Inter-connected Stock Exchange of India Ltd.

INDEX

Sr. No. Chapter

1. Indian Financial System

2. Primary Market

3. IPO & Book Building

4. Depositories & Depository Participants

5. Secondary Market – Trading , Clearing & Settlement

6. Stock Indices

7. Fundamental Analysis

8. Derivatives

9. Mutual Fund

10. Risk Management

11. Financial Planning Process

1

Overview - Indian Capital Market

The function of the financial market is to facilitate the transfer of funds from surplus sectors

(lenders) to deficit sectors (borrowers). Normally, households have investible funds or savings,

which they lend to borrowers in the corporate and public sectors whose requirement of funds far

exceeds their savings. A financial market consists of investors or buyers of securities, borrowers or

sellers of securities, intermediaries and regulatory bodies. Financial market does not refer to a

physical location. Formal trading rules, relationships and communication networks for originating

and trading financial securities link the participants in the market.

INDIAN FINANCIAL SYSTEM

The financial system is one of the most important inventions of modern society. The phenomenon

of imbalance of in the distribution of capital or funds exists in every economic system. There are

areas or people with surplus funds and there are those with a deficit. A financial system functions

as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit.

A financial system is a composition of various institutions, market, regulations and laws, practices,

money managers, analyst, transactions and claims and liabilities.

The function performed by a financial system:

1) The Savings Function

2) Liquidity Function

3) Payment Function

4) Risk Function

5) Policy Function

Financial markets

A financial market can be defined as the market in which financial assets are created or

transferred. Financial assets represent a claim to the payment of a sum of money sometime in the

future and/or periodic payment in the form of interest or dividend.

Financial markets are sometimes classified as primary and secondary markets. But, more often

financial markets are classified as money market and capital markets. The distinction between the

two markets is based on the differences in the period of maturity of the financial assets issued in

these markets. Money market deals with all transaction in short term instruments (with a period of

maturity of one year or less like treasury bills, bills of exchange, etc). Whereas capital market

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deals with transaction related to long term instruments (with a period of maturity of above one year

like corporate debentures, government bonds, etc) and stock (equity and preference shares).

Money Market

One of the important functions of a well-developed money market is to channel savings into short-

term productive investments like working capital. Call money market, treasury bills market and

markets for commercial paper and certificate of deposits are some of the examples of a money

market

Call Money Market

The call money market forms a part of the national money market, where day-to-day surplus

funds, mostly of the banks are traded. The call money loans are of very short term in nature and

the maturity period of theses loans vary from 1 to 15 days. The money that is lent for one day in

this market is known as “call money” and if exceeds one day but less than 15 days, is referred as

notice money. In this market, any amount could be lent or borrowed at a convenient interest rate,

which is acceptable to both borrower and lender. This loan are considered as highly liquid, as they

are repayable on demand at the option of either the lender or the borrower

Commercial papers

Commercial Paper are short term, unsecured promissory notes issued at a discount to face value

by well known companies that are financial strong and carry high credit rating. They are sold

directly by the issuers to investor, or else placed by borrowers through agents like merchant banks

and security houses. The flexible maturities at which they can be issued are one of the main

attractions for borrowers and investors since issues can be adapted to the needs of both. The

Commercial Paper market has the advantage of giving highly rated corporate borrowers cheaper

funds than they could obtain from the banks while still providing institutional investor with higher

interest earnings than they could obtain from the banking system the issue of Commercial Paper

imparts a degree of financial stability to the system as the issuing company has an incentive to

remain financially strong.

Certificates of deposits

With a view to further widen the range of money market instruments and to give investors greater

flexibility in the deployment of the short term surplus funds, RBI permitted banks to issue

Certificates of Deposits. Certificates of Deposits the defined as short term deposit by way of

usance promissory notes having a short maturity of not less than three months and not more than

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one year. They are bank deposits which are transferable to one party to the other they are

different from conventional time deposits due to their free negotiability. Due this negotiable nature

they are also known as negotiable certificates of deposits.

Money market mutual funds

MMMF are mutual funds that invest primarily in money market instruments of very high quality and

of very short maturity commercial banks, RBI and public financial institutions can set it either

directly or through their existing mutual funds subsidiaries. The schemes offered by MMMF can

either be open ended or close ended. In case of open-ended schemes the units are available on

continuous basis and the MMMF would be willing to repurchase the units, while a close ended

scheme is available for subscription for a limited period and is redeemed at maturity.

PRIMARY MARKET

The capital market consists of primary and secondary markets. The primary market deals with

the issue of new instruments by the corporate sector such as equity shares, preference shares

and debt instruments. Central and State governments, various public sector industrial units

(PSUs), statutory and other authorities such as state electricity boards and port trusts also issue

bonds/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. The 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. Investors who are

desirous of buying securities purchase securities through registered brokers/sub-brokers of the

stock exchange. It may have a physical location like a stock exchange or a trading floor.

Since 1995, trading in securities is screen-based and Internet-based trading has also made an

appearance in India.

The secondary market consists of 23 stock exchanges including the National Stock Exchange,

Over-the-Counter Exchange of India (OTCEI) and Inter Connected Stock Exchange of India Ltd.

The secondary market provides a trading place for the securities already issued, to be bought and

sold. It also provides liquidity to the initial buyers in the primary market to reoffer the securities to

any interested buyer at any price, if mutually accepted. An active secondary market actually

promotes the growth of the primary market and capital formation because investors in the primary

market are assured of a continuous market and they can liquidate their investments.

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Major players of primary market: 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. 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. Registrars and Transfer Agents, Custodians and

Depositories are capital market intermediaries that provide important infrastructure services for

both primary and secondary markets.

Market regulation: It is important to ensure smooth working of capital market, as it is the arena

where the players in the economic growth of the country. Various laws have been passed from

time to time to meet this objective. 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:

1. The Capital Issues Control Act 1947, which restricted access to the securities market and

controlled the pricing of issues.

2. 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.

3. 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.

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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. Organised trading activity in securities in an area takes place on a specified

recognised 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.

This legal and regulatory framework contained many weaknesses. Jurisdiction over the securities

market split among various agencies and the relevant was scattered in a number of statutes. This

resulted in confusion, not only in the minds of the regulated but also among regulators. It also

created inefficiency in the enforcement of the regulations. It was the Central Government rather

than the market that allocated resources from the securities market to competing issuers and

determined the terms of allocation. The allocation was not necessarily based on economic criteria,

and as a result the market was not allocating the resources to the best possible investments,

leading to a sub-optimal use of resources and low allocational efficiency. Informational efficiency

was also low because the provisions of the Companies Act regarding prospectus did not ensure

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the supply of necessary, adequate and accurate information, sufficient to enable investors to make

an informed decision. The many formalities associated with the issue process under various

regulations kept the cost of issue quite high. Under the SC(R)A, the secondary market was

fragmented regionally, with each stock exchange a self-regulating organisation following its own

policy of listing, trading and settlement. The listing agreement did not have the force of law, so that

issuers could get away with violations. The interests of the brokers, who were market players and

dominated the governing boards of stock exchanges, took priority over the interest of investors.

The market was narrow and investors did not have an opportunity to have balanced portfolios.

The settlement of trades took a long time, because it required physical movement of securities,

and the transfer of securities was very cumbersome under the Companies Act and SC(R)Act, thus

depriving the investor of liquidity. Law expressly forbade options and futures. These weaknesses

were corrected by passing SEBI Act and giving overall regulatory jurisdiction on capital market to

SEBI. SEBI framed regulations and guidelines to improve efficiency of the market, enhance

transparency, check unfair trade practices and ensure international standards in market practices

necessitated by the large entry of foreign financial institutions.

Securities and Exchange Board of India

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 liberalise, 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

premia 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 ADRs and

GDRs. 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

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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.

There were several statutes regulating different aspects of the securities market and jurisdiction

over the securities market was split among various agencies, whose roles overlapped and which

at times worked at cross-purposes. As a result, there was no coherent policy direction for market

participants to follow and no single supervisory agency had an overview of the securities business.

Enactment of SEBI Act was the first such attempt towards integrated regulation of the securities

market. SEBI was given full authority and jurisdiction over the securities market under the Act, and

was given concurrent/delegated powers for various provisions under the Companies Act and the

SC(R)A. The Depositories Act, 1996 is also administered by SEBI.

Disclosure and Investor Protection ( DIP ) Norms

A high level committee on capital markets has been set up to ensure co-ordination among the

regulatory agencies in financial markets. 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. Improved disclosures by listed companies: The norms for

continued disclosure by listed companies have also improved the availability of timely information.

The information technology helped in easy dissemination of information about listed companies

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and market intermediaries. Equity research and analysis and credit rating has improved the quality

of information. 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.

Capital Market Intermediaries

There are several institutions, which facilitate the smooth functioning of the securities market. They

enable the issuers of securities to interact with the investors in the primary as well as the

secondary arena.

Merchant Bankers

Among the important financial intermediaries are the merchant bankers. The services of merchant

bankers have been identified in India with just issue management. It is quite common to come

across reference to merchant banking and financial services as though they are distinct

categories. The services provided by merchant banks depend on their inclination and resources -

technical and financial. Merchant bankers (Category 1) are mandated by SEBI to manage public

issues (as lead managers) and open offers in take-overs. These two activities have major

implications for the integrity of the market. They affect investors' interest and, therefore,

transparency has to be ensured. These are also areas where compliance can be monitored and

enforced.

Merchant banks are rendering diverse services and functions. These include organizing and

extending finance for investment in projects, assistance in financial management, acceptance

house business, raising Euro-dollar loans and issue of foreign currency bonds. Different merchant

bankers specialize in different services. However, since they are one of the major intermediaries

between the issuers and the investors, their activities are regulated by:

(1) SEBI (Merchant Bankers) Regulations, 1992.

(2) Guidelines of SEBI and Ministry of Finance.

(3) Companies Act, 1956.

(4) Securities Contracts (Regulation) Act, 1956.

Merchant banking activities, especially those covering issue and underwriting of shares and

debentures, are regulated by the Merchant Bankers Regulations of Securities and Exchange

Board of India (SEBI). SEBI has made the quality of manpower as one of the criteria for renewal of

merchant banking registration. These skills should not be concentrated in issue management and

underwriting alone. The criteria for authorization take into account several parameters. These

include: (a) professional qualification in finance, law or business management, (b) infrastructure

like adequate office space, equipment and manpower, (c) employment of two persons who have

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the experience to conduct the business of merchant bankers, (d) capital adequacy and (e) past

track record, experience, general reputation and fairness in all their transactions.

SEBI authorizes merchant bankers for an initial period of three years, if they have a minimum net

worth of Rs. 5 crore. An initial authorization fee, an annual fee and renewal fee is collected by

SEBI. According to SEBI, all issues should be managed by at least one authorized merchant

banker functioning as the sole manager or lead manager. The lead manager should not agree to

manage any issue unless his responsibilities relating to the issue, mainly disclosures, allotment

and refund, are clearly defined. A statement specifying such responsibilities has to be furnished to

SEBI. SEBI prescribes the process of due diligence that a merchant banker has to complete

before a prospectus is cleared. It also insists on submission of all the documents disclosing the

details of account and the clearances obtained from the ROC and other government agencies for

tapping peoples' savings. The responsibilities of lead manager, underwriting obligations, capital

adequacy, due diligence certification, etc., are laid down in detail by SEBI. The objective is to

facilitate the investors to take an informed decision regarding their investments and not expose

them to unknown risks.

Credit Rating Agencies

The 1990s saw the emergence of a number of rating agencies in the Indian market. These

agencies appraise the performance of issuers of debt instruments like bonds or fixed deposits. The

rating of an instrument depends on parameters like business risk, market position, operating

efficiency, adequacy of cash flows, financial risk, financial flexibility, and management and industry

environment. The objective and utility of this exercise is twofold. From the point of view of the

issuer, by assigning a particular grade to an instrument, the rating agencies enable the issuer to

get the best price. Since all financial markets are based on the principle of risk/reward, the less

risky the profile of the issuer of a debt security, the lower the price at which it can be issued. Thus,

for the issuer, a favourable rating can reduce the cost of borrowed capital. From the viewpoint of

the investor, the grade assigned by the rating agencies depends on the capacity of the issuer to

service the debt. It is based on the past performance as well as an analysis of the expected cash

flows of a company when viewed on the industry parameters as well as company performance.

Hence, the investor can judge for himself whether he wants to place his savings in a "safe"

instrument and get a lower return or he wants to take a risk and get a higher return. The 1990s

saw an increase in activity in the primary debt market. Under the SEBI guidelines all issuers of

debt have to get the instruments rated. They also have to prominently display the ratings in all that

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marketing literature and advertisements. The rating agencies have thus become an important part

of the institutional framework of the Indian securities market.

R & T Agents - Registrars to Issue

R&T Agents form an important link between the investors and issuers in the securities market. A

company, whose securities are issued and traded in the market, is known as the Issuer. The R&T

Agent is appointed by the Issuer to act on its behalf to service the investors in respect of all

corporate actions like sending out notices and other communications to the investors as well as

dispatch of dividends and other non-cash benefits. R&T Agents perform an equally important role

in the depository system as well. These are described in detail in the second section of this

Workbook.

Stock Brokers

Stockbrokers are the intermediaries who are allowed to trade in securities on the exchange of

which they are members. They buy and sell on their own behalf as well as on behalf of their

clients. Traditionally in India, individuals owned firms providing brokerage services or they were

partnership firms with unlimited liabilities. There were, therefore, restrictions on the amount of

funds they could raise by way of debt. With increasing volumes in trading as well as in the number

of small investors, lack of adequate capitalization of these firms exposed investors to the risks of

these firms going bust and the investors would have no recourse to recovering their dues.

With the legal changes being effected in the membership rules of stock exchanges as well as in

the capital gains structure for stock-broking firms, a number of brokerage firms have converted

themselves into corporate entities. In fact, NSE encouraged the setting up of corporate broking

members and has today has only 10% of its members who are not corporate entities.

Custodians

In the earliest phase of capital market reforms, to get over the problems associated with paper-

based securities, large holding by institutions and banks were sought to be immobilised.

Immobilisation of securities is done by storing or lodging the physical security certificates with an

organisation that acts as a custodian - a securities depository. All subsequent transactions in such

immobilised securities take place through book entries. The actual owners have the right to

withdraw the physical securities from the custodial agent whenever required by them. In the case

of IPO, a jumbo certificate is issued in the name of the beneficiary owners based on which the

depository gives credit to the account of beneficiary owners. The Stock Holding Corporation of

India was set up to act as a custodian for securities of a large number of banks and institutions

11

who were mainly in the public sector. Some of the banks and financial institutions also started

providing "Custodial" services to smaller investors for a fee. With the introduction of

dematerialisation of securities there has been a shift in the role and business operations of

Custodians. But they still remain an important intermediary providing services to the investors who

still hold securities in a physical form.

Mutual Funds

Mutual funds are financial intermediaries, which collect the savings of small investors and invest

them in a diversified portfolio of securities to minimise risk and maximise returns for their

participants. Mutual funds have given a major fillip to the capital market - both primary as well as

secondary. The units of mutual funds, in turn, are also tradable securities. Their price is

determined by their net asset value (NAV) which is declared periodically. The operations of the

private mutual funds are regulated by SEBI with regard to their registration, operations,

administration and issue as well as trading. There are various types of mutual funds, depending on

whether they are open ended or close ended and what their end use of funds is. An open-ended

fund provides for easy liquidity and is a perennial fund, as its very name suggests. A closed-ended

fund has a stipulated maturity period, generally five years. A growth fund has a higher percentage

of its corpus invested in equity than in fixed income securities, hence, the chances of capital

appreciation (growth) are higher. In Growth Funds, the dividend accrued, if any, is reinvested in

the fund for the capital appreciation of investments made by the investor. An Income fund on the

other hand invests a larger portion of its corpus in fixed income securities in order to pay out a

portion of its earnings to the investor at regular intervals. A balanced fund invests equally in fixed

income and equity in order to earn a minimum return to the investors. Some mutual funds are

limited to a particular industry; others invest exclusively in certain kinds of short-term instruments

like money market or Government securities. These are called money market funds or liquid funds.

To prevent processes like dividend stripping or to ensure that the funds are available to the

managers for a minimum period so that they can be deployed to at least cover the administrative

costs of the asset management company, mutual funds prescribe an entry load or an exit load for

the investors. If investors want to withdraw their investments earlier than the stipulated period, an

exit load is chargeable. To prevent profligacy, SEBI has prescribed the maximum that can be

charged to the investors by the fund managers.

Depositories

The depositories are an important intermediaries in the securities market that is scrip-less or

moving towards such a state. In India, the Depositories Act defines a depository to mean "a

company formed and registered under the Companies Act, 1956 and which has been granted a

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certificate of registration under sub-section (IA) of section 12 of the Securities and Exchange

Board of India Act, 1992." The principal function of a depository is to dematerialize securities and

enable their transactions in book-entry form. Dematerialisation of securities occurs when

securities, issued in physical form, are destroyed and an equivalent number of securities are

credited into the beneficiary owner's account. In a depository system, the investors stand to gain

by way of lower costs and lower risks of theft or forgery, etc. They also benefit in terms of

efficiency of the process. But the implementation of the system has to be secure and well

governed. All the players have to be conversant with the rules and regulations as well as with the

technology for processing. The intermediaries in this system have to play strictly by the rules. A

depository established under the Depositories Act can provide any service connected with

recording of allotment of securities or transfer of ownership of securities in the record of a

depository. A depository cannot directly open accounts and provide services to clients. Any person

willing to avail of the services of the depository can do so by entering into an agreement with the

depository through any of its Depository Participants. The services, functions, rights and

obligations of depositories, with special reference to the NSDL are provided in the second section

of this Workbook.

Depository Participants

A Depository Participant (DP) is described as an agent of the depository. They are the

intermediaries between the depository and the investors. The relationship between the DPs and

the depository is governed by an agreement made between the two under the Depositories Act. In

a strictly legal sense, a DP is an entity who is registered as such with SEBI under the provisions of

the SEBI Act. As per the provisions of this Act, a DP can offer depository related services only

after obtaining a certificate of registration from SEBI.

SEBI (D&P) Regulations, 1996 prescribe a minimum net worth of Rs. 50 lakh for stockbrokers,

R&T agents and non-banking finance companies (NBFC), for granting them a certificate of

registration to act as DPs. If a stockbroker seeks to act as a DP in more than one depository, he

should comply with the specified net worth criterion separately for each such depository. No

minimum net worth criterion has been prescribed for other categories of DPs. However,

depositories can fix a higher net worth criterion for their DPs. NSDL requires a minimum net worth

of Rs. 100 lakh to be eligible to become a DP as against Rs. 50 lakh prescribed by SEBI (D&P)

Regulations. The role, functions, responsibilities and business operations of DPs are described in

detail in the second section of this book.

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Instruments

The changes in the regulatory framework of the capital market and fiscal policies have also

resulted in newer kinds of financial instruments (securities) being introduced in the market. Also, a

lot of financial innovation by companies who are now permitted to undertake treasury operations,

has resulted in newer kinds of instruments - all of which can be traded – being introduced. The

variations in all these instruments depend on the tenure, the nature of security, the interest rate,

the collateral security offered and the trading features, etc.

Debentures

These are issued by companies and regulated under the SEBI guidelines of June 11, 1992. These

are issued under a prospectus, which has to be approved by SEBI like in the case of equity issues.

The rights of investors as debenture holders are governed by the Companies Act, which prohibits

the issue of debentures with voting rights. There are a large variety of debentures that is available.

This includes:

• Participating debentures

• Convertible debentures with options

• Third party convertible debentures

• Debt/equity swaps

• Zero coupon convertible notes

• Secured premium notes

• Zero interest fully convertible debentures

• Fully convertible debentures with interest

• Partly convertible debentures.

Bonds

Indian DFIs, like IDBI, ICICI, and IFCI, have been raising capital for their operations by issuing of

bonds. These too are available in a large variety. These include:

• Income bonds

• Tax-free bonds

• Capital gains bonds

• Deep discount bonds

• Infrastructure bonds

• Retirement bonds

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In addition to the interest rates and maturity profiles of these instruments, the issuer institutions

have been including a put/call option on especially the very long-dated bonds like deep discount

bonds. Since the tenures of some of these instruments spanned some 20 or 25 years during which

the interest rate regimes may undergo a complete change, the issuer have kept the flexibility to

retire the costly debt. This they do by exercising their option to redeem the securities at pre-

determined periods like at the end of five or seven years. This has been witnessed in number of

instruments recently much to the chagrin of investors who were looking for secure and hassle-free

long-dated instruments.

Preference Shares

As the name suggests, owners of preferential shares enjoy a preferential treatment with regard to

corporate actions like dividend. They also have a higher right of repayment in case of winding up

of a company. Preference shares have different features and are accordingly available as:

• Cumulative and non-cumulative

• Participating

• Cumulative & Redeemable fully convertible to preference shares

• Cumulative & Redeemable fully convertible to equity

• Preference shares with warrants

• Preference shares

Equity Shares

As the name indicates, these represent the proportionate ownership of the company. This right is

expressed in the form of participation in the profits of the company. There has been some

innovation in the way these instruments are issued. Some hybrid securities like equity shares with

detachable warrants are also available.

Government securities

The Central Government or State Governments issue securities periodically for the purpose of

raising loans from the public. There are two types of Government Securities – Dated Securities

and Treasury Bills. Dated Securities have a maturity period of more than one year. Treasury Bills

have a maturity period of less than or up to one year. The Public Debt Office (PDO) of the Reserve

Bank of India performs all functions with regard to the issue management, settlement of trade,

distribution of interest and redemption. Although only corporate and institutional investors

subscribe to government securities, individual investors are also permitted to subscribe to these

securities.

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An investor in government securities has the option to have securities issued either in physical

form or in book-entry form (commonly known as Subsidiary General Ledger form). There are two

types of SGL facilities, viz., SGL-1 and SGL-2. In the SGL-1 facility, the account is opened with the

RBI directly. There are several restrictions on opening SGL-1 accounts and only entities, which

fulfill all the eligibility criteria, are permitted to open SGL-1 account. The RBI has permitted banks,

registered primary dealers and certain other entities like NSCCL, SHCIL, and NSDL to provide

SGL facilities to subscribers. A subscriber to government securities who opts for SGL securities

may open an SGL account with RBI or any other approved entity. Investments made by such

approved entity on its own account are held in SGL-1 account, and investments held on account of

other clients are held in SGL-2 account.

INITIAL PUBLIC OFFER

The first public offering of equity shares of a company, which is followed by a listing of its shares

on the stock market, is called the Initial Public Offering (IPO). Most businesses are privately

owned. They do not have outside investors. A few people may be management or employees and

members of their respective families, own all the outstanding stocks. Such corporations are

referred to as "Closely held corporations”. These companies are usually strong but some are

nationally recognized names. When a privately held organization needs additional capital it can

borrow cash or sell stocks to raise needed funds. Often "going public" is the best choice for

growing business. Usually an IPO is a part of business financing strategy. A well-planned and

executed business setup will have specific goals for growth and revenue accompanied by

financing needs and options to achieve these needs. The Decision to go public (or more precisely

the decision to make an IPO so that the securities of the company are listed on the stock market

and publicly traded) is very important, but not well studied, question in finance. It is a complex

decision, which calls for carefully weighing the benefits against costs.

BENEFITS OF GOING PUBLIC:

The potential advantages that seem to prod companies to go public are as follows:

1) Access to Capital – The principal motivation for going public is to have access to larger

capital. A company that does not tap the public financial market may find it difficult to grow

beyond a certain point for want of capital.

2) Respectability – Many entrepreneurs believe that they have “arrived” in some sense if

their company goes public because a public company may command greater

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respectability. Competent and ambitious executives would like to work for growth. Other

things being equal, public companies offer greater growth potential compared to non-public

companies. Hence, they can attract superior talent.

3) Window of Opportunity – As suggested by Jay Ritter and others that there are periods in

which stocks are overpriced. Hence, when a non-public company recognizes that other

companies in its industry are overpriced, it has an incentive to go public and exploit that

opportunity.

4) Benefit of Diversification – When a firm goes public those who have investment in it –

original owners, investors, managers, and others – can cash out of the firm and build a

diversified portfolio.

1) Signals from the Market – Stock prices represent useful information to the managers.

Every day, investors render judgments about the prospects of the firms. Although the

market may not be perfect, it provides a useful reality check.

2) Complements Product Marketing: Going public attracts media attention. Newspapers

and magazines are most likely to focus on public companies on which information is readily

available. This publicity can be harnessed and used towards marketing the product of the

company.

3) Competitive position: Many companies use their increased availability of capital as a

public company to enhance their competitive position. Additional capital available to a

public company permits greater market penetration.

4) Expands Business Relationship: Once a company is public company, information on

that company is readily available. Prospective suppliers, distributors and partners could

easily garner information and forge a relationship with such company.

5) Ability to take advantage of market price fluctuations: Once public, a company can

take advantage of market price fluctuations to sell stock when the markets are hot, buy

back the stock when the market is cold. This can often be an effective and low cost way to

raise significant capital.

COSTS OF GOING PUBLIC:

A public company (or, more precisely, a listed public company) is not an unmixed blessing. There

are several disadvantages of going public:

1) Adverse Selection – Investors, in general, know less than the issuers about the value of

companies that go public. Put differently they are potential victims of adverse selection.

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Aware of this trap, they are reluctant to participate in public issue unless they are

significantly under priced. Hence a company making an IPO typically has to under price its

securities in order to stimulate investor interest and participation.

2) Loss of Flexibility – The affairs of a public company are subject to fairly comprehensive

regulations. Hence when a non-public company is transformed into a public company there

is some loss of flexibility.

3) Disclosures – A public company is required to disclose a lot of information to investors

and others. Hence it cannot maintain a strict veil of secrecy over its expansion plans and

product market strategies as its non-public counterpart can do.

4) Accountability – Understandably, the degree of accountability of a public company is

higher. It has to explain a lot to its investors.

1) Public Pressure – Because of its greater visibility a public company may be pressurized to

do things that it may not otherwise do.

2) Expense: The cost of going public is substantial both initially and on an ongoing basis. As

for the initial cost the underwriters discount can run as high as 10% or more of the total

offering. Additionally one can incur significant out-of-pocket expenses. On an ongoing

basis, regulatory reporting requirements, stock holders meetings, investor relations, and

other expenses of being public are significant.

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FLOW CHART OF IPO PROCESS

The issue of securities to members of the public through a prospectus involves a fairly elaborate

process, the principal steps of which are briefly described below:

Approval of Board

An approval of the board of directors of the company is required for raising capital from the

public.

Appointment of Lead Managers

The lead manager is a merchant banker who orchestrates the issue in consultation with the

company. The lead manager must be selected carefully.

Appointment of Other Intermediaries

Several intermediaries facilitate the public issue process. A cop-manager is appointed to share

the work of the lead manager and an advisor to provide counsel. An underwriter is appointed

who agrees to subscribe to a given number of shares in the event the public does not

subscribe to them. The underwriter, in essence, stands guarantee for public subscription in

consideration for the underwriting commission. Bankers are appointed to collect money on

behalf of the company from the applicants. Brokers are appointed to the issue to facilitate its

subscription. Only members of recognized Stock Exchanges can be appointed as brokers. The

number of brokers appointed has to bear a reasonable relationship to the size of the issue. A

company may, if such a need is felt, appoint a principal broker to coordinate the work of

brokers. Registrars are appointed to the issue to perform a series of tasks from the time the

subscription is closed to the time the allotment is made. They may be selected on the basis of

experience, expertise, credibility, and cost.

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Filing of the Prospectus with SEBI

The prospectus or the offer document communicates information about the company and the

proposed security issue to the investing public. All companies seeking to make a public issue

have to file their offer document with SEBI. If SEBI or the public does not communicate its

observations within 21 days from the filing of the offer document, the company can proceed

with its public issue. The prospectus and application form (along with Articles and

Memorandum of Association) must be forwarded to the concerned stock exchange, where the

issue is proposed to be listed, for approval.

Filing of the Prospectus with the Registrar of Companies

Once the prospectus is approved by the concerned stock exchange and consents obtained

from the bankers, auditors, legal advisors, registrars, underwriters, and others, the prospectus,

signed by the directors, must be filed with the Registrar of Companies, along with requisite

documents as required by the Companies Act, 1956.

Filing of Initial Listing Application

Within ten days of filing the prospectus, the initial listing application must be made to the

concerned stock exchanges, along with the initial listing fees.

Promotion of the Issue

The promotional campaign typically commences with the filing of the prospectus with the

Registrar of Companies and ends with the release of the statutory announcement of the issue.

To promote the issue the company holds conferences for brokers, press and investors.

Advertisements are also released in newspapers and periodicals to generate interest among

potential investors.

Statutory Announcement

The statutory announcement of the issue must be made after seeking the approval of the lead

stock exchange. This must be published at least ten days before the opening of the

subscription list.

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Collection of Applications

The statutory announcement (as well as the prospectus) specifies when the subscription

would open, when it would close, and the banks where the applications can be made. During

the period the subscription is kept open, the bankers to the issue collect application money on

behalf of the company and the managers to the issue, with the help of the registrars to the

issue, monitor the situation. Information is gathered about the number of applications received

in various categories, the number of shares applied for, and the amount received.

Processing of Applications

The applications forms received by the bankers are transmitted to the registrars of the issue for

processing. This mainly involves scrutinizing the applications, coding the applications,

preparing a list of applications with all relevant details.

Establishing the Liability of Underwriters

If the issue is under subscribed, the liability of the underwriters has to be established.

Allotment of Shares

According to SEBI guidelines, one-half of the net public offers have to be reserved for

applications up to 1000 shares and the balance one-half for larger applications. For each of

these segments, the “proportionate” system of allotment is to be followed.

Listing of the Issue

The detailed listing application should be submitted to the concerned stock exchanges along

with the listing agreement and the listing fee. The allotment formalities should be completed

within 30 days after the subscription list is closed or such extended period as permitted by the

lead stock exchange.

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STAGES OF THE IPO

The IPO process begins with the management making a presentation to the board of directors,

with business plan and financial projections, proposing that the company enter the public market.

If the directors approve the proposal than the following steps are taken:

1. Pre-Issue

a) Due Diligence

b) Draft offer document to be filed with SEBI.

c) Final Offer document to be filed with SEBI.

d) Application for listing with Stock Exchange.

e) Promoter’s contribution to be brought in prior to the issue.

f) Appointment of Compliance officer.

g) In-principal approval from the Stock Exchange to be obtained and filed with SEBI.

h) Issue Advertisement.

i) Book-Building and Bidding processes to be followed.

2. Issue

j) Subscription list to be kept open for at least 3 days.

k) Issue to open with in the time prescribed.

3. Post-Issue

l) Monitoring reports to be submitted to SEBI.

m) Final Post issue monitoring reports.

n) Post issue advertisement.

o) Dispatch of share certificates etc. and allotment and listing documents.

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DUE-DILIGENCE

One of the keys to a smooth IPO is a thorough review of your business. This due diligence

process ensures you can back up everything you say in your SEBI registration statement.

During the due diligence phase, the company, its underwriters, and their attorneys will focus on the

registration statement. This phase will require the company to thoroughly review its business and

to substantiate all claims in the registration statement. For example, if a company claims that it

"will have significant first-mover and time-to-market advantages as a software-based solution in

the Internet postage market," the company must be able to back up that claim. Indeed, the

Securities and Exchange Commission may ask for such data. This review may also uncover

additional information that needs to be addressed or disclosed.

Besides inspecting the registration statement, the underwriters and counsel for both parties will

also question company officers and key employees. This will include a thorough discussion of the

company's business and marketing plans, revenue projections, product development road map,

and intellectual property portfolio, with an emphasis on identifying potential pitfalls. The due

diligence team will also speak with third parties, such as customers, retailers, and suppliers. After

all, problems with partners in the supply and distribution chain can cascade back to the company

itself. For example, a financially troubled customer may tie up a company's inventory in a

bankruptcy court proceeding, or a supplier of a key component may face an extended shutdown

as it irons out Y2K-related problems with its factory automation software.

This attention to detail is required for both brand-new dot.com companies and well-seasoned

corporations alike. Even Goldman Sachs, a veteran investment banking firm, provided this litany of

risk factors in its registration statement.

The third leg of the due diligence review involves an audit of company records. Again, the team

will be looking for hidden problems in the company's corporate documents, licenses, and material

contracts.

Finally, the company and its employees should be sensitive to personal matters that may affect an

initial public offering. For example, a confidential settlement between a senior executive and a

plaintiff for a fraud-related case, even if it had no merits, may affect public perception of the

company and its leadership. Accordingly, a frank discussion with counsel is encouraged.

The due diligence process aspires to achieve the following

1 To assess the reasonableness of historical and projected earnings of cash flows.

2 To identify key vulnerabilities, risks and opportunities.

3 To gain an intimate understanding of the company and the market in which the company

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operates such that the company’s management can anticipate and manage change.

4 To set in motion the planning for the post IPO operations.

It will result in a critical analysis of the control, accounting and reporting systems of the company

and concomitantly a critical appraisal of key personal. It will identify the value drivers of the

company thus enabling the directors to understand where the value is and to focus there efforts on

increasing that value.

Due Diligence spans the entire Public issue process. The steps involved in due diligence are given

below:

1. Decision on Public issue.

2. Business due diligence

3. Legal and Financial Due diligence.

4. Disclosure in prospectus.

5. Marketing to investors

6. Post issue compliance

The following is the list of the key areas which would come under scrutiny and a brief description

of what the due diligence exercise should focus on in each area:

1 The financial Statements—to ensure there accuracy.

2 The Assets—Confirm there value, condition existence and legal title.

3 The sales strategy—analyzing the policies and procedures in place and assessing what

works and what does not.

4 The marketing—what is driving the business and is it effective.

5 The industry in which the company operates—understands trends and new technology.

6 The competitions—identify threats.

7 The systems—how effective are they? Are upgrades required?

8 Legal and corporate and tax issues

9 Company contracts and lease—identify what the risks and obligations are.

10 Suppliers—are they expected to remain around.

CONTENTS OF OFFER DOCUMENT

At the center of the IPO is the prospectus. The prospectus is both a disclosure document and a

marketing document, since it is the only information that the law allows to be disseminated about

the offering. Because the company, its directors and promoters are liable for any mis-statement or

omission of material information in the prospectus, professionals involved should exercise due

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diligence in ensuring the accuracy and adequacy of all the statements contained in the

prospectus.

The prospectus is required to contain a detailed description of the business, a description of

management structure, management compensation figures, and a description of transactions

between the corporation and management discussions, operation and financial conditions,

together with information on the procedures, dividend policy and capitalization. Also a statement of

risk factors is essential.

It normally starts with the table of contents, definitions, risk factors, summary of the issuer and

financial data. This is followed by a detailed disclosure under three sections:

1. Issue Structure

2. Issuer Information

3. General and Statutory Information

1) Issue Structure

a. Capital structure of the company.

b. Objects of the issue.

c. Description of Equity shares and terms of AOA.

d. Build up of the capital

e. Funds requirement.

f. Funding plan.

g. Appraisal.

h. Schedule of implementation.

i. Funds deployed.

j. Sources of financing of funds already deployed.

k. Details of balanced funds deployed

l. Interim use of funds.

m. Details of shareholding of promoters.

n. Basis for issue price

o. Issue procedure

p. Tax benefit

q. Offering information

2) Issuer Information

r. Industry overview

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s. Business overview

t. History and corporate structure of the issuer company.

u. Details of business

v. Business strategy

w. Property

x. Directors and key managerial personnel

y. Shareholders agreement

z. Management

aa. Board of directors

bb. Compensation and interest of directors

cc. Employees

dd. Dividend policy

ee. Financial performance for the last 5 years

ff. Group companies and financial data

gg. Changes in accounting policies in the last three years

hh. Legal and other information

ii. Results of operations as reflected in the financial statements

jj. Outstanding litigation and material development

kk. Government approvals and licensing arrangements

ll. Industry, competition and regulatory environment

mm. Other regulatory and statutory disclosures

3) General and Statutory Information

nn. Description of basis of allotment

oo. Auditors report

pp. Extracts of AOA

qq. List of material contracts and documents

rr. General information

ss. Key industry regulation.

ELIGIBILITY NORMS FOR COMPANIES ISSUING SECURITIES

Conditions for issue of securities

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The companies issuing securities offered through an offer document shall satisfy following at

the time of filing the draft offer document with SEBI and also at the time of filling the final offer

document with the registrar of companies/Designated Stock Exchange.

Filing of offer document

Public issue:

A draft prospectus is required to be filed with SEBI through an eligible Merchant banker at

least 21 days prior to the filing of prospectus with the Registrar of Companies (ROCs). However,

if, within 21 days from the date of submission of draft prospectus, SEBI specifies changes, if

any, in the draft prospectus (without being under any obligation to do so), the issuer or the

Lead Merchant Banker shall carry out such changes in the draft prospectus before filing the

prospectus with ROCs.

A company shall not make an issue of securities if the company has been prohibited from

accessing the capital market under any order or direction passed by board.

A company is required to make an application for listening of those securities in Stock

Exchange(s) prior to any public issues of securities.

A company shall make a public issue or an offer for sale of securities, only after:

(a) The company enters into an agreement with a depository for

dematerialization of securities already issued or proposed to be issued to the

public or existing shareholders; and

(b) The company gives an option to subscribers/ shareholders/ investors to receive the security

certificates or hold securities dematerialization from

with a depository. As per the requirement, all the public issues of size in excess of Rs. 1

crore, are to made compulsorily in the demat more. Thus, if an investor chooses to apply for an

issue that is being made in a compulsory demat mode, he has to have a demat account and has

the responsibility to put the correct DP ID and client ID details in the bid/application forms.

Unlisted Company is required to fulfill the following further conditions:

An Unlisted Company may take an initial public offering (IPO) of equity shares or any

other security which may be converted into or exchanged with equity shares at a

later date only if it meets all the following conditions :

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The company has net tangible assets of at least Rs. 3 crores in each of the

preceding 3 full years (of 12 months each), of which not more than 50% is held in

monetary assets, if more than 50% of the net tangible assets are held in monetary

assets, the company is required to make firm commitments to deploy such excess

monetary assets in its business/project

The company has a track record of distributable profits in terms of Section 205 of

the Companies Act, 1956, for at least three (3) out of immediately preceding five (5)

years. For the purpose of calculation of distributable profits in terms of Section 205 of

Companies Act, 1956, extraordinary items shall not be considered.

The company has a net worth of at least Rs, 1 crore in each of the preceding 3 full

years (of 12 months each)

In case the company has changed its name within the last one year, at least 50% of

the revenue for the preceding 1 full year is earned by the company from the

activity suggested by the new name, and

The aggregate of the proposed issue and all the previous issues made in the

financial year in terms of size (i.e., offer through offer document + firm allotment +

promoters` contribution through the offer document ), does not exceed five (5)

times its pre-issue net worth as per the audited balance sheet of the last financial year.

An Unlisted Company not complying with any of the conditions specified above may

take an initial public offering (IPO) of equity shares or any other security which may

be converted into or exchanged with equity shares at a later date, only if it meets

both the conditions(a) and(b) given below :

(a) The issue is made through the book–building process, with at least 50% of the net offer to

the public being allotted to the Qualified Institutional Buyers ( QIBs ), failing which the full

subscription monies shall be refunded.

OR

(a) The ‘‘project’’ has at least 15 % participation by Financial Institutions / Scheduled

Commercial Banks, of which at least 10% comes from the appraiser(s). In addition to this, at

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least 10% of the issue size shall be allotted to QIBs, failing which the full subscription

monies shall be refunded

AND

(b) The minimum post-issue face value capital of the shall be Rs. 10 crores.

OR

(b) There shall be a compulsory market-making for at least 2 years from the date of listing of the

shares, subject to the following:

Market makers undertake to offer buy and sell quotes for a minimum depth of 300 shares ;

Market makers undertake to ensure that the bid-ask spread (difference

between quotations for sale and purchase) for their quotes shall not any time exceed

10%

The inventory of the market makers on each of such stock exchanges, as on the date

of allotment of securities, shall be at least 5% of the proposed issue of the company.

An unlisted public company shall not make an allotment pursuant to a public issue or offer

for sale of equity shares or any security convertible into equity shares unless the

prospective allot tees are not less than 1000 in number.

OFFER FOR SALE

An offer for sale shall not be made of equity shares of a company or any other security

which may be converted into or exchanged with equity shares of the company at a later

date, unless the conditions laid down with respect to IPO by unlisted companies are fulfilled.

Offer for sale can also be made if the provisions specified below are compiled at the time of

submission of offer document with the Board:

(a) The issue is made through the book–building process, with at least 50% of the net offer to

the public being allotted to the Qualified Institutional Buyers ( QIBs ), failing which the full

subscription monies shall be refunded.

OR

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(a) The ‘‘project’’ has at least 15 % participation by Financial Institutions / Scheduled

Commercial Banks, of which at least 10% comes from the appraiser(s). In addition to this, at

least 10% of the issue size shall be allotted to QIBs, failing which the full subscription

monies shall be refunded

AND

(c) The minimum post-issue face value capital of the shall be Rs. 10 crores.

OR

(b) There shall be a compulsory market-making for at least 2 years from the date of listing of the

shares, subject to the following:

Market makers undertake to offer buy and sell quotes for a minimum depth of 300 shares ;

Market makers undertake to ensure that the bid-ask spread (difference

between quotations for sale and purchase) for their quotes shall not any time exceed

10%

The inventory of the market makers on each of such stock exchanges, as on the date

of allotment of securities, shall be at least 5% of the proposed issue of the company.

An unlisted public company shall not make an allotment pursuant to a public issue or offer

for sale of equity shares or any security convertible into equity shares unless the

prospective allot tees are not less than 1000 in number.

MINIMUM LISTING REQUIREMENTS

Permission to use the name of the Exchange in an Issuer Company’s prospectus

The Exchange follows a procedure in terms of which companies desiring to list their securities

offered through public issues are required to obtain its prior permission to use the name of the

Exchange in their prospectus or offer for sale documents before filing the same with the

concerned office of the Registrar of Companies. The Exchange has since last three years

formed a ‘‘Listing Committee’’ to analyze draft prospectus/offer documents of the companies in

respect of their forthcoming public issue of securities and decide upon the matter of granting

them permission to use the name of ‘‘ The Stock Exchange, Mumbai’’ in their prospectus/ offer

documents. The committee evaluates the promoters, company, project and several other

factors before taking decision in this regard.

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Submission of Letter of Application

As per Section 73 of the companies Act, 1956, a company seeking listing of its securities on

the Exchange is required to submit a Letter of Application to all the Stock Exchanges where

it proposes to have its securities listed before filing the prospectus with the Registrar of

Companies.

Allotment of Letter of Application

As per Listing Agreement, a company is required to complete allotment of securities offered to the

public within 30 days of the date of closure of the subscription list and approach the Regional

Stock Exchange, i.e. Stock Exchange nearest its registered office for approval of the basis of

allotment.

In case of Book Building issue, Allotment shall be made not later than 15 days from the closure of

the issue failing which interest at the rate of 15% shall be paid to the investors.

Biding Permission

As per Securities and Exchange Board of India Guidelines, the issuer company should

complete the formalities for trading at all the Stock Exchanges where the securities are to

listed within 7 working days of finalization of Basis of Allotment. A company should scrupulously

adhere to the time limit for allotment of all securities and dispatch of Allotment Letters/ Share

certificates and Refund Orders and for obtaining the listing permissions of all the

Exchanges whose names are stated in its prospectus or offer documents. In the event of

listing permission to a company being denied by any Stock Exchange where it had applied

for listing of its securities, it can not proceed with the allotment of shares. However, the

company may file an appeal before the Securities and Exchange Board of India under Section 22

of the Securities Contracts (Regulation) Act, 1956.

Requirement of 1% Security

The companies making public/ rights issues are required to deposit 1% of issue amount with

the Regional Stock Exchange before the issue opens. This amount is liable to be forfeited in the

event of the company not resolving the complaints of investors regarding delay in sending

refund orders/ share certificates, non payments of commission to underwriters, brokers etc.

Payment of Listing Fees

All companies listed on the Exchange have to pay Annual Listing Fees by the 30th April of every

financial year to the Exchange as per the schedule of Listing Fees prescribed from time to

time.

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EXEMPTION FROM ELIGIBILITY NORMS

The provisions of eligibility norms shall not apply in the following cases:

i) A banking company including a Local Area Bank ( Private Sector Bank ) set up under sub-

section (c) of Section 5 of the Banking Regulation Act, 1949 and which has received license

from the Reserve Bank of India; or

ii) A corresponding new bank set up under the Banking Companies ( Acquisition and Transfer of

Undertaking) Act, 1970 Banking Companies ( Acquisition and transfer of Undertaking) Act, 1980,

State Bank of India Act, 1955 and State Bank of India (Subsidiary Banks) Act, 1959 (Public

Sector Bank);

iii) An infrastructure company:

a) whose project has been appraised by a Public Financial Institution (PFI) or

Infrastructure Development Finance Corporation ( IDFC ) or Infrastructure Leasing and

Financing Services Ltd. ( IL & FS ) or a bank which was earlier a PFI; and

b) not less than 5 % of the project cost is Financed by any of the institution referred to

in sub - clause (a), jointly or severally, irrespective of whether they appraise the project

or not, by way of loan or subscription to equity or a combination of both ;

iv) Rights issue by a listed company.

UNDERWRITING

In case the issuer company is making an issue of securities.

A. Under 100% of the net offer to the public.

B. Under 75% of the net offer to the public, it is required to be compulsorily underwritten by the

syndicate members/book runner(s)

The ‘Syndicate members’ are required to enter into an underwriting agreement with the Book

Runner(s) indicating the number of securities which they would subscribe at the predetermined

price. The Book Runner(s) are then required to enter into an underwriting agreement with the issuer

company.

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Selecting the managing underwriter

The underwriter chosen by a company to manage its offering play a critical role in the success of

the IPO. The managing underwriter is actively involved in the preparation of the company’s

registration statement as well as managing the marketing and sale of the company’s stock. While

many companies select to appoint mare than one managing underwriter, the potential for differing

views and approaches between them is significant and companies must be prepared to resolve

any issues that may arise.

In selecting the managing underwriter, the following factors should be considered:

Industry Experience : The underwriter should have substantial experience in IPOs in the

company’s industry and a good familiarity with the company and its business.

Experienced Analyst : The underwriter should have a well known analyst in the industry. Having

an analyst with a high profile in the relevant sector is the factor typically accorded great weight

by companies contemplating an IPO.

Individual Investment Bankers : The Company should feel free with the individual investment

bankers assigned to the transaction. The right chemistry between the bankers and

management is critical.

Reputation and Attention : While reputation is important, top tier underwriters may not give

smaller companies as much attention as other underwriters. On the other hand, those less

prominent underwriters may not be able to provide the resources available to the leading

underwriters.

Distribution strength : The potential managing underwriters and the company should discuss

whether the issue should be sold primarily to retail investors or institutional investors, or both.

The underwriters selected should have a substantial institutional or retail sales force, as

required.

Aftermarket Support : The underwriter should have a strong record of aftermarket price

performance for the stock of the companies that it has recently taken public. A strong

performance record indicates how well the underwriter priced and supported recent

transactions.

The company should discuss with potential underwriters and assess critically any potential

conflicts in the representation. Conflicts may result from an underwriter’s relationship with

competitors or an underwriter’s relationship with the company aside from underwriting relationship.

It is conceivable that an underwriter who holds an equity stake in the company that would be

counted as “underwriter’s compensation” would forgo the assignment in order to maximize

potential profits on the equity stake. If made after IPO registration statement is filed, however, this

decision could cripple an IPO. These and related issues should be thoroughly discussed with each

potential underwriter

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PRICING BY COMPANIES ISSUING SECURITIES

Indian primary market ushered in an era of free pricing in 1992. Following this, guidelines have

provided that the issuer in consultation with Lead Manager (L.M.) should decide the price. There is

no price formula stipulated by SEBI. SEBI does not play role in price fixation. There are two types

of issues one where company and LM fix a price (called fixed price) and other, where the company

and LM stipulate a floor price or a price band and leave it to market forces to determine the final

price (price discovery through book building process)

Fixed price offers are those offers where an issuer company is allowed to freely price the issue.

The basis of issue price is d9sclosed in the offer document where the issue discloses in detail

about the qualitative and quantitative factors justifying the issue price. The issuer company can

mention a price band of 20% (cap in the price band should not be more than 20% of the floor

price) in the Draft offer documents filed with SEBI and actual price can be determined at a later

date before filing of the final offer document with SEBI/ROCs.

Book Building means a process undertaken by which a demand for the securities proposed to be

issued by a body corporate is elicited and built up and the price for the securities is assessed on

the basis of the bids obtained for the quantum of securities offered for subscription by the issuer.

This method provides an opportunity to the market to discover price for securities.

Price Band

Issuer company can mention a price band of 20% (cap in the price band should not be more than

20% of the floor price) in the offer documents filed with the Board and actual price can be

determined at a later date before filing of the offer document with ROCs.

An eligible company shall be free to make public or rights issue of equity shares in any

denomination determined by it in accordance with compliance with the following and other norms

as may be specified by SEBI from time to time:

i. In case of initial public offer by an unlisted company.

a. If the issue price is Rs. 500/- or more, the issuer company shall have a discretion to

fix the face value below Rs. 10/- per share subject to the condition that the face

value shall in no case be less than Rs. 1 per share;

b. If issue price is less that Rs. 500 per share, the face value shall be Rs. 10/- per

share;

ii. The disclosure about the face value of shares (including the statement about the issue

price being “X” times of the face value) shall be made in the advertisement, offer

34

documents and in application forms in identical font size as that of issue price or price

band).

FIXED PRICE ISSUE BOOK BUILT ISSUE (100:0 MODEL)

MOST PREFERRED MODEL

Entire issue allotment on a proportionate

basis to retail investors, non-institutional

investors and QIBs

At least 50% of the Issue to be allotted

to retail investors (applying for up to an

amount of Rs 1,00,000)

Balance to be allotted to non-institutional

investors and QIBs (applying for an

amount of > Rs. 1,00,000)

Up to 50% allocation on a proportionary

basis to QIBs i.e. Banks, FIIs, Mutual

Funds, VCs etc.

At least 15% offer on a proportionate

basis to non-institutional investors

(bidding for an amount of >Rs1, 00,000)

Balance 35% offer on a proportionate

basis to retail investors (individuals

bidding for an amount up to Rs. 1,00,000)

Pros

Lesser number of intermediaries

Wider distribution since no requirement

of electronic bidding

Operationally simpler

Efficient price discovery could lead to

potential to capture a higher valuation

Larger institutional participation since

bidding by QIBs at 0% margin payment

and discretionary allocation to QIBs

Shorter time gap between determination

of the price band and closure of the book

(15 –20 days) reduces market risk

Cons

Price discovery not as efficient as book-

building since price band to be decided

at SEBI filing stage

Longer time between finalization of price

& closure of issue (25 - 30 days)

Very low institutional appetite since-

Institutional investors prefer bigger bites,

hence large IPO size a prerequisite

Need significant institutional demand

since retail participation alone may not

lead to efficient price discovery

35

QIBs required to pay with applications.

