially long term low risk low return ki nd of plans most suited for the conservative investors. Thus one can conclude th at the strategy of investments can not only be classified as Passive and Active but also based on the Time Horizon of the investible funds and the requirements for the funds over time. Many times it is the time based requirement of funds th at determines where the money is invested. 202 Investment Planning PDP

Review Questions: 1. In respect of investing in Index funds which one of the follo wing statements is not true? a. It is suitable to investors who seek returns muc h in excess of market returns. b. It is a very aggressive investment strategy c. It is an active investment strategy d. It is suitable to investors who expect m arket returns on the investment 2. Buy and hold is a strategy suitable for which o f the following type of investors? a. Investors who want short term returns b. I nvestors who want their shares to out perform the market c. Investors who believ e that market is an efficient place and that over long period this strategy pays d. Aggressive investors 3. Adopting the bank financing route for applying to IP Os would amount to which of the following? a. Active strategy of investments b. P assive strategy of investments c. Low risk low return strategy d. Rupee Cost Aver aging strategy 4. Trading in stock futures in the derivatives segment of the mark et would amount to which one of the following strategies? a. Active b. Passive c . Low Risk low return d. Rupee Cost Averaging 5. Which one of the following statem ents is true regarding market timing? a. It is easy for the small investor to ti me the market and maximize the gains b. Market Timing is the most important factor for success in investment decisions for small investors c. It is the time more th an the timing that has benefited the investors investors stand to benefit if they are prepared to invest for longer term rather trying to time the market d. Timing is the key for long term investors 6. An investor plans to invest some capital t o meet a requirement that is most likely to crop up within the next one or two y ears. He is not very keen on high returns on this investment. Which out of the f ollowing could be the most suitable option for him? a. A. floating rate debt fun d b. A sector specific equity fund c. Direct investment in select stocks from th e market d. Keep the money liquid in a saving bank account because returns over this period can be quite uncertain. Answers: 1. 2. 3. d c a 4. 5. 6. a c a PDP Investment Planning 203

Chapter 15 204 Investment Planning PDP

Asset Allocation T he important decision that an investor is required to take is on Asset Allocatio n. There are different asset classes like equities, bonds, real estate, cash and even foreign investments to a limited extent available to Resident Indian inves tors now. It has been a well established fact that Asset allocation has been pri marily responsible for portfolio performance more than even stock selection and timing issues. Asset allocation is the key to portfolio returns and hence it is of paramount importance. The asset allocation decision involves deciding the per centage of investable funds to be placed in stocks, bonds and cash equivalents. It is the most important investment decision made by investors because it is the basic determinant of the return and risk taken. This is a result of holding a w elldiversified portfolio, which we know is the primary lesson of portfolio manag ement. Thus asset allocation serves the purpose of diversification among differe nt asset classes and diversification among different securities within an asset class. The returns of a well-diversified portfolio within a given asset class ar e highly correlated with the returns of the asset class itself. In other words t he returns on a stock portfolio will depend on the market returns to a great ext ent no stock is expected to give phenomenal returns when the market returns are low or negative. Within an asset class diversified portfolios will tend to produ ce similar returns over time. However, different asset classes are likely to pro duce results that are quite dissimilar. Therefore, differences in asset allocati on will be the key factor, over time, causing differences in portfolio performan ce. Factors to consider in making the asset allocation decision include the inve stors return requirements (current income versus future income), the investors ris k tolerance, and the time horizon. This is done in conjunction with the investme nt managers expectations about the capital markets and about individual assets. A ccording to some analyses, asset allocation is closely related to the age of an investor. This involves the so-called life-cycle theory of asset allocation. Thi s makes intuitive sense because the needs and financial positions of workers in their 50s should differ, on average, from those who are starting out in their 20 s. According to the life-cycle theory, for example, as individuals approach reti rement they become more risk averse and hence they should allocate fewer amounts in percentage terms to equity and equity related instruments in their portfolio . Asset class risk Risk in the context of investments has different meanings for different people. To the common investor risk means the probability that he may lose his capital o r suffer loss on the investment. To the analyst it is the chance that the invest ment vehicle may not deliver the required or expected returns and thus not fulfi ll the financial goals. It is also well established through research over long p eriods that equity as an asset class, international as well as domestic, is the most volatile of asset classes. In equities the range of returns as well as the potential for capital loss is the greatest, especially in the short term. While equity may be riskier asset class it also has the potential to earn superior ret urns over long term. It is also well established that over the long term equitie s, foreign as well as domestic, have delivered returns much higher than other cl asses of financial assets. Hence equities will find a place in every bodys portfo lio but the extent could vary depending on the risk profile, age, need for highe r returns, time frame, etc. PDP Investment Planning 205

