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Chapter 1

1.1 Introduction

Simply stated an investment is any vehicle into which funds can be placed with the
expectation that they will be preserved or increase in value and/or generate positive
returns. The various types of investments can be differentiated based on a number
of factors such as whether the investment is a security or property; direct or
indirect; debt or equity or options; low or high risk and short or long term.

The investments that represent the evidence of ownership of a business or a liability


or even the legal right to acquire or sell an ownership interest in a business are
called securities. The most commonly accepted types of securities are stocks, bonds,
debentures, and options. Property on the other hand is investments in real property
or tangible personal property. This would include land, buildings, and tangible
personal property, which include gold, antiques, and art.

A direct investment is one in which an investor directly acquires a claim on a security


or property such as investment in equity, bonds or even gold. An indirect investment
is an investment made in a portfolio or group of securities or properties such as the
purchase of a mutual fund.

Broadly speaking an investment will be either in equity or in debt. An investment in


debt implies loan of funds for a certain period in exchange for the receipt of interest
at regular intervals of time and the repayment of principal at a particular future date.
Investment in equity on the other hands represents a type of ownership of a
business or property and is represented by a security showing title to a property.
Options also called derivatives simply securities that are backed by an opportunity to
buy or sell another security and its value is derived on the basis of the underlying
asset.

Finally an investment can be distinguished by its risk nature, i.e. whether it carries
higher or lower risk. In that sense the nature of risk would depend on the nature of
cash flows, the type of ownership and the potential degree of loss of value of the
asset. Equity therefore is considered more risky than debt simply because the
returns are not certain and its value is determined by the company fortunes.
Similarly, an investment can also be demarcated by the tenure of the investment i.e.
whether the investment is of long duration or of short duration.

1.2 Investment Planning

Investment Planning lies at the base of marketing an investment product. Till the
time, an appropriate amount of investment planning is not done; finding the right fit
of the investment product with the individual would be an impossible task.

Simply understood investment is nothing but postponed consumption . Not all


incomes earned are consumed immediately; some of the surplus left over is set aside
to be used at various future dates. The moment one is postponing consumption, the
concept of time value of money comes into place. Money has time value due to three
primary reasons.
a. Present consumption is more preferable to future consumption and therefore
a price must be paid to balance the utility from both
b. The future is uncertain and therefore to compensate for the uncertainty
element of perhaps not receiving the money either totally or partly
c. There will be some inflation present and therefore simply to keep the value of
money constant certain inflation adjusted minimum return needs to be built in
while factoring in future returns.

Therefore three factors are important that determine the return investors require in
order to forgo current consumption to invest.

a. The time preference for consumption that is measured by the risk free real
rate of return
b. The expected rate of inflation
c. The possible risk that is associated with the investment.

It is therefore not surprising that the required return that an investor would need
would be the sum total of the above three components.

1.2.1 Required return

= risk free real rate + expected inflation + risk premium

The risk free real rate can be reasonably approximated by default free government
treasury bills while the expected inflation is a matter of a scanning the economic
environment including past figures and future estimates by various formal and
informal sources. Though there can not be a total finality on the issue, reasonable
consensus estimates can be arrived at over shorter investment horizons. It is the
third element of risk premium that is the most difficult to estimate since it varies
across from products to products all of which may not remain at the same risk level
across different time periods even for the same investment product. Moreover the
assessment of risk premium and the returns required to compensate for the same
varies from person to person. This represents a challenge to understand the risk-
return profile of the client for the financial planner. Only a complete understanding of
the same can enable the financial planner to suggest and implement the right
proportion of investment products.

An investment product is usually denominated as a security. A security represents a


type of ownership of an asset. In other words, a security represents a claim on an
asset and any future cash flows the asset may generate. Thus, a security can cover a
wide array of assets right from stocks and shares to even real estate.

Each of the various types of securities has a different risk and return profile. In
investment analysis, return and risk is represented by specific definitions and is
measured in a certain manner.
Return Chapter- 2

2.1 The rate of return on a security can be calculated as:


In a 5 year period the average yearly return would then be 132/5 = 26.4%
R = (P1 -P0) + D1
-------------
P0

Where

R=therateofreturn
P0=thebeginningprice
P1=theendingprice
D1 or I1 = the dividends received or the interest received depending upon the type
of security

The above is simply the total of the capital appreciation earned and the regular
income received over the tenure of the investment horizon divided by the price at
which the investment was purchased.

To take an example: - The price of a security on April 1, 2006 was Rs 100. On 31st
of March, 2007 the price of the security was Rs 120. In between, the company gave
a dividend of Rs 8. In that case, the return can be calculated as

P0=100
P1=120
D1 = 8

R = (120-100) + 8
-----------------
100

=0.28
= 28.0 %

The above formula can be calculated over differing horizon periods which can be as
small as a day or over a ten year period as well. However using the above formula
for longer durations of time does not necessarily give a clear indication of the actual
returns on the security. This is simply because between the beginning and ending
prices there may be a lot of volatility and price variations that affect the actual
returns on the security. However from the point of view of the actual returns earned
by a person who bought a security at a particular time period and then sold it
another, the above formulae would clearly indicate the actual returns earned by the
investor.

In the example given below the prices of a particular security are given at various
dates. If an investor had bought a security in 2002 and sold it in 2007 the returns
that he would have got would have equaled the capital appreciation plus the
dividends of the various years.
Rate of return

= [(74-50) + 5+10+6+12+4+5] X 100


__________________________
50

= 132%

2.2 Arithmetic Average

However if one were to calculate the yearly returns and then average it out the
monthly average would work out to be

30+ 3.33+ 55.77+ 6.67+ 14.71 = 110.48/5 = 22.10%

This is how the arithmetic average of returns is calculated.

Date/Year Price of the security Dividends (Pt-Pt-1)+Dt /Pt-1 Returns in %


1.04.2002 50.00 5.00
1.04.2003 60.00 10.00 0.30 30.00
1.04.2004 52.00 6.00 0.03 3.33
1.04.2005 75.00 12.00 0.56 55.77
1.04.2006 68.00 4.00 0.07 6.67
1.04.2007 74.00 5.00 0.15 14.71

2.3 Geometric Average

The above formulae to calculate returns are mostly used over shorter durations
extending to about a year. Most popularly used are daily returns and yearly returns.
To calculate the average return over a number of years, a simple arithmetic average
of yearly returns is normally used. In case however there is too much of volatility
then in that case geometric average is used. The return estimates using geometric
average is always lower than that of arithmetic average. Over long periods, the
difference between the two comes down but over shorter durations given the
volatility; the magnitude of difference can be large. In the same example if one were
to calculate the average return using geometric average, the figures would be
slightly different depending of course on the volatility. The more volatility, the
greater the difference between arithmetic mean and geometric means. However,
there is not too much difference between the two measures if the returns are
calculated over a longer period. This is because the volatility comes down. As such,
arithmetic mean is usually used to calculate average returns being simpler to use
and understand.

Price of the (Pt-Pt-1)+Dt /Pt- Returns in Wealth


Date/Year Dividends
security 1 % Ratio
1.04.2002 50.00 5.00
1.04.2003 60.00 10.00 0.30 30.00 1.30
1.04.2004 52.00 6.00 0.03 3.33 1.03
1.04.2005 75.00 12.00 0.56 55.77 1.56
1.04.2006 68.00 4.00 0.07 6.67 1.07
1.04.2007 74.00 5.00 0.15 14.71 1.15
The wealth ratio is nothing but the Return earned in % divided by 100 plus 1. For
calculating the geometric mean each of the wealth ratio is multiplied and the square
root is taken according to the number of years. Subtract 1 from the result and after
multiplying by 100, the geometric return in percentage is obtained.

= 5√ (1.30x 1.03x 1.56X 1.07x 1.15) = 2.561/5 = 1.2068

= 1.2068-1 = .2068x100= 20.68%


RISK Chapter- 3

Risk in common parlance is usually understood as loss. Loss of course can extend
from loss of life to loss of property, job, personal relationships to even self-esteem
and respect. In investment analysis however risk is understood more as variability of
rate of return. The more variable the rate of return is, the more risky the investment
is considered as.

The most commonly accepted measure of risk in investment analysis is standard


deviation denoted as σ (pronounced as sigma).

The other measure of variability that is directly related to the standard deviation is
the variance. The variance is nothing else but the standard deviation squared or the
standard deviation is the square root of the variance. Both the standard deviation
and the variance are critical to construction of the individuals risk return matrix both
with regard to individual securities as well as with portfolios.

3.1 Standard deviation & Variance

Standard Deviation = σ

Variance = σ 2

n _
σ2= 1 Σ (rit –rt)2
.........
n-1 t=1

n _
σ=
/__ 1___ Σ (rit –rt)2
√ n-1 t=1

In the table below, standard deviation is calculated using the same example as
above for calculating returns.

To calculate standard deviation the following steps need to be taken

a. Calculate returns for each of the years for the security


b. Find the average return using the arithmetic mean
c. Take out the deviation of each return from the average return
d. Square each of the deviations
e. Find out the sum of the squared deviations
f. Divide the above sum by n-1 to get the variance
g. Find the square root of the variance to get the standard deviation
3.2 Continuing from the same example:

Returns in Deviation from the average (average Squared


Date/Year
% (rt) = 22.10) (rt - r) deviations (rt - r)2
1.04.2002
1.04.2003 30.00 7.90 62.41
1.04.2004 3.33 -18.76 351.94
1.04.2005 55.77 33.67 1133.67
1.04.2006 6.67 -15.43 238.08
1.04.2007 14.71 -7.39 54.61
Total returns 110.48 Sum of deviations 1840.71
Average returns 22.10 Variance= Sum of deviations/n-1 460.18
Standard deviation = 21.46
Types Of Risk Chapter- 4

The variability of returns or the presence of risk can be due to numerous reasons.
Though none of the risks can be independently measured, yet each of these risks can
be differentiated on account of specific factors. Some of the popular measures of risk
are as follows:

4.1 Business risk

Business risk is the risk associated with the unique circumstances of a particular
company, as they might affect the price of that company's securities. It is the risk
associated with the underlying operations of a business. The variability of the firms
operating income, before interest income: this dispersion is caused purely by
business-related factors and not by the debt burden

4.2 Country Risk

Country risk stems from country specific factors and is defined as the The risk of
adverse effects on the net cash flows of a MNC due to political and economic factors
peculiar to the country of location of FDI. Political risk is very much similar to country
risk. It can be considered as the financial risk that a country's government will
suddenly change its policies. It is also known as "Geopolitical risk

4.3 Interest Rate Risk

Interest rate risk is more widespread and affects both persons and organizations. It
stems from the potential for losses arising from changes in interest rates. Consider
the investment in a certain security at a particular interest rate let say 8% for
duration of 5 years. However within a year the level of interest rate rises to 10%. In
that case the person is locked into a low interest rate security for another 4 years as
against the possibility of earning higher interest rates. Similarly organizations and
specially banks are exposed to the variations in interest rates that can cause
significant decline in their profitability and cash flows.

4.4 Exchange Rate Risk

Exchange Rate Risk The potential loss that could be incurred from a movement in
exchange rates. Though it affects indirectly all of us, it directly affects all those who
have transactions in the international markets. This can be either due to export and
import of goods and services as well as investments made either in some sort of
financial securities, projects and real estate.

4.5 Market Risk

Market risk is defined as the day-to-day potential for an investor to experience losses
from fluctuations in securities prices. This risk cannot be diversified away. It is also
referred to as "systematic risk". In investment analysis the beta of a stock
(discussed later) is the measure of how much market risk a stock faces.
4.6 Liquidity Risk

Liquidity risk is the risk stemming from the lack of marketability of an investment
that cannot be bought or sold quickly enough to prevent or minimize a loss.

4.7 Price risk/Purchasing power risk

Price risk is simply the risk that the value of a security or portfolio of securities will
decline in the future. Basically, it's the risk that you will lose money due to a fall in
the market price of a security that you own. Purchasing power risk also stems from
the fact that money invested or received from an investment today will purchase
fewer goods and services in the future.

4.8 Reinvestment Risk

The risk that future proceeds will have to be reinvested at a lower potential interest
rate. This term is usually heard in the context of bonds. This "reinvestment risk" is
especially evident during periods of falling interest rates where the coupon payments
are reinvested at less than the yield to maturity at the time of purchase.

4.9 Systematic Risk

Systematic risk is the risk inherent to the entire market or entire market segment.
Also known as "un-diversifiable risk" or "market risk." Interest rates, recession and
wars all represent sources of systematic risk because they will affect the entire
market and cannot be avoided through diversification. Whereas this type of risk
affects a broad range of securities, unsystematic risk affects a very specific group of
securities or an individual security. Even a portfolio of well diversified assets cannot
escape all risk.

4.10 Unsystematic Risk

This is the risk that affects a very small number of assets. Sometimes it is referred to
as specific risk or as undiversifiable risk. For example, news that is specific to a small
number of stocks, such as a sudden strike by the employees of a company you have
shares in.
RETURN AND RISK Chapter-5

Return and risk have a direct relationship with each other. Higher is the return
expected on a security, higher the risk inherent in the security. It is no wonder that
the returns on fixed income instruments such as post-office savings deposits, bank
deposits, and employee provident fund have far lower returns than on equities. This
is because they are virtually risk free securities.

A study of returns from 1979 to 2003 shows that the average annual return of
equities is 17.05%, debt 10.8% and gold 5.33% . The volatility of equity has
naturally been far more vis-à-vis that of other investment options.

It is therefore not surprising that all finance planning professionals try to gauge the
risk tolerance of their clients so that they can assess the right quantum of risk that
their clients can bear in their investment portfolios.

A very high risk averse investor would prefer investments that are more secure and
thus would have higher portfolio allocations to debt and fixed income instruments.
On the other hand an investor which is less risk averse would like to have greater
exposure to equity and risky investments.

5.1 Risk Tolerance

Financial risk tolerance involves perceptions about how confident people are in their
ability to make good financial decisions, their views about borrowing money, and
how much of a risk in terms of financial loss they believe they could accept in
achieving financial gains in the longer term.

There is need to study risk tolerance for a variety of reasons some of which are
enumerated below:

a. Achievement of a level of financial independence that allows them to meet not


only their basic human needs, but also higher level needs for self-
development and self improvement.
b. Willing to accept a certain small return rather than a larger, but uncertain
profit, from their financial decisions
c. Individuals’ evaluations of their self-worth and their levels of self-esteem are
related to their levels of satisfaction with their financial situation
d. Individuals need to appreciate their personal comfort zone when they trade-
off what they are willing to accept in terms of possible losses versus possible
gains
e. Clients’ goals and objectives are often poorly developed and unrealistic.
f. It is often difficult for clients to describe in their own words their attitudes
about risk.
g. There is a good chance that new clients in particular will not understand many
of the financial and risk concepts presented by advisers.
h. Having the client complete a measure of risk tolerance allows any discussion
or communication to
i. Communication is focused around an explicit and understandable score or
profile.
j. Difficult for the planner to arrive at an accurate risk profile
k. One size fits all- lifecycle approach does not work

Normally so far as assessing risk tolerance, there are three common techniques. The
first is gaining biographical data from clients, the second is conducting an interview
and the third is Using a scientifically validated test.

Some of the key parameters on which one’s risk tolerance can depend is Age,
Personal Income, Combined family income, Sex, No of dependents, Occupation,
Marital status, Education, Access to other inherited sources of wealth.

As described earlier, return is nothing but the sum of capital appreciation and the
periodic sums of money given to the investor either in the form of dividends or
interest. Risk on the other hand is simply the volatility of returns. As shown earlier
the two measures of risk popularly used are variance and standard deviation. The
earlier calculations illustrated the concept of historical return and risk. However,
historical returns or risk would give only an incomplete indication of future returns
and risk. It is therefore important to calculate the expected return and risk on a
security. In actual practice, the calculation of future returns can only be an
approximation.
Quantifying Ex-Ante (Expected Risk and Return) Chapter- 6

6.1 Expected Risk and Return

If one were to assume that there are four scenarios which would describe the
possible situations that the economy would face. For example one could have
situations wherein

a. The economy was growing at more than 8% growth rate, inflation was under
control and interest rates were low. Moreover monsoons were also expected
to be good
b. The economy was growing between 6-8%. Inflation was a little high due to
burgeoning foreign exchange reserves. Consequently the government also
had to take certain steps to control inflation which had the impact of
increasing interest rates. Monsoons were average but the agriculture sector
growth due to a number of reasons was expected to be below average.
c. The economy was growing a sluggish pace of 5%. Both inflation and interest
rates were high. The manufacturing sector as well as the agricultural sector
was both expected to fare poorly both due to high interest burden and
infrastructural rigidities.
d. The economy is in the throes of deep recession. On top of that there is
political instability. There is also an impending oil shortage. The world
markets are also in a downswing. As such the growth rate of the economy is
not likely to be more than 2%. The stock markets are expected to be on a
downward phase.

Each of the scenarios is real life situations. However not all scenarios are equally
probable and one can assign different probabilities to each of these situations.

The expected return of the stock in the coming year can thus be calculated by
multiplying the expected return of the stock in that scenario by the probability of
that scenario and summing all the results.

Multiplying the
The expected Multiply the Taking the square of the
squared
return of the stock probability with deviations of expected
Situation Probability deviations with
in the particular the expected mean from the return of
the probability of
scenario return the particular scenario
that occurrence
A 0.40 25.00 10.00 100.00 40.00
B 0.25 15.00 3.75 0.00 0.00
C 0.20 10.00 2.00 25.00 5.00
D 0.15 -5.00 -0.75 400.00 60.00
Sum of
probabilities
1.00 Expected return 15.00 Variance 105.00
must equal
to 1
Standard deviation 10.25

The expected risk or the ex-ante risk can be then calculated in the following manner.

a. Take out the deviations of the returns in a scenario from the expected mean
b. Find the square of deviations
c. Multiply by the probability of the scenario.
d. The sum of the above would constitute the variance
e. The square root of the variance would be the standard deviation.
Return and Risk in A Portfolio Context Chapter- 7

As individuals one does not hold only single securities but a number of them. In that
case while it may be essential to find the return and risk of an individual security at
the time of purchase to gauge its risk –return profile but that would not be able to
give a clear indication of either the total returns of our portfolio and nor the risk
exposure of the same.

In that case it is imperative to be able to clearly find out the risk and return of one’s
entire portfolio. In the case of returns, the matter is relatively simple since it is
nothing but the weighted average of the returns on individual securities in a
portfolio, the risk is definitely not the weighted average.

To understand how the risk profile of a portfolio changes while combining securities,
let us take an example:

An investor would like to hedge his returns and therefore he decides to buy two
stocks. One is of a sugar company and the other that of an automobile company. He
has chosen these two stock purely because of the fact that if interest rates are low
and inflation is also low, the stock of the automobile company would do well but in
case interest rates are high and so is inflation, sugar company stocks are expected to
do comparatively better. He also decides to hold 50% of his portfolio in sugar and
50% in automobiles.

As one can see the returns on his portfolio are a weighed average of the individual
returns of each stock.

7.1 Return on a portfolio

Rp = X1R1 + X2R2

Where X1 and X2 are the proportions invested in each of the securities and R1 and
R2 are the returns of the two securities.

0.5X 10+0.5X 10 = 10%

7.2 Risk of the portfolio

The individual standard deviations of sugar and automobiles are 15% and 11.14.
What is surprising that the standard deviation of the portfolio comes out to be only
2.18% far below the standard deviation of either of the two stocks. Actually it is not
so surprising. A analysis of the figures would tell you that when the stocks are
combined the variability of the returns are actually reducing. This is specially so if
the co-relation coefficient between the two stocks is low. If the volatility of the
portfolio reduces, then of course the standard deviation would automatically be low.
In this case the investor has been wise by choosing these two stocks. While getting
the same return, he has been able to reduce his risk exposure to a great extent.
The following is the risk and return of his portfolio

Returns on Returns on Return on the portfolio


Stock- 50% sugar & 50% of Variance of Variance of Variance of
Periods Stock-Automobile
Sugar automobiles sugar automobile portfolio
Low interest
-5 20 75 225 100 6.25
rates
Moderate
interest 10 12 11 0 4 1
rates
High interest
25 -2 11.5 225 144 2.25
rates
Average
10 10 10 450 248 10
returns
225 124 4.75
Standard
15 11.14 2.18
deviation

This points to the fact that if one is able to construct a portfolio wherein the
correlation coefficient is less than one, it is possible to reduce risk by diversification.
In the above example the correlation coefficient between the stocks was
approximately -.99 and therefore one could reduce risk drastically. Only when the
co-relation becomes +1 between two stocks there is no positive impact due to
diversification. In that case the standard deviation of the portfolio is only a weighted
average of the individual standard deviation of the portfolios.

For any two security case the return and risk of a portfolio can be calculated by using
the following formula : Rp = x1R1 + X2R2

7.3 Correlation coefficient

To measure portfolio risk, it is required first to calculate correlation coefficient. This


correlation coefficient between two securities will give information about their
relative movements. A positive correlation coefficient indicates similar movement
between securities whereas a negative correlation coefficient indicates inverse
movement. A correlation coefficient of zero indicates that the two securities move
randomly without correlation.

The formula used for the calculation of Correlation coefficient (r) between returns on
security x and security y is

ρXY = ∑(X-X)(Y-Y) = Covariance (X,Y)


(n-1) σx σy σx σy

Where

ρXY = correlation coefficient between two random variables X and Y


σX = standard deviation of X
σY = standard deviation of Y
Applying the above formula we can calculate the Correlation coefficient.

(X-
Year X X-X Y Y-Y (Y-Y )2 (X-X)(Y-Y)
X)2
1 6 -1 1 20 -10 100 10
2 5 -2 4 40 10 100 -20
3 10 3 9 30 0 0 0
Sum Total 21 0 14 0 200 -10

AverageofX=7
AverageofY=30
σx=2.167
σy = 8.167

ρXY = ∑(X-X)(Y-Y)
(n-1) σx σy
= -10______
2 x 2.167x 8.167
= -0.2825

7.4 Risk of a portfolio

Risk of a portfolio is equal to Standard Deviation

Variance = σ2p = X12σ12 + X22σ22 + 2X1X2σ12

Standard deviation = σ p =√ X12σ12 + X22σ22 + 2X1X2σ12

X1 and X2 continue to be the respective proportions or weights invested in each of


the two securities respectively whereas σ1 and σ2 are the standard deviations of the
two securities. The symbol σ12 represent the covariance between the two securities.

The covariance between the two securities can also be taken as the product of the
individual standard deviations and the co-relation coefficient between the two
securities

Covariance= σ12 = σ1 x σ2 x ρ12

The correlation coefficient between the two securities is represented by ρ12

In case one were to find the standard deviation of a portfolio consisting of n


securities then in that case one would need the following calculations

a. The standard deviations of each of the securities


b. The proportions invested in each of the securities
c. The correlation coefficient between each of the securities

In the example given below the risk and return of two securities is given. The return
on equity is 14% and that on debt is 8%. The standard deviation on equity is 6%
and on debt is 3%. Depending on the correlation, the risk of the portfolio changes for
a particular portfolio composition. The sum of the weights of the two securities totals
1. As is evident the return is a weighted sum. However the risk of the portfolio
changes as per the co-relation coefficient. The risk is lowest if the correlation
coefficient is -1 and is the highest if the correlation coefficient is +1. In the second
case there would be no benefit of diversification and the standard deviation would
simply be the weighted average of the standard deviation of the two securities.

ρED ρED ρED ρED


1 -1 0 0.5
Return of Risk of Risk of Risk of Risk of
Weights
portfolio portfolio portfolio portfolio portfolio
A B R
1 0 14 6.00 6.00 6.00 6.00
0.9 0.1 13.4 5.70 5.10 5.41 5.56
0.8 0.2 12.8 5.40 4.20 4.84 5.13
0.7 0.3 12.2 5.10 3.30 4.30 4.71
0.6 0.4 11.6 4.80 2.40 3.79 4.33
0.5 0..5 11 4.50 1.50 3.35 3.97
0.4 0.6 10.4 4.20 0.60 3.00 3.65
0.3 0.7 9.8 3.90 0.30 2.77 3.38
0.2 0.8 9.2 3.60 1.20 2.68 3.17
0.1 0.9 8.6 3.30 2.10 2.77 3.04
0 1 8 3.00 3.00 3.00 3.00

ρED = co-relation coefficient between Debt and Equity

The variance of the portfolio with n assets is the sum of the expressions given below

σ2p = X12 σ12 + X22 σ22 + ……… Xn2 σn2 + 2X1X2 σ12 + 2X1X3 σ13 + …… +
2Xn-1Xn σn-1,n

Obviously there would be no investor who would be holding only 2 securities. The
moment the number of securities goes up the difficulty of calculating the variance of
the portfolio goes up in direct proportion to the number of securities in the portfolio.
For example, if there were 50 securities one would require-

50estimatesofreturns
50estimatesofstandarddeviations
(50X49)/2 =1225 estimates of correlation coefficients.

Over and above that one would have numerous permutations and combinations with
the proportions that were to be invested in each security. This would require
extremely superior computing facilities that would be out of the reach of even
sophisticated investors.
The Market Model Chapter- 8

8.1 The Market Model

The Capital Asset Pricing Model also known as the Market Model came out as solution
to the above complexity. Not only was it much simpler but also much easier to
comprehend. It required far fewer assumptions and calculations and came up with
results that were if not more were as reasonably efficient as the Markowich model.

It is also popularly known as the Market Model. Instead of finding out the
relationship of each security with the other, it would be far simpler to find out the
relationship of each security with a common benchmark. In this case the benchmark
used would be a stock market index. In that case the return relationship can simply
be captured in the following manner.

ri=αiI + βiIrm + εiI

αiI=interceptterm
ri=returnonsecurity
rm=returnonmarketindexI
βiI=slopeterm
ε iI = random error term

This relationship simply states that the returns of the security can be related to the
market return represented by rm. Alpha is the intercept term and epsilon is the error
term. The term ε is known as the random error term and simply shows that the
market model does not explain security returns perfectly. The random error term can
be viewed as a random variable that has a probability distribution with a mean of
zero and a standard deviation denoted by σei.

Graphical representation of the market model


As already mentioned the intercept term measures the return on the security even when
the market index is zero. However the slope in a security’s market model measures the
sensitivity of the security’s return to the market index’s returns. Since the slope is
positive, it means that higher the market returns, higher the security’s returns.

The slope also called the beta is nothing but the covariance of the security returns
with that of the market returns divided by the variance of the market returns. It can
be denoted as

βiI =σim/σm2

A stock that has a return that mirrors the return on the market index will have a
beta equal to 1 and an intercept of zero. Any security that has a beta over 1 can be
classified as an aggressive security and a security that has a beta of less than 1 is
called a defensive security. According to the market model the total risk can be
broken into diversifiable risk and non-diversifiable risk

a. Market or systematic risk: risk related to the macro economic factor or


market index
b. Unsystematic or firm specific risk: risk not related to the macro factor or
market index
c. Total risk = Systematic + Unsystematic

σ2=β2σM2+σ2(ei)
where;

σ2=totalvariance
β2σM2=systematicvariance
σ2(ei) = unsystematic variance

Systematic Risk can be measured by using Beta. Following is the formula for
calculating Beta:
β = n∑XY -∑X∑Y
n∑X2 – (∑X)2

where
X=ReturnonIndex
Y=ReturnonStock
n = number of stocks

This model obviously has a great many advantages since this reduces the number of
estimates of finding portfolio risk and return

In effect one would need to find out only the estimates of only the return of the
security, the covariance of the security with that of the market, the standard
deviation of the security, the returns on the market and the variance of the market.
No more does one need to figure out the covariances of the security with another
and so on. All one needs to do is find out the beta of the security. The square of the
beta multiplied by the variance of the market would give the systematic risk of the
security. If the systematic risk of the security were subtracted from the total
variance or the total risk, then one can figure out the unsystematic risk of the
security.

The above result was detailed for an individual security wherein the total risk could
be subdivided into systematic and unsystematic portions. If one were to find the risk
for a portfolio a similar procedure can be used, except in this case a portfolio beta
needed to be calculated.

While using portfolios, it is hoped that diversification would be able to reduce the
unsystematic risk to nil and that the only risk that the portfolio would bear would be
that of systematic risk which cannot be diversified away. In that case the latter term
in the equation would be equal to zero and that the risk of the portfolio can be
approximated by only β2σM2
Using Beta Chapter- 9

The portfolio beta is nothing but the individual betas of different securities multiplied
by the respective weight of the proportion of investment in the particular security.

βp=W1β1+W2β2+W3β3+W4β4+……….+Wnβn

Proportion Returns
Security Beta Proportions multiplied by the on the
beta of the security security
1 1.10 0.10 0.11 25.00 2.50
2 0.50 0.05 0.03 -5.00 -0.25
3 1.40 0.20 0.08 30.00 6.00
4 0.90 0.03 0.02 40.00 1.00
5 0.40 0.15 0.06 -20.00 -3.00
6 0.75 0.25 0.19 10.00 2.50
7 1.25 0.05 0.06 5.00 0.25
8 1.80 0.03 0.09 -8.00 -0.40
9 0.25 0.10 0.01 12.00 0.30
10 0.60 1.00 0.06 15.00 1.50
0.90 10.40

In the above table assuming one has taken a basket of 10 securities, then the
portfolio beta would be nothing but the proportion that has been invested in the
particular security multiplied by the beta of the security. In this case the portfolio
beta works out to be 0.90.

If one were to assume that the standard deviation of the market was let say 25, then
in that case the total risk of the portfolio would be equal to

=0.9 x 0.9 x 25 x 25= 506.25

9.1 The standard deviation would be 22.5

The returns of course would simply be a weighted average of the returns on


individual securities. In this case the returns are 10.40%.

The above discussion regarding finding out the risk of a security or a portfolio using
beta however has a catch. While using it for a portfolio, the systematic risk is more
or less synonymous with the total risk simply because one has diversified the
unsystematic portion. In reality, this may not be so and in that case the systematic
risk cannot be used as a proxy for the total risk. The problem becomes more
pronounced in case of an individual security. Since the unsystematic element would
be higher, using beta to calculate risk would not give the entire risk profile of the
security.

9.2 Using Beta to select securities

In the above discussion, beta was used as a means to calculate the risk of either an
individual security or a portfolio. Beta can also be used to select a particular security
for investment. As earlier explained that a security that has a beta of more than 1 is
an aggressive security and a security having a beta of less than 1 is known as a
defensive security.

What this implies is that if the market goes up by lets say 10%, then if the beta is
1.5, in that case the returns expected out of the security should be 15%. In case of
market downswing, a similar result would be expected. In this case the returns on
the security should go down by 15% if the market falls by 10%. In a defensive
security having a beta of less than 1, the returns of the security would be less than
the returns of the market in case of an upswing and the fall would also be less
pronounced than that of the market in case the market falls.

To understand the above relationship of the security with that of the market, the
market model equation is simplified

The above form of the market model is normally simplified to

ri-rf =αiI + βiI(rm-rf) + εiI

Ri = αiI + βiI(rm-rf) + εiI

If the alpha is 0, in that case the above equation reduces to:-

ri = rf + β(Rm-rf)

What this practically translates into is that the returns on a security should be at
least equal to the risk free rate of return plus beta multiplied by the risk premium on
the market. Rm-Rf is known as the risk premium that is due to the fact that there is
an additional risk associated with investing in the market.

Example:

If the risk free rate of return is 7%, the returns on the market is 12% and that the
beta of the security is 1.2, what is the minimum return that should be expected on
the security.?

= 7% + 1.2 (12%-7%)

= 7% +6%= 13%

Only if the returns from the purchase of a security are expected to be greater than or
equal to 13%, only then should the investor purchase the particular security. The
logic behind is this is fairly simple. More the risk borne, more should be the return
expected. So in this case if the systematic risk represented by beta is more, then the
return that is expected should obviously be more.

In fact most portfolio managers are always looking at mispriced securities for the
simple reason is that they would be able to give returns more than what their return-
risk profile would indicate. As and when the security is able to generate better results
than what is expected after factoring in the risk factor of Beta, in that case there
would be a positive alpha. Again while using this to select securities, it must be
represented that the risk from the security while using beta gets factored in only to
the tune of the unsystematic risk. In the actual world especially while selecting
securities the return expected must take into account both systematic and
unsystematic portions. Therefore using beta to find out the expected returns does
not take into account the other relevant risks that one is exposed to besides the
systematic portion.
Introduction to Financial Market Chapter- 10

A financial market can be defined as the market in which financial assets are created or
transferred. It consists of investors or buyers of securities, borrowers or sellers of
securities, intermediaries and regulatory bodies. Formal trading rules, relationships and
communication networks for originating and trading financial securities link the
participants in the market

Financial markets are classified as:

•MoneyMarkets
• Capital Markets

10.1 MONEY MARKET

Money market deals with all transactions in short term instruments with a period of
maturity of one year or less like treasury bills, bills of exchange, etc. The important
function of money market is to channel savings into short term productive
investments like working capital.

The money market is classified as the following:-

ORGANIZED MONEY MARKET: Indian financial system consists of money market


and capital market. The organized market is dominated by commercial banks. The
major participants are the Reserve Bank of India, Life Insurance Corporation,
General Insurance Corporation, Unit Trust of India, commercial banks and mutual
funds. The Reserve Bank of India occupies a strategic position of managing market
liquidity through open market operations of government securities, access to its
accommodation, cost (interest rates), availability of credit and other monetary
management tools.

UN-ORGANIZED MONEY MARKET: Despite rapid expansion of the organized


money market through a large network of banking institutions that have extended
their reach even to the rural areas, there is still an active unorganized market. It
consists of indigenous bankers and moneylenders. In the unorganized market, there
is no clear demarcation between short-term and long-term finance and even
between the purposes of finance. The unorganized sector continues to provide
finance for trade as well as personal consumption.

10.2 CAPITAL MARKET

The capital market deals with transactions related to long term instruments with a
period of maturity of above one year like corporate debentures, government bonds,
etc. and stocks.

The capital market functions as an institutional mechanism to channel long term


funds from those who save to those who need them for productive purposes. It
serves as a medium to bring together entrepreneurs, initiating activity involving
huge financial resources & savers, individuals or institutions, seeking outlets for
investment.

The capital market consists of primary and secondary markets.

PRIMARY MARKET deals with the issue of new instruments by the corporate sector
such as equity shares, preference shares and debt instruments. The primary market
in which public issue of securities is made through a prospectus is a retail market
and there is no physical location. Offer for subscription to securities is made to
investing community. : There are several major players in the primary market.
These include the merchant bankers, mutual funds, financial institutions, foreign
institutional investors (FIIs) and individual investors.

SECONDARY MARKET OR STOCK EXCHANGE is a market for trading and


settlement of securities that have already been issued. The investors holding securities
sell securities through registered brokers/sub-brokers of the stock exchange. The
secondary market provides a trading place for the securities already issued, to be bought
and sold. In the secondary market, there are the stock brokers (who are members of the
stock exchanges), the mutual funds, financial institutions, foreign institutional investors
(FIIs), and individual investors.

10.3 Regulatory Guidelines


The financial market in India was highly segmented until the initiation of reforms in
1992-93 on account of a variety of regulations and administered prices including
barriers to entry. The reform process was initiated with the establishment of
Securities and Exchange Board of India (SEBI). The legislative framework before
SEBI came into being consisted of three major Acts governing the capital markets:

a. The Capital Issues Control Act 1947, which restricted access to the securities
market and controlled the pricing of issues.
b. The Companies Act, 1956, which sets out the code of conduct for the
corporate sector in relation to issue, allotment and transfer of securities, and
disclosures to be made in public issues.
c. The Securities Contracts (Regulation) Act, 1956, which regulates transactions
in securities through control over stock exchanges. In addition, a number of
other Acts, e.g., the Public Debt Act, 1942, the Income Tax Act, 1961, the
Banking Regulation Act, 1949, have substantial bearing on the working of
the securities market

CAPITAL ISSUES (CONTROL) ACT, 1947

The Act had its origin during the Second World War in 1943 when the objective of
the Government was to pre-empt resources to support the War effort. Companies
were required to take the Government's approval for tapping household savings.
The Act was retained with some modifications as a means of controlling the raising
of capital by companies and to ensure that national resources were channeled into
proper lines, i.e., for desirable purposes to serve goals and priorities of the
government, and to protect the interests of investors. Under the Act, any firm
wishing to issue securities had to obtain approval from the Central Government,
which also determined the amount, type and price of the issue. This Act was
repealed and replaced by SEBI Act in 1992.

SECURITIES CONTRACTS (REGULATION) ACT, 1956

The previously self-regulated stock exchanges were brought under statutory


regulation through the passage of the SC(R)A, which provides for direct and indirect
control of virtually all aspects of securities trading and the running of stock
exchanges. This gives the Central Government regulatory jurisdiction over (a) stock
exchanges, through a process of recognition and continued supervision, (b)
contracts in securities, and (c) listing of securities on stock exchanges. As a
condition of recognition, a stock exchange complies with conditions prescribed by
Central Government. Organized trading activity in securities in an area takes place
on a specified recognized stock exchange. The stock exchanges determine their own
listing regulations which have to conform with the minimum listing criteria set out in
the Rules. The regulatory jurisdiction on stock exchanges was passed over to SEBI
on enactment of SEBI Act in 1992 from Central Government by amending SC(R)Act.
COMPANIES ACT, 1956

Companies Act, 1956 is a comprehensive legislation covering all aspects of company


form of business entity from formation to winding-up. This legislation (amongst
other aspects) deals with issue, allotment and transfer of securities and various
aspects relating to company management. It provides for standards of disclosure in
public issues of capital, particularly in the fields of company management and
projects, information about other listed companies under the same management,
and management perception of risk factors. It also regulates underwriting, the use
of premium and discounts on issues, rights and bonus issues, substantial
acquisitions of shares, payment of interest and dividends, supply of annual report
and other information.

10.4 SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

With the objectives of improving market efficiency, enhancing transparency,


checking unfair trade practices and bringing the Indian market up to international
standards, a package of reforms consisting of measures to liberalize, regulate and
develop the securities market was introduced during the 1990s. This has changed
corporate securities market beyond recognition in this decade. The practice of
allocation of resources among different competing entities as well as its terms by a
central authority was discontinued. The secondary market overcame the
geographical barriers by moving to screen-based trading. Trades enjoy counterparty
guarantee. Physical security certificates have almost disappeared. The settlement
period has shortened to three days. The following paragraphs discuss the principal
reform measures undertaken since 1992. A major step in the liberalisation process
was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. With this,
Government's control over issue of capital, pricing of the issues, fixing of premium
and rates of interest, on debentures, etc., ceased. The office, which administered
the Act, was abolished and the market was allowed to allocate resources to
competing uses and users. Indian companies were allowed access to international
capital market through issue of American Depository Receipts and Global Depository
Receipts.
However, to ensure effective regulation of the market, SEBI Act, 1992 was enacted
to empower SEBI with statutory powers for
a. protecting the interests of investors in securities,
b. promoting the development of the securities market, and
c. regulating the securities market.

Its regulatory jurisdiction extends over corporates in the issuance of capital and
transfer of securities, in addition to all intermediaries and persons associated with
securities market. SEBI can specify the matters to be disclosed and the standards of
disclosure required for the protection of investors in respect of issues. It can issue
directions to all intermediaries and other persons associated with the securities
market in the interest of investors or of orderly development of the securities
market; and can conduct inquiries, audits and inspection of all concerned and
adjudicate offences under the Act. In short, it has been given necessary autonomy
and authority to regulate and develop an orderly securities market.

In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP)
Guidelines. Issuers are now required to comply with these Guidelines before
accessing the market. The guidelines contain a substantial body of requirements for
issuers/intermediaries. The main objective is to ensure that all concerned observe
high standards of integrity and fair dealing, comply with all the requirements with
due skill, diligence and care, and disclose the truth, the whole truth and nothing but
the truth. The Guidelines aim to secure fuller disclosure of relevant information
about the issuer and the nature of the securities to be issued so that investor can
take an informed decision. For example, issuers are required to disclose any
material 'risk factors' in their prospectus and the justification for the pricing of the
securities has to be given. SEBI has placed a responsibility on the lead managers to
give a due diligence certificate, stating that they have examined the prospectus,
that they find it in order and that it brings out all the facts and does not contain
anything wrong or misleading. Though the requirement of vetting has now been
dispensed with, SEBI has raised standards of disclosures in public issues to enhance
the level of investor protection.

