1. 2. 3.

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What is Financial Market ? A mechanism that allows people to buy and sell financial securities (such as stocks and bonds) and items of value at low transaction cost. Markets work by placing many interested buyers and sellers in one place, thus making easier for them to find each other. PURPOSE OF FINANCIAL MARKETS Financial Markets facilitate : 1. The raising of capital. 2. The transfer of risk. 3. International trade. TYPES OF FINANCIAL MARKETS : CAPITAL MARKETS Stock Markets - Which provide financing through the issuance of shares or common stock, and enable subsequent trading. Bond Markets Which provide Financing through the issuance of bonds, enable subsequent trading. COMMODITY MARKETS which facilitate the trading of commodities. MONEY MARKETS which provide short term debt financing and investment. DERIVATIVE MARKETS which provide instruments for the management of financial risk INSURANCE MARKETS which facilitate redistribution of various risks. FOREIGN EXCHANGE MARKETS - which facilitate the trading of foreign exchange Types of financial market instruments 1. Money market instruments. 2. Capital market instruments. 3. Hybrid instruments. Money Market The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. Money market instruments Call/Notice Money Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is Call Money. When money is borrowed or lent for more than a day and up to 14 days, it is Notice Money. No collateral security is required to cover these transactions. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. Treasury Bills Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. Certificate of Deposit Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialized form or as a Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by: scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and inter corporate deposits. Commercial Papers Commercial Paper (CP) is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument.

2. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. 3. A company shall be eligible to issue CP provided: the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and the borrowable account of the company is classified as a Standard Asset by the financing bank/s. 4. The minimum maturity period of CP is 7 days. CAPITAL MARKET INSTRUMENTS The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity: Total assets minus total liabilities; are also called shareholder's equity or net worth or book value. Preference Shares: Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock. also called preferred stock. convertible preference shares non-convertible preference shares etc and In the debt segment Debentures: Debentures are bonds that are not secured by specific property or collateral. Instead, they are backed by the full faith and credit of the issuer, and bondholders have a general claim on assets that are not pledged to other debt. A type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture. Zero Coupon Bonds: A debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. deep discount bonds, etc. HYBRID INSTRUMENTS Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants, etc. Conclusion In India, money market is regulated by Reserve bank of India (RBI) and capital market is regulated by Securities Exchange Board of India (SEBI). Capital market consists of primary market and secondary market. All Initial Public Offerings comes under the primary market and all secondary market transactions deals in secondary market. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Secondary market comprises of equity markets and the debt markets. In the secondary market transactions, BSE and NSE plays a great role in exchange of capital market instruments. THE INDIAN MONEY MARKET AND CAPITAL MARKET INTRODUCTION The MM is a market for financial assets that are close substitutes for money.

It is a market for overnight to short term funds and instruments having a maturity period of one or less than one year. It is not a physical location like the stock market, but an activity that is conducted over the telephone. The MM constitutes a very important segment of the Indian financial system. CHARACTERISTICS OF THE MONEY MARKET MM is not a single market but a collection of markets for several instruments. MM is a wholesale market of short term debt instruments. Its principal feature is honour where the creditworthiness of the participants is important. The main players are: the RBI, the Discount and Finance House of India (DFHI), mutual funds, insurance companies, banks, corporate investors, NBFIs, state governments, provident funds, primary dealers, the Securities Trading Corporation (STCI), public sector undertakings (PSUs), and non-resident Indians. MM is a need based market wherein the demand and supply of money shape the market. FUNCTIONS OF MONEY MARKET A MM is generally expected to perform three broad functions. They are: 1) Provide a balancing mechanism to even out the demand for and supply of short-term funds. 2) Provide a focal point for central bank (CB) intervention for influencing liquidity and general level of interest rates in the economy. 3) Provide reasonable access to supplier and users of short-term funds to fulfill their borrowings and investment requirements at an efficient market clearing price. Besides, it is being as a benchmark for longer term financial instruments. BENEFITS OF MM The regulation of money market funds is the key to several advantages: It provides a stable source of funds to banks in addition to deposits, allowing alternative financing structures and competition. It allows banks to manage risks arising from interest rate fluctuations and to manage the maturity structure of their assets and liabilities. It encourages the development of non-bank intermediaries thus increasing the competition for funds. The MM supports the long term debt market by increasing the liquidity of securities. ROLE OF RBI IN INDIAN MM The aims of the Reserve Banks operations in the MM are: To ensure that liquidity and short-term interest rates are maintained at levels consistent with the monetary policy objectives of maintaining price stability; To ensure an adequate flow of credit to the productive sectors of the economy; and To bring about order in the foreign exchange market. The RBI influences liquidity and interest rates through a number of operating instruments like CRR, OMO, Repos, change in Bank rate and foreign exchange operations. INVESTMENT ALTERNATIVES The investment alternatives is available in the market is classified into two categories like: Financial Assets: it is a paper claims on some issuer such as the government or a corporate body. They are equity shares, corporate debentures, government securities, deposit with banks, mutual fund shares, insurance policies and derivative instruments. Real Assets: it represents by tangible assets like house, commercial property, agricultural farm, gold, precious stones and art objects. Non-marketable financial assets Bank deposits, Post Office Savings AccountPost Office Time Deposits (POTDs), Monthly Income Scheme of the Post Office (MISPO), Kisan Vikas Patra (KVP), National Savings Certificate (NSC), Company Deposits, Employee Provident Fund Scheme, Public Provident Fund Scheme.

MONEY MARKET CENTRES IN INDIA The important MM centres in India are at Mumbai, Delhi, and Kolkata. Mumbai is the only active MM centre in India with money flowing in from all parts of the country getting transacted there.