Types of asset allocation The two models of asset allocation are Strategic Asset Allocation and Tactical A sset Allocation. Strategic Asset Allocation n n n n n It is essentially a long t erm investment plan It is the structuring the individual asset classes within a portfolio to meet long term investment objectives. No switches between securitie s or asset classes is normally done in the short term Defined exposures are made to different assets providing for some minor adjustments within the asset class without shifting the focus of the portfolio. A right allocation among different classes of assets shall ensure that investors investment objectives are met. Tactical Asset Allocation n n n TAA is a dynamic portfolio technique that seeks to take advantage of the short term movements and opportunities in the market. T he asset allocation of a portfolio is changed, in this process, on a short term basis to take advantage of perceived differences in the values of various asset class changes. It works on the underlying principle that in the short term the s ecurities market may not be properly valued resulting in under valuation and ove r valuations it is possible to take advantage of these aberrations through switc hes between asset classes and within securities. All the same a balance is maint ained and it is ensured that each asset class in the model is maintained within the permitted range for that asset class A range for each asset class is fixed a nd short term movements/switches are made within the range to take advantage of market movements. n n Lets look at both types of Asset Allocation models in a tabular form to understan d the essential differences: Thus you will find that while the asset classes are the same the difference lies in the manner of allocation among assets fixed allocation in SAA while a ranged allocation in TAA. Lets look at TAA allocations at different equity market level s: 206 Investment Planning PDP

Thus, at any point in time, investments will be there in all asset classes but t he percentage will vary depending upon the market condition and the out look for the market over the short term but the variation will be within the fixed limit s set for each asset class. We have looked at an example of stock market valuati ons affecting allocation to equities similarly interest rate out look and curren t interest rates will influence investment in fixed income securities. If the in terest levels in the economy hover around very high levels it is only natural th at the fixed income portion would be close to the upper band of allocation which in the given example is 60%. As the interest rates start falling bonds will fet ch capital appreciation while yields will fall and the weightage will gradually shift from bond to equity. Obviously while TAA strategy has the potential to ear n higher returns it also calls for a very good understanding of the movements bo nds/securities market and the equity market and also swift decisions of moving f unds from one asset class to the other and moving back. Comparison between SAA a nd TAA TAA can be expected to deliver superior on returns. But TAA involves rese arch inputs which are very vital and also entails frequent transactions. Both th ese come at substantial cost to the investor. Thus one needs to work out whether TAA as compared to SAA has given superior returns after taking into account all the efforts in terms of time and money that has been put in. TAA essentially de als with timing issues. It is very vital to be able to time entries and exits in bonds as well as equities consistently to be able to outperform the markets. Th is is a tough call and very few specialists have done it consistently over long periods of time. The taxation issues also need to be considered. Many short term transactions would result in short gains which are essentially taxed at higher rates. SAA as being necessarily long term is better on the following counts: n n n n n No great issues of skills of timing the market decisions Does not test th e competency of the portfolio managers/advisor to the extent required under TAA Costs are lower Taxation will be lower Chances of success are better as compared to TAA where wrong decisions and costs can prove to be very costly. We may conclude the discussions on suitable asset allocation models as under: n n Some aggressive clients may be inclined towards TAA as the model, on paper, looks superior but the financial planner should make the short comings of TAA clear to the client. Advise the clients to essentially adopt a disciplined approach to investment through SAA rather than TAA The proportion of allocation to risk instruments, where the returns are uncertai n and market related, say equities is essentially a function of risk appetite, a ge, time factors, return expectations, etc. Fixed and flexible allocation Fixed a llocation is sticking to an allocation proportion among asset classes and followi ng the same religiously, till the same is revised based on the changed requireme nts, advancing age, sudden changes in the economy, etc. Flexible allocation is som ething similar to TAA where the range is fixed for different asset classes and p eriodic switching between asset classes is done. The flexible asset allocation is not necessarily an aggressive investment planning. This helps the alert investor to make use of some PDP Investment Planning 207