-Allotment on a proportionate basis

Initial Public Offering can be made through the fixed price method, Book building method or

a combination of both. Book building refers to the process of collection of bids from investors,

which is based on the price band, with the offer price being finalized after the Bid/offer closing

data. It is a mechanism where, during the period for which the book for the IPO is open, bids are

collected from investors at various prices, which are above or equal to the floor price. The process

aims at tapping both wholesale and retail investors. The offer/issue price is then determined after

the bid closing date based on certain evaluation criteria.

Every public offer through the book building process has a Book Running Lead Manager

(BRLM), a merchant banker, who manages the issue. Further, an order book, in which the

investors can state the quantity of the stock they are willing to buy, at a price within the band, is

built. Thus the term ‘book-building.’

Thus the issuer gets the best possible price for his securities as perceived by the market or

investors. Investors too have a choice and flexibility in terms of having a say in pricing and a

greater certainty of being allotted what they demand.

The principal parties involved in the Book Building Process are:

(1) The Company

(2) The Selling Shareholder

(3) The Book Running Lead Managers (BRLMs)

(4) The Syndicate Members, who are intermediaries registered with SEBI and eligible to

act as underwriters, appointed by the BRLMs.

(5) The Registrar to the office.

In case the issuer chooses to issue securities through the book building route then as per SEBI

guidelines, and Issuer Company can issue securities in the following manner:

100% of the net offer to the public through the book building route.

36

75% of the net offer to the public through the book building process and 25% through the

fixed price portion

Under the 90% scheme, this percentage would be 90 and 10 respectively

COMPARISON BETWEEN METHODS OF ISSUE

COMPARISON ACCORDING TO FEATURES

FEATURE FIXED PRICE PROCESS BOOK BUILDING PROCESS

Pricing Price at which the securities are

offered/allotted is known in advance to

the investor

Price at which securities will be

offered/allotted is not known in

advance to the investor. Only an

indicative price range is known

Demand Demand for the securities offered is

known only after the closure of the issue.

Demand for the securities offered can

be known everyday as the book is

built

Payment Payment if made at the time of

subscription wherein refund is given after

allocation

Payment only after allocation.

THE BOOK BUILDING PROCESS

The Issuer who is planning an IPO nominates a lead merchant banker as a ‘book runner’.

The Issuer specifies the number of securities to be issued and the price band for orders.

The Issuer also appoints syndicate members with whom orders can be placed by the

investors.

Investors place their order with syndicate members who input the orders into the ‘electronic

book’. This process is called ‘bidding’ and is similar to open auction.

A Book should remain open for a minimum period of at least three working days and not

more than seven working days which may be extended to a maximum of ten working days

in case the price band is revised.

Bids cannot be entered at less than the floor price

Bids can be revised by the bidder before the issue closes.

37

On the close of the book building period the ‘book runner evaluates the bids on the basis of

the evaluation criteria which may include.

o Price Aggression

o Investor quality

o Earliness of bids, etc.

The book runner and the company conclude the final price at which they are willing to issue

and allocate of securities.

Generally, the issue size gets frozen based on the price per shares discovered through the

book building process.

Allocation of securities is made to the successful bidders.

THE FLOW CHART OF BOOK BUILDING PROCESS

38

OFFER TO PUBLIC THROUGH BOOK BUILDING PROCESS (100% BOOK BUILDING

PROCESS)

An issuer company may make an issue of securities to the public through a prospectus in the

following manner:

a. 100% of the net offer to the public through book building process, or

b. 75% of the net offer to the public through book building process and 25% at the price

determined through book building.

The requirements to be complied with are:

1. Reservation or firm allotment to the extent of percentage specified in these Guidelines can be made

only to the categories mentioned in (2) below

2. The promoter’s contribution and the allocation made t the following persons shall not be included in

the book building portion:

a) Permanent employees of the issuer company and in the case of a new company the permanent

employees of the promoting companies;

b) Shareholders of the promoting companies in the case of a new company and shareholders of group

companies in the case of an existing company’ either on a ‘competitive basis’ or on a ‘firm

allotment basis’.

c) Persons who, on the date of filing of the draft offer document with the Board, have business

association, as depositors, bondholders and subscribers to services, with the issuer making an

initial public offering, provided that allotment to such persons shall not exceed 5% of the issue

size. However, no reservation shall be made for eh issue management team, syndicate members,

their promoters, directors and employees and for the group/associate companies of issue

management team and syndicate members and their promoters, directors and employees.

3. The issuer company is required to appoint an eligible Merchant Banker(s) as book runner(s) and

their name(s) are required to be mentioned in the draft prospectus.

39

4. The issuer company is required to enter into an agreement containing the required information, with

one or more of the Stock Exchange(s) which have the requisite system f online offer of securities.

5. The company may apply for listing of its securities on an exchange other than the exchange

through which it offers its securities to public through the on line system.

6. The Lead Merchant Banker is required to act as the Lead Book Runner.

7. The Front cover page of the prospectus is required to contain the names of all merchant banker(s),

who have submitted the due diligence certificate to SEBI.

8. The company is required to pay to the broker/s appointed by the merchant banker, a

commission/fee for the services rendered by him/them.

9. The red herring prospectus is required to disclose, either the floor price of the securities offered

through it or a price band along with the range within which the price can more, if any.

10. (a) In case of appointment of more than one Lead Merchant Banker or Book Runner for book

building the right obligations and responsibilities of each is required to be delineated.

(b) In case of an under subscription in an issue, the shortfall is required to be made good by the

Book Runner(s) to the issue.

11. The issuer company is required to circulate the application forms to the Brokers.

12. The pre issue obligations and disclosure a requirement as specified in the guidelines is applicable

to issue of securities through book building.

13. The Book Runner(s) and the issuer company are required to determine the issue price based on

the bids received through the ‘syndicate members’.

14. The final prospectus containing all disclosures as per these Guidelines including the price and the

number of securities proposed to be issued is required to be filed with the Registrar of Companies.

15 Arrangements are required to be made by the issuer for collection of the applications by appointing

mandatory collection centers as per the Guidelines.

40

16. Apart from meeting the disclosure requirements as specified in the Guidelines, the following

disclosures are required to be made:

(i) The particulars of syndicate members, brokers, registrars, bankers to the issue, etc.

(ii)The following statement shall be given under the ‘basis for issue price’:-

“The issue price has been determined by the Issuer in consultation with the Book Runner(s), on

the basis of assessment of market demand for the offered securities by way of Book building.”

(iii)The following accounting ratios shall be given under the basis for issue price for each of the

accounting periods for which the financial information is giver:

EPS. Pre- issue for the last three years (as adjusted for changes in capital)

P/E pre-issue.

Average return on net worth in the last three years.

Net Asset value per share based on last balance sheet.

Comparison of all the accounting ratios of the issuer company as mentioned above with the

industry average and with the accounting ratios of the peer group (i.e. companies of

comparable size in the same industry. (Indicate the source from which industry average

and accounting ratios of the peer group has been taken.)

The accounting ratios disclosed in the offer document shall be calculated after giving effect

to the consequent increase of capital on account of compulsory conversions outstanding,

as well as on the assumption that the options outstanding, if any, to subscribe for additional

capital shall be exercised.

(iv) The proposed manner of allocation among respective categories investors, in the event of

under subscription.

75% BOOK BUILDING PROCESS

In an issue of securities to the public through a prospectus the option for 75% book building

shall be available to the issuer company. The preconditions are:

i) The option of book building shall be available to all body corporate which are otherwise

eligible to make an issue of capital to the public.

ii) (a) The book building facility shall be available as an alternative to, and to the extent of the

percentage of the issue which can be reserved for firm allotment, as per these Guidelines.

(b) The issuer company shall have an option of either reserving the securities for firm

allotment or issuing the securities through book building process.

41

(iii) The issue of securities through book building process shall be separately

identified/indicated as ‘placement portion category’, in the prospectus.

(iv) (a) The securities available to the public shall be separately identified as ‘net offer to the

public’.

(b) The requirement of minimum 25% of the securities to be offered to the public shall also

be applicable.

(v) In case the book building option is availed of, underwriting shall be mandatory to the extent

of the net offer to the public.

STEPS INVOLVED IN 75% BOOK BUILDING PROCESS :

i) The draft prospectus containing all the information except the information regarding the price at

which the securities are offered is required to be filed with SEBI.

ii) One of the lead merchant bankers to the issue is required to be nominated by the issuer

company as a Book Runner and his name is required to be mentioned in the prospectus.

iii) The draft prospectus to be circulated is required to indicate the price band within which the

securities are being offered for subscription

iv) On receipt of information relating to offers received, number of securities offered, the Book

Runner and the issuer company shall determine the price at which the securities shall be

offered to the public. The issue price for the placement portion and offer to the public shall be

the same.

v) On determination of the price, the underwriter shall enter into an underwriting agreement with

the issuer indicating the number of securities as well as the price at which the underwriter shall

subscribe to the securities. However, the Book Runner shall have an option of requiring the

underwriters to the net offer to the public to pay in advance all monies required to be paid in

respect of their underwriting commitment.

vi) On determination of the issue price within two days thereafter the prospectus shall be filed with

the Registrar of Company.

42

vii) The issuer company shall open two different accounts for collection of application moneys, one

for the private placement portion and the other for the public subscription.

viii) Allotment for the private placement portion shall be made on the second day

from the closure of the issue. However, to ensure that the securities allotted under placement

portion and public portion are pare passu in all respects, the issuer company may have one

date of allotment which shall be the deemed the date of allotment for the issue of securities

through book building process.

ix) Allotment of securities under the public category shall be made as per the Guidelines.

Allotment of securities under the public category shall be eligible to be listed.

x) In case of under subscription in the net offer to the public spillover to the extent of under

subscription shall be permitted from the placement portion to the net offer to the public portion

subject to the condition that preference shall be given to the individual investors.

xi) In case of under subscription in the placement portion spillover shall be permitted from the net

offer to the public to the placement portion

xii) The issuer company may pay interest on application moneys till the date of allotment or the

deemed date of allotment provided that payment of interest is uniformly given to all the

applicants.

xiii) The Book Runner and other intermediaries associated with the book building

process shall maintain the records of book building process.

PROCEDURE FOR BIDDING

The method and process of bidding is subject to the following:

1. Bid is required to be kept open for at least three working days and no more than seven working

days, which may be extended to a maximum of ten working days in case the price band is

revised.

2. Bidding is permitted only if an electronically linked transparent facility is used.

43

3. The ‘syndicate members’ are required to be present at the bidding centers so that at least one

electronically linked computer terminal all the bidding centers is available for the purpose of

bidding.

4. (a) The number of bidding centers, in case 75% of the net offer to public is offered through the

book building process shall not be less than the number of mandatory collection centers as

specified in the regulations. In case 100% of the net offer to the public is made through book

building process, the bidding centers shall be at all the places, where the recognized stock

exchanges are situated.

(b) The same norms as applicable for collection centers shall be applicable for the bidding

centers also.

5. Individual as well as qualified institutional buyers shall place their bids only through the ‘brokers’

who shall have the right to vet the bids. The applicant is required to enclose the proof of DP ID and

Client ID along with the application, while making bid.

6. During the period the issue is open to the public for bidding, the applicants may approach the

brokers of the stock exchange’s through which the securities are offered under online system to

place an order for bidding to the securities. Every broker shall accept orders from all

clients/investors who place orders through him.

7. The investors shall have the right to revise their bids provided that Qualified Institutional Buyers

shall not be allowed to withdraw their bids after the closure of the bidding.

8. Bidding Form

There shall be a standard bidding form to ensure uniformity in bidding and accuracy.

(a) The bidding form shall contain information about the investor, the price, and the number of

securities that the investor wished to bid.

(b) The bidding form before being issued to the bidder shall be serially numbered at the

bidding centers and date and time stamped.

(c) The serial number may be system generated or stamped with an automatic numbering

machine.

(d) The bidding form shall be issued in duplicate signed by the investor and countersigned by

the syndicate member, with one form for the investor and the other for the syndicate

member(s)/Book Runner(s).

44

9. At the end of each day of the bidding period the demand shall be shown graphically on the

terminal for information of the syndicate members as well as the investors.

10. The identities of the Qualified Institutional Buyers making the bidding shall not be made public.

7. The stock exchanges shall display data pertaining to book built issues in a uniform format,

interalia giving category wise details of the bids received indicative format as given in the

guidelines. The data pertaining to an issue shall be displayed on the site for a period of at least

three days after closure of bids.

After the closure of the issue, the bids received are aggregated under different categories i.e. firm

allotment, qualified institutional buyers (QIBs), Non-Institutitional Buyers (NIBs). Retail, etc. The

oversubscription ratios are then calculated for each of the categories as against the shares

reserved for each of the categories in the offer document. Within each of these categories, the

bids are then segregated into different buckets based on the number of shares applied for. The

oversubscription ratio is the applied to the number of shares applied for and the number of shares

to be allotted for applicants in each of the buckets is determined. Then, the number of successful

allottees is determined. This process is followed in case of proportionate allotment. In case of

allotment for QIBs, it is subject to the discretion of the post issue lead manager.

Where the lead book runner has reasons not to accept a Qualified Institutional Buyers’ bid, the

same is required to be done at the time of receipt of the bids and the reasons therefore is required

to be disclosed to the bidder.

ASBA (Application Supported by Blocked Amounts) is a process developed by the Securities

and Exchange Board of India (SEBI) for applying to IPO in public issues w.e.f. May 1, 2010 all

the investors can apply through ASBA.

ASBA is an application containing an authorization to block the application money in the bank

account, for subscribing to an issue. In ASBA, an IPO applicant's account doesn't get debited until

shares are allotted to him. If an investor is applying through ASBA, his application money shall be

debited from the bank account only if his/her application is selected for allotment after the basis of

allotment is finalized, or the issue is withdrawn / failed. ASBA process facilitates retail individual

investors bidding at cut-off, with single option, to apply through Self Certified Syndicate Banks

45

(SCSBs), in which the investors have bank accounts. SCSBs are those banks which satisfy the

conditions laid by SEBI. SCSBs would accept the applications, verify the application, block the

fund to the extent of bid payment amount, upload the details in the web based bidding system of

NSE, unblock once basis of allotment is finalized and transfer the amount for allotted shares, to

the issuer. It is a supplementary process of applying in Initial Public Offers (IPO), Follow on public

offers (FPO) made through book building route and co-exists with the current process of using

cheque as a mode.

Applying through ASBA facility has the following advantages:

(i) The investor need not pay the application money by cheque rather the investor submits ASBA which accompanies an authorization to block the bank account to the extent of the application money.

(ii) The investor does not have to bother about refunds, as in ASBA only that much money to the extent required for allotment of securities, is taken from the bank account only when his application is selected for allotment after the basis of allotment is finalized.

(iii) The investor continues to earn interest on the application money as the same remains in the bank account, which is not the case in other modes of payment.

(iv) The application form is simpler.

(v) The investor deals with the known intermediary i.e. its own bank

It is not mandatory. An investor, who is eligible for ASBA, has the option of makingapplication through ASBA or through the existing facility of applying with cheque. One can make application through ASBA facility in all the issues i.e. public and rights. ASBA can be submitted to the SCSB with which the investor is holding the bank account only. Five (5) applications can be made from a bank account per issue.

SUGGESTED MODEL TIME FRAME FOR BOOK BUILDING:

T T+1 T+2 T+3 T+4 T+5 T+6

Book

Closed

Price

Determi-

nation

Registrar

draws the

allocation

list

All entered

Stock Exchanges

approve the basis of

allocation

Final prospectus

printed and

dispatched

Pay-in (only high

value)

Bankers to confirm

clearance of Fund

Board Meeting

Stock Exchange to

Brokers

account to

be credited

with shares

Broker to

Trading

commences

46

Determi-

nation of

offer size

bids

assumed as

valid

Confirmation of

Allocation Notes

(CANs) sent to QIBs

Allocation details

electronically

communicated by

Registrar/company

o brokers

issue the listing and

trading permission

Company to instruct

NSDL/CDSL to

credit shares to

demat account of

brokers.

credit

shares to

the demat

account.

PRE-ISSUE OBLIGATIONS

1. A Memorandum of understanding is required to be entered into between a lead merchant

banker & the issuing company specifying their mutual rights, liabilities & obligations related to the

issue.

2. The issuer is required to be submit an undertaking to SEBI to the effect the transactions in

securities by the ‘promoter group’ and the immediate relatives of the promoters during the period

between he date of filing the offer documents with the Registrar of Companies or Stock Exchange

as the case may be and the date of closure of the issue shall be reported to the exchange

concerned within 24 hours of the transaction(s).

3. The issuer company is required to submit to the Board the list of the persons who constitute the

Promoter’s Group and their individual shareholding.

4. The issuer company is required to submit to the Stock Exchanges on which securities are

proposed to be listed, the Permanent Account Number, Bank Account Number and Passport

Number of the promoters at the time of filing the draft offer document to them.

5. The issuer company is required to enter into a Memorandum of Understanding with the

intermediary (ies) concerned whenever required.

6. In case where the issuer company is a registered Registrar to an Issue, the issuer required to

appoint an independent outside Registrar to process its issue.

47

7. Where the number of applications in a public issue is expected to be large, the issuer company

in consultation with the lead merchant banker may associate on or more Registrars registered with

the Board for the limited purpose of collecting the application forms at different centers and

forward the same to the designated Registrar to the Issue as mentioned the offer document. The

designated Registrar to the issue shall, be primarily and solely responsible for all the activities

assigned to them for the issue management.

8. The draft offer document filed with the Board is required to be made public for period of 21 days

from the date of filing the offer document with the Board.

9. Subject to section 66 of the Companies Act, 1956, the issuer company soon after receiving final

observations, if any, on the draft prospectus or draft Red Herring Prospectus from the Board, is

required to make an advertisement in an English national Daily with wide circulation, one Hindi

National newspaper and a regional language newspaper with wide circulation at the place where

the registered office of the issuer is situated, which shall be in the format and contain the minimum

disclosures as specified in the guidelines.

10. The offer documents and application forms is required to specifically indicate that the

acknowledgement of receipt of application money given by the collection, agents shall be valid and

binding on the issuer company and other persons connected with the issue.

8. An issuer company is required to appoint a compliance officer who shall directly liaise with the

Board with regard to compliance with various laws, rules, regulations, and other directives issued

by the Board and investor’s complaints related matter. The name of the compliance officer so

appointed is required to be intimated to the Board.

MARKETING STRATEGY FOR IPO

A wide spectrum of marketing tools will be used to achieve significant over subscription from

institutional as well as retail investor segments

48

APPROACHES TO DIFFERENT CLASSES OF INVESTORS

-Management Meetings and HNI Targeting NRIs in India and abroad

Non-Institutional

Top Broker/ Press Site Visit

Retail

Elements of Marketing

Strategy

ManagementInterviews in Press &

Electronic Media

Institutional / Retail

Analyst Meet

Institutional

-Advertisements-Press Meets

Retail

Retail

49

Pre-marketing &Management Road shows

Institutional

-Broker Meets -Press Meets

60%

QualifiedInstitutional Buyers

High net worth

Retail 15%

25%

The Road Show:

The centerpiece of the marketing process is the road show, where the company and its

underwriters traverse through the country as well as abroad. The road show team conducts a

seemingly endless stream of meetings with potential investors; securities analysis, brokers and

potential underwriting syndicate members. Some of these meetings are one-to –one, but most are

group meetings. The road show is conducted in the weeks immediately preceding the

effectiveness and pricing of IPO, many indications of interest are placed immediately after a road

show stop. The company’s story-which may have been first told at the organizational meetings,

which has been converted into an onscreen summary to be conveyed in 30 minutes or less to an

astute and inquisitive audience-can make or break an IPO. A successful road show typically, has a

meaningful impact on the IPO price and on initial aftermarket trading

Marketing strategies for Retail Investors:

Broker conferences in key cities

Top 15 cities in India have contributed 97% of amount raised in public equity offerings

during the last 3 years

Site visit for key brokers from across India

Press conferences in key cities

Advertising and Public Relations campaign

Sustained awareness program before SEBI observations, through corporate advertisement

campaign

Press advertisements

Management interviews in print & electronic media

Marketing strategies for High Net Worth Investors:

Initial contact with High Net Worth Individuals (HNI) by Private Client Services (PCS) sales

person

50

Key HNI meet with the management

Marketing strategies for Qualified Institutional Investors:

Develop equity story through research report

Communicate equity story during pre-marketing where sector analysts interface with fund

managers to discuss financials and answer preliminary questions

Collate pre-marketing feedback and decide floor price

Follow-up by senior salespersons to address investor queries

Prepare senior personnel for management road shows based on interaction of the sector

analyst and salespersons with fund managers

Finalize the management road show schedule to maximize investor coverage across

investor geographies

One-on-one meetings and group functions with company management – video / telephone

conferences in secondary cities as needed

Regular interface by salespersons with fund managers to follow-up for bids

POST ISSUE OBLIGATIONS

The post issue obligations shall be as follows:

Post issue monitoring reports are required to be submitted by the Lead Merchant banker to SEBI

within 3 working days from the due date. The due dates are given below:

1. In case of issue through book building process, for book built portion, the due date shall be

3rd day from the date of allocation in the book built portion or one day prior t the opening of

the fixed price portion, whichever is earlier.

2. In all other cases, including the fixed price portion of the book built issue, the due date shall

be 3rd day form the date of closure of the issue.

3. The due date for the final post issue monitoring report for all issues shall be the 3rd day

from the date of listing or 78 days from the date of closure of the subscription of the issue,

whichever is earlier.

51

Post issue Lead Merchant Banker shall ensure that issuer company/advisors/brokers or on other

agencies connected with the issue do not publish any advertisement stating that more has been

oversubscribed or indicating investors’ response to the issue, during the period when the public

issue is still open for subscription by the public.

ALLOCATION/ ALLOTMENT PROCEDURE

CASE 1

Issuer Company makes an issue of 100% of the net offer to the public through 100% book

building process

ALLOCATION

Not less than 35% of the net offer to the public to Retail Individual investor.

Not less than 15% of the net offer to the public to Non Institutional investors i.e. investors

other than retail individual investors and qualified Institutional Buyers

Not more than 50% of the net offer to the public to Qualified Institutional Buyer (out of

which 5% to be specifically allocated to mutual funds)* However 50%of net offer to public

shall be mandatory allotted to the qualified Institutional Buyers.

CASE 2

Issues made under Rule 19(2)(b) of Securities Contract Regulation)Rules 1957, with 60%

mandatory allocation to Qualified Institutional Buyers (out of which 5% to be specifically allocated

to mutual funds)*

ALLOCATION

The percentage allocation to retail individual investors and not institutional investors shall

30% and 10% respectively

CASE 3

An issuer company makes an issue of 75% of the net offer to public through book building process

and 25% at the price determined through book building

ALLOCATION

In the book built portion, not less than 25% the net offer to the public to Non qualified

Institutional Buyers

52

Not more than 50% of the net offer to the public to Qualified Institutional Buyer (out of

which 5% to be specifically allocated to mutual funds)* However 50%of net offer to public

shall be mandatory allotted to the qualified Institutional Buyers.

The balance 25% of the net offer to the public offered at a price determined through

building to retail individual investors who either not participated or have not received

allocation, in the book built portion.

THE NEED FOR IPO

CORPORATISATION AND DEMUTUALIZATION OF STOCK EXCHANGES

The Securities and Exchange Board of India (SEBI) had approved corporatisation and

demutualization schemes of stock exchanges. Under the corporatisation scheme, the stock

exchanges that are associations of people will be converted into a for-profit company limited by

shares. The ownership and management rights and trading rights associated with membership

cards will be segregated. It will not be necessary for a shareholder to be a trading member and

vice versa. After corporatisation, the membership cardholders will become initial shareholders of

the exchange that will ensure that at least 51 percent of its equity shares are held by the public.

The corporatised exchanges will ensure that the assets and reserves are utilized only for the

operations of the stock exchange.

Corporatisation of Stock Exchanges is the process of converting the organizational structure of the

stock exchange from a non-corporate structure to a corporate structure. Traditionally, some of the

stock exchanges in India were established as "Association of persons", like BSE, ASE and MPSE.

Corporatisation of these exchanges is the process of converting them into incorporated

Companies.

Demutualization refers to the transition process of an exchange from a "mutually-owned"

association to a company "owned by shareholders". In other words, transforming the legal

structure of an exchange from a mutual form to a business corporation form is referred to as

demutualization. The above, in effect means that after demutualization, the ownership, the

management and the trading rights at the exchange are segregated from one another.

DEPOSITORY & DEPOSITORY PARTICIPANT

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A company that maintains a record of investors dematerialized, shareholding in individual

accounts, which are known as Demat account. This is as same as maintaining a bank account

credited when shares are bought and debited on sale.

There are two depositories in India, NSDL and CDSL the depositories are regulated by SEBI and

are governed by the depositories Act, 1996

Depository Operations

Any investor who wishes to avail depository services must first open an account with a depository

participant of NSDL and CDSL. The process of opening a demat account is very similar to a bank

account. The investor can open an account with any depository participant of NSDL and CDSL. An

investor may open an account with several DPs or he may open several accounts with a single

DP. There are several DPs offering various depository-related services. Each DP is free to fix its

own fee structure. Investors have the freedom to choose a DP based on criteria like convenience,

comfort, service levels, safety, reputation and charges. After exercising this choice, the investor

has to enter into an agreement with the DP. The form and contents of this agreement are specified

by the business rules of NSDL and CDSL.

Account Opening

Any investor who wishes to avail depository services must first open an account with a depository

participant of NSDL or CDSL. The process of opening a demat account is very similar to a bank

account. The investor can open an account with any depository participant of NSDL / CDSL. An

investor may open an account with several DPs or he may open several accounts with a single

DP. There are several DPs offering various depository-related services. Each DP is free to fix its

own fee structure. Investors have the freedom to choose a DP based on criteria like convenience,

comfort, service levels, safety, reputation and charges. After exercising this choice, the investor

has to enter into an agreement with the DP. The form and contents of this agreement are specified

by the business rules of NSDL / CDSL.

Types of Accounts

Type of depository account depends on the operations to be performed. There are three types of

demat accounts which can be opened with a depository participant viz.

(a) Beneficiary Account (b) Clearing Member Account and (c) Intermediary Account.

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* A DP may be required to open three categories of accounts for clients - Beneficiary Account,

Clearing Member Account and Intermediary Account.

* A Beneficiary Account is an ownership account. The holder/s of securities in this type of account

own those securities.

* The Clearing Member Account and Intermediary Account are transitory accounts. The securities

in these accounts are held for commercial purpose only.

* A Clearing Member Account is opened by a broker or a Clearing Member for the purpose of

settlement of trades.

* An Intermediary Account can opened by a SEBI registered intermediary for the purpose of stock

lending and borrowing

Documents for Verification

For the purpose of verification, all investors have to submit the following documents along with the

prescribed account opening form.

Proof of identity - A beneficiary account must be opened only after obtaining a proof of identity of

the applicant. The applicant's signature and photograph must be authenticated by an existing

account holder or by the applicant's bank or after due verification made with the original of the

applicant's valid passport, voter ID, driving license or PAN card with photograph; and further,

Proof of address - The account opening form should be supported with proof of address such as

verified copies of ration card/ passport/ voter ID/ PAN card/ driving license/ bank passbook. An

authorised official of the Participant, under his signature, shall verify the original documents. In

case any account holder fails to produce the original documents for verification within the aforesid

period of 30 days, it must be immediately brought to the notice of NSDL. Failure to produce the

original documents within the prescribed time would invite appropriate action against such account

holders, which could even include freezing of their accounts.

Beneficiary Account – Procedure for Opening an Account

Investors have the choice of selecting a DP based on their convenience, comfort, service levels,

safety, reputation charges, etc. They have the flexibility to have more than one account with the

same DP or any other DPs. No minimum balance is required for opening a depository account.

Investors also have the freedom to close an account with one DP and open another one with any

other DP.

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The type of the Account opening form to be filled by an investor and the list of documents required

depend on the type of beneficiary account to be opened - whether it is for NRIs or Corporates or

individual. Further, the individual account can be in a single name or joint names. Clearing

Members and brokers have to open a beneficiary account if they have to deal with their own

holdings. There are several client types in the depository system and different codes are allotted to

them. These are listed below.

1. Resident

_ Ordinary

_ HUF

2. Financial Institutions

_ Government-sponsored FI

_ State Financial Corporation

_ Others

3. FIIs

_ Mauritius-based

_ Others

4. NRI

_ Repatriable

_ Non-Repatriable

_ Depository Receipt

5. Body Corporate

_ Domestic Company

_ Overseas Corporate Body - Repatriable

_ Government Company

_ Central Government

_ State Government

_ Co-operative Body

_ NBFC

_ Non-NBFC

_ Broker

_ Foreign Bodies

_ Group Companies

_ Others

_ OCB - Non-repatriable

_ Depository Receipt

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6. CM (Clearing Member)

7. Foreign National - Foreign National / Depository Receipt

8. Mutual Fund - Depository Receipt

9. Trust

10. Bank

_ Foreign Bank

_ Co-operative bank

_ Nationalised Bank

_ Others

11. Intermediary

Dematerialisation

One of the methods for preventing all the problems that occur with physical securities is through

dematerialisation (demat). India has adopted the demat route in which the book entry is made

electronically against securities that are cancelled. The share certificates are shredded (i.e., its

paper form is destroyed) and a corresponding credit entry of the number of securities (written on

the certificates) is made in the account opened with the Depository Participant (DP).

The securities held in dematerialised form are fungible.3 They do not bear any distinguishable

features like distinctive number, folio number or certificate number. Once the shares are

dematerialised, they lose their identification features in terms of share certificate distinctive

numbers and folio numbers. Title to the securities owned is in terms of number of securities and

not in terms of distinctive numbers, certificates numbers etc.

Each security is identified in the depository system by ISIN and short name. For example, a

person owning 200 shares in XYZ Ltd. in physical form will record his ownership as below:

Company Name: XYZ Ltd.

No. of Shares: 200

Distinctive Nos.: 932654701 to 932654900

Certificate No.: XYZ001263

Folio No.: X658542

In NSDL depository system, the record of ownership will be shown as:

INE001A01013 XYZ by demat 200

International Securities Identification Number (ISIN)

Each of the securities dematerialised in the NSDL / CDSL depository bears a distinctive ISIN – an

identification number. International Securities Identification Number (ISIN) is a unique identification

number for each security issued in any of the International Standards Organisation (ISO) member

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countries in accordance with the ISIN Standard (ISO 6166). ISO 6166 was developed for use in an

international (cross-border) as well as domestic trades. ISIN is a 12-character long identification

mark. It has three components - a pre-fix, a basic number and a check digit. The pre-fix is a two-

letter country code as stated under ISO 3166

ISIN

(IN for India). The basic number comprises nine alphanumeric characters (letter and/or digits). The

check digit at the end of the ISIN is computed according to the modulus 10 "Double-Add- Double".

It establishes that the ISIN is valid. Securities issued by the same company, issued at different

times or carrying different rights, terms and conditions are considered different securities for the

purpose of allocating ISIN and are allotted distinct ISINs. In India, SEBI assigns ISIN to various

publicly traded securities. Different ISINs are allocated to the physical and dematerialised

securities of the same issue. To illustrate, ISIN INE 475c 01 012 has the following break up:

IN - India

E - Company

Last digit - check digit

First four digits 475c - Company serial number;

01 - equity (it can be mutual fund units, debt or Government securities);

01 - issue number;

2 - check digit.

The third digit (E in the above example) may be E, F, A, B or 9. Each one carries the following

meaning:

E - Company

F - Mutual fund unit

A - Central Government Security

B - State Government Security

9 - equity shares with rights which are different from equity shares bearing INE number.

Whenever dealing with ISIN number, it is important to pay special attention to the third digit.

Securities that can be dematerialised

The entire depository system in India is governed by the rules made by the market regulator -

SEBI. According to the SEBI (Depositories and Participants) Regulations, 1996, the following

securities are eligible for holding in dematerialised form.

1. Shares, scrips, stocks, bonds debentures, debenture stock or other marketable securities of

similar nature of any incorporated company or body corporate including underlying shares of

ADRs and GDRs.

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2. Units of mutual funds, rights under collective investment schemes and venture capital funds,

commercial paper, certificate of deposit, securitised debt, money market instruments and unlisted

securities.

Prerequisites for Dematerialisation Request

1. The registered holder of the securities should make the request.

2. Securities to be dematerialised must be recognised by NSDL / CDSL as eligible. In other words,

only those securities whose ISIN has been activated by NSDL / CDSL, can be dematerialised.

3. The company/issuer should have established connectivity with NSDL. Only after such

connectivity is established that the securities of that company/issuer are recognised to be

"available for dematerialisation".

4. The holder of securities should have a beneficiary account in the same name as it appears on

the security certificates to be dematerialised.

5. The request should be made in the prescribed dematerialisation request form.

Transposition cum Demat

NSDL has amended its Bye Laws and Business Rules to enable investors to transpose names of

the joint holders alongwith the process of dematerialisation through their DPs. Prior to this

amendment, investors having shares in joint names (Mr. X & Mr. Y), but in different sequence (Mr.

Y & Mr. X) were either required to open multiple accounts for each sequence (Mr. X & Mr. Y and

Mr. Y & Mr. X) or to effect the transposition directly with the Issuer/R&T Agent and then

dematerialise their securities through their DPs.

In case of transposition-cum-dematerialisation, the Client can get the securities dematerialized in

the same account if the names appearing on the certificates match with the names in which the

account has been opened but are in a different order, by submitting the security certificates along

with the Transposition Form and the Dematerialisation Request Form (DRF) to the DP.

Dematerialisation Process

Steps:

Client/ Investor submits the DRF (Demat Request Form) and physical certificates to DP. DP

checks whether the securities are available for demat. Client defaces the certificate by stamping

‘Surrendered for Dematerialisation’. DP punches two holes on the name of the company and

draws two parallel lines across the face of the certificate.

1. DPs provides dematerialisation request forms (DRF) to their clients.

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2. The client completes the DRF in all respects and submits to the DP along with the security

certificates to be dematerialised.

3. The DP checks the DRF for validity, completeness and correctness. The following points should

be checked particularly:

_ The security certificates sought to be dematerialised are attached to DRF.

_ The attached security certificates are marked (defaced) with the words 'Surrendered for

Dematerialisation'. This is a precautionary measure to prevent misuse of share certificates by

anyone.

_ The certificates are not mutilated or defaced in a manner affecting any material information.

_ The name of client on DRF and the certificates is exactly the same as in the client's account in

DPM. However, minor variations in the name (like abbreviated name, initials

2. DP enters the demat request in his system to be sent to NSDL/ CDSL. DP despatches the

physical certificates along with the DRF to the R&T Agent.

3. NSDL/ CDSL records the details of the electronic request in the system and forwards the

request to the R&T Agent.

4. R&T Agent, on receiving the physical documents and the electronic request, verifies and checks

them. Once the R&T Agent is satisfied, dematerialisation of the concerned securities is

electronically confirmed to NSDL/ CDSL.

5. NSDL/CDSL credits the dematerialised securities to the beneficiary account of the investor and

intimates the DP electronically. The DP issues a statement of transaction to the client.

Checklist for investors

While filling up the dematerialisation request form, investors need to check:

1. The DRF has to be obtained only from the DP with whom they have opened an account.

2. The DRF has to be filled in duplicate/triplicate as required by the DP.

3. All the information asked in the form is mandatory and has to be filled.

4. Separate forms should be filled for separate ISIN numbers of the company.

5. Separate forms should be filled for lock-in and free securities.

6. All the holders should sign the DRF form. Signatures should match with those of the specimens

on the account opening form. However if the signature with the company R&T Agent is different

from the signature with the DP, the client may affix both signatures.

7. The order of the holders should be same as that in the account opening form.

8. While submitting the shares they should be defaced by mentioning on it "surrendered for

dematerialisation".

9. After submitting the certificates, an acknowledgement slip duly signed by the DP should be

collected.

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10. Demat request form for dematerialising government securities is different and is called "DRF -

GS".

Checklist for DP

Before accepting the form and share certificates for dematerialisation the DP should check:

1. Client has submitted the securities for dematerialisation along with the Dematerialisation

Request form (DRF).

2. No dematerialisation request, other than one from a registered holder of securities, has been

entertained.

3. The certificates submitted by the client for dematerialisation belong to the eligible list of

securities admitted by the Depository.

4. Verify that the DRF submitted by the client has been filled completely and duly signed. The DP

has to issue to the client an acknowledgement slip duly signed and stamped.

5. Verify the signature of the client on the form and compare it with the specimen available in its

records. If the signatures are different, the DP has to ensure proper identification of the client.

6. NSDL issues circulars on caution to be exercised in respect of shares belonging to some

companies. Such circulars should be referred to before accepting a demat request.

7. If the form is in order, the request details are entered in its DPM and the DPM generates a

Dematerialisation Request Number (DRN).

8. The DRN so generated are entered in the space provided for the purpose in the DRF. The

details given in the DRF should match with the details of reports generated by DPM and verified by

a person other than the person who had entered the data.

9. The DRF is forwarded to the issuer or its R&T Agent only after ascertaining that the number of

certificates annexed with the DRF tallies with the number of certificates mentioned on the DRF,

within 7 days of its receipt.

10. The details of the certificates submitted for dematerialisation with the details filled up are in

consonance with the DRF.

11. The client has marked the certificates submitted for dematerialisation with the words

"surrendered for Dematerialisation".

12. The safety and security of the certificates submitted for dematerialisation till the certificates

were forwarded to the Issuer or its R&T Agent has to be ensured.

13. Punch two holes on the company name on the security certificates before forwarding them to

the issuer or its R&T Agent.

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14. Ensure that the client has filled in a separate DRF for securities having distinct ISINs.

15. Ensure that the client for has filled in a separate DRF for locked in and free securities having

the same ISIN.

16. Ensure that the client has submitted a separate DRF for each of his/their accounts maintained

with the DP.

17. DRF and certificates have to be sent to the correct address of the company where they are

accepted. NSDL issues circulars giving information about the addresses where physical

documents will be accepted.

Precautions to be taken while processing DRF

! Ensure account to have the same sequence of names of holders and name structure as printed

on the physical certificate.

! Ensure ISIN is activated

! Separate DRF for :

_ partly & fully paid-up shares

_ locked and free holdings

_ holdings locked in for different reasons

_ locked in holdings having different release date

_ different ISINs of the company

! ISIN to be entered by DP.

! All joint holders to sign DRF.

! Check DRF form with details on certificate.

Rejection of DRF

A demat request can be rejected in the case of the following objections. The table below gives the

reasons for rejection and the action that DPs need to take in case of each objection.

Description of Objection Action to be taken by DP/Client

01. Physical quantity of shares/certificates received by R&T Agent from DP is less than what is

mentioned in Demat Request Number or Form OR Physical quantity of shares/certificates received

by R&T Agent from DP is more than mentioned in Demat Request Number or Form. DRN

confirmed for partial/physical quantity received from DP or treated under objection for total/partial

quantity by R&T Agent. R&T Agent may retain documents received from DP. DPI Client may

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contact R&T Agent for any further clarification and may submit fresh Demat Request Form to R&T

Agent for excess quantity, if any, quoting reference of Objection letter and previous DRN to enable

R&T Agent to link related entries/documents.

02. All/some certificates received by R&T Agent from DP is/are found to be fake. All/some

certificates received by R&T Agent from DP is/are reported lost or stolen and a stop is recorded in

computer master file(s) of R&T Agent. Duplicate certificates earlier issued by R&T Agent in lieu of

all/some certificates received for demat by R&T Agent from DP.All/some certificates received by

R&T Agent are found to bear forged or fake endorsements of Name(s) of Holders.DRN confirmed

for genuine/valid quantity received from DP or treated under objection for total/partial quantity by

R&T Agent. R&T Agent may retain documents received from DP. DP/client may contact R&T

Agent for any further clarification, quoting reference of Objection letter to enable R&T Agent to link

related entries/documents.

03 Name(s) of Holder(s) on all/ some certificates received by R&T Agent differs in Demat Request

Form received by R&T Agent from DP. OR Details of all/some certificate(s) differ in Demat

Request Form received by R&T Agent from DP DRN confirmed for valid quantity received from DP

or treated under objection for total/

partial quantity by R&T Agent. R&T Agent may retain documents received from DP. DP/ Client

may contact R&T Agent for any further clarification, quoting reference of Objection letter to enable

R&T Agent to link related entries. DP/Client to submit fresh Demat Request Form to R&T Agent

with correct particulars, quoting reference of Objection letter and previous DRN to enable R&T

Agent to link related entries/documents. DRN confirmed for valid quantity received from DP or

treated under objection for total/partial quantity by R&T Agent.

SEBI Guidelines on Transfer-cum-Demat Scheme

SEBI has taken various policy initiatives to popularise the demat concept. In order to help

investors to dematerialise physical shares received but not yet registered in their name, SEBI has

introduced a scheme called Transfer-cum-Demat. As per the Guidelines, all companies that are

included in the SEBI compulsory list have to offer Transfer-cum-Demat facility. Investors who have

bought shares of these companies from the market can send their shares to the company for

simultaneous action of transfer-cum-demat. With effect from February 12, 2003 this facility is

applicable for shares upto 500 (in number) only. The relevant details of the Guidelines are

enumerated below.

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1. The issuer or its Registrar and Transfer (R&T) Agent, on completion of the process of

registration of shares submitted for transfer, has to intimate the investor providing an option to

dematerialise such shares. The investor intending to exercise the option of dematerialising shares

has to send the dematerialisation request within 30 days of the date of the option letter, failing

which the issuer or its R&T Agent can despatch the certificates. Requests received subsequent to

despatch of the certificates are rejected.

2. Investors exercising the option of dematerialising the shares have to submit the following

documents to the DP:

• Dematerialisation Request Form (DRF)

• Original option letter received from the issuer or its R&T Agent.

3. DP shall affix its seal and signature on the original option letter.

4. The DP has to execute the request for dematerialisation in the Depository DP Module (DPM).

5. The DP has to despatch of DRF along with the original option letter to the Issuer or its R&T

Agent and keep a copy of it for records.

6. The Issuer or its R&T Agent has to process the dematerialisation request for its validity and

verify the signatures on the DRF with those on the transfer deed.

7. If the request is in order, the Issuer or its R&T Agent defaces the certificates with the word

"Dematerialised" and confirms the dematerialisation request.

8. The Issuer or its R&T Agent has to maintain a record of the securities certificates that have

been dematerialised.

9. If the request is rejected, the Issuer or its R&T Agent has to despatch the certificates to the

investor.

10. NSDL is required to obtain from the company a certificate from a Chartered Accountant or a

Company Secretary that the company has complied with the Guidelines.

Rematerialisation

Rematerialisation is the exact reverse of dematerialisation. It refers to the process of issuing

physical securities in place of the securities held electronically in book-entry form with a

depository. Under this process, the depository account of a beneficial owner is debited for the

securities sought to be re-materialised and physical certificates for the equivalent number of

securities is/are issued. A beneficial owner holding securities with a depository has a right to get

his electronic holding converted into physical holding at any time. The beneficial owner desiring to

receive physical security certificates in place of the electronic holding should make a request to the

issuer or its R&T Agent through his DP in the prescribed re-materialisation request form (RRF).

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On receipt of RRF, the DP checks whether sufficient free balance of the securities sought to be re-

materialised is available in the account of the client. If sufficient balance is available, the DP

accepts the RRF and communicates the request to NSDL through the DPM system. When

NSDL/CDSL receives the re-materialisation request, it intimates the issuer or its R&T agent about

such requests. NSDL sends this intimation to R&T agents on a daily basis on the DPMSHR

system. DP should forward the RRF to the issuer or its R&T Agent within seven days of accepting

the RRF from the client. The issuer or its R&T Agent, after validating the RRF, should confirm to

NSDL/CDSL that the RRF has been accepted. On receipt of such acceptance from the issuer or

its R&T Agent, NSDL/CDSL removes the balances from the respective client's account. On

rematerialisation, R&T Agent issues security certificates as per the specifications given by the

client in the RRF. Thereafter, the issuer or its R&T Agent despatches the security certificates for

the re-materialised securities to the client and his name is entered in the Register of Members of

the company. The certificate of securities should be sent to the clients within a period of 30 days

from receipt of such RRF by the issuer or its R&T Agent. The new certificates may not necessarily

bear the same folio or distinctive numbers as those that investor had previously, i.e., prior to his

getting them in demat form. When a re-materialisation request is sent, the securities in the client

account will not be available for delivery/transfer immediately. The client will have to wait for

physical certificates to reach him before they can be sold. Thus the client would encounter

temporary illiquidity on the shares requested for in re-materialised form.

Prerequisite to a Re-materialisation Request

1. The beneficial owners of the securities should make the request.

2. There should be sufficient free balance of securities available in the beneficiary account to

honour the re-materialisation request.

Re-Materialisation Process

1. The DP should provide re-materialisation request forms (RRF) to clients.

2. The client should complete RRF in all respects and submit it to the DP.

3. The DP should check RRF for validity, completeness and correctness. In particular, the

following points should be checked.

• There is sufficient free balance available in the client's account to honour the rematerialisation

request.

• The name of client on RRF is exactly the same as that in the client account.

• In case of joint holding, the order of names appearing in RRF is the same as in the client's

account.

• Details like security type, face value, issuer's name and lock-in status are filled-in correctly.

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• The client has indicated his option to receive physical certificates either in jumbo lot for the entire

quantity requested or in market lot.

• Separate RRF are submitted for " free and locked-in securities; " securities locked-in for different

reasons; " each ISIN " securities of different paid-up value; and " each client account.

• RRF is signed by " the sole holder in case of single holding; " all joint holders in case of joint

holding, " authorised signatories in the case of corporate accounts, " constituted attorney in the

case of NRI accounts;

4. If RRF is not found in order, the DP should return the RRF to the client for rectification.

5. If RRF is found in order the DP should accept RRF and issue an acknowledgement to the client.

6. DP should enter the re-materialisation request in DPM. DPM will generate a remat request

number (RRN) which should be mentioned on RRF.

7. An authorised person, other than one who entered the RRF details in DPM, should verify the

details of RRN and release a request to the depository.

8. The DP should complete the authorisation of RRF and forward it to the issuer or its R&T Agent

for re-materialisation. The DP should forward RRF to the issuer or its R&T Agent within seven

days of accepting it from the client.

9. The issuer or its R&T Agent should verify the RRF for validity, completeness and correctness. It

should also match the details with the intimation received from the depository against the same

RRN.

10. In case the issuer or its R&T Agent finds RRF in order, it should confirm the remat request The

issuer or its R&T Agent should then proceed to issue the physical security certificates and

despatch them to the beneficial owner.

11. The DP, on receiving confirmation of debit entry in DPM, should inform the client accordingly.

The entire process takes a maximum of 30 days. No trading is possible on the securities sent for

remat.

Pledge and Hypothecation

The Depositories Act permits the creation of pledge and hypothecation against securities.

Securities held in a depository account can be pledged or hypothecated against a loan, credit, or

such other facility availed by the beneficial owner of such securities. For this purpose, both the

parties to the agreement, i.e., the pledgor and the pledgee must have a beneficiary account with

NSDL. However, both parties need not have their depository account with the same DP.

The nature of control on the securities offered as collateral determines whether the transaction is a

pledge or hypothecation. If the lender (pledgee) has unilateral right (without reference to borrower)

to appropriate the securities to his account if the borrower (pledgor) defaults or otherwise, the

transaction is called a pledge. If the lender needs concurrence of the borrower (pledgor) for

appropriating securities to his account, the transaction is called hypothecation.

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Procedure for Pledge/Hypothecation

The pledgor initiates the creation of pledge/hypothecation through its DP and the pledgee instructs

its DP to confirm the creation of the pledge. The pledge/hypothecation so created can either be

closed on repayment of loan or invoked if there is a default. After the pledgor has repaid the loan

to the pledgee, the pledgor initiates the closure of pledge/hypothecation through its DP and the

pledgee instructs its DP to confirm the closure of the pledge/ hypothecation. If the pledgor defaults

in discharging his obligation under the agreement, the pledgee may invoke the pledge/

hypothecation. This has to be done after taking the necessary steps under the terms of the

agreement with the pledgor and the byelaws of NSDL and rules and regulations framed by SEBI.

Trading and Settlement

A market trade is one that is settled through participation of a Clearing Corporation. In the

depository environment, the securities move through account transfer. Once the broker on the

stock exchange executes the trade, the seller gives delivery instructions to his DP to transfer

securities to his broker's account.

The broker has to then complete the pay-in before the deadline prescribed by the stock exchange.

The broker removes securities from his account to CC/CH of the stock exchange concerned,

before the deadline given by the stock exchange.

The CC/CH gives pay - out and securities are transferred to the buying broker's account. The

broker then gives delivery instructions to his DP to transfer securities to the buyer's account. The

movement of funds takes place outside the NSDL system.

1. Seller gives delivery instructions to his DP to move securities from his account to his

broker's account

2. Securities are transferred from broker's account to CC on the basis of a delivery out

instruction.

3. On pay - out, securities are moved from CC to buying broker's account.

4. Buying broker gives instructions and securities move to the buyer's account.

Transfer of securities towards settlement of transactions done on a stock exchange is called

settlement of market transaction. This type of settlement is done by transferring securities from a

beneficiary account to a clearing member account. Brokers of stock exchanges that offer

settlement through depository are required to open a 'clearing member account'. In addition to the

brokers, custodians registered with SEBI and approved by stock exchanges can open a clearing

member account. These accounts are popularly known as 'Broker settlement account'. A client

who has sold shares will deliver securities into the settlement account of the broker through whom

securities were sold.

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Freezing of Accounts

Account freezing means suspending any further transaction from a depository account till the

account is de-frozen. A depository account maintained with a DP may be frozen in certain cases.

1. If a written instruction is received from the client by the DP, requesting freezing of account; or

2. If written instructions are received from the depository pursuant to an order of the Central or

State Government, SEBI, or any order by the court, tribunal, or any statutory authority. An account

may be frozen only for debits (preventing transfer of securities out of the account). By freezing an

account for debits only, no securities can be debited from the account, however, the client can

receive securities in his account. An account can also be freezed for debits as well as credits

(preventing any movement of balances out of the account). No transaction can take place in such

an account until it is reactivated. A frozen account may be de-frozen or reactivated, by taking the

reverse steps.

1. On the valid written request of the account holder where he had requested freezing,

2. On directions of depository made in pursuance of the order of the appropriate authority. The DP

should immediately inform the client about change in status of the account from 'active' to

'suspended' and vice versa.