MONEY MARKET INSTRUMENTS T-Bills, Call/notice MM, CPs, CDs, CBs, Repos (Repurchase Agreement), Collateralised Borrowing and Lending Obligation (CBLO). TREASURY BILL (T-BILL) TREASURY BILL (T-BILL) is a government security that matures in one year or less. They are zero-coupon bonds that are sold at a discount of the par value to create a positive yield to maturity. Treasury bills are considered by many the most risk free investment. Treasury Bills are commonly issued with maturity dates of 91 days, 6 months, or 1 year FEATURES OF T-BILLS They are negotiable securities They are highly liquid There is an absence of default risk They have an assured yield, low transaction cost They are not issued in scrip form T-bills are available for a minimum amount of Rs. 25,000 and in multiples thereof. Types of T-Bills: 1. On tap bills 2. Ad hoc Bills: introduced in 1955. 3. Auctioned T-Bills: introduced in 1992 CERTIFICATE OF DEPOSITS (CDS) Certificate of deposits (CDs) represents short term deposits which are transferable from one party to another. Banks and financial institutions are the major issuers of CDs. The principal investors in CDs are banks, financial institutions, corporate, and mutual funds. CDs are issued in bearer or registered form. They generally have a maturity of 3 months to 1 year. CDs carry a certain interest rate. REASONS FOR INVESTMENT IN CDS CDs are a popular form of short-term investment for mutual funds and companies for the followings reasons: Banks are normally willing to tailor the denominations and maturities to suit the needs of the investors. CDs are generally risk-free CDs generally offer a higher rate of interest than T-Bills or term deposits CDs are transferable. COMMERCIAL PAPERS Commercial paper represents short term unsecured promissory notes issued by firms that are generally considered to be financially strong. Commercial paper usually has a maturity period of 90 days to 180 days. It is sold at a discount and redeemed at par. Hence the implicit rate is a function of the size of discount and the period of maturity. REPOS AND REVERSE REPO The term Repo is used as an abbreviation for Repurchase Agreement or Ready Forward. A repo involves a simultaneous sale and repurchase agreement. A repo works as follows. Party A needs short-term funds and Party B wants to make a short term investment. Party A sells securities to Party-B at a certain price and simultaneously agrees to repurchase the same after a specified time at a slightly higher price. The difference between the sale price and the repurchase price represents the interest cost to Party A and conversely the interest income for Party B. A reverse Repo is the opposite of a Repo it involves an initial purchase of an asset followed by a subsequent sale. It is a safe and convenient form of short-term investment.

INDIAN CAPITAL MARKETS INTRODUCTION Since 2003, Indian capital markets have been receiving global attention, especially from sound investors, due to the improving macroeconomic fundamentals. The presence of a great pool of skilled labour and the rapid integration with the world economy increased Indias global competitiveness. BACKGROUND OF THE CAPITAL MARKET The Securities and Exchange Board of India (SEBI), the regulatory authority for Indian securities market, was established in 1992 to protect investors and improve the microstructure of capital markets. In the same year, Controller of Capital Issues (CCI) was abolished, removing its administrative controls over the pricing of new equity issues. In less than a decade later, the Indian financial markets acknowledged the use of technology (National Stock Exchange started online trading in 2000), increasing the trading volumes by many folds and leading to the emergence of new financial instruments. With this, market activity experienced a sharp surge and rapid progress was made in further strengthening and streamlining risk management, market regulation, and supervision. BROAD CONSTITUENTS IN THE INDIAN CAPITAL MARKETS Fund Raisers are companies that raise funds from domestic and foreign sources, both public and private. Fund Providers are the entities that invest in the capital markets. These can be categorized as domestic and foreign investors, institutional and retail investors. The list includes subscribers to primary market issues, investors who buy in the secondary market, traders, speculators, FIIs/ sub accounts, mutual funds, venture capital funds, NRIs. Intermediaries are service providers in the market, including stock brokers, sub-brokers, financiers, merchant bankers, underwriters, depository participants, registrar and transfer agents, FIIs (Foreign Institutional Investors)/sub accounts, mutual Funds, venture capital funds, portfolio managers, custodians, etc. Organizations include various entities such as BSE, NSE, other regional stock exchanges, and the two depositories National Securities Depository Limited (NSDL) and Central Securities Depository Limited (CSDL). Market Regulators include the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI), and the Department of Company Affairs (DCA). PARTICIPANTS IN THE SECURITIES MARKET 1. SAT (Securities Appellate Tribunal) 2. Regulators (SEBI, RBI, DCA) 3. Depositories, Stock exchanges (with equity trading, Debt market segment, Derivative trading) 4. Brokers 5.Corporate brokers 6.Sub-brokers 7. FIIs 8. Portfolio managers 9.Custodians 10. Share transfer agents 11. Primary dealers 12. Merchant bankers 13. Bankers to an issue 14. Debenture trustees 15.Underwriters 16.Venture capital funds 17.Foreign venture capital investors 18.Mutual funds 19. Collective investment schemes. STRUCTURE OF THE SECURITIES MARKET Securities Market 1. Equity Market 2. Debt Market 3. Derivative markets i) Government Securities Market i) Options Market ii) Corporate Debt Market ii) Futures market iii) Money Market BONDS OR DEBENTURES Bonds or debentures represent long term debt instruments. The issuer of a bond promises to pay a stipulated stream of cash flows.

This generally comprises of periodic interest payment over the instrument and principal payment at the time of redemption. GOVERNMENT SECURITIES Debt securities issued by Central Government, state government, and quasi-government agencies are referred to as government securities or gilt-edged securities. Three types of instruments are issued. An investment that resembles a company debentures. It carries the name of the holders and is registered with the Public Debt Office (PDO). The PDO pays interest to the holders registered with it on the specified date of payment. A promissory note, issued to the original holder, which contains a promise by the President of India or the Governor of State to pay as per a given schedule. It can be transferred to a buyer by an endorsement by the seller. The current holder has to present the note to the government Treasury to receive interest and other payments. A bearer security, where the interest and other payments are made to the holder of the securities. SAVING BONDS A popular instrument for earning tax-exempt income, RBI Savings Bonds have the following features: Individuals, HUFs (Hindu Undivided Family) and NRIs can invest in these bonds. The minimum amount of investment is Rs. 1000. there is no maximum limit The maturity period is 5 years from the date of issue There are two options: the cumulative option and the non-cumulative option. The interest rate is 8% per annum, payable half-yearly. The bonds are issued in the form of Bond Ledger Account or in the form of promissory Notes. The bonds are transferable - Nomination facility is available The bonds can be offered as security to banks for availing loans. PRIVATE SECTOR DEBENTURES Similar to promissory notes, debentures are instruments meant for raising long term debt. The obligation of a company towards its debenture holders is similar to that of a borrower who promises to pay interest and principal at specified times. PUBLIC SECTOR UNDERTAKING BONDS PSUs issue debentures that are referred to as PSU bonds. There are two broad varieties of PSU bonds: taxable bonds and tax free bonds. While PSUs are free to set the interest rates on taxable bonds, they cannot offer more than a certain interest rate on tax-free bonds which is fixed by the ministry of finance. More important, a PSU can issue tax-free bonds only with the prior approval of the ministry of finance. PREFERENCE SHARES It represent a hybrid security that partakes some characteristics of equity and some attributes of debentures. The salient features of preference shares are as follows: It carry a fixed rate of dividend It is payable only out of distributable profits Dividend on preference shares is generally cumulative. Dividend skipped in one year has to be paid subsequently before equity dividend can be paid. Preference shares are redeemable the redemption period is usually 7 12 years Currently preference dividend is tax exempt. EQUITY SHARES Equity capital represents ownership capital. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership. Of all the forms of securities, equity shares appear to be the most romantic. While fixed income investment avenues may be more important to most of the investors, equity shares seem to capture their interest the most. The potential rewards and penalties associated with equity shares