SEBI has recently started a system for Electronic Data Information Filing and
Retrieval System (EDIFAR) to facilitate electronic filing of public domain information
by companies.
Equity Chapter- 11

As the name suggests, Equity represents ownership interest in a company. This


particular instrument is an outcome of the formation of the joint stock company. As
companies grew in size, there arose a need for far more capital than the promoters
of the company could raise from their own resources. As a result, the Equity share is
an instrument wherein millions of investors can invest in the company even though
they are spread far apart.

Common stock represents Equity, or an ownership interest in a corporation. It is a


residual claim in the sense that creditors and preferred shareholders must be paid as
scheduled before common stockholders can receive any payments. . It also implies
that in the event of bankruptcy, the rest of the creditors and preferred shareholders
are entitled to their dues before the Equity shareholders can lay claim to their
investments. This ensures that the Equity investment is the most risky of all
investments. Correspondingly they are entitled to all surpluses generated by the
company and therefore are in a position to earn far greater returns depending upon
the performance of the company than the other stakeholders.

Companies that are allowed to raise capital through Equity must abide by the
legislation of the Companies Act 1956.

Some of the terminology that is associated with Equity is as follows:-

• Authorised capital is the amount of capital that a company can issue as per its
memorandum
• Issued capital is the amount that has been offered by the company to its
investors
• Paid up Capital is the portion of issued capital that has actually been
subscribed to by the investors

Par value is typically stated in the memorandum and usually ranges from Rs 1000 to
Rs 1. The most popular denominations are Rs 10 and Rs 1. Dividends are quoted as
a percentage to the par value. That is if the company states that it is giving 200%
dividend, it simply means that if the par value of the share is Rs 1, it is giving a
dividend of Rs 2 per share. Issue price is the price at which the company issues
shares to the public. It can be equal to the par value but not lower than that. In
most cases it is more than the par value. In this case the difference is the share
premium per share.

Book Value of the share is nothing but the sum total of the paid up capital of the
company and the reserves and surplus divided by the number of shares.

Market price is the price at which the share is traded in the stock market. This is a
function of market dynamics and varies during trading as per the demand and supply
situation. As a result during trading hours the market price may be different even
from minute to minute. The market price may be below or greater than the issue
price or even the book value of the share.
Price-Earning multiple is popularly used to indicate the popularity of the scrip. The
higher the price earning multiple, the greater the favor of the stock. The PE multiple
is simply the market price of the share divided by the earnings per share of the
stock. The earnings per share is the net profit of the company divided by the number
of shares that a company owns.

Bonus shares is given by the company to reward its shareholders for their continued
holding in the company in case the company has been doing well. The bonus is
usually given in terms of shares. For example if an Equity shareholder hold 100
shares in a company and the company announces a bonus in the ratio of 1:5. In that
case for every 5 shares that an individual holds in the company he is entitled to 1
share. In this case the investor would get 20 additional shares and his holding would
increase to 120 shares. In terms of immediate impact, there would be no change
since in terms of the balance sheet all that would happen is that there would be a
decline in the reserves and surplus and a corresponding increase in the paid up
capital. The book value of the share would remain the same. In the long term
however he would be entitled to greater cash flow from dividends since now he
would be getting dividends on not 100 shares but 120 shares. So if he was earlier
getting Rs 5 per share as dividend, he would now receive Rs 600 as total dividends
instead of Rs 500 earlier.

Stock Split is effected by companies to increase the liquidity in the company’s


shares. Many a time if the market price of the share has increased to such high
levels that it is beyond the ability of the investor to buy a single share also then the
trading interest in the particular share gets affected. In that case the company goes
in for a stock split wherein the par value of the share gets truncated. Taking an
example in case a company’s market price of the shares is Rs 4000/- and the par
value of the share is Rs 50. The company can announce a stock split in the ratio of
5:1. In that case the par value will become 1/5th that is Rs 10. The price of the
share would come down approximately by 1/5th and the investor who holds 10
shares of the company would now hold 50 shares.

Rights issue is made by the company to raise money by first opting to ask existing
shareholders if they would further like to invest money in the company. It is a
privilege allowing existing shareholders to buy shares of an issue of common stock
shortly before it is offered to the public, at a specified and usually discounted price,
and usually in proportion to the number of shares already owned also called
subscription right. A rights issue is offered to all existing shareholders individually
and may be rejected, accepted in full or (in a typical rights issue) accepted in part by
each shareholder. To make the rights share attractive, they are always issued at a
price lower than the market price. While making a rights issue the manager has to
consider: Subscription price per new share , Number of new shares to be sold , the
value of rights , the effect of rights on the value of the current share , the effect of
rights to existing and new shareholders.

Dividend is the cash payments made by the company to its shareholders. These are
typically declared quarterly by the board of directors and paid to the stockholders of
record at a date specified by the board known as the date of record.

Earnings yield is nothing but the earnings per share divided by the market price of
the share. This measure simply denotes the earnings that is there if one were to buy
the share today.
Dividend yield like the earnings yield has its base the market price of the share. The
numerator in this case is the dividends per share.

Return on Equity is the net profits of the company divided by the net worth of the
company. The net worth of the company is equal to the paid up capital + reserves
and surplus.

2.1 Valuation of Equity shares

In general the value of any asset is derived from the cash flows associated with that
asset. The asset in question may be a financial asset or a real asset. The cash flows
are those the expected cash flows occurring in future. Therefore the value of the
asset would be the present value of the same. The general form can be expressed as
follows:-

V0 C1 C2 Cn where:
+..
= _____ + _____ + _____ V0 = Value at time 0
(1 + (1 +
(1 + i)1 C = Year's cash flow
i)2 i)n
i = Annual interest rate
n = Number of years

For instance, a three-year asset with cash flows of Rs2000 in year one, Rs 3000 in
year two and Rs 5000 in year three would be valued at Rs 9144 if interest is 4%.

Year Cash Flow x PVIF@4% = Discounted Cash Flow

1 2000 × .962 = Rs 1924


2 3000 × .925 = Rs 2775
3 5000 × .889 = Rs 4445
Rs 9144

A similar valuation philosophy is also adopted for Equity shares. The return from an
Equity share is made up of two parts one the dividends that are received from the
company and the second the capital gain that is earned by selling the stock in the
future a price that is hopefully higher than what one paid for it.

If one were to assume that the stock was held permanently and therefore there was
no question of capital gains, in that case the cash flows would consist of only
dividends. This is not an unreasonable assumption to make since Equity is a
permanent source of capital and if one sold an Equity share, there would be another
investor to buy it. The Equity share is therefore not extinguished. The three valuation
models that are associated with this particular model is.

a. Constant dividend model


b. Constant growth dividend model
c. Uneven stream of dividends
2.2 Constant dividend model

D1
P0 = ______
Ks

In the above equation D1 stands for the dividends that are to be received in the
coming year and the Ks stands for the required return. The Ks can be calculated
using the capital asset model i.e. Ks = Rf + β (Rm-Rf).

In this case the assumption is that the dividends received are going to be constant
throughout the life of the company. This model is normally not used.

2.3 Constant growth model ( Also called the Gordon model)

D1 where:
P0 = _______ D1 = Dividends Year 1
Ks - g Ks = Investors' required rate of return
g= Growth rate in dividends

D1 would be calculated by multiplying current dividends by (1 + g).

For example, price a share of common stock with current dividends of Rs 5, a


dividend growth rate of 3% if the investors' required rate of return is 15%.

5.15
P0 = _______ = Rs 42.92
.15 – .03 .

D1 was found by multiplying the current dividends of Rs 5 by 1.03 (1 + .03).

In case the prevailing price was more than Rs 42.92, in that case the investor should
not be buying it since the intrinsic value of the share comes out to be Rs 42.92.

In case the investor would like to make a decision on the valuation of the share not
on the basis of price but on the basis of the return, it can be done in the following
manner.

By manipulating the Gordon formula, the investors' required rate of return may be
estimated.

D1
Ks = _____ + g
P0
For example, find the investors' required rate of return on a share of common stock
selling for Rs 100, current dividends of Rs 3 and a dividend growth rate of 4%.

3.12
Ks = _______ + .04 = 7.12%
100

This can be compared again with the required rate of return. If the actual rate of
return is less than the required rate of return, in that case the investor would
obviously not like to purchase the share.

2.4 Unequal stream of dividends

In this case the valuation of the Equity share would be divided into two parts. The
first would represent the known cash flows and the second part would represent the
valuation for an indefinite period.

Taking an example of a share that is expected to grow in the following manner.

a. 15% growth for next 3 years


b. 10% growth for the then next 3 years
c. 5% growth for the then next 3 years d) 2% growth indefinitely

The required rate of return by the investor is 12%. The last paid dividend was Rs 3.

What should be the price paid for the share?

Method:

a. For the first 9 years find out the dividends for each of the years and discount
it to the present using the appropriate discount factor for that year
b. After the end of the explicit period, find out the price at the end of 9th year
using the constant growth model
c. Discount the price at the end of the 9th year to the base year
d. Add up all the present value sums. The intrinsic value of the share is the total
of the present values.
Required Present Present
Present value of dividends
Year Growth rate Dividends rate of value value of
and price
return factor dividends
0 3.00
1 15 3.45 1.12 0.89 3.08 3.08
2 15 3.97 1.12 0.80 3.16 3.16
3 15 4.56 1.12 0.71 3.25 3.25
4 10 5.02 1.12 0.64 3.19 3.19
5 10 5.52 1.12 0.57 3.13 3.13
6 10 6.07 1.12 0.51 3.08 3.08
7 5 6.38 1.12 0.45 2.88 2.88
8 5 6.70 1.12 0.40 2.70 2.70
9 5 7.03 1.12 0.36 2.54 2.54
10 2 7.17 71.71 25.86
∞ 2 52.87

The above methods are based on the discounted method. There are other methods
that are based on the basis of the relative valuation i.e. on the basis of PE multiple of
similar companies in the same industry. Those methods are called the relative
valuation methods.

2.5 Preferred shares

Preferred shares are stock in a company which have a defined dividend, and a prior
claim on income to the common stock holder.

Should the company wind up operations, preferred shareholders are paid any
obligations owed to them. Should a dividend be suspended by the Board of Directors,
for what ever reason, the preferred share usually has a cumulative clause in it
allowing that any unpaid dividends must be paid fully before any dividends may be
declared and paid to holders of common stock. This means that the preferred share
is a relatively more secure investment.

The corporate issuing preferred shares may add differing features to the share in
order to make it more attractive. These features are similar to those used in the
fixed income market and include convertibility into common shares, call provisions,
etc. Many have equated preferred shares with a form of fixed income security due to
its defined dividend stream.

However, with the added security offered by the guaranteed dividend stream, the
holder of preferred shares gives up the right to vote on issues related to corporate
governance. Therefore, the preferred holder has little input into corporate policy.

There are two types of preference shares in three categories:

a. Cumulative or Non Cumulative preference shares.


b. Redeemable or Perpetual preference shares.
c. Convertible or Non-Convertible preference shares.

For cumulative preference shares, the dividends will be paid on a cumulative basis,
in case they remain unpaid in any financial year due to insufficient profits. The
company will have to pay up all the arrears of preference dividends before declaring
any Equity dividends. While on the other hand, the non-cumulative shares do not
enjoy such right to dividend payment on cumulative basis.

Redeemable preference shares will be redeemed after a given maturity period while
the perpetual preference share capital will remain with the company forever.

2.6 Warrants

Warrants are a form of option which is usually added to a corporate bond issue or
preferred stock in order to sweeten the deal.
A warrant is a long dated option which allows the owner to participate in the capital
gains (losses) of a firm without buying the common stock. In effect, the holder of a
warrant has a leveraged play on the corporate common stock.

As a form of option, a warrant has an exercise price and an expiry date. The exercise
price is the price at which the holder may convert the warrant into common shares of
the issuer. The expiry date is the last date on which the warrant may be converted
into common shares. Given that a warrant is generally issued to reduce the cost of a
debt issuer, the expiry date is usually more than two years from issuance. This
allows warrants to trade separately from the bond with which they were issued.
Thereby providing the investor with a long dated option on a firm's common stock.

There is a draw back to warrants for those investors concerned with income. As an
option, a warrant does not pay a dividend, and is subject to a certain amount of price
compression as the underlying stock approaches or surpasses the exercise price. This
is only a factor if the investor is purchasing the warrants when the common stock is
trading near the exercise price.

Warrant holders have no voting rights until the warrants are converted into common
shares. Upon conversion an active role may be taken in corporate governance. If the
warrants provide for conversion into preferred shares, it is unlikely the holder will
gain any influence into corporate governance upon conversion.
Fixed Income Securities Chapter- 12

A fixed income security refers to any type of investment that offers or yields a
regular and fixed return.

A fixed income security can be contrasted with variable return securities such as
bonds in as much that equity shareholders share in both the return as well as the
risk whereas fixed income shareholders are only entitled to a fixed income in the
form of interest on the capital lent. The principal that they have lent is repaid after
some time.

There is some terminology that is associated with Fixed Income Securities:

Principal refers to the amount that is lent.

Coupon is the rate of interest that is to be paid on the security and is calculated on
the face value of the bond That is if the face value of the bond is Rs 1000 and the
coupon is 12% per year. In that case the interest will be Rs 120 yearly.

Maturity is the period for which the amount has been borrowed.

Indenture is the contract that states all the terms of the bonds.

Yield is the actual return that is given by the bond which includes the interest as
well as the capital gain/loss as the case may be. This is also called the Yield to
Maturity (YTM). The YTM is the rate of return earned on a bond held until maturity
(also called the “promised yield”).

Bond Rating: The bond rating system helps investors determine a company's credit
risk. Think of a bond rating as the report card for a company's credit rating. Blue-
chip firms, which are safer investments, have a high rating, while risky companies
have a low rating.

The chart below illustrates the different bond rating scales from the major rating
agencies: Moody's, Standard and Poor's and ICRA and CRISIL Ratings. It is to be
noted that the credit agency ICRA and CRISIL are promoted by Moody’s and
Standard and Poor (S&P) respectively.

Bond Rating Grade Risk


Moody's/ ICRA S&P/ CRISIL
Aaa AAA(20Companies) Investment Highest Quality
Aa AA+, AA Investment High Quality
A A, A+ Investment Strong
Baa BBB-, BBB, BBB+ Investment Medium Grade
Ba, B BB+, BB Junk Speculative
Caa/Ca/C B+, B, B- Junk Highly Speculative
C C, D Junk In Default

Since bonds pay a fixed income, most people that invest in them are those that are
looking for a fixed and constant return on their investment.

However it is not necessary that bonds are totally risk free. Bonds are subject to
certain risks such as Interest rate risk, Default risk and Re-investment risk. The
major factor is the interest rate risk. To understand the nature of interest rate risk,
it is important to understand how bonds and debentures are valued.

In general the value of a bond is the present value of the interest payments and the
principal payment at maturity. To take an example:

Par value of the bond = Rs 1000

Maturity of the bond = 6 years

Principal payment = at the end of 6 years at par

Required rate of interest = 10%

In that case the value of a bond will be equal to

120 PVIFA10%, 6 years + 1000 PVIFA 10%. 6 year

PVIFA = Present Value Interest Factor of an Annuity

Interest Principal Required Present Present value Present


payment payment rate of value of interest value of
0
return interest payments principal
factor
1 120 1.1 0.91 109.09
2 120 1.1 0.83 99.17
3 120 1.1 0.75 90.16
4 120 1.1 0.68 81.96
5 120 1.1 0.62 74.51
6 120 1000 1.1 0.56 67.74 564.47
522.63 564.47 1087.10
(total
(total present
present
value of
value of Total value of debenture
interest
principal
payments)
payment)

In this case one can see that the value of the bond is more than the par value. In
case the required rate of return was more than the coupon rate, in that case the
value of the bond would be less than that of par value. This is evident from the next
example. This example shows that if the required rate of return is 15%, with all
other things constant the value of the bond would now be Rs 886.47 compared to
the earlier Rs 1087.11 with 10% required rate of return.
Interest Principal Required rate Present Present Present
payment payment of return value value of value of
0
interest interest principal
factor payments

1 120 1.15 0.87 104.35


2 120 1.15 0.76 90.74
3 120 1.15 0.66 78.90
4 120 1.15 0.57 68.61
5 120 1.15 0.50 59.66
6 120 1000 1.15 0.43 51.88 432.33
454.14 432.33 886.47
(total (total
present present Total
value of value of value of
interest principal debenture
payments) payment)

A logical question in this case would be to ask that why the required rate of return is
different from that of the coupon rate.

A company may have issued a bond on a particular date given the prevailing interest
rates. A year later the interest rates might have changed due to changes in the
monetary policy or inflation etc. For an investor who had originally bought the bond
and plans to hold it to maturity would not be bothered much about valuation.
However he might be losing out if in the meantime the interest rates have moved up
and he is locked in a lesser interest rate investment. On the other hand had the
interest rates reduced, in that case the investor would have gained but the company
would have correspondingly lost out since they have to pay higher interest rates than
prevailing interest rates. These situations are common and happen in case of Fixed
Income Securities having fixed interest rates. The valuation of the bond assumes
importance if the security has to be sold. In that case the buyer of the security would
obviously be expecting a market determined yield. So in case the required return is
more than that of the coupon rate the balance yield would have to make up by the
capital appreciation. Conversely if the required rate of return is less than that of the
coupon rate, in that case there will be capital loss to balance out the difference in
interest rates.

In general the discount rate (ki ) is the opportunity cost of capital, and is the rate
that could be earned on alternative investments of equal risk. It can be calculated as
the sum total of

a. risk free rate


b. Inflation premium
c. Market risk premium
d. Default risk premium
e. Liquidity premium

ki = k* + IP + MRP + DRP + LP

Secondly

If required rate of return > coupon rate the Price of bond < par value of bond
If required rate of return < coupon rate the Price of bond > par value of the bond

If required rate of return = coupon rate the Price of bond = par value of the bond

That is why there is an inverse relationship between the interest rates and the price
of the bond.

Yield to Maturity

A very important concept with regard to bond valuation is the yield to maturity.

The yield to maturity is nothing but the yield that equates the present value of all
future interest payments and present value of the future repayment of principal to
the present value of the bond.

V = I X PVIFA, n, k%, + P X PVIFA, n, k%

PVIFA = Present Value Interest Factor of an Annuity

k = effective discount rate per payment period

n = number of payments.

Example:

If the present value of the bond is given as Rs 125, the coupon payments as Rs 12
(12% coupon rate), the maturity as 7 years and the principal repayment at par at
the end of 7 years, what would be the yield to maturity?

Present Present
Required Present
Interest Principal value value of
0 rate of value of
payment payment interest interest
return principal
factor payments

1 12 1.07 0.93 11.18


2 12 1.07 0.87 10.42
3 12 1.07 0.81 9.71
4 12 1.07 0.75 9.05
5 12 1.07 0.70 8.43
6 12 1.07 0.65 7.86
7 12 100 1.07 0.61 7.32 61.02
63.98 61.02 125.00
(total (total
present present
value of value of Total value of debenture
interest principal
payments) payment)

In the above example the YTM works out to be 7%. As the value of the bond is more
than that of the par value, it is evident that the YTM would be less than of the
coupon rate. If on the other hand one were to take the value of the bond as Rs 90
then the YTM would work out to be 14% more than that of the coupon rate.
0 Interest Principal Required rate Present Present Present value of principal
payment payment of return value value of
interest interest
factor payments

1 12 1.14 0.87 10.49


2 12 1.14 0.76 9.18
3 12 1.14 0.67 8.02
4 12 1.14 0.58 7.02
5 12 1.14 0.51 6.14
6 12 1.14 0.45 5.37
7 12 100 1.14 0.39 4.69 39.10
50.90 39.10 90.00
(total
present
(total present value of
value of
principal payment)
interest
payments)

From the above discussion it is evident that the YTM consists of two parts. One the
current yield and the other the capital gains yield.

Current Yield (CL) = ANNUAL COUPON PAYMENT


CURRENT PRICE
Capital Gains Yield (CGY) = CHANGE IN PRICE
BEGINING PRICE
Expected Total Return (YTM ) = Expected + Expected
CL CGY

A bond’s computed YTM will only actually be earned if:

• The bond is held to maturity


• The bond issuer does not default in the timing or amount of scheduled
payments
• All the cash flows are immediately reinvested to earn the bond’s YTM
Bond Pricing Theorems
• Bond prices and yields are inversely related as yields increase, bond prices
fall; as yields fall, bond prices rise
• An increase in a bond’s yield to maturity results in a small price change than
a decrease in yield of equal magnitude
• Prices of long term bonds tend to more sensitive to interest rate changes than
prices of short term bonds
• Interest rate risk is inversely related to the bond’s coupon rate. Prices of high
coupon bonds are less sensitive to changes in interest rates than prices of low
coupon bonds
• The sensitivity of a bond’s price to a change in its yield is inversely related to
the yield to maturity at which the bond currently is selling
• As maturity increases, price sensitivity increases at a decreasing rate.
• Price sensitivity is inversely related to a bond’s coupon rate.
• Price sensitivity is inversely related to the yield to maturity at which the bond
is selling.

12.1 Government Securities

1. Government securities can be bifurcated into five types depending upon the
issuing body. These are as follows:-
2. Central government securities
3. State government securities
4. Securities guaranteed by Central government for All India Financial
Institutions like IDBI, ICICI, IFCI etc.
5. Securities guaranteed by State Government for State Institutions like State
electricity boards and housing boards.
6. Treasury bills issued by RBI.
Central Government securities are all bonds and treasury bills issued by central
government, state government and other entities like corporations, municipal
authorities and companies wholly owned by the government for the purpose of
raising funds from the public. These securities are normally referred as gilt-edged
securities as repayments of principal as well as interest are totally secured by
sovereign guarantee. Hence government securities are considered as safest
securities. State Government securities are the securities issued by the respective
state governments but the RBI coordinates the actual process of selling these
securities. Each state is allowed to issue securities up to a certain limit each year.
The planning commission in consultation with the respective state governments
determines this limit. Generally, the coupon rates on state loans are marginally
higher than those of Government of India Securities issued at the same time. The
procedure for selling of state loans, the auction process and allotment procedure is
similar to that for GOI-Sec. State Loans also qualify for SLR status Interest payment
and other modalities are similar to government securities. They are also issued in
dematerialized form In general, State loans are much less liquid than government
securities.
12.1.1 Forms In Which Government Securities Can Be Held:

Government Securities can be held in three forms:


1. Stock certificates
2. Promissory notes
3. Bearer bonds

Stock certificates: When public debt is issued in the form of stock, the owner gets
a certificate specifying that he is a registered holder in the books of Public Debt
Office. The certificate indicates the interest rate, interest due dates and the face
value of the stock. A sock certificate is not transferable by endorsement. Transfer
can take place only by means of a transfer deed upon the execution of which the
transferee’s name is substituted in the place of the transferor in the books of the
PDO. Such transfer deed requires no stamp duty. A stock certificate is thus
completely secure against loss by fire, theft etc and the title of the holder is not
exposed to risks which are attached to holdings in negotiable securities. Interest
payments are through interest warrants issued by the PDO to the domicile of the
holder or a specified local office of RBI or any branch of the agent bank conducting
government securities business in India. Repayment of principal is also carried out
in the similar fashion.
Promissory Notes: Promissory notes are promises to pay a monetary value to an
individual, company, or bank by a certain time and date. These notes are used
when they are sold to a bank to make a profit of funds. They can also be used to
pay a debt. There are many elements of promissory notes that one should know
about before using this type of funds transfer. On the note, there is an amount of
money that is to be paid. This is called the face value of the note. The face value is
an important term to understand. If you write the face value of the note, it is the
total amount of money that will be paid; no taxes are taken out of this value.

The person or company who borrows money on a promissory note is known as the
maker. The maker is the person who signs his name in the bottom right corner of
the note. This is the written authorization of the note.

Bearer Bonds: Bearer bond certifies the bearer for entitlement to the specified sum
along with interest payable by interest warrants attached along with the bonds.
Such bonds are transferable by mere physical delivery.

12.1.2 Eligibility for investments

Investments in government securities may be made any person including firms,


companies, corporate bodies, institutions, state government, provident funds and
trust. NRI ,overseas corporate bodies predominantly owned by NRIS and foreign
institutional investors registered with SEBI and approved by reserved bank of India
are also eligible to invest in government securities .However investments by a
person resident outside India or a person who is not a citizen but is resident in India
or a company which is not incorporated under any law in force in India or any branch
of such company shall be subject to the provision of the foreign exchange regulation
act 1973 or the foreign exchange management act 1999.in addition to other
provisions of law applicable to government securities as per the terms and as
stipulated here in after.

12.1.3 Minimum subscriptions

The government securities will be issued for a minimum amount of Rs.10000 (face
value) and in multiples of Rs10000 thereafter.

12.1.4 Forms of security

The government securities shall be issued to investors by credit to their SGL a/c or
to a constituent SGL of the institution specified by them, maintained with RBI or by
credit to their bond Léger a/c maintained with RBI or with any institution authorized
by the RBI in this behalf as per the public debt rules 1946,or in the form of stock
certificate .the form of stock certificate will be notified separately where necessary

12.1.5 Payment of interest

Interest on government securities will be paid at public debt offices of RBI at


Ahmedabad, Kanpur and New Delhi etc... or any other office of RBI notified for this
purpose from time to time or at branches of SBI and associate banks conducting
government business or at any treasury or sub treasury served by the public debt
office where there is no office of RBI or branch of SBI or its associates.

12.1.6 Repayment of government securities

Government securities will be repaid at public debt offices of RBI or any other
institution at which they are registered at the time of repayment of the government
security may be repaid at the option of government of India before the specified
redemption date where a “call option“is specified in the specific notification relating
to the issue of government securities. The government securities may be repaid at
the option of the holder of security before the specified redemption date where a put
option is specified in the specific notification relating to issue of government security.
Government security will be repaid on the date of redemption specified in the specific
notification where neither a call option nor put option is specified.

Investors and Participants: All entities registered in India like banks, financial
institutions, Primary Dealers, firms, companies, corporate bodies, partnership firms,
institutions, mutual funds, Foreign Institutional Investors, State Governments,
Provident Funds, trusts, research organizations, Nepal Rashtra bank. Non resident
Indians and individuals of Indian origin, Overseas Corporate Bodies owned by NRIs
and Foreign institutional Investors approved by RBI are also eligible to invest in the
government securities

Modes of Issue of Government Securities

Government of India may issue from time to time government securities through the
following modes

1. Issue of Securities through auction


2. Issue of Securities with pre-announced
3. Issue of Securities through tap sale
4. Issue of Securities by conversion of treasury bill.

Features of Different modes of issue of Government securities

1) Issue of Securities through auction

A. The Securities will be Issued through auction through price basis or yield
basis Where the issue is on price basis the coupon will be pre-determined and
the bidders have to quote the price per Rs100 face value of the security, at
which they desire to purchase the security were the issue is on yield basis,
the coupon of security is decided in an auction conducted by RBI in the
manner herein as provided by the specific notification issued from time to
time. The security carries the same coupon till maturity.
B. The yield percent per annum or the price as the case may be expressed up to
or rounded of to two decimal places should be clearly stated in the
application.
C. An application may submit more than one bid at different rates of yield of
prices as the case may be through separate applications for each cases. The
aggregate amount of bids submitted by a person should not exceed aggregate
amount of government securities offered for sales.
D. On the basis of the bids received the RGI will determine the maximum return
of the yield or the minimum offer price as the case may be at which offers for
purchase of government securities will be accepted at the auction.
E. The auction for the issue of government securities will be held either on
uniform price method or multiple price method or any other method decided
by GOI or RBI.
F. Individuals and institutions as specified by RBI can participate in the auctions
on non comparative basis, indirectly through a schedule bank or a primary
dealer offering such services or any other agency permitted by RBI for this
purpose. Eligibility criteria for participation on non competitive basis and the
manner in which such bids should be submitted will be announced by RBI.
The allocation of the securities to non-competitive bidders will be at the
discretion of the RBI and will be at a price not higher than the weighted
average price arrived at on the basis of the competitive bids accepted at the
auction ,or any other price announced in the specific notification. The nominal
amount of Securities that will be allotted to the Retail investors on non-
competitive basis will be restricted to a maximum' percentage of the
aggregate nominal amount of issue within /or outside the nominal amount, as
specified by the government of India or any other percentage determined by
RBI.
G. The RBI will have the discretion to access excess subscription to extend as
may be specified in the specific notification pertaining to the issue of security
and make allotment accordingly.
H. The RBI will have full discretion to accept or reject any or all bids either
wholly or partially without assigning.

Secondary Market

The secondary market in government securities was a few years back quite narrow
and dominated by a few institutions and commercial banks. However, in early
nineties the market has turned fairly active with various trading banks and some
brokers quoting two ways prices which has imparted liquidity to this money market
instruments.

Transaction in Government Securities

RBI has been over a period of time, encouraging holding of government securities in
the dematerialized mode in the following way:-

I. All the entities having a Subsidiary General Ledger (SGL) account with RBI
are allowed to open Constituent Subsidiary General Ledger Accounts on the
behalf of their clients. Although being non-banks, depositories and
organizations such as SHCIL have been provided an additional SGL account to
open CSGL on behalf of their clients. The cost of the postage incurred by the
depositories on remitting Interest and redemption proceeds is being
reimbursed by RBI so as to encourage dematerialized holding and retail
participation in Gilts. Guidelines have been issued to the banks prescribing
the safeguards to adopted for maintenance of CSGL accounts. To impart
transparency in government securities traded by clients (through CSGL
accounts), a special feature has been incorporated in the negotiated dealing
system(NDS) for reporting and settlement of such trades. The provision has
also been made in the NDS for giving quotes on behalf of clients.
II. At present as a result of above measures 99% of the government securities
takes place through SGL a/c’s with RBI for which the delivery versus payment
system ensures simultaneous transfer of securities against funds

III. In the light of recent fraudulent transactions in the guise of government


securities transactions in physical format by a few cooperative banks with the
help of some broker entities it is now proposed to accelerate the measures
under contemplation for further reducing the scope for trading in physical
form.
IV. A specific time table is being separately indicated for each category of
regulated entities to comply with these guidelines. Those who have general
difficulties in meeting the timetable may approach the regulatory department
in the RBI.
V. Any regulated entity which requires help in this regard may approach self
regulatory organization who is equipped to tender advice in this regard.

12.2 Debentures/Bonds

A Debenture is a debt security issued by a company (called the Issuer), which offers
to pay interest in lieu of the money borrowed for a certain period. In essence it
represents a loan taken by the issuer who pays an agreed rate of interest during the
lifetime of the instrument and repays the principal normally, unless otherwise
agreed, on maturity. These are long-term debt instruments issued by private sector
companies. These are issued in denominations as low as Rs 1000 and have
maturities ranging between one and ten years. Long maturity debentures are rarely
issued, as investors are not comfortable with such maturities. Debentures enable
investors to reap the dual benefits of adequate security and good returns. Unlike
other fixed income instruments such as Fixed Deposits, Bank Deposits they can be
transferred from one party to another.

Debentures can be classified into the following broad types

a. Convertible and Non Convertible Debentures


b. Floating and Fixed Rate Debentures
c. Secured and Unsecured Debentures

Non Convertible Debentures (NCD): These instruments retain the debt character
and can not be converted in to equity shares

Partly Convertible Debentures (PCD): A part of these instruments are converted


into Equity shares in the future at notice of the issuer. The issuer decides the ratio
for conversion. This is normally decided at the time of subscription.

Fully convertible Debentures (FCD): These are fully convertible into Equity
shares at the issuer's notice. The ratio of conversion is decided by the issuer. Upon
conversion the investors enjoy the same status as ordinary shareholders of the
company.

Optionally Convertible Debentures (OCD): The investor has the option to either
convert these debentures into shares at price decided by the issuer/agreed upon at
the time of issue.
Debt Instruments with fixed coupon (interest) are called fixed rate debt
instruments.

Debt instruments which do not have a fixed coupon (interest) but a variable coupon
rate (interest) based on a predefined benchmark are known as Floating Rate-debt-
instruments

Secured Debentures: These instruments are secured by a charge on the fixed


assets of the issuer company. So if the issuer fails on payment of either the principal
or interest amount, his assets can be sold to repay the liability to the investors

Unsecured Debentures: These instrument are unsecured in the sense that if the
issuer defaults on payment of the interest or principal amount, the investor has to be
along with other unsecured creditors of the company.

12.2.1 Difference between a bond and a debenture

Long-term debt securities issued by the Government of India or any of the State
Government’s or undertakings owned by them or by development financial
institutions are called as bonds. Instruments issued by other entities are called
debentures. The difference between the two is actually a function of where they are
registered, payment of stamp duty and how they trade.

Apart from the above classification, there are other classifications of bonds that are
useful to understand

12.2.2 Type of debentures/bonds

a. Corporate bonds: They are debt securities issued by corporations, has par
value and traded in secondary market. Its price depends on market interest
rates prevailing at the time of trading. Income from it is taxable. Has the
feature of high risk and high return.
b. Zero-coupon bonds: They are deep discount bonds which pay no coupon.
They are issued a discount to face value, e.g. Treasury Bills.
c. Floating rate bonds: The interest rate is floated along with some reference
rate in the market, e.g. interest rate 15 above bank rate.
d. Indexed bonds: Here principal and coupon payment are linked to a market
index like inflation on the price index.
e. Junk bonds: They are high yield, high risk and high interest rate bonds
which are low in credit-BB,BA, etc.
f. Treasury bonds: Issued by the government for longer maturity.
g. Discount bonds: valued less than the face value; highly risky and has low
coupon rate
h. Callable bonds: These bonds can be called by the company before maturity.
A company will use this option normally only if the interest rates have fallen
compared to the interest rates on the present bond issue. However the call
feature of a bond and the call premium is specified at the time of the issue of
the bond.
i. Put table bonds: In this case the investor is given the right to sell the bonds
to the company before the maturity. Obviously the investors would exercise
their right only if the interest rates have gone up compared to the interest
rates of the present bond issue.
j. Senior bonds: These bondholders are paid before the subordinate
bondholders. As the name suggests sub-ordinate bonds are the ones whose
payment of dues comes post the other senior bonds in that category or on the
class of assets that are held as security for the issue of those bonds.
k. Registered bonds: They are transferred only by executing a transfer deed
and filing a copy of it with the company. These bondholders receive interest
cheques automatically from the company.
l. Unregistered bonds: They are freely negotiable and can be transferred by a
simple endorsement; interest paid only on presentation.
m. Government Bonds: already been discussed in the section on government
securities
n. Municipal Bonds: Municipal bonds, known as "munis", are the next
progression in terms of risk. The major advantage to munis is that the returns
are free from federal tax. Furthermore, local governments will sometimes
make their debt non-taxable for residents, thus making some municipal bonds
completely tax-free. Because of these tax savings, the yield on munis is
usually lower than that of a taxable bond. Depending on your personal
situation, munis can be a great investment on an after-tax basis
o. Tax-Saving Bonds: are those bonds that have a special provision that
allows the investor to save on tax. Examples of such bonds are:
• Infrastructure Bonds under Section 88 of the Income Tax Act, 1961
• Capital Gains Bonds (REC BONDS, NABARD BONDS etc.) Under
Section 54EC of
• the Income Tax Act, 1961
• RBI Tax Relief Bonds

Yield Curve:

It refers to the relationship between the time to maturity and the yield to maturity
of the security. It is an important concept so far as investing in bonds and
debentures are concerned simply because it indicates the trend of interest rates and
also gives an indication of the economic fundamentals

Types of Yield Curves:

i. Normal yield curve: Typically, short-term interest rates are lower than
long-term rates, so the yield curve slopes upwards, reflecting higher yields
for longer-term investments. This is referred to as a normal yield curve.
ii. Declining yield curve: An inverted yield curve occurs when short-term
interest rates exceed long-term rates.
iii. Flat yield curve: When the spread between short-term and long-term
interest rates narrows, the yield curve begins to flatten. A flat yield curve is
often seen during the transition from a normal yield curve to an inverted
one. When short- and long-term bonds are offering equivalent yields, there
is usually little benefit in holding the longer-term instruments - that is, the
investor does not gain any excess compensation for the risks associated with
holding longer-term securities. For example, a flat yield curve on U.S.
Treasury would be one in which the yield on a two-year bond is 5% and the
yield on a 30-year bond is 5.1%.
iv. Humped Yield Curve: Shape often seen when the market expects that
interest rates will first rise (fall) during a period and fall (rise) during
another.

Institutional investors/Participants in the debt market-:

There are a number of institutional investor

• Banks
• Insurance companies
• Provident funds
• Mutual funds
• Corporate treasuries
• Foreign investors (FIIs)

While banks, corporate treasuries, mutual funds and some FIIs can and do invest in
other kinds of securities like equities, provident funds, insurance companies and
trusts almost exclusively invest in various debt instruments.

PARTICIPANTS AND PRODUCTS IN DEBT MARKETS

Issuer Instruments Maturity Investors

Central Dated 2-30 years RBI, Banks, Insurance Companies,


Government Securities Provident Funds, Mutual Funds, Primary
dealers, Individuals, FIIs
Central T-Bills 91/364 RBI, Banks, Insurance Companies,
Government days Provident Funds, Mutual Funds, Primary
dealers, Individuals, FIIs
State State 7-20 years Banks, Insurance Companies, Provident
Government Development Funds, Individuals
Loans
PSUs Bonds, 1-20 years Banks, Insurance Companies, Provident
Structured Funds, Mutual Funds, Corporates,
Obligations Individuals, FIIs
Corporates Debentures, 1-15 years Banks, Mutual Funds, Corporates,
Bonds Individuals, FIIs
Corporates, Commercial 15 days-1 Banks, Mutual Funds, Financial Institution,
Primary Papers year Corporates, Individuals, FIIs
Dealers
Scheduled Certificate of 15days to Banks, Corporations, Companies, Trust,
Commercial deposits 1year Funds, Association, Individuals, FIs, NRIs
Banks

Financial
Institutions
Scheduled Bank Bonds 1- 10 Corporations, Companies, Trust, Funds,
Commercial years Association, Individuals, FIs, NRIs
Banks
PSU Municipal 0-7 years Banks, Corporations, Companies, Trust,
Bonds Funds, Association, Individuals, FIs, NRIs

12.3 Treasury Bills

Treasury Bills are money market instruments to finance the short term requirements
of the Government of India. These are discounted securities and thus are issued at a
discount to face value. The return to the investor is the difference between the
maturity value and issue price.

Treasury bills are part of the money market instruments. Other money market
instruments include Repurchase Agreements or Repos, Commercial Paper, Certificate
of Deposits, Banker Acceptances, Call money etc.

Treasury bills (T-bills, or just bills, for short) are the most marketable of all money
market instruments. T-bills are short-term securities that mature in one year or less
from their issue date. They are issued with three-month, six-month and one-year
maturities. T-bills are purchased for a price that is less than their par (face) value;
when they mature, the government pays the holder the full par value. Effectively,
your interest is the difference between the purchase price of the security and what
you get at maturity.

T-Bills are issued in the form of promissory notes or finance bills (a bill which does
not arise from any genuine transaction in goods is called a finance bill) by the
government to tide over short-term liquidity shortfalls. These short-term instruments
are highly liquid and virtually risk-free as the government issues them. They are the
most liquid instrument after cash and call money, as the repayment guarantee is
given by the central government. T-Bills do not require any grading or further
endorsement like ordinary bills, as they are claims against the government. These
instruments have distinct features like zero default risk, assured yield, low
transactions cost, negligible capital depreciation and eligible for inclusion in SLR and
easy availability, etc. apart from high liquidity. Treasury Bills are issued by the
government but the investors include among others primary dealers, financial
institutions, insurance companies, provident funds, non-banking financial companies,
corporates, foreign institutional investors and now recently even individuals. As of
now RBI issues only 91 day, 182 da and 364 day treasury bills.

12.12.1 Advantages of investing in Treasury Bills


a. No tax deducted at source
b. Zero default risk being sovereign paper
c. Highly liquid money market instrument
d. Better returns especially in the short term
e. Transparency
f. Simplified settlement
g. High degree of tradability and active secondary market facilitates meeting
unplanned fund requirements

Features

Form: The treasury bills are issued in the form of promissory note in physical form
or by credit to Subsidiary General Ledger (SGL) account or Gilt account in
dematerialised form.

Minimum Amount Of Bids Bids for treasury bills are to be made for a minimum
amount of Rs 25000/- only and in multiples thereof.

Eligibility: All entities registered in India like banks, financial institutions, Primary
Dealers, firms, companies, corporate bodies, partnership firms, institutions, mutual
funds, Foreign Institutional Investors, State Governments, Provident Funds, trusts,
research organisations, Nepal Rashtra bank and even individuals are eligible to bid
and purchase Treasury bills.

Day Count: For treasury bills the day count is taken as 365 days for a year.