Stock Lending and Borrowing

The transactions involving lending and borrowing of securities are executed through approved

intermediaries duly registered with SEBI under the Securities Lending Scheme, 1997. Such an

intermediary may deal in the depository system only through a special account (known as

Intermediary Account) opened with a DP. An intermediary account may be opened with the DP

only after the intermediary has obtained SEBI approval and registered itself with SEBI under the

Securities Lending Scheme. The intermediary also needs to obtain an approval of NSDL.

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Secondary Market Operations

TRADING, CLEARING AND SETTLEMENT

The trading in securities is buying and selling of securities listed on the recognised stock

exchanges whereas the clearing is a process of determination of obligations of member-brokers

by the stock exchanges after which the same are discharged by the concerned parties by

settlement. The settlement is a process of settling of transactions in securities between buyers

and sellers by exchange of money and securities respectively.

a) TRADING

The trading in securities on the stock exchanges was in an open outcry manner till mid 1990s

where brokers used to assemble in a trading ring for doing transactions in securities. A few

nationalized banks and financial institutions had set up the National Stock Exchange of India

Ltd (NSE) in 1994 for providing facility of trading in securities on the exchange on electronic

system known as National Exchange for Automated Trading (NEAT) System. The NSE

commenced trading in equities on an electronic platform with effect from November 3, 1994.

Following the NSE, Bombay Stock Exchange Ltd (BSE) also switched over to a fully automated

computerized mode of trading known as BOLT (BSE on Line Trading) System w.e.f. March 14,

1995. Through the NEAT system of NSE and BOLT system of BSE, the member-brokers-

brokers now enter orders for purchase or sell of securities listed or permitted to be traded on

the stock exchanges from the Trader Work Stations (TWSs) installed in their offices instead of

assembling in the trading ring as used to happen earlier in the case of BSE.

Order or quote driven system

NSE system is “order driven” from the beginning whereas, BSE system, which was initially both

order and “quote driven”, is currently only order driven. In an order driven system, the traders

only put their orders for buying or selling of securities whereas in quote driven system, the

jobbers put buy as well sell quotes in the same scrip with a price difference. The jobbers quotes

used to get priority in execution over the orders put in by other market participants at the same

price. The facility of placing of quotes has, however, since been removed by BSE w.e.f., August

13, 2001 in view of lack of market interest and to improve the order matching efficiency of the

system. The system at BSE is now only order driven. The order driven system ensures faster

processing, matching and execution of orders in a transparent manner.

The member-brokers of NSE were allowed to open trading terminals throughout India from the

beginning of setting up of the stock exchange. However, the member-brokers of the BSE till

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1996 were permitted to open trading terminals only within the city limits of Mumbai. In October

1996, BSE obtained permission from SEBI for expansion of its BOLT network to locations

outside Mumbai. In terms of the permission granted by SEBI and certain other modifications

announced later, the member-brokers of BSE are now allowed to install their trading terminals

at any place in the Country. Shri P. Chidambaram, the Finance Minister, Government of India,

inaugurated the expansion of BOLT network of BSE to cities outside Mumbai on August 31,

1997.

In order to expand the reach of NEAT and BOLT networks to centers outside Mumbai and

support the smaller Regional Stock Exchanges, both NSE and BSE have, since January 2002,

admitted subsidiary companies formed by the Regional Stock Exchanges as their member-

brokers. The member-brokers of these Regional Stock Exchanges work as sub-brokers of NSE

or BSE or both.

The objectives of granting membership to the subsidiary companies formed by the Regional

Stock Exchanges by NSE and BSE were to reach out to investors in these centers via the

member-brokers of the Regional Stock Exchanges and provide investors in these areas access

to the trading facilities in all scrips listed on both the Exchanges.

Trading on the NEAT and BOLT Systems is conducted from Monday to Friday between 9:55

a.m. and 3:30 p.m. Thus, uniform trading hours are followed by both the stock exchanges.

The scrips traded on the NSE have been divided by the exchange into normal and trade to

trade segments whereas in BSE the scrips traded have been classified by the Exchange into

‘A’, ‘B1’, ‘B2’, ‘G’, ‘S’, ‘T’, ’F’, ‘TS’ and ‘Z’ groups.

Both the Exchanges have commenced trading in Govt. Securities for retail investors w.e.f

January 16, 2003. The scrips traded in this group are classified by BSE in ‘G’ group.

The BSE has introduced a separate group called ‘Z’ group in July 1999 and this group covers

the companies that have failed to comply with listing requirements and/or have failed to resolve

investor complaints or have not made the required arrangements for dematerialisation of their

shares with both the Depositories, viz., Central Depository Services (I) Ltd. (CDSL) and

National Securities Depository Ltd. (NSDL). BSE has, thus, put scrip of certain companies in

"Z" group as a temporary measure till they make arrangements for dematerialization of their

securities.

Once they finalize the arrangements for dematerialization of their securities, trading and

settlement in their scrips is shifted to their respective erstwhile groups. The trades in scrip in ‘Z’

group are settled on a gross basis, i.e., buy and sell positions in the same scrip are not netted

and the same are required to be settled separately on the same day.

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The scrips of companies which are in demat can be traded in market lot of one but securities of

companies that are still in the physical form are traded on BSE in the market lots of generally

either 50 or 100.

BSE also provides a facility to the market participants of on-line trading in "C" group which

covers the odd lot securities (i.e., less than market lot ) in 'A', ‘B1’, ‘B2’ ‘T’, ‘S’, ‘TS’ and ‘Z’

groups and Rights renunciations in all the groups of scrips in the equity segment. The facility of

trading in odd lots of securities not only offers an exit route to investors to dispose of their odd

lots of securities but also provides them an opportunity to consolidate their securities into

market lots.

The ‘C’ group facility at BSE can also be used by investors for selling upto 500 shares in

physical form in respect of scrips of companies where trades are required to be compulsorily

settled by all investors in demat mode. This scheme of selling physical shares in compulsory

demat mode is called an ‘Exit Route Scheme’.

The ‘F’ group at BSE refers to Fixed Income Securities like bonds and debentures issued by

the listed companies or institutions.

The ‘T’ group refers to scrips in A, B1 and B2 groups, which have put by the Exchange in trade-

to-trade segment as surveillance measures and trades are settled in this group without netting.

BSE has also introduced a group called ‘S’ group also referred to as BSE Indonext segment,

wherein shares of companies listed on the Regional Stock Exchanges having capital of Rs. 3

crores to Rs. 30 crores and of those companies already listed on BSE in B1 and B2 groups are

allowed to be traded. The objective of introduction of this group is to enable the shareholders of

the companies listed on the Regional Stock Exchanges, which have since stopped trading on

their platforms, to have an exit route and enable promoters of such companies to mobilize fresh

capital from the market for their expansion or working capital requirements. ‘TS’ group at BSE

consist of scrips in the BSE-Indonext segment, which are settled on trade-to-trade basis as a

surveillance measure.

With effect from December 31, 2001, trading in all securities listed in equity or capital market

segment of both the Exchanges takes place in Compulsory Rolling Settlement.

Order execution

The orders in securities on the stock exchanges entered into by Neat or Bolt operators on

behalf of market participants are executed first on the basis of price priority and then on the

basis of time priority. If price at the time of entering order for selling is lower and at the time of

buying is higher than the previous best order waiting execution in the system, then that order

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gets priority in execution. However, if two buyers or two sellers put orders in the system at the

same price, then the order that has put first in the system will get priority in execution.

Permitted Securities

To facilitate the market participants to trade in securities of the companies which are actively

traded at other Regional Stock Exchanges but are not listed on BSE or NSE, both the

Exchanges had permitted trading in securities of companies listed on other Stock Exchanges

as " Permitted Securities" subject to the companies meeting the norms specified by the

Exchanges in this regard. This facility of allowing trading in permitted securities has, however,

since been discontinued by NSE and all securities traded on NSE are only listed securities.

However, BSE, which had commenced trading in permitted securities with effect from April 22,

2002, has continued the same.

Tick Size

Tick size is the minimum difference in rates between two orders on the same side, i.e., buy or

sell, entered into the system for a particular scrip. The trading in scrips listed on the stock

exchanges is generally with a tick size of 5 paise. However, at BSE, the tick size of scrips

quoting upto Rs. 15/-, units of MFs and securities traded in ‘F’ group is one paise.

Computation of closing price

The closing prices of scrips traded on both the Exchanges in the Cash Segment are computed

on the basis of weighted average price of all trades during the last 30 minutes of the continuous

trading session. However, if there is no trade during the last 30 minutes in scrip then the last

traded price of such scrip in the continuous trading session is taken as the official closing price.

Compulsory Rolling Settlements

With a view to introduce the best international trading practices and to achieve higher

settlement efficiency, trades in all the equity shares listed on the Exchanges in the Rolling

settlements as mandated by SEBI, were settled on T+5 basis w.e.f. December 31, 2001. The

Stock Exchanges, as per the mandate received from SEBI, had introduced the settlements on

T+3 basis with effect from April 1, 2002 for all groups of securities and now the settlements are

done on T+2 basis w.e.f from April 1, 2003. Prior to introduction of Rolling Settlements and

reduction in settlement cycle from T+5 to T+2, the transaction in securities were traded and

settled initially on a fortnightly basis and subsequently on a weekly basis. In other words, trades

done in one fortnight or a week were netted and settled at the end of the following fortnight or

week.72

Under the rolling settlements, the trades done on a particular day are settled after a given

number of business days. A T+2 settlement cycle means that the settlement of transactions

done on T, i.e., trade day by exchange of monies and securities between the buyers and sellers

respectively occurs on second business day after the trade day.

(b) CLEARING

The transactions in securities of companies which have made arrangements for

dematerialization of their securities are settled at both the stock exchanges compulsory in

demat mode on T+2 on a net basis, i.e., buy and sell positions of a member-broker in the same

scrip are netted and the net quantity is required to be settled. However, the transactions in

securities of companies, which are in ‘C’ & "Z" group at BSE or have been placed under trade

to trade by NSE or ‘T’ or ‘TS’ group by BSE as a surveillance measure, are settled only on a

gross basis on T+2, i.e., the facility of netting of buy and sell transactions in such scrips is not

available. For example, if a member-broker buys and sells 100 shares of a company on the

same day which is in ‘’Z’ or ‘T’ or ‘TS’ group, the two positions are not netted and the member-

broker has to first deliver 100 shares at the time of pay-in of securities and then receive 100

shares at the time of pay-out of securities on the same day. Thus, if one fails to deliver the

securities sold at the time of pay-in, it will be treated as a shortage and the relevant position will

be auctioned/ closed-out.

In other words, the transactions in scrips of companies that are in compulsory demat are settled

on both the stock exchanges in demat mode on T+2 after netting the buy and sell positions in

the same scrip whereas scrips in trade to trade segments at both exchanges and scrips in ‘C’,

‘TS’ and ‘Z’ groups are settled in gross basis. Transactions in ‘Z’ group scrips may be settled in

demat or physical mode.

The transactions in Fixed Income Securities (‘F’ group at BSE) and Government Securities for

retail investors (‘G group at BSE) are settled at both the Exchanges on T+2 basis.

The following table summarizes the steps in the trading and settlement cycle for scrips under

rolling settlements at NSE and BSE.

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DAY ACTIVITY

T

(Trading)

Trading on NEAT and BOLT and daily downloading

of statements showing details of transactions and

margins at the end of each trading day.

6A/7A* entry by the member-brokers confirmation

by the custodians at BSE

T+1

(Clearing)

- Confirmation of 6A/7A data by the Custodians at

BSE

- Custodial confirmation at NSE

- Downloading of securities and funds obligation

statement by member-brokers.

T+2

(settlement)

- Pay-in of funds and securities and pay-out of

funds and securities. The member-brokers are

required to submit the pay-in instructions for

funds and securities to banks and depositories

respectively.

-Debiting Account of member-brokers for shortages

in delivery – Valuation Debit

T+3

(Post -

(settlement)

-Auction on BOLT for shortage at 11.00 a.m and on

NEAT System after market hours.

T+4 Auction pay-in and pay-out of funds and

securities at BSE.

T+5 Auction pay-in and pay-out of funds and securities

at NSE.

* 6A/7A: A mechanism at BSE whereby the obligation of settling the transactions done by a

member-broker on behalf of a client is passed on to a custodian based on his confirmation.

The Stock Exchanges generate the following statements, which can be downloaded by the

member-brokers in their back offices on a daily basis.

a) Statements giving details of the daily transactions entered into by the member-brokers.

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b) Statements giving details of margins payable by the member-brokers in respect of the trades

executed by them.

c) Statement of securities and funds obligations

d) Delivery / Receive orders for delivery receipt of securities.

The member-broker can also generate other reports relating to auctions, objections, custodial

trade reports, etc.

The settlement of the trades (money and securities) done by member-brokers on his own

account or on behalf of his individual, corporate or institutional clients may be either through the

member-brokers himself or through a SEBI registered Custodian appointed by him or the

respective client. In case the delivery/payment in respect of a transaction done by a member-

broker is to be given or taken by a registered Custodian, then the latter has to confirm the trade

done by a member-broker on the NEAT / BOLT System. For this purpose, the Custodians have

been given connectivity to NEAT/BOLT System and have also been admitted as member-

brokers of the National Securities Clearing Corporation Ltd in case of NSE and Clearing House

in the case of BSE. In case a registered Custodian does not confirm a trade executed by a

member-broker, the liability for pay-in of funds or securities in respect of the same devolves on

the concerned member-broker.

The introduction of settlement on T+2 basis has considerably reduced the settlement risk,

ensured early receipt of securities and monies by the buyers and sellers respectively and has

brought the Indian Capital Markets on par with the World Capital Markets in terms of settlement

standards.

(c) SETTLEMENT

As discussed earlier, the trades done by member-brokers in all the securities on stock

exchanges in are settled by exchange of money and securities on T+2 basis. The trading of

securities is done on the stock exchanges while settlement of the same is done by independent

outside agencies. The member-brokers are compulsorily required to deliver all securities sold

by them to the Clearing Corporation in case of NSE and Clearing House in case of BSE.

The National Securities Clearing Corporation Ltd (NSCCL) in case of NSE, a subsidiary

company of NSE while the Clearing House, in case of BSE is an independent company called

the Bank of India Shareholding Ltd. (BOISL), This company was promoted jointly by Bank of

India and BSE for handling the clearing and settlement operations of funds and securities on

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behalf of the Exchange. The Clearing & Settlement Dept. of the Exchanges liaise with the

Clearing Corporation / Clearing House on a day-to-day basis.

The Stock Exchanges generate Delivery and Receive Orders for transactions done by the

member-brokers after netting purchase and sale transactions in each scrip whereas Delivery

and Receive Orders for ‘T’ group scrips in NSE and for "C", "Z" ‘TS’ and ‘T’ groups in case of

BSE are generated on gross basis, i.e., without netting purchase and sell transactions in a

scrip.

The Delivery Order provides information like scrip, quantity and the name of the receiving

member to whom the securities are to be delivered through the Clearing House. The Money

Statement provides scrip wise/item wise details of payments/receipts for the settlement. The

member-brokers can download the Delivery/Receive Orders and money statements in their

back offices

Funds pay-in

The designated bank accounts of member-brokers with the clearing banks, selected by the

respective stock exchanges, are directly debited by the Clearing Corporation / Clearing House

through computerized posting for their settlement and margin obligations and credited with

receivables on accounts of pay-out dues and refund of margins, etc.

In case, there is a funds shortage in the designated bank account of a member-broker, at the

time of meeting his settlement obligations, his payout of securities is withheld and his trading is

stopped immediately till the shortage amount is cleared. The penal interest @ 0.07% per day is

also recovered on the amount of shortage. Also the stock exchanges have the power to levy

other kind of penalties on the member-brokers to inculcate sense of discipline in them.

Securities pay-in

The securities, as per the Delivery Orders issued by the Exchanges, are required to be

delivered by the member-brokers in the Clearing Corporation Clearing House on the day

designated for securities pay-in, i.e., on T+2 day.

(1) Demat pay-in

The member-brokers can effect demat pay-in to the clearing Corporatin/Clearing House either

through National Securities Depository Ltd. (NSDL) or Central Depository Services (I) Ltd.

(CDSL). The member-brokers are required to give instructions to their Depository Participant

(DP) specifying settlement no., settlement type, effective pay-in date, quantity, etc.

In case of BSE, the member-broker may also directly affect pay-in from the clients’ beneficiary

accounts through CDSL. For this, the clients are required to mention the settlement details and

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clearing member ID through whom they have sold the securities. Thus, in such cases the

clearing member-brokers are not required to give any delivery instructions from their accounts.

(2) Auto D.O. facility

Instead of issuing Delivery Out instructions for their delivery obligations in demat mode in

various scrips in a settlement /auction, a facility has been made available to the member-

brokers of automatically generating Delivery-Out (D.O.) instructions on their behalf from their

CM Pool accounts by the Clearing House/Clearing Corporation. This Auto D.O. facility is

available for Normal, Auction and for Trade-to-Trade settlements. This facility is, however, not

available for delivery of non-pari passu shares and shares having multiple ISINs. The member-

brokers wishing to avail of this facility have to submit an authority letter to the Clearing

Corporation / Clearing House. This Auto D.O facility is currently available only for Clearing

Member (CM) Pool accounts/Principal Accounts maintained by the member-brokers with

respective depositories.

(3) Securities in Physical Form

In case of the physical securities at BSE, the member-brokers have to deliver the securities in

special closed pouches (supplied by the Exchange) along with the relevant details (distinctive

numbers, scrip code, quantity, and receiving member) on a floppy. The data submitted by the

member-brokers on floppies is matched against the master file data on the Clearing House

computer systems. If there are no discrepancies, then the Clearing House generates a scroll

number and a scroll slip is issued. The member-brokers can then submit the securities at the

receiving counter in the Clearing House.

The Clearing Corporation / Clearing House arranges and tallies the securities received against

the receiving member-wise report generated on the Pay-in day.

In case, if a member-broker fails to deliver the securities, then value of shares short delivered is

recovered from him at the standard/closing rate of the scrips on the trading day at BSE and at

NSE, the amount is recovered on the basis of closing rate of T+1. This is also known as

valuation debit at NSE.

This process of receiving securities from the member-brokers against their sale obligations is

called securities pay-in.

Funds – Pay-in

The bank accounts of member-brokers with the respective clearing banks having pay-in

obligations are debited on the scheduled pay-in day. This procedure is called Pay-in of Funds.

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Once the pay-in of securities and funds is complete, the Clearing Corporation / Clearing House

arranges for payout of securities and funds.

Securities pay-out

In case of demat securities, the same are credited in the Pool Account of the member-brokers

or the Beneficiary Accounts of the clients as per the details submitted by the member-brokers.

This is known as direct payout of securities and has been introduced by NSE and BSE with

effect from April 1, 2001. In case of Physical securities, in the case of BSE, the receiving

member-brokers are required to collect the same from the Clearing House on the payout day.

This process is called pay-out of securities.

Funds Pay-out

The bank accounts of the member-brokers having payout of funds are credited by the Clearing

Corporation / Clearing House with the Clearing Banks on the same day. This process is

referred to as Pay-out of Funds.

In case of Rolling Settlements, pay-in and pay-out of both funds and securities, as stated

earlier, is completed on the same day.

Delivery of securities and payment of money to clients

The member-brokers of both the stock exchanges viz., NSE and BSE are required to make

payment for securities sold and/ or deliver securities to their clients within one working day

(excluding Saturday, Sunday & Bank holidays) after the pay-out of the concerned settlement is

declared by the Exchanges. This timeframe is the minimum time permitted to the member-

brokers by SEBI to settle their obligations with their clients. This requirement has also been

incorporated in the Byelaws of the Stock Exchanges to ensure that the same is mandatory

complied with.

The settlement calendar, which indicates the dates of the various settlement activities, is drawn

by the stock exchanges in advance and circulated to the market participants. The settlement

calendars so drawn have to be strictly adhered to by the Exchanges and it has been observed

that there has generally been no clubbing of settlements or postponement of pay-in and/ or

payout as used to happen earlier when trading and settlement was manual.

Due to dematerialization of shares by listed companies, the trading in physical share certificate

has declined to a trickle. However, still some physical shares are in circulation. In order to

prevent circulation of fake, forged and stolen shares, BSE is maintaining a database of

fake/forged, stolen, lost and duplicate securities in physical form with the Clearing House so

that distinctive numbers submitted by member-brokers in case of physical securities on delivery

may be matched against the database to weed out bad paper from circulation at the time of

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introduction of such securities in the market. This database has also been made available to

the member-brokers so that delivering and receiving member-brokers can check the entry of

fake, forged and stolen shares in the market.

SHORTAGES AND OBJECTIONS

a) Shortages & consequent actions

The member-brokers download Delivery/Receive Orders/Obligations in their back offices.

Based on the delivery obligations, the seller member-brokers deliver the shares in case of NSE

to the National Securities Clearing Corporation Ltd in demat mode whereas in case of BSE, the

member-brokers have to deliver the shares in the Clearing House as per the Delivery Orders

downloaded. If a seller member-broker is unable to deliver the shares on the designated Pay-in

day for any reason, his bank account is debited at the standard rate which is equal to the

closing price of the scrip on the day of trading in case of BSE and closing rate on the immediate

preceding day of pay-in day in case of NSE. This is called valuation Debit at NSE. Also both the

stock exchanges impose penalties fixed by the Exchanges on member-brokers for shortages in

for the quantity of shares short delivered. The Clearing Corporation in case of NSE and

Clearing House in case of BSE arrive at the shortages in delivery of various scrips by member-

brokers on the basis of their delivery obligations and actual delivery.

The member-brokers can download the report of “shortages” in delivery of on T+2 day, i.e.,

Pay-in day. After downloading the shortage details, the member-brokers are expected to verify

the same and report discrepancy, if any, to the Clearing Corporation / Clearing House. If no

discrepancy is reported within the stipulated time, the Clearing Corporation / Clearing House

assumes that the shortage of a member-broker is in order and proceeds to auction/ close-out

the same. However, in 'C’ group, i.e., Odd Lot segment, the member-brokers of BSE are

themselves required to report the shortages to the Clearing House.

Auction

An Auction Tender Notice is issued by the Exchanges to the member-brokers informing them

about the names of the scrips, quantity slated for auction and the date and time of the auction

session on the NEAT/BOLT. The auction for the undelivered quantities in normal segment at

NSE and ‘A’, B1, B2 and ‘S’ groups in BSE is conducted on T+3 day at BSE between 11:00

a.m. and 12 noon and after normal market hours at NSE, whereas shortages in scrips in trade

to trade segment at NSE and in ‘C’, ‘Z’, ‘T’ or ‘TS’ groups at BSE are not auctioned but are

directly closed-out. The auction offers received in batch mode are electronically matched with

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the auction quantities by BSE so as to award the ‘best price’. The member-brokers, who

participate in the auction session, can download the Delivery Orders in respect of the auction

obligations on the same day, if their offers are accepted.

The member-brokers are required to deliver the shares in the Clearing House on the auction

Pay-in day, i.e, T+4. Payout of auction shares and funds is also done on the same day, i.e.,

T+4. However, at NSE, the auction session is held like normal trading on the screen after the

normal trading hours and trades done in this auction session on T+3 day are settled by

exchange of money and securities on T+5 day.

In auction, the highest offer price is allowed up to the closeout rate of scrip and the lowest offer

price can be 20% below the closing price of scrip on a day prior to day of auction. A member-

broker, who has failed to deliver the securities of a particular company on the pay-in day, is not

allowed to offer the same in auction. He can, however, participate in auction of other scrips.

Close out

In case no or partial offers are received in auction for a particular scrip, then the entire or

balance quantity of shortage respectively is closed-out at a close-out price, determined by

higher of the following:-

At BSE - close out for A, B1, B2, S and ‘F’ groups.

Highest price of the scrip from the trading day to the day prior to the day of the auction.

OR

20% above the closing price on a day prior to the day of auction,

whichever is higher

Closeout for ‘C’, ‘T’, ‘TS’ and ‘Z’ groups

(i) The highest rate from trading day to day prior to day of auction.

(ii) 10% above the closing rate on the day prior to day of auction/closeout, whichever is

higher

Incase of shortages in ‘C’ group, the shortages are closed out at Zero Copon Yield Curve

(ZCYC) plus a 5% penalty.

At NSE

- Highest price of scrip from ‘T’ day to day of close out

OR

20% higher than the closing rate on auction day whichever is higher.

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At NSE any shortage in Trade for Trade segment is closed out at relevant trade price plus 20%

mark up on trade price.

At NSE, all shortages of cum-transactions, which can not be auctioned on cum-basis or where

cum basis auction pay-out is after the book closure/record rate are closed out at the highest

traded price from “T” day to day of close out or 10% above the closing price on auction day,

whichever is higher.

The close out amounts are debited to the bank accounts of member-brokers who have failed to

deliver the securities against their sale obligations and credited to the member-brokers who had

bought the securities but not received the same.

Further, in case of short delivery, if the auction price/close-out price of scrip is higher than the

standard price/closing price of the scrip in the settlement in which the transaction was done at

BSE and T+1 at NSE, the difference is recovered from the seller who failed to deliver the scrip.

However, in case, auction/ closeout price is lower than standard price, the difference is not

given to the seller but is credited by the Exchanges to a separate fund called the Investors

Protection Fund. This is to ensure that the seller does not benefit from his failure to meet his

securities delivery obligation. Further, if an offerer member-brokers fails to deliver the shares

offered in auction, then the transaction is closed-out as per the normal procedure as explained

above and the original selling member-broker pays the difference between the standard rate

and offer rate and the offerer member-broker pays the difference between the offer rate and

close-out rate.

b) Self- Auction

As has been discussed in the earlier paragraphs, the Delivery and Receive Orders are issued

to the member-brokers after netting off their purchase and sell transactions in scrips where

netting of purchase and sell positions is permitted. It is likely in some circumstances that a

selling client of a member-broker has failed to deliver the shares to him. However, this did not

result in a member-broker’s failure to deliver the shares to the Clearing House as there was a

purchase transaction of some other buying client of the member-broker in the same scrip in his

office and the same was netted off for the purpose of settlement. However, in such a case, the

member-broker would require shares so that he can deliver the same to his buying client, which

otherwise would have taken place from the delivery of shares by the seller. At BSE, to provide

shares to the member-brokers, so that they are in a position to deliver them to their buying

clients in case of internal shortages, they have been given an option to submit the details of

such internal shortages on floppies for conducting self-auction (i.e., as if they have defaulted in

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delivery of shares to the Clearing House). Such floppies are to be given to the Clearing House

on the pay-in day. The internal shortages reported by the member-brokers are clubbed by the

stock exchange with the normal.

The Clearing House conducts combined auction in respect of shortages in settlement and those

reported in self-auction by member-brokers. A member-broker after getting delivery of shares

from the Clearing House in self-auction credits the same to the Beneficiary accounts of his

buying clients or hands over the same to them in case securities received are in physical form

and debits his seller clients with the amount of difference, if any, between the auction price and

closing price of the scrips on the day of the trading. At NSE, there is, however, no system of

reporting or conducting self-auctions.

e) Objections in case of securities in physical form.

When receiving member-brokers at BSE collect the physical securities from the Clearing House

on the Payout day, the same are required to be checked by them for good delivery as per the

norms prescribed by the SEBI in this regard. If the receiving member does not consider the

securities good delivery, he has to obtain an arbitration award from the arbitrators and submit

the securities in the Clearing House on the following day of the Pay-Out (T+3). The Clearing

House returns these securities to the delivering member-brokers on the same day, i.e., (T+3).

If a delivering member-broker feels that arbitration award obtained against him is incorrect, he

is required to obtain arbitration award for invalid objection from the member-broker of the

Arbitration Review Committee. The delivering member-brokers are required to rectify/replace

the objections and return the shares to the Clearing House on next day (T+4) to have the entry

against them removed. The Clearing House delivers the rectified securities to the buyer

member-broker on the same day (T+4). If buyer member-brokers are not satisfied with such

rectification of securities, they are required to obtain arbitration awards for invalid rectification

from the Bad Delivery Cell on T+5 day and submit the shares to the Clearing House on the

same day.

This is known as “Objection Cycle” The following table summarizes the activities involved in the

Patawat Objection Cycle of CRS.

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DAYACTIVITY

T + 2 Pay-out of securities of Rolling Settlement

T+ 3

- Patawat Arbitration session:

- Arbitration awards to be obtained from officials of the Bad

Delivery Cell.

- Securities under objection to be submitted in

the Clearing House

-The delivering member-brokers to collect such

securities under objection from the Clearing

House

- Arbitration awards for invalid objection to be

obtained from member of the Arbitration

Review Committee.

T+4 -Member-brokers and institutions to submit

rectified securities, confirmation forms and

invalid objections in the Clearing House

-Rectified securities delivered to the receiving

member-brokers

T+5 -Arbitration Awards for invalid rectification to be

obtained from officials of the Bad Delivery Cell

Securities to be lodged with the Clearing House

The un-rectified and invalid rectification of securities are directly closed-out by the Clearing

House as per the formula explained earlier instead of first inviting the auction offers for the

same.

The shares in physical form returned under objection to the Clearing House are required to be

accompanied by an arbitration award (Chukada) except in certain cases where the receiving

member-brokers are permitted to submit securities to the Clearing House without “Chukada” or

arbitration award.

These cases are as follows:

a) Transfer Deed is out of date.

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b) Cheques for the dividend adjustment for new shares where distinctive numbers are given in

the Exchange Notice is not enclosed.

c) Stamp of the Registrar of Companies on the Transfer Deed is missing.

d) Details like Distinctive Numbers, Transferors’ Names, etc. are not filled, in the Transfer

Deeds.

e) Delivering broker’s stamp on the reverse of the Transfer Deed is missing.

f) Witness stamp or signature on Transfer Deed is missing.

g) Signature of the transferor is missing.

h) Death Certificate (in cases where one or more of the transferors is/ are deceased) is missing.

A penalty at the rate of Rs.100/- per Delivery Order is levied on the delivering member-brokers

for delivering shares, which are not in order.

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STOCK INDICES

BSE Sensex

The absence of an index number of equity prices to reflect the trend of the market was felt for a

long time by the members of the Exchange, investors and other market participants. With this end

in view, The Stock Exchange, Mumbai, started compiling and publishing the BSE-SENSEX index

number of equity prices from 2nd January, 1986.

Base Period: The base period of BSE-SENSEX is 1978-79.

Base Value: The base value of BSE-SENSEX is 100 points.

Method of Compilation: BSE SENSEX is a "Market Capitalization-Weighted" index of 30 stocks

representing a sample of large, well established and financially sound companies. BSE-SENSEX

is calculated using a "Market Capitalization-Weighted" methodology. As per this methodology, the

level of index at any point of time reflects the total market value of 30 component stocks relative to

a base period. (The market capitalization of a company is determined by multiplying the price of its

stock by the number of shares issued by the company). Statisticians call an index of a set of

combined variables (such as price and number of shares) a composite index. A single indexed

number is used to represent the results of this calculation in order to make the value easier to work

with and track over time. It is much easier to graph a chart based on indexed values than one

based on actual values.

The actual total market value of the stocks in the Index during the base period has been set equal

to an indexed value of 100. The notation 1978-79=100 often indicates this. The formula used to

calculate the Index is fairly straightforward. However, the calculation of the adjustments to the

Index (commonly called Index maintenance) is more complex.

The calculation of BSE-SENSEX involves dividing the total market capitalization of 30 companies

in the Index by a number called the Index Divisor. The Divisor is the only link to the original base

period value of the BSE-SENSEX. It keeps the Index comparable over time and is the adjustment

point for all Index maintenance adjustments. During market hours, prices of the index Scrips, at

which latest trades are executed, are used by the trading system to calculate BSE-SENSEX every

15 seconds and disseminated, all-over the country through BOLT terminals in real time.

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Maintenance of the Index: One of the important aspects of maintaining continuity with the past is

to update the base year average. The base year value adjustment ensures that additional issue of

capital and other corporate announcements like bonus etc. do not destroy. the value of the index.

The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index

should not per se affect the index values.

The Index Cell of the exchange does the day-to-day maintenance of the index within the broad

index policy framework set by the Index

Committee. The Index Cell takes special care to ensure that BSE-SENSEX and all the other BSE

indices maintain their benchmark properties by striking a delicate balance between high turnover

in Index Scrips and its representative character. The Index Committee of the Exchange has

experts from different field of finance related to the capital markets. They include Academicians,

Fund-managers from leading Mutual Funds, Finance - Journalists, Market Participants,

Independent Governing Board members, and Exchange administration.

On-Line Computation of the Index: During market hours, prices of the index Scrips, at which trades

are executed, are automatically used by the trading computer to calculate the BSE-SENSEX every

15 seconds and continuously updated on all trading workstations connected to the BSE trading

computer in real time.

Adjustment for Bonus, Rights and Newly issued Capital: The arithmetic calculation involved in

calculating BSE-SENSEX is simple, but problem arises when one of the component stocks pays a

bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between

the current value of the index and its previous value despite the non-occurrence of any economic

activity of substance. At the Index Cell of the Exchange, the base value is adjusted, which is used

to deflate market capitalization of the component stocks to arrive at the BSE-SENSEX value.

The Index Cell of the Exchange keeps a close watch on the events that might affect the index on a

regular basis and carries out daily maintenance of all the 13 Indices.

Adjustments for Rights Issues :

When a company, included in the compilation of the index, issues right shares, the market

capitalisation of that company is increased by the number of additional shares issued

based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then

made to the Base Market Capitalisation (see Base Market Capitalisation Adjustment

below).

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Adjustments for Bonus Issue :

When a company, included in the compilation of the index, issues bonus shares, the

market capitalisation of that company does not undergo any change. Therefore, there is no

change in the Base Market Capitalisation, only the number of shares in the formula is

updated.

Other Issues :

Base Market Capitalisation Adjustment is required when new shares are issued by way of

conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-

back of shares, corporate restructuring etc.

Base Market Capitalisation Adjustment :

The formula for adjusting the Base Market Capitalisation is as follows:

New Base Market Capitalisation =

Old Base Market Capitalisation Old Market Capitalisation

To illustrate, suppose a company issues right shares, which increases the market

capitalisation of, the shares of that company by say, Rs.100 crores. The existing Base

Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the

aggregate market capitalisation of all the shares included in the index before the right issue

is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be:

2450 x (4781 + 100) = Rs. 2501.24

4781

This figure of 2501.24 will be used as the Base Market Capitalisation for calculating the

index number from then onwards till the next base change becomes necessary.

Criteria for Selection and Review of BSE-SENSEX Scrips

Index Review Frequency: The Index Committee meets every quarter to review the indices. In case

of a revision in the Index constituent Scrips, the announcement of the incoming and outgoing

Scrips is made six weeks in advance of the actual revision of the Index.

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Qualification Criteria: The general guidelines for adding of component Scrips in BSE-SENSEX are

as follows.

A. Quantitative Criteria :

1) Market Capitalization :

The scrip should figure in the top 100 companies listed by market capitalization. Also market

capitalization of each scrip should be more than 0.5 % of the total market capitalization of the

Index i.e. the minimum weight should be 0.5 %. Since the BSE-SENSEX is a market capitalization

weighted index, this is one of the primary criteria for scrip selection. (Market Capitalization would

be averaged for last six months)

1. Liquidity

a) Trading Frequency : The scrip should have been traded on each and every trading day for

the last one year. Exceptions can be made for extreme reasons like scrip suspension etc.

b) Number of Trades : The scrip should be among the top 150 companies listed by average

number of trades per day for the last one year.

c) Value of Shares Traded : The scrip should be among the top 150 companies listed by

average value of shares traded per day for the last one year.

d) Trading Activity : The average number of shares traded per day as a percentage of the

total number of outstanding shares of the company should be greater than 0.05 % for the

last one year.

2. Continuity :

Whenever the composition of the index is changed, the continuity of historical series of index

values is re-established by correlating the value of the revised index to the old index (index before

revision). The back calculation over the last one-year period is carried out and correlation of the

revised index to the old index should not be less than 0.98. This ensures that the historical

continuity of the index is maintained.

3. Industry Representation :

Scrip selection would take into account a balanced representation of the listed companies in the

universe of BSE. The index companies should be leaders in their industry group.

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3. Listed History :

The scrip should have a listing history of at least six months on BSE.

B. Qualitative Criteria :

1. Scrip Group : The scrip should preferably be from A group.

2. Track Record : The company should preferably have a continuous dividend paying record or

/and promoted by management having proven record.

(Source: BSE Website)

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Fundamental Analysis

Steps in fundamental analysis

Analysis of macroeconomic activity

Industry analysis

- industry classification

- structural analysis

company analysis

- financial analysis

- non-financial analysis.

An investor who plans to invest in a firm has to take into consideration three important

aspects:

a. State of the company

b. Industry performance

c. Company performance.

These three aspects are interrelated and an investor can take a better decision only when

a thorough analysis is conducted into each of them.

Steps in fundamental analysis

The essence of such an analysis is to project a firm’s sales in future years. For projecting

the future of the firms, a sound understanding of the environment in which the firm is

operating is a prerequisite. A

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typical analysis of a firm’s environment has three steps:

1. Macroeconomic environment analysis: Initially the firm’s macroeconomic environment is analyzed to

project the future employment, inflation, income regulation, taxes, etc. The macro analysis is done not only

for the home country but also for foreign countries, which affect the firm’s operations.

2. Industry analysis: Once the analysis of macro economic factors is completed, the analyst should move

on the analysis of industry to which the firm belongs. The effects of a macroeconomic environment on the

industry should be analyzed properly to understand the sensitivity of industry environment with the changes

in macroeconomic aspects. For instance, certain industries like food, healthcare, etc., are less affected by

the changes in macroeconomic conditions compared to industries like aircraft, planes, etc.

3. Company analysis: Only after a thorough knowledge of both macro environment and industry analysis

can the analyst proceed to the firm’s forecast. For instance, if the economy is predicted to grow and

consumer demand is expected to shift from low-cost products to luxury products and the firm being analyzed

is regarded for differentiated goods, then it will witness an increased demand fir its products with a shift in

customer demand.

The Analysis of Macroeconomic Activity

Measuring the Level of Economic Activity

Gross National Product (GNP) and the Gross Domestic Product (GDP) are the two most widely used

aggregates of the level of macroeconomic activity.

Gross National Product (GNP): The GNP is the value of all goods and services produced by the

resources owned by the nation. Though GNP does not differentiate between resources owned by the

citizens of the country within the country and abroad, it does not include the value of goods and services

produced totally by resources owned by foreigners.

Gross Domestic Product (GDP): the gross domestic product measures the value of the products

within the country irrespective of the ownership of resources used in the production. A high degree of

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correlation is generally observed between the GNP and the GDP through their definitions imply that

GNP is more related to the nations income then the GDP. While GNP is more useful in predicting sales

of consumption goods, GDP is more related to the nations production and hence useful in predicting the

sales of intermediate products. GNP and GDP are both used to estimate the level of economic activities

and the future sales of consumption goods and services. Apart from this, there are three types of

economic indicators: leading indicators, coincidental indicators and lagging indicators.

Leading indicators: These indicators are highly sensitive to the changes in the economic environment

and foretell the changes in economic activity i.e., they rise or fall ahead of similar changes in the

economic activity. These indicators are used for projecting the future trends in economic activity.

Coincidental indictors: These changes move in tandem with the level of economic changes and are

therefore, used to assess the current state of the economy.

Lagging indicators: These indicators move after the change in economic activity has occurred. They are

useful in assessing and comparing the various economic statistic and the actual level of economic

activity.

For valuation based on discounting future cash flows, the leading economic indicators are the most

relevant of all three types of indictors. Through there are prominent indicators, which would help in

predicting the future trends of the economy, each one of them may have some erratic behavior too. An

aggregate of a few of these indicators would serve as a better indicative measure.

Other macroeconomic factors that affect the industrial performance are:

1. Employment

2. Inflation

3. Interest rates

4. Budget deficit

5. Sentiment.

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Employment

The unemployment rate measures the proportion of labor force who are seeking

employment but are unsuccessful in their attempt. it measures the operating capacity of the

economy. Though it is mainly and often related to labor force alone, it can be extended to other

factors of production which are the major determinants of the strength of the economy.

Inflation

The rate at which the level of prices increases is termed as inflation. When the inflation rate

is high, it implies that the productive capacity is not sufficient to meet the demand for goods and

services and hence the prices show an upward trend. Most governments try to maintain full

employment with less effort on controlling the price rise. The macroeconomic policies aim at

arriving on trade-off between inflation and unemployment.

Interest Rates

High interest rates cause a decline in the present value of future cash flows which lead to

unattractive investment opportunities. Hence, real interest rates are the actual determinants of

investment decisions. Even the demand for consumer durables and property depend on interest

rates since the change in the interest rates affects the interest payments on the loans taken to

acquire them.

Budget Deficit

The difference between government spending and revenue is the budget deficit. When

there is budget deficit, the government is forced to resort to borrowing. This increase in

government borrowing will lead to increase in interest rate which will affect the business as there

will be a high demand for credit in the economy. In economic parlance, excessive government

borrowing is said to create “crowding out” effect of private borrowing.

Sentiment

The last but not least is the attitude of the consumers and producers which affects the

economic performance of a nation. If consumers are optimistic about their future income levels,

they will opt for purchasing high valued consumer durables. This will have a positive impact on the

economy. Similarly, if producers perceive higher demand for their products in the future, then they

will increase their production level. Thus the sentimental belief of the consumers and producers

has a great influence on the aggregate demand for goods and services.

Demand and Supply shocks

The influence of the above macroeconomic factors on the economic performance can be

analyzed by classifying their impact on the economy as a supply or demand shock. An event

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which influences the demand for goods and services in the economy is a “demand shock”. For

example, an increase in government spending, increase in money supply, reduction in tax rates

create positive demand shocks.

Similarly an event that affects the production capacity and the costs is a “supply shock”. For

example, changes in the prices of imports, occurrence of any natural calamity, changes in the

educational level of the economy’s workforce create supply shocks.

Characteristics of Demand Shock

Demand shock cause aggregate output in the economy to move in the direction of interest

rates and inflation. for instance, when a government increases its expenditure, it will lead to

budget deficit. this will result in increase in government borrowing and hence the demand for funds

and the interest rates. this will be followed by an increase in the inflation if the demand for goods

services rises to a level at or beyond the total productive capacity of the economy.

Characteristics of supply shock

Supply shock causes the aggregate output in the economy to move in the opposite direction of

interest rates and inflation. For instance, a big increase in the price of imported oil will lead to

increase in the cost of production thereby causing an increase in the prices of petrol products. This

will lead to inflationary pressure. This increase in inflation rates will lead to higher nominal interest

rates in the short-term. Hence aggregate output will fall. Raw materials become more expensive

and have a detrimental effect on production capacity of the economy. So the ability of individuals

to purchase goods at higher prices decreases and thereby GDP tends to decrease.

When an investor wants to identify a particular industry for his investments, he should be able to

distinguish between those which aid in development from those which hurt in any perceived

macroeconomic scenario. If one perceives a tightening of money supply in the near future, then

one will avoid investment in the automobile industry because the likelihood of increase in interest

rates will affect the sales performance of the said industry. But one should be aware that the

predictions are made only with publicly available information which may not always be reliable.

Any investment advantage can be made only by way of better analysis and not by the use of

better information. An analyst must recognize that the basis for an investment should be the

forecast for the industry relative to the forecast implicitly built into the security prices.

Industry analysis

A company analysis is often preceded by an industry analysis as the success or failure of a

company to a large extent is influenced by the environment of the industry in which it operates. A

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thorough understanding of the industry facilitates the evaluation process of overall performance of

the company.

The second step in the fundamental analysis of common stocks is industry analysis.

Convinced that the economy and the market are attractive from the standpoint of investing in

common stocks, the investor should proceed to consider those industries that promise the most

opportunities in the near future.

Industry analysis usually involves several steps. As a first step, industries are analyzed in

terms of their stage in the life cycle. The idea is to assess the general health and current position

of the industry. This may be followed by an assessment of the position of the industry in relation to

the business cycle and macroeconomic conditions; an analysis of the competitive structure

prevailing in the industry and a study of the impact of government policy changes on the industry.

Industry classification

Classification by industry life cycle

The industry life cycle can be divided into four phase: the pioneer, growth, maturity and decline

phase.

Pioneer Stage: The pioneer stage is considered to be the most risky phase in a company’s life

cycle and crucial phase in the future success of the business. In this stage, the industry is

struggling to establish a market for its products. At this stage, huge financial investment is

needed and the returns would be insignificant in the short-term as sales are low when a new

idea is first introduced to a market. Customers are not looking for the product, and may not be

aware of its benefits or advantages over current offerings. In fact, they may not even know

about it. Informative promotion is needed to tell potential customers about the new product

concept. Even though a firm promotes its new product, it takes time for customers to learn that

the product is available. Money is invested in developing the market in anticipation of future

profits. The potential success of the industry attracts equity investors who are willing to find the

industry in expectation of the growth of the industry. However, 7 out of 10 start-up business

fail to survive in the pioneer stage.

Growth: In the market growth stage, industry sales grow quickly – but industry profits rise and

then start falling. As the product gets recognition in the market, an innovator begins to make

big profits as more and more customers buy it. It cannot be sustained for a long-term as

competitors enter the market. Some of them will emulate the product and some other would try

to introduce some more improvements in the existing profile of the product to make it even

more attractive. The new entries introduce a variety in the product. This is the stage where

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industry profits are largest, but at the same time industry profits begin to decline as increased

competition creates downward pressure on prices.

Maturity: market maturity occurs when industry sales level off. Competition gets tougher as

aggressive competitors enter the race for profits. Industry profits continue to go down during

maturity because promotion costs rise and competitors continue to cut prices to attract more

business. New firms may still enter the market during this stage. These late entries skip the

early life cycle stages, including the profitable growth stage. They try to take market share from

established firms, which is difficult and expensive in a Saturated, flat market. Customers who

are satisfied with their current relationship with a particular brand may not be interested in

switching to an unknown brand.

Decline: During the decline stage, new products replace the old. Price competition from dying

products becomes more vigorous, but firms with strong brands may make profits until the end

because they successfully differentiated their products. They may also keep some sales by

appealing to the most loyal customers or those who are slow to try new ideas. These buyers

might switch later, smoothing the sales decline.

Classification by Business Cycle Reaction

Another method of classification of the industry is based on the reaction of the industry to

the business cycle. The industry behavior is identified through the following three phases: growth,

defensive or cyclical.

A growth industry achieves an above normal rate of expansion, independent of the

business cycle. The condition of the economy does not affect the sales and earnings of the growth

industry. The example of such industry is the IT industry, which is marked by innovation and new

products development. The earning and sales of this industry increase even during recession.

Defensive industries show stable performance through the business cycle. They show

strong growth during economic upturn and show a decrease in profitability during economic

recession. Defensive industries usually fall into the mature category. Examples of defensive

industries are electric and gas utilities where demand does not change with the changes in the

economic condition; also food, cigarette and beer companies, the demand for whose products is

inelastic, and government contractors since government spending does not stop in any economic

condition.

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Cyclical industries are those whose earnings depend on the business cycle. They are

highly correlated to the economic conditions. The earnings increase with economic upturn and

decrease with economic recession. The products produced in the cyclical business are

discretionary products whose sales depend on the economic conditions of the country. For

example, heavy equipment and machine tool producers are cyclical businesses, for their

customers who are capital-intensive firms do not incur any investment in recession but increase

their spending during recoveries.

There are instances in which earning of certain cyclical firms are not correlated with the

economic conditions but they trend against other economic variants. For instance, brokerage firms

show cyclicality based on stock prices. Earnings of agriculture are related to the crop price cycle.

Structural Analysis

(Michael Porter Analysis)

The nature of the competitive conditions existing in an industry can provide useful

information to assess its future. The intensity of competition in an industry determines its

profitability. Professor Michael porter in his famous book on ‘competitive strategy’ has undertaken

a detailed analysis of the forces that shape the competitive structure in an industry.

Competition in an industry continually works to drive down the rate of return on invested

capital towards the competitive floor rate of return, or the return that would be earned by the

economist’s ‘perfectly competitive’ industry. This competitive floor, or ‘free market’ return, is

approximated by the yield on long-term government securities adjusted upward by the risk of

capital loss. Investors will not tolerate returns below this rate in the long run because of their

alternative to invest in other industries, and firms habitually earning less than this return will

eventually go out of business. The presence of rates of return higher than the adjusted free market

return serves to stimulate the inflow of capital into an industry either through new entry or through

additional investment by existing competitors. The strength of the competitive forces in an industry

determines the degree to which this inflow of investment occurs and derives the return to the free

market level, and thus the ability of firms to sustain above average returns.

The five competitive forces- entry, threat of substitution, bargaining power of buyers,

bargaining power of suppliers, and rivalry among current competitors- reflect the fact that

competition in an industry goes well beyond the established players. Customers, suppliers,

substitutes, and potential entrants are all ‘competitors’ to firms in the industry and may be more or

less prominent depending on a particular circumstance. Competition in this broader sense might

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be termed extended rivalry. Of course, different forces take on prominence, in shaping competition

in each industry

Threat of Entry

New entrants to an industry bring new capacity, the desire to gain market share, and often

substantial resources. Prices can be bid down or incumbents costs inflated as a result, reducing

profitability. Companies diversifying through acquisition into the industry from other markets often

use their resources to cause a shake-up. This acquisition into an industry with an intent to build

market position should probably be viewed as entry even though no new entity is actually created.

The threat of entry into an industry depends on the barriers to entry that are present, coupled with

the reaction from existing competitors that the entrant can expect. If barriers are high and/or the

newcomer can expect share retaliation from entrenched competitors, the threat of entry is low.

Economies of Scale

Economies of scale refer to decline in unit cost of a product (or operation or function that

goes into producing a product) with an increase in the absolute volume per period. Economies of

scale deter entry by forcing the entrant to come in at large scale and risk strong reaction from

existing firms or come in at a small scale and accept a cost disadvantage, both undesirable

options. Economies of scale can be present in nearly every function of a business, including

manufacturing, purchasing, research and development, marketing, service network, sales force

utilization, and distribution.

Economies of scale may relate to an entire functional area, as in the case of a sales force,

or they may stem from particular operations or activities that are part of a functional area. For

example, economies of scale are large for the production of color tube television sets and less

significant in cabinet making and set assembly. It is important to examine each component of the

costs separately for a particular relation between unit cost and the economy of scale.

Units of multibusiness firms may be able to reap similar economies of scale if they are able

to share operations or functions with other business in the company. For example, a multibusiness

company may manufacture small electric motors, which are then used in producing industrial fans,

hairdryers, and cooling systems. If economies of scale in motor manufacturing extend beyond the

number of motors needed in any one market, the multibusiness firm diversified in this way will reap

economies in motor manufacturing that exceed those available if only manufactured motors for

use in, say, hairdryers are made. Thus related diversification around common operation or

functions can remove volume constraints imposed by the size of a given industry. The prospective

entrant is forced to be diversified or face cost disadvantage. Potentially, shareable activities or

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functions subject to economies of scale can include sales forces, distribution systems, purchasing,

and so on.