 1) 2) 3) 4) 1) 2) 3) 4) 5) 6)

make them an interesting, even exciting, proposition. No wonder, equity investment is a favourite topic of conversation in parties and get together. TERMINOLOGY Authorized Capital: It represents the amount of capital that a company can issue as per its memorandum. Issued Capital: it is the amount offered by the company to the investors Subscribed capital: a part of the issued capital that has been subscribed to by the investors. Paid-up capital: the actual amount paid The par value is stated in the memorandum and written on the share scrip. The par value of equity shares is generally Rs. 10 or Re. 1. Infrequently, one comes across par value like Rs.5, Rs. 50, and Rs. 1,000. There is a proposal to make the par value uniformly at Re. 1. The issue price is the price at which the equity share is issued. When the issue price exceeds the par value, the difference is referred to as the share premium. The book value of an equity share is equal to: Paid-up equity capital + Reserves and Surplus/ Number of outstanding equity shares The market value: an equity share is the price at which it is traded in the market. RIGHTS OF EQUITY SHAREHOLDERS Equity shareholders have a residual claim to the income of the firm. This means that the profit after tax less preference dividend belongs to equity shareholders. Equity shareholders elect the board of directors and have the right to vote on every resolution placed before the company. The board of directors, in turn appoints the top management of the firm. Equity shareholders enjoy the pre-emptive right which enables them to maintain their proportional ownership by purchasing the additional equity shares issued by the firm. Equity shareholders have a residual claim over the assets of the company in the event of liquidation. STOCK MARKET CLASSIFICATION In stock market, it is customary to classify equity shares as follows: Blue-chip Shares: shares of large, well established, and financially strong companies with an impressive record of earnings and dividends. Growth shares: shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability. Income shares: shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios. Cyclical Shares: shares of companies that have a pronounced cyclicality in their operations Defensive shares: shares of companies that are relatively unaffected by the ups and downs in general business conditions. Speculative shares: shares that tend to fluctuate widely because there is a lot of speculative trading in them. PETER LYNCHS CLASSIFICATION Slow Growers: large and ageing companies that are expected to grow slightly faster than the gross national product. Stalwarts: giant companies that are less faster than slow growers but are not alert climbers. Fast growers: small, aggressive new enterprises that grow at 10 25 per cent a year. Cyclical: companies whose sales and profit rise and fall in a regular, though not completely predictable, fashion. Turnarounds: companies which are steeped in accumulated losses but which show signs of recovery. Turnaround companies have the potential to make up lost ground quickly. MUTUAL FUND SCHEMES It represents a vehicle for collective investment. Till 1986 the UTI was the only mutual fund in India offering a small number of schemes. As the mutual fund sector was liberalized, new entrants came into the field.

At present, there are about 30 mutual funds offering over 1000 schemes. Mutual fund schemes invest in three broad categories of financial assets, viz. stocks, bonds and cash. Stocks refer to equity and equity related instruments. Bonds are debt instruments that have a maturity of more than one year Cash represents bank deposits and debt instruments that have a maturity of less than one year. TYPES OF MUTUAL FUND SCHEMES Depending on the asset mix, MF schemes are classified into three types Equity schemes: 85-95 per cent or even more, in stocks and the balance in cash. Hybrid schemes: also referred to as balanced schemes, invest in a mix of stocks and debt instruments Debt schemes: invest in bonds and cash. PROVISIONS OF THE MF REGULATION A MF shall be constituted in the form of a trust executed by the sponsor in faviour of the trustees. The sponsor, trust deed, trustees shall appoint as asset management company (AMC) The MF shall appoint a custodian No scheme shall be launched by the AMC unless it is approved by the trustees and copy of the offer document has been filed with SEBI. The offer document and advertisement materials shall not be misleading No guaranteed return shall be provided in a scheme unless such returns are fully guaranteed by the sponsor or the AMC. FINANCIAL DERIVATIVES A derivative is an instrument whose value depends on the value of some underlying asset. Hence, it may be viewed as a side bet on that asset. From the point of view of investors and portfolio managers, futures and options are the two most important financial derivatives. They are used for hedging and speculation. Trading in these derivatives has begun in India. IMPORTANT DISTINCTIONS Exchange-Traded Vs. OTC Contracts: A significant divergence in the instrument is whether the derivative is traded on the exchange or over the counter (OTC). Exchange-traded contracts are standardized (futures). It is easy to buy and sell contracts (to reverse positions) and no negotiation is required. The OTC market is largely a direct market between two parties who know and trust each other. Most common example for OTC is the forward contract. Forward contracts are directly negotiated, tailor-made for the needs of the parties, and are often not easily reversed. DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS:

Futures Contracts
Meaning: A futures contract is a contractual agreement between two parties to buy or sell a standardized quantity and quality of asset on a specific future date on a futures exchange.

Forward Contracts
A forward contract is a contractual Agreement between two parties to buy or sell an asset at a future date for a predetermined mutually agreed price while entering into the contract. A forward contract is not traded on an exchange. A forward contract is traded in an OTC market.

Trading place: A futures contract is traded on the centralized trading platform of an exchange.

Transparency in contract price: The contract price of a futures contract is transparent as it is available on the centralized trading screen of the exchange. Valuations of open position and margin requirement:In a futures contract, valuation of open position is calculated as per the official closing price on a daily basis and mark-to-market (MTM) margin requirement exists. Liquidity: Liquidity is the measure of frequency of trades that in a particular futures contract. A futures contract is more liquid as it is traded on the exchange.

The contract price of a forward contract is not transparent, as it is not publicly disclosed. In a forward contract, valuation of open position is not calculated on a daily basis and there is no requirement of MTM on daily basis since the settlement of contract is only on the maturity date of the contract. A forward contract is less liquid due to its customized nature.

Counterparty default risk: In futures contracts, the exchange clearing house provides trade guarantee. Therefore, counterparty risk is almost eliminated. Regulations: A regulatory authority and the exchange regulate a futures contract.

In forward contracts, counterparty risk is high due to the customized nature of the transaction.

A forward contract is not regulated by any exchange.

BENEFITS OF DERIVATIVES Price Risk Management: The derivative instrument is the best way to hedge risk that arises from its underlying. Price Discovery: The new information disseminated in the marketplace is interpreted by the market participants and immediately reflected in spot and futures prices by triggering the trading activity in one or both the markets. This process of price adjustment is often termed as price discovery and is one of the major benefits of trading in futures. Apart from this, futures help in improving efficiency of the markets.