Yield Calculation

The yield of a Treasury Bill is calculated as per the following formula:

(100-P)*365*100
Y= ________________
P*D
Wherein Y = discounted yield
P= Price
D= Days to maturity

Example

A cooperative bank wishes to buy 91 Days Treasury Bill Maturing on Dec. 6, 2006 on
Oct. 12, 2006. The rate quoted by seller is Rs. 99.1489 per Rs. 100 face values. The
YTM can be calculated as following:

The days to maturity of Treasury bill are 55 (October – 20 days, November – 30


days and December – 5 days)

YTM = (100-99.1489) x 365 x 100/(99.1489*55) = 5.70%

Similarly if the YTM is quoted by the seller price can be calculated by inputting the
price in above formula.
The Treasury Bills are issued on the basis of Auctions

There are two types of auction for treasury bills:

Multiple Price Based or French Auction: Under this method, all bids equal to or
above the cut-off price are accepted. However, the bidder has to obtain the treasury
bills at the price quoted by him. This method is followed in the case of 364days
treasury bills and is valid only for competitive bidders.

Uniform Price Based or Dutch auction: Under this system, all the bids equal to or
above the cut-off price are accepted at the cut- off level. However, unlike the
Multiple Price based method, the bidder obtains the treasury bills at the cut-off price
and not the price quoted by him. This method is applicable in the case of 91 days
treasury bills only. The system of Dutch auction has been done away with by the RBI
wef 08.12.2002 for the 91 day treasury T Bill.

12.12.2 Differences between Treasury Bills, Treasury Notes and Treasury


Bonds:

T-bills: -

These are extremely liquid, short-term notes that mature in 13, 26 or 52 weeks from
the date of issue. The Treasury Bills usually offers new bills every week, selling them
at a discount from face value basis. Furthermore T-Bills are issued on a “book-entry”
basis i.e. the buyer never really receives the security but only a receipt. The treasury
a gent records the purchaser’s transactions and issues receipts to the T-Bill buyers,
instead of an actual T-Bill security.

T-Notes: -

It is similar to certificates of indebtedness except with regard to their time until


maturity. T-Notes are bonds that typically have maturity from 1 to 7 years. They are
marketable debt securities that pay coupon interest semi-annually, just like the
certificates. The Treasury issues T-Notes periodically and some issues are
outstanding and traded actively.

T- Bonds: -

Bonds differ from notes and bills with respect to maturity, they generally run from 7
to 30 years from date of issue to maturity. Another significant difference is that
some issues are callable at times prior to maturity.

If the bonds are selling in the market above par, their yield to maturity is calculated
to the nearest call date. If they are selling at a discount, the yield to maturity is
calculated on the basis of their maturity date. The yield to maturity is a compounded
average rate of return calculated over the bond’s entire life.

12.4 Certificate of Deposit

A certificate of deposit is a document written by a bank or other financial institution


that is evidence of a deposit, with the issuer’s promise to return the deposit plus
earnings at a specified interest rate within a specified time period. A certificate of
deposit offers a higher rate of interest than regular fixed deposits.

CDs can be issued by scheduled commercial banks (excluding Regional Rural Banks).
Select Financial Institutions (FIs) that have been permitted to raise short-term
resources under umbrella limit fixed by RBI, can issue CDs within the umbrella limit
fixed by RBI.

CDs can be issued to individuals (other than minors), corporations, banks,


companies, trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also
subscribe to CDs. CD should be issued in denomination of Rs. 1 Lakh (1 unit) of
Maturity Value (MV)/Face Value (FV). The minimum marketable lot for a CD, whether
in physical or demat form will be Rs. 1 Lakh and in multiples of Rs. 1 lakh. Banks can
issue CD for a period not less than 15 days and not exceeding one year from the
date of issue.

Certificates of deposits (CDs) are instruments issued by the bank in the form of
usance promissory notes. The bank deposits are negotiable, and are in the
marketable form bearing specific face value and maturity. They are transferable from
one party to other unlike term deposits.

The distinct features of a CD are:

a. CD is a document of title to a time deposit and is distinct from conventional


time deposit with respect to negotiability and marketability.
b. CDs are considered as virtually risk less instruments as the default risk is
almost nil, and the investors are sure of receiving the invested amount with
interest.
c. The liquidity and marketability features are considered as hallmarks of CDs.
d. CDs are issued at a discount to face value.
e. CDs are maturity dated obligations of banks forming a part of time liabilities,
and are subjected to usual reserve requirements.
f. CDs may be either in the registered or in the bearer form. The latter form is
however considered better for secondary market operations.
g. CDs attract stamp duty and there is no grace period as in the case of bill
financing.
h. CDs are freely transferable by endorsement and delivery.
i. The CDs issued are within the limit specified by the Reserve Bank of India.
j. CDs are also issued in the demat forms. Thus the various advantaged of
dematerialization can be availed.
k. CDs held in the demat form can be transferred as per the procedure
applicable to other demat securities.
l. The trade settlement will take place on T +1 day basis, however, the
settlement period will be subject to the ceiling of T+5 days or such period of
settlement as specified by the exchanges ,whenever the trade is done on are
recognized stock exchange

The advantage of a CD is that the banks are in a better position to offer competitive
and case to case rates of interest for large deposits and for investors open a new
avenue for investing short term surpluses. Not only do they offer high yields but are
more liquid since they have a secondary market not possible in a conventional fixed
deposit.

Calculation of yield

CDs are issued at a discount to a face value. Bank CDs are always discount bills,
while CDs of DFIs (Development Financial Institutions) can be coupon bearing as
well. The discount rate is freely determined by the issuing bank, considering the
market conditions. While determining the discount rate of a CD, the issuing bank
considers the prevailing call money rates, treasury bill rate, maturity of the CD, the
amount of funds available, and its relation with customer. The discount rate varies
from one bank to the other, from time to time and even for the same customer
based on the above factors.

The discount is calculated as follows:

DR = F /(I+((I*N)/100*365))

Where:

DR=Discounted Value

N= Issuance Period

F= Face Value

I= Effective Interest Rate per annum

Innovations in CD Market

CDs are no different from any financial instrument with respect to innovation.
Innovations in CDs have flooded the money market abroad. Innovative CDs such as
• Asian dollar CDs carry both fixed and floating interest rates based on the
current level of the Singapore Interbank Offer Rate (SIBOR) and paid at the
New York clearing house. Similar to domestic CDs, they are normally traded
in $1 million units but at higher yields.
• Jumbo CDs are issued by savings and loan associates in large volumes such
as $100,000 and above.
• Yankee CDs are issued by foreign banks such as Japanese, Canadian, and
European institutions in the US who usually have offices in US cities.
• Brokered CDs are sold through brokers or dealers in denominations of
$100,000 (maximum) to qualify for federal deposit insurance. Many brokers
participate in exchanges in which their investing customers can purchase
packages of the highest yielding CDs issued by banks and thrifts.
• Returns on Bear and Bull CDs, are linked to stock market performance
allowing depositors to seek variable equity like returns.
• In Installment CDs, target level for the amount is built-up in the account by
allowing the customers to make a small initial deposit.
• In Rising Rate CDs, investors can withdraw the permitted amount of
promised yields (which increases over time) on selected yearly dates. These
deposits are usually long-term in nature and withdrawals are penalty- free.
• Foreign-Index CDs were offering a return linked to fluctuations in foreign
currency values and economic developments abroad.
• Thrift CDs are issued by large savings and loan associations. Usually, they
are issued in denominations of $100,000 so that they can be covered under
the FDIC. Sometimes, a large thrift CD is made out to of various CDs of
$100,000 or less packed into one, but as all of them are covered under the
FDIC, the risk is minimal.

12.5 Commercial Paper

Commercial papers are short term, unsecured promissory notes issued at a discount
to face value by well known companies that are financially strong and carry a high
credit rating.

They are sold directly by the issuer to the investor or else placed by borrowers
through agents like merchant banks and security houses.

The flexible maturities at which they can be issued is one of the main attractions for
borrowers and investors since issues cater to the needs of both.

The CP market has the advantage of giving highly rated corporate borrowers cheaper
funds than they could obtain from the bank while still providing the institutional
investors with higher interest earning than they could obtain from the banking
system. Also the instrument is highly marketable and liquid.

The issue of CP imparts a degree of financial stability to the system as the issuing
company should necessarily remain financially strong.

12.5.1 Features of Commercial Paper

a. Commercial paper does not originate from a specific self-liquidating


transaction like normal commercial bills which generally arise out of specific
trade transactions.
b. CPs are backed by the liquidity and earning power of the issuer. Since they
are not backed by any assets, they are unsecured.
c. The CP market provides the borrower (i.e. highly rated corporate) a cheaper
source of funds with less paperwork/ formalities when compared to bank
finance.
d. Investors prefer to invest in CPs due to high liquidity, varied maturity and
high yield ( when compared to bank deposits). The liquidity is high because it
can be transferred by endorsements and delivery.
e. Commercial Papers have a minimum maturity period of 15 days and a
maximum of 1 year. They also have a buyback facility.
f. CPs are issued in multiples of 5 lakhs and the minimum size of each issue is
Rs 5 lakhs.
g. They are issued at a discount to face value and are redeemable at par on
maturity. The discount offered is the effective interest rate.
h. The Commercial Paper before being issued necessarily has to be credit rated.

CP being a short term instrument, its primary and secondary market determination
of the interest rate i.e. the discount rate, depends upon conditions in short term
money market. The other instruments that may have an impact on the discount
rates are Interbank Call rates, Certificate of Deposit, Commercial Bills, Short-term
Forward Premiums and Treasury Bills.

The issue price of Commercial Paper is calculated as below:

P = F / I + ( I * N ) / 100 * 365

Where,

F = Face / Maturity value

P = Issue Price of CP

I = Effective interest p.a

N = Usance period ( No. of days )


Small Savings Instruments Chapter- 13

13.1 Introduction

Small saving instruments form the backbone of the savings mobilized by the
Government of India. They represent the safest instruments and therefore are the
most popular among all instruments. Even the most aggressive of investors would
make it a point to put some amount of savings in such instruments.

Some of these instruments include Kisan Vikas Patra. Public Provident Fund, Post
Office Time Deposit, National Savings Certificate, National Savings Scheme, Post
Office Monthly Income Scheme, Deposit.

13.2 Advantages of small savings schemes

Government sponsored.
All these schemes are operated either directly by the government or by government-
run organizations like post-offices or nationalised banks. Therefore one can
reasonably be assure of the timely payment of interest and repayment of principal on
maturity.

Assured returns.
In this world of volatile share market conditions and an uneasy debt market that
needs constant monitoring, these offer assured returns to the simplest of small
investor who may not have access or the know how to scrutinize the more
sophisticated investment instruments.

Easy for small investors.


In some of the schemes, you need to invest only minor amounts as a minimum
installment. This enables even poor people to invest in them.

Tax benefits.
Some of this scheme have attractive tax exemptions.

Liquidity
One can easily avail of some of sort of access for investments made in them before
maturity. There are facilities available for premature withdrawals. Also, banks give
loans against certain investments like the National Savings Schemes.

Inheritance of the amount made simple


Most of the Schemes have facilities for nomination. In case of death of depositor his/her
nominee(s) can easily withdraw the accrued amount (principal + interest). These schemes
can be shifted from one post office to another. Hence they are suitable for persons having
transferable jobs.

Some of the small saving schemes are as follows:-

a. Kisan Vikas Patra


b. Post Office Monthly Income Scheme
c. 15 Years Public Provident Fund Scheme
d. Post Office Time Deposit Scheme
e. 5-Years Post Office Recurring Deposit Scheme
f. Post Office Savings Scheme
g. National Savings Certificate (VIII Issue)
h. Senior Citizen Scheme
i. National savings scheme

13.2.1 Kisan Vikas Patra

An entirely safe instrument simple and easy to understand and invest.

• Minimum Investment Rs. 500/- No maximum limit.


• Rate of interest 8.40% compounded annually.
• Otherwise the rate of interest is 8.25%
• Money doubles in 8 years and 7 months.
• Two adults, Individuals and minor through guardian can purchase.
• Companies, Trusts, Societies and any other Institution not eligible to
purchase.
• Non-Resident Indian/HUF are not eligible to purchase.
• Maturity proceeds not drawn are eligible to Post office Savings account
interest for a maximum period of two years.
• Facility of reinvestment on maturity.
• Patras can be pledged as security against a loan to Banks/Govt. Institutions.
• Patras are encashable at any Post office before maturity by way of transfer
to desired Post office.
• Patras are transferable to any Post office in India.
• Patras are transferable from one person to another person before maturity
• Duplicate can be issued for lost, stolen, destroyed, mutilated and defaced
patras.
• Nomination facility available.
• Facility of purchase/payment of Kisan vikas Patras to the holder of Power of
attorney.
• Rebate under section 80 C not admissible.
• Interest income taxable but no TDS
• Deposits are exempt from Wealth tax.
• Interest accrued on yearly basis will be taken as income for Income Tax
purposes
• Certificates can be encashed at any time after expiry of 2 years and 6
months from the date of purchase.

In case an investor invests lets say Rs 5,000 on 1st of May, 2007 then the amount
will become Rs 10,000 on 1st of December, 2015.

The compounded rate of return is

5,000( 1+r)8 7/12 = 10,000


r = 8.41%

However if one were to calculate interest on a yearly basis it would work out to be
8.25% per year.

Beginning
of the 1st 5000.00 5412.50 End of the year
year
Beginning
of the 2nd 5412.50 5859.03 End of the year
year
Beginning
of the 3rd 5859.03 6342.40 End of the year
year
Beginning
of the 4th 6342.40 6865.65 End of the year
year
Beginning
of the 5th 6865.65 7432.07 End of the year
year
Beginning
of the 6th 7432.07 8045.21 End of the year
year
Beginning
of the 7th 8045.21 8708.94 End of the year
year
Beginning
At the end of 8 years and 7
of the 8th 8708.94 9128.06
months
year
Interest
for the
718.4876 718.4876
whole
year
For 7
419.1178 419.1178
months

As is evident one cannot take out money for the 1st two and a half years. Assuming
one would like to take it out at the end of the 3rd year the amount one could
withdraw would be equal to Rs 6342.40. If one were to go by the 8.25% rate of
interest the cumulative sum at the end of 8 years and 7 months would work out to
be Rs 9128.06. However in terms of compounding the CAGR (Compounded Annual
Growth Rate ) works out to be 8.40%

13.2.2 Post Office Monthly Income Scheme

The post-office monthly income scheme (MIS) provides for monthly payment of
interest income to investors. It is meant for investors who want to invest a sum
amount initially and earn interest on a monthly basis for their livelihood. The MIS is
not suitable for an increase in your investment. It is meant to provide a source of
regular income on a long term basis. The scheme is, therefore, more beneficial for
retired persons.

Features

a. Interest rate of 8% per annum payable monthly.


b. Maturity period is 6 years.
c. Minimum investment amount is Rs.1000/- or in multiple thereof.
d. Maximum amount is Rs. 3 lacs in single account and Rs. 6 lacs in a joint
account.
e. Account can be opened by an individual, two/three adults jointly and a minor
through a guardian.
f. A minor having attained 10 years of age can open an account in his/her own
name directly.
g. Non-Resident Indian / HUF cannot open the Account. Minor has a separate
limit of investment of Rs. 3 lacs and the same is not clubbed with the limit of
guardian.
h. A separate account is opened for each deposit.
i. Any number of accounts can be opened subject to the maximum prescribed
limit.
j. Facility of automatic credit of monthly interest to saving account if accounts
are at the same post office.
k. Facility of premature closure of account after one year @ 3.50% discount.
l. No deduction of 3.5% if account is closed on completion of three years.
m. Facility of reinvestment on maturity of an account.
n. Interest not with-drawn does not carry any interest.
o. Maturity proceeds not drawn are eligible to saving account interest rate for a
maximum period of two years.
p. Account is transferable from one post office to any Post office in India free of
cost.
q. Nomination facility available.
r. Rebate under section 80 C not admissible.
s. Interest income is taxable, but no TDS
t. Only scheme in Post office where monthly interest is payable.
u. Most suitable scheme for senior citizens and for those who need regular
monthly income.
v. Deposits are exempt from Wealth Tax
Amount deposited Monthly Interest

5000.00; 33.33
10000.00 66.67
50000.00 333.33
100000.00 666.67
200000.00 1333.33
300000.00 2000.00
600000.00 4000.00

13.2.3 15 Years Public Provident Fund


• The Public Provident Fund Scheme is a statutory scheme of the Central
Government of India.
• The Scheme is for 15 years.
• The rate of interest is 8% compounded annually.
• The minimum deposit is 500/- and maximum is Rs. 70,000/- in a financial
year.
• One deposit with a minimum amount of Rs.500/- is mandatory in each
financial year.
• The deposit can be in lump sum or in convenient installments, not more than
12 Installments in a year or two installments in a month subject to total
deposit of Rs.70,000/-.
• It is not necessary to make a deposit in every month of the year. The amount
of deposit can be varied to suit the convenience of the account holders.
• The account in which deposits are not made for any reasons is treated as
discontinued account and such account can not be closed before maturity.
• The discontinued account can be activated by payment of minimum deposit of
Rs.500/- with default fee of Rs.50/- for each defaulted year.
• Account can be opened by an individual or a minor through the guardian.
• Joint account is not permissible.
• Those who are contributing to GPF Fund or EDF account can also open a PPF
account.
• A Power of attorney holder can neither open or operate a PPF account.
• The grand father/mother cannot open a PPF behalf of their minor grand
son/daughter.
• The deposits shall be in multiple of Rs.5/- subject to minimum amount of
Rs.500/-.
• The deposit in a minor account is clubbed with the deposit of the account of
the Guardian for the limit of Rs.70,000/-.
• No age is prescribed for opening a PPF account.
• Interest is not contractual but rate is notified by Ministry of Finance, Govt. of
India, at the end of each year.
• The facility of first withdrawal in the 7th year of the account subject to a limit
of 50% of the amount at credit preceding three year balance. Thereafter one
Withdrawal in every year is permissible.
• Pre-mature closure of a PPF Account is not permissible except in case of
death.
• Nominee/legal heir of PPF Account holder on death of the account holder can
not continue the account, but account had to be closed.
• The account holder has an option to extend the PPF account for any period in
a block of 5 years on each time.
• The account holder can retain the account after maturity for any period
without making any further deposits. The balance in the account will continue
to earn interest at normal rate as admissible on PPF account till the account is
closed. One withdrawal in each financial year is also admissible in such
account.
• The PPF scheme is operated through Post Office and Nationalized banks.
• PPF account can be opened either in Post Office or in a Bank.
• Account is transferable from one Post office to another and from Post office
to Bank and from Bank to Post office.
• Account is transferable from one Bank to another bank as well as within the
bank to any branch.
• Deposits in PPF qualify for rebate under section 80-C of Income Tax Act.
• The interest on deposits is totally tax free.
• Deposits are exempt from wealth tax.
• The balance amount in PPF in PPF account is not subject to attachment under
any order or decree of court in respect of any debt or liability.
• Nomination facility available.
• Best for long term investment.
• Loan is admissible from the third financial year. Loan amount is limited to 25
% of the balance available at the end of the preceding second financial year.
• Interest is charged at the rate of 1% if prepaid within 36 months and at 6%
on the outstanding loan after 36 months.

13.2.4 Return on Public Provident Fund

Maximum
Minimum Amount Amount of
Period during which opened of Deposit in a Deposit in Rate of Interest
year (in Rs) a year (in
Rs.)

From To
01.04.1986 14.01.2000 100 60,000 12.00%
15.01.2000 28.02.2001 100 60,000 11.00%
01.03.2001 28.02.2002 100 60,000 9.50%
01.03.2002 14.11.2002 100 60,000 9.00%
15.11.2002 28.03.2003 500 70,000 9.00%
01.03.2003 onwards 500 70,000 8.00%

Other features

• An individual who is a member of a Hindu Undivided Family can subscribe to


the fund on behalf of and out of the income of the HUF any amount not less
than RS 100 and not more than RS 60,000/- in a year.
• An individual can also subscribe to the fund on behalf of an association of
persons or a body of individuals as referred to in clause (g) of sub section (2)
of Section 80 C of the Income Tax Act, 1961 out of the income of the
association of persons or body of Individuals, as the case may be, any
amount not less than Rs100/- and not more than RS 60,000/- in a year.

13.2.5 Post Office Time Deposit Account

A Post-Office Time Deposit Account (RDA) is a banking service similar to a Bank


Fixed Deposit offered by Department of post, Government of India at all post office
counters in the country. The scheme is meant for those investors who want to
deposit a lump sum of money for a fixed period; say for a minimum period of one
year to two years, three years and a maximum period of five years. Investor gets a
lump sum (principal + interest) at the maturity of the deposit. Time Deposits scheme
return a lower, but safer, growth in investment.
• Minimum amount of deposit is Rs.200/-.
• No maximum limit.
• Account can be closed after 6 months but before one year without any
interest.
• Facility of redeposit on maturity of an account.
• No interest is payable on undrawn interest amount.
• Account can be opened by an individual, two adults jointly and minor through
guardian.
• A Minor who has attained the age of 10 years can open the account in his/her
own name to be operated directly.
• Non Resident Indian / HUF can not open the account.
• Any number of accounts can be opened.
• Two, three and Five years accounts can be closed after one year at a
discounted rate of interest.
• Deposits not drawn on maturity are eligible to saving account interest rate for
a maximum period of two years.
• Account can be pledged as security against a loan to banks/ Government
institutions.
• Accounts are transferable from one Post office to any Post office in India.
• Rebate under section 80-C is not admissible.
• Interest income is taxable.
• Deposits are exempt from wealth tax.
• No T.D.S.
• Nomination facility available.

Returns On Time Deposit Account

Interest is paid annually but calculated annually at the following rates

Account Rates of interest

1 year Account 6.25 %


2 year Account 6.5 %
3 year Account 7.25 %
5 year Account 7.5 %

13.2.6 5-Years Post Office Recurring Deposit Account

• The Recurring deposit in Bank is meant for someone who want to invest a
specific sum of money on a monthly basis for a fixed rate of return. At the
end, you will get the principal sum as well as the interest earned during that
period. The scheme, a systematic way for long term savings, is one of the
best investment option for the low income groups.
• The rate of interest is 7.5% quarterly compounded
• The deposit can be made In any Head post office/Sub post office
• Investment can be made by a) A single adult (b) Two adults jointly, the
amount due on the account being payable (i) to both jointly or survivor (ii) to
either of them or survivor, (c) A guardian on behalf of a minor or a person of
unsound mind, (d) A minor who has attained the age of ten years in his own
name.
• The minimum amount that can e deposited is Rs. 10/- and there after
multiples of Rs. 5/- without limit.
• The Deposits made at the time of opening of the account shall be the
denomination of the account. The subsequent monthly deposit shall be made
before the end of the calendar month and shall be equal to the first deposit.
• Premature withdrawals are allowed after 3 years from the date of opening of
the account.
• 50% of the deposits made in the account may be allowed as loan after the
account has been in operation for at least one year.
• In case of advance deposits, the number of deposits should be six or more
but not exceeding eleven deposits made in a calendar month.
• The rebate on such is Rs 10/- for an account of Rs. 100/- denomination
• In case of advance Deposits of Twelve or more deposits made in a calendar
month, the rebate is Rs. 40/- for every twelve deposits of Rs. 100/-
denomination
• Nomination facility is available
• Once can continue account may be for a further period of five years and make
monthly deposits during such extended period.
• The Depositor may at his option continue the account and retain in it the
amount of repayment due for a further period upto maximum of five years
without making any fresh deposits.
• There is no Tax deduction at source

13.2.7 National Savings Certificate (VIII Issue)

• Minimum investment Rs. 500/- No maximum limit.


• Rate of interest 8% compounded half yearly.
• Rs. 1000/- grows to Rs. 1601/- in six years.
• Two adults, Individuals, and minor through guardian can purchase.
• Companies, Trusts, Societies and any other Institutions not eligible to
purchase.
• Non-resident Indian/HUF can not purchase.
• No pre-mature encashment.
• Annual interest earned is deemed to be reinvested and qualifies for tax rebate
for first 5 years under section 80 C of Income Tax Act.
• Maturity proceeds not drawn are eligible to Post Office Savings account
interest for a maximum period of two years.
• Facility of reinvestment on maturity.
• Certificate can be pledged as security against a loan to banks/ Govt.
Institutions.
• Facility of encashment of certificates through banks.
• Certificates are encashable any Post office in India before maturity by way of
transfer to desired post office.
• Certificates are transferable from one Post office to any Post office.
• Certificates are transferable from one person to another person before
maturity.
• Duplicate Certificate can be issued for lost, stolen, destroyed, mutilated or
defaced certificate.
• Nomination facility available.
• Facility of purchase/payment to the holder of Power of attorney.
• Tax Saving instrument - Rebate admissible under section 80 C of Income Tax
Act.
• Interest income is taxable but no TDS
• Deposits are exempt from Wealth tax.

Returns On The NSC Certificate of Rs 1000

1 year 1000.00 40.00 41.60 81.60


2 years 1081.60 43.26 44.99 88.26
3 years 1169.86 46.79 48.67 95.46
4 years 1265.32 50.61 52.64 103.25
5 years 1368.57 54.74 56.93 111.68
6 years 1480.24 59.21 61.58 120.79

13.2.8 Senior Citizen Scheme

A new savings scheme called ‘Senior Citizens Savings Scheme’ has been notified with
effect from August 2, 2004. The Scheme is for the benefit of senior citizens and
maturity period of the deposit will be five years, extendable by another three years.
Initially the scheme will be available through designated post offices through out the
country. The minimum investment is Rs 1000 and in multiples of Rs.1000 subject to
a maximum of Rs.15 lakh.

The Government of India have decided to operate the scheme through all branches
of Public Sector Banks which are operating PPF Scheme, 1968.

Eligibility

i. An individual who has attained the age of 60 years and above on the date of
opening of an account.
ii. Who has attained the age of 55 years or more but less than 60 years and who
has retired on superannuation or otherwise on the date of opening an
account.
iii. Who has retired at any time before the commencement of these rules and
attained the age of 55 years or more on the date of opening of an account,
iv. The retired personnel of Defence Services (excluding civilian Defence
employees) irrespective of the above age limits subject to fulfillment of other
specified conditions.

NRI

NRI's are not eligible to open an account under these rules.

HUF

Hindu Undivided Family is also not eligible to open an account under these rules.
Salient features

• Any depositor may open an account at any deposit office by making an


application in Form A alongwith the amount of deposit in multiple of one
thousand rupees, along with age proof.
• A depositor may operate more than one account subject to the condition that
deposits in all accounts taken together shall not exceed the maximum limit of
Rs.15 lakh and provided that deposits by depositors shall be restricted to the
retirement benefits of Rupees fifteen lakh whichever is lower.

A depositor may open the account in individual capacity or jointly with spouse.

Deposits and withdrawals

There shall be only one deposit in the account in multiple of one thousand rupees not
exceeding rupees fifteen lakhs. No withdrawal shall be permitted under these rules
before the expiry of a period of five years from the date of opening of an account.

Mode of Deposit

The deposit under these rules may be made :

a. In cash, if the amount of deposit is less than rupees one lakhs


b. By cheque or demand draft drawn in favour of the depositor and endorsed in
favour of the deposit office.

Renewal

The depositor may extend the account for a further period of three years after the
maturity period of five years. An application in Form B should be made within a
period of one year after the date of maturity period.

Interest on Deposit

The deposit made under these rules shall bear interest @ 9 % p.a. from the date of
deposit payable at the end of each calendar quarter e.g. 31st March / 30th June /
30th September / 31st December.

Nomination

The depositor may nominate a person or persons, at the time of opening of the
account or at any time after the opening of the account but before its closure, by an
application on Form C accompanied by the passbook to the Branch.

Nomination made by the depositor can be cancelled or varied.

Closure of Account

Maturity
The deposit made at the time of opening of account shall be paid by the concerned
deposit office after the expiry of five years from the date of opening of the account
on production of the passbook accompanied by a written application (withdrawal
form) Form E.

In case the depositor does not close the account on maturity and also does not
extend the account, the account will be treated as matured and the depositor will be
entitled to interest at the rate applicable to the deposits under post office savings
account during the post maturity period.

Death of the depositor

In case of death of the depositor before maturity the account shall be closed and
deposit refunded on application in Form F alongwith interest to the nominee or legal
heirs in case the nominee has also expired or nomination was not made as per
rules.

If the total amount including interest payable is upto rupees one lakh it may be paid
to the legal heirs on production of (i) letter of indemnity (ii) an affidavit (iii) a letter
of disclaimer on affidavit (iv) a certificate of death of the depositor on stamped
paper in the form as in Annexure to Form F.

Premature closure of Account

On an application in Form E the depositor may be permitted to withdraw the deposit


and close the account at any time after the expiry of one year from the date of
opening of the account subject to the following conditions :-

a. In case the account is closed after the expiry of one year but before the
expiry of two years from the date of opening of the account, an amount
equal to one and half percent of the deposit shall be deducted and the
balance paid to the depositor.
b. In case the account is closed on or after the expiry of two years from the
date of opening of the account, an amount equal to one percent of the
deposit shall be deducted and balance paid to the depositor.

Transfer of Account

A depositor may apply on Form G for transfer of his account from one deposit office
to another in case of change of residence.
Mutual Funds Chapter- 14

A Mutual Fund is a trust that pools the savings of a number of investors who share a
common financial goal. The money thus collected is invested by the fund manager in
different types of securities depending upon the objective of the scheme. The income
earned through these investments and the capital appreciations realized by the
scheme are shared by its unit holders in proportion to the number of units owned by
them. Each Mutual Fund scheme has a defined investment objective and strategy.

14.1 Mutual Fund Structure

A Sponsor is the person who acting alone or in combination with another body
corporate establishes a mutual fund. Sponsor must contribute at least 40% of the
networth of the Asset Management Company and meet the eligibility criteria
prescribed under the Securities and Exchange Board of India (Mutual Funds)
Regulations, 1996.The Sponsor is not responsible or liable for any loss or shortfall
resulting from the operation of the Schemes beyond the initial contribution made by
it towards setting up of the Mutual Fund.

All Mutual Funds are constituted as a Trust in accordance with the provisions of the
Indian Trusts Act, 1882 by the Sponsor. The trust deed is registered under the
Indian Registration Act, 1908.

The Trustee is usually a company (corporate body) or a Board of Trustees (body of


individuals). The main responsibility of the Trustee is to safeguard the interest of the
unit holders and inter alia ensure that the AMC functions in the interest of investors
and in accordance with the Securities and Exchange Board of India (Mutual Funds)
Regulations, 1996, the provisions of the Trust Deed and the Offer Documents of the
respective Schemes. At least 2/3rd directors of the Trustee are independent directors
who are not associated with the Sponsor in any manner.

The Asset Management Company is appointed by the Trustee as the Investment


Manager of the Mutual Fund. The AMC is required to be approved by the Securities
and Exchange Board of India (SEBI) to act as an asset management company of the
Mutual Fund. At least 50% of the directors of the AMC are independent directors who
are not associated with the Sponsor in any manner. The AMC must have a networth
of at least 10 crore at all times.

The AMC if so authorised by the Trust Deed appoints the Registrar and Transfer
Agent to the Mutual Fund. The Registrar processes the application form, redemption
requests and dispatches account statements to the unit holders. The Registrar and
Transfer agent also handles communications with investors and updates investor
records.

14.2 Benefits of Mutual Funds

Professional Management
Mutual Funds provide the services of experienced and skilled professionals, backed
by a dedicated investment research team that analyses the performance and
prospects of companies and selects suitable investments to achieve the objectives of
the scheme.

Diversification
Mutual Funds invest in a number of companies across a broad cross-section of
industries and sectors. This diversification reduces the risk because seldom do all
stocks decline at the same time and in the same proportion. You achieve this
diversification through a Mutual Fund with far less money than you can do on your
own.

Convenient Administration
Investing in a Mutual Fund reduces paperwork and helps you avoid many problems
such as bad deliveries, delayed payments and follow up with brokers and companies.
Mutual Funds save your time and make investing easy and convenient.

Return Potential
Over a medium to long-term, Mutual Funds have the potential to provide a higher
return as they invest in a diversified basket of selected securities.

Low Costs
Mutual Funds are a relatively less expensive way to invest compared to directly
investing in the capital markets because the benefits of scale in brokerage, custodial
and other fees translate into lower costs for investors.

Liquidity
In open-end schemes, the investor gets the money back promptly at net asset value
related prices from the Mutual Fund. In closed-end schemes, the units can be sold on
a stock exchange at the prevailing market price or the investor can avail of the
facility of direct repurchase at NAV related prices by the Mutual Fund.

Transparency
You get regular information on the value of your investment in addition to disclosure
on the specific investments made by your scheme, the proportion invested in each
class of assets and the fund manager's investment strategy and outlook.
Flexibility
Through features such as regular investment plans, regular withdrawal plans and
dividend reinvestment plans, you can systematically invest or withdraw funds
according to your needs and convenience.

Affordability
Investors individually may lack sufficient funds to invest in high-grade stocks. A
mutual fund because of its large corpus allows even a small investor to take the
benefit of its investment strategy.

Choice of Schemes
Mutual Funds offer a family of schemes to suit your varying needs over a lifetime.

Well Regulated
All Mutual Funds are registered with SEBI and they function within the provisions of
strict regulations designed to protect the interests of investors. The operations of
Mutual Funds are regularly monitored by SEBI.

14.3 Types of Mutual Funds

14.3.1 BY STRUCTURE:

Open-ended Funds
An open-end fund is one that is available for subscription all through the year. These
do not have a fixed maturity. Investors can conveniently buy and sell units at Net
Asset Value ("NAV") related prices.

Closed-ended Funds
A closed-end fund has a stipulated maturity period which generally ranging from 3 to
15 years. The fund is open for subscription only during a specified period. Investors
can invest in the scheme at the time of the initial public issue and thereafter they
can buy or sell the units of the scheme on the stock exchanges where they 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 through periodic repurchase at
NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes
is provided to the investor.

Interval Funds
Interval funds combine the features of open-ended and close-ended schemes. They
are open for sale or redemption during pre-determined intervals at NAV related
prices.

14.3.2 BY INVESTMENT OBJECTIVE:

Growth Funds
The aim of growth funds is to provide capital appreciation over the medium to long-
term. Such schemes normally invest a majority of their corpus in equities. Growth
schemes are ideal for investors having a long-term outlook seeking growth over a
period of time.
Income Funds
The aim of income funds is to provide regular and steady income to investors. Such
schemes generally invest in fixed income securities such as bonds, corporate
debentures and Government securities. Income Funds are ideal for capital stability
and regular income.

Balanced Funds
The aim of balanced funds is to provide both growth and regular income. Such
schemes periodically distribute a part of their earning and invest both in equities and
fixed income securities in the proportion indicated in their offer documents. In a
rising stock market, the NAV of these schemes may not normally keep pace, or fall
equally when the market falls. These are ideal for investors looking for a combination
of income and moderate growth.

Liquid Funds
These are also known as money market funds. They invest in securities of short term
nature, typically securities of less than one-year maturity like treasury bills issued by
the government, certificate of deposits issued by banks and Commercial Paper issued
by companies as well as in the inter-bank call money market. These funds are
considered to be at the lowest rung in the hierarchy of risks.

Equity Funds
As the name suggests, these funds invest in the equity market securities. They are
exposed to the equity price fluctuations risk at the market level, industry level and
also the specific company level. These price movements are caused by external
factors, political and social as well as economic factors. Thus the net asset values of
these funds fluctuate with all price movements. Equity investments are for a longer
time horizon and a well managed equity fund can get you higher returns but also
carries higher risks.

Gilt Funds
These funds invest in government paper called dated securities. As the investments
are in government paper these funds have little risk of default and hence offer better
protection of principal. However, one must recognise the potential changes in values
of debt securities held by the funds that are caused by changes in the market price
of these securities as a result of change in the market price of these debt securities.

Money Market Funds


The aim of money market funds is to provide easy liquidity, preservation of capital
and moderate income. These schemes generally invest in safer short-term
instruments such as treasury bills, certificates of deposit, commercial paper and
inter-bank call money. Returns on these schemes may fluctuate depending upon the
interest rates prevailing in the market. These are ideal for Corporate and individual
investors as a means to park their surplus funds for short periods.

OTHER SCHEMES:

Tax Saving Schemes


These schemes offer tax rebates to the investors under specific provisions of the
Indian Income Tax laws as the Government offers tax incentives for investment in
specified avenues. Investments made in Equity Linked Savings Schemes (ELSS) and
Pension Schemes are allowed as deduction u/s 80C of the Income Tax Act, 1961.

Special Schemes

Industry Specific Schemes

Industry Specific Schemes invest only in the industries specified in the offer
document. The investment of these funds is limited to specific industries like
InfoTech, FMCG, Pharmaceuticals etc.

Index Schemes

Index Funds attempt to replicate the performance of a particular index such as the
BSE Sensex or the NSE 50.

Sectoral Schemes

Sectoral Funds are those, which invest exclusively in a specified industry or a group
of industries or various segments.

However apart from the above classifications, there are some sub-classifications
within equity and debt.

Equity Funds

These funds invest a major part of their corpus in equities. The composition of the
fund may vary from scheme to scheme and the fund manager’s outlook on various
scrips. The Equity Funds are sub-classified depending upon their investment
objective, as follows:

• Diversified Equity Funds


• Mid-Cap Funds
• Sector Specific Funds
• Tax Savings Funds (ELSS)

Equity investments are meant for a longer time horizon. Equity funds rank high on
the risk-return matrix.

Debt Funds

These Funds invest a major portion of their corpus in debt papers. Government
authorities, private companies, banks and financial institutions are some of the major
issuers of debt papers. By investing in debt instruments, these funds ensure low risk
and provide stable income to the investors. Debt funds are further classified as:

a. Gilt Funds: Invest their corpus in securities issued by Government, popularly


known as GoI debt papers. These Funds carry zero Default risk but are
associated with Interest Rate risk. These schemes are safer as they invest in
papers backed by Government.
b. Income Funds: Invest a major portion into various debt instruments such as
bonds, corporate debentures and Government securities.
c. MIPs: Invests around 80% of their total corpus in debt instruments while the
rest of the portion is invested in equities. It gets benefit of both equity and
debt market. These scheme ranks slightly high on the risk-return matrix when
compared with other debt schemes.
d. Short Term Plans (STPs): Meant for investors with an investment horizon
of 3-6 months. These funds primarily invest in short term papers like
Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of
the corpus is also invested in corporate debentures.
e. Liquid Funds: Also known as Money Market Schemes, These funds are
meant to provide easy liquidity and preservation of capital. These schemes
invest in short-term instruments like Treasury Bills, inter-bank call money
market, CPs and CDs. These funds are meant for short-term cash
management of corporate houses and are meant for an investment horizon of
1day to 3 months. These schemes rank low on risk-return matrix and are
considered to be the safest amongst all categories of Mutual Funds.

14.4 Factors before buying a mutual fund

Scheme’s past performance: which should incorporate an analysis of its point to


point return vis-à-vis the returns of its peer and the benchmark index but also the
risk undertaken by the scheme to generate the kind of return. The risk can be
measured by either beta or standard deviation. Risk- adjusted returns comparison
are a much better way of comparing schemes as the investor knows whether the
returns generated by the scheme have adequately compensated for the extra risk
undertaken by the scheme.

The Portfolio Concentration, its Liquidity and its Corpus Size: .The nature of
the portfolio would affect its performance. Also the portfolio should be such that it
should include companies and segments that are doing well or are expected to do
well. While all open ended funds are liquid, the ELSS and the close-ended funds do
not have liquidity. It is always a good idea to balance out better performance vis-à-
vis reduced liquidity. The corpus size could be a good and a bad thing. A large corpus
size denotes investors’ confidence in the scheme and its fund manger abilities over
the years. It also allows the fund manager to diversify the portfolio, which reduces
the overall market risk. The flipside is difficulty of managing funds since the fund
manager may run out of investment avenues to deploy all the funds.

Other factors like Turnover Rates, Low Expense Ratio, Load Structure Etc of
the schemes etc should also be considered before finally zeroing down on a scheme
of your choice. Recently there are rankings given by various agencies such Value
Research, or by various business magazines as well as by some rating agencies.
These are useful to figure out information about best performing Mutual Funds.