The benefits of sharing are particularly potent it there are joint costs. Joint costs occur

when a firm producing product A(or an operation or function that is part of producing A) must

inherently have the capacity to produce product B. an example is air passenger services and air

cargo, where because of technological constraints only so much space in the aircraft can be

occupied by passenger, leaving the rest as cargo space and pay load capacity. It costs much to

put the plane into the air and there is capacity for freight regardless of the quantity of passenger

the plane is carrying. Thus the firm that competes in both the areas- passenger and freight- may

have a substantial advantage over the firm competing in only one market.

A common situation of joint costs occurs when business units can share intangible assets

such as brand names and know-how. The cost of creating an intangible asset need only be borne

once; the asset may then be freely applied to any other business, subject only to any costs of

adapting or modifying it. Thus situations in which intangible assets are shared can lead to

substantial economies.

External factors affecting sales and profitability

The growth and the performance of the companies are affected by various external factors,

which are beyond their control. These external factors affect their sales and earnings. In the first

stage of the top-down analysis, we consider the economic variables, which affect industry

performance. These factors can be classified into five groups: technology, government, social

changes, demographics and foreign influence. For each of these categories, there are some

themes that affect only a particular industry and the analyst must follow two main issues (1)

He/she should not fall into the role of a statistician; rather he should concentrate on trends that

would have significant effect on the industry over three to five-year period (2) The significant

effects he identified have to be expressed in quantifiable firm.

In many research reports, one basic assumption is that the industry’s external environment

would repeat itself. Past trends are likely to continue in the future and thus most industry sales

projections are based on time-series analysis. But in the case of new industries, historical data will

not be available as 99% of the public companies are beyond the start-up stage; an analyst can

extrapolate brief historical results into forecast. An analyst, while relying on historical data, should

be wary of important reversals ad thus make appropriate adjustment in his/her forecasts.

Technology

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The initial analysis of technology focuses on the survival of the fittest. It determines the

capability of the firms to maintain the demand for its product and not to lose the market to its

substitutes arising from newer technology. In the ever-changing technological environment, it

becomes imperative for the companies to adjust to newer technology demands lest they will lose

their competition in the industry.

Government

The government rules and regulation affect the firms to a great extent. Any firm should be well

aware of the rules and regulations governing the industry and should accordingly plan its ventures.

A negative shift in the political fortunes in the country could lead to unfavorable government

actions, resulting in lower earnings. The estimated projections may have to be modified

accordingly. Most business organizations complain about regulation, but regulations are the major

contributing factor for promoting worker safety, consumer protection and for ensuring fair play.

There are two sides to government influence. Some government regulations have helped in

encouraging multiple businesses also. On the negative side, some of its regulations may affect the

prospects of the industry itself. For instance, a ban on tobacco by a regulatory action of the

government will diminish the industry’s prospects. If the government places emphasis on

environment control, then it will be a boon to the environment services sector.

Government spending generally constitutes about 30-40 percent of gross national product. Any

changes in the spending patterns of the government organizations influences the affected

industries. Even in the analysis of foreign stocks, external factors relating to government play a

vital role.

Social changes

Social changes include fashion and lifestyle changes. Lifestyle changes related to the long-

term changes whereas fashion is highly unpredictable and occurs in short-term. The analyst

should be really careful while studying the social changes in the economy that the analyst should

not confuse fashion with lifestyle changes and vice versa. It can be highly misleading and can

tamper the efficiency of industry analysis.

Demographics

Demographics is the science that studies the vital statistics of population such as age,

distribution and income. By observing the trends in these statistics, an analyst develops

investment themes regarding various industries. Demographic trends unfold over a long period of

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time and they are more easily identifiable then other external factors. Analysts agree on the

existence of a foreign trend.

Foreign Influences

When trade extends across the borders, industries get affected by changes taking place all

over the world. For instance, US economy is indirectly dependent on imported oil. Whenever

supply/demand for oil changes considerably, it has a severe impact on several industries. US

exports also experience a setback on account of economic liberalization of several nations. Thus

analysts have to evaluate the industries based on global trends and conditions. Demand

projections are aggregated country wise and all the external influences have to be considered

from a global perspective. This approach is particularly suitable for worldwide commodity

businesses such as oil, metals, agricultural products, etc.

Intensity of Rivalry among Existing Competitors

Rivalry among existing competitors takes the familiar from of jockeying for position using

tactics like price competition, advertising battles, product introductions, and increased customer

service or warranties. Rivalry occurs because one or more competitors either feel the pressure or

see the opportunity to improve positions. In most industries, competitive moves by one firm have

noticeable effects on its competitors and thus may incite retaliation or efforts to counter the move;

that is, firms are mutually dependent. This pattern of action and reaction may or may not leave the

initiating firm but the industry as a whole may be in a better position. If moves and countermoves

escalate, then all firms in the industry may suffer and be worse off then before.

Some forms of competition, notably price competition, are highly unstable and quite likely

to leave the entire industry worse off from the standpoint of profitability. Price cuts are quickly and

easily matched by rivals, and once matched they lower revenues for all firms unless industry price

elasticity of demand is high enough. Advertising battles, on the other hand, may well expand

demand or enhance the level of product differentiation in the industry for the benefit of all firms.

Rivalry in some industries is characterized by such phrases as ‘warlike’, ‘bitter’, or ‘cut-

throat’ whereas in other industries it is termed ‘polite’ or ‘gentlemanly’. Intense rivalry is the result

of a number of interacting structural factors.

Shifting Rivalry

The factors that determine the intensity of competitive rivalry can and do change. A very

common example is the change in industry growth brought about by industry maturity. As an

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industry matures, its growth rate declines, resulting in intensified rivalry, declining Profits, and

(often) a shake out.

Another common change in rivalry occurs when an acquisition introduces a very different

personality to an industry. Also, technological innovation can boost the level of fixed cost in the

production process and rise the intensity of rivalry.

Although a company must live with many of the factors that determine the intensity of industry

rivalry because they are built into industry economics, it may have some latitude in improving

matters through strategic shifts. For example, it may try to raise buyer’s switching costs by

providing engineering assistance to customers to design its product into operations or to make

them dependent for technical advice. Or the firm can try to raise product differentiation through

new kinds of services, marketing innovations, or product changes. Focusing selling efforts on the

fastest growing segment of the industry or on market areas with the lowest fixed costs can reduce

the impact of industry rivalry. Also if it is feasible, a company can try to avoid confronting

competitors with high exit barriers and can thus side-step involvement in bitter price cutting, or it

can lower its own exit barriers.

Exit Barriers

Exit barriers are economic, strategic, and emotional factors that keep companies competing in

businesses even though they may be earning low or even negative returns on investment. The

following are the major sources of exit barriers.

Specialized assets: assets highly specialized to the particular business or location have low

liquidation values or high costs of transfer or conversion.

Fixed costs of exit: these include labor agreements, resettlement costs, maintaining

capabilities for spare parts, and so on.

Strategic interrelationship: interrelationships between the business unit and others in the

company in terms of image, marketing ability, access to financial markets, shared facilities,

and so on. They cause the firm to attach high strategic importance to being in the business.

Emotional barriers: management’s unwillingness to make economically justified exit

decisions is caused by identification with the particular business, loyalty to employees, fear

for one’s own career, price, and other reasons.

Government and social restrictions: these involve government denial or discouragement of

exit out of concern for job, loss and regional economic effects.

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When exit barriers are high, excess capacity does not leave the industry, and companies

that lose the competitive battle do not give up. Rather, they grimly hang on and because of their

weakness, have to resort to extreme tactics. The profitability of the entire industry can be

persistently low as a result.

Although exit barriers and entry barriers are conceptually different, their joint level is an

important aspect of the analysis of an industry. Exit and entry barriers are often related.

Substantial economies of scale in production, for example, are usually associated with specialized

assets, as is the presence of proprietary technology.

Taking the simplified case in which exit and entry barriers can be either high or low, we can

generalize it as follows

Exit

Barriers

Entry

Barriers

Low High

Low Low, stable

returns

Low, risky

returns

High High, stable

returns

High, risky

returns

The best case in view of industry profits is where entry barriers are high but exit barriers

are low. Here entry will be deterred, and unsuccessful competitors will leave the industry. When

both entry and exit barriers are high, profit potential is high but is usually accompanied by more

risk. Although entry is deterred, unsuccessful firms will stay and fight in industry.

The case of low entry and exit barriers is merely unexciting, but the worst case is where

entry barriers are low and exit barriers are high. Here entry is easy and will be attracted by upturns

in economic conditions or other temporary windfalls. However, capacity will not leave the industry

when results deteriorate. As a result, capacity stacks up in the industry and profitability is usually

chronically poor. An industry might be in this unfortunate position for example, if suppliers or

lenders will readily finance entry, but once in, the firm faces substantial fixed financing costs.

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Pressure from substitute product

All firms in an industry are competing, in a broad sense, with industries producing

substitute products. Substitute limit the potential returns of an industry by placing a ceiling on the

prices firms in the industry can profitably charge. The more attractive the price performance

alternative offered by substitutes, the higher the threat for the industry.

Identifying substitute products requires searching for other product that can perform the same

function as the product of the industry. Sometimes doing so can be a subtle task, which leads the

analyst into businesses seemingly far removed from the industry. Securities brokers, for example,

are being increasingly confronted with such substitutes as real estate, insurance, money market

funds, and other ways for the individual to invest capital accentuated in importance by the poor

performance of the equity markets.

Position vis-à-vis substitute products may well be a matter of collective industry action. For

example, although advertising by one firm may not be enough to bolster the industry’s position

against a substitute, heavy and sustained advertising by all industry participants may well improve

the industry’s collective position. Similar arguments apply to collective response in areas like

product quality improvement, marketing efforts, providing greater product availability, and so on.

Substitute products that deserve the maximum attention are those that are (1) subject to

trends improving their price performance trade-off with the industry’s product, or (2) produced by

industries earning high profits. In the latter case, substitutes often come rapidly into play if some

development increases competition in their industries and cause price reduction or performance

improvement.

Bargaining Power of Buyers

Buyers compete with the industry by forcing down prices, bargaining for higher quality or

more services, and playing competitors against each other – all at the expense of industry’s

profitability. The power of each of the industry’s important buyer groups depends on a number of

characteristics of the market situation and on the relative importance of the purchases from the

industry compared with the overall business. A buyer group is powerful if the following

circumstance hold true.

If they are concentrated or make purchases in large volumes relative to sales of the

supplier. A large portion of sales purchased by a given buyer raises the importance of

the buyer’s business. Large volume buyers are particularly potent forces if heavy fixed

costs characterize the industry – and raise the stakes to keep capacity filled.

The product it purchases from the industry represent a significant fraction of the buyer’s

costs or purchases. Here buyer are prone to expand the resources necessary to shop

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for a favorable price and purchase selectively. When the product sold by the industry in

question is a small fraction of buyer’s costs, buyers are usually much less price

sensitive.

The products it purchases from the industry are standard or undifferentiated. Buyers,

sure that they can always find alternative suppliers, may play one company against

another.

It faces few switching costs. Switching costs, defined earlier, lock the buyer with

particular sellers. Conversely, the buyer’s power is enhanced if the seller faces

switching costs.

It earns low profits. Low profits create great incentives for lower purchasing costs.

Highly profitable buyers, however, are generally less price sensitive( that is, of course,

if the item does not represent a large fraction of their costs) and may take a long-term

view of preserving the health of their suppliers.

Buyers pose a credible threat of backward integration. If buyers are partially integrated

or pose a credible threat of backward integration, they are in a position to demand

bargaining concessions. They engage in the practice of tapered integration, that is

producing some of their needs for a given component in house and purchasing the rest

from outside suppliers. Not only is their threat of further integration particularly credible,

but partial in house manufacture also gives them a detailed knowledge of costs which

is a great aid in negotiation. Buyer power can be partially naturalized when firms in the

industry offer a threat of forward integration into the buyers industry.

The industry’s product is unimportant to the quality of the buyer’s products or services.

When the quality of the buyers products is affected by the industry’s product, buyers

are generally less price sensitive.

The buyer has full information. Where the buyer has full information about demand,

actual market prices, and even supplier costs, it yields him greater bargaining leverage

then when information is poor. With full information, the buyer is in a better position to

ensure that he receives the most favorable prices offered to others and can counter

supplier’s claims that their viability is threatened.

Bargaining power of suppliers

Suppliers can exert bargaining power over participants in an industry by threatening

to raise prices or reduce the quality of purchased goods and services. Powerful suppliers

can thereby squeeze profitability out of an industry unable to recover cost increases in its

own prices.

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The conditions making suppliers powerful tend to mirror those which make buyers

powerful. A supplier group is powerful if the following apply.

- It is dominated by a few companies and is more concentrated than the industry it sells

to. Suppliers selling to more fragmented buyers will usually be able to exert

considerable influence in prices, quality, and terms.

- It is not obliged to contend with other substitute products for sale to the industry. The

power of even large, powerful suppliers can be checked if they compete with

substitutes.

The industry is not an important customer of the supplier group. When suppliers sell to a

number of industries and a particular industry does not represent a significant fraction of sales,

suppliers are much more prone to exert power. If the industry is an important customer, suppliers’

fortunes will be closely tied to the industry and they will want to protect it through reasonable

pricing and assistance in activities like R&D and lobbying.

The supplier’s product is an important input to the buyer’s business. Such an input is

important to the success of the buyers’ manufacturing process or product quality. This raises the

supplier power. This is particularly true where the input is not storable, thus enabling the buyer to

build up stocks of inventory.

The supplier group’s products are differentiated or it builds up switching costs. Differentiation or

switching costs facing the buyer cut off his option to play one supplier against another. If the

supplier faces switching costs, the effect is the reverse.

The supplier group poses a credible threat of forward integration. This provides a check

against the industry’s ability to improve the terms on which it purchases.

We usually think of suppliers as other firms, but labor must be recognized as a supplier as

well, and one that exerts great power in many industries. There is substantial empirical evidence

that scarce, highly skilled employees and / or tightly unionized labor can bargain away a significant

fraction of potential profits in an industry. The principles in determining the potential power of labor

as a supplier are similar to those just discussed. The key additions in assessing the power of labor

are its degree of organization, and whether supply of scarce varieties of labor can expand. Where

the labor force is tightly organized or the supply of scarce labor is contained from growing, the

power of labor can be high.

Company Analysis

Valuation of a firm cannot be done without considering the prevailing economic environment.

An analyst cannot estimate the sales, cost or capital investment unless there is an adequate

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understanding of the macroeconomic environment in which the firm operates. Thus, analysis of a

firm is a top-down approach whereby the analyst first studies the macro aspects and uses them to

deduce the prospects of the firm’s current environment.

When an investor has identified the industry in which the investment has to be made, then

the next step will be to select a firm within the industry. A firm’s stock price is calculated from its

fundamentals and it has to be compared with the ruling market price to make a decision on

investment in the firm’s stock.

Financial Analysis

Quantitative Models to Value Common stock

intrinsic value vs market price

The widely used model to assess the value of a firm as a going concern is based on the

assumption that the investor in a stock expects a return in terms of dividends and capital gains.

Let us assume a one year holding period. Suppose an XYZ stock has an expected dividend a year

hence of D1, and its current price and price expected a year hence are p0 and P1 respectively.

Holding period return on XYZ stock can be computed as follows.

Holding Period Return (HPR) = D1 + p1 – p0

Po

= D1 + P1-Po

Po Po

(1) (2)

Where (1) denotes the dividend yield, and (2) denotes the capital gains yield. This return is

the investor’s expected rate of return. The required rate of return is calculated using CAPM which

says that K= rf + β ( rm – rf ) where K is the required rate of return, rf is the risk-free rate of return,

β is the Stock Beta and rm is the return on market. The expected rate of return is compared with

the required rate of return to know if the stock return is meeting the investors’ target return. When

expected return exceeds K, then the investor would include more of the XYZ stock in his portfolio

and when it is less then K, then he would try to decrease the composition of XYZ stock in his

portfolio.

As an alternative, an investor can compare the intrinsic value of a stock with its market

price to arrive at an investment decision. The intrinsic value is denoted by Po and is defined as the

present value of future cash flows on the stock for an investor. These future cash flows include the

dividend and the proceeds from the sale of the stock. These are discounted at the appropriate

risk-adjusted interest rate K. Whenever the intrinsic value is greater then the market price, the

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stock is said to be undervalued and whenever the intrinsic value is less then the market price, the

stock is said to be overvalued. When the stock is undervalued, the investor buys the stock and

when it is overvalued, the investor sells it.

Inflation and Stock Prices

The impact of inflation on stock prices will be best understood through an example. Let us

assume that all real variables including the stock price are unaffected by inflation. Suppose a firm

X pays-out all its earnings as dividends in the absence of inflation. Assume zero growth for the firm

under consideration. Let the dividend per share be Re.1. According to the dividend discount

model, the share price is given by,

Po = D1

k - g

When the required rate of return is 12%, then the stock price is given by,

1 1

Po = = -------- = Rs. 8.33

0.12 –0 0.12

Let the inflation rate be 4%. The values of other economic variables adjust so as to leave their real

values unchanged. The required rate of return should be adjusted for inflation. so it becomes

(1.12) (1.04) – 1 = 16.48%.

Growth rate will become ( 1 + 0 % ) (1 + 0.04) – 1 = 4 %. The expected dividends at the end of the

year will become (1) (1.04) = Rs. 1. 04. The price of the stock is then given by,

Po = 1.04 = Rs.8.33

0.1648 – 0.04

This is similar to what was arrived at when no inflation assumption was made. Thus as long

as the real values are unaffected, the stock’s current price is unaffected by inflation.

Dividend yield in the above case works out to 12.48 % and the capital gains yield works out to be

4 %. much of the increase of 4.48 % in the required rate return has come in the form of capital

gains yield. This is mandatory if the real value of the stock is to remain unaffected by inflation.

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Dividend yield in the above case works out to 12.48 % and the capital gains yield works out to be

4%. Much of the increase of 4.48 % in the required rate of return has come in the form of capital

gain yield. This is mandatory if the real value of the stock is to remain unaffected by inflation.

Impact of our assumptions on the earnings, retention ratio can be explained by another example.

Suppose the firm X manufacture a product Y, which needs purchase of inventory at the beginning

of each year. The firm sells the finished product at the end of the year. assume there was no

inflation last year. The cost of the inventory is Rs.1 lakh. Labor and other processing costs work

out to Rs. 10,000 and the revenues work out to Rs. 1,20,000. The earning work out to Rs.10,000

when the firms falls under no tax bracket.

If all the earnings are distributed to 10,000 shareholders, then the return on equity is 10%.

if the expected inflation rate is 4%, the revenue will become 1,20,000 ( 1.04 ) = 1,24,800. But the

cost of goods sold remain at Rs.1 lakh because inventory is paid at the beginning of the year. But

labor and other costs will be Rs. 10,400. But the amount required to replace inventory at end of

the year would be rs.1.04 lakh. So the amount of cash that would be available to distribute as

dividends would be only Rs.10,400 and not Rs. 14,400 as shown below.

Rs.

Revenue 1,24,800

- Labor and other costs 10,400

- cost of goods sold 1,00,000

14,400

ROE 14.4%

The reported earnings of Rs. 14,400 overstate true economic earnings. this can be summarized as

follows.

No inflation 6% Inflation

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Dividends 10,000 10,400

Reported earnings 10,000 14,400

ROE 10 % 14.4 %

Retention ratio 0 0.278

Price of a share Rs. 10 Rs. 10

P/E ratio 10 6.94

We find that the real interest rate and the real earnings remain unchanged as a result of inflation.

But nominal dividends and reported earnings increase as a result of inflation. In subsequent years,

as long as inflation remains at a constant rate of 4 %, earnings will grow at 4 %.

Ratio Analysis

Financial analysis mainly deals with ratio analysis. When the financial ratios are used by

the security analysts, some strange aspects have to be considered. Since different ratios can be

grouped into different categories and within each group some may be identical, in that, some

conclusion can be drawn from them, analysts can pickup one among the identical ratios to infer

something and may leave others unattended. For instance, return on assets and the return on

equity will yield the same result since there will not be any significant difference in the denominator

of these ratios. However, the analyst has to use his judgment capacity to make a selection of

these ratios to arrive at a meaningful comparison and conclusion. The analysts should also look

into the ways in which these ratios are calculated because there may not be any consistency in

their calculations.

Per Share Ratios

The frequently used per share ratios are :

1. Earnings per share

2. Dividend per share

3. Sales per share

4. Cash flow per share

5. Book value per share

6. Current assets per share

7. Quick assets per share

8. Cash per share.

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For the first four of these ratios, the denominator is weighted average of the number of common

share at the end of the year in which these ratios are calculated. For the rest of the ratios, the

denominator is the number of common shares outstanding on the balance sheet date. This is

because in the former category, the numerator figures are income statement figures and in the

latter the numerators are balance sheet figures. Definitions of these ratios are given in the

appendix to this chapter. Here let us focus on the shortcoming of using these ratios and how they

can be overcome.

Limitations of per Share Ratios

The per share ratios are less concentrated on the magnitudes of sales, profits, invested

capital and the aggregate market value of the firm than on the share value. The earnings per

share does not take all the details of the income statement into account and may lead to

misinterpretation by the user.

A share does not indicate a fixed proportion of the ownership of a company and this year’s

share value cannot be compared with that of the last year in economic terms. Thus if comparison

of the per share figures over a period is done without taking economic factors such as inflation into

account, then the conclusions may not be meaningful.

The analysts may have to adjust the reported profits in the income statement occasionally to

arrive at “true and realistic” earnings figure. When the operating profits are adjusted, the

corresponding figures of the earnings per share are also to be adjusted. If the differences between

original reported profits and the adjusted profits is large, then emphasis should be made on the

revised computation of the profits by the analysts.

While computing the future earnings per share, provisions have to be made for the number

of share expected to be outstanding for the year in which the ratio is to be calculated.

The number of share outstanding at a given point of time may be influenced by the actions

of the firms such as introduction of stock splits, rights issues, etc. A stock split will dilute the

earnings per share. So an analyst must be aware of such changes taking place in the activities of

the firm.

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The change in capitalization may also result from the conversion clause attached to certain

bond issues of a firm. In conversion of a bond or a preferred stock to common equity, the interest

or preferred dividend, which is paid earlier, is adjusted for tax if any, and then added back to

earnings figure. This new figure is then used to compute the new EPS for increased number of

shares.

Dividend per Share

To calculate this ratio, outstanding shares should be weighted by the dividends paid.

Historical dividends would be adjusted for splits, stock dividends, rights, etc.

Sales per Share

It is calculated by dividing sales by number of shares outstanding.

Cash flow per share

This ratio gives an idea about the ability of a firm to leverage itself, to pay dividends and to enjoy

financial flexibility. But cash flow do not belong to the equity holders alone because the debtors

also have claim over them.

Price Ratios

A security analyst should gain additional information from the relationship between the

price of a share and the earnings, dividends, asset value and sales. These relationship are defined

by the following ratios:

1. Price-earnings ratio

2. Earnings yield

3. Dividend yield

4. Price-to-book value.

The major problem encountered in the calculation of these ratios is the time period considered. For

instance, the earnings may be the mean of earnings over a certain number of years or merely the

last year’s result. Earnings used in P/E multiple is the last year’s figure or current fiscal year’s or

an estimate of the forthcoming year. Since the earnings change widely from one period to another

due to a number of factors, an analyst must be cautious to identify the time period used and also

to know if the figures are actual or estimated. Even the price used may be actual or estimated. It

may be an average or the price at a peak period. So the analyst should exercise due diligence in

interpreting the price ratios so that misconceptions can be avoided.

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Price-Earnings ratios

This ratio has two sensitive components. The numerator depends on the market expectations and

perceptions about the firm’s performance. The denominator represents the earnings left for

distribution to the firm’s shareholder after meeting the claims of the debtors. Both these

components are subject to wide fluctuations from time to time.

A better way to overcome this problem is to use the average price over a representative

period of time and the average earnings for the same period. A strong and a prospective firm

usually has a higher value of earnings than one which is less strong and less promising.

Factors which influence the price/earnings ratio

Tangible factors are:

1. Growth rate of past earnings and sales

2. Profitability

3. Consistency of past earnings

4. Dividend rate

5. Creditworthiness and the financial strength.

Intangible factors are:

1. Quality of management

2. Nature and future prospects of the industry

3. Competitive nature and status of the firm

4. Future growth prospects of the firm.

Of these, tangible factors can be quantified and are available in the financial statements for an

analyst. But intangible factors, as the name suggests, are difficult to be quantified and hence an

analyst must be careful to infer about the influence of these factors. One should not overlook the

fact that the unquantifiable factors would have exerted its influence in stating quantifiable results

and hence the latter themselves give a clear picture of the financial position of the firm.

Ratios measuring tangible factors can be grouped into five categories

a) Profitability ratios

b) Growth rate

c) Co-stability ratios

d) Pay-out ratio

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e) Credit ratio.

These differ from the valuation ratios discussed earlier in that they measure the financial strength

and the performance of firm.

Profitability Ratios

The most commonly used profitability ratio is the ratio of net profit to total capital. This ratio

is a measure of overall performance of a business in terms of total funds provided by all types of

investors rather than s single group of investors. It measures management’s ability to deploy its

funds profitably irrespective of the mode of funding used. The numerator is usually an after tax

figure but it can also be Earnings Before Interest and Tax (EBIT) so that it can be used for inter-

firm comparisons effectively, irrespective of their taxable nature.

With profitability ratios, caution should be exercised while choosing the numerator and the

denominator in that they should be mutually consistent. For example, if short-term borrowings are

excluded from the capital used in the denominator, then the corresponding interest should be

deducted from the return used in the numerator.

Which capital is to be used to calculate the return on capital?

The common problem faced in calculating the return on capital is the dispute over value to

be used in the denominator. Common practice is to use the value of the capital as at the end of

the period. This may not give a realistic picture because the capital that existed at the beginning of

the period would have been different and it might not have been tha same throughout the year. It

would be the amount that had been accumulated at the end of the year. A better way to calculate

the return on capital may be of using either the average value of the capital employed during the

year, or the capital that existed at the beginning of the year. Consistency should be maintained,

whichever method is used. When the capital is infused during the year, then using average capital

proves to be advantageous.

Constituents of the capital used in calculation of return on capital

Short-term borrowings such as bank loans, and commercial paper and the deferred tax

liability are included in the invested capital. Operating leases should also be included in the

invested capital. Current accrued payable are excluded from the invested capital to maintain

consistency between the figures used in the numerator and the denominator as these do not bear

any interest for their period of existence.114

Some adjustments have to be made to the equity capital. For firms which used LIFO

method for inventory valuation, the LIFO reserve should be added back to equity. Goodwill or any

other intangible assets which lack a market price or an identifiable stream of revenues should be

deducted from the equity capital. The present value of operating leases would appear in both the

assets and liabilities side of the balance sheet.

This liability would be a part of the capital but will not be a part of equity capital and hence

should not be included in the equity capital. The unpaid preferred stock dividends should be

shown either as a liability or as an increase in the preferred stock claim and an equivalent amount

should be subtracted from the equity capital. If goodwill and other intangible have been deducted

from equity, then their amortization, write offs and tax effects should be removed from earnings. If

the present value of operating leases is included in the denominator, then the numerator should be

adjusted for the associated interest component and taxes paid, if any, on the leases.

To facilitate comparison of similar firms, interest expenses should be adjusted for the

appropriate tax rate. Then firms with different capital structures can also be compared in terms of

profitability of their capital

Return on Common Equity

The second most important profitability ratio is return on equity. This reflects the preference

of the market for the stock of the firm over the fixed income securities. Analysts use tha trade-off

between higher earnings and the increased variability of earnings to infer the optimal mix of debt

and equity used by the management.

Turnover Ratios

These are also termed as activity ratios. They provide information on changes that take place

in a firm and would demand an explanation from the analysts. They are:

a) Total capital turnover ratio

b) Asset turnover

c) Inventory turnover

d) Equity turnover

e) Plant turnover

f) Accounts receivable

g) Working capital turnover.

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These ratios are prone to wide variations based on changes in operations and the financial

structure of a corporation.

Allowing for differences in depreciation

The changes in the depreciation policies adopted by the firms may affect the firm’s

performance. The analyst must look for changes in the figures of depreciation resulting from

changes in methods used for calculating it.

Non-financial analysis

The important non-financial parameters to be examined by an investor are as follows:

Business of the company

The investor should know whether the company is well established one, whether it has a

good product range and whether its lines of business have considerable potential to grow.

Top management

The quality of top management team, particularly, the competence and the commitment o

the chief executive officer matters a lot in shaping the destiny of the company.

Product Range

Progressive companies like ITC and Hindustan lever create competition for their existing

products by launching new products with regular frequency. Hence investors must examine

whether the company under review belongs to this group or not.

Diversification

An issue related to that of product range is diversification. To reduce the degree of

business risk and improve profitability, many companies resort to diversification. Hence this issue

is to be carefully examined by the investor.

Foreign collaboration

Where a company has entered into technical collaboration with a foreign company, the

investor must find out more about the nature of the collaboration agreement.

Availability of Cost of Input

If the company depends upon imported raw materials, it is important for the investors to

assess the raw material position, because any shortage of the raw material and/or escalation in

the cost of raw material will adversely affect the profitability.

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Research and Development

Progressive companies spend substantial amount of money on R&D to upgrade their

existing products, introduce new products, adapt foreign technology to suit the local conditions,

achieve import substitution, etc.

Government regulations

The investor must assess the implications of government regulations such as MRTP Act,

FERA, etc., for the company under review.

Pattern of shareholding and listing

The pattern of shareholding has a baring on the floating stock available in the market and

the trading volume of these issues will have an affect on the company, hence it will be analyzed by

the investor before taking any investment decision.

Conclusion

Industries are sensitive to the business cycle. Though leading indicators can be used to

anticipate the evolution of the business cycle since their values tend to change prior to other key

economic variables, sometimes it may be difficult to predict these indicators accurately. So in

addition to the quantitative analysis, an investor has to do structural analysis to study an industry.

We have discussed about some key ratios which are helpful in analyzing a company’s

performance and are useful in arriving at its value. Analysis of financial parameters along with non-

financial parameters would help an investor make good investment decisions.

Appendix

Table of Ratios

Per Share Ratios

1. Earnings per share = Earnings available for the common share

Weighted average common share outstanding

2. Dividend per share = annual dividends paid to common shareholders

Weighted average common share outstanding

3. Sales per share = Sales

Weighted average common share outstanding

4. Cash flow per share = Cash flow of operations after taxes

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Weighted average common share outstanding

5. Book value per share =

Book value of common equity – goodwill – most other intangible assets

Common shares outstanding at balance sheet date

6. Current assets per share = Current assets- all claims prior to common stock

Common shares outstanding at balance sheet date

7. Quick assets per share = Cash + receivables – all claims prior to common stock

Common shares outstanding at balance sheet date

8. Cash per Share = Cash – all claims prior to common stock

Common shares outstanding at balance sheet date

Yield ratios

9. Price earnings ratio = price pre share

Earnings per share

10. Earnings yield = Earnings per share

Market price per share

11. Dividend yield = Dividend per share

Market price per share

12. Sales per dollar of common at market value = Sales

Weighted average shares outstanding stock price

13. Price-to-book value = Market price per share

Book value per share

Profitability Ratios

14. Return on capital = Net income + Minority + Tax – adjusted interest

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Tangible assets – short-term accrued payables

15. Capital turnover = Sales

Tangible assets – short-term accrued payables

16. Earnings margin = Net income + Minority interest + Tax-adjusted interest

Sales

17. Return on capital before depreciation =

Net income + minority interest + Tax-adjusted interest + Depreciation

Tangible assets – short-term accrued payables

18. Return on common equity =

Net income- preferred dividend requirements

Common equity – Goodwill – Most intangible assets + Deferred tax liability

Turnover Ratios

19. Inventory turnover = Cost of goods sold

Inventory including LIFO reserve(if any)

20. Accounts receivable turnover = Sales

Accounts receivable

Derivatives – Futures & Options

1.0 Introduction:

The pursuit of commerce is fraught with innumerable risks since the profit that a commercial

venture seeks to make, comes as a reward for the risks taken. For example, an investor investing

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in equities faces the risk that price of the equity shares bought might come down, thereby eroding

his capital and resulting in losses, or price of the shares sold by him may rise after he has

liquidated them from his portfolio causing him an opportunity loss. An investor in the fixed income

securities faces the risk of default and the interest rate risk. An entity engaged in the international

trade or the cross-border financing additionally faces the exchange rate risk. Even the farmers

producing crops and miners mining the metals face the price risks. Apart from these price risks,

businesses also face a risk on account of a mismatch in the timing of their cash inflows and cash

outflows. At times, these risks tend to be so enormous as to threaten the very survival of the

business.

The job of a Finance manager in any business is primarily to manage these risks and to keep them

within a reasonable limit so as to ensure the financial health and continuance of the business.

Towards this end, he or she has to continuously take decisions concerning the Risk-Return

tradeoff. In this context, derivatives have been proving an extremely useful tool available to the

today’s finance manager. Derivatives are widely used by finance managers as a means of altering

the nature of risk and its profile, through transfer of the entire financial risk or a part thereof from

the relatively risk averse market participant to a risk-taker, while not affecting its normal business

transactions.

The Present Text aims at providing the reader a thorough understanding of the theoretical

concepts underlying the derivatives is general and stock derivatives in particular. It also aims at

equipping them with the requisite knowledge to use the stock derivatives and various combinations

thereof, effectively to achieve the desired objective.

1.1 Nature of Derivatives:

Derivatives are the instruments, which derive value from another, more basic, financial instrument,

commodity or parameter. It is a contractual relationship between two (or more) parties where the

price and hence value of the contract varies with change in the underlying variable. An example of

this could be a ‘US $ Forward contract’ between a bank and its customer where the customer

contracts with the bank for purchasing say $ 1,000,000 at the end of three months at Rs. 45.1255

per Dollar.

Apart from this basic version of derivatives, complex derivatives in the form of derivatives on

derivatives such as Options on Futures or Swaptions, have also been gaining popularity. In these

derivatives, the underlying is in itself a derivative product.

A derivatives contract explicitly provides specifications for the medium and the mode of repayment

or settlement of the contract by each of the contracting parties. The repayment may involve

exchange of currencies, securities or a commodity such as Gold, Silver, Guar, Steel, Oil. The

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quantum or amount that needs to be paid may be tied to movement in stock indices, stock price, a

particular interest rate, value of a foreign currency etc.

1.2 Types of Derivatives:

The popular categories of financial derivatives available to the finance managers today are –

1. Forwards: Forward contracts are the agreements to exchange a specified quantity of a

security, index basket, currency or a commodity, of a specified quality, at a specified

time in future but at the price agreed upon at the time of entering into the contract.

Forward contracts are normally traded over-the-counter and are typically highly

customized or tailor-made to suit the requirements of contracting parties. Forwards can

be available for maturities as long as 10 years or more. Examples of forward are the

currency forwards or the erstwhile Vyaj-Badala system on the Bombay Stock

Exchange.

2. Futures: Futures are nothing but standardized and exchange-traded forward contracts.

These differ from forwards in standardization of quantity, quality, delivery or expiry date

and the mode of settlement. Normally futures are available for a maturity of up to 12

months.

3. Options: Options confer upon the buyer of the options a right but no obligation to

demand exchange of a specified quantity and quality of the underlying, on or before a

specific date in future, but at a price agreed upon at the time of buying the option. A

seller of an option has an obligation to fulfill his part of the contract if the buyer insists

on exercising his option. In short, seller of an option sells a right to the buyer for which

the buyer has to pay an amount called ‘premium’. Options are generally available for a

maturity of up to 12 months.

4. Swaps: Swaps are agreements to exchange future cash-flows according to a

predetermined formula. They are, in essence, a basket of forward contracts. The

common types of swaps are interest rate swaps, currency swaps and a combination

thereof called cross-currency coupon swaps. They are generally traded over-the-

counter and hence are highly customized with maturities spanning several years.

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5. Warrants: Warrants are the over-the-counter version of options which are available for

longer periods. In India, they have so far made appearance only as sweeteners or

enhancers by the issuers of equities and debentures.

6. Swaptions: Swaptions are the options to enter into a swap on or before a specified

period of time which make them options of forward swaps. A Receiver Swaption has

an option to receive a fixed cash-flow in exchange for a cash-flow calculated according

to a floating rate whereas a Payer Swaption has an option to receive a floating cash-

flow in exchange for a fixed one.

1.3 History of Derivatives:

The commodities derivatives date back to the 19th century. The first ever commodities forward

contract was recorded at the Chicago Board Of Trade (CBOT) in March 1851 for the maze corn.

CBOT later on developed grain futures contracts in 1865 and continues to be the most prominent

commodity derivatives exchange even today.

The equity and currency derivatives emerged in the capital markets of the United States in early

1970s in the midst of an environment of financial chaos. Thereafter their use rapidly spread to the

other financial centers such as London, Paris, Tokyo, Sydney, Zurich, Singapore and Hongkong.

By the beginning of the 1980s they were virtually all over the globe.

1.4 Features of Derivatives Markets:

The derivatives market consists of both the ‘Over-The-Counter’ (OTC) as well as ‘Exchange

Traded’ products. While the OTC market offers products which are highly customized to suit the

needs of the customers, the exchange traded products have their own advantages in terms of

elimination of the counter-party risk and enhanced liquidity as well as accessibility.

The derivatives market continues to be more liquid than the traditional ‘spot’ or ‘cash and carry’

market as a result of its leveraging effect providing more stability for the prices. It is also a highly

regulated market as the unrestrained speculation can create havoc in the entire financial system

and can distort the pricing structure in the capital markets. It also offers the risk management

solutions to the participants at relatively lower costs and without affecting the nature of the

transaction being hedged, as would be discussed subsequently.

1.5 Functions of Derivatives Market:

The derivatives enable market participants to trade in price of the underlying without actually

trading in the underlying. They help in transfer of risks from the relatively risk-averse to the risk-

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oriented people without affecting the normal business operations i.e. they alter the risk profile

without affecting the normal transactions. For example, a software company exporting its services

gets exposed to exchange rate risk if the pricing is in another countries currency. Its main

business activity do not involve taking the exchange rate risk but the risk accretion is incidental to

their normal business operations. It can mitigate the risk by selling the receivables forward to a

bank whose job is to profit from taking a well-calculated risk. Thus, derivatives incidentally

increase the breadth and depth of the markets by encouraging risk-averse people to participate in

the market. This makes them attractive instruments for hedging price risks arising out of normal

business transactions.

Derivatives normally function through payment of margins or premiums which are a small fraction

of contract values and do not require a payment of full contract value. They allow a greater control

of the risks with the use of a relatively small amount of cash and usually have a smaller transaction

cost. Thus, they also allow leveraging whereby one can take a position in multiples of the funds at

one’s disposal. As a result, the obligations of the contracting parties tend to multiply, either

favorably or unfavorably, depending on the changes in the value of the underlying. This feature of

derivatives makes them an attractive instrument from a speculator’s point of view.

Derivatives assist the markets in the price discovery. They also promote the savings and

investment over the long term, thereby increasingly contributing to the betterment of the

economies.

1.6 Traders in Derivatives Markets:

The market participants in the derivatives markets can be classified in three categories on the

basis of their intentions or objectives behind trading in derivatives. These categories are Hedgers,

Speculators and Arbitrageurs.

A Hedgers intention while entering into a derivatives transaction is to hedge or mitigate a risk

which has accrued on account some other transaction which could be as a result of his or her

normal business activity. Since his or her normal business is something else than profit from the

trading in derivatives, he or she enters into a derivatives contract to eliminate or at the least to

reduce the risk.

On the contrary, a speculator enters into a derivatives transaction to profit from an anticipated

movement in value of the underlying to a derivative product. He or she is willing to take the risk of

any adverse movement in the underlying to earn returns.

An Arbitrageur trades to simply benefit from the market imperfections which could be in the form of

discrepancy between the prices of a security or commodity in two different markets or discrepancy

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between the spot (i.e. the present) and futures price of a financial asset or a commodity.

Arbitrageur aims at earning a risk-less profit by simultaneously entering into two opposing trades in

two different markets.

1.7 Global Derivatives Market:

The global financial centers such as Chicago, New York, Tokyo and London dominate the trading

in derivatives. Some of the world’s leading exchanges for the exchange-traded derivatives are -

1. Chicago Mercantile Exchange and London International Financial Futures Exchange (for

currency & interest rate futures);

2. Philadelphia Stock Exchange, London Stock Exchange and Chicago Board Options

Exchange (for currency options);

3. New York Stock Exchange and London Stock Exchange (for equity derivatives);

4. Chicago Mercantile Exchange and London Metal Exchange (for commodities).

These exchanges account for a large portion of the trading volume in the respective derivatives

segment.

1.8 Derivative Markets in India:

Indian Equity market had a hybrid system of ‘Carry Forward’, for a specified group of shares, at the

Bombay Stock Exchange called the “Vyaj-Badala” system till the year 2001. Under this system,

the ‘Buy’ (long) and Sell (short) positions taken in equities could be carried forward from settlement

to settlement using a mechanism of Badala which was akin to a Repo. In this system, traders

used to take long or short position in the cash market itself (A long position is one where the trader

buys the security without the intention of taking delivery and a short position is created a security is

sold without having it or without the intention of delivery). The traders paid margins on these

positions. The position could be carried forward till the end of settlement (which was of a week’s

duration) and at the end of settlement, the financing of the buy and sell positions was done by a

separate set of Badala financiers. The financiers charged interest in the form of Vyaj-badala

charges and the position could be carried forward till the end of next settlement when again

Badala charges were levied afresh by a new set of financiers. The Badala charges were market

determined in the sense that a screen-based Badala financing session used to be held at the end

of settlement where the financing used to be done on the “market traded best rate basis”. Badala

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financing was rendered essential as the selling party to a long buyer could be a seller giving the

delivery requiring payment of consideration at the end of settlement and buyer could require

deliveries, since the trading under Badala was not segregated from the cash market.

The vyaj-badala transactions, however, differed from a Repo as the holder did not surrender the

securities to the financier and the financing was on the basis of only the claims to the securities.

The badala position could be carried forward for a period of three months and could be simply

rolled-over at the end of this period. There was no strict position limit and a badala position could

be initiated with a very small amount which further fuelled speculation. The trading was, as

aforesaid, not segregated from the cash market trading. As a result of this, the leveraged badala

positions could be used to severely distort the cash market prices. Hence, it was not truly a

derivatives market. In the view of the market turmoil subsequent to the meltdown in prices of the

so-called new economy ‘IT-Communications-Telecom’ stocks, the capital market watch-dog SEBI

raised serious objections about desirability and stability of the Vyaj-Badala system and directed

the Bombay Stock Exchange to discontinue the system. The brokers and traders lobbied hard for

a carry forward system without which they feared a serious crunch in the market activity sine the

Badala trading accounted for more than ¾th of the trading volumes.

The promulgation of the Securities Laws (Amendment) Ordinance, 1995 made it possible to

introduce derivatives trading in India by withdrawing the prohibition on derivatives trading. SEBI

had already been exploring the alternatives to the vyaj-badala system since long and saw

derivatives as a better alternative to the vyaj-badala system. It had set up a 24–member

committee under the Chairmanship of Dr.L.C.Gupta in November 18, 1996 to develop appropriate

regulatory framework for derivatives trading. The committee submitted its report on March 17,

1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. SEBI

also set up a committee under the chairmanship of Prof. J. R. Varma to recommend measures for

risk management in derivatives market. The committee submitted its report in October 1998

detailing the margining system, norms for brokers and real–time monitoring requirements. The

SCRA was suitably amended in December 1999 and the regulatory framework was put in place.

Derivatives trading commenced in India in June 2000 to replace the Vyaj-Badala system after

SEBI granted the final approval to this effect in May 2000. Thought the replacement of badala

was definitely on SEBI’s mind since long, the market turmoil post-February 2000 may have

hastened their entry in Indian capital market.

SEBI permitted derivative trading of two stock exchanges, NSE and BSE. Index futures

commenced trading on the National Stock Exchange (NSE) index S&P CNX NIFTY and the

Bombay stock Exchange (BSE) index BSE Sensex from June 12, 2000 and June 9, 2000

respectively. Index options were subsequently introduced in June 2001 followed by individual

stock options and futures in July 2001 and November 2001 respectively. NSE also subsequently

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introduced futures and options in its IT sectoral index CNX IT and interest rate derivatives in 91

days Treasury Bills and coupon bearing and non-coupon bearing 10-year bonds.

Equity derivatives trading has gained depth and width over the period since its launch and the

average daily trading turn-over has been gradually increasing from a miniscule Rs. 413 Crores in

the fiscal 2001-02 to cross Rs. 9000 Crores in the fiscal 2004. The derivative trading has gained

more popularity with the NSE. Today, NSE allows trading in futures and options of 2 indexes and

52 stocks. Table 1.1 provides the data on volumes clocked in NSE’s derivatives segment since

their inception. It can be concluded from the phenomenal growth in volumes and popularity of the

equity derivatives that the future will undoubtedly provide even brighter options for the Indian

capital market participants.

Table 1.1: Turnover data for derivatives at NSE (in Rs. Crores)

Month &

Year

Index

Futures

Stock

FuturesIndex Options Stock Options

Int. Rate

FuturesTotal

Average

Daily

Turnover

Call Put Call Put

Nov.04 38,277 113,524 4,979 3,813 11,968 3,237 0 175,798 8,790

Oct.04 47,188 111,695 5,029 3,501 11,685 3,121 0 182,220 9,111

Sep.04 49,497 107,123 4,280 3,164 10,762 3,546 0 178,373 8,108

Aug.04 57,924 99,590 4,192 3,192 8,501 2,603 0 176,000 8,000

Jul.04 61,124 94,009 6,059 3,853 7,611 2,682 0 175,340 7,970

Jun.04 64,018 78,392 4,915 3,558 5,338 2,085 0 158,304 7,538

May.04 82,149 92,629 6,824 3,468 7,716 1,974 0 194,760 9,274

Apr.04 79,555 121,044 4,348 2,967 9,640 2,736 0 220,293 11,015

2003-04 554,446 1,305,939 31,794 21,022 167,967 49,240 2022,130,612 8,877*

2002-03 43,952 286,533 5,669 3,577 69,643 30,488 - 439,863 1,832*

2001-02 21,482 51,516 2,466 1,300 18,780 6,383 - 101,925 413

2000-01 2,365 - - - - - - 2,365 12

*Daily turn-over calculated assuming 240 working days in a year.

Apart from equity derivatives, another well developed derivatives class happens to be the currency

derivatives which made its entry in the capital market arena in 1970s. However, initially there were

severe restrictions on the use of these derivatives and the RBI ensured that these were exclusively

used to hedge the foreign exchange risks. The liberalization process of Indian financial system set

forward in 1991-92 has resulted in the gradual removal of many restrictions which gave a boost to

the use of these derivatives. Presently, the a gamut of basic currency derivatives such as

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forwards, futures, options, swaptions and the innovative products such as Forward Spreads

Agreements (FSA), Exchange Rate Agreements (ERA), Forward Exchange Agreements), Futures

options, range forward, participating forwards, conditional forward etc. are now available to the

Indian capital market participants and their turnover is increasing by leaps and bounds.

Other Rupee derivatives such as Interest rate swaps and Forward rate agreements made their

way to Indian capital markets in July 1999. The interest rate swaps have grown from a modest

beginning in 1999 to clock a volume in excess of Rs. 1000 crore per day at present. The two-

thirds of the volume of these swaps are linked to Mumbai Interbank Forex Offer Rate (MIFOR),

which is defined as London Inter-Bank Offer Rate (LIBOR) plus INR/USD premium for the relevant

tenor, and the rest to the Overnight Interest Swaps (OIS) linked to Mumbai Inter-Bank Offer Rate

(MIBOR). There is also a significant increase in FRA trading over the same period.

The organized commodities futures trading in India dates back to 1875 when the Bombay Cotton

Trade association was formed. The futures trading in Oilseeds began in 1900 organized wheat

futures trading was established in 1913 followed by gold and silver bullion in 1920. The futures

trading in jute dates back to 1919. The commodities futures trading was, however, largely banned

during 1960s which saw a reopening in 2003 through establishment of National Commodities &

Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange of India Limited (MCX).

Presently, Futures trading is permitted in a few types of fibers, spices, oilseeds and oils, food

grains, pulses, a few other agricultural commodities such as Gur, Potato, Sugar, Rubber & Coffee

and metals. While MCX provides opportunity to trade in futures of almost all of these

commodities, NCDEX allows futures trading in 2 precious metals viz., Gold & Solver, and 22

agricultural commodities. The growing popularity of these products has enabled NCDEX & MCX

to witness average daily turnovers of over Rs. 1000 crores and Rs. 500 crores respectively, during

the calendar year 2004.

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Chapter 2. Index

2.0 Introduction:

Over the past decade or so, the BSE Sensex has become a familiar term to the Indian public and

a favorite topic of discussion among the investing community whose much of discussion during

and after the market hours is centered around the likely path of the same. The stock indices such

as Sensex and Nifty have become the barometers of the health of the Indian economy. With the

growing number of Index mutual funds, popularity of the indices is likely to grow even further. In

the subsequent discussion, we will see what constitutes the various stock indices and how they

function.

2.1 Definition of Index:

An Index is a representative basket of a class of underlying instruments or securities or variables.

Stock Indices are prepared by making a basket of the underlying shares in proportion of their

market capitalization1. The index is then calculated by multiplying these weights with the ruling

market prices, as on a specific reference date called the ‘Base Period’, of the respective shares

and reducing the sum of the products of these multiplications to 100 or 1000 or any other desired

starting index value. Changes in the market capitalization of constituent companies on account of

corporate actions such as stock splits, rights, etc are incorporated in the index through

adjustments without affecting the index value.

Let’s clarify this process with a hypothetical numerical example. Suppose we want to construct an

index consisting of shares of four companies A, B, C and D with the reference date being April 1,

2004 when we want to start with an index of

The market capitalization is the market value of a company’s total outstanding issued and paid-up

share capital and can be obtained by multiplying the number of paid-up equity shares of the

company by the ruling market price. BSE Sensex is now said to be a ‘free float’ index since for

calculating the weights in the Sensex, BSE uses free-float market capitalization by excluding the

number of shares held by the promoters from the total outstanding shares of the company from

the calculations.

100. The issued and paid capital and market prices of these shares as on the reference date April

1, 2004 and the process of calculation of respective weights in the proposed index are given in

table 2.1.

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Table 2.1

Name of

company

no. of

outstanding

shares (in

millions)

Market price of

share on April 1,

2004 (Rs.)

market capitalization

(Rs. Millions)

Weight in

index (%)

1 2 3 4 5

A 5 100 500 3.45

B 10 500 5000 34.48

C 15 200 3000 20.69

D 20 300 6000 41.38

14500 100.00

We now proceed to calculate the index by multiplying these weights by ruling market price (table

2.2).