opportunities that come periodically in the market due to random developments wh ich simply cannot be predicted in advance. Asset Allocation is an Investment Pla nning Tool, not an Investment Strategy... Investment Strategies are used to sele ct and to manage the securities that are allocated to either the Equity or Debt/fi xed income securities. An Asset Allocation Formula is a long-range, semi-permane nt, planning decision that has absolutely nothing to do with market timing or hed ging of any kind. Certainly, a 40% asset allocation to Fixed Income may soften th e fall in the portfolio bottom line during a stock market downturn, but that has nothing to do with the purpose of Fixed Income Securities nor is it in any way related to the reasons for having an asset allocation plan in the first place. S imilarly, the movement of a persons assets from a falling bond market to a rising stock market or vice versa is about as far away from the principles of asset al location as one can get! n n n n Investors should arrive upon the most suitable Asset Allocation Plan Investors should not focus exclusively on market value, Inve stors should not dwell upon comparisons of ones own unique portfolio with Market Averages Investors should not expect performance during specific time intervals as this investment plan is expected to perform over a long period of time Portfolio rebalancing Once an asset allocation plan is finalized; then securitie s are chosen for investments and the investment process is completed. Thereafter the portfolio of investments comprising of debt, equity, etc. should be monitor ed on a periodic basis. The frequency of review could be once in 6 months or eve n once a year a higher frequency is generally not necessary for a long term inve stment plan but sometimes, some economic developments may necessitate an urgent review. One of the most important factors that will have a big influence on the performance of the portfolio is the interest rate (which generally moves with in flation). Whenever large scale, protracted interest rate movements are expected then a rebalancing will become absolutely essential in a rising interest rate sc enario the corporate profitabilites will suffer and consequently the stock price s will fall. Bond prices dip to adjust to the current yields of the market. Redu cing equity exposure of the portfolio may become necessary and moving from long term debt swiftly into short term or from fixed rate long term debt funds to flo ating rate and short term debts could also become necessary. If economic slow do wn is seen, through falling growth rates, then portfolio rebalancing will become necessary again. These economic factors are external factors that will have to be taken into account as their long term impact on the portfolios will be severe and hence suitable rebalancing will have to be done. It should simultaneously b e remembered these are turn around situations and these happen over long term. T here can be some internal family developments also that may make portfolio rebal ancing necessary. A portfolio is built to meet certain financial objectives; not all objectives are met at the same time. One after the other the financial goal s get completed, over a period of time, as the investor gets older and older. So me of the common objectives are buying a bigger home; buying a new car; educatio n of children; marriage of children; retirement capital etc. As these objectives are fulfilled the return requirements may come down and it may be necessary to switch to less aggressive asset allocation plan reducing the exposure to equitie s and increasing the exposure to debt may be made. . It is an established fact t hat the proposition, that a rebalancing strategy can increase expected return is incorrect but on the contrary rebalancing costs definitely reduces expected ret urns. 208 Investment Planning PDP