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EXCHANGE PLATFORM Domestic Exchanges Indian equities are traded on two major exchanges: Bombay Stock Exchange Limited (BSE) and National Stock Exchange of India Limited (NSE). Bombay Stock Exchange (BSE) BSE is the oldest stock exchange in Asia. The extensiveness of the indigenous equity broking industry in India led to the formation of the Native Share Brokers Association in 1875, which later became Bombay Stock Exchange Limited (BSE). BSE is widely recognized due to its key and most excellent role in the development of the Indian capital market. In 1995, the trading system transformed from open quarrel system to an online screen-based order-driven trading system. The exchange opened up for foreign ownership (foreign institutional investment). Allowed Indian companies to raise capital from abroad through ADRs and GDRs. Expanded the product range (equities/derivatives/debt). Introduced the book building process and brought in transparency in IPO (Initial Public Offering) issuance. Depositories for share custody (dematerialization of shares). Internet trading (e-broking). Governance of the stock exchanges (demutualization and corporatization of stock exchanges) and internet trading (e-broking). BSE has a nation-wide reach with a presence in more than 450 cities and towns of India. BSE has always been at par with the international standards.

 It is the first exchange in India and the second in the world to obtain an ISO 9001:2000 certification. It is also the first exchange in the country and second in the world to receive Information Security Management System Standard BS 7799-2-2002 certification for its BSE Online Trading System (BOLT). Asset Class: Derivatives, especially futures, offer an exclusive asset class for not only large investors like corporate and financial institutions but also for retail investors like high net worth individuals. Equity futures offer the advantage of portfolio risk diversification for all business entities. This is due to the fact that historically it has been witnessed that there lies an inverse correlation of daily returns in equities as compared to commodities. High Financial Leverage: Futures offer a great opportunity to invest even with a small sum of money. It is an instrument that requires only the margin on a contract to be paid in order to commence trading. This is also called leverage buying/selling. Transparency: Futures instruments are highly transparent because the underlying product (equity scripts/index) are generally traded across the country or even traded globally. This reduces the chances of manipulation of prices of those scripts. Secondly, the regulatory authorities act as watchdogs regarding the day-to-day activities taking place in the securities markets, taking care of the illegal transactions. Predictable Pricing: Futures trading is useful for the genuine investor class because they get an idea of the price at which a stock or index would be available at a future point of time. NATIONAL STOCK EXCHANGE (NSE) NSE was recognized as a stock exchange in April 1993 under the Securities Contracts (Regulation) Act. It commenced its operations in Wholesale Debt Market in June 1994. The capital market segment commenced its operations in November 1994, whereas the derivative segment started in 2000. NSE introduced a fully automated trading system called NEAT (National Exchange for Automated Trading) that operated on a strict price/time priority. This system enabled efficient trade and the ease with which trade was done. NEAT had lent considerable depth in the market by enabling large number of members all over the country to trade simultaneously, narrowing the spreads significantly. The derivatives trading on NSE commenced on June 12, 2000. The futures contract on NSE is based on S&P CNX Nifty Index. The Futures and Options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen based trading for S&P CNX Nifty futures on a nationwide basis and an online monitoring and surveillance mechanism. It supports an order-driven market and provides complete transparency of trading operations. INTERNATIONAL EXCHANGES Due to increasing globalization, the development at macro and micro levels in international markets is compulsorily incorporated in the performance of domestic indices and individual stock performance, directly or indirectly. Therefore, it is important to keep track of international financial markets for better perspective and intelligent investment. Clearing and settlement Process 1. Trade details from Exchange to NSCCL 2. NSCCL notifies the consummated trade details to custodians who affirm back. Based on the affirmation, NSCCL determines obligations. 3. Download of obligation and pay-in advice of funds/ securities. 4. Instructions to clearing banks to make funds available by pay-in-time. 5. Instructions to depositories to make securities available by pay-in-time. 6. pay-in of securities (NSCCL advises depository to debit pool account of custodians and credit its account and depository does it). 7. pay-in of funds (NSCCL advises Clearing Banks to debit account of custodians and credit its account and clearing bank does it).

8. Pay-out of securities (NSCCL advises depository to credit pool account of custodians and debit its account and depository does it). 9. Pay-out of funds (NSCCL advises Clearing Banks to credit account of custodians and debit its account and Clearing Banks does it). 10. Depository informs custodians 11. Clearing Banks inform custodians SETTLEMENT CYCLE ROLLING SETTLEMENT At NSE and BSE, trades in rolling settlement are settled on a T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded. Typically trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on. A tabular representation of the settlement cycle for rolling settlement Activity Trading Clearing Settlement Rolling Settlement Trading Custodial Confirmation Securities and Funds pay in Securities and Funds pay out Day T T+1 working days T+2 working days T+2 working days

MARGIN TRADE, SHORT SALES AND CONTINGENT ORDERS What is Margin Trading? Margin trading is buying stocks without having the entire money to do it. The exchanges have an institutionalized method of buying stocks without having the capital through the futures market. In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. The portion that is borrowed incurs an interest charge. This interest is based on the brokers call money rate. The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts. Example: Margin Accounts If you are to buy 2000 shares of say Company A, which trades at Rs 300, you will need about Rs 6 lakh. But if you buy a future contract of that company, which comprises 2000 shares, you only need to pay a margin of 15 per cent. So by putting Rs 90,000, you can get an exposure of Rs 6 lakh. The same operation can also be executed through margin trading. Here, the trader will buy 2,000 shares, which are partly funded by the broker, and the rest by the trader. Types of Margin Trading and Accounts In a margin purchase, the minimum margin that must be supplied is called the initial margin. The maintenance margin is the margin amount that must be present at all times in a margin account. Customer establishes account with broker (margin account). Margin trading magnifies returns to investor. Investor must pay interest on borrowed funds Investor returns higher/lower with lower equity than a 100 % purchase When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call. Stock price falls below maintenance margin requirements Margin call is a request for cash to maintain maintenance margin Broker/lender may sell stock to protect loan EXAMPLE: MARGIN ACCOUNTS, You buy 1,000 Reliance shares at Rs.24 per share. You put up Rs.18,000 and borrow the rest. Amount borrowed = Rs. 24,000 Rs.18,000 = Rs. 6,000 Margin = Rs.18,000 / Rs. 24,000 = 0.75 (75%)