Table 2.2

Name of

company

Weightage in

Index

Market price of

share on April 1,

2004 (Rs.)

Product of

MP x

Weight

Contribution to

the index *

1 2 3 4 5

A 3.45 100 345 1.01

B 34.48 500 17240 50.50

C 20.69 200 4138 12.12

D 41.38 300 12414 36.37

100.00 34137 100.00

Since we want to begin with an index of 100, we needed to reduce the sum of the products of

Market Price (MP) and Weight calculated in the column 4 to 100. This has been achieved by

dividing the sum of products contributions to the index by a factor of 341.37 (column 5). This factor

is used subsequently every time while crystallizing the contribution of each share to the index.

Now on the next day, as prices of the underlying shares move to different levels, the market

capitalization of the companies and hence the weights of their shares will change. The index can

then be calculated by replacing the respective weights and market prices by the revised weights

and ruling market prices and reducing their product by the factor of ‘341.37’. This is illustrated in

table 2.3.

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Table 2.3

Name of

company

Market Price (MP)

on April 2, 2004

(Rs.)

Market Cap.

(Rs.

millions)

Weightag

e in Index

Product of

MP x

Weight

Contribution

to the index

1 2 3 4 5 6

A 103 515 3.52 362.56 1.06

B 495 4950 33.79 16726.05 49.00

C 207 3105 21.19 4386.33 12.85

D 304 6080 41.50 12616.00 36.96

14650 100.00 - 99.87

Thus, it can be seen that on April 2, 2004, the index has moved down by 0.13 to 99.87. Similarly,

the index can be recalculated every moment and will change with every change in the price of any

of its constituent stocks.

One of the world’s oldest stock index, which still exists, happens to be the Dow Jones Industrial

Average which dates back to May 26, 1896. This index prepared by Charles Dow, the founder of

famous Dow theory of Technical analysis, comprised of 12 stocks. It was, however, a successor

of another index comprising of 11 stocks which Charles Dow had founded in 1984 and reported in

a financial press bulletin which later on became the famous ‘Wall Street Journal’. This index was

probably the world’s first ever stock index.

BSE Sensex, India’s most celebrated stock index so far, is a basket of the 30 leading stocks listed

and traded on the Bombay Stock Exchange. NSE’s S&P CNX Nifty, an another popular index

consists of 50 leading shares on the NSE. The stocks constituting Sensex and Nifty along with

their weights, are enlisted in table 2.4 and table 2.5, respectively. BSE Sensex is prepared by

using the reference date or base year of 1978-79 and a base value of 100. The value of Sensex is

calculated by BSE after every 15 second interval based on the latest trade prices of index scrips.

The base period for the Nifty has been the closing prices of November 3, 1995 when it was

established and set to 1000.

Another familiar Indian indices are RBI G-sec index, Index of Industrial Production (IIP), Wholesale

Price Index, Consumer Price Index etc. It may be appreciated by looking at these diverse indices

that a index can be created to represent any group of securities or variables by using appropriate

weights and values of the underlying securities and variables, to present the summary picture of

the changes in that class of securities or variables.

Table 2.4 List of stocks making up the BSE Sensex and Weights on December 23, 2004

130

Sr.

No.

Stocks in Sensex Free-Float Adj. Factor Weight (%)

1 Associated Cement Company Ltd. 0.90 1.36

2 Bajaj Auto Ltd. 0.70 2.14

3 Bharat Heavy Electricals Ltd. 0.35 1.67

4 Bharti Tele Ventures Ltd. 0.20 2.07

5 Cipla Ltd. 0.60 1.46

6 Dr Reddy's Laboratories Ltd. 0.75 1.31

7 Grasim Industries Ltd. 0.80 2.52

8 Gujarat Ambuja Cements Ltd. 0.75 1.39

9 HDFC 0.85 4.32

10 HDFC Bank Ltd. 0.75 2.83

11 Hero Honda Motors Ltd. 0.50 1.46

12 Hindalco Industries Ltd. 0.75 2.47

13 Hindustan Lever Ltd. 0.50 4.32

14 Hindustan Petroleum Corp Ltd. 0.50 1.70

15 ICICI Bank Ltd. 1.00 7.16

16 Infosys Technologies Ltd. 0.80 11.85

17 ITC Ltd. 0.70 6.02

18 Larsen & Toubro Limited 0.90 3.05

19 Maruti Udyog Ltd. 0.30 1.09

20 ONGC Ltd. 0.15 4.83

21 Ranbaxy Laboratories Ltd. 0.70 4.32

22 Reliance Energy Ltd. 0.50 1.33

23 Reliance Industries Ltd. 0.55 10.40

24 Satyam Computer Services Ltd. 0.90 3.08

25 State Bank of India 0.45 3.86

26 Tata Iron & Steel Co. Ltd. 0.75 3.85

27 Tata Motors Ltd. 0.60 2.93

28 Tata Power Co. Ltd. 0.70 1.42

29 Wipro Ltd. 0.20 2.80

30 Zee Telefilms Ltd. 0.55 1.05

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Table 2.5 List of stocks making up the S&P CNX Nifty and weights as on November 30, 2004

Sr. Company Name Industry Weight (%)

1 Asea Brown Boveri Ltd. Electrical Equipment 0.48

2

Associated Cement Companies Ltd.

Cement And Cement

Products 0.61

3

Bajaj Auto Ltd.

Automobiles - 2 And 3

Wheelers 1.22

4 Bharat Heavy Electricals Ltd. Electrical Equipment 1.81

5 Bharat Petroleum Corporation Ltd. Refinaries 1.40

6

Bharti Tele-Ventures Ltd.

Telecommunication -

Services 3.83

7 Britania Industries ltd. Foods & Food Processing 0.22

8 Cipla Ltd. Pharmaceuticals 0.99

9 Colgate-Palmolive (India) Ltd. Personal Care 0.28

10 Dabur India Ltd. Personal Care 0.30

11 Dr. Reddy's Laboratories Ltd. Pharmaceuticals 0.72

12 Gas Authority of India Ltd. Gas 2.20

13 Glaxo-smithkline Pharmaceuticals

India Ltd. Pharmaceuticals 0.77

14 Grasim Industries Ltd. Diversified 1.23

15

Gujarat Ambuja Cements Ltd.

Cement And Cement

Products 0.79

16 HCL Technologies Ltd. Computer Software 1.32

17 HDFC Bank Ltd. Banks 1.69

18

Hero Honda Motors Ltd.

Automobiles - 2 And 3

Wheelers 1.17

19 Hindalco Industries Ltd. Aluminium 1.44

20 Hindustan Lever Ltd. Diversified 3.79

21 Hindustan Petroleum Corporation Ltd. Refineries 1.37

22 Housing Development Finance Corp.

Ltd. Finance – Housing 2.35

23 I T C Ltd. Cigarettes 3.81

24 ICICI Banking Corporation Ltd. Banks 2.94

25 Indian Hotels Co. Ltd. Hotels 0.27

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26 Indian Petrochemicals Corporation

Ltd. Petrochemicals 0.53

27 Infosys Technologies Ltd. Computers – Software 6.85

28

Mahanagar Telephone Nigam Ltd.

Telecommunication -

Services 1.22

29 Mahindra & Mahindra Ltd. Automobiles - 4 Wheelers 0.68

30 Maruti Udyog Ltd. Automobiles - 4 Wheelers 1.45

31 National Aluminium Company Ltd. Aluminium 1.38

32 Oil & Natural Gas Corporation Ltd. Gas 13.84

33 Oriental Bank of Commerce Banks 0.69

34 Punjab & National Bank Banks 1.10

35 Ranbaxy Laboratories Ltd. Pharmaceuticals 2.48

36 Reliance Energy Ltd. Power 1.24

37 Reliance Industries Ltd. Petrochemicals 8.60

38 Satyam Computer Services Ltd. Computers – Software 1.64

39 Shipping Corporation of India Shipping 0.61

40 State Bank of India Banks 3.32

41 Steel Authority of India Ltd Steel & Steel Products 2.70

42 Sun Pharmaceutical Industries Ltd. Pharmaceuticals 1.10

43 Tata Chemicals Ltd. Diversified 0.37

44 Tata Engineering & Locomotive Co.

Ltd. Automobiles - 4 Wheelers 2.06

45 Tata Iron & Steel Co. Ltd. Steel And Steel Products 2.13

46 Tata Power Co. Ltd. Power 0.81

47 Tata Tea Ltd. Tea And Coffee 0.30

48

Videsh Sanchar Nigam Ltd.

Telecommunication -

Services 0.78

49 Wipro Ltd. Computers – Software 6.38

50 Zee Telefilms Ltd. Media & Entertainment 0.75

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2.2 Need of Index:

Any financial market consists of a large number of securities being traded at any point of

time. At any moment, the prices of some of them may appreciate while the prices of

others decline or remain unchanged with respect to their prices a moment ago. By

observing these prices of individual securities, it is very difficult to precisely judge the

mood of the market. An index, since it provides a representative basket of the class of

securities being observed, can capture the summary of these individual movements and

helps in understanding the general trend in that segment of the capital market. It

provides a single measure to compare the movement in the prices of that class as a

whole and assists in identifying the general trend or direction of that class of securities.

The indices such as Nifty or Sensex represent the leading stocks listed on the NSE or

the BSE, respectively and just by looking at the movement of these indices, an investor

can understand the general trend in the entire range of stocks listed on these

exchanges.

2.3 Types of Stock Indices:

The stock indices could be general indices representing the entire gamut of securities

traded on an exchange or in a market. Examples of these indices are S&P CNX Nifty

and BSE Sensex. Other indices in this category of general indices are S&P CNX 500,

CNX Nifty Junior, S&P CNX Defty, BSE 200, BSE 500, BSE 100,

Another types of stock indices are sectoral or sector-specific indices representing the

securities belonging to a select segment of a market. Examples of these types of

indices are BSE Bankex which represents Banking industry sector stocks traded on the

BSE or CNX IT of NSE which represents the stocks from Information Technology

industry sector traded on NSE. Apart from industry sector indices, indices such as Mid-

Cap index of NSE CNX Midcap 200 represents stocks of the companies whose market

capitalization and size of operation is relatively small.

2.4 Global Indices:

A stock Index basket can be created to represent equity shares listed on several stock

exchanges spread over the world or a group of countries. This index is called a global

index. An example of this is Morgan Stanley’s Emerging Market Index. In this index,

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Morgan Stanley has included stocks from developing economies such as India, Brazil,

Argentina, China, etc. Apart from applying the usual selection criteria for an individual

stock to be included in the index (which is discussed in the following section 2.5), the

country weight needs to be decided while preparing a global index. The stocks from a

particular country will then together have weights equal to the country weight.

The world’s leading agency credited with the creation of many celebrated indices viz.,

Standard & Poor (S&P) has three global indices –

1. S&P Global 1200 (covering S&P 500, S&P Europe 350, S&P/TSX, S&P/TOPIX

150, S&P/ASX 50, S&P Asia 50 and S&P Latin America 40);

2. S&P Global 100 and

3. S&P ADR Index.

The S&P Global Index constituents are leading companies from each of the 10 sectors

of the Global Industry Classification Standard (GICS). Each stock is analyzed for

liquidity, and each component region has appropriate sector representation. The size of

each region corresponds to its relative size in the global equity market based on

adjusted market value. The S&P Global indices are calculated in real time. Each

component index provides adequate country balance as well as sector balance,

mirroring the mix of that region or market. Stocks are eligible for the S&P Global Indices

if they meet criteria for size, liquidity, profitability, and sector and market representation.

Each of the component indices is balanced across country and sector weights in the

region/market. The S&P Global Indices begin with an eligible investible universe of

stocks covering 95% of each country’s total market capitalization. Stocks with relatively

small market capitalizations or insufficient liquidity are excluded.

2.5 Selection Criteria:

There are thousands of stocks listed on any well-established stock exchange or market.

From among these stocks, choosing a few stocks for their inclusion in the stock index

becomes a daunting task. It necessitates evolution of an objective selection criteria

which will help in identifying the stocks that can truly be a representative sample of the

underlying class of stocks and which will be amenable to as minimum a distortion as

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possible. Following selection criteria are normally used for selection of such index

stocks.

1. Market Capitalization & Industry Representation:

While designing a non-sectoral index, It is first necessary to identify a tentative

proportion of representation for stocks from various industrial sectors.

Scrip selection takes into account a balanced representation of the listed companies in

the universe of the stock exchange. The index companies should be leaders in their

industry group. For example, companies eligible for inclusion in Nifty must have a six

monthly average market capitalization of Rs.500 crores or more during the last six

months. BSE requires a company to belong to top 100 companies listed with the BSE

by market capitalization to be considered for inclusion in Sensex.

2. Liquidity and Impact Cost:

The stock chosen should have sufficient liquidity. This means that the stock should

witness a large trading volume. This will ensure that the stock is among one of the

popular stocks from a particular sector and will truly reflect the market participants’ view

of the sector as well, apart from their view of the stock itself. This will also discourage

any manipulation in the price of the stock as an illiquid stock can be manipulated at the

expense of very limited resources whereas to manipulate an actively traded stock with

large volume, much more resources would be required.

Apart from trading volumes, another measure of liquidity is impact cost. To be eligible

for inclusion in an index, a security should be trading at a fairly low average impact cost.

Impact cost is cost of executing a transaction in a security in proportion to the weight of

its market capitalization as against the total market capitalization of the index at any

point of time. This is the percentage mark up suffered while buying / selling the desired

quantity of a security compared to its ideal price (best buy + best sell) / 2.

For example, the market shows following pending buy / sell order position at a particular

time:

Buy (Qty.) Buy (Price) Sell (Qty.) Sell (Price)

1000 98 1000 99

2000 97 1500 100

1000 96 1000 101

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To Buy 1500 Shares : Ideal Price would be = (99 + 98)/2 = 98.5.

Actual Buy Price will, however, be = (1000 X 99 + 500 X 100)/1500 = 99.33.

Hence for buying 1500 shares, Impact Cost would be = [(99.33 - 98.5)/98.5] X 100 =

0.84%.

BSE judges the liquidity of a company to be included in sensex on three parameters viz.,

trading frequency, average daily turnover and average daily trades and requires that the

scrip to be considered for inclusion in sensex should be among the top 150 traded scrips

listed on BSE every day for the previous one year.

3. Floating Stock:

The floating stock means stocks which are not held by the promoters and their

associated entities. It is desirable to include companies with higher floating stock in the

index. This will in turn improve the liquidity in the stock and reduce the chances of

manipulation. For example, the companies eligible for inclusion in S&P CNX Nifty need

to have at least 12% floating stock.

4. Listed History & Track Record:

The company is required to have listing for a specific past period and is expected to

have a good track record for being considered for inclusion in the index.

2.6 Sectoral Indices:

Some of the sectoral stock indices developed by NSE are CNX IT, CNX Bank,

CNXFMCG, CNX PSE, CNX MNC, whereas BSE has its own sectoral indices viz., BSE

IT, BSE Consumer Durables, BSE TECk and BSE PSU. NSE additionally has industry

indices created by segregating stocks forming a part of S&P 500 index by their

respective industrial sector.

2.7 Index-based Funds:

The past decade has witnessed a launch of several Index-based mutual fund schemes

by the Indian mutual funds. Index based mutual fund scheme aims at creating a

portfolio of investments which is an exact replica of the index it is tracking. So, a

scheme based on S&P CNX Nifty will have 50 stocks in its portfolio in the same

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proportion as their respective weight in the Nifty. However, although the fund managers

endeavor to replicate the index as closely as possible, there remains a small tracking

error in the neighborhood of 1% to 1.5%. The returns on the fund could (generally) fall

short or (rarely) exceed the returns on the underlying index. This discrepancy arises on

account of a few factors such as “the tracking error”, transaction costs and cash portion

of the total investible funds, as explained below:

1. Tracking Error:

As it has been seen from the section 2.1 above that the weights of the securities in the

index are directly proportionate to their market capitalization, the weights change, albeit

by a very small fraction, with every small change in the prices. Hence, it becomes

practically impossible for the fund managers to maintain exactly the same proportion of

each stock in their portfolio resulting in a slight deviation in the composition of fund

scheme vis-à-vis the composition of index going forward which in turn, leads to a

deviation in the scheme returns.

Second factor giving rise to tracking error is the limitation that a stock can not be bought

in fractional value. The minimum quantity one can buy is one share and if portfolio

weight of a particular stock, say Infosys Technologies, in index demands that the

number of shares of Infosys in a particular fund scheme with a corpus of Rs. 400 crores

be equal to 1304.7619, it is not possible to have exactly the same number of shares as

0.7619 shares can not be bought. So the fund manager can either settle for 1304

shares or 1305 shares in his portfolio. These two factors give rise to the tracking error.

2. Transaction Costs:

Loading of transaction costs while buying and selling the shares lead to reduction in

returns to the index fund unit holders.

3. Cash component:

Funds need to hold a small portion of the investible funds in the form of cash to take

care of daily redemptions etc. This cash portion is just 1% to 2%. However, this portion

yields no return to the scheme and hence returns from the scheme can fall short of the

return on the index by that much fraction.

The loading of fund management fees also contribute to the reduction of returns to

investors to a small extent of 2% to 3%.

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The major index-based mutual fund schemes available in India are listed below:

1. Birla Sunlife Index (Dividend)1 and Index (Growth)1 Funds

2. Canbank Index (G) & (D) Funds

3. HDFC Index Nifty & Index Sensex Funds

4. LIC Index Nifty (G) & (D) Funds and Index Sensex (G) & (D) Funds

5. LIC Index Sensex Advantage (G) & (D) Funds

6. Principal Index Fund

7. Prudential ICICI Index Fund

8. Tata Index Nifty A & B Funds and Index Sensex A & B Funds

9. UTI Index Adv. Nifty Fund and Index Adv. BSE Sensex Fund

10. UTI Master Index Fund & UTI Nifty Index Fund

11. UTI Index Select Equity Fund

2.8 Exchange Traded Funds:

Exchange Traded Funds (ETFs) are simply portfolios of securities that are formed to

replicate the index to be tracked and are traded, like individual stocks, on an exchange.

They first came into existence in the USA in 1993 and have gained such a tremendous

popularity over years that about 60% of trading volumes today on the American Stock

Exchange are from ETFs.

Unlike the Mutual funds, the units of ETFs are not sold to the public. The Asset

Management Company that sponsors the ETF takes the shares of companies

comprising the desired index from large investors and institutions in exchange for ETF

units. Since dividend may have accumulated for the stocks at any point in time, a cash

component to that extent is also taken from such investors. Thus, a large block of ETF

units called a "Creation Unit" is exchanged for a "Portfolio Deposit" of stocks and "Cash

Component".

The number of outstanding ETF units is also not limited, as with traditional mutual funds.

It may increase if investors deposit additional shares to create ETF units; or it may

reduce on a day if some ETF holders redeem their ETF units for the underlying shares.

These transactions are conducted by sending creation / redemption instructions to the

Fund. The Portfolio Deposit closely approximates the proportion of the stocks in the

index together with a specified amount of Cash Component.

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ETF units are continuously created and redeemed based on investor demand. Investors

may use ETFs for investment, trading or arbitrage. The price of the ETF tracks the value

of the underlying index. This provides an opportunity to investors to compare the value

of underlying index against the price of the ETF units prevailing on the Exchange. If the

value of the underlying index is higher than the price of the ETF, the investors may

redeem the units to the Sponsor in exchange for the higher priced securities.

Conversely, if the price of the underlying securities is lower than the ETF, the investors

may create ETF units by depositing the lower-priced securities. This arbitrage

mechanism eliminates the problem associated with closed-end mutual funds viz. the

premium or discount to the NAV. This “in-kind” creation / redemption facility ensures

that ETFs trade close to their fair value at any given time.

2.8.1. Advantages of ETFs

ETFs provide exposure to an index or a basket of securities that trade on the exchange

like a single stock. They offer a number of advantages over traditional open-ended index

funds as follows :

1. While redemptions of Index fund units takes place at a fixed NAV price (usually

end of day), ETFs offer the convenience of intra-day purchase and sale on the

Exchange, to take advantage of the prevailing price, which is close to the actual NAV of

the scheme at any point in time.

2. Unlike listed closed-ended funds, which trade at substantial premia or more

frequently at discounts to NAV, ETFs are structured in a manner which allows

Authorized Participants and Large Institutions to create new units and redeem

outstanding units directly with the fund, thereby ensuring that ETFs trade close to their

actual NAVs.

3. Since an ETF is listed on an Exchange, costs of distribution are much lower and

the reach is wider. These savings in cost are passed on to the investors in the form of

lower costs. Further, the structure helps reduce collection, disbursement and other

processing charges.

4. ETFs protect long-term investors from inflows and outflows of short-term

investors. This is because the fund does not incur extra transaction cost for

buying/selling the index shares due to frequent subscriptions and redemptions.

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5. Tracking error, which is divergence between the NAV of the ETF and the

underlying Index, is generally observed to be low as compared to a normal index fund

due to lower expenses and the unique in-kind creation / redemption process.

6. ETFs are highly flexible and can be used as a tool for gaining instant exposure to

the equity markets, equitising cash or for arbitraging between the cash and futures

market.

2.8.2. The first ETF in India, “Nifty BeEs (Nifty Benchmark Exchange Traded Scheme)

based on S&P CNX Nifty, was launched in January 2002 by Benchmark Mutual Fund. It

can be bought and sold like any other stock on NSE.

Other ETFs Launched on NSE are -

1. S&P CNX Nifty UTI Notional Depository Reciepts Scheme (SUNDER)

2. Liquid Benchmark Exchange Traded Scheme (Liquid BeES)

3. Junior Nifty BeES

4. Bank BeES

2.8.3. A schematic diagram of functioning on ETF is reproduced below with the

courtesy of the National Stock Exchange.

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3. Forwards & Futures

3.1. Forward Contract:

The simplest and the most basic form of derivative products is a forward contract. A

Forward Contract is an agreement between two parties to buy or sell a specific number

of securities or a specific quantity of commodities at a certain time in future but at a price

determined at the time of entering into the contract.

Forward contracts are traded in the Over-The-Counter market. It is a highly customized

derivatives product where the terms of the contract are decided by two contracting

parties through one to one negotiations. Forward contracts for the Currencies and

Interest Rates are actively traded in India. However, forward contracts in stocks are not

traded.

Examples of a forward contract could be a forward contract entered into by two parties A

& B on December 20th, 2004 where A has contracted to buy 10 tons of Kalyansona

wheat for a price of Rs. 20,000 per ton from B on April 20, 2005. On April 1, 2005, B will

deliver 10 tons of wheat to A and A will make a payment of Rs. 200,000 to B. Here, one

can say that A has bought 10 tons of wheat forward and B can be said to have sold 10

tons of wheat forward, for four months.

The commodity or security being sold or bought forward is called as the ‘underlying’, a

notation which we will be using throughout the further discussion.

3.2. Features of Forward Contracts:

The key terms of a forward contract are-

1. Delivery date or Maturity date: Delivery date or Maturity date of a forward

contract is the date on which the exchange of the security or commodity bought or sold

forward and its consideration, takes place. Since the forward contracts are entered into

by two parties through one-to-one negotiations, the delivery date could span a wide

range of time period, from 1 day to several years.

2. Contract Size: The size of the contracts means the number of securities

or quantity of commodity bought or sold forward. This again can vary widely depending

upon the needs of the contracting parties.

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3. Mode of Delivery or Settlement : The forward contract will specify the mode of

delivery particularly for commodity and currency forwards. The party buying the

commodity or the currency forward will indicate where the delivery of the currency or

commodity should be given and the parties selling will indicate where the payment

should be made. For the commodity forwards or even for interest-bearing securities

forwards, the parties will also include clauses on quality of the delivery. This means that

the parties to a forward contract for rice will specify the quality of the rice to be delivered

in terms of their classification, grade, etc.

4. Price: The price to be paid by the buyer of the forwards is decided or fixed at the

time of entering into the contract. It is obligatory on the part of the seller to sell the

underlying commodity or security and buyer to buy the same at this price irrespective of

the ruling price of that commodity or security at the maturity date.

Thus, a forward contract, once entered upon, creates an obligation for both the parties to

the contract to perform their part of the contract. A failure to do so would expose them to

the provisions of the Indian Contract Act, 1872.

Forward contract provides an opportunity to businesses to hedge their risks at a

reasonable cost. Business entities having a future obligation or liability in some foreign

currency are exposed to the risk that the currency in which they need to make a future

payment might appreciate substantially vis-à-vis their home currency by the time the

payment becomes due, requiring them to acquire that currency at a substantially higher

cost. The businesses which expect to receive a foreign currency asset in future are

exposed to a risk of depreciation of that currency which will result in reduction the value

of the asset when it is acquired. Similarly, the businesses which need an agricultural

commodity of a metal as their raw-material face the risk of increase in price of the

commodity in future which they need to guard against. Alternatively, a farmer producing

crop faces the risk of the prices of the commodities falling by the time he is able to

produce them & sell them in the market. All of these parties can use forward contracts

to eliminate their price risks altogether.

Needless to say that forwards provide one more trading ground to the speculators and

arbitrageurs.

3.3. Forward price:

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The forward price is normally different from the spot or the cash-market price. It is either

higher or lower than the ruling spot price. When forward price for an underlying is higher

than the spot price, the underlying is said to be at a ‘forward premium’ and if the price is

lower than spot price, the underlying is said to be trading at a ‘forward discount’. But

why should it be at a forward premium or discount? Lets consider a few situations:

For a hedger entering into a forward contract to hedge a future liability or requirement, or

for a speculator entering into a forward contract in expectation of a rise in the price of the

underlying, another alternative would be to buy the underlying and hold it till the delivery

date. But this will require them to make the immediate payment for the same and in

case of commodities such as food grains or metals would also require them to incur the

storage cost. The forward price should ideally include the interest cost of the funds

locked-in by purchasing the underlying right now instead of contracting forward and also

the storage costs, if applicable. These costs are together referred to as the ‘cost of

carry’ or the ‘carrying cost’ and the price of a forward contract is theoretically expected

to reflect these costs.

Thus, Forward Price = Spot Price + Cost of Carry.

This consideration of cost of carry requires forwards to be at a premium as a rule. This

is generally the case for commodity forwards. The forward premium also goes on

reducing in a linear fashion till the maturity date and on maturity, the forward price

equals the spot price. This could be shown graphically below in figure 3.1.

Fig.3.1. Movement in the Forward price as compared to Spot Price of underlying

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However, apart from these costs, there is an additional risk of loss of profits in case the

underlying you are selling might command a higher price on the maturity date. At times,

the market forces may have a pessimistic view of the prices of the underlying and

forward price is also governed by the market expectations of the price of the underlying.

If the expected depreciation of the price of the underlying surpasses the cost of carry,

then it forces the underlying to trade at a discount, at times. This is particularly obvious

for currencies where the factors such as interest rate differentials between two countries

force a currency to trade at a discount with respect to another currency.

3.4.Futures:

Futures are nothing but exchange-traded and standardized forward contracts. The

futures are standardized in terms of size of a contract, maturity dates and delivery

mechanism. The futures are traded on organized exchanges and significantly differ from

the forward contracts in terms of the regulation of trading and enforceability as brought

out in the subsequent discussion. The party which buys the future is said to be going

long and if the price of the underlying appreciates in between the date of entering into

the contract and the expiry date of the contract, the ‘long’ gains and if price falls in the

intermediate period till expiry, it loses. The party which sells the future is on the other

hand is called going ‘short’ and the ‘short’ gains on falling price and loses on the rising

price.

The Indian stock exchanges viz., NSE &BSE have introduced stock index and stock

futures beginning June 2000. There are also well established international exchanges

for trading in commodity futures, currency futures, and interest rate futures which can be

selectively accessed by the Indian nationals subject to certain compliances.

For example, buying one Tata Power, January 2005 futures contract of NSE for Rs.

380.60 confers a right and obligation on the buyer to purchase 800 shares of Tata Power

at the end of trading day on January 27, 2005 at the rate of Rs. 380.60 per shares. It

also confers a right and obligation on the seller of the contract to sell those 800 Tata

Power shares at the agreed price on the expiration day mentioned above.

One Soy Bean Futures contract on NCDEX has following specifications:

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Table 3.2:

Hours of Trading

Mondays through Fridays

Morning Session - 10:00 AM to 05:00 PM

Pre-open Session - 05:25 PM to 05:30 PM

Evening Session - 05:30 PM to 11:55 PM

Saturdays

10:00 AM to 02:00 PM

On the expiry date, contracts expiring on that day

will not be available for trading after 5 PM

Unit of trading 100 Quintal (=10 MT)

Quotation/Base Value Rs. per Quintal

Tick size 5 paise

Price BandLimit 10%. Limits will not apply if the limit is

reached during final 30 minutes of trading.

Quality specification

Moisture: 10% Max

Sand/Silica: 2% Max

Damaged: 2% Max

Green Seed: 7% Max

Quantity variation +/- 2%

No. of active contracts

At any date, 3 concurrent month contracts will be

active. There will be a total of twelve contracts in

a year.

Delivery Centers Indore

Opening of Contracts

Trading in any contract month will open on the

21st day of the month, 3 months prior to the

contract month i.e. Feb 2003 contract opens on

21th November 2002.

Due Date20th day of the delivery months, if 20th happens

to be holiday then previous working day.

Position limits Member-wise: Max (Rs. 40 crore, 15% of open

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interest)

Client-wise: Max (Rs. 20 crore, 10% of open

interest)

Similarly, one futures contract on ‘Euro’ currency on the Chicago Mercantile Exchange

(CME) has a contract size of Euro 125,000 and contracts are available for 6 months

including March, June, September, December, Current month & next month. One 13-

weeks US Treasury Bill Interest Rate future on CME represents a 3-month US Treasury

Bill of face value USD 1,000,000 and contracts available for 6 maturities viz., March,

June, September, December, Current month & next month. Expiry date for the CME

contracts is third Wednesday of the respective month.

3.5. Difference between Futures & forwards:

Futures are standardized forward contracts. The standardization in features that

segregates the futures as a distinct class of forward contracts as against the general

OTC forward contracts, are brought out in Table 3.1 below.

Sr. Forwards Futures

1. Forwards contracts are traded

Over The Counter.

Futures are traded on organized

exchanges.

2. Forward contracts are bilateral

contracts and hence, the parties

to the contract are exposed to the

counter-party default risk. In case

of the default of the opposite

party, a trader in forwards has to

seek legal recourse under Indian

Contract Act 1872 which is

expensive and time-consuming.

Futures traders deal not with one another

but with the clearing house of the

exchange. As is the case with trading in

shares on stock exchanges where every

buyer or seller buys or sells the shares from

or to the clearing house of the exchange, in

case of futures also, the default risk is

bourn by the clearing house of the

exchange in which the trading is taking

place. The buyers and sellers are thus

insulated from the counter party default risk.

3. Forward contracts are highly Futures contracts are standardized in terms

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customized and each contract is

unique in size, maturity and asset

quality.

of size, expiry and asset quality. For

example, one futures contract in the Nifty

index is for 200 units of index baskets,

contracts for three months viz., current

month and the next two months, are

available and composition of Nifty is well-

defined (quality).

4. Settlement of contract normally

takes place through delivery. If,

however, a party wishes to

reverse the contract before expiry,

it has to go to the same counter-

party.

Settlement of contracts can be either

through delivery of the underlying or

through a cash settlement of the difference

in contract price and the actual ruling

market price of the underlying on the expiry

date. Futures position, however, can be

easily ‘closed out’ by any party by entering

into an opposite contracts on the same

exchange. Any difference in the two

contract prices viz., initial contracted price &

reversing contract price, will be its profit or

loss.

5. Forward contracts normally result

in delivery.

Delivery is rare in the futures contracts and

the majority of the contracts are closed out

before maturity by the participants and are

settled by payments of differences without

any actual delivery of the underlying assets

taking place.

6. Forward markets are normally

preferred by the hedgers who

need customized contracts. It

does not really help the markets in

price discovery.

Futures market, due to its ease of access,

attracts all three classes of traders viz.,

hedgers, speculators, arbitrageurs, and

greatly helps in price discovery of the

underlying.

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7. Forwards do not require payment

of margins

Exchanges have well-defined margin

payment requirement for the futures

trading. The margin is collected by the

exchange from the traders at the end of

trading day on which the contract is entered

into. The margin is marked-to-market at the

end of every subsequent trading day based

on the day’s closing prices and traders with

adverse margins are required to pay the

differences.

Advantages and Limitations of Forwards & Futures:

Advantages

1. Since forward contracts do not have

margin requirements and brokerage to

be paid to the intermediaries, the cost of

entering into the transaction for both the

parties is zero.

1. Absence of credit risk – The

counter-party risk is eliminated altogether. At

any point, the maximum credit risk to the

exchange is also limited to a day’s

fluctuation in prices through marked-to-

market margin payment requirements.

2. High Liquidity – Futures market

allow the traders to close-out their positions

at any point of time.

3. Price stabilization – Futures market

helps the participants to hedge their cash

positions and helps to reduce the violent

price fluctuations.

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Limitations

1. Presence of counter-party default

risk

2. The prices are not transparent as

there is neither a reporting requirement

nor is any centralized trading platform.

3. The profit or loss is crystallized

only on expiry of the contract.

4. Compulsory settlement.

1. Futures are not tailor-made. Hence, they

offer poor hedging instruments as the

futures which exactly match the maturity

and size of the exposure to be hedged may

not be available.

Also, the futures to hedge medium to long

term exposures are totally unavailable.

3.6. Different Terminologies of Futures:

Finance, like any other discipline, has a language of its own. The various terms one

encounters when tracking the futures market, are discussed below:

1. Futures Price: This is the monetary price consideration per unit of the

underlying, at which the party selling the futures contract agrees to sell. At

any point in time, there will be several buy and sell orders pending on the

exchange’s trading system which are continuously matched by the system.

The price of an order for buying is called ‘Bid’ price and the price for selling is

called ‘Ask’ or ‘Offer’ price. The trade takes place when the bid and ask

prices match or when a bid exceeds the ask price of an order.

2. Delivery Date or Maturity Date or Expiration Date: This is the date on

which the performance of the obligation under the futures contract is carried

out by the two contracting parties. This date normally corresponds to a fixed

day of the month in which the contract expires.

3. Lot Size or Market Lot: It is the quantity of the underlying, which will be

exchanged under one futures contract.

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4. Tick Size or Price Step: It is the minimum price variation allowed in the price

of the futures contract. A trader can increase or decrease his bid or offer

price by this amount.

5. Contract Months or Delivery Months: These are the months for which a

futures contract is available or permitted to trade.

6. Price Limit or Price Band: This is the price band in which futures trading is

allowed. If the futures trading is not permitted at a price, which is beyond the

either limit of this band. This price band is valid for one day. There could

also be a larger price band applicable to a week’s trading.

7. Settlement price: This is the price used for settlement of the futures contract

on delivery or expiry date when the option of settlement of future by payment

of cash difference is permitted.

Marking-to-market mechanism of the futures effectively results in daily

settlement of the contract. For the daily settlement, the day’s closing price is

taken as the settlement price. For NSE’s index and stock futures, the closing

price is actually the weighted average price of the last half-hour of trading.

This price is used for calculation of the changes in the margins of the traders.

8. Number of active contracts: This is the number of futures contracts for

different delivery months available for trading at any point of time.

9. Delivery Center: For commodities or currencies, it is the place at which

physical delivery of the underlying commodity or currency is given and

accepted.

10. Contract Value: This is nothing but value of one futures contract and is

obtained by multiplying the lot size of one futures contract by the ruling

market price of the same.

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11. Open Interest: This represents the quantity of underlying pertaining to the

futures contracts outstanding at the given point of time. Whenever, futures

contract is traded by two parties, an open position is created equal to the lot

size of the futures contract. This is obtained simply by

multiplying the number of futures contracts outstanding in a specific

underlying by the lot size of one futures contract in the same.

12. Position Limits: These represent the maximum futures contract position that

can be created. There are restrictions imposed by the exchange on the

client-wise position, member-wise position and market-wide position.

A client-wise position limit specifies maximum open interest a single client

can create in the futures contracts of an underlying with a specific expiry

date. A member-wise position limit dictates the maximum position in

particular contracts that can be built by a trading member of the exchange,

whether on his own account or combined with his clients positions.

A market-wide position limit restricts the creation of the total open position in

a particular futures contract. Once the open interest in a particular futures

contract reaches this level, no further building of position is permitted in that

contract.

For example, the client-wise and market-wide position limits for TISCO

January 2005 futures on NSE have been fixed at 4079001 and 81580033.

Any client is allowed to build an open position in TISCO January 2005 futures

up to 4079001 underlying TISCO shares and no further. Similarly, the

moment the open interest in TISCO reaches to 81580033 underlying shares,

no further creation of open position will be allowed by the exchange. Only the

members who already have positions will be able to square their position up.

13. Base Price: The base price for the first day of trading of a contract is the

theoretical futures price. For subsequent days, the base price would be

settlement price meaning the previous day’s closing price.

14. Quantity Freeze: If a buy or sell order for futures is greater than 1% of

market-wide trading position or Rs. 5 crores of value of the futures contracts,

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the exchange requires the member placing the order to reconfirm to the

Exchange that there is no inadvertent error in the order entry and that the

order is genuine.

3.7. Index & Stock Futures:

The Indian capital market witnessed commencement of index futures trading in June

2000. As has been already brought out in the introduction, Index futures were allowed

on the National Stock Exchange’s prime index S&P CNX NIFTY and the Bombay stock

Exchange’s prime index BSE Sensex from June 12, 2000 and June 9, 2000 respectively.

Individual stock futures were introduced subsequently in November 2001 on both the

exchanges. Today, NSE allows trading in futures of its 2 indices and 52 individual

stocks whereas BSE permits futures trading in its Sensex and 50 individual stocks.

Like forwards, the price of the index and stock futures may be different than the spot or

cash price of the underlying and it may trade at a premium or discount or ‘at par’ with

respect the ruling market price of the underlying based on considerations of the cost of

carry which reflects the ruling interest rates and other market expectations.

A list of the index, stock and interest rate futures permitted to be traded on the NSE

along with the industrial sectors of the underlying stocks and lot sizes of the contracts is

given in table 3.3.

3.7.1. Futures Trading:

The futures trading system involves mechanisms for trading, clearing & settlement.

Trading: Trading on NSE & BSE is carried out through the online real-time

electronic screen-based systems. NSE facilitates the trading in derivatives segment

through its online real-time 'National Exchange for Automated Trading' (NEAT) system

which has a network covering 323 cities in India as of the end-November 2004. BSE

has its own ‘BSE On-Line Trading’ (BOLT) system and now allows its member-brokers

to set up trading terminals anywhere in the country. The trading on screen-based

electronic system significantly improves the efficiency and accessibility of the trading

compared to the earlier ‘Open Outcry’ system, ensures utmost transparency, reduces

transaction costs significantly and facilitates stricter regulation of the trading.

The trading system involves 3 components viz., a Host Computer where trade is

processed, Computer trade terminals where trade orders are keyed in and network joining

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trade terminals with the host computer. The host computer continuously matches the

orders entered into the system.

Futures on Indices

No. Underlying Symbol Market Lot

1 S&P CNX Nifty FUTIDX NIFTY 100

2 CNX IT FUTIDX CNXIT 100

Futures on Individual Securities

No.Underlying

Sector Market Lot

1 Associated Cement Co. Ltd. Cement 1500

2 Andhra Bank Banking 4600

3 Arvind Mills Ltd. Textiles 4300

4 Bajaj Auto Ltd. Automobiles 400

5 Bank of Baroda Banking 1400

6 Bank of India Banking 3800

7 Bharat Electronics Ltd. Engineering 550

8 Bharat Heavy Electricals Ltd. Electrical Equipment 600

9 Bharat Petroleum Corp. Ltd. Oil & Gas 550

10 Canara Bank Banking 1600

11 Cipla Ltd. Pharmaceuticals 1000

12 Dr. Reddy's Laboratories Ltd. Pharmaceuticals 200

13 GAIL (India) Ltd. Oil & Gas 1500

14 Grasim Industries Ltd. Diversified 350

15 Gujarat Ambuja Cement Ltd. Cement 1100

16 HCL Technologies Ltd. Information Technology 1300

17 Housing Dev. Finance Corp. Ltd. Financial Services 600

18 HDFC Bank Ltd. Banking 800

19 Hero Honda Motors Ltd. Automobiles 400

20 Hindalco Industries Ltd. Aluminium 300

21 Hindustan Lever Ltd. Diversified 2000

22 Hindustan Petroleum Corp. Ltd. Oil & Gas 650

23 ICICI Bank Ltd. Banking 1400

24 I-FLEX Solutions Ltd. Information Technology 300

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25 Infosys Technologies Ltd. Information Technology 200

Futures on Individual Securities

No.Underlying

Symbol Market Lot

26 Indian Petrochemicals Corp. Ltd. Petrochemicals 1100

27 Indian Oil Corporation Ltd. Oil & Gas 600

28 ITC Ltd. Diversified 300

29 Mahindra & Mahindra Ltd. Automobiles 625

30 Maruti Udyog Ltd. Automobiles 400

31 Mastek Ltd. Information Technology 1600

32 Mahanagar Telephone Nigam Ltd. Telecommunications 1600

33 National Aluminium Co. Ltd. Aluminium 1150

34 National Therm. Power Corp. Ltd. Power 3250

35 Oil & Natural Gas Corp. Ltd. Oil & Gas 300

36 Oriental Bank of Commerce Banking 1200

37 Punjab National Bank Banking 1200

38 Polaris Software Lab Ltd. Information Technology 1400

39 Ranbaxy Laboratories Ltd. Pharmaceuticals 400

40 Reliance Energy Ltd. Power 550

41 Reliance Industries Ltd. Petrochemicals 600

42 Satyam Computer Services Ltd. Information Technology 1200

43 State Bank of India Banking 500

44 Shipping Corporation of India Ltd. Shipping 1600

45 Syndicate Bank Banking 7600

46 Tata Consultancy Services Ltd. Information Technology 250

47 Tata Power Co. Ltd. Power 800

48 Tata Tea Ltd. Tea 550

49 Tata Motors Ltd. Automobiles 825

50 Tata Iron and Steel Co. Ltd. Steel 1350

51 Union Bank of India Banking 4200

52 Wipro Ltd. Information Technology 600

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The following list has been changed and is updated to 118 Securities.

Futures on Interest Rates

No. UnderlyingSymbol

Market Lot

1 Notional 10 year bond

(6 % coupon )

N FUTINT NSE10Y06 2000

2Notional 10 year zero coupon bond

N FUTINT NSE10YZC 2000

3 Notional 91 day T-Bill N FUTINT NSETB91D 2000

The exchanges allow only their members to trade in futures similar to individual stocks.

Futures traders other than exchange members are essentially required to transact

through a member of the exchange (popularly called as the broker). However, a

member of the exchange who is allowed to trade in the capital markets (Cash market)

segment does not automatically get entitled to trade in derivatives or F & O segment.

The derivatives trading entitlement has to be obtained by the member separately from

the exchange.

Traders are required to open an account with a member-broker who is entitled to trade in

derivatives segment on the exchange, by completing the formalities requiring filling up of

the account-opening form, signing up of the legal contract and submitting the required

documents towards personal verification, address proof and a letter from a bank

attesting signature. Thereafter, the trader can buy or sell a futures contract by placing

an order with the broker or his sub-broker. The order is normally placed through

telephone. The trader is required to specify the future of which underlying is to be

bought or sold, the number of contracts, delivery month. Depending on the type of order

being placed, trader may or may not specify the price at which the trade should be

carried out. The various types of orders that can be placed are enumerated below.

Order types: Various types of orders that can be placed by the traders in stock & index

futures segment with NSE are-

1. Market order - The trader placing a market order does not specify a specific price for

buying or selling a futures contract but instructs the broker to buy or sell at the currently

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best available price. Thus a market order essentially means trading at the best available

price in the market and results in immediate execution. The market order also has

variants viz., ‘Market on Open’ order which requires the broker to trade at the opening

price range and ‘Market on Close’ which requires the trade to be carried out at the last

moment of trading for the day.

There is another variant of market orders viz., ‘All or None’ orders. An ‘All or None’

order requires that a buy order for a specific number of contracts, be matched with

another single sell order which has specified exactly same number of contracts for

selling. This feature allows the market participants to execute ‘Block Deals’. NSE

presently disallows this type of order.

2. Limit Orders – The limit order for selling specifies a lower limit up to which sell should

take place and a limit order for buying specifies the maximum price up to which the

buying should be carried out. The order takes the form of the limit price or better.

A variant of the limit order is ‘Minimum Fill’ or ‘Fill or Kill’ order which specifies that a

minimum number of contracts should be immediately available for buying or selling. If

this minimum quantity is not available for buying or selling within the limit price, the order

is cancelled. This variant is also presently disallowed by NSE.

3. Stop loss order - Stop loss orders are placed by the traders after executing their

trade. It specifies a trigger in the loss zone1 for the trader beyond which if the price

moves, the order is converted into a market order and the trader’s position is

immediately liquidated to prevent further losses. After placing stop-loss order, the

system automatically activates the order once trigger price is crossed.

Example: A trader buys Nifty index January 2005 future at 1972.15 and puts a stop loss

order at 1960 which is immediately fed into the trading system by the broker. It,

however, remains in the memory of the system and does not get activated till Nifty falls

below 1960. If the Nifty index subsequently falls and crosses below 1960 by any value,

the stop loss order will get activated to take a form of a market order and the trader’s buy

position will be immediately liquidated by execution of a sell order at the ruling market

price. Thus a trader would be shielded from any further losses and his loss would be

limited to a slightly above Rs. 2,430/- plus brokerage costs.

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4. Good till Day order - This offer remains valid and pending in the trading system till

the end of the trading day. However, if it could not get executed till the end of the trading

day, it is automatically removed from the system. On the next trading day, the trader

would be required to specify another order, if he chooses to do so.

5. Good till Cancelled order - This offers remains valid till it is cancelled, if such

cancellation takes place within the next 7 calendar days. It, however, lapses

automatically at the end of 7th calendar day from the day of placing of such order.

6. Good till Date order - This type of order is placed by specifying a date in future till

which time the order will remain valid and pending in the trading system.

Order Matching: As has been said earlier, at any moment, there would be several

buy and sell orders pending on the trading system of the exchange which are

continuously matched with each-other. The matching process is prioritized on the basis

of their price and time of entry into the system. The trade orders with the highest bid and

lowest ask will get priority over the others and amongst the same price orders, the order

that has been entered first will get priority over the other orders. The matching process

halts when there are no overlapping bid & ask orders left. Then the highest bid price

(which is lower than lowest ask price) and the lowest ask price are displayed on system

screen. At the next moment, a next bid order could be placed which matches the ask or

a bidder may be tempted to raise his bid to match the ask, resulting in a new futures

contract. After this trade takes place, the best i.e. highest bid and the best i.e. lowest

ask from amongst the remaining pending orders are displayed on the screen as the best

‘buy’ and ‘sell’ quotes.

Table 3.4 provides a sample futures quotes from the NSE. It lists top 10 most active

contracts on NSE on January 13, 2005 at 3.30 pm.

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Table 3.4.

As on 13-JAN-2005 15:30:08 Hours IST

Instru-

ment

Type

Underlying Expiry DateHigh

Price

Low

Price

Prev.

Close

Last

Price

No. of

contract

s traded

Turnover

in Rs.

Lakhs

Underlying

Value

1 2 3 4 5 6 7 8 9 10

FUTIDX NIFTY 27JAN2005 1960.00 1907.40 1916.05 1950.25 98742384347.3

11958.90

FUTSTK TCS 27JAN2005 1344.00 1275.55 1304.55 1295.85 38343125619.3

41293.10

FUTSTK TISCO 27JAN2005 361.85 348.90 346.15 358.70 14348 69043.65 358.00

FUTSTKINFOSYSTC

H27JAN2005 1997.00 1946.10 1914.55 1974.70 13094 51688.30 1980.00

FUTSTK ACC 27JAN2005 356.85 338.00 335.25 353.00 8000 41763.60 354.15

FUTSTKSATYAMCO

MP27JAN2005 374.00 360.95 357.15 370.50 8607 37922.79 371.75

FUTSTKTATAMOTO

RS27JAN2005 492.50 475.00 473.40 486.50 7592 30389.39 491.80

FUTSTK SBIN 27JAN2005 598.90 580.00 574.45 595.30 9667 28569.85 594.50

FUTSTK NTPC 27JAN2005 83.00 80.00 79.35 82.35 9801 26055.96 82.25

FUTSTK RELIANCE 27JAN2005 528.50 521.55 521.10 522.90 8106 25537.79 520.40

The column 1 in the above shows type of the instrument. Index Futures are denoted as

FUTIDX and stock futures are represented as FUTSTK. The column 2 specifies the

underlying index or stock of the futures contract. Column 3 brings out the expiry date.

The Column 4 signifies the highest price for the day at which a trade has taken place

whereas column 5 shows the lowest trade price for the day. The columns 6 shows the

previous day’s closing price and & column 7 displays the price at which the last trade

has taken place.

Column 8, 9 & 10 represent the total number of contracts traded till the moment during

the day, Total value of the contracts traded during the day and the cash market price of

the underlying index or stock for the respective future contract.

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Futures Payoff: Suppose Ram buys a January 2005 stock futures contract of Reliance

Industries (RIF) on January 04, 2005 at Rs. 538.40 from Shyam. Lets assume that

transaction costs are – brokerage @ 0.1%, transaction tax at 0.01% of futures, service

tax at 10% of brokerage amount. Hence, after considering the transaction costs the cost

of acquisition for Ram is Rs. 539.05 and net sales realization for Shyam is Rs. 537.75,

which will be their respective break-even price. If price of RIF goes above Rs. 539.05,

Ram gains and Shyam loses. If price remains below Rs. 537.75, Ram loses and Shyam

gains. If price remains in the range between Rs. 537.75 and Rs. 539.05, only the broker

and the government gains and both Ram & Shyam lose money.

The pay-off for Ram & Shyam from the Reliance Industries Futures (RIF) at different

prices of RIF is shown schematically in figure 3.2.

Fig.3.2 Pay-off of Ram & Shyam

The pay-off matrix for Ram & Shyam for different prices of Reliance Industries futures

will be as per table 3.5. The lot size for RIF is 600.

Price of RIF 525 530 535 540 545 550 555

Ram Pay-off -8430 -5430 -2430 570 3570 6570 9570

Shyam Pay-off 7650 4650 1650 -1350 -4350 -7350 -10350

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Clearing: As a result of the clearing mechanism of the exchange, a futures trader does

not, in effect, deal with another trader, but deals with the clearing house of the exchange

which guarantees the trade. For NSE, National Securities Clearing Corporation Limited

(NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives

(Futures & Options) segment. NSCCL acts as legal counter-party to all deals on NSE's

F&O segment and guarantees settlement. All the derivatives trade have to cleared

through the clearing members of the exchange which is a subset of members of the

exchange.