Probably the best rule of thumb on rebalancing is to look at the overall stock/b ond ratio quarterly, since it is the primary determinant of expected returns, an d examine individual equity asset classes once a year, or so. Rebalance only whe n asset classes, and particularly, the equity/fixed ratio, gets out of balance f ar enough to produce a significant expected difference in returns. Monitoring an d revision of portfolios It is the financial planners function to monitor clients portfolios. When the portfolios are monitored it could be observed that the prop ortion among different asset classes has changed substantially. For example if t he original Asset allocation was Equity 40%, Debt 55% and Cash 5% but on monitor ing if it was found to have changed to Equity 50% Debt 45% and Cash 5% then it a mounts to higher exposure to equity than originally planned. This situation migh t have arisen mainly because of rising stock market and the appreciation of stoc ks held in the portfolio. While deciding on an asset allocation plan a formula i s generally discussed and agreed upon. This formula for revision essentially hin ges on defining substantial shift in emphasis of a particular asset class or even a particular security in an asset class. It could be, say 5% which means that if the Equity proportion has moved above the fixed proportion of 40% by 5% or more , then a rebalancing would be done by selling excess equity and moving to debt o r cash to maintain the Asset allocation proportions decided earlier. Thus monito ring helps in maintaining a balanced portfolio all the time but also ensures pro fit booking when the markets are high and buying when the market prices fall sub stantially. The formula could vary from investor to investor but it is essential so that portfolios are properly monitored to deliver the desired returns over t he long term. A portfolio revision may become necessary because of government po licy changes; economic factors of growth rate; budget and fiscal deficits; infla tion and interest rates, strength of domestic currency, etc. While implementing the investment plan certain securities were bought based on their and the over a ll economic fundamentals. These factors may change over time; fortunes of compan ies also fluctuate, generally in line with the over all economy but some times o n their own as well. For example a strong domestic currency may not be good for export oriented companies but will benefit import dependant companies. A lower i nterest rate on loans may not be good news for banks and financial institutions but good news for consumer durables; automobiles and housing sector as the same spurs demand. While a Buy and Hold strategy is fine it makes sense to observe cr ucial economic factors that may specifically affect some of the securities held and it would be prudent at time to switch out of these securities and move into others. PDP Investment Planning 209

Review Questions: 1. Which of the following statements is not true of Strategic Asset Allocation? a. It is a long term investment plan b. The proportion of each asset class is fixed in advance c. The transaction costs are very high because of frequent switches d. Taxation will be lower because short term transactions a re generally not done 2. Which of the following statement is not true of Tactica l Asset Allocation? a. It is a conservative, long term investment plan b. The pr oportion of each asset class is set in a range of values c. The transaction cost s are very high because of frequent switches d. Taxation will be higher because of short term transactions 3. An investor is very keen on adopting Tactical Asse t Allocation plan. What should be your advise to such an investor? a. The risks are high and the chances of success are low b. Requires exceptional skills of ti ming which nobody in fact can claim to possess c. Strategic Asset Allocation has a better success rate as proved in a majority of cases d. All of the above 4. F requent portfolio rebalancing will cause which one of the following? a. Increase the costs without necessarily contributing to increased returns b. Increase the potential to earn higher returns c. Decrease the costs d. Will ensure that inve stment objectives are achieved quickly 5. Which one of the following could be th e rule of thumb for portfolio rebalancing? a. Keep switching between debt and eq uity on a quarterly basis b. Keep on removing and adding securities on a half ye arly basis c. Look at the equity/debt ratio every quarter and individual stock o nce a year d. The more frequently it is done the better Answers: 1. 2. 3. 4. 5. c a d a c 210 Investment Planning PDP