Snapshot of Mutual Fund Schemes

Mutual Fund Type Objective Risk Investment Who should Investment


Portfolio invest horizon
Money Market Liquidity + Negligible Treasury Bills, Those who 2 days -
Moderate Certificate of park their 3 weeks
Income + Deposits, funds in
Reservation of Commercial current
Capital Papers, Call accounts or
Money short-term
bank
deposits
Call Money,
Commercial
Papers, Those with
Short-term Funds Liquidity + Little 3 weeks
Treasury Bills, surplus
(Floating - short- Moderate Interest -3
term) CDs, Short- short-term
Income Rate months
term funds
Government
securities.
Predominantly
Debentures, More
Credit Risk Salaried &
Bond Funds (Floating Regular Government than 9 –
- Long-term) & Interest conservative
Income securities, 12
Rate Risk investors
Corporate months
Bonds
Salaried & 12
Security & Interest Government
Gilt Funds conservative months &
Income Rate Risk securities
investors more
Aggressive
Long-term investors
3 years
Equity Funds Capital High Risk Stocks with long
plus
Appreciation term out
look.
To generate
returns that
Portfolio
are NAV varies
indices like Aggressive 3 years
Index Funds commensurate with index
BSE, NIFTY investors. plus
with returns of performance
etc
respective
indices
Balanced ratio
Capital of equity and
Growth &
Market Risk debt funds to Moderate &
Balanced Funds Regular 2 years
and Interest ensure igher Aggressive
Income
Risk returns at
lower risk

Net Asset Value (NAV)

Net Asset Value is the market value of the assets of the scheme minus its liabilities.
The per unit NAV is the net asset value of the scheme divided by the number of units
outstanding on the Valuation Date.

= NAV = Net assets of scheme/Number of units outstanding.


In other words:

(Market value of investments + Receivables + Other Accrued Income +


Other Assets — Accrued Expenses — Other Payables — Other Liabilities)

Number of units outstanding on the NAV calculation date

NAV is affected by a host of factors. They are:

Valuation of investments: While listed securities are easily valued using daily
closing prices, untraded or thinly traded securities are trickier. Sebi lays down strict
guidelines for their valuation, and also defines untraded/thinly traded security for
more transparency. If a mutual fund invests more in such unlisted securities, it
would affect their valuation.

Purchase/sale of securities: Ultimately, a fund’s performance depends largely on


the fund manager’s management abilities. Eventually, so does your NAV. The fund
manager decides which stocks to buy, and when to sell. And this impacts your NAV.

Other assets & liabilities: Other assets include any income due to the fund but not
yet received–like company dividends. Other liabilities include expenses payable from
the scheme, including AMC fees that are paid to your Asset Management Company
for managing your funds.

Units sold & redeemed: Your NAV is affected each time an investor buys into the
fund or sells units. As the NAV is largely shared profits made from the fund’s
investments, the more the number of units, the less the share per unit and vice-
versa. In reality, fund managers handle it differently. Increased number of units
implies more inflows and this allows the fund manager to buy more stocks or
increase exposure in the stocks the fund already holds.

Your fund’s NAV is adversely impacted when there is a large-scale redemption of


units. Usually, all Mutual Funds maintain a small cash reserve to meet redemption,
but large-scale redemption may force the fund manager to sell stocks to raise the
money. If this is done at an unfavourable price, your NAV will suffer. If your fund
manager sells stocks expected to go up in future, the interests of existing investors
is affected as they are deprived of future gains.

Dividend distribution: Any gains like dividends that are distributed from your
portfolio ultimately come from your NAV. Since dividends are paid out of your NAV, it
will be reduced to the extent of the amount paid. If your scheme’s NAV is, say, Rs 10
and it goes up to Rs 15, and the fund decides to pay a dividend of Rs 5, your NAV
will be reduced by Rs 5 to come back to Rs 10. The Rs 5 comes to your hands as
dividend income.

Thus, the NAV of your scheme on any day reflects the realisable value of your
investments (multiplied by the number of units held) on that day.

14.5 Some Innovations in Mutual Funds

Fixed Maturity Plans


In the fixed maturity plans, the investments are made by the funds in instruments
whose maturity will coincide with a specific time period indicated in advance by the
mutual fund. In other words, if you want an investment for a specific period in a
mutual fund, fixed maturity plans are the answer.

Fixed maturity plans invest in a portfolio of instruments whose maturities match the
term-to-maturity targeted by the scheme.

A fixed-maturity bond fund immunizes horizon risk. This is because the bonds held in
the portfolio at the horizon are redeemed with the issuer-companies and are
therefore not affected by interest-rate factors or other yield curve risk. Such funds
are, however, exposed to inflation risk. It also controls for market risk since the
investment in equity which does not have a fixed maturity is negligible.

Secondly with the Finance Act 2005 withdrawing Sec. 80L, all fixed income
instruments have become fully taxable. If one belong to the 33.66% tax bracket,
after paying tax, the left-over return may be hardly enough even to cover inflation.
Plus there is the lock-in factor to contend with. Thus, FMP’s provide an arbitrage
opportunity as far as the tax rate is concerned. You may belong to the highest tax
bracket but the distribution tax that is payable by the MF on the dividend is fixed at
14.025%, which is much better than paying tax at the highest rate. Corporates too
indulge in tax arbitrage by investing in FMP’s as the distribution tax rate applicable to
them @22.44% is lower than the maximum marginal rate. Even for the growth
option, a tax of 10% on the gains will work out fiscally much more advantageous
than the traditional tax rate.

14.6 Criteria for evaluating mutual fund performance:-

Past Performance:

The past performance is simply the returns given by a mutual fund. The returns are
calculated on the basis of their NAV and dividends given. Mutual Funds are also
required to publish their performance in the form of half-yearly results which also
include their returns/yields over a period of time i.e. last six months, 1 year, 3 years,
5 years and since inception of schemes. Investors can also look into other details like
percentage of expenses of total assets as these have an affect on the yield and other
useful information in the same half-yearly format. The Mutual Funds are also
required to send annual report or abridged annual report to the unitholders at the
end of the year. Various studies on mutual fund schemes including yields of different
schemes are being published by the financial newspapers on a weekly basis. Apart
from these, many research agencies also publish research reports on performance of
Mutual Funds including the ranking of various schemes in terms of their
performance. Investors should study these reports and keep themselves informed
about the performance of various schemes of different Mutual Funds. Investors can
compare the performance of their schemes with those of other Mutual Funds under
the same category. They can also compare the performance of equity oriented
schemes with the benchmarks like BSE Sensitive Index, S&P CNX Nifty, etc.

Market Timing using Beta

Beta is the measure of a particular security or portfolio’s systematic risk.


• A beta of 1 indicates that the security's price will move with the market.
• A beta less than 1 means that the security will be less volatile than the
market. It indicates a defensive security or portfolio
• A beta greater than 1 indicates that the security's price will be more volatile
than the market. This indicates an aggressive security or portfolio.

In a rising market the beta of a mutual fund should be more than 1 while in a
consistently falling market the beta should be less than 1. This indicates a fund
manager’s ability to time the market and be able to thus beat the markets. In actual
practice, it is difficult to do that all throughout but over periods with clear signs of
rising and falling markets, one can attempt to select certain stocks which have a
clear potential of beating the market.

The beta of a stock is also used as a measure of risk. There are some measures that
consider the ability of the fund manager to give returns after adjusting for the risk.
They will be discussed later in this section.

R-Square

The R-square of a fund simply is an indicator of how well a fund is correlated with
that of the market measured by an appropriate benchmark. R-square values range
between 0 and 100, where 0 represents the least correlation and 100 represents full
correlation. If a fund's beta has an R-squared value that is close to 100, the beta of
the fund can be taken as reliable. In other words a high R-square denotes that the
risk of the fund is mainly composed of systematic risk and the other risk is negligible.
On the other hand, an R-squared value that is close to 0 indicates that the beta is
not particularly useful because the fund is being compared against an inappropriate
benchmark.

The above discussion makes it quite evident that return alone should not be
considered as the basis of measurement of the performance of a mutual fund
scheme, it should also include the risk taken by the fund manager because different
funds will have different levels of risk attached to them. Risk associated with a fund,
in a general, can be defined as variability or fluctuations in the returns generated by
it. These fluctuations in the returns generated by a fund are resultant of two guiding
forces. First, general market fluctuations, which affect all the securities, present in
the market, called market risk or systematic risk and second, fluctuations due to
specific securities present in the portfolio of the fund, called unsystematic risk. The
Total Risk of a given fund is sum of these two and is measured in terms of Variance
of returns of the fund. Systematic risk, on the other hand, is measured in terms of
Beta, which represents fluctuations in the NAV of the fund vis-à-vis market. The
more responsive the NAV of a mutual fund is to the changes in the market; higher
will be its beta.

Some of the important risk adjusted measures are as follows:-

• The Treynor Measure


• The Sharpe Measure
• Jenson Model
• Fama Model

The Treynor Measure


Developed by Jack Treynor, this performance measure evaluates funds on the basis
of Treynor's Index. This Index is a ratio of return generated by the fund over and
above risk free rate of return and the systematic risk measured by beta

Treynor's Index (Ti) = (Ri - Rf)/βi.

Where, Ri represents return on fund, Rf is risk free rate of return and βi is beta of
the fund.

All risk-averse investors would like to maximize this value. A high and positive
Treynor's Index shows a superior risk-adjusted performance while a low and
negative Treynor's Index is an indication of unfavorable performance.

The Sharpe Measure

In this case, the performance of a fund is evaluated on the basis of Sharpe Ratio,
which is a ratio of returns generated by the fund over and above risk free rate of
return and the total risk measured by the standard deviation. According to Sharpe, it
is the total risk of the fund that the investors are concerned about. So, the model
evaluates funds on the basis of reward per unit of total risk. Symbolically, it can be
written as:

Sharpe Index (Si) = (Ri - Rf)/Si

Where, Si is standard deviation of the fund.

While a high and positive Sharpe Ratio shows a superior risk-adjusted performance
of a fund, a low and negative Sharpe Ratio is an indication of unfavorable
performance

Comparison of Sharpe and Treynor

Sharpe and Treynor measures are similar in a way, since they both divide the risk
premium by a numerical risk measure. The systematic risk is appropriate when we
are evaluating the risk return relationship for well-diversified portfolios. This is
because the unsystematic risk ahs been diversified away and does not need to be
accounted for. On the other hand, the total risk is the relevant measure of risk when
we are evaluating less than fully diversified portfolios or individual stocks. For a well-
diversified portfolio the total risk is equal to systematic risk. Rankings based on total
risk (Sharpe measure) and systematic risk (Treynor measure) should be identical for
a well-diversified portfolio, as the total risk is reduced to systematic risk.

Jenson Model

This measure was developed by Michael Jenson and is sometimes referred to as the
Differential Return Method. This measure involves evaluation of the returns that the
fund has generated vs. the returns actually expected out of the fund given the level
of its systematic risk. The surplus between the two returns is called Alpha, which
measures the performance of a fund compared with the actual returns over the
period. Required return of a fund at a given level of risk (βi) can be calculated as:

Ri = Rf + βi (Rm - Rf)
Where, Rm is average market return during the given period. After calculating it,
alpha can be obtained by subtracting required return from the actual return of the
fund.

Higher alpha represents superior performance of the fund and vice versa. This again
assumes that the only risk that the portfolio bears is that of systematic risk and
therefore is valid only for well-diversified portfolios.

Fama Model

The Eugene Fama model is an extension of Jenson model. This model compares the
performance, measured in terms of returns, of a fund with the required return
commensurate with the total risk associated with it. The difference between these
two is taken as a measure of the performance of the fund and is called net
selectivity.

The net selectivity represents the stock selection skill of the fund manager, as it is
the excess return over and above the return required to compensate for the total risk
taken by the fund manager. Higher value of which indicates that fund manager has
earned returns well above the return commensurate with the level of risk taken by
him.

Required return can be calculated as: Ri = Rf + Si/Sm*(Rm - Rf)

Where, Sm is standard deviation of market returns. The net selectivity is then


calculated by subtracting this required return from the actual return of the fund.

EXAMPLE

If Anil has the options to invest in 2 funds whose details are as below , find Jensen’s
index for fund A , Treynor index for fund B and Sharpe index for the market.

Mean Standard Deviation Beta

Fund A 0.13 15% 1.0


Fund B 0.18 19% 2.0
Market Index 0.12 8%

Jensen’s Index for fund A

= 13 –((8+1*(12-8)))

=1

Treynor Index for Fund B

= (18-8)/2

=5

Sharpe Index for Market


= (12-8)/8

=1

14.7 TAX IMPLICATIONS ON Mutual Funds INVESTMENT

TYPES OF INCOME TAXED UNDER TAX CALCULATION SET OFF RULES

Equity oriented
schemes: tax free
Income from
Dividend in the hands of
other sources
investors and
mutual fund
Debt oriented
schemes: tax free
in the hands of the
investor .Mutual
Funds have to pay
a dividend
distribution tax of
12.5%plus
2.5%surcharge
Capital
Irrespective of
appreciation (For Capital gains
income slab:
Debt Fund Only)
Long term
capital gains/
loss Long term capital loss from MF
investment in 20% with can be set off against long-
the Mutual indexation benefits term capital gain from mf or
Funds held for any other capital asset
more than 12
months
Any unabsorbed long-term
loss in a year can be carried
10% without
forward for set off in
indexation benefit
subsequent years against any
other long term capital gains.
Short term capital loss from
MF can be set off against both
short term and long term
capital gain from MF or any
other capital asset.
short term treated as any
capital gains/ other income
any unabsorbed short term
loss: applicable rates
loss in a year can be carried
investments 10%,20%30%(with
forward for set off in
in the mutual or without
subsequent years against both
fund scheme surcharge)
short and long term capital
held for 12 according to the
gains
Months or income slabs of the
less investor
Fixed Deposits Chapter-15

A deposit account is an account at a institution that offer banking services and


allows money to be held on behalf of the account holder. Some banks charge a fee
for this service, while others may pay the client interest on the funds deposited.

The account holder retains rights to their deposit, although restrictions placed on
access depend upon the terms and conditions of the account and the provider.

A deposit is a type of asset.

15.1 Types of deposits

Based on the period of deposits and the frequency of transactions, there are four
types of deposits with the banks, which come under the category of Cash or bank
deposits:-

a. Savings account Deposits


b. Current Account Deposits
c. Recurring Deposits
d. Time Deposits

Based on the nationality of the account holder, the deposits can be classified into two
categories:-

a. Domestic Deposits
b. NRI Deposits

Based on the kind of transactions, the deposits can be classified into

a. Cash Deposits
b. Bank Deposits

Savings Account :-

Savings Bank Accounts are meant to promote the habit of saving among the citizens
while allowing them to use their funds when required for their day to day needs. A
savings bank account is not only extremely safe but the most liquid instrument.
Savings banks earn a certain moderate interest rate on them. Presently, the rate of
interest is 3.5% compounded half yearly. he amount of interest will be calculated for
each calendar month on the lowest balance in credit of any account between the
close of the tenth day and the last day of each month. Most banks pay interest on a
half yearly basis. It is the most common operating account for individuals and others
for non-commercial transactions. A Banks generally put some ceilings on the total
number of withdrawals permitted during specific time periods. Banks also stipulate
certain minimum balance to be maintained in savings accounts. Normally a higher
minimum balance is stipulated in cheque operated accounts as compared to non-
cheque operated accounts.
The minimum balance to be maintained in an ordinary savings bank account varies
from bank to bank. It is less in case of public sector banks and comparatively higher
in case of private banks. In most of the public sector banks, minimum balance to be
maintained is Rs. 100. In accounts where cheque books are issued, a minimum
balance of Rs. 500/- has to be maintained. For Pension Savings Accounts, minimum
balance to be maintained is Rs. 5/- without cheque facility and Rs. 250/- with cheque
facility.

Who can open a Savings Account?

a. By a person in his / her name


b. By two or more persons in their joint names payable to
c. Both or all of them or the survivor or survivors of them
d. Either or any more of them or the survivor or the survivors of them; or
former / latter or survivor of a particular person during his lifetime or
survivors jointly or survivor.
e. Certain non-profit welfare organizations are also permitted to open savings
bank accounts with banks

Current Account:-

Current accounts are cheque operated accounts maintained for mainly business
purposes. Unlike savings bank account no limits are fixed by banks on the number of
transactions permitted in the Account. Banks generally insist on a higher minimum
balance to be maintained in current account. Considering the large number of
transactions in the account and volatile nature of balances maintained overnight
banks generally levy certain service charges for operating a Current account.

In terms of RBI directive banks are not allowed to pay any interest on the balances
maintained in Current accounts. However, legal heirs of a deceased person are paid
interest at the rates applicable to Savings bank deposit from the date of death of the
account holder till the date of settlement.

Recurring Bank Deposits:-

Under a Recurring Bank Deposit, a specific amount is invested in bank on monthly


basis for a fixed rate of return. The deposit has a fixed tenure, at the end of which
the principal sum as well as the interest earned during that period is returned to the
investor.

Recurring Bank Account provides the element of compulsion to save at high rates of
interest applicable to Term Deposits along with liquidity to access those savings any
time. There is great flexibility in period of deposit with maturity ranging from 6
months to 120 months. The minimum monthly deposit varies from bank to bank. In
most of the public sector banks, one can start a Recurring Deposit Account with a
monthly installment of Rs. 100/- only. Loan/overdraft facility is also available against
Recurring Bank Deposits.

Time Deposits:-

Bank Time Deposits are also known as Fixed Deposits or Term Deposits. In a Fixed
Deposit Account, a certain sum of money is deposited in the bank for a specified time
period with a fixed rate of interest. In terms of RBI directives the minimum period for
which term deposits can be accepted is 15 days. The banks generally do not accept
deposits for periods longer than 10 years.

Following are some of the features of bank deposits:

a. Banks pay interest on term deposits based on the period of deposits and
normally pay higher interest for longer term deposits.
b. Banks have full discretion to fix their interest rates on deposits and these
rates are varied from time to time depending on market conditions.
c. Changes made in interest rates from time to time do not alter the interest
paid on the existing deposits.
d. When banks quote a certain percentage of interest per annum for a given
period it is understood that interest payments are made on a quarterly basis
The depositor can collect interest on every quarter or its discounted value at
monthly rests or avail quarterly compounding benefits and receive principal
and interest on maturity.
e. RBI has now permitted banks to quote a higher rate of interest for individual
deposits more than Rs.15 lacs.
f. Banks are allowed to levy a penalty for premature encashment of deposits at
their discretion. Banks generally pay interest on such deposits as applicable
for the period which deposit has been kept with the bank (less penalty if
levied).
g. Bank allow loans against the Fixed Deposits on demand. Margin retained over
the deposit outstanding and interest rate charged thereon are decided by the
bank and may vary from bank to bank.

Normally the requirements as given under savings bank account apply to time
deposits also. However, photographs are not insisted for deposits below Rs.10,000/-.
Also the requirements regarding furnishing of PAN number applies only to time
deposits over Rs.50,000/- made in cash.

To suit the needs of the customers banks have introduced innovative variations in
the basic time deposit format. Flexible deposit is one such innovation. In this case a
given deposit is split into units of smaller amounts for accounting purposes. This
enables the customer to encash any number of units prematurely at any time during
the currency of the deposit and earn the contracted rate of interest on the balance
amount.

Domestic Deposits: -

A domestic deposit is the deposit/saving by a native resident of a country, in his own


country. So the money stays within the economy. It could be any of the deposits
discussed above.

NRI Deposits:-

An Indian Citizen who stays abroad for employment/carrying on a business or


vocation outside India, or stays abroad under circumstances indicating an intention
for an uncertain duration of stay abroad is a non-resident. Non-resident foreign
citizens of Indian Origin are treated on par with non- resident Indian citizen (NRIs).
Person can have Indian origin, if,

• He/she, at any time, held an Indian passport, or


• Parents or any of his grand parents having Indian citizenship.

NRIs can have the following investments in India.

• Maintain bank accounts in India.


• Investments in securities/shares, and deposits with Indian firms/companies.
• Investments in immovable properties in India.

Types of Non-Resident Bank Accounts

• Ordinary Non-Resident Accounts in Rupees [NRO]


• Non-Resident (External) Accounts in Rupees [NR(E)]
• Foreign Currency (Non-Resident) Account (Bank) Scheme [FCNR(B)]
• Non-Resident Non-Repatriable Rupee Account [NR(NR)]

Ordinary Non resident account in rupees

As the name suggests, it's an Ordinary Non-Resident Accounts in Rupees, known as


NRO account. The existing accounts of any Indian Nationals can be designated as
Ordinary Non-Resident Accounts, upon your NRI status, or these accounts can also
be opened with initial deposits paid into any bank or post office (saving a/c)
authorized to open Non-Resident accounts. NRO account can be of any type Saving,
current or Fixed deposit. Interest payable on NRO accounts is the same as on
resident accounts. They vary from bank to bank as they have been freed from RBI
regulation. You can also have a joint account with residents in India. NRO accounts
may be re-designated as resident accounts on the account holder becoming resident
in India.

Disadvantages of NRO:

i. Interest earned on balances in NRO Accounts is not exempted from Indian


Income tax. Instead income tax (at present @ 20%) is deducted at source
(TDS) i.e. at the time of payment of interest by the bank.
ii. Balance held in NRO account can neither be repatriated nor is any remittance
in foreign currency allowed without prior approval of Reserve Bank.

NRE Non Residential (External) ACCOUNT

The rates of interest on term deposit kept under NR(E) are generally higher than the
rates of interest on NRO deposits.

i. No income Tax.
ii. No joint account with an Indian residence.
iii. Non-Resident account holders can grant a power of attorney or such other
authority to any residents in India for operating their NR(E) Accounts in India.
Such authority is however, restricted to withdrawals for local payments. The
attorney holder cannot repatriate funds held in accounts outside India under
any circumstances or make payment of gifts on behalf of the account holder.
The rates of interest payable on NR(E) accounts are subject to change from time to
time as per directions issued from Reserve Bank of India.

An eligible Non-Resident Indian can open an account with any RBI approved
authorized bank.

A NRO account can't be converted into NRE, or funds can't be transferred from NRO
to NRE account without a special permission from RBI and proof of all existing funds
required, which is a complex procedure than opening a new NRE account.

The entire credit balance (inclusive of interest earned thereon) can be repatriated
outside India at any time without any reference to Reserve Bank of India.

Upon your returning and becoming Indian resident, NRE account can be converted
into your normal Resident Rupee Account.

Disadvantages of NR(E) Accounts:

NR(E) Accounts are opened in Indian rupees, and all foreign exchange remittances
received for credit of that account are first converted to Indian rupees at the buying
rates by the banks. The bank will permit any withdrawal in foreign currency, by
converting Indian rupees in the account to foreign currency at the selling rate. All
balances in the account are held in Indian rupees and are thus exposed to exchange
fluctuation risk.

FCNR (Foreign currency non-repatriable account)

The deposits under FCNR (Banks) scheme is held in foreign currency. The interest
and the repayment of the deposit is also made in the same foreign currency in which
the account is maintained. The depositor may at his own will, obtain repayment in
Indian rupees, converted at the buying rate on the date of repayment.

Deposits under this scheme are held for the following period: 6 months and above,
but less than 1 yr-1 yr and above but less than 2 yrs-2 yrs and above but less than 3
yrs-3 yrs only. Premature withdrawal is allowed, but there will be a penalty.

Non-Resident Account holders can grant power of attorney or such other authority to
residents in India for operating their FCNR(B) accounts in India. Interest rates are
subject to the RBI guidelines.

FCNR Accounts can be maintained in U.S. Dollar, Pound Sterling, Japanese Yen and
Deutshe Mark.

NRNR(Non- resident Non Repatriable) rupee deposit scheme

Accounts under the Non-Resident (Non-Repatriable) Rupee Deposit Scheme may be


opened in Indian rupees, out of the funds in freely convertible foreign exchange
transferred, for the purpose of India in an approved manner, from the country of
residence of the prospective non-resident account holder, or from any other country.
Transfer of funds from the existing NRE/ FCNR Accounts of the non-resident account
holder may also open accounts. No penal interest is charged in case of premature
withdrawal of existing NRE/ FCNR deposits for the purpose of making investment
under the Scheme.

Based on the kind of transactions

Cash Deposits:-

Cash deposits are the deposits with the banks or the financial institutions, where the
transactions happen in cash e.g. depositing cash, with drawing cash etc.

Bank Deposits:-

These are the deposits, where the transactions are bank-bank or bank-customer, but
is not in cash, these transfers may be through different financial instruments.
Unit Linked Plans Chapter-16

A ULIP is a unit linked insurance plan. In a unit linked plan the characteristics of both
insurance and mutual fund are combined wherein certain part of the investment is
directed towards providing insurance cover and remaining is put into asset classes in
a manner pre decided by the investor.

Insurance is a promise of compensation for specific potential future losses in


exchange for a periodic payment. Insurance is designed to protect the financial well-
being of an individual, company or other entity in the case of unexpected loss. Some
forms of insurance are required by law, while others are optional. Agreeing to the
terms of an insurance policy creates a contract between the insured and the insurer.
In exchange for payments from the insured (called premiums), the insurer agrees to
pay the policy holder a sum of money upon the occurrence of a specific event. In
most cases, the policy holder pays part of the loss (called the deductible), and the
insurer pays the rest. Examples include car insurance, health insurance, disability
insurance, life insurance, and business insurance.

A unit-linked insurance policy is a market – linked insurance plan with life cover
thrown in it. They can be viewed as a combination of insurance and mutual funds.
The difference between a ULIP and other insurance plans is the way in which the
premium money is invested. Premium from, say, an endowment plan, is invested
primarily in risk-free instruments like government securities and AAA rated corporate
paper, while ULIP premiums can be invested in stock markets(debt and Equity) in
addition to corporate bonds and government securities. The number of units that a
customer would get would depend on the unit price when he pays his premium. The
daily unit price is based on the market value of the underlying assets (equities,
bonds, government securities, et cetera) and computed from the net asset value.

In other words, it enables the buyer to secure some protection for his family in the
event of his untimely death and at the same time provides him an opportunity to
earn a return on his premium paid. In the event of the insured person's untimely
death, his nominees would normally receive an amount that is the higher of the sum
assured (insurance cover) or the value of the units (investments).

16.1 Key Features of ULIPS

a. Premiums paid can be single, regular or variable. The payment period too can
be regular or variable. The risk cover can be increased or decreased.
b. As in all insurance policies, the risk charge (mortality rate) varies with age.
However, for an individual the risk charge is always based on the age of the
policyholder in the year of commencement of the policy. These charges are
normally deducted on a monthly basis from the unit value. For instance, if
there is an increase in the value of units due to market conditions, the sum at
risk (sum assured less the value of investments) reduces and so the risk
charges are lower
c. The maturity benefit is not typically a fixed amount and the maturity period
can be advanced or extended.
d. Investments can be made in gilt funds, balanced funds, money market funds,
growth funds or bonds.
e. The policyholder can switch between schemes, for instance, balanced to debt
or gilt to equity, etc. The investment risk is transferred to the policyholder
f. The maturity benefit is the net asset value of the units(Number of units * the
market value of unit at that time).
g. The costs in ULIP are higher because there is a life insurance component in it
as well, in addition to the investment component.
h. Insurance companies have the discretion to decide on their investment
portfolios.
i. Being transparent the policyholder gets the entire episode on the performance
of his fund.
j. ULIP’s lead to an efficient utilization of capital(i.e. it lead to capital
appreciation)
k. ULIP products are exempted from tax and they provide life insurance.
l. Investor has the option to balance his risk by choosing among debt, balanced
and equity funds.

16.2 Differences Between Normal Insurance & ULIP

i. In ULIP the entry costs are high and the brokerage, commission could be as
high as 30% of the premium in the first year as compared to normal
insurance programs
ii. Management fee is low in a normal life insurance.
iii. The price of an insurance cover is higher in a ULIP than in a plain vanilla
insurance policy.
iv. Risk involved is high in unit linked insurance projects
v. Returns are erratic and linked to the vagaries of stock market.
vi. In ULIP the customer has the flexibility to determine his risk & return.

16.3 How does a ULIP work:

Rahul is a thirty-year old who wants a product that will give him market-linked
returns as well as a life cover. He wants to invest Rs 50,000 a year for 10 years in an
equity-based scheme. Based on this premium, the sum assured works out to Rs
532,000, the exact amount of premium being Rs 50,032.

Based on the current NAV of the plan that Rahul chooses to invest in, he is allotted
units in the scheme. Then, units equivalent to the charges are deducted from his
portfolio.

The charges in the first year include a 14 per cent sales charge, an administration
charge (7 per cent for the first Rs 20,000 and 3 per cent for the remaining Rs
30,000) and underwriting charges, which are deducted monthly.

Besides, mortality charges or the charges for the life cover are also deducted. For
the remaining nine years a 3.5 per cent sales charge and an administrative charge of
4 per cent (for the first Rs 20,000 and 2 per cent for the remaining Rs 30,000) are
levied in addition to mortality charges.

Fund management fee of 1.5 per cent (equity) and brokerage are also charged. This
cost is built into the calculation of net asset value(NAV)
On maturity - that is, after 10 years - Rahul would receive the sum assured of Rs
532,000 or the market value of the units whichever is higher.

Assuming the growth rate in the market value of the units to be 6 per cent per
annum Rahul would receive Rs 581,500; assuming the growth rate in the market
value of the units to be 10 per cent, Rahul would receive Rs 724,400.

In case of Rahul's untimely death at the end of the ninth year, his beneficiaries
would receive the sum assured of Rs 532,000 or the market value of the units
whichever is higher. Assuming the growth rate in the market value of units is 6 per
cent per annum, the value of investment would be Rs 510,200.

However, his family will get Rs 532,000 as it is the sum assured.

Assuming a growth rate of 10 per cent per annum, the value of units at the end of
the ninth year would be Rs 621,900. Hence, the beneficiaries would get Rs 621,900.

ULIPs offer a variety of options to the individual depending on his risk profile. For
instance, an individual with an above-average risk appetite can choose a ULIP option
that invests up to 60% of premium in equities. Likewise, an individual with a lower
risk appetite can select a ULIP that invests up to 20% of premium in equities.
However while there are no two opinions on the flexibility that ULIP’S afford to the
individual, ULIP costs are another issue altogether. An example would make things
clearer.

Suppose an individual, aged 30, wants to invest money in a ULIP from an insurance
company, ABC Ltd. The sum assured is Rs 200,000 and the tenure is 10 years. He
has opted for 100% investment in equities i.e. he has opted for the aggressive
growth fund option. The annual premium in this case works out to approximately Rs
19,000.

The following table gives a clearer picture of the cost breakup for ULIPs of ABC Ltd.
and what amount is invested to generate returns.

Premium breakup for ULIP from ABC Ltd

Premium Breakup 1st year 2nd year Onwards

Sales/Mktg expenses 14.0% 3.5%


Admn. Expenses 7.0% 4.0%
Underwriting expenses As Applicable
Mortality Charges As Applicable
Fund mngt. Expenses 1.5% 1.5%
Total (Approximately;
including underwriting and 25.0% 11.5%
mortality charges)

(The examples given above are illustrative. The figures will vary for
different companies).
From this premium, approximately 25.0% is deducted on account of various charges
in the 1st year by ABC Ltd. Sales and marketing expenses would account for 15.0%,
annual fund management fees 1.5% and administration expenses another 7.0%. The
rest (1.5%) would go towards covering mortality charges, underwriting charges and
other charges as may be applicable. This means only Rs 14,250 (75% of Rs 19,000)
worth of premium is invested in the portfolio of the investor’s choice in the initial
year. After the first year, these charges fall down to around 11.5% of the premium.
This means approximately Rs 16,815 (88.5% of Rs 19,000) would be invested.

The charges stated above would remain the same irrespective of whether the
individual has invested in debt funds or equity funds. Only the fund management
charges would vary.

If the same individual were to invest in a ULIP of another company, XYZ Ltd, a net of
27% each year would be deducted from his premium for the first 2 years and the
remainder would be invested. Third year onwards, these charges would fall to
approximately 5%.

Premium breakup for ULIP from XYZ Ltd

Premium Breakup Initial 2 years 3rd year onwards

Total expenses 27% 5%

(The examples given above are illustrative. The figures will vary for
different companies).

It is pretty apparent that investing in ULIPs from company XYZ Ltd would make more
sense than investing in ULIPs offered by ABC Ltd. This is due to XYZ Ltd’s
significantly lower costs third year onwards, despite higher costs in the initial period.
As can be seen from the table given below, the total premium invested by XYZ Ltd
over a 10-year period is Rs 172,140 which is higher than that invested by ABC Ltd
(Rs 165,585). This means that your money works harder for you in XYZ Ltd than if
invested in ABC Ltd.

‘Net investment’ comparison for ABC Ltd v/s XYZ Ltd

ABC Ltd (Rs) XYZ Ltd (Rs)

Premium for years 1 & 2 190,000 190,000


Actual amount invested in years 1 & 2 165,585 172,140

(The ULIP costs are based on those of existing life insurance companies.
The costs could vary for other companies).

An important point to be noted here: Returns announced by most companies on


ULIPs are on net premium (i.e. gross premium minus all expenses) and not the
actual premium paid by an individual.

An individual also has the choice to switch between various fund options. For
example, if he feels that the equity markets are too hot for him to handle, he could
switch to a debt fund. Most companies normally allow individuals to switch, a fixed
number of times annually free of cost. Later, they charge approximately Rs 100 per
switch. This cost too, has to be factored in while talking of implications on the overall
cost of investing in ULIPs.

Individuals therefore, when they decide to buy a ULIP, need to take these costs into
consideration as they have a long-term implication on the returns generated.

While the need for insurance is paramount in a person’s financial portfolio, it would
be advisable for him to understand his own risk appetite at the very outset and the
cost he will incur on investing in the unit-linked product.

• Administration charges: This ranges between Rs 15 per month to Rs 60 per


month and is levied by cancellation of units.
• Risk charges: The charges are broadly comparable across insurers.
• Asset management fees: Fund management charges vary from 0.6 per
cent to 0.75 per cent for a money market fund, and around 1.5 per cent for
an equity-oriented scheme. Fund management expenses and the brokerage
are built into the daily net asset value.
• Switching charges: Some insurers allow four free switches in every year but
link it to a minimum amount. Others allow just one free switch in each year
and charge Rs 100 for every subsequent switch. Some insurers don't charge
anything.
• Top-ups: Usually attracts 1 per cent of the top-up amount. Top-up normally
goes directly into your investment account (units) unless you specifically ask
for an increase in the risk cover.
• Surrender value of units: Insurers levy certain charges if the policy is
surrendered prematurely. This levy varies between insurers and could be
around 75 per cent in the first year, 60 per cent in the second year, 40 per
cent in the third year and nil after the fourth year.
• Fund performance: You could check out the performance of similar schemes
(balanced with balanced; equity with equity) across insurance companies.
Look at NAV performance over a period of at least two to three years. This
can only give you some indication about the credibility of the fund manager
because past performance is no guarantee to future returns, especially in
insurance products where the emphasis is on long-term performance (10
years or more).

Matters to be stated in life insurance policy

1. A life insurance policy shall clearly state:


a. The name of the plan governing the policy, its terms and conditions;
b. Whether it is participating in profits or not;
c. The basis of participation in profits such as cash bonus, deferred
bonus, simple or compound reversionary bonus;
d. The benefits payable and the contingencies upon which these are
payable and the other terms and conditions of the insurance contract;
e. The details of the riders attaching to the main policy;
f. The date of commencement of risk and the date of maturity or date(s)
on which the benefits are payable;
g. The premiums payable, periodicity of payment, grace period allowed
for payment of the premium, the date the last installment of premium,
the implication of discontinuing the payment of an installment(s) of
premium and also the provisions of a guaranteed surrender value.
h. The age at entry and whether the same has been admitted;
i. The policy requirements for
i. conversion of the policy into paid up policy,
ii. surrender
iii. non-forfeiture and
iv. revival of lapsed policies;
j. Contingencies excluded from the scope of the cover, both in respect of
the main policy and the riders;
k. The provisions for nomination, assignment, and loans on security of
the policy and a statement that the rate of interest payable on such
loan amount shall be as prescribed by the insurer at the time of taking
the loan;
l. Any special clauses or conditions, such as, first pregnancy clause,
suicide clause etc.; and
m. The address of the insurer to which all communications in respect of
the policy shall be sent.
n. The documents that are normally required to be submitted by a
claimant in support of a claim under the policy.

2. While acting under regulation 6(1) in forwarding the policy to the insured, the
insurer shall inform by the letter forwarding the policy that he has a period of
15 days from the date of receipt of the policy document to review the terms
and conditions of the policy and where the insured disagrees to any of those
terms or conditions, he has the option to return the policy stating the reasons
for his objection, when he shall be entitled to a refund of the premium paid,
subject only to a deduction of a proportionate risk premium for the period on
cover and the expenses incurred by the insurer on medical examination of the
proposer and stamp duty charges.
3. In respect of a unit linked policy, in addition to the deductions under sub-
regulation (2) of this regulation, the insurer shall also be entitled to
repurchase the unit at the price of the units on the date of cancellation.
4. In respect of a cover, where premium charged is dependent on age, the
insurer shall ensure that the age is admitted as far as possible before
issuance of the policy document. In case where age has not been admitted by
the time the policy is issued, the insurer shall make efforts to obtain proof of
age and admit the same as soon as possible.

16.4 DISADVANTAGES OF ULIPS

1. LOWER COVER - ULIPs are market-linked insurance plans with a life cover
thrown in. But the said cover is lower than most plain-vanilla plans (like
endowment plans) as a sizable portion of the premium goes towards
investments in market-linked instruments like stocks, corporate bonds and
government securities. The argument that IRDA has put forth is that the
primary purpose of insurance is to provide life cover; returns should play
second fiddle to the cover. This makes sense but the insurance companies
don’t seem to think so.
2. HIGHER COSTS- The primary focus of life insurance agents for selling ULIPs
has always been the alluring market returns compared to say, a plain
endowment plan. In a rising market, the returns do look good. But what these
agents fail to convey many a times, is the downside, were the markets to fall.
The agent sometimes handles this fact by telling the individual that he can
‘exit’ (by surrendering) from a ULIP any time after a minimum of three years
and also benefit from a ‘possible’ appreciation in stock prices over this period.
While this may be true, what individuals do not realise is, it is a costly affair
to exit a ULIP after just three years due to the high costs charged by ULIPs
upfront. ULIPs, due to their very nature, should always be considered with a
long-term view.
3. LACK OF QUALITY ADVICE TO CUSTOMERS-The life insurance industry
should also be proactive in educating individuals about life insurance. This is
especially so in case of ULIPs where individuals definitely need to be informed
about the risk-return proposition that ULIPs offer. Although one might argue
that the insurance agent is supposed to play that role, the current state of
affairs suggest otherwise. An issue worth contemplating is the so-called
‘financial consultants’ who sell, not a basket of financial products but only life
insurance. How can one be qualified to be a ‘financial consultant’ without
having the right credentials and with just one product at his disposal? No
doubt there is a certification course that needs to be cleared. But simply
clearing the Insurance Regulatory and Development Authority (IRDA) exam
doesn’t make anyone a financial consultant. Financial planning requires a lot
more grey cells and experience.
4. HIGHER RISKS–ULIP’s are risky investments and an ill – informed or
ignorant investor can lose his money. People who do not evaluate their risk –
profile can repent at later stages. Unit Linked products are finally products of
choice. If you feel equipped to manage your investments on your own or are
not comfortable with long lock-ins or you can't make the most of these tax
breaks, you may be better off investing elsewhere after securing your life
insurance needs.
1. There is a great need to disclose the risk involved in the schemes
properly to the investor/insurance seeker by the insurance/investment
companies.
2. The Insurance Regulatory and Development Authority has to issue set
of guidelines on ULIP policies offered in the market.
3. The charges in the initial years should be brought down.
4. The high returns (above 20 per cent) are definitely not sustainable
over a long term, as they have been generated during the biggest bull
Run in recent stock market.
5. Investors/Insurance seeker has to take switching charges into
consideration as they have a long-term implication on the returns
generated.
6. Investors should balance their risk - return profile before investing.
Derivatives Chapter-17

Derivative is a product whose value is derived from the value of one or basic
variables called bases (underlying asset, index or reference rate) in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset.

In the Indian context the Securities Contract (Regulation) Act 1956 (SC(R)A)
defines derivative to include-

a. A security derived from a debt instrument, share, loan whether secured or


unsecured, risk instrument or contract for differences or any other form of
security
b. A contract which derives it value from the prices or index of prices of
underlying securities

Derivatives are securities under the SC(R)A and hence the trading of derivatives is
governed by the its regulatory framework. There are four basic type of derivatives
under which all derivatives can be clubbed:-

a. A forward contract is an agreement to buy something at a specified price on


a specified future date
b. A futures contract is a standardized forward contract executed at an
exchange, a forum that brings buyers and sellers together
c. A swap contract is an agreement to exchange future cash. Typically one cash
flow is based on a variable or floating price and the other on a fixed one
d. An option contract grants its holder the right but not the obligation to buy or
sell something at a specified price on or before a specified future date. Most
are executed at an exchange

The main advantage of the derivative market is that it helps to transfer risk from
those who have them but may not like them to those who can manage them better.