Margin Mechanism:

Futures are distinguished from forwards on account of the margin requirement imposed

on their trading by the exchange on which these futures are traded. The exchange

requires its member to collect the margin stipulated for the individual contract from their

clients and deposit the same with the clearing house of the exchange at the end of the

day of taking the position in the future contract. This margin safeguards the clearing

house against the default risk of the traders.

The margin is stipulated by the exchange based on the concept of the Value-at-Risk

(VaR) which is measured in terms of standard deviation δ. For index future the VaR is

taken as 3 δ whereas for individual securities, it is 3.5 δ. NSE uses a software called

“Standard Portfolio Analysis of Risk” system with acronym SPAN. It collects an ‘initial

margin’ equal to 99% of VaR. Apart from this initial margin, NSE also requires its trading

members to deposit client-wise ‘premium margin’ which is margin required to be paid on

the position created by the trading members on their clients’ account. The clearing

members have to pay additional ‘assignment margin’ towards the position of the trading

members whose position gets cleared through them. The exchange thus requires the

clearing members to collect the total margin comprising of initial margin, premium margin

& assignment margin and deposit the same with the clearing house. This margin is

expressed as a percentage of futures value.

The margin is calculated by the online real-time SPAN system instantaneously as the

trade takes place. At the end of the day of trading, the margin is recalculated by using

the day’s closing price or settlement price1 and appropriate debit and credit entries are

made to the buyer’s and seller’s account. If the settlement price is higher than the

purchase price of the futures contract, the buyer of the futures contract will get a credit

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equal to appreciation in price in his favour multiplied by the lot size and the seller will get

the equivalent amount as debit and vice versa. The trader with credit is required to pay

a margin reduced by this credit amount and trader with the debit will be required to pay

total margin calculated at the time of entering of contract plus debited amount. The

same procedure of marking to market is repeated every day till the futures position is

closed out by the trader. When a trader closes out the position, this margin is adjusted

with the payout required to be made or the balance margin is refunded if the position has

run into a loss and the margin is paid back along with the profit to the trader making a

profit on the position.

Let’s clarify the margin mechanism and cash-flows involved in the futures trading with

the aforesaid example: Ram buys a January 2005 stock futures contract of Reliance

Industries on January 04, 2005 at Rs. 538.40. This contract is sold to him on NSE by

Shyam. Lets assume that NSE’s margin requirement in Reliance futures at that moment

is 15%. The margin requirement for Ram & Shyam will be Rs. 48456/- (538.40 x 600 x

15%) each. Now if Reliance Industries future closes at Rs. 536.90 on January 4, 2005

then, since the price has moved by Rs. 1.50 in favour of Shyam, there will be a credit to

Shyam of Rs. 900/- and Ram will have a debit of Rs. 900/- (1.50 x 600) being subject to

unfavourable or adverse price difference. Hence, at the end of January 4, 2005, Ram

will be required to pay Rs. 49356/- and Shyam will be required to pay Rs. 47556/- to the

clearing house through their respective clearing members. On January 5, 2005, if the

Reliance future price closes at Rs. 534.90 then Ram will be required to pay a further

amount of Rs. 1200/- being adverse difference and Shyam’s account will be credited to

the extent of Rs. 1200/-.

Settlement:

For derivatives segment, there is a marked-to-market settlement every trading day and a

final settlement when the trader closes the futures position.

Marked-to-market Settlement:

The positions in the futures contract for each member is marked-to-market to the daily

settlement price of the futures contracts at the end of each trade day. As has been

explained above, the profits/ losses are computed as the difference between the trade

price or the previous day’s settlement price, as the case may be, and the current day’s

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settlement price. The Members who have suffered a loss are required to pay the mark-

to-market loss amount to NSCCL which is in turn passed on to the members who have

made a profit. This is known as daily mark-to-market settlement. The pay-in and payout

of the mark-to-market settlement is on T+1 days ( T = Trade day). The mark to market

losses or profits are directly debited or credited to the respective Clearing Member’s

clearing bank account.

Final Settlement:

The settlement is through payment of the cash difference. Settlement through delivery is

presently not permitted. On the expiry of the futures contracts, NSCCL marks all

positions to the final settlement price and the resulting profit / loss is settled in cash. The

final settlement of the futures contracts is similar to the daily settlement process except

for the method of computation of final settlement price. The final settlement profit / loss is

computed as the difference between trade price or the previous day’s settlement price,

as the case may be, and the final settlement price of the relevant futures contract.

Final settlement loss/ profit amount is debited/ credited to the relevant Clearing

Member’s clearing bank account on T+1 day which is in turn passed out to the trader.

Open positions in futures contracts cease to exist after their expiration day and a

compulsory final settlement takes place in the manner explained above using the

settlement price of the expiry date.

From the example given above for expounding the margin calculation mechanism, if

Ram closes his futures position on January 6, 2005 by selling a January 2005 Reliance

future on NSE for Rs. 528.70, his loss would be Rs. 5820/- (9.70 x 600). He will be

refunded his mark-to-market margin after deducting losses made by him and he will thus

be paid back Rs. 44736/- (50556 - 5820).

3.8. Need For Index & Stock Futures:

For Hedging:

Index futures present an extremely useful tool to the investors to hedge their investment

risks. It had been a very fond quote of technical analysts of the past that “…though

prediction based on technical analysis works best for averages (indices), one can not

buy the index…”. The advent of index futures has deprived the modern technical

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analysts of this quote. Now with index futures available, one can actually go ahead and

buy the index itself. It so happens many a times that an investor cleverly understands

that stock market is likely to turn bearish due to some developments in the economy but

how severely the individual companies will be affected due to the adverse developments

can not be ascertained and how far down the prices individual securities will move could

not be predicted. In such a scenario, selling index futures while holding on to one’s

stock portfolio can provide to be a very effective hedge against the likely erosion of

portfolio value.

Also, in a bear phase one can not short sell the stocks as stock-lending has not yet

become the order of the day in Indian capital markets. In such bear phases, selling

stock futures can insulate the investors from erosion in portfolio of stock investments.

Had the option of selling index and stock futures been not available to investors in a

prolonged bear phase, an astute investor would have to sell entire portfolio at the

beginning of such a phase and sit idle waiting for turn in the market direction.

A hedger needs to address following issues while choosing a futures hedge for an

exposure:

1. The Choice of the underlying : If the futures are not available for the stock

whose exposure is to be hedged, then the futures for some other stocks or index

would have to be used.

The decision as to which stock or index future is to be used would depend upon

the correlation between the stock and the respective indices or stocks. The

Coefficient of correlation ‘beta’ provides a useful toll with which the underlying for

hedge can be chosen. Choice of a stock or index future which has a beta of 1 or

as close as possible to 1 with respect to the stock to be hedged, would provide

the best possible hedge.

2. Choice of maturity of the contract: The choice of maturity of the contract will

be a function of the maturity of the underlying exposure. Since the futures

available in the market have a fixed maturity date which may not match with the

maturity of the underlying exposure, whether to chose a future with maturity

before the maturity of underlying exposure or whether to go for a future maturing

after the expiry of underlying exposure needs to be considered carefully.

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However, since the futures could be sold in the market when the underlying

exposure matures, it would be advisable to go for the later.

However, a further consideration for the choice of maturity would be required if

the future to be used for hedging is quoting at a premium or discount to the spot

value of the underlying. For example, if the future is quoting at a premium, then

a hedger who has to buy the future is at a disadvantage if he chooses a future

with maturity close to the maturity of the exposure since the premium would

gradually vanish over the period of the future. In such cases, it would be

advisable to go for a future with a longer maturity which can be squared off at the

maturity of the underlying exposure and some of the premium may in fact be

intact. In this example, the premium was against the hedger. In case the

premium / discount is in favor of hedger, a contract with as close a maturity as

possible to the maturity of underlying exposure be chosen so as to lock-in the

favorable premium / discount.

3. Choice of the number of contracts: The exposure to be hedged may not be in

multiple of the lot size of the futures to be used for hedging. Hence, one has to

settle for some amount of under-hedging or over-hedging. The choice would

depend on the perception of the risk. If it is felt that an underlying long position is

more likely to go in losses, it is better to over-hedge with a view that excess short

hedge position will provide some returns. Hence for the excess or short hedging

position should be looked at as if it is an independent position being taken in the

market.

In this contest, a hedge ratio is defined as –

Value of Futures Position

Hedge Ratio = ------------------------------------

Value of underlying exposure

A hedge ratio on 1 will represent a perfect hedge of the underlying exposure.

For Speculation:

The futures market attracts the speculators due to availability of gearing effect where

one can take positions in futures market that are far excess of the funds available.

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For Arbitrageurs:

The futures provide arbitrageurs an opportunity to make risk-less profits by exploiting the

anomalies in the ‘cost of carry’ and the futures premium. In this way, futures also help

the market in the price discovery and in overcoming the irrationalities in the stock market

as well as the money market that threaten to weaken the very foundation of the financial

markets at times.

4. Pricing of Futures.

4.1. Relationship between Futures Price and Expected Spot Price:

It has been said in the preceding discussion of futures that futures and forwards help the

market in the ‘Price Discovery’. It essentially means that their price provides the market

with an unbiased estimate of the expected spot price at the time of maturity of the given

futures contract or forward contract. This argument has an intuitive appeal as in a

market dominated by hedgers, the futures price at any time reflects a collective estimate

of the expected spot price of the underlying at maturity. If it is not so, then there is a

profit potential for either buyer or seller and also a room for arbitrage.

The difference between the futures price and the spot price is called ‘basis’ and is given

as (Ft,T - St,T) where ‘St’ denote the spot price of the underlying stock or index at time ‘t’

and let ‘Ft’ be the price of futures maturing at time ‘T’, at time ‘t’ such that T > t. The

basis could be have positive or negative value or a value equal to zero, at times. When

the basis is positive, the future is said to be at a ‘premium’ whereas a futures contract

with negative basis is said to be ruling at a ‘discount’. There are three theories for

explaining the different types of behaviors of the futures price in respect of the spot

price. These are-

1. Normal Backwardation Hypothesis.

2. Contango

3. Net Hedging Hypothesis

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The normal backwardation hypothesis argues that the majority of the hedgers would be

investors holding the stocks or for commodities, it will producers who expect to produce

the commodity at a future date and they would want to take a net short position for

hedging their price risk. A part of the exposure would be hedged by contracting with the

investors who would want to acquire these stocks or users who use these commodities.

But in the absence of the matching hedging needs, a part of the long position will have to

be taken by speculators in the market. These speculators would want to be

compensated for taking these risks off the shoulders of the hedgers. In other words,

they would not like to take a long position unless they are convinced that the futures are

underpriced. Hence, the price of the futures will have to be less than the expected spot

price of the underlying at maturity. The price of the futures will then linearly rise to

become equal to the expected spot price on maturity (assuming the spot price indeed

equals the expected spot price on maturity). The normal backwardation hypothesis can

be represented graphically as in figure 4.1.

Fig. 4.1 Behavior of Futures price vis-à-vis expected spot price (Normal Backwardation

hypothesis)

However, if the hedgers are net long, then the behavior of the futures will be exactly

opposite. This pattern of behavior of futures price vis-à-vis expected futures price is

referred to as ‘Contango’. It is represented through figure 4.2.

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Fig. 4.2 Contango pattern of behavior of futures price.

A third situation is argued by a few researchers that the hedgers would be net short to

begin with but as the time progresses, they become net long. This pattern of futures

price, known as ‘Net Hedging Hypothesis’, is represented graphically in the figure 4.3.

Fig. 4.3 Behavior of futures price according to the net hedging hypothesis.

However, there has been an extensive debate going on presently whether price of

futures provides an unbiased estimate of expected spot price or not. The empirical

evidence also suggests that it may not be possible to predict whether hedgers are net

short or net long at any point of time. Consequently, it may not be possible to judge

whether the futures price is over-estimated or underestimated at any given point of time.

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4.2. The Cost of Carry model of futures pricing:

The futures price, like price of a forward contract, consists of an element of cost of carry,

which is nothing, but the interest cost of funds involved. As has been said earlier while

discussing the pricing of a forward contract, any trader has options of either entering into

a futures contract or taking a similar position in the cash market and carrying the same.

This is referred to as ‘Cash and Carry’ arbitrage. The cash and carry arbitrage is

expected to ensure that the futures price does not get out of the line with the ‘cost of

carry’ which is again a function of the ruling interest rates.

Let ‘St’ denote the spot price of the underlying stock or index at time ‘t’ and let ‘F t’ be the

price of futures maturing at time ‘t1’ for the same underlying, at time ‘t’ where t1 > t. Let

the short term interest rate for a maturity equal to ‘t1 – t’ be ‘r’. Then, the futures price Ft

should be equal to equation 4.1 given below.

Ft = St [1 + r (t1- t)] ----- equn. 4.1

Now if at any point of time equation 4.1 does not hold and F t > St [1 + r (t1- t)], then

instead of buying the futures, an investor would be well off by buying the underlying

stocks in cash market and holding the same till the maturity when he will be able to

realize profit on his carried position. This is called the ‘cash and carry’ arbitrage. In this

manner, if a large number of arbitrageurs buy the underlying security in the cash market

and sell the same in the futures market, it will force the spot prices to go up on account

of increased demand and futures price to go down due to increased supply. This

process will continue till the time the spot and futures price become equal to the

equilibrium prices suggested by the equation 4.1. Once the equation 4.1 holds, there

will be again no room for the cash and carry arbitrage.

If, however, Ft < St [1 + r (t1- t)], then ‘reverse cash and carry arbitrage’ will take place

whereby investors will sell the securities in cash market, invest the sales consideration at

the ruling interest rate and buy the same securities in the futures market. This process

will also ensure that the equation 4.1 holds once again.

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If the underlying security is expected to result into an income stream before the maturity

of the futures contract, then the equation 4.1 is required to be modified to account for the

present value of the expected income stream as in equation 4.2 below.

Ft = (St – It) [1 + r (t1- t)] ----- equn. 4.2

Where It is present value of expected income stream from underlying security.

However, it may be noted that above equation does not account for the transaction costs

such as brokerage, transaction tax and service tax for buying and selling the securities

and their futures. The Bid – Ask spread further narrows down the arbitrage profits that

can be made. It also disregards the fact that the interest rate is also likely to change

from time to time and that the lending and borrowing rates for the same person would be

different on account of the bid – ask spread. Once these are accounted for, then the

instead of one single ‘no arbitrage’ value for the futures price, one would get a range of

futures price over which there is no cash and carry or reverse cash and carry arbitrage

opportunity.

Valuation of stock futures by using the cash-and-carry arbitrage model:

Lets try to find out the no arbitrage value for a futures of a stock by using a numerical

example. Let the spot bid / ask price quotes of State Bank of India stock be 595.20 / 40

and let the annualized prime rate of interest for 1 month be 7.00 / 7.50. Lets also

assume that no cash inflows are expected from the stock as generally dividends are

declared in the months from May to July and rarely after half-yearly results in November

– December.

Hence, for cash and carry arbitrage, according to Equation 4.2:

Ft = (St – It) [1 + r (t1- t)]

Ft = ( 595.40 – 0) [1 + 0.075 / 12 (1 )]

Ft = 599.12

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Now, for reverse cash and carry arbitrage, substitution of values in equation 4.2 will yield

-

Ft = (595.20 – 0) [1 + 0.07 / 12 (1)]

Ft = 598.67

If the futures price is higher than 599.12, the cash and carry arbitrage will yield profits

and if the futures price is below 598.67, the reverse cash and carry arbitrage will result in

profits. Hence, it may be seen that so long as the futures price remains in the range

between 598.67 and 599.12, there is no arbitrage opportunity.

Valuation of Index futures using the cash-and-carry arbitrage model:

Let the spot value of Nifty be 1945.60 / 1945.75 and let the annualized interest rate for 2

months be 8% - 8.25%. Now lets assume that 2 stocks comprising Nifty viz., Infosys

Technologies and Ranbaxy Laboratories with respective weights in Nifty of 6.85 and

2.48, are expected to pay dividends during the time period from now till the maturity of

the Nifty futures @ 40% and 35% respectively. Lets try to find out the mean value of the

fair valuation of Nifty index futures at a time when there 58 days left for maturity of the

contract.

The dividend from Infosys is expected to be received 20 days from now and dividend

from Ranbaxy is expected to come 35 days from the present. Infosys dividend will be

Rs. 2/- per Infosys Share since the face value of Infosys share is Rs. 5/- and dividend for

Ranbaxy will be Rs. 3.50 per Ranbaxy share since face value of its shares is Rs. 10/-.

The lot size of Nifty is 200, hence value of a futures contract will be 389135 (being mean

value of bid / ask). For this value of index, Nifty contract will include Infosys shares of

value 26655.75 (389135 x 6.85%) which at the ruling market price of 1990 will mean

13.39 shares of Infosys. Similarly, the value of Ranbaxy in the Nifty futures contract will

be 9650.55 which translates into 9 shares of Ranbaxy at its ruling market price of Rs.

1072.

The present value of dividends per basket of Nifty index will be –

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It = (2x13.39/200) / [1+(0.08125 /365)]20 + (3.5x9/200) / [1+(0.08125/365]35

It = 0.133305 + 0.156278

It = 0.289583 or 0.29

Now, substituting values in Equation 4.2,

Ft = (St – It) [1 + r (t1- t)]

Ft = (1945.675-0.29) [1+(0.08125x58/365)]

Ft = 1970.50

Thus, we have obtained mean fair value of Nifty futures as 1970.50.

Limitations of the cost of carry model:

The cost of carry model helps to establish theoretical or fair value range of the futures

price. However, it fails to account for the differences in futures price in real life on

account of expectations about spot price at maturity. The prices of futures observed in

real life are a result of the price-discovery mechanism. Hence, this model of futures

valuation often offers little help to the market participants in providing realistic futures

valuation.

5. Options

5.1. Introduction:

It was seen earlier that futures confer upon the parties to the contract, a right as well as

an irrevocable obligation to fulfill their part of the contract. Another popular type of

derivatives product is Option which gives one party a right but no obligation and another

party has no right but only obligation. Due to this peculiar characteristic of the option, it

provides an ideal product to the risk-averse market participants to hedge their risks

without any obligation.

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An option is defined as a derivatives product which provides the buyer or holder, a right

to purchase or sell the underlying securities, commodities or instruments at a pre-agreed

price on or before a specific date in future for payment of up-front fees called option

premium.

The history of the options trading can be traced back to Europe and the US as early as

the seventeenth century. However, the options market was largely OTC and there have

been only sporadic instances of trade in derivatives recorded in the financial history of

the world. In the early 1900s, there had been an attempt to arrange an organized trade

of options when a group of firms set up the put and call Brokers and a Dealers

Association with an aim to bring option buyers and sellers together. However, there was

no active secondary market and no mechanism to guarantee that the contract would be

honored. There had also been no theoretical framework or research back-up for

valuation of the options. In 1973, Black, Merton and Scholes invented the famous Black-

Scholes model for the option valuation. Chicago Board Options Exchange, set up in

1973, was the world’s first organized exchange set up for the purpose of trading options.

The market for options developed rapidly by early 1980s on the back of increased

volatility and uncertainty in the world financial market and a pressing need for risk

management tools to manage the risk of increasingly growing and globalized trade and

commerce. Since then, the growth of volumes in the options market have left many

other financial markets far behind.

5.2. Nature of the Options:

The buyer of the options has a right but no obligation to perform his side of the contract.

The seller of options, however, has only an obligation to perform his side of the contract

if the buyer insists on enforcing his right. Hence, obviously, there is a mismatch in the

rights and privileges conferred upon the two parties to option contract. It is but natural

that the seller of option would want to be compensated for offering a privilege to the

buyer of the option. This compensation takes the form of an up-front fees paid by the

buyer of an option to its seller, also called as the writer of the option, which is called the

option premium. Hence, for payment of this option premium, seller sells a right of

exercise to the buyer.

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The buyer of the option pays a small up-front amount in the form of a premium to the

seller and acquires a right to exercise the option whereby the buyer is entitled to

purchase the underlying on or before a future date for a specific price agreed at the time

of entering into the contract. The buyer, however, may or may not exercise his option

during the period of existence of the option and may simply waive his right to do so if the

price of the underlying has moved in a manner unfavorable to his options position. This

feature of options has made it an attractive product to hedge the price risk for the

holders of the underlying. They can hedge their price risk entirely by paying a small cost

in the form of premium.

Since, the liability of option buyer is limited to the up-front premium to be paid to the

option writer, he is not subjected to the payment of any further amount. The liability of

an options writer is unlimited and he is subject to payment of margins on similar lines of

those paid by the futures traders.

Unlike for cash market transactions and futures transaction where transaction costs such

as brokerage are fixed as a fraction of the purchase price, for options, these costs are

calculated as a fraction of ‘Strike Price + Premium’. The options also have concept of

notional value of contract, which is a product of the strike price and lot size of the

contract. This notional value is used to represent the volumes traded for the options.

Call options and Put options are the two basic types of options available to the investors.

5.3. Options Terminology:

1. Buyer of the option:

A buyer of the option is one who acquires a right to buy or sell the underlying at a fixed

price by paying the up-front option premium. Buyer of the option is also called ‘Holder of

the option’.

2. Seller of the option:

A seller of the option is one who sells the right of exercise to the buyer and undertakes

the obligation to buy the underlying from or sell the same to the buyer of the option, in

return for the premium amount. A seller of the option is also known as ‘Option Writer’.

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3. Call Option:

A call option is also called a ‘Buyer’s Option’. It gives a right to the buyer of the option

to buy a specific quantity of the underlying, of specific quality, from the seller of

the option for a fixed price, on or before the maturity date of the option.

4. Put Option:

A put option is a ‘seller’s option’. It gives a right to the buyer or holder an option to sell

specific quantity of the underlying, of specific quality, to the seller of the option for a fixed

price, on or before the maturity date of the option.

5. Option Premium:

Option premium is the amount paid up-front by the buyer or holder of the option to the

seller or writer in exchange for acquiring a right from him or her. The option premium is

expressed in terms of a price to be paid per unit of the underlying. The option premium

is paid by the buyer at the time of acquiring the right in the form of option from the seller.

Whether the buyer subsequently chooses to exercise his right or waives it, the option

premium is neither adjusted towards the acquisition price of the underlying nor is it

refunded back. Option premium payment is simply a consideration to the writer or seller

for selling the right and once the seller sells the options contract, the premium is earned

by him or her irrespective of the subsequent turn of events.

6. Expiry date or Maturity date:

Expiry date or Maturity date of the option is the date in future till which the options

contract continues to exist. If the option is not exercised on or before the expiry date,

the option ceases to exist and the buyer’s right is forfeited without any reimbursement or

recourse. The option expires at the end of trading on the maturity date and its value

becomes zero. This is why an option is called a wasting asset.

7. Strike Price:

Strike price of the option is the price at which the buyer or holder can exercise his right

to buy or sell the underlying. The strike price, also called as exercise price, is expressed

as the price per unit of the underlying.

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8. Lot Size:

Like futures, an option contract also has a lot size which specifies the quantity of the

underlying that would change hands per option contract should the option holder

exercise his right.

9. European Option:

An European option can be exercised only on the expiry date or maturity date and not

before that.

10. American Option:

An American option can be exercised any time from its acquisition till the maturity date

or expiry date of the option, at the choice of the option buyer. It provides the option

buyer with much more flexibility for exercising his option.

11. Index Option:

An Index option has a specific number of index baskets as the underlying.

12. Stock Option:

For a stock option, the underlying is a specific number of common stock of a particular

company.

13. In-The-Money Options:

The options are said to be In-The-Money (ITM) when the ruling market price is favorable

to the buyer of the option as compared to the exercise or strike price.

The ITM call Options have a strike price which is below the ruling market price and

hence there is an incentive for the buyers to exercise the same as they can buy the

underlying at a price below the ruling market price and realize profits by selling the

underlying in spot or cash market. The ITM Put options have the strike price above the

ruling market price of the underlying once again prompting the holder to exercise their

right. However, though the holders of ATM options will be better of by exercising their

right, the ATM status does not guarantee them a profit since the profit will start accruing

to them only after the market price of the underlying moves sufficiently above or below

the strike price, depending on which type of option they are holding, to cover their

premium payment expenses as well.

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14. At-The-Money Options:

The options are said to be At-The-Money (ATM) when the ruling market price is exactly

equal to the exercise or strike price. An index option will be ATM if the value of the index

equals the strike price of the index option.

The holder’s cash-flows will remain unaltered whether or not he or she chooses to

exercise an ATM option.

15. Out-of-The-Money Options:

Out-of-The-Money (OTM) Call Options have a strike price which is above the ruling

market price for the underlying and Out-of-The-Money Put Options have a strike price

which is below the ruling market price for the underlying.

When the option is OTM, there is no incentive for the holders to exercise their right for

exercising their right will result in negative cash-flows for them.

16. Intrinsic Value of the option:

Intrinsic value of an option is the amount by which an option is In-The-Money.

The option premium paid by the holder to writer of the option has two components viz.,

intrinsic value of the option and a time value of the option. For CalI options, intrinsic

value is calculated as (St – K) where ‘St’ is the ruling spot price of the underlying and ‘K’

is the strike price of the option. For a put option, on the other hand, (K - St), represents

it.

Only ITM options have a positive intrinsic value. For ATM and OTM options, the intrinsic

value is zero (or negative, which is as good as zero since an OTM option will not be

exercised by the holder). Hence, the intrinsic value is represented as Max[0, (St – K)] for

a call option and Max[0, (K - St)] for a put option.

17. Time Value of the option:

The time value of the option is the component of premium paid by the holder for holding

the option till the maturity period in the hope that the price of underlying will, in the mean

time, move in his or her favor.

This component of the premium is paid to the seller to compensate for undertaking a risk

that the price of the underlying could move in a direction unfavorable to the seller

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whereby his losses will be unlimited. An ITM option premium will include both time value

component and intrinsic value component whereas, ATM and OTM options will have

only time value component in the premium since intrinsic value for them is zero.

More the time till maturity, higher will be the time value of the option. Time value is

highest for the ATM options. However, in practice, it is often observed that more deep

in-the-money an option is, lesser will be the time value component in its premium since

the possibility of the spot prices again moving unfavorably to the holder would become

even greater with the steady rise in the price of the underlying.

5.4. Index and Stock Options in India:

The trading in Index options commenced on NSE & BSE in June 2001 followed by stock

options in July 2001. NSE allows trading in options of its 2 indices and 52 individual

stocks whereas BSE permits options trading in its Sensex and 50 individual stocks. The

options allowed to be traded in all the indices and stocks in which futures trading is

permitted. A list of these indices and stocks is given in table 3.3. The lot size for options

is also similar tot hat of futures. It may be noted that the settlement through delivery is

not permitted so far. Settlement is strictly through payment of cash difference.

The index options are European option while stock options are American options.

However, the position in index options can be squared off by selling the option on the

market to a third party.

Index Options:

An Index Call option gives its buyer or holder, a right to purchase a specific number of

the underlying index baskets for a pre-agreed value viz., the strike price of the option, in

return for payment of a premium, whereas an Index Put options gives its buyer of holder

a right to sell a specific number of the underlying index baskets at the strike price in

return for a premium, on or before the expiry date of the option.

Index option provides a useful risk management tool to the market participants for

managing their portfolio risks. The usefulness of the index options can be elaborated as

follows:

1. Index options provide a very useful tool to the institutional investors and

portfolio managers to hedge their portfolio risks through one single tool.

Since broad-based indices are prepared to represent the entire the range of

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stocks listed on a stock exchange, they are often representatives of the

portfolios of the investors as well. Hence, the investors can effectively hedge

their diverse portfolios containing many stocks by using a single instrument.

2. Stock indices are much less volatile than the individual stocks, which subjects

them to less margins and lower capital adequacy norms. Hence, investors

find the more suitable choices for hedging.

3. Unlike a stock, which can be more easily manipulated by a group of

investors, index is more stable and much more difficult to manipulate. Hence,

it provides a true indicator of the overall market sentiments.

NSE presently allows trading of index options for its two indices viz., CNX NIFTY and

CNX IT. The lot size of a CNX Nifty index option is 200 index baskets and that for CNX

IT is 100 index baskets. The contracts specification of CNX IT options is reproduced

below as a representative of index options. The contract specification for NIFTY options

would be similar to CNX IT options.

Contract Specification for CNX IT options:

1. Instrument Type : OPTIDX

2. Option Type : Call European / Put European

3. Underlying Instrument : The underlying index is CNXIT.

4. Trading cycle : CNX IT options contracts have a maximum of 3-month trading

cycle - the near month (one), the next month (two) and the far month (three). On expiry

of the near month contract, new contracts are introduced at new strike prices for both

call and put options, on the trading day following the expiry of the near month contract.

The new contracts are introduced for three month duration.

5. Expiry day : CNX IT options contracts expire on the last Thursday of the expiry

month. If the last Thursday is a trading holiday, the contracts expire on the previous

trading day.

6. Strike Price Intervals : The Exchange provides a minimum of seven strike

prices for every option type (i.e. call & put) during the trading month. At any time, there

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are three contracts in-the-money (ITM), three contracts out-of-the-money (OTM) and one

contract at-the-money (ATM). The strike price interval is 10. New contracts with new

strike prices for existing expiration date are introduced for trading on the next working

day based on the previous day's close CNX IT values, as and when required. In order to

decide upon the at-the-money strike price, the CNX IT closing value is rounded off to the

nearest 10. The in-the-money strike price and the out-of-the-money strike price are

based on the at-the-money strike price.

BSE allows trading in its broad-based BSE Sensex. The lot size is 50 and contracts for

3 consecutive months are permitted to trade.

Stock Options:

A stock option has a specific number of common stocks or equity shares of a company

as its underlying. A Stock Call option gives its buyer or holder, a right to purchase a

specific number of the equity shares of a specific company for a pre-agreed value viz.,

the strike price of the option, in return for payment of a premium. Similarly a Stock Put

option gives its buyer of holder a right to sell a specific number of the equity shares of a

specific company at the strike price in return for a premium, on or before the expiry date

of the option.

The contracts specifications of ACC option are reproduced below as a representative of

stock options.

Contract Specification for ACC options:

1. Instrument Type : OPTSTK

2. Option Type : Call American / Put American

3. Underlying Instrument : The underlying stock is ACC.

4. Trading cycle : ACC options contracts have a maximum of 3-month trading

cycle - the near month (one), the next month (two) and the far month (three). On expiry

of the near month contract, new contracts are introduced at new strike prices for both

call and put options, on the trading day following the expiry of the near month contract.

The new contracts are introduced for three month duration.

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5. Expiry day : ACC options contracts expire on the last Thursday of the expiry

month. If the last Thursday is a trading holiday, the contracts expire on the previous

trading day.

6. Strike Price Intervals: The Exchange provides a minimum of seven strike prices

for every option type (i.e. call & put) during the trading month. At any time, there are

three contracts in-the-money (ITM), three contracts out-of-the-money (OTM) and one

contract at-the-money (ATM). The strike price interval is Rs. 10. New contracts with new

strike prices for existing expiration date are introduced for trading on the next working

day based on the previous day's closing price for ACC, as and when required. In order

to decide upon the at-the-money strike price, the CNX IT closing value is rounded off to

the nearest 10. The in-the-money strike price and the out-of-the-money strike price are

based on the at-the-money strike price.

Call Options:

As aforesaid, call options are the buyers’ options. They give the holder a right to buy a

specific number of underlying equity shares of a particular company at the strike price on

or before the maturity. The buyer may choose not to exercise his right in case the ruling

market price of the particular share continues to remain below the strike price. In such

instances, the holder of the option would find it less expensive to buy the underlying

shares from the cash market and waive the right conferred upon him by the option. He

would, in any case, have additional expenses on his account in the form of premium paid

to the option writer. His liability is thus limited to the premium paid. However, since the

underlying shares could appreciate to any extent before the maturity of the option, his

gains would tend to be unlimited.

The seller or writer of the call options, however, is obliged to sell the underlying shares

to the holder at strike price irrespective of the ruling market price if the option holder

demands. Hence, he has unlimited liability as the market price of the underlying shares

may have appreciated significantly during the tenure of the option but the option writer

has to sell them at the strike price to the holder. His gain is limited to the option

premium amount he has received from the holder since the option holder is not likely to

exercise his option if the market price of the underlying shares is below the strike price.

It was seen that futures have linear or symmetrical pay-offs for both buyer and seller of

futures. The options, on the contrary, give rise to a non-linear or asymmetrical pay-off

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for buyer and seller. The pay-offs of the call option buyer and call option seller is

demonstrated below with the help of an example.

Ex. 1: Suppose, Hari buys a January 2005 call of strike price Rs.80/- of National

Thermal Power Corporation Ltd. (NTPC) from Ganapat on 19th January 2005 at a

premium of Rs.2/- per share when the ruling market price of NTPC is Rs.79.50 per

share. The expiry date for January 2005 call option is January 2005 being the last

Thursday of the month. Hence, he has 7 days left for expiry of call within which he has

to exercise his option, if at all. Now, NTPC call option has a lot size of 3250 equity

shares of NTPC. Table 5.1 brings out likely pay-offs of Hari and Ganapat at different

market prices of NTPC shares.

Table 5.1. Pay-off matrix for Hari & Ganapat for different market prices of NTPC.

NTPC mkt. Price 76 78 80 81 82 84 86 88

Pay-off for Hari -6500 -6500 -6500 -3250 0 6500 13000 19500

Pay-off for Ganapat 6500 6500 6500 3250 0 -6500 -13000 -19500

This pay-off matrix is shown graphically in figure 5.1.

Fig. 5.1. Pay-offs for Hari and Shyam as a result of NTPC call option trading

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Put Options:

Put options, on the other hand, are the sellers’ options. They give the holder a right to

sell a specific number of underlying equity shares of a particular company at the strike

price on or before the maturity. The buyer may waive his right if the ruling market price

of the particular share remains above the strike price when the holder of the option

would be better off by selling the underlying shares in the cash market for a price higher

than the strike price. His of her liability is limited to the premium paid. However, since

the underlying shares could depreciate to any extent before the maturity of the option

and buyer of the put option will still be able to sell them to the option writer at strike price

which could be substantially higher, his gains would tend to practically unlimited. The

maximum gain of course can not exceed the product of the strike price and the lot size

since the maximum depreciation of the stock price could take its price to zero and not

beyond. Nevertheless, his gains could be substantially large at times.

The seller or writer of the put options, on the contrary, is bound honor his commitment to

buy the underlying shares from the holder at strike price irrespective of the ruling market

price if the option holder demands so. Hence, he has unlimited liability as although the

market price of the underlying shares may depreciate to any extent during the tenure of

the option, the option writer has to buy them from the holder of the option at the strike

price. His gain is limited to the option premium amount he has received from the holder

since the option holder is not likely to exercise his option if the market price of the

underlying shares is above the strike price.

The put options also give rise to a non-linear or asymmetrical pay-off for the buyer and

the seller. The pay-offs of a put option buyer and put option seller is demonstrated

below with the help of an example.

Ex. 2: Anand buys a January 2005 put option of strike price Rs.350/- of Satyam

Computers from Vishal at a premium of Rs.9/- per share when the ruling market price of

Satyam shares is Rs.351.35 per share. A Satyam put option has a lot size of 1200

equity shares of Satyam Computers. Table 5.2 brings out likely pay-offs of Anand and

Vishal at different market prices of NTPC shares.

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Table 5.2. Pay-off matrix for Anand & Vishal for different market prices of Satyam

Computers.

Satyam market

price

310 320 330 340 350 360 370

Pay-off for Anand 37200 25200 13200 1200 -10800 -10800 -10800

Pay-off for Ganapat -37200 -25200 -13200 -1200 10800 10800 10800

This pay-off matrix is shown graphically in figure 5.2

Fig. 5.2. Pay-offs for Anand and Vishal as a result of Satyam put option trading

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Risk Of Options Traders:

The risks faced by the options traders is summarized in table 5.3 below:

Table 5.3. Risk profiles of options traders.

Potential Profits Potential Losses

Call Option Holder Unlimited Limited to Premium paid

Call Option Writer Limited to Premium paid Unlimited

Put Option Holder Unlimited Limited to Premium paid

Put Option Writer Limited to Premium paid Unlimited

5.5. Distinction between Futures and Options:

Table 5.4 brings out the differences between the futures and options.

Table 5.4. Distinction between futures and options

Sr. Futures Options

1. Both buyer and seller are subject to

the price risk, hence both have to pay

the margins

Only seller is subject to the price risk

and hence only seller has to pay the

margin

2. Futures provide a linear or

symmetrical pay-offs to both buyer

and seller

Options provide non-linear or

asymmetrical pay-offs to buyer and

seller

3. Cost of entering into a futures contract

is zero to both the buyer and seller,

ignoring the transaction costs.

A options buyer has a cost of entering

in options contract, apart from

transaction costs

4. Acquisition cost or price of a futures

contract is fixed and the strike price of

the contract moves in line with the

market price of the underlying

The strike price of an options contract

is fixed and the price of the contract

moves in line with the market price of

the underlying

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5.6. Factors affecting the Pricing of Options:

The following factors affect the price of a call and put option, which is in the form of

option premium:

1. Price of the underlying stock or index:

The premium on a call option of a specific strike price increases as the price or of the

underlying stock or value of the underlying index appreciates and vice versa. This is

because as the underlying stock price or index value appreciates, the buyer of the

underlying would be naturally better off.

The premium on a put option of a particular strike price decreases with increasing price

or value of the underlying. This is likely since the seller of underlying would be worse off

with decreasing price or value as his or her sales realization will also go down should he

or she go to the market to sell the underlying after acquiring the same through the

exercise of the option.

2. Strike Price:

Higher the strike price of a call option, per se, lower will be the premium on the call

option and vice versa. This is also obvious since a call option is a buyer’s option and

higher strike price of the call mean higher cost of acquisition for the buyer of the option.

Similarly, higher the strike price of a put option, higher will be the premium as the buyer

of put option can sell the underlying stocks at a higher price realizing higher gains in the

process.

3.Time to expiration:

Higher the time to expiration for a call option or put option, higher will be the call value as

the both the types of options will have more time value associated with them.

4.Volatility:

The premiums on both call and put options tend to increase with increase in the volatility

in the prices of the underlying, given that all the other factors remain constant.

Increased volatility would increase the chances of a larger appreciation or depreciation

in the underlying and would consequently increase the risk of the option writer.

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Naturally, the option writer would be willing to take the additional risk in return for a

higher premium.

5.Interest rates:

Higher the ruling interest rates, higher will be premium on a call option and lower will be

the premium on a put option. The higher interest rate essentially mean increased cost of

carry.

A call option buyer is essentially postponing the purchase of the underlying to a future

date while buying a call option. His opportunity cost will be higher with the higher

interest rates and hence he would not mind paying a higher premium.

A call option seller on the other hand is likely to be holding the underlying as an

investment and instead of selling the same in the cash market or spot market,

postponing the sale to a later date. Should he sell the underlying in the cash market and

raise cash, he would be able to deploy the same at a higher interest rate generating

more returns. Since he is foregoing that option, he will require a higher compensation

which at least equals his opportunity cost. Hence, he would be willing to write a call

option for a higher premium than what he would have charged had the interest rates

been lower.

By a similar logic, a put option holder can generate higher returns by selling his holding

in the cash market and raising cash. He would be willing to forego that option only if the

put option premium is attractively low enough. A put option writer on the other hand will

be willing to sell the option for a lower premium as he would prefer to post-pone his

purchase of the underlying securities to a future date and be in cash for the present

which is generating him higher returns.

6. Dividend:

Higher the dividend normally paid by a company, lower the call option premium for the

call options of the company’s shares and vice versa. On the other hand, higher the

payment of dividend, higher will be the put option premium for the company’s shares.

A call option buyer is postponing his purchase of the underlying shares to a future date.

Should the company declare and pay a dividend during the period before the maturity,

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he will not receive the same. By the time he purchases the underlying shares by

exercising his right, the stock price for the company would have gone down as its shares

become ex-dividend. Hence, a call option buyer will always be willing to pay a lower

premium for call options on such company’s shares. This is not a very valid concern

though for an American option as the option buyer holding the same can exercise their

option before the payment of dividend.

With a similar logic, a put option premium for such high-dividend paying companies tend

to be high as the put option holder receives the dividend on the underlying before the

maturity in case of European options and hence should compensate the option writer

adequately for that risk. For American put options, however, this concern is not very

valid as explained above.

The above discussion is presented in a summarized form in table 5.5 below.

Table 5.5. Effect of Increase in value of Variables on the option premium.

Increase in - Call Option Premium Put Option Premium

Market Price of underlying Increases Decreases

Strike Price of the option Decreases Increases

Time to Expiration of contract Increases Increases

Volatility in price of underlying Increases Increases

Interest Rates Increases Decreases

Dividend Decreases Increases

7.Options Pricing:

As discussed above, the value of an option depends on a number of determinants and

as such the valuation of option becomes a tedious exercise unlike the value of a futures

contract which is largely the function of the carrying costs and demand-supply.

The most commonly used option pricing models are –

1. Black-Scholes Option Pricing Model (BSOPM)

2. Binominal Option Pricing Model ( BOPM )

3. Put-Call Parity Model (PCPM)

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The Black-Scholes Model assumes that the stock-returns to have a log-normal

probability distribution whereas Binomial model treats them to be binomially distributed.

The Black-Scholes Model is widely used due to its simplicity and convenience. NSE’s

fair value calculator for options is based on Black-Scholes Option Pricing model. Hence,

we will focus on the BSOPM here.

Black-Scholes Option Pricing Model for Call Options

Fischer Black and Myron Scholes provided a simple solution to option pricing problem by

reducing the process of option valuation into an equation, making it comparatively easy

to use.

All the other option pricing models have much in common with the Black–Scholes model.

Black and Scholes start by specifying a simple and well–known equation for stock price

fluctuation, called Geometric Brownian Motion which implies that stock returns will have

a lognormal distribution, meaning that the logarithm of the stock’s return will follow the

normal (bell shaped) distribution. Black and Scholes model allows only two variables:

time and the underlying stock price, while other factors - the volatility, the exercise price,

and the risk–free rate which affect the option’s price are held constant.

Black-Scholes Call Option Pricing Model, (BSOPM), is based on the following

assumptions:

1. We are operating in a perfect market , i.e.

a) there are no transaction costs or taxes,

b) arbitrage opportunities do not exist, and

c) there are no constraints on trading.

2. Funds can be borrowed and lent at the same risk-free rate of interest.

3. No dividends are paid on stocks.

4. The option would be exercised only at expiration.

5. The price changes in the stock are continuous, i.e. smooth and not bumpy.

The Black and Scholes formula for computing a reasonable value of a call option is

given as follows:

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C = S.N(d1) – X.e-rt .N(d2)

Where:

t = Time to expiration

S = Price of underlying stock

X = Exercise price of the call option

r = Risk less rate of interest

e = A constant which is the base of natural logarithm with value 2.71828

In (S/X) + (r + 0.5σ2) t

d1 = _----------------------------------------------_________________________________

σ √t

d2 = d1 - σ √t

and where,

In (S/k) is the natural logarithm of (S/k).

σ is the standard deviation of the continuously compounded annual rate of return

on the stock.

The exponential e is the base of natural logarithm having a value of 2.71828.

N (d1) and N (d2) represent the possibilities that deviations of less than d1 and d2

respectively will occur in a normal distribution that has a mean of 0 and a

standard deviation of 1.

Example:

Consider a call option having the following features:-

Price of the share (S) = Rs. 200

Exercise price (X) = Rs. 210

Expiration period (t) = 2 months

Standard Deviation (σ) = 0.4

Risk-free interest rate (r) = 8% p.a.

Therefore,

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In (200/210) + [0.08 + 0.50 (0.4)2 ] x 2/12

d1 = ___________________________________________

0.40 √0.1667

-0.04879 + 0.02667

d1 = _______________________

0.50 √0.16667

d1 = - 0.108

and

d2 = - 0.108 - 0.50 √0.1667

d2 = - 0.312

N (d1) = N (- 0.108) = 0.4570

N (d2) = N (- 0.312) = 0.3775

Thus, we can now get the value of C as follows:

C = (200 x 0.4570) – (210 x e –(0.08 x 0.1667) x 0.3775)

C = 13.2

In case this call option is presently selling for more than Rs. 13.20, then it is underpriced

and the investor should consider selling, i.e. writing that call option. However, in case the

call option is selling for less than Rs. 13.20, it is overpriced and the investor should buy

that call option.

The Black-Scholes option pricing formula for put options is given as –

P = X.e-rt .N(-d2) – S.N(-d1)

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Where values of d1 and d2 and other notations have the same meaning as it has for the

equation for call option valuation.

Calculating Implied volatility using BSOPM:

Volatility is a measure of the amount and speed of price changes, in either direction.

Implied volatility is the market’s estimate of how volatile the underlying

will be from the present until the option’s expiration. It can be obtained using BSOPM by

entering all parameters into the model and then solving for volatility.

Binomial Option Pricing Model:

The BOPM works on the principle of equating the asset-borrowing position to the option

value. The value of a call option is given by BOPM through the following formulae:

C = NS – B

Where,

N = Number of shares

S = Spot price

B = Borrowing required to acquire N shares.

However, the model applies on the concept of unit trading interval and gets quite

complicated and tedious for multiple trading time intervals.

Put – Call Parity:

The Put-Call Parity relationship is represented as -

Put value (P) + Spot Price (S) = Call Value (C) + Present Value of Strike Price X

The violation of the above relationship is likely to give rise to arbitrage opportunities.

5.8. The Option Greeks

The sensitivity of option prices to change in the underlying and factors affecting the

underlying are measured using the Greeks. In option trading these Greeks have different

impact on calls and puts. A derivative product obtains its value from the underlying

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commodity or asset. So, if there is a change in any parameters of the underlying or the

factors affecting the underlying, the value of the derivative instrument is also affected.

These factors are, as aforesaid, stock price, strike prices, time to expiration, volatility,

interest rate and dividend. It is necessary to understand the impact of Greeks on options

before venturing into the options market.

Delta

Change in the price of the option due to change in the price of the underlying is termed

as the Delta of that option. The value of Delta is between –1 to + 1. In case of calls the

value of Delta is between 0 to 1 while in case of puts it is between –1 to 0.

In case of calls, there is a direct relation between the spot price and the option price, i.e.,

if the stock price increase the price of the option increases an vice versa. The reason is,

with the increase in price, the profit on an in-the-money call increases and the loss on

an-out-of –the-money call reduces. A deep-in-the-money call option has a Delta near to

1 and deep-out-of-the-money call option has a Delta near to 0. At the money call,

options trade at a Delta near to 0.5.

But in case of puts, the option price and spot price have an inverse relationship. If the

spot price increases, the profit on an in-the-money put reduces and the loss on an out-of

–the-money put increases.

Gamma

Gamma basically shows the extent to which Delta moves due to the change in spot

price. It is the second-degree derivative of an option’s value. If the spot price changes by

1, the extent of change in value of the Delta is captured by Gamma.

The Gamma for calls and puts is the same so it is dependent on the position and not the

option type, i.e., its impact on both is similar as far as Delta is concerned. If one has

bought an option, the Gamma is positive but if one has sold an option, the Gamma is

negative. It is highest for at-the-money options or where Delta is 0.5.

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Vega

Vega is the change in price of an option due to the change in the volatility of the

underlying. The volatility in this case is of two types – historical and implied.

Historical volatility is the price fluctuation seen by the underlying in the past. On the other

hand, implied volatility is the expected volatility of the market players in the current

situation. In other words, it is the volatility of option prices. The difference between the

theoretical price and the actual price is because of the difference in historical and implied

volatility.

It is the same for both calls and puts. For options with longer duration the Vega is high

as the volatility is perceived to be higher in case of an option with a longer duration.

Also, the Vega of high priced stocks is higher than the low priced ones. Like Gamma, it

is highest for at-the-money options.

Theta

Theta indicates the change in price as the time to expiry approaches. This factor is also

called “time decay”. The reason behind this is time value of money. The Theta of an

option with shorter duration is higher as compared to that of one with longer duration, as

it has a direct relation with volatility.

Like Gamma and Vega, it is the same for both call and put. The difference is in the

position taken. For a buyer of an option, it is the daily cost that an option buyer for

hedging or transferring his risk and in case of a seller it is his income for taking the risk.

It is highest at, at-the-money levels.

As the expiry nears, we see huge reduction in value of option due to Theta.

Rho

The change in the value of an option due to change in the interest rate it termed as Rho.

It has direct relation with calls and inverse relation with puts. It has lower impact in case

of out-of-the-money options as compared to in-the-money options.

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A summary of what each Option Greek signifies is presented below:

Greek What it signifies

Delta Change in option price due to change in the value of the underlying.

Gamma Extent of change in Delta due to change in price of the underlying.

Vega Change in option price due to change in volatility of the underlying.

Theta Change in option price as time to expiration approaches.

Rho Change in option price due to change in interest rates.

6.Strategies for Futures and Options Trading:

Strategies for Derivative trading are combinations of futures, options and cash market

transactions. By combining two or more transactions, different risk-return profile can be

created to suit the requirements of various traders. The strategies can be categorized

on the basis of the products being combined in the strategy as follows:

1. Strategies involving cash market position and futures

2. Strategies involving futures

3. Strategies involving cash market position and options

4. Strategies involving futures and options

5. Strategies involving options

6.1. Strategies involving Cash Market position and Futures:

The strategies involving cash market position, index futures and stock futures are further

segregated user-wise i.e. strategies used by Hedgers, speculators and arbitrageurs.

6.1.1. Strategies using Index Futures:

There are eight basic modes of trading on the index futures market:

Hedging

1. Long stock, short index futures

2. Short stock, long index futures

3. Long portfolio, short index futures

4. Have Cash, long index futures

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Speculation

1. Long index futures

2. Short index futures

Arbitrage

1. Lending cash to the market

2. Lending stocks to the market

Hedging strategies using index futures:

1. Long stock, short Index futures

An Investor always looks out for a stock, which is intrinsically undervalued. He would

always aim to purchase a stock which is undervalued and worth more than its ruling

market price according to his analysis. However, he may not make any gains if it so

turns out that his analysis was wrong and the company’s shares were really not worth

more than the market price. Alternatively, it may be possible that his understanding

about the company was right but the entire market moved against him after his purchase

and his acquisition generated losses even though the investment idea was correct.

For example, a person may buy Satyam Computers at Rs.370 thinking that it would

announce good results and the stock price would rise. Immediately after his acquisition,

there could be a heavy drop in market, which would take the price of Satyam down along

with most of other scrips. Thus, the investor makes losses, even though his

understanding of Satyam stock may be right.