Chapter 16 PDP Investment Planning 211

Structuring Portfolio for Investors Identification of client needs A financial planner can go about his job after understanding his clients needs thor oughly. It is necessary to collect information from the client about his financi al background, investment objectives, time horizon, expected returns on investme nts, etc. All clients generally have some existing investments in shares, mutual funds, fixed income products, tax saving instruments, life insurance, house pro perty, etc. It is essential to obtain information in respect of the same because while constructing the financial plan restructuring of existing portfolio is eq ually important. Information from clients, therefore, basically comprises of the following components: n Personal information name, age, names of other family m embers, ages, occupation of all family members, address, telephone number, e mai l ID, and such other information that are matters of record and which shall be h elpful in assessing general needs Information on their existing investments and levels of income and taxation for each member of the family. Investment objectiv es buying a luxury car, bigger apartment, childrens education, childrens marriage, retirement planning, holidays especially abroad, etc. Risk profile; attitude, i ntentions, required/expected returns on investments, etc. n n n Information is collected in a manner that is suitable for the investor and the p lanner. However, in order to avoid time delays and to facilitate more meaningful discussions, it may be a good idea to obtain personal information and details o f existing investments (the first two out of the parameters listed above in adva nce). The financial planners, normally, have a data sheet format where the colum ns/questions of personal information are already provided and it is easier for t he client to fill the same. The data collection format may also be made availabl e online or mailed electronically to the client. The client may be encouraged to fill the same and send through e mail, before the meeting. Thus before the pers onal meeting the financial planner has a good idea of the background of the clie nt. This advance collection of information and that too in a specified format sa ves a lot of time which other wise is lost during the meeting with the client. I nformation on the other two parameters namely the objectives/goals and risk prof ile, etc. is best gathered through a personal, informal talk with the client. It may be more useful if both husband and wife, are present during the discussions , so that it becomes easier to identify the objectives, etc. (in case of married clients). It may become necessary to educate the investors primarily, some time s, on matters of risk and return. Many clients may prefer the ultra conservative route while there is nothing with that approach, the client in such circumstanc e should be made to realize the kind of compromise he is making on returns and w hether he can afford to make such compromises. The ultimate objective of underst anding a whole lot of investment avenues available, the risks involved, the retu rns that be expected, how to measure the risk and returns on different investmen t products, etc. is to empower the financial planner so that he can understand t he clients needs and suggest an investment plan that shall be able to achieve the investment goals of the investors. The ultimate financial plan will revolve aro und the risk profile of the client and the required return. If a 212 Investment Planning PDP

client is inclined to take a higher risk the same may be advised and accordingly incorporated by the financial planner in the investment plan provided in the op inion of the planner it is necessary to do so for getting the desired return. Th e planner may advise a more conservative approach if high returns are not requir ed. In case the client is not inclined towards riskier investments and if higher returns are required to meet the financial goals then the financial planner sho uld explain the consequences of a very conservative approach and the need for ta king risk in a certain proportion. Quantum of risk is subjective and it is bound to be different for different client profiles. But in general the extent of ris k that a client may be prepared to take is a function of the following factors: n n n n Age Socio economic status Background academic and work place General nat ure aggressive, modest, timid, humble, practical, etc. Some economic factors that point towards risk profile of the client are: n n Liq uidity a high concern for liquidity will imply a more conservative approach. Inc ome many investors would prefer to have an income flow on all their investments and too preferably guaranteed returns. This again is a very conservative approac h. Income flow should be close to the required level and anything received in ex cess of requirement needs to be deployed for productive purposes to earn higher returns Inflation a lower concern for inflation will mean more exposure to debt/ income oriented investments and less to growth. Taxation a high concern for taxa tion will mean higher exposure to growth and equity oriented instruments where t he incidence of taxation is lower compared to deb/income oriented instruments. V olatility some clients are very concerned about loss of capital that would mean that even a stock portfolio should contain more defensive and large cap stocks l ower on risk and return. n n n Asset allocation plan- in structuring client portfolios After having assessed th e clients needs, background, risk profile etc. the next step is deciding on an A sset Allocation plan that shall best serve the clients needs. We have studied in detail about various financial products available in our market - from the point of risk, return, taxability, etc. We have also studied about the two types of A sset Allocation plans. Based on the clients background information which we have obtained though data sheet and meetings we should prepare an Asset Allocation Pl an specifically for the client. The ultimate success of the financial planning p rocess that helps the investor to meet his financial objectives depends to a lar ge extent on the right Asset Allocation Plan. Hence due care and lot of thoughts should go into preparing the same. Basically financial assets are equity orient ed and debt oriented. The equity oriented assets whether direct investment in eq uities or indirect investments in equities through the mutual funds do not assur e any returns; the returns are market oriented and these act as ideal hedge agai nst inflation. Equity, as an asset class has delivered superior returns over lon g periods of time. Hence, equity shall form an integral part of any portfolio th e proportion will vary according to the profile of the investor. Debt oriented a re fixed income instruments and many of these assets like bank deposits, small s avings schemes, corporate debentures and fixed deposits carry fixed rates of int erest and as such there are no uncertainties about the same. However the indirec t investments in debts through the mutual fund route do not offer any fixed rate of return. These investments are relatively safer with lower rate of return and market oriented PDP Investment Planning 213