The most commonly used underlying assets include:-

a. Commodities
b. Foreign exchange currency
c. Interest rates
d. Equities

17.1 Indices and cash settlement

Many derivatives have as their underlier not only some simple item such as a share
of stock or type of oil but rather an index or average price of a broad group of
related items.. Obviously one cannot buy or sell on a spot market the average stock
represented by ad equity index. . This is done using cash settlement. This means
that when the time comes for the underlying to be sold( or even before) the parties
don’t actually buy and sell the underlier. Instead the cash value of the derivative is
calculated and the cash is exchanged.

17.2 The forward contract


A forward contract is an agreement to buy or sell an asset at a future time for a
certain price. A forward contract is traded in the over the counter market usually
between two financial institutions or between a financial institution and its clients.

One of the parties to a forward contract assumes a long position and agrees to buy
the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same
date for the same price,. The party with an obligation to buy is known as the long
party as they hold the long position. The party with an obligation to sell is the short
party as they hold the short position. The guaranteed price is the delivery price of
the contract price and date on which the sale will transpire is the delivery date.

The key benefit of a forward is the mitigation of uncertainty since both the buyer and
the seller lock in a price that does not change. However one party would stand to
lose unless of course spot price equals the contract price. In most cases either the
long party will pay more than the spot or the spot party will receive less than the
spot.

A distinguishing characteristic of the forward is its bestowal of obligation. No matter


what the spot price of the underlier will be the long party must pay and the short
party must sell. For example if you are long at Rs 40 and the market price is Rs 30
on delivery date one must buy at Rs 40. Alternatively if the market price is Rs 40 and
you are short on Rs 30 you will still have to sell at Rs 30. This obviously can lead to
defaults. In a forward contract this is a credit risk one must take into account. In
practice forward counterparties can post collateral with each other in the form of
cash or marketable securities.

17.2.1 The following are the payoffs for a forward contract

P,fwd,long=S-K
P,fwd,short=K-S
S=spotprice
K = delivery price

Long and short forward payoff table:

S K P, fwd, long = S-K P, fwd, short = K-S


600 400 200 -200
500 400 100 -100
400 400 0 0
300 400 -100 100
200 400 -200 200

17.3 Difference between futures and forward contracts

a. While futures and forward contracts are both a contract to deliver a


commodity on a future date, key differences include:
b. Futures are always traded on an exchange, whereas forwards always trade
over-the-counter, or can simply be a signed contract between two parties.
c. Futures are highly standardized, whereas some forwards are unique
d. The price at which the contract is finally settled is different:
e. Futures are settled at the settlement price fixed on the last trading date of
the contract (i.e. at the end)
f. Forwards are settled by the delivery of the commodity at the specified
contract price.
g. The credit risk of futures is much lower than that of forwards:
h. Traders are not subject to credit risk because the clearinghouse always takes
the other side of the trade. The day's profit or loss on a futures position is
marked-to-market in the trader's account. If the mark to market results in a
balance that is less than the margin requirement, then the trader is issued a
margin call.
i. The risk of a forward contract is that the supplier will be unable to deliver the
grade and quantity of the commodity, or the buyer may be unable to pay for
it on the delivery day.
j. In case of physical delivery, the forward contract specifies to whom to make
the delivery. The counterparty on a futures contract is chosen randomly by
the exchange.
k. In a forward there are no cash flows until delivery, whereas in futures there
are margin requirements and a daily mark to market of the traders' accounts.

17.4 Futures contract

A futures contract is a type of derivative instrument, or financial contract, in which


two parties agree to transact a set of financial instruments or physical commodities
for future delivery at a particular price. If you buy a futures contract, you are
basically agreeing to buy something that a seller has not yet produced for a set
price. But participating in the futures market does not necessarily mean that you will
be responsible for receiving or delivering large inventories of physical commodities.
Buyers and sellers in the futures market primarily enter into futures contracts to
hedge risk or speculate rather than to exchange physical goods (which is the primary
activity of the cash/spot market). That is why futures are used as financial
instruments by not only producers and consumers but also speculators.

Unlike parties to a forward, the buyer and seller of a futures contract do not know
each other. The exchange takes care of matching buyers and sellers thus providing
liquidity. Also the liquidity is provided by strictly defining the terms of every contract
executed. The type, quantity and grade of the underlying, its delivery price and date
and sometimes even the delivery location is specified much before hand.

Parties to a forward contract realize their payoff only on delivery whereas the parties
to a futures contract realize a payoff at the end of every trading day. This helps to
reduce counterparty risk substantially. At the end of each trading day all outstanding
futures positions are valued or market to market by the exchange. Parties to a
positive mark to market get a gain the same day and those who have a negative
mark to market Parties to a forward contract realize their payoff only on delivery
whereas the parties to a futures contract realize a payoff at the end of every trading
day. This helps to reduce counterparty risk substantially. At the end of each trading
day all outstanding futures positions are valued or market to market by the
exchange. Parties to a positive mark to market get a gain the same day and those
who have a negative mark to market have to pay up accordingly. However losing
parties do not have to pay their entire bill. Instead based on creditworthiness and
other exchange rate rules, they may be entitled to pay only some percentage of their
obligation into a margin account. If their obligations should exceed a certain
threshold they will receive a margin call.
Though an exchange provides liquidity by always having buyers for prospective
sellers and vice-versa some contracts are more liquid than others. Also the liquidity
may change over time. This leads to liquidity risk which is simply the chance that
you may not find a trading opportunity at a desirable price when you are ready to
get out of a position.

Futures contracts ensure their liquidity by being highly standardized, usually by


specifying:

a. The underlying asset or instrument.


b. The type of settlement, either cash settlement or physical settlement.
c. The amount and units of the underlying asset per contract.
d. The currency in which the futures contract is quoted.
e. The grade of the deliverable.
f. The delivery month.
g. The last trading date.
h. Other details such as the commodity tick, the minimum permissible price
fluctuation

17.5 Pricing of a Futures Contract

17.5.1 In a futures contract the following factors affect the valuation

a. The difference between the spot and delivery. The spot keeps on changing but
the delivery price is constant. Hence the difference between the two keeps
changing
b. The cost of carry. This includes the cost of maintaining or carrying a forward
position over time. In case of commodities it would be storage and in case of
others it would be interest. Other costs of carry can include income paid to
the holder of an underlier such as dividends for stock underliers and
sometimes less tangible known as convenience yield this is the benefit of
possessing the underlier such as the ability to survive a shortage.

Forward Value long = (Spot price – Delivery price) + carry


Forward value short = (Delivery price – Spot price) + carry

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t),
will be found by compounding the present value S(t) at time t to maturity T by the
rate of risk-free return r.

F(t) = S(t) x (1+r)(T-t)

or, with continuous compounding

F(t) = S (t)er(T-t)

This relationship may be modified for storage costs, dividends, dividend yields, and
convenience yields.

In a perfect market the relationship between futures and spot prices depends only on
the above variables; in practice there are various market imperfections (transaction
costs, differential borrowing and lending rates, restrictions on short selling) that
prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage
boundaries around the theoretical price.

The above relationship, therefore, is typical for stock index futures, treasury bond
futures, and futures on physical commodities when they are in supply (e.g. on corn
after the harvest). However, when the deliverable commodity is not in plentiful
supply or when it does not yet exist, the futures price cannot be fixed by arbitrage.
In this scenario th price is set by simple supply and demand for the futures contract.

In a deep and liquid market, this supply and demand would be expected to balance
out at a price which represents an unbiased expectation of the future price of the
actual asset and so be given by the simple relationship.

F (t) = Et {S (T) }.

In case of a contract with storage the pricing relationship would be as follows:

When an underlier incurs a fixed storage cost, the forward price is the future value of
the sum of two things: spot S plus the present value of storage (By fixed we mean it
does not change with the price of the underlier)

Inthiscase
F = (S+U) ert

Example:

Assuming that a retailer company agrees to buy 5000 kilo of bananas from a local
farmer at one year forward. The banana is selling at the spot market at Rs 32 per
kilo. The cost of storing these bananas is 1.50 per kilo per quarter that is payable at
the beginning of the quarter. He risk free rate of interest is 3%. What is the correct
forward price.

First let us find the present value of the storage costs


5000X1.5=7500foreachquarter/
PV=7500+7500e-.03(.25)+7500e-.03(.50)+7500e.-.03(.75)
PV=7500+7443.96+73817.34+7333.13
PV=29665.43
S=32X5000=160,000
U=29665.43
R=.03
T=1
F=(S+U)ert
=(160,000+29665.43)*e.03(1)F = 195441.60

When storage costs change with the spot price of the underlier, then they are known
as proportional storage costs. Such costs are not unlike the cost of interest which
also depends on the price of the underlier. The forward price of an underlier with
proportional storage costs then is the future value of the underlier given a spot price
S, annual interest rate r an time period t with the interest rate adjusted by the
proportional storage cost u.

F = Se(r+u)t
In the above example if one were to assume that 2% cost of the spot prices was due
to spoilage, then the valuation would be such

S=5000X32=160,000
U=.02
R=.03
T=1
F=Se(r+u)t
=160000X2.7184(.03+.02)1
=160000X1.051273
= 168203.07

17.6 Forward/Futures with income

Incomes such as dividends on a stock underlier are like storage costs in reverse.
They represent benefits to the short party. Therefore the forward price is just the
future value of spot less the present value of income

F = (S-E)ert

Example

Assuming one agrees to buy 400 shares from a close friend in a year. The shares of
this company lets call it X is currently trading at Rs 36 per share. X pays to its
shareholders a quarterly dividend to its shareholders and the expected dividend is
0.25 paisa pr share. The risk free interest rate is 2%. What is the fair market forward
price?

There will be four dividend payments made at the end of each quarter for Rs 100.

PV income = 100 e-.02(.25) + 100e.-02(.50) + 100e.-02(.75) + 100e-.02(1)

PV=99.50+99.01+917.51+98.02
PV=395.04

S=36X400=14400
I=395.04
r=.02
t=1
F=(S-I)ert
F = (14400-395.04)X e.02(1)

F = 14287.88

Incase the underlier income is proportional to its spot price. In that case the formula
becomes

F = Se(r-i)t

Assuming in the above example instead of quarterly dividends, one expects that the
dividends will be . 5% of the share price per year.
In that case the value of the contract would be

14400X2.7184(.02-.005)1
14400 X 1.015114= 14617.64

17.7 Options

Options are types of derivative contracts, including call options and put options,
where the future payoffs to the buyer and seller of the contract are determined by
the price of another security, such as a common stock. More specifically, a call option
is an agreement in which the buyer (holder) has the right (but not the obligation) to
exercise by buying an asset at a set price (strike price) on (for a European style
option) or not later than (for an American style option) a future date (the exercise
date or expiration); and the seller (writer) has the obligation to honor the terms of
the contract. A put option is an agreement in which the buyer has the right (but not
the obligation) to exercise by selling an asset at the strike price on or before a future
date; and the seller has the obligation to honor the terms of the contract.

NOTE : It is the European style option which is used in India.

Since the option gives the buyer a right and the writer an obligation, the buyer pays
the option premium to the writer. The buyer is considered to have a long position,
and the seller a short position. For every open contract there is a buyer and a seller.
Traders in exchange-traded options do not usually interact directly, but through a
clearing house.

When ever there is an option contract the following things should be clearly
understood:

a. Whether it is call option or a put option


b. Who is the option buyer and who is the seller
c. What is the underlying security
d. What is the strike price
e. What is the premium to be paid for the contract?

Options will be in-the-money when there is a positive intrinsic value; when the strike
price is above/below (put/call) the security's current price. They will be at-the-
money when the strike price equals the security's current price. They will be out-of-
the-money when the strike price is below/above (put/call) the security's current
price. Options at-the-money or out-of-the-money have an intrinsic value of zero.

The time to expiration. The time value decreases to zero at its expiration date. The
option style determines when the buyer may exercise the option. Generally the
contract will either be

American style — Which allows exercise up to the expiration date — or

European style — Where exercise is only allowed on the expiration date — or

Bermudan style — Where exercise is allowed on several, specific dates up to the


expiration date.
17.8 Option payoffs

17.8.1 CALL OPTIONS

P, call, long = Max (0, S-K) ( Buyer of a call)

P, call, short = Min (0, K-S) ( Seller of a call)

Long call option payoff table

S K P, call, long = Max (0, S-K)


30 40 0
50 40 10
60 40 20

17.8.2 Short call option payoff table

S K P, call, long = Max (0, -K-S)


30 40 0
50 40 -10
60 40 -20

17.8.3 Put Option

P, put, long = Max(0, K-S) = Buyer of a put


P, put, short = Min( 0, S-K) = Seller of a put

17.8.4 Long Put Option Payoff Table:

S K P, call, long = Max (0, -K-S)


30 40 10
50 40 0
60 40 0

S K P, call, long = Max (0, S-K)


30 40 -10
50 40 0
60 40 0

Index futures/options, Stock futures/options:

http://www.bseindia.com/about/derivati.asp

http://www.lkpsec.com/website/index_futures.htm
Real Estate Chapter-18

The term ‘real estate’ is defined as land, including the air above it and the ground
below it, and any buildings or structures on it. It is also referred to as realty. It
covers residential housing, commercial offices, trading spaces such as theatres,
hotels and restaurants, retail outlets, industrial buildings such as factories and
government buildings. Real estate involves the purchase, sale, and development of
land, residential and non-residential buildings. The main players in the real estate
market are the landlords, developers, builders, real estate agents, tenants, buyers
etc. The activities of the real estate sector encompass the housing and construction
sectors also.

Realty would cover :

a. Residential housing
b. Commercial offices
c. Trading spaces (theatres, hotels and restaurants)
d. Retail outlets
e. Industrial buildings (factories and government buildings.)

Real estate deals in

a. Purchase
b. Sale
c. Development of land, residential and non-residential buildings
d. Housing And Construction Sectors.

18.1 The main players in the real estate market are the:

a. Landlords
b. Developers
c. Builders
d. Real estate agents
e. Tenants
f. Buyers etc.

18.1.1 Residential Property

In real estate brokerage terminology it simply means, owner-occupied housing. It


includes rental units used for dwelling purposes, not of a transient (hotel, motel)
nature. To qualify as residential at least 80% of a building's income should be
derived from dwelling units.

18.1.2 Commercial Property

Property designed for use by retail, wholesale, office, hotel/motel, or service users.

18.1.3 Industrial Property


Property used for industrial purposes, such as factories, industrial yards, or
developmental parks.

18.1.4 Retail Outlet

A retail outlet is a facility maintained by a manufacturer for selling a product at


retail. A facility may be a retail outlet even though some sales are made at wholesale
at such facility.

18.1.5 Landlord

A individual or an organization that owns and rents land, buildings or dwelling units.

18.1.6 Developers

A real estate developer builds on land, thereby increasing its value. The developer
may be an individual, but is often a partnership or a corporation.

18.1.7 Agent

A licensed salesperson working as a real estate agent. If the agent sells a house
successfully, then he/she receives a portion of the sale price as a commission.

18.1.8 Broker

Any person who for another, and for commission, money or other thing of value,
negotiates or offers or attempts to negotiate a sale, exchange, purchase or rental of
an interest or estate in real estate.

18.1.9 Tenant

A person/group of people who dwell in a residential property for a given period of


time at a specified amount of rent payable to the landlord of the property.

18.2 Types of real estate investments

18.2.1 REIT's

Real Estate Investment Trusts are companies that own, manage and operate income
producing real estate. They are organized so that the income produced is taxed only
once, at the investor level. By law, REITs must pay at least 90% of their net income
as dividends to their shareholders. Hence REITs are high yield vehicles that also offer
a chance for capital appreciation.

18.2.2 Real Estate Mutual Funds

These funds mostly invest in a select portfolio of REITs. Others invest in both REITs
and other publicly traded companies involved in real estate ownership and real
estate development. Real estate mutual funds offer diversification, professional
management and high dividend yields. Unfortunately, the investor ends up paying
two levels of management fees and expenses; one set of fees to the REIT
management and an additional management fee of 1-2% to the manager of the
mutual fund.

18.3 Real Estate Limited Partnerships

A limited partnership is a group investment whereby multiple individual investors


collectively finance a real estate venture by purchasing small shares of ownership in
the property. With a limited partnership, the limited partners have no say in
managing the investment; only the general partners do. Limited Partnerships are a
way to invest in real estate, without incurring a liability beyond the amount of your
investment. However, an investor is still able to enjoy the benefits of appreciation
and tax deductions for the total value of the property. LPs can be used by landlords
and developers to buy, build or rehabilitate rental housing projects using other
peoples money. Because of the high degree of risk involved, investors in Real Estate
Limited Partnerships expect to earn 20% + annually on their invested capital.

Real Estate Limited Partnerships allow centralization of management, through the


general partner. They allow sponsors/developers to maintain control of their projects
while raising new equity. The terms of the partnership agreement, governing the on-
going relationship, are set jointly by the general and limited partner's. Once the
partnership is established, the general partner makes all day to day operating
decisions. Limited partner's may only take drastic action if the general partner
defaults on the terms of the partnership agreement or is grossly negligent, events
that can lead to removal of the general partner. The LPs come in all shapes and
sizes, some are public funds with thousands of limited partners, others are private
funds with as few as 3 or 4 friends. Most partnerships do not go beyond 5-10 years.

18.4 High Yield Private Mortgage Notes

These notes are fully collaterized by income producing real estate, and are used by
the professional real estate investor for the acquisition, rehabilitation or equity cash
out of residential and commercial properties. Investors have the opportunity to
obtain above market returns of 12 - 14% in first trust deed positions and 15 - 18%
returns in second trust deed positions. These loans are usually for duration of one
year and provide a monthly income with interest only payments. These loans never
exceed 65% of the current appraised property value.

18.5 Rental of vacation property

Purchasing vacation property is one way for the average person to invest in real
estate. Properties in many areas can be purchased and rented out on a short-term
basis to vacationers. Most real estate investments are growth oriented, meaning the
return on our investment is based on how much our property increases in value from
the time you purchase it until the time you sell it. However, when we purchase rental
property (either residential or vacation), your focus will be on current income and
cash flow as well as possible personal use. Although you might someday sell the
property at a profit, the greater part of your return will likely come from rental
income.

18.5.1 Rental property


Rental property is distinct from vacation property. It typically refers to a dwelling
(single-family or multi-family) that you purchase with the intention of renting out.
Most real estate investments are growth oriented, meaning the return on your
investment is based on how much your property increases in value from the time
you purchase it until the time you sell it. However, when you purchase rental
property (either residential or vacation), your focus will be on current income and
cash flow. Although you may someday sell the property at a profit, the greater part
of your return will likely come from rental income. For this reason, rental property is
typically a long-term investment. For more information, see Rental Property.

18.5.2 Raw land

Investing in raw land involves the purchase of unimproved property, often with the
intent of building, leasing, or selling the land at a later date. Investing in raw land
may be as simple as purchasing a single lot in a subdivision on which to build a
home, or as complex as accumulating hundreds of unimproved acres to hold for
future development and subdivision. Speculators often invest in raw land, acquiring
tracts of land in anticipation of future rezoning. Regardless of your position and
purpose, the success of an investment in raw land depends on a few important
factors. Among these factors are the location and physical features of the property
itself, the timing of the investment, the opportunity cost of the investment, and (in
the case of a large-scale investment) whether the community and local governing
bodies are supportive of the development. For more information, see Raw Land.

18.5.3 Strategies for real estate

You can maximize the returns you get from real estate and/or reduce the risks if you
utilize the proper strategies. Although a number of possible strategies exist, the two
main ones are to invest directly in residential property and to invest directly in
commercial property. Residential property includes single-family dwellings, duplexes,
condominiums, and apartments. Commercial property includes business properties,
warehouses, factories, and professional office buildings. Despite the differences
between them, both strategies share certain potential advantages (e.g., capital
growth, current income) and risks (e.g., changes in general and local economic,
financial, and environmental conditions, interest rate changes, default risks).

18.5.4 Investing in commercial property

Compared to residential property investments, commercial property offers some key


advantages:

18.6 Advantages of Investing in Commercial Property:

18.6.1 Long-term secure cash flow

Commercial lets normally have long lease contracts, with periods of 10 years and
more not being uncommon. In addition to this, commercial property tenants are less
likely to default on payments and even if the tenant goes into liquidation, the
liquidator may continue paying the rent in order to stop the lease being forfeited.

18.6.2 Maintenance
Commercial tenants are generally liable for the maintenance and upkeep of the
property, contrasting with residential leasing, where the onus tends to be on the
landlord.

18.6.3 Income yield

Commercial property tends to deliver a relatively high income yield throughout the
rental period. In comparison residential property investors rely on the capital value
of the house increasing to generate a good return. This is fine during periods of
rising property prices, but less beneficial during property slumps.

Commercial property investments have also performed well in terms of growth and
stability, compared to equities and gilts over recent years.

18.6.4 Commercial Property Risks

In line with all investments, commercial property investment comes with its own
risks.

18.6.5 Poor liquidity

Compared to equities and bonds, property has poor liquidity, both in the time spent
finding a buyer and making the transaction. This can be further emphasised in poor
market conditions when the ability to find a buyer offering the right price will become
very difficult.

18.6.6 Poor diversification

The more diverse an investment portfolio, the less susceptible it will be to tough
market conditions. Investing in a single property can be a risky challenge.

18.6.7 Market performance

The property market is prone to cycles, as yields grow and decline depending on the
level of supply and demand for commercial property. Current rental rates could
decline in the future.

18.6.8 Sector performance

A decline in the sector that your property services could affect your investment. For
example a period of poor sales performance and market withdrawal in the retail
sector could lead to the demand for small store, supermarket, department store and
warehouse property to decline sharply.

18.7 What to look for when buying commercial property?

18.7.1 Location

The location of the property is very important and will be a major factor in
determining the value of property and rental income. Easy access to transport
networks is an obvious plus factor for most tenants, but consideration should also be
given to future developments in the area. For example, the development of a new
supermarket, might depreciate the value of small shops.

18.7.2 Type of building

The requirements of tenants can change over time, with implications on the type of
building they need. For example the move to open plan office space, could make
older buildings with their rigid enclosed spaces redundant. Many companies also look
for facilities like air conditioning and the ability to connect computer terminals
through under floor wiring.

18.7.3 Tenant quality

Properties whose tenants are reliable, present a low credit risk and hold a long-term
lease will hold a premium value.

18.7.4 Market factors

Try to identify which sectors and sub-sectors of the market will perform well in the
future. The same can be said for geographic regions, which might receive future
government or multi-national investment.

18.7.5 Legislative Issues

Much of the over 100 laws governing various aspects of real estate dates back to the
19th century. Despite the plethora of laws, the situation appears to be far from
satisfactory and major amendments to existing laws are required to make them
relevant to modern day requirements. The Central laws governing real estate
include:

a. Indian Contract Act, 1872


b. Transfer of Property Act, 1882
c. Special Relief Act, 1963
d. Urban Land (Ceiling And Regulation) Act (ULCRA), 1976
e. Land Acquisition Act, 1894
f. The Indian Evidence Act, 1872
g. The Rent Control Act,

http://planningcommission.nic.in/plans/planrel/fiveyr/10th/
volume2/v2_ch7_6.pdf

18.8 Valuation of real estate

In real estate the concept of market value must be interpreted differently from the
way it is in stocks and bonds. This is because each property is different, the terms
and conditions of sale differ widely, there is imperfect market information and
sometimes buyer and seller constraints and circumstances also affect property
valuation

There are three approaches to determining the fair market value of a


property: cost approach, sales comparison approach and income approach
18.8.1 Cost approach

The Cost approach is based on the approach that an investor should not pay more
for a property than it would cost to rebuild it at today’s price for land, labour and
construction. It can also be calculated also as the land value, plus the cost to
reconstruct any improvements, less the depreciation on those improvements. While
using the cost approach, in actual practice a combinaton of the cost and market data
methods is used. For instance, while the cost to construct a building can be
determined by adding the labor and materials costs together, land values and
depreciation must be derived from an analysis of the market data. This approach is
typically most reliable when used on newer structures, but the method tends to
become less reliable as properties grow older.

18.8.2 Sales comparison approach

The sales comparison approach uses the sales price of properties that are similar to a
subject property as the basic input variable. It simply means that the sales of
properties similar to the subject are analyzed and the sale prices adjusted to account
for differences in the comparables to the subject to determine the fair market value
of the subject. This method is good since it is able to demarcate an approximate
range of properties. Of course the requisite adjustments need to be made to account
for the supposed inferiority or superiority of the property.

18.8.3 Income approach or Income capitalization approach

The most popular is the income approach andit is called direct capitalisation. It is
represented by the following formula

Market value V) = Annual net operating income(NOI)/ market capitalisation rate(R)

V + NOI/R

The Net operating income (NOI) is gross potential rental income (GPI), less vacancy
(= Effective Gross Income) less property operating expenses and insurance (but
excluding debt service or depreciation charges applied by accountants).

18.8.4 Real estate in India Emerging Prospects:

http://www.ficci.com/realestatesummit2006/new-
htm/summit2005/backgroung2005.doc
Chapter 19

19.1 Art and Antiques

Art and antiques are extremely vulnerable to fluctuations in public tastes and other
factors, so they are considered high-risk, speculative investments. Most investment
consultants feel that one should invest in art and antiques primarily because one
likes them, and only secondarily because they may return a profit. Also not more
than 10-15 percent of the value of the investment portfolio must not be kept into art
and antiques.

19.1.1 Basic Rules for Investing In Art and Antiques

Before buying art and antiques for investment purposes, keep the following basic
rules in mind:

a. Limit the field of your investment collection. Risk is reduced by information.


It's not so important what you collect but that you like it and want to learn
about it. Read everything you can about your specific area of interest. Consult
museums, design centers, universities, other collectors or dealers in your
specialty, trade journals, magazines, books and related associations.
b. Find a reputable dealer who has been in the business for many years -- long
enough to know about quality, market trends and pricing practices in the field
in which you want to collect/invest.
c. Buy top quality. Top-quality items are expensive; however, they tend to
appreciate even in poorer market times. Medium-quality items often do little
more than keep pace with inflation. Limit yourself to a field in which top
quality is within your budget.
d. Obtain a written appraisal or certificate from a leading appraiser or certifier in
your field attesting to the quality and authenticity of the item.
e. Maintain the item properly with appropriate environmental conditions and
regular maintenance. If repairs are required, they should be made only by
well-trained experts.
f. Insure the item adequately. Most homeowner policies allow for fire and theft
but not natural disasters, such as floods, or accidents. Have your works
included on a scheduled form of all risks for coverage in the event of theft,
fire or breakage.
g. Make a detailed plan for disposal. Your attorney or estate manager may not
be sensitive to the value or importance of your investment collection.

19.1.2 Evaluating the appraisal for art and antiques:

a. The amount of money that a seller originally paid for art has no bearing on
that art's fair market value. Sellers overpay for art all the time and you, as a
buyer, are not required to compensate them for their mistakes.
b. A work of art that's appraised at Rs 5 lakh for example, but that's priced for
sale at Rs 2 lakh, is not necessarily a bargain. As stated above, a retail or
insurance appraisal can be for many times the fair market value of a work of
art. Always determine fair market value first, no matter how big a bargain the
seller makes you think you're getting.
c. Make sure any appraisal you are given is current and has been done within
the past three years or so. Art prices fluctuate over time. An appraisal dating
from the art boom of the late 1980's, for instance, can easily state a dollar
amount far beyond what the art currently sells for.

19.1.3 Quality

Top quality is the best investment. The following generalized guidelines should be
helpful in identifying quality. Reputable dealers will have years of experience to offer,
and most are willing educators. However, dealers and galleries generally operate at
retail, often resulting in a 50 to 100 percent markup to the buyer.

Major auction houses may not offer educational resources for a special field and
generally are not places for a beginning investor to buy. However, once you have
developed a level of expertise, auction houses can be excellent sources of art and
antiques. Two major advantages are the sheer volume and variety of items offered,
and the lack of retail markups, resulting in lower prices.

To locate dealers, ask other collectors or officials of your local or regional art
museum for names and addresses of those specializing in your area of interest.
Some of the leading auction houses are listed below. Find out which ones hold
special sales for your area of interest and get on their mailing lists for future sales.
Most publish pre-sale exhibition catalogs describing the items to be sold.

19.1.4 Antiques

a. The particular school of the artist or craftsman and that person's degree of
skill.
b. A traditional, classical form produced in limited number.
c. Good proportion and choice selection of materials.
d. State of preservation -- excellent condition and original finish.

19.1.5 Fine Art

a. The artist's technical skill in handling the chosen medium.


b. The strength of the message conveyed by the artist.
c. The condition and degree of restoration.

19.1.6 The Advantage Of Investing In Good Art

It survives economic downturn. In art markets cumulative selling pressure arises


only during economic depression and that is primarily confined to the lower segment
of the art market. "The long-term trend in inflation adjusted art prices follows the
general economic trend, i.e., art prices rise above average compared to the prices of
other goods. However, lower priced categories react quickly to worsening economic
environment. An economic slowdown causes drop in demand and an increase in
supply (plummeting assets and income trigger offloading), leading to forced selling.
This, however, does not apply at all or only rarely to artworks in the top price
category. Consequently, top-quality art tends to be more stable than most financial
investments in difficult times.

The long term trend for art prices would tend to be upward simply because art is F a
scarce product and not reproducible at will. Rising incomes over the long-term
ensure a steady rise in demand for works of art against falling supply.
Secondly art and antiques popularity as an investment option arises due to its low
correlation with other financial assets.

19.1.7 Risks in investing in art and antiques:

The unique investment as it is, art market has some unique risks. Successful
investment in art requires not only extensive know-how about the artistic quality and
authenticity but also the peculiar nuances of the art market. As each work of art is
different, the markets are everything but transparent. Evaluating quality and price
requires knowledge of the market inside out. There are potentially large differences
in expertise between buyers and sellers. And the art markets are often cloaked by
veil of secrecy.

Investment horizons typically run for years or even decades, and the market is
generally illiquid, which significantly limits an investors' ability to convert a holding to
cash. Transaction costs (auction fees, appraisal fees, insurance, handling costs etc.)
are by far larger than in other markets. Though there has been increase in
availability of and access to data from art-research firms, websites dedicated to
prices of art, indices of the art market and art auctions, it is far from adequate.

The main trouble with investing in art is that it is almost impossible to identify an
intrinsic value. When evaluating individual purchases, there are few risks that may
not arise when investing in securities. For example, there is no official registration
office or certification authority that can authenticate the ownership of individual
artworks. Other transaction risks include absence of clear title, forgery, mislabeling,
and auction fraud. These risks have made art market a place for insiders.

On a physical level, art typically requires a specially controlled environment where


temperature, humidity and light are continuously monitored.

The increase in the market rate of an art piece is also quite subjective and
unpredictable – two contemporary paintings of different style or similar style
paintings done in different periods by the same artist and of identical size and
subject fetch drastically different prices. Market price is not entirely a function of
demand and supply, but is considerably determined by what the critics and curators
have to say about the value of the piece. And until the piece is sold, there is no
income the investor receives like dividend in equity or interest in bonds. It is in the
end an unregulated market.

The minimum investment needed to begin investing in art is quite high and therefore
this route is available to only very high networth individuals.

Possible Risks and Benefits of Art Investment.


Risks Benefits
Possibility of owning/selling frauds and fakes Possession of rare or one of a kind item.
Illiquid auction/dealer markets. “Non paper” financial asset.
Maintenance, restoration costs. Potential price appreciation.
Artworks produce no income unless sold. May have limited correlation to other assets.
High transaction fees Possible diversification benefits.

19.2 Investing in Gold


Gold was in use as a form of money, in one form or another, at least from 100% BC
until the end of the Bretton Woods system in 1971. It was used as a store of value
both by individuals and countries for much of that period. However in recent times it
is still considered as a store of value, a safe haven, anti inflationary and as an
insurance in crisis situations.

Considering its high density and high value per unit mass, storing and transporting
gold is very easy. Gold also does not corrode. Gold has the potential for
appreciation (or depreciation), but lacks the two other components of total return:
interest and compound interest. Besides physical gold now gold can be purchased
through a gold exchange traded fund or in the form of gold certificate.

19.2.1 Why own Gold?

There are six primary reasons why investors own gold:

a. As a hedge against inflation.


b. As a hedge against a declining dollar.
c. As a safe haven in times of geopolitical and financial market instability.
d. As a commodity, based on gold’s supply and demand fundamentals.
e. As a store of value.
f. As a portfolio diversifier.

Gold is a monetary metal whose price is determined by inflation, by fluctuations in


the dollar and U.S. stocks, by currency-related crises, interest rate volatility and
international tensions, and by increases or decreases in the prices of other
commodities. The price of gold reacts to supply and demand changes and can be
influenced by consumer spending and overall levels of affluence. Gold is different
from other precious metals such as platinum, palladium and silver because the
demand for these precious metals arises principally from their industrial
applications. Gold is produced primarily for accumulation; other commodities are
produced primarily for consumption. Gold’s value does not arise from its usefulness
in industrial or consumable applications. It arises from its use and worldwide
acceptance as a store of value. Gold is money. In contrast to other commodities,
gold does not perish, tarnish or corrode, nor does gold have quality grades. Gold
mined thousands of years ago is no different from gold mined today. Therefore, gold
existing in the aboveground gold stock is interchangeable with newly mined gold.

19.2.2 Hedge Against Inflation

Gold is considered as a hedge against inflation. The most consistent factor


determining the price of gold has been inflation - as inflation goes up, the price of
gold goes up along with it. Since the end of World War II, the five years in which
U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During
those five years, the average real return on stocks, as measured by the Dow, was -
12.33%; the average real return on gold was 130.4%.

a. Oil, Inflation and Gold


Although the prices of gold and oil don't exactly mirror one another, there is no
question that oil prices do affect gold prices. If oil prices rise or fall sharply, investors
can expect a corresponding reaction in gold prices, often with a lag.

There have been two major upward moves in the price of gold since it was freed to
float in 1968. The first occurred between 1972 and 1974 when oil prices climbed
325%, from $2.44 to $10.36. During the same period, gold prices rose 268% (on a
quarterly average basis) from $47.45 to $174.76.

The second major price move occurred between 1978 and 1980, when oil prices
increased 105%, from $12.70 to $26.00. Over the same period, quarterly average
gold prices rose 254% from $178.33 to $631.40.

19.2.3 Gold - Hedge Against a Declining Dollar

Gold is bought and sold in U.S. dollars, so any decline in the value of the dollar
causes the price of gold to rise. The U.S. dollar is the world's reserve currency - the
primary medium for international transactions, the principal store of value for
savings, the currency in which the worth of commodities and equities are calculated,
and the currency primarily held as reserves by the world's central banks. However,
now that it has been stripped of its gold backing, the dollar is nothing more than a
fancy piece of paper.

19.2.4 Gold as a Safe Haven

Despite the fact that the United States is the world's only remaining superpower,
there are a myriad of problems festering around the world, any one of which could
erupt with little warning. Gold has often been called the "crisis commodity" because
it tends to outperform other investments during periods of world tensions. The very
same factors that cause other investments to suffer cause the price of gold to rise. A
bad economy can sink poorly run banks. Bad banks can sink an entire economy.
And, perhaps most importantly to the rest of the world, the integration of the global
economy has made it possible for banking and economic failures to destabilize the
world economy. As banking crises occur, the public begins to distrust paper assets
and turns to gold for a safe haven.

When all else fails, governments rescue themselves with the printing press, making
their currency worth less and gold worth more. Gold has always risen the most when
confidence in government is at its lowest.

19.2.5 Gold - Supply and Demand

First, demand is outpacing supply across the board. Gold production is declining;
copper production is declining; the production of lead and other metals is declining.
It is very difficult to open new mines when the whole process takes about seven
years on average, making it hard to address the supply issue quickly.

19.2.6 Gold – Store Of Value

will always maintain an intrinsic value. Gold will not get lost in an accounting scandal
or a market collapse.
“…although the gold price may fluctuate, over the very long run gold has consistently
reverted to its historic purchasing power parity against other commodities and
intermediate products. Historically, gold has proved to be an effective preserver of
wealth. It has also proved to be a safe haven in times of economic and social
instability. In a period of a long bull run in equities, with low inflation and relative
stability in foreign exchange markets, it is tempting for investors to expect continual
high rates of return on investments. It sometimes takes a period of falling stock
prices and market turmoil to focus the mind on the fact that it may be important to
invest part of one’s portfolio in an asset that will, at least, hold its value.”

Economist Stephen Harmston of Bannock Consulting had this to say in a 1998 report
for the World Gold Council,

19.2.7 Gold - Portfolio Diversifier

The most effective way to diversify your portfolio and protect the wealth created in
the stock and financial markets is to invest in assets that are negatively correlated
with those markets. Gold is the ideal diversifier for a stock portfolio, simply because
it is among the most negatively correlated assets to stocks.

Investment advisors recognize that diversification of investments can improve overall


portfolio performance. The key to diversification is finding investments that are not
closely correlated to one another. Because most stocks are relatively closely
correlated and most bonds are relatively closely correlated with each other and with
stocks, many investors combine tangible assets such as gold with their stock and
bond portfolios in order to reduce risk. Gold and other tangible assets have
historically had a very low correlation to stocks and bonds.

http://www.blanchardonline.com/gold_as_investment/why_own_gold.php
Investment Process Chapter-20

Investing is a process that comprises of many elements. Successful investment to


fulfill the myriad goals consists of a step by step analysis of the needs of the person,
the constraints and the options that are available to meet those requirements. The
task becomes all the more difficult considering that each individual is unique and a
one size approach fits all does not work. One has to understand the financial
condition of the person, his attitude towards risk, his needs and preferences and
above all his ability to sustain the investments that he has entered into. Beyond
that investments have to be selected from the vast universe of investments that fit
the profile and needs of the individual.

The steps that are involved in this process can be summed as follows:

a. Determine financial condition, goals and risk tolerance.

i. What are you worth? How much are you saving/ spending?
ii. What are your goals? How much and when?
iii. How much risk are you willing to take to reach your goals?
iv. Should you be handling your own investments?

b. Determine the appropriate asset allocation

c. Select investment vehicles and implement strategy


i. Taxable or tax free
ii. Active or passive
iii. Mutual funds, individual securities, or others
iv. Market timing

d. Monitor portfolio, reevaluate goals and constraints and rebalance


i. Rank performance
ii. Reevaluate goals and constraints
iii. Rebalance portfolio

e. Document your results

20.1 Financial Conditions


Financial conditions consist of figuring out the various expenses and income heads
and realistically finding out the savings that one can make over various periods. It
also consists of finding out one’s net worth at the present moment and also how it is
expected to change in the next ten years. Given below is an example of worksheets
designed to calculate one’s budget and savings as well as net worth.
20.1.1 Cash Flow Calculation
a. Net Income

Target Actual Per period


1. My after tax salary or wages
2. My partner's after tax salary or wages
3. Business income
4. Interest / earnings on investment
5. Board or rent received
6. Superannuation received
7. Child support
8. Family support
9. Social assistance
10. Student allowance / loan
11. Family help
12. Other

Current Regular Saving

20.20.2 pending

Target Actual Per period


Car
1.Registration
2. Insurance
3. Petrol
4. Maintenance
Rent
Debt repayments
1. Mortgage
2. Student loan
3. Other loans
4. Hire purchase
5. Credit cards

Current Regular Saving

Insurance
1. Home
2. Contents
3. Medical
4. Your life
5. Your partner's life
6. Your income protection / disability
7. Your partner's income protection / disability
8. Other
Education
1. Children's school expenses (e.g. transport, school trips, books)
2. School uniforms
3. School fees
4. Tertiary education fees
5. Student services levy
6. Other levies
7. Text books / photocopying etc.
8. Other
Utilities
1. Electricity
2. Gas
3. Water
4. Telephone
5. Rates
6. Body corporate fees (apartments)
7. Mobile phone's

Food etc.
1. The big shop / supermarket
2. Bought lunches/Takeaways
Child care
1. Creche / nanny
2. Babysitting

Clothing / grooming
1. Adults' clothes
2. Children's clothes
3. Hairdresser
4. Chemist / toiletries
Support to family
Child support payments
Gardening / landscaping
Medical
1. Doctor
2. Dentist
3. Prescriptions and medicines
4. Other
New or replacement items
1. Car
2. Bikes / sports gear
3. Furniture
4. Appliances
5. House contents
6. Musical instruments
Repairs - Appliances
Repairs & maintenance - House
1. Painting and decorating
2. Plumbing
3. Electrical
4. Alterations / improvements
Travel to work
Alcohol/Cigarettes
Donations
Entertainment / Recreation
1. Dining out/bars/clubs
2. Club subscriptions (e.g. gym)
3. Children's activities
4. Tickets for sports games and concerts/outdoor recreation
5. Movies
Gifts
1. Family
2. Other
Holidays
1. The big annual holiday
2. Short breaks, weekends away
3. Overseas trips
Newspaper / magazines
Pay TV
Pets

20.2 Net Worth Calculation

2007 2012 2017


ASSETS (What you own)
Your home
Other properties
Superannuation savings
Shares
Other savings
Value of business
Vehicles
Trust
Other

LIABILITIES ( What you owe)


Mortgages
Personal loan
Hire purchase
Student loan
Credit card debt
Other

Net Worth = Assets - Liabilities

20.2.1 Goal Setting

The next step is figure out the various goals and their priority. It is important to
spend substantial amount of time on the same so as to be able to clearly identify
one’s priorities and the amount that is needed to achieve them.