THE BALANCE SHEET Assets

Liabilities

1,000 Shares, Reliance Rs. 24,000

Margin Loan Account Equity

Rs. 6,000 Rs. 18, 000

Total Rs. 24, 000 Total Rs. 24, 000 Example: The Workings of a Margin Account, I Your margin account requires: An initial margin of 50% and A maintenance margin of 30% A Share in Indian Oil, Bharat Petroleum and Reliance Petroleum (IBR) is selling for Rs 50. You have Rs.20, 000, and you want to buy as much IBR as you can. You may buy up to Rs.20, 000 / 0.5 = Rs.40, 000 worth of IBR. Assets Liabilities

Margin Loan 800 Shares of IBR @ Rs.50 Rs. 40,000 Account Equity

Rs. 20,000 Rs. 20, 000

Total Rs. 40, 000 Total Rs. 40, 000 Example: The Workings of a Margin Account-II After your purchase, shares of IBR fall to Rs.35. New margin = Rs.8,000 / Rs.28,000 = 28.6% < 30% Therefore, you are subject to a margin call. Liabilities and Account Equity Assets

Margin Loan 800 Shares of IBR @ Rs.50 Rs. 28,000 Account Equity Total Rs. 28, 000 Total

Rs. 20,000 Rs. 8, 000 Rs. 28, 000

SHORT SELLING The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. In a short sale, investor Promises to pay back stock later. Short seller hopes stock price declines to provide gain. Short seller covers dividend payments while borrowing stock. Limited gain; unlimited losses Short Interest Ratio as market forecast SHORT SALES-I Short Sale is a sale in which the seller does not actually own the security that is sold.

Today In the Future Short Sales - II An investor with a long position benefits from price increases. Easy to understand You buy today at Rs. 34, and sell later at Rs. 57, you profit! Buy low, sell high An investor with a short position benefits from price decreases. You sell today at Rs. 83, and buy later at Rs. 27, you profit. Sell high, buy low.

UNIT 2 MARKET EFFICIENCY AND BEHAVIOURAL FINANCE MARKET EFFICIENCY The expectations of the investors regarding the future cash flows are translated or reflected on the share prices. The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency. Market efficiency research examines the relationship between stock prices and available information. TYPES OF MARKET EFFICIENCY Operational Efficiency: it is measured by factors like time taken to execute the order and the number of bad deliveries. Investors are concerned with the operational efficiency of the market. Informational Efficiency: it is a measure of the swiftness or the markets reaction to new information. New information in the form of economic reports, company analysis, political statements and announcement of new industrial policy is received by the market frequently. EFFICIENT MARKET HYPOTHESIS The Efficient Market Hypothesis (EMH) is a hypothesis that emphasizes: As a practical matter, the major financial markets reflect all relevant information at a given time. Efficient markets hypothesis emphasizes: Large number of market participants Incentives to gather and process information about securities and trade on the basis of their analysis until individual participants valuation is similar to the observed market price Prices in such markets reflect information available to the participants, which means opportunities to earn above-normal rates of return on a consistent basis are limited Prediction: Stock returns are (almost) impossible to predict Except that riskier securities on average earn higher rates of returns compared to less risky firms The Random Walk Theory The theory that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, this is the idea that stocks take a random and unpredictable path. A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time - in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments. Forms of Market Efficiency A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the market. I f so, then technical analysis is of little use. A Semi-strong form Efficient Market is one in which publicly available information is of no use in beating the market. I f so, then fundamental analysis is of little use. A Strong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating the market. If so, then inside information is of little use. Securities la w regulates insider trading, so the la w believe markets are not strong form efficient. Types of Stock Analysis Technical Analysis - using prices and volume information to predict future prices. If securities markets are weak form efficient, then technical analysis is useless Fund a mental Analysis - using economic and accounting information to predict stock prices. If securities markets are semi strong form efficient, then fundamental analysis is useless

WHAT DOES BEAT THE MARKET MEAN? AND WHY WOULD A MARKET BE EFFICIENT? Beating the market means consistently earning a positive excess return The driving force toward market efficiency is simply competition and the profit motive. Even a relatively small performance enhancement can be worth a tremendous amount of money. This creates incentives to unearth relevant information and use it. WEAK FORM OF EMH The type of information used in the weak form of EMH is the historical prices. According to it, current prices reflect all information found in the past prices and traded volumes. Future prices can not be predicted by analysing the prices from the past. Buying and selling activities of the information traders lead the market price to align with the intrinsic value. The intrinsic value changes at times, t and t + 1. In the weak form of market the price of the stock and its intrinsic value diverges substantially. In the weak efficient market short term traders may earn a positive return. On an average, short term traders will not outperform the blind folded investor picking the stock with a dart. This is traders may earn by the native buy and hold strategy, while some may incur loss, the average buy and hold strategy cannot be beaten by the chartist. FILTER RULE To earn returns technical trading strategies based on historical prices have been used. Filter rule is one among such strategies. According to this strategy, if a price of a security rises by atleast x per cent, investor should buy and hold the stock until its price declines by atleast x per cent from a subsequent high. Short sellers can use the filter to earn profits by liquidating their holdings when the price decreases from a peak level by x per cent. They can take up short position as the price declines till the price reaches a new low and then increases by x percentage. Different filter rules are used by different traders. It ranges from as small as 0. 5 per cent to as large as 50 per cent. EXAMPLE FOR FILTER RULE Take a company X Y and assume the filter to be 10 per cent. The price fluctuates between Rs. 20 to Rs. 30. assume the starting point to be Rs. 20. when there is an increase in the price of the share is Rs. 22 (i.e., 10 per cent rise) one has to buy it. The rally may continue up to Rs. 30 and decline. If the price falls the sell signal is given at Rs, 27 i.e. 10 per cent of Rs. 30 and the trader can take up the short position till it reaches its low level. When there is a rise in price the same exercises have to be followed. Runs Test Runs test is used to find out whether the series of price movements have occurred by chance. A run is an uninterrupted sequence of the same observation. If a coin is tossed the following sequence may occur. HHTTTHHHTHH Here occurrence of H H is a run and T T is another run. When the sequence of the observations change we count it as a run. R X/ Runs Test Z =