Every buy position on a security is also a buy position on the market index as both could

be positively co-related. This so happens because, although a part of risk faced by a

company is company-specific risk, a large component of risk is still the systematic risk

which is the risk faced by the industry and economy as a whole and is shared by all the

companies operating in that industry and economy. As a result, a LONG Satyam

position generally gains if market index, say Nifty, rises and generally loses if Nifty

drops. In this sense, a LONG satyam position is not a focused play on the valuation of

satyam alone. It carries a LONG Index position along with it, as incidental baggage.

This is equally true of the stocks which do not even form a part of the index.

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Every trader who has a LONG position in a share is forced to be an index speculator,

even though he may have no interest in the index. It is useful to ask: does the person

feel bullish about the stock or about the index?

Those who are bullish about the index should just buy Nifty futures; they need not trade

individual securities and those who are bullish about individual stock should not be

carrying along a long position on Nifty as well.

This is possible through selling Nifty futures every time one adopts a long position on a

security. This offsets the hidden Nifty exposure that is inside every long–security

position. Once this is done, you will have a position, which is purely about the

performance of the security. The position LONG Satyam + SHORT NIFTY is a pure play

on the value of Satyam, without any extra risk from fluctuations in the market index. By

undertaking this strategy, an investor “hedges away” his index exposure.

It may however be noted that here hedging does not carried out as a safeguard against

losses, but to remove the unwanted exposure, i.e. unnecessary risk. More often than

not, a position hedged in this manner will make less profits than the un-hedged position.

But it must be borne in mind that one should not always enter into a hedging strategy

hoping to make excess profits at lower risk. Often, it is advisable to hedge to manage

the risks even by settling for lower profit since the profit is normally proportionate to the

risks taken.

How to hedge this market risk component?

One need to first know the “beta” of the security, which is a correlation coefficient of the

security with respect to the index. It signifies the average impact of a 1% move in index

upon the security. The beta of a security could have any positive or negative value,

though normally the betas for stocks will have a positive value since most of the

companies will invariably have some element of systematic risks. If beta is 1, there is

perfect correlation between the stock and index. If beta is more than 1, the stock will be

an aggressive stock, which is more volatile and gives a larger movement than index. A

beta of between 0 to 1 will be a defensive, less volatile stock. Beta of zero value

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indicates no correlation at all between the stock and index. If beta of a stock is not

known, it is generally safe to assume that the beta is 1.

Example:

Ram analyses performance of Infosys Technologies, whose beta is 1.51, and concluding

that infosys is undervalued at the current market price, takes a LONG Infosys position of

Rs.250, 000. The size of the position that Ram needs on the index futures market, to

completely remove the hidden Nifty exposure, is 1.51 x 250,000, i.e. Rs.377, 500.

Suppose Nifty is at 1920, and the market lot on the futures market is 200. Hence each

market lot of Nifty is Rs.384,000. To sell Rs.377,500 of Nifty, Ram need to sell one

market lot.

We sell one market lot of Nifty to get the position:

LONG Infosys Rs.250,000

SHORT NIFTY Rs.384,000

Notice that due to the restrictions of available lot size considerations, Ram was forced to

take a small excess position of Rs.6,500 on Nifty. Hence, his position of Infosys

Technologies will be essentially immune to fluctuations of Nifty. The profit / loss position

will truly reflect price changes intrinsic to Infosys and success will be a true reflection of

analysis of Infosys’s performance. However, apart from a pure Long Infosys position of

Rs. 250,000, he has built an additional position of Rs.6,500 on Nifty. Hence, while

hedging through Nifty futures in this manner, the considerations for choosing a hedge

brought out in section 3.8 need to be considered.

The betas of actively traded securities are available in the NSE Newsletter or over the

Internet on http://www.nse-india.com.

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2. Short security, long Index futures

This is exactly reverse of the strategy elaborated above. Here a short position in a stock

is hedged by creating a long position in the relevant Index futures to diversify away the

systematic risk.

3. Long portfolio, short index futures

Investors who own portfolios suffer from the overall market movements driven often by

sentiments than purely on the basis of valuations. Events such as presentation of union

budget, presentation of credit policies and the periods of quarterly and annual results

declaration, lead to significant volatility in the market. Many investors simply do not have

an appetite for such violent fluctuations in the market.

The alternatives for such investors are:

1. Sell the entire portfolio immediately.

2. Do nothing, i.e. suffer the pain of the volatility.

3. Hedge against temporary index fluctuations using index futures.

As explained above, every portfolio contains a hidden index exposure, whether a

portfolio is composed of index securities or not. It is estimated that 30–60% of the

individual securities risk is accounted for by index fluctuations.

Hence a position Long Portfolio + Short Index can often reduce the systematic risk of the

portfolio substantially.

Example:

ABC Investments has a portfolio of Rs.10 crores which has a beta of 1.2. Then a

complete hedge is obtained by selling Nifty futures of value Rs.12 crores.

The hedging strategy is undertaken to avoid budget–related volatility for the budget

announcement of March 1, 2005. The working of this strategy is summarized in table

6.1.

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Table 6.1.

Name of Stock Quantity Price

20/2/05

Price

5/3/05

Profit /

Loss

Infosys Technologies 15000 1950 1890 -900000

Reliance Industries 30000 520 485 -1050000

Larsen & Toubro 20000 960 920 -800000

Divi’s Lab 10000 1170 1150 -200000

BPCL 40000 430 410 -800000

MTNL 50000 145 155 500000

Total Portfolio Loss 100150000 96900000 -3250000

Short Nifty futures 257 1950 1890 3084000

Net loss using strategy -166000

4. Have Cash, buy index futures

An investment decision is not a decision to be taken with haste. One needs to

meticulously research and judiciously choose the stock to invest. An investor holding

cash can not jump in the market without doing proper homework, which may take a long

time. The investor may be apprehensive of losing on the opportunities in the meantime

should the prices of the stocks being considered for purchase go up. On the other hand,

an investor expecting investible cash resources in near future may face the same risk.

Both these investors can hedge this risk by buying index futures.

Speculation Strategies using index futures:

1. Long index futures

If an investor is bullish on index and expects the index to go up, then using index futures,

an investor can “buy” or “sell” the entire index by trading on one single security. Once a

person is ‘Long’ on Index using the futures market, he gains if the index rises and loses

if the index falls.

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2. Short index futures

If an investor is bearish on index and foresees a fall in the market index, he can sell the

index futures and benefit from the fall if it really materializes.

Arbitrage Strategies using index futures:

1. Lending cash to the market

A lender desirous of lending money to stock market through traditional lending method

has to face counter-party credit risk and price risk of the securities. These risks can be

mitigated by using the index futures route of lending money to the market.

This is nothing else but to the ‘cash and carry’ arbitrage explained in section 4.2. Here,

a lender simply buys all 30 securities of Sensex or 50 securities of Nifty on the cash

market, and simultaneously sells them on the futures market. A lender find this

transaction attractive if the interest rate represented by the ‘cost of carry’ on index

futures is higher than the ruling market interest rate.

It is akin to a ‘repo’ transaction. There is no price risk since the position is perfectly

hedged through simultaneous sell in futures. There is no credit risk since the counter

party for both transactions is the clearing corporation of exchange. Thus, this is an ideal

lending vehicle for risk-averse lenders.

2. Lending stocks to the market

Owners of a portfolio of shares would be willing to enhance their returns by earning

revenues from stock lending. However, stock-lending schemes presently do not exist in

India. The index futures market offers a riskless mechanism for loaning out shares and

earning a positive return therefrom.

This is the ‘reverse cash and carry’ arbitrage strategy explained in section 4.2. An

investor desiring to lend shares would sell off all the securities in index in proportion to

their weights in index and buy them back at a future date using the index futures. He

would receive money for the shares sold which can deployed to yield returns until the

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futures expiration. On this date, the investor would buy back his shares, and pay for

them.

An investor would find this strategy useful if the cost of carry is less than the ruling

interest rates of appropriate maturity when he can earn riskless returns by using this

strategy.

Strategies involving Stock Futures:

Like Index futures, there are trading strategies using stock futures which help to mitigate

risk arising out of cash market exposure as well as to speculate and arbitrage using

stock futures.

Hedging strategies using stock futures:

1. Long on stock, sell its futures

If a trader is holding onto a stock in his portfolio for which futures are available and

though is quite comfortable concerning long term prospects of his investment, fears a

short term depreciation in the value of his investment, can benefit from selling the stock

futures. If indeed the price of the stock depreciates, he would be hedged from the

losses. If the price appreciates contrary to his expectations, the loss on futures would be

compensated by the appreciation of his portfolio. Thus, without having to sell his stock,

he can hedge against the short term fluctuations in his holding by using this strategy.

2. Speculation strategies using stock futures:

1. Bullish on Stock, Buy its Futures

2. Bearish on Stock, Sell its Futures

3. Arbitrage strategies using stock futures:

1.Overpriced futures: buy spot, sell futures

If the futures of a stock are overpriced, then traders would profit from undertaking the

‘cash-and-carry arbitrage’ as explained in section 4.2 while discussing cash-and-carry

model of futures pricing. Here a trader would be arbitraging between the basis of futures

in futures market and interest rates in the money market to earn riskless profits.

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2.Underpriced futures: buy futures, sell spot

This is again nothing but the ‘reverse cash and carry arbitrage’ explained in section 4.2,

where arbitrageur buys the underpriced future, sells the underlying spot and earns

higher returns on the funds such unlocked by deploying them in the money market at

higher interest rate till the maturity of future. Thus arbitrageur earns riskless profits

thereby also helping the futures market to remove the anomaly in pricing of futures.

Strategies involving only Futures:

Spread trading

As explained in section 4.1, the difference between the spot and the futures prices is

called ‘basis’. Basis is expected to reflect the fair value of the futures contract.

Mispricing of the basis between spot and futures or the spread between two futures

contracts of different maturities, gives rise to arbitrage opportunities.

To exploit this mispricing, a trader can undertake the following trades. When the spread

between the two futures contracts narrows, buy the far month contract and sell the near

month one.

For example, if the fair spread between January 2005 contract and February 2005

contract for Bank of Baroda (BoB) is Rs.2/-, but the presently the actual spread observed

from the market quotes is Rs.1/-, then the far month contract i.e. February contract is

said to be underpriced and the near month is said to be overpriced. Hence, a trader

would buy the February 2005 BoB futures contract and sell January 2005 BoB futures

contract.

This mispricing will be soon removed as many traders start buying February contract,

thereby pushing its price up and selling January contract creating a downward pressure

on its price. This process will go on till the time the basis spread is restored close to its

fair value, which is when the position taken by trader should be squared off by entering

into a reverse trade, i.e. sell the far month contract and buy the near month.

6.3. Strategies involving cash market position and options

These are strategies used to either hedge the cash market position or to speculate or

arbitrage between cash market position and options.

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6.3.1. Hedging strategy using options:

1. Buying index puts to hedge portfolio

The argument for this strategy is similar to the one given while explaining the strategy

‘Long portfolio, short index futures’ in section 6.1.1.1 above. However, in this

strategy, the investor is holding a portfolio through buying a put option instead of selling

index futures.

This strategy of using index put instead of index futures is more beneficial to the hedger.

If there is a rise in the stock prices subsequent to selling of the index futures, the losses

on the short position in index futures will wipe away a large part of the appreciation in the

portfolio being hedged. However, buying an index put will, on one hand, allow the

hedger to hedge the risk of portfolio erosion should there be a fall in the market and on

the hand, limit his losses to the premium paid for purchasing the put, should the market

rise contrary to his fears.

The number of index puts to be bought will be a function of portfolio value and its beta

with respect to the index as discussed in section 6.1.1.1 strategy 1.

2. Buying Index puts to hedge stock position

The logic for this strategy will be similar to the explanation given for strategy 1 in section

6.1.1.1. However, the use of an index option instead of a index future for hedging

purpose will help to achieve the same hedging effect while limiting the cost of hedging to

the premium paid.

3. Buying Stock puts to hedge stock position

This is also called buying a ‘Protective Put’. Here, the investor buys a put on the stock

he is holding in the cash market, if the instrument is available for that stock. It will

insulate the investor from losses should his underlying position get into the losses on

account of depreciation in the stock price where the losses made through such

depreciation will be made good by the pay-off on the put bought. If the stock price does

not fall, the investor will lose the premium paid which will be the ‘cost of hedging’ for the

investor.

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6.3.2. Speculation strategies using options:

1.Selling covered calls

If investor is holding a stock in which options are permitted and doesn’t mind holding the

stock longer even though he foresees a short term depreciation or stagnation in the

prices of the stock, then he can benefit from his position by writing an OTM call option. If

the prices of the stock remain stagnant or fall, the call will not be exercised by the buyer

and investor can earn the premium.

If the prices rise, he can simply sell his underlying in the cash market at the maturity of

the call and pay the cash difference to the call holder. Even in such an eventuality, he

would have managed a better price realization for his holding which will be equal to the

‘strike price + premium received’.

6.3.3. Arbitrage strategies using options:

1. Put-call parity with spot-options arbitrage

As seen in the section 5.7, the put and the call prices are related by the condition of the

put-call parity.

Lets explain this with the help of an example. A trader buys the asset on spot, paying S.

She buys a put at X, paying P, so her downside below X is taken care of. She also sell a

call at X, earning C, so if S > X, the call holder will exercise on her, so her upside beyond

X is gone. This gives her X at maturity ‘t’ with certainty. This means that the portfolio of

S+P-C is nothing but a zero-coupon bond, which pays X on date t.

If the above equation does not hold good, it gives rise to arbitrage opportunities. The

put-call parity basically explains the relationship between put, call, stock and bond

prices. It is expressed as:

P + S = C + X / (1+r) t

Where:

S = Current spot price

X = Exercise price of option

t = Time to expiration, in years

C = Price of call option

P = Price of put option

r = risk-free annualized rate of interest

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The above expression shows that the value of a European call with a certain exercise

price and exercise date can be deduced from the value of a European put with the same

exercise price and date and vice versa. It basically means that the payoff from holding a

call plus an amount of cash equal to C + X / (1+r) t is the same as that of holding a put

option plus the stock.

Example :

Suppose SBI stands at 610, the risk-free rate of interest is 10% per annum, the price of

a two month SBI 620 call is Rs.14/- and the price of a two month SBI 620 put is Rs.22.

In this case, by substituting values, we get -

LHS = 22 + 610 = 632

RHS = 14 + [620 / (1 + 0.1)0.1667] = 624.23

LHS > RHS

Here LHS is overpriced relative to RHS. Hence, the arbitrage strategy would be to buy

the SBI 620 call at Rs.14 and selling SBI spot at Rs.610 and also selling a 620 put on

SBI at Rs.22. These transactions will generate an up-front cash-flow of (610+22-14) =

Rs.618. This amount can be invested at 10% p.a. to grow to Rs.627.90 at the maturity in

2 months time.

At expiration, if the price of SBI is higher than 620, she will exercise the call. If the price

is lower than 620, the buyer of the put will exercise on her. In either case, she ends up

buying SBI at Rs.620. Hence the net profit on the entire transaction is Rs.7.90 (i.e.

627.90-620.00).

Strategies involving futures and options

1. Long stock futures + long stock put

A trader who has a bullish view of a stock goes long on its futures and at the same time,

buys a protective put of the same stock to hedge against the possibility of stock price

going down.

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2. Long stock futures + long index put + long stock put

A trader who has a bullish view of a stock goes long on its futures. Under this strategy,

the trader buys a protective put of the same stock to hedge against the possibility of

stock price going down. In addition, he also buys a nifty put to ensure a pure play on the

stock by removing the component of systematic risk as discussed in detail under section

6.1.1.1 (1).

Strategies involving only options

Speculation strategies involving options

1. Bullish index, buy index calls or sell index puts

If a trader feels that the index is likely to go up, he will buy index calls or sell index puts.

If he buys index call and the index indeed goes up as per his forecast, he can gain a

positive cash-flow which would be equal to the difference in settlement price and the

strike price of the call less premium aid. However, if index goes down contrary to his

expectations, his maximum loss will be the entire premium paid to the call writer.

On the other hand, if he sells index put and index goes up, the put will not be exercised

by the option holder and his gain would premium received. If, however, index goes

down, the put holder will exercise the same and his losses could be unlimited. However,

break-even of the strategy of selling put will be much lower than buying the same strike

call.

Example:

Gopal is bullish on Nifty, which is currently ruling at 1925. He buys a February 2005

Nifty Call of strike price 1920 for Rs.32. He also sells a Nifty February 2005 Put of strike

price 1940 for Rs.40. Market lot for Nifty is 200. The pay-off from his call for various

scenarios of Nifty values is presented in table 6.2 below:

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Table 6.2.

Nifty

Value

1840 1860 1880 1900 1920 1940 1960 1980 2000

Call

Payoff

-6400 -6400 -6400 -6400 -6400 -2400 1600 5600 9600

Put

Payoff

-12000 -8000 -4000 0 4000 8000 8000 8000 8000

His payoff is shown graphically in figure 6.1 below.

Figure 6.1.

2. Bullish on stock, buy stock calls or sell stock puts

This strategy is similar to strategy 1 above with only difference being the stock calls are

bought or stock puts are sold instead of index calls or puts.

3. Bearish on index, sell index calls or buy index puts

Here the trader is bearish about index and sells call options on index or alternatively

buys put options on index. If index goes down as expected by her, she will make

unlimited profits on puts or gain premium on calls. If index goes up contrary to her

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expectations, she will lose premium on puts or make unlimited losses on calls written

depending on the extent to which the index goes up.

4. Bearish on stock, sell stock calls or buy stock puts

This strategy is applied with stock calls or puts but otherwise similar to strategy 3 above.

Example:

Keshav’s view of Ranbaxy Laboratory happens to be very bearish and he decides to

take advantage of the likely fall in Ranbaxy shares. He sells February 2005, Strike 980

Call of Ranbaxy for Rs. 19 and also buys a February 2005, Strike 980 Put of Ranbaxy

for Rs. 21. Ranbaxy options have a market lot of 400 Ranbaxy shares. His payoffs at

various prices of Ranbaxy shares is summarized in table 6.3 and also represented

graphically in figure 6.2 below.

Figure 6.2.

Table 6.3.

Ranbaxy

share Price

920 935 950 965 980 995 1010 1025 1040

Call payoff 7600 7600 7600 7600 7600 1600 -4400 -10400 -16400

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Put payoff 15600 9600 3600 -2400 -8400 -8400 -8400 -8400 -8400

5. Bull spreads, Buy a call and sell another

Under this strategy, a trader buys an index call or a stock call of lower strike price and

sells a call with a higher strike in the same underlying. This strategy returns a pay-off

consisting of a limited profit or a limited loss.

A variation of this strategy can be undertaken using puts where a trader sells a put of

higher strike and buys a put of lower strike in the same underlying.

Example 1:

Vivek has a bullish view on TISCO. He decides to use a Bullish Call Spread strategy to

profit from his forecast. He buys a 360 strike, February 2005 TISCO Call at Rs.16 and

writes 380 strike, February 2005 TISCO Call for Rs.7. Market lot for TISCO is 1350

TISCO shares. His payoff from the Bull Call Spread is illustrated through table 6.4 and

figure 6.3.

Figure 6.3.

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Table 6.4.

TISCO Price350 360 370 380 390 400 410

360 Call payoff -21600 -21600 -8100 5400 18900 32400 45900

380 Call payoff 9450 9450 9450 9450 -4050 17550 -31050

Combined

payoff

-12150 -12150 1350 14850 14850 14850 14850

Example 2:

Chetan has a similarly bullish view on TISCO. He, however, decides to use a Bullish Put

Spread strategy to profit from his forecast. He sells a 360 strike, February 2005 TISCO

Put at Rs.15 and buys a 350 strike, February 2005 TISCO Put for Rs.10. His payoff

from the Bull Put Spread is illustrated through table 6.5 and figure 6.4.

Table 6.5.

TISCO Price320 330 340 350 360 370 380

360 Put payoff -33750 -20250 -6750 6750 20250 20250 20250

350 Put payoff 27000 13500 0 -13500 -13500 -13500 -13500

Combined

payoff

-6750 -6750 -6750 -6750 6750 6750 6750

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Figure 6.4.

6. Bear spreads, Sell a call and buy another

A Bear spread is a strategy exactly opposite to the bull spread. Here, a trader has a

bearish view of the index or stock and tries the benefit through using this combination of

calls or puts.

In a Bear Call Spread, a seller sells a lower call to earn premium and buys higher call to

limit the losses in case his forecast goes wrong.

Alternatively, one can go for a Bear Put Spread where one buys a Put with higher strike

to gain from the fall in prices of index or stock and writes a put with a lower strike as an

insurance in the same underlying.

Example: Sandeep has a bearish view on Tata Motors. He decides to use a Bear Call

Spread strategy to trade on this forecast. He sells a 450 strike, February 2005 Tata

Motors Call at Rs.18 and buys a 470 strike, February 2005 Tata Motors Call for Rs.7.

Tata Motors option has a market lot of 825 shares. His payoff from the Bear Call Spread

is illustrated through table 6.6 and figure 6.5.

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Table 6.6.

Tata Motors Price430 440 450 460 470 480 490

450 Call payoff 14850 14850 14850 6600 -1650 -9900 -18150

470 Call payoff -5775 -5775 -5775 -5775 -5775 2475 10725

Combined payoff 9075 9075 9075 825 -7425 -7425 -7425

Figure 6.5.

7. Straddle

A straddle strategy is undertaken at times of great volatility. The periods such as the

annual budget is to be announced or the financial results of the company are to be

announced or some decision from a court of law or statutory authority on a dispute

concerning a company is to be decided or the buy-back price of the shares is to be

announced by the company, are the periods of great volatility for the company’s shares.

The price of a company’s shares or value of a market index can be expected to show a

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large movement in either direction based on the outcome of such events. In such

situation, a trader benefits from the straddle strategy.

This strategy involves buying a ATM Call and a ATM Put of the same strike for an index

or stock so that when the subsequent move takes place in either direction, one of the

option position yields a payoff which far exceeds the cost of the strategy. The strategy

however results is losses if price remains stagnant.

Example:

Gujarat Ambuja Cement and HOLCIM are together going to make an open offer for

acquisition of ACC shares during the 3rd week of January 2005. Hence Charu decides to

buy a Straddle on ACC. She buys a 360 Strike January 2005 Call of ACC for Rs.12 and

a same strike January 2005 Put of ACC for Rs.11. Market lot for ACC options is 1500

shares. Table 6.7 and figure 6.6 illustrate the payoff of Charu for different price levels of

ACC subsequent to announcement.

Table 6.7.

ACC Price 300 320 340 360 380 400 420

360 Call payoff -18000 -18000 -18000 -18000 12000 42000 72000

360 Put payoff 73500 43500 13500 -16500 -16500 -16500 -16500

Combined payoff 55500 25500 -4500 -34500 -4500 25500 55500

Figure 6.6.

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8. Strangle

A Strangle is executed on the same logic as a straddle. The only difference is that the

Call and Put are both OTM in nature so that the upfront premium required to be paid is

reduced. But at the same time, it pushes the break-even points of the strategies even

farther away from the spot price so that a still higher movement in the price of the

underlying is required to break-even. Hence, it is a somewhat less aggressive strategy

than a straddle.

Example:From the above ACC example, Abhijeet wants to trade in a more conservative

way and decides to go for a strangle. Hence he buys a 370 January ACC Call at Rs.7

and 350 January ACC Put at Rs.8. Table 6.8 and figure 6.7 illustrate the Abhijeet’s

payoff for different price levels of ACC subsequent to announcement.

Table 6.8.

ACC Price 320 330 340 350 360 370 380 390

360 Call payoff -10500 -10500 -10500 -10500 -10500 -10500 4500 19500

360 Put payoff 33000 18000 3000 -12000 -12000 -12000 -12000 -12000

Comb. Payoff 22500 7500 -7500 -22500 -22500 -22500 -7500 7500

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Figure 6.7.

9. Butterfly Spread:

A Butterfly Call spread involves three strike prices and is carried out by buying one call

at lowest strike price, buying two calls of the middle strike price and again selling one

call at the top strike price. If as a result of this strategy, a net premium amount is

received by the trader, then he will earn that much of profit if the price moves

significantly in either direction. He will make losses if the price remains in a small range

around the middle strike price.

Similarly, a Butterfly Put spread can be undertaken by buying or selling 2 middle strike

puts and buying a put each at a lower strike and a higher strike.

The Butterfly Spread will yield profit or loss to the extent of the net premium amount

received if price moves far away from a range around middle strike. Hence, a trader has

to undertake a reverse strategy of paying out a net premium if the price is expected to

remain in a certain narrow range around the middle strike price of the strategy.

Example 1: Srinivasan undertakes a butterfly call spread in Satyam Computers. He buys

two January Calls of Strike 370 at Rs.10 and sells one January call each of 360 strike and

380 strike at Rs.18 and Rs.6, respectively. Market lot is Satyam is 1200. Table 6.9 and

figure 6.8 illustrate Abhijeet’s payoff from a Butterfly Call Spread for different price

levels of Satyam Computers.

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Table 6.9.

Satyam Price 340 350 360 370 380 390 400

360 Call payoff 21600 21600 21600 9600 -2400 -14400 -26400

370 Calls payoff -24000 -24000 -24000 -24000 0 24000 48000

380 Call payoff 7200 7200 7200 7200 7200 -4800 -16800

Comb. Payoff 4800 4800 4800 -7200 4800 4800 4800

Figure 6.8.

Example 2:

Praveen decides to go for a Butterfly Put Spread in Satyam Computers. He sells two

January Puts of Strike 370 at Rs.10. He buys one January put of 360 strike at Rs.5 and

one January 380 strike Put at Rs.16.

Praveen will have a positive payoff from this strategy if the price of Satyam remains

between 363 and 377. If price moves away from this range, then he will incur a fixed

loss of 1200. Table 6.10 and figure 6.9 illustrate Praveen’s payoff from a Butterfly Put

Spread for different price levels of Satyam Computers.

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Table 6.9.

Satyam Price 350 360 370 380 390

360 Put payoff 6000 -6000 -6000 -6000 -6000

370 Puts payoff -24000 0 24000 24000 24000

380 Put payoff 16800 4800 -9600 -19200 -19200

Comb. Payoff -1200 -1200 8400 -1200 -1200

Figure 6.8.

MUTUAL FUND

Chapter . 1.

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Working of mutual funds.

Definition of mutual fund.

A mutual fund is a pool of money from numerous investors who wish to save or make

money just like you. Investing in a mutual fund can be a lot easier then buying and

selling individual stocks and bonds on your own. Investor can sell their shares when

they want.

Professional management.

Each fund’s investments are chosen and monitored by qualified professionals who use

this money to create a portfolio. That portfolio could consist of stocks, bonds, money

market instruments or a combination of those.

Fund Ownership. As an investor, you own shares of the mutual fund, not the individual

securities. Mutual funds permit you to invest small amounts of money, however much

you would like, but even so, you can benefit from being involved in a large pool of cash

invested by other people. All shareholders share in the fund’s gains and losses on an

equal basis, proportionately to the amount they’ve invested.

Mutual Funds are diversified.

By investing in mutual, you could diversify your portfolio across a large number of

securities so as to minimize risk. By spreading your money over numerous securities,

which is what a mutual fund does, you need not worry about the fluctuation of the

individual securities in the fund’s portfolio.

Mutual Funds Objectives.

There are many different types of mutual funds, each with its own set of goals. The

investment objective is the goal that the fund manager sets for the mutual fund when

deciding which stocks and bonds should be in the fund’s portfolio. For example, an

objective of a growth stock fund might be: this fund invests primarily in the equity

markets with the objective of providing long-term capital appreciation towards meeting

your long-term financial needs such as retirement or a child’s education.

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Depending on investment objective, funds can be broadly classified in the following 5

types:

Aggressive growth means that you will be buying into stocks, which have a chance

for dramatic growth and may gain value rapidly. This type of investing carries a high

element of risk with it since stocks with dramatic price appreciation potential often

lose value quickly during downturns in the economy. It is a great option for investors

who do not need their money within the next five years, but have a more long-term

perspective. Do not choose this option you are looking to conserve capital but

rather when you can afford to potentially lose the value of your investment.

As with aggressive growth, growth seeks to achieve high returns; however, the

portfolio will consist of a mixture of large-, medium- and small-sized companies.

The fund portfolio chooses to invest in stable, well-established, blue chip

companies together with a small portion in small and new businesses. The fund

manager will pick, growth stocks which will use their profits grow, rather than to pay

out dividends. It is a mdeiu8m – long-term commitment, however, looking at past

figures, sticking to growth funds for the long-term will almost always benefit you.

They will be relatively volatile over the years so you need to be able to assume

some risk and be patient.

A combination of growth and income funds, also known as balanced funds, are those

that have a mix of goals. They seek to provide investor with current income while

still offering the potential for growth. Some funds buy stocks and bonds so that the

portfolio will generate income whilst still keeping ahead of inflation. They are able

to achieve multiple objectives which may be exactly what you are looking for.

Equities provide the growth potential, while the exposure to fixed income securities

provide stability to the portfolio during volatile times in the equity markets. Growth

and income funds have a low-to-moderate stability along with a moderate potential

for current income and growth. You need to be able to assume some risk to be

comfortable with this type of fund objective.

That brings us to income funds. These funds will generally invest in a number of

fixed-income securities. This will provide you with regular income. Retired

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investors could benefit from this type of fund because they would receive regular

dividends. The fund manager will choose to buy debenture, company fixed

deposits etc. in order to provide you with a steady income. Even though this is a

stable option, it does not go without some risk. As interest-rates go up or down,

the prices of income fund shares, particularly bonds, will move in the opposite

direction. This makes income funds interest rate sensitive. Some conservative

bond funds may not even be able to maintain your investments buying power due to

inflation.

The most cautious investor should opt for the money market mutual fund which aims

at maintaining capital preservation. The word preservation already indicates that

gains will not be an option even though the interest rates given on money market

mutual funds could be higher than that of bank deposits. These funds will pose very

little risk but will also not protect your initial investments buying power. Inflation will

eat up the buying power over the years when your money is not keeping up with

inflation rates. They are, however, highly liquid so you would always be able to

alter your investment strategy.

Closed-End funds.

A closed-end fund has a fixed number of shares outstanding and operates for a

fixed duration (generally ranging from 3 to 15 years). The fund would be open for

subscription only during a specified period and there is an even balance of buyers and

sellers, so someone would have to be selling in order for you to be able to buy it.

Closed end funds are also listed on the stock exchange so it is traded just like other

stocks on an exchange or over the counter. Usually the redemption is also specified

which means that they terminate on specified dates when the investors can redeem

their units.

Open-Ended Funds.

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An open-end fund is one that is available for subscription all through the year and

is not listed on the stock exchanges. The majority of mutual funds are open-end funds.

Investors have the flexibility to buy or sell any part of their investment at any time at a

price linked to the fund’s Net Asset Value.

Chapter .2

Investing with mutual funds.

Start with your financial needs

People have different investment needs depending on their financial goals, tolerance

for risk and time frame—when they need the money they invested.

Our mutual funds are created with these needs in mind-we start with you. Before you

choose investments, think about your financial goals, risk tolerance and time

frame. Then choose investments that match them. For more information about these

topics, see the relevant links box to the right.

The investment pyramid

The investment pyramid below shows fund categories that are suitable for different

time frames, with the longest time frames at the top and the shortest at the base of

the pyramid.

INVESTMENT PYRAMID

Investment experts recommend growth investment such as stocks and stock funds

for long-term goals, where you won’t need to sell your investment for 5 years or

more. For short-term goals, where you might sell your investment in 1 year or less,

they recommend fixed income funds and other liquid investments. Of course, their

specific recommendations will depend on your comfort with risk.

Benefits of mutual funds

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Stock, bonds, money market instruments-as an investor, you have a wide variety of

choices, and it would be difficult to find one type of investment vehicle that effectively

takes advantage of all of to day investment options. That’s why you may want to

consider diversifying your portfolio over a variety of investment vehicles as mutual

funds do for you.

In addition to providing you with the flexibility to create an investment plan based on

your individual goals, mutual funds offer many other advantages such as professional

management, affordability and diversification.

Chapter. 3 Advantages of investing in mutual funds.

As an investor, one would like to get maximum returns on your investments. But you

may not have the time continuously study the stock market to keep track of them. You

need a lot of time and knowledge to decide what to buy or when to sell. A lot of people

take a chance and speculate, some get lucky, most don’t. this is where mutual funds

come in. mutual funds offer you the following advantages:

Professional management.

Qualified professionals manage your money, but they are not alone. They have a

research team that continuously analyses the performance and prospects of companies.

They also select suitable investment to achieve the objectives of the scheme. It is a

continuous process that takes time and expertise which will add value to your

investment. Fund managers are in a better position to manage your investments and get

higher returns.

Diversification.

The cliché, “don’t put all your eggs in one basket” really applies to the concept of

intelligent investing. Diversification lowers your risk of loss by spreading your money

across various industries and geographic regions. It is a rare occasion when all stocks

decline at the same time and in the same proportion.

Sector funds spread your investment across only one industry so they are less

diversified and therefore generally more volatile.

More choice.

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Mutual funds offer a variety of schemes that will suit your needs over a lifetime. When

you enter a new stage in your life, all you need to do is sit down with your financial

advisor who will help you to rearrange your portfolio to suit your altered lifestyle.

Affordability.

As a small investor, you may find that it is not possible to buy shares of larger

corporations. Mutual funds generally buy and sell securities in large volumes which allow

investors to benefit from lower trading costs. The smallest investor can get started on

mutual funds because of the minimal investment requirements.

You can invest with a minimum of Rs.500 in a systematic investment plan on a regular

basis. Tax benefits. Investments held by investors for a period of 12 months or more

qualify for capital gains and will be taxed accordingly (10 % of the amount by which the

investment appreciated, or 20 % after factoring in the benefit of cost indexation,

whichever is lower). These investment also get benefit of indexation.

Liquidity.

With open-end funds, you can redeem all or part of your investment any time you wish

and receive the current value of the shares. Funds are more liquid than most

investments in share, deposits and bonds. Moreover, the process is standardized,

making it quick and efficient so that you can get your cash in hand as soon as possible.

Rupee-cost averaging.

With rupee-cost averaging, you invest a specific rupee amount at regular intervals

regardless of the investment’s unit price. As a result, your money buys more units when

the price is low and fewer units when the price is high, which can mean a lower average

cost per unit over time. Rupee-cost averaging allows you to discipline yourself by

investing every month or quarter rather than making sporadic investments.

The Transparency.

The performance of a mutual fund is reviewed by various publications and rating

agencies, making it easy for investors to compare fund to another. As a unitholder, you

are provided with regular updates, for example daily NAVs, as well as information on the

fund’s holding and the fund manager’s strategy.

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Regulations. All mutual funds are required to register with SEBI (Securities Exchange

Board of India). They are obliged to follow strict regulations designed to protect

investors. All investors are protected by Securities and Exchange Board if India

(Securities and Exchange Board if India).

Chapter. 4.

Equity Funds.

Types of equity funds

One fund may invest in only the stocks of well-established companies while others

concentrate their investment in companies in one specific industry. Some examples:

Growth funds. These funds invest in rapidly growing companies which tend to use

their profits to finance future growth instead of paying them out as dividends.

Balance funds. These funds invest in blue chip stocks-large, established companies

with long histories of steady growth and reliable dividends. The

income from the dividends can help reduce the fund’s volatility over the long term.

Sector funds. These funds concentrate their investments in a particular market

sector or industry such as health care, communication or biotechnology. Because of

their specific focus and lack of diversification, sector funds are generally best used

as a complement to a well-diversified portfolio.

Global funds. The ability to invest anywhere in the world is the biggest advantage

global equity funds offer because they have the greatest number of stocks to choose

from. Investing globally, however may involve higher risks depending on market

conditions, currency exchange rates and economic, social and political climates of

the countries where the fund invests.

Investing styles of people.

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Another dimension for looking at an equity fund is whether it’s following a value or

growth style of investing. Both growth-and value-oriented investments can be important

components of a diversified portfolio.

Value investing. Value managers tend to look for companies trading below their

intrinsic value, but whose true worth they believe will eventually be recognized.

These securities typically have low prices relative to earnings or

book value, and often have a higher dividend yield. For example, these companies

are found in out-of-favor industries.

Growth investing. Growth managers look for companies with above-average

earnings growth and profits which they believe will be even more valuable in the

future. They also look for companies that are well position to capitalize on long-term

growth trends that may drive earnings higher. Because these companies tend to

grow earnings at a fast pace, they typically have higher prices relative to earnings.

Risk . Stocks historically have outperformed other asset classes over the long term,

but tend to fluctuate in value more dramatically over the short term. These and other

risks are discussed in each fund’s prospectus.

Advantages of equity funds

Diversification.

Equity mutual funds allow you to spread your money across a larger number of

securities than you probably could on your own. This diversification dramatically reduces

the risk of anyone company’s losses adversely affecting your investment as a whole.

Professional management.

Professional money managers closely monitor the securities market and individual

companies, buying and selling securities as they see opportunities arise. Few individual

investors can devote time or resources to daily management of a sizable portfolio or stay

up to date on the thousands of securities available in the financial markets.

Liquidity.

We may sell some or all of your mutual fund shares at any time and receive their current

value(net asset value). The value may be more or less than your original cost.

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Convenience.

Mutual funds offer shareholders many services that make investing easier. You may buy

or sell shares each business day, automatically add to or withdraw from your account

each month, and have income dividends and capital gains paid out to you or

automatically reinvested.

Investing in Equity Related Mutual Funds.

Bottom-up approach.

Normally mutual funds follow a bottom-up approach to stock picking. Their goal is to pick

the best companies regardless of the sector. And once our fund managers are confident

about a company’s prospects, they fully back their decision, investing heavily into that

company. That’s why typically the top 5 to 10 companies in a portfolio account for a

substantial portion of the fund’s total assets. However, we do keep a close watch on

sector exposure in diversified funds and individual stock exposure in sector funds to

ensure that the exposure does not till too much towards one sector or stock.

Fundamental Investors

We are fundamental investors. We rely on in-house research as the basis for our

investment decision-making. Our research is not restricted to looking at the financial

numbers – it goes much beyond the published reports. Our fund managers and research

analysts meet as many people in a company as possible to get a much better overall

perspective, and to discover the not-so-obvious pieces and trends that can turn into big

opportunities over time.

Focus on quality

We focus on ‘quality’. Companies where we have the slightest doubts on management

or the quality of their financials and business models are ignored. Our focus on quality

and an aversion to excessively speculative companies may result in giving up short-term

gains as happens when markets overheat, but this strategy gives our funds superior

performance over market cycles.

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Long-term investors

We are patient investors and do not get perturbed by market volatility. Once we have

identified ‘value’ in a stock and invested, we stick to it as long as there is no fundamental

‘negative’ changes even if the particular stock goes out-of-favour in market. In fact , we

use volatility as an opportunity to buy more as we believe that sooner or later, the market

will recognize the inherent value and the stock will bounce back.

Methodical and Deliberate

We are also methodical and deliberate in our investment style. We focus more on

emerging themes, the big picture and the long term-ignoring rumours, ‘hot tips’ and

‘whisper estimates’.

Look for Trends

One should believe spotting changes and trends early can be rewarding. So mutual

funds try to understand not just how companies and industries are today but also how

they will be tomorrow. As a result. We make substantial investments to ensure that we

have a grasp on significant changes.

Chapter.5 Income funds

Income funds

Income funds invest their pool of money primarily in individual bonds which is why they

are sometimes call bond funds. Income funds make loans to corporations and

government by investing in their bonds and other interest-earning securities. In return

the corporations and governments pay interest to the fund.

These funds are interest-rate sensitive, meaning that if interest rates fall, the value of

income fund shares may rise, and if interest rates are rising, the value of a bond fund

share may fall. Money bonds in which mutual funds invest have no guarantees but they

have traditionally provide higher current income than other fixed-income alternative such

as money market funds and certificates of deposit.

Portfolio managers constantly monitor the securities within the fund, buying and selling

bonds to maintain or improve the fund’s share value as they seek to achieve the best

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return that market conditions will allow. The share price of all mutual funds is calculated

daily by dividing the total value of the securities held by the fund by the number of

shares outstanding

Maturity.

Maturities are the length of time in which a bond must be paid. Bonds can have short,

intermediate or long-term maturities. Short-term bonds mature in less than 2 years

intermediate-term bonds mature in 2 to 10 years, and long-term bonds have maturities of

10 to 30 years.

Generally, bonds with longer maturities pay higher interest rates to compensate

investors for greater interest-rate risk. Longer-term bonds are more sensitive to interest

rate movements than bonds with shorter maturities, causing longer-maturity investments

to experience a greater degree of price volatility.

A bond fund’s share price generally tends to fluctuate less than the price of an individual

bond, however, due to the wide variety of maturities and individual characteristics of

various bonds within a fund’s portfolio.

Bond Prices.

Investors are often concerned about the fluctuation of their bond fund’s share price.

Because of changes in the market price of the bonds held, the value of the bonds in a

fund’s portfolio changes daily. The value of these bonds changes for a variety of

reasons, primarily in response to the movement of interest rates. Bond prices and

interest rates generally have an inverse relationship, moving up and down like a see-

saw. When interest rates go down, the prices of bonds generally go up, and vice versa.

For example, a Rs. 1,000 bond with a fixed annual rate of 7 % and current interest rates

fell to 5 %, the 7 % bond become more attractive to other investors, thus increasing its

resale value. However, if current interest rates climb to 10 %, the bond would be less

attractive, causing its value to fall.

The prices of bonds are also affected by their credit quality and availability in the market.

If there is an abundance of bonds paying a certain interest rate, demand may not meet

supply, thus lowering prices. The reverse is also generally true. For example, as interest

rates decline, people tend to look to corporate bonds for higher yields. Such increased

demand can lead to increased prices in the corporate bond sector.

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The price of a given bond also depends on its credit quality, which may change.

However, despite the rating that bonds are assigned by the rating agencies, their values

are continually changing. If a corporation with questionable credit strength restructures,

the value of any outstanding bonds may increase.

Advantages of income funds

Diversification. Income funds allow investors to spread their principal across a

large number of securities, thus cushioning the effect that one bond can have on

overall investment results. As market and economic conditions change, the

portfolio managers can make adjustments in an attempt to meet the fund’s stated

objectives.

Active management. Experienced portfolio managers closely monitor a mutual

fund, buying and selling securities when necessary. This takes the burden off

investors who may not have the time to do in-depth research about various

investment possibilities.

Affordability. Bond mutual funds can be purchased with an initial investment

which is sometimes as low as Rs.1,000/- and subsequent investments are as low

as Rs.250. individual bonds usually require a minimum investment of Rs. 5000

and sometimes more, depending on the type of bond.

Monthly income. For investors seeking a steady stream of income, bond mutual

funds generally pay monthly dividends, whereas most individual bonds pay semi-

annually. Interest payments from an individual bond are fixed; monthly dividends

from a mutual fund will fluctuate with market conditions. A mutual fund pays fees

to its manager, which does not apply to holders of individual bonds.

Easy access to your money. Mutual funds allow investors to redeem shares at

any time-at the current net asset value.

No maturity date. Individual bonds eventually mature, leaving the investor with a

lump-sum that must then be reinvested-possibly at a lower interest rate. Bond

funds never mature-portfolio managers constantly roll the proceeds from

maturing securities into new bonds. However, the share prices of mutual funds

fluctuate with market conditions, and investors may have a gain or loss when

shares are sold. Owners of individual bonds are generally paid their principal

investment at maturity.

Chapter . 6. Income funds.

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Money markets and money markets instruments.

Money markets allow banks to manage their liquidity as well as provide the central bank

means to conduct monetary policy. Money markets are markets for debt instruments

with a maturity up to one year.

The most active part of the money market is the call money market (i.e. market for

overnight and term money between banks and institutions) and the market for repo

transactions the former is in the form of loans and the latter are sale and buyback

agreements – both are obviously not traded. The main traded instruments are

commercial papers (CPs), certificates of deposit (CDs) and treasury bills (T-Bills).

Commercial paper.

A commercial paper is a short term unsecured promissory note issued by the raiser of

debt to the investor. In India corporates, primary dealers (PD), satellite dealers (SD) and

financial institutions (FIs) can issue these notes.

It is generally companies with very good rating, which are active in the CP market,

though RBI permits a minimum credit rating of crisil-P2. The tenure of CPs can be

anything between 15 days to one year, though the most popular duration is 90 days.

Companies use CPs to save interest costs.

Certificates of Deposit

These are issued by banks in denominations of Rs.5 lakh and have maturity ranging

from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of less than one

year while financial institutions are allowed to issue CDs with a maturity of at least one

year.

Treasury Bills

Treasury bills are instruments issued by RBI at a discount to the face value and form an

integral part of the money market. In india treasury bills are issued in four different

maturities-14 days, 90 days, 182 days and 364 days.

Apart from the above money market instruments, certain other short-term instruments

are also in vogue with investors. These include short-term corporate debentures, bills of

exchange and promissory notes.

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Debt market instruments.

Debt instruments typically have maturities of more than one year. The main types are

government securities called G-secs or Gilts.

Like T-bills, Gilts are issued by RBI on behalf of the government. These instruments

form a part of the borrowing program approved by Parliament in the Finance Bill each

year (Union Budget). Typically, they have a maturity ranging from 1 year to 20 year.

Like T-bills, Gilts are issued through auctions but RBI can sell/buy securities in its

Open Market Operations (OMO). OMOs cover repos as well and are used by RBI to

manipulate short-term liquidity and thereby the interest rates to desired levels:

Other types of government securities include:

Inflation-linked bonds

Zero-coupon bonds

State government securities (state loans)

Difference between bonds and debentures.

A debenture is a debt security issued by a corporation that is not secured by specific

assets, but rather by the general credit of the corporation. Stated assets secure a

corporate bond, unlike a debenture, but in India these are used interchangeably. Bonds

are IOUs between a borrower and a lender. The borrowers include public financial

institutions and corporations. The lender is the bond fund, or an investor when an

individual buys a bond. In return for the loan, the issuer of the bond agrees to pay

specified rate of interest over a specified period of time.

Typically bonds are issued by PSUs, public financial institutions and corporates.

Another distinction is SLR (Statutory liquidity ratio) and non-SLR bonds. SLR bonds are

those bonds which are approved securities by RBI which fall under the SLR limits of

banks.

Statutory liquidity ratio (SLR) :

It is the percentage of its total deposits a bank has to keep in approved securities.

Bond price are primarily affected by 2 factors:

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The current interest rate. The price of a bond, and therefore the value of your

investment fluctuates with changes in interest rates. For example, you buy a bond for

Rs. 1,000 that pays 5 % interest. If you hold the bond until maturity, you get your Rs.

1,000 back plus the 5% interest payments you’ve received from the issuer. However,

between the time you bought the bond and the date it matures, the bond won’t

always be worth Rs. 1,000. If interest rates rise, your bond is worth less than Rs.

1,000. If interest rates fall, your bond is worth more than Rs. 1,000.

The credit quality of the issuer. If the rating agencies change the credit rating of the

issuer while you hold the bond, the value of your bond will be affected.

If the credit rating declines, the value of your bond will also decline. However, if you

hold the bond to maturity and the issuer doesn’t default, you will get your entire Rs.

1,000 back. When the bonds are initially priced, the maturity also helps determine

the price. Longer maturities tend to pay higher interest rates than shorter maturities.

That’s because your investment is exposed to interest-rate risk for a longer period of

time.

Factors affecting Interest Rates.

1. The government is the biggest borrower in the debt market, the level of borrowing

also determine the interest rates. On the other hand, supply of money is controlled

by the central bank by either printing more notes or through its Open Market

Operations (OMO).

2. RBI. RBI can change the key rates (CRR, SLR and bank rates) depending on the

state of the economy or to combat inflation. RBI fixes the bank rate which forms the

basis of the structure of interest rates and Cash Reserve Ratio (CRR) and Statutory

Liquidity Ratio (SLR), which determine the availability of credit & the level of money

supply in the economy.

3. CRR is the percentage of its total deposits a bank has to keep with RBI in cash or

near cash assets and SLR is the percentage of its total deposits a bank has to keep

in approved securities. The purpose of CRR and SLR is to keep a bank liquid at any

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point of time. When banks have to keep low CRR or SLR, it increases the money

available for credit in the system. This eases the pressure on interest rates and these

move down.

4. Typically a higher inflation rate means higher interest rates. The interest rates

prevailing in an economy at any point of time are nominal interest rates, i.e., real

interest rates plus a premium for expected inflation. Due to inflation, there

is a decrease in purchasing power of every rupee earned; therefore the interest rates

must include a premium for expected inflation.

Yield Curve.

The relationship between time and yield on securities is called the yield curve. The

relationship represents the time value of money-showing that people demand a positive

rate of return on the money they are willing to part-with today for a payback into the

future. A yield curve can be positive, neutral or flat.

A positive yield curve, which is most natural, is when the yield at the longer end is

higher than that at the shorter end of the time axis. This is because people demand

higher returns for longer term investments.

A neutral yield curve has a zero slope, i.e. is flat across time. This occurs when

people are willing to accept more or less the same returns across maturities.

The negative yield curve (also called an inverted yield curve) occurs when the long-

term yield is lower than the short-term. It is not often that this happens and has

important economic ramifications when it does. It generally represents an impending

downturn in the economy, where people are anticipating lower interest rates in the

future.

Yield to maturity.

Yield to maturity is the annualised return an investor would get by holding a fixed income

instrument until maturity. It is the composite rate of return of all payouts and coupon.

Average maturity period.

LIBOR. Stands for the London Inter Bank offered Rate. This is a very popular

benchmark and is issued for US Dollar , GB Pound , Euro , Swiss Franc, Canadian

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Dollar and the Japanese Yen . The British Bankers Association (BBA) asks 16 banks

to contribute the LIBOR for each maturity and for each currency. The BBA weeds out

the best four and the worst 4 , calculates the average of the remaining 8 and the

value is published as LIBOR

MIBOR

Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the

LIBOR Currently there are 2 calculating agent for the benchmark-Reuters and the

National Stock Exchange (NSE) . The NSE MIBOR benchmark is the more popular of

the two and is based on rates polled by NSE from a representative panel of 31 bank /

institutions/primary dealers .

Credit Rating

Rating organization evaluate the credit worthiness of an issuer with respect to debt

instruments or its general ability to pay back debt over the specified period of time. The

rating is given as an alphanumeric code that represents a graded structure or

creditworthiness. Typically the highest credit rating is AAA and the lowest is D (for

default). Within the same alphabet class, the rating agency might have different grades

like A, AA, and AAA and within the same grade AA+, AA- where the “+” denotes better

than AA and “-” indicates the opposite. For short-term instruments of less than one year,

the rating symbol would be typically “p” (varies depending on the rating agency).

In India, we have 4 rating agencies:

CRISIL

ICRA

CARE

Fitch

Currency valuation.

The floating exchange rate system is a confluence of various demand and

supplyfactors prevalent in an economy such as:

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Current account balance. The trade balance is the difference between the value of

exports and imports. If India is exporting more than it is importing, it would have a

positive trade balance with USA, leading to a higher demand for the home currency.