securities like Government Securities, corporate bonds, etc. face interest rate risk over time. Real estate/property/commodity/bullion, etc. are not financial a ssets and hence not considered in structuring An Asset Allocation Plan but many people do resort to investments in these classes of assets as well. While consid ering these assets in evaluating portfolio risk and return it has to be borne in mind that these assets are risky and the returns are not assured hence resemble equities rather than debts. Here are some thoughts how Asset Allocation Plans a re made, for different classes of investors: Example 1 n n n n n n Old couple Ag e around 60 years Retired Children financially independent Preserving capital; r egular income and inflation are their concerns Conservative approach Asset alloc ation can be as under: Example 2 n n n n n n n Mature couple with grown children: Age around 45 years C hildren undergoing education Capital growth at a moderate rate and some income f low are their requirements Around this age the income level is quite high; the c apacity to invest is high Commencement of some retirement planning is also essen tial Moderate risk The asset allocation suggested can be as under: 214 Investment Planning PDP

Example 3 n n n n n n Young couple with small children Age around 30 years Incom e flow reasonable Outgo on account of home loans, etc. on the higher side Expens es high because of small children Reasonably aggressive portfolio with emphasis on growth asset allocation suggested is : Example 4 n n n n n n Young single professional Age around 20/25 years Can affor d to take risk No liabilities built up Need to save on a systematic basis High r isk portfolio desirable Asset allocation may be as under: The actual portfolios Once the asset allocation is finalized then the next step is selecting the right products under each asset class. The financial planner sh ould be fully informed about the various financial products, the risk, the retur n, track record of performance, suitability to the client and such other feature s that are relevant. Based on his assessment, research and the asset allocation plan, as decided, the planner shall recommend to the client a list of securities bonds, shares, mutual funds, etc. for investment. After finalizing the list of securities or the actual investment plan the planner shall forward the same to PDP Investment Planning 215

the client for his perusal. It is desirable to meet after the plan is sent to th e client and discuss with the client the rationale for the selection of securiti es and the structure of the portfolio. The client may have some doubts and conce rns on certain issues or in respect of some products that have been recommended. The meeting will serve the purpose of clearing such doubts and making the clien t understand the reasons for the selection. All issues of related risks and expe cted returns also should be discussed in the meeting. If necessary some changes may be made in the suggested portfolio within the broad Asset Allocation Plan al ready finalized. The portfolio is then finalized and the plan is put into action through purchase of securities, making the investments, etc. Monitoring and rev iew This is a very important step in the investment process. A proper monitoring and review system is as critical to the success of the investment plan as selec ting the right securities and going ahead with the right mix of assets. While mo nitoring performance of the funds is considered carefully. Funds and stocks have been selected on the basis of certain criteria. A review is to ensure that thes e funds/stocks are performing in line with the expectations. This exercise will enable the investors to take into consideration the developments in the capital market and various economic factors such as inflation, interest rates, performan ce of companies, performance of the economy, etc. Gradual changes in some of the se economic fundamental factors will drive portfolio restructuring decisions. Th e portfolio has been created with certain objectives. The percentage of assets w ithin the asset class for example the percentage of equity in the portfolio may undergo changes because of changes in the values of these assets with the market movements. For example when the stock market goes up the values of equities wil l go up and consequently the proportion of equities in the total portfolio will also go up. This will necessitate some selling of equity shares and moving funds to debts to bring down the proportion of equities to the desired level, as per the asset allocation plan. Thus a rebalancing becomes necessary in a constant pr oportion asset allocation model. Rebalancing may be required to adjust the marke t risks in a portfolio or because of maturity selection as well. The client and the planner while implementing the financial plan can lay down certain parameter s for review generally time based and at times event based. A review can be more frequent; say once in 3 months if active strategies are being employed otherwis e a periodic review of debts say once a year and stocks and equity funds, say on ce in 3 months could be a good suggestion to the client. 216 Investment Planning PDP