20.3 Where do I want to be financially?

Write your goals here and work out the appropriate time frame.

a. In six months?
b. In two years?
c. In five years?
d. In ten years?
e. At retirement

20.3.1 Your priorities

What's important to you? What are the key things you need to do to improve your
financial position? Take a look at this list to help you work out your priorities for
getting sorted. Rank these from 1 being most important, to 5 being least important .

LIABILITIES ( What you owe) 1 2 3 4 5


Improve my income or my ability to earn future income.
Get better control over my spending to help me to save or reduce debts.
Get started on a regular long term (over 10 years or for retirement) savings
programme or increase my level of savings.
Start a short term savings programme to buy a house or other major asset
Protect the income and assets I already have and ensure I have properly
provided for my family and other dependants.
Any other

Actions I will take to achieve my goals (be very specific).

Priority 1: By: Date(__/__/__) I plan to :


Priority 2:
Priority 3
Priority 4:
Priority 5:
20.4 Investment Profile/Risk Profile

Broadly speaking there are four factors that one considers while looking at the
investment profile of a person. The first is the duration of the investment which
would vary depending upon the type of goal. The duration various from very short
that is less than one year, short term – 1-3 years, medium term- 3-7 years and long
term more than 7 years. The second the returns that is required both on individual
investments and on the whole portfolio. It also means how much of returns one
would like as capital appreciation or lump sum and how much as regular income. The
third is the approximate estimate of liquidity. A certain amount of the investment
portfolio needs to be put in liquid assets so that you can pay for daily expenses and
also keep some for a rainy day. However since the return on liquid assets is less, the
more you keep in those assets the lower would be the overall return on your
investments. The fourth aspect to be considered is the taxation on various
investments that affect the overall return. The fifth and the last aspect is the risk
inherent in various forms of investment and your attitude towards it. The higher the
risk you take, the higher returns you could receive, but the more chance you have of
taking a loss. With a low risk investment, you generally know the return you will
receive right up front.

Higher returns are only available with higher risk. The risks come in two types,
volatility, which is the possibility that the value of your investment will go up and
down, and performance, which is the possibility that the investment could be a flop
and you lose all or part of your money. Or, the investment gives you a lower return
than you expected or needed.

Most portfolio managers recommend you take a risk tolerance test. Each one has is
or her own risk tolerance assessment tests. Given below is a small example of what
a risk tolerance questionnaire would look like. However these tests are not watertight
and there is a fair amount of subjectivity involved in the process. Moreover each
different test one takes there is a fair chance that the results may be different. In
addition they have to be supplemented with an understanding of your financial
situation, and the advisor’s own assessment of your needs and requirements.

20.5 Risk Recommender Calculator

1. Indicate your age group

a. Over 50
b. 40-50
c. Under 40

2. Indicate your annual income group

a. Below 40,000
b. 40,000 - 60,000
c. Over 60,000

3. How long do you expect to have others substantially dependent on you for
financial support?

a. More than 10 years


b. Up to 10 years
c. Not at all

4. How do you see the security of your job or business over the next 5 years?

a. Not good
b. Satisfactory
c. Very Good

5. Relative to your goals, what level of savings and other assets do you have now?

a. Very Low
b. On Track
c. High

6. Which description best fits you?

a. Conservative, worry about money


b. I like things to go according to my plans - I like to be in control
c. Very comfortable in taking a calculated risk with money

Investing does not have to be rocket science, but you should understand the basics
of portfolio management and diversification and be familiar with Historical rates of
returns and risks for the major Asset classes.

Summary Statistics of U.S. Investments from 1926 through March, 1995. Source: Ibbotson Associates
Investment geom. mean arith.mean std high ret. low ret.
S&P total return 10.30 12.45 22.28 42.56 -29.73
U.S. Small Stock TR 12.28 17.28 35.94 73.46 -36.74
U.S. LT Govt TR 4.91 5.21 8.00 15.23 -8.41
U.S. LT Corp. TR 5.49 5.73 7.16 13.76 -8.90
U.S. 30 day T-Bills 3.70 3.70 .96 20.35 -0.06

1926-1996 Average annual rates of return

Small Stocks 12.5%


Real Estate 120.1%
DJI 10.0%
Bonds 5.2%
T-Bills 3.7%
Inflation 3.1%

Source: Ibbotson associates


Asset Allocation Chapter-21

Asset Allocation involves dividing an investment portfolio among different asset


categories, such as stocks, bonds, and cash. The Asset Allocation that works best for
you at any given point in your life will depend largely on your time horizon and your
ability to tolerate risk.
The time horizon is the expected number of months, years, or decades you will be
investing to achieve a particular financial goal. An investor with a longer time horizon
may feel more comfortable taking on a riskier, or more volatile, investment because
he or she can wait out slow economic cycles and the inevitable ups and downs of our
markets.
Risk tolerance is your ability and willingness to lose some or all of your original
investment in exchange for greater potential returns. An aggressive investor, or one
with a high-risk tolerance, is more likely to risk losing money in order to get better
results. A conservative investor, or one with a low-risk tolerance, tends to favor
investments that will preserve his or her original investment.
Apart from the mandatory understanding of an individual’s financial situation and his
risk tolerance, Asset Allocation also involves an understanding of the capital market
and the investment opportunities. This study should include current levels of stock
and bond indices, their historical changes, inflation projections and also studies of
therealestatevalues.
http://www.sec.gov/investor/pubs/assetallocation.htm

The final analysis is to match the available investment opportunities with the
investor’s risk tolerance and then go about Asset Allocation. This process is known as
integrated Asset Allocation. Sometimes it may be desirable to skip some of the steps
in the allocation process. Depending upon the steps that are skipped, Asset
Allocation can be of three types- strategic Asset Allocation, tactical Asset Allocation
and insured Asset Allocation.

21.1 Strategic Asset Allocation


The strategic Asset Allocation is also termed as policy allocation analysis. This
process is carried out at regular time gap maybe once in three years. This process
uses Monte Carlo simulation to find the outcomes of each asset mix. Once the
analysis is complete the investor is asked to look at the range of outcomes and
select the preferred one. In most of such analysis, each asset mix is expressed in
terms of the percentage of the total amount invested in each asset class. This
approach is termed as constant asset mix strategy.

It is to be noted that in such studies one assumes long run capital market studies.
In such studies the expected returns, risk and the various correlations remain
constant throughout the simulation process. Also one assumes that the risk
tolerance as well as the percentage asset mix is held constant.
21.1.1 Tactical Asset Allocation
Tactical Asset Allocation is more of a routine activity performed as a part of
continuing asset management. It seeks to take advantage of the inefficiencies in the
different class of securities. However the risk tolerance of the investor is held
constant.
21.1.2 Insured Asset Allocation
Similar to the tactical Asset Allocation procedures, the insured Asset Allocation is
also carried on in a routine and timely manner. It is aimed at achieving the
objectives of the investor without depending on market timing, unlike tactical Asset
Allocation. The insured Asset Allocation seeks more to suit long term investors
objectives. It switches between bonds and treasury bills. A minimum value of the
net worth or asset value as the case may be is based on the goal which is also
called the floor. If the value of the assets or net worth crosses the floor the
allocation to risky asset is increased. Above the floor higher the value higher is the
allocation to risky assets. Similarly lower the values lower the allocation to risky
assets. Thus the asset mix is conservative. This type of Asset Allocation does not as
can be seen focus on the desirability of investing in more risky assets based on their
risk-return characteristics. The strategy is based on the assumption that expected
risks and correlations remain the same over the period during which the insurance
is in force. The risk tolerance of the investor is also expected to be constant.

21.2 Different approaches to Asset Allocation decision


a) 100 minus your age method: According to this method, the percentage of your
total investment that can be invested in equities depends on your age and is based
on the premise that you will live upto 100 years. The rest may be placed in bonds
and other safe investments.

b) Financial objectives method: It simply says plan your financial needs in future
and invest enough money so that you will be able to realize them

c) Cash flows needs method: This involves projecting the cash flows of the future
and estimating the deficit if any. Investments will then be aimed at filling the deficit.
The outflows expected should be subtracted from the inflows expected. If there is a
surplus then one can go in for conservative or safe investments. In case there is a
deficit, investments will have to be made aggressive and the degree of
aggressiveness will depend on the amount of deficit and the amount now available
for investment

d) Risk tolerance method: This method only focuses only on the psychology of the
individual. A risk averse investor should invest all his money in safe instruments and
a risk lover may invest in high risk instruments
21.3 Why Asset Allocation Is So Important
By including asset categories with investment returns that move up and down under
different market conditions within a portfolio, an investor can protect against
significant losses. Historically, the returns of the three major asset categories have
not moved up and down at the same time. Market conditions that cause one asset
category to do well often cause another asset category to have average or poor
returns. By investing in more than one asset category, you'll reduce the risk that
you'll lose money and your portfolio's overall investment returns will have a
smoother ride. If one asset category's investment return falls, you'll be in a position
to counteract your losses in that asset category with better investment returns in
another asset category. The practice of spreading money among different
investments to reduce risk is known as diversification. By picking the right group of
investments, you may be able to limit your losses and reduce the fluctuations of
investment returns without sacrificing too much potential gain.
In addition, Asset Allocation is important because it has major impact on whether
you will meet your financial goal. If you don't include enough risk in your portfolio,
your investments may not earn a large enough return to meet your goal. On the
other hand, if you include too much risk in your portfolio, the money for your goal
may not be there when you need it. A portfolio heavily weighted in stock or stock
mutual funds, for instance, would be inappropriate for a short-term goal, such as
saving for a family's summer vacation.

21.4 The Connection Between Asset Allocation and Diversification


Diversification is a strategy that can be neatly summed up by the timeless adage
"Don't put all your eggs in one basket." The strategy involves spreading your money
among various investments in the hope that if one investment loses money, the
other investments will more than make up for those losses.

Many investors use Asset Allocation as a way to diversify their investments among
asset categories. But other investors deliberately do not. For example, investing
entirely in stock, in the case of a twenty-five year-old investing for retirement, or
investing entirely in cash equivalents, in the case of a family saving for the down
payment on a house, might be reasonable Asset Allocation strategies under certain
circumstances. But neither strategy attempts to reduce risk by holding different
types of asset categories. So choosing an Asset Allocation model won't necessarily
diversify your portfolio. Whether your portfolio is diversified will depend on how you
spread the money in your portfolio among different types of investments.

A diversified portfolio should be diversified at two levels: between asset categories


and within asset categories. So in addition to allocating your investments among
stocks, bonds, cash equivalents, and possibly other asset categories, you'll also
need to spread out your investments within each asset category. The key is to
identify investments in segments of each asset category that may perform
differently under different market conditions.

One of way of diversifying your investments within an asset category is to identify


and invest in a wide range of companies and industry sectors. But the stock portion
of your investment portfolio won't be diversified, for example, if you only invest in
only four or five individual stocks. You'll need at least a dozen carefully selected
individual stocks to be truly diversified.

Because achieving diversification can be so challenging, some investors may find it


easier to diversify within each asset category through the ownership of mutual
funds rather than through individual investments from each asset category. A
mutual fund is a company that pools money from many investors and invests the
money in stocks, bonds, and other financial instruments. Mutual funds make it easy
for investors to own a small portion of many investments. A total stock market
index fund, for example, owns stock in thousands of companies. That's a lot of
diversification for one investment!

Be aware, however, that a mutual fund investment doesn't necessarily provide


instant diversification, especially if the fund focuses on only one particular industry
sector. If you invest in narrowly focused mutual funds, you may need to invest in
more than one mutual fund to get the diversification you seek. Within asset
categories, that may mean considering, for instance, large company stock funds as
well as some small company and international stock funds. Between asset
categories, that may mean considering stock funds, bond funds, and money market
funds. Of course, as you add more investments to your portfolio, you'll likely pay
additional fees and expenses, which will, in turn, lower your investment returns. So
you'll need to consider these costs when deciding the best way to diversify your
portfolio.
21.5 Changing Your Asset Allocation
The most common reason for changing your Asset Allocation is a change in your
time horizon. In other words, as you get closer to your investment goal, you'll likely
need to change your Asset Allocation. For example, most people investing for
retirement hold less stock and more bonds and cash equivalents as they get closer
to retirement age. You may also need to change your Asset Allocation if there is a
change in your risk tolerance, financial situation, or the financial goal itself.

But savvy investors typically do not change their Asset Allocation based on the
relative performance of asset categories - for example, increasing the proportion of
stocks in one's portfolio when the stock market is hot. Instead, that's when they
"rebalance" their portfolios.

http://www.sec.gov/investor/pubs/assetallocation.htm
21.6 Some sample Asset Allocation strategies5

The hierarchy of risk and return6


5Data Source: Ibbotson Associates, 2006 (1926–2005) taken from : www.
personal.fidelity.com/planning/retirement/content/
how_to_invest.shtml
6Croome, Shauna, Achieving Optimal Asset Allocation, June 15, 2005,
http://www.investopedia.com/articles/pf/05/061505.asp

As you can see, equities have the highest potential return, but also the highest risk.
On the other hand, Treasury bills have the lowest risk since they are backed by the
government, but they also provide the lowest potential return.

The chart also demonstrates that when you choose investments with higher risk,
your expected returns also increase proportionately. But this is simply the result of
the risk-return tradeoff. They will often have high volatility and are therefore suited
for investors who have a high risk tolerance (can stomach wide fluctuations in
value), and who have a longer time horizon.

It's because of the risk-return tradeoff - which says you can seek high returns only if
you are willing to take losses - that diversification through Asset Allocation is
important. Since different assets have varying risks and experience different market
fluctuations, proper Asset Allocation insulates your entire portfolio from the ups and
downs of one single class of securities. So, while part of your portfolio may contain
more volatile securities - which you've chosen for their potential of higher returns -
the other part of your portfolio devoted to other assets remains stable. Because of
the protection it offers, Asset Allocation is the key to maximizing return while
minimizing risk.

To make the Asset Allocation process easier for clients, many investment companies
create a series of model portfolios, each comprising different proportions of asset
classes. These portfolios of different proportions satisfy a particular level of investor
risk tolerance. In general, these model portfolios range from conservative to very
aggressive:
Conservative model portfolios generally allocate a large percent of the total portfolio
to lower-risk securities such as fixed-income and money market securities. Your
main goal with a conservative portfolio is to protect the principal value of your
portfolio. As such, these models are often referred to as "capital preservation
portfolios".

A moderately conservative portfolio is ideal for those who wish to preserve a large
portion of the portfolio’s total value, but are willing to take on a higher amount of
risk to get some inflation protection. A common strategy within this risk level is
called "current income". With this strategy, you chose securities that pay a high
level of dividends or coupon payments

Moderately aggressive model portfolios are often referred to as "balanced portfolios"


since the asset composition is divided almost equally between fixed-income
securities and equities in order to provide a balance of growth and income. Since
these moderately aggressive portfolios have a higher level of risk than those
conservative portfolios mentioned above, select this strategy only if you have a
longer time horizon (generally more than five years), and have a medium level of
risk tolerance.
Aggressive portfolios mainly consist of equities, so these portfolios' value tends to
fluctuate widely. If you have an aggressive portfolio, your main goal is to obtain
long-term growth of capital. As such the strategy of an aggressive portfolio is often
called a "capital growth" strategy. To provide some diversification, investors with
aggressive portfolios usually add some fixed-income securities.

Very aggressive portfolios consist almost entirely of equities. As such, with a very
aggressive portfolio, your main goal is aggressive capital growth over a long time
horizon.
Since these portfolios carry a considerable amount of risk, the value of the portfolio
will vary widely in the short term.
Active and Passive Investment Strategies Chapter-22
22.1 Active Management
Active Management investment strategies involve picking up the most attractive
stocks, bonds and mutual funds. It also tries to pick up the most opportune time to
move into the markets and move out of it. Also and place leveraged bets on the
future direction of securities and markets with options, futures, and other
derivatives. The objective is to make a profit, and, often without intention, to do
better than they would have done if they simply accepted average market returns.
In pursuing their objectives, active managers search out information they believe to
be valuable, and often develop complex or proprietary selection and trading
systems. Active management encompasses hundreds of methods, and includes
fundamental analysis, technical analysis, and macroeconomic analysis, all having in
common an attempt to determine profitable future investment trends.

22.1 .1 Passive Management


Passive investment management makes no attempt to distinguish attractive from
unattractive securities, or forecast securities prices, or
7
http://www.evansonasset.com/index.cfm/Page/2.htm
Passive investment management makes no attempt to distinguish attractive from
unattractive securities, or forecast securities prices, or time markets and market
sectors. Passive managers invest in broad sectors of the market, called asset
classes or indexes, and, like active investors, want to make a profit, but accept the
average returns various asset classes produce. Passive investors make little or no
use of the information active investors seek out. Instead, they allocate assets based
upon empirical research delineating probable asset class risks and returns, diversify
widely within and across asset classes, and maintain allocations long-term through
periodic rebalancing of asset classes.

22.2 INDEX INVESTING


Index investing is a form of passive investing in which portfolios are based upon
securities indexes which sample various market sectors and are constructed by
committee. Best known is the Dow Jones Industrial index, a basket of thirty very
large U.S. companies. Indexes are available for most domestic and international
markets, and rise and fall as individual securities within the index rise and fall.

Active investment management substantially boosts costs and decreases returns


compared to properly design passive portfolios. Research employed in the
development of passive and index investment strategy has shown that:

22.2.1 MARKETS AND ECONOMIES ARE UNPREDICTABLE.


Given that there are thousands of stock market experts, mutual fund managers,
private money managers, and advisors, there will be some who will make
spectacular calls. But as a group the performance of experts is not so different than
would be achieved by chance guessing. In any case past success is unrelated to
future performance.

22.2.2 FUTURE SECURITIES PRICES ARE UNPREDICTABLE.


Several statistical studies have found that the price behavior of securities, such as
stocks, bonds and commodities, is indistinguishable from that of random numbers.
Patterns in numbers occur, technicians attribute great significance to them, but they
have no demonstrated persistence or predictive power. Over many decades, the
prices of securities trend upward due to inflation and economic growth. Otherwise,
future securities prices are unpredictable.
22.2.3 RISK AND RETURN ARE ABSOLUTELY CORRELATED.
High potential returns always involve high potential risks. There are no low-
risk/high-return investments. Investment risk comes in many forms but, to most
investors, risk means the potential for losing investment capital and the duration or
permanency of that loss. Through analyzing the best available long-term data,
researchers have carefully defined the risk/return ratios of all major asset classes
and identified the correlation or interdependence of different types of investments.
These findings provide our best approximation of future risk and return for any
given asset class or mix of asset classes, and clearly show that there are no high
return, low risk asset classes.

22.3 ACTIVE MANAGEMENT IS MUCH MORE EXPENSIVE THAN PASSIVE


MANAGEMENT.
Active investors must overcome many costs to match the returns of the average
passively managed portfolio. These include trading costs, much higher management
fees, market impact costs as active managers affect the prices they pay, dilution
from maintaining higher cash positions than passive managers, taxes in taxable
accounts due to high turnover rates, and, commissions, if an investment "product",
like a mutual fund, is purchased through a broker or financial salesperson. These
costs create a handicap for the active investor of 2.5% to 9% per year, depending
upon asset class mix, and whether a salesperson is involved. The least expensive
forms of active management, no-load mutual funds and "wrap fee" accounts,
typically consume 2.5% per year from investor's returns, while the average passive
or index portfolio costs under 0.5% per year.
22.3.1 ACTIVE MANAGEMENT IS MORE RISKY THAN PASSIVE
MANAGEMENT.
Active managers attempt to choose securities which will outperform the market and,
therefore, concentrate their "bets" across relatively few securities. If an active
manager bets wrong, they may very significantly under perform market averages.
Passively constructed portfolios, however, are highly diversified and contain
thousands of securities allocated amongst various investment categories which have
been identified by research and have predictable and quantifiable risks and returns.
Further, research has shown that diversification itself produces higher returns with
lower risks than simply investing in one or two investment categories.
22.3.2 ACTIVE MANAGEMENT UNDERPERFORMS PASSIVE MANAGEMENT.
Because of increased costs and risks, about 75% of active managers, as a group,
under perform passive portfolios during any given year and, over time, this
percentage increases until only a few outperform market averages. When matched
for asset type and mix, passive managers outperform active managers by about 2%
per year, on average. In addition, active management in taxable accounts creates a
constant stream of capital gains taxes which must be paid each year. Studies show
that after-tax returns in active accounts are 30% lower, or more, over long
investment time-frames. INVESTORS EMPLOYING ACTIVE MANAGEMENT DO FAR
WORSE THAN THE ADVERTISED NUMBERS, AND WOULD DO BETTER BUYING C.D.'S
AT A BANK.

Studies of the real returns achieved by investors are hard to find. Two studies
covering ten to fifteen year time frames have found that broker advised investors,
and investors self-managing their accounts, captured only one-quarter or less of the
total returns produced by indexes and less than half the return reported by
managers and mutual funds. This is due to the tendency of brokers and investors to
move around too rapidly, ultimately picking a losing asset class. Another study
pitted five prominent advisors specializing in mutual fund selection against the S & P
500, a widely used market and index benchmark. The best advisor lagged the S & P
by about 40% for the six years from 1993 through 1997.
22.3.3 EXCEPTIONAL" ACTIVE MANAGERS CANNOT BE IDENTIFIED IN
ADVANCE.
A tiny handful of superstar money managers with outstanding past performance are
constantly promoted by the media as evidence for the benefits of active
management. Yet, no one knew in advance who would outperform, the odds of
selecting one are low, and the results they achieved may be due to luck. Hundreds
of carefully done studies have found that past performance of money managers,
mutual fund managers, investment analysts, and others is unrelated to their future
performance. Track records mean nothing. The two greatest superstar active
managers of our time, Warren Buffet and Peter Lynch, both recommend index
funds.
22.3.4 ASSET CLASS MIX IS THE MOST IMPORTANT DETERMINANT OF .
An asset class is a group of securities which have similar risk and return
characteristics. One year Treasury bonds, or commercial real estate, or small
company U.S. growth stocks, or emerging market stocks, are examples of asset
classes. Research has clearly established that performance differences between
different professional money managers are due predominantly (90%, or more) to
the asset class they choose. Markets, not managers, produce returns.
To sum up passive investment offers low cost, reduced uncertainty of decision
errors and even style consistency. If appropriate indexes are allowed, investors can
control their overall allocation. Indexing is also regarded as more tax efficient.
Active investment strategies too have something going in their favour. It is
generally regarded that index strategies usually have large cap bias.

This is natural since indices are normally based on market capitalization. Secondly even
the best performing markets would have some sort of inefficiencies and this can be
successfully exploited by good fund managers. Active managers also are able to act much
faster simply because they adjust to new information far quicker than passive investors
which take longer to absorb new information about the company.

At the end, this debate of active versus passive does not really solve the other critical
questions. As academically interesting as the debate between active and passive
management may be, it does not answer the most important questions facing an
individual investor9.

• How much money do I need to retire?…to fund education?


• How many years do I need to keep working?
• How much should I save?
• Is my business protected if my partner dies?
• How much can I afford to spend based on my assets?
• How much can I afford to lose in a year without jeopardizing
my goals?
• Is my family protected if I die or become disabled?
• Are my assets going to benefit my family and my favorite charity, or
the government?
• Will there be enough???
The active-versus-passive management debate should be addressed only after a
solid investment foundation has been built. A solid planning foundation consists of
goal identification, coordination of various financial planning aspects, and
development of an investment policy based on specific goals and risk tolerance.
With this context of comprehensive planning, understanding the main drivers of
portfolio returns is a major step in properly implementing an investment strategy. In
order of their influence on results, these drivers are:

Voicu, Andrei, ‘Passive Versus Active Investment Strategies: Comparisons,


Perspectives and the Relevance to Financial Advisors,
http://www.fpanet.org/journal/BetweenTheIssues/Contributions/070104B.cfm
Voicu, Andrei, ‘Passive Versus Active Investment Strategies: Comparisons,
Perspectives and the Relevance to Financial Advisors,
http://www.fpanet.org/journal/BetweenTheIssues/Contributions/070104B.cfm
investment strategy. In order of their influence on results, these drivers are:
1.Strategic asset allocation investment policy between growth and fixed-income
investments. This allocation should be based on each client’s unique objectives and
risk tolerance. The policy allocation should be the foundation block of any long-term
investment strategy.

2.Actively managed tactical allocation versus a market neutral, static allocation.


Significant value can be added (or detracted) by concentrating the portfolio in
certain asset categories.

3.Selection of investments for each asset category may add (or detract) an
additional layer of value.
A holistic approach based on the analysis of an investor’s unique circumstances
should provide a strategic investment policy on what percentage of a portfolio
should be in growth/equity oriented investments and what percentage in fixed
income.
Tactical allocation among specific types of stocks (such as small or large, value or
growth, foreign or domestic) and bonds (such as long or short, high-quality or low-
quality) can be handled in one of two ways:

1.Investors retain the tactical asset allocation decision and actively manage the
exposure to various categories. Most investors fall in this category whether they
manage allocations in a disciplined, pre-determined fashion or simply let it fall where
it may, as a residual of other decisions.

2.The investor ignores tactical allocation by selecting a neutrally weighted portfolio


that reflects the entire available investment universe. Few investors select this truly
passive asset allocation strategy. Given factors such as homeland bias, investors
tend to over-emphasize areas closer to home, consistently under-weighting foreign
securities.
Only after both the strategic stock/bond allocation and the handling of the tactical
allocation are decided upon, can we begin examining the merits and pitfalls of
passive versus active investment selection strategies.
Rebalancing Portfolios Chapter- 23

Rebalancing is bringing your portfolio back to your original asset allocation mix. This
is necessary because over time some of your investments may become out of
alignment with your investment goals. You'll find that some of your investments will
grow faster than others. By rebalancing, you'll ensure that your portfolio does not
overemphasize one or more asset categories, and you'll return your portfolio to a
comfortable level of risk.

For example, let's say you determined that stock investments should represent 60%
of your portfolio. But after a recent stock market increase, stock investments
represent 80% of your portfolio. You'll need to either sell some of your stock
investments or purchase investments from an under-weighted asset category in
order to reestablish your original asset allocation mix.

When you rebalance, you'll also need to review the investments within each asset
allocation category. If any of these investments are out of alignment with your
investment goals, you'll need to make changes to bring them back to their original
allocation within the asset category.
There are basically three different ways you can rebalance your portfolio:

1. You can sell off investments from over-weighted asset categories and use the
proceeds to purchase investments for under-weighted asset categories.
2. You can purchase new investments for under-weighted asset categories.
3. If you are making continuous contributions to the portfolio, you can alter your
contributions so that more investments go to under-weighted asset categories until
your portfolio is back into balance.
Before you rebalance your portfolio, you should consider whether the method of
rebalancing you decide to use will trigger transaction fees or tax consequences. Your
financial professional or tax adviser can help you identify ways that you can minimize
these potential costs.

Secondly shifting money away from an asset category when it is doing well in favor
an asset category that is doing poorly may not be easy, but it can be a wise move.
By cutting back on the current "winners" and adding more of the current so-called
"losers," rebalancing forces you to buy low and sell high.

23.1 When to Consider Rebalancing


You can rebalance your portfolio based either on the calendar or on your
investments. Many financial experts recommend that investors rebalance their
portfolios on a regular time interval, such as every six or twelve months. The
advantage of this method is that the calendar is a reminder of when you should
consider rebalancing.
Others recommend rebalancing only when the relative weight of an asset class
increases or decreases more than a certain percentage that you've identified in
advance. The advantage of this method is that your investments tell you when to
rebalance. In either case, rebalancing tends to work best when done on a relatively
infrequent basis.
Some of the situations which can lead to rebalancing are as follows:
(a) Change in wealth. In most situations the risk profile of a person increases when
his wealth increases. However it may happen that after accumulating a lot of wealth
a person may become conservative
(b) Change in time horizon: Due to various life situations for eg sickness,
unemployment, divorce, death, birth, marriage, environment related happenings a
person’s investment horizon may undergo a drastic realignment

c) Change in liquidity needs. This may also change due to special needs that may
require some amount of portfolio revision

(d) Changes in taxes: A change in the tax rates related to various investment
instruments as well as horizon period for computing capital gains tax will lead to
some amount of changes in the portfolio composition

(e) Bull and bear markets: The fluctuations in the capital markets would obviously
have an impact on the investor’s portfolio. In a bull market the exposure to market
related investments would increase and vice-versa in a bull market

(f) Monetary and fiscal conditions: Policy pronouncements related to credit,


liquidity, interest rates have an impact both on market returns as well as inflation.
This alters the risk return profile of various investment instruments thus prompting
changes in the asset allocation.

(g) Other reasons: This may include transaction costs, risk return characteristics of
investment products, transaction environment. All of these may have some impact
on the need for portfolio rebalancing.
Portfolio Revision Techniquess Chapter-24

Portfolio Revision Techniques can also be done by using formula plans. The advantage of
formula plans is that they are based on predetermined rules and therefore they specify the
nature, timing and proportion of change. Thus any emotional responses to market
conditions are automatically eliminated. Though formula plans have their own
advantages, some of the weaknesses are as follows:

(a) They do not offer adequate flexibility


(b) They may not be the right answer for very short periods of time and may also not
work for long periods of time either
(c) They offer no advice as to the selection of securities

24.1 Types of plans

Some of the common formula plans that are commonly used are:
(a) Constant Rupee value plan
(b) Constant Ratio plan
(c) Variable Ratio Plan
(d) Rupee Cost Averaging

Constant rupee value plan: In this the rupee or the cash value of the aggressive portfolio
should be held constant.. If the value of the aggressive portfolio rises, the investor should
sell a part of his holding to bring back the value of the portfolio to the initial value. The
opposite action will take place if the value of the aggressive portfolio declines.

Constant Ratio Plan: In this case the value of the aggressive portfolio is fixed as a ratio to
the conservative plan. In this case the ratio of the aggressive to the conservative would
remain constant. In the earlier plan the ratio would keep changing since only the value of
the aggressive plan was to be constant

Variable ratio plan; In this case the ratio of the aggressive portfolio to the conservative
portfolio changes with change in the value of the aggressive portfolio. The ratio will
decrease when there is an increase in the value of the portfolio and will increase when
there is a decrease in the value of the aggressive portfolio. In simple words the shares will
be bought when prices fall and will be sold when prices rise. To achieve this successfully
one should start the plan when the stock prices are at median value Rupee cost
Averaging: Rupee cost averaging is a technique designed to reduce market risk through
the systematic purchase of securities at predetermined intervals and set amounts. Instead
of investing assets in a lump sum, the investor works his way into a position by slowly
buying smaller amounts over a longer period of time. This spreads the cost basis out over
several years, providing insulation against changes in market price.

24.1.1 Setting Up a Rupee Cost Averaging Plan


In order to begin a rupee cost averaging plan, you must do three things:
(1) Decide exactly how much money you can invest each month. Make certain that
you are financially capable of keeping the amount consistent; otherwise the plan will
not be as effective.

(2) Select an investment (index funds or mutual funds are particularly appropriate)
that you want to hold for the long term, preferably five to ten years or longer.

(3) At regular intervals (weekly, monthly or quarterly works best), invest that
money into the security you’ve chosen.
An Example of a Rupee Cost Averaging Plan
You have Rs 15,000 you want to invest in ABC mutual fund. The date is January 1,
2000. You have two options: you can invest the money as a lump sum now, walk
away and forget about it, or you can set up a dollar cost averaging plan. You opt for
the latter and decide to invest Rs 1,250 each quarter for three years.

Had you invested your Rs 15,000 in January 2000, you would have purchased 300
units at Rs 50 each. When the stock closed for the year in December of 2002 at Rs
55, your holdings would only be worth Rs 16,500/-!

Had you Rupee cost averaged into the stock over the past three years, however,
you would own 356.88 units; at the closing price, this gives your holdings a market
value of Rs 19628/-

24.2 Rupee cost averageing

Investment Price of ABC No of units Cumulative Value of


every quarter unit bought units holding

Jan.
2000 1250 50 25.00 25.00 1250
Apr.
2000 1250 55 22.73 47.73 26224.15
Jul.
2000 1250 32 39.07 86.80 2777.6
Oct.
2000 1250 45 27.78 114.58 5156.1
Jan.
2001 1250 42 29.77 144.35 6062.7
Apr.
2001 1250 32 39.07 183.42 5869.44
Oct.
2001 1250 38 32.90 216.32 8220.16
Jan.
2002 1250 56 22.33 238.65 13364.4
Apr.
2002 1250 48 26.05 264.70 12705.6
Jul.
2002 1250 30 41.67 306.37 9191.1
Oct.
2002 1250 45 27.78 334.15 15036.75
Dec.
2002 1250 55 22.73 356.88 19628.4
356.88
Total 15000 44 shares
owned
Lumpsum
Investment Price of ABC No of units
unit bought Value of holding
Jan-00 15000 50 300 15000
Dec-02 55 300 16500

The Rupee cost averaging component reduces market risk, while the index fund
investment reduces company-specific risk. This combination can be among the best
investment options for individuals looking to build up their long term wealth by having a
portion of their portfolio in equities.
Regulatory Functions 0f Financial Institutions Chapter-25

25.1 Reserve Bank of India

25.1.1 Establishment :-

The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934.

The Central Office of the Reserve Bank was initially established in Calcutta but was
permanently moved to Mumbai in 1937. The Central Office is where the Governor
sits and where policies are formulated.

Though originally privately owned, since nationalization in 1949, the Reserve Bank is
fully owned by the Government of India.

25.25.2 The Preamble :-

The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank as:

"...to regulate the issue of Bank Notes and keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage."

25.25.3 Main Functions:-

A. Monetary Authority:
i. Formulates implements and monitors the monetary policy.
ii. Objective: Maintaining price stability and ensuring adequate flow of
credit to productive sectors.
B. Regulator and supervisor of the financial system:
i. Prescribes broad parameters of banking operations within which the
country's banking and financial system functions.
ii. Objective: Maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services to the
public.
C. Manager of Foreign Exchange:
i. Manages the Foreign Exchange Management Act, 1999.
ii. Objective: To facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange market in
India.
D. Issuer of currency:
i. Issues and exchanges or destroys currency and coins not fit for
circulation.
ii. Objective: To give the public adequate quantity of supplies of currency
notes and coins and in good quality.
E. Developmental role:
i. Performs a wide range of promotional functions to support national
objectives.
F. Related Functions:
i. Banker to the Government: Performs merchant banking function for
the central and the state governments; also acts as their banker.
ii. Banker to banks: Maintains banking accounts of all scheduled banks.

25.25.4 Financial Supervision:-


The Reserve Bank of India performs this function under the guidance of the Board for
Financial Supervision (BFS). The Board was constituted in November 1994 as a
committee of the Central Board of Directors of the Reserve Bank of India.

Objective
Primary objective of BFS is to undertake consolidated supervision of the financial
sector comprising commercial banks, financial institutions and non-banking finance
companies.

25.25.5 Some of the initiatives taken by BFS include:-

i. restructuring of the system of bank inspections


ii. introduction of off-site surveillance,
iii. strengthening of the role of statutory auditors and
iv. Strengthening of the internal defenses of supervised institutions

25.2 Insurance Regulatory and Development Authority

To regulate, promote & maintain the growth of insurance industry in India and to
protect the interest of the policyholders, Insurance Regulatory and Development
Authority (IRDA) was constituted in 1999 by an Act of Parliament. It is a national
agency of Government of India which is now situated at Hyderabad.

As per Section 4 of IRDA Act 1999, IRDA is a ten member team consisting of:-

• A Chairman
• Five whole-time members
• Four part-time members

25.2.1 Mission :-

To protect the interest of the policyholders, to regulate, promote and ensure orderly
growth of the insurance industry and for matters connected therewith or incidental
thereto.

25.2.2 Duties, Powers and Functions of IRDA :-

Subject to the provisions of this Act and any other law for the time being in force,
the Authority shall have the duty to regulate, promote and ensure orderly growth of
the insurance business and re-insurance business.
Without prejudice to the generality of the provisions contained in sub-section (1), the
powers and functions of the Authority shall include :-

i. Issue to the applicant a certificate of registration, renew, modify, withdraw,


suspend or cancel such registration.
ii. Protection of the interests of the policy holders in matters concerning
assigning of policy, nomination by policy holders, insurable interest,
settlement of insurance claim, surrender value of policy and other terms and
conditions of contracts of insurance.
iii. Specifying requisite qualifications, code of conduct and practical training for
intermediary or insurance intermediaries and agents.
iv. Specifying the code of conduct for surveyors and loss assessors.
v. Promoting efficiency in the conduct of insurance business.
vi. Promoting and regulating professional organizations connected with the
insurance and re-insurance business.
vii. Levying fees and other charges for carrying out the purposes of this Act.
viii. Calling for information from, undertaking inspection of, conducting enquiries
and investigations including audit of the insurers, intermediaries, insurance
intermediaries and other organizations connected with the insurance
business.
ix. Control and regulation of the rates, advantages, terms and conditions that
may be offered by insurers in respect of general insurance business not so
controlled and regulated by the Tariff Advisory Committee under section 64U
of the Insurance Act, 1938 (4 of 1938).
x. Specifying the form and manner in which books of account shall be
maintained and statement of accounts shall be rendered by insurers and
other insurance intermediaries.
xi. Regulating investment of funds by insurance companies.
xii. Regulating maintenance of margin of solvency.
xiii. Adjudication of disputes between insurers and intermediaries or insurance
intermediaries.
xiv. Supervising the functioning of the Tariff Advisory Committee.
xv. Specifying the percentage of premium income of the insurer to finance
schemes for promoting and regulating professional organizations referred to
in clause (f).
xvi. Specifying the percentage of life insurance business and general insurance
business to be undertaken by the insurer in the rural or social sector.
xvii. Exercising such other powers as may be prescribed.

25.3. Association of Mutual Fund in India:-

The Association of Mutual Fund in India (AMFI) is dedicated to developing the Indian
Mutual Fund Industry on professional, healthy and ethical lines and to enhance and
maintain standards in all areas with a view to protecting and promoting the interests
of mutual funds and their unit holders.

AMFI is an apex body of all Asset Management Companies (AMC) which has been
registered with SEBI. Till date all the AMCs that have launched mutual fund schemes
are its members. It functions under the supervision and guidelines of its Board of
Directors. All the Asset Management Companies must have a minimum corpus of Rs.
10 crores.
25.3.1 The objectives of Association of Mutual Funds in India

A. AMFI maintains professional codes & ethical standards which is followed in all
areas of operation of the industry.
B. AMFI interacts with SEBI and works according to SEBI’s guidelines in the
mutual fund industry.
C. AMFI develops training programme and certification for all intermediaries and
other engaged in the mutual fund industry.
D. AMFI undertakes all India awareness programme for investors in order to
promote proper understanding of the concept and working of mutual funds.
E. At last but not the least association of mutual fund of India also disseminate
information on Mutual Fund Industry and undertakes studies and research
either directly or in association with other bodies.

In general, its main functions are:-

• Formulate sound and ethical business practices and to provide investor


protection.
• Provide information, assistance and other services to its members.
• Promote public awareness of the benefits & the risk of investing in mutual
funds.

25.3.2 Mutual Fund:-

A Mutual Fund is a trust that pools the savings of the investors having a common
financial goal. The money thus collected is then invested in capital market
instruments such as shares, debentures and other securities. The income generated
through these investments is shared by its unit holders in proportion to the number
of units owned by them. Thus a Mutual Fund is the most suitable investment for the
common man as it offers an opportunity to invest in a diversified, professionally
managed basket of securities at a relatively low cost.