As a result, the demand will translate into appreciation of the currency and vice

versa.

Inflation rate. Theoretically, the rate of change in exchange rate is equal to the

difference in inflation rates prevailing in the 2 countries. So, whenever, inflation in

one country increases relative to the other country, its currency falls.

Interest rates. the funds will flow to that economy where the interest rates are higher

resulting in more demand for that currency.

Speculation. Another important factor is the speculative and arbitrage activities of

big players in the market which determines the direction of a currency. In the event

global turmoil, investors flock towards perceived safe haven currencies like the US

dollar resulting in a demand for that currency.

Assured Return Schemes. Some investors look for investment options which

guarantee them a fixed amount of return year after year because they believe they

stand to gain without taking any risk. However, they could be exposing themselves to

a much bigger risk the risk of not keeping ahead of inflation. This is why it may be

wise to have an investment portfolio that consists of more than just guaranteed

return schemes.

Fixed-Income funds : Fixed-income funds have the potential to earn a rate of

interest commensurate with market interest rates.

Credit Ratings.

Credit ratings of companies are rapidly changing. Well-diversified income funds are able

to spread this risk as research analysts are were equipped to track company credit rating

changes.

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Investing through a bond/fixed income fund does not mean giving up liquidity as is

normally required with fixed deposits such as assured returns schemes. For steady and

regular income, mutual funds that invest primarily in bonds and other fixed income

instruments may be the right addition to your portfolio. Bonds have traditionally provided

higher current income than bank fixed deposits, and they are also considered to be more

conservative and less volatile than stocks in general. That is why many investors select

fixed income/bond funds to balance their investment portfolio. Bear in mind though, that

fixed income fund returns and NAV prices can fluctuate with changes in the debt market

conditions. Historically, however, fixed income/bond funds have offered a higher degree

of price stability than stock funds.

Money market funds.

Money funds provide investors with current income and are managed to maintain a

stable share price. Because of their stability, money funds are often used for cash

reserves or money that might be needed right away.

Money funds typically invest in short-term, high-quality, fixed-income securities, such as

treasury bills, short-term bank certificates of deposit (CDs), banker’s acceptances and

commercial paper issued by corporations. The average maturity of a money fund’s

portfolio must be 90 days or less to help protect against interest rate risk. The income

money funds provide is generally determined by short-term interest rates.

Chapter. 7.

Choosing of funds.

When it comes down to it, the decision to invest in a mutual fund is one you have to

make on your own. When you try to choose an investment, however, it is a good idea

to seek the guidance of a financial advisor who will review its objective to make sure

it supports your financial goal.

As an investor, your goals are unique, and a financial advisor can help match you with

the best funds. Remember, however, when you are choosing funds, to consider how

much risk you are comfortable with and when you’ll need the money. If you have the

time to weather the market’s ups and downs, you may want to consider equity

investments.

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Before you select a mutual fund, it is essential to read the prospectus carefully to learn

all you can about the fund’s performance, investment goals, risks, charges and

expenses.

Decision-making factors

Before looking at the mutual funds available to you, it may be best to decide the mix

of stock, bond, and money market funds you prefer. Some experts believe this is the

most important decision in investing. Here are some general points to keep in mind

when deciding what your investment strategy should be.

Diversify. It is a good idea to spread your investment among mutual funds that invest

in different types of securities. stocks, bonds, and money market securities work

differently. Each offers different advantages and disadvantages. You may also want

to diversify within the same class of

Securities. Diversifying can keep you from putting all your eggs in one basket and

therefore, may increase your returns over a long period of time.

Consider the effects of inflation. Since the money you set aside today may be

intended to be used several years down the road, you need to look at inflation.

Inflation measures the increase of general prices over time.

Conservative investments like money market funds often may be popular because

they are managed to keep a steady value. But their return after accounting for the

inflation rate can be very low, perhaps even negative.

For example, a 4% inflation rate over a period of many years could erase a money

funds 3% yield over the same period of time. So even though such an investment

may give some safety of principal, it may not be able to grow enough in value over

the years or even keep up with the rate of inflation.

Patience is a virtue. It’s no secret—the price of common stocks can change quite a

bit from day to day. Therefore, the part of your account invested in stock funds would

likely fluctuate in value much the same way.

If you don’t need your money right away (for at least 5 years), you probably don’t

need to panic if the stock market declines or you find that your quarterly statement

shows the value over time. Although you are not assured it will do so in the future ,

try to be patient and allow your stock funds time to recover.

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Remember the saying, “buy low, sell high.” Switching out of a stock mutual fund when

prices are low is usually not the way to make the most of your investment. Of course, if a

fund continues to under-perform over time as well as your other fund choices, you may

want to consider changing funds.

Look at your age. Younger investors may be more at ease with stock funds, because

they have time to wait out the short-term ups and downs of stock prices. By investing in

a stock fund, they might be able to receive high returns over the long-term.

On the other hand, people who are closer to retirement may be more interested in

protecting their money from possible drops in prices, since they’ll need to use it soon. In

this case, it may be wise to place a greater percentage of money in bond and/or money

market funds, which may not have such large changes in value.

How can you determine an investment mix appropriate for your age? One may is to

subtract your age from 100. The answer you come up with may be a good number to

start with in deciding what portion of your total investments to put into stock mutual

funds.

Risk. When you are choosing funds, be sure to consider how much risk you are

comfortable with and how close you are to retirement. If retirement is around the corner,

you may want a portfolio with very little risk. On the other hand, if you are younger, and

have the time to weather the market’s ups and downs, you may want to choose a more

aggressive investment strategy.

Start with your financial goals

Before one choose investment, one write down your financial goals-retirement children’s

education and so forth. For each goal, be sure to consider:

Your risk tolerance

Your time frame

The more time you have to reach your goal, the more choices you have. Its much easier

to tolerate risk when you have plenty of time to ride out short-term volatility—the ups and

down in the value of your investment. A long time frame means you can choose to go

after the higher long-term returns that equities have historically delivered. Another

advantage of a long time frame is that the more years you money compounds, the less

you need to save to reach your goal.

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Next understand your investment options

While there are hundreds of mutual funds to choose from, they mostly fall into 3

categories.

Equities (also called stocks)

Fixed-income (also called bonds)

Cash equivalents (a type of liquid investment such as a money market fund)

The risk of losing money with cash-equivalent investment s is low, but so is the long-

term return as compared with equities. With equities, the risk of losing money in the

short run is much higher, but the potential for higher lone-term returns is also there. The

best asset mix is a very personal decision. One size definitely doesn’t fit all investors. If

you’re a long-term investor, investing solely in cash equivalents could leave you open to

the risk of inflation. Short-term investors on the other hand, need to be more concerned

with the risk posed by volatility.

Strategies for reducing risk

Successful investors use several strategies to reduce their investment risk including:

Diversification

Asset allocation

Rupee-cost averaging

Diversification is a big word that means it’s not a good idea to put all your eggs in one

basket. It’s not the same as asset allocation which is how you divide your money

between stocks, bonds and liquid investments. The best asset allocation will give you

the return you need while not having more risk than you can tolerate.

Even though your investment strategy is in place, you may be hesitant to start investing.

Maybe the financial markets are ready to tumble. No one wants to invest at the wrong

time, but investment professionals will tell you that there no way to know the perfect

time. That’s where rupee-cost averaging comes in. it’s an automatic investing technique-

you put in the same amount at a regular frequency( monthly, for example).

Mutual funds invest primarily in three types of securities:

Stocks, Bonds and Cash-like securities

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Each has a place in your investment portfolio. You’ll use more of one and less of another

depending on your financial goal and your answers to 3 questions:

Is the date you need the money flexible or fixed?

Will you invest a lump sum or save periodically?

How much volatility can you handle?

Stocks and stock funds

When a company needs to grow or expand, it may sell part of it’s ownership to the public

in the form of shares (stock). In exchange for the money received from the sale, the

company gives shareholders a portion of it’s future profits, as well as a measure of its

decision-making power. When a mutual fund buys stocks, the fund’s shareholders

become part owners of the companies that issued those stocks.

Stock price can change greatly from day to day, depending on the supply and demand

for the stock. If many investors want to buy the stock, the price may go up. If fewer

investors are interested in buying the stock, the price may go down.

Not all stock funds are alike.

A stock funds risk and return depend on the types of companies it buys. Pure growth

funds buy companies that are expected to grow rapidly. These companies tend to use

their profits to finance future growth rather than paying them out as dividends. Other

stock funds invest more conservatively, favouring large, established companies that pay

reliable dividends which provide income that can reduce the fund’s volatility.

Benefits of investing for growth.

People invest in stock funds because they hope their investment will have grown

substantially when they finally sell it. Over the long term, stock funds have outperformed

bond funds and money market funds and have been the best hedge against inflation. In

order to enjoy the benefits of investing in stock funds, you should maintain a long-term

view. While stocks have produced the greatest returns over time stocks prices fluctuate,

sometime widely.

If your time frame is flexible, you might be able to wait out any temporary downward

price movements in the value of your stock fund. On the other hand, if your time frame is

fixed, and especially if it’s short, volatile investments such as stock funds can be risky.

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While volatility is not of great concern to the average long term, buy-and-hold investor, it

can be worrisome to people who check fund prices daily and can’t get a good night’s

sleep when a stock fund is losing value. Using rupee-cost averaging rather than a lump-

sum approach to buying and selling investments helps ameliorate the average person’s

discomfort.

Bonds and Fixed-Income Funds.

A bond is a negotiable IOU, or debt security, issued by a corporation, government or

government agency. When investors buy a bond, they’re lending a certain sum of money

(principal) to the bond issuer for a specified time period (term).

In return, the issuer promises to:

Make regular interest payments during the term at a rate set when the bond is

issued.

Repay the face value of the bond on the maturity date.

About maturity. A bond’s maturity indicates when its issuer is required to repay the

principal. Bonds are classified in 3 general maturity ranges:

Short-term—usually less than 3 years

Intermediate-term—between 3 and 10 years

Long-tern—greater than 10 years

In general, the longer the maturity, the higher the bond’s interest rate. This is to

compensate you for the risk of tying up your money at a fixed-interest rate for a longer

period of time.

How interest rates affect price. Between the time you buy a bond or bond fund and the

time you sell it the value of your principal will fluctuate. Generally, when interest rates go

up, bond prices move lower-and when they move down, bond prices move higher. As

you might expect, the best time to invest in bonds generally is when interest rates are

declining. Typically, the longer a bond’s maturity, the higher the interest-rate risk, or the

more sensitive its price will be to interest rate changes.

Can one lose money investing in bonds. People mistakenly assume that the word “fixed-

income” means they can’t lose money owning a bond. But the interest rate that the

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issuer pays is the only part of the investment that is “fixed”. The value of your principal,

on the other hand, has the ability to increase or decrease depending on whether

interests rates move up or down.

It’s different with bond funds. The fund typically doesn’t hold all the bonds until they

mature. When you buy a bond fund, you get diversification because the fund owns many

bonds, not just one. This diversification helps protect you from credit risk—the risk that

the issuer fails to make timely interest payments or to repay principal. However, this

means that the income you receive from the fund fluctuates along with your principal, as

the fund buys and sells bonds paying different rates of interest.

Types of bonds. There are many types of fixed-income securities to choose from.

Funds will often emphasize one type or another to help investors meet their investment

objectives.

Government securities issued by the Indian government are considered the most

credit worthy of all debt instruments-since they are backed by the full faith and credit

of the government. Treasury bonds, bills and notes have a wide range of maturities.

Corporate bonds are issued by companies in order to finance projects ranging from

building a new plant to modernising at a current location. Risk and return vary,

depending on the financial strength of a corporation. Bonds issued by corporations

with lower credit quality generally pay a higher rate of interest to compensate

investors for the higher repayment risk.

State government bonds are issued by local governments in order to finance a

variety of projects, ranging from water systems and public schools, to hospitals and

police protection. State government bonds are generally considered to be relatively

low risk investments, second only to securities issued by the federal government and

its agencies. However, within state government bonds themselves, there is a wide

range of credit quality.

These bonds are exempt from federal taxes and, in the state of issue, often free of state

and local income tax as well. Before choosing a tax-free fund, you should consider the

equivalent taxable yield-what a taxable investment would have to yield before taxes to

equal the tax-free yield of a particular tax-free bond investment.

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Do bond funds make sense for you. Nearly all investors can benefit from having a

portion of their portfolio allocated to bonds. Even for investors whose primary objective is

long-term growth, bonds can play an important role in building a well-diversified portfolio.

Let’s go back to the questions we posed earlier. First is your frame. Bond funds offer

greater potential return than cash-equivalent investments such as money market funds,

But they can be riskier than money market funds for people with very short time frames

and for those who need to withdraw all their money on a fixed date.

Bond funds provide diversification and can be a key element in your asset

allocation strategy to combat the volatility of stock, while bond prices and returns can

fluctuate, over the long haul bond funds have been less volatile than stock funds, for

people who are very risk averse, while bond funds lag behind stock funds as an inflation

fighter, they are better than cash-equivalent investments are at preserving your

purchasing power.

Cash-equivalent investments and money market funds

In many respects, most money market instruments are just short-term versions of bonds.

They are short-term, high-quality, fixed-income securities, such as treasury bills, short-

term bank certificates of deposit 0(CDs), and commercial paper issued by corporations.

The average maturity of a money fund’s portfolio must be 90 days or less to help protect

against interest rate risk. The income money funds provide is generally determined by

short-term interest rates.

Money funds provide you with current income and seek to preserve your principal.

Because of their stability, money funds are often used for emergency cash reserves or

for a very short-term financial goal.

Cash-equivalent investments and money market funds are the least volatile of the

investment types we discussed and are therefore ideal for people with extremely low risk

tolerance. However, the income from this type of investment is only slightly higher than

interest rates offered by banks on saving accounts making them poor choices to combat

the damage inflation inflicts on your purchasing power.

Risk and reward go Hand-in-hand

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When choosing investments, remember the tradeoff between risk and return. The

higher the return you seek, the more risk you’ll need to accept. There’s no such thing as

a low risk-high return investment.

As always, you will want to consult your financial advisor about how fixed income

funds could playa role your investment strategy.

Golden rules for investment in Mutual Funds.

1. If you begin with a prayer, you can think more clearly and make fewer mistakes.

2. Outperforming the market is a difficult task. The challenge is not simply making

better investment decisions than the average investor. The real challenge is making

investment decisions that are better than those of the professionals who manage the

big institutions.

3. Invest—don’t trade or speculate. The stock market is not a casino, but if you move in

or out of stock every time they move a point or tow, the market will be your casino.

And you may lose eventually or frequently.

4. Buy value, not market trends or the economic outlook. Ultimately, it is the individual

stocks that determine the market, not vice-versa. Individual stocks can rise in a bear

market and fall in a bull market. So buy individual stocks, not the market trend or

economic outlook.

5. When buying stocks, search for bargains among quality stocks. Determining quality

in a stock is like reviewing a restaurant. You don’t expect it to be 100% perfect, but

before it gets three or four stars you want it to be superior.

6. Buy low. So simple in concept. So difficult in execution. When prices are high, a lot of

investors are buying a lot of stocks. Prices are low when demand is low. Investors

have pulled back, people are discouraged and pessimistic. But, if you buy the same

securities everyone else is buying, you will have the same results as every one else.

By definition, you can’t outperform the market.

7. There’s no free lunch. Never invest on sentiment. Never invest solely on a tip. You

would be surprised how many investors do exactly this. Unfortunately there is

something compelling about a tip. Its very nature suggests inside information, a way

to turn a fast profit.

8. Do your homework or hire wise experts to help you. People will tell you: Investigate

before you invest. Listen to them. Study companies to learn what makes them

successful.

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9. Diversify—by company, by industry. In stocks and bonds, there is safety in numbers.

No matter how careful you are, you can neither predict nor control the future. So you

must diversify.

10. Invest for maximum total real return. This means the return after taxes and inflation.

This is the only rational objective for most long-term investors.

11. Learn from your mistakes. The only way to avoid mistakes is not to invest—which is

the biggest mistake of all. So forgive yourself for your errors and certainly do not try

to recoup your losses by taking bigger risks. Instead, turn each mistake into a

learning experience.

12. Aggressively monitor your investments. Remember, no investment is forever. Expect

and react to change. And there are no stocks that you can buy and forget. Being

relaxed doesn’t mean being complacent.

13. An investor who has all the answers doesn’t even understand all the questions. A

cocksure approach to investing will lead, probably sooner than later, to

disappointment if not outright disaster. The wise investor recognizes that success is

a process of continually seeking answers to new questions.

14. Remain flexible and open-minded about types of investment. There are times to buy

blue-chip stocks, cyclical stocks, convertible bonds, and there are times to sit on

cash. The fact is there is no one kind of investment that is always best.

15. Don’t panic. Sometimes you won’t have sold when everyone else is buying, and you

will be caught in a market crash. Don’t rush to sell the next day. Instead, study your

portfolio. If you can’t find more attractive stocks, hold on to what you have.

16. Don’t be fearful or negative too often. There will, of course, be corrections, perhaps

even crashes. But over time our studies indicate,stocks do go up…. And up…. And

up. In this century or the next, it’s still “buy low, sell high”.

Investment Strategy

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Finding the right investment has become quite a challenge. Most of us fall prey to buying

the latest top performers and accumulating a few shares of this and that without really

considering our financial goals, timeframe and tolerance for risk.

Whether you are planning for you individual retirement, investing to meet the expenses

of your child’s higher education, or simply building cash reserves, it is important to match

your financial goals with a mix of assets that may help you meet those goals.

To build a successful investment strategy you should carefully structure your plan to

achieve your goals without taking more risk than you can afford or are comfortable with.

You also need to consider how much time you have to reach your various goals.

1) The first step is to define our financial goals. Our choice of investment should always

be driven by what you want your money to do for you, and when. You may want your

investments to fill specific needs such as buying a house or a car, paying children’s

education costs or simply building a comfortable retirement nest egg. Your goals

may be more general—like building cash reserves or accumulating wealth. Either

way, spending time to determine your financial goals will help you choose the most

appropriate investments.

2) The next step is to identify the approximate time frame within which you wish to

achieve the goals you have listed. For example, do you aim to buy a house in five

years, or retire in the next twenty years? Setting time frames for your goals is critical.

3) Different time frames require different investment strategies. The sooner you need to

spend the money now invested, the greater is the need to invest for principal stability

and liquidity. Conversely, the longer you can leave your money invested. The less

you need to worry about short-term price fluctuations and the more you can focus on

earning a high return over time.

4) Risk, return and timing are all related. Generally, the riskier an investment, the higher

its potential return over time and the more suitable it is for an investor with a long

time frame.

5) Most of us fail to take into account inflation and taxes. Therefore, it would be

advisable to spend some time and take into consideration, the future cost of the goal.

how much risk can you afford to take.

6) Each and every individual has a personal tolerance for risk and in order to set an

investment course that you will be comfortable with—and will not abandon

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prematurely—you need to think about your willingness to accept fluctuations in the

value of your investment s.

7) As you assess your risk tolerance, you will need to consider how soon you need to

reach every investment goal. Longer-term goals allow you to pursue more

aggressive and potentially more rewarding strategies because the investment has

time to recover from market setbacks.

8) Financial goals that need to be met sooner rather than later call for lower or

moderate risk approaches. Whatever the investment profile may be, one of the best

ways to reduce overall risk is to diversify your investments.

9) No single asset class (stocks, bonds, or money market instruments) is appropriate

for all of your goals. At any given point in your life, you will probably want to keep

part of your money secure and accessible, part invested for income and part

invested for growth. But the proportions will change as you prepare for and achieve

successive investment objectives.

10) It is a good idea to review your goals and investments once a year, keeping in mind

the objective each time a new investment is made. As your circumstances change,

so will you investing strategy.

Certain Investment Mistakes made by Individuals

1. Investing without a clear plan of action. Many people neglect to take the time to think

about their needs and long-term financial goals before investing. Unfortunately, this

often results in their falling short of their expectations. You should decide whether

you are interested in price stability, growth, or a combination of these. Determine

your investment goals. Then, depending on your timeframe and your tolerance for

risk, select mutual funds with objectives similar to yours.

2. Meddling with your account too often. You should have a clear understanding of your

investments so that you are comfortable with their behaviour. If you

keep transferring investments in response to downturns in prices, you may miss the

upturns as well. Even in the investment field, the “tortoise” who is more patient, may

win over the “hare”. While past performance does necessarily guarantee future

performance, your understanding of the behaviour of various investments over time

can help prevent you from becoming short-sighted about your long-term goals.

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3. Losing sight of inflation. While you may be aware of the fact that the cost of goods

and services is rising, people tend to forget the impact inflation will have on

investments in long-term. You have to keep in mind that inflation will eat into your

savings faster than you can imagine.

4. Investing too little too late. People do not “pay themselves first”. Most people these

days have too many monthly bills to pay, and planning for their future often takes a

backseat. Regardless of age or income, if you do not place long-term investing

among your top priorities, you may not be able to meet your financial goals. The

sooner you start, the less you have to save every month to reach your financial goals

5. Putting all your eggs in one basket. When it comes to investing, most of us do not

appreciate the importance of diversification. While we know that we should not “put

all our eggs in one basket” , we often do not relate this concept to stocks and bonds.

Take the time to discuss the importance of diversifying your investments among

different asset categories and industries with your financial advisor. When you

diversify, you do not have to rely on the success of just one investment.

6. Investing too conservatively. Because they are fearful of losing money, many people

tend to rely heavily on fixed-income investments such as bank fixed deposits and

company deposits. By doing this, however, you expose yourself to the risk of

inflation. consider diversifying with a combination of investments. Include stock

funds, which may be more volatile, but have the potential to produce higher returns

over the long term.

Net Asset Value (NAV).

The net asset value of the fund is the cumulative market value of the assets fund net of

its liabilities. In other words, if the fund is dissolved or liquidated, by selling off all the

assets in the fund, this is the amount that the shareholders would collectively own. This

gives rise to the concept of net asset value per unit, which is the value, represented by

the ownership of one unit in the fund. It is calculated simply by dividing the net asset

value of the fund by the number of units. However, most people refer loosely to the NAV

per unit as NAV, ignoring the “per unit”. We also abide by the same convention.

Calculation of NAV

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The most important part of the calculation is the valuation of the assets owned by the

fund. Once it is calculated, the NAV is simply the net value of assets divided by the

number of units outstanding. The detailed methodology for the calculation of the asset

value is given below.

Asset value is equal to

Sum of market value of shares/debentures

+Liquid assets/cash held, if any

+Dividends/interest accrued

Amount due on unpaid assets

Expenses accrued but not paid

Details on the above items

For liquid shares/debentures, valuation is done on the basis of the last or closing market

price on the principal exchange where the security is traded for illiquid and unlisted

and/or thinly traded shares/debentures, the value has to be estimated. For shares, this

could be the book value per share or an estimated market price if suitable benchmarks

are available. For debenture and bonds, value is estimated on the basis of yields of

comparable liquid securities after adjusting for liquidity. The value of fixed interest

bearing securities moves in a direction opposite to interest rate changes valuation of

debenture and bonds is a big problem since most of them are unlisted and thinly traded.

This gives considerable leeway to the AMCs on valuation and some of the AMCs are

believed to take advantage of this and adopt flexible valuation policies depending on the

situation. Interest is payable on debentures/bonds on a periodic basis say every 6

months. But, with every passing day, interest is said to be accrued, at the daily interest

rate, which is calculated by dividing the periodic interest with the number of days in each

period. Thus, accrued interest on a particular day is equal to the daily interest rate

multiplied by the number of days since the last interest payment date.

Usually, dividends are proposed at the time of the Annual General Meeting and become

due on the record date. There is a gap between the dates on which it becomes due and

the actual payment date. In the intermediate period, it is deemed to be “accrued”.

Expenses including management fees, custody charges etc. are calculated on daily

basis.

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Chapter.8. History of Mutual Funds in India.

History of the Indian Mutual Fund Industry. The mutual fund industry in india

started in 1963 with the formation of unit trust of India, at the initiative of the

Government of India and The Reserve Bank. The history of mutual funds in India can

be broadly divided into four distinct phases

First phase – 1964-87 Unit Trust of India (UTI) was established on 1963 by an Act

of parliament. It was set up by The Reserve Bank of India and functioned under the

Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was

de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over

the regulatory and administrative control in place of RBI. The first scheme launched

by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of

assets under management.

Second phase – 1987-1993 (Entry of Public Sector Funds) 1987 marked the entry

of non- UTI, public sector mutual funds set up by public sector bank and life

insurance corporation of india (LIC) and general insurance corporation of india

(GIC) , SBI mutual fund was the first non – UTI mutual established in June 1987

followed by Canbank mutual fund (Dec 87), Punjab National Bank Mutual fund (Aug

89) , Indian Bank Mutual Fund (Nov 89) , Bank of India (Jun 90), Bank of Baroda

Mutual Fund (Oct 92) , LIC established its mutual fund in June 1989 while GIC had

set up its mutual fund in December 1990 , At the end of 1993 ,the mutual fund

industry had assets under management of Rs . 47,004 corers.

Third Phase – 1993 – 2003 (Entry of Private Sector Funds) with the entry of private

sector funds in 1993, a new era started in the Indian mutual fund industry, giving the

Indian investors a wider choice of fund families. Also, 1993 was the year in which the

first Mutual Fund Regulations came into being, under which all mutual funds, except

UTI were to be registered and governed. The erstwhile Kothari Pioneer(now merged

with Franklin Templeton) was the first private sector mutual fund registered in July

1993. The 1993 SEBI (Mutual Fund) Regulations were substituted by a more

comprehensive and revised Mutual Fund Regulations in 1996. The industry now

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functions under the SEBI (Mutual Fund) Regulations 1996. The number of mutual

fund houses went on increasing, with many foreign mutual funds setting up funds in

India and also the industry has witnessed several mergers and acquisitions. As at

the end of January 2003, there were 33 mutual funds with total assets of Rs.1,21,805

crores. The Unit Trust of India with Rs.44,541 crores of assets under management

was way ahead of other mutual funds.

Fourth phase – since February 2003 In February 2003, following the repeal of the

Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the

specified undertaking of the Unit Trust of India with assets under management of

Rs.29,835 crores as at the end of January 2003, representing broadly, the assets of

US 64 scheme, assured return and certain other schemes. The Specified

Undertaking of Unit Trust of India, functioning under an administrator and under the

rules framed by Government of India and does not come under the purview of the

Mutual Fund Regulations. The second is the UTI Mutual Fund Ltd, sponsored by

SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual

Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000

more than Rs.76,000 crores of assets under management and with the setting up of

a UIT Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with

recent mergers taking place among different private sector funds, the mutual fund

industry has entered its current phase of consolidation and growth. As at the end of

September, 2004, there were 29 funds, which manage of Rs.1,53,108 crores under

421 schemes.

Comparison Between Investment in Banks and Mutual Funds.

Banks v/s Mutual Funds

BANKS MUTUAL FUNDS

Returns Low Better

Administrative exp. High Low

Risk Low Moderate

Investment options Less More

Network High penetration Low but improving

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Liquidity At a cost Better

Quality of assets Not transparent Transparent

Interest calculation Minimum balance between

10th. & 30th. Of every month

Everyday

Chapter.9. Regulatory Aspects of Mutual Funds in India.

Schemes of a Mutual Fund

The asset management company shall launch no scheme unless the trustees

approve such scheme and a copy of the offer document has been filed with the

Board.

Every mutual fund shall along with the offer document of each scheme pay filing

fees.

The offer document shall contain disclosures which are adequate in order to enable

the investors to make informed investment decision including the disclosure on

maximum investments proposed to be made by the scheme in the listed securities of

the group companies of the sponsor A close-ended scheme shall be fully redeemed

at the end of the maturity period. “Unless a majority of the unit holders otherwise

decide for its rollover by passing a resolution”.

The mutual fund and asset management company shall be liable to refund the

application money to the applicants,-

i. If the mutual fund fails to receive the minimum subscription amount referred to in

clause(a) of sub-regulation (1);

ii. If the moneys received from the applicants for units are in excess of subscription as

referred to in clause (b) of sub-regulation (1).

The asset management company shall issue to the applicant whose application has

been accepted, units certificates or a statement of accounts specifying the number of

units allotted to the applicant as soon as possible but not later than six weeks from

the date of closure of the initial subscription list and or from the date of receipt of the

request from unit holders in any open ended scheme.

Rules Regarding Advertisement:

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The offer document and advertisement materials shall not be misleading or contain any

statement or opinion, which are incorrect or false.

Investments Objectives and Valuation Policies:

The price at which the units may be subscribed or sold and the price at which such units

may at any time be repurchased by mutual fund shall be made available to the investors.

General Obligations:

Every asset management company for each scheme shall keep and maintain proper

books of accounts, records and documents, for each scheme so as to explain its

transaction and to disclose at any point of time the financial position of each scheme

and in particular give a true and fair view of the state of affairs of the fund and

intimate to the Board the place where such books of accounts, records and

documents are maintained.

The financial year for all the schemes shall end as of march 31 of each year. Every

mutual fund or the asset management company shall prepare in respect of each

financial year an annual report and annual statement of accounts of the schemes

and the fund as specified in Eleventh Schedule.

Every mutual fund shall have the annual statement of accounts audited by an auditor

who is not in any way associated with the auditor of the asset management

company.

Procedure for Action In Case Of Default:

On and from the date of the suspension of the certificate or the approval, as the case

may be, the mutual fund, trustees or asset management company, shall cease to carry

on any activity as a mutual fund, trustee or asset management company, during the

period of suspension, and shall be subject to the directions of the board with regard to

any records, documents, or securities that may be in its custody or control, relating to its

activities as mutual fund, trustees or asset management company.

Restrictions on Investments:

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A mutual fund scheme shall not invest more than 15% of its NAV in debt instruments

issued by a singal issuer, which are rated not below investment grade by a credit

rating agency authorized to carry out such activity under the Act. Such investment

limit may be extended to 20% of the NAV of the scheme with the prior approval of

the Board of Trustees and the Board of asset management company.

A mutual fund scheme shall not invest more than 10% of its NAV in unrated debt

instruments issued by a single issuer and the total investment in such instruments

shall not exceed 25% of the NAV of the scheme. All such investments shall be made

with the prior approval of the Board of Trustees and the Board of asset management

company.

No mutual fund under all its schemes should own more than ten percent of any

company’s paid up capital carrying voting rights.

Such transfers are done at the prevailing market price for quoted instruments on spot

basis.

The securities so transferred shall be in conformity with the investment objective of

the scheme to which such transfer has been made.

A scheme may invest in another scheme under the same asset management

company or any other mutual fund without charging any fees, provided that

aggregate inter scheme investment made by all scheme under the same

management or in scheme under the management of any other asset management

company shall not exceed 5% of the net asset value of the mutual fund.

The initial issue expenses in respect of any scheme may not exceed six per cent of

the funds raised under that scheme.

Every mutual fund shall buy and sell securities on the basis of deliveries and shall in

all cases of purchase, take delivery of relative securities and in all cases of sale,

deliver the securities and shall in no case put itself in a position whereby it has to

make short sale or carry forward transaction or engage in bad finance.

Every mutual fund shall, get the securities purchased or transferred in the name of

the mutual fund on account of the concerned scheme, wherever investments are

intended to be of long-term nature.

Pending deployment of funds of a scheme in securities in terms of investment

objective of the scheme a mutual fund can invest the funds of the scheme in short

term deposits of scheduled commercial banks.

No mutual fund scheme shall make any investments in;

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i. Any unlisted security of an associate or group company of the sponsor; or

ii. Any security issued by way of private placement by an associate or group company

of the sponsor; or

iii. The listed securities of group companies of the sponsor which is in excess of 30%

of the net assets [ of all the schemes of a mutual fund]

No mutual fund scheme shall invest more than 10 per cent of its NAV in the equity

shares or equity related instruments of any company. Provided that, the limit of 10

per cent shall not be applicable for investments in index fund or sector or industry

specific scheme.

A mutual fund scheme shall not invest more than 5% of its NAV in the equity shares

or equity related investments in case of open-ended scheme and 10% of its NAV in

case of close-ended scheme.

Risk Management in the Indian Markets

The major risks the market faces in such crunch situations are that of a settlement and

payment crisis, or a market-wide liquidity crisis. This time, any such untoward incident

did not happen either on and after the Black Monday. Sebi, stock exchanges and RBI

had excellent the risk management procedures in place; no settlement, payment or

liquidity crisis hit the market after the largest intraday fall in the market.

Risk Faced by the Markets

It is usually seen that during a big crash, the risk management systems go awry, and the market tumbles to lower levels even days after the crash. Problems in settlement among brokers erupt, and this pulls the entire system apart. Consider Ketan Parekh’s example. In April 2001, Calcutta Stock Exchange was engulfed in one of the country’s worst-ever payment crises, sending the markets into a dizzy trip. On the occasion, ten defaulting brokers or broking firms belonging to three major players failed to pay up settlements. The crisis depleted Rs.48 Cr of CSE’s Settlement Guarantee Fund and Rs.20 cr from the general reserves. This was the doing of the Big Bull No.2, Ketan Parekh, who allegedly used some CSE brokers as his front for deals in the information, communication and entertainment shares.

Sebi’s Stock Watch System

Sebi has an extensive Stock Watch System, a system with a common framework across

all the stock exchanges in place. The objectives of this system are to give suitable

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indicators for the detection of potential illegal or improper activities to protect investor

confidence and integrity of the securities market and its players. The Stock Watch

System has standardized information available with all the stock exchanges. This

standardized information is stored in the form of four databases classified a issuer,

securities, trading and member databases. Sebi performs the overall surveillance of the

markets through these extensive databases.

Risk Management at Stock Exchanges

The Stock Watch System, in concert with stock exchanges, also generates on-line and

off-line alerts based on order ad trade related information during the trading hours and

the trade related information at the end of the day respectively. There is rigid system for

alert generation based on various parameters and monitoring the ‘price bands’ is one

such parameter. When the price of a security hits an upper or lower limit, its price is

restricted to that price band for a predetermined period of time. Daily price bands are

applicable on the Previous Day’s Close Price. These price bands are applicable across

exchanges. When the price hits the price band in any one exchange, the other

exchanges too takes similar action. The ‘quantity freeze percentage’ is another

parameter for generating alerts. Here, any order, whose value is greater than or equal to

Rs.5 cr (subject to a ceiling of 1.00% of the issue size), results in a ‘quantity freeze’ and

does not go directly into the order books. Instead such orders go into the books only

after the exchange’s approval. A rejected quantity freeze results in the cancellation of

the order. This process ensures that large-scale manipulation in a stock price by large

shareholders like an FII or the promoter does not take place.

Some of the other alerts are auction market, price variation, high-low variation, open

price variation, consecutive trade price variation, quantity variation and price movement

in relation to the index. This is a complex system and ensures, on a minute to minute

basis that there is no manipulation in stock prices.

There is a rigorous off-line monitoring system that related to margins, exception

handling, capital adequacy norms for brokers and a rigorous set of compliance

procedures.

Margins: Margin represents a prescribed token amount that serves as a evidence of the

commitment made by a broker in the form of cash and/or securities or in any other form

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to honor the executed transaction / contract / trade. In other words, margins are charged

so that brokers honor their commitments. These margins are a security against non-

payment of dues. The various kinds of margins are the ‘Mark to Market’ margin,

‘Volatility Margin’ and the ‘Gross Exposure Margin.’

The Mark to Market margin, as the name suggests, is a margin levied on the

market price of the stock. Every day, at the closing price, the net outstanding

profit or loss is calculated and the same is payable by the broker. For each

security, this is worked out by multiplying the difference between the close price

and the price at which the trade was executed by the cumulative buy and sell

open positions. The aggregate across all securities is Mark to Market margin

payable by the broker. It is calculate das under.

Mark to Market Profit / Loss = [(Total Buy Quantity x Close Price) – Total Buy

Value) + (Total Sale Value – (Total Sale Quantity x Close Price)]

Volatility margin is imposed to curb excessive volatility in the market. It also acts

as a deterrent for brokers to build up excessive exposures. The actual Volatility

of a security is determined on the basis of fluctuations in stock prices over a six-

week period. The volatility percentage is defined as:

Six-Week High Price – Six-Week Low Price x 100

Six-Week Low Price

The Gross Exposure margin is the margin payable on the total rupee value of the

exposure of the broker.

All these margins ensure that brokers do not take very high risks and make

speculative trades in the market. Also, it ensures that brokers always take risks

that are commensurate with their risk taking capacity, which is determined by

their size of operations.

Capital Adequacy Norms for Brokers: Brokers have various levels of capital adequacy

norms, based on which they need to limit their exposure. First is the ‘base minimum

capital’ as stipulated by Sebi, second is the ‘additional base capital’ that is required to be

deposited with the clearing house for taking any additional exposure. In other words, if

the broker wants to have higher intraday limit and / or gross exposure limit, additional

deposit will have to be placed with the clearing house for a specified period. In addition

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to capital adequacy, ‘turnover limits’ have been placed on members. These are the

‘intraday turnover limit’ and the ‘gross exposure limit’.

Intraday Turnover Limit: Intraday gross turnover (i.e., buy value + sell value) of a

member should not exceed 25 times the base capital. If members violate this limit at any

time, their trading is topped for the remainder of the day.

Gross Exposure Limits: Members are also subject to gross exposure limits. Gross

exposure for a member, across all securities in rolling settlement, is computed as

absolute (buy value –sell value), i.e. ignoring positive and negative signs, across all

open settlements. Open settlements would be all those settlements for which trading has

commenced and for which settlement pay-in is not yet completed. The total gross

exposure for a member on any given day would be the sum total of the gross exposure

computed across all the securities in which a member has an open position.

Gross exposure limit would 8.5 times the total base capital, if the total base capital is

less than Rs.1cr. If the total base capital exceeds Rs.1 cr, the limit would be Rs.8.5 cr +

10 times the total base capital in excess of Rs.1 cr, or any such lower limits as

applicable to the members.

The total base capital being the base minimum capital (cash deposit and security

deposit) and additional deposits, not used towards margins in the nature of securities,

bank guarantee, FDR, or cash with the clearing house or the exchange.

Settlement Guarantee Mechanism: One of the chief methods employed for

comprehensive risk management by the clearinghouses is the Settlement Guarantee

Mechanism. The clearinghouse assumes the counter party risk of each member and

guarantees of trade settlements. Counter party risk is guaranteed through a fine-tuned

risk management system and an innovative method of online position monitoring and

automatic disablement. At NSCCL, a large Settlement Guarantee Fund, which stood at

Rs.1550.90 cr as on March 31, 2004 provides the cushion for any residual risk. As a

consequence, despite the fact that daily traded volumes have crossed Rs.10,000 cr,

credit risk no longer poses any problem to the market. It operates like a self-insurance

mechanism where members contribute to the fund. In the event of the failure of a trading

member to meet settlement obligations or committing default, the fund is utilized to the

extent required for successful completion of the settlement. This has eliminated counter-

party risk of trading on the exchange. A separate Settlement Guarantee Fund is

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maintained for the Futures and Options segment, which was worth Rs.4,356.85 cr on

March 31, 2004.

Circuit Breakers: The stock exchanges also have in place, what are known as ‘market-

wide circuit breakers’. Market-wide circuit breakers were introduced on June 28, 2001.

Much like an individual stock, the circuit breaker stops trading for the entire exchange if it

is hit. The circuit breakers get activated at three stages of index (NSE Nifty or BSE

Sensex) movement either way at 10%, 15% and 20%.

These percentage would be translated into absolute points of index variations on a

quarterly basis, and at the end of each quarter, these absolute points of index variations

would be revised and be applicable for the next quarter. The absolute points would be

calculated base don the closing level of the index on the last day of trading in a quarter

and rounded off to the nearest 25 points in the case of the BSE Sensex and the nearest

10 points in the case of the S & P CNX Nifty.

Technology: The application of information technology has helped in upgrading risk

management procedures tremendously. While online surveillance is totally dependent on

the technology, other features such as brokers hitting their margins or freeze quantity

percentages could not have been possible but for the advanced technology used in the

stock market to monitor the risks in the market.

Settlement Cycles: The short settlement cycle of T + 2 also was a leap forward in

attaining better risk management in the market. Longer settlement cycles invariably

allowed too much time between trade execution and settlement for a trading party to

become insolvent or for the value of a trade to deteriorate. The then Finance Minister,

Jaswant Singh, had also stated on July31, 2002 in the Parliament, “…market risk

management becomes far more efficacious at shorter settlement cycle. There is need,

therefore, to move to T + 1 rolling settlement from the existing T + 3 by tuning up the

funds and securities processing cycle.”

Indian markets are, thus, moving towards the T + 1 or straight through processing so

that there is minimum settlement risk. The faster the money moves after the trade, the

lesser time for a party to default payments, and the lesser the risk to the entire market.

Hedge Funds

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Although hedge funds had their beginning in 1950s, their popularity increased only in the

last decade. Though LTCM was bailed under the guidance of Federal Reserve and Wall

Street it marked a dark period for hedge funds. With this, the clamor for reforms, the

eagerness to understand their functioning and concern to protect investor and prevent

major shocks to world economies increased. And now hedge funds are back with a

bang. They are growing both in number (now totaling to an estimated 8,500 funds) and

worth of total assets managed. The industry now manages assets worth well over $ 1 tn,

compared to $50 bn in 1990. Although weak capital markets across the world over the

past few years have made hedge funds an attractive investment alternative, another

major reason for the recent spurt in their growth is funds of hedge funds.

Gone are the days when hedge funds were considered exclusive for high net worth

investors with a risk appetite. Funds of hedge funds enable retail investors to invest in

hedge funds. They are pooled investments in several hedge funds. In the US, these

funds can be registered with the Securities and Exchange Commissions (SEC). The

registered ones can be offered to an unlimited number of investors, with a minimum

investment of as low as $ 25,000.

Funds of hedge funds allow investors to diversify risk by spreading money across

different hedge funds, different investment styles, strategies and fund managers.

According to Morgan Stanley, these funds have grown at a staggering annual rate of

50% in the past three years. As per The Economist, in the same period, their share of

hedge-fund assets rose from one-fifth to one-third of the total assets managed. Any

investor would love to invest in avenues, which make money even in falling equity

markets. Hedge funds provide that opportunity. They offer investors to make money

irrespective of the rise or fall of the markets. The mutual funds also shun from applying

high-risk strategies like using leverage and short selling, which if diligently applied can

boost returns, “Institutions are more and more drawn to absolute returns that are

uncorrelated to the markets and hedge funds represent the ability to generate these

kinds of returns. As a consequence, the hedge fund sector is attractive and likely to be

increasingly so to pension funds and other institutions.”

Risk-return profile

The funds of funds invest primarily in hedge funds; it is necessary for investors to gauge

the risk-return profile of hedge funds. Till date, statistics suggest that hedge funds have

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managed to out- perform the benchmark indices. Consider this: from 1987 to 2002, one

of the Hedge Fund Index has returned an annualized 15.1% versus 11% of the S&P 500

Index. According to The Street, quoting from the recent figures from the CSFB/Tremont

Hedge Fund Index, the average hedge fund returned 15.44% last year, and was up

3.42% for the current year till May. While hedge funds, in 2003, managed modest

returns compared to the return of S&P 500 index, the average gain benchmark index.

Then there are aberrations too. According to research firm Hedge Fund Research, many

hedge funds lost money in April and May 2004.

The average annualized returns of hedge funds are good enough to lure many funds of

funds to invest in them, but then what about the risk that hedge funds are undertaking.

“Risks associated with hedge funds might be non-systematic forms of risk unrelated to

the markets since a particular strategy may not be vulnerable to shifts in market

direction.” And “A well-constructed, well-diversified fund of funds is the least risky way to

get exposure to hedge funds. Funds of funds generally have lower volatility and less

total risk than investing in single strategy managers.” Thus, investors can reap the

benefits of investing in hedge funds through funds of hedge funds with possibly lesser

risk compared to investing in hedge funds directly. But then there are two risks, which

funds of hedge funds face. Considering the kind of investments vehicles hedge funds

are and the kind of risks they take, the greatest risk that funds f hedge funds face are

leverage and liquidity risk- the same risk famously ignored by LTCM, leading to its

downfall.

Leveraging into troubles

It is rather a common practice for hedge funds to apply leverage for boosting total

returns. In addition to the invested equity, which is provided by the investors of hedge

funds, they also borrow cash from banks for investing. This strategy is predominant

especially when cost of borrowing is low. Now when funds of hedge funds are also

borrowing to invest in hedge funds it tantamount to second level of leveraging. The issue

attains dangerous magnitude, when investors investing in funds of hedge funds and

hedge funds invest borrowed money. A single failure can lead to a vicious cycle of

defaults.

It is currently estimated that borrowings of funds range from one to four times of equity,

which is minuscule, compared to the leverage that LTCM applied. LTCM borrowed as

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much as 50 times of the equity employed, in its heyday. Applying leverage to that extent

is always dangerous. There should be a prudent mix of debt and equity in investments.

The real issue, “is to what underlying instrument are investors applying the leverage and

what kinds of scenario.” He adds, “Judicious application of leverage can actually

enhance the risk-return profile of a multi-manager fund. For example, by adding leverage

selectively to lower volatility managers, you actually deploy more investment capital to

the lower risk portion of a multi-manager portfolio, which ultimately improves the

portfolio’s efficiency.”

Also, the competition system in the hedge fund industry encourages managers to

aggressively apply leverage, which they wouldn’t have done otherwise. It is a normal

practice in the industry to calculate management fee on the basis of the money being

managed, which includes debt and equity. The management fees for funds of hedge

funds and hedge funds range from 1% to 3% of the total assets managed. In addition to

this, managers also charge performance fees, which in case of hedge funds is a

staggering 20% or more of profits. But post LTCM fiasco, it is very unlikely that

managers would apply excessive leverage and risk the funds they manage, unless

investors allow them to do so. “No prudent manager would lever up his fund to such as

degree as to place the entire operation in jeopardy. Moreover, leverage is closely

monitored by financial institutions that provide hedge funds with their leverage facility

using shares of the funds as collateral.” The idea of performance –based fees tends to

align the interests of the manager with is a compensation mechanism, which ensures

that managers are not rewarded when they employ excessive leverage.

Liquidity

Another risk, which can have a serious impact on hedge funds, is liquidity risk. In simple

terms, liquidity risk is the danger that sellers will not be able to find buyers. Any major

event can trigger a selling spree among hedge funds, where everybody wants to sell

with no buyers left. No one understands this better than Noble laureate Mayron Scholes,

co-founder of LTCM.

He left the fund after 1998. He later suggested ways and means through which hedge

funds can counter the liquidity risk. These include liquidity options and dynamic

cushions. Liquidity options and dynamic cushions. Liquidity options give financial

institutions the right, but not the obligation, to sell their assets at a pre-agreed price. This

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allows a risky portfolio to be liquidated at a predicable pace and cost when prices fall

and liquidity dries up. The price of these options would reflect the price of liquidity, and

would change in tune with market conditions.

Funds of hedge funds – Too big to fail?

The popularity of funds of hedge funds and the kind of investments that these funds are

witnessing brings to the fore important questions: Will they become too big and not be

allowed to fail? Critics of hedge funds point out the LTCM scenario and the lack of

proper regulation of hedge funds. “LTCM was a single strategy manager with huge

leveraged exposure to particular credit events in the market. Funds of funds, on the

other hand, are well-diversified across strategies and managers and while there might

be draw downs, it is unlikely they risk blowing up.”

The other favorite issue of critics of hedge funds is poor regulations. The situation in the

US in such that sooner or later hedge funds will be required to register with the SEC. “As

long as this does not become excessively burden some and distracting from the core

enterprise, of hedge funds, which is achieving absolute returns, it is not necessarily a

bad thing, especially, if this raises the comfort level for investors. It is also important to

realize that even though unregistered, hedge funds do not exist in an environment where

they are impervious to regulatory scrutiny.”

If hedge funds are to be registered and reveal all the information regarding their

investment, it is likely that they will mirror mutual funds and can risk their very existence

as unique investment vehicles. With more pension funds and other institutional investor

investing in hedge funds, transparency will become the norm of the day. “This

phenomenon suggests hedge funds are going to become more institutionalized. They

will necessarily have to more responsive to the demands of institutional allocators, which

means such things as reporting, transparency, and risk management will be improved.”

If hedge funds become too focused on benchmarks and thereby closet index trackers, it

will make the industry lose its edge.”

Hedge funds as an investing option

An investor has to understand his risk-return profile and decide whether investing in

funds of hedge funds is worth it or not. Since the underlying investments in funds of

hedge funds are hedge funds, which carry excessive risk and proportional returns, it is

naïve to expect minimum risk and maximum returns. But looking at the investments that

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fact that risk averse investors are pumping money into funds of hedge funds and hedge

funds, there is no doubt that they have gained public acceptance as a mainstream asset.

The fact that adding hedging funds to a mix of other traditional asset classes enhances

the risk-adjusted return of a portfolio “For any investor looking at allocating to hedge

funds, the fund of funds approach is probably the best route with the benefits of

diversification, better liquidity terms and smoother and more consistent return.”

PERSONAL FINANCIAL PLANNING PROCESS

It is often best to describe the process in two stage:

Stage A

Your role in the financial planning process: an introduction to the discussion.

Stage B

The Financial planning process: a detailed discussion.

Stage A : - Our role in the financial planning process

Initial consultation

At the first meeting, we explain how we operate and what you expect. You meet us and

decide whether you feel comfortable with us, and we decided whether we would work

with you as a client. This is important because the relationship can possibly last for the

rest of our lives. We also spend considerable time gathering information on your current

circumstances and objectives. This first meeting has no cost or obligation. If we feel we

can be assistance to you, we will agree to prepare a comprehensive, written financial

plan for a fixed fee.

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Plan preparation

Having gathered the necessary information, which may require a number of meetings,

we prepare the final plan.

Plan presentation

We then meeting against to present and explain our written recommendation, which

cover many issues including investment and strategies and also any cost and fees

associated with those recommendations. Attention is paid to how our recommendations

will achieve your objectives.

Implementation

You may take the financial plan away for further consideration. We may need to meet

once or twice again to clarify or adjust the plan accordingly, before you provide us with

the authority to implement the recommendation. The implementation may take some

time and we will monitor it progressively.

Ongoing service and review

We offer a comprehensive ongoing service which for a flat fee, provides you with

comprehensive quarterly reports on any investments, check performance against

objectives, recommends any change we think necessary and provides you with ongoing

access to your adviser as part of the service.

Stage B : The financial planning process

Having explained your role, you should confirm that the prospective client is comfortable

with that role. Then some time should be taken to explain the financial planning process

itself.

There are different ideas of what financial planning involves. The financial planning

process includes the following six steps;

1. data gathering

2. goal gathering

3. identification of financial problems

4. preparation of written alternatives and recommendations

5. implementation of agreed – upon recommendation and

6. review and revision of the plan.

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