NEXT 2 SLIDES IN PPT. The consecutive rise in prices would be counted as a positive run and the decline would be counted as a negative run According to the probability theory, 95 per cent of the area under the normal curve lies within 1.96 S.D of the mean. Since the calculated value 0.622 is less than 1.96, the runs have occurred by chance. Published results of the studies using test have suggested that the runs in the price series of stocks are not significantly different from the runs in the series of random numbers. SERIAL CORRELATION To test the independence between successive price changes serial correlation technique is used. Serial correlation or auto-correlation measures the correlation co-efficient in a series of numbers with the lagging values of the same series. Price changes in period t + 1 (or t + any number) are correlated with the preceding period. Scatter diagrams can be used to find out the correlation. If there is correlation between the price of t and t + 1 period, the points plotted in the graph would form a straight line. If the price rise (or fall) in period is followed by price rise (or fall) in period t+1 then the correlation co-efficient would be + 1. But many studies conducted on the security price changes have failed to show any significant correlations. Fama computed serial correlations for 30 stocks for the period 1958 62 with varying t periods from t+1 to t+10. The results of the autocorrelations were generally found to be significant, with most falling with in the range of + .10 to - .10. If there is little correlation between stock price over time, chart analyses cannot be of much use in predicting the future. SEMI STRONG FORM OF EMH It states that the security price adjusts rapidly to all publicly available information. In the semi-strong efficient markets, security prices fully reflect all publicly available information. The prices not only reflect the past price data, but also the available information regarding the earnings of the corporate, dividend, bonus issue, right issue, mergers, acquisitions and so on. In the semi-strong efficient market a few insiders can earn a profit on a short run price changes rather than the investors who adopt the naive buy and hold policy. Empirical Evidence Fama, Fisher, Jensen and Roll were the fore runners in examining the semi strong form of EMH. They analysed the effect of stock split on share prices. Their study was important because: It provided evidence to semi-strong form of market It analysed whether the stock splits increase the wealth of the shareholders and They developed a research method to test the market efficiency They have developed a method to compute abnormal returns by using the simple regression technique. The equation is given below: rit = 1 + 1 rmt + eit where rit = realised return for the i the stock in the time period t rmt = realised return for index in time period t 1 , 1 = regression coefficients eit = error term, or residual for the time period t The normal return for any time period is assumed to be as follows: Normal return = 1 + 1 rmt Here eit is assumed to indicate the abnormal return For any particular time period Arit is eit = rit - (1 + 1 rmt) This method of estimating the abnormal return is frequently referred to as the residual analysis.

The regression equation represents normal returns and eit represents abnormal returns. The average of abnormal return (AAR) can be obtained by adding the returns over time and dividing it by n. The AAR can be measured around a date of event or the announcement date of stock split or bonus issue. 1 N AARt = ---- ARit n i=1 CAAR = AAR. The CAAR (Cumulative Average Abnormal Return) is computer by adding the AAR for each period. Period generally begins several before the event and ends several weeks after the event. The cumulative average of abnormal return provides a picture of average price behaviour of securities over time. If the markets are efficient, the CAAR should be close to zero. Strong Form The strong form EMH states that all information is fully reflected prices. It represents an extreme hypothesis which most observers do not expect it to be literally true. The strong form of the efficient market hypothesis maintains that not only the publicly available information is useless to the investor or analyst but all information is useless. Information whether it is public or inside cannot be used consistently to earn superior investors return in the strong form. This implies that security analysts and portfolio managers who have access to information more quickly than the ordinary investors would not be able to use it to earn more profits. Empirical Evidence Many of the tests of the strong form of the efficient market hypothesis deal with mutual fund performances. Financial analysis have studied the risk adjusted rates of return from hundreds of mutual funds and found out that the professionally managed funds are not able to out perform the naive buy-hold strategy. Jensen had studied 115 funds over a decade. He concluded that even though the analysts are well endowed with wide ranging contacts and associations in both the business and financial committees, they are unable to forecast returns accurately enough to recover the research and transaction costs. He holds this, at a striking piece of evidence for the strong form of the efficient market hypothesis. MUTUAL FUNDS An open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. Mutual funds raise money by selling shares of the fund to the public, much like any other type of company can sell stock in itself to the public. COMPUTING NET ASSET VALUE For investors, the performance of their investment depends on what happens to the funds per share value, or net asset value (NAV). NAV= Market Value of Assets Liabilities _____________________________ Number of Shares Outstanding NAV1=NAV0+All Incomes-All Distributed Example: NAV0=Rs.100, Distributed 1) Net Realized Gains=Rs.2 and 2) Net Investment Income=Re.1. NAV1= Rs.100-Rs.2-Re.1=Rs.97]] MUTUAL FUND RETURNS Three sources of return: Income distributions (ID) - Bond interest, stock dividends (2) Capital gain distributions (CGD) - Realized gains/losses from selling assets (3) Changes in NAV (DNAV) - From unrealized gains/losses from assets]

MUTUAL FUND RETURNS Return = (ID + CGD Payments + DNAV)/Beg.NAV Ex. NAV0=Rs.35,NAV1=Rs.35.2, Net Realized Gain Rs.2, Net Investment Income =Rs..5. Return= (2+.5+35.2-35)/35=7.714% Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares TYPES OF MUTUAL FUNDS Funds can be classified according to the type of security in which they invest 1. Stock Funds 2. Taxable Bond Funds 3. Municipal Bond Funds 4. Stock and Bond Funds 5. Money Market Funds Common Stock Funds Common stock funds provide investment diversification and offer time savings over researching, buying and selling individual stocks. Common stocks are shares of ownership in a corporation that doesn't confer any special privileges, such as guaranteed dividends or preferred creditor status. Investing in a fund that specializes in common stock can provide cost savings if the fund's loads and management fees are lower than the commissions associated with buying and selling individual stocks. Most popular type of fund Wide variety with different objectives and levels of risk Growth Industry or sector funds Geographic areas International or Global Equity Index funds Taxable Bond Funds Generally seek to generate current income with limited risk Can vary by maturity Short-term, Intermediate-term, Long-term Can vary by type of bond Government Corporate Mortgage-backed International/Global Bond Index funds Municipal Bond Funds A mutual fund that invests in municipal bonds, or "munis." Municipal bonds are debt securities issued by a state, municipality, county, or special purpose district (public schools, airports, etc.) to finance capital expenditures. They are exempt from Central tax, and are generally exempt from state taxes for residents of the state in which they are issued. This type of bond is very common in US. Provide investors with income exempt from Federal taxation Often concentrate on single states to avoid state income taxation as well Stock and Bond Funds Seek to provide a combination of income and value appreciation. Different names Balanced funds (60% equity+40% of debt securities) Goal: to conserve principal, by maintaining a balanced portfolio of both stocks and bonds Blended funds: Multipurpose funds (e.g., balanced target maturity, convertible securities that invest in both stocks and bonds Flexible funds: Flexible income, flexible portfolio, global flexible and income funds, that invest in both stocks and bonds Money Market Funds Provide safe, current income with high liquidity Invest in money market securities T-bills, Bank CDs, Commercial paper, etc. NAV stays at Re.1; income either paid out or reinvested daily Provide an alternative to bank deposits, but not FDIC insured.