In India, Mutual Funds have recently moved to the concept of monthly average AUM
calculation.

25.3.3 Advantages of Mutual Funds

i. The funds are managed by professional people; therefore lesser degree of risk
ok loss is there as compared to investing directly in the market.
ii. It helps in diversifying the investment which means holding a large number of
stocks or securities so that the entire holding is not influenced in the same
way due to a certain event in the market. An investment in a mutual fund can
provide one with the necessary diversification even with the small amounts
that one may have.

For example, with a sum of Rs 5,000 an investor might be able to get just 1
share of Infosys, 1 share of Bajaj Auto and 1 share of Tata Steel at July 2006
price levels. On the other hand the same amount invested in a mutual fund
which is diversified in nature would help the investor get around 20-25 shares
which would reduce the risk as compared to the small holdings in an
individual capacity.
iii. There is adequate liquidity for mutual fund investors when they want the
necessary funds.
iv. The large amount of mutual funds offers the investor a wide variety to choose
from. An investor can pick up a scheme depending upon his risk/return
profile.
v. Investor who invests in mutual funds enjoys various tax benefits also.
vi. Low cost.
vii. Transparency.

25.4. Securities and Exchange Board of India:-

The Government of India established Securities and Exchange Board of India, by an


Act of Parliament in 1992, as the apex regulatory body for all the entities that either
invest in capital market or raise funds from there. The investment or raising funds is
done through shares and debentures listed on stock.

Basically the SEBI was established for fulfillment of the twin objectives of investor
protection and market development. Mutual Fund is one of the important institutional
investor in capital market securities. Hence they come under the preview of SEBI.
Apart from this SEBI also regulate the derivative market in India.

To provide the facility of hedging and enhance the liquidity in the market SEBI
appointed the L.C.Gupta Committee to develop appropriate regulatory framework for
the derivatives trading in India. The Board of SEBI accepted the L.C.Gupta
Committee recommendations.

With the acceptance of the L.C.Gupta Committee report, derivatives trading in India
beginning with Stock Index Futures. SEBI has also framed suggestive byelaw for
Derivative Exchanges/Segments and their Clearing Corporation/ House which lay's
down the provisions for trading and settlement of derivative contracts.

The SEBI formulated regulations in 1993 (fully revised in 1996) regarding mutual
fund and from time to time issues number of guidelines for the protection of
investor.

The Mutual funds in India are either promoted by public or by private sector entities.
SEBI requires all mutual funds to be registered with them. It issues guidelines for all
mutual fund operation including where they can invest, investment limits and
restrictions, how they should account for income and expenses and how they should
make disclosers of the information to the investors. All the mutual funds are required
to update NAV of their scheme on daily basis for open ended schemes and weekly for
close ended schemes.

25.5 THE SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

No.15 of 1992

[4th April ,1992.]

An Act to provide for the establishment of a Board to protect the interests of


investors in securities and to promote the development of, and to regulate, the
securities market and for matters connected therewith or incidental thereto.
Be it enacted by Parliament in the Forty-third Year of the Republic of India as
follows:

• CHAPTER I (Preliminary)
• CHAPTER II (Establishment Of The Securities And Exchange Board Of India)
• CHAPTER III (Transfer Of Assets, Liabilities, etc., Of The Existing Securities
And Exchange Board To The Board)
• CHAPTER IV (Powers And Functions Of The Board)
• CHAPTER V (Registration Certificate)
• CHAPTER VI (Finance, Accounts And Audit)
• CHAPTER VIA (Penalties and Adjudication)
• CHAPTER VIB (Establishment, Jurisdiction, Authority and Procedure of
Appellate Tribunal
• CHAPTER VII (Miscellaneous)

CHAPTER I

25.5.1 PRELIMINARY

Short title, extent & commencement.

1. This Act may be called the Securities and Exchange Board of India Act, 1992.
2. It extends to the whole of India.
3. It shall be deemed to have come into force on the 30th day of January, 1992.

Definitions.

1. In this Act, unless the context otherwise requires, -


a. "Board" means the Securities and Exchange Board of India established
under section 3;
b. (b) "Chairman" means the Chairman of the Board; 1[1][(ba) "collective
investment scheme" means any scheme or arrangement which
satisfies the conditions specified in Section 11AA;]
c. "existing Securities and Exchange Board" means the Securities and
Exchange Board of India constituted under the Resolution of the
Government of India in the Department of Economic Affairs No.1
(44)SE/86, dated the 12th day of April, 1988;
d. "Fund" means the Fund constituted under Section 14; (e) "member"
means a member of the Board and includes the Chairman;
e. "notification" means a notification published in the Official Gazette;
f. "prescribed" means prescribed by rules made under this Act;
g. "regulations" means the regulations made by the Board under this Act;
2[2]
[(ha) "Reserve Bank" means the Reserve Bank of India constituted
under section 3 of the Reserve Bank of India Act, 1934(2 of 1934);]
h. "securities" has the meaning assigned to it in section 2 of the
Securities Contracts (Regulation) Act,1956 (42 of 1956).
2. 3[3][Words and expressions used and not defined in this Act, but defined in the
Securities Contracts (Regulation) Act, 1956(42 of 1956), [4][or the
Depositories Act, 1996], shall have the meanings respectively assigned to
them in that Act.]
CHAPTER II

25.6 ESTABLISHMENT OF THE SECURITIES AND EXCHANGE BOARD OF


INDIA

25.6.1 Establishment and incorporation of Board.

a. With effect from such date as the Central Government may, by notification,
appoint, there shall be established, for the purposes of this Act, a Board by
the name of the Securities and Exchange Board of India.
b. The Board shall be a body corporate by the name aforesaid, having perpetual
succession and a common seal, with power subject to the provisions of this
Act, to acquire, hold and dispose of property, both movable and immovable,
and to contract, and shall, by the said name, sue or be sued.
c. The head office of the Board shall be at Bombay.
d. The Board may establish offices at other places in India.

25.6.2 Management of the Board.

a. The Board shall consist of the following members, namely:-


i. a Chairman;
ii. two members from amongst the officials of the 5[5][Ministry] of the
Central Government dealing with Finance 6[6][and administration of
the Companies Act, 1956(1 of 1956)];
iii. one member from amongst the officials of 7[7][the Reserve Bank];
8[8]
iv. [five other members of whom at least three shall be the whole-
time members] to be appointed by the central Government.
b. The general superintendence, direction and management of the affairs of the
Board shall vest in a Board of members, which may exercise all powers and
do all acts and things which may be exercised or done by the Board.
c. Save as otherwise determined by regulations, the Chairman shall also have
powers of general superintendence and direction of the affairs of the Board
and may also exercise all powers and do all acts and things which may be
exercised or done by that Board.
d. The Chairman and members referred to in clauses (a) and (d) of sub-section
(1) shall be appointed by the Central Government and the members referred
to in clauses (b) and (c) of that sub-section shall be nominated by the
Central Government and the [9][Reserve Bank] respectively.
e. The Chairman and the other members referred to in clauses (a) and (d) of
sub-section (1) shall be persons of ability, integrity and standing who have
shown capacity in dealing with problems relating to securities market or have
special knowledge or experience of law, finance, economics, accountancy,
administration or in any other discipline which, in the opinion of the Central
Government, shall be useful to the Board.

25.6.3 Term of office and conditions of service of Chairman and members of


the Board.
a. The term of office and other conditions of service of the Chairman and the
members referred to in clause (d) of sub- section (1) of section 4 shall be
such as may be prescribed.
b. Notwithstanding anything contained in sub-section (1), the Central
Government shall have the right to terminate the services of the Chairman or
a member appointed under clause (d) of sub-section (1) of section 4, at any
time before the expiry of the period prescribed under sub-section (1), by
giving him notice of not less than three months in writing or three months’
salary and allowances in lieu thereof, and the Chairman or a member, as the
case may be, shall also have the right to relinquish his office, at any time
before the expiry of the period prescribed under sub-section (1), by giving to
the Central Government notice of not less than three months in writing.

25.6.4 Removal of member from office.

The Central Government shall remove a member from office if he -

a. is, or at any time has been, adjudicated as insolvent;


b. is of unsound mind and stands so declared by a competent court;
c. has been convicted of an offence which, in the opinion of the Central
Government, involves a moral turpitude;
d. has, in the opinion of the Central Government, so abused his position as to
render his continuation in office detrimental to the public interest:Provided
that no member shall be removed under this clause unless he has been given
a reasonable opportunity of being heard in the matter.

25.6.5 Meetings.

a. The Board shall meet at such times and places, and shall observe such rules
of procedure in regard to the transaction of business at its meetings
(including quorum at such meetings) as may be provided by regulations.
b. The Chairman or, if for any reason, he is unable to attend a meeting of the
Board, any other member chosen by the members present from amongst
themselves at the meeting shall preside at the meeting.
c. All questions which come up before any meeting of the Board shall be decided
by a majority votes of the members present and voting, and, in the event of
an equality of votes, the Chairman, or in his absence, the person presiding,
shall have a second or casting vote.

25.6.6 Member not to participate in meetings in certain cases.

12[12]
[“7A. Any member, who is a director of a company and who as such director has
any direct or indirect pecuniary interest in any matter coming up for consideration at
a meeting of the Board, shall, as soon as possible after relevant circumstances have
come to his knowledge, disclose the nature of his interest at such meeting and such
disclosure shall be recorded in the proceedings of the Board, and the member shall
not take any part in any deliberation or decision of the Board with respect to that
matter”.]

25.6.7 Vacancies etc., not to invalidate proceedings of Board.


No act or proceeding of the Board shall be invalid merely by reason of

a. any vacancy in, or any defect in the constitution of, the Board; or
b. any defect in the appointment of a person acting as a member of the Board;
or
c. any irregularity in the procedure of the Board not affecting the merits of the
case.

25.6.8 Officers and employees of the Board.

a. The Board may appoint such other officers and employees as it considers
necessary for the efficient discharge of its functions under this Act.
b. The term and other conditions of service of officers and employees of the
Board appointed under sub- section (1) shall be such as may be determined
by regulations.

CHAPTER III

25.7 TRANSFER OF ASSETS, LIABILITIES, ETC., OF THE EXISTING


SECURITIES AND EXCHANGE BOARD TO THE BOARD

a. On and from the date of establishment of the Board,-


i. any reference to the existing Securities and Exchange Board in any law
other than this Act or in any contract or other instrument shall be
deemed as a reference to the Board;
ii. all properties and assets, movable and immovable, of, or belonging to,
the existing Securities and Exchange Board, shall vest in the Board;
iii. all rights and liabilities of the existing Securities and Exchange Board
shall be transferred to, and be the rights and liabilities of, the Board;
iv. without prejudice to the provisions of clause (c), all debts, obligations
and liabilities incurred, all contracts entered into and all matters and
things engaged to be done by, with or for the existing Securities and
Exchange Board immediately before that date, for or in connection
with the purpose of the said existing Board shall be deemed to have
been incurred, entered into or engaged to be done by, with for, the
Board;
v. all sums of money due to the existing Securities and Exchange Board
immediately before that date shall be deemed to be due to the Board;
vi. all suits and other legal proceedings instituted or which could have
been instituted by or against the existing Securities and Exchange
Board immediately before that date may be continued or may be
instituted by or against the Board; and
vii. every employee holding any office under the existing Securities and
Exchange Board immediately before that date shall hold his office in
the Board by the same tenure and upon the same terms and
conditions of service as respects remuneration, leave, provident fund,
retirement and other terminal benefits as he would have held such
office if the Board had not been established and shall continue to do as
so an employee of the Board or until the expiry of the period of six
months from that date if such employee opts not to be the employee
of the Board within such period.
b. Notwithstanding anything contained in the Industrial Disputes Act, 1947(14 of
1947), or in any other law for the time being in force, absorption of any
employee by the Board in its regular service under this section shall not
entitle such employee to any compensation under that Act or other law and
no such claim shall be entertained by any court, tribunal or other authority.

CHAPTER IV

25.8 POWERS AND FUNCTIONS OF THE BOARD

25.8.1 Functions of Board.

a. Subject to the provisions of this Act, it shall be the duty of the Board to
protect the interests of investors in securities and to promote the
development of, and to regulate the securities market, by such measures as it
thinks fit.
b. Without prejudice to the generality of the foregoing provisions, the measures
referred to therein may provide for -
i. regulating the business in stock exchanges and any other securities
markets;
ii. registering and regulating the working of stock brokers, sub-brokers,
share transfer agents, bankers to an issue, trustees of trust deeds,
registrars to an issue, merchant bankers, underwriters, portfolio
managers, investment advisers and such other intermediaries who
may be associated with securities markets in any manner; 13[13][(ba)
registering and regulating the working of the depositories, 14[14]
[participants,] custodians of securities, foreign institutional investors,
credit rating agencies and such other intermediaries as the Board may,
by notification, specify in this behalf;]
iii. registering and regulating the working of [15][venture capital funds
and collective investment schemes],including mutual funds;
iv. promoting and regulating self-regulatory organisations;
v. prohibiting fraudulent and unfair trade practices relating to securities
markets;
vi. promoting investors' education and training of intermediaries of
securities markets;
vii. prohibiting insider trading in securities;
viii. regulating substantial acquisition of shares and take-over of
companies;
ix. calling for information from, undertaking inspection, conducting
inquiries and audits of the [16][ stock exchanges, mutual funds, other
persons associated with the securities market] intermediaries and self-
regulatory organizations in the securities market; 17[17][“(ia) calling for
information and record from any bank or any other authority or board
or corporation established or constituted by or under any Central,
State or Provincial Act in respect of any transaction in securities which
is under investigation or inquiry by the Board;”]
x. performing such functions and exercising such powers under the
provisions of [18][...]the Securities Contracts (Regulation) Act,
1956(42 of 1956), as may be delegated to it by the Central
Government;
xi. levying fees or other charges for carrying out the purposes of this
section;
xii. conducting research for the above purposes; 19[19][“(la) calling from or
furnishing to any such agencies, as may be specified by the Board,
such information as may be considered necessary by it for the efficient
discharge of its functions;”]
xiii. performing such other functions as may be prescribed. 20[20][“(2A)
Without prejudice to the provisions contained in sub-section (2), the
Board may take measures to undertake inspection of any book, or
register, or other document or record of any listed public company or a
public company (not being intermediaries referred to in section 12)
which intends to get its securities listed on any recognised stock
exchange where the Board has reasonable grounds to believe that
such company has been indulging in insider trading or fraudulent and
unfair trade practices relating to securities market.”]
21[21]
c. [Notwithstanding anything contained in any other law for the time being
in force while exercising the powers under [22][clause (i) or clause (ia) of
sub-section (2) or sub-section (2A)], the Board shall have the same powers
as are vested in a civil court under the Code of Civil Procedure, 1908 (5 of
1908),while trying a suit, in respect of the following matters, namely :
i. the discovery and production of books of account and other
documents, at such place and such time as may be specified by the
Board;
ii. summoning and enforcing the attendance of persons and examining
them on oath;
iii. inspection of any books, registers and other documents of any person
referred to in section 12, at any place;
23[23]
iv. [(iv) inspection of any book, or register, or other document or
record of the company referred to in sub-section (2A);
v. issuing commissions for the examination of witnesses or documents.]
24[24]
d. [Without prejudice to the provisions contained in sub-sections (1), (2),
(2A) and (3) and section 11B, the Board may, by an order, for reasons to be
recorded in writing, in the interests of investors or securities market, take any
of the following measures, either pending investigation or inquiry or on
completion of such investigation or inquiry, namely:-
i. suspend the trading of any security in a recognized stock exchange;
ii. restrain persons from accessing the securities market and prohibit any
person associated with securities market to buy, sell or deal in
securities;
iii. suspend any office-bearer of any stock exchange or self- regulatory
organization from holding such position;
iv. impound and retain the proceeds or securities in respect of any
transaction which is under investigation;
v. attach, after passing of an order on an application made for approval
by the Judicial Magistrate of the first class having jurisdiction, for a
period not exceeding one month, one or more bank account or
accounts of any intermediary or any person associated with the
securities market in any manner involved in violation of any of the
provisions of this Act, or the rules or the regulations made thereunder.
Provided that only the bank account or accounts or any transaction
entered therein, so far as it relates to the proceeds actually involved in
violation of any of the provisions of this Act, or the rules or the
regulations made thereunder shall be allowed to be attached;
vi. direct any intermediary or any person associated with the securities
market in any manner not to dispose of or alienate an asset forming
part of any transaction which is under investigation:
vii. Provided that the Board may, without prejudice to the provisions
contained in sub-section (2) or sub-section (2A), take any of the
measures specified in clause (d) or clause (e) or clause (f), in respect
of any listed public company or a public company (not being
intermediaries referred to in section 12) which intends to get its
securities listed on any recognized stock exchange where the Board
has reasonable grounds to believe that such company has been
indulging in insider trading or fraudulent and unfair trade practices
relating to securities market:
viii. Provided further that the Board shall, either before or after passing
such orders, give an opportunity of hearing to such intermediaries or
persons concerned.

25.9 25[25][Board to regulate or prohibit issue of prospectus, offer document


or advertisement soliciting money for issue of securities.

A. 11A (1) Without prejudice to the provisions of the Companies Act, 1956(1 of
1956), the Board may, for the protection of investors, -
a. specify, by regulations –
i. the matters relating to issue of capital, transfer of securities
and other matters incidental thereto; and
ii. the manner in which such matters shall be disclosed by the
companies;
b. by general or special orders –
i. prohibit any company from issuing prospectus, any offer
document, or advertisement soliciting money from the public
for the issue of securities;
ii. specify the conditions subject to which the prospectus, such
offer document or advertisement, if not prohibited, may be
issued.
B. [Without prejudice to the provisions of section 21 of the Securities Contracts
(Regulation) Act, 1956(42 of 1956), the Board may specify the requirements
for listing and transfer of securities and other matters incidental thereto."]

25.9.1 Collective Investment Scheme.

a. 11AA (1) Any scheme or arrangement which satisfies the conditions referred
to in sub-section (2) shall be a collective investment scheme.
b. Any scheme or arrangement made or offered by any company under which,--
-
i. the contributions, or payments made by the investors, by whatever
name called, are pooled and utilized solely for the purposes of the
scheme or arrangement;
ii. the contributions or payments are made to such scheme or
arrangement by the investors with a view to receive profits, income,
produce or property, whether movable or immovable from such
scheme or arrangement;
iii.the property, contribution or investment forming part of scheme or
arrangement, whether identifiable or not, is managed on behalf of the
investors;
iv. the investors do not have day to day control over the management
and operation of the scheme or arrangement.
c. Notwithstanding anything contained in sub-section (2), any scheme or
arrangement –
i. made or offered by a co-operative society registered under the co-
operative societies Act,1912(2 of 1912) or a society being a society
registered or deemed to be registered under any law relating to
cooperative societies for the time being in force in any state;
ii. under which deposits are accepted by non-banking financial companies
as defined in clause (f) of section 45-I of the Reserve Bank of India
Act, 1934(2 of 1934);
iii. being a contract of insurance to which the Insurance Act,1938(4 of
1938), applies;
iv. providing for any scheme, Pension Scheme or the Insurance Scheme
framed under the Employees Provident Fund and Miscellaneous
Provisions Act, 1952(19 of 1952);
v. under which deposits are accepted under section 58A of the
Companies Act, 1956(1 of 1956);
vi. under which deposits are accepted by a company declared as a Nidhi
or a mutual benefit society under section 620A of the Companies Act,
1956(1 of 1956);
vii. falling within the meaning of Chit business as defined in clause (d) of
section 2 of the Chit Fund Act, 1982(40 of 1982);
viii. under which contributions made are in the nature of subscription to a
mutual fund; shall not be a collective investment scheme.

26[27]
25.9.2 [Power to issue directions.

11B. Save as otherwise provided in section 11, if after making or causing to be made
an enquiry, the Board is satisfied that it is necessary,-

a. in the interest of investors, or orderly development of securities market; or


b. to prevent the affairs of any intermediary or other persons referred to in
section 12 being conducted in a manner detrimental to the interest of
investors or securities market; or
c. to secure the proper management of any such intermediary or person, it may
issue such directions,-
d. to any person or class of persons referred to in section 12, or associated with
the securities market; or
e. to any company in respect of matters specified in section 11A, as may be
appropriate in the interests of investors in securities and the securities market

25.9.3 27[28][Investigation.

a. 11C. Where the Board has reasonable ground to believe that –


i. the transactions in securities are being dealt with in a manner
detrimental to the investors or the securities market; or
ii. any intermediary or any person associated with the securities market
has violated any of the provisions of this Act or the rules or the
regulations made or directions issued by the Board thereunder.
iii. It may, at any time by order in writing, direct any person (hereafter in
this section referred to as the Investigating Authority) specified in the
order to investigate the affairs of such intermediary or persons
associated with the securities market and to report thereon to the
Board.
b. Without prejudice to the provisions of sections 235 to 241 of the Companies
Act, 1956(1 of 1956), it shall be the duty of every manager, managing
director, officer and other employee of the company and every intermediary
referred to in section 12 or every person associated with the securities market
to preserve and to produce to the Investigating Authority or any person
authorised by it in this behalf, all the books, registers, other documents and
record of, or relating to, the company or, as the case may be, of or relating
to, the intermediary or such person, which are in their custody or power.
c. The Investigating Authority may require any intermediary or any person
associated with securities market in any manner to furnish such information
to, or produce such books, or registers, or other documents, or record before
it or any person authorized by it in this behalf as it may consider necessary if
the furnishing of such information or the production of such books, or
registers, or other documents, or record is relevant or necessary for the
purposes of its investigation.
d. The Investigating Authority may keep in its custody any books, registers,
other documents and record produced under sub-section (2) or sub-section
(3) for six months and thereafter shall return the same to any intermediary or
any person associated with securities market by whom or on whose behalf the
books, registers, other documents and record are produced: Provided that the
Investigating Authority may call for any book, register, other document and
record if they are needed again: Provided further that if the person on whose
behalf the books, registers, other documents and record are produced
requires certified copies of the books, registers, other documents and record
produced before the Investigating Authority, it shall give certified copies of
such books, registers, other documents and record to such person or on
whose behalf the books, registers, other documents and record were
produced.
e. Any person, directed to make an investigation under sub-section (1),may
examine on oath, any manager, managing director, officer and other
employee of any intermediary or any person associated with securities market
in any manner, in relation to the affairs of his business and may administer
an oath accordingly and for that purpose may require any of those persons to
appear before it personally.
f. If any person fails without reasonable cause or refuses –
i. to produce to the Investigating Authority or any person authorised by
it in this behalf any book, register, other document and record which it
is his duty under sub-section (2) or sub-section (3) to produce; or
ii. to furnish any information which is his duty under sub-section (3) to
furnish; or
iii. to appear before the Investigating Authority personally when required
to do so under sub-section (5) or to answer any question which is put
to him by the Investigating Authority in pursuance of that sub-section;
or
iv. to sign the notes of any examination referred to in sub-section (7), he
shall be punishable with imprisonment for a term which may extend to
one year, or with fine, which may extend to one crore rupees, or with
both, and also with a further fine which may extend to five lakh rupees
for every day after the first during which the failure or refusal
continues.
g. Notes of any examination under sub-section (5) shall be taken down in
writing and shall be read over to, or by, and signed by, the person examined,
and may thereafter be used in evidence against him.
h. Where in the course of investigation, the Investigating Authority has
reasonable ground to believe that the books, registers, other documents and
record of, or relating to, any intermediary or any person associated with
securities market in any manner, may be destroyed, mutilated, altered,
falsified or secreted, the Investigating Authority may make an application to
the Judicial Magistrate of the first class having jurisdiction for an order for the
seizure of such books, registers, other documents and record.
i. After considering the application and hearing the Investigating Authority, if
necessary, the Magistrate may, by order, authorise the Investigating
Authority –
i. to enter, with such assistance, as may be required, the place or places
where such books, registers, other documents and record are kept;
ii. to search that place or those places in the manner specified in the
order; and
iii. to seize books, registers, other documents and record, it considers
necessary for the purposes of the investigation:Provided that the
Magistrate shall not authorize seizure of books, registers, other
documents and record, of any listed public company or a public
company (not being the intermediaries specified under section 12)
which intends to get its securities listed on any recognised stock
exchange unless such company indulges in insider trading or market
manipulation.
j. The Investigating Authority shall keep in its custody the books, registers,
other documents and record seized under this section for such period not
later than the conclusion of the investigation as it considers necessary and
thereafter shall return the same to the company or the other body corporate,
or, as the case may be, to the managing director or the manager or any other
person, from whose custody or power they were seized and inform the
Magistrate of such return; Provided that the Investigating Authority may,
before returning such books, registers, other documents and record as
aforesaid, place identification marks on them or any part thereof.
k. Save as otherwise provided in this section, every search or seizure made
under this section shall be carried out in accordance with the provisions of the
Code of Criminal Procedure, 1973(2 of 1974), relating to searches or seizures
made under that Code.

25.9.4 Cease and desist proceedings.

11D. If the Board finds, after causing an inquiry to be made, that any person has
violated, or is likely to violate, any provisions of this Act, or any rules or regulations
made thereunder, it may pass an order requiring such person to cease and desist
from committing or causing such violation:

Provided that the Board shall not pass such order in respect of any listed public
company or a public company (other than the intermediaries specified under section
12) which intends to get its securities listed on any recognized stock exchange unless
the Board has reasonable grounds to believe that such company has indulged in
insider trading or market manipulation.

CHAPTER V

25.10 REGISTRATION CERTIFICATE

25.10.1 Registration of stock brokers, sub-brokers, share transfer agents,


etc.

a. No stock-broker, sub- broker, share transfer agent, banker to an issue,


trustee of trust deed, registrar to an issue, merchant banker, underwriter,
portfolio manager, investment adviser and such other intermediary who may
be associated with securities market shall buy, sell or deal in securities except
under, and in accordance with, the conditions of a certificate of registration
obtained from the Board in accordance with the 28[29][regulations] made under
this Act: Provided that a person buying or selling securities or otherwise
dealing with the securities market as a stock- broker, sub-broker, share
transfer agent, banker to an issue, trustee of trust deed, registrar to an issue,
merchant banker, underwriter, portfolio manager, investment adviser and
such other intermediary who may be associated with securities market
immediately before the establishment of the Board for which no registration
certificate was necessary prior to such establishment, may continue to do so
for a period of three months from such establishment or, if he has made an
application for such registration within the said period of three months, till the
disposal of such application. 29[30][Provided further that any certificate of
registration, obtained immediately before the commencement of the
Securities Laws (Amendment) Act, 1995, shall be deemed to have been
obtained from the Board in accordance with the regulations providing for such
registration.
i. No depository, [31][participant,] custodian of securities, foreign
institutional investor, credit rating agency or any other intermediary
associated with the securities market as the Board may by notification
in this behalf specify, shall buy or sell or deal in securities except
under and in accordance with the conditions of a certificate of
registration obtained from the Board in accordance with the
regulations made under this Act: Provided that a person buying or
selling securities or otherwise dealing with the securities market as a
depository, [participant,] custodian of securities, foreign institutional
investor or credit rating agency immediately before the
commencement of the Securities Laws (Amendment) Act, 1995, for
which no certificate of registration was required prior to such
commencement, may continue to buy or sell securities or otherwise
deal with the securities market until such time regulations are made
under clause (d) of sub-section (2) of section 30.
ii. No person shall sponsor or cause to be sponsored or carry on or cause
to be carried on any venture capital funds or collective investment
schemes including mutual funds, unless he obtains a certificate of
registration from the Board in accordance with the regulations:
Provided that any person sponsoring or causing to be sponsored,
carrying on or causing to be carried on any venture capital funds or
collective investment schemes operating in the securities market
immediately before the commencement of the Securities Laws
(Amendment) Act, 1995, for which no certificate of registration was
required prior to such commencement, may continue to operate till
such time regulations are made under clause (d) of sub-section (2) of
section 30.
b. Every application for registration shall be in such manner and on payment of
such fees as may be determined by regulations.
c. The Board may, by order, suspend or cancel a certificate of registration in
such manner as may be determined by regulations. Provided that no order
under this sub-section shall be made unless the person concerned has been
given a reasonable opportunity of being heard.

31[32] CHAPTER V(A)

25.11 PROHIBITION OF MANIPULATIVE AND DECEPTIVE DEVICES, INSIDER


TRADING AND SUBSTANTIAL ACQUISITION OF SECURITIES OR CONTROL

25.125.1 Prohibition of manipulative and deceptive devices, insider trading


and substantial acquisition of securities or control.

12A. No person shall directly or indirectly – ]

a. use or employ, in connection with the issue, purchase or sale of any securities
listed or proposed to be listed on a recognized stock exchange, any
manipulative or deceptive device or contrivance in contravention of the
provisions of this Act or the rules or the regulations made thereunder;
b. employ any device, scheme or artifice to defraud in connection with issue or
dealing in securities which are listed or proposed to be listed on a recognized
stock exchange;
c. engage in any act, practice, course of business which operates or would
operate as fraud or deceit upon any person, in connection with the issue,
dealing in securities which are listed or proposed to be listed on a recognized
stock exchange, in contravention of the provisions of this Act or the rules or
the regulations made thereunder;
d. engage in insider trading;
e. deal in securities while in possession of material or non-public information or
communicate such material or non-public information to any other person, in
a manner which is in contravention of the provisions of this Act or the rules or
the regulations made thereunder;
f. acquire control of any company or securities more than the percentage of
equity share capital of a company whose securities are listed or proposed to
be listed on a recognized stock exchange in contravention of the regulations
made under this Act.

25.12 FINANCE, ACCOUNTS AND AUDIT

25.12.1 Grants by the Central Government.

The Central Government may, after due appropriation made by Parliament by law in
this behalf, make to the Board grants of such sums of money as that Government
may think fit for being utilised for the purposes of this Act.

25.12.2 Fund.
a. There shall be constituted a Fund to be called the Securities and Exchange
Board of India General Fund and there shall be credited thereto-
i. all grants, fees and charges received by the Board under this Act;
32[33]
[***] 33[34][***]
ii. all sums received by the Board from such other sources as may be
decided upon by the Central Government.
b. The Fund shall be applied for meeting -
a. the salaries, allowances and other remuneration of members, officers and
other employees of the Board;
b. the expenses of the Board in the discharge of its functions under section 11;
c. the expenses on objects and for purposes authorised by this Act.

25.12.3 Accounts and Audit.

a. The Board shall maintain proper accounts and other relevant records and
prepare an annual statement of accounts in such form as may be prescribed
by the Central Government in consultation with the Comptroller and Auditor-
General of India.
b. The accounts of the Board shall be audited by the Comptroller and Auditor-
General of India at such intervals as may be specified by him and any
expenditure incurred in connection with such audit shall be payable by the
Board to the Comptroller and Auditor-General of India.
c. The Comptroller and Auditor-General of India and any other person appointed
by him in connection with the audit of the accounts of the Board shall have
the same rights and privileges and authority in connection with such audit as
the Comptroller and Auditor-General generally has in connection with the
audit of the Government accounts and, in particular, shall have the right to
demand the production of books, accounts, connected vouchers and other
documents and papers and to inspect any of the offices of the Board.
d. The accounts of the Board as certified by the Comptroller and Auditor-General
of India or any other person appointed by him in this behalf together with the
audit report thereon shall be forwarded annually to the Central Government
and that Government shall cause the same to be laid before each House of
Parliament.

34[35]
CHAPTER VI(A)

25.13 PENALTIES AND ADJUDICATION

15A. Penalty for failure to furnish information, return, etc.- If any person, who
is required under this Act or any rules or regulations made thereunder,-

a. to furnish any document, return or report to the Board, fails to furnish the
same, he shall be liable to [36][a penalty of one lakh rupees for each day
during which such failure continues or one crore rupees, whichever is less];
b. to file any return or furnish any information, books or other documents within
the time specified therefor in the regulations, fails to file return or furnish the
same within the time specified therefor in the regulations, he shall be liable to
36[37]
[a penalty of one lakh rupees for each day during which such failure
continues or one crore rupees, whichever is less];
c. to maintain books of accounts or records, fails to maintain the same, he shall
be liable to 37[38][a penalty of one lakh rupees for each day during which such
failure continues or one crore rupees, whichever is less.]

15B. Penalty for failure by any person to enter into an agreement with
clients.- If any person, who is registered as an intermediary and is required under
this Act or any rules or regulations made thereunder to enter into an agreement with
his client, fails to enter into such agreement, he shall be liable to 38[39][a penalty of
one lakh rupees for each day during which such failure continues or one crore
rupees, whichever is less.]

15C.Penalty for failure to redress investors' grievances.- 39[40][If any listed


company or any person who is registered as an intermediary, after having been
called upon by the Board in writing, to redress the grievances of investors, fails to
redress such grievances within the time specified by the Board, such company or
intermediary shall be liable to a penalty of one lakh rupees for each day during which
such failure continues or one crore rupees, whichever is less.]

15D.Penalty for certain defaults in case of mutual funds.-If any person, who
is -

a. required under this Act or any rules or regulations made thereunder to obtain
a certificate of registration from the Board for sponsoring or carrying on any
collective investment scheme, including mutual funds, sponsors or carries on
any collective investment scheme, including mutual funds, without obtaining
such certificate of registration, he shall be liable to 40[41][a penalty of one lakh
rupees for each day during which he sponsors or carries on any such
collective investment scheme including mutual funds, or one crore rupees,
whichever is less.]
b. registered with the Board as a collective investment scheme, including mutual
funds, for sponsoring or carrying on any investment scheme, fails to comply
with the terms and conditions of certificate of registration, he shall be liable to
41[42]
[a penalty of one lakh rupees for each day during which such failure
continues or one crore rupees, whichever is less.]
c. registered with the Board as a collective investment scheme, including mutual
funds, fails to make an application for listing of its schemes as provided for in
the regulations governing such listing, he shall be liable to 42[43][a penalty of
one lakh rupees for each day during which such failure continues or one crore
rupees , whichever is less.]
d. registered as a collective investment scheme including mutual funds fails to
despatch unit certificates of any scheme in the manner provided in the
regulation governing such despatch, he shall be liable to 43[44][a penalty of
one lakh rupees for each day during which such failure continues or one crore
rupees, whichever is less.]
e. registered as a collective investment scheme, including mutual funds, fails to
refund the application monies paid by the investors within the period specified
in the regulations, he shall be liable to pay 44[45][a penalty of one lakh rupees
for each day during which such failure continues or one crore rupees,
whichever is less.]
f. registered as a collective investment scheme, including mutual funds, fails to
invest money collected by such collective investment schemes in the manner
or within the period specified in the regulations, he shall be liable to 45[46][a
penalty of one lakh rupees for each day during which such failure continues or
one crore rupees, whichever is less.]

15E. Penalty for failure to observe rules and regulations by an asset


management company.- Where any asset management company of a mutual fund
registered under this Act, fails to comply with any of the regulations providing for
restrictions on the activities of the asset management companies, such asset
management company shall be liable to 46[47][a penalty of one lakh rupees for each
day during which such failure continues or one crore rupees, whichever is less.]

15F. Penalty for failure in case of stock brokers.- If any person, who is
registered as a stock broker under this Act, -

a. fails to issue contract notes in the form and in the manner specified by the
stock exchange of which such broker is a member, he shall be liable to a
penalty not exceeding five times the amount for which the contract note was
required to be issued by that broker;
b. fails to deliver any security or fails to make payment of the amount due to the
investor in the manner within the period specified in the regulations, he shall
be liable to 47[48][a penalty of one lakh rupees for each day during which such
failure continues or one crore rupees, whichever is less.]
c. charges an amount of brokerage which is in excess of the brokerage specified
in the regulations, he shall be liable to 48[49][a penalty of one lakh rupees] or
five times the amount of brokerage charged in excess of the specified
brokerage, whichever is higher.

15G.Penalty for insider trading.- If any insider who,-

either on his own behalf or on behalf of any other person, deals in securities of a
body corporate listed on any stock exchange on the basis of any unpublished price
sensitive information; or

communicates any unpublished price- sensitive information to any person, with or


without his request for such information except as required in the ordinary course of
business or under any law; or

counsels, or procures for any other person to deal in any securities of any body
corporate on the basis of unpublished price-sensitive information, shall be liable to a
penalty 49[50][of twenty-five crore rupees or three times the amount of profits made
out of insider trading, whichever is higher.]

15H.Penalty for non-disclosure of acquisition of shares and take-overs.-If


any person, who is required under this Act or any rules or regulations made
thereunder, fails to,-

a. disclose the aggregate of his shareholding in the body corporate before he


acquires any shares of that body corporate; or
b. make a public announcement to acquire shares at a minimum price;
c. 50[51][make a public offer by sending letter of offer to the shareholders of the
concerned company; or
d. make payment of consideration to the shareholders who sold their shares
pursuant to letter of offer.] he shall be liable to a penalty 51[52][ twenty-five
crore rupees or three times the amount of profits made out of such failure,
whichever is higher.]

52[53]
[15HA.Penalty for fraudulent and unfair trade practices.- If any person
indulges in fraudulent and unfair trade practices relating to securities, he shall be
liable to a penalty of twenty-five crore rupees or three times the amount of profits
made out of such practices, whichever is higher.

15HB.Penalty for contravention where no separate penalty has been


provided.- Whoever fails to comply with any provision of this Act, the rules or the
regulations made or directions issued by the Board thereunder for which no separate
penalty has been provided, shall be liable to a penalty which may extend to one
crore rupees.]

15I.Power to adjudicate.-

a. For the purpose of adjudging under sections 15A, 15B, 15C, 15D, 15E, 15F,
15G, [54][15H, 15HA and 15HB] ,the Board shall appoint any of its officers
not below the rank of a Division Chief to be an adjudicating officer for holding
an inquiry in the prescribed manner after giving any person concerned a
reasonable opportunity of being heard for the purpose of imposing any
penalty.
b. While holding an inquiry, the adjudicating officer shall have power to summon
and enforce the attendance of any person acquainted with the facts and
circumstances of the case to give evidence or to produce any document which
in the opinion of the adjudicating officer, may be useful for or relevant to the
subject matter of the inquiry and if, on such inquiry, he is satisfied that the
person has failed to comply with the provisions of any of the sections
specified in sub-section (1), he may impose such penalty as he thinks fit in
accordance with the provisions of any of those sections.

15J.Factors to be taken into account by the adjudicating officer.-While


adjudging quantum of penalty under section 15, the adjudicating officer shall have
due regard to the following factors, namely:

a. the amount of disproportionate gain or unfair advantage, wherever


quantifiable, made as a result of the default;
b. the amount of loss caused to an investor or group of investors as a result of
the default;
c. the repetitive nature of the default.

54[55]
[15JA.Crediting sums realized by way of penalties to Consolidated Fund
of India.-

All sums realised by way of penalties under this Act shall be credited to the
Consolidated Fund of India.]

25.14 ESTABLISHMENT, JURISDICTION, AUTHORITY AND PROCEDURE OF


APPELLATE TRIBUNAL
15K.Establishment of Securities Appellate Tribunals.-

a. The Central Government shall, by notification, establish one or more Appellate


Tribunals to be known as the Securities Appellate Tribunal to exercise the
jurisdiction, powers and authority conferred on such Tribunal by or under this
Act 55[56][or any other law for the time being in force ]
b. The Central Government shall also specify in the notification referred to in
sub-section (1) the matters and places in relation to which the Securities
Appellate Tribunal may exercise jurisdiction.

56[57]
[15L.Composition of Securities Appellate Tribunal. A Securities Appellate
Tribunal shall consist of a Presiding Officer and two other Members, to be appointed,
by notification, by the Central Government: Provided that the Securities Appellate
Tribunal, consisting of one person only, established before the commencement of the
Securities and Exchange Board of India (Amendment) Act, 2002, shall continue to
exercise the jurisdiction, powers and authority conferred on it by or under this Act or
any other law for the time being in force till two other Members are appointed under
this section.

15M.Qualification for appointment as Presiding Officer or Member of the


Securities Appellate Tribunal.

a. A person shall not be qualified for appointment as the Presiding Officer of a


Securities Appellate Tribunal unless he is a sitting or retired Judge of the
Supreme Court or a sitting or retired Chief Justice of a High Court: Provided
that the Presiding Officer of the Securities Appellate Tribunal shall be
appointed by the Central Government in consultation with the Chief Justice of
India or his nominee.
b. A person shall not be qualified for appointment as Member of a Securities
Appellate Tribunal unless he is a person of ability, integrity and standing who
has shown capacity in dealing with problems relating to securities market and
has qualification and experience of corporate law, securities laws, finance,
economics or accountancy: Provided that a member of the Board or any
person holding a post oat senior management level equivalent to Executive
Director in the Board shall not be appointed as Presiding Officer or Member of
a Securities Appellate Tribunal during his service or tenure as such with the
Board or within two years from the date on which he ceases to hold office as
such in the Board.]