Review Questions: 1. A retired couple should ideally prefer which of the followi ng asset allocation plans? a. 60% equity, 35% debt and 5% cash b. 50% equity, 40 % debt and 10% cash c. 80% equity, 20% debt d. 30% equity, 60% debt and 10% cash 2. 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. Should invest all his mon thly savings in Life insurance plans c. He should leave the job of investments t o his father and concentrate on his own job he is too young to understand d. Mak e lump sum investments in index funds 3. A financial planner should concentrate on which of the following? a. Understanding the clients needs and preparing an as set allocation plan that shall best meet the clients financial objectives b. Dist ributing financial products to his clients to meet his targets with mutual funds and insurance companies c. Constant restructuring and rebalancing of clients por tfolios resulting in frequent selling and buying of securities d. None of the ab ove Answers: 1. 2. 3. c a a PDP Investment Planning 217

Chapter 17 218 Investment Planning PDP

Regulation of Financial Planners T he profession of financial planning does not require any licence nor is it regul ated in India. Now, however SEBI is considering regulation of investment advisor and a process of registration so that the investors get proper advice from qual ified, trained, informed investment advisors who will be accountable to SEBI and the investors. The financial planners may be selling financial products and pro viding financial services. Some of the products are small saving instruments, mu tual funds, stocks, insurance linked products, government bonds, etc. A mutual f und distributor is required to be registered with Association of Mutual Funds of India (AMFI). A mutual fund distributor is required to qualify for an examinati on conducted by National Stock Exchange on mutual funds before being registered with AMFI. The AMFI registered mutual fund distributor is required to abide by t he code of conduct stipulated by AMFI. The distributor is also required to give an undertaking on a yearly basis to each mutual fund with whom he is registered that he is abiding by the code of conduct set by AMFI. Thus mutual fund distribu tors are regulated and AMFI ensures that distributors are informed about mutual fund functioning, their products, etc. and that the distributors do not resort t o undesirable practices to push the sales of mutual fund products. If a distribu tor employs marketing people/counter staff to market mutual funds it is required that each one of them has passed a specific examination conducted by NSE. A mut ual fund distributor can be inspected by AMFI to ensure that he complies with al l the regulations and code of conduct. The mutual funds are regulated by SEBI. S tock markets are regulated by stock exchanges in the first place and ultimately by SEBI. Stock brokers and sub brokers are required to be registered with SEBI. SEBI has clearly spelt out the terms of operations of stock brokers and sub brok ers. One of the most important conditions is client registration. SEBI has stipu lated that all brokers/sub brokers should obtain information from clients in a s pecified format along with documentary evidence in support of client personal in formation called Know Your Client (KYC) norms. Then the broker is required to en ter into an agreement with the client in a specified format and allot a unique c lient ID number to the client. The clients dealings on the stock exchanges throug h the broker will be allowed only after compliance with the above. SEBI has laid down a number of conditions in the interest of investor protection and the brok ers have to comply with the same. Small savings mobilizations are done through s mall savings agents. These agents are appointed by respective state governments on behalf of the Government of India and are subject to terms and conditions lai d by Ministry of Finance, Government of India, on this behalf. Insurance advisor s are registered and subject to the regulations of Insurance Regulatory Developm ent Authority of India (IRDA). IRDA has laid down the conditions under which an advisor will perform. IRDA is also the supreme authority in respect of insurance companies as well. A Certified Financial Planner voluntarily submits himself to a code of conduct laid down by the parent body Financial Planning Standards Boar d, India and vows to abide by the ethics while practicing as a Certified Financia l Planner. One of the most important purposes of the regulation of market player s in insurance, mutual funds, PDP Investment Planning 219

stock markets, etc. is that the investor should get informed advice and quality service. It is stipulated by all the regulators that each distributor/advisor/br oker should have investor service departments and investor grievance redressal m echanisms in place in their respective workplaces. You will observe that the fin ancial services profession is evolving. In future it will be a much better regul ated place where the advisors will essentially be well informed players who valu e professional ethics the most. 220 Investment Planning PDP