Mutual Fund Innovations Life-stage funds => Offer different mixes of securities based on the age of the investor Supermarket funds Offer a wide variety of funds with one-stop fund shopping Transfer services between funds Expenses/fees can be high Mutual Fund Prospectus Must be available to investors and should be review by investors. Contains: Funds investment objective Investment strategy Principal risks faced by investors Recent investment performance Expenses and fees Lots of other detailed information
MANAGEMENT AND INVESTMENT STRATEGIES Introduction A well-planned investment strategy is essential before having any investment decisions. A business strategy is generally based upon long run period. Formation of business strategy largely dependent upon the factors such as long-term goals and risk on the investment. As the return on investment is not always clear, so the investors prepare the strategy so as to face the ongoing challenges in investment. A balanced investment strategy is generally required in the process of investment, which possesses long time period and some risk tolerance. In the case, when a strategy is aggressive the chance of attaining a higher goal is higher. An efficient strategy can be obtained from portfolio theory, which shows good estimates on risk and return. Concept of Investment Strategy Investment Strategy is usually considered to be more of a branch of finance than economics. It is defined as set of rules, a definite behavior or procedure guiding an investor to choose his investment portfolio. For example, investing in mutual funds has recently emerged as a very favorable investment strategy. An investment strategy is centered on a risk-return tradeoff for a potential investor. High return investment instruments such as real estate and mutual funds usually have more risks associated with it than low return-low risk investment opportunities. Return on investment can be calculated on past or current investment or on the estimated return on future investment. Symbolically, it can be expressed as: Vf/Vi -1 where Vf denotes final investment value and Vi is the initial investment value. Return on investment (ROI) is profitable when Vf/Vi -1 > 0 and the investment is deemed to be unprofitable when the value of final investment is less than that of the initial investment. ROI is calculated to be 1 or 100% when the value of the final investment is twice the value of the initial investment. Types of investment strategies Types of investment strategies can be defined as follows: Passive investment strategy: minimize transaction costs. Active investment strategy: maximize returns value investing domestic investment and FDI profitable investment green investments A passive investment strategy attempted to minimize transaction costs.

An active investment strategy guide used to maximize returns based on moves such as proper market timing. This usually mean, buying in the lows and selling in the highs or buying investment instruments when they are cheap and selling them off when their price appreciates. This strategy, however, is not very beneficial for small time investors. Small time investors can adopt the buy and hold investment strategy to invest in equities, which although volatile in nature, give favorable long run returns. Investing in equity markets for small time investors is associated with the investors holding on for very long periods. The strategy of value investing, a classic investment strategy propagated by Benjamin Graham simply concentrates on the strategy that an investor buys shares of a company as if he was buying off the whole company without paying any attention to the stock market scenario or any exterior conditions such as the political climate. At the end of the day, if he can buy the stock at less than that its actual future worth to the buyer, the person is said to have discovered a value investment. Investment strategies can also denote the investment strategies a national or federal government should follow to bring about economic growth in a country. This can only be achieved by domestic investment as well as significant FDI (Foreign Direct Investment) flows to particular sectors of countries, especially the less developed ones of Asia and Africa. An investment strategy in mutual funds is probably the best bet for a profitable investment. Mutual funds is defined as a pool of money supplied by different investors and in turn used by the mutual fund company to invest in various assets such as stocks and bonds. However, a detailed research has to be conducted for choosing the mutual fund companies and only those should be considered which have a professional investment manager. This will ensure that the funds get channeled towards the right investments. This also applies for investing in stock markets where a decision to invest should follow a through research about the past and current trends of the stock prices and their Net Asset Values (NAV). Analyses from market researchers about the predicted future trends should also be considered otherwise gains from capital appreciation; capital gain distribution (in case of mutual funds) and dividends might not be realized. Lastly, investment strategies leading to green investments or investments in renewable sources of energy will be the next big thing in the investment spectrum. Mutual Fund Management Most funds are started by investment management companies who hire the fund manager to make investment decisions. Fidelity, Vanguard, etc. Usually offer many different funds and allow investors to switch between funds. Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares. Why invest with mutual funds? Liquidity Funds buy and sell their own shares quickly, even if fund investments are illiquid Diversification Small minimum investment buys a typically well-diversified investment Professional management and record-keeping Expertise and services Choice and flexibility Families of funds offer a variety of investments to match investor needs Indexing Some funds track a broad market index which insures that investors will earn the market return Increasingly popular mutual fund alternative Mutual Fund Drawbacks Active trading contributes to high costs which lower fund returns (Turnover) Tax consequences can be a disadvantage Tax impacts of asset trading are passed through to investors Tax bill can be large even when the NAV falls

Stocks Stocks can build long-term growth into our overall financial plan. History has repeatedly demonstrated that stocks, as an asset class, have outperformed every other type of investment over long periods of time.

Stock represents an ownership or equity stake in a corporation. Stocks are considered to be a riskier investment than bonds or cash. Stock prices tend to fluctuate more sharply both up and down than other types of asset classes. Be sure to research a stock before investing. We should understand its products or services, its market, as well as whether it has a sound balance sheet, cash-flow management, and competent directors and managers. You should also consider analysts' projected earnings estimates. Margin borrowing is available. Buying stock on margin allows us to extend the financial reach of our brokerage account by borrowing money from Wells Fargo Advisors in order to purchase the stock. Margin privileges are subject to approval. Margin borrowing involves additional risks and is not suitable for all investors. Stocks Stocks can build long-term growth into our overall financial plan. History has repeatedly demonstrated that stocks, as an asset class, have outperformed every other type of investment over long periods of time. Stock represents an ownership or equity stake in a corporation. Stocks are considered to be a riskier investment than bonds or cash. Stock prices tend to fluctuate more sharply both up and down than other types of asset classes. Be sure to research a stock before investing. We should understand its products or services, its market, as well as whether it has a sound balance sheet, cash-flow management, and competent directors and managers. You should also consider analysts' projected earnings estimates. Margin borrowing is available. Buying stock on margin allows us to extend the financial reach of our brokerage account by borrowing money from Wells Fargo Advisors in order to purchase the stock. Margin privileges are subject to approval. Margin borrowing involves additional risks and is not suitable for all investors. Corporations, governments and municipalities issue bonds to raise funds, and in return they typically pay the bond owners a fixed interest rate. In this way, a bond is like a loan. Bonds may provide a regular income stream or diversify a portfolio. Bonds are fixed income investments most pay periodic interest and principal at maturity. Interest rates may be the most significant factor affecting a bond's value. When interest rates fall, the value of existing bonds rise because their fixed-interest rates are more attractive in the market than the rates for new issues. Similarly, when interest rates rise, the value of existing bonds with lower, fixed-interest rates tend to fall. Inflation may erode the purchasing power of interest income. Generally, bonds with longer maturities are more sensitive to inflation than bonds with shorter maturities. Economic conditions may cause bond values particularly corporate bonds to fluctuate. An economic change that adversely affects a companys business may reduce the ability of a company to make interest or principal payments. Mutual Fund Expenses and Considerations Loads Commission to the broker to financial advisor who sold the fund to the investor For load funds, the offer price is the funds NAV less the load (while no-load funds are sold at their NAV) Load range from around 3% (low-load) to 8.5% 12b-1 Fees Fees deducted from the asset value of the fund to cover marketing expenses An alternative to loads Deferred Sales Loads Redemption charges when fund shares are sold (rather than when purchased) Often high (5-7%) if shares are sold within the first year, but then fall over time, perhaps even disappearing eventually Share Classes Many funds offer several different classes of shares (A-B-C) with different fee structures Best choice usually depends of investment horizon Management Fees Fees deducted from the funds asset value to compensate the fund managers Some adjust fees according to the funds performance