57[58]
[15N. Tenure of office of Presiding Officer and other Members of
Securities Appellate Tribunal. The Presiding Officer and every other Member of a
Securities Appellate Tribunal shall hold office for a terms of five years from the date
on which he enters upon his office and shall be eligible for re-appointment:

Provided that no person shall hold office as the Presiding Officer of the Securities
Appellate Tribunal after he has attained the age of sixty-eight years:

Provided further that no person shall hold office as Member of the Securities
Appellate Tribunal after he has attained the age of sixty-two years.]

15 O. Salary and allowances and other terms and conditions of service of


Presiding Officers.- The salary and allowances payable to and the other terms and
conditions of service (including pension, gratuity and other retirement benefits) of
the [59][Presiding Officer and any other Member of a Securities Appellate Tribunal]
shall be such as may be prescribed:

Provided that neither the salary and allowances nor the other terms and conditions of
service of the [60][Presiding Officer and other Members of a Securities Appellate
Tribunal] shall be varied to their disadvantage after appointment.

15P.Filling up of vacancies. - If, for reason other than temporary absence; any
vacancy occurs in 60[61][the office of the Presiding Officer or any other Member] of a
Securities Appellate Tribunal, then the Central Government shall appoint another
person in accordance with the provisions of this Act to fill the vacancy and, the
proceedings may be continued before the Securities Appellate Tribunal from the
stage at which the vacancy is filled.

15Q.Resignation and removal.

61[62]
a. [The Presiding Officer or any other Member of a Securities Appellate
Tribunal] may, by notice in writing under his hand addressed to the Central
Government, resign his office: Provided that 62[63][the Presiding Officer or any
other Member] shall, unless he is permitted by the Central Government to
relinquish his office sooner, continue to hold office, until the expiry of three
months from the date of receipt of such notice or until a person duly
appointed as his successor enters upon his office or until the expiry of his
term of office, whichever is the earliest.
b. The 63[64][Presiding Officer or any other Member] of a Securities Appellate
Tribunal shall not be removed from his office except by an order by the
Central Government on the ground of proved misbehaviour or incapacity after
inquiry made by a Judge of the Supreme Court, in which the 64[65][Presiding
Officer or any other Member] concerned has been informed of the charges
against him and given a reasonable opportunity of being heard in respect of
these charges.
c. The Central Government may, by rules, regulate the procedure for the
investigation of misbehavior or incapacity of the 65[66][the Presiding Officer or
any other Member].

15R.Orders constituting Appellate Tribunal to be final and not to invalidate


its proceedings. -No order of the Central Government appointing any person as the
[67][Presiding Officer or a Member] of a Securities Appellate Tribunal shall be called
in question in any manner, and no act or proceeding before a Securities Appellate
Tribunal shall be called in question in any manner on the ground merely of any
defect in the constitution of a Securities Appellate Tribunal.

15S.Staff of the Securities Appellate Tribunal.

a. The Central Government shall provide the Securities Appellate Tribunal with
such officers and employees as that Government may think fit.
b. The officers and employees of the Securities Appellate Tribunal shall
discharge their functions under general superintendence of the Presiding
Officer.
c. The salaries and allowances and other conditions of service of the officers and
employees of the Securities Appellate Tribunal shall be such as may be
prescribed.

15T.Appeal to the Securities Appellate Tribunal.

67[68]
a. Save as provided in sub-section (2), any person aggrieved,-
i. by an order of the Board made, on and after the commencement of
the Securities Laws (Second Amendment) Act, 1999, under this Act, or
the rules or regulations made thereunder; or
ii. by an order made by an adjudicating officer under this Act, may prefer
an appeal to a Securities Appellate Tribunal having jurisdiction in the
matter.
b. No appeal shall lie to the Securities Appellate Tribunal from an order made__
i. by the Board on and after the commencement of the Securities Laws
(Second Amendment) Act, 1999;
ii. by an adjudicating officer, with the consent of the parties.]
c. Every appeal under sub-section (1) shall be filed within a period of forty-five
days from the date on which [69][a copy of the order made by the Board or
the adjudicating officer, as the case may be,]is received by him and it shall be
in such form and be accompanied by such fee as may be prescribed: Provided
that the Securities Appellate Tribunal may entertain an appeal after the expiry
of the said period of forty-five days if it is satisfied that there was sufficient
cause for not filing it within that period.
d. On receipt of an appeal under sub-section (1), the Securities Appellate
Tribunal may, after giving the parties to the appeal, an opportunity of being
heard, pass such orders thereon as it thinks fit, confirming, modifying or
setting aside the order appealed against.
e. The Securities Appellate Tribunal shall send a copy of every order made by it
to the [70][Board, the parties] to the appeal and to the concerned
Adjudicating Officer.
f. The appeal filed before the Securities Appellate Tribunal under sub-section (1)
shall be dealt with by it as expeditiously as possible and endeavour shall be
made by it to dispose of the appeal finally within six months from the date of
receipt of the appeal.

15U.Procedure and powers of the Securities Appellate Tribunal.

a. The Securities Appellate Tribunal shall not be bound by the procedure laid
down by the Code of Civil Procedure, 1908(5 of 1908), but shall be guided by
the principles of natural justice and, subject to the other provisions of this Act
and of any rules, the Securities Appellate Tribunal shall have powers to
regulate their own procedure including the places at which they shall have
their sittings.
b. The Securities Appellate Tribunal shall have, for the purposes of discharging
their functions under this Act, the same powers as are vested in a civil court
under the Code of Civil Procedure, 1908(5 of 1908), while trying a suit, in
respect of the following matters, namely:
i. summoning and enforcing the attendance of any person and
examining him on oath;
ii. requiring the discovery and production of documents;
iii.receiving evidence on affidavits;
iv. issuing commissions for the examination of witnesses or documents;
v. reviewing its decisions;
vi. dismissing an application for default or deciding it ex parte;
vii. setting aside any order of dismissal of any application for default or
any order passed by it ex parte;
viii. any other matter which may be prescribed.
c. Every proceeding before the Securities Appellate Tribunal shall be deemed to
be a judicial proceeding within the meaning of sections 193 and 228, and for
the purposes of section 196 of the Indian Penal Code(45 of 1860), and the
Securities Appellate Tribunal shall be deemed to be a civil court for all the
purposes of section 195 and Chapter XXVI of the Code of Criminal Procedure,
1973(2 of 1974).

70[71]
[15V.Right to legal representation. - The appellant may either appear in
person or authorise one or more chartered accountants or company secretaries or
cost accountants or legal practitioners or any of its officers to present his or its case
before the Securities Appellate Tribunal.

Explanation:- For the purposes of this section,-

a. "chartered accountant" means a chartered accountant as defined in clause(b)


of sub-section(1) of section 2 of the Chartered Accountants Act, 1949(38 of
1949) and who has obtained a certificate of practice under sub-section (1) of
section 6 of that Act;
b. "company secretary" means a company secretary as defined in clause(c) of
sub-section(1) of section 2 of the Company Secretaries Act,1980(56 of 1980)
and who has obtained a certificate of practice under sub-section (1) of section
6 of that Act;
c. " cost accountant" means a cost accountant as defined in clause(b) of sub-
section(1) of section 2 of the Cost and Works Accountants Act, 1959(23 of
1959) and who has obtained a certificate of practice under sub-section (1) of
section 6 of that Act;
d. ) "legal practitioner" means an advocate, vakil or any attorney of any High
Court, and includes a pleader in practice.]

15W.Limitation. -The provisions of the Limitation Act, 1963 (36 of 1963), shall, as
far as may be, apply to an appeal made to a Securities Appellate Tribunal.

71[72]
[15X.Presiding Officer, Members and staff of Securities Appellate
Tribunals to be public servants. - The Presiding Officer, Members and other
officers and employees of a Securities Appellate Tribunal shall be deemed to be
public servants within the meaning of section 21 of the Indian Penal Code(45 of
1860).]

15Y.Civil Court not to have jurisdiction. - No civil court shall have jurisdiction to
entertain any suit or proceeding in respect of any matter which an Adjudicating
Officer appointed under this Act or a Securities Appellate Tribunal constituted under
this Act is empowered by or under this Act to determine and no injunction shall be
granted by any court or other authority in respect of any action taken or to be taken
in pursuance of any power conferred by or under this Act.
72[73]
[15Z.Appeal to Supreme Court.- Any person aggrieved by any decision or
order of the Securities Appellate Tribunal may file an appeal to the Supreme Court
within sixty days from the date of communication of the decision or order of the
Securities Appellate Tribunal to him on any question of law arising out of such order:

Provided that the Supreme Court may, if it is satisfied that the applicant was
prevented by sufficient cause from filing the appeal within the said period, allow it to
be filed within a further period not exceeding sixty days.]

CHAPTER VII

25.15 MISCELLANEOUS

25.15.1 Power of Central Government to issue directions.

a. Without prejudice to the foregoing provisions of [74][this Act or the


Depositories Act, 1996], the Board shall, in exercise of its powers or the
performance of its functions under this Act, be bound by such directions on
questions of policy as the Central Government may give in writing to it from
time to time: Provided that the Board shall, as far as practicable, be given an
opportunity to express its views before any direction is given under this sub-
section.
b. The decision of the Central Government whether a question is one of policy or
not shall be final.

25.15.2 Power of Central Government to supersede the Board.

a. If at any time the Central Government is of opinion-


i. that on account of grave emergency, the Board is unable to discharge
the functions and duties imposed on it by or under the provisions of
this Act; or
ii. that the Board has persistently made default in complying with any
direction issued by the Central Government under this Act or in the
discharge of the functions and duties imposed on it by or under the
provisions of this Act and as a result of such default the financial
position of the Board or the administration of the Board has
deteriorated; or
iii. that circumstances exist which render it necessary in the public
interest so to do, the Central Government may, by notification,
supersede the Board for such period, not exceeding six months, as
may be specified in the notification
b. Upon the publication of a notification under sub-section (1) superseding the
Board,-
i. all the members shall, as from the date of supersession, vacate their
offices as such;
ii. all the powers, functions and duties which may, by or under the
provisions of this Act, be exercised or discharged by or on behalf of the
Board, shall until the Board is reconstituted under sub-section (3), be
exercised and discharged by such person or persons as the Central
Government may direct; and
iii. all property owned or controlled by the Board shall, until the Board is
reconstituted under sub-section (3), vest in the Central Government.
c. On the expiration of the period of supersession specified in the notification
issued under sub-section (1), the Central Government may reconstitute the
Board by a fresh appointment and in such case any person or persons who
vacated their offices under clause (a) of sub-section (2), shall not be deemed
disqualified for appointment: Provided that the Central Government may, at
any time, before the expiration of the period of supersession, take action
under this sub-section.
d. The Central Government shall cause a notification issued under sub-section
(1) and a full report of any action taken under this section and the
circumstances leading to such action to be laid before each House of
Parliament at the earliest.

25.15.3 Returns and reports.

a. The Board shall furnish to the Central Government at such time and in such
form and manner as may be prescribed or as the Central Government may
direct, such returns and statements and such particulars in regard to any
proposed or existing programme for the promotion and development of the
securities market, as the Central Government may, from time to time,
require.
b. Without prejudice to the provisions of sub-section (1), the Board shall, within
[75][ninety days] after the end of each financial year, submit to the Central
Government a report in such form, as may be prescribed, giving a true and
full account of its activities, policy and programmes during the previous
financial year.
c. A copy of the report received under sub-section (2) shall be laid, as soon as
may be after it is received, before each House of Parliament.

25.15.4 Delegation

The Board may, by general or special order in writing delegate to any member,
officer of the Board or any other person subject to such conditions, if any, as may be
specified in the order, such of its powers and functions under this Act (except the
powers under section 29) as it may deem necessary.

25.15.5 Appeals

Any person aggrieved by [76][an order of the Board made, before the
commencement of Securities Laws (Second Amendment) Act, 1999,] under this Act,
or the rules or regulations made thereunder may prefer an appeal to the Central
Government within such time as may be prescribed.

No appeal shall be admitted if it is preferred after the expiry of the period prescribed
therefore: Provided that an appeal may be admitted after the expiry of the period
prescribed therefor if the appellant satisfies the Central Government that he had
sufficient cause for not preferring the appeal within the prescribed period.

Every appeal made under this section shall be made in such form and shall be
accompanied by a copy of the order appealed against and by such fees as may be
prescribed.
The procedure for disposing of an appeal shall be such as may be prescribed:

Provided that before disposing of an appeal, the appellant shall be given a


reasonable opportunity of being heard.

76[77]
[20A.Bar of jurisdiction.-No order passed by the [78][Board or the
Adjudicating officer] under this Act shall be appealable except as provided in
[79][section 15T or section 20] and no Civil Court shall have jurisdiction in respect of
any matter which the [80][Board or the Adjudicating officer] is empowered by, or
under, this Act to pass any order and no injunction shall be granted by any court or
other authority in respect of any action taken or to be taken in pursuance of any
order passed by the [81][Board or the adjudicating office] by, or under, this Act.]

25.15.6 Savings.

Nothing in this Act shall exempt any person from any suit or other proceedings which
might, apart from this Act, be brought against him.

25.15.7 Members, Officers and employees of the Board to be public


servants.

All members, officers and other employees of the Board shall be deemed, when
acting or purporting to act in pursuance of any of the provisions of this Act, to be
public servants within the meaning of section 21 of the Indian Penal Code (45 of
1860).

25.15.8 Protection of action taken in good faith.

No suit, prosecution or other legal proceedings shall lie against the Central
Government [82][or Board] or any officer of the Central Government or any
member, officer or other employee of the Board for anything which is in good faith
done or intended to be done under this Act or the rules or regulations made
thereunder.

25.15.9 82[83][24.Offences. -

Without prejudice to any award of penalty by the Adjudicating Officer under this Act,
if any person contravenes or attempts to contravene or abets the contravention of
the provisions of this Act or of any rules or regulations made thereunder, he shall be
punishable with imprisonment for a term which may extend to 83[84][ten years, or
with fine, which may extend to twenty-five crore rupees or with both.]

If any person fails to pay the penalty imposed by the Adjudicating Officer or fails to
comply with any of his directions or orders, he shall be punishable with imprisonment
for a term which shall not be less than one month, but which may extend to [85][ten
years or with fine, which may extend to twenty-five crore rupees or with both].]

25.15.1085[86][Composition of certain offences.

24A. Notwithstanding anything contained in the Code of Criminal Procedure, 1973(2


of 1974), any offence punishable under this Act, not being an offence punishable
with imprisonment only, or with imprisonment and also with fine, may either before
or after the institution of any proceeding, be compounded by a Securities Appellate
Tribunal or a court before which such proceedings are pending.

25.15.11 Power to grant immunity.

24B. (1) The Central Government may, on recommendation by the Board, if the
Central Government is satisfied, that any person, who is alleged to have violated any
of the provisions of this Act or the rules or the regulations made thereunder, has
made a full and true disclosure in respect of the alleged violation, grant to such
person, subject to such conditions as it may think fit to impose, immunity from
prosecution for any offence under this Act, or the rules or the regulations made
thereunder or also from the imposition of any penalty under this Act with respect to
the alleged violation: Provided that no such immunity shall be granted by the Central
Government in cases where the proceedings for the prosecution for any such offence
have been instituted before the date of receipt of application for grant of such
immunity: Provided further that recommendation of the Board under this sub-section
shall not be binding upon the Central Government.

(2) An immunity granted to a person under sub-section (1) may, at any time, be
withdrawn by the Central Government, if it is satisfied that such person had, in the
course of the proceedings, not complied with the condition on which the immunity
was granted or had given false evidence, and thereupon such person may be tried
for the offence with respect to which the immunity was granted or for any other
offence of which he appears to have been guilty in connection with the contravention
and shall also become liable to the imposition of any penalty under this Act to which
such person would have been liable, had not such immunity been granted.]

25.15.12 Exemption from tax on wealth and income.

Notwithstanding anything contained in the Wealth Tax Act, 1957(27 of 1957), the
Income Tax Act, 1961(43 of 1961) or any other enactment for the time being in
force relating to tax on wealth, income, profits or gains -

the Board;

the existing Securities and Exchange Board from the date of its constitution to the
date of establishment of the Board, shall not be liable to pay wealth-tax, income-tax
or any other tax in respect of their wealth, income, profits or gains derived.

25.15.13 Cognizance of offences by courts.

a. No court shall take cognizance of any offence punishable under this Act or any
rules or regulations made thereunder, save on a complaint made by the
Board. 86[87][ ]
b. No court inferior to that of [88][a Court of Session] shall try an offence
punishable under this Act.

25.15.14 Offences by companies.

a. Where an offence under this Act has been committed by a company, every
person who at the time the offence was committed was in charge of, and was
responsible to, the company for the conduct of the business of the company,
as well as the company, shall be deemed to be guilty of the offence and shall
be liable to be proceeded against and punished accordingly: Provided that
nothing contained in this sub-section shall render any such person liable to
any punishment provided in this Act, if he proves that the offence was
committed without his knowledge or that he had exercised all due diligence to
prevent the commission of such offence.
b. Notwithstanding anything contained in sub-section (1), where an offence
under this Act has been committed by a company and it is proved that the
offence has been committed with the consent or connivance of, or is
attributable to any neglect on the part of, any director, manager, secretary or
other officer of the company, such director, manager, secretary or other
officer shall also be deemed to be guilty of the offence and shall be liable to
be proceeded against and punished accordingly.

Explanation.-

For the purposes of this section, -

a. "company" means any body corporate and includes a firm or other association
of individuals; and
b. "director" in relation to a firm, means a partner in the firm.

25.15.15 Power to exempt.

[Omitted by the Securities Laws (Amendment) Act,1995(9 of 1995), S.15 (w.e.f. 25-
1-1995).]

25.15.16 Power to make rules.

A. The Central Government may, by notification, make rules for carrying out the
purposes of this Act.
B. In particular, and without prejudice to the generality of the foregoing power,
such rules may provide for all or any of the following matters, namely:-
a. the term of office and other conditions of service of the Chairman and
the members under sub-section (1) of section 5;
b. the additional functions that may be performed by the Board under
section 11;
c. the manner in which the accounts of the Board shall be maintained
under section 15;
89[90]
i. [the manner of inquiry under sub-section (1) of section 15-
I;
ii. the salaries and allowances and other terms and conditions of
service of the [91][Presiding Officers, Members] and other
officers and employees of the Securities Appellate Tribunal
under section 15-O and sub-section (3) of section 15S;
iii. the procedure for the investigation of misbehaviour or
incapacity of the [92][Presiding Officers, or other Members] of
the Securities Appellate Tribunal under sub-section (3) of
section 15Q;
iv. the form in which an appeal may be filed before the Securities
Appellate Tribunal under section 15 -T and the fees payable in
respect of such appeal;]
v. the form and the manner in which returns and report to be
made to the Central Government under section 18;
vi. any other matter which is to be, or may be, prescribed, or in
respect of which provision is to be, or may be, made by rules.

25.15.17 Power to make regulations.

a. The Board may, 92[93][***] by notification, make regulations consistent with


this Act and the rules made thereunder to carry out the purposes of this Act.
b. In particular, and without prejudice to the generality of the foregoing power,
such regulations may provide for all or any of the following matters, namely:-
i. the times and places of meetings of the Board and the procedure to be
followed at such meetings under sub-section (1) of section 7 including
quorum necessary for the transaction of business;
ii. the terms and other conditions of service of officers and employees of
the Board under sub-section (2) of section 9
93[94]
iii. the matters relating to issue of capital, transfer of securities and
other matters incidental thereto and the manner in which such matters
shall be disclosed by the companies under section 11A;
iv. the conditions subject to which certificate of registration is to be
issued, the amount of fee to be paid for certificate of registration and
the manner of suspension or cancellation of certificate of registration
under section 12.]

25.15.18 Rules and regulations to be laid before Parliament.

Every rule and every regulation made under this Act shall be laid, as soon as may be
after it is made, before each House of Parliament, while it is in session, for a total
period of thirty days which may be comprised in one session or in two or more
successive sessions, and if, before the expiry of the session immediately following
the session or the successive sessions aforesaid, both Houses agree in making any
modification in the rule or regulation or both Houses agree that the rule or regulation
should not be made, the rule or regulation shall thereafter have effect only in such
modified form or be of no effect, as the case may be; so, however, that any such
modification or annulment shall be without prejudice to the validity of anything
previously done under that rule or regulation.

25.15.19 Application of other laws not barred.

The provisions of this Act shall be in addition to, and not in derogation of, the
provisions of any other law for the time being in force.

25.15.20 Amendment of certain enactments.

The enactments specified in Parts I and II of the Schedule to this Act shall be
amended in the manner specified therein and such amendments shall take effect on
the date of establishment of the Board.
25.15.21 Power to remove difficulties.

a. If any difficulty arises in giving effect to the provisions of this Act, the Central
Government may, by order, published in the Official Gazette, make such
provisions not inconsistent with the provisions of this Act as may appear to be
necessary for removing the difficulty: Provided that no order shall be made
under this section after the expiry of five years from the commencement of
this Act.
b. Every order made under this section shall be laid, as soon as may be after it
is made, before each House of Parliament.
25.15.22 Repeal and saving.
a. The Securities and Exchange Board of India Ordinance, 1992 (Ord. 5 of
1992), is hereby repealed.
b. Notwithstanding such repeal, anything done or any action taken under the
said Ordinance, shall be deemed to have been done or taken under the
corresponding provisions of this Act.

THE SCHEDULE

[See section 33]

25.16 Amendment of Certain Enactments

25.16.1 PART I: AMENDMENT TO THE CAPITAL ISSUES (CONTROL) ACT,


1947

(29 of 1947)

In section 10 for “to that Government” substitute “to that Government or the
Securities and Exchange Board of India”.

25.16.2 PART II: AMENDMENTS TO THE SECURITIES CONTRACTS


(REGULATION) ACT, 1956

(42 of 1956)

a. Section 2 in clause (h) for sub-clause (ii), substitute the following: –


i. Government securities;
ii. such other instruments as may be declared by the Central Government
to be securities; and”.
b. Section 6,—
i. in sub-section (1), for “Central Government”, substitute “Securities
and Exchange Board of India”;
ii. in sub-section (2) for “by the Central Government”, substitute “by the
Securities and Exchange Board of India”.
iii. in sub-section (3), for “Central Government”, wherever it occurs,
substitute “Securities and Exchange Board of India”;
c. Section 9, for “Central Government” wherever it occurs, substitute “Securities
and Exchange Board of India”;
d. Section 10, for “Central Government” wherever it occurs, substitute
“Securities and Exchange Board of India”;
e. Section 17, in sub-section (1), for “licence granted by the Central
Government”, substitute “licence granted by the Securities and Exchange
Board of India”;
f. Section 21 for “Central Government”, substitute “Securities and Exchange
Board of India”;
g. Section 22A, in sub-section (3), for clause (b), substitute the following—
i. that the transfer of the securities is in contravention of any law or
rules made thereunder or any administrative instructions or conditions
of listing agreement laid down in pursuance of such laws and rules.";
h. In sub-section (2) of section 23, for “Central Government under section 21 or
section 22”, substitute “Securities and Exchange Board of India under section
21 or the Central Government under section 22”;
i. After section 29 insert the following:
“29A.Power to delegate. — The Central Government may, by order published in the
Official Gazette, direct that the powers exercisable by it under any provision of this
Act shall, in relation to such matters and subject to such conditions, if any as may be
specified in order, be excusable also by the Securities and Exchange Board of India”
94[1]
Inserted by the Securities Laws (Amendment) Act, 31 of 1999, S. 11 ( w.e.f. 22-
2-2000).
95[2]
Inserted by the SEBI (Amendment) Act, 2002, S. 2(w.e.r.f. 29-10-2002).
96[3]
Substituted by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-01-1995.
Prior to its substitution, sub-section (2) reads as under:
“Words and expressions used and not defined in this Act but defined in the Capital
Issues (Control) Act, 1947 or the Securities Contracts Regulation Act, 1956 shall
have the same meanings respectively assigned to them in those Acts.”
97[4]
Inserted by the depositories Act, 1996, w.e.f. 20-09-1995.
98[5]
Substituted by the SEBI (Amendment) Act, 2002, S. 3(a) (i) (A) (w..r.e.f. 29-10-
2002) , for “Ministries”.
99[6]
Substituted by the SEBI (Amendment) Act, 2002, S. 3(a) (i) (B) (w..r.e.f. 29-10-
2002) , for “and Law”
100[7]
Substituted by the SEBI (Amendment) Act, 2002, S. 3(a) (ii) (w..r.e.f. 29-10-
2002) , for “the Reserve Bank of India constituted under section 3 of the Reserve
Bank of India Act, 1934 (2 of 1934)”.
101[8]
Substituted by the SEBI (Amendment) Act, 2002, S. 3(a) (iii) (w..r.e.f. 29-10-
2002) , for “(d) two other members,”.
102[9]
Substituted by the SEBI (Amendment) Act, 2002, S. 3(b) (w..r.e.f. 29-10-2002)
, for “ Reserve Bank of India”.
103[10]
The brackets and figure “(1)” omitted by Act 9 of 1995, S. 3 (w.e.f. 25-1-
1995)
104[11]
Clause (d) omitted by Act 9 of 1995, S. 3 (w.e.f. 25-1-1995)
105[12]
Inserted by Act 9 of 1995, S. 4 (w.e.f.25-1-1995).
106[13]
Inserted by Act 9 of 1995, S. 5 (w.e.f.) 25-1-1995
107[14]
Inserted by the Depositories Act, 1996,w.e.f. 20-9-1995
108[15]
Substituted by Act 9 of 1995, S. 5 (w.e.f. 25-1-1995) , for “collective
investment schemes”
109[16]
Substituted by Act 9 of 1995, S. 5 (w.e.f. 25-1-1995) , for “stock exchanges
and”
110[17]
Inserted by the SEBI (Amendment) Act, 2002 , S. 4(a) (w.e.f. 29-10-2002).
111[18]
The words “the Capital Issues (Control) Act, 1947 (29 of 1947) and” omitted
by Act 9 of 1995, S. 5 (w.e.f. 25-1-1995)
112[19]
Inserted by Act 9 of 1995 S. 5 (w.e.f. 25-1-1995)
113[20]
Inserted by the SEBI (Amendment) Act, 2002 , S. 4(b) (w.e.f. 29-10-2002).
114[21] Inserted by Act 9 of 1995 S. 5 ( w.e.f. 25-1-1995)
115[22] Inserted by the SEBI (Amendment) Act, 2002 , S. 4(c) (i) (w.e.f. 29-10-
2002).
116[23] Inserted by the SEBI (Amendment) Act, 2002 , S. 4(c) (ii) (w.e.f. 29-10-
2002).
117[24] Inserted by the SEBI (Amendment) Act, 2002 , S. 4(d) (w.e.f. 29-10-2002).
118[25] Substituted by the SEBI (Amendment) Act, 2002 , S. 5 (w.e.f. 29-10-2002)
, for S. 11A. Prior to this substitution , S. 11A read as under:-
11A. Matters to be disclosed by the companies.-Without Prejudice to the Provisions
of the Companies Act , 1956 (1 of 1956), the board may , for the protection of
investors , specify , by regulations,-
the matters relating to issue of capital, transfer of securities and other matters
incidental thereto; and
the manner in which such matters, shall be disclosed by the companies.
119[26] Inserted by Act 31 of 1999 , S. 11 (w.e.f. 22-2-2000).`
120[27] Inserted by Act 9 of 1995 , S. 6(w.e.f. 25-1-1995)
121[28] Inserted by SEBI (Amendment) Act , 2002, w.e.f.29-10-2002.
122[29] Substituted by Act 9 of 1995, S.7 (a) (i) (w.e.f. 25-1-1995), for “ rules”.
123[30] Inserted by Act 9 of 1995 , S. 7 (w.e.f.25-1-1995).
124[31] Substituted by Act 22 of 1996 (w.e.f. 20-9-1995)
125[32] Chapter VA inserted by the SEBI (Amendment) Act, 2002, S. 7(w.e.f. 29-
10-2002).
126[33] The word “ and ” omitted by Act 9 of 1995, S.8 (w.e.f. 25-1-1995).
127[34] Cl . (aa) omitted by the SEBI (Amendment) Act, 2002, S. 8 (w.e.f. 29-10-
2002).Prior to its omission, Cl . (aa) reads as under:- “ (aa) all sums realized by way
of Penalties under this Act ; and ”. [ this clause had been inserted by Act 9 of 1995,
S. 8, ( w.e.f. 25-1-1995) ].
128[35] Chapters VI A and VI B containing Ss. 15A to 15J and 15K to 15Z
respectively, inserted by Act 9 of 1995 , S. 9 (w.e.f. 25-1-1995).
129[36] Substituted by the SEBI (Amendment) Act , 2002 , S. 9 (i) (w.e.f. 29-10-
2002), for “ a penalty not exceeding one lakh and fifty thousand rupees for each
such failure ”.
130[37] Substituted by the SEBI (Amendment) Act , 2002 , S. 9 (ii) (w.e.f. 29-10-
2002), for “ a penalty not exceeding one lakh and fifty thousand rupees for each
such failure ”.
131[38] Substituted by the SEBI (Amendment) Act , 2002 , S. 9 (iii) (w.e.f. 29-10-
2002), for “ a penalty not exceeding one lakh and fifty thousand rupees for each
such failure ”.
15H”.
148[55] Inserted by the SEBI (Amendment) Act,2002, S.19 (w.e.f. 29-10-2002).
149[56] Inserted by the SEBI (Amendment) Act 32 of 1999, S.8 (w.e.f.16-12-1999).
150[57] Substituted by the SEBI (Amendment)Act, 2002, S.20 (w.e.f. 29-10-2002),
for Sections 15L and 15M. Prior to their substitution, Section 15L and 15M read as
under:-
“15-L. Composition of securities Appellate Tribunal. – A Securities Appellate Tribunal
shall consist of one person only (hereinafter referred to as the Presiding Officer of
the Securities Appellate Tribunal ) to be appointed, by notification, by the central
Government. 15M. Qualifications for appointment as Presiding Officer of the
Securities Appellate Tribunal . – A person shall not be qualified for appointment as
the Presiding Officer of a Securities Appellate Tribunal unless he-
(a) is, or has been, or is qualified to be, a Judge of a High Court; or
(b) has been a member of the Indian Legal Service and has held a post in Grade I of
that service for at least three years.
(c) has held office as the Presiding Officer of a tribunal for at least three years.”
151[58] Substituted by the SEBI (Amendment)Act, 2002, S.21 (w.e.f. 29-10-2002),
for Sections 15N. Prior to their substitution, Section 15N read as under:-
“15N. Term of office.- The Presiding officer of a Securities Appellate Tribunal shall
hold office for a term of five years from the date on which he enters upon his office
or until he attains the age of sixty-five years, whichever is earlier.”
152[59] Substituted by the SEBI (Amendment)Act, 2002, S.22 (w.e.f. 29-10-2002),
for “Presiding Officer of a Securities Appellate Tribunal”.
153[60] Substituted by the SEBI (Amendment)Act, 2002, S.22 (w.e.f. 29-10-2002),
for “ the said Presiding Officer”.
154[61] Substituted by the SEBI (Amendment)Act, 2002, S.23 (w.e.f. 29-10-2002),
for “ office of the Presiding Officer”.
155[62] Substituted by the SEBI (Amendment)Act, 2002, S.24(a) (i) (w.e.f. 29-10-
2002), for “ Presiding Officer of a Securities Appellate Tribunal”.
156[63] Substituted by the SEBI (Amendment)Act, 2002, S.24 (a) (ii) (w.e.f. 29-10-
2002), for “ the said Presiding Officer”.
157[64] Substituted by the SEBI (Amendment)Act, 2002, S.24 (b) (w.e.f. 29-10-
2002), for “ Presiding Officer”.
158[65] Substituted by the SEBI (Amendment)Act, 2002, S.24 (b) (w.e.f. 29-10-
2002), for “ Presiding Officer”.
159[66] Substituted by the SEBI (Amendment)Act, 2002, S.24 (c) (w.e.f. 29-10-
2002), for “ the said Presiding Officer”.
160[67] Substituted by the SEBI (Amendment)Act, 2002, S.25 (w.e.f. 29-10-2002),
for “ Presiding Officer”.
161[68] Substituted by the Act 32 of 1999, S. 9 (w.e.f. 16-12-1999), for Sub-sec (1)
& (2). Prior to their substitution, Sub-sec were read as under:

1. Save as provided in sub-section (2), any person aggrieved by any order made
by any Adjudicating Officer under this Act, may prefer an appeal to a
Securities Appellate Tribunal having jurisdiction in the matter.

2. No appeal shall lie to the Securities Appellate Tribunal from an order made by
an Adjudicating Officer with the consent of the parties.

162[69] Substituted by the Act 32 of 1999, S. 9 (w.e.f. 16-12-1999), for “a copy of


the order made by the adjudicating officer”
163[70] Substituted by the Act 32 of 1999, S. 9(w.e.f. 16-12-1999), for “parties”
164[71] Substituted by the Act 32 of 1999, S. 9(w.e.f. 16-12-1999), for S. 15V.
prior to their substitution, S. 15V read as under:-
“15V. The appellant may either appear in person or authorise one or more legal
practitioners or any of its officers to present his or its case before the Securities
Appellate Tribunal.
165[72] Substituted by the SEBI (Amendment) Act, 2002, S.26 (w.e.f. 29-10-2002),
for S. 15X. Prior to its substitution, it was read as under: -
15X. The Presiding Officer and other officers and employees of a Securities Appellate
Tribunal shall be deemed to be public servants within the meaning of section 21 of
the Indian penal Code( 45 of 1860).
166[73] Substituted by the SEBI (Amendment)Act, 2002, S.27 (w.e.f. 29-10-2002),
for S. 15Z. Prior to its substitution , it was read as under:-
15Z. Appeal to High Court.- Any person aggrieved by any decision or order of the
Securities Appellate Tribunal may file an appeal to the High Court within sixty days
from the date of communication of the decision or order of the Securities Appellate
Tribunal to him on any question of fact or law arising out of such order:
Provided that the High Court may, if it is satisfied that the appellant was prevented
by sufficient cause from filing the appeal within the said period, allow it to be filed
within a further period not exceeding sixty days.
167[74] Substituted by Act 22 of 1996, S. 30(w.e.f. 20-9-1995), for “this Act”
168[75] Substituted by Act 9 of 1995, S. 10 (w.e.f. 25-1-1995), for “sixty days”
169[76] Substituted by Act 32 of 1999, S. 11 (w.e.f. 16-12-1999), for “an order of
the Board made”
170[77] Inserted by Act 9 of 1995, S. 11 (w.e.f. 25-1-1995).
171[78] Substituted by Act 32 of 1999, S. 12 (w.e.f. 16-12-1999). For “Board”
172[79]Substituted by Act 32 of 1999, S. 12 (w.e.f. 16-12-1999). For “Section 20”
173[80] Substituted by Act 32 of 1999, S. 12 (w.e.f. 16-12-1999). For “Board”
174[81] Substituted by Act 32 of 1999, S. 12 (w.e.f. 16-12-1999). For “Board”
175[82]Inserted by Act 9 of 1995, S. 12 (w.e.f. 25-1-1995).
178[83] Substituted by Act 9 of 1995, S.13 (w.e.f. 25-1-1995), for S. 24. Prior to its
substitution the section was read as under:
24. Penalty.- Whoever contravenes or attempts to contravene or abets the
contravention of the provisions of this Act or of any rules or regulations made
thereunder, shall be punishable with imprisonment for a term which may extend to
one year, or with fine, or with both.
177[84] Substituted by the SEBI (Amendment) Act, 2002, S. 28(a) (w.e.f. 29-10-
2002), for “one year, or with fine, or with both”.
178[85] Substituted by the SEBI (Amendment) Act, 2002, S. 28(a) (w.e.f. 29-10-
2002), for “three years or with fine which shall not be less than two thousand rupees
but which may extend to ten thousand rupees or with both”.
179[86] Inserted by the SEBI (Amendment) Act, 2002, S. 29 (w.e.f. 29-10-2002).
180[87]The words “with the previous sanction of the Central Government” omitted
by Act 9 of 1995, S. 14 (w.e.f. 25-1-1995).
181[88] Substituted by the SEBI (Amendment) Act,2002, S. 30 (w.e.f. 29-10-2002),
for “a Metropolitan Magistrate or a judicial Magistrate of the first class”.
182[89] CL. (c) omitted by Act 9 of 1995, S. 16 (w.e.f. 25-1-1995).
183[90] Inserted by Act 9 of 1995, S. 16 (w.e.f. 25-1-1995).
184[91] Substituted by the SEBI (Amendment) Act, 2002, S. 31(i) (w.e.f. 29-10-
2002), for “Presiding Officers”
185[92] Substituted by the SEBI (Amendment) Act, 2002, S. 31(ii) (w.e.f. 29-10-
2002), for “Presiding Officers”
186[93] The words “with the previous approval of the Central Government” omitted
by Act 9 of 1995, S. 17 (w.e.f. 25-1-1995).
187[94] Substituted by the Act 9 of 1995, S. 17 (w.e.f. 25-1-1995), for the existing
clause (c). Prior to their substitution it clauses was read as under:
(c) the amount of fee to be paid for registration certificate and manner of suspension
or cancellation of registration certificate under sub-section (2) and (3) of section 12.
Complaints Handling Chapter-26

26.1 Grievance Redressal Cell

Grievance Redressal Cell of IRDA looks into the complaints filed by the insured or the
claimant policyholders. The policyholders with complaints against the insurers have
to approach the Customer Complaint Cell first. If not heard or dissatisfied then
Grievance Cell of IRDA can be approached.

Only delayed or non-responsive cases regarding claims/policies are taken up by the


Cell with the insurers for speedy disposal. Otherwise claims/policies in disputes need
to be adjudicated through judicial channels i.e. Insurance Ombudsmen, the list of
which is available on the website. Complaints sent through email should contain
complete details of the complaint as required in the complaint form. Also
policyholders can fill up the registration form available on the website to register the
complaints.

26.2 Ombudsman

The institution of Insurance Ombudsman institution was created by Government of


India notification on 11th November, 1998 to dispose off grievances of the insured
customers and to lessen their problems involved in Redressal of grievances.

The institution helps to protect the interests of the policyholders. An Insurance


Ombudsman is appointed only once for a term of three years or till the incumbent
attains the age of 65 years(whichever is earlier), on the recommendations of
Chairman’s of IRDA, LIC, GIC and a representative from the central government.

In all there are 12 Ombudsman located all over the country to speed up the disposal
of complaints. Insurance Ombudsman performs the function of conciliation and
award making. Ombudsman’s powers are restricted to insurance contracts of value
not exceeding Rs. 20 lakhs. An Ombudsman may be removed from service for gross
misconduct committed during the office tenure.

The complaint should be in writing and addressed to the respective insurance


Ombudsman of the jurisdiction. The settled complaints are recommended within a
month and sent to both the complainant and the insurance company concerned. An
Ombudsman passes an award within a period of three months from the receipt of the
complaint. If the complainant is not satisfied he can approach other venues like
courts of law or consumer forums.

Source:- http://www.irdaindia.org/
26.3 List of Insurance Ombudsmen

NAME OF THE AOMBUDSMAN AND Contact


Office of the Ombudsman Areas of Jurisdiction
Details

AHMEDABAD Shri B.C. Bose


2nd Flr., Ambica Gujarat, UT of Dadra &
(O)079-27546150, 27546139
House, Nagar Haveli, Daman
Nr. C.U. Shah College, Fax:079-27546142 and Diu
5, Navyug Colony, E-mail: insombahd@rediffmail.com
Ashram Road,
AHMEDABAD - 380 014

BHOPAL Shri R.P. Dubey


Madhya Pradesh &
1st Floor, 117, Zone- (O)0755-2769200, 2769202, Chhattisgarh
II, 2769201
(Above D.M. Motors
Fax:0755-2769203
Pvt. Ltd.)
Maharana Pratap E-mail:
Nagar, bimalokpalbhopal@airtelbroadband.in
BHOPAL - 462 011

BHUBANESWAR Shri M.N. Patnaik Orissa


62, Forest Park, (O)0674-2535220, 2533798
BHUBANESWAR- 751
Fax:0674-2531607
009
Email : ioobbsr@dataone.in