Expense ratio Adding all fees and calculating expenses as a percentage of the funds asset Portfolio Turnover Not an explicit cost, but very important determinant of shareholder returns Trading costs rise with turnover In order for high turnover to pay off, fund managers must be successful in their active trading strategies Mutual Fund Return and Risk Performance Return Performance On a risk-adjusted basis, portfolio managers seem to out-perform the market before expenses, but net returns are below the market index Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?) These results help to explain the growing popularity of index funds Mutual Fund Return and Risk Performance Risk Performance While returns are not consistent, risk is Objectives lead to strategies that lead to varying degrees of investment risks Return is positively related to the level of risk Risk is therefore an important consideration Style-shifting funds earn less on average Mutual Fund Investment Strategies Choose in funds consistent with your objectives, constraints, and tax situation. Consider index funds for a large portion of your fund portfolio. When possible, invest in no-load funds with below-average expense and turnover ratios. Invest at least 10-20% in international or global funds. Own funds in different asset classes and consider life-cycle investing. If you actively manage your portfolio, consider the past years hot funds. Do not attempt to time the market; timing strategies add little except costs and risk. Avoid investing money shortly before the capital gain distribution dates (prospectus). Do not own too many funds. You will get average returns with high expenses. When should you sell a mutual fund? Personal considerations Portfolio rebalancing points due to life cycle considerations Be aware of the quick trigger, selling on the first dip in NAV; think long-term Be aware of capital gains with selling fund shares Fund considerations Change in portfolio manager Change in investment style Fund is growing too large or too fast Persistent bad performance Other Managed Investments Closed-end investment companies Shares trade like stock rather than being bought and sold from the fund Number of shares are fixed Often sell at a discount from NAV (a puzzle for modern finance) Often a means of investing in a pool of assets from a foreign country.. Exchange-traded funds (EFTs) Relatively new, yet very popular Like closed-end funds, they trade like individual stocks Passively managed to mirror a market index, both broad and narrow Low expenses, but do involve brokerage commissions Tax and liquidity concerns

Variable Annuities Many offered by insurance companies Offers investors with choices of investments with tax-deferred growth Insurance product: payment in the case of death or else retirement income stream Expenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual funds Income stream taxed as regular income What is hedging? An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale. Hedge Fund- A fund that can take both long and short positions use arbitrage buy and sell undervalued securities trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedging Strategies There are approximately 14 distinct investment strategies used by hedge funds All hedge funds are not the same. The investment returns, volatility, and risk vary enormously among the different strategies Styles of Hedge Funds Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes Tends to be "long-biased." Expected Volatility: High Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization Profits from the market's lack of understanding of the true value of the deeply discounted securities Majority of institutional investors cannot own below investment grade securities. Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available Expected Volatility: Very High Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles Blend of different strategies and asset classes aims to provide stable long-term return than any of the individual funds. Returns, risk, and volatility can be controlled Capital preservation is generally important Volatility depends on the mix and ratio of strategies employed Expected Volatility: Low - Moderate - High Income: Invests with primary focus on yield or current income rather than solely on capital gains May use leverage to buy bonds or fixed income derivatives, in order to profit from principal appreciation and interest income. Expected Volatility: Low Macro: Aims to profit from changes in global economies Typically brought about by shifts in govt. policy that impact interest rates, in turn affecting currency, stock, and bond markets Uses leverage and derivatives to accentuate the impact of market moves Uses hedging, but largest performance impact is from the leveraged directional investments

Expected Volatility: Very High Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer Eg. Can be long convertible bonds and short the underlying issuers equity. Focuses on obtaining returns with low or no correlation to both the equity and bond markets Relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closedend fund arbitrage Expected Volatility: Low Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market Market risk is greatly reduced Effective stock analysis and stock picking is essential to obtaining meaningful results Leverage may be used to enhance returns Usually low or no correlation to the market Expected Volatility: Low Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes Unpredictability of market movements, and the difficulty of timing entry and exit from markets increase volatility Expected Volatility: High Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, hostile bids, etc. May utilize several of these investing styles at a given time Not restricted to any particular investment approach or asset class Expected Volatility: Variable Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains Other strategies: Systems trading such as trend following and various diversified technical strategies Allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities Expected Volatility: Variable Short Selling: Sells securities short, in anticipation of being able to repurchase them at a future date at a lower price Result of anticipated overvaluation, earnings disappointments, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios by those who expect bearish cycle. Expected Volatility: Very High Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, LBOs etc. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company Results generally not dependent on direction of market Expected Volatility: Moderate Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth Such securities may be out of favor or under-followed by analysts Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market Expected Volatility: Low - Moderate

Relationship between Diversification and Risk Risk

no of securities Market Risk Vs Unique Risk The portfolio risk does not fall below a certain level, irrespective of how wide the diversification is. Total risk = Unique risk + Market risk The unique risk of a security represents that portion of its total risk which stems from firm-specific factors like the development of a new product, a labour strike, or the emergence of a new competitor. In a diversified portfolio, unique risks of different stocks tend to be cancel each other a favourable development in one firm may offset an adverse happening in another and vice versa. Hence unique risk is also referred to as diversified risk or unsystematic risk. The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like the growth rate of GNP, the level of government spending, money supply, interest rate structure, and inflation rate. Since these factors affect all firms to a greater of lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolio may be. Hence, it is also referred to as systematic risk or non diversifiable risk.

Calculation of Portfolio Risk p2 = w12 12 + w22 22 + 2w1w2 121 2 Where p2 is the variance of the portfolio return, w1w2 are the weights of securities 1 and 2 in the portfolio, 12 22 are the variance of the returns on securities 1 and 2 and 121 2 is the covariance of the return on securities 1 and 2.